Shift from service providers to business providers

Essay add: 27-11-2017, 20:50   /   Views: 191

The paper basically deals with motivations for going for outsourcing i.e. advantages as well as disadvantages & associated risks involved with outsourcing. Paper also discusses the framework to decide when to buy/ make for modular & integral products with a hierarchical model. All these discussions on outsourcing in turn affects logistics outsourcing because it forms part of the entire outsourcing strategy.


In the 90's outsourcing was the main focus of many industrial manufacturers ; firms considered outsourcing everything from procurement function to production and manufacturing. Executives were focused on stock value, and huge pressure was placed on organizations to increase profits is by reducing costs through outsourcing. Indeed, in the mid 90s there was a significant increase in purchasing volume as a purchase of the firm's total sales. More recently, between 1998 and 2000, outsourcing in electronics industry has increased from 15 percent of all components of all components to 40 percent [1].

Some motivations for outsourcing are [2,3] :-

Economics of scale- An important objective is to reduce manufacturing costs through the aggregation of orders from many different buyers. Indeed, the aggregation allows suppliers to take advantage of economies of scale, both in purchasing and manufacturing.

Risk pooling- Outsourcing allows buyers to transfer demand uncertainty to CEM. One advantage that CEMs have is that they aggregate demand from many buying companies and thus reduce uncertainty through risk pooling effect. The CEMs can thus reduce component inventory levels while maintaining or even increasing service level.

Reduce capital investment - Another important objective in outsourcing is to transfer not only demand uncertainty to CEM but also capital investment. Of course, the CEM can make this investment it is implicitly shared between many CEM's customers.

Focus on core competency- By carefully choosing what to outsource, the buyer is able to focus on core strength that is specific talent, skills, knowledge sets that differentiate the company from it's competitors and give it an advantage in the eye of customers.

Increased flexibility- Here we refer to three issues:- (i) the ability to better react to changes in customer demand, (ii) the ability to use the supplier's technical knowledge to accelerate product development cycle time, and (iii) the ability to gain access to new technologies and innovation. These are critical issues in industries where technologies change very frequently .

However there are also two substantial risks associated with outsourcing as follows:-

Loss of competitive advantage - Outsourcing critical components to suppliers may open up opportunities for competitors (as in IBM PC example). Similarly, outsourcing implies that companies loose their ability to introduce new designs based on their agenda rather than the supplier's agenda [3]. Finally outsourcing the manufacturing of various components to different suppliers may prevent the development of new insights , innovations, and solutions that typically require cross-functional teamwork [3].

Conflicting objectives - Suppliers and buyers typically have conflicting & different objectives. For instance increased flexibility is a key objective when buyers outsource the manufacturing of various components. This implies an ability to better match supply and demand by adjusting production rates as needed. Unfortunately, this objective is in direct conflict with suppliers' objective of long term firm , and stable commitment from buyer. [2]

Framework for Buy/make decisions

How can firm decide on which component to manufacture and which to outsource? Consultants and supply chain pundits typically suggest focus on core competencies, but how can firm identify what is core, and hence should be made internally, and what is outside the core, and hence should be purchased from outside suppliers?

Below we introduce a framework developed by Fine & Whitney [4]. To introduce the framework, they classify the reasons for outsourcing into major categories:

Dependency on capacity- In this case, the firm has the knowledge and skills required to produce the component but for various reasons decide to outsource.

Dependency on Knowledge- In this type of dependency, the company does not have the people , skills and knowledge required to produce the component and outsources in order to have access to these capabilities. Of course, the company has to have the knowledge and skills to evaluate customer needs and convert these into key requirements and characteristics that component should have.

To illustrate these two concepts, Fine & Whitney consider outsourcing decisions at Toyota. As a successful Japanese car manufacturer, the company designs and makes about 30 percent of it's car components. These details are quite revealing:

Toyota has both the knowledge and capacity to produce its engines and indeed 100 percent of the engines are produced internally.

For transmissions, the company has the knowledge and indeed designs all the components but depends on suppliers capacities, since 70 percent of components are outsourced.

Vehicle electronics systems are designed and produced by Toyota's suppliers. Thus, in this case, the firm has a dependency on both capacity and knowledge.

Fine & Whitney observe that "Toyota seems to vary its outsourcing practice depending on the strategic role of the components and subsystems." The more strategically important the component is, the smaller the dependency on knowledge or capacity. This suggests the need for a better understanding of product architecture when considering what to outsource.

For this purpose, and following Ulrich [5] and Swaminathan [6] , we distinguish between integral and modular products. A modular product can be made by combining different components. The definition of modular products implies [7]

Components are interchangeable

Components are independent of each other

Standard interfaces are used

A component can be designed or upgraded with little or no regard to other components

Customer preference determines the product configuration

An integral product on the other hand, is a product made up from components whose functionalities are tightly related. Thus,

Integral products are not made from off-the-shelf components

Integral products are designed as a system by taking a top-down design approach

Integral products are evaluated based on system performance, not based on component performance

Components in integral products perform multiple functions

However in real life very few products are either modular or integral. The degree of modularity varies from a airlines which is a highly integral product to laptop which is a highly modular product.

So, in order to overcome this issue we will next introduce the framework which will consider both integral as well as modular products. For modular product it is very important to capture knowledge. For them having production facility is not of much importance. E.g. if a PC manufacturer has the knowledge of design & then if they outsource it then it will lead to reduction in cost. However if the company doesnot have the knowledge as well as the capacity to produce it then outsourcing can be risky strategy as the knowledge developed by supplier will be transferred to competitor's products. However it is very important to acquire both knowledge & capacity for integral products. Although it might be quite difficult but if it so then company can go for in-house production. But if the organization doesn't have either knowledge or capacity then it's quite clear that the company is in the wrong business.

Table 1 - Framework for make/ buy decisions [7,4]

ProductDependency on knowledge and capacityIndependent for knowledge , dependent for capacityIndependent for knowledge and capacityModular

Outsourcing is risky

Outsourcing is an opportunity

Outsourcing to reduce cost through outsourcing


Outsourcing is very risky

Outsourcing is an option

Keep product internal

The above framework provides a general approach for make/buy decisions but doesn't help with component level outsouring strategies. How should a firm determine whether a specific component can be outsourced can be answered by Fine[4] , where they come up with a hierarchical model that includes five criteria :-

Customer importance- How important is component to customer? What is the impact of the component on customer experience? Does the component affect customer choice? In short what is the value customers attach to the components?

Component clockspeed- How fast does the component's technology change relative to other component in the system?

Competitive position- Does the firm have a competitive advantage producing this component?

Capable suppliers- How many capable suppliers exist?

Architecture- How modular or integral is this element to the overall architecture of the system?

Few examples can be :-

When component is not important to customer, the clockspeed is slow, and the firm doesnot have competitive advantage , outsourcing is appropriate independent of the last two criteria.

When the component is important to customer , the clock speed is fast and firm has a competitive advantage , clearly keeping the component manufacturing inhouse is appropriate independent of the number of suppliers and the component architecture.

If the customer value is high , clockspeed is fast, and the competitive position is weak, the firm should either invest to develop in-house capability , acquire a supplier , or develop strategic partnering depending on the number of supplier in the market.

Finally if customer value is high , clock speed is slow and competitive position is weak , the strategy depends on component architecture. When component architecture is modular , outsourcing is appropriate. On the other hand when component is an integral part of the system , joint development with suppliers or even development of in-house capability , is the right course of action.

As with any business function there are four ways for firm to ensure that a logistics related business function is completed[144]

Internal activities - If the activity is core then firm is in best position to do this activity by their own.

Acquisitions- However if the firm doesn't have expertise internally then they can acquire companies which have such expertise.

Arm's length transactions- Here a short term arrangement is made to fulfill a specific business need like logistics function, maintenance of automobile etc. However this won't lead to long term relationships.

Strategic alliances- These are goal oriented, multifaceted long term relationships between two companies in which risks & rewards both are shared. In many cases , the problems of outright acquisition can be avoided while at the same time mutual goals can lead to the commitment of many resources than in case of arm's length transactions. Strategic alliances typically lead to long term strategic benefits for both the partners.

Three most important types of supply chain related strategic alliances include third party logistics (3PL), retailer supplier partnerships (RSP) & distributor integration (DI). However in this paper we will mainly focus on 3PL

Third Party Logistics

3PL is simply the use of an outside company to perform all or part of the firm's material management and product distribution functions. 3PL relationships are typically more complex than traditional logistics supplier relationship as they are truly strategic alliances.

Although orgnisations have used outside firms to provide particular services such as trucking & warehousing, for many years these relationships had two typical characteristics: they were transaction based and companies hired were often single-function specific. Mordern 3PL arrangements involve long term commitments and often multiple functions or process management.

3PL providers come in all sizes and shapes, from small companies with few million dollars in revenues to huge companies with revenues in billions. Most of these companies can manage many stages of the supply chain. Some third party logistics providers own assets as trucks and warehouses; others may provide coordination services but not own assets on their own. Non-asset-owning third party logisitics firms are sometimes called fourth-party logistics providers (4PL).

Advantages of 3PL

Focus on core strength - Logistics outsourcers provide a company with an opportunity to focus on that company's particular area of expertise, leaving the logistics expertise to logistics companies. But if logistics is one of the area of expertise of the host company then it doesn't make sense to outsource it.

Provide technological Flexibility- The ever-increasing need for technological flexibility is another important advantage of the use of 3PLproviders. As requirements change and technology such as RFID becomes more prevalent, the better 3PL providers constantly update their IT and equipment. Often individual companies do not have the time, resources, or expertise to constantly update their technology. Different retailers may have different, and changing, delivery and IT requirements, and meeting these requirements may be essential to a company's survival. Third party logistics providers often can meet requirements in a quicker, more cost-effective way [104]. Also, third party providers already may have capability to meet the needs of a firm's potential customers, allowing the firm's potential customers, allowing the firm access to certain retailers that might not otherwise be possible or cost effective.

Provide other flexibilities- By utilizing 3PL providers for this warehousing, a company can meet customer requirements without committing capital and limiting flexibility by constructing a new facility or committing to a long term lease. Also, flexibility in service offerings may be achieved through the use of third parties, which may be equipped to offer retail customers a much larger variety of services than the hiring firm. In some cases, the volume of customers demanding these services may be low to the fir, but higher to 3PL provider , who may be working for several different firms across different industries[237]. In addition, flexibility in resource and workforce size can be achieved through outsourcing. Managers can change what would be fixed costs into variable costs, in order to react more quickly to changing business conditions.

Important disadvantages of third-party logistics

Loss of control is quite inherent in outsourcing of a particular function. This is especially true for outbound logistics where 3PL company employees themselves might interact with a firm's customers. Many 3PL firms work very hard to address these concerns. Efforts including painting company logos on the sides of trucks, dressing 3PL employees in uniforms of the hiring company, and providing extensive reporting on each customer interaction.

Also, if logistics is one of the core competencies of a firm, it makes no sense to outsource these activities to a supplier who may not be as capable as the firm's in-house expertise.

3PL issues and requirements

A third party logistics contract is typically a major and complex business decision. Other than the pros and cons listed above, there are many considerations that are critical in deciding whether an agreement should be entered into with a particular 3PL provider.

Know your own costs- Among the most basic issues to consider in selecting a 3PL provider is to know your own costs so they can be compared with the cost of using an outsourcing firm. Often it is necessary to use activity based costing techniques, which involve tracing overhead and direct costs back to specific products & services [104]

Customer orientation of the 3PL- The most important is customer orientation of the provider; that is, the value of a 3PL relationship is directly related to the ability of the provider to understood the needs of the hiring and to adapt its service to the special requirements of that firm. The second most important factor was reliability. The flexibility of the provider , or its ability to react to the changing needs of the hiring firm and the needs of that firm's customers, was third. Significantly further down the list were cost savings.

Specializations of the 3PL- Companies should consider firms whose roots lie in the particular area of logistics relevant to the logistics requirements in question.

Asset-owning versus non-asset -owning 3PL- There are also advantages and disadvantages to utilizing an asset-owning versus a non-asset owning 3PL company. Asset owning companies have significant size, access to human resource a larger customer base, economies of scope and scale, and systems in place, but they tend to favor their own divisions in awarding work, to be bureaucratic, and to have a long decision making cycle. Non-asset owning companies may be more flexible and able to tailor services and have the freedom to mix and match providers. They also may have low overhead costs and specialized industry expertise at the same time, but limited resources and lower bargaining power [10]

3PL implementation issues to be taken care to make them service provider

The company purchasing the services must identify exactly what it needs for relationship to be successful and be able to provide specific performance measures and requirements to 3PL firm. The logistics provider, in turn, must consider and discuss these requirements honestly and completely, including their realism and relevance [28]. Both parties must be committed to devoting the time and effort needed to making a success of relationship. It is critical that both parties remember that this is a mutually beneficial third-party alliance, with shared risk and reward. The parties are partner- neither party can take a "transaction pricing" mentality[9].

In general, effective communication is essential for any outsourcing project to succeed. First, within the hiring company, managers must communicate to each other and to their employees exactly why they are outsourcing and what they expect from the outsourcing process, so that all relevant departments are on the "same page" and can become appropriately involved. Obviously, communication between the firm & 3PL provider is also critical. It is easy to speak in generalities, but specific communication is essential if both companies are to benefit from outsourcing arrangement[28].

On a technological level, it is usually necessary to enable communications between the 3PL supplier's systems and those of the hiring customer. Along the same line, a firm should avoid 3PL supplier's systems and those of the hiring customer. Along the same line, a firm should avoid 3PL providers who utilize proprietary information systems, these are much more difficult to integrate with other systems.

Other important issues to discuss with potential 3PL providers include the following:-

The third party and its service providers must respect the confidentiality of the data that you provide them.

Specific performance measures must be agreed upon.

Specific criteria regarding subcontractors should also be discussed

Arbitration issues should be considered before entering into a contract

Escape clauses should be negotiated into the contract

Methods of ensuring that performance goals are being met should also be discussed [9]

Is insurance sufficient way to manage 3PL risks?

Regardless of the cause like trade embargos, governmental seizures of products or property, product recalls, natural disaster, and terrorism etc when supply chain glitches occur then it's always 3PL provider who is held liable. The logistics provider must also protect from information technology liability. As 3PL develop deeper client relationship & offer more complex services, they have greater access to proprietary & highly sensitive data (such as customer credit card details and Social Security Numbers). Security breaches are all too common, and exposures can be too catastrophic.

3PL must recognize these and other new and emerging exposures, as well as global exposures related to transportation, shipping, warehousing & cargo. Effective risk management requires regular & ongoing risk assessment at entry level. It's not unusual for 3PLs to assume tremendous professional liability risks yet it is remarkable to know that a majority of them fail to carry errors & omissions coverage. The business relationships that 3PL develop, partnerships they establish and businesses they acquire open them to potentially cost exposures that may not be immediately relevant. E.g. a trucker company acquires warehouse in some other company may not recognize the risks when they acquire a warehousing operation in another continent then that overseas exposure may cause legal action.

Across the 3PL industry, risk managers are challenged to structure coordinated and comprehensive insurance programs that accurately reflect and protect against the risk of their organization. Maintaining a patchwork of insurance covers is the least effective way of dealing with these type of risks. So the suggestion is not to risk the assets of the company by waiting so long to find out since insurers also will not be able to consider such a complex risk.

Labor Performance Management to strengthen 3PL relationships

Too often 3PL logistics partners & lack business relationship that extend beyond the standard three- to five-year contract length. Reasons cited for these unsuccessful relationships range from service level agreements not being met, to costing and pricing issues, to cultural differences. While there is no one size fits all solution to address these relationship challenges, there is one tool that is often overlooked as a way to potentially strengthen a 3PL's relationship with its customer: a distribution center (DC) labor performance management program.

DC labor performance management programs have long been recognized by supply chain organizations as tools to increase productivity and throughput capacity, reduce operating expenses and improve accuracy & safety in DCs. Built around several core components, successful programs typically include engineered labor standards (ELS), a robust labor management system (LMS) with the ability to track and report cost and performance & well defined program policies and procedures. Strong corporate sponsorship of the program and the adoption of a continuous improvement culture throughout the organization are equally important, as these elements are the glue that holds the program together and helps drive its short- and long-term success.

If implemented in a 3PL DC environment, this type of program can provide the 3PL and its customer with many benefits. Of course the level of benefits realized depends largely on organization commitment to the program, as well as the type of price contract employed. The DC labour performance management program offers each organization the tools to succeed. It is up to the business partners to determine the level of benefit each will realize. Under a fixed cost or cost-plus arrangement, the implementation of a DC labor performance management program benefits both parties. It allows the 3PL's customer to defer capital and operating expenses it might have incurred if 3PL productivity and throughput gains had not been realized as part of the program. The 3PL can benefit by maintaining its pricing structure while increasing profit margins through decreased costs.

Under an open-book arrangement, both parties enjoy many of the same benefits realized under the fixed cost or cost-plus arrangement. Additional benefit is gained through collaboration and understanding of the true work content and costing. The most critical elements required to build this understanding and collaboration under the open-book arrangement are accurate engineered labor standards (ELS) and a high-quality LMS.

ELS's enable the 3PL to develop accurate, activity-based pricing that is representative of the work content actually performed by the 3PL, In turn, this allows the 3PL to maintain adequate margin levels and fair pricing for the customer.

Using an LMS provides visibility of DC performance, accuracy and cost associated with specific DC operations. The LMS is a powerful tool that helps build understanding between the 3PL and customer. It provides unbiased, fact-based reporting that details the successes of and opportunities for the 3PL's DC. Working with these reports, the 3PL and its customer can collaborate to develop tactics and strategies to capitalize on success and overcome challenges faced at the DC.

The success of a DC Labour Performance Management Program hinges on corporate sponsorship for the program from both the 3PL and its customer.

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