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).
Purchasing Western Europe
Purchasing Low-Cost-Countries
Total Costs
Risks (quality,
financial)
Terms of payment
Material handling
and stocktaking
Delivery costs
Price
Total Costs
Risks (quality,
financial)
Terms of payment
Material handling
and stocktaking
Delivery costs
Price
?
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 firsthand interviews with experienced practitioners within the machinery industry.
The course of action during the project
1.
2.
3.
4.
5.
6.
7.
8.
9.
Choosing the topic
Studying the literature within the chosen topic
Choosing a specific area of interest
Choosing the methodology for the project
Constructing a conceptual model from the literature review
Making qualitative interviews
Formulating the major findings
Making a comparative analysis with the conceptual model
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 valuechain (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).
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):
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.
2
3
Analyze
strategic
consequences
Analyze costs and
performance
capacity
?
?
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-costcountries 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):
Marketing Mix
Product
Promotion
Price
Place
Variety
Quality
Design
Features
Brand name
Packaging
Services
Warranties
Advertising
Promotions
Personal selling
Publicity
List price
Discounts
Allowances
Payment period
Credit terms
Channels
Coverage
Assortments
Locations
Ïnventory
Transport
Target market
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).
Price
Cost of Delivery
Utility Cost
Material Handling and Stock
Holding
Lead Times
Administrative Efficiency
Duplication of Work
Terms of Payment
Costs
Quality of Arriving Goods
Delivery Precision
Response Times
Reliability of Information
Risk Exposure (Financial, Political)
Risks
Total Costs
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).
BILD MED EXEMPEL?
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 totalcost-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
Order handling
Vendor rating
All-round
Service oriented
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:
2
Analyze
strategic
consequences
- Establish a presence
in a foreign market
- Risk of intellectual
property losses
- React to the action of
competitors
- Introduce competition
to domestic suppliers
- Innovation and
geographical distance
- Cultural distance
- Product quality
- Product brand
- Pricing strategy and
costs
- Place - marketing
and logistics
3
Analyze costs and
performance
capacity
Total cost of
ownership (TCO)
- Lead times
- Effects on current
supplier relations
- Increased demands
on the purchasing
department
- Financial risk
- Socio-Political risks
- Currency risks
- Dependence on
supplier
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
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Internet
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