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2007 Pearson Education 13-1
Chapter 14
Sourcing Decisions in a Supply Chain
Supply Chain Management
(3rd Edition)
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Outline
The Role of Sourcing in a Supply Chain
Supplier Scoring and Assessment
Supplier Selection and Contracts
Design Collaboration
The Procurement Process
Sourcing Planning and Analysis
Making Sourcing Decisions in Practice
Summary of Learning Objectives
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Some Definitions
Sourcing:Finding sources of supply, guaranteeing continuity in supply,ensuring alternative sources of supply and gathering knowledge of
procurable resources.
Procurement:All activities that are required in order to get the product andservices from the supplier to its final destination
Purchasing:
All activities for which the company receives an invoice fromoutside parties
Outsourcing:
in-house performed activities are transferred to a third party
13-3
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The Role of Sourcing
in a Supply Chain
Sourcing processes include:
Supplier scoring and assessment
Supplier selection and contract negotiation Design collaboration
Procurement
Sourcing planning and analysis
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Benefits of Effective
Sourcing Decisions
Better economies of scalecan be achieved if orders areaggregated
More efficient procurement transactions can significantlyreduce the overall cost of purchasing
Design collaborationcan result in products that areeasier to manufacture and distribute, resulting in loweroverall costs
Good procurement processes can faci l i tate coordinationwith suppliers
Appropriate suppl ier contractscan allow for the sharingof r isk
Firms can achieve a lower purchase price by increasingcompetition through the use of auctions
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In-house or Outsource Decision
Make or buy materials or components is a strategic decisionthat can impact an organizations competitive position.
Buy/ Outsourcing
In-house Make
Backward Integration
Forward IntegrationVS.
Strategic Decision Drivers:
Strategic Advantage Cost
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Reasons for Making
Protect proprietary technology
No competent supplier
Better quality control
Use existing idle capacity
Control of lead-time, transportation, and
warehousing cost
Lower cost
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Rationales for outsourcing
Strategicreasons for
outsourcing
1. Improve company focus
2. Gain access to world class capabilities
3. Get access to resources that are not available
internally
4. Accelerate reengineering benefits
5. Improve customer satisfaction
6. Increase flexibility
7. Sharing risks
Tactical reasons
for outsourcing
1. Reduce control costs and operating costs
2. Free up internal resources
3. Receive an important cash infusion
4. Improve performance
5. Ability to manage functions that are out of control
All these reasons underlie one overall objective: to improve the overall
performance of the outsourcing firm
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Strategic decision for outsourcing
Maintain / invest (opportunistically)
Competencies are not strategic
but provide important advantages;
keep in-house as long these
advantages are (integrally) real
In-house / invest
Competencies are strategic and
world-class;
focus on investments in technology
and people; maximize scale and
stay on leading edge
Outsource
Competencies have
no competitive advantage
Collaborate / maintain control
Competencies are strategic but
insufficient to compete effectively;
explore alternatives such aspartnership, alliance, joint-venture,
licensing, etc.
High
Low
Levelofcompetit
iveness
relativetosupp
liers
Strategic importance of competenceHigh
(core)
Low
(non-core)
Savelkoul, 2008
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How Do Third Parties Increase the
Supply Chain Surplus
Capacity aggregation gives economies of scale
Inventory aggregation reduces uncertainty
Transportation aggregation allows to convertLTL/LCL to TL/FCL
Consolidated deliveries reduce distance per drop
Warehouse aggregation
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How Do Third Parties Increase the
Supply Chain Surplus
Procurement aggregation gives economies of scale
Information aggregation
Receivables aggregation
Relationship aggregation
Low costs and higher quality
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Risk of Using Third Party
The process is broken
Cost of coordination
Reduction of customer/supplier contact
Loss of internal capability and growth in third-party
power
Leakage of sensitive data and information
Ineffective contracts
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3PL and 4PL
A thirdparty logistics (3PL) provider performs one or more
of the logistics activities relating to the flow of product,
information, and funds that could be performed by the firm
itself.
A fourth-party logistic is an integrator that assembles the
resources, capabilities and technology of its own organization
and other organizations to design, build and run comprehensive
supply chain solutions. Andersen Consulting (now
Accenture) A general contractor who manages other 3PLs, truckers, forwarders,
custom brokers, and others essentially taking responsibility of a
complete process for the customer
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Sources of Information
Current suppliers
Preferred suppliers
Sales representatives
Information databases
Experience
Trade journals
Trade directories
Trade shows
Second-party or indirect
information
Internal sources
Internet searches
gement, 4e 14
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Supplier Scoring and Assessment
Supplier performance should be compared on the
basis of the suppliers impact on total cost
There are several other factors besides purchase price
that influence total cost
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Supplier Assessment Factors
Replenishment Lead Time
On-Time Performance
Supply Flexibility
Delivery Frequency /Minimum Lot Size
Supply Quality
Inbound Transportation Cost
Pricing Terms
Information Coordination
Capability
Design CollaborationCapability
Exchange Rates, Taxes,
Duties
Supplier Viability
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The Weighted-Criteria Evaluation
system
1. Select mutually acceptable performance dimensions
2. Assign weight based on their relative importance to the company
objectives
3. Monitor and collect performance data (0100)
4. Calculate weighted sum of the performance data
5. Classify suppliers based on their overall score:
i. Unacceptable (less than 50)
ii. Conditional (between 50 and 70)iii. Certified (between 70 and 90)
iv. Preferred (greater than 90)
6. Audit and perform ongoing certification review
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Example for the XYZ Supplier company
Performance Measure Rating X Weight = Final Value
Technology 80 0.10 8.00
Quality 90 0.25 22.50
Responsiveness 95 0.15 14.25
Delivery 90 0.15 13.50
Cost 80 0.15 12.00
Environmental 90 0.05 4.50
Business 90 0.15 13.50
Total Score 1.00 88.25
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Supplier Selection- Auctions and
Negotiations
Supplier selection can be performed through competitive
bids, reverse auctions, and direct negotiations
Supplier evaluation is based on total cost of using a
supplierAuctions:
Sealed-bid first-price auctions
English auctions
Dutch auctions
Second-price (Vickery) auctions
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Supply Contract
Supply Contract can include the following:
Pricing and volume discounts.
Minimum and maximum purchase quantities.
Delivery lead times.
Product or material quality.
Product return policies.
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Supply Contracts for Strategic
Components
1. Make to Order Supply Chain Contractsi. Sequential Supplier, Contracts?
ii. Buy Back Contracts
iii. Revenue Sharing Contracts
iv. Quantity-Flexibility Contracts
v. Sales Rebate Contract
vi. Global Optimization
2. Make to Stock Supply Chain Contractsi. Pay Back Contracts
ii. Cost Sharing Contracts
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Supply Contracts for Strategic
Components
1. Contracts with Asymmetric Information
i. Capacity Reservation Contracts
ii. Advance purchase contracts
2. Contracts for Non-Strategic Componentsi. Long-Term Contracts
ii. Flexible, or option, Contract
iii. Spot Purchase
iv. Portfolio Contract
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1. Make to Order Supply Chain
Contracts
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2-Stage Sequential Supply
Chain
A buyer and a supplier who want to optimize ownprofit.
Buyers activities:
generating a forecast determining how many units to order from the supplier
placing an order to the supplier so as to optimize his ownprofit
Purchase based on forecast of customer demand
Suppliers activities: reacting to the order placed by the buyer.
Make-To-Order (MTO) policy
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Swimsuit Example
2 Stages: a retailer who faces customer demand
a manufacturer who produces and sells swimsuits to theretailer.
Retailer Information: Summer season sale price of a swimsuit is $125 per unit.
Wholesale price paid by retailer to manufacturer is $80 perunit.
Salvage value after the summer season is $20 per unit
Manufacturer information: Fixed production cost is $100,000
Variable production cost is $35 per unit
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What Is the Optimal Order
Quantity?
Retailer marginal profit is the same as the marginal profit of themanufacturer, $45.
Retailers marginal profit for selling a unit during the season,$45, is smaller than the marginal loss, $60, associated with
each unit sold at the end of the season to discount stores.Optimal order quantity depends on marginal profit and
marginal loss but not on the fixed cost.
Retailer optimal policy is to order 12,000 units for an averageprofit of $470,700.
If the retailer places this order, the manufacturers profit is12,000(80 - 35) - 100,000 = $440,000
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Sequential Supply Chain
FIGURE 4-1: Optimized safety stock
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Risk Sharing
In the sequential supply chain: Buyer assumes all of the risk of having more inventory than
sales
Buyer limits his order quantity because of the huge financial risk.
Supplier takes no risk.
Supplier would like the buyer to order as much as possible Since the buyer limits his order quantity, there is a
significant increase in the likelihood of out of stock.
If the supplier shares some of the risk with the buyer
it may be profitable for buyer to order more reducing out of stock probability
increasing profit for both the supplier and the buyer.
Supply contracts enable this risk sharing
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Buy-Back Contract
Seller agrees to buy back unsold goods from the buyer
for some agreed-upon price.
Buyer has incentive to order more
Suppliers risk clearly increases.
Increase in buyers order quantity
Decreases the likelihood of out of stock
Compensates the supplier for the higher risk
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Buy-Back Contract
Swimsuit Example
Assume the manufacturer offers to buy unsoldswimsuits from the retailer for $55.
Retailer has an incentive to increase its order quantityto 14,000 units, for a profit of $513,800, while themanufacturers average profit increases to $471,900.
Total average profit for the two parties
= $985,700 (= $513,800 + $471,900)
Compare to sequential supply chain when total profit= $910,700 (= $470,700 + $440,000)
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Buy-Back Contract
Swimsuit Example
FIGURE 4-2: Buy-back contract
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Revenue Sharing Contract
Buyer shares some of its revenue with the supplier
in return for a discount on the wholesale price.
Buyer transfers a portion of the revenue from each
unit sold back to the supplier
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Revenue Sharing Contract
Swimsuit Example
Manufacturer agrees to decrease the wholesale pricefrom $80 to $60
In return, the retailer provides 15 percent of theproduct revenue to the manufacturer.
Retailer has an incentive to increase his order quantityto 14,000 for a profit of $504,325
This order increase leads to increased manufacturersprofit of $481,375
Supply chain total profit= $985,700 (= $504,325+$481,375).
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Revenue Sharing Contract
Swimsuit Example
FIGURE 4-3: Revenue-sharing contract
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Other Types of Contracts
Quantity-Flexibility Contracts
Supplier provides full refund for returned (unsold) items
As long as the number of returns is no larger than a certainquantity.
Sales Rebate Contracts
Provides a direct incentive to the retailer to increase sales bymeans of a rebate paid by the supplier for any item soldabove a certain quantity.
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Global Optimization Strategy
What is the best strategy for the entire supply chain?
Treat both supplier and retailer as one entity
Transfer of money between the parties is ignored
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Global Optimization
Swimsuit Example
Relevant data Selling price, $125
Salvage value, $20
Variable production costs, $35
Fixed production cost.Supply chain marginal profit, 90 = 125 - 35
Supply chain marginal loss, 15 = 3520
Supply chain will produce more than average demand.
Optimal production quantity = 16,000 unitsExpected supply chain profit = $1,014,500.
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Global Optimization
Swimsuit Example
FIGURE 4-4: Profit using global optimization strategy
Global Optimization and Supply
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Global Optimization and Supply
Contracts
Unbiased decision maker unrealistic Requires the firm to surrender decision-making power to an unbiased
decision maker
Carefully designed supply contracts can achieve as much as
global optimizationGlobal optimization does not provide a mechanism to allocate
supply chain profit between the partners. Supply contracts allocate this profit among supply chain members.
Effective supply contracts allocate profit to each partner in a
way that no partner can improve his profit by deciding todeviate from the optimal set of decisions.
I l t ti D b k f
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Implementation Drawbacks of
Supply Contracts
Buy-back contracts Require suppliers to have an effective reverse logistics system
and may increase logistics costs.
Retailers have an incentive to push the products not under thebuy back contract.
Retailers risk is much higher for the products not under the buyback contract.
Revenue sharing contracts Require suppliers to monitor the buyers revenue and thus
increases administrative cost.
Buyers have an incentive to push competing products withhigher profit margins. Similar products from competing suppliers with whom the buyer
has no revenue sharing agreement.
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2. Contracts for Make-to-Stock Supply Chains
Previous contracts examples were with Make-to-
Order supply chains
What happens when the supplier has a Make-to-Stocksituation?
Supply Chain for Fashion Products
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Supply Chain for Fashion Products
Ski-Jackets
Manufacturer produces ski-jackets prior to receivingdistributor orders
Season starts in September and ends by December.
Production starts 12 months before the selling season
Distributor places orders with the manufacturer six months later.
At that time, production is complete; distributor receives firmsorders from retailers.
The distributor sales ski-jackets to retailers for $125 per unit.
The distributor pays the manufacturer $80 per unit.
For the manufacturer, we have the following information: Fixed production cost = $100,000.
The variable production cost per unit = $55
Salvage value for any ski-jacket not purchased by the distributors= $20.
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Profit and Loss
For the manufacturer Marginal profit = $25
Marginal loss = $60.
Since marginal loss is greater than marginal profit, themanufacturer should produce less than average demand, i.e., lessthan 13, 000 units.
How much should the manufacturer produce? Manufacturer optimal policy = 12,000 units
Average profit = $160,400.
Distributor average profit = $510,300.Manufacturer assumes all the risk limiting its
production quantity
Distributor takes no risk
M k t St k
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Make-to-Stock
Ski Jackets
FIGURE 4-5: Manufacturers expected profit
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Pay-Back Contract
Buyer agrees to pay some agreed-upon price for anyunit produced by the manufacturer but not purchased.
Manufacturer incentive to produce more units
Buyers risk clearly increases.Increase in production quantities has to compensate
the distributor for the increase in risk.
P B k C t t
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Pay-Back Contract
Ski Jacket Example
Assume the distributor offers to pay $18 for each unit producedby the manufacturer but not purchased.
Manufacturer marginal loss = 55-20-18=$17
Manufacturer marginal profit = $25.
Manufacturer has an incentive to produce more than averagedemand.
Manufacturer increases production quantity to 14,000 units
Manufacturer profit = $180,280
Distributor profit increases to $525,420.
Total profit = $705,400Compare to total profit in sequential supply chain
= $670,000 (= $160,400 + $510,300)
P B k C t t
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Pay-Back Contract
Ski Jacket Example
FIGURE 4-6: Manufacturers average profit (pay-back contract)
P B k C t t
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Pay-Back Contract
Ski Jacket Example (cont)
FIGURE 4-7: Distributors average profit (pay-back contract)
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Cost-Sharing Contract
Buyer shares some of the production cost with the
manufacturer, in return for a discount on the
wholesale price.
Reduces effective production cost for themanufacturer
Incentive to produce more units
C t Sh i C t t
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Cost-Sharing Contract
Ski-Jacket Example
Manufacturer agrees to decrease the wholesale pricefrom $80 to $62
In return, distributor pays 33% of the manufacturerproduction cost
Manufacturer increases production quantity to 14,000Manufacturer profit = $182,380
Distributor profit = $523,320
The supply chain total profit = $705,700
Same as the profit under pay-back contracts
C t Sh i C t t
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Cost-Sharing Contract
Ski-Jacket Example
FIGURE 4-8: Manufacturers average profit (cost-sharing contr
C t Sh i C t t
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Cost-Sharing Contract
Ski-Jacket Example (cont)
FIGURE 4-9: Distributors average profit (cost-sharing contract
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Implementation Issues
Cost-sharing contract requires manufacturer to shareproduction cost information with distributor
Agreement between the two parties:
Distributor purchases one or more components that themanufacturer needs.
Components remain on the distributor books but are shippedto the manufacturer facility for the production of thefinished good.
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Global Optimization
FIGURE 4-10: Global optimization
3 Contracts with Asymmetric
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3. Contracts with Asymmetric
Information
Implicit assumption so far: Buyer and supplier share
the same forecast
Inflated forecasts from buyers a reality
How to design contracts such that the informationshared is credible?
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Two Possible Contracts
Capacity Reservation Contract Buyer pays to reserve a certain level of capacity at the
supplier
A menu of prices for different capacity reservationsprovided by supplier
Buyer signals true forecast by reserving a specific capacitylevel
Advance Purchase Contract Supplier charges special price before building capacity
When demand is realized, price charged is different Buyers commitment to paying the special price reveals the
buyers true forecast
4 Contracts for Non Strategic
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4. Contracts for Non-Strategic
Components
Variety of suppliers
Market conditions dictate price
Buyers need to be able to choose suppliers and change
them as neededLong-term contracts have been the tradition
Recent trend towards more flexible contracts
Offers buyers option of buying later at a different price thancurrent
Offers effective hedging strategies against shortages
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Long-Term Contracts
Also calledforward or fixed commitment contracts
Contracts specify a fixed amount of supply to be
delivered at some point in the future
Supplier and buyer agree on both price and quantityBuyer bears no financial risk
Buyer takes huge inventory risks due to:
uncertainty in demand inability to adjust order quantities.
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Flexible or Option ContractsBuyer pre-pays a relatively small fraction of the product
price up-frontSupplier commits to reserve capacity up to a certain level.
Initial payment is the reservation price orpremium.
If buyer does not exercise option, the initial payment islost.
Buyer can purchase any amount of supply up to theoption level by:paying an additional price (execution price orexercise
price)
agreed to at the time the contract is signed Total price (reservation plus execution price) typically
higher than the unit price in a long-term contract.
Fl ibl O ti C t t
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Flexible or Option Contracts
Provide buyer with flexibility to adjust order quantities
depending on realized demandReduces buyers inventory risks.
Shifts risks from buyer to supplier Supplier is now exposed to customer demand uncertainty.
Flexibility contracts Related strategy to share risks between suppliers and
buyers
A fixed amount of supply is determined when the contractis signed
Amount to be delivered (and paid for) can differ by nomore than a given percentage determined upon signing thecontract.
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Spot Purchase
Buyers look for additional supply in the open market.
May use independent e-markets or private e-markets
to select suppliers.
Focus: Using the marketplace to find new suppliers
Forcing competition to reduce product price.
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Portfolio Contracts
Portfolio approach to supply contracts
Buyer signs multiple contracts at the same time optimize expected profit
reduce risk.
Contracts
differ in price and level of flexibility
hedge against inventory, shortage and spot price risk.
Meaningful for commodity products a large pool of suppliers each with a different type of contract.
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Appropriate Mix of Contracts
How much to commit to a long-term contract? Base commitment level.
How much capacity to buy from companies selling optioncontracts? Option level.
How much supply should be left uncommitted? Additional supplies in spot market if demand is high
Hewlett-Packards (HP) strategy for electricity or memoryproducts About 50% procurement cost invested in long-term contracts
35% in option contracts Remaining is invested in the spot market.
Risk Trade-Off in Portfolio
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Contracts
If demand is much higher than anticipated Base commitment level + option level < Demand,
Firm must use spot market for additional supply.
Typically the worst time to buy in the spot market
Prices are high due to shortages.
Buyer can select a trade-off level between price risk, shortagerisk, and inventory risk by carefully selecting the level of long-term commitment and the option level. For the same option level, the higher the initial contract commitment,
the smaller the price risk but the higher the inventory risk taken by the
buyer. The smaller the level of the base commitment, the higher the price and
shortage risks due to the likelihood of using the spot market.
For the same level of base commitment, the higher the option level, thehigher the risk assumed by the supplier since the buyer may exercise
only a small fraction of the option level.
Risk Trade-Off in Portfolio
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Risk Trade-Off in Portfolio
Contracts
Low High
Option level
Base commitment level
HighInventory risk
(supplier)N/A*
LowPrice and shortage
risks (buyer)
Inventory risk (buyer)
*For a given situation, either the option level or the base commitment level may be high, but not
both.
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Design Collaboration
50-70 percent of spending at a manufacturer isthrough procurement
80 percent of the cost of a purchased part is fixed inthe design phase
Design collaboration with suppliers can result inreduced cost, improved quality, and decreased time tomarket
Important to employ design for logistics, design formanufacturability
Manufacturers must become effective designcoordinators throughout the supply chain
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DESIGNING FOR MANUFACTURING
The designers consideration of the organizations
manufacturing capabilities when designing a product
Concurrent EngineeringComputer-Aided Design (CAD)Recycling
Remanufacturing
Design for DisassemblyComponent Communality
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Concurrent Engineering To achieve a smoother transition from product design to production, and to
decrease product development time, many companies are Usingsimultaneous development, or concurrent engineering.
In its narrowest sense, it brings design and manufacturing engineering
people together early in the design phase to simultaneously develop theproduct and the processes for creating the product.
May mean to include include manufacturing personnel (e.g., materialsspecialists) and marketing and purchasing personnel in loosely integrated,cross-functional teams.
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Computer-Aided Design (CAD)Computer-aided design (CAD) , Product design using
computer graphics.
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RecyclingRecovering materials for future use.
Cost savings., Environment concerns. Environmental regulations
An interesting note: Companies that want to do business
in the European Economic Com munity must show that a
specified proportion of their products are recyclable.
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Design for Recycling
Design for Recycling (DFR), referring to productdesign that takes into account the ability to
disassemble a used product to recover the recyclableparts.
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RemanufacturingRemanufacturing refers to refurbishing used products by
replacing worn-out or defective components, and
reselling the products.
This can be done by the original manufacturer, or anothercompany.
Among the products that have remanufactured components are
automobiles, printers, copiers, cameras, computers, and telephones.
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Design for Disassembly
Design for Disassembly (DFD) includes using fewerparts and less material, and using snap-fits where
possible instead of screws or nuts and bolts.
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The Purchasing Process
The process in which the supplier sends product in response toorders placed by the buyer
Goal is to enable orders to be placed and delivered on scheduleat the lowest possible overall cost
Two main categories of purchased goods: Direct materials: components used to make finished goods
Indirect materials: goods used to support the operations of a firm
Differences between direct and indirect materials listed in Table 14-7
Focus for direct materials should be on improving coordinationand visibility with supplier
Focus for indirect materials should be on decreasing thetransaction cost for each order
Procurement for both should consolidate orders where possibleto take advantage of economies of scale and quantity discounts
Manual Purchasing Process (Simplified)
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Manual Purchasing Process (Simplified)
User/Requisition
Storage/
Warehouse
Purchase
Accounting
Suppliers
Yes No
MR
PR
PO
PO
Invoice & PO
DO
Invoice
MR
MR= Material Requisition
PR = Purchase Requisition
PO = Purchase Order
DO = Delivery Order
RFQ/
RFP
& SO
RFQ= Request for Quotation
RFP = Request for Proposal
SO = Sales Order
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e-Procurement
MaterialUser
PurchasingDepartment/Buyer
Supplier
Material
Requisition
into ITsystem
Supplier
selection &
Issue PO
Bids
evaluation
Assigns
suppliers to
requisition
on B2Bsystem for
bidding
and
specificclosing
date and
other
conditions
Extracts &
merges
material
requisitiondata into
Internet
based B2B
system
Purchase
Order
Product Categorization by Value
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Product Categorization by Value
and Criticality (Figure 14.2)
Critical Items Strategic Items
General Items Bulk Purchase
Items
Low
Low
High
HighValue/Cost
Critica
lity
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Sourcing Planning and Analysis
A firm should periodically analyze its procurementspending and supplier performance and use thisanalysis as an input for future sourcing decisions
Procurement spending should be analyzed by part and
supplier to ensure appropriate economies of scaleSupplier performance analysis should be used to build
a portfolio of suppliers with complementary strengths
Cheaper but lower performing suppliers should be used tosupply base demand
Higher performing but more expensive suppliers should beused to buffer against variation in demand and supply fromthe other source
Making Sourcing
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a g Sou c g
Decisions in Practice
Use multifunction teams
Ensure appropriate coordination across regions
and business units
Always evaluate the total cost of ownershipBuild long-term relationships with key suppliers