IMPROVING SOURCING DECISION USING TOTAL COST OF OWNERSHIP AND RISK ANALYSIS: THE CASE STUDY OF IMPORTED PRODUCT

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1 IMPROVING SOURCING DECISION USING TOTAL COST OF OWNERSHIP AND RISK ANALYSIS: THE CASE STUDY OF IMPORTED PRODUCT Sopee Khumloa, Manisra Baramichai and Suwannee Adsavakulchai University of the Thai Chamber of Commerce, Thailand ABSTRACT Total cost of ownership is a methodology and philosophy that looks beyond the price of a purchase to include many other purchase related costs in making the purchasing decision. However the numbers of papers that aim to illustrate the application of this methodology in practice are still very limited. In this paper, we illustrate how the total cost of ownership (TCO) can affect the sourcing decisions for the major consumer product. Currently, based on the DDP price, the product is purchased and imported from suppliers in Philippines to be sold in Thailand. However, under DDP price the other cost such as inventory management cost, warehouse management cost and risk cost are not considered. Therefore, the company tends to obtain the product with a cheaper price but a higher risk and a higher logistics cost. To look for the best choice for the business, four sourcing alternatives were proposed and evaluated based on the total cost of ownership and the risk cost. The four alternatives include purchasing the product from international suppliers in Philippines, Indonesia, Australia, and one local supplier in Thailand. The result from the study indicate the potential savings by changing the sourcing policy from relying only on supplier in Philippine to relying on both Philippine and Thailand suppliers. Keywords: Supply Management, Sourcing Decision, Total Cost of Ownership INTRODUCTION The globalization of competition has resulted in a highly competitive business environment. Product life cycles have become shorter and new products are introduced into the marketplace faster as customer expectations rapidly evolve. In this new environment, many companies derive much of their product value from their suppliers. Today, external purchases of products and services generally account for more than 60 percent of the total cost of goods sold, and this has become a vital determinant of business organizations profitability and competitiveness. For example, Hendrick and Singhal (2003) show that companies reporting supply chain disruptions typically experience 12 percent decreases in their shareholder returns. Even the purchasing decisions made during a single selling period affect a firm s long-term financial results. In this paper, the method for supplier selection using the total cost of ownership is illustrated using the real life case study. The total cost of ownership (TCO) is a complex cost accounting approach, which requires a buying company to consider all the costs that are important and significant in the acquisition, possession, use, and disposition of the purchased item. The use of total cost of ownership to value purchase opportunities allows a buying company to make a better decision on supplier selection as it takes into consideration not only the direct costs related to the purchase of items, but also the indirect 217

2 Improving Sourcing Decision Using Total Cost of Ownership and Risk Analysis: The Case Study of Imported Product costs occurring in other business functions along the value chain (e.g., supplier qualification and development, order placement and receiving, freight and transportation). To determine the total cost of ownership, the activity-based costing methodology is suggested. A notable difference in the total cost of ownership with typical activity-based costing applications is that the cost needs to be captured by supplier, by order, by item, or by unit purchased (Ellram, 1995). The examples of total cost of ownership and activity-based costing applications in supplier selection can be found in Cavinato (1992), Ellram (1993), Roodhooft and Konings (1997), and Degraeve and Roodhooft (1998, 1999, 2004, 2005). THE BACKGROUND OF THE PROBLEM The case study company is facing with several problem related to their current purchasing decision for their main product. Currently, the company follows the single sourcing strategy that relies on a single supplier in Philippine. The critical problem of this strategy is that the company has to bear themselves on several risks and also lost their negation power. With almost 2 month lead time for importing the product from Philippine, the company and have to keep the inventory on hand and also lost their flexibility in changing their order to accommodate customer changes. The external warehouse has been rented recently to keep the products for being used during these two months period. In addition to the problem of long lead time, the performance of Philippine supplier to respond to urgent order also limited because the products need to be shipped in full container. When there are the urgent orders from the customers. The company needs to pay additional cost for urgent import shipments by air freight or LCL shipments. Facing with this problem, the company considers changing their sourcing strategy. They have been searching for another supplier to either substitute the Philippine supplier or to be a second supplier. There are three suppliers in Thailand, Indonesia, and Australia whose manufacturing technology fulfill the requirements of the company. To make a supplier selection decision, The Total cost of Ownership approach has been applied to reflect the true cost of buying a good from a particular supplier, especially under the global context. One of the strengths of the TCO approach in calculating costs of purchasing is that it does regard the other costs associated with purchasing decision. Traditional approaches to supplier selection and evaluation are often based on price and or qualitative performance alone. For some supplier, their listed price may be significantly low; however, the extended distance and the numerous other problems related to international trade often complicated the profit picture THE INITIAL INFORMATION The case study product is delivered in 40 dry container. One container consists of 6,336 cases and one case consists of 12 pieces. The annual requirements of this product are approximately containers To compare the supplier based on their total cost of ownership, it is necessary for the company to determine the costs it considers significant in the acquisition, possession and use of a certain purchased good which may include costs related to: Supplier performance evaluation Order transaction and order management Transportation including freight charge, consolidation, transfer fee and pickup and delivery. 218

3 Product inspection and reception Warehouse and Inventory holding Customs duty fee including customs clearance, brokerage fee and allocation fee. Risk, damage and insurance In this case study, we classified all costs related to the purchasing decision into four categories as follows; The Purchasing Management Cost The purchasing management cost includes the expenses for both equipment and employees who perform the sourcing and purchasing related activities such as supplier performance reviews, contract negotiations, purchase orders preparation and purchase order release, The Transportation Cost and Handling Cost: The transportation cost include the cost for moving the products in the country of origin, the cost for moving the products from the original port to the destination port, and the cost for product handling. The transportation cost in the country of origin includes; Inland transportation charge Labor cost for loading, moving and unloading the product Terminal handling charge The cost for moving the products from the original port to the destination port include; The oversea freight charge The terminal charge The labor cost for Lift on Liftoff activities The Insurance Cost The insurance premium rate that the company need to purchase is required by the company headquarters. The Customs Duty Cost The custom duty rate in year 2009 for the case study product that are as follow; Import from Philippines Supplier : FTA AFTA, Duty = 5% in 2009 and free duty in 2010 Import from Indonesian Supplier : FTA AFTA, Duty = 5% in 2009 and free duty in 2010 Import from Australian Supplier : FTA THAI-AUSTRALIA, Duty = 5% in 2009 and free duty in 2010 The Inventory Holding Cost The inventory holding cost is determined based on the value of in transit inventory and the value of cycle stock inventory. It includes the labor cost of employees working in warehouse, the cost of capital, and the cost of warehouse and equipment depreciation or rental. 219

4 Improving Sourcing Decision Using Total Cost of Ownership and Risk Analysis: The Case Study of Imported Product TOTAL COST OF OWNERSHIP ANALYSIS Currently the prices of the product quoted by four suppliers from Philippine, Thailand, Indonesia, and Australia are as Shown in Table 1. Table 1: The Product Price of Each Supplier Country Supplier Incoterms Unit Price Philippines A EXW Australia B FOB Indonesia C FOB Thailand D DDP** 0.92 To determine the total cost of ownership for with respect to each specific supplier, the following cost elements were included The Purchasing Management Cost To manage the purchasing activities such as supplier performance evaluation, order transaction and order management, three departments, planning marketing and purchasing are involved. Therefore, to determine the purchasing management cost, the labor cost and the equipment cost from these three departments are included based on the proportion of time being spent for this product. For example, in the purchasing department, two employees are responsible for purchasing the case study product. However, as these two employees are also responsible for purchasing another two products, their salary will be partially allocated to the case study product. Table 2 illustrates how the labor cost is allocated in the purchasing department and Table 3 illustrates how the purchasing management cost is determined Table 2: The Allocation of the Labor Cost in Purchasing Department Category % of Job Assignment Employee cost ($) Employee Salary (2 persons) 100% Product A 60% Product B 30% Product C 10%

5 Table 3: The Purchasing Management Cost Breakdown Description Amount( $) Unit Labor cost from three departments (Planning/Marketing/Purchasing) $/Month Equipment in office ex. Telephone, Internet $/Month Quantity of container per purchase order 35 Container/Month Quantity of pieces per purchase order 2,661,120 Piece/Month Operation management per piece $/PC The Transportation Cost in the Country of Origin This cost is the local charge at the origin country before the product shipment is shipped from the supplier port. Suppliers from Indonesia, Australia, and Thailand already include this cost in their prices based their incoterm. Therefore, the company will incur this cost only if they purchase the product from Philippine supplier. This supplier sell product A as EX-works for $ 0.76 per piece. This cost will increase $ per piece from transportation charge from factory to port (Export Charge). This price becomes FOB Manila (as shown in Figure 1). Table 4 illustrates the comparison of each supplier s cost after including the transportation cost in the country of origin. Table 4: Comparison of Each Supplier s Cost after Including the Transportation Cost in the Country of Origin Country Port Supplier Incoterms Unit Price ($) Export charge Total Cost per Unit ($)** Philippines Manila A EXW Australia Sydney B FOB Orginal Indonesia Surabaya C FOB Orginal Thailand Chonburi D DDP * * DDP of Supplier D, cost per piece from origin factory to final warehouse. ** FOB Original The International Transportation Cost In this case, The International transportation cost includes the oversea freight charge and the Bunker Adjustment Factor (BAF). Table 5 summarizes this cost based on the global freight rate in The total cost per unit shown in this table is the FOB Bangkok price Table 5: Comparison Of Each Supplier s Cost after Including the International Transportation Cost Country Port Supplier Nominate Freight for 40' Container ($) Price per Unit ($) BAF Freight Total BAF Freight Total Total Cost per Unit ($)** Philippines Manila A Australia Sydney B Indonesia Surabaya C Thailand Chonburi D * * DDP of Supplier D, cost per piece from origin factory to final warehouse. ** FOB Bangkok 221

6 Improving Sourcing Decision Using Total Cost of Ownership and Risk Analysis: The Case Study of Imported Product The Marine Insurance Cost Marine insurance course is for the case study product is one percent of the FOB destination price according to the requirement from the Corporate Headquarter. Table 6 displays the marine insurance cost for four suppliers. The total cost per unit shown in this table is the CIF price. Table 6: Comparison of Each Supplier s Cost After including the Insurance Cost Country Port Supplier FOB Original (Unit Price) ($) Insurance Rate (%) Insurance Charge per Unit ($) FOB Bangkok Total Cost per Unit ($)** (Unit Price) ($) Philippines Manila A Australia Sydney B Indonesia Surabaya C Thailand Chonburi D * *DDP of Supplier D includes insurance cost. **CIF The Customs Import Duty Cost As shown in Table 7, in 2009, the custom import duty charge for product A is 5%. This rate will be changed to zero in 2010 according to the FTA agreement. The custom duty fee can be calculated from the custom duty rate multiply by CIF price (FOB Price+ Freight Cost + Insurance Cost). Table 8 displays the custom import duty charges of four suppliers. Table 7: Table 8: The Custom Import Duty Rate Country Port Supplier Duty Rate 2009 Duty Rate 2010 Philippines Manila A 5% 0 Australia Sydney B 5% 0 Indonesia Surabaya C 5% 0 The Custom Import Duty Charge Country Port Supplier CIF (Unit Price) ($) Custom Duty Rate Customs Import Duty ($) Philippines Manila A % Australia Sydney B % Indonesia Surabaya C % Thailand Chonburi D * DDP includes Insurance cost. The Product Handling Cost The product handling cost is the cost related to the operations that occur after the arrival of the products at the Bangkok Port. This includes the shipping service charge, the cost for transportation fee from Port 222

7 to warehouse, and the labor cost for Lift on/lift Off as shown in Table 9. The total cost per unit shown in Table 10 is the DDP price. Table 9: The Product Handling Cost Bangkok Port Service Rate For Container Size 1*40 Rate Quantity Per Container Cost/ Unit Service charge , Lift on / Lift off , Passing port , Total Product Handling cost , Table 10: Comparison of Each Supplier s Cost after including the Product Handling Cost Country Port Supplier CIF (Unit Price) ($) Custom Duty Rate Customs Import Duty ($) Product Handling Cost per Unit ($) Total Cost per Unit ($)** Philippines Manila A % Australia Sydney B % Indonesia Surabaya C % Thailand Chonburi D * * DDP includes product handling cost ** DDP The In Transit Inventory Cost In this case, the in transit inventory cost is the cost of capital that can be determined based on the in transit inventory value, the days of clearance, and the interest rate. The in transit inventory value = CIF Price * Quantity per shipment The cost of capital = CIF Price * Quantity per shipment * Daily Interest Rate * Days of clearance For this product, the days used for custom clearance is approximately 8 days due to the problem of port congestion in Bangkok Port Thailand. Table 11 illustrates the capital cost per unit for products that are purchased from each supplier. 223

8 Improving Sourcing Decision Using Total Cost of Ownership and Risk Analysis: The Case Study of Imported Product Table 11: The In Transit Inventory Cost Country Supplier CIF Unit Price ($) Quantity Per Shipment In Transit Inventory Value (Quantity per Shipment CIF Price) Total Cost of Capital (In Transit Inventory Value Days Of Clearance Daily Interest Rate )** Cost of Capital Per Unit. Philippines A , , , Australia B , , , Indonesia C , , , Thailand* D , * The delivery lead time is less than 3 hours (No inventory in- transit) ** The annual interest rate is 15% Inventory Holding Cost For the case study product, the Inventory holding cost include the cost of capital, the warehouse storage charge, and the labor cost for handling both cycle stock and safety stock of this product. According to the purchasing policy, the order cycle for this product is seven days if being imported. In addition at least six containers of the product must be kept in the warehouse. This results in the average inventory level of the case study product as shown in Table 12. Table 13 illustrates the example of the capital cost calculation for the product purchased from Philippine supplier and Table 14 summarizes the capital costs for the product purchased from all 4 four suppliers. Table 12: The Average Inventory Level Description Quantity/Amount Remark Cycle Stock Inventory 228,069 pieces Cycle stock = Delivery Lot Size/ 2 ( )/2 Safety Stock Inventory 456,192 pieces Six Containers= 456,192 pieces Total Inventory level 684,288 pieces Table 13: The Example of The Cost of Capital Calculation for The Product Purchased from Philippine Supplier Description Quantity/Amount Remark Total Inventory 684,288 pieces Unit Price (Philippines) $0.828 DDP Price Inventory Value $556,942 Inventory Value= 684,288 * $0.83 Total Capital Cost $ The Annual Interest Rate Is 15% Capital Cost = 7 Days* Inventory Value* Annual Interest Rate/ 365 Capital Cost =7 * $556,942* 15%/

9 Table 14: The Cost of Capital for The Product Purchased from Four Suppliers. Country Supplier DDP Unit Price ($) Average Inventory Level Average Inventory Value ($) Average Cost Of Capital ($) Capital Cost Per Unit. ($) Philippines A , , Australia B , , Indonesia C , , Thailand* D * The products can be delivered everyday due to the supplier location (No inventory) For the warehouse cost, to operate the warehouse, the company incurs the costs for the equipment and the employees who are responsible different functions in the warehouse. Table 15 displays the warehouse management cost in detail and Table 16 displays the total cost per unit after including the entire inventory in transit and the inventory holding cost. Table 15: The Warehouse Management Cost Description Employee Inbound and Outbound Warehouse staff and Quality Analysis Staff Weekly Cost($) Equipment Rental Total Warehouse Management Cost Weekly Inventory Level Warehouse cost 684,288 Pieces $ / Piece Table 16: Comparison of Each Supplier s Cost after Including the Inventory in Transit Cost and Inventory Holding Cost Country Supplier DDP Unit Price ($) Cost of Capital per Unit. (In Transit Inventory) Cost of Capital per Unit. (Safety Stock+ Cycle Stock Inventory) Warehouse Cost Total Cost Per Unit ($) Philippines A Australia B Indonesia C Thailand* D Payment Transfer Cost The HSBC Bank payment fee rate for payment transfer in yeas 2009 is $25 per order or per piece. This cost need to be included in total cost of ownership analysis. Table 17 displays the total cost per unit after including the Bank payment fee. 225

10 Improving Sourcing Decision Using Total Cost of Ownership and Risk Analysis: The Case Study of Imported Product Table 17: Comparison of Each Supplier s Cost after Including the Bank Payment fee Country Supplier DDP Unit Price ($) Cost of Capital per Unit ($) (In Transit Inventory) Cost of Capital per Unit ($) (Safety Stock+ Cycle Stock Inventory) Warehouse Cost ($) Bank Payment Fee Rate ($) Total Cost Per Unit ($) Philippines A Australia B Indonesia C Thailand* D Table18 summarizes all costs related to the calculation of total cost for ownership based on the previous analysis. The result indicates that purchasing the products from Philippine suppliers still yield the lowest total cost of ownership followed by purchasing from Thai supplier. Table 18: Total Cost of Ownership Analysis for Year 2009 Cost Details A B C D Pre-Transaction Costs Purchasing Management Transaction Costs Price Per Unit (Piece) Transaction Costs Export Charge Total FOB Origin Port Transaction Costs Freight Charge Transaction Costs BAF Transaction Costs Insurance Total CIF Bangkok Transaction Costs Customs Import Duty Transaction Costs Service Charge Transaction Costs Local Charge Transportation To Warehouse Transaction Costs Local Charge Labor Charge Total Delivery Duty Paid Cost Per Piece Post-Transaction Costs Pipeline Stock Total DDP + Pipeline Stock Post-Transaction Costs Safety Stock Post-Transaction Costs Management (Warehouse And QA) Post-Transaction Costs Transfer Total Cost Of Ownership For Normal Shipment According to the AFTA agreement, in year 2010 the custom duty rate will be reducing to 0 which also affect the total cost of ownership analysis. Table19 summarizes all costs related to the calculation of 226

11 total cost for ownership by using the zero custom duty rates. The result indicates that purchasing the products from Philippine suppliers still yield the lowest total cost of ownership followed by purchasing from Indonesia supplier. Table 19: Total Cost of Ownership Analysis under Zero Custom Duty Rate Pre-Transaction Costs Purchasing Management Transaction Costs Price Per Unit (Piece) Transaction Costs Export Charge Total FOB Origin Port Transaction Costs Freight Charge Transaction Costs BAF Transaction Costs Insurance Total CIF Bangkok Transaction Costs Customs Import Duty Transaction Costs Service Charge Transaction Costs Local Charge Transportation To Warehouse Transaction Costs Local Charge Labor Charge Total Delivery Duty Paid Cost Per Piece Post-Transaction Costs Pipeline Stock Total DDP + Pipeline Stock Post-Transaction Costs Safety Stock Post-Transaction Costs Management (Warehouse And QA) Post-Transaction Costs Transfer Total Cost Of Ownership For Normal Shipment Risk Analysis Based on the current strategy of the company that relies on only supplier in Philippine to supply the product to them, the company have find some difficulties in accommodating the urgent orders that frequently arrive from customers. The main reason for this is that the company may not be able to fulfill all these urgent orders due to the long delivery lead time of Philippine supplier. In addition, the severe environments in Philippine such as storm and floating also create the problem of supply disruption and causes the company lose their business because they cannot delivery products to customers. For some critical orders, the products may need to be sent in small shipment with some extra charges. Table 20 and Table 21 displays the special shipments for urgent orders during year through LCL import shipment and air import shipment respectively. Table 22 and Table 23 illustrate the extra charges which were the result of these urgent orders. 227

12 Improving Sourcing Decision Using Total Cost of Ownership and Risk Analysis: The Case Study of Imported Product Table 20: The LCL Import Shipment LCL Import Shipment Table 21: The Air Import Shipment Air import shipment Year Quantity Quantity Year Quantity Quantity Cases Pieces Cases Pieces , , , , , ,340 Table 22: LCL Shipment Expense in LCL Import Shipment Extra Charge Analysis Year Total LCL Shipments (Piece) General Expenses Freight Total Cost (S) , , , ,460 1, , , ,460 63, , , Total 213, Include port storage charge,freight forwarder service charge, labor charge Table 23: Air Fright Import Shipment Expense in Year Air Freight Import Shipment Total Air Freight Shipments (Piece) Extra Charge Analysis General Expenses Freight Total , , , , , , Total 65,764 9, Based on the information on Table 20 and Table 21, to fulfill customer orders, the companies have to pay $ to ship the product by LCL shipment and $ to ship the product by Air shipment from supplier in Philippines. This additional expenses; however, could be lower if the company purchased the products from another suppliers that have the shorter lead time. Moreover, between year , severe weather conditions problems, flood and volcano explosion in Philippines put the company be in the conditions of supply shortages and unable to fulfill customer orders. These situations affected the company performance from customers view points and caused the company to incur some loss of goodwill cost that might not be exactly estimated. As a result of risk analysis, relying on only one supplier is not the good strategy for the company. It might be beneficial for the company to consider having another supplier in order to mitigate some risks from having single supplier. 228

13 CONCLUSION Based on the total cost of ownership analysis, the company should still purchase the products from the current supplier in Philippines because it has the lowest total cost of ownership. However, it is not the best strategy for the company to rely on this supplier only. The long delivery lead time of this supplier has affected the ability of the company to fulfill urgent orders. In addition, the growing risk of natural disaster in Philippine also impact the company business because of the supply shortage. According to the total cost of ownership, after the custom duty rate has been changed to zero percent, Indonesia supplier should be considered as a secondary supplier because they have the second lowest total cost ownership. However, when consider the issue of risk associated with the customer urgent orders, it might be more advantageous for the company to select Thai supplier as their secondary supplier. The same geographical location of Thai supplier and the company can shorten the delivery lead time to only one day which will help the company reducing some extra cost from shipping the product in LCL or air fright shipment sand being more responsive to customer requirements. BIBLIOGRAPHY Alan Branch International Purchasing and Management. Australia: Thomson Learning Amy Z.Zeng and Cristian Rossetti Journal of Business Logistics Developing a framework for evaluating the logistics costs in global sourcing processes An implementation and insights Arjan J. van Weele Purchasing and Supply Chain Management Analysin, Plannng and Practice.3 rd ed. Australia: Thomson Learning Carlos F.Daganzo A Theory of Supply Chains.Germany:Springer Henri Janhonen Int. J. Technology Intelligence and Planning. Planning of global sourcing from total acquisition cost perspective. 4, 1, 95 Lisa M. Ellram and Sue P. Siferd Journal of Business Logistics.Total Cost of Ownership A Key concept in strategic cost management decisions Lieven Quintensa,_, Pieter Pauwelsa, Paul Matthyssensb,c Journal of Purchasing & Supply Management.Global purchasing: State of the art and research directions amaastricht University Potter, A., Mason, R. and Lalwani, C Analysis of Factory Gate Pricing in the UK Grocery Supply Chain. Cardiff Business School Cardiff University. United Kingdom Robert Monczka, Robert Trent, and Robert Handfield Purchasing and Supply Chain Management. 2 nd ed. Australia: South-Western, a division of Thomson Learning Richard Russill Hampshire. Purchasing Power Your Suppliers, Your Profits : Prentice Hall Europe Stuart Heinritz, Paul V. Farrell, C.P.M., Larry C. Giunipero, and Michael G. Kolchin. D.B.A Purchasing Principles and Applications.8 th ed. USA: Prentice-Hall Internaitonal, Inc