Addis Ababa University

College of Business and Economics

School of Commerce
Logistics and Supply Chain Management Department

Principles of Supply Chain Management

Prepared By: Kirubel Bruck (PhD) 1

 Chapter 2
Sourcing Decisions in a Supply Chain

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The Role of Sourcing in a Supply chain
• Purchasing, also called procurement, is the process by
which companies acquire
– raw materials,
– components,
– products,
– services, or
– other resources from suppliers to execute their operations.
• Sourcing is the entire set of business processes
required to purchase goods and services.
• Purchasing can be broadly classified into two
categories: merchant and industrial buyers.
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The Role…
• Merchant buyers include the wholesalers and retailers who primarily
purchase for resale purposes.
– Generally, merchants purchase their merchandise in volume to take advantage
of quantity discounts and other incentives such as transportation economy
and storage efficiency.
– They create value by consolidating merchandise, breaking bulk, and providing
the essential logistical services.
• Industrial buyers primary task is to purchase raw materials for conversion
purposes.
– Industrial buyers also purchase
• services,
• capital equipment,
• MRO supplies.
• The typical industrial buyers are the manufacturers, although some service
firms such as restaurants, landscape gardeners, and florists also purchase
raw materials for conversion purposes.

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The Role…
• An effective and efficient purchasing system is crucial
to the success of a business.
• Indeed, the Annual Survey of Manufactures
consistently shows that the total cost of materials
exceeds value added through manufacturing in the
United States.
• Thus, it is not surprising that purchasing concepts and
theories that evolved over the last three decades
focused on industrial buyers’ purchases of raw
materials and how purchasing can be exploited to
improve competitive success.
• Hence, the focus will be on industrial buyers

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The Role…
• For any supply chain function, the most
significant decision is whether to outsource
the function or perform it in-house.
• Outsourcing results in the supply chain
function being performed by a third party.
• Outsourcing decisions are important and tend
to vary across firms and industries.

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The Role…
• We address the outsourcing of supply chain activities
by a firm based on the following three questions:
– Will the third party increase the supply chain surplus
relative to performing the activity in-house?
– To what extent do risks grow upon outsourcing?
– Are there strategic reasons to outsource?
• The supply chain surplus is the difference between the
value of a product for the customer and the total cost
of all supply chain activities involved in bringing the
product to the customer.
• A sourcing decision should aim to increase the net
value created by the supply chain.

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 IN-HOUSE OR OUTSOURCE?
• The decision to outsource is based on the growth
in supply chain surplus provided by the third
party and the increase in risk incurred by using a
third party.
• A firm should consider outsourcing if the growth
in surplus is large with a small increase in risk.
• Performing the function in-house is preferable if
the growth in surplus is small or the increase in
risk is large.
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 How Do Third parties increase the
Supply chain Surplus?
• Third parties increase the supply chain surplus if
they either increase value for the customer or
decrease the supply chain cost relative to a firm
performing the task in-house.
• Third parties can increase the supply chain
surplus effectively if they are able to aggregate
supply chain assets or flows to a higher level
than a firm itself can.
• Here, we discuss various mechanisms that third
parties can use to grow the surplus.
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 1. Capacity aggregation.
• A third party can increase the supply chain
surplus by aggregating demand across multiple
firms and gaining production economies of scale
that no single firm can do its own.
• This is the most common reason for outsourcing
production in a supply chain.
• The growth in surplus from outsourcing is highest
when the needs of the firm are significantly lower
than the volumes required to gain economies of
scale.
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 2. Inventory aggregation.
• A third party can increase the supply chain
surplus by aggregating inventories across a large
number of customers.
• The third party performing inventory aggregation
adds most to the supply chain surplus when
demand from customers is fragmented and
uncertain.
• When demand is large and predictable, an
intermediary adds little to the surplus by holding
inventory.
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 3. Transportation aggregation by
transportation intermediaries.
• When shippers want to send small quantities, the
transportation intermediary aggregates shipments
across multiple shippers, thus lowering the cost of each
shipment below what could be achieved by the shipper
alone.
• A transportation intermediary can also grow the
surplus for TL shipping by aggregating across multiple
firms having unbalanced transportation flows, with the
quantity coming into a region being very different from
the quantity leaving the region.

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 4. Transportation aggregation by
storage intermediaries.
• A third party that stores inventory can also increase the supply
chain surplus by aggregating inbound and outbound transportation.
• Storage intermediaries such as W.W. Grainger and McMaster-Carr
stock products from more than a thousand manufacturers each and
sell to hundreds of thousands of customers.
• On the inbound side, they are able to aggregate shipments from
several manufacturers onto a single truck. This results in a lower
transportation cost than could be achieved by each manufacturer
independently.
• On the outbound side, they aggregate packages for customers at a
common destination, resulting in a significantly lower
transportation cost than can be achieved if each supplier shipped to
each customer separately.

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 5. Warehousing aggregation.
• A third party may increase the supply chain surplus by
aggregating warehousing needs over several firms.
• The growth in surplus is achieved in terms of lower real
estate costs and lower processing costs within the
warehouse.
• Savings through warehousing aggregation arise if a firm’s
warehousing needs are small or if its needs fluctuate over
time.
• In either case, the intermediary with the warehouse can
exploit economies of scale in warehouse construction and
operation by aggregating across multiple customers.
• Warehousing aggregation is unlikely to add much to the
surplus for a large supplier or customer whose warehousing
needs are large and relatively stable over time.
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 6. Procurement aggregation.
• A third party increases the supply chain
surplus if it aggregates procurement for many
small players and facilitates economies of
scale in ordering, production, and inbound
transportation.
• Procurement aggregation is most effective
across many small buyers.
• Procurement aggregation is not likely to be a
big factor with a few large customers.

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 7. Information aggregation.
• A third party may increase the surplus by aggregating information
to a higher level than can be achieved by a firm performing the
function in-house.
• All retailers aggregate information on products from many
manufacturers in a single location.
• This information aggregation reduces search costs for customers.
• Information aggregation reduces search costs and allows better
matching of truckers and shipments.
• Information aggregation increases the surplus if both buyers and
sellers are fragmented and buying is sporadic.
• Information aggregation is not likely to be a big factor for a car
manufacturer that regularly buys steel from a single supplier.

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 8. Receivables aggregation.
• Receivables aggregation is likely to increase
the supply chain surplus if retail outlets are
small and numerous and each outlet stocks
products from many manufacturers that are
all served by the same distributor.

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 9. Relationship aggregation.
• An intermediary can increase the supply chain surplus by
decreasing the number of relationships required between multiple
buyers and sellers.
• Without an intermediary, connecting a thousand sellers to a million
buyers requires a billion relationships.
• The presence of an intermediary lowers the number of
relationships required to just over a mil lion.
• A third party, however, does not increase the surplus by being a
relationship aggregator between a few buyers and sellers for which
the relationships are longer term and large.
• For example, Covisint failed to become a relationship aggregator in
the automotive industry, especially for direct materials.

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10. Lower costs and higher quality.
• A third party can increase the supply chain surplus if it provides
lower cost or higher quality relative to the firm.
• If these benefits come from specialization and learning, they are
likely to be sustainable over the longer term.
• A specialized third party that is further along the learning curve for
some supply chain activity is likely to maintain its advantage over
the long term.
• A common scenario, however, is one in which the third party has a
low-cost location that the firm does not have.
• In such a situation, lower labor and overhead costs are temporary
reasons for outsourcing, because if the wage differential is
persistent and the third party offers none of the other advantages
discussed earlier, it is best for the firm to maintain ownership and
offshore production to the low-cost location.
• The following slide discusses the make or buy decision in terms of
cost.
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 Make-or-Buy - Break-Even Analysis
• Assumptions
– All costs involved can be classified as either fixed
or variable cost,
– Fixed cost remains the same within the range of
analysis,
– A linear variable cost relationship exists,
– Fixed cost of the make option is higher because of
initial capital investment in equipment,
– Variable cost of the buy option is higher due to
supplier profits.

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 Example: Make-or-Buy
• A firm has the option to make or buy a part. Its annual
requirement is 15,000 units. A supplier is able to supply the
part at $7 per unit. The firm estimates that it costs $500 to
prepare the contract with the supplier. To make the part,
the firm must invest $25,000 in equipment, and the firm
estimates that it costs $5 per unit to make the part.

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Break-Even Analysis…

If the requirement is less

than 12,250 units, it is
cheaper to buy. It is cheaper
to make the part if the firm
needs more than 12,250
units.

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Break-Even Analysis…

23
Break-even Analysis

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 Additional Reasons for Outsourcing
• Insufficient capacity
• Lack of expertise

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 Reasons for Making
• Protect proprietary technology
• No competent supplier
• Better quality control
• Use existing idle capacity
• Control of lead time, transportation, and
warehousing costs
• Lower cost

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Factors influencing growth of Surplus
by a Third party
• Three important factors affect the increase in
surplus that a third party provides:
– Scale,
– Uncertainty, and
– Specificity of assets.

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 Scale
• If the scale is large, it is likely that sufficient economies of scale are
achieved internal to the firm itself.
• In this case, it is unlikely that a third party can achieve further scale
economies and increase the surplus.
– Walmart has sufficient scale in terms of its transportation needs that it
achieves economies of scale on trucking by itself. Going to a third
party would not increase the surplus and would result in some loss of
control.
• In contrast, if a firm’s needs do not provide sufficient economies of
scale, the third party can increase the surplus by a large amount.
– Even though Grainger has a large number of outbound packages, given
their geographical dispersion, it would not be able to achieve
economies of scale for door-to-door delivery. A third-party package
carrier adds to the surplus in this case.

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 Uncertainty
• The second important factor is the uncertainty of a firm’s
needs.
• If the needs are predictable, the increase in surplus from a
third party is limited, especially if the firm has sufficient
scale.
• In contrast, if the firm’s needs are highly variable over time,
the third party can increase the surplus through
aggregation with other customers.
– For example, Grainger has predictable needs in terms of
warehouse space required. Given sufficient scale, it owns and
operates its own distribution centers.
– In contrast, most firms have very uncertain demand for MRO
products. They prefer not to hold these items in stock and use
Grainger as an intermediary.

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 Specificity of assets
• Finally, the growth in surplus is influenced by the specificity of assets
required by the third party.
• If the assets required are specific to a firm and cannot be used for others,
a third party is unlikely to increase the surplus because all it does is move
the assets from one firm to another.
• The third party has no opportunity to aggregate across other customers.
– For example, if a distributor holds inventory that is specific to a customer, the
distributor is unable to aggregate it to a higher level than the customer.
– The presence of the distributor does not increase the surplus in this case.
– Similarly, if a third-party logistics provider manages a warehouse exclusively
for a single firm, it has few opportunities to increase the surplus unless it can
aggregate the use of management or information systems across other
warehouses.
– In contrast, if assets (inventory or warehouses, in the previous examples) are
less specific and can be used across multiple firms, a third party can increase
the surplus by aggregating uncertainty across multiple customers or improving
economies of scale.

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 Growth in Surplus by Third Party as
a Function of Scale, Uncertainty, and
Specificity
• One instance in which a firm may outsource to a third party even when none of
the mentioned factors suggests outsourcing is shortage of capital or a third
party with a much lower cost of capital.
• In either of these scenarios, the third party can grow the surplus by bringing
lower-cost capital to the supply chain.
• This discussion on how and when a third party can increase the supply chain
surplus is summarized in the following Table.

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 Risks of using a Third party
• Firms must evaluate the following risks when
they move any function to a third party:
– The process is broken.
– Underestimation of the cost of coordination.
– Reduced customer/supplier contact.
– Loss of internal capability and growth in third-party
power.
– Leakage of sensitive data and information.
– Ineffective contracts.
– Loss of supply chain visibility.
– Negative reputational impact.

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 1. The process is broken.
• The biggest problems arise when a firm
outsources supply chain functions simply
because it has lost control of the process.
• Keep in mind that introducing a third party
into a broken supply chain process only makes
it worse and harder to control.
• The first step should be to get the process
under control, then do a cost–benefit analysis,
and only then decide on outsourcing.

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 2. Underestimation of the cost of
coordination.
• A common mistake when outsourcing is to
underestimate the effort required to coordinate
activities across multiple entities performing supply
chain tasks.
• This is especially true if a firm plans to outsource specific
supply chain functions to different third parties.
• Outsourcing functions to many third parties is feasible
(and can be very effective) if the firm views being a
coordinator as one of its core strengths.

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 3. Reduced customer/supplier
contact.
• A firm may lose customer/supplier contact by
introducing an intermediary.
• The loss of customer contact is particularly
significant for firms that sell directly to
consumers but decide to use a third party to
either collect incoming orders or deliver
outgoing product.

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 4. Loss of internal capability and
growth in third-party power.
• A firm may choose to keep a supply chain
function in-house if outsourcing will
significantly increase the third party’s power.

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 5. Leakage of sensitive data and
information.
• Using a third party requires a firm to share demand
information and, in some cases, intellectual property.
• If the third party also serves competitors, leakage is
always a danger.
• Firms have often insisted on firewalls within the third
party, but a firewall increases the specificity of assets,
limiting the growth in surplus that the third party can
provide.
• When leakage is an issue, especially with regard to
intellectual property, firms often choose to keep the
function in-house.

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 6. Ineffective contracts.
• Contracts with performance metrics that distort the third party’s
incentives often significantly reduce any gains from outsourcing.
• For example, cost-plus pricing of third-party services presents incentive
problems even if the third party opens its books.
• This form of pricing eliminates incentives for the third party to innovate
further to reduce costs.
• The onus for improvement falls back on the firm.
• Another example occurs when firms require suppliers or distributors to
maintain a certain number of days of inventory as part of the contract.
• Such a contract reduces the third party’s incentive to take actions that
reduce inventories.
• In such a situation, it is better for the firm to contract on a desired service
level and leave the third party more freedom with regard to the amount of
inventory.
• The third party then has an incentive to work on reducing the inventory
required to provide a given level of service.

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 7. Loss of supply chain visibility.
• Introducing third parties reduces the visibility
of supply chain operations, making it harder
for the firm to respond quickly to local
customer and market demands.
• This loss of visibility can be particularly
harmful for long supply chains.

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 8. Negative reputational impact.
• In many instances, actions regarding labor or the
environment taken by the third party can have a
significant negative impact on the reputation of the firm.
– Nike has had difficulty with several of its suppliers regarding
labor practices and the environment.
– In 2008, Nike produced its first supply chain report on
suppliers in China and reported several questionable labor
practices, including underage workers, unpaid wages, and
falsified documents.
– The reputational loss from actions by a supplier can be
particularly damaging to firms like Nike with strong brands.

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 Strategic factors in Sourcing
• Besides economic factors and risks, strategic
factors must be accounted for when making
sourcing decisions.
1. Support the business strategy.
2. Improve firm focus.

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SUPPLIER SELECTION—AUCTIONS
• In general, auctions are best used when the
quantifiable acquisition cost is the primary
component of total cost.
• If ownership or post-ownership costs are
significant, auctions are not appropriate when
selecting suppliers.
• In such settings, direct negotiations often lead
to the best outcome.

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 Auctions in the Supply chain
• The qualification process is important because there are multiple
attributes of performance that the buyer cares about.
• When conducting an auction based primarily on unit price, it is thus
important for the buyer to specify performance expectations along
all dimensions other than price.
• Setting up an auction that accounts for multiple attributes, not all of
which can be precisely quantified, is difficult.
• Thus, the qualification process is used to identify suppliers that
meet performance expectations along the non-price attributes.
• If the number of important non price attributes is large, it is often
best to engage in direct negotiations rather than use an auction.

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Auctions…
• From the buyer’s perspective, the purpose of an
auction is to get bidders to reveal their underlying
cost structure so the buyer can select the supplier
with the lowest costs.
• A commonly used mechanism that achieves this
outcome is the second-price (Vickrey) auction.
• In this type of auction, each potential supplier
submits a bid and the contract is assigned to the
lowest bidder— but at the price quoted by the
second-lowest bidder.
• In general, it is in the buyer’s interest to reveal all
available information before bidding.
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Auctions…
• If bidders perceive a lack of information, they are all likely
to increase their bids to account for this lack of
information.
• A significant factor that must be accounted for when
designing an auction is the possibility of collusion among
bidders.
• Second-price auctions are particularly vulnerable to
collusion.
• If there is collusion and all bidders but the lowest cost
bidder raise their bids, the contract goes to the lowest-cost
bidder, but at a high price.
• Firms must take care to ensure that no collusion occurs
when using an auction.

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SUPPLIER SELECTION - Basic principles
of Negotiation
• Firms enter into negotiations both for supplier selection and to set the terms of
the contract with an existing supplier.
• When the total cost of ownership has multiple components besides the cost of
acquisition, negotiations generally result in a better outcome compared with the
use of auctions.
• Negotiation is likely to result in a positive outcome only if the value the buyer
places on outsourcing the supply chain function to a supplier is at least as large as
the value the supplier places on performing the function for the buyer.
• The value that a supplier places on performing a function is influenced by its cost
as well as other alternatives that are available for its existing capacity.
• Similarly, the value that the buyer places is influenced by the cost of performing
the function in-house and the price available from alternative suppliers.
• The difference between the values of the buyer and seller is referred to as the
bargaining surplus.
• The goal of each negotiating party is to ideally create a situation in which the
surplus grows, thus increasing the size of the pie they have to share.

46
Negotiation…
• To create a win–win negotiation, the two parties must identify
more than one issue to negotiate.
• Identifying multiple issues allows the opportunity to expand the pie
if the two parties have different preferences.
• This is often easier than it seems in a supply chain setting,
especially if both parties focus on the total cost of ownership.
• A buyer focused on TCO cares not just about the acquisition cost,
but also about responsiveness and quality.
• If the supplier finds it harder to lower the purchase price but easier
to reduce the response time, there is an opportunity for a win–win
resolution, in which the supplier offers better responsiveness
without changing the price.

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 Supplier Evaluation Methods

• There are number of approaches being used to

assist the supplier performance evaluation. The
following four effective evaluation methods are
commonly used today in many industries.
– The categorical method
– The weighted point Method
– The cost ratio method
– The total cost of ownership (TCO)
– The analytic hierarchy process (AHP)
 The categorical method
• Involves categorizing each vendor's performance in specific
areas defined by a list of relevant performance variables.
• It consists of a procedure whereby the buyer keeps a record
of all vendors to be monitored, along with their actual
performance by product.
• A list of significant performance factors is developed for
evaluation purposes, and the buyer assigns a "grade" in
simple categorical terms, such as "good," "neutral," and
"unsatisfactory," indicating the vendor's actual
performance in each area.
• Operating personnel in related departments (e.g., quality
control, receiving, and operations) may also be asked to
evaluate suppliers on performance factors relevant in their
operations.
Example: The categorical method
Vendor Performance characteristics
Cost Product quality Speed Total
A Good (+) Unsatisfactory (-) Neutral (0) 0
B Neutral (0) Good (+) Good (+) ++
C Neutral (0) Unsatisfactory (-) Neutral (0) -

In this example, other things being equal, Vendor B

appears to have generated the best performance
record.
 Weighted-point method
• Weighted-point method is the most frequently used
method for evaluation process.
• With weighted-pointed method, different attributes
which are important to the customers are weighted as
per their importance level.
• The evaluator assigns the score to each supplier
performance in each attribute and then the score will
be multiplied by the assigned weight of each factor.
• Finally, the weighted score will be totaled to find out
the final performance rating of each supplier. The
supplier who obtains highest score will then be the
best performer.
Example: The weighted point Method
• A focal firm often uses weighted point method to select suppliers.
The firm has determined the following criteria and their respective
points
Criteria Weight
Quality 40
Delivery 30
Cost reduction suggestion 20
Price 10

The accompanying table shows the performance rating of three suppliers and
price per unit they quoted now.
Supplier Quality Delivery Cost reduction Suggestion Price/unit(birr)
A 90% 80% 1= 1/5= 20% 40 = 40/40= 100%
B 80% 90% 1= 1/5= 20% 50 = 40/50= 80%
C 70% 100% 3= 3/5= 60% 60 = 40/60= 67%

Required: Rank the suppliers and select one

 Solution: The weighted point Method
Supplier Quality Delivery CRs rating Price/rating Comparison
rating rating rating
A 0.9x40=36 0.8x30=24 0.2x20 =4 1x10=10 74
B 0.8x40=32 0.9x30=27 0.2x20=4 0.8x10=8 71
C 0.7x40=28 1x30=30 0.6x20=12 0.67x10=6.7 76.7

Supplier Rank
A 2nd
B 3rd
C 1st Decision:
Supplier C is selected
 The Cost ratio method
• When using this method, the buying firm identifies the
additional cost it incurs when doing business with a given
supplier.
• These are separated as cost associated with the quality,
service and price elements of supplier performance.
• Each of these costs are converted to cost ratio which
expresses the additional cost as a percent the buyer’s total
dollar purchase from that supplier.
• It will be totaled to get the supplier’s overall additional cost
ratio.
• For purpose of analysis the supplier’s price is adjusted by
applying its overall cost ratio.
• The higher is the ratio of the cost the lower is the rating
and therefore lower chance for being selected.
The Cost ratio method…
 Example: The Cost ratio method
• Suppose you are the purchaser of a focal firm and you want to select among
supplies A, B, C and D based on the performance of the suppliers during the year
just ended and forward your proposal to the higher mgt based on cost ratio
method. The records were given below:
Deliver costs (in birr) Quality costs (in birr)
Items A B C D Items A B C D
Telephone call 400 100 200 300 Visit 300 500 400 200
Telegrams 475 275 425 200 Sample approval 400 700 800 600
Expediting 875 300 975 750 Incoming inspection 100 275 250 225
Premium shipment 750 225 900 950 Re-work 0 425 450 400
Miscellaneous 500 300 700 600 Reject 200 1500 975 675
Total 3000 1200 3200 2800 Other costs 0 200 325 700
Total 1000 3600 3200 2700
The total value of shipments (purchase) and
the quoted prices are given as follows.
Supplier Total value purchase (Birr) Quoted price
A 100,000 85
B 120,000 86
C 80,000 82
D 140,000 83
Example: The Cost ratio method…
Service rating (service in points)
Factors Max pt. A B C D
Financial stability 20 20 18 15 15
Filed service 25 20 21 15 12
Labor relation 10 8 10 10 8
Geographic location 15 10 15 6 0
Flexibility 5 5 5 3 5
Expansion capacity 10 10 8 7 9
Warranty 10 8 10 8 0
Miscellaneous 5 3 4 0 0
Total 100 84 91 64 49

Assume that the service rating is 60 points and the maximum value of service
package is 20% of price.
Required: which supplier is the best based on the cost ratio-method
 Solution: Cost ratio method
Step1. Summary of the costs

Supplier Delivery(Birr) Quantity (Birr) Service

A 3000 1000 84
B 1200 3600 91
C 3200 3200 64
D 2800 2800 49

Step 2. Cost ratio summary Service Cost Rating – SCR

for supplier A
Supplier DCR QCR SCR Total
 84 
A 3 1 -8 -4  x100  −100 = 40% x 0.2 = 8%
B 1 3 -10.3 -6.7  60 
C 4 4 -1.33 6.67
D 2 2 +3.67 7.67
 Solution: Cost ratio method
Step 3. Adjust to the Quoted Price
Supplier Quoted price (1) Incremented/decree price(2) Net (1+2)adjusted price
A 85 85x0.04 =3.4 81.6 = (85-3.4)
B 86 86x0.067=5.76 80.24 = (86-5.76)
C 82 82x0.0667=5.4694 87.4694= (82 +5.4694)
D 83 83x0.0767=6.37 89.37= (83 +6.37)

Supplier Rank Decision: Supplier B is selected

A 2nd
B 1st
C 3rd
D 4th
 Total Cost of Ownership (TCO)
• The total cost of ownership concept extends the
traditional break-even analysis beyond considering
only the original purchase cost and capital equipment
cost;
• Other qualitative and quantitative factors, including
freight and inventory costs, tooling, tariffs and duties,
currency exchange fees, payment terms, maintenance,
and nonperformance costs should be considered.
• Firms can use a total cost analysis to select the most
cost-effective supplier or as a negotiation tool to
inform suppliers regarding areas where they need to
improve.

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Example - A TCO Analysis
Kuantan ATV, Inc. assembles five different models of all-terrain vehicles (ATVs) from various ready-made
components to serve the Las Vegas, Nevada, market. The company uses the same engine for all its ATVs. The
purchasing manager, Ms. Jane Kim, needs to choose a supplier for engines for the coming year. Due to the size of
the warehouse and other administrative restrictions, she must order the engines in lot sizes of 1,000 each. The
unique characteristics of the standardized engine require special tooling to be used during the manufacturing
process. Kuantan ATV agrees to reimburse the supplier for the tooling. This is a critical purchase, since late delivery
of engines would disrupt production and cause 50 percent lost sales and 50 percent back orders of the ATVs. Jane
has obtained quotes from two reliable suppliers but needs to know which supplier is more cost-effective. She has
the following information:
Two qualified suppliers have submitted the following
quotations:

Jane also obtained the following freight rates from her carrier:
Truckload (TL ≥ 40,000 lbs): $0.80 per ton-mile
Less-than-truckload (LTL): $1.20 per ton-mile
Note: per ton-mile = 2,000 lbs per mile; number of days per year =
365
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 Total Cost of Ownership Computation –supplier 1
Note that due to the size of the warehouse, order lot size, Q, is limited to 1,000 units.
Total Engine Cost = Annual requirement × Unit cost = 12,000 units × $500/unit =
$6,000,000.00
• Cash Discount (based on 365 days per year)
– A cash discount of 2/10 net 30 means the invoice must be paid within 30 days, but a 2%
discount is given if the invoice is paid within 10 days of the invoice date.
– The calculation of the cash discount is done in two parts—whether the buyer pays the invoice
on the 10th day (receives a 2% discount) or 30th day (pays the full amount).
– It is assumed that the buyer will take advantage of the largest discount.
A. Net 30 = Saving on the cost of capital by paying invoices on the 30th day = Total engine cost × cost of
capital × 30/365 = $6,000,000.00 × 10% × 30/365 = $49,315.07
B. 2/10 cash discount = Saving on the cost of capital and 2% discount by paying invoices on the 10th day =
Total engine cost × (cost of capital + 2% discount) = $6,000,000.00 × (10% ×10/365 + 2%) = $136,438.36
Hence, the buyer should pay invoices on the 10th day to take advantage of the $136,438.36 cash discount
provided by the 2/10 term.
• Tooling Cost = $22,000.00

62
TCO Computation…
• Transportation Cost
Total Transportation Cost = distance × quantity × weight/unit
× rate/ton-mile = = 125 miles × 12,000 units × 22 lbs/unit × $1.20/2,000 lbs-mile
= $19,800.00
• Ordering Cost = number of orders × order processing cost
= (12,000 units/1,000 units) × $125 = $1,500.00
• Carrying Cost = Average inventory × price per unit × inventory carrying rate
= (order size/2) × price per unit × inventory carrying rate
= (1,000 units/2) × $500/unit × 20% = $50,000.00
• Quality Cost = Total engine cost × defect rate
= $6,000,000.00 × 2% = $120,000.00
• Delivery Rating
– Backorder Cost (50%) = Total quantity × late delivery rate × back order percentage × unit
back order cost
= 12,000 units ×1% × 50% × $15/unit = $900.00
– Lost Sales (50%) = Total quantity × late delivery rate × lost sales percentage × price of ATV × profit
margin
= 12,000 units ×1% × 50% × $4,500/unit × 18% = $48,600.00
Total Cost of Supplier 1 = $6,000,000.00 − $136,438.36 + $22,000.00 +
$19,800.00 + $1,500.00 + $50,000.00 + $120,000.00 + $900.00 +
$48,600.00 = $6,126,361.64

63
 Total Cost of Ownership Analysis

• The total cost analysis shows that Supplier 1 is more cost-effective, although its unit price and tooling costs are slightly
higher than those of Supplier 2.
• The cash discount, quality cost, and delivery performance set Supplier 1 apart from Supplier 2.
• Using unit cost as the sole criterion to select a supplier would have ultimately cost the company $138,925.75
($6,265,287.40 – $6,126,361.64)

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 HOW MANY SUPPLIERS TO USE
• Reasons Favoring a Single Supplier
– To establish a good relationship
– Less quality variability
– Lower cost
– Transportation economies
– Proprietary product or process purchases
– Volume too small to split

65
How many suppliers…
• Reasons Favoring Multiple Suppliers
– Need capacity
– Spread the risk of supply interruption
– Create competition
– Information
– Dealing with special kinds of businesses

66
 Creating and Managing
Supplier Relationships
• In the last few decades, we have learned that good
supplier relations can provide many benefits such as
– Delivery flexibility,
– Better quality,
– Better information, and
– Faster material flows between buyers and suppliers.
• Many companies believe strongly that better supplier
partnerships are important for achieving competitive
corporate performance.
• As such, companies are realizing the importance of
developing win–win, long-term relationships with
suppliers.

67
Creating and Managing…
• It is critical that customers and suppliers develop
stronger relationships and partnerships based on a
strategic rather than a tactical perspective and then
manage these relationships to create value for all
participants.
• Successful partnerships with key suppliers can
contribute to innovations and have the potential to
create a competitive advantage for the firm.
• Selecting the right supply partners and successfully
managing these relationships over time is thus
strategically important; it is often stated
“a firm is only as good as its weakest suppliers.”

68
 Supplier partnership
• A commitment over an extended time to work
together to the mutual benefit of both parties,
• Sharing relevant information and the risks and
rewards of the relationship.
• These relationships require
– A clear understanding of expectations,
– Open communication and information exchange,
– Mutual trust and
– A common direction for the future.
• Such arrangements are a collaborative business
activity that does not involve the formation of a
legal partnership.
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 DEVELOPING SUPPLIER
RELATIONSHIPS
1. Building trust
2. Shared vision and objectives
3. Personal relationship
4. Mutual benefits and needs
5. Commitment and top management support
6. Change management
7. Information sharing and lines of communication
8. Relationship capabilities
9. Performance metrics
10. Continuous improvement
11. Monitoring supplier relationships.

70
 DEVELOPING SUPPLIER
RELATIONSHIPS
1. Building Trust
– It must be built at all levels of the organization
– It enables organizations to share valuable
information, devote time and resources to
understand each other’s business.
– Achieve results beyond what could have been
done individually.
– Creates goodwill between the partners.

71
Developing supplier…
2. Shared Vision and Objectives
– Both partners must share the same vision and have
objectives that are not only clear but mutually
agreeable.
– Many alliances and partnerships have failed because
objectives are not well aligned or are overly
optimistic.
– The focus must move beyond tactical issues and
toward a more strategic path to corporate success.
– When partners have equal decision-making control,
the partnership has a higher chance of success.

72
Developing supplier…
3. Personal Relationships
– An alliance or partnership is a relationship between
specific individuals.
– Whoever is interfacing with the other company, they
are the company.
4. Mutual Benefits and Needs
– Should result in a win–win situation, which can only
be achieved if both companies have compatible
needs.
– the relationship will be productive and long lasting.

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Developing supplier…

5. Commitment and Top Management Support

– Both parties must dedicate their time, best people,
and resources to make the partnership succeed.
– Commitment must start at the highest management
level.
– Partnerships tend to be successful when top
executives are actively supporting them.
– Since partnerships are likely to encounter bumps
along the way, it is critical that management adopt a
collaborative approach to conflict resolution instead
of assigning blame.

74
Developing supplier…
6. Change Management
– Companies must avoid distractions from their core businesses as a
result of the changes brought about by the partnership.
7. Information Sharing and Lines of Communication
– Both formal and informal lines of communication should be set up
to facilitate free flows of information.
– Any conflict that occurs can be resolved if the channels of
communication are open.
– For instance, early communication to suppliers of specification
changes and new product introductions are contributing factors to
the success of purchasing partnerships.
– Buyers and sellers should meet regularly to discuss any change of
plans, evaluate results, and address issues critical to the success of
the partnerships.

75
Developing supplier…
8. Relationship Capabilities
– Organizations must develop the right capabilities for creating long-term
relationships with their suppliers.
– Companies aspiring to be world class must develop cross-functional team
capabilities.
– In addition, the employees must not only be able to collaborate successfully
within the company in a cross-functional team setting but also have the skills to
do so externally.
– Key suppliers must have the right technology and capabilities to meet cost,
quality, and delivery requirements.
– In addition, suppliers must be sufficiently flexible to respond quickly to changing
customer requirements.
– Before entering into any partnership, it is imperative for an organization to
conduct a thorough investigation of its suppliers’ capabilities and core
competencies.
– Organizations prefer working with suppliers who have the technology and
technical expertise to assist in the development of new products or services
that would lead to a competitive advantage in the marketplace.

76
Developing supplier…
9. Performance Metrics
– The old adage “You can’t improve what you don’t
measure” is particularly true for buyer–supplier alliances.
– Measures related to quality, cost, delivery, and flexibility
have traditionally been used to evaluate how well
suppliers are doing.
– Information provided by supplier performance will be used
to improve the entire supply chain.
– Thus, the goal of any good performance evaluation system
is to provide metrics that are understandable, easy to
measure, and focused on real value-added results for both
the buyer and supplier.

77
Developing supplier…
• By evaluating supplier performance,
organizations hope:
– To identify suppliers with exceptional performance
or developmental needs,
– To improve supplier communication,
– To reduce risk, and
– To manage the partnership based on an analysis of
reported data.

78
Developing supplier…

• Over the past several years, total cost of ownership

(TCO), a broad-based performance metric, has been
widely discussed in the supply chain literature.
• TCO is defined as “the combination of the purchase or
acquisition price of a good or service and additional
costs incurred before or after product or service
delivery.”
• Costs are often grouped into
– Pre-transaction,
– Transaction, and
– Post-transaction costs.

79
Developing supplier…
• Pretransaction costs: These costs are incurred prior to order and
receipt of the purchased goods.
– Examples are the cost of certifying and training suppliers, investigating
alternative sources of supply, and delivery options for new suppliers.
• Transaction costs: These costs include the cost of the goods/services
and cost associated with placing and receiving the order.
– Examples are purchase price, preparation of orders, and delivery costs.
• Post-transaction costs: These costs are incurred after the goods are
in the possession of the company, agents, or customers.
– Examples are field failures, company’s goodwill/reputation,
maintenance costs, and warranty costs.

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Developing supplier…

10. Continuous Improvement

– Continuous improvement involves continuously
making a series of small improvements over time,
resulting in the elimination of waste in a system.
– Both buyers and suppliers must be willing to
continuously improve their capabilities in meeting
customer requirements pertaining to things like
cost, quality, delivery, sustainability, and
technology.

81
Developing supplier…
11. Monitoring Supplier Relationships
– An assessment of how the relationships with an organization’s
suppliers are doing will enable these relationships to be
managed better.
– In a study of the food industry, five key performance indicators
were identified to objectively measure supply chain
relationship performance:
• Creativity—promoting quality, innovation, and a long-term approach
by encouraging high performance.
• Stability—investment, synchronization of objectives, and confidence
building.
• Communication—frequent, open dialogue and information sharing.
• Reliability—concentrating on service and product delivery, lowering
joint costs.
• Value—creating a win–win relationship in which each side is delighted
to be a part.

82
Developing supplier…
• In the same study, several intrinsic characteristics of relationship
performance were also identified as follows:
– Long-term Orientation—encouraging stability, continuity, predictability, and
long-term joint gains.
– Interdependence—loss in autonomy is compensated through the expected
gains.
– C3 Behavior—collaboration, cooperation, coordination, jointly resourcing to
achieve effective operations.
– Trust—richer interaction between parties to create goodwill and the incentive
to go the extra mile.
– Commitment—the relationship is so important that it warrants maximum
effort to maintain it.
– Adaptation—willingness to adapt products, procedures, inventory,
management, attitudes, values, and goals to the needs of the relationship.
– Personal Relationships—generating trust and openness through personal
interaction.

83
 SUPPLIER DEVELOPMENT
• Supplier development is defined as
– “any activity that a buyer undertakes to improve
a supplier’s performance and/or capabilities to
meet the buyer’s short- and/or long-term supply
needs.”

84
Supplier development…
• Supplier development requires financial and human
resource investments by both partners and includes a wide
range of activities such as
– Training of the supplier’s personnel,
– Investing in the supplier’s operations, and
– Ongoing performance assessment.
• As companies outsource more and more parts, a larger
portion of costs lies outside the company in a supply chain,
and it becomes increasingly difficult to achieve further cost
savings internally.
• One way out of this dilemma is for companies to work with
their suppliers to lower the total cost of materials
purchased.

85
 A seven-step approach to supplier
development
1. Identify critical goods and services.
– Goods and services
• That are purchased in high volume,
• That do not have good substitutes,
• That have limited sources of supply are considered strategic supplies.
2. Identify critical suppliers not meeting performance requirements.
– Suppliers of strategic supplies not currently meeting minimum
performance
• In quality,
• On-time delivery,
• Cost,
• Technology,
• Cycle time are targets for supplier development initiatives.
3. Form a cross-functional supplier development team.
– Next, the buyer must develop an internal cross-functional team and
arrive at a clear agreement for the supplier development initiatives.

86
A seven-step approach…
4. Meet with the top management of suppliers.
– The buyer’s cross-functional team meets with the suppliers’ top
management to discuss details of:
• strategic alignment,
• Supplier performance expectations and measurement,
• A time frame for improvement, and
• Ongoing professionalism.
5. Rank supplier development projects.
– After the supplier development opportunities have been identified,
they are evaluated in terms of:
• feasibility,
• resource and time requirements,
• supply base alternatives, and
• expected return on investment.
– The most promising development projects are selected.

87
A seven-step approach…
6. Define the details of the buyer–supplier
agreement.
– After consensus has been reached on the
development project rankings, the buyer and supplier
representatives jointly decide on the performance
metrics to be monitored such as percent
improvement in quality, delivery, and cycle time.
7. Monitor project status and modify strategies.
– To ensure continued success, management must
actively monitor progress, promote exchange of
information, and revise the development strategies as
conditions warrant.

88
 SUPPLIER RECOGNITION PROGRAMS

• It is not sufficient just to reward your best

suppliers with more business; companies need
to recognize and celebrate the achievements
of their best suppliers.
• As award-winning suppliers, they serve as role
models for a firm’s other suppliers.

89
 SUPPLIER RELATIONSHIP
MANAGEMENT (SRM)
• SRM encompasses a broad suite of capabilities
that facilitate
– collaboration,
– sourcing,
– transaction execution and
– performance monitoring between an organization
and its trading partners.

90
SRM…
• SRM leverages the latest technology capabilities
to integrate and enhance supplier oriented
processes along the supply chain such as
– design-to-source,
– source-to-contract and
– procure-to-pay
• SRM involves streamlining the processes and
communication between the buyer and supplier
and using software applications that enable
these processes to be managed more efficiently
and effectively.

91
SRM…
• Many organizations are investing in SRM software modules due to
the wealth of information that can be derived from these systems.
• SRM software can organize supplier information and provide
answers to questions such as:
– Who are our current suppliers? Are they the right set of suppliers?
– Who are our best suppliers, and what are their competitive rankings?
– What are our suppliers’ performances with respect to on-time
delivery, quality, and costs?
– Can we consolidate our buying to achieve greater scale economies?
– Do we have consistency in suppliers and performance across different
locations and facilities?
– What goods/services do we purchase?
– What purchased parts can be reused in new designs?

92
SRM - Types
• Transactional SRM enables an organization to
track supplier interactions such as
– order planning,
– order payment, and
– returns.
• Transactional SRM tends to focus on short-term
reporting and is event driven, focusing on such
questions as:
– What did we buy yesterday?
– What supplier did we use?
– What was the cost of the purchase?

93
SRM - Types
• Analytic SRM allows the company to analyze the
complete supplier base.
• The analysis provides answers to questions such
as:
– Which suppliers should the company develop long-
term relationships with?
– Which suppliers would make the company more
profitable?
• Analytic SRM enables more difficult and
important questions about supplier relationships.

94
SRM - Types
• Thus, transactional SRM addresses tactical
issues such as order size, whereas analytic
SRM focuses on long-term procurement
strategies.
• With analytic SRM, an organization can assess
– Where it was yesterday,
– where it stands today, and
– where it wants to go in the future to meet its
strategic purchasing goals.

95
 ETHICAL SOURCING
• Business ethics is the application of ethical principles to
business situations.
• Generally speaking, there are two approaches to deciding
whether or not an action is ethical.
• The first approach is known as utilitarianism.
– This would mean that an ethical act creates the greatest good
for the greatest number of people.
• The second approach is known as rights and duties
– This states that some actions are right in themselves without
regard for the consequences.
– This approach maintains that ethical actions recognize the rights
of others and the duties those rights impose on the ones
performing the actions.

96
Ethical sourcing…
• Ethical sourcing can be defined as:
– That which takes into account the public consequences of
organizational buying, or bringing about positive social
change through organizational buying behavior
• Ethical sourcing practices include promoting diversity
by intentionally buying from
– Small firms,
– Ethnic minority businesses, and
– Women-owned enterprises;
– Firms in underdeveloped nations.
– Discontinuing purchases from firms that use child labor or
other unacceptable labor practices; or

97
Ethical sourcing…
• Purchasing managers and other corporate
executives play a central role in promoting
ethical sourcing by:
– Creating a supportive organizational culture,
– Developing policies that outline the firm’s desire
to practice ethical sourcing,
– communicating these policies to supply chain
trading partners, and
– then developing tactics that specifically describe
how ethical sourcing will be implemented.
98
 Sustainable Sourcing
• The term sustainability can be defined as
– “the ability to meet the needs of current supply
chain members without hindering the ability to
meet the needs of future generations in terms of
economic, environmental, and social challenges.

99
Sustainable Sourcing…
• Three key areas to focus on to establish sustainable sourcing:
– Respect human rights and reduce poverty by creating profitable
trading;
– Work within the finite limits of the planet’s resources; and
– Move toward a low carbon economy.
• In other words Purchasing,
– fairly,
– Profitably, and
– Environmentally
• For Unilever, the multinational consumer goods company with over
400 product brands, sustainable agriculture sourcing means:
– Growing food in ways which sustain the soil,
– Minimize water and fertilizer use, and
– Protect biodiversity
– Enhancing farmers’ livelihoods.
100
Sustainable Sourcing…
• Growing out of environmental awareness is the idea
of green purchasing.
• Green purchasing is a practice aimed at ensuring
that purchased products or materials meet
environmental objectives of the organization such
as
– Waste reduction,
– Hazardous material elimination,
– Recycling,
– Remanufacturing, and
– Material reuse.

101
Sustainable Sourcing…
• Sustainable sourcing includes:
– Green purchasing,
– Some form of financial benefit,
– Ethical sourcing.
• Very simply, It has been defined as a process of
purchasing goods and services that takes into
account the long-term impact on people, profits, and
the planet.

102
Sustainable Sourcing…
• Leading companies practicing sustainable sourcing seek
to:
– Grow revenues by introducing new and differentiated
sustainable products and services;
– Reduce costs by increasing resource efficiencies, avoiding
use of noncompliant suppliers, and rethinking
transportation and distribution systems;
– Manage risk by managing brand and reputation, and
developing approaches for meeting regulations and
capturing sustainability-conscious customers; and
– Build intangible assets by further enhancing brand and
reputation through social and environmental
responsibility.
25

103
 References and Further Reading
• Wisner, J. D., Tan, K., & Leong, G. K. (2019).
Principles of Supply Chain Management: A
Balanced Approach. Fifth Edition. Cengage
Learning.
• Chopra, S., Peter M., & Kalra, D. (2016). Supply
Chain Management: Strategy, Planning,
Operation. Sixth Edition, Pearson.

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