Distinctions and Benefits of Strategic Sourcing


Originally published - August 8, 2007

Global sourcing, despite its inherent risks, offers numerous benefits to enterprises in terms of lower costs for materials and labor. It also requires a much closer integration among the supply chain partners. Supplier relationship management (SRM), a methodology designed to structure and support the relationships between buyers and suppliers, becomes essential when a supply chain recognizes the benefits of strategic sourcing. For more background, please see The Blessing and Curse of Global Sourcing and Supplier Management.

Bundled with the notion of SRM, strategic sourcing (as opposed to traditional sourcing) involves finding and building ongoing relationships with trading partners that will account for the majority of an enterprise's purchasing funds (spend). These close relationships will also provide materials or services that are key constituents in the final product or service, or that can help the buyer meet its profitability and customer satisfaction goals.

Strategic sourcing differs in its focus and execution from traditional purchasing and offers several obvious benefits. For one, traditional purchasing focuses on purchase price, whereas strategic sourcing focuses on the true cost to the customer. One should note the distinction between price and cost, since choosing a component based on the lowest nominal price may not necessarily translate into low cost if, for instance, the low-priced components are not reliable and fail early.

Further, the initial savings in producing the finished goods will be negatively impacted by the costs of reverse logistics (the process of shipping the failed goods back and repairing or disposing of them) and the loss of potential business from a prospective lifetime customer. At the same time, strategic sourcing can reduce costs by consolidating purchases with a limited number of suppliers and by allowing the centralized purchasing departments negotiating leverage via a purchase of increased volumes (economies of scale). By the same token, strategic sourcing can also help reduce the frequency (ordering costs) of purchasing orders (which are often maverick, or "on the spot" in nature), and thus reduce inventory handling costs.

Traditional purchasing is sporadic and transactional (not ongoing), and treats each purchase as a discrete transaction. Communication typically entails haggling over prices, complaining about late shipments, or disputing the quality of products. To be fair, there may be some exchange of information via electronic communication between parties, if only of a tactical nature (billing or change orders, for example).

Also referred to as "buy on the market," a traditional approach to purchasing is opportunistic in that organizations buy in response to immediate needs, choosing freely from among all the suppliers that can supposedly meet those needs. There is some sharing of technical purchasing requirements (such as specifications, proposal components, certification processes, etc.) between parties, but not strategies or plans. The relationship is transactional, and it is certainly not exclusive; the buyer may be buying from competing suppliers either simultaneously or sequentially.

In contrast to traditional sourcing, strategic sourcing involves ongoing relationships, so an opportunity exists for mutually beneficial collaboration between the buyer and the suppliers. This can result in improved profitability for each partner throughout the entire supply chain, and added value to the final product or service. Under the SRM and strategic sourcing concepts and methodologies, a company shares information with its suppliers in real time (or close to it) with the aim of cutting the cost of materials, minimizing inventory, reducing shortages, and expediting deliveries. More importantly, the suppliers can participate in improving the system, which should result in better products, higher customer satisfaction, and greater customer retention.

Furthermore, while traditional purchasing hardly ever crosses the boundaries that demarcate the two business entities, strategic sourcing allows opportunities for realigned (meaning improved and redesigned) and collaborative business processes, information flows, and workflows to eliminate redundancies and non-value-added work. Collaborative design and execution of plans for forecasting and replenishment allow supply chain partners to coordinate work and purchasing plans with customer demands. This helps in avoiding unpredictability in stock levels (the so-called bullwhip effect) upstream. The bullwhip effect, as defined by the APICS Dictionary (11th edition), is as an extreme change in the supply position upstream, generated by a small change in demand downstream in the supply chain. When this happens, inventory can quickly move from being backordered to being excess. This is caused by the serial nature of communicating orders up the chain with the inherent transportation delays of moving product down the chain.

This coordination of work and purchasing plans by supply chain partners also results in improved service to distributors, retailers, and customers; lower cost; and optimized use of capacity on the downstream side of the supply chain.

Strategic Sourcing

According to the APICS Dictionary (11th edition), a strategic alliance is "a relationship between two or more organizations that share information, participate in joint investment, and develop linked and common processes to increase the performance of all the organizations." Many companies form strategic alliances to increase the performance of their common supply chains, and these alliances can entail interaction among many counterpart functional departments, such as engineering, marketing, production planning, inventory, or quality management. Goals for these relationships may include cost reduction, quality improvement, better delivery performance, increased flexibility, or faster introduction of new product. Alliances need to be flexible, and each partner must bring value to the relationship relative to the scope of collaboration.

Even from a simple, knee-jerk (reactive) standpoint, companies with certain types of supply situations may be able to manage risk better in close alliance with their strategically valuable suppliers. The most obvious alliance to form is with a supplier offering an expertise that undoubtedly lies outside the company's core competencies. Also, if only a sole supplier (or a few at best) is available in the market to provide the valuable component or service, the enterprise may need to maintain a close relationship with that supplier to ensure availability and opportunities for developing customized components that could provide competitive differentiation.

Complexity (whether referring to the relationship between the bought component and the final product, or to the supply chain itself) and uncertainty are also factors that should compel a company to develop a close relationship with a crucial supplier. The more complex the relationship is between the component and the final product, the more value there will be in collaborative design. On the other hand, more value-added points in the supply channel vouches for greater opportunities for more efficient management of supply and demand. The uncertainty is in terms of changes in raw material or component cost, quality, or availability that can obstruct a business from meeting its goals.

Web-based Systems Expand Strategic Global Sourcing

What also contributes to today's popularity of strategic global sourcing might be the fact that, for years, many larger companies have had the wherewithal to operate complex and pricey import and export software systems. Conversely, today's technology has leveled the playing field for international trade, given that inexpensive Web-based systems, designed for simplicity and easier deployment, can now enable much smaller companies to engage in global sourcing with a wide range of suppliers.

The unstoppable march of the Internet and growth of online shopping mean that we are all operating in a new, electronic, real-time world (that is, the global village), with inherent visibility into important events. These new systems make it possible for a small retail company to engage, even if just once, with a supplier and still record a profitable and efficient transaction. This has brought about what some experts call "the great leap" in global sourcing—it is no longer the privilege of only a few giant companies; it is becoming a viable strategy for almost any company.

More and more organizations are using affordable and intuitive Web-based applications for a variety of supply chain activities, including procurement, order processing and financial flow coordination, and new product design. Businesses are also using such applications to manage transactions and inventory. The advent of Web-based technologies has given cross-channel teams the ability to interweave common and specialized knowledge, making collaboration easier and more seamless, and optimizing productivity.

Furthermore, data warehousing and analytical applications allow the information gleaned by one application within one company to be used productively by other applications or partnering organizations. These tools can go beyond information sharing to enable information analysis and decision making, and they can increasingly do so across platforms. This means that one department's or organization's choice of hardware, database, and operating system (OS) is no longer an impediment when these tools' outputs can be used by another department, which might run on a disparate system. This cross-functional sharing of knowledge and analysis makes true collaboration much more possible.

Coming back to the benefits of strategic sourcing, while traditional purchasing may benefit from information technology (IT) in terms of effectiveness, it cannot really leverage IT to the same degree that strategic sourcing does. Neither can traditional purchasing increase the visibility of the entire supply chain the way strategic sourcing can via true collaboration.

Historically, the purchasing department's ability to work with suppliers, communicate requirements, and negotiate pricing, quality, and delivery of goods and services has been driven by crude technology tools such as the telephone, the fax machine and, more recently, e-mails and enterprise applications (to a limited degree). But the use of the Internet and compatible software systems, backed by the commitment and trust among strategic partners, allows buyers and suppliers to share information and synchronize demand and supply from virtually any point in the supply chain network, and at any time. Again, potential benefits of this include shorter cycle times, increased inventory turns, and the enabling of purchasing personnel to eliminate low-value, mundane activities so that they can focus on more strategic issues.

Collaboration reveals more information about all the critical points in the supply chain given that when information from suppliers, manufacturers, distributors, retailers, and customers is available for analysis, visibility of the supply chain and opportunities for improvement is enhanced. Demand information, inventory status, capacity status, capacity plans, production schedules, promotion plans, shipment forecasts, and demand forecasts can all be shared and, ideally, accessed by all parties on a real-time, online basis. Expanded information sharing can lessen the upstream bullwhip effect and provide early problem detection, faster response, better contingency planning, and stronger relationships, all because of increased trust. In short, the need for supply chain integration is here, and the means now exist to address that need much more efficiently and cost-effectively.

In fact, collaborative supply chain networks may benefit their participants in many ways. For one, by identifying common goals shared by all participants in the supply chain, and by increasing their ability to efficiently reach those common goals, a company's own (and often conflicting) goals can also be pinpointed and resolved. It is needless to say that information sharing initiatives can increase profitability throughout the supply chain through cost reduction, demand augmentation, and better ability to respond quickly and accurately to market changes.

This is part two of the series The Blessing and Curse of Global Sourcing and Supplier Management. Part three takes a look at the retail sector to see how global sourcing and supplier relationship strategies can contribute to the success of retailers.

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