Enterprises with offshore spend growth that is outpacing decision-making capabilities are dangerously close to spiraling out of control. But companies that accurately identify total cost of ownership factors can ensure global sourcing success.
Global sourcing, distilled to its simplest terms, is the cross-border procurement of goods. That also sums up everything that is simple about global sourcing.
Rapidly expanding sourcing opportunities in current low-cost countries and developing low-cost countries entice firms that want to significantly reduce material costs. Cost of goods reductions becomes essential both to meet internal cost-cutting goals and to provide favorable cost economics for products. Cost reductions also help sales efforts to remain competitive — and profitable — both when growing existing markets and entering effectively into new ones.
However, companies pursuing offshore spend want to know what other offshore costs exist and want to know how to ensure cost-savings promised offshore materialize. Logistics and sourcing staff know that the answers, based on an enterprise's global sourcing management process, or lack thereof, determine success or failure in identifying, managing and executing changes required for global supply management success.
But it is becoming increasingly impossible for businesses to analyze the detailed total cost of ownership (TCO) factors for tens of millions of dollars of spend using manual techniques and obsolete data: Once materials spend crosses borders, so does the range of transportation and other costs. In global trade, these costs can range from 20 percent to 50 percent (up to 80 percent in some industries) of the costs of goods sold (COGS), easily erasing savings estimates based solely on lower material costs.
When sourcing overseas, transportation costs dramatically increase. The Other Costs category expands to include import duties, taxes, fees and payments for services to ease the regulatory burdens of crossing borders. In addition, because of longer transit times and supplier distances from destination plants, costs rise from the not worth the effort of tracking closely to the significant level, including carrying costs, quality costs, supply risk and safety stock.
Firms that want to move through the global sourcing maturation process must make at least two critical decisions. First, how to create realistic objectives to accomplish cost-saving mandates; second, where to get the tools to deliver on these objectives.
The Stages of Global Sourcing Maturation
The following are common plateaus that most companies progress through on the path of global sourcing consciousness and best practices:
* Stage 1: Just Getting Started in Global Sourcing (75 percent+ of Fortune 500 firms in 2003)
Firms at this level are just starting to dabble in global sourcing. Their primary concern is usually on-schedule delivery of goods from overseas suppliers. They are primarily looking to sources in China. They are in transition from using sales agents to direct procurement activities overseas. At this point, they still buy goods on a delivery duty paid (DDP) basis (i.e. having the goods delivered to their plant by the supplier). The anticipated savings expectations here range from 10 to 20 percent.
* Stage 2: Expanding Global Sourcing Efforts (15 percent of Fortune 500 firms in 2003)
As firms expand their global sourcing efforts, they start looking to other current low-cost countries such as China, Latin America and Eastern Europe. At this stage, firms start sourcing larger quantities of product overseas. Some understanding of hidden costs is developing, and alternative Incoterms are being explored. Incoterms are the roles and responsibilities associated with any given cross-border transactions; each Incoterm defines a different set of costs and liabilities for the buyer and seller. There are 13 standard Incoterms, ranging from free on board (FOB) to DDP. Companies at this level may also have a few analysts (logistics and/or finance based) begin looking at some of the cost factors for areas of greatest spend. The anticipated savings by this group is in the 10 to 15 percent range.
* Stage 3: Moving from PPV- to TCO-based Metrics (7 percent of Fortune 500 firms in 2003)
Growing sophistication in global sourcing sees firms moving their focus, and compensation plans, from purchase price variance (PPV) to TCO. Firms at this level are aggressively seeking global sources for a large range of commodities and exploring emerging sources beyond hot low-cost countries. Having reaped the low-hanging fruit of offshore supply sources, firms are now looking for the next 10 percent of savings they can realize through true supply network and TCO optimization. At this point, elaborate spreadsheets are breaking under the weight of these increased expectations.
* Stage 4: Evolving to a Tax Efficient Supply Chain (Less than 3 percent of Fortune 500 firms in 2003)
Firms at this level are seeking to expand their global sourcing expertise to accurately model their entire supply chain costs. Executive management is driving the design of a tax efficient supply chain to use as a competitive advantage in their industry. Companies at this stage are designing world products to support a "source anywhere/build anywhere" strategy. Internal processes depend on a team of mathematicians and information technology (IT) Top Guns that are either seeking or building TCO-based supply chain optimization platforms.
The Many Facets of Global Sourcing
Like most factors in the current global market, low-cost country sources constantly evolve. China, currently the low-cost country favorite for many items, is rapidly increasing its ability to produce higher-quality goods. As the suppliers find local markets for these higher-end goods, they will be less willing to focus on low-revenue goods and dedicate their resources to higher-profit, higher-quality products. To do this, China will need to attract or train more expensive labor and invest in more sophisticated equipment, raising their cost structure accordingly. This will provide an opportunity for a new low-cost supplier to emerge, say in Indonesia or Kazakhstan or Kenya.
In terms of power, nations have always wielded trade as a political instrument. Now more than ever, global trade is emerging as a potent political weapon. Nations that control global trade or use it to their advantage will gain power. Countries have developed mechanisms to rapidly reward allies with lower duties. Conversely, they punish non-allies with increased tariffs or other trade barriers. In the more extreme cases, countries have adroitly positioned their cases so effectively with the World Trade Organization (WTO) as to gain WTO approval of retaliatory tariffs. A recent example of this phenomenon occurred with the European Union's (EU's) successful request to assess retaliatory tariffs against the United States to balance what was perceived to be an unfair advantage in the U.S. Foreign Sales Corp. (FSC) export subsidy. These geo-political cases can happen very quickly. Nations and trade oversight organizations streamline mechanisms for implementing retaliatory tariffs, as illustrated by the ease of implementation, and then rescinding, of the U.S. Steel tariffs last year.
Globalization — defined by the World Bank as the increasing worldwide integration of markets for goods, services and capital — attracted special attention in the late 1990s. Firms developing world products that can be built and sold anywhere demonstrate this accelerated global integration. The subsequent demand volatility of supplying global markets from a continuously evolving supply base creates unforeseen stresses on still maturing global supply chains. This volatility undermines the ability of supply chain professionals to depend on traditional cost models to handle their constantly evolving material flows, simply because so many new, often unknown, factors come into play.
Bid analysis, another key component of global sourcing, requires significant sophistication when evaluating cross-border supply sources. The cost determination intricacy expands exponentially when a global sourcing equation includes Incoterms. For example, while FOB may be commonly accepted for domestic transactions, international transactions have a more technical interpretation of FOB as the seller delivers when the goods pass the ship's rail at the named port of shipment, so FOB must include a named port of shipment: i.e. FOB Busan, Korea.
Limits of In-house Global Sourcing Toolsets
Companies today move millions of dollars offshore to reduce their material spend. Many then further negotiate with new suppliers for weeks and months to squeeze another couple of percentage points off their price. They then unconsciously let 5 to10 percent of their materials spend slip away by not paying attention to their other cross-border supply chain costs. As companies expand their global sourcing efforts they tend to over-simplify the complexities of a dynamic global supply chain, attempting to fit everything into a spreadsheet. Too often a decision is made to use average cost factors based on an assumption that the cross-border aspects of global supply chains are too extensive to properly track.
Supply chain executives base this erroneous assumption on conflicting feedback regarding the impossible complexities inherent in accurately modeling global supply costs. Defaulting to a common practice, companies attempt to use in-house resources, such as logistics staff already cut to the bone and buried in fire-fighting exercises, or they rely on third-party logistics (3PL) resources, which have the primary objective of expediting shipment traffic, not minimizing import duty and tax exposure, to populate local spreadsheets. This default process only magnifies the inherent inadequacy of in-house tools to handle critical cost drivers of a global supply chain, which include: Rapid rate of change; extensive use of exceptions and situational rules; subjective interpretation of foreign import regulations; and the application of non-linear tariff formulas.
Unfortunately, firms often identify that the 10 to 30 percent projected savings anticipated from moving spend to a low-cost country (LCC) source is not showing up on the bottom line.
Usually in a company's next step, a project team forms to explore where the savings went. Starting with finance, but quickly expanding to include a supply chain and procurement specialist, the team's research focuses on the spreadsheets used by various groups attempting to model each person's specific areas of responsibility. The logistics representative works on the transportation rates, the procurement representative on the supplier invoices, and finance on payment records.
After surveying the available information, the domain specialists start to uncover the real factors that limit their ability to accurately model, or even understand, all the costs associated with moving goods from low-cost country suppliers to their plants.
For example, if logistics can get the correct transportation rates, and if the supply chain group can get the duty and import fees, and if procurement can get the Incoterm information, and if finance can supply the new supplier costs and if this data gets integrated correctly into a spreadsheet, then it is possible to make some initial calculations.
But what if an organization wants to enrich this process and run What if? scenarios to identify the best possible cost options based on current capacity and demand constraints. Even for a simple study involving two suppliers, four parts, one plant and two to three variables for transportation and other costs, requires over 50,000 calculations to reach an optimal cost estimate.
Today, as this problem grows too large to ignore, efforts to remain competitive force firms to optimize their global sourcing planning and execution. Companies understand that they cannot expand dependency on offshore suppliers without accurate assessment of total costs. They also recognize that to ignore global sourcing allows competitors a 5 to 10 percent cost advantage.
World merchandise trade ended 2003 4.5 percent above the 2002 mark, and global GDP rose by 2.5 percent. The WTO is predicting even faster growth in 2004, forecasting that world trade will shoot up by 7.5 percent and world GDP will rise 3.7 percent. (Source: World Trade Organization.)
Creating a global sourcing process with an emphasis on evaluating all costs (i.e. TCO) is a task that can be accomplished with relative ease and immediacy.
Ingersoll-Rand is one of many leading manufacturers that sought to cut costs by sourcing materials overseas. When the company began using a TCO methodology to look closely at its offshore sourcing patterns, the company discovered that making the shift to a low-cost country source wasn't as financially promising as first glance would suggest.
In some cases Ingersoll-Rand found that parts were actually more expensive to source overseas; one particular part actually increased costs 200 percent. Ingersoll Rand also learned that it was not uncommon for up to 25 percent of the total cost of a commodity purchased internationally to be duties, taxes, freight and other related fees.
In analyzing its total cost of ownership, the company determined that utilizing regional suppliers on a global basis could gain greater savings in their overseas sourcing patterns. Adopting this strategy with one part family alone yielded savings of 26 percent.
Another Fortune 500 industrial company based in the Midwest found that it could dramatically reduce its TCO by shifting overseas supplier locations. Using the same supplier to minimize the start-up costs associated with a new supplier, and taking delivery from the supplier's manufacturing location in another country, the company enjoyed import duty and tax advantages that drove material costs down by 38 percent.
By taking the time to understand where your company is in terms of global sourcing and best practices, and then by charting where you'd like to be, particularly by moving to a TCO-based sourcing process, your company will have the opportunity to ensure global sourcing success.
About the Author: Frank Cirimele is an expert on global trade and the practical interpretations of global customs regulations for business application. He actively represents the U.S. on the United Nations International Trade Procedures working Group (UN/CEFACT ITPWG), which addresses Trade Facilitation, and e-business issues around the world. In addition, the U.S. Department of Commerce, International Trade Administration selected Frank to join the FTAA Committee on Electronic Commerce as a private sector expert.
At XPORTA, Frank is vice president of Global Supply Strategy and the architect of the methodology to collect, standardize and automate cross-border trade regulations, tariffs and rules to power the XPORTA Global Sourcing Solution.
For more information about global supply chains, please see the August/September 2004 issue of Supply & Demand Chain Executive magazine.