THE COST OF OFFSHORE MANUFACTURING: How Accounting Information Undermines Profitability

Transcription

1 THE COST OF OFFSHORE MANUFACTURING: How Accounting Information Undermines Profitability 6 th Annual Orthopaedic Manufacturing & Technology Exposition and Conference June 16, 2010 Douglas T. Hicks, CPA, CMC D. T. Hicks & Co Orchard Lake Road Suite 207 Farmington Hills, MI dthicks@dthicksco.com

2 Suppliers in low-cost countries such as China have been able to offer perceived prices 25 to 40 percent lower than those available on shore the typical threshold or tipping point for moving offshore. The actual cost advantage all along may never have been more than 15 percent and for some products as little as 5 percent when considering the all in costs of offshoring as understood by applying a robust total cost model. Ferreira, John and Prokopets, Len, Does Offshoring Still Make Sense? Supply Chain Management Review, January/February 2009, pp

3 Devise a stupid way of measuring my performance and I guarantee you I ll act stupid. Devise a stupid way of determining my compensation and I guarantee you I ll act really, really stupid. - 99% of All Company Employees

4 What is the Purpose of a For-Profit Manufacturing Organization? Maximize the business GAAP-based profit as a percentage of sales? Maximize the business return on the owners investment? Maximize the business gross margin? Minimize the prices paid to suppliers for their products and services?

5 HealthCo Manufacturing Corporation s Costs Direct Material, Services and Components Manufacturing Costs Direct Labor Manufacturing Costs Overhead Non- Manufacturing Costs Direct-Labor Based Overhead Rate Percentage of Total Accumulated Cost HealthCo Manufacturing Corporation s Cost Objectives

6 Decision Situation HealthCo Corporation s cost to manufacture Product A at its own domestic plant is $ A domestic supplier has offered to sell it the component for $8.00. It also has an opportunity to purchase the same component from an offshore manufacturing firm for $4.00. Should HealthCo outsource Product A and, if so, should it be to the domestic or offshore supplier? 2009 D. T. Hicks & Co.

7 Issues Does HealthCo really know what it costs to produce this product in-house? Does HealthCo really know what costs would be eliminated if it ceased manufacturing the product? Does HealthCo know what the cost would be if it purchased the product domestically for $8.00? Does HealthCo know what the cost would be if it purchased the product offshore for $4.00?

8 The Critical Decision Tool the all in costs of offshoring as understood by applying a robust total cost model

9 HealthCo Corporation Costs HealthCo Corporation Cost Objectives

10 HealthCo Corporation Costs Service and Operations Throughput or Direct Costs Throughput or Direct Cost Direct or Value-Adding Event or Transaction Market or Customer Product or Product Line General and Admin HealthCo Corporation Cost Objectives

11 HealthCo Corporation Costs Service and Operations Throughput or Direct Costs Throughput or Direct Cost Direct or Value-Adding Event or Transaction Market or Customer Product or Product Line General and Admin HealthCo Corporation Cost Objectives

12 HealthCo Corporation Costs Service and Operations Throughput or Direct Costs Throughput or Direct Cost Direct or Value-Adding Event or Transaction Market or Customer Product or Product Line General and Admin The Cost of Purchases HealthCo Corporation Cost Objectives

13 Costs & That Purchases Inbound Freight General freight from overseas is $4,000 per 40,000 lb container Freight from West Coast to Midwest is $1,000 per 40,000 lb container Emergency air freight from overseas is $250 per 20 lb package Purchasing, Engineering & Quality Costs Separating Engineering & Manufacturing hamstrings concurrent engineering Cost of no local presence, travel and lodging Cost of resolving product design, quality and delivery issues (different time zones, languages, and cultures Confidence in compliance potential liability problems Intellectual property at risk

14 Costs & That Purchases Internal Handling Costs Breakdown of container content Repackaging Labeling and Relabeling Redistribution from central receiving point Administration Costs Tracking foreign content The paperwork snake Additional part numbers if dual sourcing Fees and expenses: freight forwarder, customs broker, continuous bond, merchandise processing, harbor maintenance, letters of credit, duties, insurance

15 Costs & That Purchases Inventories Transfer of ownership point Need to manage container loads of goods Higher safety stocks due to long cycle times and unreliable delivery Higher obsolescence due to inability to adjust orders in short term Payments made sight unseen Often entire order shipped at once Cost of Capital Deposits for letters of credit Frozen Money Advance payment items Financing higher inventories

16 Costs & That Purchases Remanufacturing/Rework Costs Other Return and replace cycle too long must salvage parts Supply chain interruptions Currency fluctuations Third-party representative costs Obstruction of competitive differentiation strategies based on customization Offshoring is generally anti-lean, anti-mass customization and anti-jit

17 Cost Components of a Product Purchased Offshore Other Costs & Sacrifices Remanufacturing & Rework Cost of Capital Inventories Administration Internal handling and storage Purchasing, Engineering, Quality Fees, duties, expenses Inbound freight All part of the cost of offshore purchases Direct / Throughput Activity Offshore Purchases

18 I May Be Wrong, But I Doubt It: How Accounting Information Undermines Profitability By Douglas T. Hicks, CPA, CMC It may be effective in reporting historical results to outsiders, but relying on the information generated by a GAAP-based accounting system when making management decisions seriously undermines a company s ability to grow into a profitable future. The case is presented in Doug Hicks new book I May Be Wrong, But I Doubt It:: How Accounting Information Undermines Profitability Included in the sixteen essays that comprise this book are arguments describing why: Profit as a percentage of sales is an incomplete and misleading measure of product or service profitability Depreciation is not only totally irrelevant for decision makers, it can be one of the most damaging concepts in accounting Evaluating management performance using financial accounting turns managers into game players whose actions are directed at generating the best short-term scores at the expense of long-term success Popular solutions to today s cost information problems (ABC/M, Lean Accounting, GPK, Resource-Driven Accounting, etc.) are so narrowly focused as to be irrelevant for a majority of decision makers The phrase Management Accountant might qualify as an oxymoron and true management accountants may be as rare a Boston Red Sox fan living in New York Traditional accounting has trouble distinguishing among a cost, an investment, and a profit The discipline of accounting is so focused on arbitrary rules and regulations that accountants may be incapable recognizing economic reality when they see it The best solution may be to relieve accountants of their duties as providers of decision support information and assign those duties to individuals whose thought processes have not been tainted with GAAP. Does your company s accounting information guide or misguide management? Does it promote or undermine your company s profitability? Does it result in management making decisions based on fiction instead of on reality? Find out how your company stacks up by reading I May Be Wrong, But I Doubt It: How Accounting Information Undermines Profitability. You can purchase a copy at D. T. Hicks & Co.

19 I May Be Wrong, But I Doubt It Chapter Twelve: The Cost of Offshore Purchases Do companies really understand the cost of offshore purchases? More companies than ever are purchasing raw materials, components, and other manufacturing services from offshore suppliers. The reason is obvious; the prices charged by these offshore suppliers are considerably less than those charged by domestic suppliers. But are these savings as significant as they seem? Is the cost of an item purchased from an offshore vendor sometimes much greater than the price paid for the item? There are, of course, some obvious costs that relate to offshore purchases that are much higher than for domestic purchases. Inbound freight costs are probably the most visible. In investigating this question for our clients, however, we have found many other areas where the move to offshore vendors has added significantly to the client s costs. Purchasing, engineering and quality costs often increase as the additional work required in dealing with distant suppliers in far different times zones with different primary languages leads to an increase in headcount and higher travel and communications costs. One of our clients moved several million dollars worth of purchases to several suppliers in China. To support this initiative, they hired two individuals to set up a permanent base in China and manage the new suppliers. Their stateside procurement, quality, and engineering personnel began making regular visits to China which occupied enough of their time that several new engineers had to be 88

20 The Cost of Offshore Purchases hired. Top executives made frequent visits to the suppliers as well. All of this cost remained buried in departmental budgets at the corporate office and was never linked to the parts purchased from these offshore suppliers. Internal handling costs are often impacted by offshore purchases. Items received from offshore vendors have usually been ordered in large quantities well in advance of their required date to allow for transportation problems. In addition, products produced overseas are often floor loaded meaning that they are containerized as produced with boxes of various products mixed in each shipping container. This leads to increased costs for sorting and organizing upon receipt as well as movement to and retrieval from intermediate storage locations. The client mentioned earlier had four plants using the parts supplied by China-based suppliers. They noted that having four separate destinations for the parts made managing these purchases very cumbersome so they rented a new central warehouse where all parts from China would be received, sorted, repackaged, stored, and distributed to its plants. The warehouse was staffed with a dozen new employees and a new truck was purchased to make plant deliveries on a regular schedule. The new warehouse was set up as a new cost center on the company s books and the costs carefully accumulated there. No attempt was made to link the cost of the warehouse to the parts purchased from China, the only parts to which its costs related. Carrying costs are almost always increased by offshore purchases. Additional storage space must be procured for the higher safety stocks resulting from less controllable deliveries and insurance 89

21 I May Be Wrong, But I Doubt It and tax costs increase. Payment terms for these purchases usually require that funds be spent much sooner than they would under the terms of standard domestic purchase arrangements. Even more important is the increased cost of capital resulting from these higher inventories. If an organization can earn a 12% return on a capital investment, tying up an additional $1 million in inventory costs that organization $120 thousand an amount that offsets part of the lower price of the offshore purchase. Since a cost of capital is not included in most companies cost models, this added cost is never linked to the offshore purchases it supports. Obsolescence costs are usually overlooked in costing offshore purchases. Since the lead time for ordering from an offshore vendor is generally much longer than from a domestic vendor, the quantities ordered must be based on longer-term forecasts that are less likely to match future realities. Further complicating the matter is the fact that unexpediting an offshore order is usually next to impossible. As a result, items are often received that are not currently needed and, in some cases, may never be needed. Remanufacturing and rework costs are sometimes incurred to make right parts that don t quite meet specifications. When a part is needed and the vendor is overseas there is often not enough time to return the items and/or get replacements. In such cases, rework can sometimes save the parts and enable them to meet the immediate need. The client mentioned earlier needed to buy additional equipment and add two hourly employees to take care of the remanufacturing and rework of parts received from their new China-based suppliers. 90

22 The Cost of Offshore Purchases Most of the companies with whom I have discussed outsourcing decisions never performed an analysis that measured the total cost of ownership of raw materials, components, or finished goods purchased from offshore suppliers and compared it with the total cost of ownership from their current domestic suppliers. Outsourcing was either an action demanded by a major customer if they wanted to keep the business or was driven internally by offshore suppliers attractive prices. Perhaps a vast majority of the decisions to buy materials, components, and finished products from offshore suppliers have been economically sound. But then again, perhaps they have not. Without costing methodologies that effectively link operating costs with their causes such as linking the costs noted above with offshore purchases companies will simply never know for sure and continue to operate either in the dark or after looking at themselves in a distorted, fun-house mirror. 91