L4M4 Chapter 1: Options for sourcing requirements

 

There are two main ways for an organisation to procure its requirements:

1.     Make: buy the materials and produce things in-house

2.     Buy: contract the work out to an external provider

 

What is sourcing?

Sourcing is the stage of procurement that occurs before purchasing, i.e. it’s the first half of the CIPS procurement cycle.

·       It explores where products can be found in the market

What is outsourcing?

Outsourcing means procuring products from external providers. More specifically, it’s come to mean the contracting out of work that had previously been done in-house.

·       Contracting the work out overseas is called offshoring

o   Popular categories for outsourcing are logistics, ICT services, Facilities Management (FM) and even procurement activities

o   Sometimes employees are transferred from the organisation to a third party when a function is outsourced to a third party. In this case, the UK requires employees’ terms of employment to be preserved, under the TUPE regulations

·       Business process outsourcing is becoming popular: this is the procuring of business services that were done in-house

·       Non-core competencies should be outsourced if there are identified benefits to doing so. Core competencies should be kept in-house

The key factors to consider when deciding to outsource is the competency of suppliers and the importance of the activity.

Outsourcing differs from subcontracting.

·       Outsourcing is a long-term and strategic approach, whereas subcontracting is more short-term to fill work that the buyer can’t do itself

·       In other words, outsourcing is a strategic decision to contract out certain activities that used to be done internally

·       Subcontracting can be used by contractors in order to fill gaps in their skillset that other entities can provide, when fulfilling obligations under a contract

 

Make or buy decisions

What do we make in-house, versus procure from suppliers?

·       Strategic make or buy decisions: these decisions outline the long-term strategy of the organisation’s capabilities. What services will it offer? Which resources will it keep in-house, and where will it invest?

·       Tactical make or buy decisions: a decision made based on short-term trends, responding to the organisation’s current capacity and customer demand

·       Operational / component make or buy decisions: decisions at the component level about whether something is produced in-house or not

 

Make or buy decisions require collaboration across functions. Procurement will be involved with estimating the costs of externally sourced inputs (Make), and the evaluation of an externally sourced service to provide the product (Buy).

 

Intra-company trading

This refers to commercial trading between companies that are part of a larger group of companies i.e. they are owned by a common parent company.

·       Subsidiary companies under the parent company may be grouped together as Strategic Business Units (SBU)

Each subsidiary company will have its own budget, profit and loss reporting.

Some subsidiaries might only trade with other subsidiaries, whereas others trade with external companies too.

·       The principles of procurement apply as usual between subsidiary companies, as they are still different entities

 

Transfer prices

This is the price charged in intra-company transactions.

·       These prices can be reached through negotiations between the two parties, or through a head office decision

·       The transfer price reached affects the profitability of both parties, and their competitiveness in external markets

Transfer pricing needs to be regulated because it can cause manipulation of markets (undercutting other companies) and enable transnational tax avoidance by funnelling profits to entities in different countries.

·       Profits might be shifted to ‘tax havens’ through transfer pricing, so regulations have tried to stop this to some extent

 

There may be internal policies for intra-company trading, which instruct subsidiaries to buy from each other, regardless of price.

·       This creates a risk for procurement staff, as it might stop them from identifying the best goods to meet the demand

·       From a procurement perspective, it would be preferable to allow buyers to competitively evaluate internal quotations with external suppliers’ quotations, and go with the best supplier

·       What happens if there is a breach of contract? There are more limitations in the routes for buyers to claim compensation

 

Strategic and tactical sourcing

Strategic sourcing: planning for an organisation’s activities to be conducted by external suppliers under long-term relationships.

Tactical sourcing: short-term approach, mostly one-off decisions about sourcing a product from somewhere based on select criteria e.g. price. This could be under time pressure.

·       You might use tactical sourcing for low-risk procurements, and use strategic sourcing for large quantities or critical services for the business

 

Costs and benefits

Strategic costs: costs of internal production or outsourcing that are long-term are strategic costs.

Tactical costs: costs of switching between internal and outsourcing are one-off costs / tactical.

Costs and benefits can be financial and non-financial.

 

Long-term / strategic financial costs

Internal production costs	Outsourcing costs
Costs of ongoing production: materials, labour, utilities costs associated with production	The price of external supply of the goods/services being outsourced (beware of hidden costs though)
Costs of investment e.g. into machinery	Costs of contract and relationship management of the supplier

 

There might be an opportunity cost of internal production if the organisation has limited resources that it could have dedicated elsewhere.

There might be hidden costs of outsourcing, that are difficult to estimate or anticipate:

·       Extra procurement and other administrative staff required to manage the contract

·       Loss of experience and knowledge within the organisation

·       If the supplier fails to deliver, what costs are there on the business to cope with this?

Moving from internal production to outsourcing generally means a move away from fixed costs towards variable costs.

·       In-house production involves fixed costs such as staff, property and maintenance bills

·       Outsourcing is more of a variable cost because the organisation only pays for the service, not the fixed costs it would otherwise need to pay

·       This doesn’t mean that outsourcing is necessarily cheaper: this only shows that the type of cost is different

 

Short-term / tactical financial costs

If a company chooses to outsource a service that was done in-house, it might need to:

·       Make some employees redundant, which incurs a cost

·       Retrain employees to do other things, which has a cost involved

There might be short-term benefits, such as now-redundant assets that you can sell.

 

Non-financial costs

Make or buy decisions have effects that aren’t quantifiable, such as a loss of in-house control, skills and impacting morale of staff, if things are outsourced.