International Operations Management

MGMT 6367

Lecture 02

Instructor: Yan Qin

Fall 2013

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Outline

Concepts!

Key decisions in Outsourcing

1. What should be outsourced?

2. Which vendors/providers are most suitable partners?

3. What forms of relationship with partners should be used?

Guidelines in Global Sourcing

Risks of Outsourcing

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Get to know the concepts!

They can be confusing…

◦Outsourcing: Procuring from external sources services or products that are normally part of an organization.

◦Offshoring: Moving a business process to a foreign country but retaining control of it.

◦Backsourcing: The return of business activity to the client firm. A client firm is an organization that outsources from outsource provider.

◦Nearshoring: Choosing an outsource provider in the home country or in a nearby country.

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Examples: What practice is it?

1. Electronic Data Systems (EDS) provides information technology for Delphi Automotive and Nextel.

2. If a firm owns two production facilities, one in the home country and the other in a foreign country, and later decides to shift production from the first to the second.

3. Dell believed it could save cost by moving some of its technical support for corporate customers to Bangalore, India. But faced with complaints from customers, it shifted some of help desk service phone calls back to Tennessee and Texas.

4. A US-based company outsources from Canada or Mexico.

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Offshoring, Outsourcing, and Control

Moderate Control

Low Control

High Control Moderate Control

Outsourcing Decision

Partnership Risk

Offshoring Decision

Foreign Business Risk

Owned Contracted

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Source: Robert S. Huckman, HBS No. 606-094

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Supplement: Hold-up problems

A hold-up problem arises when one party makes a sunk, relationship-specific investment and then engages in bargaining with an economic trading partner.

That partner may be able to appropriate some gains from the sunk investment, thus hurting the first party’s investment incentives.

The first party may as a result make less investment than required.

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Why Outsourcing?

Strategic Reasons Tactical ReasonsImprove business focus

Reduce or control operating costs

Gain access to world class capabilities

Make capital funds available

Accelerate re-engineering benefits by having less internal processes

Create cash infusion

Share risks Compensate for lack of internal resources

Free assets/resources for other purposes

Improve management of difficult or out-of-control functions

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Why global outsourcing?

The motivation for global outsourcing comes from the theory of comparative advantages.

Theory of comparative advantage: A theory which states that countries benefit from specializing in (and exporting) products and services in which they have relative advantages, and importing goods in which they have a relative disadvantages.

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Key Decisions in Outsourcing

What should be outsourced?

Which vendors/providers are most suitable partners?

What forms of relationship with partners should be used?

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Q1: What should be outsourced?

NOVELTY(Outsource/In-house)Technology; Quality;

Service

PROPRIETARY(In-house)

Technology; Quality

COMMODITY(Outsource)

Price

UTILITY(Outsource)

Cooperation; Service

High

High

Low

LowCriticality of the part to final assembly

Strategic Importance and Criticality Matrix (SIC Matrix)

Strategic value of the part in isolation

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Interpretation – Cont.

Proprietary components usually embody the core competencies of the company and should not be outsourced.

Commodities usually involve low or standard technology and having minimal contribution to the principal functions of the final products.

Novelties are components that require sophisticated technology but are not essential to the functioning of the final product.

Utilities are critical to the final product but are based on low or readily available technology, such as radiator caps in vehicles.

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Q2: Vendor Selection Methodologies – Factor RatingSteps to take in Factor Rating:

1. Make a list of criteria that are critical to that particular outsourcing activity

2. Place an importance weight on each of the factors. The sum of the importance weights must sum to 1.

3. Rate each provider based on the criteria, on a, say, 1-5 scale with 5 being the most satisfactory and 1 being the least satisfactory;

4. Multiply each rating by the corresponding weight and sum the products for each supplier.

5. Pick the one with the highest overall rating.

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Example: Factor Rating

A company has decided to outsource its information technology function. Three outsourcing providers are being actively considered: one in US, one in India, and one in Israel. Seven criteria are identified. Importance weights are attached to each criterion.Criteria Weig

htSupplier 1

Supplier 2

Supplier 3

1. Can reduce operating costs

.2 3 3 5

2. Can reduce capital investment

.2 4 3 3

3. Skilled personnel .2 5 4 3

4. Can improve quality .1 4 5 2

5. Access to technology not in company

.3 5 3 5

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Q2: Vendor Selection Methodologies – Break-even Analysis

In an outsourcing situation, a break-even analysis may be applied to compare the total in-house production cost () to the total outsourcing cost ().

where refers to the fixed in-house cost, represents the variable in-house cost per unit, and is the in-house production quantity.

Similar for the outsourcing costs and production quantity.

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Break-even Analysis – Cont. At an ideal break-even point, .

So let and

To solve for , the break-even quantity, we have

If the current or expected production amount is less than X, pick the one with the lower fixed cost, usually outsourcing.

If the current or expected production amount is greater than X, pick the one with the lower variable cost, usually in-house.

Example: Break-even

Kamal-Gursoy Electronics is currently performing all its single-product production in house, with a yearly fixed cost of $5 million and a variable cost per unit of $2. The firm is approached by a Vietnamese outsourcing provider that can manufacture the product with equal quality for a yearly fixed cost payment of $2 million. Kamal-Gursoy is now facing a yearly demand of 2 million units.

(1) Suppose the Vietnamese company offers a variable cost per unit of $6. What is the break-even quantity?

(2) Should Kamal-Gursoy outsource the production to the Vietnamese company when the variable cost per unit is $6?

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Break-even with Quantity Discounts

All-unit quantity discount

◦ The unit price offered by a supplier declines on a step function basis.

Incremental quantity discount

◦ Under incremental quantity discounts, discounts are only applied to additional units beyond the breakpoints. The unit cost/price _ for the quantity interval 𝑣 𝑖( _( −1), _ ] decreases as increases.𝑞 𝑖 𝑞 𝑖 𝑖

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Q3: Buyer – Supplier Relationships

The number of suppliers, their locations, and their sizes are important considerations in deciding the type of relationship to establish.

Five typical Buyer – Supplier relationships:◦ Negotiate with many suppliers and play one supplier

against another;

◦ Develop long-term “partnering” relationship with a few suppliers;

◦ Use vertical backward integration by buying the supplier;

◦ Keiretsu: suppliers become part of a company coalition;

◦ Develop virtual companies that use suppliers on an as-needed basis.

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Many Suppliers

A common strategy when products are commodities.

Suppliers respond to demands and specifications of a “request for quotation”. Order goes to the low bidder.

Suppliers are responsible for maintaining the necessary technology, expertise, cost, and quality competencies.

Long-term “partnering” relationships are not the goal.

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Few Suppliers

Rather than focusing solely on low cost, a buyer can benefit from forming a long-term relationship with a few dedicated suppliers.

Suppliers in this relationship are expected to participate in the Just-In-Time system and provide design innovations and technological expertise.

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Vertical Integration

Vertical integration can take the form of forward or backward integration.

Backward integration: a company buys its suppliers, such as Ford Motor when it decided to produce its own car radio.

Forward integration: a manufacturer of components make the finished product.

Benefits? ◦ Cost reduction in purchasing components/raw

materials◦ Quality adherence◦ Timely delivery◦ Inventory reduction

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Vertical Integration – Cont.

Interested in Vertical Integration? ◦ Enough capital◦ Large management talent◦ Required technology

In high-tech industry, companies tend to keep a close relationship with their suppliers and focus on their specific contribution instead of doing everything by themselves. One good reason is that the R&D costs are too high for a single company to bear in order to just keep up with the rapid technological changes.

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Keiretsu Networks

Keiretsu is somewhere between few suppliers and vertical integration.

In Keiretsu, manufacturers become financial supporters of suppliers through ownership or loans. Suppliers’ suppliers can also be made as part of the coalition.

It features long-term “partnering” relationship. Technical expertise and quality production are expected from the suppliers.

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Virtual companies

Virtual companies rely on a variety of supplier relationships to provide services on demand.

The relationship may be short- or long-term and may include true partners, collaborators, or simply able suppliers and subcontractors.

This form offers specialized management expertise, low capital investment, flexibility, and speed.

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Guidelines for Global Sourcing

Characteristics of the sourcing country (the country where the company wants to source is located) matter.

Either the production cost differential or the knowledge differential between the sourcing country and the source country must be sufficient to overcome the costs of transacting across borders.

◦ It is either a much lower production cost or a far more superior product/service.

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Guidelines for Global Sourcing

Products suitable for global sourcing:

◦ Labor intensive products

◦ Standardized products: Design, specifications and production technology do not change frequently.

◦ Products with a predictable sales pattern as opposed to products with abrupt shifts in demand

◦ Products that are easy to ship and face low import duties.

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Guidelines for Global Sourcing

The size of the firm matters.

◦ Smaller companies might have more barriers due to the lack of knowledge of foreign supply markets, formal requirements for shipping goods overseas, lower bargaining power to force foreign suppliers to do their job.

◦ Transaction cost, cost of conducting transactions overseas and receiving products in the home country, is relatively independent of transaction volume. The cost becomes smaller relative to production cost as volume increases. Bigger companies might find the cost more bearable due to their larger volume.

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Guidelines for Global Sourcing

◦ Some multi-national firms already have global network established, which makes things a lot easier.

The structure of the sourcing firm matters.

◦ The closer the different functional areas are in the sourcing company, the easier to source abroad.

Fit in culture matters.

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Guidelines for Global Sourcing

Focus on the total cost incurred by offshoring, instead of the savings on unit cost.

◦ Ferreira and Prokopets (2009) suggest that companies should evaluate the impact of off-shoring on the following key factors of total cost: Supplier price Terms: costs are affected by net payment terms and

volume discounts Delivery costs Inventory and warehousing Cost of quality: for example, cost of validation, cost of

performance drop due to poor quality Custom duties Exchange rate trends, and etc.

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Risks of Outsourcing

Increased transportation costs due to expanded network

Loss of control

Creating future competition in case core technology leaks

Negative impact on employee due to lay-off

Significantly higher uncertainty in the global context

◦ Possible delays in custom clearance, changes in certain foreign regulations that might be detrimental to the profitability or feasibility of outsourcing, occurrence of natural disasters in the source country that might disrupt the supply, and differences in culture and economy environment.

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Next Week

Introduction to Supply Chain Management

◦ What is a Supply Chain

◦ Bullwhip Effect and mitigating strategies

◦ Domestic Vs. Global Supply Chain