The total cost of sourcing from China

Here I would like to return on the topic of the calculation of the total cost of sourcing, but now with the specification of the China. I wrote already a post about: https://inspiringscm.wordpress.com/2009/08/13/global-sourcing-2-logistics-costs-in-the-global-sourcing/

Many researchers have stated that cost savings are a major reason for global sourcing. However, global sourcing can be costly. In order to calculate the real cost of global sourcing, consideration of all the costs involved is necessary.

The author argue that it is generally agreed that manufacturing cost is significantly lower in developing countries; however, the extended distance, the coordination between the partners, and numerous other problems related to international trade often complicated the profit picture. In addition, outsourcing to China involves the increased difficulties associated with differences in culture, language, poor in and transportation and antiquated customs procedure. When sourcing from China, the cross culture supplier relationship management is one of the topics frequently addressed as an obstacle.

In order to investigate the costs in a comprehensive and consistent manner, a cost framework based on the literature and input from practitioners was developed.

Based on the inputs from both academic literature and practitioner interviews, a framework of TAC of global sourcing from China was developed (Table 1). In this framework, the cost items are classified into set up costs and ongoing costs. The set up costs (Category 1) occur at the beginning stage of global sourcing projects. These are the one-off costs involved in identifying and selecting suppliers, and in setting up the supply relationship in terms of both technical capability and commercial relationships. Ongoing costs (Categories 2-8) are the costs incurred repetitively during the China sourcing process.

Table 1 A framework of TAC of China sourcing

1 Set up costs

1 Cost of collecting information to search for suppliers (e.g. participate trade fairs, pay for agent, etc)

2 Cost of engineering time involved for transfer (e.g. gather information, modify the design due to different environment and IP concern, etc)

3 Postage for sending technical data, samples, etc

4 IP registration fee in the host country

5 Payment to the previous supplier for the design

6 Quality audit and validation cost

7 Staff’s time cost for searching for, visiting and negotiating with supplier, preparing contracts, adding the

supplier to internal IT system etc

8 Travel expenditure (transport, food and hotel)

9 Cost of phone call, fax or video conference

10 Tooling cost

11 Invest in suppliers’ IT systems (e.g. MRP, ERP)

12 Cost of expanding warehouse

13 Personnel recruit and training

14 Cost of removing redundant capacity and labour

15 Cost of sending employees to work overseas for a long term (e.g. costs of settlement, children’s international school, insurance, etc)

2 Extended Price (ongoing)

1 Price

2 Tax and import duty

3 Loss from payment terms changes

4 Loss from currency exchange rate fluctuation

3 Administrative costs (ongoing)

5 Extra cost of forecasting/ordering process

6 Extra cost of payment/billing process

7 Bank charges

4 Logistics costs (ongoing)

8 Transportation by sea, by road or by train (including cost for transportation agents)

9 Insurance

10 Expediting by airfreight

11 Loss of sales due to late deliveries or longer lead time

12 Holding and administrative costs related to unexpected early delivery

13 Compared with before China sourcing, extra costs for receiving (e.g. handling the products into warehouse, disposal of the heavy packaging)

14 Compared with before China sourcing, extra costs for inspecting the products (labour and equipment)

5 Inventory costs (ongoing)

15 Extra warehouse costs due to sourcing from China (rent, rate, light, heating, maintenance, insurance, etc)

16 Obsolescence

17 Capital cost of increasing inventory

6 Quality issue (ongoing)

18 Rejection, returning and re-receiving

19 Rework

20 Cost of disposal or discarding of defective products

21 Loss from scrap, including labour cost of handling scraps

22 Loss from production line downtime

23 Cost of staff’s time of analysing quality problem, re-arranging schedule, asking for compensation

24 Cost of handling warranty and customer complaints

25 Loss of sales because of quality

7 Supplier management (ongoing)

26 Ongoing travel expenditure (transport, food and hotel)

27 Cost of engineering time for technical support

28 Cost of staff’s time of performance review and, meeting and renegotiation

29 Costs of phone calls, faxes, video conferences with the supplier

30 Costs resulting from culture and language differences (translators, gifts, social events, etc)

31 Cost of litigation with the supplier

32 In case of buying other parts from the previous supplier, the loss because of the increasing prices of other parts supplied by this supplier due to the reduced order volume

8 Other costs related to China sourcing

33 Cost of dealing with inferior infrastructure (e.g. road, power supply, internet)

34 Impact of “made in China” on customers

35 Cost of dealing with special regulations or even corruption from local government

36 Cost for dealing with counterfeit products or IP infringement

 

A survey was made to comparing the costs perceived and the real cost of sourcing in the companies.  From the survey the staff’s time cost for searching for, visiting supplier, for the set up costs, and the price cost, were the most significant costs.

By comparing the results from case studies and survey, it was found that the total cost of sourcing from China is usually under-estimated in practice. The companies overestimate the price in the total ongoing costs and underestimate the add-on costs of sourcing from China. Detailed case studies showed that the add-on costs averaged about 50 per cent of the quoted price; the perception of companies from the survey was that these add-on costs were less, averaging about 25 per cent of the quoted price. This difference was statistically significant. The implication here is that companies need to be more thorough in their identification of the true costs of overseas outsourcing and to be wary of significantly underestimating these costs.

This survey revealed that companies generally do not comprehensively measure the costs of global sourcing, and significantly underestimate the true costs incurred. This confirms the benefit of a comprehensive cost framework, such as that presented in Table 1, as a checklist that will prompt companies to think about all the possible sources of cost when sourcing globally. This should both guide their decision-making, and also act to identify possible cost reduction activities.

Sources:

–          Platts, Song, “Overseas sourcing decisions – the total cost of sourcing from China”, (Supply Chain Management: An International Journal, 2010)

–          Zeng, Rosetti, “Developing a framework for evaluating the logistics costs in global sourcing processes”, (International Journal of Physics Distribution and Logistics Management, 2004)

–          Song, Platts, Bance, “Total acquisition cost of overseas outsourcing/sourcing – a framework and a case study”, (Journal of Manufacturing Technology Management 2007)

Riccardo Simeoni

The supply chain innovation in the emerging countries

I would like to write here about how is changing the supply chain or better the network in the emerging country. These countries are growing very much more than the industrialized counties and the reason is not only because they have a big resource of cheap labor but also because they are innovating and developing a new and different industrial system than the western counties. These counties in the next years will have a new middle class with new needs and possibility to buy new products. This means rethinking everything from products to distribution systems. The new companies that are growing in these countries can compete with the companies from the industrialized countries. Indeed, they have many skilled workers, there are many R&D centers and these companies can understand better their markets than a foreigner western company.

In this post I will write about the innovation that the emerging counties have in the supply chain and because it is different from the industrialized countries.

The supply chain of a product is changing from the beginning of the proces, the R&D. Western companies are embracing “polycentric innovation” as they spread their R&D centres around the world. Non-Western companies are becoming houses of innovation in everything from telecoms to computers. And some companies, or States, from the emerging countries are buying prestigious western companies as Jaguar, Volvo or IBM computers, for the knowledge that they can acquire through these acquisition.

In the recent years the supply chain in the western countries have stressed the efficiency, the efficacy, the optimization of the process for the upper end of the customers, because the western companies thinks that the customer want pay a premium for the always availability of the product or the always new enhancements. In the emerging countries many of the most important innovations consist of incremental improvements to products and processes aimed at the middle or the bottom of the income pyramid. Two examples are Wal-Mart’s supply system or Dell’s application of just-in-time production to personal computers. These two companies are designing the products and the processes to reach the billions of consumers who are just entering the global market. These consumers are different from the western consumers because their income is very much lower than the westerns and they don’t need a top performance product with a top performance supply chain. They need more a frugal innovation than new products or top products\x.

The Chinese have made a distinctive contribution to frugal innovation in the supply chain. This is the use of flexible networks—powered by guanxi or personal connections—to reduce costs and increase flexibility. Li & Fung, a Hong Kong-based retailer and distribution company, has long been a pioneer, working closely with a network of about 12,000 companies operating in more than 40 countries. It puts together customised supply chains from its vast network of associates and keeps an eye on quality and order fulfilment. Similarly, Dachangjiang, a motorcycle-maker in China’s Guangdong province, works with hundreds of parts suppliers. These post-modern guanxi have several powerful qualities. They can contract or expand with demand. Li & Fung and Dachangjiang seldom have problems with excess capacity when times are hard or with waiting lists when times are flush. And they can be turned into engines of innovation. Li & Fung relies on its partners to help solve problems, not just fulfil orders. Dachangjiang provides its suppliers with rough sketches rather than detailed blueprints and encourages them to innovate.

In the distribution side there are also some innovations to resolve the problems that these countries have. In the emerging countries there is not a widespread distribution network as in the industrialized countries. The distances are huge and the transportation difficult. Modern retail chains account for only a third of consumer goods sold in China and a fifth in India. The problem is not only to enter in the market with the right product, it is also that the costumers cannot get the product physically. Even the most sophisticated companies have to fall back on established distribution systems. That might mean working with local “mom and pop” shops. Or it might mean using local women to sell things to their friends and neighbours. In India Unilever employs an army of shakti entrepreneurs who sell goods from their homes and educate their friends in health and hygiene. In Brazil Nestlé sends its comestibles to local entrepreneurs who sell them to their neighbours. Some companies provide locals with bicycles so they can cover a wider geographical range.

The emerging countries have also a different approach to the production. Western companies have spent the past century perfecting “push” models of production that allocate resources to areas of expected demand. But in emerging markets, particularly those where the Chinese have a strong influence, a very different “pull” model often prevails, designed to help companies mobilise resources when the need arises. Hong Kong’s Li & Fung or China’s Chingquing Lifan Group can use their huge supply chains to produce fashion items or motorcycles in response to demand. These pull models fundamentally change the nature of companies. Instead of fixed armies looking for opportunities, firms become loose networks that are forever reconfiguring themselves in response to a rapidly shifting landscape. Such models are not peculiar to emerging markets: Dell builds computers to its Western customers’ specifications, and Western management gurus have been advocating networks for decades. But according to Messrs Hagel and Seely Brown they are far more widespread in emerging countries.

Inn the end I can agree that the world’s creative energy is shifting to the developing countries, which are becoming innovators in their own right rather than just talented imitators.

Sources:

– “Special report Innovation in the emerging markets” (The economist, 17^th April 2010)

Riccardo Simeoni

The control mechanisms in the global sourcing.

In order to have an efficient global sourcing, it is important to implement the appropriate control mechanisms based on the international strategy that the company adopts and the distribution of information among the subsidiaries.

In literature there are three types of international strategy based on the integration/coordination advantages versus differentiation/responsiveness in a company. These are: multidomestic strategy (combining low integration and high responsiveness), global strategy (combining high integration with low responsiveness) and transnational strategy (combining high integration with high responsiveness. In analysing the information processing implications for each strategy type, it becomes apparent that information processing requirements are highest when interdependencies among organisational units becomes more complex. While for multidomestic firms the need to process information across countries is very low it increases strongly for global firms. In the transnational companies the need to integrate activities along highly differentiated and interdependent departments require much greater and more unstructured and non-routine information flows across country units with the highest degree of uncertainty and ambiguity, so the most difficult process information to manage. Here I gave only an abstract of the international strategy and related process information. More information is available in the articles by Bartlett, Ghoshal, Doz and Prahalad.

The theory literature indicates a number of control mechanisms that can be used for achieving effective integration among units. By differentiating between personal/impersonal and direct/indirect types of control, a classification scheme results that embraces four categories.

1. Category 1: Centralisation of decision-making refers to the level of locus of decision-making authority In the context of MNCs, centralisation means that decision-making authority remains within headquarters where a better overview of the activities of the dispersed units exists.
2. Category 2: Bureaucratic formalized control. Formalisation refers to the use of policies, rules and standardised work procedures that are written at headquarters and subsequently distributed to subsidiaries as guidelines for their activities. The effectiveness of this mechanism will increase the more activities can be codified into rules and procedures, without leading to low flexibility and rigidity.
3. Category 3: Output control. Output control relies on assessing performance by measuring desired performance targets or the quality of output. This means of control becomes most effective, when appropriate output measures can be defined for the tasks to be monitored. Planning is considered to be a central mechanism for coordinating activities of organisational units. The plan, as the basis of measure, serves as an instrument to coordinate the activities of different organisational actors.
4. Category 4: Coordination via socialisation refers to processes by which members of an organisation internalise organisational behaviours, rules and norms. In the context of multinational companies, socialisation processes aim at aligning the values and norms of subsidiary managers and employees with those of the parent company.

Here the four categories of control mechanisms.

These control mechanisms are now applied to the different type of organisational configurations.  The companies usually adopted two different types of organisational configurations for implementing global sourcing: the global organisation and the transnational organisation.

Here how the companies implements the control mechanisms based on the organisation of the company:

1. Category 1: Personal centralised control:  global companies show higher levels of centralisation than transnational companies. Global companies strongly relied on centralisation as a means to integrate global sourcing activities. The transnational companies followed a more decentralised approach. The unit with highest capability assumes responsibility for strategic purchasing, while operational purchasing remained within the scope of authority at each local site.
2. Category 2: Bureaucratic formalised control:  purchasing executives at headquarters consider formalisation as an indispensable requirement for global sourcing. At the same time, they warned that overly formalised structures lead to deterioration in subsidiary managers’ motivation and increased rigidity in the organisation. Three key areas where was emphasised the importance of formalisation for global sourcing are: 1) governance and policies, 2) processes and 3) controlling. Governance and policies relates to the establishment of manuals including general rules, codes of conduct and the description of different roles and their respective competences. The processes clearly defined roles and responsibilities, help to overcome differences among purchasing managers from headquarters, subsidiaries and internal clients. Controlling refers to the establishment of common performance measurement methods or unified reporting templates to monitor and compare subsidiary performance efficiently.
3. Category 3: Output control:  The transnational companies involved subsidiaries more actively in the strategic planning process than global companies. About the planning: In global companies, subsidiary involvement in the strategic planning process was very limited. However, some meetings are held to gain subsidiaries’ commitment rather than to enable them to actively participate in the strategic goal setting process. In contrast, transnational companies encouraged subsidiaries to actively participate in the strategic planning process. Purchasing committees were established, consisting of purchasing heads from the most important sites and senior managers at headquarters, which jointly decide on the strategic course of the purchasing function. About the output control: High levels of output control were observed among all companies in general. Within the strategic control process, all of the companies translated their yearly strategic objectives into multiple key performance indicators (KPIs). These KPIs were monitored at different time intervals, depending on their perceived importance for the company.
4. Category 4: Control by socialisation and networks: global companies primarily relied on fostering personal interaction between headquarters and subsidiary managers, while transnational companies strongly aimed to foster informal networks among subsidiaries.

Sources:

– Bartlett, Ghoshal, “Managing across border. The transnational solution” (Harvard business school press, 1989)

– Bartlett, Ghoshal, “Transnational management: text cases and readings in cross-border management” (Irwin, Chicago, 1992)

– Hartmann, Trautmann, Jahns, “Organisational design implication of global sourcing: a multiple case study analysis on the application of control mechanisms.” (Journal of purchasing and supply chain management, 2008)

Riccardo Simeoni

Global sourcing 6: How to find the synergy in the global sourcing.

When a purchasing strategy is defined between the whole organization, a company should focus how to get organised at a corporate level to capture the potential purchasing synergies between business units.

In business usage, synergy refers to the ability of two or more units to generate greater value working together than each of them could by working apart.

The most business synergy can be identified in these six forms:

1)      Pooled negotiation power (buying together): By combining their purchases, different units can gain greater leverage over suppliers, reducing the cost or even improving the quality of the goods they buy.

2)      Sharing intangible resources (knowledge and information): business units can improve their position by exchanging and sharing information about product specifications, company wide contracts, product prices, suppliers, purchasing procedures, and supply market developments.

3)      Shared tangible resources:  Units can gain economies of scale sharing the purchasing specialists, purchasing information and communication systems, and space and other facilities.

4)      Vertical integration: Co-ordinating the flow of products or services from one unit to another can reduce inventory, speed product development, or increase capacity utilisation.

5)      Co-ordinated strategies: Aligning the strategies of two or more business units can be an important source of synergy, but difficult to achieve.

6)      Combined business creation: Can be facilitated by combining know-how from different units in a new unit, or by establishing internal joint ventures.

Applying the concept of synergy to the purchasing with the six forms, it can be defined as: the value that is added when two or more business units (or purchasing departments) join their forces and/or share resources, information, and/or knowledge in the area of purchasing.

If a company reaches the synergy between the business units, there are five major benefits of a co-ordinated purchasing:

1) Better internal exchange of information,

2) Improved market negotiation strategy,

3) Significant cost savings,

4) More impact on monopolistic supply markets,

5) Improved insight in market and cost structures.

But for improve and manage correctly the synergy in the company should be in the company some pre-conditions:

1) top management involvement

2) appointment of a senior management problem owner

3) setting of a clear and measurable target

4) explicit synergy projects should be identified, prioritised and decided on

5) implementation of a well-designed organisation structure (working rules, clear communication and reporting lines, balance between incentives and contribution)

6) allocation of all the necessary resources over the different teams

7 teams formulating and implementing the strategy for their specific projects

8)teams are supported with training, networking and proper ICT systems implementation is monitored and improvements are initiated where necessary

A hypothetical model indicating the approach to purchasing synergy that can best be used, given the level of business unit homogeneity and purchasing maturity in a specific company situation, was developed. To establish a successful intra-company purchasing consortium, there has to be a minimum of homogeneity in demand between the several business units, and higher is the homogeneity, the higher is the possible degree of centralization and synergy.

With high business unit homogeneity and low purchasing maturity we suggest that a central buying group captures the purchasing synergies (often mainly bundling of volumes). This approach does not fit in a situation of high homogeneity and high purchasing maturity. Here, the decentralised groups will not accept a central purchasing group, because they are able to do the initial purchasing themselves. In this quadrant we suggest a cross-functional team approach. If business units homogeneity is low, purchasing synergies are mainly found in sharing best practices and information. With low homogeneity and low purchasing maturity, there are not so many best practices to share. In this situation we suggest facilitating sharing information on prices, suppliers, product features by use of working groups. In the situation of low homogeneity and high purchasing maturity the focus should be on facilitating sharing best practices.

Here the matrix with the purchasing maturity versus business unity homogeneity.

This is my last post about global sourcing, and the last part of my chapter in my thesis about global sourcing.

 

Sources:

– Rozemeijer, “How to manage corporate purchasing synergy in the decentralised company? Toward design rules for managing and organising purchasing synergy in decentralised companies”. (European journal of purchasing and supply chain management, 2000)

– Essig, “Cooperative sourcing: strategies and tactics of consortium purchaising.” (Working paper, proceedings of the fourth IFPMM summer school, Salzburg, 1998)

– Faes, Matthijssens, “Managing purchasing coordination: how to built an effective intracompany relationship.” (Proceedings of the 7th IPSERA conference, London, 1998 )

 

Riccardo Simeoni

Global sourcing 5: Global sourcing configuration.

In the global sourcing, the organizational problems are dominated by the question of the degree of centralization. The pendulum of centralization swings periodically towards the option full centralization or full decentralization. In terms of global sourcing, centralization, decentralization, is the variation of purchasing elements (departments, procurement processes, responsibilities) within the global sourcing system. If there is not accumulation of elements the degree of centralization is low.

Decentralization can be a chance and in the same time a risk. It is a risk because the purchasing departments of business units might be too small to purchase globally and in an efficient way. Strategic orientation of all procurement activities may be neglected. On the other hand, decentralization is a chance because it makes it easier to cross borders and to establish business units with procurement functions in foreign countries.

Here the arguments in favour to centralization and decentralization.

A model for analyzing companies depending on their degree of internationalization and their degree of centralization, in general and in purchasing, is explained here. With this analysis we can indentify three types of global sourcing organisation.

To understand the structure of an organization and the degree of internationalization and centralization, the analytical model adopts four dimensions. First, internationalization itself is described by two dimensions: the general internationalization and the internationalization of procurement. Secondly, these two levels (whole company and purchasing function) are examined concerning their degree of centralization. As a result, four types of organization can be identified each in the internationalization and in the centralization matrix.

The ‘global player’ has international activities in all fields including purchasing (type A), whereas the ‘domestic player’ (type D) is not internationally orientated in any value chain activity. A mixture of a generally international company with a low global sourcing ratio is called ‘global sourcing deficit’ (type C). The ‘global sourcing focus’ (type B) combines low interest in general international activities with a high global sourcing ratio.

The centralization matrix combines the degree of centralization in the general organization with the degree of centralization in the purchasing organization. In the ‘hierarchical structure’ (type 1) these two degrees are high, in the ‘atomized structure’ (type 4) both degrees are low. A highly decentralized company with a centralized purchasing function is called ‘hierarchical purchasing structure’ (type 2), whereas the ‘atomized purchasing structure’ (type 3) combines a centralized general organization with a decentralized supply management.

The second step of the global sourcing analysis combines the results of the internationalization matrix with the results of the centralization matrix in a two-dimensional typology.

With this model we can classify a company in one of three ideal types for the global sourcing organization:

• The central purchasing model is useful for organizations with generally low international/global sourcing activities and a high degree of centralization. In this situation a regionally decentralized purchasing structure does not make sense. A central purchasing function within the company is responsible for global sourcing to realize economies of scale. Centralized purchasing helps to realize economies of scale by bundling demand and economies of scope by establishing a central purchasing process.
• The coordination model also makes use of economies of scale. This other model for centralization refers to the idea of cooperation among the regions/business units. A central committee is responsible for all major purchasing decisions especially global sourcing. Every regional purchasing department sends a representative to the committee. This participation generates a strong coordination without too strong hierarchy. The coordination model is appropriate for centralized internationally active companies. It combines the advantages of independent regional business units with best market know how and the advantages of demand bundling in purchasing.
• The outsourcing model makes sense in a highly decentralized but very internationally oriented company. Its main idea is to enable the autonomous and decentralized business units and their purchasing functions to source globally. Therefore, a kind of outsourcing of their procurement function for international duties is established. Outsourcing in this case means to give a purchasing mandate for a specific foreign supply market to the business unit located there or to establish an international trading organization which acts separately in its market fields.

The global sourcing organization model explained above is not just an instrument for analyzing. It refers also to concrete recommendations about the optimal structure for the global sourcing strategy. The three organization models for global sourcing give suggestions for different types of organizations to meet the structure and the orientation strategy that a company want develop.

 

Sources:

-Arnold “Organization of global sourcing: ways towards an optimal degree of centralization”, (Purchasing and supply management, 1999)

 

Riccardo Simeoni