Complete Cost Structure

The Paradox of Procurement

the paradox of procurementWhen an overheated economy begins to cool off, most manufacturers begin to look for ways to improve efficiency in production in order to help reduce costs.  For many companies, rationalization of production processes can generate material savings, but they can involve lengthy labor negotiations, steep investments in new tools and/or technologies, and process reorganization that can dramatically reduce the savings over the short run that these same manufacturers are trying to capture.  Outsourcing is often considered a quicker fix that can have a more immediate impact on costs, especially when trying to reach short-term stretch goals for a given year.  However, it is critical that companies understand the complete cost structure related to outsourcing or many of the savings thought to have been realized will quickly disappear as hidden costs find their way back into the cost structure.

Uncovering Hidden Costs

Typical Company USA Ltd., much like many of the companies that have gone before it, decides to 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 and locates several manufacturers in China that can provide a competitively priced alternative to their current supplier.  It decides to abandon North American and European procurement sources and makes a large-scale shift to China without fully understanding the underlying cost structure of this decision.  Everything seemed to be pointing toward a significant reduction in cost of goods until Chinese manufacturers failed to meet important deadlines.  Some product had to be air-freighted and even though they had spent a significant amount of time embedding into their purchase order all of the critical spec, they ended up receiving product that was short of acceptable.  On top of workmanship concerns, there were packaging problems and some missing parts that cost Typical Company USA thousands of USD to remedy.  The delay to market also pushed their client’s to begin seeking alternative sources and Typical Company USA lost several key customers as a result.  What was expected to be thousands of USD in savings actually resulted in tens of thousands of USD in hidden costs and hundreds of thousands USD in foregone income.

In a comprehensive report by Booze Allen Hamilton China’s Gold Rush: Should You Make the Journey East? where the authors identify five key dimensions that must be considered when purchasing from China, or run the risk of cost creep that can eat away pre-determined savings.

These factors are:

  • Manufacturing costs
  • Transportation efficiency
  • Lead time and scheduling
  • Product design
  • Technical capabilities

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.

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