Yes, companies are outsourcing commodities to increase value. Value is lowering costs and improving performance (e.g., quality, service, and flexibility). A commodity is defined as being something for which several qualified suppliers exist. Typically, buying organizations will use several rounds of the competitive bidding process to pick a low cost supplier. Buying organizations will send out RFQs to get bids from suppliers. RFQ stands for a Request for Quotation. In other words, please give us a quote for this business.
However, the data seems to indicate several iterations of the competitive bidding process does not get you the lowest price. Why? Suppliers pad their quotes from beginning to end because they know you will play this game. Data indicates that the most effective way to get the lowest bid is to tell suppliers that they will only have once chance to bid/quote on the business. If they really believe that, then they will deliver their best quote the first time around (because it is the only time). However, very few companies actually make bidding a one shot deal. Most companies are too greedy and are not convinced that the one time only cycle works.
Another problem with competitive bidding is that you are just trying to get suppliers to low ball each other and that means you are just messing with their profit margins. If you have a current supplier that charges $1.00 per part, and it costs them $.90 to make it, they have about a 10% margin. If you have them rebid and rebid and rebid on the business, and then they agree to $.93 per part, you are indeed paying less per part, but you have reduced the supplier’s margin down to nothing. Heaven forbid that you as a buying organization just sit down with your supplier and help them reduce their direct costs (e.g., labor and material). Most of their costs are coming from labor and material which means there are probably some really big cost savings ideas there. What if you could cut their direct costs by 30% and then you tell them you can still keep your 10% margin? That supplier would say thank you so much because their margins do not change, they are just more cost competitive and probably end up getting more business because of it (and you now pay around $.70 per part).
One final note. We talked about how some companies are going beyond just outsourcing commodities to also outsourcing core/strategic parts. It can be done effectively. Chrysler has mastered it. They use things like co-location, long-term contracts, and legally they establish joint ownership of all design and mfg capabilities developed. However, with core stuff there might only be 1, 2, or 3 suppliers to choose from. Also, if it is core, chances are you need to go with one supplier because using more than one might be too complicated and sensitive. For example, Chrysler outsources interior seating systems to one supplier (JCI). JCI does not want to do business with Chrysler if they also use their competitor (Lear). Ford will use Lear though and not JCI. I am embellishing here a little to make a point.
Companies do not use competitive bidding when they outsource core parts. Why? One, how do you use competitive bidding if there are only 1 or 2 suppliers to choose from? You cannot. Have you heard about the government awarding multi billion dollar contracts to suppliers like Halliburton with no bids? People often ask why don’t they use competitive bidding to get the same price. Maybe it is because they do not hire ISM students. Some people think it is because our former Vice President (Dick Cheney) used to be the CEO of Halliburton and he has lots of stock in the company. A $2 billion contract from the government makes him $ 2 million dollars richer. Or, is it because Halliburton is the only supplier that can give the government everything they need and want? You decide. It is probably a little bit of both.
I hope this clarifies our future discussion and please let me know if this sourcing strategy stuff is making sense to you. Usually, with core parts, price is not the most important thing. They of course care about price. But how much do you know about price with something as complicated as a core part like seating systems? It is not a commodity like a widget. They will usually establish cost target goals and reward the supplier if they exceed those goals. Usually, it is about performance (e.g., quality, service, and flexibility). That is why they usually use negotiation to find a supplier for core parts. Junior buyers (like yourself) will use competitive bidding for commodities. Senior buyers (you 5 years from now) will negotiate the terms and conditions of a contract with suppliers for strategic parts.
Remember, here are the video lectures to accompany this discussion:
A great read on Sourcing Strategy with my field notes…
Pasted below are the sample stories I read in class about the previous internship experiences of former WMU ISM students. Pasted below each one is the moral of the story (i.e., the sourcing strategy). Thank you. Sime
Last summer, I was a sourcing “analytics” intern at FirmA and the main part of my job was sending and receiving RFQs for the FirmA Parts and Service Department. We tell suppliers that we will only participate in “one round” of RFQs and we expect their best price the first time.
I had a small tube manufacturer in Iowa contact me one day stating that they were having issues lowering their prices and wondering if they could get assistance so they could be a better supplier. I discussed this with my boss and he sent a quality engineer and a Senior Buyer to the supplier to assist them (I asked to go but unfortunately HR would not approve Intern travel to a facility that wasn’t owned by our company). My internship ended before I could see the results of the visit implemented, but the pair that went estimated that they reduced the cost of some products by up to 10%! I very much enjoyed my internship at FirmA and helping suppliers was a thrill.
“From Sime”: Sourcing = procurement = purchasing (companies use different terms).
Rather than mess with a supplier’s profit margins via competitive bidding to get a lower price, why not just help your suppliers reduce their Direct Costs? That way you do not mess with their margins and chances are you get a much lower price. However, it takes a strategic effort (time).
The single chance to bid is a great option even though it seems counter intuitive. The “single bid only” is the same model that FirmB uses for its commodity bidding. I have used this very technique successfully when purchasing Oil for FirmB (lubricant, not the combustible kind). FirmB had an oil supplier who we felt was too expensive, so I send out a series of RFQ’s to other competing firms (Shell, Exxon, etc.). Through this process I found FirmB was paying significantly more than we should be paying. I then went back to our original supplier and said “We have found significant cost savings with alternative suppliers. You need to come back to us with the most competitive price you can offer, or we will place our last purchase order on [date roughly two weeks away]”. After this they were able to miraculously lower their price by 46% for all oil. This goes to show you that even a novice negotiator can find significant cost savings when using this technique.
“From Sime”: Notice the one shot deal to bid on the business. By giving suppliers only one chance to bid on the business, you tend to get their best price. However, that was not the case with this lubricant supplier. By the way, this sounds like an MRO purchase to support its factories. Remember, your P.O. with your suppliers will likely have terms and conditions that say you can reopen bidding on the business for any competitive reason (i.e., you think you are overpaying!).
The two companies that I’ve worked for choose to have “vendors” bid “once”. At FirmC, our vendors have learned that we expect the best up front and quotes are to be turned around within 3 days. Our quoting process moves insanely fast and we definitely pay for it. At FirmC, I was able to host over 10 Ariba events and we also taught our “vendors” that we expect “one and done”. I did see the problem that you point out there. The vendors at SupplierA for the super specialized, engineered items are not local or utilized as much so their quotes are most definitely padded. I had a few vendors call me to say that if they’re close to the lowest bidder, they would drop their pricing to match. Or they would say that they would have given us better pricing if they were guaranteed the business. I thought this was interesting.
“From Sime”: Notice how this student worked for a company that called their suppliers “vendors”. I think that is fine if you are buying “indirect” material. Otherwise, call them “suppliers”, especially if they design and build stuff that goes directly into your product. It sounds like this supplier did low volume customized engineered work and this supplier did not need their business. It sounds like this supplier had some leverage to talk to a potential customer like this.
I would like to defend myself on my previous emails referring to suppliers as “vendors”. The last 4 months at FirmD introduced me to using the term “vendors”. The definition you gave refers to vendors as suppliers of “indirect” materials. Everything bought at FirmD is an “indirect” cost and their acronyms used frequently are as followed: VIMS (Vendor Invoice Management System) and CVM (Central Vendor Maintenance). Now that I know other companies will cringe at that word, I will stop using “vendors” and refer to all suppliers as “suppliers”. I’m very grateful that you pointed this out.
“From Sime”: She made a good point. She worked for a company that did not design and build anything. All of their spend was therefore INDIRECT spend. So, I guess it is OK to call suppliers “Vendors” if they only provide stuff that does not go into anything that you build. In this case again, they do not build anything so all their spend is INDIRECT. Note, 90% of Americans work in the service sector for companies that do not build anything. All of their spend is INDIRECT.
This summer at FirmE, I did some work preparing for engine negotiations with SupplierA (they design and build engines). SupplierA does not provide ANY cost transparency with their engines, because they know they produce the best engines in the world and have the leverage to say NO to providing transparency. As a result, we had to do a lot of “should costing” with SupplierA’s engine components, and even tear down an engine of theirs, to prepare our “cost breakdown” for their engines. That way we could do our homework, and show what price SupplierA should be making their engines for.
If you are working with a commodity like fasteners (a true commodity, tons of suppliers), you can get away with sourcing from multiple suppliers. Fasteners do not vary too much from one another, so it sometimes may be necessary to have a larger supplier base, as a method to assure there will always be a supply of parts.
I was able to learn this first hand, by working in procurement on FirmE’s Powertrain Category Management Team. I was able to work with the Supply Chain Manager for engines, and learned that we (FirmE) used to make their engines! However, FirmE began to outsource their engines to SupplierA nearly a decade ago because they could make better engine’s than we (FirmE) could, and at a better price, therefore, we (FirmE) outsourced their engines and became much less reliant on vertical integration (making our own engines).
Based on my personal experience, it makes a lot of sense why companies would outsource “strategic” parts. This can help companies rely on assembly and their final product, rather than wasting a lot of resources on strategic parts, that another company can make better, faster and cheaper.
“From Sime”: There is so much in this one. FirmE started to outsource a core part (engines). Over time, they lost design and manufacturing capabilities on engines. Once SupplierA of engines realized this, they started jacking up their prices and telling FirmE that the cost breakdown was none of their business. I have no issues with FirmE outsourcing engines for over 10 years, but you better make sure you that you never forget how to design and build them if you sell buses. FirmE should have told SupplierA ten years ago that they can have the business if they have joint ownership of all design and mfg capabilities associated with their business and that a cost breakdown will always be required. Had they done this Day One, they likely would have not lost leverage in this buyer supplier relationship. FirmE got greedy and sloppy. Note, the person that made that decision ten years ago might have gotten a huge bonus ten years ago and retired, and now someone else has to fix this sourcing decision. A sourcing decision today can impact your company 10, 20, 30 years down the road. 10, 20, 30 years ago, a bunch of managers decided to source stuff from China because it was soooo much cheaper (or so they thought on the surface). As it turns out 10, 20, 30 years later, it actually ended up costing them more (i.e., quality, lead times, control, insurance, inventory, etc.).
I can support the statement of companies mostly outsourcing their “manufacturing” capabilities. Johnson & Johnson just recently sold their entire Medical Device manufacturing plants to a third party manufacturer called Jabil.
“From Sime”: So, if J & J outsources mfg for medical devices, what the heck is their Core competency? Answer: Scaling and ramping up small companies that they buy. J & J has tons of cash and credit and can buy small businesses with great ideas. J & J has a super sophisticated supply chain and J & J manages their supply chain very well. So they can take a medical device that someone is building in their garage and take it global super fast. That start up company in the garage has no idea what supply chain management even means. That start up needs J & J (or Stryker in Kzoo) to help them scale up. Otherwise, the product never leaves their garage.
Back to Jabil. Jabil is a manufacturing subcontractor. Jabil’s core competency is building stuff for entire industries like medical device. Jabil does it for the entire industry (not just for J & J) and gets the economies of scale, so that it does it better, faster and cheaper than companies like J & J could if they built it themselves. Products and technology change so fast for medical devices that the product might be outdated in 6 months, so J & J does not want to build factories to support such short product life cycles. Jabil can make money doing it for them (and everyone else in the industry) and that is Jabil’s thing (core competency).
Student # 7 (this was a bad day for the WMU ISM program):
I wanted to let you know we had at least three WMU students attend the early session of MSU’s career fair. I was thrilled they made the drive and spent time with our team. Unfortunately, we had a bit of a situation. We selected John Smith as one of our top picks for first round interviews based on multiple members of our team talking to him. He had completed the intake form indicating he had a 3.0 GPA which is our minimum requirement. During the interview we realized his GPA was actually 2.64. This is unacceptable that he lied to us and completely goes against our core values of Integrity, Commitment, Quality and Innovation. I won’t be able to invite WMU students to MSU if we have a situation like this again.
“From Sime”: Do not lie. Be honest on job applications. Sometimes they do not even care about the details. They just want to check and see if you are lying. Lying is a “falsification of records” (kind of a big deal in SCM). Also, do not renege. Be a leader.
In the above link, people came after me a little in the “comments” section.
As I work for a smaller company I have been on the receiving end of the negative impacts of this idea that you strategically source core parts of our valves. A specific example is one of our molded xxxxx, sure we save a lot of money and no longer have to mold a rubber to a metal xxxxxxx but recently the supplier went through a management change, and switched from an outdated ERP system to SAP. This created huge problems for them, and ended up shutting down our lines for almost a week. As a smaller company we do not have a lot of leverage with this supplier. We ended up coming to an understanding and moving molds to another location but shutting down for that long is less than ideal for any manufacturer. Just an example of where it can come back to bite you if you do not upkeep a safety stock or have good relationships with a supplier for a core part.
From Sime: Yes, most of you will work for companies that will be bigger than your suppliers and you will be a hugely important customer to your suppliers. Enjoy that leverage! However, some of you might work for a smaller company and your suppliers might be much larger than you. Further, you might not be an important customer to your suppliers. Finally, you might ask these suppliers to do low volume customized highly engineered stuff for you. In other words, it is NOT a commodity. If you are ever in this situation, good luck with that. Hopefully, your company is very good at something and your customers are OK with paying a premium.
Lastly, when outsourcing strategically, you always want to look at if the supplier makes parts “in-house” or “outsources” themselves because that plays a key role when choosing a supplier. Yes, during covid, some supply chains broke down because companies were outsourcing stuff to suppliers who then flipped it to other suppliers and the companies did not even know about it (until that supplier in China shut down for 8 weeks because of covid).
Thank you. Sime
Sample Lectures & Should You Major in Supply Chain Management?
Dr. Sime (Sheema) Curkovic, Ph.D., Professor, Operations/Supply Chain
Western Michigan University, Haworth College of Business
“WMU Integrated Supply Management (ISM)…Nation’s best undergraduate SCM program (Gartner); 2nd in SCM technology (SoftwareAdvice); 2nd in top global SCM talent (SCM World)”