Outsourcing

1
Outsourcing

• An easy way to increase profits
• Nike, Cisco, Apple outsource most of their
  manufacturing
• Each could focus on research, marketing
• Each has gotten into trouble
• 2001 Nike reported unexpected profit shortfalls
  due to inventory problems
• 2000 Cisco had to write down billions in
  obsolete inventory
• 1999 Apple was unable to meet customer demand
  for new products

2
Outsourcing Benefits and Risks

• Benefits
• Economies of scale reduce manufacturing costs
• Risk pooling demand uncertainties are
  transferred
• Reduced capital investment
• Focus on core competencies
• Increased flexibility
• Risks
• Loss of competitive knowledge
• Conflicting objectives
• Flexibility vs. long-term, stable commitments,
  etc.
• Consider the IBM PC example.

3
A Framework for Outsourcing

• Reasons for outsourcing
• Dependency on capacity
• Dependency on knowledge
• Product architecture
• Integral products components are tightly
  related
• Designed as a system
• Not off-the-shelf components
• Evaluated based on system performance
• Modular products independent components

4
A Framework for Outsourcing (Fine Whitney)
5
The Move to B2B Commerce
6
B2B is Huge...
Source Forrester Research, Inc.
7
FreeMarkets Online

• FreeMarkets is an online market making firm that
  enabled industrial buyers to link up with their
  potential suppliers in a live electronic bidding
• The end result of such interaction among a
  network of suppliers was procurement cost savings
  of about 15 for the buyers
• The company was founded in 1995 and was on the
  verge of breaking even in 1998
• It was expecting to receive commissions and fees
  of nearly 6 million for arranging procurement of
  200 million worth of industrial components and
  parts

8
The company went public in 12/99...
Freemarkets Stock Price
9
Where is FreeMarkets today?

• For the three months ended in 3/31/01
• Revenue totaled 33M
• Net loss totaled 43.7M
• For the three months ended in 12/31/01
• Revenue totaled 44.8M
• Net loss totaled 2.8M

10
Highly Fragmented

• Most product categories are highly fragmented,
  with numerous suppliers each offering different
  level of quality, service and pricing options
• Buyers incur significant cost in the actual
  purchase process
• A buyer must invest internal resources to manage
  the process of collecting, analyzing and acting
  upon all the information in the market
• In addition to purchase price companies spend
  over 10 in additional procurement costs
• On the suppliers side, there are significant
  costs in using the manufacturing reps
• These commissions range from 4 to 7 of purchase
  price

11
How Does FreeMarkets Online Create Value for its
Customers?

• Consulting/Purchase outsourcing
• Putting together specs, drawings, lot sizes,
  documentation and RFQs
• Identifying potential savings opportunities
• Identifying and qualifying suppliers
• Educating and training buyers
• Conducting the Competitive Bidding Event (CBE)
• Providing post bid analysis and support

12
How Does FreeMarkets Online Create Value for its
Customers?

• Consulting/Purchase outsourcing
• Distribution Intermediary

13
Traditional B2B Trading Exchanges
14
Internet Based B2B Trading Exchanges
15
How Does FreeMarkets Online Create Value for its
Customers?

• Consulting/Purchase outsourcing
• Distribution Intermediary
• Network Enabler/Software Provider

16
What are the Barriers for the buyers?

• Elimination of established relationships with the
  suppliers and their representatives
• Elimination of manufacturing reps could result in
  loss of convenience

17
What is the value to the suppliers?

• Less value for the suppliers
• Commission costs fell from 7 to 2.5
• Table 7.5 implies reduction in commission by
  174M(4.5)8M
• Table 7.5 also shows 35M drop in revenue for the
  suppliers
• Suppliers could benefit from lower sales,
  marketing and distribution costs and better
  utilization of capacity

18
The Revenue Model

• A hybrid of service fees and sales commissions
• FreeMarkets charged monthly fee from the buyer
  based on the size of the market making team
  dedicated to the event
• Winning supplier paid sales commissions this was
  paid in installments as suppliers shipped
  products

19
Problems with the revenue model

• Buyer side
• FreeMarkets invests substantially in a project
• Consulting revenue is independent of the value
  created
• Does not lead to another intensive purchasing
  study for the customer
• Gross margin on consulting is about 22
• Doesnt scale well
• Supplier side
• FreeMarkets does not represent the supplier
• FreeMarkets success depends on their ability to
  identify many potential suppliers
• Suppliers pay commissions to the company that
  reduced their margins

20
Vertical vs Horizontal Focus?

• Vertical
• Advantage FreeMarkets can capitalize on its deep
  knowledge of supplier industries
• Disadvantage Hard to scale-up
• Horizontal
• Advantage Ability to generate multiple contracts
  from one buyers
• Disadvantage FreeMarkets does not bring much
  expertise to the transaction

21
How about licensing the technology?

• Are buyers capable of using the technology by
  themselves?
• If not, how will this hurt?
• If they are, where is revenue going to come from?
• How can these problems be addressed?

22
By the end of 1998

• FreeMarkets was pursuing the horizontal market
  expansion
• In 2000, the company started licensing its
  software

23
E-Marketplaces The Initial (95-99) business model

• The e-marketplace concept started as a new way to
  procure products, particularly non-production
  items. E-marketplaces
• Expand everyones market reach
• Generate lower price for the buyers
• Cut operational costs for buyers and suppliers
• Automating the procurement process will reduce
  processing cost per order from as high as 150 to
  as low as 5 per order
• Focus on liquidity
• Transaction fee paid by the suppliers
• Serve as a virtual distributor

24
Problems with this Business Model

• Sellers resist paying a fee to the company whose
  main objective is to reduce the purchase price
• Buyers resist paying a fee
• The revenue model needs to be flexible
• Sometimes the wrong party is charged
• Low barriers to entry created a fragmented
  industry flooded with participants
• Just in the chemical industry there were about 30
  e-markets

25
Continuous evolution of the business model

• Transaction fees (typically paid by the sellers)
• Sometimes the wrong party is charged
• Buyers and suppliers resist paying
• Subscription fees (typically paid by the buyer)
• Depends on a number of dimensions
• Licensing the software

26
Evolving Market Types

• Value-added independent e-markets
• They are expanding their offering to include
  inventory management and financial services
  (Zoho) supply chain planning (Covisint, e2open,
  Converge, TheSupply)

27
A Framework for eProcurement

• Type of Component
• Strategic Components
• Part of the finished product
• Not industry specific company specific
• Examples PC motherboard and chassis
• Commodity Products
• Can be purchased from a large number of suppliers
• Price is determined by market forces
• Examples Memory unit in a PC
• Indirect Material
• MRO

28
A Framework for eProcurement

• Level of Risk
• Uncertain Demand (Inventory risk)
• Volatile market price (Price Risk)
• Component availability (Shortage Risk)

29
Risk Commodity Products

• Can be purchased either
• in the open market through on-line auction, or
• through the use of long term contracts
• Long term contracts guarantee certain level of
  supply but may be risky for the buyer
• Inventory risk, shortage risk or price risk

30
A Framework for eProcurement

• Indirect Material
• Typically low risk and hence the focus is on
  content based hubs.
• The objective is to use an MRO-hub that
  specializes in unifying catalogs from many
  suppliers
• Examples MRO.com, Grainger on-line catalogs

31
Grainger

• W. W. Grainger has been selling industrial
  supplies for 72 years
• In 1995 Grainger established Grainger.com, an
  on-line catalogue for more than 220,000 products
  from 12,000 suppliers
• In 1999, Grainger experienced revenue growth of
  102M through its internet channel
• The MRO supply industry is growing at a rate of
  3-4 a year. From 1996 to 1999 Grainger internet
  sales grew 32 a year and 20 in offline due to
  customers that were lured to Grainger from the
  web site

32
A Framework for eProcurement

• Strategic Components
• Typically high risk components that can be
  purchased from a small number of suppliers
• The objective is to use private or
  consortia-based e-marketplace.
• The focus is on an e-marketplace that allow
  collaboration with the suppliers

33
Consortia or Private?

• Transaction volume
• Number of suppliers
• Cost of building and maintaining the site
• The importance of protecting proprietary business
  practices
• Technology and product life cycles

34
A Framework for eProcurement

• Commodity Products
• Products go directly into finished goods
• High risk
• Many potential options to choose from
• Long Term Contracts
• Buyer and supplier commit to certain volume
  (called the commitment level)
• Supplier guarantees a level of supply for a
  committed price
• Flexible, or Option Contracts
• Buyer pre-pay a relatively small fraction of the
  product price up-front, in return for a
  commitment from the supplier to satisfy demand up
  to a certain level (called the option level)
• The buyer can purchase any amount up to the
  option level by paying additional price for each
  unit purchased
• Spot Purchasing

35
A Framework for eProcurement A Portfolio Approach

Option Level
H L
N/A
Inventory Risk (Supplier)
Inventory Risk (Buyer)
Price, Shortage Risks (Buyer)
Commitment Level
L H
36
B2B Software Vendors

• Oracle (Indirect and Direct)
• i2 Technologies and Manugistics (Direct)
• Ariba (Indirect and Direct)
• Commerce One (Indirect and Direct)
• Agile (Direct)
• VerticalNet (Indirect)

37
E-Procurement The reality

• Companies conducting greater than 20 of
  procurement transactions online have reduced
  their transaction processing cost by nearly a
  third (Hackett Benchmarking)
• Product savings and process cost improvements
  effect operating cost by 10 (Credit Suisse First
  Boston Technology Group)

38
E-Procurement The reality

• To capture this benefits purchasing organization
  needs to invest heavily in
• Changing internal procurement processes
• Integrating e-marketplaces in internal systems
• Purchasing B2B applications, and
• Paying e-marketplace transaction fee/subscription
  fee

Source Forrester Research
39
Positive Aspects of Trading Exchanges (Companies
who use exchanges)

• Reduce costs or labor (31)
• Better access to products/vendors (24)
• Increase speed or efficiency (29)
• Access to more customers (21)

Source AMR Research
40
Positive Aspects of Trading Exchanges (Companies
who plan to use exchanges)

• Reduce costs or labor (43)
• Better access to products/vendors (26)
• Increase speed or efficiency (23)
• Access to more customers (10)

Source AMR Research
41
Negative Aspects of Trading Exchanges (Companies
use exchanges)

• Security trust (17)
• Start Up cost (5)
• Loss of face-to-face relationships (12)
• Lack of standards (5)
• Immature technology (5)
• Integration issues (7)

Source AMR Research
42
Negative Aspects of Trading Exchanges (Companies
who plan to use exchanges)

• Security trust (16)
• Start Up cost (15)
• Loss of face-to-face relationships (11)
• Lack of standards (6)
• Immature technology (6)
• Integration issues (4)
• Pricing pressure (6)

Source AMR Research