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CHAPTER 13

GLOBAL SOURCING
AND PROCUREMENT

Learning Objectives
LO13–1 Explain what strategic sourcing is.
LO13–2 Explain why companies outsource processes.
LO13–3 Analyze the total cost of ownership.
LO13–4 Evaluate sourcing performance.

HOW THE COVID-19 PANDEMIC LED TO

EMPTY SHELVES
When the Covid-19 pandemic hit in early 2020, consumers suddenly exhibited
panic-buying behavior. The behavior was caused by the uncertainty of prolonged
shelter-in-place regulations. The immediate impact on grocery stores was empty
shelves. Consumers instantly bought medical supplies, groceries, and other
nonperishables in bulk. This shift resulted in immediate stock-outs since supply
chains were not able to quickly react to the sudden shift in demand.
While grocery store suppliers were struggling to keep up, restaurant suppliers
saw the opposite. A sudden stop in demand due to restaurant closures caught

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these suppliers swimming in unneeded

produce and meats. To make matters
worse, the restaurants and suppliers
had no idea when they might be able
to reopen.
The grocery store suppliers quickly
ramped-up in response to the demand,
and the restaurant suppliers canceled all orders and shut down. Over time, grocery
stores saw the demand from the panic buying quickly drop when everyone had
what they needed. The restaurants slowly began to open, running at low capacity
due to social distancing and other health measures. The restaurant suppliers had to
quickly ramp back up to meet the new demand.
These rapid shifts in demand often induce a phenomenon known as the bull-
whip effect. The effect is characterized by inventory levels cycling between exten-
sive stock-outs, followed by large amounts of excess inventory. Think about it. If
stores are faced with inventory shortages, customers will react by buying more and
stockpiling when products become available. Unfortunately, there will come a time
when consumer demand falls again simply because no one needs to buy any more.
Who needs to buy a 10-pack of toilet paper when you have a three-month supply
in storage?
The bullwhip effect on many products during the pandemic has exposed many
vulnerabilities in existing supply chains. Many companies are realizing the impor-
tance of having agile supply chains, supply chains that can cope with uncertain
demand. Strategy and digital technology will be more important than ever to deal
with the needs of the more responsive supply chain of the future

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436 OPERATIONS AND SUPPLY CHAIN MANAGEMENT

STRATEGIC SOURCING
LO13–1 Explain Strategic sourcing is the development and management of supplier relationships to acquire
what strategic goods and services in a way that aids in achieving the immediate needs of the business. In the
sourcing is. past, the term sourcing was just another term for purchasing, a corporate function that finan-
cially was important but strategically was not the center of attention. Today, as a result of glo-
Strategic sourcing balization and inexpensive communications technology, the basis for competition is changing.
The development A firm is no longer constrained by the capabilities it owns; what matters is its ability to make
and management of the most of available capabilities, whether they are owned by the firm or not. Outsourcing is so
supplier relationships sophisticated that even core functions such as engineering, research and development, manu-
to acquire goods and facturing, information technology, and marketing can be moved outside the firm.
services in a way that Sourcing activities can vary greatly and depend on the item being purchased. Exhibit 13.1
aids in achieving the maps different processes for sourcing or purchasing an item. The term sourcing implies
needs of a business.
a more complex process suitable for products that are strategically important. Purchasing
Sourcing processes that span from a simple “spot” or one-time purchase to a long-term strategic alli-
A process suitable ance are depicted on the diagram. The diagram positions a purchasing process according to
for procuring the specificity of the item, contract duration, and intensity of transaction costs.
products that Specificity refers to how common the item is and, in a relative sense, how many sub-
are strategically stitutes might be available. For example, blank USB flash drives are commonly available
important to the firm. from many different vendors and would have low specificity. A custom-made envelope that
Specificity is padded and specially shaped to contain a specific item that is to be shipped would be an
Refers to how example of a high-specificity item.
commonly available Commonly available products can be purchased using a relatively simple process. For low-
the material is and volume and inexpensive items purchased during the regular routine of work, a firm may order
whether substitutes from an online catalog. Often, these online catalogs are customized for a customer. Special user
can be used. identifications can be set up to authorize a customer’s employees to purchase certain groups of
Request for items, with limits on how much they can spend. Other items require a more complex process.
proposal (RFP) A request for proposal (RFP) is commonly used for purchasing items that are more
A solicitation that complex or expensive and where there may be a number of potential vendors. A detailed
asks for a detailed information packet describing what is to be purchased is prepared and distributed to poten-
proposal from a tial vendors. The vendor then responds with a detailed proposal of how the company
vendor interested in
supplying an item.
exhibit 13.1 The Sourcing/Purchasing Design Matrix

Short Low
Request for
proposal Spot
purchase

Request for bid

Contract and
Specificity
duration reverse auctions

Electronic
catalog
Strategic Vendor
alliance managed
Long inventory High

High Transaction costs Low

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GLOBAL SOURCING AND PROCUREMENT chapter 13 437

intends to meet the terms of the RFP. A request for bid or

reverse auction is similar in terms of the information packet
needed. A major difference is how the bid price is negotiated.
In the RFP, the bid is included in the proposal, whereas in a
request for bid or reverse auction, vendors actually bid on the
item in real time and often using internet software.
Vendor managed inventory is when a customer actu-
ally allows the supplier to manage the inventory policy of
an item or group of items for them. In this case, the supplier
is given the freedom to replenish the item as they see fit.
Typically, there are some constraints related to the maximum
that the customer is willing to carry, required service levels,
and other billing transaction processes. Selecting the proper
process depends on minimizing the balance between the sup-
plier’s delivered costs of the item over a period of time, say INSTEAD OF SENDING PURCHASE ORDERS, CUSTOMERS
a year, and the customer’s costs of managing the inventory. ELECTRONICALLY SEND DAILY DEMAND INFORMATION TO THE SUPPLIER.
THE SUPPLIER GENERATES REPLENISHMENT ORDERS FOR THE
This is discussed later in the chapter in the context of the
CUSTOMER BASED ON THIS DEMAND INFORMATION.
“total cost of ownership” for a purchased item.
Charlie Westerman/Getty Images

The Bullwhip Effect

In many cases, there are adversarial relations between supply chain partners as well as dys- Vendor managed
functional industry practices such as a reliance on price promotions. Consider the common inventory
food industry practice of offering price promotions every January on a product. Retailers When a customer
allows the supplier to
respond to the price cut by stocking up, in some cases buying a year’s supply—a practice
manage the inventory
the industry calls forward buying. Nobody wins in the deal. Retailers have to pay to carry
policy of an item or
the year’s supply, and the shipment bulge adds cost throughout the supplier’s system. For group of items.
example, the supplier plants must go on overtime starting in October to meet the bulge.
Even the vendors that supply the manufacturing plants are affected because they must Forward buying
quickly react to the large surge in raw material requirements. A term that refers to
The impact of these types of practices has been studied at companies such as Procter & when a customer,
Gamble. Exhibit 13.2 shows typical order patterns faced by each node in a supply chain that responding to a
consists of a manufacturer, a distributor, a wholesaler, and a retailer. In this case, the demand promotion, buys far
is for disposable baby diapers. The retailer’s orders to the wholesaler display greater variabil- in advance of when
an item will be used.
ity than the end-consumer sales; the wholesaler’s orders to the manufacturer show even more
oscillations; and, finally, the manufacturer’s orders to its suppliers are the most volatile. This
phenomenon of variability magnification as we move from the customer to the producer in
the supply chain is often referred to as the bullwhip effect. The effect indicates a lack of syn- Bullwhip effect
chronization among supply chain members. Even a slight change in consumer sales ripples The variability in
backward in the form of magnified oscillations upstream, resembling the result of a flick of demand is magnified
a bullwhip handle. Because the supply patterns do not match the demand patterns, inventory as we move from
accumulates at various stages, and shortages and delays occur at others. This bullwhip effect the customer to
the producer in the
has been observed by many firms in numerous industries, including Campbell Soup and
supply chain.
Procter & Gamble in consumer products; Hewlett-Packard, IBM, and Motorola in electron-
ics; General Motors in automobiles; and Eli Lilly in pharmaceuticals.
Campbell Soup pioneered a program called continuous replenishment that typifies Continuous
what many manufacturers are doing to smooth the flow of materials through their supply replenishment
chain. Here is how the program works. Campbell establishes electronic data interchange A program for
(EDI) links with retailers and offers an “everyday low price” that eliminates discounts. automatically
Every morning, retailers electronically inform the company of their demand for all supplying groups of
items to a customer
Campbell products and of the level of inventories in their distribution centers. Campbell
on a regular basis.
uses that information to forecast future demand and to determine which products require

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438 OPERATIONS AND SUPPLY CHAIN MANAGEMENT

exhibit 13.2 Increasing Variability of Orders Up the Supply Chain

Consumer Sales Retailer’s Orders to Wholesaler

20 20

15 15
Order Quantity

Order Quantity
10 10

5 5

0 0
Time Time

Wholesaler’s Orders to Manufacturer Manufacturer’s Orders to Supplier

20 20

15 15
Order Quantity

Order Quantity

10 10

5 5

0 0
Time Time

replenishment based on upper and lower inventory limits previously established with each
supplier. Trucks leave the Campbell shipping plant that afternoon and arrive at the retail-
ers’ distribution centers with the required replenishments the same day. Using this sys-
tem, Campbell can cut the retailers’ inventories, which under the old system averaged four
weeks of supply, to about two weeks of supply.
This solves some problems for Campbell Soup, but what are the advantages for the
retailer? Most retailers figure that the cost to carry the inventory of a given product for a year
equals at least 25 percent of what they paid for the product. A two-week inventory reduction
represents a cost savings equal to nearly 1 percent of sales. The average retailer’s profits
equal about 2 percent of sales, so this saving is enough to increase profits by 50 percent.
Because the retailer makes more money on Campbell products delivered through continuous
replenishment, it has an incentive to carry a broader line of them and to give them more shelf
space. Campbell Soup found that after it introduced the program, sales of its products grew
twice as fast through participating retailers as they did through other retailers.

Supply Chain Uncertainty Framework

The Supply Chain Uncertainty Framework (Exhibit 13.3) is designed to help managers
understand the nature of demand for their products and then devise the supply chain that
can best satisfy that demand. Many aspects of a product’s demand are important—for
example, product life cycle, demand predictability, product variety, and market standards
for lead times and service. Products can be categorized as either primarily functional or
primarily innovative. Because each category requires a distinctly different kind of supply

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GLOBAL SOURCING AND PROCUREMENT chapter 13 439

Supply Chain Uncertainty Framework exhibit 13.3

PRODUCT (DEMAND) CHARACTERISTICS

FUNCTIONAL INNOVATIVE
Stable Efficient Supply Chain Responsive Supply Chain
Grocery, basic apparel, Fashion apparel, low-end
(Supply) Process
Characteristics
Manufacturing

food, oil and gas computers, seasonal

products
Evolving Risk-Hedging Supply Agile Supply Chain
Chain Cell phones, high-
Hydroelectric power, food end computers,
dependent on weather semiconductors

PRODUCT (DEMAND) CHARACTERISTICS MANUFACTURING (SUPPLY) PROCESS CHARACTERISTICS

FUNCTIONAL INNOVATIVE STABLE EVOLVING

Demand Predictable Unpredictable Breakdowns Few Higher
Product Life Long Short Process Yield High Lower
Inventory Value Low High Quality Problems Few More
Product Variety Low High Supply Sources Many Few
Volume High Low Process Changes Few Many
Stock-out Cost Low High Lead Time Dependable Difficult to predict
Based on research conducted by Marshall Fisher (University of Pennsylvania) and Hau Lee (Stanford University)

chain, the root cause of supply chain problems is a mismatch between the type of product
and type of supply chain.
Functional products include the staples that people buy in a wide range of retail out- Functional products
lets, such as grocery stores and gas stations. Because such products satisfy basic needs, Staples that people
which do not change much over time, they have stable, predictable demand and long life buy in a wide range
cycles. But their stability invites competition, which often leads to low profit margins. of retail outlets, such
Specific criteria for identifying functional products include the following: product life as grocery stores
cycle of more than two years, contribution margin of 5 to 20 percent, only 10 to 20 product and gas stations.
variations, an average forecast error at time of production of only 10 percent, and a lead
time for make-to-order products of from six months to one year.
To avoid low margins, many companies introduce innovations in fashion or technol-
ogy to give customers an additional reason to buy their products. Fashionable clothes and
personal computers are good examples. Although innovation can enable a company to
achieve higher profit margins, the very newness of the innovative products makes demand
for them unpredictable. These innovative products typically have a life cycle of just a few Innovative products
months. Imitators quickly erode the competitive advantage that innovative products enjoy, Products such as
and companies are forced to introduce a steady stream of newer innovations. The short fashionable clothes
life cycles and the great variety typical of these products further increase unpredictability. and high-end
Exhibit 13.3 summarizes the differences between functional and innovative products. personal computers
that typically have
We expand on this idea by focusing on the “supply” side of the supply chain. While the
a life cycle of just a
Supply Chain Uncertainty Framework captures important demand characteristics, there few months.
are uncertainties revolving around the supply side that are equally important drivers for the
right supply chain strategy.

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440 OPERATIONS AND SUPPLY CHAIN MANAGEMENT

Stable supply A stable supply process is where the manufacturing process and the underlying technology
process are mature and the supply base is well established. In contrast, an evolving supply process is
A process where where the manufacturing process and the underlying technology are still under early develop-
the underlying ment and are rapidly changing. As a result, the supply base may be limited in both size and
technology is stable. experience. In a stable supply process, manufacturing complexity tends to be low or manage-
Evolving supply able. Stable manufacturing processes tend to be highly automated, and long-term supply con-
process tracts are prevalent. In an evolving supply process, the manufacturing process requires a lot of
A process where fine-tuning and is often subject to breakdowns and uncertain yields. The supply base may not
the underlying be reliable, as the suppliers themselves are going through process innovations. Exhibit 13.3
technology changes summarizes some of the differences between stable and evolving supply processes.
rapidly. While functional products tend to have a more mature and stable supply process, that
is not always the case. For example, the annual demand for electricity and other utility
products in a locality tends to be stable and predictable, but the supply of hydroelectric
power, which relies on rainfall in a region, can be erratic year by year. Some food products
also have a very stable demand, but the supply (both quantity and quality) of the products
depends on yearly weather conditions. Similarly, there are also innovative products with
a stable supply process. Fashion apparel products have a short selling season and their
demand is highly unpredictable. However, the supply process is very stable, with a reli-
able supply base and a mature manufacturing process technology. Exhibit 13.3 gives some
examples of products that have different demand and supply uncertainties.
In most cases, it is more challenging to operate a supply chain that is in the right column
of Exhibit 13.3 than in the left column, and similarly, it is more challenging to operate a
supply chain that is in the lower row of Exhibit 13.3 than in the upper row. Before setting
up a supply chain strategy, it is necessary to understand the sources of the underlying
uncertainties and explore ways to reduce these uncertainties. If it is possible to move the
uncertainty characteristics of the product from the right column to the left or from the
lower row to the upper, then the supply chain performance will improve.
Using the supply and demand characteristics discussed so far, four types of supply chain
strategies, as shown in Exhibit 13.3, are possible. Information technologies play an impor-
tant role in shaping such strategies.

∙ Efficient supply chains. These are supply chains that utilize strategies aimed at creat-
ing the highest levels of cost efficiency. For such efficiencies to be achieved, non-value-
added activities should be eliminated, scale economies should be pursued, optimization
techniques should be deployed to get the best capacity utilization in production and
distribution, and information linkages should be established to ensure the most efficient,
accurate, and cost-effective transmission of information across the supply chain.
∙ Risk-hedging supply chains. These are supply chains that utilize strategies aimed
at pooling and sharing resources in a supply chain so that the risks in supply dis-
ruption can be shared. A single entity in a supply chain can be vulnerable to sup-
ply disruptions, but if there is more than one supply source or if alternative supply
resources are available, then the risk of disruption is reduced. A company may, for
example, increase the safety stock of its key component to hedge against the risk of
supply disruption, and by sharing the safety stock with other locations that also need
this key component, the cost of maintaining this safety stock can be shared. This type
of strategy is common in retailing, where different retail stores or dealerships share
inventory. Information technology is important for the success of these strategies
since real-time information on inventory and demand allows the most cost-effective
management and transshipment of goods between partners sharing the inventory.
∙ Responsive supply chains. These are supply chains that utilize strategies aimed
at being responsive and flexible to the changing and diverse needs of the customers.

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GLOBAL SOURCING AND PROCUREMENT chapter 13 441

To be responsive, companies use build-to-order and mass customization processes as

a means to meet the specific requirements of customers.
∙ Agile supply chains. These are supply chains that utilize strategies aimed at being
responsive and flexible to customer needs, while the risks of supply shortages or dis-
ruptions are hedged by pooling inventory and other capacity resources. These supply
chains essentially have strategies in place that combine the strengths of “hedged”
and “responsive” supply chains. They are agile because they have the ability to be
responsive to the changing, diverse, and unpredictable demands of customers on the
front end, while minimizing the back-end risks of supply disruptions.

Demand and supply uncertainty is a good framework for understanding supply chain
strategy. Innovative products with unpredictable demand and an evolving supply process
face a major challenge. Because of shorter and shorter product life cycles, the pressure
for dynamically adjusting and adopting a company’s supply chain strategy is great. In the
following section, we explore the concepts of outsourcing, green sourcing, and total cost
of ownership. These are important tools for coping with demand and supply uncertainty.

OUTSOURCING
Outsourcing is the act of moving some of a firm’s internal activities and decision respon- LO13–2 Explain
sibility to outside providers. The terms of the agreement are established in a contract. why companies
Outsourcing goes beyond the more common purchasing and consulting contracts because not outsource processes.
only are the activities transferred, but also resources that make the activities occur, including
people, facilities, equipment, technology, and other assets. The responsibilities for making Outsourcing
decisions over certain elements of the activities are transferred as well. Taking complete Moving some
responsibility for this is a specialty of contract manufacturers such as Flex Ltd. of a firm’s
The reasons why a company decides to outsource can vary greatly. Exhibit 13.4 lists internal activities
examples of reasons to outsource and the accompanying benefits. Outsourcing allows a and decision
responsibility to
outside providers.

Reasons to Outsource and the Resulting Benefits exhibit 13.4

FINANCIALLY DRIVEN REASONS

Improve return on assets by reducing inventory and selling unnecessary assets.
Generate cash by selling low-return entities.
Gain access to new markets, particularly in developing countries.
Reduce costs through a lower cost structure.
Turn fixed costs into variable costs.
IMPROVEMENT DRIVEN REASONS
Improve quality and productivity.
Shorten cycle time.
Obtain expertise, skills, and technologies that are not otherwise available.
Improve risk management.
Improve credibility and image by associating with superior providers.
ORGANIZATIONALLY DRIVEN REASONS
Improve effectiveness by focusing on what the firm does best.
Increase flexibility to meet changing demand for products and services.
Increase product and service value by improving response to customer needs.

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442 OPERATIONS AND SUPPLY CHAIN MANAGEMENT

firm to focus on activities that represent its core competencies. Thus, the company can cre-
ate a competitive advantage while reducing cost. An entire function may be outsourced, or
some elements of an activity may be outsourced, with the rest kept in-house. For example,
some of the elements of information technology may be strategic, some may be critical,
and some may be performed less expensively by a third party. Identifying a function as a
potential outsourcing target, and then breaking that function into its components, allows
decision makers to determine which activities are strategic or critical and should remain
in-house and which can be outsourced like commodities. As an example, outsourcing the
logistics function will be discussed.

Logistics Outsourcing
Logistics There has been dramatic growth in outsourcing in the logistics area. Logistics is a term
Management that refers to the management functions that support the complete cycle of material
functions that flow: from the purchase and internal control of production materials; to the planning and
support the control of work-in-process; to the purchasing, shipping, and distribution of the finished
complete cycle of product. The emphasis on lean inventory means there is less room for error in deliver-
material flow: from
ies. Trucking companies such as Ryder have started adding the logistics aspect to their
the purchase and
businesses—changing from merely moving goods from point A to point B, to managing
internal control of
production materials; all or part of all shipments over a longer period, typically three years, and replacing the
to the planning and shipper’s employees with their own. Logistics companies now have complex computer
control of work- tracking technology that reduces the risk in transportation and allows the logistics com-
in-process; to the pany to add more value to the firm than it could if the function were performed in-house.
purchasing, shipping, Third-party logistics providers track freight using electronic data interchange technology
and distribution of and a satellite system to tell customers exactly where its drivers are and when deliveries
the finished product. will be made. Such technology is critical in some environments where the delivery win-
dow may be only 30 minutes long.
FedEx Corporation has one of the most advanced systems available for tracking items
being sent through its services. The system is available to all customers over the internet.
It tells the exact status of each item currently being carried by the company. Information on
the exact time a package is picked up, when it is transferred between hubs in the company’s
network, and when it is delivered is available on the system. You can access this system at the
FedEx website (www.fedex.com). Select your country on the initial screen and then select
“Track.” Of course, you will need the actual tracking number for an item currently in the sys-
tem to get information. FedEx has integrated its tracking system with many of its customers’
in-house information systems.
One of the drawbacks to outsourcing is the layoffs that often result. Even in cases where
the outsourcing partner hires former employees, they are often hired back at lower wages
with fewer benefits. Outsourcing is perceived by many unions as an effort to circumvent
union contracts.

Framework for Supplier Relationships

In theory, outsourcing is a no-brainer. Companies can unload noncore activities, shed bal-
ance sheet assets, and boost their return on capital by using third-party service providers.
But in reality, things are more complicated.
Exhibit 13.5 is a useful framework to help managers make appropriate choices for the
structure of supplier relationships. The decision goes beyond the notion that “core com-
petencies” should be maintained under the direct control of management of the firm and
that other activities should be outsourced. In this framework, a continuum that ranges from
vertical integration to arm’s-length relationships forms the basis for the decision.

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GLOBAL SOURCING AND PROCUREMENT chapter 13 443

A Framework for Structuring Supplier Relationships exhibit 13.5

DO NOT OUTSOURCE OUTSOURCE

Coordination characteristics Coordination and interfaces are not well defined. Standardized interfaces, required
The information and coordination is specific to information is highly codified and
each job. standardized (prices, quantities, delivery
Technology is immature and there is a need for schedules, etc.).
“expert” knowledge obtained by experience.
Investment in strategic assets Significant investments in highly specialized Assets are commonly available from a large
characteristics assets are needed. The investments cannot be number of potential suppliers.
easily recovered if the relationship terminates.
Long-term investments in specialized R&D, and
lengthy learning curves.
Intellectual property Weak intellectual property protection. Easy-to- Strong intellectual property protection
characteristics imitate technology when access is given. Difficult-to-imitate technology

An activity can be evaluated using the following characteristics: required coordination,

strategic control, and intellectual property. Required coordination refers to how difficult it
is to ensure that the activity will integrate well with the overall process. Uncertain activi-
ties that require much back-and-forth exchange of information should not be outsourced,
whereas activities that are well understood and highly standardized can easily move to
business partners who specialize in the activity. Strategic control refers to the degree of
loss that would be incurred if the relationship with the partner were severed. There could be
many types of losses that would be important to consider, including specialized facilities,
knowledge of major customer relationships, and investment in research and development.
A final consideration is the potential loss of intellectual property through the partnership.
Intel is an excellent example of a company that recognized the importance of this type
of decision framework in the mid-1980s. During the early 1980s, Intel found itself being
squeezed out of the market for the memory chips it had invented by Japanese competi-
tors such as Hitachi, Fujitsu, and NEC. These companies had developed stronger capa-
bilities to develop and rapidly scale up complex semiconductor manufacturing processes.
It was clear by 1985 that a major Intel competency was its ability to design complex
integrated circuits, not in manufacturing or developing processes for more standardized
chips. As a result, faced with growing financial losses, Intel was forced to exit the memory
chip market.
Learning a lesson from the memory market, Intel shifted its focus to the market for
microprocessors, which it had invented in the late 1960s. To keep from repeating the mis-
take with memory chips, Intel felt it was essential to develop strong capabilities in process
development and manufacturing. A pure “core competency” strategy would have suggested
that Intel focus on the design of microprocessors and use outside partners to manufacture
them. Given the close connection between semiconductor product development and pro-
cess development, however, relying on outside parties for manufacturing would likely have
created costs in terms of longer development lead times. Throughout the late-1980s, Intel
invested heavily in building world-class capabilities in process development and manufac-
turing. These capabilities are one of the chief reasons it has been able to maintain approxi-
mately 80 percent of the personal computer microprocessor market, despite the ability of
competitors like AMD to “clone” Intel designs relatively quickly. Expanding its capabili-
ties beyond its original core capability of product design has been a critical ingredient in
Intel’s sustained success.

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444 OPERATIONS AND SUPPLY CHAIN MANAGEMENT

Good advice is to keep control of—or acquire—activities that are true competitive dif-
ferentiators or have the potential to yield a competitive advantage, and to outsource the
rest. It is important to make a distinction between “core” and “strategic” activities. Core
activities are key to the business, but do not confer a competitive advantage, such as a
bank’s information technology operations. Strategic activities are a key source of competi-
tive advantage. Because the competitive environment can change rapidly, companies need
to monitor the situation constantly, and adjust accordingly. As an example, Coca-Cola,
which decided to stay out of the bottling business in the early 1900s, partnered instead with
independent bottlers and quickly built market share. The company reversed itself in the
1980s when bottling became a key competitive element in the industry.

Green Sourcing
Being environmentally responsible has become a business imperative, and many firms
are looking to their supply chains to deliver “green” results. A significant area of focus
relates to how a firm works with suppliers where the opportunity to save money and ben-
efit the environment might not be a strict trade-off proposition. Financial results can often
be improved through cost reductions and by boosting revenues.
Green sourcing is not just about finding new environmentally friendly technologies or
increasing the use of recyclable materials. It can also help drive cost reductions in a variety
of ways, including product content substitution, waste reduction, and lower usage.
A comprehensive green sourcing effort should assess how a company uses items that are
purchased internally, in its own operations, or in its products and services. As costs of com-
modity items like steel, electricity, and fossil fuels continue to increase, properly designed
green-sourcing efforts should find ways to significantly reduce and possibly eliminate the
need for these types of commodities. As an example, consider retrofitting internal lighting
in a large office building to a modern energy-efficient technology. Electricity cost savings
of 10 to 12 percent per square foot can easily translate into millions of dollars in associated
electricity cost savings.
Another important cost area in green sourcing is waste reduction opportunities. This
includes everything from energy and water to packaging and transportation. A great exam-
ple of this is the milk jug now in common use by grocery retailers. Using the jug, with rect-
angular dimensions and a square base, cuts the associated water consumption of the jugs
by 60 to 70 percent compared to earlier jug designs because the design does not require
the use of milk crates. Milk crates typically become filthy during use due to spillage and
other natural factors; thus, they are usually hosed down before reuse, consuming thousands
of gallons of water. The current design also reduces fuel costs. Since crates are no longer
used, they also do not have to be transported back to the dairy plant or farm distribution
point for future shipments. Furthermore, the jugs have the unexpected benefit of fitting
better in modern home refrigerator doors and allow retailers to fit more of them in their in-
store coolers. Breakthrough results like the milk jug design can result from comprehensive
partnerships between users and their suppliers working to find innovative solutions.
Working with suppliers can result in opportunities that improve revenue. They can be
the opportunity to turn waste products into sources of revenue. For example, a leading
beverage manufacturer operates a recycling subsidiary that sources used aluminum cans
from a large number of suppliers. The subsidiary actually processes more aluminum cans
than are used in the company’s own products, consequently developing a strong secondary
revenue stream for the company.
In other cases, green sourcing can help establish entirely new lines of business to serve
environmentally conscious customers. In the cleaning products aisle of a supermarket,

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GLOBAL SOURCING AND PROCUREMENT chapter 13 445

shoppers will find numerous “green” cleaning product

options from a variety of consumer products compa-
nies. These products typically use natural ingredients
in lieu of chemicals, and many are in concentrated
amounts to reduce overall packaging costs.
Logistics suppliers could find business opportunities
coming directly to them as a result of the green trend.
A large automobile manufacturer completed a project
to green its logistics/distribution network. The auto-
maker analyzed the shipping carriers, locations, and
overall efficiency of its distribution network for both
parts and finished automobiles. By increasing the use
of rail transportation for parts, consolidating shipments
in fewer ports, and partnering with its logistics provid- Pressmaster/Shutterstock
ers to increase fuel efficiency for both marine and road
transportation, the company reduced its overall distribution-related carbon dioxide emis-
sions by several thousand tons per year.
The following is an outline of a six-step process (see Exhibit 13.6) designed to
transform a traditional process to a green-sourcing process:

1. Assess the opportunity. For a given category of expense, all relevant costs need
to be taken into account. The five most common areas include electricity and other
energy costs; disposal and recycling; packaging; commodity substitution (alterna-
tive materials to replace materials such as steel or plastic); and water (or other
related resources). These costs are identified and incorporated into an analysis of
total cost (sometimes referred to as “spend” cost analysis) at this step. From this
analysis, it is possible to prioritize the different costs based on the highest potential
savings and criticality to the organization. This is important in directing effort to
where it will likely have the most impact on the firm’s financial position and cost-
reduction goals.

Six-Step Process for Green Sourcing exhibit 13.6

1. Assess the 2. Engage 3. Assess the

opportunity sourcing agents supply base
— Evaluate and — Encourage cross- — Engage vendors
prioritize costs functional ownership in the process
of the process

6. Institutionalize the 5. Implement 4. Develop the

sourcing strategy sourcing strategy sourcing strategy
— Implement metrics and — Select vendors and — Develop
audits to monitor products based on quantitative criteria
performance criteria

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446 OPERATIONS AND SUPPLY CHAIN MANAGEMENT

2. Engage internal supply chain sourcing agents. Internal

sourcing agents are those within the firm that purchase items
and have direct knowledge of business requirements, product
specifications, and other internal perspectives inherent in the
supply chain. These individuals and groups need to be “on-
board” and be partners in the improvement process to help
set realistic green goals. The goal of generating no waste, for
example, becomes a cross-functional supply chain effort that
relies heavily on finding and developing the right suppliers.
These internal managers need to identify the most signifi-
cant opportunities. They can develop a robust baseline model
of what should be possible for reducing current and ongoing
costs. In the case of procuring new equipment, for example, the
baseline model would include not just the initial price of the
equipment as in traditional sourcing, but also energy, disposal,
recycling, and maintenance costs.
3. Assess the supply base. A sustainable sourcing process
requires engaging new and existing vendors. As in traditional
sourcing, the firm needs to understand vendor capabilities, con-
straints, and product offerings. The green process needs to be
augmented with formal requirements that relate to green oppor-
tunities, including possible commodity substitutions and new
manufacturing processes. These requirements need to be incor-
porated in vendor bid documents or the request for proposals
FLY ASH IS GENERALLY STORED AT COAL POWER PLANTS OR (RFPs).
PLACED IN LANDFILLS AS SHOWN HERE. ABOUT 43 PERCENT A good example is concrete that uses fly ash, a by-product
IS RECYCLED, REDUCING THE HARMFUL IMPACT ON THE from coal-fired power plants. Fly ash can be substituted for
ENVIRONMENT FROM LANDFILLS.
Portland cement in ready-mix concrete or in concrete blocks
Carolyn Kaster/AP Images
to produce a stronger and lighter product with reduced water
consumption. Fly ash substitution helps a company reduce its
exposure to volatile and rapidly increasing prices for cement. At the same time,
the reduced weight of the block lowers transportation costs to the company’s new
facilities. A company is also able to establish a specification incorporating fly ash
for all new construction sites to follow. Finally, the substitution also helps power
plants by providing a new market for fly ash, which previously had to be discarded.
4. Develop the sourcing strategy. The main goal with this step is to develop quan-
titative and qualitative criteria that will be used to evaluate the sourcing process.
These are needed to properly analyze associated costs and benefits. These crite-
ria need to be clearly articulated in bid documents and RFPs when working with
potential suppliers so that their proposals will address relevant goals related to
sustainability.
5. Implement the sourcing strategy. The evaluation criteria developed in step 4
should help in the selection of vendors and products for each business require-
ment. The evaluation process should consider initial cost and the total cost of
ownership for the items in the bid. So, for example, energy-efficient equipment
that is proposed with a higher initial cost may, over its productive life, actually
result in a lower total cost due to energy savings and a related lower carbon foot-
print. Relevant green opportunities such as energy efficiency and waste reduction
need to be modeled and then incorporated into the sourcing analysis to make it as

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GLOBAL SOURCING AND PROCUREMENT chapter 13 447

comprehensive as possible and to facilitate an effective vendor selection process

that supports the firm’s needs.
6. Institutionalize the sourcing strategy. Once the vendor is selected and con-
tracts finalized, the procurement process begins. Here, the sourcing and procure-
ment department needs to define a set of metrics against which the supplier will
be measured for the contract’s duration. These metrics should be based on perfor-
mance, delivery, compliance with pricing guidelines, and similar factors. It is vital
that metrics that relate to the company’s sustainability goals are considered as well.
Periodic audits may also need to be incorporated in the process to directly observe
practices that relate to these metrics to ensure honest reporting of data.
A key aspect of green sourcing, compared to a traditional process, is the
expanded view of the sourcing decision. This expanded view requires the incorpo-
ration of new criteria for evaluating alternatives. Further, it requires a wider range
of internal integration such as designers, engineers, and marketers. Finally, visual-
izing and capturing the green-sourcing savings often involves greater complexity
and longer payback periods compared to a traditional process.

TOTAL COST OF OWNERSHIP

The total cost of ownership (TCO) is an estimate of the cost of an item that includes LO13–3 Analyze
all the costs related to the procurement and use of an item, including any related costs in the total cost of
disposing of the item after it is no longer useful. The concept can be applied to a com- ownership.
pany’s internal costs or it can be viewed more broadly to consider costs throughout the
supply chain. To fully appreciate the cost of purchasing an item from a particular vendor, Total cost of
an approach that captures the costs of the activities associated with purchasing and actu- ownership (TCO)
ally using the item should be considered. Depending on the complexity of the purchasing Estimate of the
process, activities such as pre-bid conferences, visits by potential suppliers, and even visits cost of an item that
to potential suppliers can significantly impact the total cost of the item. includes all the
A TCO analysis is highly dependent on the actual situation; in general, though, the costs costs related to the
outlined in Exhibit 13.7 should be considered. The costs can be categorized into three procurement and
use of the item,
broad areas: acquisition costs, ownership costs, and post-ownership costs. Acquisition
including disposing
costs are the initial costs associated with the purchase of materials, products, and ser- of the item after its
vices. They are not long-term costs of ownership but represent an immediate cash outflow. useful life.
Acquisition costs include the prepurchase costs associated with preparing documents to
distribute to potential suppliers, identifying suppliers and evaluating suppliers, and other
costs associated with actually procuring the item. The actual purchase prices, including
taxes, tariffs, and transportation costs, are also included.
Ownership costs are incurred after the initial purchase and are associated with the ongo-
ing use of the product or material. Examples of costs that are quantifiable include energy
usage, scheduled maintenance, repair, and financing (leasing situation). There can also be
qualitative costs, such as aesthetic factors (e.g., the item is pleasing to the eye), and ergo-
nomic factors (e.g., productivity improvement or reducing fatigue). These ownership costs
can often exceed the initial purchase price and have an impact on cash flow, profitability,
and even employee morale and productivity.
Major costs associated with post-ownership include salvage value and disposal costs.
For many purchases, there are established markets that provide data to help estimate rea-
sonable future values, such as the Kelley Blue Book for used automobiles. Other areas that

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448 OPERATIONS AND SUPPLY CHAIN MANAGEMENT

exhibit 13.7 Total Cost of Ownership

Acquisition costs
∙ Purchase planning costs
∙ Quality costs Total cost of ownership
∙ Taxes
∙ Purchase price
∙ Financing costs

Ownership costs
∙ Energy costs
∙ Maintenance and repair
∙ Financing
∙ Supply chain/supply
network costs

Post-ownership costs
∙ Disposal
∙ Environmental costs
∙ Warranty costs
∙ Product liability costs
∙ Customer dissatisfaction costs

can be included are the long-term environmental impact (particularly when the firm has
sustainability goals), warranty and product liabilities, and the negative marketing impact of
low customer satisfaction with the item.
Overemphasis on acquisition cost or purchase price frequently results in failure to
address other significant ownership and post-ownership costs. TCO is a philosophy for
understanding all relevant costs of doing business with a particular supplier for a good or
service. It is relevant not only for a business that wants to reduce its cost of doing business
but also for a firm that aims to design products or services that provide the lowest total cost
of ownership to customers. For example, some automobile manufacturers have extended
the tune-up interval on many models to 100,000 miles, thereby reducing vehicle operating
cost for car owners. Viewing TCO in this way can lead to an increased value of the product
to existing and potential customers.
These costs can be estimated as cash inflows (the sale of used equipment, etc.) or out-
flows (such as purchase prices, demolition of an obsolete facility, etc.). The following
example shows how this analysis can be organized using a spreadsheet. Keep in mind that
the costs considered need to be adapted to the decision being made. Costs that do not vary
based on the decision need not be considered, but relevant costs that vary depending on the
decision should be included in the analysis.

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Example 13.1: Total Cost of Ownership Analysis

Consider the analysis of the purchase of a copy machine as might be used in a copy center. The
machine has an initial cost of $120,000 and is expected to generate income of $40,000 per year.
Supplies are expected to be $7,000 per year, and the machine needs to be overhauled during year 3
at a cost of $9,000. It has a salvage value of $7,500 when we plan to sell it at year 6. Assume a 20
percent discount factor.

SOLUTION
Laying out these costs over time can lead to the use of net present value analysis to evaluate the deci-
sion. Consider Exhibit 13.8, where the present values of each yearly stream are discounted to now.
(See Appendix C for a present value table.) As we can see, the present value in this analysis shows
that the present value cost of the copier is $12,955.

TCO actually draws on many areas for a thorough analysis. These include finance
(net present value), accounting (product pricing and costing), operations management
(reliability, quality, need, and inventory planning), marketing (demand), and information
technology (systems integration). It is probably best to approach this using a cross-
functional team representing the key functional areas.
It is important that any analysis is adapted to the particular scenario. Such factors as
exchange rates, the risk of doing business in a particular region of the world, transpor-
tation, and other items are often important. Depending on the alternatives, there are a
host of factors, often going beyond cost, that need to be considered. Adapting this type
of cost analysis and combining it with a more qualitative risk analysis are useful in actual
company situations.

Analysis of the Purchase of an Office Copier exhibit 13.8

YEAR NOW 1 2 3 4 5 6
Cost of copier including installation −$120,000
Manufacturer required overhaul −$ 9,000
Cash inflows from using the machine $40,000 $40,000 $40,000 $40,000 $40,000 $40,000
Supplies needed to use the machine −$ 7,000 −$ 7,000 −$ 7,000 −$ 7,000 −$ 7,000 −$ 7,000
Salvage value $ 7,500
Total of annual streams −$120,000 $33,000 $33,000 $24,000 $33,000 $ 33,000 $40,500
Discount factor from 1.000 0.833 0.694 0.579 0.482 0.402 0.335
Appendix C (1 + 0.2)− Year
Present value – yearly −$120,000 $27,500 $22,917 $13,889 $15,914 $13,262 $13,563
Present value −$ 12,955
Discount factor = 20%.
Note: These calculations were done using the full precision of a spreadsheet.

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450 OPERATIONS AND SUPPLY CHAIN MANAGEMENT

MEASURING SOURCING PERFORMANCE

LO13–4 One view of sourcing is centered on the inventories that are positioned in the system.
Evaluate sourcing Exhibit 13.9 shows how hamburger meat and potatoes are stored in various locations in a
performance. typical fast-food restaurant chain. Here we see the steps that the beef and potatoes move
through on their way to the local retail store and then to the customer. Inventory is carried
at each step, and this inventory has a particular cost to the company. Inventory serves as a
buffer, thus allowing each stage to operate independently of the others. For example, the
distribution center inventory allows the system that supplies the retail stores to operate
independently of the meat and potato packing operations. Because the inventory at each
Inventory turnover stage ties up money, it is important that the operations at each stage are synchronized to
A measure of supply minimize the size of these buffer inventories. The efficiency of the supply chain can be
chain efficiency. measured based on the size of the inventory investment in the supply chain. The inven-
Cost of goods sold
tory investment is measured relative to the total cost of the goods provided through the
The annual cost supply chain.
for a company to Two common measures to evaluate supply chain efficiency are inventory turnover and
produce the goods weeks-of-supply. Inventory turnover is calculated as follows:
or services provided
to customers. Cost of goods sold
Inventory turnover = _____________________________ [13.1]
Average aggregate Average aggregate inventory value
inventory value
The average total
value of all items The cost of goods sold is the annual cost for a company to produce the goods or
held in inventory for services provided to customers; it is sometimes referred to as the cost of revenue. This
the firm, valued at does not include the selling and administrative expenses of the company. The average
cost. aggregate inventory value is the average total value of all items held in inventory for

exhibit 13.9 Inventory in the Supply Chain—Fast-Food Restaurant

Beef patties—$1.00/lb.
Potatoes— Potatoes— Bags of frozen Frozen French
25 /lb. 30 /lb. French fries— fries—40 /lb.
35 /lb.

Potato
Potato processing and packing
farm
Distribution Retail
Customer
center store
Cattle Slaughter Meat
farm house packing

Frozen beef
patties— Hamburgers—
Cows— Beef 65 /lb. $8.00/lb.
50 /lb. carcasses— Beef loins—
French fries—
55 /lb. 60 /lb.
$3.75/lb.

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the firm valued at cost. It includes the raw material, work-in-process, finished goods, and
distribution inventory considered owned by the company.
Good inventory turnover values vary by industry and the type of products being han-
dled. At one extreme, a grocery store chain may turn inventory over 100 times per year.
Values of six to seven are typical for manufacturing firms.
In many situations, particularly when distribution inventory is dominant, weeks of Weeks of supply
supply is the preferred measure. This is a measure of how many weeks’ worth of inventory Preferred measure
is in the system at a particular point in time. The calculation is as follows: of supply chain
efficiency that is
mathematically the
( )
Average aggregate inventory value
Weeks of supply = ____________________________ × 52 weeks [13.2] inverse of inventory
Cost of goods sold turn times 52.

When company financial reports cite inventory turnover and weeks of supply, we can assume
that the measures are being calculated firmwide. We show an example of this type of calcu-
lation in the example that follows using Apple Computer data. These calculations, though,
can be done for individual entities within the organization. For example, we might be inter-
ested in the production raw materials inventory turnover or the weeks of supply associated
with the warehousing operation of a firm. In these cases, the cost would be that associated
with the total amount of inventory that runs through the specific inventory. In some very-
low-inventory operations, days or even hours are a better unit of time for measuring supply.
A firm considers inventory an investment because the intent is for it to be used in the future.
Inventory ties up funds that could be used for other purposes, and a firm may have to borrow
money to finance the inventory investment. The objective is to have the proper amount of
inventory and to have it in the correct locations in the supply chain. Determining the correct
amount of inventory to have in each position requires a thorough analysis of the supply chain
coupled with the competitive priorities that define the market for the company’s products.

Example 13.2: Inventory Turnover Calculation

Apple Inc. reported the following information in a recent annual report (all dollar amounts are
expressed in millions):

Total revenue $274,515

Cost of revenue $169,559
Inventory $ 4,061

The cost of revenue corresponds to what we call cost of goods sold. One might think that U.S. com-
panies, at least, would use a common accounting terminology, but this is not true. The inventory
turnover calculation is

$169,559
Inventory turnover = _______ = 41.75 turns per year
$4,061

This is amazing performance for a high-tech company, but it explains much of why the company is
such a financial success.
The corresponding weeks of supply calculation is

( $169,559 )
$4,061
Weeks of supply = _ × 52 = 1.25 weeks

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452 OPERATIONS AND SUPPLY CHAIN MANAGEMENT

CONCEPT CONNECTIONS
LO13–1 Explain what strategic sourcing is.
∙ Sourcing is a term that captures the strategic nature of purchasing in today’s global and
internet-connected marketplace.
∙ The sourcing/purchasing design matrix captures the scope of the topic that ranges from one-
time spot purchases, to a complex strategic alliance arrangement with another firm.
∙ A phenomenon known as the bullwhip effect has been observed in many industries. This is
when changes in demand are magnified as they move from the customer to the manufacturer.
The phenomenon is caused by long lead times and the fact that there are often multiple
stages in a supply chain.
∙ Supply chains can be categorized based on demand and supply uncertainty characteristics.
Four types of supply chains are identified: (1) efficient, (2) risk-hedging, (3) responsive, and
(4) agile.
Strategic sourcing The development and management of supplier relationships to acquire goods
and services in a way that aids in achieving the needs of a business.
Sourcing A process suitable for procuring products that are strategically important to the firm.
Specificity Refers to how commonly available the material is and whether substitutes can be used.
Request for proposal (RFP) A solicitation that asks for a detailed proposal from a vendor
interested in supplying an item.
Vendor managed inventory When a customer allows the supplier to manage the inventory
policy of an item or group of items.
Forward buying A term that refers to when a customer, responding to a promotion, buys far in
advance of when an item will be used.
Bullwhip effect The variability in demand is magnified as we move from the customer to the
producer in the supply chain.
Continuous replenishment A program for automatically supplying groups of items to a
customer on a regular basis.
Functional products Staples that people buy in a wide range of retail outlets, such as grocery
stores and gas stations.
Innovative products Products such as fashionable clothes and high-end personal computers that
typically have a life cycle of just a few months.
Stable supply process A process where the underlying technology is stable.
Evolving supply process A process where the underlying technology changes rapidly.

LO13–2 Explain why companies outsource processes.

∙ Outsourcing is when a firm contracts with an outside provider for activities essential to the
firm’s success.
∙ The transportation of a firm’s products (referred to as logistics) is often outsourced.
∙ Whether an activity is outsourced or not often depends on criteria related to (1) coordination
requirements, (2) strategic control, and (3) intellectual property issues.
∙ Green sourcing has become an imperative for many firms, and it may create new markets for
a firm’s products.
Outsourcing Moving some of a firm’s internal activities and decision responsibility to outside
providers.

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Logistics Management functions that support the complete cycle of material flow: from the
purchase and internal control of production materials; to the planning and control of work-in-
process; to the purchasing, shipping, and distribution of the finished product.

LO13–3 Analyze the total cost of ownership.

∙ This is an approach to understanding the total cost of an item.
∙ Costs can generally be categorized into three areas: (1) acquisition costs, (2) ownership costs,
and (3) post-ownership costs.
Total cost of ownership (TCO) Estimate of the cost of an item that includes all the costs related
to the procurement and use of the item, including disposing of the item after its useful life.

LO13–4 Evaluate sourcing performance.

∙ Inventory turn and weeks of supply are the most common measures to evaluate supply chain
efficiency. These measures can vary greatly depending on the industry.
Inventory turnover A measure of supply chain efficiency.
Cost of goods sold The annual cost for a company to produce the goods or services provided to
customers.
Average aggregate inventory value The average total value of all items held in inventory for
the firm, valued at cost.
Weeks of supply Preferred measure of supply chain efficiency that is mathematically the inverse
of inventory turn times 52.

Cost of goods sold

Inventory turnover = _____________________________ [13.1]
Average aggregate inventory value

( )
Average aggregate inventory value
Weeks of supply = ____________________________ × 52 weeks [13.2]
Cost of goods sold

DISCUSSION QUESTIONS
LO13–1 1. What recent changes have caused supply chain management to gain importance?
2. Describe the differences between functional and innovative products.
3. What are characteristics of efficient, responsive, risk-hedging, and agile supply
chains? Can a supply chain be both efficient and responsive? Risk-hedging and
agile? Why or why not?
LO13–2 4. With so much productive capacity and room for expansion in the United States,
why would a company based in the United States choose to purchase items from a
foreign firm? Discuss the pros and cons.
5. As a supplier, which factors about a buyer (your potential customer) would you
consider to be important in setting up a long-term relationship?
6. Describe how outsourcing works. Why would a firm want to outsource?
LO13–3 7. Have you ever purchased a product based on purchase price alone and were
surprised by the eventual TCO, either in money or in time? Describe the situation.

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454 OPERATIONS AND SUPPLY CHAIN MANAGEMENT

8. Why might managers resist buying a more expensive piece of equipment, known
to have a lower TCO, than a less expensive item?

LO13–4 9. Why is it desirable to increase a company’s inventory turnover ratio?

10. Research and compare the inventory turnover ratios of three large retailers:
Walmart, Target, and Nordstrom. Use the same financial website for all three, and
compare numbers from the same time frame. What do these ratios tell you? Are
you surprised by what you found?

OBJECTIVE QUESTIONS
LO13–1 1. What term refers to the development and management of supplier relationships
in order to acquire goods and services in a way that helps achieve the immediate
needs of a business?
2. Sometimes a company may need to purchase goods or services that are unique,
very complex, and/or extremely expensive. These would not be routine purchases,
but there may be a number of vendors that could supply what is needed. What
process would be used to transmit the company’s needs to the available vendors,
asking for a detailed response to the needs?
3. Sony Electronics produces a wide variety of electronic products for the consumer
marketplace, such as laptop computers, PlayStation game consoles, and tablet
computers. What type of products would these be considered in the Supply Chain
Uncertainty Framework?
4. One product that Staples sells a lot of is copy paper. According to the Supply
Chain Uncertainty Framework, what supply chain strategy is appropriate for this
product?

LO13–2 5. What is the term used for the act of moving some of a company’s internal
activities and decision-making processes to outside providers?
6. What is the term used for a company moving management of the complete cycle
of material flow to an outside provider?
7. Many bottled water manufacturers have recently worked with their suppliers to
switch over to bottles using much less plastic than before, reducing the amount of
plastic that needs to be transported, recycled, and/or disposed of. What sourcing
practice is this an example of?
8. What term is used to refer to those activities that are the key source of competitive
advantage?

LO13–3 9. What three main categories of costs are considered in figuring the total cost of
ownership?
10. Which category of lifetime product costs are sometimes overemphasized, leading
to a failure to fully recognize the total cost of ownership?
11. One of your Taiwanese suppliers has bid on a new line of molded plastic parts
that is currently being assembled at your plant. The supplier has bid $0.10 per
part, given a forecast you provided of 200,000 parts in year 1; 300,000 in year
2; and 500,000 in year 3. Shipping and handling of parts from the supplier’s
factory is estimated at $0.01 per unit. Additional inventory handling charges
should amount to $0.005 per unit. Finally, administrative costs are estimated at
$20 per month.
Although your plant is able to continue producing the part, the plant would
need to invest in another molding machine, which would cost $10,000. Direct

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GLOBAL SOURCING AND PROCUREMENT chapter 13 455

materials can be purchased for $0.05 per unit. Direct labor is estimated at $0.03
per unit plus a 50 percent surcharge for benefits; indirect labor is estimated at
$0.011 per unit plus 50 percent benefits. Up-front engineering and design costs
will amount to $30,000. Finally, management has insisted that overhead be
allocated if the parts are made in-house at a rate of 100 percent of direct labor
cost. The firm uses a cost of capital of 15 percent per year.
Should you continue to produce in-house or accept the bid from your
Taiwanese supplier?
12. Your company assembles five different models of a motor scooter that is sold
in specialty stores in the United States. The company uses the same engine for
all five models. You have been given the assignment of choosing a supplier
for these engines for the coming year. Due to the size of your warehouse
and other administrative restrictions, you must order the engines in lot sizes
of 1,000 each. Because of the unique characteristics of the engine, special
tooling is needed during the manufacturing process for which you agree to
reimburse the supplier. Your assistant has obtained quotes from two reliable
engine suppliers and you need to decide which to use. The following data have
been collected:

Requirements (annual forecast) 12,000 units

Weight per engine 22 pounds
Order processing cost $125 per order
Inventory carry cost 20 percent of the average value of inventory per year
Note: Assume that half of the lot size is in inventory, on average (1,000/2 = 500 units).

Two qualified suppliers have submitted the following quotations:

SUPPLIER 1 SUPPLIER 2
ORDER QUANTITY UNIT PRICE UNIT PRICE
1 to 1,499 units/order $510.00 $505.00
1,500 to 2,999 units/order 500.00 $505.00
3,000+ units/order 490.00 488.00
Tooling costs $22,000 $20,000
Distance 125 miles 100 miles

Your assistant has obtained the following freight rates from your carrier:

Truckload (40,000 lb. each load): $0.80 per ton-mile

Less-than-truckload: $1.20 per ton-mile
Note: Per ton-mile = 2,000 lb. per mile

a. Perform a total cost of ownership analysis and select a supplier.

b. Would it make economic sense to order in truckload quantities? Would your
supplier selection change if you ordered truckload quantities?

LO13–4 13. Which supply chain efficiency measure is more appropriate when the majority of
inventory is held in distribution channels?
14. What do you call the average total value of all items held in inventory for a firm,
at cost?

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456 OPERATIONS AND SUPPLY CHAIN MANAGEMENT

15. The owner of a large machine shop has just finished its financial analysis from the
prior fiscal year. Following is an excerpt from the final report:

Net revenue $375,000

Cost of goods sold 322,000
Value of production materials on-hand 42,500
Value of work-in-process inventory 37,000
Value of finished goods on-hand 12,500

a. Compute the inventory turnover ratio (ITR).

b. Compute the weeks of supply (WS).
16. The McDonald’s fast-food restaurant on campus sells an average of 4,000
quarter-pound hamburgers each week. Hamburger patties are resupplied
twice a week, and on average the store has 350 pounds of hamburger in stock.
Assume that the hamburger patties cost $1.00 a pound. What is the inventory
turnover for the hamburger patties? On average, how many days of supply are
on-hand?
17. U.S. Airfilter has hired you as a supply chain consultant. The company makes air
filters for residential heating and air-conditioning systems. These filters are made
in a single plant located in Louisville, Kentucky, in the United States. They are
distributed to retailers through wholesale centers in 100 locations in the United
States, Canada, and Europe. You have collected the following data relating to the
value of inventory in the U.S. Airfilter supply chain:

QUARTER 1 QUARTER 2 QUARTER 3 QUARTER 4

(JANUARY (APRIL (JULY THROUGH (OCTOBER THROUGH
THROUGH MARCH) THROUGH JUNE) SEPTEMBER) DECEMBER)
Sales (total quarter):
United States 300 350 405 375
Canada 75 60 75 70
Europe 30 33 20 15
Cost of goods 280 295 340 350
sold (total quarter)
Raw materials at 50 40 55 60
the Louisville
plant (end-of-quarter)
Work-in-process 100 105 120 150
and finished
goods at the
Louisville plant
(end-of-quarter)
Distribution center
inventory (end-of-quarter):
United States 25 27 23 30
Canada 10 11 15 16
Europe 5 4 5 5
All amounts in millions of U.S. dollars.

a. What is the average inventory turnover for the firm?

b. If you were given the assignment to increase inventory turnover, what would
you focus on? Why?
c. The company reported that it used $500M worth of raw material during the
year. On average, how many weeks of supply of raw material are on-hand at
the factory?

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GLOBAL SOURCING AND PROCUREMENT chapter 13 457

ANALYTICS EXERCISE: GLOBAL SOURCING DECISIONS—

GRAINGER: REENGINEERING THE CHINA/
U.S. SUPPLY CHAIN
W. W. Grainger, Inc. is a leading supplier of maintenance, From there, individual items are sent to regional warehouses
repair, and operating (MRO) products to businesses and in nine U.S. locations, a Canadian site, and Mexico.
institutions in the United States, Canada, and Mexico with
an expanding presence in Europe, Japan, India, China, and
Panama. The company works with more than 4,500 suppliers
The Current China/Taiwan Logistics
and runs an extensive website (www.grainger.com), where Arrangement
it offers nearly 26 million products. The products range from The contracts that Grainger has with Chinese and Taiwanese
industrial adhesives used in manufacturing, to hand tools, suppliers currently specify that the supplier owns the product
janitorial supplies, lighting equipment, and power tools. and is responsible for all costs incurred until the product is
When something is needed by one of its customers, it is often delivered to the shipping port. These are commonly referred
needed quickly, so quick service and product availability are to as free on board (FOB) shipping port contracts. Grainger
key drivers to Grainger’s success. works with a freight forwarding company that coordinates all
Your assignment involves studying a specific part of shipments from the Asian suppliers.
Grainger’s supply chain. Grainger works with over 250 sup- Currently, suppliers have the option of either shipping
pliers in the China and Taiwan region. These suppliers pro- product on pallets to consolidation centers at the port loca-
duce products to Grainger’s specifications and ship to the tions or packing the product in 20- and 40-foot containers that
United States using ocean freight carriers from four major are loaded directly on the ships bound for the United States.
ports in China and Taiwan. From these ports, product is In many cases, the volume from a supplier is relatively small
shipped to U.S. entry ports in either Seattle, Washington, or and will not sufficiently fill a container. The consolidation
Los Angeles, California. After passing through customs, the centers are where individual pallets are loaded into the con-
20- and 40-foot containers are shipped by rail to Grainger’s tainers that protect the product while being shipped across
central distribution center in Kansas City, Kansas. The con- the Pacific Ocean and then to Grainger’s Kansas City distri-
tainers are unloaded and quality is checked in Kansas City. bution center. The freight forwarding company coordinates

ZUMA Press Inc/Alamy Images

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458 OPERATIONS AND SUPPLY CHAIN MANAGEMENT

the efficient shipping of the 20- and 40-foot containers. 10 percent is shipped from Kaohsiung in Taiwan. The final
These are the same containers that are loaded onto rail cars 38 percent is shipped from the southern Yantian/Hong Kong
in the United States. port. Consolidation centers are currently run in each location.
Currently, about 190,000 cubic meters of material are Grainger management feels that it may be possible to
shipped annually from China and Taiwan. This is expected make this part of its supply chain more efficient.
to grow about 15 percent per year over the next five years.
About 89 percent of all the volume shipped from China and Specific Questions to Address in
Taiwan are sent directly from the suppliers in 20- and 40-foot
containers that are packed by the supplier at the supplier site. Your Analysis
Approximately 21 percent are packed in the 20-foot contain- 1. Evaluate the current China/Taiwan logistics costs.
ers and 79 percent in 40-foot containers. The 20-foot con- Assume a current total volume of 190,000 CBM and
tainers can hold 34 cubic meters (CBM) of material and the that 89 percent is shipped direct from the supplier plants
40-foot containers, 67 CBM. The cost to ship a 20-foot con- in containers. Use the data from the case and assume
tainer is $480 and a 40-foot container, $600 from any port that the supplier-loaded containers are 85 percent
location in China or Taiwan and to either Los Angeles or full. Assume that consolidation centers are run at each
Seattle. Grainger estimates that these supplier-filled contain- of the four port locations. The consolidation centers
ers average 85 percent full when they are shipped. use only 40-foot containers and fill them to 96 percent
The remaining 11 percent shipped from China and Taiwan capacity. Assume that it costs $480 to ship a 20-foot
go through consolidation centers that are located at each port. container and $600 to ship a 40-foot container. What
These consolidation centers are run by the freight forwarding is the total cost to get the containers to the United
company and cost about $75,000 per year each to operate. At States? Do not include U.S. port costs in this part of
the volumes that are currently running through these centers, the analysis.
the variable cost is $4.90 per CBM. The variable cost of run- 2. Evaluate an alternative that involves consolidating
ning a consolidation center could be reduced to about $1.40 all 20-foot container volume and using only a single
per CBM using technology if the volume could be increased consolidation center in Shanghai/Ningbo. Assume that
to at least 50,000 CBM per year. Now there is much vari- all the existing 20-foot container volume and the exist-
ability in the volume run at each center, and it only averages ing consolidation center volume is sent to this single
about 5,000 CBM per site. consolidation center by suppliers. This new consolida-
Material at the consolidation centers is accumulated on tion center volume would be packed into 40-foot con-
an ongoing basis, and as containers are filled they are sent to tainers filled to 96 percent and shipped to the United
the port. Volume is sufficient that at least one 40-foot con- States. The existing 40-foot volume would still be
tainer is shipped from each consolidation center each week. shipped direct from the suppliers at 85 percent capac-
Grainger has found that the consolidation centers can load all ity utilization.
material into 40-foot containers and utilize 96 percent of the 3. What should be done based on your analytics analy-
capacity of the container. sis? What have you not considered that may make your
Grainger ships from four major port locations. analysis invalid or that may strategically limit success?
Approximately 10 percent of the volume is shipped from What do you think Grainger management should do?
the north China port of Qingdao, and 42 percent is shipped Many thanks to Gary Scalzitti of Grainger for help with developing this
from the central China port of Shanghai/Ningbo. Another case.

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GLOBAL SOURCING AND PROCUREMENT chapter 13 459

PRACTICE EXAM
1. Refers to how common an item is or how many substi- 7. In order to cope with high levels of supply uncertainty,
tutes might be available. a firm would use this strategy to reduce risk.
2. When a customer allows the supplier to manage inven- 8. Used to describe functions related to the flow of mate-
tory policy for an item or group of items. rial in a supply chain.
3. A phenomenon characterized by increased variation in 9. When a firm works with suppliers to look for opportu-
ordering as we move from the customer to the manu- nities to save money and benefit the environment.
facturer in the supply chain. 10. Refers to an estimate of the cost of an item that
4. Products that satisfy basic needs and do not change includes all costs related to the procurement and use
much over time. of an item, including the costs of disposing after its
5. Products with short life cycles and typically high useful life.
profit margins.
6. A supply chain that must deal with high levels of both
supply and demand uncertainty.

8. Logistics 9. Green sourcing 10. Total cost of ownership

4. Functional products 5. Innovative products 6. Agile supply chain 7. Multiple sources of supply (pooling)
Answers to Practice Exam 1. Specificity 2. Vendor managed inventory 3. Bullwhip effect

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