ANCILLARY LECTURE 14-3 INTERNATIONAL SOURCING DECISIONS ---
Instructor’s Note: The purpose of this lecture is to supplement material in the text. A good portion of this material is already in the book. Therefore, instructors should use either this version or the shorter version in the book.
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Refact: Over the last 20 years, importing has gone from a small segment of the production strategy for apparel to a dominant force, now accounting for about 67 percent of all goods sold at retail.i
Take a look at what you are wearing to see if anything is made in the US. Chances are your shirt or blouse is made in Hong Kong. Your jeans are made in Italy. Those beautiful new shoes are Brazilian, while those old sweat socks are from China. Your undergarments are from Honduras.
To top it off, your watch is probably from either Japan or Switzerland.
A decision that is closely associated with branding decisions, which we discussed in the previous section, is to determine where the merchandise is made. A product’s country of origin is often used as a signal of quality. Certain items are strongly associated with specific countries, and products from those countries, such as chocolate from Switzerland or cars from Japan, often benefit from those linkages.ii But there is more to global sourcing decisions that simply buying from those countries with reputations for high quality merchandise.
In this section we will first examine the cost implications of international sourcing decisions. On the surface, it often looks like retailers can get merchandise from foreign suppliers cheaper than from domestic sources. Unfortunately, there are a lot of “hidden” costs, including managerial issues, associated with sourcing globally that make this decision more complicated. The influence of Collaborative supply chain management inventory systems on Global sourcing decisions is then examined. Clearly it takes longer to source globally than it does to buy from a vendor close to home. Since Collaborative supply chain management inventory systems have become such an important facet of merchandise management, we will examine ways that retailers can derive benefits from Collaborative supply chain management while still sourcing globally.
This section concludes with an examination the ethical issues associated with retailers who buy from vendors engaged in human rights and child labor violations. We discuss what some retailers are doing to eliminate the problem.
Costs Associated with Global Sourcing Decisions
A demonstrable reason for sourcing globally rather than domestically is to save money. Retailers must examine several cost issues when making these decisions. The cost issues discussed in this chapter are: Country of origin effects, foreign currency fluctuations, tariffs, free trade zones, inventory carrying costs, and transportation costs.
Country of Origin Effects
The next time you are buying a shirt that is made in Western Europe -- Italy, France, or Germany -- notice that it is probably more expensive than a comparable shirt made in a developing country like Hungary, Ecuador, or Taiwan. These European countries have a reputation for high fashion and quality. Unfortunately for the US consumer, however, the amount of goods and services that can be purchased in those countries with US dollars is significantly less than in the developing countries. When making international sourcing decisions, therefore, retailers must weigh the
savings associated with buying from developing countries with the panache associated with buying merchandise from a country that has a reputation for fashion and quality. Jeans from Italy, for example, can retail for over $100; whereas those made in Ecuador or even in the United States are much less. Other countries, such as Japan for instance, might have a technological advantage in the production of certain types of merchandise and can therefore provide their products to the world market at a relatively lower price than other countries. For example, Japan has always been a leader in the development of consumer electronics. Although these products often enter the market at a high (penetration) price, the price soon drop as manufacturers learn to produce the merchandise more efficiently.
Foreign Currency Fluctuations
An important consideration when making global sourcing decisions is fluctuations in the currency of the exporting firm. Unless currencies are closely linked, for example, between the US and Canada, changes in the exchange rate will increase or reduce the cost of the merchandise.
Suppose that Service Merchandise is purchasing watches from Swatch in Switzerland for
$100,000, which is equivalent to 120,000 Swiss Francs (SFr) since the exchange rate is 1.2 Sfr for each US dollar. If Service Merchandise believes the value of the dollar will fall to, say 1.1 SFr, before they have to pay for the watches, they should negotiate payment for the watches in US dollars. In this case, Service Merchandise would pay $100,000 and the risk of devaluation of the dollar lies with Swatch. If, however, Swatch demands payment is Swiss Francs, Service Merchandise assumes the currency fluctuation risk. In this case, Service Merchandise would end up paying $109090 (120,000 SFr ÷ 1.1).
To lessen the risk of a falling currency exchange, i.e., the US dollar becoming less valuable compared to the currency of the vendor, Service Merchandise could engage in the foreign
exchange market. Suppose that Service Merchandise believes that the value of the dollar will fall in relation to the Swiss Franc before payment is due, as in our example. Service Merchandise can get a bank to agree to guarantee the Swiss Francs at the $1.20 rate for an additional fee to be used to pay for the watches at the time that payment is due. There is still a risk involved with this strategy, however. Service Merchandise could miss an opportunity to get the watches at a lower price by locking in the $1.20 rate if the value of the US dollar goes up instead of down.
Tariffs
A tariff, also known as a duty, is a list of taxes placed by a government upon imports or exports.
Import tariffs have been used to shield domestic manufacturers from foreign competition and to raise money for the government. Although more common in less developed countries, export taxes are only used to generate additional revenue. For instance, the Argentinean government may impose an export tariff on wool that is exported. An export tariff actually lowers the competitive ability of domestic manufacturers, rather than protecting them, as is the case with import tariffs. In general, since tariffs raise the cost of imported merchandise, retailers have always had a strong incentive to reduce them. In this section we will discuss several mechanisms used for reducing tariffs: the General Agreement on Tariffs and Trade (GATT), the North
American Free Trade Agreement (NAFTA), and Foreign Trade Zones.
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In 1993, a GATT accord was reached that has far-reaching effects on the reduction of tariffs and other trade barriers. Importantly, in January 1995, the World Trade Organization (WTO) was formed to supervise and arbitrate GATT agreements and encourage future negotiations.
North American Free Trade Agreement (NAFTA). The ratification of NAFTA on January 1, 1994 created a tariff free market with 364 million consumers and a total output of $6 trillion.iv NAFTA members are currently the US, Canada, and Mexico, but other Latin American countries are expected to join in the next few years.
US retailers stand to gain from NAFTA on several fronts. First, Mexican labor is relatively low-cost and abundant. Thus, retailers can either search for lower-low-cost suppliers in Mexico or begin manufacturing merchandise there themselves. Maquiladoras -- plants in Mexico that make goods and parts or process food for export to the United States -- are plentiful, have lower costs than their US counterparts, and are located throughout Mexico, but particularly in border towns such as Nogales and Tijuana. Second, with the growing importance of Collaborative supply chain management inventory systems, the time it takes to get merchandise into stores has become even more critical than in the past. Transit times are shorter and managerial control problems are reduced when sourcing from Mexico, compared to the Far East or Europe. Finally, many US retailers view Mexico as an attractive market for expansion (See Chapter 5 (Strategy chapter).) NAFTA was not passed without opponents, however. There are segments of the US economy that will suffer. Since US employers will be able to buy or manufacturer merchandise cheaper in Mexico, the wages and employment of US unskilled workers may decrease. Further, some labor intensive industries such as furniture, and clothing are likely to suffer. Finally, those involved in the production of sugar, peanuts, citrus, vegetables and seafood may loose business to Mexican competition.
Foreign Trade Zones
Retailers involved in foreign sourcing of merchandise can avoid import tariffs completely by using foreign trade zones. A foreign trade zone is a special area within a country that can be used for warehousing, packaging, inspection, labeling, exhibition, assembly, fabrication or transshipment of imports without being subject to that country’s tariffs.
To illustrate how a foreign trade zone can benefit retailers, consider how German cars are imported to a foreign trade zone in Guatemala for distribution throughout Central America. The duty for passenger vehicles is 100 percent of the landed cost of the vehicle. The duty for commercial vehicles, however, is only 10 percent. The German manufacturer imported commercial vans with no seats or carpeting, and with panels instead of windows. After paying the 10% import duty, they converted the vans to passenger station wagons in the foreign trade zone in Guatamala and sold them throughout Latin America.
Cost of Carrying Inventory
The cost of carrying inventory is likely to be higher when purchasing from suppliers outside the US than from domestic suppliers. Recall from Chapter 6 that:
Cost of carrying inventory = Average inventory value (at cost) X Opportunity cost of capital.
The opportunity cost of capital is the rate available on the next best use of the capital invested in the project at hand.
There are several reasons for the higher inventory carrying costs. Consider The Spoke bicycle store in Aspen, Colorado that is buying Moots bicycles manufactured in Steamboat Springs, Colorado. They know that the lead time -- the amount of time between recognition that an order needs to be placed and the point at which the merchandise arrives in the store and is ready for sale -- is usually two weeks plus or minus three days. But if The Spoke is ordering their bikes from Italy, the lead time might be three months, plus or minus three weeks.
Why is the lead time typically longer when sourcing globally? The lead time tends to be longer because order transmission, order filling, packing and preparation for shipment, and
transportation tends to be longer and more complicated for global transactions. Order transmission time -- the time it takes for the order to get from the retailer to the supplier -- depends on whether electronic data interchange (EDI), telephone, fax, or mail is used in communicating. The order filling time may also increase because of a lack of familiarity of customs and procedures between the retailer and their foreign supplier. Packing and shipment preparation require more attention. Finally, and probably most important, transportation time increases with the distances involved. v
Since lead times are longer, retailers must maintain larger inventories to insure that merchandise is available when the customer wants it. Larger inventories mean larger inventory carrying costs.
It is also more difficult to predict exactly how long the lead time will be when sourcing globally.
When the bicycle goes from Steamboat Springs to Colorado, the worst that could happen is that it gets caught in a snow storm for a day or two. On the other hand, the bicycle from Italy might be significantly delayed because of multiple handlings at sea or airports, customs, strikes of carriers, poor weather, or other bureaucratic problems. Similar to longer lead times, inconsistent lead time require the retailer to maintain higher levels of safety stock.
Transportation Costs:
In the previous section, we described how the cost of carrying inventory is higher when sourcing globally than when sourcing domestically. Part of this cost is due to longer shipping distances -- the longer the distance, the higher the transportation cost for any particular mode of
transportation. For instance, the cost of shipping a container of merchandise by ship from China to New York is significantly higher than from Panama to New York.
The introduction of different modes into the transportation cost equation complicates the sourcing decision. Suppose The Spoke in Aspen decides to have the bicycles from Italy shipped by
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It is easier to stay in stock with the bicycles that are most popular, and they can promote special orders.
Retailers can use the following rule of thumb to determine which transportation mode is best.
First, relatively high weight/high density/low cost staple merchandise such as furniture is more likely to be shipped via lower cost modes such as water, truck, or train. Alternatively, relatively low weight/low density/high value fashion merchandise such as jewelry is more likely to be shipped by air. What do retailers that are in the middle of this weight/density/cost spectrum do?
Some of the best have chosen airfreight. The Limited, for example, leases Boeing 747s to airfreight merchandise from the Orient to its distribution centers in the United States.
Managerial Issues Associated with Global Sourcing Decisions
In the previous section we examined the specific costs associated with global sourcing decisions.
In most cases, retailers can obtain hard cost information that will help them make their global sourcing decisions. The managerial issues discussed in this section -- quality control and developing strategic alliances -- are not as easily evaluated.
Quality Control
When sourcing globally, it is more difficult to maintain and measure quality standards than when sourcing domestically. Typically these problems are more pronounced in countries that are further away and that are less developed. For instance, it is easier to address a quality problem if it occurs on a shipment of dresses from Costa Rica to the US than if the dresses were shipped from Singapore. In the same way, since Germany is known for its high engineering standards and since Volkswagen’s corporate offices are in Germany, one might expect fewer defects on
Volkswagens made in Germany than those made in Mexico.
There are both direct and indirect ramifications for retailers if merchandise is delayed because it has to be remade due to poor quality. Suppose Banana Republic is having pants made in Haiti.
Before leaving the factory, Banana Republic representatives find that the workmanship is so poor that the pants need to be remade. This delay reverberates throughout the system. Banana
Republic could carry extra safety stock to carry them through until the pants can be remade.
More likely, however, they won’t have advance warning of the problem, so the stores will be out-of-stock.
A more serious problem occurs if the pants are delivered to the stores without detecting the problem. This could happen if the defect is subtle, such as inaccurate sizing. In this case, customers must try on multiple pants, and special orders and transfers from other stores are useless since there is no size integrity. In the end, customers can become irritated and question merchandise quality. Also, markdowns ensue because inventories become unbalanced and shop-worn.
Building Strategic Alliances
The importance of building strategic alliances is examined later in this chapter. It is typically harder to build these alliances when sourcing globally, particularly when the suppliers are further away and are from less developed countries. Communications are more difficult. There is often a language barrier, and there are almost always cultural differences. Business practices -- everything from terms of payment to the mores of trade practices such as commercial bribery -- are different in a global setting. The most important element in building a strategic alliance -- maintaining the supplier’s trust -- is more arduous in an international environment.
The Influence of Collaborative supply chain management on Global Sourcing Decisions Sourcing globally and collaborative supply chain management inventory systems are inherently incompatible. Yet both are important and growing trends in retailing. Collaborative supply chain management systems are based on short and consistent lead times (See Chapter X -- systems).
Vendors provide frequent deliveries with smaller quantities. There is no room for defective merchandise. For a Collaborative supply chain management system to work properly, there needs to be a strong alliance between vendor and retailer that is based on trust and a sharing of information through electronic data interchange (EDI). In the preceding section we argued that each of these activities are more difficult to perform globally than domestically. Further, each of these activities is more difficult to perform globally than domestically. Further, the level of difficulty increases with distance and the vendor’s sophistication.vi
What can a retailer do to lessen the impact of these seemingly incompatible trends? Retailers can use third party logistics companies and source closer to home. In the next section, we examine how third party logistics companies can help retailers and why so many retailers are choosing suppliers that are located closer to their stores.
Third Party Logistics Companies
Third party logistics companies are companies that facilitate the movement of merchandise from manufacturer to retailer, but are independently owned. These companies provide transportation, warehousing, consolidation of orders, and documentation, or a combination of several of these services. Increasingly, third party logistics companies provide information services called Value Added Networks (VANs) that facilitate the electronic data interchange that is such an integral part of collaborative supply chain management systems.
Transportation. Retailers must choose their shippers carefully and demand reliable, customized services. After all, to a large extent, the retailer’s lead time and the variation in lead time is determined by the chosen transportation company. Also, many retailers are finding that airfreight is worth the added costs. Some retailers mix modes of transportation in order to reduce overall cost and time delays. For example, many Japanese shippers send Europe-bound cargo by ship to the U.S. West Coast. From there, the cargo is flown to its final destination in Europe. By combining the two modes of transport, sea-air, the entire trip takes about two weeks, as opposed to four or five weeks with an all-water route, and the cost is about half of an all-air route.vii Warehousing. To lessen the chance of being out-of-stock as a result of long and inconsistent lead times on overseas shipments, retailers are insisting that their vendors maintain inventories in warehouses in the US. Rather than owning these warehouses themselves, the vendors typically use public warehouses which are owned and operated by a third party. By using public
warehouses, vendors can provide their retailers with the same level of service as domestic suppliers can.
International freight forwarder. Although there are several types of organizations that help in the
International freight forwarder. Although there are several types of organizations that help in the