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Operations Strategy

Building and Evaluating Firms Operating Systems


Week2 Partha Priya Datta

Supply Network Strategy

= Deciding on appropriate supply relationships for each activity. Three step approach: 1. Identify the activity and its requirements; 2. Make-or-buy decision: which activities are internal or not? 3. SRM: define, contract and manage the supplier relationship

Strategic Sourcing What is it?

Distinguish: Strategic buyers: lead cross-functional sourcing teams that develop sourcing strategy Tactical buyers: execute transactional purchase order processes

Purchasing, sourcing, procurement is the biggest single cost for most firms
Accounts for 60% of the average companys total cost

Strategic Sourcing Why it is important

Great potential for bottom-line improvement.


E.g., 20% profit margin and purchasing is 85% of COGS.
Price = $100, COGS = $80, Purchasing = .85*$80 = $68 Say purchasing improves 10% Then margin becomes $20+$6.8, which is a 34% increase And even greater leverage on net income!

Sourcing must be strategic: 1. Cost containment is fundamental


Control prices and prevent wasteful spending

2.

If well practiced, it can also drive innovation, quality, flexibility or responsiveness


Need talent and mindset beyond transactional purchasing Need to integrate with overall operations strategy

Strategic Sourcing A strategic framework


1. Is outsourcing feasible?

Is a stable supply base with necessary capabilities available? Is outsourcing politically viable?
Yes

No

Yes

2. Is outsourcing necessary?
Are internal financial and operational capabilities insufficient?
No No

3. Is outsourcing in line with strategic priorities and risks?


Is this activity non-core? Is the risk of outsourcing it tolerable?


Yes

4. Is outsourcing desirable given our value proposition?

No

Can external suppliers do it better? (TCO & NPV)


Yes

5. Do we have the ability to manage suppliers and ongoing risk?


Can we contract on detailed requirements? Can we coordinate incentives and operational flows?
Easy Difficult Impossible

Market Buy

Long Term Relationships

Vertical Integration

Two Main Reasons for Outsourcing


Dependency on capacity
Firm has the knowledge and the skills required to produce the component For various reasons decides to outsource

Dependency on knowledge
Firm does not have the people, skills, and knowledge required to produce the component Outsources in order to have access to these capabilities.

Outsourcing Decisions at Toyota


About 30% of components in-sourced Engines:
Company has knowledge and capacity
100% of engines are produced internally

Transmissions
Company has the knowledge Designs all the components Depends on its suppliers capacities 70 % of the components outsourced

Vehicle electronic systems


Designed and produced by Toyotas suppliers. Company has dependency on both capacity and knowledge

Outsourcing Decisions at Toyota

Toyota seems to vary its outsourcing practice depending on the strategic role of the components and subsystems
The more strategically important the component, the smaller the dependency on knowledge or capacity.

Sourcing Strategy Questions


How many suppliers should the company engage in total and for a given part or commodity? What role should each supply play? Should overseas sourcing be used, and if so, how much? How should supplier relationships be structured and managed?

Choosing the Right Number of Suppliers: Value to Reducing the Supply Base
Lower cost and effort to manage relationships overall Greater potential to coordinate designs Increased capability to synchronize schedules Increased capability to evaluate suppliers on multiple criteria, not just cost Capabilities of procuring modules rater than parts Ease of tracking performance Ease of exchanging information

Choosing the Right Number of Suppliers: Disadvantages to Multi-tier Supply Chains


Lack of visibility over inventory leading to:
More stockouts as information is late to arrive from lower levels of the supply chain More inventory throughout the supply chain as each tier buffers against uncertainty

Increased cost of quality Greater demand volatility Diminished new product or service performance:
Increased cycles times Less effective optimization of integral designs

Choosing the Right Number of Suppliers: Per Item Outsourced Depends On Uniqueness of sourced item or equipment Viability and reliability of suppliers Stability of the technology associated with the item being sourced Significance of the buying companys business to the total business of the supplier Branding implications of sourcing decision Competitiveness of market

Fishers Functional vs. Innovative Products


Functional Products Innovative Products

Product clockspeed Demand Characteristics

Slow Predictable

Fast Unpredictable

Profit Margin Product Variety Average forecast error at the time production is committed

Low Low Low

High High High

Average stockout rate

Low

High

Supply Chain Strategy


Functional Products Diapers, soup, milk, tiers Appropriate supply chain strategy for functional products is push Focus: efficiency, cost reduction, and supply chain planning. Innovative products Fashion items, cosmetics, or high tech products Appropriate supply chain strategy is pull Focus: high profit margins, fast clockspeed, and unpredictable demand, responsiveness, maximizing service level, order fulfillment

Procurement Strategy for the Two Types


Functional Products

Focus should be on minimizing total landed cost


unit cost transportation cost inventory holding cost handling cost duties and taxation cost of financing

Sourcing from low-cost countries, e.g., mainland China and Taiwan is appropriate Innovative Products Focus should be on reducing lead times and on supply flexibility. Sourcing close to the market area Short lead time may be achieved using air shipments

Different Contracts & Service Level


Demand for novels follow normal distribution with average of 5000 and s.d. of 3000. Bookstore buys at a wholesale price from publisher at $10 and sells for $20, discards all unsold items, service level = 50%, order 5000 Assume manufacturing cost of $2, the supply chain optimal service level = $18/$20= 90% Buy-back contracts: supplier buys back unsold books at $6, thus reducing overage cost to $4 for bookstore and increasing service level to 71% Revenue sharing contracts: Buyers share 45% of revenue with suppliers while the supplier sells books at reduced wholesale price of $3, thus underage cost reduces to $8 and overage cost becomes $3, increasing service level to 73%

Contracting: Learning points


Strategic contracting specifies commitments and contingency options in terms of quantity flexibility, quality, and responsiveness in addition to price Strategic contracting goes beyond coordination and aims to
Balance risk and align incentives (reduce or eliminate double marginalization) Allocate capacity to buyer Can lead to win-win if advantages (e.g. higher orders) outweigh downsides (e.g. overage risk) for each party.

It also is a tool in strategic sourcing Structured contracts include:


Buy Back VMI Profit & Revenue sharing Quantity-Flexibility & option contracts Performance-based contracts (e.g., performance-based logistics)

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