Tuesday, November 24, 2009

Off-sourcing: Is it For You?

Off-sourcing in itself is not a new phenomenon. It is estimated that more than 3/4 of American corporations are engaged in international sourcing. However, the changes in the last couple of years warrant that the decisions for off-sourcing be re-evaluated. The changes in cost of fuel, regulatory environment, and the recession are several reasons driving such evaluation. To evaluate the off-sourcing decisions made in the last few years, it is imperative to understand the drivers, considerations, and the effects of off-sourcing on the supply chain. We cover these aspects as follows.

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What drives off-sourcing?

The most overwhelming reason for the companies to off-source is the lure of reducing the cost of merchandise. A recent study by Grant Thornton (International sourcing: Offshore or near shore?) found that lower costs were the driving factor in the off-sourcing decisions for 79% of the respondents in the survey. That is an overwhelming number, but it is not surprising. What is surprising is how little the companies usually know about the total cost of their off-sourced products. Most companies do not have any established process or system to collect and compute the total landed costs for their products. While the cost of merchandise is easily obtained from the purchase orders, the other costs like transportation and warehousing are harder to establish and accurately allocate to products. Most companies have questionable processes to capture and allocate these costs. The value of ordered products is the most commonly used factor for allocation of logistics (transportation and warehousing) costs. However, these costs should be better allocated using the handling and storage characteristics of the products rather than simply using their value. A set of outdoor garden furniture is always going to have a substantially higher cost of transportation, handling, and stocking in the warehouse than a Wii game system, even though they may both have comparable purchase costs. The solution lies in capturing transportation costs using the weight and volume characteristics, warehouse handling costs using activity based costing, and warehouse stocking costs using the number of days and space utilized by a product stocked in the warehouse.

But, these three components only make part of the total cost of the products, other costs such as the cost of receiving, unpacking, and making it ready for the sales floor and the cost of promotion and clearance. These costs become significant for the off-sourced products simply because of the longer replenishment lead-time, which means that the demand forecasts driving the replenishments must be made for longer time horizons which tend to be less accurate than the short-term demand forecasts. Less accurate demand forecasts mean higher promotion and clearance budgets and in some cases, additional logistics costs associated with warehousing and dynamic inventory re-balancing to move products within the network where they can potentially fetch better prices. All of these factors add costs that are complex to model and capture, and harder to correctly allocate for any meaningful comparison among products.

No wonder the same report (International sourcing: Offshore or near shore?) found that, "nearly half of respondents (47%) see off-shoring as neutral or detrimental to their ROI".

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Considerations for Sourcing Decisions

Given the firm has a clear understanding of the total costs, what other factors should be considered for making sourcing decisions? Here are some considerations that would directly affect your total costs and should be considered for any off-sourcing decision. Not only do they affect the direct costs, but they also add process complexity that the corporation must be ready to deal with.

  1. Regulations and Trade Agreements: What are the regulatory requirements for the products under consideration? Most of the international trade is subject to additional taxes, excise duties, value added taxes (VAT), etc, find out how this adds up to the total cost of the products when off-sourced. Find out if there are any trade agreements favorable to the products under consideration. These agreements may reduce your duties and taxes, or provide other financial incentives. The international trade is also subject to regulatory process requirements which means the importer typically has more paper work to prepare and file with the customs. Managing the extra paperwork is bound to add to your costs as this requires more processes, systems, or a contract with a service provider.
  2. Type of Merchandise: Not all merchandise is equally suitable for off-sourcing. Products that are innovative, fashion, and highly seasonal in nature may not be suitable for off-sourcing due to volatile nature of demand. These types of products require the ability to quickly react to the demand by either increasing the supplies or shutting them down, both of which are easier with shorter replenishment times. Other products that are more utilitarian in nature and have relatively stable demand may be good candidates for off-sourcing.
  3. Financing and Payment Terms: Off-sourcing may involve financial terms that are typically different from those in domestic sourcing situations. Make sure that the added complexity of procedures, advance financing, and/or guarantees are considered in making the case for off-sourcing.
  4. Multi-modal Transportation and Port Management: Managing the product at the port: loading, unloading, customs-clearance, and onwards shipment adds to the costs as well. Managing multi-modal transportation needs more complex systems for planning, optimization, and execution of the shipments. While this can be outsourced to a 3PL provider, corporations may lose the opportunity to optimize their transportation spend.

Finally, ensure that you have the systems in place to provide inventory visibility for the products in transit, which may allow you to dynamically plan their final destination as the ship moves closer to the home port to better match with any changes in demand during the time in-transit.

Off-sourcing: Effect on Supply Chain

All sourcing decisions affect the supply chains in several ways. They affect the costs as well as the ability of the supply chain to respond to changes in demand and supply. Evaluating how the supply chain will react to off-sourcing and ensuring that it is designed to address the process requirements involved in the off-sourcing is paramount for a successful execution of such decisions.

  1. Costs: Off-sourcing almost always will have additional supply chain costs in freight, inspection, financial instruments, drayage management, trade tariffs, and costs related to managing these processes. Make sure that these have been thought and properly estimated for an objective decision making exercise.
  2. Lead-time: Off-sourcing also typically results in much longer replenishment lead-time to the plants, warehouses, and stores. The effect of a longer lead-time on the supply chain is the reduced ability to react to changes in demand and supplies. This causes considerable strain on the processes, calls for more accurate demand forecasts, relatively stable demand, and reliable supplies.
  3. Risk: Increased costs, replenishment lead-time, and length of the supply chain all add to the supply chain risk. Longer chain and additional nodes provide new points of failure in the supply chain and substantially increase the risk of disruption, making it prone to factors that are not typical in domestic supply chains such as international politics, wars, and piracy.

Summary

Many companies are considering or reevaluating off-sourcing due to changes in the business environments such as cost of fuel, regulatory environment, and the ongoing sluggishness in the economy. Successful reevaluation requires that the managers clearly understand the drivers, considerations, and the effects of off-sourcing on the supply chain. Only an objective analysis of all these aspects can help establish the true value of off-sourcing for a company.

© Vivek Sehgal, 2009, All Rights Reserved.

Want to know more about supply chain processes? How they work and what they afford? Check out my book on Enterprise Supply Chain Management at Amazon. You will find every supply chain function described in simple language that makes sense, as well as see its relationship to other functions.

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