OUTSOURCING AND LOGISTICS SERVICE PROVIDERS: SUMMARY OF THE CASE STUDY IN THE FINNISH METAL INDUSTRY Kai Häkkinen Technical Research Centre of Finland (VTT), Department of Industrial Systems, Tekniikantie 12, Espoo, P.O.Box 1000, 02044 VTT, Finland. Phone: +358 20 722 4684. Fax: +358 20 722 7046. Email:
[email protected]. Erno Salmela Lappeenranta University of Technology (LUT), Department of Industrial Engineering and Management, P.O. Box 20, 53851 Lappeenranta, Finland. Phone: +358 5 621 6610. Fax: +358 5 621 2644. E-mail:
[email protected]. Anita Lukka Lappeenranta University of Technology (LUT), Department of Industrial Engineering and Management, P.O. Box 20, 53851 Lappeenranta, Finland. Phone: +358 5 621 2608. Fax: +358 5 621 2699. E-mail:
[email protected]. Abstract The goal of the study was to increase the understanding of outsourcing of logistics in the metal industry. The study was carried out in association with eight Finnish companies in the field of metal industry. Outsourcing of the logistics functions is a very common practice in Finland today. There are three main factors affecting the outsourcing decision: 1) production costs, 2) transaction costs, and 3) innovation, information sharing and learning capability. In this study, material flows are divided into four parts: 1) outbound, 2) in-house, 3) inbound and 4) outside. The second dimension relates to the management of labour. Material flows can be supervised 1) by the company itself or 2) by an external logistics service provider. The most important reason for outsourcing the logistics functions in the case companies is to decrease the transaction and production costs. Innovation, information sharing and learning capabilities were less important for the participating companies. The class C items are mostly managed with VMI models. There is a common interest to apply VMI models also to class A and B items. However, there seems to be only a few logistics service providers in these two classes in Finland. One explanation for the scarcity can be the complexity level of production processes, which hinders the development and standardization of the VMI type of models for class A and B items.
Keywords: logistics service provider, logistics, outsourcing, metal industry Introduction Outsourcing of the logistics functions is a very common practice in industry today. We can find many areas of outsourcing. Different kinds of transportation activities have been in focus for a long time. We can find global logistics companies offering many kinds of logistics services for industry; inventory optimization, materials management, transport management, just-in-time deliveries, procurement activities, etc. Consequently, some of these companies have implemented an Internet-based information system to support their customers’ logistics operations. The background to outsourcing has been under intense discussion during recent decades. The question is basically about the definition of the firm. The whole supply chain can be very long, with a number of independent companies organized vertically. When an industrial company outsources some of the logistics activities, it increase activities in some of the organizations in the supply chain, or creates a totally new organization to the supply chain. According to Coase (1937), Williamson (1985) and Rao (2003), outsourcing the production phases to the market increases external transactions (marketing, negotiations, co-ordination and control) and thus transaction costs. Consequently, they say that a factory’s own production phases affect internal transactions and thus transaction costs. Langlois et al. (1995) have introduced an idea of the boundaries of the firm based on the cumulative knowledge and learning capability of the organization compared to the market. Pajarinen (2001) has formulated a transaction cost theory into a quite short book. He summarizes that there are three main factors affecting the outsourcing decision:
Production costs in own production process compared to the outsourcing alternative.
Transaction costs in own organization compared to the outsourcing alternative. Innovation, information share and learning capability of the organization in both alternatives.
In this paper we use these three criteria to consider the rationales of the outsource cases. Because of the wide outsourcing of the logistics operations in Finland, VTT and LUT started a 1 research study in association with 8 Finnish industrial companies. The SERVIISI project was established to investigate the possibilities of developing a standard type of the logistics services to absorb the outsourcing demand in the metal industry. One often used example of a successful 2 outsourcing model is the VMI concept. Well-known examples of VMI users are Wal-Mart and Proctor & Gamble in the U.S. In industry we did not find the same kind of success stories. Elvander (2005) made an interesting mapping of the different kinds of VMI concepts. He found in literature a versatile collection of VMI-related concepts: Co-managed inventory (CMI), co-managed replenishment (CMR), distributor managed inventory (DMI), jointly managed inventory (JMI), retailer managed inventory (RMI), vendor managed replenishment (RMI), vendor managed replenishment (VMR), vendor stocking programs (VSP), supplier managed inventory (SMI), supplier owned inventory (SOI). Consequently he found a collection of the supply chain related concepts: Efficient consumer response (ECR), quick response (QR), collaborative forecasting and replenishment (CPFR) and continuous replenishment (CR). According to Elvander’s paper (2005), there are a number of different kinds of models in use in business life. His paper is a fine discovery of the versatile logistics world. The VMI with related concepts is only one part of the whole logistics field in companies. The goal of the study was to increase the understanding of the logistics outsourcing phenomena in the metal industry. Methods The research study was carried out using the action-oriented approach. The emphasis was on the understanding of the current operation in the field of outsourced logistics. All of the 8 companies were interviewed. Three of the companies were customers who had outsourced their logistics operations. Five of the companies were logistics service providers (LSP). The investigated cases were documented carefully. In this paper we do not mention the company names. Results During the interview session we found that outsourcing cases can be found in four different phases of the material flow: 1. 2. 3. 4.
Outbound In-house Inbound Outside
3
Logistics from the focus company to their market. Logistics in the focus company’s factory. Logistics in the focus company’s receiving department. Logistics outside the focus company in the subcontractor’s site.
Independent of the previous categorization, we found that the personnel involved in the logistics operation can be supervised: A. By the focus company itself B. By an external logistics service provider. The results of the interviews are given in Table 1.
1
The SERVIISI-project (in Finnish) was funded by TEKES (Finnish Funding Agency for Technology and Innovations), Ministry of Transport and Communications Finland, VTT and participating companies (http://partnet.vtt.fi/serviisi). 2 VMI = Vendor Managed Inventory. 3 Focus company = The company who has outsourced their logistics operations
In Table 1 there is a term illustrating the extent of the operation in the focus companies: Common Some Few
Means that the operation model is common and there are many logistics service providers available. Means that some dedicated cases were discovered. Means that only a few dedicated cases were discovered.
Table 1. Summary of the cases ===================== Direction of the material flow ======================== SUPERVISED
1. OUTSIDE
2. INBOUND
3. INHOUSE
4. OUTBOUND
A. By LSP or subcontractor
E.g. Warehousing and packaging at the subcontractor’s site and transport management by the subcontractor. (Common) Not discovered
E.g. Subcontractor’s machines are located in the focus company’s factory and the subcontractor is responsible for the logistics operation. (Few) E.g. Participating in the material flow handling operations at the focus company’s factory. (Few)
E.g. The warehousing of the completed products from the focus company’s factory and management of the deliveries. (Some)
B. By the focus company
E.g. VMI operation from suppliers and deliveries from subcontractor’s warehouse to the focus company’s assembly line. (Common) E.g. Reception and shelving of goods in the focus company. (Few)
E.g. Packaging and delivering the finished goods at the focus company’s factory. (Few)
Description of the boxes: A1
The focus company has outsourced some manufacturing operations to the subcontractor. E.g. the subcontractor, who is responsible for manufacturing, carries out warehousing, packaging and deliveries. Manufactured products can be mainly categorized in the A and B classes. The subcontractor manages the operation.
A2
An external logistics operator is in response to the adequate service level of the focus company’s stocks. The VMI model is common. All kinds of transactions have been minimized in the focus company. Some of them have been removed. The logistics service provider can be a local retailer, wholesaler, subcontractor, etc. It can be a separate operator without its own manufacturing operation or product-based business. Mostly these operators have several focus companies using the same operation model. The VMI model can be developed in different ways, as explained earlier according to Elvander’s paper. The logistics planning and control systems can be owned by the focus company or by the logistics operator. Products are 4 mainly MRO items or/and C-class items. The logistics operator manages the operation.
A3
An external service company operates inside the focus company’s factory. All of the cases were part manufacturing subcontractors. Mostly, they had similar manufacturing processes inside some other customer factories. Because the manufacturing operation is carried out in the same factory building where the focus company’s assembly line is, the material transfers are carried out without the packaging operation. The subcontractor is typically integrated into the focus company’s production planning and control system. Products are mainly A-class items. The subcontractor manages the operation.
A4
The logistics service provider has its own warehouse space where all of the finished goods from the focus companies are delivered in batches. The LSP stores, packages and delivers
4
MRO = Maintenance, repair and operation items
the finished goods to the focus company’s customers according to the dispatch list from the focus company. The LSP typically has its own computerized logistics planning and control system. Products are mainly A-class items. The LSP manages the operation. B1
This kind of company was not discovered.
B2-4
An external LSP operates inside the focus company’s factory. The personnel of the LSP are managed by the focus company. They participate in different kinds of logistics operations in the whole production process. Their working time is the same as the focus company’s personnel. They use the focus company’s information systems. Products can be materials, components, semi-finished products or finished products.
Discussion In the beginning of this paper, we introduced three dimensions behind the outsourcing decision:
Production costs in own production process compared to the outsourcing alternative. Transaction costs in own organization compared to the outsourcing alternative. Innovation, information share and learning capability of the organization in both alternatives.
Based on the discussions in the companies, we can analyse the cases grouped to eight boxes in Table 1. Production costs were seen to be most important factor in the boxes A1, A4, B2, B3 and B4. The explanation of the focus companies is that using a flexible personnel capacity from an external LSP, there is not need to have surplus personnel capacity to manage the demand fluctuations. The LSP have typically many customers and can serve all of them using the same personnel in many companies. Transaction costs were seen to be most important factor in the boxes A2 and A3. VMI-based inbound operation was seen to be cost-effective. It seems to be clear that the internal transaction costs in the focus company have decreased a lot. On the other hand, these eliminated transactions have been partly moved to the LSP, who invoices them from the focus company. The VMI model is based on the standard type of service. This means that the focus company’s eliminated internal transaction and production costs are bigger than the same costs in the LSP’s operation. We could not get any kind of formal calculations from the case companies about the sensibility of the use of the VMI model. The common opinion in the companies was that the calculation of the transaction costs in different operation models is difficult, which is the reason why some of the focus companies are willing to increase the transparency of the pricing. Some of them have made such a contract with an LSP where the product prices and service prices are separated from each other. The decision making concerning the use of the VMI model seems to be based more on human thinking and not on numerical calculations. Innovation, information share and learning capability were seen to be a less important idea. The explanation for this opinion could be that commonly the companies seek cost savings in the short run. Innovation, information sharing and learning can be seen to be very important in the long run. Considering boxes B2, B3 and B4, we can see that the same personnel are working in many companies. Every one of them is an expert in a certain logistics operation. In this model, they learn something in every focus company. We can state that a knowledge transfer can be found between companies, which mean that the cumulative learning in these focus companies will increase continually. All of the discovered models are in use today in the Finnish metal industry. In the companies of this study, the most interesting model seems to be the VMI concepts with related variants. Most commonly, the VMI model is used to manage C-class items and MRO-items. All of the three customer companies in the study were interested in expanding the VMI model to cover the material flows of the item classes A and B. There seems to be a common interest to outsource more logistics operations. According to the customer companies, there are only a few logistics service providers in that field of operation. Some kind of dedicated VMI models in the item classes A and B were found. These models were planned and implemented in co-operation with focus companies and their suppliers.
These three customer companies expressed their willing to decrease their number of suppliers. One of the tools to carry out this is to outsource the operation to the external LSP. This study highlights a new question about the scarcity of the LSP’s covering the material flows in the A and B class items. What are the reasons for that scarcity? One of the explanations could be the lack of standardization. Typical VMI cases are reported to work well. The reason is quite easily seen. There is a standard service model which is designed mainly by the LSP who has sold that model to many customers. It is very important to recognize that a typical VMI model requires a stock at the customer company’s site. That stock can be managed by using such parameter settings that there are always items on the shelves. The value of the items is typically low and the availability of those items is good. Looking at the material flows in the classes A and B, we can find that there are often fewer possibilities to adjust the parameters than in class C. If the LSP needs to deliver the items straight to the assembly line, the problems can be seen. There is not a stock to absorb the demand fluctuations from the customer’s end of the market. The logistics service model to feed the assembly line must be very flexible and agile. In practice, we can find many kinds of production processes. Probably we cannot use the same model though for all kinds of production processes. Based on this study, we can take into discussion the question of standardization. Could it be so that the LSP model for A and B classes require standardization? If different kinds of production processes could be standardized in many companies, the LSP could be able to develop a new kind of VMI-like model for A and B class material flows. The challenge lies in the complexity and versatility of production processes. Literature
Coase, R. (1937), “The nature of the firm”. Economica 4, pp.386-405.
Elvander, M.S. (2005), A theoretical mapping of the VMI concept – A literature review. Report ISRN LUTMDU/TMTD-4016—SE, Lund University, Lund.
Langlois, R. & Robertson, P. (1995), Firms, markets and economic change – A dynamic theory of business institutions, Routledge, New York.
Pajarinen, M. ( 2001), Make or Buy – Outsourcing in Finnish Industry (in Finnish), ETLA B:181, Taloustieto Oy, Vantaa.
Rao, P.K. (2003), The Economics of Transaction Costs: Theory, methods, and Applications, Palgrave MacMillan, New York.
Williamson, O.E. (1985), The Economic Institutions of Capitalism, Free Press, New York.
