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Article
Total Cost in Sourcing Decisions:
The Road Less Traveled By

Total cost analysis methodology and tools can help remove some of the guesswork for sourcing decisions. They provide a financial analysis, rather than using gut-feel or opinions, to consider the total impact of different sourcing alternatives and their outcomes.


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Several years ago I was talking to a supply chain manager about supply and manufacturing locations.  He told me that it sure looked like “all roads lead to China”. Since then, selecting China has gone from being a risky decision to being almost a reflex choice in sourcing decisions. Certainly China is appealing, not just for its low labor cost, but also for its increasingly sophisticated expertise in manufacturing and related infrastructure (transportation, IT, vendor compliance, etc.)  However, smart companies
use a total cost approach to sourcing decisions,
leading some to realize that not all roads lead to China. On the other side of the relationship, manufacturers and suppliers who have a labor cost disadvantage will need to leverage other total cost advantages (shorter lead times, agility, lower transportation costs, lower or no duties and tariffs, lower buffer inventory requirements, etc.) in order to maintain and grow their business.

Total cost analysis methodology and tools can help remove some of the guesswork for sourcing decisions. They provide a financial analysis, rather than using gut-feel or opinions, to consider the total impact of different sourcing alternatives and their outcomes.

Recent Evolution

Total cost sourcing as a concept has been around a while, but it has evolved a lot in recent years, and its adoption is still not nearly as widespread as it should be. Early versions of total cost analysis simply added transportation costs to the material costs. Then, with globalization came the importance of total landed cost calculation, which included tariffs and duties as well.

Moreover, dramatically different lead times between domestic and off-shore sources have made consideration of such things as transit times and the resulting extra safety stocks required. These other factors become critical in making sourcing decisions, as they can impact a company’s agility—the speed and reliability of product introductions, ability to ramp up and down with demand fluctuations, and the amount of markdowns and write-offs when it is time to retire the product.

The emerging best practice is the ability to consider the full spectrum of impacts on a firm when making sourcing decisions, as illustrated in the following chart. Ideally, you should quantify the total financial impact of all of these factors for each competing choice.

----------------------------- Figure 1 — Total Cost Sourcing Analysis - Source ChainLink Research


Off-the-Shelf Versus Homegrown Tools

Tools from vendors have gotten increasingly sophisticated, although none covers the full spectrum described in Figure 1. Total landed cost analysis tools typically include the material costs; duties, tariffs, and customs fees; transportation and insurance; and possibly other items. These tools usually have a means to update their own database any time that tariffs or trade rules change (for example, denied party lists). Alerts may be sent to sourcing personnel, because these changes may affect sourcing decisions that already have been made.

Some vendors have offered tools, including analysis of the impact of lead times on safety stock inventory as well as quality costs. Vivecon has tools that quantify the cost of demand-supply matching risks (the ability of the supplier to meet upside and downside demand, and the costs of shortages and excess inventory). Companies, like Dell, who wanted to do advanced total cost beyond these kinds of things, have created their own total cost modeling tools internally, generally with Microsoft Excel. The fact that quite a few companies still create their own total cost analysis tools highlights the relative lack of completeness of available off-the-shelf solutions. However, the evolution of commercial total cost calculators has been toward increasingly broader, deeper, and more sophisticated solutions, so it is definitely worth investigating these commercial solutions before jumping in to build your own.

Sample Applications of Total Source Costing

Total landed cost calculators can be useful, for example, in duty engineering, which is playing “what if” for various sourcing scenarios to explore the impact on duties and tariffs. For example, if a high duty is imposed on imported sheet steel, and no duty on imported enclosures, you may decide to fabricate metal enclosures offshore.

This ability to do “what if” analysis and compare relative total costs of different scenarios can be very useful when considering the impact of actual product requirements specifications and design thinking. The following example from Dell illustrates this. Dell has always been very focused on driving to ever lower manufacturing assembly costs. But, in some cases, it made supply chain cost higher. In one case, the manufacturing engineer specified a design with the power supply already assembled in the chassis, because it shaved 90 seconds off the assembly time. Manufacturing labor was cheaper, but it created a “reverse postponement” situation that forced decisions on SKU mix 60 days in advance of the actual orders.

This meant that the cost of the 90-second savings in assembly labor was a much larger pool of inventory than was needed to meet the required service levels, and total cost actually went up. The design engineers agreed on a single power supply for all models, so they were able to get the best of both worlds—faster assembly and pooling of inventory.

Dell developed a total cost modeling tool to analyze these kinds of tradeoffs. One of their corporate customers wanted a custom configuration with the USB plug in the back instead of the standard configuration in the front—a legitimate request from a very large customer. This required two variations of the chassis, which meant losing the pooling of inventory. A total cost analysis revealed that the increase in total cost was very high, so Dell rejected the request.

Ingersoll-Rand uses a form of total cost analysis that they refer to as total acquisition cost. Basically it is total landed cost, which includes things like materials, transportations, tariffs and duties, taxes, insurance, and so on, and then adds on the impact of lead times on safety stock and the impact of Incoterms[1] on cash flow. Ingersoll-Rand found that the nonmaterial costs ranged from 13 percent to 24 percent of the price of the imported materials, but could range as high as 200 percent in cases where anti-dumping or other special fees were involved. These tools enabled Ingersoll-Rand to “engineer” their supply chains (taking into account duties and tariffs, etc.) and make sourcing decisions to achieve the lowest total cost.

Total Source Costing is a Silo-buster

The practice of true total cost sourcing forces a company to break down its functional silos. Creating and using a total cost model requires active participation from many functions across the whole firm (logistics, engineering, manufacturing, service and support, and so on), as well as from partners outside the company, such as 3PLs, service and repair partners, contract manufacturers, and channel partners. Because of this, taking a true total cost approach needs to be championed and supported by someone with clout across the whole firm, typically at the COO or CEO level. These projects have a higher likelihood of success in firms that already have a culture of breaking down silos and integrating or continuing ongoing dialog across the functional groups.

Total Cost, Corporate Strategy, and Competitiveness

For many, widely different retailers (Zara and Wal-Mart come to mind), their supply chain is an integral part of their overall strategy. In these cases, sourcing decision are interwoven with corporate strategy and, ultimately, competitiveness. It is why a company like Zara sources from regional suppliers as a key part of its overall strategy to offer unique, rapidly changing fashion items, while limiting excess inventory and markdowns. It is why more than 10% of the world’s pharmaceuticals are manufactured in Puerto Rico, even though it has relatively high labor cost.   It is why some manufacturers still survive and thrive in the U.S., in spite of some of the highest labor costs in the world. Ultimately, total cost is why some companies take the road less traveled in their sourcing decisions!


Parts of this article are excerpted from a report “Next Generation Best Practices in Managing Suppliers—Part 1: The Outcome Economy”, available on ChainLink’s website.

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[1] International Commercial Terms – a standard for expressing terms between international buyers and sellers. Defined by the International Chamber of Commerce http://www.iccwbo.org/index_incoterms.asp

 




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