Counting the costs of global sourcing

LinkedIn +

The world’s economy has been growing steadily for at least fifty years. Figures from the World Trade Organisation show that since 1950, the world’s GDP has increased more than sevenfold. At first sight this figure might seem substantial; however, it is modest when compared to the 25-fold increase in global exports of merchandise and the 50-fold increase in global exports of manufactured products during the same period.

There is no doubt that these trends will continue – at least for a while. However, there is an increasing concern that the total impact of global sourcing may not always be positive. Cranfield’s Centre for Logistics and Supply Chain Management has recently produced a report for the UK Department for Transport which suggests that the true cost of global sourcing may be significant – not just for the company but for the environment and society.

The true costs
This research revealed that whilst the main motivation for offshore sourcing was the need to reduce costs, it was often the case that the true costs of those decisions were not always fully recognised.

Interviews with managers indicated that typically most companies take a very narrow view of cost. The main focus seems to be on the actual purchase cost or manufacturing costs plus transport and customs duties. Often the INCO terms that are applied to the transactions will further disguise the component cost elements. Rarely, for example, will these sourcing decisions take account of the additional inventory financing cost, the cost of lost sales and/or obsolescence as a result of longer lead-time or the risks of supply chain disruption.

The importance of managing risk across the business is now widely recognised and in many cases is a legal requirement. However, our research suggests that when decisions to move manufacturing and/or sourcing offshore have been made, the impact of those decisions on the supply chain risk profile may not always have been factored into the equation.

There are a number of ways that global sourcing decisions can impact supply chain risk.

Firstly, longer lead-times are inevitable when moving from domestic to offshore sourcing. According to research conducted by Accenture indications are that for a typical business the end-to-end lead-time might actually double. This is not just because of longer transit times but also because there is an increased likelihood of delay at both ends of the pipeline due to the need for freight consolidation, customs clearance, port congestion, etc.

Clearly those longer lead-times are reflected in the additional inventory now required – every day of lead-time requires at least a day of inventory to cover that lead-time. Furthermore, the likelihood is that as well as lead-times being longer they may also be more variable. This implies more safety stock to buffer that variability. As a result the working capital requirement of the business increases and thus the financing costs.

A further source of risk is that as markets become more turbulent and product life-cycles continue to shorten, the chance of obsolescence increases. Mark-downs and even write-offs are more likely when demand volatility and longer lead-times coincide.

It is interesting to note that Asda, the UK supermarket business owned by Wal-Mart, has recently announced that it is switching some of its sourcing for its successful ‘George’ range of clothing back to the UK. This reflects the need in markets where demand is volatile – and clothing is a case in point – the need is for agility and responsiveness to enable supply and demand to be matched more accurately.

Managing critical stages
Additional risks that attach to the global sourcing decision are the problems of managing critical stages in a supply chain that may be many thousands of miles away. With local sourcing or manufacturing if a problem arises with a supplier in a factory it can often be resolved with a visit the same day – obviously this is not possible when that problem arises on the other side of the globe. There may also be the risk of the loss of Intellectual Property (IP), quality management issues, and a lack of visibility.

Often, too, there is the risk of cost over-runs and the consequent erosion of margins when global sourcing is involved. A study by the Aberdeen Group highlighted the most frequent sources of variances from budgeted costs as being transportation, raw materials costs and additional supplier charges.

Finally, of course, there are the wider geo-political risks associated with off-shore sourcing. Whilst these can be monitored and, to a certain extent, mitigated through contingency planning it is still a source of further uncertainty and cost.

Because these multiple sources of risks can be critical to business continuity, it is important that they be reflected in the calculation of the true cost of global sourcing. In effect, the requirement is to assess the ‘Risk Adjusted Total Cost of Ownership’.

There has been considerable concern for some time amongst many academics, businesses and government and non-governmental organisations about the so-called ‘carbon footprint’ of supply chains. However, it is only recently that the debate over the environmental impact of extended supply chains has really taken off.

Carbon accountability
There is now a growing realisation that in the not-too-distant future, organisations and even individuals will probably have to pay for the carbon impact of their activities. For the business sector, this penalty may take the form of taxes, levies or the capping of allowable emissions under carbon trading regimes. Potentially, these additional costs may bring the commercial viability of their operations into question. Hence the argument is starting to be heard that companies should review their current carbon footprint and identify strategies for its reduction.

For any organisation, it is not just the carbon impact of its in-house activities that needs to be understood, but rather the total carbon effect of its wider supply chain. With the current trend to off-shore sourcing continuing apace, the implications for total carbon impact are significant. To understand the true carbon footprint of a supply chain for any product requires the ability to conduct a ‘Through Life’ analysis of the emissions generated from cradle to grave: what is the total environmental cost from raw material sourcing through manufacturing and distribution to consumption and disposal? This new focus on carbon has served to bring the supply chain into greater prominence – in particular, the decisions that organisations are taking regarding manufacturing and sourcing locations. The significant trend to low-cost country sourcing over the last 10 years or so has transformed the shape of many supply chains, particularly through the creation of longer and more transport-intensive pipelines.

Because transport represents such a large proportion of total worldwide greenhouse gas emissions – about 20 per cent and growing – it is inevitable that supply chains will be under increasing scrutiny in the future. Put very simply, the search is on for ways to make supply chains less transport intensive.

The global sourcing model developed as part of the Cranfield research has been designed to help practitioners make better sourcing decisions by allowing them to estimate the impact of different sourcing decisions and compare the differences between local and global sourcing options. The model looks at four main elements of the sourcing decision:

  • Costs: the model helps the user to capture the key costs of sourcing decisions. It includes both costs that are clearly visible, such as the cost of manufacturing and international shipping, and the hidden costs such as interstate and cross border taxes, quota costs and inventory holding costs (including financing and opportunity costs).
  • Time: the model estimates the total time for both local and global sourcing. This provides a measure of agility to respond to sudden changes in the market.
  • Risks: The model enables the capturing of the different types of risks that affect the sourcing decision and assessing their impact and probability of occurrence. This provides the user with a profile of the risks involved and their priorities.
  • Environment: As we have seen, global sourcing can have substantial environmental implications. The model focuses on the impact on one key environmental indicator which is the emission of carbon dioxide into the environment. The model assists the user by estimating the impact of sourcing decisions on CO2 emissions.

The model has been developed based on research in different industries and it can be adapted to different circumstances and industrial contexts. It is not meant to replicate all of the complexities of a specific situation but to compare and contrast the most important variables of the sourcing decision, thus providing a strategic perspective.

Our research has highlighted the fact that few companies understand or seek to measure the true costs of global sourcing. One reason for this, it would appear, is that because of internal organisational ‘silos’, rarely are all the costs transparent and available to decision makers. Hence the lack of ‘joined-up thinking’ that seemed to emerge as we interviewed managers for the research project.

It is clear that there are many situations where global sourcing does make good sense but equally there are occasions when it does not. The challenge is to put in place appropriate decision -making procedures which are supported by detailed assessments of true cost and the impact on the supply chain risk profile.

To make this happen we suggest that there are a number of priorities for action:

  1. The underlying sourcing philosophy should move from ‘opportunistic’ to ‘strategic’. In other words, rather than viewing sourcing decisions purely in cost terms, the impact of those decisions on the company’s ability to compete in volatile markets should be paramount. Perhaps the exemplar here is the Spanish retailer Zara who will source standard, more predictable products from low cost locations, but where lines are more fashion-oriented and available for sale for only a limited period they will source or manufacture them much nearer to their markets.
  2. Because off-shore sourcing decisions can have a big impact on the risk profile of the business as well as involving a total cost of ownership that goes well beyond the purchase price, it follows that these decisions need to be well-informed. We would advocate the use of tools such as the Cranfield cost model as described above. The very process of gathering the data necessary to calculate the risk-adjusted total cost of ownership is in itself an enlightening experience.
  3. To make existing global sourcing arrangements more cost-effective a greater emphasis needs to be placed on reducing the transport-intensity of the supply chain. Often the true transport costs may be obscured by the INCO terms that are used in the transaction. Equally, if the transport arrangements are the suppliers’ responsibility, then when multiple vendors are involved there will be a wasted opportunity for consolidation. The customer needs to be in control of in-bound logistics if the transport-intensity is to be reduced. Again, the opportunities for ‘postponement’ should be explored. If standard or semi-finished products can be shipped in bulk for localisation at a later stage, then significant opportunities for transport cost reduction, coupled with less inventory, can be achieved.
  4. Increasingly, as the carbon-related costs of supply chains start to be a charge against those who incur them, there will be a need to recognise what some have called the ‘Triple Bottom-Line’. In other words as well as understanding the real economic impact of global sourcing on the company’s profits, the environmental and social effect of those decisions will need to be factored into the decision-making process. These are early days in terms of our understanding of supply chain footprints, but the likelihood is that in the future this factor as much as anything will determine global sourcing decisions.

This research revealed that whilst the main motivation for offshore sourcing was the need to reduce costs, it was often the case that the true costs of those decisions were not always fully recognised.

Prof. Martin Christopher, Omera Khan, Carlos Mena and Andrew Palmer are with the Centre for Logistics and Supply Chain Management, Cranfield University


Share this story: