Global Sourcing and Procurement

• Why is it important for firms to focus on global procurement and sourcing?
• What are ways firms can be more efficient through improved global procurement and sourcing?
• How should firms go about making the decision whether or not to outsource?

Jacobs, F.R. & Chase, R.B. (2014). Operations and supply chain management (14th ed). New York, NY: McGraw-Hill

Explain what strategic sourcing is.

STRATEGIC SOURCING

Strategic sourcing is the development and management of supplier relationships to acquire goods and services in a way that aids in achieving the needs of the business. In the past the term sourcing was just another term for purchasing, a corporate function that financially was important but strategically was not the center of attention. Today, as a result of globalization and inexpensive communications technology, the basis for competition is changing. A firm is no longer constrained by the capabilities it owns; what matters is its ability to make the most of available capabilities, whether they are owned by the firm or not. Outsourcing is so sophisticated that even core functions such as engineering, research and development, manufacturing, information technology, and marketing can be moved outside the firm.

Strategic sourcing

The development and management of supplier relationships to acquire goods and services in a way that aids in achieving the needs of a business.

Sourcing activities can vary greatly and depend on the item being purchased. Exhibit 16.1 maps different processes for sourcing or purchasing an item. The term sourcing implies a more complex process suitable for products that are strategically important. Purchasing processes that span from a simple “spot” or one-time purchase to a long-term strategic alliance are depicted on the diagram. The diagram positions a purchasing process according to the specificity of the item, contract duration, and intensity of transaction costs.

Strategy

exhibit 16.1

The Sourcing/Purchasing Design Matrix

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Specificity refers to how common the item is and, in a relative sense, how many substitutes might be available. For example, blank DVD disks are commonly available from many different vendors and would have low specificity. A custom-made envelope that is padded and specially shaped to contain a specific item that is to be shipped would be an example of a high-specificity item.

Commonly available products can be purchased using a relatively simple process. For low-volume and inexpensive items purchased during the regular routine of work, a firm may order from an online catalog. Often, these online catalogs are customized for a customer. Special user identifications can be set up to authorize a customer’s employees to purchase certain groups of items with limits on how much they can spend. Other items require a more complex process.

A request for proposal (RFP) is commonly used for purchasing items that are more complex or expensive and where there may be a number of potential vendors. A detailed information packet describing what is to be purchased is prepared and distributed to potential vendors. The vendor then responds with a detailed proposal of how the company intends to meet the terms of the RFP. A request for bid or reverse auction is similar in terms of the information packet needed. A major difference is how the bid price is negotiated. In the RFP, the bid is included in the proposal, whereas in a request for bid or reverse auction, vendors actually bid on the item in real time and often using Internet software.

Vendor managed inventory is when a customer actually allows the supplier to manage the inventory policy of an item or group of items for them. In this case the supplier is given the freedom to replenish the item as it sees fit. Typically, there are some constraints related to the maximum that the customer is willing to carry, required service levels, and other billing transaction processes. Selecting the proper process depends on minimizing the balance between the supplier’s delivered costs of the item over a period of time, say a year, and the customer’s costs of managing the inventory. This is discussed later in the chapter in the context of the “total cost of ownership” for a purchased item.

Vendor managed inventory

When a customer allows the supplier to manage the inventory policy of an item or group of items.

INSTEAD OF SENDING PURCHASE ORDERS, CUSTOMERS ELECTRONICALLY SEND DAILY DEMAND INFORMATION TO THE SUPPLIER. THE SUPPLIER GENERATES REPLENISHMENT ORDERS FOR THE CUSTOMER BASED ON THIS DEMAND INFORMATION.

The Bull whip Effect

Marshall Fisher¹ argues that in many cases there are adversarial relations between supply chain partners as well as dysfunctional industry practices such as a reliance on price promotions. Consider the common food industry practice of offering price promotions every January on a product. Retailers respond to the price cut by stocking up, in some cases buying a year’s supply—a practice the industry calls forward buying. Nobody wins in the deal. Retailers have to pay to carry the year’s supply, and the shipment bulge adds cost throughout the supplier’s system. For example, the supplier’s plants must go on overtime starting in October to meet the bulge. Even the vendors that supply the manufacturing plants are affected because they must quickly react to the large surge in raw material requirements.

The impact of these types of practices has been studied at companies such as Procter & Gamble. Exhibit 16.2 shows typical order patterns faced by each node in a supply chain that consists of a manufacturer, a distributor, a wholesaler, and a retailer. In this case, the demand is for disposable baby diapers. The retailer’s orders to the wholesaler display greater variability than the end-consumer sales; the wholesaler’s orders to the manufacturer show even more oscillations; and, finally, the manufacturer’s orders to its suppliers are the most volatile. This phenomenon of variability magnification as we move from the customer to the producer in the supply chain is often referred to as the bullwhip effect. The effect indicates a lack of

Bullwhip effect

The variability in demand is magnified as we move from the customer to the producer in the supply chain.

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synchronization among supply chain members. Even a slight change in consumer sales ripples backward in the form of magnified oscillations upstream, resembling the result of a flick of a bullwhip handle. Because the supply patterns do not match the demand patterns, inventory accumulates at various stages, and shortages and delays occur at others. This bullwhip effect has been observed by many firms in numerous industries, including Campbell Soup and Procter & Gamble in consumer products; Hewlett-Packard, IBM, and Motorola in electronics; General Motors in automobiles; and Eli Lilly in pharmaceuticals.

KEY IDEA

Any practice that smooths the flow of material to the customer helps manufacturing and reduces inventory..

Campbell Soup has a program called continuous replenishment that typifies what many manufacturers are doing to smooth the flow of materials through their supply chain. Here is how the program works. Campbell establishes electronic data interchange (EDI) links with retailers and offers an “everyday low price” that eliminates discounts. Every morning, retailers electronically inform the company of their demand for all Campbell products and of the level of inventories in their distribution centers. Campbell uses that information to forecast future demand and to determine which products require replenishment based on upper and lower inventory limits previously established with each supplier. Trucks leave the Campbell shipping plant that afternoon and arrive at the retailers’ distribution centers with the required replenishments the same day. Using this system, Campbell can cut the retailers’ inventories, which under the old system averaged four weeks of supply, to about two weeks of supply.

This solves some problems for Campbell Soup, but what are the advantages for the retailer? Most retailers figure that the cost to carry the inventory of a given product for a year equals at least 25 percent of what they paid for the product. A two-week inventory reduction represents a cost savings equal to nearly 1 percent of sales. The average retailer’s profits equal about 2 percent of sales, so this saving is enough to increase profits by 50 percent. Because the retailer makes more money on Campbell products delivered through continuous replenishment, it has an incentive to carry a broader line of them and to give them more shelf space. Campbell Soup found that after it introduced the program, sales of its products grew twice as fast through participating retailers as they did through other retailers.

exhibit 16.2

Increasing Variability of Orders Up the Supply Chain

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Strategy

Supply Chain Uncertainty Framework

Fisher has developed a framework to help managers understand the nature of demand for their products and then devise the supply chain that can best satisfy that demand. Many aspects of a product’s demand are important—for example, product life cycle, demand predictability, product variety, and market standards for lead times and service. Fisher has found that products can be categorized as either primarily functional or primarily innovative. Because each category requires a distinctly different kind of supply chain, the root cause of supply chain problems is a mismatch between the type of product and type of supply chain.

Functional products include the staples that people buy in a wide range of retail outlets, such as grocery stores and gas stations. Because such products satisfy basic needs, which do not change much over time, they have stable, predictable demand and long life cycles. But their stability invites competition, which often leads to low profit margins. Specific criteria suggested by Fisher for identifying functional products include the following: product life cycle of more than two years, contribution margin of 5 to 20 percent, only 10 to 20 product variations, an average forecast error at time of production of only 10 percent, and a lead time for make-to-order products of six months to one year.

Functional products

Staples that people buy in a wide range of retail outlets, such as grocery stores and gas stations.

To avoid low margins, many companies introduce innovations in fashion or technology to give customers an additional reason to buy their products. Fashionable clothes and personal computers are good examples. Although innovation can enable a company to achieve higher profit margins, the very newness of the innovative products makes demand for them unpredictable. These innovative products typically have a life cycle of just a few months. Imitators quickly erode the competitive advantage that innovative products enjoy, and companies are forced to introduce a steady stream of newer innovations. The short life cycles and the great variety typical of these products further increase unpredictability. Exhibit 16.3 summarizes the differences between functional and innovative products.

Innovative products

Products such as fashionable clothes and personal computers that typically have a life cycle of just a few months.

Hau Lee² expands on Fisher’s ideas by focusing on the “supply” side of the supply chain. While Fisher has captured important demand characteristics, Lee points out that there are uncertainties revolving around the supply side that are equally important drivers for the right supply chain strategy.

exhibit 16.3

Demand and Supply Uncertainty Characteristics

Lee defines a stable supply process as one where the manufacturing process and the underlying technology are mature and the supply base is well established. In contrast, an evolving supply process is where the manufacturing process and the underlying technology are still under early development and are rapidly changing. As a result the supply base may be limited in both size and experience. In a stable supply process, manufacturing complexity tends to be low or manageable. Stable manufacturing processes tend to be highly automated, and

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long-term supply contracts are prevalent. In an evolving supply process, the manufacturing process requires a lot of fine-tuning and is often subject to breakdowns and uncertain yields.

exhibit 16.4

Hau Lee’s Uncertainty Framework—Examples and Types of Supply Chain Needed

KEY IDEA

Supply and demand uncertainly drive the design of a supply chain.

The supply base may not be reliable, as the suppliers themselves are going through process innovations. Exhibit 16.3 summarizes some of the differences between stable and evolving supply processes.

Lee argues that while functional products tend to have a more mature and stable supply process, that is not always the case. For example, the annual demand for electricity and other utility products in a locality tends to be stable and predictable, but the supply of hydroelectric power, which relies on rainfall in a region, can be erratic year by year. Some food products also have a very stable demand, but the supply (both quantity and quality) of the products depends on yearly weather conditions. Similarly, there are also innovative products with a stable supply process. Fashion apparel products have a short selling season and their demand is highly unpredictable. However, the supply process is very stable, with a reliable supply base and a mature manufacturing process technology. Exhibit 16.4 gives some examples of products that have different demand and supply uncertainties.

According to Lee, it is more challenging to operate a supply chain that is in the right column of Exhibit 16.4 than in the left column, and similarly it is more challenging to operate a supply chain that is in the lower row of Exhibit 16.4 than in the upper row. Before setting up a supply chain strategy, it is necessary to understand the sources of the underlying uncertainties and explore ways to reduce these uncertainties. If it is possible to move the uncertainty characteristics of the product from the right column to the left or from the lower row to the upper, then the supply chain performance will improve.

Lee characterizes four types of supply chain strategies as shown in Exhibit 16.4. Information technologies play an important role in shaping such strategies.

•Efficient supply chains. These are supply chains that utilize strategies aimed at creating the highest levels of cost efficiency. For such efficiencies to be achieved, non–value added activities should be eliminated, scale economies should be pursued, optimization techniques should be deployed to get the best capacity utilization in production and distribution, and information linkages should be established to ensure the most efficient, accurate, and cost-effective transmission of information across the supply chain.

•Risk-hedging supply chains. These are supply chains that utilize strategies aimed at pooling and sharing resources in a supply chain so that the risks in supply disruption can be shared. A single entity in a supply chain can be vulnerable to supply disruptions, but if there is more than one supply source or if alternative supply resources are available, then the risk of disruption is reduced. A company may, for example, increase the safety stock of its key component to hedge against the risk of supply disruption, and by sharing the safety stock with other companies that also need this key component, the cost of maintaining this safety stock can be shared. This type of strategy is common in retailing, where different retail stores or dealerships share inventory. Information technology is important for the success of these strategies since real-time information on Low(Functional Products) High (Innovative Products)

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inventory and demand allows the most cost- effective management and transshipment of goods between partners sharing the inventory.

•Responsive supply chains. These are supply chains that utilize strategies aimed at being responsive and flexible to the changing and diverse needs of the customers. To be responsive, companies use build-to-order and mass customization processes as a means to meet the specific requirements of customers.

•Agile supply chains. These are supply chains that utilize strategies aimed at being responsive and flexible to customer needs, while the risks of supply shortages or disruptions are hedged by pooling inventory and other capacity resources. These supply chains essentially have strategies in place that combine the strengths of “hedged” and “responsive” supply chains. They are agile because they have the ability to be responsive to the changing, diverse, and unpredictable demands of customers on the front end, while minimizing the backend risks of supply disruptions.

Demand and supply uncertainty is a good framework for understanding supply chain strategy. Innovative products with unpredictable demand and an evolving supply process face a major challenge. Because of shorter and shorter product life cycles, the pressure for dynamically adjusting and adopting a company’s supply chain strategy is great. In the following section, we explore the concepts of outsourcing, green sourcing, and total cost of ownership. These are important tools for coping with demand and supply uncertainty.

LO16–2

Explain why companies outsource processes.

OUTSOURCING

Outsourcing is the act of moving some of a firm’s internal activities and decision responsibility to outside providers. The terms of the agreement are established in a contract. Outsourcing goes beyond the more common purchasing and consulting contracts because not only are the activities transferred, but also resources that make the activities occur, including people, facilities, equipment, technology, and other assets, are transferred. The responsibilities for making decisions over certain elements of the activities are transferred as well. Taking complete responsibility for this is a specialty of contract manufacturers such as Flextronics.³

Outsourcing

Moving some of a firm’s internal activities and decision responsibility to outside providers.

Strategy

exhibit 16.5

Reasons to Outsource and the Resulting Benefits

The reasons why a company decides to outsource can vary greatly. Exhibit 16.5 lists examples of reasons to outsource and the accompanying benefits. Outsourcing allows a firm to focus on activities that represent its core competencies. Thus, the company can create a competitive advantage while reducing cost. An entire function may be outsourced, or some

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elements of an activity may be outsourced, with the rest kept in-house. For example, some of the elements of information technology may be strategic, some may be critical, and some may be performed less expensively by a third party. Identifying a function as a potential outsourcing target, and then breaking that function into its components, allows decision makers to determine which activities are strategic or critical and should remain in-house and which can be outsourced like commodities. As an example, outsourcing the logistics function will be discussed.

Logistics Outsourcing

There has been dramatic growth in outsourcing in the logistics area. Logistics is a term that refers to the management functions that support the complete cycle of material flow: from the purchase and internal control of production materials; to the planning and control of work-in-process; to the purchasing, shipping, and distribution of the finished product. The emphasis on lean inventory means there is less room for error in deliveries. Trucking companies such as Ryder have started adding the logistics aspect to their businesses—changing from merely moving goods from point A to point B, to managing all or part of all shipments over a longer period, typically three years, and replacing the shipper’s employees with their own. Logistics companies now have complex computer tracking technology that reduces the risk in transportation and allows the logistics company to add more value to the firm than it could if the function were performed in-house. Third-party logistics providers track freight using electronic data interchange technology and a satellite system to tell customers exactly where its drivers are and when deliveries will be made. Such technology is critical in some environments where the delivery window may be only 30 minutes long.

Logistics

Management functions that support the complete cycle of material flow: from the purchase and internal control of production materials; to the planning and control of work-in-process; to the purchasing, shipping, and distribution of the finished product.

FedEx has one of the most advanced systems available for tracking items being sent through its services. The system is available to all customers over the Internet. It tells the exact status of each item currently being carried by the company. Information on the exact time a package is picked up, when it is transferred between hubs in the company’s network, and when it is delivered is available on the system. You can access this system at the FedEx website (www.fedex.com). Select your country on the initial screen and then select “Track Shipments” in the Track box in the lower part of the page. Of course, you will need the actual tracking number for an item currently in the system to get information. FedEx has integrated its tracking system with many of its customers’ in-house information systems.

Another example of innovative outsourcing in logistics involves Hewlett-Packard. Hewlett- Packard turned over its inbound raw materials warehousing in Vancouver, British Columbia, to Roadway Logistics. Roadway’s 140 employees operate the warehouse 24 hours a day, seven days a week, coordinating the delivery of parts to the warehouse and managing storage. Hewlett-Packard’s 250 employees were transferred to other company activities. Hewlett- Packard reports savings of 10 percent in warehousing operating costs.

One of the drawbacks to outsourcing is the layoffs that often result. Even in cases where the outsourcing partner hires former employees, they are often hired back at lower wages with fewer benefits. Outsourcing is perceived by many unions as an effort to circumvent union contracts.

Strategy

Framework for Supplier Relationships

In theory, outsourcing is a no-brainer. Companies can unload noncore activities, shed balance sheet assets, and boost their return on capital by using third-party service providers. But in reality, things are more complicated. “It’s really hard to figure out what’s core and what’s noncore today,” says Jane Linder, senior research fellow and associate director of Accenture’s Institute for Strategic Change in Cambridge, Massachusetts. “When you take another look tomorrow, things may have changed. On September 9, 2001, airport security workers were noncore; on September 12, 2001, they were core to the federal government’s ability to provide security to the nation. It happens every day in companies as well.”⁴

Exhibit 16.6 is a useful framework to help managers make appropriate choices for the structure of supplier relationships. The decision goes beyond the notion that “core competencies” should be maintained under the direct control of management of the firm and that other

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activities should be outsourced. In this framework, a continuum that ranges from vertical integration to arm’s-length relationships forms the basis for the decision.

exhibit 16.6

A Framework for Structuring Supplier Relationships

Source: Robert Hayes, Gary Pisano, David Upton, and Steven Wheelwright, Operations Strategy and Technology: Pursuing the Competitive Edge (New

An activity can be evaluated using the following characteristics: required coordination, strategic control, and intellectual property. Required coordination refers to how difficult it is to ensure that the activity will integrate well with the overall process. Uncertain activities that require much back-and-forth exchange of information should not be outsourced whereas activities that are well understood and highly standardized can easily move to business partners who specialize in the activity. Strategic control refers to the degree of loss that would be incurred if the relationship with the partner were severed. There could be many types of losses that would be important to consider including specialized facilities, knowledge of major customer relationships, and investment in research and development. A final consideration is the potential loss of intellectual property through the partnership.

KEY IDEA

Companies usually outsource standard activities when they are not part of the “core competency” of the firm..

Intel is an excellent example of a company that recognized the importance of this type of decision framework in the mid-1980s. During the early 1980s, Intel found itself being squeezed out of the market for the memory chips that it had invented by Japanese competitors such as Hitachi, Fujitsu, and NEC. These companies had developed stronger capabilities to develop and rapidly scale up complex semiconductor manufacturing processes. It was clear by 1985 that a major Intel competency was its ability to design complex integrated circuits, not in manufacturing or developing processes for more standardized chips. As a result, faced with growing financial losses, Intel was forced to exit the memory chip market.

Learning a lesson from the memory market, Intel shifted its focus to the market for microprocessors, which it had invented in the late 1960s. To keep from repeating the mistake with memory chips, Intel felt it was essential to develop strong capabilities in process development and manufacturing. A pure “core competency” strategy would have suggested that Intel focus on the design of microprocessors and use outside partners to manufacture them. Given the close connection between semiconductor product development and process development, however, relying on outside parties for manufacturing would likely have created costs in terms of longer development lead times. Over the late-1980s Intel invested heavily in building world-class capabilities in process development and manufacturing. These capabilities are one of the chief reasons it has been able to maintain approximately 90 percent of the personal computer microprocessor market, despite the ability of competitors like AMD to “clone” Intel designs relatively quickly. Expanding its capabilities beyond its original core capability of product design has been a critical ingredient in Intel’s sustained success.

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OSCM AT WORK

Capability Sourcing at 7-Eleven

The term capability sourcing was coined to refer to the way companies focus on the things they do best and outsource other functions to key partners. The idea is that owning capabilities may not be as important as having control of those capabilities. This allows many additional capabilities to be outsourced. Companies are under intense pressure to improve revenue and margins because of increased competition. An area where this has been particularly intense is the convenience store industry, where 7-Eleven is a major player.

Before 1991, 7-Eleven was one of the most vertically integrated convenience store chains. When it is vertically integrated, a firm controls most of the activities in its supply chain. In the case of 7-Eleven, the firm owned its own distribution network, which delivered gasoline to each store, made its own candy and ice, and required the managers to handle store maintenance, credit card processing, store payroll, and even the in-store information technology (IT) system. For a while 7-Eleven even owned the cows that produced the milk sold in the stores. It was difficult for 7-Eleven to manage costs in this diverse set of functions.

At that time, 7-Eleven had a Japanese branch that was very successful but was based on a totally different integration model. Rather than using a company-owned and vertically integrated model, the Japanese stores had partnerships with suppliers that carried out many of the day-to-day functions. Those suppliers specialized in each area, enhancing quality and improving service while reducing cost. The Japanese model involved outsourcing everything possible without jeopardizing the business by giving competitors critical information. A simple rule said that if a partner could provide a capability more effectively than 7-Eleven could itself, that capability should be outsourced. In the United States the company eventually outsourced activities such as human resources, finance, information technology, logistics, distribution, product development, and packaging. 7-Eleven still maintains control of all vital information and handles all merchandising, pricing, positioning, promotion of gasoline, and ready-to-eat food.

The following chart shows how 7-Eleven has structured key partnerships:

ACTIVITY	OUTSOURCING STRATEGY
GASOLINE	Outsourced distribution to Citgo. Maintains control over pricing and promotion. These are activities that can differentiate its stores.
SNACK FOODS	Frito-Lay distributes its products directly to the stores. 7-Eleven makes critical decisions about order quantities and shelf placement. 7-Eleven mines extensive data on local customer purchase patterns to make these decisions at each store.
PREPARED FOODS	Joint venture with E. A. Sween: Combined Distribution Centers (CDC), a direct-store delivery operation that supplies 7-Eleven stores with sandwiches and other fresh goods two times a day.
SPECIALTY PRODUCTS	Many are developed specially for 7-Eleven customers. For example, 7-Eleven worked with Hershey to develop an edible straw used with the popular Twizzler treat. Worked with Anheuser-Busch on special NASCAR and Major League Baseball promotions.
DATA ANALYSIS	7-Eleven relies on an outside vendor, IRI, to maintain and format purchasing data while keeping the data proprietary. Only 7-Eleven can see the actual mix of products its customers purchase at each location.
NEW CAPABILITIES	American Express supplies automated teller machines. Western Union handles money wire transfers. CashWorks furnishes check-cashing capabilities. Electronic Data Systems (EDS) maintains network functions.

Good advice is to keep control of—or acquire—activities that are true competitive differentiators or have the potential to yield a competitive advantage, and to outsource the rest. It is important to make a distinction between “core” and “strategic” activities. Core activities are key to the business, but do not confer a competitive advantage, such as a bank’s information technology operations. Strategic activities are a key source of competitive advantage. Because the competitive environment can change rapidly, companies need to monitor the situation constantly, and adjust accordingly. As an example, Coca-Cola, which decided to stay out of the bottling business in the early 1900s, partnered instead with independent bottlers and quickly built market share. The company reversed itself in the 1980s when bottling became a key competitive element in the industry.

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Green Sourcing

Being environmentally responsible has become a business imperative, and many firms are looking to their supply chains to deliver “green” results. A significant area of focus relates to how a firm works with suppliers where the opportunity to save money and benefit the environment might not be a strict trade-off proposition. Financial results can often be improved through both cost reductions and boosting revenues.

Deloitte (www.deloitte.com) has developed a green strategic sourcing process that can be used with conventional sourcing techniques to enhance sourcing savings by taking advantage of environmental factors. Before looking at its six-step process, it is worth considering the long-term benefits of this type of approach. Green sourcing is not just about finding new environmentally friendly technologies or increasing the use of recyclable materials. It can also help drive cost reductions in a variety of ways including product content substitution, waste reduction, and lower usage.

A comprehensive green sourcing effort should assess how a company uses items that are purchased internally, in its own operations, or in its products and services. As costs of commodity items like steel, electricity, and fossil fuels continue to increase, properly designed green sourcing efforts should find ways to significantly reduce and possibly eliminate the need for these types of commodities. As an example, consider retrofitting internal lighting in a large office building to a modern energy-efficient technology. Electricity cost savings of 10 to 12 percent per square foot can easily translate into millions of dollars in associated electricity cost savings.

Another important cost area in green sourcing is waste reduction opportunities. This includes everything from energy and water to packaging and transportation. A great example of this is the redesigned milk jug introduced recently by leading grocery retailers. Using the new jug, with more rectangular dimensions and a square base, cuts the associated water consumption of the jugs by 60 to 70 percent compared to earlier jug designs because the new design does not require the use of milk crates. Milk crates typically become filthy during use due to spillage and other natural factors; thus, they are usually hosed down before reuse, consuming thousands of gallons of water. The new design also reduces fuel costs. Since crates are no longer used, they also do not have to be transported back to the dairy plant or farm distribution point for future shipments. Furthermore, the new jugs have the unexpected benefit of fitting better in modern home refrigerator doors and allow retailers to fit more of them in their in-store coolers. Breakthrough results like the new milk jug can result from comprehensive partnerships between users and their suppliers working to find innovative solutions.

A recent supply chain survey by Florida International University (see business.fiu.edu/ greensupplychain) revealed that working with suppliers can result in opportunities that improve revenue. They can be the opportunity to turn waste products into sources of revenue. For example, a leading beverage manufacturer operates a recycling subsidiary that sources used aluminum cans from a large number of suppliers. The subsidiary actually processes more aluminum cans than are used in the company’s own products, consequently developing a strong secondary revenue stream for the company.

In other cases, green sourcing can help establish entirely new lines of business to serve environmentally conscious customers. In the cleaning products aisle of a supermarket, shoppers will find numerous options of “green” cleaning products from a variety of consumer products companies. These products typically use natural ingredients in lieu of chemicals, and many are in concentrated amounts to reduce overall packaging costs. Logistics suppliers could find business opportunities coming directly to them as a result of the green trend. A large automobile manufacturer completed a project to “green” its logistics/distribution network. The automaker analyzed the shipping carriers, locations, and overall

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efficiency of its distribution network for both parts and finished automobiles. By increasing the use of rail transportation for parts, consolidating shipments in fewer ports, and partnering with its logistics providers to increase fuel efficiency for both marine and road transportation, the company reduced its overall distribution-related carbon dioxide emissions by several thousand tons per year.

exhibit 16.7

Six-Step Process for Green Sourcing

Source: Adapted from www.deloitte.com. This article was first published in the November 2008 Supply Chain Management Review and was reproduced with permission.

The following is an outline of a six-step process (see Exhibit 16.7) designed to transform a traditional process to a green sourcing process:

Process

1.Assess the opportunity. For a given category of expense, all relevant costs need to be taken into account. The five most common areas include electricity and other energy costs; disposal and recycling; packaging; commodity substitution (alternative materials to replace materials such as steel or plastic); and water (or other related resources). These costs are identified and incorporated into an analysis of total cost (sometimes referred to as “spend” cost analysis) at this step. From this analysis it is possible to prioritize the different costs based on the highest potential savings and criticality to the organization. This is important to directing effort to where it will likely have the most impact on the firm’s financial position and cost reduction goals.

2.Engage internal supply chain sourcing agents. Internal sourcing agents are those within the firm that purchase items and have direct knowledge of business requirements, product specifications, and other internal perspectives inherent in the supply chain. These individuals and groups need to be “on-board” and partners in the improvement process to help set realistic green goals. The goal of generating no waste, for example, becomes a cross-functional supply chain effort that relies heavily on finding and developing the right suppliers. These internal managers need to identify the most significant opportunities. They can develop a robust baseline model of what should be possible for reducing current and ongoing costs. In the case of procuring new equipment, for example, the baseline model would include not just the initial price of the equipment as in traditional sourcing, but also energy, disposal, recycling, and maintenance costs.

3.Assess the supply base. A sustainable sourcing process requires engaging new and existing vendors. As in traditional sourcing, the firm needs to understand vendor capabilities, constraints, and product offering. The green process needs to be augmented with formal requirements that relate to green opportunities, including possible commodity substitutions and new manufacturing processes. These requirements need to be incorporated in vendor bid documents or the request for proposals (RFP).

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A good example is concrete that uses fly ash, a by- product from coal-fired power plants. Fly ash can be substituted for Portland cement in ready-mix concrete or in concrete block to produce a stronger and lighter product with reduced water consumption. Fly ash substitution helped a company reduce its exposure to volatile and rapidly increasing prices for cement. At the same time, the reduced weight of the block lowered transportation costs to the company’s new facilities. The company was also able to establish a specification incorporating fly ash for all new construction sites to follow. Finally, the substitution also helped the power plant, by providing a new market for the fly ash, which previously had to be discarded.

4.Develop the sourcing strategy. The main goal with this step is to develop quantitative and qualitative criteria that will be used to evaluate the sourcing process. These are needed to properly analyze associated costs and benefits. These criteria need to be clearly articulated in bid documents and RFP when working with potential suppliers so that their proposals will address relevant goals related to sustainability.

5.Implement the sourcing strategy. The evaluation criteria developed in step 4 should help in the selection of vendors and products for each business requirement. The evaluation process should consider initial cost and the total cost of ownership for the items in the bid. So, for example, energy-efficient equipment that is proposed with a higher initial cost may, over its productive life, actually result in a lower total cost due to energy savings and a related lower carbon footprint. Relevant green opportunities such as energy efficiency and waste reduction need to be modeled and then incorporated into the sourcing analysis to make it as comprehensive as possible and to facilitate an effective vendor selection process that supports the firm’s needs.

6.Institutionalize the sourcing strategy. Once the vendor is selected and contracts finalized, the procurement process begins. Here the sourcing and procurement department needs to define a set of metrics against which the supplier will be measured for the contract’s duration. These metrics should be based on performance, delivery, compliance with pricing guidelines, and similar factors. It is vital that metrics that relate to the company’s sustainability goals are considered as well. Periodic audits may also need to be incorporated in the process to directly observe practices that relate to these metrics to ensure honest reporting of data.

A key aspect of green sourcing, compared to a traditional process, is the expanded view of the sourcing decision. This expanded view requires the incorporation of new criteria for evaluating alternatives. Further, it requires a wider range of internal integration such as designers, engineers, and marketers. Finally, visualizing and capturing the green sourcing savings often involve greater complexity and longer payback periods compared to a traditional process.

FLY ASH IS GENERALLY STORED AT COAL POWER PLANTS OR PLACED IN LANDFILLS AS SHOWN HERE. ABOUT 43 PERCENT IS RECYCLED, REDUCING THE HARMFUL IMPACT ON THE ENVIRONMENT FROM LANDFILLS.

LO16–3

Analyze the total cost of ownership.

TOTAL COST OF OWNERSHIP

The total cost of ownership (TCO) is an estimate of the cost of an item that includes all the costs related to its procurement and use, including any related costs in disposing of the item after it is no longer useful. The concept can be applied to a company’s internal costs or it can be viewed more broadly to consider costs throughout the supply chain. To fully appreciate the cost of purchasing an item from a particular vendor, an approach that captures the costs of the activities associated with purchasing and actually using the item should be considered. Depending on the complexity of the purchasing process, activities such as prebid conferences,

Total cost of ownership

Estimate of the cost of an item that includes all the costs related to the procurement and use of the item including disposing of the item after its useful life.

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visits by potential suppliers, and even visits to potential suppliers can significantly impact the total cost of the item.

exhibit 16.8

Total cost of ownership

A TCO analysis is highly dependent on the actual situation; in general, though, the costs outlined in Exhibit 16.8 should be considered. The costs can be categorized into three broad areas: acquisition costs, ownership costs, and post-ownership costs.⁵Acquisition costs are the initial costs associated with the purchase of materials, products, and services. They are not long-term costs of ownership but represent an immediate cash outflow. Acquisition costs include the prepurchase costs associated with preparing documents to distribute to potential suppliers, identifying suppliers and evaluating suppliers, and other costs associated with actually procuring the item. The actual purchase prices, including taxes and transportation costs, are also included.

Ownership costs are incurred after the initial purchase and are associated with the ongoing use of the product or material. Examples of costs that are quantifiable include energy usage, scheduled maintenance, repair, and financing (leasing situation). There can also be qualitative costs such as aesthetic factors (e.g., the item is pleasing to the eye), and ergonomic factors (e.g., productivity improvement or reducing fatigue). These ownership costs can often exceed the initial purchase price and have an impact on cash flow, profitability, and even employee morale and productivity.

Major costs associated with post-ownership include salvage value and disposal costs. For many purchases, there are established markets that provide data to help estimate reasonable future values, such as the Kelley Blue Book for used automobiles. Other areas that can be included are the long-term environment impact (particularly when the firm has sustainability goals), warranty and product liabilities, and the negative marketing impact of low customer satisfaction with the item.

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Overemphasis on acquisition cost or purchase price frequently results in failure to address other significant ownership and post-ownership costs. TCO is a philosophy for understanding all relevant costs of doing business with a particular supplier for a good or service. It is not only relevant for a business that wants to reduce its cost of doing business but also for a firm that aims to design products or services that provide the lowest total cost of ownership to customers.

For example, some automobile manufacturers have extended the tune-up interval on many models to 100,000 miles, thereby reducing vehicle operating cost for car owners. Viewing TCO in this way can lead to an increased value of the product to existing and potential customers.

These costs can be estimated as cash inflows (the sale of used equipment, etc.) or outflows (such as purchase prices, demolition of an obsolete facility, etc.). The following example shows how this analysis can be organized using a spreadsheet. Keep in mind that the costs considered need to be adapted to the decision being made. Costs that do not vary based on the decision need not be considered, but relevant costs that vary depending on the decision should be included in the analysis.

Analytics

EXAMPLE 16.1: Total Cost of Ownership Analysis

Consider the analysis of the purchase of a copy machine that might be used in a copy center. The machine has an initial cost of $120,000 and is expected to generate income of $40,000 per year.⁶ Supplies are expected to be $7,000 per year and the machine needs to be overhauled during year 3 at a cost of $9,000. It has a salvage value of $7,500 when we plan to sell it at year 6.

SOLUTION

Laying these costs out over time can lead to the use of net present value analysis to evaluate the decision. Consider Exhibit 16.9, where the present values of each yearly stream are discounted to now. (See Appendix E for a present value table.) As we can see, the present value in this analysis shows that the present value cost of the copier is $12,955.

For a step-by-step walkthrough of this example, visit www.mhhe.com/jacobs14e_sbs_ch16.

exhibit 16.9

Analysis of the Purchase of an Office Copier

Discount factor = 20%.

Note: These calculations were done using the full precision of a spreadsheet.

TCO actually draws on many areas for a thorough analysis. These include finance (net present value), accounting (product pricing and costing), operations management (reliability,

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quality, need, and inventory planning), marketing (demand), and information technology (systems integration). It is probably best to approach this using a cross-functional team representing the key functional areas.

It is important that any analysis is adapted to the particular scenario. Such factors as exchange rates, the risk of doing business in a particular region of the world, transportation, and other items are often important. Depending on the alternatives, there are a host of factors, often going beyond cost, that need to be considered. Adapting this type of cost analysis and combining it with a more qualitative risk analysis are useful in actual company situations.

LO16–4

Evaluate sourcing performance.

MEASURING SOURCING PERFORMANCE

One view of sourcing is centered on the inventories that are positioned in the system. Exhibit 16.10 shows how hamburger meat and potatoes are stored in various locations in a typical fast-food restaurant chain. Here we see the steps that the beef and potatoes move through on their way to the local retail store and then to the customer. Inventory is carried at each step, and this inventory has a particular cost to the company. Inventory serves as a buffer, thus allowing each stage to operate independently of the others. For example, the distribution center inventory allows the system that supplies the retail stores to operate independently of the meat and potato packing operations. Because the inventory at each stage ties up money, it is important that the operations at each stage are synchronized to minimize the size of these buffer inventories. The efficiency of the supply chain can be measured based on the size of the inventory investment in the supply chain. The inventory investment is measured relative to the total cost of the goods that are provided through the supply chain.

Two common measures to evaluate supply chain efficiency are inventory turnover and weeks of supply. These essentially measure the same thing. Weeks of supply is the inverse of inventory turnover times 52. Inventory turnover is calculated as follows:

Inventory turnover

A measure of supply chain efficiency.

$\text{Inventory turnover=}\frac{\text{Cost of goods sold}}{\text{Average aggregate inventory value}}$

$\text{Inventory turnover=}\frac{\text{Cost of goods sold}}{\text{Average aggregate inventory value}}$

[16.1]

exhibit 16.10

Inventory in the Supply Chain—Fast-Food Restaurant

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Analytics

The cost of goods sold is the annual cost for a company to produce the goods or services provided to customers; it is sometimes referred to as the cost of revenue. This does not include the selling and administrative expenses of the company. The average aggregate inventory value is the total value of all items held in inventory for the firm valued at cost. It includes the raw material, work-in-process, finished goods, and distribution inventory considered owned by the company.

Cost of goods sold

The annual cost for a company to produce the goods or services provided to customers.

Average aggregate inventory value

The total value of all items held in inventory for the firm, valued at cost.

Good inventory turnover values vary by industry and the type of products being handled. At one extreme, a grocery store chain may turn inventory over 100 times per year. Values of six to seven are typical for manufacturing firms.

In many situations, particularly when distribution inventory is dominant, weeks of supply is the preferred measure. This is a measure of how many weeks’ worth of inventory is in the system at a particular point in time. The calculation is as follows:

Weeks of supply

Preferred measure of supply chain efficiency that is mathematically the inverse of inventory turnover times 52.

$\text{Weeks of supply}\text{=}\left(\frac{\text{Average aggregate inventory value}}{\text{Cost of goods sold}}\right)\times \text{52 weeks}$

$\text{Weeks of supply}\text{=}\left(\frac{\text{Average aggregate inventory value}}{\text{Cost of goods sold}}\right)\times \text{52 weeks}$

[16.2]

When company financial reports cite inventory turnover and weeks of supply, we can assume that the measures are being calculated firmwide. We show an example of this type of calculation in the example that follows using Dell Computer data. These calculations, though, can be done for individual entities within the organization. For example, we might be interested in the production raw materials inventory turnover or the weeks of supply associated with the warehousing operation of a firm. In these cases, the cost would be that associated with the total amount of inventory that runs through the specific inventory. In some very-low-inventory operations, days or even hours are a better unit of time for measuring supply.

A firm considers inventory an investment because the intent is for it to be used in the future. Inventory ties up funds that could be used for other purposes, and a firm may have to borrow money to finance the inventory investment. The objective is to have the proper amount of inventory and to have it in the correct locations in the supply chain. Determining the correct amount of inventory to have in each position requires a thorough analysis of the supply chain coupled with the competitive priorities that define the