With Sertus' China Sourcing Experts as your partners, China is an ideal procurement center based on the entire cost structure and the factors that influence total cost. This report shares some insight into total cost structure.

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Total Cost Structure
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2. Jay Peirce Understanding Total Cost: The Complete Cost Structure of Procurement
(305) 215-3414 January 2006
jay@sertusllc.com
The Paradox of Procurement
When an overheated economy begins to cool off, cost Typical Company USA thousands of USD to
most manufacturers begin to look for ways to remedy. The delay to market also pushed their
improve efficiencies in production in order to help client’s to begin seeking alternative sources and
reduce costs. For many companies, rationalization Typical Company USA lost several key customers
of production processes can generate material as a result. What was expected to be thousands of
savings, but they can involve lengthy labor USD in savings actually resulted in tens of
negotiations, steep investments in new tools and/or thousands of USD in hidden costs and hundreds of
technologies, and process reorganization that can thousands USD in foregone income.
dramatically reduce the savings over the short run
that these same manufacturers are trying to In a recent report by Booze Allen Hamilton
capture. Outsourcing is often considered a quicker (China’s Gold Rush: Should You Make the Journey
fix that can have a more immediate impact on East?, by Ronald Haddock, Peter Obdeijn,
costs, especially when trying to reach short-term Mitchell Quint, Vikas Sehgal, Dermot Shorten, and
stretch goals for a given year. However, it is Edward Tse, Booz Allen Hamilton, 2004,
critical that companies understand the complete http://bit.ly/qNSzB3), the authors identify five key
cost structure related to outsourcing or many of the dimensions that must be considered when
savings thought to have been realized will quickly purchasing from China, or run the risk of cost
disappear as hidden costs find their way back into creep that can eat away pre-determined savings.
the cost structure. These factors are:
Manufacturing costs;
Transportation efficiency;
Uncovering Hidden Costs Lead time and scheduling;
Typical Company USA Ltd., much like many of Product design;
the companies that have gone before it, decides to Technical capabilities.
begin a strategic sourcing initiative to help lower
its cost of goods. The company began to seek non-
domestic sources to satisfy cost reduction demands Manufacturing Costs
and locates several manufacturers in China that can
provide a competitively priced alternative to their Companies are easily lured by a competitive sales
current supplier. It decides to abandon North price when seeking procurement alternatives. In
American and European procurement sources and China, where man hour costs are low by global
makes a large-scale shift to China without fully standards, labor intensive goods are still very
understanding the underlying cost structure of this competitively priced. Within China, however,
decision. Everything seemed to be pointing toward there are wage differences depending on the
a significant reduction in cost of goods until location of production. In the interior, where
Chinese manufacturers failed to meet important wages tend to be lower than in the large industrial
deadlines. Some product had to be air-freighted and highly populated cities, companies can find
and even though they had spent a significant more competitively priced product. However, this
amount of time embedding into their purchase can add a number of unforeseen costs due to
order all of the critical spec, they ended up logistics challenges that not only impact delivery
receiving product that was short of acceptable. On but can also influence the supply of raw materials
top of workmanship concerns, there were to the manufacturers in these locations. There are
packaging problems and some missing parts that large comparative advantages for factories that are

3. Jay Peirce Understanding Total Cost: The Complete Cost Structure of Procurement
(305) 215-3414 January 2006
jay@sertusllc.com
located in the center of excellence for a particular necessitates larger order quantities and the dollars
product because most of the suppliers of raw tied up in inventory investments are often
materials tend to concentrate around the large exaggerated due to rounding up practices to fill
consumers of these inputs. The risks involved with containers and minimize the unit freight factor for
disruptions to the inland logistics infrastructure can each piece shipped. Higher quantities also pose
add costs to factories that are located any higher risks – with manufactured defects having a
significant distance from their suppliers. These much greater impact than for small order
disruptions can influence not only timely delivery quantities, where the damage is limited due to the
but also quality as factories attempt to claw back smaller order size. Getting a qualified
unforeseen expenses by reducing cost elsewhere. intermediary to help control quality is crucial when
Therefore, when searching for a low cost provider, buying from China due to the increased risk posed
it is critical that appropriate controls are in place to by a number of factors, not least of which is
ensure there are no quality concessions due to cost correlated to the large order quantities China
pressure or delays due to logistics considerations. procurement necessitates.
Consider hiring a good partner to help you monitor
your supplier relationships, whether it is through Product Design
quality control or through production monitoring,
because these hidden costs can destroy value very
Engineering change orders present a whole new set
quickly.
of complexities when sourcing from China mostly
because of the differences in local technical
Transportation Efficiencies capabilities and the risks posed by long lead times
and large order quantities. The amount of obsolete
There can be distinct pricing advantages that product that is received after changes are
influence your selection process when dealing with implemented can be material in quantity and
suppliers in more remote areas. As we discussed, extend for some time due to the considerations
the wage differential is often significant. Yet the mentioned. Therefore, it is imperative that buyers
freight considerations, to bring product from these either deploy their own engineering specialists to
remote areas to port, should not be overlooked. oversee the entire process at origin or hire
Transportation efficiency, which measures the ratio professional procurement specialists that can send
of the cost of transport to the total product cost, engineers and QC inspectors to oversee change
favors remote production for smaller, higher-value orders and ensure on-time deliveries of product
added items, which will have a lower freight factor that meets desired specifications.
since the cost of transportation is generally fixed
per unit volume.
Technical Capabilities
Lead Time & Scheduling China is generally not recognized for its technical
specialization in manufacturing. Although Chinese
Shipping out of China can add anywhere from four factories have made huge strides in the last few
to seven weeks on the water to Western years, the challenges posed by highly specialized
Hemisphere markets, depending on inland and application specific product are not easily
transportation distances and final destination. The handled by most Chinese suppliers. Factory
risks associated with this longer lead time need to selection is even more important when dealing
be carefully contemplated and the potential impact with highly specialized manufacturing and finding
on stock-outs and excess or obsolete inventory experts that can assist with this process is a critical
must be incorporated into procurement costing success factor if considering China as a
analyses. Furthermore, the additional lead time procurement option.

4. Jay Peirce Understanding Total Cost: The Complete Cost Structure of Procurement
(305) 215-3414 January 2006
jay@sertusllc.com
Putting it All Together
For Typical Company USA Ltd., and for many
others considering China as a procurement center,
an understanding of the entire cost structure and
the factors of influence that affect total cost are
incredibly important in order to realize the
anticipated savings that are motivating the decision
to shift procurement in the first place. This
understanding involves going beyond typical
procurement unit price analysis. It requires a
holistic approach that brings in engineering and
manufacturing experience to define an optimal
purchasing strategy.
For more information, please contact
info@sertusllc.com or visit www.asiatradepro.com