15.1 The Role of Sourcing in a Supply Chain

Purchasing, also called procurement, is the process by which companies acquire raw materials, components, products, services, or other resources from suppliers to execute their operations. Sourcing is the entire set of business processes required to purchase goods and services. For any supply chain function, the most significant decision is whether to outsource the function or perform it in-house. Outsourcing results in the supply chain function being performed by a third party. Outsourcing decisions are important and tend to vary across firms and industries. For example, W.W. Grainger, an MRO distributor, has consistently owned and managed its distribution centers. In contrast, outbound transportation of packages from distribution centers to customers has consistently been outsourced to a third party. What factors can explain Grainger’s decisions?

Until 2005, Dell was credited with improving profits by keeping the retail function in-house and selling directly to customers. Since 2007, however, Dell has started to outsource retailing to firms such as Walmart. Dell has also increased the fraction of assembly that it outsources to contract manufacturers. Why was vertical integration into retailing a good idea for Dell until about 2005 but not after 2007? Was Dell right in outsourcing a greater fraction of assembly to contract manufacturers? In contrast to Dell, Apple has significantly expanded the insourcing of retailing during the same period by growing Apple retail stores. Procter & Gamble (P&G) has never attempted to sell detergent directly to customers, and no one is calling on it to bring the retail function in-house. What made vertical integration into retailing a good idea for Apple but a bad idea for P&G? Most companies outsource assembly in consumer electronics. In contrast, most companies insource assembly in the automotive industry. What factors may explain this difference?

We address the outsourcing of supply chain activities by a firm based on the following three questions:

1. Will the third party increase the supply chain surplus relative to performing the activity in-house?
2. To what extent do risks grow upon outsourcing?
3. Are there strategic reasons to outsource?

Recall that the supply chain surplus is the difference between the value of a product for the customer and the total cost of all supply chain activities involved in bringing the product to the customer. Our basic premise is that outsourcing makes sense if it increases the supply chain surplus (assuming we get to keep some of the increase) without significantly increasing risks. A sourcing decision should aim to increase the net value created by the supply chain.

For example, P&G has historically outsourced retailing of its products to others. The third parties increase the supply chain surplus by aggregating many products that customers need (not just P&G products) in a single retail store. This aggregation allows them to spread facility costs, selling costs, personnel costs, and transportation costs across many consumer goods manufacturers. This aggregation also allows the retailer to increase customer value by allowing them to purchase many products they need in a single visit to the store. Clearly, outsourcing retailing to a third party increases the value created by the supply chain to a greater extent than if P&G managed its own retailing. Good sourcing decisions grow value by assigning each activity within the supply chain to the party that can add the most value.

Effective sourcing processes within a firm can improve profits for the firm, as well as total supply chain surplus, in a variety of ways. It is important that the drivers of improved profits be clearly identified when making sourcing decisions. The following are some of the benefits from effective sourcing decisions:

• Identifying the right source can result in an activity performed at higher quality and lower cost.
• Better economies of scale can be achieved if orders within a firm are aggregated.
• More efficient procurement transactions can significantly reduce the overall cost of purchasing. This is most important for items for which a large number of low-value transactions occur.
• Design collaboration can result in products that are easier to manufacture and distribute, resulting in lower overall costs. This factor is most important for components that contribute a significant amount to product cost and value.
• Good procurement processes can facilitate coordination with the supplier and improve forecasting and planning. Better coordination lowers inventories and improves the matching of supply and demand.
• Appropriate sharing of risk and benefits can result in higher profits for both the supplier and the buyer.
• Firms can achieve a lower purchase price by increasing competition through the use of auctions.

When designing a sourcing strategy, it is important for a firm to be clear on the factors that have the greatest influence on performance and target improvement on those areas. For example, if most of the spending for a firm is on materials with only a few high-value transactions, improving the efficiency of procurement transactions will provide little value, whereas improving design collaboration and coordination with the supplier will provide significant value. In contrast, when sourcing items with many low-value transactions, increasing the efficiency of procurement transactions will be valuable.

In the next section, we discuss factors that influence the outsourcing decision.