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Chapter 9 Procurement and
Outsourcing Strategies
BUS 144 Ming Zhou
• Outsourcing: definition, pros and cons
• Third Party Logistics: Industry Overview
• Strategic thinking:
– Make or buy
– Procurement/outsourcing strategies
• Industry Best Practice
• Procurement Process: self-reading
• Outsourcing:
– Delegating a job to an external firm
• IBM: in late 1981, IBM did not have the
infrastructure to enter the PC market and
decided to outsource all of its major
components. IBM replaced Apple as the
number one PC maker in 1985.
• Downside: Compaq were able to use the
• By the end of 1995, IBM market share fell
to 8%, from 40% in 1985.
•85% of Cayenne’s
wholesale value created
by VW workers
•Cayenne shares 65% of
its parts and modules
with Touareg
Porsche versus VW
• The development of Cayenne: only $420
– It could cost Porsche $1.2 to $1.8 billion
(German Center for Automotive Research)
• Cayenne is now mostly produced by VW
• A new model, Porsche Panamera, is also
produced by VW
• What about Audi?
– Porsche raise its VW stake to 18.5% (20%)
Outsourcing Benefits and Risks
• 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 risk-pooling
• Reduce capital investment
– Capital investment transferred to suppliers.
– Suppliers’ higher investment shared between
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
– The ability to use the supplier’s technical knowledge
to accelerate product development cycle time
– The ability to gain access to new technologies and
– Critical in certain industries:
• High tech where technologies change very frequently
• Fashion where products have a short life cycle
Benefits of Outsourcing
• Cost Reduction
• Service Level Improvement
• Focus on core competencies and free up
• Employee base reduction
• Capital cost reduction
– Reduce administrative and operation cost
– Cash infusion
• Inter-firm communication and learning
– Access to world-class capabilities and IT
– Accelerate re-engineering
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 supplier’s 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
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.
Risks of Outsourcing
• Control
• Cost
– Coordination cost
• Service commitment
– Undelivered
– Lack of contact with customers
• Function too critical
• Failed communication and cooperation:
– Cost fluctuate
– Technology capability not delivered
– Lack of trust
3rd Party Logistics: Inbound Logistics
Inbound Logistics:
Top 3PLs and Types of 3PL
– SC Design
– Distribution domestically and internationally
– Reverse logistics
– System solution
• Ryder:
– Information technology to share information
– Redesign SC process
– Transportation services
Top 3PLs and Types of 3PL
• C.H.Robinson:
– All modes of transportation services
– Strategic sourcing and information services
• Schneider Logistics:
– Transportation management
– Network optimization
– International trade services
• Bax Global:

Inventory management
Order fulfillment and transportation
Custom compliance
Top 3PLs and Types of 3PL


Landstar Logistics:

Warehousing and transportation
Total Logistics Control:

Supply chain technology for transportation
Sourcing, distribution, and information technology
Menlo Logistics:

Warehousing, transportation, SC design,
information technology
Buying Electronics
Make or Buy? Fine and Whitney
Fine and Whitney (1996)
• As a firm outsource:
– Dependency for capacity:
• Could make the product by itself, but for reasons
like time, money, space etc. choose to outsource
– Dependency for knowledge:
• Lacks the skill to make the product.
• Seek a expertise supplier.
Decision Matrix:
Fine and Whitney (1996)
• Japanese companies that fit into the trend:
– Toyota, Nissan, IBM Japan, Sony, Hitachi,
Matsushita, Mitsubishi, Nippondenso, Epson,
and Ricoh
– Companies that build manufacturing
equipment are better at buying equipment as
well: They can competently specify their
needs and evaluate suppliers on capability
and price.
Dependent for Capacity versus

Half Shafts:
A purely mechanical example is provided by automobile half shafts
which connect the transmission to the wheels in front wheel drive cars. Half
shafts are highly-stressed, safety-critical assemblies which contain carefully
engineered and precisely made constant velocity (CV) joints. A major US car
firm makes half shafts for itself plus US and Japanese competitors and notes
differences in the degree of oversight each such customer provides. The US
customer provides basic requirements like torque and mechanical interfaces.
The Japanese customer provides as much and more: a highly detailed set of
test and evaluation specifications that the design must pass. A half shaft
design engineer said of the Japanese customer, “They wouldn’t dream of
telling us how to design the CV joints but they will become very ‘helpful’ if
our design fails any of the tests. They will lead us to find the answer they
already know is right. They know because they make similar shafts
themselves. I have visited them; they are the best in the world and they want
us to be, too.” In other words, both US and Japanese customers “depend” on
their half shaft supplier, but the Japanese customer is dependent for capacity
while the US customer depends in an entirely different way. It is dependent
for knowledge.
Dependent for Capacity
• HP designed and produced Kittyhawk disk drive
in 1990s. HP determined the requirements for
key elements, such as spindle motor, disk
platters, and read/write head etc. The supply
partners took the requirements and assembled
the parts. HP designed the disk operating
software and its control system. HP felt safe due
to its control of direct access to market trend and
its system design capability. The outsourced
jobs are component knowledge only.
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
• 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
– Evaluated on system performance, not on component
– Components perform multiple functions.
Integral product
Decision Matrix:
Criteria for Component

Customer Importance

Component Clockspeed

Does the firm have a competitive advantage producing this
Capable Suppliers

How fast does the component’s technology change relative to
other components in the system?
Competitive Position

How important is the component to the customer?
What is the impact of the component on customer experience?
Does the component affect customer choice?
How many capable suppliers exist?

How modular or integral is this element to the overall
architecture of the system?
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
Kraljic’s Supply Matrix
• Firm’s 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
Kraljic’s Supply Matrix
FIGURE 9-4: Kraljic’s supply matrix
Kraljic’s Supply Matrix
• 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
Kraljic’s Supply Matrix
• 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
Outsourcing or even Off-shore
• Best Practices (BusinessWeek):
– The right reason:
• a broken system would NOT be fixed
• Clear expectation
– Choose the right model:
• Completely outsourcing or simply partnering
• Baker & McKenzie: own draft team in Manila
• BofA teamed up with InfoSys and Tata Consultancy
– Get your people on-board:
• Middle managers and employees make things happen
• Dutch Bank ABN Amro:
– A dedicated team to explain the outsourcing move
– Town hall meeting for all employees
– All 12 CTOs to reach concensus on the partner and workforce

Outsourcing or even Off-shore
• Best Practices (BusinessWeek):
– Be patient, both time and effort:
• “It took a heck of a lot more involvement on the
part of myself and my team than I expected.”
(Frank, Cocuzza, CFO, Penske Truck)
– Treat your partner as equals
• In order to get the best results
• Wolter Kluwer Publishing: Tata Consultancy
Fisher’s Functional vs. Innovative
Functional Products
Innovative Products
Product clockspeed
Demand Characteristics
Profit Margin
Product Variety
Average forecast error at the time
production is committed
Average stockout rate
Supply Chain Strategy
• Functional Products: global
– Diapers, soup, milk, tiers
– Appropriate supply chain strategy for functional
products is push
– Focus: efficiency, cost reduction, and supply chain
• Innovative products: local
– 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
Component Criteria:

Component forecast accuracy
Component supply risk
Component financial impact
Component clockspeed
Chapter 5 The Value of
Ming Zhou
BUS 144
□ The Beer Game
□ The Bullwhip Effect
□ Strategies to alleviate the bullwhip
effect problem
The Beer Game
□ Players
□ Retailer, Wholesaler, Distributor and Manufacturer.
□ Goal
□ Minimize system-wide (chain) long-run average cost.
□ Information sharing: Mail.
□ Demand: Unknown
□ Costs
□ Holding cost: $0.5/case/week.
□ Penalty cost: $1.00/case/week.
□ Leadtime: 2 weeks physical delay
Every Week:
□ Beginning:
– New order received from consumers.
– New shipments received from your supplier.
– Customer order and backorders are filled from inventory.
□ Any balance goes into backorders.
□ Cost is:
□ $0.50 per case in ending inventory;
□ $1.00 per case in backlog
□ End:
□ You place an order with your suppliers
□ Backorders do not go away!!
□ All orders must eventually be filled
□ No communication with other teams
□ If you have played before…
□ Lowest cumulative cost team is the
□ Retailer: 14 units of inventory on hand
□ Wholesaler: 26 units of inventory on
□ Distributor: 26 units of inventory on
□ Factory: unlimited capacity
Did we replicate this ?
Reason 1:
□ Demand Signaling:
□ Retailer:
□ mean demand 400 units, demand std is 100
□ Order: 400 + 100 = 500
□ Wholesaler:
□ Demand? 500
Reason 2:
□ Order Batching:
□ In order to take advantage of economies
of scale:
□ Transportation
□ Inventory holding
□ Price discount
□ Order a large amount at a time
Reason 3:
□ Price fluctuation:
□ Retailer: promotion => demand shoots up
□ Manufacturer: promotion => forward
Reason 4
□ Shortage Gaming:
□ Order more than what a customer really
□ Anticipation of shortage
Reason 5
□ Long lead time or long supply chain:
□ You have to prepare for the lead time
□ Your goods go through more echelons
Reason 6
□ Machine breakdown
□ Quality issues
Reason 7
□ Human constrained rationality
□ Underweight in-transit inventory
(Management Sciences, 2006)
□ Safe harbor behavior: lack of security
□ Panic: over-concerned of excessive
inventory (Nienhaus et al., 1995)
Strategies for Bullwhip Effect
□ JIT system with more frequent, but smaller orders
and shipment.
□ “Everyday low price” to even out demand
□ Allocate demand base on past sales record.
□ Centralized decision making system.
□ Joint forecasting
□ Lead time reduction
□ Strategic Partnership
□ Reduce supply chain echelons
The Trade-offs
□ Inventory vs Transportation Cost:
□ Delay production
□ Combine batches
□ Cross-docking
□ Lead time vs Transportation Cost:
□ Better information system
□ Reduce lead time
The Trade-offs
□ Product Variety vs Inventory:
□ Delayed differentiation
□ Customer service vs costs:
□ Trans-shipment
□ Centralized warehouse
□ Direct retailing
How about the service industry?
□ Service and Manufacturing
□ Labor intensive
□ Customer involvement
□ Service heterogeneity
□ Intangibility
□ Simultaneity of production and
□ Supplier-customer duality:
□ Can not start until customer input provided
How about the service industry?
□ Akkermans and Vos, POMS, 2003:
□ Analyzed a large telecommunication
company in the US
□ Workload and backlog
How about the service industry?
How about the service industry?
□ Reasons for bullwhip effect:
□ Not batching and shortage gaming
□ Demand signaling is one of the major
□ Price fluctuation is another one
□ Workload and quality
□ Capacity reservation: No
□ High training and hiring costs
□ Lead time based: possible
□ EDLP: against the commercial strategy
□ Information sharing: modest benefits
□ Strict quality control: promising
Concepts, Strategies, and Case
David Simchi-Le vi
Massachusetts Institute of T echnology (MIT ), Cambridge, Massachusetts
Philip Kaminsky
University of California, Berkeley
Edith Simchi-Le vi
LogicT ools, Inc., Lexington, Massachusetts
Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco
St. Louis
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T oronto
Published by McGraw-Hill/Irwin, a business unit of T he McGraw-Hill
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Library of Congre ss Cataloging-in-Publication Data
Simchi-Levi, David.
Designing and managing the supply chain : concepts, strategies, and
case studies / David
Simchi-Levi, Philip Kaminsky, Edith Simchi-Levi.—3rd ed.
p. cm—(McGraw-Hill/Irwin series in operations and decision
Cover title: Designing & managing the supply chain
Includes index.
ISBN-13: 978-0-07-298239-8 (alk. paper)
ISBN-10: 0-07-298239-X (alk. paper)
1. Physical distribution of goods—Management. 2. Marketing channels
—Management. 3. Business logistics. 4. Industrial procurement. I.
Kaminsky, Philip. II. Simchi-Levi, Edith. III. T itle. IV. T itle: Designing
& managing the supply chain.
HF5415.7.S425 2008
The McGraw-Hill/Irwin Series
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