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The Case Against Global Sourcing

Author(s):

Michael Harding, C.P.M., CPIM
Michael Harding, C.P.M., CPIM, Harding & Associates, Bristol, VT 05443, 802/453-5379.

80th Annual International Conference Proceedings - 1995 - Anaheim, California

Abstract: Buyers in many industries have for the past 30 years sought lower purchased prices of materials by sourcing with foreign suppliers. Few companies have fully assessed the actual cost of purchasing and using these foreign goods and comparing these costs with those of domestic producers. This a reexamination of the actual costs, not foreign source "bashing." The results may surprise you.

Since the late 1950s, U.S. companies have sought to lower manufacturing costs by locating plants in low labor cost regions of the world. One can follow the migration of the domestic textile industry. From early in the nineteenth century and Slater's Mill in Providence Rhode Island, New England was the home of the textile industry. Early in the twentieth century the mills moved to the South to reduce labor and transportation costs. During the 1950s the industry moved to Japan to capitalized on cheap Oriental labor. As years passed and Japanese labor cost increased, the textile mills took up residence in Taiwan and Korea. Today, a major textile center of the world resides in Shanghai, China - today's ultimate in cheap labor pool. As goes the textile (weaving) industry, so goes the garment industry. For many consumers today, it is difficult to find clothing made in the U.S. Labels trace the chase for lower labor costs - China, the Philippines, India, and so on. Many, if not most, domestic industries have followed a similar route to the point that industrial buyers have little choice in sourcing many items needed to support their employers, manufacturing and distribution.

Of course, the oddity (if not folly) in all of this is there is an average of four minutes of labor content in the production of a typical garment (Source: The National Apparel Technology Center). In a 100 dollar sweater, the labor cost savings between a Chinese and American labor amounts to $1.70. But much of the industry is located in the Pacific Rim and will remain there until lower labor sources are discovered elsewhere. When come to trends in foreign sourcing, the tracks are in the snow: Textiles were followed by toys, low-end consumer electronics (telephones and tape players), electronic components manufacture, high-end consumer electronics (TVs, computers), and ultimately, automobiles. Stranger still is the fact that direct labor represents only two percent of the cost to manufacture TVs and three percent for computers.

The cost accountants have been telling purchasing departments that purchase prices must be reduced. Translated this has meant that the price on new purchase orders must be lower than the price on past purchase orders. Given the historical high cost of domestic labor, buyers have been and are encouraged to look to regions of the world with lower labor costs: "If only we can buy that widget for $1.50 instead of $2.25." Often the comparison is based on prices on purchase orders and measuring purchase price variances.

Such comparisons present a number of problems:
Prices on foreign purchase often fail to consider -

  • Transportation times and costs
  • Import duties
  • Customs house and brokerage fees
  • The risk of currency fluctuation
  • Reaction time to market and customer changes
  • The costs and problems associated with quality issues
  • Variation and yields in the buyers, processes
  • Communication and scheduling problems
  • Engineering changes
  • Flexibility (or the lack thereof)
  • Geopolitical instabilities

In fairness, many companies add on the costs of transport and import duties. Some add as much as 17 percent to the foreign quoted prices to equalize them against domestic quotations. But this is insufficient.

  1. Nearly all international sales are F.O.B. origin which means that the buyer pay for the goods at the shippers dock or at portside either through sight draft or letter of credit. From that moment, the goods are in the buyers raw material inventory. The cost of carrying such inventories has been understated for years. The actual cost is 75 percent per year or 1.5 percent per week. If the transit time to the buyer's production line is five weeks, add 7.5 percent to the quoted price. And since many buyers carry raw inventory to cover for shipping difficulties/uncertainties equal to at least one transit lead time, add an additional 7.5 percent.
  2. Those of us who have purchased goods over the past seven years have notices growing strength in the Yen - from 240 to 96 to the dollar. The purchasing power of the dollar has shrunk considerably. While the inflation rate in the U.S. has held in the three to four percent range, inflation in many other countries has skyrocketed. During 1993 the inflation rate in Brazil was one percent per day. Even China has been unable to control inflation which during 1994 ran at 12 percent and 20 percent in 1995 on average with many industrial goods far exceeding those numbers. And yet, China is now our second largest trading partner. During 1995 the inflation rate in Hong Kong was 13 percent, 17 percent in the Philippines, 10 percent in Thailand, and eight percent in South Korea. Some of the initial advantages of foreign sourcing are not eroding, they are caught in a landslide. Add in the cost of inflation (foreign minus U.S. inflation rates) to quoted prices - an estimate will do.
  3. Many NDCs (Newly developing Countries) offer government subsidies to local and multinational corporations to manufacture and export goods. These subsidies can include: tax incentives, raw material price supports, export incentives, and favorable currency exchange rates. Once the government's objectives have been attained whether it is balance of payments, market penetration, or technology transfers, the subsidies and incentive are often withdrawn.
  4. Many NDCs do not have a record of stable government or government policies. A friendly foreign trade policy can quickly become victim to a change in leadership, political self-interest, internal strife, etc. Many people wonder, for instance, at the fate of Hong Kong after its absorption into China on July 1, 1997. Will Hong Kong be allowed to operate in the world as it has in the past. The political undercurrents suggest significant transitional problems.
  5. Oops! There is a problem at the foreign factory - quality, schedules, raw material, labor - how will the buying firm resolve it? Telephone calls and faxes have their limitations. Shall we send someone? Station someone in the area? At what cost? Even though the expenses will be charged to a general overhead account, add a factor to the quoted price.
  6. A less subtle cost is the cost of technology and job transfer. When U.S. companies first went offshore to manufacture (and utilize low cost/skill labor), we provided the facilities and equipment. As the plants grew, we transferred the product and process technologies. These were absorbed by other local companies. This spawned competitors many of whom had a more favored position with the native government. Once native companies had the technology and began to improve and capitalize on it, they syndicated themselves along nationalistic lines.

    The September 25, 1991 issue of the Wall Street Journal reported that the General Accounting office confirmed that many Japanese suppliers withheld critical semiconductors from their U.S. customers and sold these components to Japanese competitors of the U.S. customers. The damage to the U.S. customers exceeded $2 billion. How much will you add to the quoted price to cover for this possibility?
  7. The U.S. balance of payments deficits effect all of us. We are the world's largest debtor nation. One of the results was well stated by Ken McGuire:"In the 1990s it is not the American worker who is at peril, it is the ownership of American companies."

    Industry Week magazine projects that the GDP of the continents will shift significantly in the next few years:

      1994 GDP 2000 GDP
    North America $7.255T $8.755T
    Asia $6.693T $9.076T
    Europe $7.165T $9.304T

    During 1993, U.S. imports exceeded exports by $142 billion.
  8. If foreign sourcing is such a deal why are companies like Sony, Panasonic, NEC, Nissan, Honda, Seimens, BMW, Phillips, Thompson, have set up manufacturing plants in the U.S. Could it be they are taking advantage of cheap American labor? Perhaps they know something we don't.
  9. Unfavorable news reports from some countries indicate that prison and Dichensonian labor conditions pervade in the manufacture of American label items. These reports have reflected poorly on the public image of some American customers. Public relations offices have performed "damage control" exercises to save the reputations of a number of clothing distributors and retailers.

Source Globally when:

  • The technology is not available domestically
  • The cost to use (installed value) offers you a competitive advantage
  • It is a condition of selling in foreign markets and the difference in installed value is off-set 10 fold
  • To purchase traded commodities (copper, mercury, bauxite, oil, etc.)
  • When you are directed by a customer or foreign owner

Do not Source Globally when:

  • You transfer proprietary technology
  • The advantage is measured in terms of price paid alone
  • Continued availability, stability or pricing are in question
  • Inducements and incentives are temporary
  • You require quick response times
  • Cooperative technology and process development is required

Protect Your Company's Interests
Work with finance to pull out the "hidden" import costs from overhead accounts and assign those costs as direct material costs.

Remain "Geopolitically Savvy." Be aware of the politics and customs of the nations from which you buy.

Assure that your company's core competency or technology is not being compromised.

REFERENCES
Harding, Michael and Mary Lu, Purchasing, New York: Barron's Educational Series, 1991, p. 205.


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