Out-sourcery: Myth or Magic?

Outsourcing the purchasing function, or some part of it, is not new. What is new are the players, the formalized business approach, and the generous savings that follow when companies aggregate and focus their direct spend.


[From iSource Business, September 2001] When Ingersoll-Rand (IR) began mulling over ways to expand its market share, one thing became clear: over its many decades in business, the $8 billion manufacturer of industrial equipment had built an impressive sourcing and supply chain management knowledge base. And that base got IR executives thinking.

"Ingersoll-Rand has a good reputation for being a top manufacturer," says Bill Lindquist, who was a key participant in the strategy process. "So we started looking at marketing the way we manage suppliers and how we manage supply chain issues."

A tidy ending to this story would suggest that IR, knowing where its core competencies lay, established a business unit selling its supply chain management expertise. But the corporate byways are littered with now-defunct business plans that had so-called "tidy endings." Lindquist et al knew they had to drill down even further to find their true niche in the supply chain.

One statistic they kept coming back to was the oft-cited industry lore that most companies tend to purchase 80 percent of direct materials and components from 20 key suppliers. That 80 percent is already well covered by solution providers, software suppliers and tech consultants in the multi-billion dollar e-commerce community, not to mention the massive internal resources companies tend to throw at their most significant purchases. The leftover 20 percent of direct purchases is not as well covered, but even there IR saw enough competition to give pause. Finally, IR realized that the Fortune 1000-sized companies (with revenues between $900 million to $1 billion that spend maybe $500 million on direct materials) and their 20 percent of was definitely not being targeted.

Bingo.

And so Ingersoll-Rand launched a business unit, headed by Lindquist, called 21st Supplier, a procurement service that aggregates and coordinates a customer's direct spend. It chose SupplyWorks, a supply chain management tech supplier, to host its application for the venture through SupplyWorks MAX; and Roberson Transportation to manage the logistics end of the operations. 21st Supplier became operational last month with its first customer, and the business model is a sure winner, Lindquist says. "This problem exists and everyone agrees it's an opportunity to exploit."

Will It Work?

There is no doubt that the numbers seem to pan out, for Ingersoll-Rand, at least, but the company had other motives besides wanting to expand its repertoire of services. IR also began the initiative to help facilitate its own $4 billion direct materials supply chain, which is populated with close to 10,000 suppliers, not all of them on the Internet or tied into Ingersoll-Rand's Oracle-powered network. As a manufacturer of such diverse products as Schlage locks, Thermo King temperature control equipment, Club Car golf carts and Torrington bearings, the company understandably needs to continue to innovate its supply chain if it wants to stay competitive.

A longer-term strategy, says Lindquist, might include "aggregating the spend between our suppliers and [our clients'] suppliers." Would-be clients would probably be buying the same products that IR does, he says. "So they will be confident that we know the suppliers."

In the more immediate term, however, IR wants to make money. And 21st Supplier makes its money by using a per-unit-pricing model, based on the total cost of managing a particular item. While Lindquist would not give specific dollar amounts, he did offer the simplified example of a manufacturer that is paying $1 for a certain part. "Once we evaluate all the related costs that go into sourcing and procuring that part, we might find it really costs $1.28. So we would offer to procure and deliver it to the client for $1.25."

And the mechanics sound easy enough: The client's manufacturing planning system is integrated with the 21st Supplier system, allowing it to coordinate the purchase requests, invoices, delivery and payment of materials. The client's supplier can then tap into the database to see what orders it is expected to fill and, when the time comes, the resulting payment data, which can be integrated into its financial system. Finally, the client gains a bird's-eye view of all this activity.

"We call this process supplier relationship management," says Jeff Herrmann, president and CEO of SupplyWorks Inc. "All buying relationships need to be maintained."

Of course, with any sort of collaborative supply chain activity, success hinges on getting the customer's suppliers to cooperate. But Lindquist doesn't see this as a problem. "We promise them we will be a better customer," he says. "They are probably not getting paid on time, so we will pay them on time and give them a better cash flow. They are probably not getting much face-time with their client, so we will work with them to get them what they need."

As for the Fortune 1000 clients targeted by 21st Supplier, the sales pitch almost writes itself. "Return on investment begins the first day," Lindquist says. "There are no startup costs, no transaction fees, no licensing fee, no maintenance costs."

Even systems integration is a minor issue for clients of 21st Supplier, Herrmann says. "Typically it would take 90 days to be up and running."

The Case against Outsourcing Purchasing

For all its careful planning and market research, 21st Supplier is ultimately one of many new entrants into this particular niche. To be sure, outsourcing, especially business process outsourcing, is rapidly becoming very popular. It has been around for a long time, says Peter Quittmeyer, a partner at Sutherland Asbill & Brennan LLP, who has represented both large and small companies, as well as purchasing co-ops, in outsourcing deals. "But lately it has become formalized and recognized as a money saving technique."

Certainly, in many instances, the business case for outsourcing is a no-brainer, says John Funk, a partner at Jones, Day, Reavis & Pogue. "There could be significant savings on MRO [maintenance, repair and operation] and other types of purchases. This type of non-core function to a third party expert means a company can concentrate on what it does best," he says.

However there are some factors a company should weigh before handing over its sourcing, supplier management and supply chain operations to a third party, be it a brand name such as Ingersoll-Rand or a startup using leading-edge technology.

If the outsourcer is a company active in your same industry, it could lead to conflict of interest problems, Quittmeyer says. But, he adds, "conflicts of interest can be managed." Losing control of competitive purchasing information is a related issue. "The outsourcer may be offering the same service to your competitor down the street. You have to decide if you can trust a third party with your purchasing information."

Another reason is the inflated expectations. "What is interesting is that we still may be talking about a relatively small percentage of a business's expenses," Funk says. "Even though the percentage savings looks fairly attractive, the overall savings impact may not be as large as the business may think." But that, he says, is just a matter of doing the math. "My sense is that most of these financial models [for outsourcing] are very logical but over-hyped because they focus on a fairly small percentage of business spend," he says.

If a company does decide to go ahead with an outsourcing arrangement, there are any number of legal issues to consider, Funk says. "When I am representing a company, I look for service levels measurable commitments of how well or how fast the supplier will perform the service. And there have to be consequences for any failure to meet those service levels."

Funk acknowledges that service-level agreements (SLAs), which were once very rare 10 years ago, are now common in most service agreements. Many suppliers offer them in their form contracts, he says. "But I notice the SLAs offered by suppliers are not that hard to meet. It is up to companies to negotiate what they really need and want."

The most important step of all is to "nail down in the contract the expectation of cost savings. Businesses get sold on the concept of outsourcing because of promised cost savings, but oftentimes you don't see them anywhere in the contract." Sometimes a supplier's response is that the cost savings are just an estimate, Funk says. "But even then, the contract should reflect a range of committed savings."

Nor is Funk particularly impressed with those models that don't charge clients a fee if no savings are to be had. "You are giving up some degree of control over your procurement function and possibly making a long-term commitment to use this provider. Simply staying with the status quo is an unacceptable return."

IR's 21st Supplier is about going beyond the status quo and maintaining supplier relationships. Outsourcing this function means handing your company's relationships over to a third party, which takes confidence and trust. But it can be done.

Credentials + Chemistry = Outsourcing

Looking to outsource some part of your procurement or supply chain operation? One thing you won't have to worry about is a paltry selection of outsourcers. "Until recently, outsourcing hasn't been an option for smaller companies, because no one was interested in serving this niche," says Peter Bendor-Samuel, CEO of The Outsourcing Center in Dallas.

But procurement and supply chain management has come into its own over the last five to 10 years, gaining the attention and respect of the upper echelons of management, and more than a few service providers and tech suppliers have already entered this space.

"Business process outsourcing started to get really hot, maybe five years ago," says John Funk, a partner at Jones, Day, Reavis, & Pogue. However, now it is a very fragmented market "with a lot of niche suppliers going after very specific parts of the market."

The down side, he says, is that all this new activity has led to concerns about the financial stability of the supplier.

Despite these risks, "this is a pretty exciting time to be around supply chain management," says Thomas Parry, a managing partner in Accenture. "There are a whole host of new tools and strategies in the e-procurement space, such as auctions and strategic sourcing programs, and for each of those strategies there is outsourcing potential."

While there are any number of criteria to examine when selecting an outsourcer, Parry's colleagues have honed it down to two Cs: credentials and chemistry.

CHEMISTRY: "You have to ask yourself if these are the people you want to have a close relationship with," says Dow Bauknight, managing partner, Accenture. So make sure you meet with the actual operations staff not the sales force more than once to see if you can work with them, he advises.

CREDENTIALS: This is one self-explanatory. A company will clearly feel more comfortable with, say, an Ingersoll-Rand or the new logistics unit formed by Eastman Kodak than a dot-com named "Sources R Us." But, says Richard Cosgrove, an associate partner at Accenture, you do need to delve into even a brand name company's expertise. "Ask if the company has the expertise to manage your particular category of materials. Can they talk the same language? Have they been there at some point themselves?"

Erika Morphy is a freelance writer based in Maryland.

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