Boundaries of the Firm

In section 2 we discussed the strategic choices involved in the Make/Do or Buy/ Trade decision and the answers to this will largely determine to where the boundaries of the firm or business extend. Activities performed by third parties in the supply market are definitely supply chain ones with the opportunities and threats that that implies. Choosing the trade rather than do option suggests more flexibility to respond to market changes but the company has to choose its partners carefully since much of the success of the value delivery to ultimate customers is now going to be dependent on these third parties. Ideally we do not want them to think like third parties but to consider themselves as part of our extended capability family. However each of the interacting parties needs to want to think like this for it to happen and there has to be a strong business justification for so doing.

Whether an activity is performed by employees or contractors should not make a fundamental difference to the customer experience but there is always the threat that the contractor is maximizing their own situation and possible future opportunities rather than delivering what their client wishes for the client’s own customer. This is the principle and agent problem discussed already and if the agent behaves in ways detrimental to the principal’s best interests then there is a problem to be solved but such behavior may not be apparent or recognized in time to avoid the customer’s experiences being damaged. Trust on both sides of the principal and agent divide needs to be demonstrated in actions and be visible and tangible in coordinated plans.

When the actual performance in the presence or awareness of the customer is key to future business opportunities, it may be safer not to entrust such activities to an outsourced supplier and rather to retain that activity in the same way one would choose to retain intellectual property knowledge in house rather than outsource its use or manufacture to those less directly motivated or indeed motivated to steal the business away.

This is the similar concern to that mentioned in the design section earlier. There we were worried about information leaking back out to suppliers producing to our design specifications whereas here we are worried about information gathered from the customers which we need but which may not be fully communicated to us if at all.

Choosing the buy option increases the importance of both the purchasing or procurement activity and the subsequent contract management one.

The Contract Life cycle

All contracts go through the same kinds of stages, which we can label as follows.

  1. Specification of the requirement and proposed solution

  2. Make/Do or Buy/Trade choices and extent

  3. Source the supplier and evaluate/negotiate the bid and Award the contract

  4. Implement the contract and make it operational

  5. Operate and manage the contract

  6. Consider the choices at the end of the current contract

  7. Document and discuss the lessons learn from the current contract to inform the thinking for, and behaviours in, subsequent contracts.

We will discuss each of these in turn.

Specification

In order to buy from the market we need to be very clear what we as customers want as minimum as well as ideal requirements. Sometimes of course we need guidance from the suppliers (who know what is or could be possible), to inform our requirements but however reached, the definition of the requirement then needs to be translated into detailed specifications. These will then inform the search process in the supply market for existing products or the discussions and sourcing process to have this specified product produced in some way from the selected supplier.

The process of defining and subsequently designing the product/service and delivery system is a key stage in any business process for it is here that decisions will be made that will affect the function, appearance, quality and usability over time as well as raw material and other resource usage and subsequent re-cycling. Thinking this through and making cost effective and customer satisfying decisions are critical to any success.

If the thinking and the detail are not good enough at this stage then every subsequent stage will always struggle to recover the ground lost here, if indeed it is possible at all to do so.

Make/Do or Buy/Trade

We have discussed already the importance of the Make/Do or Buy/Trade decisions as these determine what is done in house through ownership and management of dedicated resources and what external resources need to be purchased or otherwise accessed through market driven contracts. Truly these decisions are defining the boundaries of the firm or business.

Care needs to be taken in these since the costs and time to change them later can be significant and if the wrong choices of supplier partners for example are made it may not be possible to start over again with the same freedom of choice since your competitors may now be working closely with your new preferred supplier. The extent of total outsourcing and the percentage of your spend in any category with one or two suppliers become indicators of the closeness or otherwise of the needed relationships with these key suppliers.

The degree of dependence on key customers and suppliers is very variable across industries but these are the important few on whom your future success will be dependent so it needs to be a small enough number so that they can be properly managed and integrated into the thinking and planning process. For many companies this number will be in the range 6-15 but remember that Toyota (who taught us much of this thinking) has 2-300 first tier suppliers who are key in the terms that we have been describing. They of course are a brand company at the top of an extended network and compete with other similar large scale enterprises. For the business more in the middle of the network they cannot exercise the same power and influence and so need to focus their efforts more.

Source and Award

A business wishing to buy from a market place is faced with a variety of problems from finding a company with the right capability and skills to deliver their requirement, checking on this capability and the financial risk of contracting with them and then judging if they will be able to deliver as they have promised in the discussions or contract acceptance process. For companies in the private sector they can more or less do this in any way that they see fit however the public sector take its accountability to the population at large and their political masters more centrally in their considerations and so must look for and contract with suppliers in more prescribed ways. (We will be discussing some of this later in this section.)

Finding potential suppliers can range from talking to incumbent suppliers of other goods and services which are currently subject to existing contracts to advertising in a variety of ways for possible new suppliers. Dealing with known suppliers might provide some comfort through familiarity but does not allow new suppliers to challenge and offer their new processes and commitment. There is therefore a tension between looking for new opportunities and capabilities not offered before and depending on existing connections and understanding built up perhaps over many years of working together.

Careful evaluation of the best strategic choices of possible sources for the particular client requirement is needed and as will be discussed later it is likely that a company working with a variety of suppliers will have a variety of relationships with different companies or parts of the same company.

To find completely new suppliers electronic buying platforms can be a great help. The difficulty then revolves around how one can evaluate such a new opportunity with no direct experience and with a supplier who operates in a completely different market place and part of the world. With the new opportunity comes the risk of unfamiliarity and potential dishonest representation of their experience, capability and commitment.

Often companies will not risk high value purchases to such unknown organizations but might incrementally contract for safer and lower value goods or services so as to build up some understanding and data on performance and wider capability. Over time this can lead to bigger orders being placed as capability is demonstrated.

If we accept that much new innovative thinking comes from the supply market then there is a need to access this wherever it occurs but not at the risk of the whole business. There is a need to balance the new potential with the existing risk. Decisions like this are not simple one dimensional issues and should not be made by any one group of people in purchasing or technical for example without thinking through the choices with all the relevant stakeholders and agreeing the sensible balance in the current situation and for the future development of the supply marketplace.

However the invitation to suppliers to tender for a contract is presented there will come a time when the alternatives need to be evaluated. It can be difficult to be sure that all of the bids are covering the same things and have produced detailed costs of all of the features for which the supplier will invoice. This is why in the European Union Procurement Directives there are major constraints on processes and communications so that all bids can be fairly evaluated and a decision made on objective and transparent decision criteria, which were clearly communicated to all bidders at the start of the whole process.

The stakeholder group which was involved in the process of defining the requirement and specifications at the beginning of the contract life cycle now need to take part in some way in the evaluation process so that they can be comfortable that the best choice representing their interests has been made so that a purchasing decision can be made and communicated to the winning bidder.

It is also good practice, and in some cases required by law, to communicate the contract award decision to the failed bidders. In the public sector they are allowed to challenge the process of reaching the award decision and if the process is found by an arbitrator to be flawed, the contract award can be put aside and the sourcing, tendering and awarding process re-run. Failed bidders, even if they accept the final decision, can still learn how they were evaluated and can learn how to do better in a subsequent contracting process. In this way the whole supply market has the chance to learn but of course the ones who failed do not receive any financial return on the costs of their bid, which can be substantial.

If no challenge to the award is received within the limited time period allowed for the challenge then the award is confirmed and the contract can be made operational.

In the public sector it is not acceptable for the purchaser to go back to the successful supplier at this stage and see if further concessions (on their prices perhaps) can be negotiated but for private companies the law does not constrain this behavior. However, this action is not in the spirit of fair dealings and while it is often possible for companies to ‘get away with’ such sharp practice in the short run they run the risk of getting a reputation as an organization that cannot be fully trusted and this will be factored into the supplier’s future bid processes as a safety factor in their pricing structures perhaps. They would therefore build extra money into their offer prices expecting to have to give some of it away in the subsequent negotiation.

In certain situations the buyer is not fully aware of what is possible or even what they actually want in detail so there are times when rather than using a formal bid against clearly specified criteria process a more interactive process is needed. Here there can be more of a debate about what is required and what should be paid. If the buyer is doing this with a number of suppliers then there is a tension for the supplier about how much of their most creative ideas they want to expose to the buyer for the buyer might then take the idea to another supplier and ask for a better price to deliver a similar offer.

There is much in the sourcing process that has the potential to build long term intercompany relationships for mutual advantage or alternatively create conditions in which conflict and sometimes breach of contract legal court cases can result.

Sourcing is therefore an area where high strategic decisions are made but also where very small details can have huge impacts if they are wrong or badly understood.

Implement the contract

Now that the contract has been approved it is time for both the customer side and the supplier side to put it into action. This means that all of the details of required performance, communication processes as well as the important invoicing and payment systems are set up and all necessary personnel are informed and, if necessary, trained in the new processes. There is also a requirement to securely store all the agreement documents and contract details in a place where they can be accessed for management control purposes. All of the agreed management processes must also be instigated at this time with agreed agendas and meeting schedules established. For certain contracts, security approvals of systems and key individuals will also need to be put into operation.

It is likely that the teams of people involved in sourcing the contract will not all be involved in managing the contract. We also have the users on whose behalf all of this was initiated. They need to be put in contact with their new suppliers and personal introductions and social contacts established to allow for rapid response when necessary to solve operational problems or challenges.

Some businesses choose to separate the procurement function from the contract management one. This requires careful handover of all relevant information at the beginning of the contract implementation process but, as we shall see later, after the contract is concluded there may need to be a reverse transfer to allow the sourcing team to take action for the next contract. It is important that someone in the organization takes responsibility to gather and evaluate the performance of the supplier on the current project so that lessons can be learned for use in the future.

Operate

Once the initial set up processes have been completed then we can move into the day-to-day operation of the contract. There will have been the setting of agreed performance indicators and the methods of their collection. Details about contact and delivery points and any escalation procedures in the event of a dispute, all need to be agreed and documented and then regular communication and meeting processes are required. Meetings should be for planning and problem solving but sometimes it is good to meet just to build a wider understanding and to begin to explore if there are more things that the parties could collaborate on for mutual benefit.

Performance, problems occurring and solved and issues raised from both sides about practice, which is not in the spirit of the agreement, need to be documented and appropriate responses implemented and recorded. This performance history is important as an audit trail for problem solving or, if the worst fears are realized and there is a contract dispute, we might need this data to argue in court about a breach of contract. This data should also be useful to inform lessons learnt investigations later on in the lifecycle.

End of contract options

A number of options can emerge at the end of a contract, or in reality towards the end of a contract since some forward planning will be required.

The requirement from clients or users might be fully satisfied so that the end of the contract finishes the need for the interaction with the supplier. However there might still be contract process lessons to be learnt. What went well and could be used in other contracts, what created difficulty and how were these resolved or not and what new understandings and processes should be considered as appropriate for other circumstances? How did the people cope and how should that be incorporated into promotions and career development training and development?

If the customer requirement is ongoing then there are two basic options. These are called the straight re-buy or the modified re-buy. The first is to re-run the sourcing exercise if it is a requirement (for example under public sector procurement rules) or if desired to ‘test the market’ and see if there are new suppliers or ideas to deliver a better product or service. The alternative might be to redefine (modify) the requirement and run a whole new sourcing exercise for the next contracting process. In both cases the experiences gained from the first contract should inform the next sourcing exercise.

Review and learn

It is here that the separation of sourcing and contract management teams can create some issues since the experiences of operating the contract should have been properly analyzed and recorded so that the incumbent supplier’s performance can be considered for a new contract award if such is permitted (it is of restricted use under EU procurement rules) or any performance lessons which might be generic are built into new specifications and management processes.

Private and Public Sector differences

We have already mentioned a few times the differences between the private sector and the public sector in the rules and procedure for the procurement processes so let us take some time to explore this in more detail.

The essential difference between the private sector and the public sector relates to whom the managers report. The private sector will have owners or shareholders and other kinds of investors who will be interested in the economic and other performance measurements. The public sector act for wider society members to whom they are ultimately responsible but operationally they report to line managers who are part of a political organization structure, which can be subject to major changes when political change occurs. Within the public sector we also have the possibility that a political leader of some sort might use procurement processes for their narrow political ends and allocate taxpayers’ money to reward their friends or relatives or simply to keep their electorate in favour of them staying in power. This form of corruption is seen all over the world and it is a major challenge to reduce its extent or limit its impact.

Within the European Union this was recognized as was the version in which local politically motivated purchasers would only award government or other public sector contracts to businesses which were local to the spending authority. The European Union sees this as not in the spirit of a ‘free market’ zone or shared economic community and so they have put in place procurement rules which aim to make it normal to award contracts to the ‘best’ bid regardless of any influence from location or other factor based on prejudice rather than rational economic arguments.

To make this happen it is mandatory to open up the contract possibilities to all possible bidders; to make sure that the decision criteria for the award are clear and clearly communicated to all and that the final selection is based on objective criteria (again communicated to all bidders in advance) with the whole process capable of being audited and if necessary challenged for an incorrect process in a court. If such a challenge is made, the challenge must be evaluated and in the meantime the contract cannot begin. At the heart of this is the belief that the best results come from competitive tendering processes and that the market should be tested on a frequent basis so that there is always the possibility of a new supplier being selected and the benefits of the taxpayer’s spend is spread around more in the community. For this reason contracts are time limited and even if everything has worked well with an existing arrangement between the purchaser and the supplier there still has to be a new competition and the supplier’s good performance in the old contract is not allowed to influence the decision for the new one. Bad performance on an old contract can be used to disqualify a supplier bidding for a new contract.

In the private sector there is no such requirement to re-tender so in theory a supplier can continue to supply a customer as long as they both wish the contract to be in operation.

As ever, there are good and bad points about both forms of market interaction.

In the private sector, good performance can be rewarded by renewed contracts thus avoiding the need to re-tender and begin a new procurement process. This avoids the search costs for the customer to find other bidders and the costs to evaluate the alternative bids. The suppliers who might have bid but would have been unsuccessful avoid incurring these costs but of course they had no chance to win the business and therefore no opportunity to make a profit on the business and must find another customer to supply.

Staying with one supplier might limit the chances of benefitting from new thinking or technology.

In the public sector the limitation on the duration of the contracts (four years is a typical upper limit for framework agreements) means that the supplier cannot invest in a long term improvement process since they might not be there after the next tender competition. Also as the end of the contract approaches there is an understandable tendency to begin to look for the replacement business and the concentration on the current contract begins to weaken.

The need to provide a minimum number of bidders and the time limited contracts suggests to some public sector buyers that cooperative relationships between customer and supplier do not have any possibility of being used but this is not true. Certain of the procedures allow for a more collaborative approach at the beginning where for example there is a more interactive approach to the specification of the desired product or service. However the requirement to run regular competitions does work against any long term commitment or mutual understanding being a realistic goal.

Some see the EU rules as very bureaucratic however it is possible to argue that the need for transparency in decision making, in full and fair communication about requirement and assessment and the capability to provide an objective set of decision criteria and processes capable of being audited and used to argue a case in court, as all being very worthwhile and best practice.

Procurement position

It was argued in the discussion of the contract lifecycle that the procurement activity needs to be seen as part of a business wide approach and that it cannot be seen as the only or even main player in the sourcing exercise. However there are also decisions needed about where in the organizational structure the activity should best reside.

The essential dichotomy is whether procurement should be centralized or de-centralized. This argument applies to other functions as well. Procurement centralization allows for consistency of treatment, training and specialization of staff and visible data collection. It may also be possible to aggregate demand from a variety of parts of the customer’s business and use the demand volume argument to leverage a better unit price from a supplier. The counter argument, especially for large and diverse businesses, is that centralization can create inertia and lack of a speedy response to requests from the dispersed parts of the business. If these sub-divisions are really operating in different customer and supplier markets then this argument suggests that flexibility and rapid response allows customization for local need to be accommodated more effectively. However in this situation, control from the centre can be more difficult and the data gathering and analysis more complicated. We might also be duplicating some staff roles or not be able to provide enough experience for the staff in the sub divisions in all aspects of the main business.

There can of course be hybrid forms where much local procurement is performed locally but the centre sets policy and standards, acts as trainer and developer and negotiates and procures the large expense items for example on power or corporate travel and accommodation.

Goods or services

There are two basic end points for items which are procured whether these are for goods or services. The key factor is whether the items being purchased are intended to support or be incorporated directly into the goods or services which are then supplied to downstream customers. This represents ‘direct’ procurement.

If on the other hand what is being procured is for more general things which are needed to make the business function but are not so directly transferred in some way to the customer, then these are called indirect items. These cover items from office cleaning to financial auditing. Some of these items consume large budgets and much can be done relatively quickly to make savings in these items of expenditure. Interestingly however the attention paid to these spend categories in many businesses is a lot less than for the direct items. The direct items seem to be regarded as contributing to competitive differentiation and order winning while getting the indirect procurement correct might be regarded more as a qualifier.

Usually more attention is paid to, and better people allocated to manage the direct spend than the indirect. This segment of the business will also tend to have much closer control than the indirect spend and in many businesses the control processes over the indirect spend will be very lax compared to the direct area. Like any other qualifier, getting it correct is a minimum requirement but some of these areas are also order losing sensitive or perhaps better to say business mission critical. For example a financial audit that misses a major accounting error or misappropriation of funds can put the future of the business at risk.

Given these considerations it is hard to see why some of these decisions are taken by the internal function heads without the expertise of a trained and professional procurement group, but such is too often the practice. It is like the marketing department deciding on an advertising agency contract award without involving the procurement and contract experts based on the argument that ‘they’ would not understand or be able to evaluate the creative arguments in favour of one advertising agency over another. The counter to this is of course one we have already used which is to make the process of procurement a team one where different expertise can be brought to bear in a coherent and controlled way with mutual respect and responsibility allocated, understood and accepted by all involved.

Customer satisfaction might depend mainly on the performance of the supplier on the direct procurement activities but the discussion above suggests that from a customer viewpoint there may be less difference between the two areas than has been assumed so far in some businesses.

Relationship portfolios

In the business-to-business supply chain world companies will have multiple customers and multiple suppliers. They will operate through interconnected contracts to form an extended network and in this way resources which are not owned can become available during the time of the contract and will be managed through the contract management mechanisms and through the company to company and person to person interactions and relationships. However not all of these are as important as others and this importance can change with changing market opportunities and demands.

Populations of customers and also of suppliers exhibit the same features of human populations as discovered centuries ago by the Italian economist Pareto. This property is that wealth and importance is not uniformly distributed in a population. Rather they are distributed according to the 80:20 rule where 20% of the number of items in the population accounts for 80% of the wealth or importance of the items in the population.

In the relationship portfolio we make use of the same thinking and patterns and recognize that relative few customers and suppliers account for most of our income and expenditure. These important few are the ones we need to get very close to and work collaboratively with since their importance to us, and to our future success, is paramount.

This means that suppliers look carefully at prospective customers and ask how attractive are they and what are the prospects of gaining and retaining a good income flow from business contracts with them into the future. The customers look at the suppliers and ask similar questions. How important is the technology or service that they provide to us to meet our customers’ expectations, are they showing signs of being able to work collaboratively with us and share their innovative ideas with us and can we see mutual support and investment opportunities to build a shared capability to the exclusion of our competitors.

The ideal situation is when a customer chooses a supplier as their preferred one for the future and the supplier regards that customer as their preferred customer as well. For this relationship the other party always considers the benefits of the other as creating benefits for themselves as well. Often this is spread over a longer time period than if an aggressive deal was done for larger but short term benefits which might have been obtained in the open market.

When this alignment occurs then both sides can afford to share and commit to a long term relationship which might be supported by a formal contract but might not need one. It will have mutually agreed investments in building interconnecting communication and management systems and sharing best practice, market information and forward plans. It will support innovation and cost reduction and process improvement and success in this will deliver performance incapable of being matched by the competitors.

It does mean that the selection of this kind of supplier and customer is of the utmost importance since getting it wrong will be expensive and time consuming as the relations and systems have to be disconnected and new ones established.

For customers and suppliers who do not fall into this mutually attractive and beneficial relationship category we might still trade together but we might see the contract as a limited life, minimal commitment relationship or even outsource that kind of activity to a third party to manage on our behalf.

Not all suppliers (especially monopoly ones) are interested in forming this kind of relationship with only one or a few customers. Rather they will use their monopoly to their advantage to dictate terms to all customers that they supply.

Thus both customer and supplier organizations are managing a variety of close and arms length contracts and relationships and need to make sure that the right people are in touch with their counterparties and understand what roles they are playing in the relationship and what is acceptable behavior in each situation.

Getting the important few relationships working well is hugely important to deliver the economic benefits of building and protecting a highly capable supply chain to satisfy the ultimate customer.

Supplier involvement

The reason that a company goes to the market to source a capability is that they do not have it themselves. This might because they never had it or they had it but outsourced it. Either way the key issue is that the buying organization has chosen not to be expert or to have competitive advantage in the good or service that they now need to buy. They have avoided investing in this capability in the hope that others would be better able and committed to being the expert in that particular capability. This logic therefore suggests that these suppliers have more expertise than the people who are buying from them and therefore are best placed to innovate and cost reduce in that field.

These are the kinds of suppliers who are likely to fall into the important few category and the way to manage them is to recognize their expertise and try and capture it in support of your own business requirements. Thus the buyer should not tell this supplier how to do things. Rather they should discuss with the supplier what the need is to be satisfied and allow the supplier to use their own creativity to suggest solutions. Thus this kind of supplier is responsible for the design to meet a required functionality and appearance in a more interactive and considerate way.

In evaluating this supplier’s value proposition the customer is less concerned about the unit price as other features are likely to be relatively more important. Plus the customer wants the supplier to make an acceptable profit margin so that they can survive and thrive together for the longer term.

Such suppliers are more like business partners or even family members and these social ties also make the relationship stronger and different to purely transactional contract management ones. Such relationships offer support when either party runs into difficulties and the networks created in this way can extend back to the supplier’s supplier and forward to the customer’s customer. They can provide a buffer against the occurrence of a major disruption (a supply failure elsewhere perhaps or a natural disaster impacting the production flow). Activating all of the collaborative wellbeing and mutual interest relationships to problem solve can allow all to cope with and mitigate the impact of traumatic events.

Thus such suppliers provide not just the collective capability to provide customer satisfaction but longer term survival capability as well for both their immediate customer and that customer’s customer.

Peer collaboration

In discussing the relationships between buying companies and their suppliers we are talking of a vertical relationship but cooperation can also occur horizontally between customer or supplier peers. For example it is quite possible for competitors in a final market place to cooperate with each other on the introduction of new products or standards, usually in the early stages of a new development when the technology for example is just being introduced to the market place. Often a new innovation will have different technical solutions and it is not clear in the early stages of its introduction which version will finally be accepted by the users in the market place. We have seen that repeatedly in new audio recording formats and it is not necessarily the most technically superior product that users decide to adopt. However remember the story of Apple and the IPod, IPhone and ITunes where the hardware and software innovations provided a package which the users liked and bought in great volume.

In other situations peer competitors will often collaborate in the early non-competitive stages and then as the new standard becomes accepted in the market place will then revert to their competitive behavior and try to gain market share from each other by operating better to the now common standard.

Similarly suppliers can cooperate with each other and this is a feature of the suppliers who are part of the Toyota supply network.

In both of these situations however, and indeed in the vertical situations as well, there has to be care taken that cooperation does not degenerate into collusion against the consumers for this is a crime in many legal jurisdictions. Such cartels can operate against the public interest to keep prices higher than they would otherwise be to the benefit of the cartel members.

The counter argument from those arguing in favour of the cooperative approaches discussed here is that the cooperation is intended to promote innovation and the reduction of real cost so that the offer to the consumer is enhanced rather than restricted. Of course the cooperating supply chain members are interested in beating the competing supply chain so that someone will lose relatively but that is the way of market competition.

Here again it is important to think carefully about which companies to choose to work with and judge that they will enter into a cooperative agreement and behave according to the agreed rules.

Summary

In this section we have discussed the decisions that have to be made on the supply side to match up to the decisions made on the demand side to satisfy the customer requirement. These decisions are sometimes rather fixed (public or private sector) and in others are much more a function of the analysis of the situation by the management teams at that point in time. There are few a priori correct answers but the need to make a decision and try and make the solution work, is an ongoing challenge. In this, some ways of thinking seem to be important. The need to see customers and suppliers as being part of an interconnected and collaborating supply chain raises the consideration set above just the employing company and requires more vision and commitment to a better way of working than has traditionally been the case when all other parties were regarded as enemies to be beaten and taken advantage of. As we shall see in the next section this also means that the people employed need to have new skills to operate complicated systems to make it all work as intended.

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