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Don't Get Boxed into Making the Wrong In-Shoring Decision

July 18, 2016
The overall goal of business—generating revenue and profit—cannot be achieved exclusively through a focus on cost control.

Original equipment manufacturer (OEM) sourcing decisions are typically based on Total Acquisition Cost (TAC) formula comparisons. Because of this, such tools play a primary role in decisions about whether to purchase from domestic or overseas sources. TAC formulas attempt to take into account all cost factors related to buying from a particular source.

There is no standard industry TAC tool. Instead, OEMs tend to create and use their own in-house, home-brewed TAC formulas and because of this there are a myriad of variations. Some are fairly straight forward, focusing on basic elements typically associated with supply chain costs such as piece price, transportation, packaging, tariffs, etc. Others can reach staggering levels of complexity, including lesser-used cost elements such as currency exchange rate variation risk, bondage (which ensures payment to suppliers), extended ownership exposure (FOB for overseas suppliers is often at the exporting port), etc.

Most arguments that I’ve seen advocating in-shoring are based on the proposition that if a complete job is done identifying and quantifying TAC formula supply chain cost elements, these tools will show that the competitive advantage of foreign sources is dramatically overstated. At first glance this seems like a good approach. After all, using a TAC formula-based argument communicates in a language that OEM purchasing personnel should understand. Unfortunately, experience shows that this approach is marginally effective for two primary reasons:

• First, decisions to re-source material currently purchased from overseas to domestic sources are not usually based on re-computed TAC values. Rather, they are in response to ongoing performance problems with the foreign supplier in question.

• Second, the fact is that low piece-price country sources do enjoy certain cost element advantages. Consequently, even when a comprehensive OEM-like TAC formula is used as the basis for justifying in-shoring, the cost advantage of the domestic source—if there is one—tends to be minimal. This is a problem since re-sourcing from incumbent to new sources can involve significant expense and effort, which most OEMs won’t take-on unless there is a strong business case-based imperative, i.e., significant TAC advantage.

I believe that the box re-shoring advocates fall into is the same one that relegates many OEM purchasing functions to secondary, tactical roles. Specifically, such procurement functions focus almost exclusively on cost control, primarily through piece-price reduction. You might ask, “How can this be a bad strategy?” The answer is found in acknowledging that the overall goal of business—generating revenue and profit—cannot be achieved exclusively through a focus on cost control. Sure, managing piece-price and cost are two factors that impact profitability, but they do not represent the whole story.

In addition, TAC formulas (at least the ones I’m familiar with) don’t even take into account all consequential supply chain-related cost elements. So, even if cost was the whole story, most TAC formulas are inaccurate calculators of Total Acquisition Cost. Finally, I’ve yet to see a TAC formula account for revenue and profit generation factors tied to specific sources.

First let me try to give you a flavor for those cost elements that are missing from current TAC formulas. There are many but for the purposes of this column I’ll focus on ones related to order fulfillment. You may be surprised to hear that sourcing decisions impact costs involved in the filling of customer orders. Let me explain.

Most large OEMs have an executive level performance exhibit called (something along the lines of) Customer Order Fill-Rate. This metric measures a company’s ability to satisfy market demand, i.e., being able to provide a product to a customer when that customer wants to buy. Not having a high Customer Order Fill-Rate means lost sales, revenues and profits. The closer a company is build-to-demand capable, the less it relies on levels of raw, WIP and pre-built finished goods inventory to support high Customer Order Fill-Rates. On the other hand, the longer an OEM’s order fulfillment lead-time, the more that inventories are needed in support of them.

For most OEMs the longest part of their order fulfillment lead-time is made up of supplier Manufacturing Critical-path Times (MCTs), i.e. “true” supplier lead-times. Longer supplier MCTs, then, drive OEM need for higher levels of OEM raw, WIP and pre-built finished goods inventory, i.e., cost!

The existence of this inventory translates to cost in many ways, with the most obvious—investment carrying charges—playing only a minor role. For instance, unneeded raw and WIP inventory can become obsolete, reducing its value to that of scrap. Similarly, it is not unusual for OEMs to have to offer significant discounts on excess finished goods inventory in order to “move it,” which not only reduces overall “current year” product line profitability but can negatively affect future year sales.

Among the dozens of OEM TAC formulas I have reviewed over the years I have only seen one that tries to account for supplier MCTs in their TAC menu of cost elements. Since MCTs of overseas sources are almost always significantly longer than MCTs of lean domestic suppliers, not including them in in-aourcing justification disregards a significant cost advantage that domestic suppliers give their OEM customers.

Another domestic supplier cost advantage similar to the one outlined above is realized when OEMs over-forecast demand. This is because forecasts drive the creation of orders to suppliers. Most overseas suppliers require extended firm order commitment periods above and beyond those given to domestic suppliers. Consequently, when over-forecasts occur, OEMs are required by contract to honor longer periods of schedule commitment to their overseas suppliers, and this translates to having excess raw material. I’ve never seen this accounted for in any of the OEM TAC formulas I’ve reviewed over the years. If your company routinely over-estimates your product demand (either overall and/or SKU-specific), the above costs need to be considered to ensure the validity of sourcing decisions.

The impact of supplier order fulfillment capability, however, is even greater related on revenue. When forecasts underestimate customer demand, OEMs want to increase production output in order to support increased sales. Guess which metric is the most accurate indicator of a supplier’s ability to support unanticipated demand? It is their MCT. So the significantly longer MCTs of overseas suppliers also compromise an OEM’s ability to sell additional realized increased revenue and profit.

Does having the ability to ramp up production contribute significantly to an OEM’s bottom line? In a word, YES! Let me explain.

Accountants calculate product Cost-of-Goods-Sold based on the forecasted demand. This means that all overhead costs are allotted to the quantity forecast. Consequently, sales above this forecast level—incremental sales—don’t have overheads allocated to them. This means that incremental sales generate significantly higher unit profit than the ones that were forecasted.

I once heard a chief financial officer describe supporting incremental sales as the closest thing that a company can do to printing their own currency. He was right. And having suppliers capable of supporting short-fuse production ramp-ups is usually the key to achieving them.

We see the lack of ability to support incremental sales just about every Christmas season when popular toys are often sold-out by Thanksgiving. Since most toys are sourced to overseas low piece-price companies overseas, companies are unable to—as described above—bring more than was in their original forecast to the market. Those sales are lost forever, as the demand usually dries up right after Christmas Day. How much more profit could companies generate if they sourced toys with upside potential to more order fulfillment capable supply chains? Lots. But again, I’ve only seen one company over the years take supplier MCT into account in their MCT, and that was in a very general way.

The case for re-shoring is real but fighting that battle from within the OEM TAC formula box is a lot like being in a fist fight with one-hand tied behind your back. What I’d really like to see is an industry standard TAC formula created by a panel of experienced manufacturers and academics. The result of such an effort would go a long ways towards presenting a complete set of sourcing cost elements to sourcing decision makers and ensuring that those revenue/profitability factors related to supplier capability/location are taken into account.

My next article will detail two online auction case studies.

Industry Week has recently combined several of my earlier articles into what we’ve called a Next Generation Supply Management Guidebook. If you’ve only started reading my articles over the last year-and-a-half, this Guidebook has a lot of good content you’ll have missed out on. The Guidebook would be a great way to catch up on that content. On the other hand, if you’ve read the column from the beginning (April 2014) and would like to introduce it to others, the Guidebook represents a vehicle for doing so. It is available free-of-charge.

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