What's the True Cost of International Outsourcing? The Case for Calculating Total Delivered Costs. Linda M. Taylor Industry Marketing FedEx

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1 What's the True Cost of International Outsourcing? The Case for Calculating Total Delivered Costs Linda M. Taylor Industry Marketing FedEx

2 EXECUTIVE BRIEF What's the True Cost of International Sourcing? The Case for Calculating Total Delivered Costs By Linda M. Taylor The promise of dramatic cost savings has attracted manufacturers to source overseas. Low-cost labor means reduced final product costs and increased profit margins. However, not all manufacturers are prepared for the expense and complexity of international sourcing. Sourcing globally is complicated by taxes, duties and higher transportation costs. Longer lead times bring inventory management challenges, larger safety inventories and greater business risks. These issues all add to the total cost of products. How can supply chain directors accurately determine the costs of sourcing internationally? To address these concerns, manufacturers are examining the total cost of purchasing products from overseas. By adding transportation, taxes and duties, inventory and risk to unit costs, the calculation of total delivered costs helps manufacturers accurately determine the expected savings from international sourcing. This white paper will examine the cost challenges of international sourcing and introduce the many advantages of calculating total delivered costs. Global Sourcing Trends Many manufacturers are experiencing unexpected costs and increased risk when sourcing globally Complex supply chains are swallowing many of the expected cost savings from international sourcing. "China is a solution for a lot of things, but it's not the panacea everyone thought it would be. In manufacturing, direct labor which is China's greatest cost advantage is only a small part of the total cost," stated TFI analyst Eric Miscoll. 1 For many manufacturers the anticipated cost savings from sourcing offshore is negated because of the higher cost of operating more complex supply chains. Complex logistics, especially those related to logistics can offset the reasons that motivated the move to overseas. A recent Aberdeen Group report said, "Companies going global are experiencing unexpected transportation costs, higher inventory investment, and longer and more unpredictable cycle times, while at the same time their local customers are demanding lower prices, more unique execution and improved responsiveness." 2 The report found that transportation expenses,

3 Page 2 raw materials, supplier charges, taxes and tariffs, broker/forwarder fees, inventory costs and third-party warehousing and handling costs were common areas for cost discrepancies. Global Sourcing Challenges Figure 1: Longer lead times, unexpected supply chain costs and documentation errors are the top challenges faced by manufacturers sourcing globally. 3 Supply chain management will play a central role as global sourcing grows. As more manufacturers are sourcing internationally, the competitive advantage is diminished. Companies must look for the alternate ways of competing. Businesses that streamline the supply chain will gain an edge. The risks of global sourcing must also be examined. Supply risks will increase through 2009 due to offshore market instability, new regulatory requirements, natural disasters and terrorism, according to The Supply Risk Benchmark Report. 4 An international supply chain inheritably has greater risks with the added distance, shipping segments, handling and amounts of product in transit. Add the language differences, cultural differences and tax/duty regulations, it becomes even more complex. International Sourcing Challenges The complexity and risks of global sourcing must be understood prior to extending the supply chain overseas While often necessary to remain competitive, sourcing overseas creates a number of challenges. The attraction of low-cost global labor actually brings many other expenses. "In the real world, cost savings in one area often result in cost increases in another. Raw materials and freight are cheaper in volume, for example. But warehousing and inventory costs go up when that volume lands on your dock," explains an Inbound Logistics article. 5

4 Page 3 "If you don't understand the true cost of the products from whatever source, then you cannot make the right buying decision," stated Ned Blinick, vice president of sales and marketing at global commerce management software provider Blinco Systems. He continued, "Being able to allocate the cost of freight and other supply chain costs back to the original goods will help companies make better and more informed buying decisions." 6 The Complexity of Global Sourcing Global sourcing complicates the supply chain, adds physical distance, introduces inventory management challenges, and incurs duties and taxes. Supply chain: Unlike the efficient state-to-state distribution system common in the United States, international sourcing involves many touch points, including foreign manufacturer to port, foreign port to U.S. port and finally movement to the U.S. manufacturer. With three primary transit stages in the supply chain, the likelihood of problems occurring increases significantly, along with costs. Add multiple transportation providers, brokers, customs and letters of credit, and the process becomes complex. Physical distance: The location of offshore vendors creates challenges. For example, with more than 6000 miles by way of air between Los Angeles and Shanghai, China, and a 16-hour time difference, transportation and communication problems emerge. Manufacturers must be prepared to work nights and overcome language and cultural differences. Inventory management: Moving product through multiple transportation channels increases the complexity of managing inventory. Once product moves to a ship, it is often very difficult to track. Because ocean transit is time-consuming, larger quantities are always in transit. That inventory is tied up on a slow-moving cargo ship essentially a warehouse at sea. When delivered, more warehouse space must be secured and the chance of damage or obsolescence increases. Larger inventories represent a large percentage of capital that is unavailable to other parts of the business. Taxes and Duties: Duties are usually a tax imposed on imports by the customs authority of a country. They generally are based on the value of the goods and a combination of other factors. Goods entering the United States may be subject to a duty depending on their classification under the Harmonized Tariff Schedule and country of origin. Customs fines often occur because products are wrongly classified or poorly documented. Often brokers are hired to arrange the movement of products and handle tax and duty payments.

5 Page 4 Business Risks International procurement is not just a sourcing decision and companies often make the mistake of looking at only unit costs instead of factoring in all costs associated to the business. Manufacturers must weigh risk factors that can increase inventory requirements and working capital as well as disrupt production, sales and customer service. Some of the business risks may include shipping delays, customs clearance issues and improperly documented letters of credit. More challenging risks may involve political instability, cultural differences and different legal terms and processes. Itisimportanttounderstand that not all countries recognize the United States patent and copyrighting policies. It can be easy for products to be duplicated by foreign manufacturers and sold without your knowledge or consent. One method of minimizing risks is establishing a backup U.S. supplier to ensure product delivery on short notice, often with substantially higher unit costs. The Solution: Calculating Total Delivered Costs By calculating total delivered costs, manufacturers can estimate the true advantages of global sourcing Designed to help manufacturers manage the complexities and understand the costs of international sourcing, a total delivered cost calculation reveals realistic advantages of international sourcing. The term total delivered costs is an extension of the widely referenced term total landed costs. Total landed costs usually refer to the costs to move products to the shores of the United States. However, total landed costs leave out the less obvious and harder-to-calculate costs, overstating the benefits of international sourcing. Total delivered costs are comprised of all direct and indirect costs of purchasing products overseas. The core components of total delivered costs include unit, transportation, inventory and tax costs, along with business risks (see Figure 2). Determining total delivered costs helps justify the actual benefits of international sourcing. This cost calculation is really more of a business calculation and decision. International sourcing should never be viewed as simply a cost savings without considering the impact on the supply chain. Savings often come with arippling effect in other areas, and not always a positive or desired impact.

6 Page 5 Figure 2: Shows the key elements of total delivered costs: The cost of the unit, transportation, taxes, inventory and risk. Unit Costs A calculation of total delivered costs begins with the unit price. The total cost per unit can be reduced by as much as 50 percent when moving sourcing from the United States to countries like China. This often results from a combination of lower labor costs and larger lot sizes to achieve perceived economies of scale. Because product traverses over a slow supply chain, larger quantities need to be in transit, often tying up a significant amount of capital. Transportation Transportation costs include overseas transportation from vendor to port, port to port and port to final destination. More costly transportation by air may be appropriate or necessary depending on the circumstances. "Although using faster modes of transportation increases costs, it lowers the total cost of holding inventory," explained a Supply Chain Management Review article. 7 Total delivered cost calculations should factor in emergency air shipments, since it is often not a matter of if, but when a major supply chain event will trigger the need for a rush shipment.

7 Page 6 Taxes Taxes, duties and tariffs must also be taken into account. These expenses are determined based on harmonized codes that classify goods. Depending on the harmonized code, an item may have a higher tax rate. For example, a printer with ink cartridges installed in the printer is taxed at a different rate than one without cartridges installed. Inventory Inventory costs include all of the expenses associated with acquiring and holding inventory. Because of international sourcing's large inventory requirements, these costs can be significant. Inventory costs include carrying and handling costs, product damage, shrinkage, insurance, product rework, storage space and systems and opportunity costs. Risks Although harder to quantify into an actual cost, the risks of international sourcing must be well-understood. For example, when establishing a relationship with a vendor in China, cultural norms demand face-to-face meetings. Language, time zone, foreign holidays and cultural nuances must also be understood. Other risks may include customs delays, late vendor shipments, the need for backup suppliers, expedited airfreight, product obsolescence and inferior product quality. The Benefits of Calculating Total Delivered Costs Calculating total delivered costs helps weigh the benefits of global sourcing Determining the total delivered costs of global sourcing provides many significant benefits. Determines all financial and business costs, providing a complete view of all direct and indirect costs. Enables a manufacturer to determine which products should be sourced overseas for maximum profit. Identifies all key global sourcing cost elements, ensuring no important aspect is overlooked, such as added inventory costs. Helps identify possible risks so a plan can be established to respond to problems, should they arise. Provides supply chain directors greater credibility by clarifying the full cost and risks of global sourcing. Reveals areas where outside advice should be sought to fully understand the costs and risks of total delivered costs.

8 Page 7 Example: Sourcing Lighting Fixtures From China Below is a side-by-side comparison of the costs associated with sourcing lighting fixtures from China versus the United States. (see Figure 3). 8 Supplier Domestic International Unit Price $ $60.00 % Unit Cost Transportation: 27.42% Mfg to port (Int'l) $0.86 Ocean port to port $8.98 Port to U.S. destination $0.99 U.S. vendor to destination $0.38 Port of entry fee $1.60 Cartage fee $0.22 Fuel surcharge $0.17 Customs Clearance fee $0.27 Marine insurance $0.19 Customs brokerage fee $1.31 Misc fees $1.86 Taxes/Duties Inventory Carrying Costs: $ % 15.25% Obsolesence costs $0.31 $1.25 Handling costs $0.06 Product damage $0.30 $1.20 Inventory shrinkage $0.15 $0.60 Insurance costs $0.15 $0.60 Product rework or scrap $3.00 Added storage & systems $1.80 Taxes $0.06 $0.24 Opportunity costs $0.40 Int'l Adminstrative Costs $ % Total Costs: $ $ % Figure 3: Demonstrates a cost comparison between sourcing in the U.S. versus internationally. This example assumes 500 units per lot and 6,000 units per year. Each unit weight is 4 pounds, bringing the lot weight to 2,000 pounds. Each unit is valued at $60, making each lot worth $30,000.

9 Page 8 Although not intended to include all of the possible fees and costs associated with international sourcing, Figure 3 reveals the major elements that should be considered. The costs will vary by organization, product and international vendors. The contents of the chart are explained below. Transportation Fees: Terminology for transportation fees differs widely between freight forwarders and with each shipment based on many variables. Typically, the more times a shipment is handled, the greater the fee. Additional fees commonly seen on freight forwarder invoices can include cross-docking, transloading, loading/unloading, storage, security, terminal, handling, extra handling, communications, drayage, harbor maintenance and accessorial. Notable transportation fees include: Port of entry fee: A cost assessed for moving cargo through a port. Cartage fee: Afee for loading and unloading containers. Fuel surcharge: A charge to cover fluctuating fuel prices. Customs clearance fee: Duties on items coming into the United States. Marine insurance: Thecost to insure products during ocean transit. Customs brokerage fee: A fee for a third-party to handle customs paperwork. Miscellaneous fees: May include handling fees, security fees, financial transactions, currency conversion, terminal fees, demurrage or related fees. Getting an accurate account of the fees that will be assessed is challenging even for the experienced professional. Because freight forwarders may use different terminology or invoicing styles, it can be difficult to identify all applicable fees. Working with a reputable freight forwarder who fully understands the country of origin and ports being used is critical to accurately estimating transportation fees. Factoring in all the costs may result in decisions that support faster modes of transportation. Taxes and Duties: In this example, there are over 20 harmonized codes for lighting fixtures, with duties ranging from 2.9 percent to 7.6 percent. Selecting the correct code is critical not only to prevent customs fines, but also to ensure excess duties are not paid. In this example, the rate difference between the highest and lowest code could result in a savings of $84,600 over 5 years. Selecting the correct harmonized code is essential. Relying on a trained broker who understands your products can prevent expensive fines and delays. The impact of trade agreements should be understood. For example, if the products in Figure 3 were produced in Mexico, no duties would be assessed. Inventory Costs: The costs of carrying inventory can be substantial and vary with each company. Financial experts within your company should provide insight into how these costs are calculated. The assumption made in Figure 3 is that an additional four weeks of inventory must be maintained due to additional lead time for ships to move product from overseas. This example assumes no supply chain disruptions.

10 Page 9 Notable inventory carrying costs include: Obsolescence costs: The cost of obsolete products. Handling costs: The cost to breakdown large lots of products. Product damage: The more product is handled, the more likely it may be damaged. A 2 percent of inventory value was used in this example. Inventory shrinkage: This is inventory that is on the books but does not exist. Used 1 percent of inventory value in Figure 3 Insurance costs: The more inventory, the higher the cost to insure. Used 1 percent of inventory value in this calculation. Product rework or scrap: Substandard product cannot be easily returned overseas, resulting in much higher costs to rework or discard. Added storage and systems: Thepriceforadditional warehouse space, shelving, transporting equipment and security. Taxes: More inventory on hand means increased valuation and higher taxes. Opportunity costs: Cash invested in inventory is unavailable for other opportunities or interest accumulation. International Administrative Costs: Not only is additional labor often needed to administer the complexity of international sourcing and invoicing, but communications can be costly. Regular trips to international vendors are often necessary. Risks: Figure 3 does not calculate risks. However, these qualitative factors must be taken into account and a plan should be established. Risks such as late shipments, product obsolescence, customs delays, natural disasters and political instability can have a huge impact on the business. More importantly, these risks can impact service to customers. Losing customers is a risk no manufacturer can afford. Risks do not easily fit into a cost calculation, but should be part of the business decision process in evaluating international sourcing. Risk analysis should also include the cost to recover from supply chain delays. Many of the above costs are not easy to calculate, but supply chain professionals must develop credible estimates of transportation, taxes, inventory carrying costs and risks. Exclusion of these costs will understate the true cost of global sourcing. The results from Figure 3 clearly show that the direct and indirect costs substantially increase the total delivered costs of the products. The delivered cost is actually more than48 percent greater than the unit costs, without factoring in the risks. This example shows how companies can overstate the impact of international sourcing if not all business costs are included when making these decisions. Gaining insight and expertise is essential for a comprehensive view of the impact of importing. Aligning with experts will help ensure the total delivered cost calculation reflects actual costs.

11 Page 10 What to Look for in a Transportation Provider in Your Supply Chain Seek a company with a physical presence in the foreign nation you are seeking to do business with When seeking a company to help transport products sourced outside the United States, be sure consider the following important requirements: Employees onsite in export nation: Work with a company that has employees permanently stationed in the nation you wish to do business with. This expedites transit, ensures direct communication among all parties and provides peace of mind. Duties and tax estimator: Look for a company that provides an online system to determine tariff costs by country and harmonized code to help calculate projected costs. Online reporting: Look for an online ability to view and manage brokerage, freight, duties and taxes. This helps determine the total delivered costs on an ongoing basis. Electronic customs clearance: Seek a company that provides electronic customs clearance to preclear products before they enter the United States, reducing delays. Online transit documentation: Make sure the company provides online retrieval of critical documents, such as invoices, packing lists and bills of lading, to remain in compliance with United States Customs and streamline transit. Compliance services: Advanced transportation companies can help ensure you are meeting record retention requirements, properly declaring products and compliant with legislation, such as certification with Customs-Trade Partnership Against Terrorism (C-TPAT). The FedEx Advantage FedEx is a leading transportation provider between China and the United States and will be opening a very large hub in southern China in 2008 FedEx is uniquely positioned to serve the global sourcing needs of U.S. manufacturers especially those importing components and finished goods from Asia. Our history in China dates back more than 20 years. FedEx offers manufacturers a comprehensive list of full-service options. For example, FedEx Trade Networks offers expert trade and customs advisory services, including faster customs processing, assistance with product classification and import advisory services. To find out how FedEx can help with your manufacturing transportation needs, contact Linda M. Taylor at linda.taylor2@fedex.com or by phone at For information about other industries, go to industry.fedex.com.

12 Page 11 Endnotes: 1 Jorgensen, B. (October 2005). Electronic Business. Global sourcing: Getting there from here. 2 Aberdeen Group. (January 2006). Best practices in international logistics. 3 Ibid. 4 Foster, T. (March 2006). Global Logistics & Supply Chain Strategies. Your supplier is cheap but unreliable. Now what do you do? 5 Bianco, R. (January 2006). Inbound Logistics. Minimize total landed cost: Strategize, Model, Act. 6 Murphy, J. (February 2006). Global Logistics & Supply Chain Strategies. Global sourcing benefits can be jeopardized by unanticipated supply chain costs. 7 Timme, S. (July/August 2003). Supply Chain Management Review. The real cost of holding.