Bcg Procurement Report

8/11/2019 Bcg Procurement Report

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Special Report

T HE I MPORTANCE OF

P ROCUREMENT IN A G LOBAL E NVIRONMENT

The second in a series of special reports on operations in business

http://www.bcg.com • http://knowledge.wharton.upenn.edu



Contents

The Importance of Procurement in a Global EnvironmentUntil recently, procurement was a necessary, but seldom celebrated, component of mul -tinational corporations. But times have changed: These days, procurement organizationswithin companies are playing pivotal roles in the success of global firms in ways thatold-fashioned purchasing managers could never have imagined. In this special report,

Wharton faculty and procurement experts at The Boston Consulting Group discuss whythe procurement function has risen to such prominence in a highly competitive globalenvironment, and how, as supplies of critical commodities tighten and prices rise, com -panies can strategize to mitigate these and other risks.

Procurement — The Strategic Perspective 1

Challenges Facing Procurement Organizations 4

Global Supply Chain Strategy 8

Building Customer-supplie r Relationships 13

Sourcing from China 17

Subcontracting and Product Quality in China 21

Managing Commodity Risk 25

Performance-based Logistics 29


http://slidepdf.com/reader/full/bcg-procurement-report 3/35The Importance of Procurement in a Global Environment

Procurement has taken on greaterstrategic importance in multinational companiesin recent years — and it will assume even greatersignificance in the years to come, according to HalSirkin, senior partner and managing director atThe Boston Consulting Group and global leader

of BCG’s operations practice. In an interview withKnowledge@Wharton, Sirkin discusses procurementin the context of global business, and the waysin which companies from rapidly developingeconomies are challenging traditional multinationals.

Knowledge@Wharton: Companies have beensourcing from China and other low-cost locationsfor years now. What level of expertise and costsavings are you seeing?

Sirkin: We’ve seen cost savings in the range of 20%to 40%, depending on what the product is. On theother hand, we’ve also seen examples where therewere no cost savings when companies tried it.There are a lot of advantages to going to low-costcountries to source, but it has to be done right. Ithink the biggest mistake that companies make isthat they try to source things and forget it — andyou can’t forget it.

There are really three things that you have to getright: the product, the process, and the location.First, you have to think about what the productis. Are you sourcing the right part or the right

product? That really means that the company you’rebuying from needs to have the technical capabilityto produce it well and the practical capability toexecute it well. But you also need to see if it evenmakes sense to source it from China or otherlow-cost locations. If a part requires 50% labor, itmakes a lot of sense to go to countries that havelow-cost for labor. But if it only has 10% laborcontent, then it makes more sense to buy closer tohome and save on the transportation costs.

The second thing is having the right process withregard to the supply chain and quality. From asupply chain perspective, you have to make surethat the costs don’t eat up the savings. So, itemsthat are difficult to transfer — such as large, bulkyor perishable products — become an issue. Or, ifyou have a fashion product or something with a lotof variable demand, sourcing it far away means thatyou’ll have to hold a lot more inventory. That meanshigher costs and a greater risk of obsolescence.We’ve seen people trying to offshore and outsourceparts and products with 300% variation in demand,and when that happens, the value goes down.

In addition to the right supply chain, you have tohave a quality process in place. Now, we’ve seen alot of examples recently where companies have hadproblems with the quality of the products that arecoming in. Some products were unsafe and otherswere unusable. Whenever you outsource, you haveto invest your time and people to make sure that thequality process is in place, because your brand ison that product, whether you make it in Chicago or

Procurement — The Strategic Perspective

“There are a lot of advantages togoing to low-cost countries to sourcbut it has to be done right. I think tbiggest mistake that companies mais that they try to source things andforget it — and you can’t forget it.”

—Hal Sirkin, senior partner anmanaging director, BC


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Sirkin: Three things come to mind. One is to rethinkwhat you do. Again, if you move to an environmentwith a much lower labor cost, you need to thinkabout things differently. Fundamentality, there iswhat we call the capital/labor trade-off. If you’rein an environment of $25- or $50-an-hour wagesfully loaded, you think about the trade-off betweencapital and labor very differently than if you’re in anenvironment like China where wages are $1 to $2 anhour.

At that point in time, you may say, “I want toproduce things. I don’t want to spend as muchmoney on capital assets because wages are so low.”I want to think about how to set up my factory, but Ialso want to think about the design of my product. IfI want to avoid high-cost labor, I’ll design a simplerproduct with fewer screws and other small parts,something that can be made with an automatedproduction process. But if wages are only about 4%of what I would pay in the West, the capital/labor

trade-off is different. I may design a product with amuch more manual production process with thingslike screws rather than more fancy welding becauseit’s fundamentality cheaper.

Many automotive factories fall into this trap. U.S.and European companies copied their plants andthen sent them to China. In doing so, they actuallyended up with a higher cost position, because theyput in lots of automation and they were sub-scale.To succeed at low-cost sourcing, companies firstneed to rethink what they do.

Second, they need to rethink the whole opportunityand that doesn’t mean just sourcing. If you’re goingto produce in China and India — where there is acombined population of about 2.5 billion people —you may want to think about using your productionfacilities as a platform to start selling in thosemarkets or expanding sales in those markets. Or[you may want to] use your plants for more than justthat single part or that single product or that singledivision of your company. Use them as a lever to doeven more sourcing there for the r ight products.

Third — and this is the most controversial [and]people worry about it tremendously — you have tofind ways to protect your intellectual property. Youneed to be explicit about the trade-off between thecost savings and the risk of losing your intellectualproperty and make some real decisions. We’ve seencompanies lose intellectual products because theysent them to countries with lower protection.

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China. And because your brand is on that product,you have to make sure that you defend it andwhatever you produce. Saying that it was “Madein China” or “Made in India” does not defend youagainst a quality problem. In fact, it may make itworse in the public’s mind.

The third thing is to outsource to the right location.The absolute lowest direct cost is not always the

best thing to do. Back to supply chain issues, ifyou’re thinking about bringing something to China,you’ll also probably — if you’re in the U.S. — wantto consider Mexico. Or if you’re in Western Europe,you’ll want to consider Eastern Europe becauseyou may have a much better balance there [eventhough the direct cost may be higher] of avoidingsupply chain problems, such as large variability andinventories, and the hidden costs of other things.

In the U.S., with increasing port constraints, we maybe seeing delays over time. And Mexico, which ofcourse does not require importing through ports,may be a good alternative. So, get it right [and] youcan see a lot of savings. Get it wrong and your costsactually go up.

Knowledge@Wharton: So then, would you say thatthe level of expertise that you are seeing amongstthe companies that are sourcing globally is prettygood — or do they have a way to go?

Sirkin: Well, some companies do it well. They’ve gota lot of experience and their expertise is extremelygood. They avoid a lot of the problems and they

are making the right decisions. Other companies,normally the ones that are starting, are going insometimes way too fast without the right level ofexpertise and they are making a lot of mistakes. It’sfine to make mistakes as you learn, but it’s better tomake them on small things than big things.

Some companies spend billions of dollars buildingplants and then recognize that they’ve mademistakes. The biggest mistake that they oftenmake is to duplicate a plant that they have eitherin Europe or in the U.S. And because in low-costcountries the value is in the low wages, you don’tnecessarily want to put in a lot of automation. Ifyou’ve put in a lot of automation, of course, youhaven’t taken advantage of the fact that the wagesare lower.

Knowledge@Wharton: Can you think of any specificexamples of things companies should be doingdifferently, if they haven’t quite yet done everythingperfectly, so to speak?



But we’ve also seen companies make some verysmart decisions. I’m thinking about a Frenchcompany that makes a tri-metal alloy for which theend part of the production process is the importantpart of the intellectual property. They made adecision not to bring that technology to a low-costcountry, but to keep it in France even though it coststhem more. They put all of the complex assembly inChina, but ship the tri-metal from France to protecttheir intellectual property.

Knowledge@Wharton: Can you take a minute ortwo to talk about your forthcoming book calledGlobality ? What does it entail?

Sirkin: Globality is a book that we believe takesa very different perspective on how all of thecompetition between companies will go forwardin the future. Its subtitle says a lot about whatit is, which is “Competing with Everyone fromEverywhere for Everything.” And by that we meanthat your competition will change and you will becompeting with everyone — not just your traditionalcompetitors – [including] new companies fromcountries like China, India, Brazil, Russia, EasternEurope, Southeast Asia and just about everywhere.

The second point is that competition will come“from everywhere.” Your competitors will no longerlook a lot like you. It may be a small company inIndonesia. It may be a large company in China.It may be a big-sized company in India. But,competition will be coming from everywhere andcompeting for everything. By “everything,” we mean

for resources, for people, for customers, for distri -bution systems and for supply chains.

We’re expecting a wealth of competition to springup because companies from low-cost countries aremoving from being outsourcing vehicles for thetraditional Western multi-nationals, to becomingcompanies in their own right that are growing andgrowing rapidly. So you see companies like TataSteel and Mahindra that are starting to take roleson the global stage, with their own brands and theirown products. They should not be ignored.

Globality looks at not just the Western companies,the traditional multi-nationals, but the new emergingcompanies that are starting to become large and thatare challenging those multi-nationals, and what thelessons are both for emerging companies and, moreimportantly, for the multi-nationals.

Knowledge@Wharton: The book has been written byfolks at BCG?

Sirkin: Yes, myself, a colleague from China, and acolleague from India.

Knowledge@Wharton: Before we wrap up theinterview today, is there anything that you wouldlike to add that we have not talked about, anyimportant points that you think our listeners shouldtake away from our conversation, and that wehaven’t gotten to yet?

Sirkin: Yes, the most important point is to seriouslyconsider your procurement on a global basis. Somecompanies have jumped in too quickly and too fastand haven’t thought it through, whereas others aresitting back and saying, “This is a lot of work, andI don’t really want to do it.” For that last group, Iwould caution them and say, “If you can get a 20%cost savings in a business that might have a 10%or 15% margin, that creates a massive competitive

advantage.”

You can forego that competitive advantage, butif you do, one of your competitors will eventuallyfigure it out, and you’ll be at a competitive disad -vantage. There’s a value to going early, and there’sa value to making sure that you go slowly enoughthat you get it right, but quickly enough that yourcompetitors don’t get ahead. v


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Challenges Facing Procurement Organizations

Procurement has become an integralpart of corporate performance and is drawingincreased attention from senior management.In this interview, Andreas Gocke, a BCG partnerand managing director, spoke with Knowledge@Wharton about the most critical challenges facingprocurement organizations over the next five to 10years, including training and employee development,managing global sourcing offices and ensuring col -laboration across corporate departments.

Knowledge@Wharton: Can you talk a little bit aboutthe biggest challenges that procurement organiza -tions face today?

Gocke: BCG did a procurement roundtable withabout 30 European CPOs. We did a quick surveyabout the most challenging topics for the next fiveto 10 years. Surprisingly enough, people — trainingand development — was the number-one topic asthe key challenge for procurement organizations.That includes: skill development; the right recruiting

and retention practices; and career paths in otherfunctions outside of procurement.

Number two was also related to organizationalaspects. It was the organization of global sourcing.

That is, how to set up and how to manage globalsourcing offices. That is also more in terms ofprocesses, a linkage between the global sourcingoffices and the headquarters. It’s also how theglobal sourcing offices do work with other non-pro -curement functions.

And number three is cross-function and collabora -tion. That is, how does procurement work with notonly engineering and quality management — whichhas been the nature of the procurement departmentfor a long time already — but also with otherfunctions like sales and marketing when it comes torequirements management? That’s also with financeand controlling, and that’s also with logistics andsupply chain management.

These are the top three: people training anddevelopment, global sourcing organization, andcross-function and collaboration.

Knowledge@Wharton: Are those three muchdifferent from the challenges that facedprocurement people 10, 15 or 20 years ago?

Gocke: I would say that 10 or 15 years ago,

procurement was still fighting for, let’s say, orga -nizational significance. Have they listened and dothey have the right organizational position? In mostorganizations we see right now, this point has beenreached already.

There’s not so much a challenge anymore forprocurement to be accepted as a strategic businesspartner inside the organization or to be acceptedas the adding-value partner in the organization.

“We did a quick survey about themost challenging topics for the nextfive to 10 years…people — trainingand development — was the number-one topic as the key challenge forprocurement organizations.” — Andreas Gocke, partner and managing director,

BCG

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So now it’s more how to move forward in thissignificant strategic position inside an organization.

The war for talent [is seen] in all three regions, bythe way. It’s not only a European or an Americanissue. “People, people, people” will also face theprocurement department, for sure.

Knowledge@Wharton: You mentioned a momentago that procurement has become more acceptedas an integral part of organizations. Therefore, itseems like it’s more strategic than ever. Can you talka little bit about the reasons why that’s the case?

Gocke: If you look into major global corpora -tions’ profit and loss accounts you see the answeralready. The share of material costs and the shareof purchased services are growing continuously.We have some comparisons. What kind of externaldelivery for automotive OEMs, for instance, is likethat — the pacesetter of these developments [over]the next couple of years? The ratio is between 5%

and 10% in absolute terms per annum over thenext couple of years. That’s a very quantitativeaspect. But if you see the qualitative aspect as well,sourcing now also becomes the gatekeeper forsupplier innovation….

The technology competence with suppliers isgrowing more and more. You can easily measure itby the number of patents which are applied for inmany industries. And even in the customer organi -zations, the supplier will influence our technologicaldevelopment more and more. Therefore, sourcing

will be the organizational unit which will managethese aspects.

Knowledge@Wharton: If procurement is becomingincreasingly important and strategic, getting back tosomething that you mentioned, which was retentionand development of key people in this area, whereare organizations finding the best people? How dothey go about doing that and is it a difficult task?

Gocke: This is one of the key questions where weneed to confess to not having the right answeryet. CPOs don’t have the answer either. Unlike

most other functions, there is not the academicpurchasing manager education. You don’t find, orvery seldom find, a master education in purchasing.Very few universities around the world really focusand specialize on purchasing as an education pathby itself.

So, we are working with our clients to developthose career paths by themselves. They cannotwait for the outside world. They need to develop itinternally by setting up career paths across different

functions, by setting up education programs forhard skills — language, engineering, etc. — andalso soft skills, which are becoming more and moreimportant, like project management, working indifferent cultures, and working in different businesscontexts. These skills need to be developed by yourown organization. Don’t wait for the outside worldto support you on this.

Knowledge@Wharton: And because global sourcingis the second of those three important topics thatwere discussed at the summit that you talked abouta little while ago, it would seem that the type ofpeople that would be best suited for global sourcingwould be people with the kind of skills that you justmentioned also a moment ago.

Gocke: Yes, and I would even stress that they haveadditional skills…. If you need to set up a globalsourcing office somewhere in China or in India, it’smore entrepreneurial groundwork, so to speak. Andthe people there need to be much more like entre -preneurs. They need to improvise.

They need to bridge their home organizations— their headquarters — with their local suppliermarkets. So the intercultural management skills …are regarded as even more important than that of adomestic purchasing manager.

Knowledge@Wharton: Is being a purchasingmanager — or a chief procurement officer, orwhatever the organizational title happens to be — agood career path for those people? If procurement

is increasingly important, is it a good idea forpeople to seek those jobs out, if they think that theycan do well at them?

Gocke: In terms of status quo, I would be honestand rather critical. In terms of potential, I would bevery positive. Let me just talk about the status quoand those managers who traditionally are in salesand marketing. Those who contribute to the topline are still regarded as contributing the most tocorporate success.

Those who improve the bottom line [with things

like] cost improvements [and] volume reduction …still have less of a reputation [for] contributing tocorporate success. This is changing. As I mentionedin my answer five minutes ago, as purchasingbecomes more and more the gatekeeper forinnovation of suppliers, for instance, this innovationsome time later will result in additional sales.

Suddenly, you have a bridge from supplier — hisinnovation power — bringing this innovation power



into the customer organization, thereby developingmore and more to customers’ innovation andthereby contributing to our own corporate successon the top line. So, suddenly purchasing not onlybecomes a bottom line impact, but also a top lineimpact, and at this moment the sales purchasingmanager has a huge potential.

We see that also reflected in the corporate orga -

nizations. More and more organizations in theautomotive industry, which is like the front runnerin this dimension, have a CPO function on the boardlevel. That had not been the case some 10 or 15 yearsago. In most organizations, the CPOs reported eitherto the chief technical officer, the chief engineeringofficer, the COO, or the CFO. Now we see that theCPO has his own position in the organization.

Knowledge@Wharton: Let’s address the issue, if wecan, about the importance for procurement to workin tandem with other functions in the company.Could you say that at one time procurement wasmore of a standalone kind of operation, off to theside, and that it’s more integrated today? Would thatbe accurate?

Gocke: It depends. If we see the history ofpurchasing then that would give you a kind ofmaturity progress. And when we see differentorganizations across history, we see six differentsteps. The first step was [something] like “Servethe Factory,” if you call that the theme. Purchasingwas more in clerical and logistics activities, so theseskills were requested.

The next step was more like reaching the lowestunit cost. Call this theme, “Lowest Unit Cost.” Herethe purchasing organization was [focused on]pushing and pressing the supplier, and negotiatingtasks, and that was sufficient enough. Suddenly,[we had] the third step — we will call this theme,“Coordinated Purchasing.” Sourcing needed to havethe input of other functions to make the supplier-customer relationship better.

In the fourth step, we had the theme “Cross-Functional Purchasing,” which is what you askedabout. Suddenly, the purchasing department wasan equal part across different functions, in which allcontributed to the corporate success. Each functionwas dependent on the other, especially technicalimprovement leaders like make or buy; like standard -ization; like design to cost and process improvementleaders; [and] like demand bundling. So, to enablethose leaders, you need to have cross-functional

work, where purchasing is across engineering,quality management, and sales/marketing.

The fifth step is “World-Class SupplierManagement,” and here you have even more ofan intercultural aspect. And, the sixth step, whichwe regard as the highest aspirational level, is“Entrepreneurial Purchasing.” And with entrepre -neurial purchasing, purchasing behaves like a cost

and profit center as well.

And so, they are building up supplier networks bythemselves. They are offering supplier networksto the rest of the organization. They bring in ideas.They are the gatekeepers of suppliers’ ideas into theorganization. So, purchasing is not reacting to theorganization demand, but it is vice versa. Sourcingbrings in its own initiatives and thereby triggers therest of the organization.

Knowledge@Wharton: That’s a very importantpoint. A few minutes ago, you mentioned again

as one of those important themes that emergedfrom your meeting on global sourcing: Does globalprocurement, in your view, demand any specialskills or organizational needs?

Gocke: Yes, and I think that’s the reason why manyorganizations … are not where they want to be withregard to global sourcing. Global sourcing is not

just identifying the Chinese supplier in mainlandChina, signing the contract, and that’s it. It’s theneed to change the entire sourcing process.

What do I mean by that? If you are really takingglobal sourcing seriously, you need to sometimesextend your development process to allow a longerscreening phase from your suppliers, to allowlonger trial periods with new suppliers, etc. If youdon’t reflect that in your incumbent processes, youwill not have success with global sourcing.

And this also then comes into play for the need inthe organization to reflect those requirements interms of processes. So you need people and alsodepartments who know how to deal with thosechallenges. For a global sourcing organization you

need to ensure that the global sourcing officesaround the world have equal power with their, let’ssay, competitors inside the headquarters organiza -tion which do domestic or just regional sourcing.

You sometimes need to have more resourcesbecause you need to write specifications sometimesin the language of the global sourcing country, likeChinese. In India it is mostly English, but in China,



it’s a huge challenge. Eastern Europe is also a hugechallenge. You need maybe more resources in termsof supplier qualification management. So in termsof skills, resources, and new processes, organiza -tions need to learn more.

Knowledge@Wharton: You’re based in Munich,Germany. Do you see any significant differencesbetween the way companies in Europe and

companies, say, in North America approach thewhole topic of purchasing?

Gocke: Yes, in maybe two dimensions, I wouldsay. For the first dimension, I’m rather sure. Thesecond one is still at the hypothesis level. The firstone is the openness toward global sourcing, sinceEurope has its global sourcing market directlynext door, which is Eastern Europe. And let’s sayWestern Europe [has become] used to working withPolish, with Czech, and also with Turkish suppliers[over] the last 30 and even 50 years. It’s still a hugechallenge to expand this global sourcing leveltoward Asia.

And that’s the big difference with U.S. purchasingorganizations. They might have a link toward Mexicoin the NAFTA region. But this is not comparableto dealing with 10 to 12 different EasternEuropean countries — including Turkey — andthen [expanding to] 13 or 14 countries. This is thedifference.

Number two is that there might be a slightlydifferent understanding in terms of supplier-custom -

er relationship management in Europe comparedto the U.S., especially with the automotive industry.The openness for more trustful supplier-customerrelationships is slightly higher and more developedin Europe.

But we see that the “Big Three” in Detroit are alsoopening up more and are seeing some successfulmodels in Europe. They have learned that theycannot rely on those supplier-customer relationshipswhich are doomed to fail because they are just builton market power.

That will not be successful and the result, unfortu -nately, is that many tier one suppliers are close tobankruptcy and are not managed well. There needsto be, I would even say, a turnaround managementfor most of the relationships.

Knowledge@Wharton: Well, from everything thatyou have discussed today, it certainly sounds as ifpurchasing will only become more important in theyears ahead, for organizations of all kinds.

Gocke: Yes, I’m pretty sure of this. The technologyindustry and the automotive industry — I thinkthey have already put sufficient emphasis on theprocurement organization, and their reputation ishigher. As I mentioned, we have a CPO on the boardlevel. We have cross-functional teamwork. We havemore and more sophisticated supplier-relationshipmanagement tools and also processes.

And now [it’s spreading] to other industries as well,like the machinery industry and also the utilities-supplier industry. So, I definitely agree with yourobservation that purchasing will become more andmore relevant in strategic function. v


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Marshal l L. Fisher, director of Wharton’sFishman-Davidson Center for Service and OperationsManagement, has been researching issues relatedto retail supply chain strategy for many years. In thisinterview, Fisher highlights some of the challengesfacing global procurement, and he discussesthe example of Luen Thai, a Chinese companythat built a giant “supply-chain city,” becoming aone-stop shop for clothing manufacturers looking tooutsource to low-cost producers.

Knowledge@Wharton : Before we began recordingour conversation, you were talking about some ofthe interesting and far-reaching changes that haveoccurred in the area of procurement in the last 10 or20 years. Can you tell our listeners a little about that?

Fisher : I’d be happy to. My knowledge on this isbased on working with a number of U.S.-basedproduct companies on supply-chain strategy andI’ve been struck by two phenomenons: outsourcingand offshoring of their manufacturing operations.

In the 1980s, thinking back a couple of decades,there was a pretty vigorous debate within the U.S.about the need to strengthen and preserve U.S.manufacturing. This is a time when the Japaneseeconomy was in its ascendancy, and it was believedthat was due to their prowess in manufacturing. Thebelief was that you couldn’t have a viable economy,particularly the U.S. economy, without strong manu -facturing. So the message was: Keep manufacturingin the U.S. and make it stronger.

Boy, things have changed a lot in the last twodecades. Most companies now are outsourcingand offshoring manufacturing vigorously, almost tothe point where you will find companies that don’tmake anything themselves or in the United States.It’s going to low-labor-cost regions, predominantly

Global Supply Chain Strategy

Asia, Eastern Europe and Latin America, and, withinAsia, predominantly China.

I wrote a case on a very interesting Chinesecompany called Luen Thai, based in southern China.

They’re the largest private-label apparel manufac -turer, so they make for large retailers [like] Gap,Limited, Dillard’s, or branded apparel companieslike Liz Claiborne in the United States and someEuropean companies.

And they’ve done a phenomenal thing. They’ve setup this supply-chain city, which is a massive facility,probably the largest apparel production facility inthe world, intending to leverage a change in traderegulations that happened Jan. 1, 2005.

Prior to that, apparel production was heavily

regulated. There were quotas as to how much anycountry could export to the United States by variouscategories of apparel, which caused apparel to bespread all over the world. But basically, [it was] afragmented supply chain with production in lotsof different countries because no one country hadenough quotas to supply the industry needs.

That quota system was ostensibly eliminated Jan.1, 2005. And if you look at other categories, saytoys [or] consumer electronics, where there is noquota, you’ll see something like 80% to 90% ofthe production coming out of China. So Luen Thaibelieves that’s going to happen in apparel and theyset up this giant supply-chain city to leverage that.

Knowledge@Wharton : Now this giant city thatyou’ve mentioned, that’s very interesting becausethat was a step that Luen Thai took after lookingat the landscape for world manufacturing andcoming to a certain set of decisions as to howit was going to respond to these changes. Whatsorts of challenges has Luen Thai faced and what

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have they done, in addition to building this largecity for its workers and its production? What sortsof things has Luen Thai done and what kind oftakeaways might there be for our listeners whowant to learn more about the way a giant Chinesecompany goes about doing its business in this kindof environment?

Fisher : Well, some of their challenges are perhaps

unique to apparel. So in that category there’s alot of political pressure to continue some form ofrestriction on apparel imports. There’s a provisioncalled safeguards that limit [and] that kind of putback quotas to some extent.

That lesson is less transferable to other crosssegments where you don’t have those same restric -tions, such as toys and consumer electronics. Theother thing they have been struggling with, whichmight translate to other industries, is essentially,what’s the best place to locate various functions? Soyou think about all the steps involved in sizing upa market, designing a product, and then producingthat product. What gets located where?

So Luen Thai’s original vision is: “We’ll do it all inChina. We’ll do design in China. It’ll be one-stopshopping for apparel buyers. So they’ll fly over,we’ll give them really nice offices just like theiroffices back at home, and we can quickly design agarment, make a prototype, get that critiqued by thebuyers, and redesign it within a few hours.” This is aprocess that used to take a few weeks to go aroundthat iteration loop.

What they found out is that total outsourcing fromoriginal conception of the design of a productthrough production and delivery to the store —they call it design-to-store — doesn’t work. Why?Number one, designers don’t want to live insouthern China. They want to live in the fashioncapitals [like] Manhattan.

Knowledge@Wharton : Sure.

Fisher : So it’s hard to get creative people to gothere. The Chinese are turning out their own

designers, but they don’t have the reputation andprobably not the skill of U.S. designers. And thensecondly, it helps a lot to be close to the market. Sothey’ve been evolving close to the market you’redesigning for, to understand the end-consumer. Sothey’ve been refining that concept and their thoughtis that there’s a … customer-facing aspect of design.In apparel, what’s the artistic look of the garmentthat would appeal to a particular customer’s lookand feel?

And then there’s a production-facing design. Forexample, a garment is a three-dimensional objectmade from two-dimensional pieces of cloth. Sothere’s an engineering function called pattern-mak -ing that translates that three-dimensional object intoa series of two-dimensional shapes cut out of cloth.That engineering-production-type step could bedone in China with an interface between them.

So as supply chains become global, companiesneed to think about what they put where and howthey coordinate across those various functions.

Knowledge@Wharton : And in the case of Luen ThaiHoldings, that was a major decision, was it not?

Fisher : It was absolutely a big bet. They’re a fairlyold company, and they had thrived under the oldquota system. One of their people joked that if youhad a sewing factory and owned quota, which is theright to export to the United States or Europe, it waslike a license to print money. And we printed a lot ofmoney. But [after] Jan. 1, 2005, that quota systemwas going to go away, so their license was about tobe revoked.

And several years prior to that, they startedthinking, “Life is good, but we can’t continue in that

old way because this elimination of quota is goingto change things, so we need to have a plan.” Andthis was their answer.

Knowledge@Wharton : Now, did Luen Thai have anydifficulty convincing its customers in North Americaand Europe and elsewhere that this “design tostore” concept would work for them?

Fisher : Absolutely, because apparel buying ishighly cost-driven. Why? Cost is very visible, so

“…design-to-store [outsourcing]doesn’t work. Why? Number one,designers don’t want to live insouthern China. They want tolive in the fashion capitals [like]Manhattan.”

—Marshall L. Fisher, professor of operatioand information management, Wharton



a buyer knows whether or not they’re getting thelowest cost. If they pay a higher cost, but they getadditional service, well, it’s hard to evaluate whatthose services are worth. It’s a qualitative judgment,which is harder to size up.

So there’s a bias toward basing decision-makingon the tangible, highly knowable cost. And buyerswill move production for a few pennies a garment

because it’s a highly competitive, cost-driven industry.It’s sometimes called “chasing the cheapest needle.”

And you’ll see apparel is a great way for a countryto move up the economic ladder because you canstart out making easy-to-produce stuff like T-shirts.It’s very easy to find used sewing equipment [and]low-skill labor, so any underdeveloped country canget started that way.

But then … they move up the ladder.... China wasthere maybe 20 or 30 years ago, but graduallyover time, they’ve moved way up in their skills and

sophistication. And with it, wages have movedup, so China’s no longer the dirt cheap, lowestcost production site. So what you see happen iscompanies will move to a much less developedcountry, maybe Bangladesh ... because wage ratesare lower [and] you get lower production costs— “chasing the cheapest needle.” So it’s hard tocompete on service in a cost-driven industry. That’sone of the challenges that Luen Thai has faced.

Knowledge@Wharton : That’s why the company hada bit of a challenge in store for it when it tried to

convince its customers that their model ...Fisher : Yes, they did. They absolutely did. Theirconcept, I think, makes sense. You look at the coststo design, produce and deliver a garment to thestore. Only about a third of that cost is manufac -turing cost, and that’s the cost that all the buyersgravitate to. The other two-thirds are soft costs:design, logistics, handling, [and] transportation. SoLuen Thai wants to attack that other two-thirds andtry to improve on that.

Knowledge@Wharton : Is the model that it has

devised being copied by other manufacturers inlow-cost countries?

Fisher : I think it’s almost the other way around. Inindustries like consumer electronics, which have nothad the same degree of trade restrictions as apparelhas had, they’re much further along in the supply-chain-city concept.

I’d visited Luen Thai in the summer of 2006 and [on]that same visit I spent a day at a Chinese company,Taiwan-based, in the U.S. called Foxconn. In China,they’d be called “Hon Hai.” And I’d not heard ofthem previously. I was surprised to find out they’reabout $32 billion in revenue. They’d be a Fortune 50company if they were based in the U.S.

They produce all of the branded consumer products.

So they produce for Dell, Motorola, and Apple —you name it — all the well-known companies. Thisis one of 12 facilities, and I was struck by the sizeof it. And I asked somebody how big it was, andthey said, “Well, let me put it this way. You came inthe front gate, and if you’d started walking from thefront gate toward the back gate, it would take you 45minutes to get there.” So [with] 245,000 employees,[it’s] literally a city [with] their own police force,hospital, [and] school.

Knowledge@Wharton : That’s remarkable.

Fisher : It’s remarkable what’s happened. I was trulyshocked at the scale of outsourcing, offshoring, thedegree to which China has become a juggernaut,almost resembling Japan in its ascendancy in the1980s.

Knowledge@Wharton : That’s an interesting point.And of course, Japan, which began post-World WarII as a low-cost manufacturer, grew its economytremendously ...

Fisher : Yes.

Knowledge@Wharton : And moved out of thatbracket to become the world’s second-largesteconomy. Do you see the same thing happeningfor China? Are there any differences with the Japanexperience? Or is China mostly similar to Japan inthe way it’s growing its economy now?

Fisher : That’s a very interesting suggestion. I’m surethere are differences, but I’m struck more by thesimilarities. It looks very, very similar. Post-WorldWar II Japan was very, very low-cost labor. “Madein Japan” was, at the time, synonymous with lowquality. China, in the 1980s, looked the same way.Now, 20 years later, China’s synonymous withhigh quality, just as Japan became synonymouswith high quality. It looks very similar. It’s almostfollowing Japan, 30 years lagged.

And they’re starting to have some of the problemsthat Japan had as they became more prosperousand it was harder for them to compete at lowwages. China’s running into rising cost pressures.



There was a student of mine. His name is Gang Yu[and he] grew up in Wuhan, China, got his Ph.D.at Wharton, taught at the University of Texas for awhile, and then left [as] the VP of supply chain atAmazon, and now he runs Asian sourcing for Dell.So I stay in touch with him.

And when I got back [from] this visit to Foxconn, Iwas truly blown away by what a powerhouse China

had become. And he said, “Well, don’t worry toomuch. We’ve got our problems in China.” And hetalked about rising costs [and] lack of labor avail -ability — so it was labor scarcity pushing up costs –[which were] some of the same things that began toafflict the Japanese economy in the early 1990s.

So it will be interesting to see. Maybe “interesting”is too weak a word. It will be highly important to seewhat is going to happen in China.

Knowledge@Wharton : Well, China of course as youwell know has faced a lot of bad publicity here in

the U.S. and elsewhere for shoddy products beingshipped to the United States, is that a reason for …

Fisher : They are second only to Wal-Mart in the badpress they are getting.

Knowledge@Wharton : Is that a reason for concernon the part of their customers here and elsewherewho might have turned to China in the explosionof outsourcing abroad only to find that therehave been some serious drawbacks. I mean howshould customers here in the U.S. and Europe andelsewhere think about these problems that Chinahas had with quality?

Fisher : I am not sure whether their quality problemsare any more frequent or greater than if those sameproducts, say 40 years ago, were being producedin the United States because there would be qualityproblems then, too. You may recall there was a bigtire recall in the U.S. 10, 20 years ago. So that iskind of point one. I don’t really know the objectivefacts on whether this speaks to substandard qualitycoming out of China. It is a different governmentregulating quality than when you are producing

in the U.S. and it was your government, the U.S.government, regulating it. So I guess the phrase,“Trust but verify,” would come to mind.

Knowledge@Wharton : Before we end our con -versation, I did want to loop back to somethingyou began discussing in the beginning of our talkwhich was the tremendous change in outsourcingin the last couple of decades. Do you think that

companies in North America and Europe and otherdeveloped countries have responded well in seekingout countries like China and India, etc? Have theymostly done the right thing in finding the rightpartners to do business with and in approachingthat issue in the right way? Are they getting themost benefit from it or are there still areas wherethere could be some improvement on the way firmsin developed countries go about their purchasingand procurement activities abroad?

Fisher : Well obviously, the answer to your questionis “yes” and “yes.” It is a complex subject, but onbalance I think that they are doing more things rightthan wrong, but of course there is always room forimprovement. Having looked through the 1980s andteaching operations management at Wharton, it wasalmost like a religion that … real men did manufac -turing and real economies did manufacturing. Andso it was troubling to me the idea of hollowing outthe U.S. economy.

But if you think it through, all work — this is a slightoversimplification, but not much — can be dividedinto muscle work and brain work. And so what weare doing right now talking to each other is mostlybrain work. A lot of manufacturing is a blend of thetwo, but many types of manufacturing are moremuscle work than brain work.

So brain work tends to pay better than muscle work.So if an economy wants to ascend, it has to becarefully managed, but it makes sense to offshoreand outsource the muscle work to low-wage-rate

countries and retain the higher-margin brain work.So in manufacturing product companies, that wouldinclude things like market research and productdesign.

Now that certainly makes sense, but you betterbe very sure that you are excellent at the brainwork. It is not enough to say, “We are going todo the product design and marketing and thenproduce me-too products or ho-hum, uninterestingproducts.” You’ve got to really be world-class at that.

Because these low-cost-labor countries that we areoutsourcing to, they want to get into the brain-workgame, too. So you see Chinese companies, forexample Foxconn on their corporate video. Theystarted out in 1970 making TV knobs, if you couldbelieve that, the most pedestrian product you couldthink of. Now they have gone to making reallyhigh-tech stuff, but it is largely based on low-costlabor. They want to get into innovation.



So, it is a little bit like riding a tiger, I think, that inoutsourcing to low-labor-cost countries you get ashort-term benefit, but there is the risk you may bespawning a competitor.

Knowledge@Wharton : That is an excellent point,and is it one that firms in the U.S. and Europe aregoing to have to worry about in the next five to 10years? As you well know there has been a lot of

political consternation over the quote-unquote lossof jobs in America to low-cost countries if indeedthe brain work, so to speak, is going to be the nextchallenge to be faced by, say, U.S. firms. Is it a realreason for concern? Could the Chinese and India becritical competitors to U.S. companies in that area?

Fisher : Absolutely they could be. I think the key to aprosperous economy is to compete on things that paywell. Brain work, I think, pays well. I think implicitlyor explicitly by outsourcing labor-intensive activities,anything from manufacturing to call centers, to low-labor-cost countries, the U.S. is moving down a pathof competing on brain work. But that implies a wholebunch of things. Like you better have a very goodeducation system or else segments of society get leftbehind in the U.S. So there are a lot of challenges Ithink our economy is facing.

The education systems in foreign countries are quitegood. Right now, labor rates are low there. They’realso low for professional services, so you are seeingbrain-work-type activities getting outsourced tolow-labor-cost countries, not to laborers but toengineers. So software going to India would be an

example.

Knowledge@Wharton : Is there anything in termsof research that you’re working on now that mightbe pertinent to what we have been talking about?You wrote the case study on Luen Thai, which youshared with us today. Is there anything else that youare working on right now that might be of interestto readers and to follow up on when that project iscompleted?

Fisher : Right now, and really for the last decade, myresearch has been focused on retail supply chainmanagement and I’ve been led to be intrigued withand aware of these global issues because retailsupply chain management has come to mean globalsupply chain management. So I haven’t focusedexplicitly on that in my research, but I was sointrigued with this, I am planning to introduce anMBA minicourse next year on global supply chainmanagement, almost as a way to launch a nextwave of my research on that topic.

There is a joke that the first time a course is taught,the instructor learns. The second time, the studentslearn. And this is probably overly harsh, but thenthe third time, nobody learns.

Knowledge@Wharton : Well, they move on tosomething else. v



In the never-ending quest for costsavings, many companies have reduced the numberof suppliers they use, consolidated their purchases,and negotiated better prices. So, where can chiefprocurement officers and other managers now turnfor savings? In this interview, Bob Tevelson, a BCGpartner and managing director, says firms mustsegment suppliers to identify those that can deliverwhat he calls “partnership value” by establishing rela -tionships that move beyond the transactional level.

Knowledge@Wharton: Many companies havealready reduced the number of suppliers that theyuse and consolidated their purchases and negotiatedbetter prices. Where do you think the next level ofcost savings will come from in procurement?

Tevelson : I think many companies have, in fact,reduced the number of suppliers they work with sig -nificantly, but I still think there is an opportunity todo more. I think what the next level of benefits willaccrue from is looking at the suppliers that are used,the smaller subset, and really segmenting those.

What I mean by that is breaking them into differentgroups in terms of what we’re looking for fromthe suppliers and taking the supplier-relationshipmanagement to the next level, which is to segmentbased on what the suppliers can do versus ourobjectives, and then being willing to invest in thosesuppliers to be able to drive value.

Knowledge@Wharton : What are the biggestchallenges that companies face today with regard tosuppliers?

Tevelson : I think the biggest challenge is to be ableto segment the suppliers into those that are reallymeaningful and can deliver partnership value. WhatI mean by that is moving beyond the transactional,

Building Customer-supplier Relationships

moving beyond getting a better price, [and] movingto some of the more interesting areas around realcollaboration [and] trust-based relationships.

Also, taking the focus beyond the transactional

[and] beyond the day-to-day, looking at what thesupplier can do from an innovation perspectiveto drive where the company is focused from astrategic perspective, and also focus on drivingperformance to the next level.

Knowledge@Wharton : You’ve raised someinteresting issues, so let’s pause for a second andtalk about how supplier relationships have changedover time and some of the changes you’ve seenhappening. What has been the genesis for that?Why have companies changed their relationships inrecent years?

Tevelson : I think they’ve been forced to change.If you take the automotive industry, for example,and the economics they face — a couple of yearsago, when profits were up, the focus was all aboutpartnering, tight relationships, and sharing benefitsand innovation. Then, when the chips are down, thefocus is more on the dollars and more on price.

“The next level of benefits willaccrue from looking at the supplierthat are used, the smaller subset, anreally segmenting those.” — Bob Tevelson, partner and managing dire

BCG



And so, there’s a natural ebb and flow cycle torelationships. I think what companies are findingnow is that margins are pushed down to wheresuppliers are making a reasonable profit and gettinga reasonable return, [and] that they need to findother ways to get more value from the suppliers,and it goes back to segmentation. Who are the coresuppliers you want to work with? Why do we wantto work with them? What can they do?

What they can do is beyond price. It’s innovation,it’s helping us go to market, and it’s working with usto understand our business better and identifyingbest practices.

Knowledge@Wharton: Are there differences amongindustries? You’ve mentioned, for instance, the autobusiness, which is certainly one that we read aboutall the time in the press, trying to control coststhrough their relationships with suppliers. But arethere differences, say, between the auto industryand other industries?

Tevelson : I think there’s a significant difference, andyou’ll find relationships varying by industry. If youtake the automotive industry, it’s more arm’s length.High-tech is more integrated. It’s more integratedbecause obsolescence happens so fast that wehave to have tighter relationships. We also have toleverage the capability of suppliers to be able todrive product development, innovation and the fastcycle times in the supply chain.

Knowledge@Wharton: Does that mean that,

necessarily, things are more difficult, say, forhigh-tech firms as opposed to autos, or is it just amatter of difference and not really levels of difficultyin managing these relationships?

Tevelson : I think the value is different and whatthe suppliers can do is different. But also, historyis different. So, the automotive industry is startingfrom a base where there’s less trust becausethere’s been this great focus on price and makingagreements and then pushing suppliers further.With the high-tech industries, for example, there’smore collaboration.

Another example would be the pharmaceuticalindustry, where some partnerships are emergingeven in mundane categories like packaging.Companies are working with their packagingsuppliers to differentiate not only based onmarketing opportunities, but [also] based on thecustomer experience with the package from a safetyperspective [and] from an information perspective.

And ultimately, what the pharmaceutical companiesare interested in is the patient using the prescrip -tion, persistence and compliance.

Knowledge@Wharton: You mentioned trust, whichis something we want to talk about in a moment,but how can companies prepare for the changesyou’ve described, and what will these supply rela -tionships look like in the future?

Tevelson : I think companies can prepare byundertaking some basics of understanding theirsupply market and then understanding from thatwhere they need to go with the business. So, howcan procurement contribute to the company goals?And therefore, what do our suppliers need to do?Then, setting kind of a baseline as to where we arefrom the starting perspective, what are we securingfrom a value perspective, and what do we reallyneed to get from our suppliers going forward?

Knowledge@Wharton: What will those relationships

look like, do you think?

Tevelson : I think the word “partnership” is alwaysthrown out, so lawyers jump in and they get allupset about the implications of that. But I think whatyou’ll find are tighter, longer-lasting, integratedrelationships that are based on trust [and] …information sharing, while the contract will sitbehind and ensure the right incentives are in placeon both the upside and the downside. I think you’llsee more integrated relationships [and] deeperinvestments by both parties with fewer suppliers.

Knowledge@Wharton: Can you talk about theimportance of trust in relationships and maybe evendiscuss the possible consequences that can arisewhen trust is lacking or is weak?

Tevelson : That’s very interesting because I don’tbelieve personally that a good, deep, collabora -tive relationship can exist without trust. I think it’sa table stake that one has to have going in. If youdon’t, one is always holding back either informationor opportunities. If you don’t have good collabora -tion, too much energy and focus is concerned with

whether the agreement and the situation is fair.I think that undermines the ability to really driveforward and get after the most value.

So again, I think it’s a starting point that has to exist.You segment your suppliers. Are they importantfrom a strategic perspective to the business, andwhere are they along the continuum on the trustmatrix? What do we need to do [to] move it to theright place?



Knowledge@Wharton: Do you think, in general,that trust has eroded between suppliers and theircustomers in recent years, and if so, why do youthink that’s happened?

Tevelson : I think it varies by industry, and in theautomotive industry there has been clear erosion. Insome of the high-tech industries there has been less.You also need to think about the whole movement

of supply chains and supply sources overseas wherethese long-term relationships may exist.

Lower-priced suppliers, perhaps without the samesophistication, are brought to the fold. Then you geta conflict between the value a domestic suppliercan provide around innovation, around speed,and around helping their customers operate moreefficiently and effectively versus the offshore supplybase, which has a great advantage around price butnot necessarily leading-edge innovation or speed inthe cycle chain, the supply cycle.

Knowledge@Wharton: What types of value—a wordagain that you mentioned a little while ago—canadvanced supplier relationships offer?

Tevelson : I think value is really changing the rules ofthe game. If you’re effective at procurement, you’vealready pushed down pricing with your supplier tothe point where they’re making a reasonable return.[If you] push it too far, they’re not going to be happyor a long-term supplier. It’s really around drivingchanges in supply chains — opening up the infor -mation-sharing and looking at how we can change

the interface, how we can change processes to takeout time [and] take out inefficiency and cost.

Also, how can we change what we buy so that wemay be able to take advantage of specifying toneeds versus wants and coming closer to what thecustomer needs versus overdelivering? Suppliershave a lot to offer when asked the question, and Ithink it’s critical that you have these types of rela -tionships so that you leverage that insight. Theyhave a good perspective, and it’s only a value if itcan be leveraged.

Knowledge@Wharton: If we can try to pull all thistogether, what do you think the common themes arefor success in these very important relationships?

Tevelson : I think there are a couple of things andI’d start with clear segmentation of suppliers. Youcan’t have deep, collaborative relationships with allyour suppliers, and you need to really identify whichones are the players. The second issue is senior

management buy-in. And while it seems obviousthat in many corporate initiatives you need to havethat, I’m talking about buy-in to the point of differen -tiated investment and investment in terms of dollars,investment in terms of senior management time,participating in conferences, [and] participating indiscussions with suppliers directly and indirectly.

I think the other issue is developing a track record

of success, being able to identify prior successes,perhaps pilots or case studies that can be com -municated and provide justification to extend theprogram. Another key is treating the suppliers well.They have to have some vested interest in partici -pating, so the benefits, the savings, the improvedcycle times, [and] the opportunities need to be

jointly shared.

I’m not sure if it’s a 25, 50, 75 sharing, but at somepoint the suppliers need to have an incentive toparticipate, which is my last point. [You need]common objectives — common objectivesinternally, common objectives with the suppliers,and [you need to] make sure they’re alignedincentives. We all know what we’re going after andwe know why we’re going after it, and then thereare incentives to support that.

Knowledge@Wharton: Are there any issues that wehave not discussed that you’d like to bring up? Forinstance, I don’t know if we’ve really talked aboutprice volatility and how that can affect supplier rela -tionships. Maybe there’s something else you’d alsolike to bring up?

Tevelson : I can talk about the price volatility andalso supply-chain risk, which is somewhat related. Interms of supply-chain risk, these tighter supply rela -tionships enable companies to share and developcontingency plans. So, you may choose to go withone supplier, but work with that supplier to developa contingency plan around what will happen ifthere’s a natural disaster. Then, from a price-volatil -ity perspective, it’s really hard to have a collabora -tive type of relationship if the risk is disproportion -ately burdened or borne by one of the two parties.

So often, when there’s a lot of volatility in thepricing or economics of the relationship, you canestablish some type of risk-sharing and the rightlevel of divisibility so that no one is taking on anundue burden of that risk.

Knowledge@Wharton: Can you think of a real-worldexample where volatile prices have led to some kindof friction in a relationship, and how it was resolved?



Tevelson : Actually, I can think of a couple. The oneI like the best was in the appliance industry andit was around the supply of some critical metals.There was a longstanding relationship in place andpeople were happy, in terms of the buyer side, withthe ability to buy at a fairly low price historically.Then when the markets got tighter, things seemedto change. The partners were both happy, but whenthere was an opportunity to share what became ascarce capacity with other buyers who were willingto pay a bigger price, a conflict ensued.

You have a longstanding relationship focused onquality, service and delivery undermined because,on the margin, there was opportunism, and the rela -tionship fell apart quite a bit, actually.

Knowledge@Wharton: Is that the exception ratherthan the rule these days?

Tevelson : I think in many cases the price-volatilityissue, which is really topical at the moment, is

addressed through transparency, so the commoditynature typically can’t be influenced by both parties.There’s an index and the price floats to that. Andwhere there’s a reasonable way of resetting theprice based on an objective measure, the partiescan work together and not be arguing oversomething they can’t control. v



Multinational corporations have beensourcing from China for years, but that doesn’tmean that all the questions have been answeredabout how to engage in procurement activitiesin the world’s fastest-growing economy. In thisinterview, David Lee, a partner and managingdirector at BCG, says that plenty of challengesremain. Among them: finding good suppliers thatoffer products at relatively low costs, and beingwilling and able to outsource a sufficient volume ofone’s business to Chinese suppliers.

Knowledge@Wharton: We’d like to talk to youa little today about China sourcing. As you wellknow, that’s a very important and particular issueof interest to companies around the world. Can youbegin by giving us an idea of how China sourcing

differs from sourcing in other parts of the world?

Lee: I think China sourcing, to a certain extent, isvery similar to a lot of the low-cost country sourcingor overseas sourcing. There are some things thatare particularly different because China is still goingthrough a lot of transitioning right now. So, thereare a lot of issues that need to be addressed. Forexample, Chinese suppliers do not always have thesame capabilities and the quality level can be highlyuneven.

But on top of that, we have a very non-transparentsupplier market. We don’t have, for example, a lot ofthe supplier databases that you would like to havein the Western world. When they first come to China,the first major problem a lot of companies faceis: Where do you find a good supplier? There aredefinitely a lot of suppliers out there, but whetheryou can find a good one will be a big question.

And, of course, China is going through a lot ofchanges as we speak. Chinese culture, historically,

Sourcing from China

is slightly different from the Western world in termsof language, in terms of culture, and in terms ofthe business norm because we are still going froma planned economy to a more open economy.All of these things are changing. I think one of

the interesting things that a lot of Westerners willalways say is, “When a supplier says yes, they don’treally mean yes. They are just very polite.”

Knowledge@Wharton: A moment ago, you saidthe lack of transparency can be a challenge forcompanies that want to source in China. How doorganizations go about surmounting that challenge?

Lee: I’ve personally done a lot of sourcing in theWest and also in China. In the West, things arerelatively easy in terms of identifying the suppliermarket, so you can always go to some database anddownload a list of suppliers that are capable.

In China, there’s no such database. Everybody saysthey have some database, but our experience hasbeen that most of the databases are about 50% wrongand then another 10% to 20% are outdated. So, younever really can find a very good supplier database.

“When they first come to China,

the first major problem a lot ofcompanies face is: Where do you fia good supplier?”

—David Lee, partner and managing directBCG



Often, you need to do a lot of legwork before youcan do the sourcing activities. This becomes verydangerous and very difficult for a lot of people whohave no experience working in China. We have seenin a number of companies, when they do Chinasourcing, instead of casting a wide net to find theright supplier, they usually follow whoever yourcompetitors are sourcing from and go find thosesuppliers.

So, we see that the good are getting betterand the worst are still staying there withoutbeing developed. We see that quite often in theautomotive sector. At the very beginning, five, sixor seven years ago, when foreigners started comingto China to source, they all came to the same place.They all sourced the same parts.

Nowadays, with the supply base getting much morecapable and the local demand getting higher, wesee suppliers being developed to a certain level thatsome are actually supplying to Western companiesfor future models, which is a new thing in China.

Knowledge@Wharton: If an organization is dis -satisfied or unhappy with the results of their Chinasourcing programs, what should they think aboutdoing to improve their results? And secondly,is there any industry against which they canbenchmark best practices, to try to find a goodexample to follow?

Lee: I think those are very interesting questions.First of all, when you say that a company is not

doing well in China sourcing, there are usuallytwo issues. Number one is they can’t find goodsuppliers that can supply them at a relativelylow cost. Number two is they can’t move enoughvolume over to China. I think that these twothings are usually interlinked, but they can also beseparate.

What we have seen is that China has a lot of goodsuppliers that are capable. And in a recent surveywith a number of China sourcing office directors,what we have seen is that the savings ranges from10% to 60%. And on average usually it is about 20%to 30% on most commodities. If it is less than 20%then it usually doesn’t really make sense for you tosource in China.

So, Chinese suppliers definitely do offer significantsavings potential. But when we talk to thesecompanies and ask, “Why don’t you source morefrom China?” the consensus is “because our head -quarters is not willing to send more volume.” If you

use baseball terminology, the catcher is alwaysready to catch but the pitcher is not ready to throwthe ball. These are some of the issues that we seetime and time again across all industries and acrossall companies.

We think that these are the major issues. Of course,if we talk to the R&D people, the engineeringpeople, [and] the quality people at their headquar -

ters, there are always reasons why they are not100% willing to move their product over there.Extending the supply chains [and] the risk withchanging suppliers — all of these are risks. But thequestion of how much risk each company is willingto take will determine how successful they are inthe China sourcing arena.

Knowledge@Wharton: Despite the challengesthat exist in China sourcing, I assume that youwould say it’s still well worth it for companies topursue China because they can really reduce theirprocurement costs. Is that accurate?

Lee: I think that would be right. But I wouldprobably go a little further. If you don’t go to Chinaand if you just stay with your incumbent suppliers,your competitors will not stay with you. Yourcompetitors are going to move to China anyway.So, “What are you leaving on the table?” would bea question.

We already see that a lot of suppliers in China aregetting to a kind of scale that is unheard of in theWest. And they have the capability of eventually

migrating to overseas markets and start attackingyour home turf. So, having a China sourcing teamover there, number one, can help you close thatgap. Number two, it will also help you understandthe supplier market dynamics so you can planaccordingly.

I think that recently BCG has worked with a numberof clients that are expressing concern about “allof these Chinese [and] Indians” — or, in the olddays, the “low-cost-country suppliers” — that areemerging very quickly and now they might bechanging the dynamics of the markets.

Knowledge@Wharton: You mentioned a momentago that of course you have a lot of experiencesthat you can discuss regarding BCG clients. I knowthat you’re probably reluctant to identify them. Butcan you think of an example of one of your clientswhich is doing procurement very well in China?And, perhaps you could give an illustration of whythey are doing so well and what kind of steps theyhave taken in that area?



Lee: I can think of one very recent example. Anautomotive company came to China about five orsix years ago to set up their China sourcing office.At the time, not that many people were thinkingabout China. But over the years they have increasedtheir China sourcing volume substantially.

It’s still relatively small — around 5% to 10% of theglobal total spent. But it’s substantially higher than

some of their competitors. How did they do it?When they came to China, instead of just lookingat the supply base, they knew very well that inautomotive, with the stringent requirements inthe West — the PPAP, the APQP — all these thingsare pretty much a foreign language to a lot of theChinese suppliers.

As a result, they’ve developed a huge supplydevelopment team focused on helping suppliersget up to the company’s standard and also up tothe automotive standard. Through this process, theywere able to develop suppliers that are much moreloyal to them. Number two is that they are able towork with suppliers that are not locked in by theircompetitors because they were not the first one tomove to China in terms of the automotive sector.

By doing so, they have created a supply base thatover the years has blossomed quite substantially.And after five or six years, they are sourcing up to5% to 10% of their volume from China. This is quitesubstantial for automotive companies, given the JITrequirements that you can’t source everything fromoverseas. So, I think that this company basicallyentered into this particular angle by leveragingsupplier development.

Knowledge@Wharton: What sorts of benefits has thiscompany particularly seen from its efforts in China?Can you tell us how much they’ve saved in terms ofcosts and other things that they’ve achieved?

Lee: Well, I think there have been substantial costsavings. And of course in the automotive area,what we have seen quite generally [is that] in mostof the companies coming over to China to sourceautomotive parts, in terms of casting toolings, theycan save up to 40% to 60% from the cost that theywould have paid if they were made in the U.S. or inWestern Europe.

If you are talking about harnesses, if you are talkingabout aluminum wheels — some of these productsrange from the low teens to about 30%. So a widerange of products really depends on what kind ofproducts you want to source and how well you’resourcing.

Knowledge@Wharton: What are some of the mis -conceptions about sourcing in China that companiesmight have before they embark on that kind of anendeavor or when they are just getting into it?

Lee: I think that the one major misconception is:“Well, we need to go to China. Let’s build a Chinasourcing office and once you finish cutting theribbon, that everything [will be] business as usual.”

We have seen quite a number of cases in a lot ofWestern companies when they come to China thatway.

Yes, of course you will always save money fromChina. You will always increase maybe 10% to 20%annually. We have seen a lot of the good companiesdoubling every two to three years in terms of theirChina sourcing volume. Given that you are startingfrom a very, very small percentage of turnoverbeing sourced from China, unless you have quite asubstantial increase in volume like this, you will nothave a major impact in your organization.

I always work with our clients to give them anestimate. Usually it would take you years just to get10% of your volume sourced from China. You aretalking about, on average, saving about 20%. So thatis probably about 2% impact on your EBIT. This isquite substantial, but it takes years for you to obtain.

The question for a lot of companies is, “How canI go beyond 10%? How can I go to 20% or 30%?”This will require a lot of commitment, not onlyfrom the CEO, but all the way to the operating-level

people. A lot of the disconnect we have seen in thepast is that the CEO will tell Wall Street about onething, and then the operating-level people have noidea how he came up with all these targets. Andas a result of this, they gave up. We have seen thathappen all the time.

Knowledge@Wharton: Is there anything else thatyou would like to talk about to give our listenersan idea of what the current hot issues are in termsof sourcing and what the next couple of years arelikely to look like in the area of procurement?

Lee: Well, I think the major issue that we have seenin the past — and probably will [see] in the nearfuture – [is] convincing headquarters or convincingyour technical team that China is a viable source. Ithink a lot of companies have found different waysto achieve that. Definitely, there are a lot of internalmarketing tools that the China sourcing teamleader is implementing in China, and [is] actuallygoing back to the U.S. and to Europe to do a lot of



marketing or a “road show” to tell everybody howgreat Chinese suppliers are.

We have seen some companies doing what theycall “China Supply Day.” They fly a lot of theirexecutives, including the quality people [and] theengineering people, to China to look at all thesesuppliers and have a sourcing conference in China.

One company has flown in about 70 people from allover the world to meet with 200 selected suppliers.And through this week of meetings, they havearranged about 400 face-to-face meetings, oneon one, with some of these suppliers. As a resultof these activities, they were able to increase theamount of sourcing.

I think given that I’m based in China right now, alot of things don’t really surprise me anymore inChina. But I remember when I was still working inthe U.S. that a lot of the image of China was verybackward — [that it was] not very automated, that

machinery was rare, and that you basically have alot of sweat-shop work. And I think this is far fromthe truth right now.

A lot of suppliers are extremely capable, highlyautomated, and as a result, by bringing a lot of thedecision-makers to China to see for themselves,it actually opened their eyes and changed theperception. You cannot underestimate the impact ofchanging the nonbelievers [and] the impact of thaton the entire organization. And by changing theirattitude, the entire organization will start moving

toward the right direction. v



Marshall W. Meyer, professor ofmanagement at Wharton, has made many trips toChina to research the rapid growth of its economyand the successes and difficulties it has hadin growing so quickly. In this interview, Meyerdiscusses the recent controversy surroundingChina’s exports of substandard toys and pharma -ceuticals to the United States, and the implicationsfor supply-chain management.

Knowledge@Wharton: As you know, there’s beenno shortage of press reports in recent months aboutthe questionable quality of many of the productsthat are coming out of China. What is your take onthis issue? How serious a problem is this?

Meyer: Any time a product poses risks to children

and poses risks to people who are seeking medicaltreatment it’s a serious problem. So the magnitudeof the problem may be limited, but still I think wehave to take all of these issues quite seriously.

Knowledge@Wharton: In your view do the pressreports that we have been seeing on China’sproducts parallel in any way the products that wereproduced, say, by Japan back in the 1950s when itwas emerging from World War II and trying to getits economy going. Are there historical parallels tothese issues with China?

Meyer: There are and there aren’t. The parallel isthis: If you look at Japan prior to the 1960s or Koreaprior to the 1980s, a lot of the products they wereproducing were inexpensive products. People wouldsometimes joke about them. I don’t think that theproducts coming out of Japan and Korea at thosetimes posed threats to kids, but my memory couldbe wrong on this.

Subcontracting and Product Quality in China

I do have a distinct recollection, however, fromthe early 1970s when model railroad shops wereretailing some HO trains from Korea [that] weremarketed as “the disaster series.” They were so badthat they were a joke. But of course, things have

changed very, very rapidly for Japan and for Korea.

Knowledge@Wharton: And in the case of China,would you say that the experience of these shoddyproducts, for lack of a better word, has beenlimited? Is there something inherent in manu -facturing systems in that country or in the waythat companies in China approach manufacturingthat has led to these kinds of problems? Is thereanything inherently awry in China that would causethis kind of thing?

Meyer: I don’t know if it’s inherently awry in China,but I think there are some differences betweenChinese and U.S. systems that U.S. firms and U.S.distributors don’t fully appreciate. Let me start withan example close to home. We’ve all been readingabout the Boeing 787, and as of this morning,Boeing promises that the Dreamliner will bedelivered on time.

“Any time a product poses risks tochildren and poses risks to peoplewho are seeking medical treatment,it’s a serious problem.”

—Marshall W. Meyer, professor omanagement, Wharto





to take. As everyone knows, in China transactionsoccur between people who know one another. Youhave dinner three or four times and do a transaction.[It’s] not the other way around. As a consequence,in order to be sure that contracts are carried out aswritten, you have to have people over there.

You have to have people in-country. You haveto have people who are actively monitoring the

execution of contracts. I think Western firms haveunderestimated the need to have people on theground actually watching what their suppliers aredoing. I don’t think the suppliers would take thisas a burden. They would take it as a compliment— someone’s there, they want to talk with us, theywant to be our friend, and they want to eat mealswith us.

This will cost money. But I think in the end, the costto the firms — also, most important, the cost tothe consumer — is going to be a heck of a lot less.So I would strongly urge firms to reconsider theirpolicies encouraging arm’s length and low-costtransactions and investing more in putting their ownpeople on the ground over there with their suppliersand subcontractors, if there are any, so that theycan be sure who is producing the goods for whichthey are ultimately responsible.

Knowledge@Wharton: Are there any impedimentsin place within China, perhaps imposed by thegovernment or maybe just cultural impedimentsthat would not permit procurement people outsideChina from going into the country?

Meyer: I think quite the opposite. I think that itwould be encouraged over there because peopleare always complimented when someone comes tovisit them. You know, so many conversations withfolks in China end up, “Come visit Beijing. Comevisit Shanghai. Come visit Suzhou.” So I think quitethe opposite. I think that would be welcome by allparties. I think that at the end of the day it’s goingto be far more effective than relying on the centralgovernment to take care of these issues.

Knowledge@Wharton: Let’s assume for example,that a firm, someone listening to our podcast, hisor her company is thinking of sourcing from China,or if they already are maybe increasing the amountof business they do there. What specific people,employees, should be going to China to do thethings that you suggest? Should they be peoplewho are well-versed in procurement? Or shouldthey be more senior company managers in order toshow the Chinese that they have a great interest inworking with suppliers?

Meyer: If senior people have time, a courtesy visitor two always is very helpful. You get your picturetaken, your picture is on the wall, [and] you becomea presence. But I think some operational peopleshould take a look alongside the procurementpeople. The procurement folks are motivated bycost, the operational people more likely by quality.

So I think it is very important that people have deep

familiarity with a production process. Look at thecontractors’ and subcontractors’ processes in orderto verify that those processes are going to produceproducts to the standard you are expecting.

Knowledge@Wharton: Does this mean that folksfrom outside China, who are going there, shouldexpect to spend, what would you say, days, weeks,months at a time at a given site? Or should they betraveling back and forth frequently? As a practicalmatter, how much time do you think would beinvolved in this?

Meyer: I don’t think weeks are required. I thinkdays are required on-site. It would depend on theindustry: the more complicated the technology, themore time. But a single visit is not going to do it.You’ve got to go and renew those relationshipsevery four months [to] six months. Probably once ayear is not enough. So it’s not extended travel, butit’s perhaps more frequent travel that’s in order.

Knowledge@Wharton: Do you think that there areany lessons that can be learned by procurementpeople who are perhaps sourcing from other

countries, from countries other than China, whetherit’s in Latin America or India that can be applied tothe Chinese experience?

I guess what I am saying is, if Company X has beensourcing from, say, India for a while and decidesthat they want to increase their activity in China, isthere anything that’s transferable from one countryto another?

Meyer: It’s hard to say. You know people developa general savvy about working outside their homecountry and that’s always quite valuable. But I think

that China is almost unique in the extensivenessof subcontracting. India, which has very, very largefirms, may not be similar. My guess, but I don’tknow, may be that Latin America is also going tohave much larger companies than China and not beso involved in subcontracting.

Knowledge@Wharton: In terms of the Chineseexperience with quality issues, do you think thatit’s going to take a long time for a lot of thoseissues to be resolved, in terms of China bringing



its processes up to snuff, etc., educating the rightpeople and finding the managers to run thesesmaller companies that you have talked about? Isthis going to be a long time coming or are we goingto be reading about quality issues in China for manyyears to come?

Meyer: I think that the issue will always be withus, but I also think its significance will fade a bit

because the market will punish firms bringinginferior goods into the U.S. or any Western country.In the U.S. we have strict liability. Everyone in thesupply chain is liable. And, as a consequence, firmslike Mattel again will pay a lot more attention thanthey used to to the quality of goods that are comingout of China. I think the longer-term issue is goingto be the quality of goods available to the Chineseconsumer because the laws in China are notenforced with the same rigor as they are in the U.S.

And so it’s going to be a longer time, I think, beforethe Chinese public can be as confident of what theyare buying as can the public in the U.S., WesternEurope and the like. v







at a premium, so that if your more distant supplychain partner is not able to deliver, you have abackup plan.

Knowledge@Wharton: What should a company doto increase the odds that it will be successful?

Tevelson: I think increasing the odds of successis having clear objectives. And that’s more so onthe pricing/hedging end, which is understand -ing what it is we are trying to accomplish, whatare the objectives of the program, what degreeof risk we’re willing to take on, and then basicallyinvesting appropriately in resources to ensure thatwe have a solid foundation of fact [and] we havea good perspective on what may happen in thefuture. Obviously, the more speculative it is, themore informed it is [and] the better the strategy andhopefully the better the result.

Knowledge@Wharton: What changes do youforesee in commodity risk management in the

months and years to come?

Tevelson: I think companies are going to get moresophisticated as their P&Ls are exposed every dayto more and more of this volatile raw materialinput cost. So I think companies are going toincrease their sophistication. I think you’ll see morecompanies engaging in hedging.

I think one thing that we haven’t talked about [that]I’d like to touch on is the types of hedges that youcan get involved with. The most simple of courseis a financial instrument in a liquid market, whereyou could just basically buy the insurance in themarketplace. What’s more interesting to me andsomewhat trickier is when the liquid market doesn’texist. And then you look at: How do I hedge myprice through, for example, longer supplier relation -ships, meaning contract duration?

Or, two, looking at potentially vertical integration:Am I best suited to buy the raw materials to assuresupply and manage the price? You are seeing a lot ofconsolidation in the steel market at the moment andalso a lot of concentration in the raw materials, in

terms of ore and coke going into the industry. And Ithink that that’s a very, very interesting dynamic.

And then finally, another thing that companies aredoing is trying to identify things that are correlatedin terms of performance, a proxy hedge if youwill, hedging one item because it is correlated toanother. And those get to be tricky because thereare a lot of accounting issues. But I think the non-financial-instrument hedging strategies are the most

interesting because they’re pretty strategic andrequire creativity.

Knowledge@Wharton: Do you think that thehedging strategies you’ve just discussed briefly willcontinue to be important in the years to come?

Tevelson: I think they’ll increase in importance. Ithink what we are seeing in the commodity marketsright now is exposing companies to what themarketplace has been doing in maybe a smallersubset. And I think the impact, in terms of thegrowth of prices and the volatility up and down, isgetting people to think more and more about whatneeds to be done.

So, I would suggest that commodity hedgingstrategies are growing in importance and you’llsee more and more people pursuing them. I thinkwhat will be interesting is to see what the evolutionis on the more creative side, how industries mayrestructure based on commodity risk management,

and how people will come up with innovativeways to work with their suppliers to offset that to adegree.

Knowledge@Wharton: Finally, do you have anyviews on where commodity risks are heading? WhatI mean by that is, we know that the price of oil hasbeen soaring in recent months, for instance, and itis a key commodity to everyone, every business,every industry in the world. Are there other sectorswhere you see risks increasing in terms of supplierprice that organizations should be aware of?

Tevelson: I think oil is a great example [as wellas] precious metals, with gold where it is atthe moment — some people are predicting itto be $1,000 an ounce. I think it’s at $823-plusthis morning. So I think it’s a broad range ofcommodities which will be exposed to this.

I think part of it is the dynamics of the worldeconomy — India and China pulling a lot more ofthe natural resources in terms of demand. Theireconomies are growing at a rapid rate and theirconsumption of basic commodities is growing.

And I think it’s that kind of draw in growth that willcontinue to increase pressure and will continueto get companies thinking differently aboutcommodities and commodity risk management.

Knowledge@Wharton: From what you are saying,it sounds like no company is immune from theserisks — that pretty much, it’s going to affecteveryone who’s doing business.



Tevelson: I think it will affect companies, somemore so than others.…. I was talking to a seniorexecutive in procurement just yesterday from oneof the major [airline industry] players in the U.S.,and fuel this year has eclipsed labor as the numberone cost element in their business. It has increasedseven-fold over the last few years. That’s just aphenomenal growth rate. And I just think that it’sabsolutely critical that companies get on top of it,and I think it will just increase in importance. v



These days, when the U.S. Department ofDefense buys a fighter jet from Lockheed Martin,it doesn’t simply pay Lockheed for the physicalproduct. Instead, the government has a “perfor -mance-based contract” with the defense supplier,according to Serguei Netessine, professor ofoperations and information management atWharton. This contract says, in effect, that thegovernment’s reimbursement to Lockheed hingeson the jets’ performance –- that is, how often theplanes are able to fly. In this interview, Netessinedescribes how performance-based contracts arebecoming more common in a variety of industries.

Knowledge@Wharton: We are going to talk aboutsomething called “performance-based logistics,” andthere is another interesting phrase called “power

by the hour.” In some recent research that you havedone, you have also talked about the aerospaceindustry and even Rolls-Royce, which factor intoour discussion today. You worked on a researchproject with Morris Cohen, who is also a professorat Wharton, on this whole idea of something calledperformance-based logistics. Can you take a minuteor two to describe what that means?

Netessine: Sure. I guess the project itself startedwith our joint work with Lockheed Martin. LockheedMartin is one of the biggest suppliers to the [U.S.]

Department of Defense, as they manufacture a varietyof products. One of the best-known products is theJoint Strike Fighter, which is a fighter jet. … LockheedMartin is going to be manufacturing and servicing [it]over the next 50 or 70 years and that is going to be astandard fighter jet used by all NATO nations.

So this product is extremely expensive [and]extremely costly to manufacture, but it is evencostly to service because the life span of thisproduct is very long. An airplane is going to be

Performance-based Logistics

in service maybe 30, 40, 50 years, and over thislifetime Lockheed Martin will have to make sure theairplane is operational.

Now what the Department of Defense wants from

Lockheed Martin is a performance-based contract.That is, Lockheed Martin doesn’t get paid if anairplane doesn’t fly. And this is a very radical trans -formation, a very radical departure from the waythe Department of Defense used to operate let’ssay 40, 50 and even 10 years ago. Previously, theDepartment of Defense would ask their suppliersto open their books and basically report to theDepartment of Defense how much money theyspent on maintenance of military equipment. Andthen the Department of Defense would reimbursethose suppliers and maybe give them a little

something to make a small profit margin. That ishow it used to work.

And for suppliers it was very easy and under -standable. They didn’t really need to keep track oftheir costs. They could just charge whatever wasnecessary and then open their books and be surethat they would be reimbursed. Not anymore. Nowthe Department of Defense says, “I don’t care howyou make this plane fly, whether you open morewarehouses for spare parts or maybe you train youremployees better, or maybe you design a better

“…Lockheed Martin doesn’t get paif an airplane doesn’t fly. And this a very radical transformation…. ”

—Serguei Netessine, professor of operatioand information management, Whart



product. All I care about is that the plane flies.”

And now suppliers have to basically start thinkinghard about how much it is going to cost them tomake sure that this airplane flies most of the time.Typically the Department of Defense requires a veryhigh availability, something like 95% of the time theplane has to fly.

So that in a nutshell is the basic idea behind per -formance-based logistics. You are compensated noton promise of performance and not on your cost oranything like that. You are compensated based onthe actual performance of your product.

Knowledge@Wharton: When you say LockheedMartin will be compensated for the amount of timethat their planes fly, do you mean then in a sensethat when the planes are mechanically fine andoperational and able to fly or do you mean actuallyhours spent in the air doing missions?

Netessine: This is a great question and this isthe kind of kink that is still being worked on.So typically what happens is the Department ofDefense gives a certain forecast of how much theyneed to fly this plane, and there is some kind of afloor and some kind of a ceiling because everybodyunderstands that if there is a new war, for example,then demand is going to go up and if there is a cutin the budget then demand is going to go down.

But there are certain limits within which theDepartment of Defense promises Lockheed Martin,for example, that the plane will be used between1,000 and 2,000 hours in a given month. Andthen whenever the Department of Defense needsthis plane, it has to fly 95% of the time, it has tobe available 95% of the time. So it is kind of acombination. On one hand, there should be demandfor flying hours from the Department of Defense.On the other hand, Lockheed Martin is protected alittle bit from wild fluctuations in demand for theairplane.

Knowledge@Wharton: The whole notion of perfor -mance-based contracting applies to other industries,

not just say the Defense Department and a defensecontractor. Can you discuss a couple of the otherbusinesses, other industries that are affected byperformance-based contracting or are beginning toadopt it?

Netessine: Absolutely. Actually the precursor toperformance-based contracting was, I believe, anarrangement in the commercial airline industrywhich was called “power by the hour.” For example,if you just look at any kind of commercial airplane

flown by any commercial airline, typically theengines are covered by a separate contract betweenthe airline and engine manufacturer.

There are only a few engine manufacturers. Thereis General Electric, there is Pratt & Whitney, andthere is Rolls-Royce, for example. And the contracteven going back 10 or 20 years would basicallyspecify that the airline pays for the flying hours of

the engine. And then the engine manufacturer orany kind of a third party that is providing service forthose engines has to make sure that those enginesare operational whenever they are needed.

So these kinds of arrangements existed for a longtime and they were basically the driving forcebehind this decision of the Department of Defenseto switch to performance-based contracting,because over the years those relationships workedvery well in commercial aerospace.

Knowledge@Wharton: And it was Rolls-Royce that

coined that phrase “power by the hour?”

Netessine: I believe so. Of course, this was someyears back and it is hard to trace it now, but Ibelieve that Rolls-Royce was the first one. I alsobelieve they probably have the best experiencewith those kinds of contracts. So Rolls-Royce, forexample, provides engines to commercial airlines,but they also provide engines to military aircraft andmilitary helicopters. So for them it was probablythe easiest transformation to bring it from thecommercial side to the military side.

Knowledge@Wharton: The industries that you’vediscussed so far are certainly key industries for theUnited States and really for any other industrialcountry. But I think that there may be some appli -cations of this idea in the retail sector as well, andfor products that may impact consumer-goodscompanies and average people like you and I andour listeners in terms of the products they buy. Isthat true?

Netessine: Possibly. So what we have seen sofar, for example, is there are a few applications of

performance-based contracting. In the chemicalindustry, where, let’s put it simply, a chemicalcompany needs from its supplier some kind ofservice, let’s say cleaning of equipment with somekind of chemicals. Previously we would see thatthe company would just buy those chemicals [and]pay for those chemicals to the supplier to clean theequipment. But in reality, what the company caresabout is that the equipment gets cleaned. So thecompany doesn’t really want to buy those chemicalsand care about those chemicals.



So we see a transformation toward what is called“servicization,” and servicization is kind of a biggerumbrella word for transforming the business from

just buying parts, buying products, [and] procuringproducts to procuring services. In the chemicalindustry example, this would be procuring cleaningservices, and you would pay for the quality ofcleaning rather than for the chemicals that are used.

Another example is commercial and residentialair conditioning systems. In those again, thereare very large systems, and very often a buildingowner would buy an air conditioning system for thebuilding and pay for the air conditioning system,and then pay for services of this air conditioningsystem. But really, all the owner cares about is thatthe system works and it delivers cold air to thebuilding.

So a lot of companies, a lot of manufacturers ofthose air conditioning systems, for example, havebeen moving toward paying for performance. Abuilding owner would pay the provider of an airconditioning system for the time the system isoperational, paying for system uptime, for systemoperation 99% of the time or better.

So that’s another example of moving toward ser -vicization and performance-based contracting, or“power by the hour.”

Knowledge@Wharton: A recent study that you andProfessor Cohen worked on is titled “PerformanceContracting in After-Sales Service Supply Chains,”

which is a lengthy title, but it is the “after-salesservice” that is interesting. That is a big componentof the revenue and profitability components ofcompanies, is it not?

Netessine: I think it is much bigger than manycompanies realize. There are a few studies that havebeen done and they demonstrated that very oftenwhen you have complex sophisticated equipmentlike an airplane, let’s say, companies pay muchmore for servicing this equipment than for buyingthis equipment. Moreover, this turns out to be amuch more profitable line of business. On average,providing service, providing maintenance on anairplane, for example, is at least twice as profitableas selling airplanes themselves.

So I think the best class of companies has beenslowly moving toward providing more and moreservices rather than selling equipment. A goodexample might be Best Buy with their Geek Squad.Geek Squad is those guys who come to your houseand service your computer or TV or whateverelse you might have. And this turned out to be a

business that is still in high demand and a highlyprofitable business.

So I absolutely agree, this is becoming a hugepart of our economy, and companies are realizingmore and more that you can make more money byservicing rather than by selling.

Knowledge@Wharton: And is performance-basedcontracting or performance-based logistics aconcept that executives and managers andprocurement departments in companies know aboutnow and have accepted and are thinking aboutand are implementing, or is it for some companiesperhaps a relatively new idea that hasn’t beenpercolating to the executive suite yet?

Netessine: I believe it is a relatively new idea.It depends on the industry. So in commercialaerospace, for example commercial aircraft, thisidea has existed for about 20 [to] 30 years now.And when you look [at] the military -- how the

Department of Defense did business historically --that’s a very new idea.

What executives need to understand, I believe, isthat whenever you have a contract with a supplierfor delivery of any kind of service, you have tothink carefully about what incentives are createdby such contracts. As I mentioned in the beginning,historically the Department of Defense used to, forexample, reimburse all suppliers based on theircosts.

Well what kind of incentives does this arrangementcreate? Very clearly, the supplier has absolutely noincentive to reduce costs because everything thatthe supplier incurs in terms of cost is going to bereimbursed. So why should I care about reducingmy costs? On the contrary, I am going to inflate mycosts to the extent possible. So that created veryperverse incentives and great dissatisfaction withthe Department of Defense with respect to efficiencyof suppliers.

On the other hand, when you go to perfor -mance-based logistics and you start reimbursing

suppliers just on performance of the airplane orwhatever that might be -- some weapons systemsmaybe -- then both the supplier and the buyer ofthe service care about the same thing. The buyerwants to increase availability of the airplane andthe supplier wants to increase availability of theairplane because the supplier is paid based on avail -ability.

If you apply this kind of relatively simple thinking toany kind of relationship that the company has with





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