The notion of outsourcing



Introduction 2

Objective 4

Scope 4

Methodology 5

The course of action during the project 5

Theoretical framework 6

Small companies 6

How is a small business defined? 6

The importance of a strong small business community to the nation 6

The characteristics of small corporations 7

The strategic planning process in small business 8

The notion of outsourcing 9

The driving forces behind outsourcing 9

The process of outsourcing 10

The two steps in focus 12

Strategic aspects of outsourcing to low-cost-countries 13

Establish a presence in a foreign market 13

Risk of intellectual property losses 13

React to the action of competitors 13

Introduce competition to domestic suppliers 14

Innovation and geographical distance 14

Cultural distance 15

The Marketing Mix – the tactical marketing tools 16

Product quality 17

Product brand 17

Pricing strategy and costs 18

Place - marketing and logistics 18

Economic aspects of outsourcing to Low-cost-countries 20

Total cost of ownership (TCO) 20

Lead times 22

Effects on current supplier relations 23

Increased demands on the purchasing departmen 23

Financial risk 25

Socio-Political risks 26

Currency risks 27

Dependence on supplier 28

A conceptual model 29

Empirical findings and comparative analysis 30

Conclusion 31

References 32

Introduction

During the past few years purchasing and supply chain management as a discipline has changed considerably in many companies. Moving away from their traditional, operational roles, purchasing- and supply managers are assuming more strategic roles in their organizations (Van Weele 2002). Considering that organizations today are much more dependent on suppliers – purchasing share in the total turnover typically ranges from 50-90 % - this is not so strange. In addition, today the globalization of trade and the Internet enlarge a purchaser’s choice set. Changing customers preferences require a broader and faster supplier selection. These developments strongly urge for a more systematic and transparent approach to purchasing decision-making, especially regarding the area of supplier selection (De Boer et al 2000).

Decades ago western companies began to manufacture physical goods in offshore locations with the low wages as the primary driver. Despite the cost of transporting the goods, it was cheaper to make them there, then to keep the factory onshore. With the rise of cheap and reliable global communications and the emergence of skilled labor force in many developing countries, remote outsourcing has become real in most industries (Daruvala 2003). The rise of outsourcing manufacturing, R&D and service operations from high-cost countries (HCCs) to low-cost countries (LCCs) are well under way and accelerating fast. No major industry will be immune. In industry after industry, globalization is redrawing the playing field and creating new winners and losers (Adler et al 2004).

However, even though companies are starting to realize that the competitive advantages to be gained from global sourcing are huge, they are also discovering that the process is complex. The bottom-line economic advantages to be gained in various regions are not always easy to assess or compare. Many kinds of risk need to be taken into account, from operational, monetary and intellectual property risk to geopolitical risk (Adler et al 2004). A rapport from the consulting firm Booz Allen Hamilton shows that one third of the Swedish companies fail their outsourcing initiatives. The problems are said to arise already during planning, because the firms don’t consider the consequences of outsourcing enough before executing the plans (Mattsson 2002).

If the problems and complexity of global sourcing are significant for the large companies, the challenge is even greater for the small and medium size enterprises (SMEs). Effective purchasing needs resources and capital, which is rarely the case in SMEs. In one study the results shows that just 19 % of small firms have a purchasing function and 65 % view purchasing as not important. Another important issue is that smaller firms often are the minority partner within the supply chain, limiting their possibilities to negotiate (Quayle 2002).

Handling the globalization of business seems to be the most challenging task the western business world will face during this decade. Up till now, the classic Swedish industrial base of producing machinery has been relatively mildly affected. This is about to change. A rapport, written by the Boston Consulting Group (Adler et al 2004), indicates that industrial metal products and machine shops will be the next wave of global outsourcing. LCCs penetration of these products is still relatively low but accelerating quickly – in some cases by more then 15 % per year. Companies in these sectors face the greatest opportunities but also the greatest threats, because much of their business will face new cost competition. Establishing a method for handling these new issues will be absolutely critical if these companies are to maintain their competitive positions.

In general, this research intends to construct a model, which considers the special conditions of SMEs and brings out all aspects of outsourcing production of machinery to low-cost countries.

Objective

The major objective of this paper is to construct a generic model for SMEs, able to perform a comparative evaluation between outsourcing to a Swedish supplier and one situated in a low-cost country. The evaluation should include both economical and strategic aspects of the action. The generic research question thereby becomes:

What are the economic and strategic consequences and risks that a small company has to consider, when outsourcing production to low-cost countries?

Scope

Since the research question is very wide, this project had to be limited in a number of ways:

• The model will be constructed from the perspective of a specific case company.

• The case firm belongs to the sector of forest machinery.

• The strategic analysis is based in a Marketing perspective.

Methodology

Two common types of research projects, which can be undertaken as a basis for a thesis at the master’s level, are empirical and conceptual projects (Hackley, 2003).

A conceptual project is based mainly on existing sources of information: literature, academic papers and published economic data. The main part of the project thereby becomes an extended critical review of the available literature around a particular set of problems. Normally the review spots gaps of knowledge in a particular area, in order to make suggestions about needed future research. The conceptual project can also induce a conceptual model from the literature review, relating different theories for summarizing particular relationships (Hackley, 2003).

In opposite, an empirical project utilizes first-hand information gathered by the research student. The primary data, collected through interviews or surveys, is placed in the context of the literature and the analyzed for insights and findings (Hackley, 2003).

This project will try to combine elements of both conceptual and empirical approaches. The first part of the project will be to construct a conceptual model from the literature review. This model will then be compared with the findings from first-hand interviews with experienced practitioners within the machinery industry.

The course of action during the project

1. Choosing the topic

2. Studying the literature within the chosen topic

3. Choosing a specific area of interest

4. Choosing the methodology for the project

5. Constructing a conceptual model from the literature review

6. Making qualitative interviews

7. Formulating the major findings

8. Making a comparative analysis with the conceptual model

9. Refining the conceptual model according to the empirical findings

Theoretical framework

First this chapter consists of a brief summary of the special conditions that signifies small companies. Then the notion of outsourcing and the driving force behind it will be discussed. This background will be followed by a presentation of a generic model of the process of outsourcing. The two steps in the model that handle the strategic and cost analysis, will be further developed into a conceptual model with the aid of a vide variety of theories relevant to the objective of the project. After that, the chapter will conclude with more detailed presentations of the different consequences and risks that have been identified in the literature review.

Small companies

This part of the theoretical framework tries to clarify what a small corporation is and its characteristics.

How is a small business defined?

Today, the dominant basis for classifying the size of the firm is the number of employees. The primary reason is that this measurement, in contradiction to the monetary based ones, is not influenced by inflation and changes in prices. This simplifies comparisons over time (Bohman and Boter, 1984). Within this thesis, the definitions drawn up by the European Union will be used (Lundström et al, 1994):

• Microenterprises – firms that employs 0-9 people.

• Small enterprises – corporations that employs 10-99 people.

• Medium-sized enterprises – ranges between 100-499 people.

• Large enterprises – employs more then 500 people.

This means that the companies included in the purpose of this paper, called SMEs, employs a staff that ranges from 0-499 people.

The importance of a strong small business community to the nation

The existence of a strong, healthy small business community has always been recognized as the best way to preserve competition in a capitalistic society. They prevent the monopolistic control of any industries and thus assure the population of the benefits of competition through better prices and quality products (Steinhoff & Burgess, 1986).

In Sweden, this image has been partly replaced by a view that instead recognises the SMEs as a necessary complement to the large corporations. This complementary role divides into two different branches: partly as a supplier of components to the large industrial firms and partly as a manufacturer of products omitted by the large corporations (Bohman and Boter, 1984).

The characteristics of small corporations

The SMEs relationship to the environment is often characterised by a geographical concentration. Both the customers and the suppliers tend to be located close, local and regional. This implies that the share of the total market often is relatively small, since the SMEs do not have the same prerequisites of dominance. Many smaller firms choose a small market niche, and can thereby acquire the profile and competence needed to dominate a specific segment (Bohman and Boter, 1984).

The structure of the customers can indicate an important aspect of the environment of the smaller businesses; if the turn-over is limited to a few numbers of clients, the loss of one customer could mean a financial crisis. This dependence to the environment is also valid when discussing suppliers and their deliveries. However, this dependence does not have to be negative, since an intimate relationship can cause a foundry of stability that facilitates the development of the company (Bohman and Boter, 1984).

A direct consequence from this common dependence is a greater limitation in strategic choices, due to their lack of resources. Instead the primary strategy of the SMEs will be adaptation; they compensate their weak power towards their environment with flexible actions (Bohman and Boter, 1984).

When it comes to organisational structure, it is often characterised by lack of hierarchy and specialized workforce. Instead the owner-manager (usually the same individual) has a dominant role as responsible for a lot of functions, and the employees often have a variety of tasks demanding multi-skilled personal. A limited administrative system also means that the distance between management and personal is small, implying that the flexibility is higher there in large corporations due to the high amount of informal communication (Bohman and Boter, 1984).

As mentioned earlier, the resources available for change and adaptation is restricted. This could be one of the main reasons that small firms generally are local/regionally oriented. A small business thereby has fewer possibilities to market their products abroad, due to limitations in administrative and lingual resources (Bohman and Boter, 1984).

Another important issue for the SMEs is the identification and handling of risks. Every firm operates with daily risks and the total costs may be much greater for large firms, but they are relatively more important for small firms. The small firm is characteristically less able to absorb losses from risks, making it essential for all small firms to understand the risks to which it is subjected (Steinhoff & Burgess, 1986).

Thus, the generic SME characteristics are:

• High level of external dependence, both with customers and suppliers.

• Limited resources of time, money and competence.

• High flexibility; fast adaptation to new conditions.

• The owner-manager often has a dominant role.

• Normally has a strong local/regional orientation.

• Generally more vulnerable for risks

• Often a component supplier or specializes in a market niche.

The strategic planning process in small business

All these characteristics of the small firms affect the possibilities for strategic planning and evaluation. Thereby the starting-point for creating a planning process in a small company will be the external environment and the size of the internal resources (Bohman and Boter, 1984).

The conclusion of this part of the theoretical framework thus becomes that the SMEs has a set of distinct characteristics, compared to larger companies. Furthermore, these characteristics create limitations for the generic model that is the main objective of the thesis. In the second half of the theoretical framework, the implications of these characteristics when outsourcing will be further analyzed.

The notion of outsourcing

There are several definitions of outsourcing circulating in literature and media. In this essay outsourcing is defined as “when a company hires an external supplier to perform services previously done in-house” (Asplund 2002). This means that outsourcing differs both from purchasing products never manufactured and selling businesses no longer needed. However, this definition does not give any clues to why a firm would make the decision to outsource. To understand the logic behind outsourcing, one must grasp the underlying driving forces.

The driving forces behind outsourcing

The reasoning behind outsourcing is largely based on the concept of Porter’s value-chain (Asplund 2002). The value-chain is an attempt to explain the total value of a company, made up of all the activities creating value and a profit margin (Figure XX). According to the model a company consists of a number of primary activities related to actual production and various supportive activities. Both the primary and the supportive activities can contribute to the competitive advantage by adding value to the product.

Porter means that all companies should analyze the value it creates for its customers. The value is calculated as the company’s total income; the product price multiplied with the annual sales. If the value exceeds the total costs for delivering the product to the customer the company is profitable (Porter 1985).

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FIGUR XX

This implies that a company’s competitive advantage, or the creation of value, often lies in certain parts of its value-chain. Thereby the primary motive to outsource often is a will to focus on these strategically important parts, also known as core competence, and use best-practice suppliers to perform other activities distant from its core. The suppliers enhances the execution of the distant activities (either with better quality or lower costs), thereby increasing the value for the final customer (Asplund 2002).

The Porter value-chain model is widely accepted and its impact on corporate strategy has been immense. As all models that have the ambition of being generic, the model has received some criticism. The main issue is whether or not Porter has made to many simplifications and disregarded the problems with implementing the strategies (Holm 2002). And no doubt about it, executing an outsourcing strategy is a costly and time-consuming process, demanding the outmost attention from upper management. All the departments will be effected by the decision, not just the one being outsourced. Naturally the process and its effects will differ depending on the outsourcing object and the firm (for example the size). However, all firms realizing an outsourcing strategy has to carry out the same major generic steps.

The process of outsourcing

A first step towards dividing the process of outsourcing into actual activities, is to separate between the transaction part and the transition part. The transactional part is similar to a regular purchase, including selection of supplier and negotiating of the contract. Once the contract is signed the transitional part takes over, involving the actual move of resources and employees (Wasner 1999). However, this distinction overlooks the fact that outsourcing is more then a regular purchase. When a company decides to outsource, this will have a vast number of consequences for the future structure of the company. In the model formulated by Greaver (1999), the emphasis on analyzing both the strategic consequences and the costs is more adequate. According to Greaver, all companies considering outsourcing should follow a seven step path (se figure XX):

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FIGURTEXT OCH RITA MARKERING AV 2 OCH 3

1. Plan initiative - The initial step, after deciding to further exploit the possibilities with outsourcing, should be the formation of a project group responsible for the initiative. This group should contain representatives from all the relevant departments. After planning the project, including important goals and dates, the group should revise what outsourcing competence the firm possesses. This will be aid the firm in deciding what sort of external aid needed during the process.

2. Analyze strategic consequences – To be able to control the effects of outsourcing during implementation, the project group needs to understand the consequences it will have for the company’s generic strategies. The answers to these questions are received by relating the outsourcing to the present and expected future structures, core competencies, costs, abilities and competitive advantages

3. Analyze costs – By using an activity-based cost analysis the project group can clarify which activities that can be outsourced. Then a future cost analysis should be made, where both the remaining internal costs and the new external costs are calculated. In this step actual make/buy decision is made.

4. Supplier selection - Now is the time for the project group to formulate the list of criteria for qualifying suppliers based on the outsourcing needs. Potential suppliers are identified and an RFP (Request For Proposal) is sent with: grounds for outsourcing, specification of the service, qualifications requested from supplier and assessment methods. Once the proposals arrive they should be evaluated and compared with the organizations expectations. Naturally references should be checked and on-site visitations made. Then a short-list is made with the two-three most interesting suppliers. These make formal presentations, which will be the basis for the actual choice.

5. Negotiating the contract – When it’s time to finish the agreement the project group needs to clarify a negotiation strategy. In the final contract the following areas should be included: the service levels, the transition terms, management and control, price-model and terms in case of a termination.

6. Transition resources – During the transition process the management of human resources is of the outmost significance. The focus should be on communication and compensation, since the treatment of these employees leaving the company will have a great impact on acceptance of future outsourcing.

7. Managing relations – Once the supplier has taken control of the outsourcing object, the needed management changes. The key to a successful relationship is having the same view on controlling performance, evaluating results and solving problems. However, the foundation of the collaboration should always be mutual trust.

The objective with this research implies that the thesis will focus on steps two and three: the analysis of strategic consequences, costs and abilities.

The two steps in focus

In order to connect Greaver’s generic process of outsourcing to the different aspects of outsourcing production to LCCs a conceptual model will be constructed. The model should specify what the two steps ought to contain, so that a comparative analysis is possible. In the next part of the chapter, a review of contemporary literature will be presented. After a short presentation of each element, a discussion on how this could affect SMEs in particular will follow. In the conclusive part of the chapter, a summary of the theoretical framework will be presented in the form of a conceptual model.

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Figure 1. The two steps in Greaver’s outsourcing process that will be the basis for the conceptual model.

Strategic aspects of outsourcing to low-cost-countries

Globalization will create real advantages in the short to medium term as cost structures are significantly improved. However, many companies struggle with the strategic level - deciding what products and processes to globalize (Adler et al 2004). It’s important to remember that a decision to outsource production to low-cost-countries has an immense impact on the generic strategy and therefore has to be well thought-out.

Establish a presence in a foreign market

Marketing may have plans to sell to a foreign market where it currently does no business. As a way of developing goodwill with a foreign country, purchasing may first choose to source items from that country. The business relationship with members of the foreign country may later support an expanded marketing presence (Monczka et al 2003). This synergetic effect might be more important for SMEs considering outsourcing, since their resources are less abundant.

Risk of intellectual property losses

Advanced industrial countries will have legal systems that provide the buyer protection and fair treatment. This may not be true in LCCs; many countries offer no effective protection against the piracy of intellectual property. Therefore, it is necessary to perform a thorough check of prospective suppliers before releasing designs or other proprietary information (Monczka et al 2003). However, since there is no foolproof method of protecting intellectual property, companies might want to consider keeping the most sensitive products – or at least critical elements – in-house (Adler et al 2004).

For the SMEs having product patents, this risk could form a considerable threat. If a small firm faces the competition of an identical low-cost product on the international market, the consequences could be fatal. Making legal claims in developing countries, without local representation could take years. In the mean time the firm risks facing plunging sales, thereby going out of business.

React to the action of competitors

Most firms do not want to admit they are reacting to the practices of competitors since this is the “fashion and fear” motive. A purchaser may try to duplicate the factors that provide an advantage to a competitor, which may mean sourcing from the same regions of the world. There may be a belief that not sourcing in the same regions may create a competitive disadvantage. This is especially true today with many firms believing they must source in low-cost-countries or risk being at a cost disadvantage (Monczka et al 2003). However, since the risks associated with global sourcing are huge, it’s important that a move to low-cost-countries is a well-balanced decision instead of a trendy measure (Abrahamsson, Andersson & Brege 2003). Since small businesses often is controlled by a small number of individuals, the risk of being affected by trends increases.

Introduce competition to domestic suppliers

Companies that rely on competitive forces to maintain price and service levels within their industry sometimes use worldwide sourcing to introduce competition to the domestic supply base. In industries characterized by limited domestic competition, this can diminish a supplier’s power (Monczka et al 2003). In the previous part of the chapter it was concluded that SMEs often is heavily dependent on its external environment (e.g. their suppliers). Global sourcing might be a way to even the stakes between a small firm and its suppliers.

Innovation and geographical distance

Today the era of mass production and brands has come under threat. Markets have become more fragmented (making target marketing more difficult), product and service life cycles are shortening and innovation is quicker then ever before. Whatever the paradigm for this new modern era is called, it addresses the need to combine high volume and variety, together with high levels of quality as the norm and rapid, ongoing innovation. It follows that an operations strategy cannot focus simply on the core manufacturing, but must take into account the market and delivery (Brown et al 2000).

This new paradigm forms a new environment that calls for fresh strategies, able to optimizing all the elements of the product during its lifecycle. Concurrent engineering, which focuses on the integration of construction and production in cross-functional teams, is an example of such a strategy. The team considers all aspects of the product lifecycle; construction, development, production, marketing, usage and environmental effects (Jarfors et al 2000). As a part of this strategy, large companies strive to create long-term relationships with their suppliers, making them able to participate in parts of the process of product development (Brulin 1997).

Irrespective of a company is applying concurrent engineering or not when it considers outsourcing part of their production, problems related to product development and quality demands frequent personal meetings. Standardized information, such as orders and invoices, can be communicated with the aid of information technology. But when it comes to more intense relations between the customer and the supplier there is a need of spontaneous and unstructured information, which is immensely facilitated with geographic closeness (Asplund 2002).

As said in the previous part of this chapter, one of the major advantages of SMEs is the high amount of informal communication. This could mean that a small firm that decides to outsource production to LCCs loses some of its core competence: the flexibility.

Cultural distance

The internationalization of business has increased management interest for cultural variations between nations. If the geographical distance can have a devastating effect on innovation, the cultural distance might worsen the results. If two corporations doing business are from completely different cultures, the risk for misunderstandings and errors increases dramatically. A classical study in the area is the work made by the Dutch researcher Hofstede, where he identified four dimensions that can be used to classify cultural differences between nations. The four dimensions are (Mabon 1992):

1. Individualism versus collectivism – identifies the extent to which a culture emphasizes the individual versus the group. Individualist cultures value hard work and promote entrepreneurial risk-taking. On the contrary, collectivist cultures feel a strong association to groups, including family and work units.

2. Power distance – conveys the degree to which a culture accepts inequality among its people. A culture with large power distance tends to be characterized by inequality and hierarchy, with power deriving from prestige force and inheritance. On the other hand, cultures with small power distance show a greater degree of equality. The power derives from hard work and entrepreneurial drive and is therefore often considered more legitimate.

3. Uncertainty avoidance – identifies the extent to which a culture avoids uncertainty and ambiguity. A culture with large uncertainty avoidance values security and places its faith in strong systems of rules and procedures in society. Cultures scoring low on uncertainty avoidance tend to be more open to change and new ideas. This helps explain why individuals in this type of culture tend to be more entrepreneurial and organizations tend to welcome best business practices from other cultures.

4. Achievement versus nurturing – this dimension captures the extent to which a culture emphasizes personal achievement and materialism versus relationships and quality of life. Cultures scoring high on this index tend to be characterized more by accumulation of wealth, while cultures scoring low generally have more relaxed lifestyles.

These dimensions, described in the Hofstede framework, are important for companies engaged in international business, since people living in broadly different cultures tend to respond differently in similar business situations. The fact that most SMEs have a strong local/regional focus, implies that the risk for cultural clashes is greater for them. Furthermore, the SMEs are more vulnerable to the risks involved in international business.

The Marketing Mix – the tactical marketing tools

The marketing mix is one of the dominant ideas in modern marketing, formulated by Jerome McCarthy in 1960 (Feurst 1999), and can be defined as the set of controllable tactical marketing tools that the firm blends to appeal to a chosen segment of the market. This means that the marketing mix consists of everything the organization can do to influence the demand for its product. The many possibilities gather into four groups of variables known as the “four Ps”; product, price, place and promotion (Kotler 2002):

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Product quality

Quality is one of the marketer’s major positioning tools, choosing a level that supports the functions, including reliability, precision, ease of operation and other valued attributes (Kotler 2002). Even though sourcing to low-cost-countries no longer means low quality, at least not once the LCC plant has moved along its learning curve, there are exceptions (Adler et al 2004). Given that quality today is seen as something that affects international competitiveness and is too important to be left behind, this should be an important aspect when considering sourcing to LCCs (Brown et al 2000). Since many SMEs are highly dependent on a small group of clients, receiving a shipment of products with inadequate quality becomes a critical risk that needs consideration.

Product brand

One of the most distinctive skills of professional marketers is their ability to create, maintain, protect and enhance brands and their products. Consumers in general view a brand as an important part of a product, and branding can add value to a product. Companies that develop brands with a strong consumer franchise are insulated from competitors’ promotional strategies. A brand can deliver up to four levels of meaning (Kotler 2002):

1. Attributes – A brand first brings to mind certain product attributes, for example: “well built”, “expensive” and “durable.

2. Benefits – Customers don not but attributes, they buy benefits. Therefore, attributes must be translated into functional and emotional benefits. “Durable” could translate into a functional benefit, while “expensive” might translate into an emotional benefit.

3. Values – A brand also says something about the buyers values; Mercedes buyers might value high performance, safety and prestige.

4. Personality – A brand also projects a personality; consumers might visualize a Mercedes as being a wealthy, middle-aged business executive. The brand will attract people whose actual or desired self-images match the brand’s image.

The most lasting and sustainable meanings of a brand are its core values and personality. A company must build its brand strategy around creating and protecting this brand personality. For example, Mercedes has recently introduces lower-price models due to market-pressures. This might prove risky, since marketing less expensive models might dilute the personality that the company has built up over the decades (Kotler 2002). The risk that sourcing to LCCs might diminish the value of a firm’s brand ought to be greater for the larger companies. They are the ones that can afford costly marketing campaigns, building a brand personality. Furthermore, a brand is often used to differentiate a large-scale product in a highly competitive market. Since SMEs rarely compete in these markets, they actually might be able to neglect the risk of undermining the corporate brand.

Pricing strategy and costs

Costs set the floor for the price that the company can charge for its product, and may thereby be an important element in its pricing strategy. Many companies work hard to become “low-cost producers” in their industries, since this means being able to lower prices that result in greater sales and profits (Kotler 2002). As mentioned before this has been the primary driver of sourcing to LCC; the savings often reaches 20 to 40 percent (Adler et al 2004) which can be used to both to increase profits and market share (Kotler 2002). However, a change in price will affect buyers; customers do not always interpret prices in a straightforward way. They may view a price cut in several ways; belief that the quality is reduced or that the company is in financial trouble and not may stick around to supply them with parts in the future (Kotler 2002).

Increasing profits by constantly reducing costs is a natural part of any business today, no matter the size. However, the fact that SMEs often is dominated by a owner-manager, that receives a more direct reward when the profits increases, might effect the perceived importance of low costs.

Place - marketing and logistics

Even though marketing is described in the textbooks as the management of the “four Ps”, its probably true to say that in practice most of the emphasis has been placed on the first three. “Place” has rarely been considered part of mainstream marketing. This view is rapidly changing, as the power of customer service as a potential means of differentiation is recognized. In more and more markets the power of the brand has declined and customers are willing to accept substitutes. This situation implies that customer service is the only way a company can difference itself from its competitors (Christopher 1998).

Faced with the continual development of customers’ expectations and the diminishing power of the brand, the overriding influence may well be “availability” - in other words, is the product in stock? Put another way, there is no value in the product or service until it’s in the hand of the customer. “Availability” is impacted upon by a number of factors, including delivery frequency, reliability, stock levels and order cycle time (Christopher 1998).

Recent studies have identified a significant cost penalty incurred when a stock-out occurs on the shelf, as this may well encourage the shopper to choose an alternative and stay there. Many companies have suffered in this new competitive environment because in the past they have focused on the traditional aspects of marketing – product, promotion and price. However, not all customers – or industries for that matter - will have the same service requirements. The logistics planner therefore needs to know what impact changes in “availability” have on the customers’ perceived value (Christopher 1998).

Since SMEs often is highly dependent on a small amount of customers, the need to satisfy their special requirements of availability could be even greater. This implies that evaluating the change in availability - due to extended order cycle time etc. - caused by global sourcing is vital for SMEs.

Economic aspects of outsourcing to Low-cost-countries

The primary driver of the move to LCC sourcing remains the very large cost advantage that companies can achieve. However, to make a realistic assessment of the magnitude of its potential, each company has to consider all “hidden” costs that can reduce the hoped-for savings (Adler et al 2004). In order to handle this type of purchase effectively and avoid too much emphasis on price, buyers need to base their decisions on TCO-models where the initial purchase of the product is balanced with the total cost of ownership (van Weele 2002).

Total cost of ownership (TCO)

The TCO-model is more then a purchasing tool; it’s a philosophy which is aimed at understanding the true cost of buying a particular good or service from a particular supplier. Total cost of ownership is a complex approach, which requires that the buying firm determines which costs it considers most important or significant in the acquisition, possession, use and disposition of the specific good or service. In addition to the purchasing price, TCO may include transportation, receiving, inspection, rejection, downtime caused by failure and so on. The tool may be applied to any type of purchase, but the cost factors considered is often unique by item or type of purchase (Ellram 1995).

As starting-point the model takes the quoted price from each supplier and then each issue being considered is replaced by a cost factor. During the process the organization first determines the factors important, and then these factors are translated into a cost component that is added to each supplier’s quoted price. The

Purchase is awarded to the supplier with the lowest total cost per unit (Bhutta & Huq 2002).

Barriers and benefits

The major barrier that has limited the widespread adoption of TCO is the complexity of the process (Ellram 1995). Companies wanting to implement a total cost supplier selection process often stumble over how to include non-monetary issues such as delivery and quality performance, lead-time and services (Bhutta & Huq 2002).

However, if this barrier is overcome, TCO provides a variety of benefits. Primary benefits of adopting a TCO approach, documented in literature and confirmed by case studies, are that the TCO analysis:

• provides a consistent supplier evaluation tool

• improves the purchaser’s understanding of supplier performance issues and cost structure

• provides excellent data for negotiations

• provides an opportunity to justify higher initial prices based on better quality or lower total costs in the long run

• provides a long-term purchasing orientation by emphasizing the TCO rather then just price

There are two major approaches to determining TCO used by organizations today; dollar-based and value-based approaches.

Dollar-based approach

The dollar-based system relies on gathering or allocating actual cost data for each of the relevant TCO elements, thereby making it possible to trace the costs of a purchased item cost element by cost element (Ellram 1995).

A variation on the dollar-based approach is the use of a formula to allocate actual costs by item purchased by supplier. The formulae are based on the effort of resource level required to support a given activity, much like the practice of activity-based costing. This approach creates a methodology for using the TCO approach for repetitive decisions, rather then creating a new analysis each time for each commodity (Ellram 1995).

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Value-based approach

The value-based TCO model combines cost/dollar data with other performance data that are difficult to price. These models have a tendency to become rather complex, as qualitative data are transformed to quantitative data. Therefore, they often require long explanations of each cost category. Value-based models tend to focus on a small number of major cost issues, generally around three or four, because calculations beyond this point tend to become too complex. The supplier’s performance is then scored within these cost categories, reflected by the buying organization’s estimate of the coat of various performance discrepancies. This means that when the costs and organizations priorities change, the weighting of cost factors can be altered accordingly. The major disadvantage of the value-based models is the effort required to develop and maintain the proper weightings and point allocations so that they reflect the present TCO (Ellram 1995).

BILD MED EXEMPEL?

The philosophy of the TCO models is easy to grasp, the real challenge lies in calculating the costs for the alternatives. In those cases when it’s not possible to gather adequate relevant data to make an estimate of how all costs is affected, the philosophy should still be applied. Being able to show which costs are affected, and if they rise or fall, is a better base for decision-making then nothing at all (Aronsson et al 2003).

From the SMEs point-of-view the most important feature of a calculation model ought to be simplicity, due to their lack of time and specialized competence. However, since SMEs has a higher degree of vulnerability for risks, a miscalculation of the total costs could have disastrous consequences for the whole corporation. This implies that the TCO-model should be simple and still precise. Demands hard to fulfill; calculation models that considers all aspects tend to be rather complex.

Lead times

One of the major problems with the Wilson formula is the fact that it doesn’t consider the lead-time as a potential cost driver, due to its assumption that the demand is known. Naturally the demand is never certain in the reality of fast changing markets; the prognoses made by the sales department are rarely precise (Aronsson et al 2003).

Three different scenarios can be identified where changes in demand affect the total-cost-of-ownership of a product due to lead-time (Jonsson & Svensson 2002):

1. Increased demand, actual demand < ordered quantity

In this case the demand has increased during the lead-time, however the order quantity still satisfies the actual demand. This should have a positive effect on the total cost, since cost of capital due to products in stock decreases.

2. Increased demand, actual demand > ordered quantity

This scenario implies a shortage of the product, since actual demand has become higher then the ordered quantity. A shortage means that the firm risks a number of negative effects, depending on how they solve the problem. To avoid bad-will and loss of sales and in worst case customers, companies often purchase (if possible) the articles at a higher price from another supplier. This also means increased administrative costs, due to the extra activities needed; finding and negotiating with an alternate supplier.

3. Decreased demand, actual demand < ordered quantity

Finally in the third scenario the actual demand decreases during the lead-time, meaning an increase in total cost due to higher quantities in stock then planned.

Irrespective of which of the identified scenarios the company will face, it will have a substantial impact on the actual total cost of the product. However, since the actual demand always remains unknown, the actual increase or decrease of total cost also remains unknown. For SMEs this risk – due to their high vulnerability - might have fatal consequences.

Effects on current supplier relations

Another problem that the decision to change suppliers may bring, if the purchasing company still has business with the previous supplier, is a loss of negotiating power. Since the value of the orders declines, any discounts may disappear when some of the products are moved to low-cost-countries (Ellram & Billington 2001). Naturally the loss of discounts would have a negative effect on the total cost. However, since SMEs are less likely to have these – due to small quantities – this effect might actually be easier to neglect for them.

Increased demands on the purchasing department

When a company decides to initiate global sourcing, this will affect the role and position of the purchasing department. These changes will influence the tasks, responsibilities and authority of the purchasing function; thereby leading to significant changes in the necessary skills and abilities required by the purchasing department. The most important skills and abilities of different buyer profiles are summarized in table XXX (van Weele 2002).

Function Responsibilities Skills required

Corporate Buyer Strategic commodities Specialist commercial skills

Long term planning horizon

Broad Business orientation

Communication

Purchasing engineer New materials and supplier All-round technician

Medium-term planning

Commercial skills

Project buyer Equipment and services Project management skills

MRO buyer MRO supplies Generalist

Efficient order handling

Service oriented

Materials planner Materials and order planning All-round

Order handling Service oriented

Vendor rating Problem-solving skills

FIGURTEXT

Given the importance of having the right personnel participate in the process, what knowledge and skills does global sourcing require? A partial list includes cost analytic skills, an understanding of worldwide supply markets and the ability to negotiate global contracts. Effective communication and presentation skills, an understanding of global strategy development, the ability to think holistically beyond a site or region and working effective with people from other cultures are also important (Monczka 2003).

Although English is supposedly the international language of business, one will doubtless encounter varying levels of proficiency in people for whom it is not their first language. Indeed, when one considers the range of countries one might deal with, to gain adequate proficiency in that range of languages becomes a daunting task. However, learning a few phrases in a particular language to be able to greet a foreign visitor or host might be regarded at least as a basic courtesy. Sensitivity to potential problems when communicating in English and the ability to adapt one’s use of language in communicating with a non-native speaker are regarded as a basic element of intercultural competence. Intercultural competence is an elusive concept which partly rests on a simple desire to understand different values, points of view and approaches to life (Foot & Hook 2002).

The ability to recruit qualified personnel to participate in global sourcing is often a difficult barrier to overcome in the short term. The knowledge and skills required for global sourcing differ dramatically from those required of day-to-day operational purchasing (Monczka 2003).

For SMEs the increased demand on the purchasing department could be hard to satisfy, due to the limited resources of competence. Naturally, a firm with a single person handling purchasing might encounter greater difficulties then the larger corporations with their purchasing departments. This means that SMEs might need external help for handling the outsourcing to LCCs, which could become a significant part of the total cost both initially and during daily operations.

Financial risk

If a supplier does not fulfill his obligations in the realization of the project, this can lead to considerable damages or loss for the firm. To limit the risk of as much as possible the company can carry out an analysis of the financial risks related to doing business with suppliers. These risks are related to the degree in which the supplier company is considered to function soundly and effectively for the duration of the project. Of importance in this respect are: financial condition, investment elasticity and a solid financial condition in the near future (van Weele 2002).

The financial assessment of suppliers is carried out on the basis of annual financial reports, which can be obtained from the supplier. When conducting this analysis, one should keep in mind that it’s based on historical data, but still the results give a first impression of the quality of the supplier’s management. Such an analysis enables the buyer to visit the supplier well-prepared, and to ask pointed questions (van Weele 2002).

Should a supplier - irrespective of if it’s located in an LCC - go out of business, this would have a sever impact on the financial situation of any small business. At worst this means bankruptcy for them as well. Minimizing the risks, when outsourcing to a supplier in an LCC, then becomes vital. However, SMEs rarely has the competence in-house to make a financial assessment of a potential supplier. This means that a smaller business probably needs external help for this part as well, implying that costs might rise even more.

Socio-Political risks

Basically the price ultimately paid for materials and services is the result of environmental factors – both internal and external. Examples of external factors are changes in general economic conditions and legislation (van Weele 2002), factors that are related to the socio-political climate in the country where the supplier is located.

Managers need to be aware of how political risk can affect their companies when entering international business. If taken in a broad view, political risk can be categorized according to the range of companies that subjected to it. Macro risks threaten all companies within a country, regardless of industry, whereas a micro risk only threatens companies within a particular industry or even smaller groups (Wild 2003).

In addition to these two broad categories, we can classify political risk according to the actions that causes it to arise (Wild 2003):

• Conflict and violence – Violent disturbances impair a company’s ability to manufacture and distribute products, obtain materials and equipment and recruit talented personnel. Open conflict also threatens physical assets and the lives of employees.

• Property seizure – Governments sometimes decide to seize the assets of companies within their borders. The seizure falls into one of three categories; confiscation (a forced transfer without compensation), expropriation (a forced transfer with compensation) or nationalism (the government seizes a whole industry).

• Policy changes – Government policy changes are the result of a variety of influences; ideals of newly empowered political parties, political pressure from lobbyists and civil or social unrest.

In order to reduce their companies’ exposure to political risk, managers should monitor and constantly predict potential political changes that might affect their interest (Wild 2003).

Monitoring potential political changes is another important part of a full risk analysis, also less likely that SMEs can perform by themselves. Also the consequences of an actual action – as concluded in the previous part – proberbly is more sever.

Currency risks

Movement in a currency’s exchange rate has substantial affects on international sourcing, and most important on the profits made. When a country’s currency is weak (valued low relative to other currencies), the price of its exports on world markets declines. In the other hand unfavorable movements in exchange rates can be costly for companies involved in global sourcing. Stable exchange rates improve the accuracy of financial planning, including cash flow forecasts. Although methods do exist for insuring against potentially adverse movements in exchange rates, most of these are to expensive for small and medium-sized businesses (Wild 2003).

The business of forecasting exchange rates is a rapidly growing industry. This trend seems to provide evidence that a number of people believe it is possible to improve the current forecasts, however difficulties remain. Despite highly sophisticated statistical techniques in the hands of well-trained analysts, forecasting is not a science. There are few forecasts that are even close to 100 percent accurate, due to the unexpected events that occur. Other problems can be traced back to the human element involved, for example people might miscalculate the importance of a new technology (Wild 2003).

Companies use a variety of measures to address the risk associated with currency fluctuations. These range from very basic measures to the sophisticated management of international currencies involving the corporate finance department (Monczka et al 2003):

• Purchase in your own currency – This implies that the buyer shifts the currency risk to the seller. However, the foreign supplier is also aware of this problem and may be unwilling to accept the risk by itself. Also, many foreign suppliers anticipate exchange rate fluctuations by incorporating a risk factor into their price. A purchaser willing to accept some of the risk may obtain a more favourable price.

• Sharing currency risk – Sharing of risk requires equal division of a change in a agreed-upon price due to currency fluctuation. Equal sharing of risk permits the seller to price its product without a having to factor in the risk.

• Currency adjustment contract clauses - With currency adjustment clauses, both parties agree that payment occurs as long as exchange rates do not fluctuate outside an agreed-upon range. If exchange rates move outside this range, both parties can ask to renegotiate or review the contract. This provides a mutual degree of protection since no firm can be certain of which direction future fluctuations will have.

• Currency hedging – Hedging is a form of risk insurance that can protect both parties from currency fluctuations. It involves the simultaneous purchase and sale of currency contracts in two markets, and the expected result is that a gain realized on one contract will be offset by a loss on the other.

Irrespective of which steps the purchasing company takes to manage the risks associated with currency fluctuations in individual cases, it should always track the movements of currencies over time to identify long-term changes and sourcing opportunities due to changing economics (Monczka et al 2003).

In line with the financial and socio-political risks, the changing exchange rates might raise the total cost more. Since SMEs – in opposite to the larger corporations - rarely has their own financial departments, this might be yet another part that demands external aid.

Dependence on supplier

Once the firm has chosen a supplier and the cooperation has begun, there is always a risk that the buyer ends up in the suppliers palm if he’s the dominant part of the relationship. Afterwards it’s difficult for a buying firm to escape from its dependence of the supplier, especially if the supplier market is limited due to specific needs. This may very well lead to a situation where the supplier takes advantage of its monopoly and starts raising the prices (Abrahamsson, Andersson & Brege 2003). Inexperienced companies often neglect to prepare strategically for situations when the relationship with the supplier is suffering; for example when the supplier fails to reach an adequate quality (Momme & Hvolby 2002).

The risk of becoming dependent of a supplier is greater for the SMEs, due to their small quantities. Choosing the “right” supplier thereby becomes vital for smaller companies. This also implies that SMEs has a greater need of “securing” a balance of power with new business partners. If the chosen supplier takes advantage of the purchasing company, this could mean that the initial cost advantage might rapidly disappear.

A conceptual model

With the aid of an extensive literature examination, can Greaver’s generic outsourcing process now be adapted to the specific aspects of outsourcing production to LCCs. A method for assessing the economical consequences has been identified: the TCO-model. Unfortunately, no similar methodology for analyzing the strategic aspects has been found. The result of the literature review thereby becomes the conceptual model below:

[pic]

Empirical findings and comparative analysis

• Inkurans även det en risk

• Kartell? – har teori att jämföra med

•

• ADL:s investeringsmodell – lägga ihop startegi och kostnad (inte sekventiellt)

•

Conclusion

However, when considering outsourcing production to an LCC, a firm rarely performs a strategic and a cost analysis. Instead an estimation of the profits (e.g. the difference between the cost structures) is made as a part of the strategic analysis. = Greavers model should in this case be modified into a single analysis step before initiating the sourcing step.

Before Asking Where and What to outsource, a small company should ask Do we have the resources to outsource?

References

Literature and Reports

Abrahamson, Mats, Andersson, Dan & Brege, Staffan (2003). Från mode och trend till ett balanserat strategibeslut: Outsourcing. Management Magazine, vol. 1: 5.

Adler, Barry et al (2004). Capturing global advantage. Boston: The Boston Consulting Group.

Arnold, Ulli (2000). New dimensions of outsourcing: a combination of transaction cost economics and the core competence concept. European Journal of Purchasing & Supply Management, vol. 6, pp. 23-29.

Aronsson, Håkan et al (2003). Modern Logistik. Lund: Liber AB

Asplund, Ola (2002). Outsourcing – erfarenheter i svenska företag. Stockholm: Metalls utredningsavdelning

Bhutta, Khurrum and Huq, Faizul (2002). Supplier selection problem: a comparison of the total cost of ownership and analytical hierarchy process approaches. Supply Change Mangament: An International Journal, vol. 7, pp. 126-135

Bohman, Håkan and Boter, Håkan (1984). Planering i mindre och medelstora företag. Umeå: TID-Tryck.

Brown, Steve et al (2000). Strategic Operations Management. Oxford: Elseveier Nutterworth-Heinemann

Brulin, Göran and Nilsson, Tommy (1997). Arbetets Ekonomi. Stokholm: Rabén Prisma

Christopher, Martin (1998). Logistics and Supply Chain Management. London: Prentice Hall.

Daruvala, Toos (2003). When, Where, How an Other Questions on Going Offshore. New York: Thomson Media.

De Boer, Luitzen et al (2000). A review of methods supporting supplier selection. European Journal of Purchasing and Supply Management, vol. 7, pp. 75-89.

Ellram, Lisa (1995). Total cost of ownership – an analysis approach for purchasing. International Journal of Physical Distribution & Logistics Management, vol. 25, pp. 4-23.

Ellram, Lisa & Billington, Corey (2001). Purchasing leverage considerations in the outsourcing decision. European journal of purchasing & supply management, vol. 7, pp. 15-27.

Feurst, Ola (1999).One-to-One Marketing. Malmö: Liber AB

Foot, Margaret & Hook, Caroline (2002). Introducing Human Resources Management 3rd edition. Gosport: Prentice Hall

Greaver, Maurice (1999). Strategic outsourcing. New York: AMA Publications

Hackley, Chris (2003). Doing Research Projects in Marketing, Management and Consumer Research. London: Routledgde

Holm, Olof (2002). Strategisk Marknadskommunikation.

Jarfors et al (2000). Tillverkningsteknologi. Lund: Studentlitteratur

Jonsson, Olof and Svensson, Anders (2002). Leverantörsval vid Flextronics Malmö - en totalkostnadsmodell för inköp. Lund: Lunds Tekniska Högskola

Kotler, Phillip et al (2002). Principles of Marketing. Essex: Prentice Hall.

Lauterbom, Robert (1990). Advertising Age. London: Prentice Hall.

Lundström, Anders (1994). Småföretagen – Sveriges framtid? Stockholm: Nutek Förlag.

Mattsson, Susanna (2002). Outsourcing kan bli farlig fälla. Dagens Nyheter, 2002-02-06, pp. C03.

Mabon, Hunter (1992). Organisationsläran – struktur och beteende. Stockholm: Psykologiförlaget AB.

Momme, Jesper & Hvolby, Hans-Henrik (2002). An outsourcing framework: action research in the heavy industry sector. European journal of purchasing & supply management, vol. 8, pp. 185-196.

Monczka, Robert et al (2003). Purchasing and Supply Chain Management. Ohio: Thomson South-Western.

Porter, Michael (1985). Competitive Advantage.

Porter-Roth, Bud (2002). Request For Proposal – A Guide to Effective RFP Development. Boston: Pearson Education Inc.

Quayle, Michael (2002). Purchasing in small firms. European Journal of Purchasing and Supply Management, vol. 8, pp. 151-159.

Senge, Peter et al (1999). The dance of change – the challenge of sustaining momentum in learning organisations. New York: Currency Doubleday.

Steinhoff, Dan and Burgess, John (1986). Small business management fundamentals. New York: McGraw-Hill Book Company.

Van Weele, Arjan (2002). Purchasing and Supply Chain Management. Singapore: Thomson Learning.

Wasner, Reine ( ). The process of outsourcing.

Wild, John et al (2003). International Business. New Jersey: Prentice Hall.

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