Supply Chain Management

Inventory Management
The objective of inventory

management is to strike a balance
between inventory investment and
customer service
2011 Pearson Education, Inc. publishing as Prentice Hall
12 - 1
Importance of Inventory
One of the most expensive assets
of many companies representing as
much as 50% of total invested
capital
Operations managers must balance
inventory investment and customer
service
12 - 2
Functions of Inventory
1. To decouple or separate various
parts of the production process
2. To decouple the firm from
fluctuations in demand and
provide a stock of goods that will
provide a selection for customers
3. To take advantage of quantity
discounts
4. To hedge against inflation
12 - 3
Types of Inventory
Raw material
Purchased but not processed
Work-in-process
Undergone some change but not completed
A function of cycle time for a product
Maintenance/repair/operating (MRO)
Necessary to keep machinery and
processes productive
Finished goods
Completed product awaiting shipment
12 - 4
The Material Flow Cycle

Cycle time
95%
Input
Wait for
inspection
Wait to
be moved
5%
Move Wait in queue Setup Run

time for operator time time
Output
Figure 12.1
12 - 5
Managing Inventory
1. How inventory items can be
classified
2. How accurate inventory records
can be maintained
12 - 6
ABC Analysis
Divides inventory into three classes
based on annual dollar volume
Class A - high annual dollar volume
Class B - medium annual dollar
volume
Class C - low annual dollar volume
Used to establish policies that

focus on the few critical parts and
not the many trivial ones
12 - 7
ABC Analysis
Item
Stock
Number
#10286
Percent of
Number of
Items
Stocked
Unit
Cost
Annual
Dollar
Volume
Class
1,000
$ 90.00
$ 90,000
38.8%
#11526
500
154.00
77,000
33.2%
#12760
1,550
17.00
26,350
11.3%
350
42.86
15,001
6.4%
1,000
12.50
12,500
5.4%
#10867
#10500
20%
Annual
Volume
(units)
Percent of
Annual
Dollar
Volume
30%
72%
23%
B
B
12 - 8
ABC Analysis
Item
Stock
Number
Percent of
Number of
Items
Stocked
Annual
Volume
(units)
Unit
Cost
Annual
Dollar
Volume
Percent of
Annual
Dollar
Volume
Class
#12572
600
$ 14.17
$ 8,502
3.7%
#14075
2,000
.60
1,200
.5%
100
8.50
850
.4%
#01307
1,200
.42
504
.2%
#10572
250
.60
150
.1%
$232,057
100.0%
#01036
50%
8,550
5%
12 - 9
Percent of annual dollar usage
ABC Analysis
80
70
60
50
40
30
20
10
0
A Items
B Items
|
|
|
|
10 20 30 40
C Items
|
50
60
70
80
90 100
Percent of inventory items

Figure 12.2
12 - 10
ABC Analysis
Other criteria than annual dollar
volume may be used
Anticipated engineering changes
Delivery problems
Quality problems
High unit cost
12 - 11
ABC Analysis
Policies employed may include
More emphasis on supplier
development for A items
Tighter physical inventory control for
A items
More care in forecasting A items
12 - 12
Record Accuracy
Accurate records are a critical
ingredient in production and inventory
systems
Allows organization to focus on what
is needed
Necessary to make precise decisions
about ordering, scheduling, and
shipping
Incoming and outgoing record
keeping must be accurate
Stockrooms should be secure
12 - 13
Cycle Counting
Items are counted and records updated
on a periodic basis
Often used with ABC analysis
to determine cycle
Has several advantages
1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and
corrected
5. Maintains accurate inventory records
12 - 14
Cycle Counting Example

5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C
items
Policy is to count A items every month (20 working days), B
items every quarter (60 days), and C items every six months
(120 days)
Item
Class
Quantity
500
Each month
1,750
Each quarter
2,750
Every 6 months
Cycle Counting Policy
Number of Items
Counted per Day
500/20 = 25/day
1,750/60 = 29/day
2,750/120 = 23/day
77/day
12 - 15
Control of Service
Inventories
Can be a critical component
of profitability
Losses may come from
shrinkage or pilferage
Applicable techniques include
1. Good personnel selection, training, and
discipline
2. Tight control on incoming shipments
3. Effective control on all goods leaving
facility
12 - 16
Independent Versus
Dependent Demand
Independent demand - the
demand for item is independent
of the demand for any other
item in inventory
Dependent demand - the
demand for item is dependent
upon the demand for some
other item in the inventory
12 - 17
Holding, Ordering, and

Setup Costs
Holding costs - the costs of holding
or carrying inventory over time
Ordering costs - the costs of
placing an order and receiving
goods
Setup costs - cost to prepare a
machine or process for
manufacturing an order
12 - 18
Holding Costs
Category
Housing costs (building rent or
depreciation, operating costs, taxes,
insurance)
Cost (and range)

as a Percent of
Inventory Value
6% (3 - 10%)
Material handling costs (equipment lease or

depreciation, power, operating cost)
3% (1 - 3.5%)
Labor cost
3% (3 - 5%)
Investment costs (borrowing costs, taxes,

and insurance on inventory)
Pilferage, space, and obsolescence
Overall carrying cost
11% (6 - 24%)
3% (2 - 5%)
26%
Table 12.1
12 - 19
Holding Costs
Cost (and range)
as a Percent of
Inventory Value
Category
ding
n
e
p
e
d
y
l
b
a
r
Housing costs (building rent
ornside
6% (3e-s10%)
o
c
y
r
t .
a
a
v
r
t
s
t
s
s
e
r
o
e
c
t
depreciation,
operating
costs,
taxes,
n
g
i
n
i
, and
Hold
n
o
i
t
a
c
o
l
ch
,
e
s
t
s
h
insurance)
e
g
n
i
i
h
s
u
e
b
m
so
t he
,
%
on
5
1
n
a
h
t
r
0(1%- .3.5%)
te(equipment lease
4
a
e
n
r
a
g
h
t
y
l
r
l
e
a
t
r
Material
handling
costs
or
3%
a
e
gre
Gen
s
t
s
o
c
g
n
i
d
l
depreciation,
ave hooperating cost)
items hpower,
Labor cost
Investment costs (borrowing costs, taxes,

and insurance on inventory)
Pilferage, space, and obsolescence
Overall carrying cost
3% (3 - 5%)
11% (6 - 24%)
3% (2 - 5%)
26%
Table 12.1
12 - 20
Inventory Models for

Independent Demand
Need to determine when and how
much to order
1. Basic economic order quantity
2. Production order quantity
3. Quantity discount model
12 - 21
Basic EOQ Model

Important assumptions
1. Demand is known, constant, and
independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stockouts can be completely avoided
12 - 22
Inventory level
Inventory Usage Over Time

Order
quantity = Q
(maximum
inventory
level)
Usage rate
Average
inventory
on hand
Q
2
Minimum
inventory
0
Time
Figure 12.3
12 - 23
Minimizing Costs
Objective is to minimize total costs
Total cost of
holding and
setup (order)
Annual cost
Minimum
total cost
Table 12.4(c)
Holding cost
Setup (or order)

cost
Optimal order
quantity (Q*)
Order quantity
12 - 24
The EOQ Model

Annual setup cost =
Q
Q*
D
S
H
D
S
Q
= Number of pieces per order

= Optimal number of pieces per order (EOQ)
= Annual demand in units for the inventory item
= Setup or ordering cost for each order
= Holding or carrying cost per unit per year
Annual setup cost = (Number of orders placed per year)
x (Setup or order cost per order)
Annual demand
Setup or order
= Number of units in each order
cost per order
=
D (S)
Q
12 - 25
The EOQ Model

Annual setup cost =
Q
Q*
D
S
H
D
S
Q
Q
Annual holding cost =
H
2

Annual holding cost = (Average inventory level)

x (Holding cost per unit per year)
=
Order quantity
(Holding cost per unit per year)
2
Q (H)
2
12 - 26
The EOQ Model

Annual setup cost =
Q
Q*
D
S
H
D
S
Q
Q
Annual holding cost =
H
2

Optimal order quantity is found when annual setup cost

equals annual holding cost
D
Q
S =
H
Q
2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* =
2DS/H
12 - 27
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year
Q* =
2DS
H
Q* =
2(1,000)(10)
=
0.50
40,000 = 200 units
12 - 28
An EOQ Example
D = 1,000 units
Q* = 200 units
S = $10 per order
Expected
Demand
D
number of = N = Order quantity = Q*
orders
1,000
N=
= 5 orders per year
200
12 - 29
An EOQ Example
D = 1,000 units
Q* = 200 units
S = $10 per order
N = 5 orders per year
Expected
time between = T =
orders
Number of working
days per year
T=
N
250
= 50 days between orders
5
12 - 30
An EOQ Example
D = 1,000 units
Q* = 200 units
S = $10 per order
T = 50 days
Total annual cost = Setup cost + Holding cost
D
Q
S +
H
Q
2
1,000
200
TC =
($10) +
($.50)
200
2
TC =
TC = (5)($10) + (100)($.50) = $50 + $50 = $100

12 - 31
Robust Model
The EOQ model is robust
It works even if all parameters
and assumptions are not met
The total cost curve is relatively
flat in the area of the EOQ
12 - 32
An EOQ Example
Management underestimated demand by 50%
D = 1,000 units 1,500 units Q* = 200 units
S = $10 per order
T = 50 days
D
Q
TC =
S +
H
Q
2
1,500
200
TC =
($10) +
($.50) = $75 + $50 = $125
200
2
Total annual cost increases by only 25%
12 - 33
An EOQ Example
Actual EOQ for new demand is 244.9 units
D = 1,000 units 1,500 units Q* = 244.9 units
S = $10 per order
T = 50 days
D
Q
TC =
S +
H
Q
2
1,500
244.9
TC =
($10) +
($.50)
244.9
2
TC = $61.24 + $61.24 = $122.48
Only 2% less
than the total
cost of $125
when the
order quantity
was 200
12 - 34
Reorder Points
EOQ answers the how much question
The reorder point (ROP) tells when to
order
ROP =
Lead time for a

Demand
per day new order in days
=dxL
D
d = Number of working days in a year
12 - 35
Inventory level (units)
Reorder Point Curve

Q*
Resupply takes place as order arrives
Slope = units/day = d
ROP
(units)
Figure 12.5
Lead time = L
Time (days)
12 - 36
Reorder Point Example

Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days
D
d=
Number of working days in a year
= 8,000/250 = 32 units
ROP = d x L
= 32 units per day x 3 days = 96 units
12 - 37
Production Order Quantity

Model
Used when inventory builds up
over a period of time after an
order is placed
Used when units are produced
and sold simultaneously
12 - 38
Inventory level

Model
Part of inventory cycle during
which production (and usage)
is taking place
Demand part of cycle
with no production
Maximum
inventory
Time
Figure 12.6
12 - 39

Model
Q = Number of pieces per order
p = Daily production rate
H = Holding cost per unit per year
d = Daily demand/usage rate
t = Length of the production run in days
Annual inventory
Holding cost
= (Average inventory level) x
holding cost
per unit per year
Annual inventory
= (Maximum inventory level)/2
level
Maximum
Total produced during
=
inventory level
the production run
Total used during

the production run
= pt dt
12 - 40

Model
t = Length of the production run in days
Maximum
Total produced during
=
inventory level
the production run
Total used during

the production run
= pt dt
However, Q = total produced = pt ; thus t = Q/p

Q
Maximum
=p
inventory level
p
Q
p
=Q 1
d
p
Maximum inventory level

Q
Holding cost =
(H) =
2
2
d
p
H
12 - 41

Model
D = Annual demand

Setup cost = (D/Q)S

Holding cost = 1 HQ[1 - (d/p)]
2
(D/Q)S = 2 HQ[1 - (d/p)]

2DS
2
Q =
H[1 - (d/p)]
Q*p =
2DS
H[1 - (d/p)]
12 - 42

Example
D = 1,000 units
S = $10
H = $0.50 per unit per year
Q* =
2DS
H[1 - (d/p)]
Q* =
2(1,000)(10)
0.50[1 - (4/8)]
p = 8 units per day

d = 4 units per day
80,000
= 282.8 or 283 hubcaps

12 - 43

Model
Note:
d=4=
D
Number of days the plant is in operation
1,000
250
When annual data are used the equation becomes

Q* =
2DS
annual demand rate
H 1
annual production rate
12 - 44
Quantity Discount Models

Reduced prices are often available when
larger quantities are purchased
Trade-off is between reduced product cost
and increased holding cost
Total cost = Setup cost + Holding cost + Product cost
TC =
D
Q
S+
H + PD
Q
2
12 - 45

A typical quantity discount schedule
Discount
Number
Discount Quantity
Discount (%)
Discount
Price (P)
0 to 999
no discount
$5.00
1,000 to 1,999
$4.80
2,000 and over
$4.75
Table 12.2
12 - 46

Steps in analyzing a quantity discount
1. For each discount, calculate Q*
2. If Q* for a discount doesnt qualify,
choose the smallest possible order size
to get the discount
3. Compute the total cost for each Q* or
adjusted value from Step 2
4. Select the Q* that gives the lowest total
cost
12 - 47

Total cost curve for discount 2
Total cost $
Total cost
curve for
discount 1
Total cost curve for discount 3
b
a
Q* for discount 2 is below the allowable range at point a

and must be adjusted upward to 1,000 units at point b
1st price
break
2nd price
break
1,000
2,000
Order quantity
Figure 12.7
12 - 48
Quantity Discount Example

Calculate Q* for every discount
Q* =
Q1* =
2(5,000)(49)
= 700 cars/order
(.2)(5.00)
Q2* =
2(5,000)(49)
= 714 cars/order
(.2)(4.80)
Q3* =
2(5,000)(49)
= 718 cars/order
(.2)(4.75)
2DS
IP
12 - 49

Calculate Q* for every discount
Q* =
2DS
IP
Q1* =
2(5,000)(49)
= 700 cars/order
(.2)(5.00)
Q2* =
2(5,000)(49)
= 714 cars/order
(.2)(4.80)
1,000 adjusted
Q3* =
2(5,000)(49)
= 718 cars/order
(.2)(4.75)
2,000 adjusted
12 - 50

Order
Quantity
Annual
Product
Cost
Annual
Ordering
Cost
Annual
Holding
Cost
Discount
Number
Unit
Price
$5.00
700
$25,000
$350
$350
$25,700
$4.80
1,000
$24,000
$245
$480
$24,725
$4.75
2,000
$23.750
$122.50
$950
$24,822.50
Total
Table 12.3
Choose the price and quantity that gives

the lowest total cost
Buy 1,000 units at $4.80 per unit
12 - 51
Probabilistic Models and

Safety Stock
Used when demand is not constant
or certain
Use safety stock to achieve a desired
service level and avoid stockouts
ROP = d x L + ss
Annual stockout costs = the sum of the units short
x the probability x the stockout cost/unit
x the number of orders per year
12 - 52
Safety Stock Example

ROP = 50 units
Orders per year = 6
Stockout cost = $40 per frame

Carrying cost = $5 per frame per year
Number of Units
ROP
Probability
30
.2
40
50
.2
60
.2
70
.1
.3
1.0
12 - 53
Safety Stock Example

ROP = 50 units
Orders per year = 6
Stockout cost = $40 per frame

Carrying cost = $5 per frame per year
Safety
Stock
Additional
Holding Cost
20
(20)($5) = $100
10
(10)($5) = $ 50 (10)(.1)($40)(6)
Total
Cost
Stockout Cost
$0
$100
= $240
$290
0 (10)(.2)($40)(6) + (20)(.1)($40)(6) = $960
$960
A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames
12 - 54
Inventory level
Probabilistic Demand
Minimum demand during lead time
Maximum demand during lead time
Mean demand during lead time
ROP = 350 + safety stock of 16.5 = 366.5
ROP
Normal distribution probability of

demand during lead time
Expected demand during lead time (350 kits)
Safety stock
0
Figure 12.8
Lead
time
Place
order
16.5 units
Time
Receive
order
12 - 55
Use prescribed service levels to set safety
stock when the cost of stockouts cannot be
determined
ROP = demand during lead time + Z dLT
where
Z = number of standard
deviations
dLT =
standard deviation of
demand during lead time
12 - 56
Risk of a stockout
(5% of area of
normal curve)
Probability of
no stockout
95% of the time
Mean
demand
350
0
ROP = ? kits
Quantity
Safety
stock
z
Number of
standard deviations
12 - 57
Probabilistic Example
Average demand = = 350 kits
Standard deviation of demand during lead time = dLT = 10 kits
5% stockout policy (service level = 95%)
Using Appendix I, for an area under the curve

of 95%, the Z = 1.65
Safety stock = Z dLT = 1.65(10) = 16.5 kits
Reorder point
= expected demand during lead

time + safety stock
= 350 kits + 16.5 kits of safety
stock
= 366.5 or 367 kits
12 - 58
Other Probabilistic Models

When data on demand during lead time is
not available, there are other models
available
1. When demand is variable and lead
time is constant
2. When lead time is variable and
demand is constant
3. When both demand and lead time
are variable
12 - 59

Demand is variable and lead time is constant
ROP = (average daily demand
x lead time in days) + Z dLT
where
d = standard deviation of demand per day

dLT = d
lead time
12 - 60
Average daily demand (normally distributed) = 15
Standard deviation = 5
Lead time is constant at 2 days
Z for 90% = 1.28
90% service level desired
From Appendix I
ROP = (15 units x 2 days) + Z dLT

= 30 + 1.28(5)( 2)
= 30 + 9.02 = 39.02 39
Safety stock is about 9 iPods
12 - 61

Lead time is variable and demand is constant
ROP =
(daily demand x
average lead time in days)
=
where
Z x (daily demand) x LT
LT = standard deviation of lead time in days
12 - 62
Z for 98% = 2.055
From Appendix I
Daily demand (constant) = 10

Average lead time = 6 days
Standard deviation of lead time = LT = 3
ROP = (10 units x 6 days) + 2.055(10 units)(3)

= 60 + 61.65 = 121.65
Reorder point is about 122 cameras
12 - 63

Both demand and lead time are variable
ROP = (average daily demand
x average lead time) + Z dLT
where
standard deviation of demand per d
LT
standard deviation of lead time in d
dLT =
(average lead time x d2)
+ (average daily demand)2 x LT2
12 - 64
Average daily demand (normally distributed) = 150
Standard deviation = d = 16
Average lead time 5 days (normally distributed)
Standard deviation = LT = 1 day
Z for 95% = 1.65
From Appendix I
ROP = (150 packs x 5 days) + 1.65 dLT
= (150 x 5) + 1.65 (5 days x 162) + (1502 x 12)
= 750 + 1.65(154) = 1,004 packs
12 - 65
Single Period Model

Only one order is placed for a product
Units have little or no value at the end of
the sales period
Cs = Cost of shortage = Sales price/unit Cost/unit
Co = Cost of overage = Cost/unit Salvage value
Service level =
Cs
Cs + Co
12 - 66
Single Period Example

Average demand = = 120 papers/day
Standard deviation = = 15 papers
Cs = cost of shortage = $1.25 - $.70 = $.55
Co = cost of overage = $.70 - $.30 = $.40
Service level =
Cs
Cs + Co
.55
=
.55 + .40
= .55 = .578
.95
Service
level
57.8%
= 120
Optimal stocking level
12 - 67
Single Period Example

From Appendix I, for the area .578, Z .20
The optimal stocking level
= 120 copies + (.20)()
= 120 + (.20)(15) = 120 + 3 = 123 papers
The stockout risk = 1 service level
= 1 .578 = .422 = 42.2%
12 - 68
Fixed-Period (P) Systems

Orders placed at the end of a fixed period
Inventory counted only at end of period
Order brings inventory up to target level
Only relevant costs are ordering and holding
Lead times are known and constant
Items are independent from one another
12 - 69
Fixed-Period (P) Systems
On-hand inventory
Target quantity (T)

Q4
Q2
Q1
Q3
P
Time
Figure 12.9
12 - 70
Fixed-Period (P) Example

3 jackets are back ordered
It is time to place an order
No jackets are in stock

Target value = 50
Order amount (Q) = Target (T) - Onhand inventory - Earlier orders not yet
received + Back orders
Q = 50 - 0 - 0 + 3 = 53 jackets
12 - 71
Fixed-Period Systems
Inventory is only counted at each
review period
May be scheduled at convenient times
Appropriate in routine situations
May result in stockouts between
periods
May require increased safety stock
12 - 72
7
3
Aligning Objectives
What markets will the firm compete
in, and on what basis?
What are the long-term and shortterm business goals?
What are the budgetary and economic
resource constraints, and how will
these be allocated to functional
groups and business units?
Purchasing & Supply Chain Management, 4e
12 - 73
7
4
How Companies Make

Money
Raise prices
1. Increase
revenues
Increase volume
Reduce cost of
employees
2. Decrease costs
Reduce cost of
processes/waste
Reduce cost of
goods/services
12 - 74
7
5
Integrative Strategy
Development
12 - 75
7
6
Development
Corporate strategy
Definition of businesses in which to
participate
Acquisition and allocation of resources to
those businesses
Business unit strategy

Scope or boundaries of those businesses
Basis of competitive advantage
12 - 76
7
7
Development
Supply management strategy
Support the desired competitive
business-level strategies
How to complement other functional
areas
Sourcing strategy
How to purchase commodities to
support higher-level strategies
12 - 77
7
8
Components of Integrative
Strategy
12 - 78
7
9
Translating Objectives
Goals
Cost reduction objectives goals
Be low-cost producer in industry
Reduce material costs by 15%
Reduce levels of inventory required
to supply internal customers
Reduce raw material inventory
20 days supply
12 - 79
8
0
Goals
Technology/new product development
objectives goals
Outsource non-core competency
activities
Qualify 2 new suppliers by end of
year
Reduce product development time
Develop a formal supplier integration
process manual by 12/31
12 - 80
8
1
Goals
Supply base reduction objectives
goals
Reduce the number of suppliers used
Reduce the supply base by 30% in
next 6 months
Joint problem solving with remaining
suppliers
Identify $300,000 in cost savings with
2 suppliers by end of fiscal year
12 - 81
8
2
Goals
Supply assurance objectives goals
Assure uninterrupted supply from identified
suppliers
Reduce order cycle time on key parts 1
week
Quality objectives goals

Increase quality of services and products
Reduce average defects by 200 ppm on
all receipts in next fiscal year
12 - 82
8
3
Enabling Effective Category

Strategies
Spend money on resources initially,
including assessment of current
spend, data collection, market
research, training, and people
Validate savings or contribution to
other company objectives achieved
by supply management and drive
them to bottom line
12 - 83
8
4
Enabling Effective Category

Strategies
Sustain the initiative through
presentations to senior executives
who support the move towards an
integrated supply management
function with other functional
groups in the supply chain
12 - 84
8
5
Conducting a Spend
Analysis
What did the business spend its
money on over the past year?
Did the business receive the right
amount of products and services
given what was paid for them?
What suppliers received the
majority of the business?
12 - 85
8
6
Conducting a Spend
Analysis
Did the suppliers charge an accurate
price across all divisions vs. P.O.
requirements, contracts?
Which divisions spent their money on
products and services that were
correctly budgeted for?
Are there opportunities to combine
volumes and standardize purchases?
12 - 86
8
7
%
Procurement KPIs Example
12 - 87
8
8
Spend Analysis
Spreadsheet
Sort by commodity
Find total spend by commodity
Chart top 10 in descending $ amount
Sort by number of suppliers/commodity
Chart top 10 by descending # of
suppliers
Find average spend/supplier/commodity
Apply Pareto analysis for opportunities
12 - 88
Sample Spend Categories

Supplier
Commodity
Annual Spend
Rebate Company
Rebate fulfillment & call center
$329,873,663
Invest Company
Investments
$130,328,512
Advert Company
Advertising
$56,134,490
Repair Company
Service repairs
$49,339,218
Benefits Company
Benefits
$48,969,149
Hardware Company
Hardware
$40,572,450
Partco
Service parts
$39,910,372
Telecom
Telecommunications
$31,055,599
Display Company
Store displays
$30,020.969
Penpaper Company
Paper
$29,175,843
Labor Company
Contract labor
$27,880,363
Supply Company
Paper
$23,844,707
Contract Company
General contracting
$22,579,113
Office Company
Paper
$22,257,690
Graphics Company
Graphic design
$21,966,989
Payment Company
Business & management services
$20,380,275
Freight Company
Surface freight
$19,369,010
Paper Company
Paper
$15,603,682
Service Plan Company
Service plan
$15,478,827
Service Company
Service parts
$14,868,023
Consumer Company
Consumer financing
$14,833,333
Energy Company
Energy
$14,087,177
12 - 89
9
0
Million
$
Spend by Commodity
12 - 90
9
1
Suppliers by Commodity
12 - 91
9
2
Spend/Supplier by
Commodity
12 - 92
9
3
Percent of Total Spend
12 - 93
9
4
The Strategic Sourcing

Process
Goal:
Develop a
statement of work
and plan
Goal:
Understand the
supply market
Goal:
Classify suppliers
and define
sourcing approach
Goal:
Negotiate a win-win
contract
Goal:
Continuously
improve
performance
Inputs and Tools:

Project leader;
other team
members
Inputs and Tools:

Interviews; online
research;
conferences
Inputs and Tools:

Market research;
portfolio matrix;
forecasted spend
Inputs and Tools:

Negotiation plan;
supplier evaluation
tool
Inputs and Tools:

Contract; supplier
scorecard
Outputs:
Baseline data;
project charter;
work plan
Outputs:
Report on supply
trends; changes;
pricing; capacity;
etc.
Outputs:
Supplier evaluation
tool with desired
relationship
Outputs:
Signed contract
Outputs:
Supplier
development plan;
communication
12 - 94
9
5
Step 1: Team and Project

Charter
Identify key cross-functional team
members
Define the scope of the category
strategy
Publish a team charter
Develop a work plan and
communication plan
12 - 95
9
6
Step 2: Conduct Market

Research
Understand the purchase
requirement relative to business
unit objectives
Conduct thorough spend analysis
Identify specific internal users
Identify current suppliers
Research supply marketplace
12 - 96
9
7

Research
Information required
Total annual purchases
Interviews with stakeholders
External Available
market capacity
research
Key
suppliers
Technology
trends
Price data and

trends
Cost data and

trends
Technical
requirements
Environmental
issues
Regulatory issues
Other available
data
12 - 97
9
8

Research
Triangulation explore, compare,
and contrast data from multiple
sources
Trade
Annual
journals
reports
Snow-ball
sampling
Trade
consultants
Suppliers
Investment
reports
Internet
Books
Category
managers
Headlines
12 - 98
9
9

Research
Porters Five Forces Model
SWOT analysis
Establish benchmarks through
industry databases
Requests for information
Value chain analysis
Supplier research
12 - 99
1
0
0
Porters Five Forces Model

Threat of New
Entrants
Supplier
Bargaining
Power
Source:
Competitive Strategy
Michael E. Porter (1980)
Market Internal
Competition
Pressure from
Substitutes
Buyer Bargaining
Power
Other possible forces:

Globalization
Digitization
Deregulation
12 - 100
1
0
1
Market Internal Competition

Speed of industry growth
Capacity utilization
Exit barriers
Product differences
Switching costs
Diversity of suppliers
12 - 101
1
0
2
Threat of New Entrants

Capital markets
Availability of skilled workers
Access to critical technologies,
inputs, or distribution
Product life cycles
12 - 102
1
0
3
Threat of New Entrants

Brand equity and customer loyalty
Government deregulation
Risk of switching
Economies of scale
12 - 103
1
0
4
Pressure from Substitutes

Relative performance of substitute
products and services
Relative price
Switching costs
Buyers propensity to switch
12 - 104
1
0
5
Buyer Bargaining Power

Buyer concentration
Buyer volume
Buyer switching costs
Price sensitivity
Product differences
12 - 105
1
0
6
Buyer Bargaining Power

Brand identity
Impact on quality or performance
Buyer profits
Availability of substituttes
12 - 106
1
0
7
Supplier Bargaining Power

Price of major inputs
Ability to pass along price increases
Availability of key technologies or other
resources
Threat of forward or backward integration
Industry capacity utilization
Supplier concentration
Importance of volume to supplier
12 - 107
1
0
8
SWOT Analysis
Broad
customer base
Established
product range
Established
distribution
channels
Emergence of
other uses and
markets
Emerging
overseas
markets
High entry
barriers
Strengths
Internal Factors
External Factors
Opportunities
Weaknesses
Threats
Low product
innovation
Traditional,
unionized
business
processes
Low patent
protection
Emerging
overseas
suppliers
NPD costs are
high
Environmental
regulations
12 - 108
1
0
9
Benchmarks
Identify critical performance criteria
Identify relative competitive
performance
Use of industry benchmarks
CAPS
Third party consulting firms
12 - 109
1
1
0
Requests for Information

(RFIs)
Use before a specific requisition is issued
Use to obtain general information about
services, products, or suppliers
Does not constitute a binding document
Use when a large or complicated purchase

is considered and when pool of suppliers
must be prequalified
12 - 110
1
1
1
Supplier Research
Cost structure
Financial status
Customer
satisfaction levels
Support capabilities
Relative strengths
and weaknesses
Buyers fit with
supplier
How the company

is viewed
Core capabilities
Strategy/future
direction
Culture
12 - 111
1
1
2
Step 3: Strategy
Development
Portfolio analysis
Critical commodity strategic supplier
Routine commodity
Leverage commodity preferred supplier
Bottleneck commodity transactional
supplier
Process and design capabilities

Management capability
12 - 112
1
1
3
Step 3: Strategy
Development
Financial condition and cost structure
Planning and control systems
Environmental regulation compliance
Longer-term relationship potential
Weighted point supplier evaluation
systems
12 - 113
1
1
4
Portfolio Analysis
Complexity or
Risk Impact
Hig
h
Low
Bottleneck
Critical
Commodity Commodity
Routine
Leverage
Commodity Commodity
Low
Value Potential
Hig
h
12 - 114
1
1
5
Critical Commodity
Critical to profitability and
operations
Few qualified sources of supply
Large expenditures
Design and quality are critical
Complex and/or rigid specifications
12 - 115
1
1
6
Critical Commodity
Strategy
Form partnership with suppliers
Tactics
Increase role of selected supplier
12 - 116
1
1
7
Critical Commodity
Actions
Heavy negotiation
Supplier process management
Prepare contingency plans
Analyze market and competition
Use functional specifications
12 - 117
1
1
8
Routine Commodity
Many alternative products and
services
Many sources of supply
Low value, small individual
transactions
Everyday use, unspecified items
Anyone could buy it
12 - 118
1
1
9
Routine Commodity
Strategy
Simplify acquisition process
Tactics
Increase role of systems
Reduce buying effort
12 - 119
1
2
0
Routine Commodity
Actions
Rationalize supply base
Automate requisitioning, e.g., EDI,
credit cards
Stockless procurement
Minimize administrative costs
Little negotiations
12 - 120
1
2
1
Leverage Commodity
High expenditures
Large marketplace capacity with
ample inventories
Many alternate products and
services
Many qualified sources of supply
Market / price sensitive
12 - 121
1
2
2
Leverage Commodity
Strategy
Maximize commercial advantage
Tactics
Concentrate business
Maintain competition
12 - 122
1
2
3
Leverage Commodity
Actions
Promote competitive bidding
Exploit market cycles / trends
Procurement coordination
Use industry standards
Active sourcing
12 - 123
1
2
4
Bottleneck Commodity
Complex specifications requiring
complex manufacturing or service
process
Few alternate productions / sources of
supply
Big impact on operations /
maintenance
New technology or unleaded processes
12 - 124
1
2
5
Strategy
Ensure supply continuity
Tactics
Decrease uniqueness of suppliers
Manage supply
12 - 125
1
2
6
Actions
Widen specifications
Increase competition
Develop new suppliers
Medium-term contracts
Attempt competitive bidding
12 - 126
1
2
7
Step 4: Contract Negotiation

Establishing and tasks and time lines
Assigning accountabilities and process
ownership
Ensuring adequate resources are made
availability
Strategy communicated to all
stakeholders
Price analysis
12 - 127
1
2
8
Step 4: Contract Negotiation

Preferred supplier lists
Competitive bidding
Negotiation
12 - 128
1
2
9
Price Analysis
Defined marketplace
Best price
Average price
Business units price
Expected trends in pricing
12 - 129
1
3
0
Effective Competitive
Bidding
Buying firm can provide qualified
suppliers with clear descriptions of
the items or services to be purchased
Volume is high enough to justify the
cost and effort
Buying firm does not have a preferred
supplier
Price is dominant criterion
12 - 130
1
3
1
Effective Negotiation
Item is new or technically complex
item with only vague specifications
Purchase requires agreement about a
wide range of performance factors
Buyer requires supplier to participate
in the development effort
Supplier cannot determine risks and
costs without buyers input
12 - 131
1
3
2
Step 5: SRM
Continuous monitoring of both the
strategy and the supplier
Continuous monitoring of the
suppliers performance on key goals
and objectives
Supplier scorecard
Use quarterly and review results with
supplier
12 - 132
1
3
3
Elements of the Monitoring

Process
Regular review
meetings to ensure that
the strategy is still congruent with
organizational objectives
Share results with top management

Assess internal customer and supplier
perceptions
Determine if key goals have been
achieved
Provide feedback
12 - 133
1
3
4
Types of Strategies
Supply base optimization
Supply risk management
Global sourcing
Longer-term supplier relationships
Early supplier design involvement
Supplier development
Total cost of ownership
12 - 134
1
3
5
Facilitating E-Reverse
Auctions
Buyers and suppliers able to
communicate in real-time,
worldwide, via the Internet
Development of robust, userfriendly, third-party auction systems
Significant improvements in goods
and service quality and cycle time
reduction
12 - 135
1
3
6
Evolving Sourcing
Strategies
Basic
Moderate
Limited
Fully Integrated
Beginnings
Development
Integration
Supply Chains
Quality/cost
teams
Longer-term
contracts
Volume
leveraging
Supply base
consolidation
Supplier quality
focus
E-RAs
Ad hoc supplier
alliances
Cross-functional
sourcing teams
Supply base
optimization
International
sourcing
Cross-location
sourcing teams
Global sourcing
Strategic
supplier
alliances
Supplier TQM
development
Total cost of
ownership
Nontraditional
purchase focus
Parts/service
standardization
Early supplier
involvement
Dock-to-stock
pull systems
Global supply
chains with
external
customer focus
Cross-enterprise
decision making
Full-service
suppliers
Early sourcing
Insourcing/
outsourcing to
maximize core
competencies of
firms throughout
the supply chain
E-systems
12 - 136
1
3
7
Phase 1: Basic Beginnings

Supply management characterized
as a lower-level support function
Short-term approaches
Reactionary
Impetus for change is driven by
management
Ensure adequate capacity
12 - 137
1
3
8
Phase 1: Basic Beginnings

Adversarial supplier relationships
Limited resources for improvement
Mid-level reporting
Efficiency-related performance
measures
Focus on price reduction
Transaction-based information systems
12 - 138
1
3
9
Phase 2: Moderate
Development
Centralization of supply
management function
Commodity management
Company-wide databases
Company-wide agreements
Single sourcing with long-term
agreements
12 - 139
1
4
0
Phase 2: Moderate
Development
Limited cross-functional integration
Recognition of strategic supplier
relationships
Evaluated on achievement of
competitive objectives
Supplier viewed as a resource
Informal internal integration
12 - 140
1
4
1
Phase 3: Limited Integration

Concurrent engineering
Supplier development
Lead time reduction
Early supplier involvement
Supply management strategies
integrated early in product and
process design activities
12 - 141
1
4
2
Phase 3: Limited Integration

Evaluated on strategic contribution
Extensive functional integration
Focus on building competitive
advantage
Strong external customer focus
Global databases
Total cost modeling
12 - 142
1
4
3
Phase 4: Full Integration

Assumed a strategic orientation
Automated non-value-adding activities
Greater focus on strategic objectives
and activities
Developing global supplier capabilities
Systems thinking approach over entire
supply chain
12 - 143
1
4
4
Observations on Strategic
Sourcing
Few organizations have fully
executed complex Phase 3 and Phase
4 strategies
Relative complexity
Inadequate resources and commitment
Lack of supply base optimization
Personnel requiring higher level skills
12 - 144
Introduction
Outsourcing components have
increased progressively over the years
Some industries have been outsourcing
for an extended time
Fashion Industry (Nike) (all manufacturing
outsourced)
Electronics Industry
Cisco (major suppliers across the world)
Apple (over 70% of components outsourced)
12 - 145
Not Just Manufacturing but

Product Design, Too
Taiwanese companies now design
and manufacture most laptop sold
around the world
Brands such as Hewlett-Packard
and PalmOne collaborate with Asian
suppliers on the design of their
PDAs.
12 - 146
Questions/Issues with
Outsourcing
Why do many technology companies
outsource manufacturing, and even
innovation, to Asian manufacturers?
What are the risks involved?
Should outsourcing strategies depend
on product characteristics, such as
product clockspeed, and if so how?
12 - 147
Discussion Points
Buy/make decision process
Advantages and the risks with outsourcing
Framework for optimizing buy/make decisions.
Effective procurement strategies

Framework for identifying the appropriate
procurement strategy
Linkage of procurement strategy to outsourcing
strategy.
The procurement process

Independent (public), private, and consortium-based
e-marketplaces.
New developments mean higher opportunities and
greater challenges faced by many buyers
12 - 148
9.2 Outsourcing Benefits and

Risks
Benefits
Economies of scale
Aggregation of multiple orders reduces costs,

both in purchasing and in manufacturing
Risk pooling
Demand uncertainty transferred to the suppliers
Suppliers reduce uncertainty through the riskpooling effect
Reduce capital investment

Capital investment transferred to suppliers.
Suppliers higher investment shared between
customers.
12 - 149
Outsourcing Benefits
Focus on core competency
Buyer can focus on its core strength
Allows buyer to differentiate from its competitors
Increased flexibility
The ability to better react to changes in customer demand
The ability to use the suppliers technical knowledge to
accelerate product development cycle time
The ability to gain access to new technologies and
innovation.
Critical in certain industries:
High tech where technologies change very frequently
Fashion where products have a short life cycle
12 - 150
Outsourcing Risks
Loss of Competitive Knowledge
Outsourcing critical components to suppliers
may open up opportunities for competitors
Outsourcing implies that companies lose their
ability to introduce new designs based on their
own agenda rather than the suppliers agenda
Outsourcing the manufacturing of various
components to different suppliers may prevent
the development of new insights, innovations,
and solutions that typically require crossfunctional teamwork
12 - 151
Outsourcing Risks
Conflicting Objectives
Demand Issues
In a good economy
Demand is high
Conflict can be addressed by buyers who are willing to
make long-term commitments to purchase minimum
quantities specified by a contract
In a slow economy
Significant decline in demand
Long-term commitments entail huge financial risks for
the buyers
Product design issues

Buyers insist on flexibility
would like to solve design problems as fast as possible
Suppliers focus on cost reduction

implies slow responsiveness to design changes.
12 - 152
Examples of Outsourcing
Problems
IBM
PC market entry in 1981

Outsourced many components to get to market
quickly
40% market share by 1985 beating Apple as the
top PC manufacturer
Other competitors like Compaq used the same
suppliers
IBM tried to regain market by introducing the
PS/2 line with the OS/2 system
Suppliers and competitors did not follow
IBM market share shrunk to 8% in 1995
Behind Compaqs 10% leading share
Led to eventual sale of PC business to Lenovo
12 - 153
Examples of Outsourcing
Problems
Cisco
2000 problem:
Forced to announce a $2.2 billion write-down for
obsolete inventory
8,500 employees were laid off.
Significant reduction in demand for

telecommunication infrastructure
Problem in its virtual global manufacturing
network
Long supply lead time for key components
Would have impacted delivery to customers
Cisco carried component inventory which were
ordered long in advance of the downturn.
Competition on limited supplier capacities
Long-term contracts with its suppliers
12 - 154
9.3 Framework for Make/Buy

Decisions
How can the firm decide on which
component to manufacture and
which to outsource?
Focus on core competencies
How can the firm identify what is in
the core?
What is outside the core?
12 - 155
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.
12 - 156
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
12 - 157
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.
12 - 158
Product Architectures
Modular product
Made by combining different components

Components are independent of each other
Components are interchangeable
Standard interfaces are used
Customer preference determines the product
configuration.
Integral product
Made up from components whose functionalities are
tightly related. =
Not made from off-the-shelf components.
Designed as a system by taking a top-down design
approach.
Evaluated on system performance, not on component
performance
Components perform multiple functions.
12 - 159
A Framework for Make/Buy

Decisions
Product
Dependency on
knowledge and
capacity
Independent for
knowledge,
dependent for
capacity
Independent for
knowledge and
capacity
Modular
Outsourcing is risky
Outsourcing is an
opportunity
Opportunity to reduce
cost through
outsourcing
Integral
Outsourcing is very
risky
Outsourcing is an
option
Keep production
internal
12 - 160
Hierarchical Model to Decide

Whether to Outsource or Not
Customer Importance
How important is the component to the customer?
What is the impact of the component on customer experience?
Does the component affect customer choice?
Component Clockspeed
How fast does the components technology change relative to other
components in the system?
Competitive Position
Does the firm have a competitive advantage producing this
component?
Capable Suppliers
How many capable suppliers exist?
Architecture
How modular or integral is this element to the overall architecture of
the system?
12 - 161
Examples of Decisions
Criteria
Example 1
Example 2
Example 3
Example 4
Customer
Importance
Important
Not important
Important
Important
Clockspeed
High
Slow
High
Slow
Competitive
Position
Competitive
Advantage
No advantage
No advantage
No advantage
Capable
Suppliers
Key variable to
decide
strategy
Architecture
DECISION
Inhouse
Outsource
Key variable to
decide
strategy
Inhouse,
Acquire
supplier,
Partnership
Outsource with
modular;
Inhouse or
joint
development
with integral.
12 - 162
9.4 Procurement Strategies

Impact of procurement on business performance
2005 profit margins for Pfizer (24%), Dell (5%),
Boeing (2.8%).
Reducing procurement cost by exactly 1% of
revenue would have translated directly into
bottom line, i.e., net profit.
To achieve the same impact on net profit
through higher sales
Pfizer would need to increase its revenue by 4.17
(0.01/0.24) %
Dell by 20% and Boeing by 35.7%
The smaller the profit margins, the more

important it is to focus on reducing procurement
costs.
12 - 163
Appropriate Strategy
Depends on:
type of products the firm is purchasing
level of risk
uncertainty involved
Issues:
How can the firm develop an effective purchasing
strategy?
What are the capabilities needed for a successful
procurement function?
What are the drivers of effective procurement
strategies?
How can the firm ensure continuous supply of
material without increasing its risks?
12 - 164
Kraljics Supply Matrix

Firms supply strategy should depend on
two dimensions
profit impact
Volume purchased/ percentage of total
purchased cost/ impact on product quality or
business growth
supply risk
Availability/number of suppliers/competitive
demand/ make-or-buy opportunities/ storage
risks/ substitution opportunities
12 - 165
Kraljics supply matrix
12 - 166

Top right quadrant:
Strategic items where supply risk and impact on profit
are high
Highest impact on customer experience
Price is a large portion of the system cost
Typically have a single supplier
Focus on long-term partnerships with suppliers
Bottom right quadrant

Items with high impact on profit
Low supply risk (leverage items)
Many suppliers
Small percentage of cost savings will have a large
impact on bottom line
Focus on cost reduction by competition between
suppliers
12 - 167

Top left quadrant:
High supply risk but low profit impact items.
Bottleneck components
Do not contribute a large portion of the product cost
Suppliers have power position
Ensure continuous supply, even possibly at a
premium cost
Focus on long-term contracts or by carrying stock (or
both)
Bottom left quadrant:

Non-critical items
Simplify and automate the procurement process as
much as possible
Use a decentralized procurement policy with no
formal requisition and approval process
12 - 168
Supplier Footprint
Supply Strategies have changed over the years
American automotive manufacturers
1980s: Suppliers either in the US or in Germany.
1990s: Suppliers in Mexico, Spain, and Portugal.
2000s: Suppliers in China
High-tech industry
1980s: Sourcing in the US
1990s: Singapore and Malaysia
2000s: Taiwan and mainland China
Challenge:
Framework that helps organizations determine the
appropriate supplier footprint.
Strategy should depend on the type of product or
component purchased
12 - 169
Fishers Functional vs.

Innovative Products
Functional Products
Innovative Products
Product clockspeed
Slow
Fast
Demand Characteristics
Predictable
Unpredictable
Profit Margin
Low
High
Product Variety
Low
High
Average forecast error at the

time production is committed
Low
High
Average stockout rate
Low
High
12 - 170
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
12 - 171
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
12 - 172
Sourcing Strategy for

Components
Fishers framework focuses on
finished goods and demand side
Kraljics framework focuses on
supply side
Combine Fishers and Kraljics
frameworks to derive sourcing
strategy
12 - 173
Integrated Framework
Component forecast accuracy
Component supply risk
Component financial impact
Component clockspeed
12 - 174
Component Forecast
Not necessarilyAccuracy
the same forecast accuracy as for
finished goods
Risk pooling concept implies higher accuracy for
components
Sourcing strategy may be minimizing total landed

costs, lead time reduction, or increasing flexibility.
Cost-based sourcing strategy

High component forecast accuracy/Low supply risk/High
financial impact/Slow is appropriate.
Lead time reduction strategy

Low component forecast accuracy/High financial
risk/Fast clockspeed
Flexibility and lead time strategy

Low component forecast accuracy/High financial
risk/Fast clockspeed/High supply risk
12 - 175
HPs Portfolio Strategy

Exponential growth in demand for Flash memory
resulted in high demand uncertainty
Uncertain price and supply
Significant financial and supply risk.
Commitment to purchase large amount of
inventory
huge financial risk through obsolescence cost.
Not have enough supply to meet demand

both supply risk and financial risk
purchasing from the spot market during shortage periods
yield to premium payments
HPs solution: the portfolio strategy

Combined fixed commitment, option contracts, and
spot purchasing
12 - 176
Qualitative Approach to Sourcing

Strategy
FIGURE 9-5: A qualitative approach for

evaluating component sourcing strategy
12 - 177
9.5 E-Procurement
Mid to late 90s: B2B automation was
considered a trend that would have a profound
impact on supply chain performance.
1998-2000:
Multiple e-markets established in various
industries
Promised:
increased market reach for both buyers and
suppliers
reduced procurement costs
paperless transactions
Processing cost per order proposed to be

reduced to $5/order from as high as $150/order
12 - 178
Business Environment in the

1990s
Many manufacturers desperately looking to

outsource their procurement functions.
Procurement process highly complex, significant
expertise required and expensive
B2B transactions an enormous portion of the
economy (much larger
B2B marketplace highly fragmented
a large number of suppliers
competing in the same marketplace
offering similar products.
Opportunities and challenges

Lowered procurement costs (Suppliers)
Significant expertise in procurement process absent
(Buyers)
12 - 179
Opportunities for the

Marketplaces
Initial offerings of independent emarketplaces
Either a vertical-industry focus or a
horizontal-business-process or a
functional focus.
Companies offered:
expertise in the procurement process
ability to force competition between a
large number of suppliers.
12 - 180
Value Proposition to Buyers

Serving as an intermediary between
buyers and suppliers.
Identifying saving opportunities.
Increasing the number of suppliers
involved in the bidding event.
Identifying, qualifying, and supporting
suppliers.
Conducting the bidding event.
12 - 181
The Result
Reduction in procurement costs from
15-40%
Buyers focused on the spot market or
on leverage component
Long term relationships with suppliers
not important
Value proposition to suppliers not
clear
12 - 182
Benefits of e-markets to
Suppliers
Relatively small suppliers could expand
their market horizon
Allows suppliers to access spot markets.
Advantageous in:
Fragmented markets
Reducing marketing and sales costs
Increasing ability to compete on price.
Allows suppliers to better utilize their

available capacities and inventories.
12 - 183
Issues of the Benefits

Do the benefits compensate for a
reduction in revenue?
Average 15%, sometimes as high as 40%.
Many suppliers may not feel comfortable

competing on price alone.
Suppliers, especially those with brandname recognition, may resist selling
their services through e-markets.
12 - 184
What about the e-markets

Themselves?
Revenue generation through transaction costs
Typically 1-5% of price paid by buyer
Transaction fees pose serious challenges to the

market maker:
Sellers resist paying a fee to the company whose main
objective is to reduce the purchase price.
Revenue model needs to be flexible enough so that
transaction fees are charged to the party that is more
motivated to secure the engagement.
Buyers also resist paying a fee in addition to the
purchase price.
Low barriers to entry created a fragmented industry
12 - 185
Fragmented e-markets in the

Chemical Industry
About 30 e-markets
CheMatch, e-Chemicals,
ChemB2B.com, ChemCross,
OneChem, ChemicalDesk,
ChemRound, Chemdex
Low margins and inability to build
scale resulted in a major shake-up of
this industry
12 - 186
Challenges Lead to Evolution of

the e-markets
Changes in the way clients are charged
Licensing fee
software vendor licenses its software so
that the company can automate the access
to the marketplace
Subscription fee
marketplace charges a membership fee
Fee depends on the size of the company, the
number of employees who use the system,
and the number of purchase orders
12 - 187
Challenges Lead to Evolution of

the e-markets
Modification of value proposition
Initial proposition was market reach
Changed through creation of four types
of markets.
12 - 188
Value-Added Independent Public

e-Markets
Expanded value proposition by offering
additional services:
inventory management
supply chain planning
financial services
Examples:
Instill.com focuses on the food service industry
Provides an infrastructure that links together operators
Additional services like forecasting, collaboration, and
replenishment tools.
Pefa.com services the European fresh fish market

Offers buyers access to a large number of independent
fresh fish auctions.
Provide visibility on price from many European ports
Provide information on product quality
12 - 189
Private e-markets
Many companies have established their own
private e-markets
Key activities:
to run reverse auctions
on-line supplier negotiation.
Examples:
Subway restaurant franchise
16,000 members in over 70 countries
Allows the different restaurants to purchase from over 100
suppliers.
Motorola
Implemented supplier negotiation software
Allows firm to conduct bids, negotiate and select an
effective procurement strategy.
12 - 190
Consortia-Based e-markets
Similar to public e-markets
Established by a number of companies within the
same industry.
Examples:
Covisint in the automotive industry

Exostar in the aerospace industry
Trade-Ranger in the oil industry
Converge and E2Open in the electronic industry.
Provides suppliers with a standard system that

supports all the consortias buyers
Some of the consortia have exited the auction
business
Focus on technology that enables business
collaboration between trading partners (Examples:
Covisint and E2Open)
12 - 191
Content-Based e-markets
Two types of markets
Maintenance, repair, operations (MRO) goods
Industry-specific products.
Focus on content
Achieved by integrating catalogs from many
industrial suppliers.
Unify suppliers catalogs
Provide effective tools for searching and
comparing suppliers products.
Example:
Aspect Development (now part of i2) offers
electronics parts catalogs that integrate with
CAD systems.
12 - 192
SUMMARY
Outsourcing has both benefits and risks
Buy/make decisions should depend on:
Whether a particular component is modular or integral
Whether or not a firm has the expertise and capacity
to manufacture a particular component or product.
Variety of criteria including customer importance,
technology clockspeed, competitive position, number
of suppliers, and product architecture.
Procurement strategies vary from component to

component
Four categories of components, strategic, leverage,
bottleneck and non-critical items
Four categories important in selecting suppliers:

component forecast accuracy, clockspeed, supply
risk, and financial impact.
12 - 193
Transportation in a Supply
Chain
12 - 194
Role of transportation
IKEA has built a global network, with about
350 stores in 42 countries, primarily on the
basis of effective transportation
Seven-Eleven Japan uses responsive
transportation system along with
aggregation to decrease transportation
and receiving costs
Amazon relies on package carriers and the
postal system to deliver customer orders
from centralized warehouses
12 - 195
Modes of transportation and

their Performance
Characteristics
The effectiveness of any mode of transport
is influenced by:
Equipment investments and operating
decisions by the carrier
Available infrastructure and transportation
policies
Carrier decisions are affected by
Equipment cost
Fixed and variable operating costs
Responsiveness to its target segment
Prices the market will bear
12 - 196
Air Carriers
Airlines have three cost components:
Fixed cost of infrastructure and
equipment
Cost of labour and fuel
Variable cost depending on passengers
or cargo carried
Air carriers offer a fast and expensive

mode of transport for cargo
Suitable for small, high-value items or
time-sensitive emergency shipments
12 - 197
Package Carriers
Transportation companies like FedEx,
UPS, Postal Service
Use air, truck and rail to transport timecritical smaller packages
Offer rapid and reliable delivery
Also provide value added services like
package tracking
Package carriers have trucks that make
local deliveries and pick up packages
12 - 198
Trucks
Trucking is more expensive than rail
Offers advantage of door-to-door shipment
and shorter delivery time
Consists of two major segments: truckload
(TL) or less-than-truckload (LTL)
The goal of a TL carrier is to schedule
shipments that provide high revenue while
minimizing idle and empty travel time
LTL is suited for shipments that are too large
to be mailed but constitute less than half of
a TL
12 - 199
Rail
Most suitable for moving large amounts
of commodities over large distances
Ideal for heavy, low-value shipments that
are not time-sensitive
Coal is a major part of railroad shipments
Not suitable for small, time-sensitive,
short-distance or short-lead-time
shipments
12 - 200
Water
Major global ocean carriers are
Maersk, Evergreen Group and other
shipping companies
Suited for carrying large loads at low
cost
Slowest of all modes and significant
delays occur at ports and terminals
Difficult to operate for short-haul trips
A significant trend has been the growth
in the use of containers
12 - 201
Others
Pipeline: Used primarily for transport of
crude petroleum, refined petroleum
products and natural gas
Intermodal: Use of more than one mode
of transport
Truck rail are used in combination
Intermodal traffic has grown with the
increased use of containers for shipping
and rise of global trades
12 - 202
Design options for a

transportation network
Direct transportation or through
intermediate site
Intermediate site to stock product
or serve as cross-docking location
Each delivery route to supply single
destination or multiple ones
12 - 203
Direct shipment network to

Single Destination
Buyer structures the transportation
network so that all shipments come directly
from each supplier to each buyer location
Eliminates intermediate warehouses
Simplifies operation and coordination
Decision made for one shipment does not
influence others
Transportation time is short
12 - 204
Direct Shipping with Milk

Runs
Milk run is a route on which a truck either
delivers product from single supplier to
multiple retailers or from multiple suppliers to
a single buyer location
Supply chain manager must decide on the
routing of each milk run
Eliminates intermediate warehouses and
lowers transportation costs
Makes sense when quantity for each location
is too low to fill a truck and multiple locations
are close to one another so that their
combined quantity fills the truck
12 - 205
Milk Runs from multiple

suppliers or to multiple buyer
locations
Supplier
locations
Buyer locations
Supplier
Buyer
12 - 206
All Shipments via Intermediate

Distribution
Centre
with
Storage
Suppliers
Buyer
Locations
DC
12 - 207
All Shipments via Intermediate

Transit Point with CrossDocking
Suppliers send their shipments to an
intermediate point where they are cross-docked
and sent to buyer locations without storing
them
Little inventory needs to be held
Product flows faster in the supply chain
Saves on handling cost
Appropriate when economies of scale in
transportation can be achieved on both inbound
and outbound sides
12 - 208
Shipping via DC using Milk Runs

Suppliers
Locations
Buyer
DC
12 - 209

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Supply Chain Management

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Inventory Management

The objective of inventory

2011 Pearson Education, Inc. publishing as Prentice Hall

2011 Pearson Education, Inc. publishing as Prentice Hall

The Material Flow Cycle

Move Wait in queue Setup Run

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Used to establish policies that

2011 Pearson Education, Inc. publishing as Prentice Hall

2011 Pearson Education, Inc. publishing as Prentice Hall

Percent of annual dollar usage

Percent of inventory items

2011 Pearson Education, Inc. publishing as Prentice Hall

2011 Pearson Education, Inc. publishing as Prentice Hall

Cycle Counting Example

Cycle Counting Policy

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Holding, Ordering, and

Cost (and range)

Material handling costs (equipment lease or

Investment costs (borrowing costs, taxes,

2011 Pearson Education, Inc. publishing as Prentice Hall

Investment costs (borrowing costs, taxes,

2011 Pearson Education, Inc. publishing as Prentice Hall

Inventory Models for

Basic EOQ Model

Inventory Usage Over Time

2011 Pearson Education, Inc. publishing as Prentice Hall

Setup (or order)

The EOQ Model

= Number of pieces per order

2011 Pearson Education, Inc. publishing as Prentice Hall

The EOQ Model

= Number of pieces per order

Annual holding cost = (Average inventory level)

2011 Pearson Education, Inc. publishing as Prentice Hall

The EOQ Model

= Number of pieces per order

Optimal order quantity is found when annual setup cost

2011 Pearson Education, Inc. publishing as Prentice Hall

2011 Pearson Education, Inc. publishing as Prentice Hall

40,000 = 200 units

2011 Pearson Education, Inc. publishing as Prentice Hall

2011 Pearson Education, Inc. publishing as Prentice Hall

TC = (5)($10) + (100)($.50) = $50 + $50 = $100

2011 Pearson Education, Inc. publishing as Prentice Hall

2011 Pearson Education, Inc. publishing as Prentice Hall

Lead time for a

Inventory level (units)

Reorder Point Curve

Reorder Point Example

Production Order Quantity

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Production Order Quantity

2011 Pearson Education, Inc. publishing as Prentice Hall

Production Order Quantity

Total used during

2011 Pearson Education, Inc. publishing as Prentice Hall

Production Order Quantity

Total used during

However, Q = total produced = pt ; thus t = Q/p

Maximum inventory level

Production Order Quantity

p = Daily production rate