offshore contract manufacturing (2)
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OFFSHORE CONTRACT MANUFACTURING: UNDERSTANDING
THE TRUE COSTS
APICS, THE GREATER SAN JOSE CHAPTER
UNDERSTANDING THE TRUE COSTS
The purpose of bailing the water (saving costs) is so your boat (company) stays afloat (earns a profit).
Focusing only on COGS (Cost of Goods Sold) will strongly correlate directly to improved gross margins and partially correlate to improved net margins or overall profits for the company.
UNDERSTANDING THE TRUE COSTS
“The further the distance between the host location and the outsourcer, the more the uncertainties and risks are. These uncertainties and risks can lead to large unexpected costs which offset gains from cheaper labor, or even worse, result in enormous loss to the outsourcer.”
Transportation costs / Reverse logistics costs
Administrative cost of maintaining relationships with new suppliers; including the travel costs to and from your supplier
Cost resulting from longer lead time and poor delivery, such as increased inventory, obsolescence, expediting, downtime
Negative purchase price variance (NPV)
UNDERSTANDING THE TRUE COSTS
“The further the distance between the host location and the outsourcer, the more the uncertainties and risks are. These uncertainties and risks can lead to large unexpected costs which offset gains from cheaper labor, or even worse, result in enormous loss to the outsourcer.”
Cost entailed by inferior quality, such as additional quality inspection, rejection, rework, downtime, scrap, warranties
Delayed shipment (revenue) Additional NRE costs for
tooling and fixtures Additional staffing Duties and taxes Inventory and Inventory
carrying costs Overseas supplier training and
engineering support expenditure
UNDERSTANDING THE TRUE COSTS
There are areas that can negatively impact your profitability that are a part of a world-wide economy.
Currency fluctuation risk; if you are building in a region where the US dollar has declined against the host currency.
Cost related with Intellectual Property (IP) protection
Dealing with local government for special policies, constraints or even corruption;
brand reputation degrading and loss of market share
UNDERSTANDING THE TRUE COSTS(a basic Income Statement)
Income Statement for XYZ Company
Net Sales (Revenue) $166,000,000
Cost of Goods Sold and Operating Expenses $140,000,000
COGS %age 84%
Gross profit $26,000,000
Gross profit %age 16%
Sales, general, and administrative expenses (SG&A) $13,000,000
Operating Profit $13,000,000
Other Income (Expenses) -$250,000
Interest expense $2,500,000
Provision for Federal Income Taxes $800,000
Net Income $9,950,000
Net Income %age 6%
UNDERSTANDING THE TRUE COSTS
The following slide is to show where outsourcing events affect the income statement.
Significant items affect the income statement below COGS & Gross Margin.
"Before" using Manufacturing Cost I mpacts toUSA Company I ncome Stmt
ManufacturingNegative PPV for shortage materials w/ offshore sources who do not have access to all materials
Net Sales (Revenue) $166,000,000 lowering of unit costs
Cost of Goods Sold $100,000,000
decline of dollar relative to an offshore valuation & therefore impact to your unit costs to the negative
Operating Expenses $40,000,000transportation costs more expensive with offshore outsourcing model
COGS % age 84%
travel, communications, added resources to work with & manage offshore outsource partners
Gross profit $26,000,000
NRE costs associated with additional equipment/ tooling/ fixturing for offshore source
Gross profit % age 16%
executive costs to travel & be involved w/ offshore outsource partners
Sales, general, and administrative expenses (SG&A) $13,000,000
other company functions who staff to assist w/ managing offshore outsource partners
Operating Profit $13,000,000
Other Income (Expenses) ($250,000)duties / taxes with foreign countries who build your products
Interest expense $2,500,000
write-down associated with product recalls/ losses due to major quality issues found w/ offshore outsource companies
Provision for Federal Income Taxes $800,000
financial xactions required w/ offshore outsource companies
Net I ncome $9,950,000
Net I ncome % age 6%
financing greater levels of inventory as a result of elongating your supply chain w/offshore sourcing
UNDERSTANDING THE TRUE COSTS
On the following slide we add typical examples of outsourcing situations to the income statement.
Do these sound familiar to you???
"Before" using Manufacturing Cost I mpacts toUSA Company I ncome Stmt
Manufacturing
Negative PPV for shortage materials w/ offshore sources who do not have access to all materials
offshore CM could not locate all parts in lead-time you needed for delivery, higher than Std cost paid to brokers to fill immediate need
Net Sales (Revenue) $166,000,000 lowering of unit costscost reduction of 10% for going offshore
Cost of Goods Sold $100,000,000
decline of dollar relative to an offshore valuation & therefore impact to your unit costs to the negative
dollar has declined for 2 years, by 15%, your offshore CM is raising your cost by 10% due to the dollar decline
Operating Expenses $40,000,000transportation costs more expensive with offshore outsourcing model
your logistics costs are higher by 2% with routing your products via ocean freight
COGS % age 84%
travel, communications, added resources to work with & manage offshore outsource partners
added 1 Jr. Buyer to help with the offshore mgmt of your new offshore outsource CM
Gross profit $26,000,000
NRE costs associated with additional equipment/ tooling/ fixturing for offshore source
adding tooling & test equipment needed for new outsource CM
Gross profit % age 16%
executive costs to travel & be involved w/ offshore outsource partners
your VP of Ops & COO wish to visit your new offshore CM for mid-year review
Sales, general, and administrative expenses (SG&A) $13,000,000
other company functions who staff to assist w/ managing offshore outsource partners
added Cost Accountant, Legal, QA, Engineeringpersons added to support the offshore CM
Operating Profit $13,000,000
Other Income (Expenses) ($250,000)duties / taxes with foreign countries who build your products
your products have a tax for importing into the USA based on Harmnized Tarriff codes
Interest expense $2,500,000
write-down associated with product recalls/ losses due to major quality issues found w/ offshore outsource companies
you shipped some product which required recall due to lead found in the paint, product was scrapped
Provision for Federal Income Taxes $800,000
financial xactions required w/ offshore outsource companies
added Accounting Transactions, (Letter of Credit)
Net I ncome $9,950,000
Net I ncome % age 6%
financing greater levels of inventory as a result of elongating your supply chain w/offshore sourcing
your intransit time has increased from 2 days to 4 weeks, you now carry additional inventory so you can maintian ocean shipments and keeep your logistics costs down to 2%
UNDERSTANDING THE TRUE COSTS
On the following slide we add the associated costs for the previously outlined situations in order to show the financial impact to our income statement.
"Before" using Manufacturing Cost I mpacts to Change Change "After" usingUSA Company I ncome Stmt Dollars % age offshore
Manufacturing Manufacturing
Negative PPV for shortage materials w/ offshore sources who do not have access to all materials $50,000 0.05%
Net Sales (Revenue) $166,000,000 lowering of unit costs ($10,000,000) -10.0% $166,000,000
Cost of Goods Sold $100,000,000
decline of dollar relative to an offshore valuation & therefore impact to your unit costs to the negative $10,000,000 10.0% $100,050,000
Operating Expenses $40,000,000transportation costs more expensive with offshore outsourcing model $2,000,000 5.0% $42,190,000
COGS % age 84%
travel, communications, added resources to work with & manage offshore outsource partners $40,000 0.1% 86%
Gross profit $26,000,000
NRE costs associated with additional equipment/ tooling/ fixturing for offshore source $150,000 0.4% $23,760,000
Gross profit % age 16%
executive costs to travel & be involved w/ offshore outsource partners $10,000 0.08% 14%
Sales, general, and administrative expenses (SG&A) $13,000,000
other company functions who staff to assist w/ managing offshore outsource partners $280,000 2.2% $13,290,000
Operating Profit $13,000,000 $10,470,000
Other Income (Expenses) ($250,000)duties / taxes with foreign countries who build your products ($100,000) 40.0% ($290,000)
Interest expense $2,500,000
write-down associated with product recalls/ losses due to major quality issues found w/ offshore outsource companies $50,000 -20.0% $2,875,000
Provision for Federal Income Taxes $800,000
financial xactions required w/ offshore outsource companies $10,000 -4.0% $800,000
Net Income $9,950,000 $7,085,000
Net I ncome % age 6%
financing greater levels of inventory as a result of elongating your supply chain w/offshore sourcing $375,000 15.0% 4%
Significant impact to Net Margin based on array of cost events which impact several sections of the I ncome Stmt associated onlywith outsourcing, and specifically the difference between USA based manufacturing versus offshore based manufacturing.All are based on very real risks and costs with the severity of the impact dependent upon your product, product life cycle, design,manufacturing requirements, labor content versus material content, sophistication and management of your outsource offshoremanufacturer.
UNDERSTANDING THE TRUE COSTS
Each of you can use this model for a single product or a group of products in assessing your situation.
Assess your:– Volumes– Where on product life cycle– The Risks– Technology– All the potential cost factors that can be encountered– The Transitional costs
UNDERSTANDING THE TRUE COSTS (Benefits to YOU !!!)
By understanding the potential costs & risks, you can actually construct a simple income statement model to analyze your supply chain decisions & what their overall impact would be.
You can form a stronger work relationship with your Accounting Controller & together help align improved supply chain decisions with aligned functions.
You can up level the discussions with your peers, boss, & others that a simple cost savings goal, might not achieve what a “smarter” supply chain can achieve.
Your financial rewards with successfully managing your sourcing.
Additional Information:
Bringing it All Back Home: The Reshoring Initiative by John Sprovieri April 1, 2011
“According to a 2009 survey by Archstone Consulting, 60 percent of manufacturers use only rudimentary calculation methods to determine what it costs them to offshore,” he explains. “On average, they miss about 20 percent of the total costs of offshoring.”
to download a free copy of the total cost of ownership spreadsheet, visit www.reshorenow.org
Additional Information:
'We spend how much internally to manage our contract manufacturers?!'By Pamela J. Gordon, CMC
New analysis tool reveals that many OEMs spend more internally on managing outsourced manufacturing than for outsourced value added services
The model reveals that for an outsourcing spend of approximately US$100 million, most OEMs spend internally in support of their outsourcing program more than 20% that total program's invoice. (Smaller outsourcing engagements typically incur even higher internal expense.) In many cases, the OEM's internal cost exceeds the price paid for the product's manufacture -- minus material.
Additional Information:
Total Cost Modeling for Overseas Sourcing/Outsourcingby Ninghua Song
Overseas outsourcing/sourcing in manufacturing industry can be costly. The cost savings may not be as great as they seem. Recently, many UK manufacturers have transferred their production to low cost regions all over the world including Mexico, India, and China. Among the various motives for these international outsourcing/sourcing projects, seeking cost effectiveness is most frequently mentioned.
The further the distance between the host location and the outsourcer, the more the uncertainties and risks are. These uncertainties and risks can lead to large unexpected costs which offset gains from cheaper labor, or even worse, result in enormous loss to the outsourcer. Therefore, in order to have a complete picture of all the potential costs of the offshore outsourcing projects, companies should adopt a total cost model.
Additional Information:
How To Reduce Offshore Hidden Costs By Zinnov Offshoring Research and Consulting
Companies spend anywhere between $20,000 and $70,000 on the salary of the internal vendor selection manager. (That assumes that vendor selection is one of several projects handled by that person.) Travel, communication and the time-cost of senior management and engineering resources increases the price tag.
Additional Information:
Transition Costs: the success of the transition process often defines the success of the offshore initiative. To be on the safe side, companies are increasingly spending more during the transition process. Arranging for onsite or offshore team visits or a combination of both is a key transition mechanism that has proven to have a high success rate. However, the associated costs can sometimes be prohibitive.
Additional Information:
Assumption: This three-year project is worth $5 million/year and the number of offshore resources is around 120.
a. Offshore team visit to onsiteTeam size = 12 engineersBilling rate = $3,000/monthOnsite living expense = $3,000/monthTravel = $2,000/monthTotal: 3 months of visits by 12 offshore engineers = ~$288,000
b. Onsite visit to offshoreUsually the number of client's engineers needed to visit offshore during the knowledge transfer is smaller than the number required to visit onsite.Team size = 5 engineersSalary = $8,000/monthOffshore living expense = $2,000/monthTravel = $2,000/monthTotal: 3 months of visits by 5 offshore engineers = ~$180,000
c. Combination of bothWe estimate that the combination of both with shorter offshore and onsite visits will cost around $230,000.
Additional Information:
The transition cost should be calculated as a percentage of the project cost over a period of 3 years due to the length of offshore engagement. The transition cost is approximately 1% to 2% of the project cost for a transition period of 3 months.
Also, because the offshore team isn't productive during this period, the cost of the rest of the offshore team (~$1 million for 3 months) should be added to the transition cost.
That brings the transition cost to about 8% of the total project cost -- with the client actually losing money during the initial months.
Questions ?