total cost structure

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With Sertus' China Sourcing Experts as your partners, China is an ideal procurement center based on the entire cost structure and the factors that influence total cost. This report shares some insight into total cost structure.

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Page 2: Total Cost Structure

Jay Peirce Understanding Total Cost: The Complete Cost Structure of Procurement (305) 215-3414 January 2006 [email protected]

The Paradox of Procurement

When an overheated economy begins to cool off, most manufacturers begin to look for ways to improve efficiencies in production in order to help reduce costs. For many companies, rationalization of production processes can generate material savings, but they can involve lengthy labor negotiations, steep investments in new tools and/or technologies, and process reorganization that can dramatically reduce the savings over the short run that these same manufacturers are trying to capture. Outsourcing is often considered a quicker fix that can have a more immediate impact on costs, especially when trying to reach short-term stretch goals for a given year. However, it is critical that companies understand the complete cost structure related to outsourcing or many of the savings thought to have been realized will quickly disappear as hidden costs find their way back into the cost structure. Uncovering Hidden Costs Typical Company USA Ltd., much like many of the companies that have gone before it, decides to begin a strategic sourcing initiative to help lower its cost of goods. The company began to seek non-domestic sources to satisfy cost reduction demands and locates several manufacturers in China that can provide a competitively priced alternative to their current supplier. It decides to abandon North American and European procurement sources and makes a large-scale shift to China without fully understanding the underlying cost structure of this decision. Everything seemed to be pointing toward a significant reduction in cost of goods until Chinese manufacturers failed to meet important deadlines. Some product had to be air-freighted and even though they had spent a significant amount of time embedding into their purchase order all of the critical spec, they ended up receiving product that was short of acceptable. On top of workmanship concerns, there were packaging problems and some missing parts that

cost Typical Company USA thousands of USD to remedy. The delay to market also pushed their client’s to begin seeking alternative sources and Typical Company USA lost several key customers as a result. What was expected to be thousands of USD in savings actually resulted in tens of thousands of USD in hidden costs and hundreds of thousands USD in foregone income. In a recent report by Booze Allen Hamilton (China’s Gold Rush: Should You Make the Journey East?, by Ronald Haddock, Peter Obdeijn, Mitchell Quint, Vikas Sehgal, Dermot Shorten, and Edward Tse, Booz Allen Hamilton, 2004, http://bit.ly/qNSzB3), the authors identify five key dimensions that must be considered when purchasing from China, or run the risk of cost creep that can eat away pre-determined savings. These factors are:

Manufacturing costs; Transportation efficiency; Lead time and scheduling; Product design; Technical capabilities.

Manufacturing Costs Companies are easily lured by a competitive sales price when seeking procurement alternatives. In China, where man hour costs are low by global standards, labor intensive goods are still very competitively priced. Within China, however, there are wage differences depending on the location of production. In the interior, where wages tend to be lower than in the large industrial and highly populated cities, companies can find more competitively priced product. However, this can add a number of unforeseen costs due to logistics challenges that not only impact delivery but can also influence the supply of raw materials to the manufacturers in these locations. There are large comparative advantages for factories that are

Page 3: Total Cost Structure

Jay Peirce Understanding Total Cost: The Complete Cost Structure of Procurement (305) 215-3414 January 2006 [email protected]

located in the center of excellence for a particular product because most of the suppliers of raw materials tend to concentrate around the large consumers of these inputs. The risks involved with disruptions to the inland logistics infrastructure can add costs to factories that are located any significant distance from their suppliers. These disruptions can influence not only timely delivery but also quality as factories attempt to claw back unforeseen expenses by reducing cost elsewhere. Therefore, when searching for a low cost provider, it is critical that appropriate controls are in place to ensure there are no quality concessions due to cost pressure or delays due to logistics considerations. Consider hiring a good partner to help you monitor your supplier relationships, whether it is through quality control or through production monitoring, because these hidden costs can destroy value very quickly. Transportation Efficiencies There can be distinct pricing advantages that influence your selection process when dealing with suppliers in more remote areas. As we discussed, the wage differential is often significant. Yet the freight considerations, to bring product from these remote areas to port, should not be overlooked. Transportation efficiency, which measures the ratio of the cost of transport to the total product cost, favors remote production for smaller, higher-value added items, which will have a lower freight factor since the cost of transportation is generally fixed per unit volume. Lead Time & Scheduling Shipping out of China can add anywhere from four to seven weeks on the water to Western Hemisphere markets, depending on inland transportation distances and final destination. The risks associated with this longer lead time need to be carefully contemplated and the potential impact on stock-outs and excess or obsolete inventory must be incorporated into procurement costing analyses. Furthermore, the additional lead time

necessitates larger order quantities and the dollars tied up in inventory investments are often exaggerated due to rounding up practices to fill containers and minimize the unit freight factor for each piece shipped. Higher quantities also pose higher risks – with manufactured defects having a much greater impact than for small order quantities, where the damage is limited due to the smaller order size. Getting a qualified intermediary to help control quality is crucial when buying from China due to the increased risk posed by a number of factors, not least of which is correlated to the large order quantities China procurement necessitates. Product Design Engineering change orders present a whole new set of complexities when sourcing from China mostly because of the differences in local technical capabilities and the risks posed by long lead times and large order quantities. The amount of obsolete product that is received after changes are implemented can be material in quantity and extend for some time due to the considerations mentioned. Therefore, it is imperative that buyers either deploy their own engineering specialists to oversee the entire process at origin or hire professional procurement specialists that can send engineers and QC inspectors to oversee change orders and ensure on-time deliveries of product that meets desired specifications. Technical Capabilities China is generally not recognized for its technical specialization in manufacturing. Although Chinese factories have made huge strides in the last few years, the challenges posed by highly specialized and application specific product are not easily handled by most Chinese suppliers. Factory selection is even more important when dealing with highly specialized manufacturing and finding experts that can assist with this process is a critical success factor if considering China as a procurement option.

Page 4: Total Cost Structure

Jay Peirce Understanding Total Cost: The Complete Cost Structure of Procurement (305) 215-3414 January 2006 [email protected]

Putting it All Together For Typical Company USA Ltd., and for many others considering China as a procurement center, an understanding of the entire cost structure and the factors of influence that affect total cost are incredibly important in order to realize the anticipated savings that are motivating the decision to shift procurement in the first place. This understanding involves going beyond typical procurement unit price analysis. It requires a holistic approach that brings in engineering and manufacturing experience to define an optimal purchasing strategy. For more information, please contact [email protected] or visit www.asiatradepro.com