The Application of Total Cost of Ownership on Low Cost Country Sourcing: evidence from case study and the future research direction

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Faculty of Economics & Business

Master Thesis

Research Master

Operations Management & Operations Research

The Application of Total Cost of Ownership on Low Cost Country

Sourcing: evidence from case study and the future research direction

Final version

First supervisor: Prof. Dr. Jan de Vries Second supervisor: Dr. Taco van der Vaart

July 27th, 2011 Zhida Xu

S1546511

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Abstract

This thesis contributes to our knowledge pool of Low-Cost-Country Sourcing (LCCS) by applying Total Cost of Ownership principle on low-cost-country selection process. It contains two parts. Chapter 1 used case study method to develop a low-cost-country evaluation model. It answers two questions: 1) Which countries offer low cost sourcing opportunities? and 2) Is it attractive to buy from that country in the medium and long term? The research findings showed that: 1) a country with significant low labor cost advantage may not be the ideal sourcing destination. A total cost evaluation model is required for decision making; 2) due to age structure transition of the population in the low-cost-country, there is a limited time window for the low-cost advantage; 3) insufficient cross-functional cooperation and communication can act as organizational barriers to implement LCCS project. In order to further explore these organizational barriers and to capture the recent development of LCCS research, a literature review was performed in chapter 2. 44 peer-reviewed articles published between 2006 and 2011 were peer-reviewed. It classified these articles on their research theme and research methods. Analysis results showed that LCCS research no longer largely relies on qualitative and descriptive methods. It also summarized the organizational and environmental barriers for successful LCCS project. This thesis advised researchers to perform more theory-building research. Comparative case study method was found an effective tool for exploration research. Researchers should also pay attention to behavioral and organizational research for LCCS in the future.

Key Words: Low-Cost-Country Sourcing, Total Cost of Ownership, Case Study, Literature Review

Acknowledgement

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Introduction

International purchasing and outsourcing have become pervasive business activities. Companies in developed economies buy materials and components from some low-cost-countries such as China and India, in order to take the advantage of low production cost, especially the low labor cost. Therefore, buying from those countries is often tagged as Low-Cost-Country Sourcing (LCCS). Reports from consultancy firms claimed that LCCS can provide cost savings and directly benefit the bottom line (Aberdeen Group, 2005; IBM Global Business Service, 2006). Besides the advantages of low production cost, companies can focus on core business, benchmark competitors in their outsourcing endeavors, own a broad supply base and establish a sales footprint for future market entry (Cater et al, 2005; Andersson et al, 2007).

On the other hand, LCCS can lead to higher risk than local sourcing, such as supply disruption and long lead time due to long distance transportation, security issues due to political instability in the host country and ―hidden cost‖ such as foreign exchange control, tariffs, duties and other kind of taxes (Fitzgerald, 2005). Besides, some indirect risks include communication difficulty because of culture difference, insufficient intellectual property protection, spillover effect of technical know-how and corporate social responsibility issues such as use of child labor in the low cost countries. Poor quality is often reported as a concern.

In the recent years, the global business environment for LCCS has been changing contrasted to the previous two decades. Taking China as an example, its significant price inflation has been witnessed since 2007 (National Bureau of Statistics of China). According to Bradsher (2008) and Kumar, Medina & Nelson (2009), Inflation, the appreciation of the Chinese currency, shortages of skilled workers and changing labor legislation are among the factors that contribute to the rising sourcing costs in China. According to The Economist Intelligence Unit (Kumar et al., 2009), China has lost its cost advantage ($2.03/h) to Vietnam ($0.44/h), Indonesia ($0.7/h) and India ($0.92/h) in terms of production labor rates. In a press release from Boston Consulting Group, it was reported that with Chinese wages rising at about 17 percent per year and the value of the Yuan continuing to increase, the labor costs of manufacturing in China and the US could pull even by 2015.1 Therefore, the United States is expected to experience a manufacturing renaissance with the label of ―Made in USA‖. In addition, due to fluctuation of oil prices, oversea transportation cost also increased. The increasing risk of global supply chain disruption should also draw our attention. Natural hazards and un-natural disasters are critical sources of this kind of risk. In recent years, it is witnessed that the frequency of these crisis increased. The 2004 earth quakes and tsunami in Southeast Asia, the 2008 massive earth quake in China, the 2010 Iceland volcano ash and the very recent quakes and tsunami in Japan with the subsequent nuclear crisis, all of these disasters not only lead to the humanitarian crises, but also damaged the global production and logistics activities. It is difficult to predict the Mother Nature, but it is reasonable to give more weight for consideration to these kinds of risks during low-cost-country sourcing activities. These changes in the business environment are acting as threats to realizing the benefits of LCCS.

Given this situation, a question has to be posted: will Low-Cost-Country Sourcing still be feasible in the future? For example, as a recently detected phenomenon, many LCCS projects cannot

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generate the expected return. Therefore, instead of outsourcing to low-cost-countries, many companies moved to ―back-sourcing‖ as a remedy of prior unsuccessful decision (Kinkel & Maloca, 2009). The main reason for these unsuccessful LCCS projects is that complains relied largely on labor cost comparison when they made the outsourcing decision. However, a ―Total Cost‖ model is required to consider more cost drivers. The framework of Total Cost of Ownership (TCO) can provide useful guidance. There has been lots of intensive discussion about Total Cost of Ownership in the literature (Ellram, 1993, 1995, 1996; Ellram and Maltz, 1995; Olsen and Ellram, 1997; Ferrin and Plank, 2002). But limited study applies this view in the situation of Low-Cost-Country Sourcing. Especially, it is necessary to study how the low cost countries should be selected.

The objective of this thesis is to develop a model for LCCS country selection based on Total Cost of Ownership. It contains two parts. The first chapter reported an empirical case study which was conducted in 2009 at a European plastic pipe manufacturer. It answered two research questions: 1) Which countries offer low cost sourcing opportunities? And 2) Is it attractive to purchase from that low cost country in the medium and long term? During this study, it was also found that the lack of cross-functional cooperation and communication can act as a barrier to implement the LCCS project. Meanwhile, it was found that the LCCS literature lacks its theoretical foundation, and our knowledge on LCCS is worth reviewing. Therefore, in the second chapter, a literature study was performed in order to capture the recent development of our knowledge on Low-Cost-Country Sourcing. It displays what we already know about LCCS and what we still need to study. To achieve this objective, the following research questions were brought out: 1) What are the research themes within the study of LCCS? 2) What research methods have been used to study LCCS? And 3) What factors act as barriers to realize the expected outcome from LCCS? The third question aims to summarize the barriers of realizing the expected return from LCCS as the continuation of the study in chapter 1.

Regarding the contribution of this thesis, it is the first known paper which studies the Low-Cost-Country selection based on Total Cost of Ownership principle. The proposed model with its combination of country evaluation and sustainable purchasing can provide management teams the ―one-stop shopping‖ for LCCS decision making. The literature study provides some general recommendation on the future research direction of Low-Cost-Country Sourcing. The summarized organizational barriers for LCCS implementation give researchers a reference point to look into this research area in the future.

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Chapter1 Decision making

process for Low Cost Country Sourcing based on Total Cost of Ownership: a

case study in European plastic pipe and fitting industry

1.1 Introduction

Limited existing literature has studied the application of Total Cost of Ownership principle in Low-Cost-Country Sourcing, especially, it is necessary to study how the low cost countries should be selected. Therefore, the objective of this paper is to develop a model for LCCS country selection based on Total Cost of Ownership. The study in this chapter intends to answer two questions: 1) Which countries offer low cost sourcing opportunities?

2) Is it attractive to purchase from that country in the medium and long term?

A case study was performed in one European plastic pipe and fitting manufacturer and it addressed the following sub research themes: product selection for low cost country sourcing, low-cost country selection based on Total Cost of Ownership and the sustainability of the low cost in that country. These issues were integrated into a decision process model for LCCS. As the contribution to the literature, the model provides management a ―one stop shopping‖ for LCCS analysis and decision making. The main finding of the study is that, among 21 evaluated low-cost countries, India, Indonesia, Egypt, Philippines, and Tunisia are found to be attractive as destination of LCCS, and their low cost condition are sustainable in the medium term (3 to 5 years). Vietnam, Morocco, Turkey, Argentina, Mexico, and Brazil also have the potential, but with relatively lower total ranking. China is an ideal destination compared with other low-cost countries, but the country’s labor cost is expected to rise significantly in the near future. In addition, as an objective observation, it was found that insufficient cross-functional cooperation and communication act as the organizational barriers to implement the LCCS project in the case company. These barriers were analyzed and recommendations were provided.

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1.2 Theoretical Framework

1.2.1 Defining Low Cost Country Sourcing (LCCS)

Global sourcing, international purchasing and low cost country sourcing, as names of business practices, are interchangeable for business practitioners. However, to be rigorous for the research, they should be clearly distinguished, because these terms do differ from scale and scope. Starting with the term ―sourcing‖, according to Kotabe and Murray (2004, page 9), sourcing is used to describe management the flow of component and finished products in serving foreign and domestic markets. Global sourcing is a broad term. It is a discussion of sourcing on a more strategic level. Trent and Monczka (2003) defines global sourcing as the worldwide integration of engineering, operations and procurement centres within the upstream portion of a firm’s supply chain. They also provide a continuum model of different stages of worldwide sourcing (Table 1). According to this continuum, international purchasing (lever 2 and 3) is a tactical buying activity which is short-term oriented and its responsibility is distributed solely to the purchasing department. A true global sourcing practice (level 4 and 5) is based on the long-term commitment on the supply market and it requires cross-functional cooperation within the company. This process model is consistent with the internationalization process model of Johanson and Vahlne (1977).

Table 1 A continuum of different levels of worldwide purchasing practice (Trent and Monczka, 2003)

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noticed that LCCS is a subset of global purchasing due to its targeted supply markets.

1. 2.2 Total Cost of Ownership and Low Cost Country Selection criterion

Assessing which low cost country to purchase from on a macro level involves a lot of considerations. Besides the purchasing price of product from that country, factors such as the capability of industry sector, product quality and transportation time/cost are important. This comprehensive way of evaluation complies with the modern principle of purchasing which is called Total Cost of Ownership.

Traditionally, the mission of purchasing function is to buy materials, components or services from outside parties with low prices. Therefore, it is common that purchasers’ primary concern is the low price. However, with the development of modern supply chains, purchasing begin to play a strategic role for the company, and it is important to pay attention to other performance objectives besides cost price, such as quality, speed, dependability and flexibility (Slack and Lewis, 2001), since bad performance on these aspects will also cost money. Since 1980s’ there has been some development and evolution of methods to find the ―total price‖ for purchasing. Some contribution include the concept of Total Cost (Cavinato 1991, 1992), Life cycle costing (Jackson and Ostrom, 1980), Product life cycle costs ( Shields and Young, 1991) and Total Cost of ownership (Ellram 1993, 1994, 1995). These concepts are all related and share the same belief that purchasers should not only focus on the face price, but they should take into account other factors in the purchasing activities in order to derive the total price. Among those concepts, Total Cost of Ownership (TCO) has been widely accepted and Ellram did a serial of contribution in this field.

According to Ellram and Siferd (1993, page 164), Total Cost of Ownership implies that all costs associated with the acquisition, use and maintenance of an item be considered in evaluating that item and not just the purchase price. Ellram (1993) classified the total cost of purchasing into three categories: 1) Pre-transaction cost, such as investigating and qualifying sources, selecting and educating suppliers; 2) transaction cost, such as price, order placement, delivery, tariffs/ duties, billing, inspection and follow-up; 3) Post-transaction cost, such as failure cost, return and repair costs, etc. It is believed that taking

a TCO perspective not only helps to disclose the ―real price‖ or ―hidden cost‖ in purchasing activities, and it is also a valuable method to analyze purchasing process in order to find improvement opportunities.

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management system among the manufactures. ISO certificate is a widely accepted measurement of quality management system; therefore, percentage of ISO certificate ownership of manufactures is an acceptable indicator. Thirdly, the importance of logistics does not need to be over emphasized. Besides the direct transportation cost and lead time, time to export, such as time to pass custom sometime can cause delay of responsiveness. The facility of infrastructure is also need to be checked. For international purchasing, duty and tariff are important concern, especially the anti-dumping tariff and safeguard measures. These special tariff could suddenly take away all the saving potential.

Last but not least, the ―Business environment‖ contains a lot of cost drivers which are normally hidden from the surface. When product requirement and specification are disclosed, the spill-over effect of know-how is somewhat inevitable. Therefore, it is critical to protect purchasing party’s intellectual property. In some low cost countries, child labour use is common practice and industrial pollution is serious. This will damage the reputation of the purchasing party. Finally, the foreign exchange risk sometimes could also take away all the saving effect on LCCS when there is dramatic exchange rate fluctuation against the purchaser. To sum up, the above discussion can be summarized into a country selection model for low cost country sourcing based on total cost view. These country selection criterions are summarized in a tree chart in Figure 1.

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1.2.3 Product selection for Low Cost Country Sourcing

What kind product is suitable for purchasing from low cost countries is a very critical issue. Due to different product nature and other contingency factors, some product can show significant saving potential when buying from the same low cost country, but some may not, and in some cases, it could end up with negative savings. Therefore, this issue needs to be carefully addressed. Literature on this topic suggests two perceptive: a top-down, macro method which starts the analysis from strategic requirement and a bottom-up, micro method which focuses on product nature, quality, and lead time, etc. Kamann, Harasek and El-Kadi (2001) proposed a P-O-P model in order to link the purchasing function with the general business strategy of a company. They maintain that companies as an open system formulates a business strategy based on external environment and internal competence. This strategy will be translated into certain Policy (P), and the Organizational design (O) and business Process (P) of each function in the company. Since purchasing has transformed from only a business function into strategically important activities, the purchasing policy, purchasing organization and purchasing process should be coincide with the general business strategy. Therefore, in order to select the item to purchase from outside parties, the first consideration will be what the core competence is, so the company should keep in-house, and what should be purchased in order to better use the specialty and other benefits from the suppliers.

On a micro level, Andersson et al. (2007) used a multiple case study method to link product characteristics and low cost country sourcing. They maintain that Volume of the sourced product and the demand pattern are the dominant forces to be studied in LCCS. Their primary finding is that products considered for LCCS are characterized by high volumes, low level of design changes, regular demand/regular shipments and high value density. Meredith Smith (1999) summarized the selection criterion into six categories, namely product specification and its change, product technology and its change, impact of quality failure, impact of logistics, product criticality and volatility and product/delivery cost.

Fisher (1997) classifies products into two categories and matched them with two types of supply chain designs. Functional product (long life cycle, low profit margin, good prediction for demand, low product variety, low requirement for lead time) is suitable for an efficient supply chain, which aims to supply predictable demand efficiently at the lowest possible cost. In contrast, an innovative product (unstable environment, unpredictable demand, short life cycle, high risk for stock out, high requirement for responsiveness) requires a responsive supply chain, which strives for fast speed and more flexibility. In the situation of Low Cost Country Sourcing, due to the long transportation distance, hence long lead time and low responsiveness are inevitable, it seems reasonable that a simple, functional product with an efficient supply chain is appropriate.

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In addition, it is necessary to study the cost model of purchased product and build a link with the low cost country. Multinationals join LCCS for the low production cost, especially low labor cost; therefore, it is reasonable to purchase the products which have more share of labor cost. According to IBM Global Business Service (2006), component with low complexity and high labor costs usually present the best opportunity for savings in the low cost countries. Fraering and Prasad (1999) proposed a contingency model to link sourcing and logistics strategies and they maintain that product with high proportion of material cost is suitable for low cost country sourcing, because if materials cost is high, a firm would be unable to reduce its expenses significantly by just minimizing managerial overhead. Therefore, it must seek external or international suppliers who may provide the materials at a lower price (Cavusgil et al., 1993; Nichols and Taylor, 1995). To summarize the literature, Figure 2 combines both top-down and bottom-up views and summarize the selection criterion and characteristics for LCCS.

1.2.4 Sustainability of the low labor cost

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and look for other low cost countries. Therefore, it is necessary to investigate the sustainability of the low cost in the host country to prevent optimistic businesses.

Why the production costs are low in certain countries? Why the low cost is relatively stable in certain period? And why after that period the production costs increases rapidly? These phenomenon are witnessed in the Far East world after World War II. The ―demographic bonus‖ theory in demography provides some systematic explanations. ―Demographic bonus‖ is in the form of a large group of working-age people supporting relatively fewer older and younger dependents that creates a one-time opportunity for growth (window of economic opportunity), may have accounted for as much as a third of the East Asian economic miracle (The Economist, March 15th 2003). It explains the relationship between Age Structure Transition (AST) of the population in a country with its economic development.

There are two factors which influence age structure transition, namely fertility rate (the average number of births per woman per lifetime) and mortality rate (the total number of deaths per year per 1000 people). Furthermore, the population is classified into 3 age groups: children (0~14 years), working age adult (15~64 years) and elderly (65+ years). One key indictor which monitors age structure transition is the dependency ratio. The ―total dependency ratio‖ is calculated by using the sum of children and the elderly divided by amount of working age adult. 1 According to research (Sedano, 2008; Wong, 2005; Navaneetham, 2002; Mari Bhat, 2001; Hussain, 2002, Chu & Lee, 2000), the process of age structure transition goes through several stages: I. Mortality begins to decline, causing an increase of children in the population, which increases the total dependency ratio; II. Fertility then begins to decline, which initiates a period of declining child-dependency ratios and declining total dependency ratios. Working Age Adult accounts for the largest proportion while life expectancy keeps increasing. III. Finally, the elderly population begins to increase, and then elderly dependency ratios and total dependency ratios rise again, so the society becomes aging. Fertility rate drops to around 2, which is a natural replacement for the population to stay stable. If the fertility rate is lower than 2, the total population of that country will decrease. As an example, Figure 3 shows the Age Structure Transition in Brazil in the form of demographic pyramid.

Figure 3 Age Structure Transition in Brazil

Source: Wong, 2005, ―Demographic bonuses and the challenges of the Age Structure Transition in Brazil‖, data originally from United Nations (2003)

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Sedano (2008) summarized contributing effects of stage II. First, when a ―baby booming‖ generation enters the 15~64 age cohort, labor supply per capita rises. Since women tend to have fewer children, female work participation rate increases. These factors elevate per capita production levels and provide a supply-side boost to the economy. Second, given that young people are in general net borrowers, so Working Age Adults tend to save their earnings. This provides potential resources for investment, which in turn leads to economic development. Thirdly, given that life expectancy gets longer, a longer life creates the belief that educational investments will yield a higher return, therefore, education participation rate tends to increase. This will improve education level of the whole population which acts as a powerful engine for long term economic development. To sum up, the stage II of AST is a gift or “bonus‖. If a country could grasp this opportunity, it can enjoy a ―golden age‖ for economic development.

The process of age structure transition is a slow process in most developed countries, which took approximately two centuries to complete. But it is witnessed that this process happened faster in certain developing countries, especially after WWII, such as in East and Southeast Asia. There are some strong evidences which show that demographic bonus contributes significantly for economic development. Some economic miracles in Asia such as Japan and China are a typical Beneficiary of this bonus. Statistics show that demographic bonus contributes for 27% of the fast economic development of China in the past 20 years. Research also shows that for the whole Asia, the contribution of age structure change to economic growth from 1970 to 1990 is around 14%. (Bloom, Canning and Malaney, 1995, appendix table 4b) However, demographic bonus is only a necessary but not sufficient condition for economic take-off. If the policy makers of the country cannot create enough employment opportunities for the large labor supply, it will lead to massive unemployment, poverty, rampant crime, civil unrest and other social-economic problems.

Because the whole population will gradually move to stage III, the demographic bonus is a ―window of opportunity‖. It will happen once and only once. A demographic window opens as the numbers of younger children decrease, and the signal of diminishing window is the rise of total dependency ratio which is contributed by the rise of elderly dependency ratio. When the window is closed, the bonus will become onus, because of the aging of the large amount of Working Age Adults. In that case, the economy will have heavy burden due to social security cost to elderly people. Therefore, it is very important for the countries which are still in the bonus window to build a proper social security system.

There are other factors which facilitate the effect of demographic bonus, and migration plays an important role. Peng and Cheng (2005, page 4) argue that there are differential regional patterns of demographic dynamics and consequent conditions of demographic bonus. Internal migration is the bridge to match the conditions of harvesting demographic bonus in both sending and receiving areas, and therefore could prolong the time span of harvesting demographic bonus in the urban areas, while provide opportunities for the poor rural areas to be able to harvest demographic bonus, which results in a win-win situation.

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To summarize the literature, the reason that production cost is low mainly because there is abundant supply of labor for a period of time, while total domestic demand does not increase dramatically. This low cost is relatively stable in a period due to the effect of Demographic Bonus. When the window of opportunity is closed, labor becomes a scarce production factor and therefore cost increase significantly. When the management of MNEs makes decision for LCCS, accessing the countries’ current cost level is a part of the input. What is more important is to investigate whether that country is enjoying demographic bonus and until when. When both sides of stories are heard, a final list of candidate countries could be generated.

1.2.5 LCCS decision process model

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Figure 4 Decision process model for LCCS based on TCO view

1.3 The Case

Given that there is limited literature to apply Total Cost of Ownership into Low Cost Country Sourcing, this study has an exploratory nature. Therefore, case study is one of the proper strategies. By using case study, the business practice in one company is systematically analyzed and the result is also influenced by that specific industry. To conduct the research, both qualitative and quantitative methods are used. Especially, a serial of interviews with structured and semi-structured questions were performed with the managers in the company. They are regarded as experts in their work fields. During the interviews, the Delphi method was applied. By using the Delphi method, common agreement of interviewees towards certain issues is used to derive principles, while different opinions are excluded.

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Group is the leading European supplier of plastic pipe system with operating activities in 28 European countries and over 6700 employees. The company operates in several market segments in the plastic pipe industry, including tap water, surface heating and cooling, soil and waste, rain- and storm water, distribution of drinking water and gas and telecom applications. These businesses are organized in two Strategic Business Units: Building & Installation and Civil & Infrastructure. SMIT’s activities focus on Europe, but it has long history and extensive experience on global sales through agents and selling know-how through licensing. SMIT’s strategic objectives include: being the leading supplier of plastic pipe systems and solutions, focusing on European market, investing in innovation and providing customers with large range of products and services. Evaluated by the typology of strategy proposed by Porter (1985) which includes Cost Leadership, Differentiation and Niche-Focus, SMIT’s strategy can be classified as Differentiation, because it provides a package of product and service so that customers can do ―one stop shopping‖ when they seek plastic pipe solutions. The high value-added service is supported by large investment in innovation, and being a service provider also puts SMIT the high end of the value chain. When looking at the nature of the pipe and fitting industry, the market demand depends on the housing and construction market. The change of product technology is relatively slow and the product life cycle is long. Once the system is installed, warranties are provided for up to 50 years. Besides, across Europe, each region (e.g. Southern Europe, North West Europe, Central Europe, Nordic Europe, etc.) has its own requirement for pipe system due to climate conditions or tradition of use. This requires different materials and product design issues. Given these factors, SMIT group is managed in a decentralized way and a large range of product portfolio is maintained to meet various market demands. However, this practice brings challenge for complexity management and optimization of the product portfolio. In recent years, SMIT has been optimizing its supply base by creating some competitions between suppliers. In order to further trigger this process and take the advantage of low cost countries, SMIT stepped out of local sourcing and began to purchase from China. The products that currently purchased from China are mainly steel and brass parts, such as valves, fittings, connectors and manhole cover. The total savings based on landed price varies from 20% to 50%. According to Management’s experience, product quality is the major concern. Quality levels of different suppliers vary a lot. Products from some suppliers are good and impressive, and for others, it takes time to train the supplier to reach SMIT’s quality standard. It is also important to maintain a local purchasing office in China to coordinate the activities, perform quality control and the follow-ups. However, the increase of labor cost of China in recent years gives a warning signal, so management wants to search for backup sources. Therefore, the management questions are: which other low cost countries can SMIT purchase from and how sustainable the low cost can be?

1.4 Product selection for LCCS

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- Brass valve: normally with a brass body and nickel coating on the surface; - Brass fitting: mainly used for connecting pipes, similar material as the valve; - Grating: a kind of metal cover of the drainage, raw material is cast iron; - Rubber Ring: mainly used in water applications for sealing;

- Plastic end caps: insert at the end of a pipe to protect it, used for packing purpose.

The industry-wide (according to North American Industry Classification System) cost models for these products are provided in Table 2. As shown in the table, share of material cost for the proposed products are quite high. Their shares of labor cost are also higher than Plastics Pipe and Pipe Fitting Manufacturing. According to the product selection criterion discussed in section 2.3, it shows that it is wise to purchase those proposed products from low cost countries.

Afterwards, a survey is conducted to the purchasing managers by using a self administrated questionnaire. The questionnaire is designed based on the Smith method (1999). In his contribution, he proposed a method to evaluate the proper purchasing areas for products with different characteristics by using multiple case studies. Different domains of supply market include local sourcing (travelling distance within 50 km or 60 min.), national-wide sourcing, sourcing within trade-bloc (such as EU) and finally purchase globally. For global purchasing, purchasers could choose to buy directly or go through a local agent. A questionnaire was designed based on the six categories of considerations discussed in section 2.3. Respondents were asked to score from -10 to 10 for the questions, and the weighted average score was calculated. The results were plotted into a matrix, which is shown in Figure 5. In the case of SMIT, this is a useful tool to assess whether the selected item are really suitable to purchase globally.

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significant saving effect from low cost countries, then more similar items could be purchased from that country to take full advantage.

Figure 5 Smith matrixes (Smith, 1999, page 124)

The questionnaire contains 18 questions. The purpose of the survey is threefold. The first 2 questions are designed to learn whether the product specification (e.g. drawing) and product cost model are available within the company, not for calculation. Questions 3 to 17 are used to gather the opinions towards 5 aspects: nature of product characteristics and its change, purchasing volume and frequency, impact of quality, volatility/ criticality and freight vs. product value density. The object of evaluation is the product family, not any specific item or article. Respondents are asked to give a rating from 1 (in favour of local sourcing) to 5 (in favour of low cost country sourcing), and the results will be converted to -2~2 in order to plot the coordinate into the matrix. Question 18 is a multiple choice question with 3 answers required. It is designed to ask purchasing managers which 3 of the above aspects should receive more consideration when they choose to do LCCS. The result of this question will be used to determine the different weight of each aspect for the

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There are two aspects mentioned by Smith but are not included in this model, namely product technology and product availability. The reason is, according to the interview with managers, the production technology for the 5 proposed products are relatively basic in the manufacturing sector, such as forging, cast (moulding), extrusion moulding and injection moulding. The degree of complexity of these technologies does not vary significantly therefore it will have little influence on the survey result. Secondly, given that the technologies are relatively basic, they should be available in most of the industrialized and transition economies. Therefore, these two aspects are excluded from the model; instead, the issue of purchasing volume and order frequency are emphasized by the model, because for low value-added product, the way to realize saving from global sourcing is from high volume and large batch size.

Non-random sampling is used to select the respondents of the questionnaire because they must be experts of the proposed purchasing items. The respondents include group lead buying managers who have a general view of corporate purchasing, and local strategic buyers who have more in-depth views of each region. Regarding the number of questionnaires, 5 were designed and sent out for brass valve, 6 for brass fitting, 4 for metal grating, 5 for rubber ring and 3 for plastic end caps. In total, 23 questionnaires were sent out to 11 purchasing managers and 21 respondents were received. One of them had insufficient answer so it was excluded for analysis. Therefore, a valid response rate is 87% which is sufficient.

Findings

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frequency, 5 for product nature, 5 for Volatility/criticality and 3 for Freight/product value density. This gathered opinion is not product-specific but is in general for LCCS. The number of ―vote‖ is used directly as the weight of its corresponding aspect. The results of question 3 to 16 were converted from the scale [1, 5] to [-2, 2]. Finally, the weighted average of X and Y dimensions were calculated for each product family, and the results are shown in Table 4.

The result in the above table shows that, first, purchasing managers think only plastic end cap is a very suitable product for global sourcing. Valve, fitting and grating should be purchased from national trade bloc, in this case, the EU. Rubber ring product is best to purchase from local suppliers.

Second, the findings do not show a significant direction about proper purchasing areas, because the

final coordinates are all very close to the origin point. Therefore, one conclusion from the calculation is that purchasing those 5 kinds of product globally is not strongly supported by the result. This is out of the expectation of the researcher, which could either caused by the design of research or the data input.

Going back to the original data, it is interesting to find that purchasing managers’ opinions towards whether the product should be sourced globally is heterogeneous. Respondents voted for the same direction on certain consideration aspects, but in some cases their opinions are completely opposite (e.g. one votes 2 while another votes -2). Table 5 shows the distribution tendency of data by calculating standard deviation for each

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The findings that buying those products from low cost countries is not significantly supported and the fact that these purchasers’ opinions are heterogeneous can be explained by the following reasons. First, low cost country sourcing is still in the initial phase within SMIT. Due to organizational inertia, some purchasers are not ready to move the supplier base or they are not fully convinced that LCCS can work within this organization. Second, SMIT’s purchasing activities are managed in a de-centralized way in order to adjust to requirement of local market. Each market has different product portfolio. Therefore, for the same brass fitting, for example, the volume could be huge in one region but limited in another.

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1.5 Low cost country selection

It is difficult to generate a list of low cost countries by using one single quantitative threshold, e.g. GDP per capita, given that the concept and standard for ―low cost country‖ is rather vague. Due to limited time for the study, it is planned to have a final list with 5 countries. Therefore, when generating the long list by looking around the globe, 4 areas are identified and around 5 countries were picked from each area. Table 6 shows the list of candidate countries.

Those countries were selected because they are frequently mentioned by business practitioner as destination of LCCS. China will be in the final list as a benchmark of comparison, in order to see whether other countries are better places for SMIT to purchase than from China. ―Emerging Europe‖ mainly refers to former European socialism countries. These countries are joining the integration process of European Union and it is witnessed that their economies were growing fast in recent years.

The next step is to collect labour cost data for those 21 countries. It is necessary to first distinguish the definition of labour cost from wage. The primary stakeholder of labour cost is the employer. It is defined by the U.S. Bureau of Labour Statistics (BLS) as (1) direct pay and (2) employer social insurance expenditures and (3) other labour taxes. Wage cost, on the other hand, only refers to the first part of labour cost, which is workers’ ―take-home money‖. However, labour cost data are not widely available from a lot of countries, mainly because the statistical capability from some developing countries need to be improved. Furthermore, each country has its own economic census standard and there is always a lag between latest data and present, which make it less comparable. Therefore, data of wage cost were collected instead, and data on non-wage cost were collected by other means in order to measure it indirectly.

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compared with the Netherlands. The result shows how much lower of monthly wage of that low cost country than the Netherlands. Table 7 presents the results of comparisons.

Monthly earning EUR % lower than NL Year of 2 reference Source of data Argentina 384 86 2006 ILO Mexico 310 89 2007 ILO Chile 398 85 2005 ILO Brazil 463 83 2006 BLS Bulgaria 164 94 2006 ILO Romania 280 90 2006 ILO Croatia 794 71 2006 ILO Czech 671 75 2006 ILO Hungary 683 75 2007 ILO Slovakia 596 78 2007 ILO Ukraine 86 97 2004 UNIDO Turkey 672 76 2006 other3 Morocco 571 79 2005 UNIDO Egypt 108 96 2006 ILO Tunisia 305 88 2003 UNIDO India 113 96 2004 UNIDO Vietnam 39 99 2008 other4 China 163 94 2007 ILO Philippines 128 95 2006 ILO Poland 490 82 2006 BLS Indonesia 81 96 2008 other5

Table 7 Result of wage data and comparison with Netherlands

The TCO model for low cost country selection has been discussed in section 1.2.2. When applied in SMIT’s case, the model is extended by using more detailed indicators. The complete model is shown in Table 8, together with the weight of each indicator. The weights were determined based on purchasing managers’ experience of current China sourcing practice. Statistics for the indicators are all from sound database, especially the Global Competitiveness Report 2008-2009 (World Economic Forum) which provides the rankings of very comprehensive indicators for 144 countries. Logistics data (cost and lead time) are based on real quotation from the transportation company. There are two kinds of data: hard data are directly collected from the database, and index data are extracted from the Global Competitiveness Report 2008-2009 (country ranking from 1~144). Then

2

This is the year to be compared with Netherlands, within its correspondent database

3

Turkish Statistical institute, press release 2006

4

Vietnamese Statistical bureau

5

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these original data are converted into a score within a range of 1 ~ 10. The original score for each country is attached in the appendix 2.

Table 8 Low Cost Country selection model: indicator and weight

Model dimension

Indicator Direct measure Type of

data

Source of data

Labor Cost, 35%

Wage cost level

(70%) Wage per month,% lower than NL Hard ILO, UNIDO, BLS,etc.

Non-wage

labour costs

(30%)

Social security payment and payroll taxes as a percentage of worker’s salary

Index Global Competitiveness

Report (GCR) Competence, 20% Industrial performance (30%)

Manufacturing Value-added, average

annual real growth rate (2000-2006) - 33% Hard UNIDO

Manufacturing Value-added per capita, at

constant 2000 US$ prices(2006) - 33% Hard UNIDO

Manufacturing Value-added as percentage of GDP at constant 2000 prices(2006)- 33%

Hard UNIDO

Primary

education (10%)

Quality of primary education - 33% Index GCR

Primary school enrolment rate - 33% Index GCR

Government Education expenditure - 33%

Index GCR Higher education and training (30%) Index GCR Innovation (30%) Index GCR Quality, 15% ISO ownership ratio (50%)

The percentage of manufactures that receive ISO certificates

Hard Enterprise survey

Supplier quality rating (50%) Index GCR Logistics, 20% Logistics cost 6 (20%)

Hard Maersk or Schenker

Transportation time (30%)

Hard Maersk or Schenker

Time to export (days) (25%) Hard www.Doingbusiness.org Cost to export 6

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(15%) US$ per container Hard www.Doingbusiness.org

Infrastructure rating (10%)

Index GCR

* Special duty (If Applicable) Hard EU trade commission

Business Environment, 10%

IPR (15%) Intellectual property protection Index GCR

Institutions (20%)

Efficiency of legal framework - 25% Index GCR

Transparency of government policymaking - 25%

Index GCR

Business costs of crime and violence - 25% Index GCR

Ethical behaviour of firms - 25% Index GCR

Macroeconomic stability (15%) Index GCR Goods market efficiency (10%)

Total local tax rate - 33% Index GCR

Number of procedures required to start a business - 33%

Index GCR

Time required to start a business - 33% Index GCR

Technological readiness (10%)

Access rate to telephone, mobile and internet, etc.

Index GCR

Business sophistication (10%)

Local supplier quantity - 33%

Index

GCR

State of cluster development - 33% Index GCR

Production process sophistication - 33% Index GCR

Social

Responsibility (10%)

Child labour use - 10% Hard UNICEF

Corruption (10%)

Corruption Perceptions Index (CPI) - 10% Index

Transparency International

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differ significantly. Data on energy cost, on the other hand, are not quite available on a country level. Given that labour cost is normally used by academics and practitioners as a lead indicator for low cost country, it is reasonable to only consider labour cost in this case. The input for wage cost level is the result shown in table 7. Non-wage labour cost is measured by the percentage of social security payment and payroll taxes in worker’s salary. These two indicators receive 70% and 30% weight respectively, because the former one comes from hard data and the later on comes from index data. Given that index is an indirect way of measuring, hard data is believed to be more reliable and therefore receives more weight.

The dimension of Competence aims to measure ―what can they do?‖ of a country on a general level. Industry performance monitors the capability of a country’s industrial sector and the key indicator is Manufacturing Value-Added (MVA). Primary education is involved aiming to check the knowledge level of front line workers. It should be a qualifying factor and therefore only receives 10% attention. Higher education and Innovation aim to examine a country’s research and development capability and therefore receive more attentions. Quality, which is an important issue, receives 15% of weight in the whole model. This is not a signal that quality is not important. Quality can only be judged based on real product and assessing the quality level of a country is difficult. ISO ownership ratio tests whether quality management system is prevalent in a country and supplier quality rating is based on survey to management executives which is performed by Global Competitiveness Report. However, these two indicators have relatively weak measurement validity. For example, it is observed that companies can ―purchase‖ the ISO

certificate in some countries and ISO certification has become a fashion and a qualifying factor to stay in business. Therefore, the quality dimension is assigned with less weight to prevent bringing bias to the result.

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Findings

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Given that the design of weight is the key factor to determine the ranking of countries, in order to ensure the validity of the model, a sensitivity analysis is performed by adjusting the weight of certain indicators. The above weight system (table 8) belongs to Model C, which is considered most suitable for final use. Model A and B and their relevant country ranking are shown in Appendix 2. The calculation based on un-weighted average is also performed. When comparing Model A, B and C, it is found that the ―top 5 country‖ remains the same, although their ranking against each other slightly changes. The second group of countries (number 6~10) and the bottom 5 countries are also nearly the same. Therefore, there is no dramatic change of ranking when altering the weights. Comparing Model A, B, C with the un-weighted model, it finds that certain countries on the top and the bottom remain at the same position, while positions of countries in the middle range change. This implies that the indicators’ scores of top (bottom) countries are consistently high (low) and cannot be significantly influenced by the design of weight. Countries in the middle range could score high on certain indicators while score low on others, therefore their ranking can be influenced by the design of weight. The above sensitivity analysis shows that the design of measurement is reasonable and valid, and it is also a process of fine-turning the model design in order to find the most suitable one for decision making.

When looking at Table 9, the result of country selection model shows that, certain country is very attractive when only consider the wage (and labour) cost, however, when a TCO view is taken, that country could look less attractive, such as Vietnam and Ukraine. This shows the importance of taking a total cost view. Besides analyzing the ranking of countries, it is also necessary to ―open the black box‖ and find out which country is good at what. This is to investigate which of the 5 aspects (labour cost, competence, quality, logistics and business environment) contribute the most to a country’s attractiveness for LCCS. The best candidate country should score high on all aspects and its performance is relatively balanced. If a country scores high on one or two aspects but low on others, it brings some concerns for management decisions. The break-down view is shown as a Radar Chart for each country which is attached in the Appendix 3.

The results show that among countries of Mediterranean region, Tunisia is the most attractive country, although it scores relatively low on quality aspect. Morocco and Egypt show significant advantage on logistics service, but other aspects need to be improved. Turkey’s labour cost is a disadvantage. Among Asian countries, China, India and Indonesia are all attractive. China has the most balanced radar shape among all countries, while India and Indonesia need to improve on quality and business environment. Vietnam and Philippines’s low labour cost is very attractive, but other aspects show some risks. Countries in Latin America have relative balanced performance on 5 aspects, but all score relatively low. Countries in ―Emerging Europe‖ show good performance on several aspects, except on labour cost. Actually labour cost is becoming a disadvantage for them as a low cost country.

The issue of special duty should be discussed separately. The 21 countries could be classified into 2 groups. Countries which are members of EU have the advantage of no import duty when purchasing from there. Rate of import duty for other countries varies from 2.2% to 5.7%, depends on the product to purchase. No anti-dumping duty or sage guard measures are found against the product to purchase. Regarding policy benefit from host country on international trade, Chile has signed Free Trade Agreement with EU; therefore, there is no import duty from Chile.

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calculation. Second, this model assesses countries on an aggregate level by taking all industries or sectors. It cannot make an evaluation for specific industry; therefore, this model can only give a general direction. Whether the savings from LCCS could be realized depends on the actual situation of that industry.

The benefit of this model is that it could be used for repetitive decision making. The weights are tailor made for this company and in the future the model could be used to search for other countries.

1.6 Sustainability of low cost country sourcing

Based on the theoretical guideline of demographic bonus, a model is developed to briefly analyze the sustainability of low cost in the 21 countries. The model intends to study the ―window‖ in the following way: first, in order to analyze when the bonus window will close for each country, population data of the 21 countries are collected from international database of U.S. census bureau, and then dependency ratio (children, elderly and total) are calculate from the year 1990 to 2030 (estimation data). Population growth rate of these years is also collected as a reference. These statistics are compared and received a score from -2 to 2. Table 11 provides an overview of data and scores. For the threshold of assigning scores, please refer to Appendix 4. The original data of dependency ratio are presented as line chart and they are provided in the Appendix 5. Second, urbanization rate is used as a measurement of population migration. Urbanization rate of the 21 countries at the year of 2020 are collected, and the rate is compared with the urbanization rate of developed economies, afterwards they received a score from -2 to 2. For the threshold of assigning scores, please refer to table A3 in the appendix 4. The design of threshold is only for the purpose of differentiating those countries on that indictor. Those two scores will be used to calculate the weighted average score, but the weight of each aspect is different. Age structure transition (AST) has the fundamental influence; therefore, it receives 80% of the weight, while migration as a facilitating factor receives 20% of weight.

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Morocco 2022 1,0 1 Argentina 2030 + 0,9 2 Brazil 2024 1,0 2 China 2012 0,5 0 Tunisia 2016 0,8 1 Chile 2016 0,8 1 Romania 2012 -0,2 -1 Hungary 2010 -0,3 -1 Croatia 2014 -0,1 -1 Poland 2012 -0,2 -1 Slovakia 2012 0 -1 Czech 2008 -0,2 -1 Ukraine 2012 -0,7 -2 Bulgaria 2008 -0,9 -2

Table 11 size of bonus window: overview of data and score

Finally, in order to measure whether the low-cost country are making good policies to grasp the gift of demographic bonus, the country ranking from Global Competitiveness Report (2008) is used as input data because it includes comprehensive factors of a country’s development. The ranking is converted to a score of [1, 10] and then divided by 10, so that the result of calculation acts as a factor of multiplication. It is multiplied to the weighted average result of first two aspects. The full calculation model is shown in table 12 and the calculation follows the formula:

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Table 12 calculation of sustainable purchasing score

Findings

The above results should draw some attentions for management decision towards LCCS. China, the very hot destination for low cost sourcing and outsourcing, positions at the middle of the list. China has been enjoying the demographic bonus since middle 1980s’ and at this moment it is at the edge of stepping out of the window. Certain research in China estimates that the bonus effect will end at 2015 (Pool, Wong and Vilquin, 2006). This explains why it is witnessed that labour cost in China has been increasing significantly. Countries like India, Egypt, and Philippines are in the prime of the bonus. It is estimated that the window of opportunity could be open until 2025 or 2030. Given that India is actively participating in globalization and adjusting its policy to create a good environment for economic development, it is an attractive country regarding sustainable low cost purchasing. Other Asian countries, such as Vietnam and Indonesia also have the potential, but there policy environment should be improved. Countries in Latin America are in the bonus window but

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the size of window is different for each country. Argentina could still enjoy the window until 2030. Brazil and Mexico could step of out the window around 2025. However, the window for Chile could close soon at around 2015. It is also deemed that Latin American countries are not utilizing this one time gift very well except for Chile. The governments must try to make better policy to increase employment and improve economic environment, otherwise the gift will be wasted (Sedano, 2008).

Countries in ―Emerging Europe‖ are not attractive regarding sustainable low cost sourcing. It is witnessed that the population growth rate has been negative in recent years, which means in near future, those countries will experience shortage of labor. The reason that labor costs in those countries are relatively low is not due to the effect of demographic bonus. Those countries are about to pass the window. Rather, it is because their economies are recovering from the negative effect of central planning regime. Given that those countries have joined the EU (or will do in near future), it is believed that their economies will closely integrated with more advanced economies in Europe, so it can be expected that the labor cost will increase fast in near future.

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1.7 Discussion of results

1.7. 1 Discussion of LCCS country selection

According to the LCCS decision making process model, the final country selection should combine the results of both total cost view and sustainable purchasing findings. Therefore, in order to integrate the result of section 5 and 6, a final calculation is performed by adding up the score of TCO country selection and the score of sustainable purchasing. Result of calculation and ranking of countries are provided in Table 13. Ranking of countries when only consider the current situation is also shown at the right hand box for comparison purpose.

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only they are attractive destination for LCCS, but the low cost is sustainable in the medium term (3~5 years). The positions of Vietnam, Philippines and Egypt are promoted after considering sustainable purchasing issue, which means they are also worth being considered by management for investment in the long term, but with more caution. It is important to note that the ranking of China and Chile are lowered down when consider the future. This shows that in the near future, labour cost in these countries could increase significantly. They are getting less competitive for low cost sourcing given that their economies are experiencing transition from cheap production factor driven to innovation driven, which means they are getting more attractive for other types of foreign investments. Other Latin American countries rank in the middle range of final calculation. Those countries are still enjoying the demographic bonus, but a lot of work should be done to improve the economic and business environment, and they are more suitable for Northern American companies to do LCCS. Countries in “emerging Europe‖ score at the bottom mainly because the low cost is not sustainable in the near future.

This whole process of low cost country selection can provide a guideline for management decision making regarding where to go, however, it does not show a ―black or white‖ answer. A lot of practical issues must be taken for consideration. For example, although Indonesia shows attractiveness on both cost side and sustainable purchasing side, purchasing managers are rather conservative to go to this country, mainly due to the problem of corruption based on their practical experience. Although corruption has only 1% impact power in the TCO country selection model, when comes to detailed business matters, it could act as a major barrier. Therefore, management can use the decision making process model as a useful tool to get general direction, but final decision making needs to consider other risks which cannot be directly assessed by the model.

In order to test the effectiveness of the whole country selection model, the company began to search for suppliers in India, Tunisia and Turkey. Within limited time, several quotations of different products were received from suppliers. Although judging from the initial price offer no significant saving can be obtained from those suppliers, this is not regarded as a signal that the whole selection model is invalid. Instead, it is attributed to the fact that those suppliers are from unknown business network. Receiving an opportunistic offer from a ―cold contact‖ is common in purchasing practice. Therefore, further supplier searching and development are required.

Based on the above result, when it comes to the management decision of which country to go, it is recommended that big country is relatively good choice. By ―big country‖ it refers to size of territory and also the scale of economy. The reason is that, firstly, countries with large territory normally possess various and abundant natural resources, which ensures the country to be independent on resources consumption. Secondly, Countries with large territory normally have unbalanced situation among different areas regarding economic development and age structure transition, such as China, India and Brazil. For example, the eastern coastal regions of China are more developed than inland areas and attract most of foreign investment. The populations of some coastal provinces have finished age structure transition and are becoming aging, while inland provinces can still enjoy the demographic bonus.

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peripheral areas, therefore, firms need to offer higher labour compensation to attract workers. The effect of industrial agglomeration also contributes to the inequality of development among different areas. Statistics of wage development in China shows that the 2008 average wages in coastal provinces7 is 35.2% higher than interior provinces (China Statistical Year Book, 2008). Therefore, due to industrial agglomeration, cost of production factor, such as land rent and labour cost will gradually rise. Then this industrial cluster will become less cost competitive, therefore, these firms tend to relocate to less developed areas, and the developed area will experience industry upgrading, normally from manufacturing to service business. For big countries with unbalanced development situation, there is much more room to relocate the low cost driven industries. Since this process is relative slow, the increase of cost for the whole country is also slower than small country. Besides, countries with less scale on economies, such as Vietnam and Thailand, can be relatively easier be influenced by global economic crisis. Examples include the Asian financial crisis happened in 1997 and recent economic crisis of Vietnam in 2008.

1.7.2 Discussion of organization issue

In section 4, the finding of item selection for low cost country sourcing shows that, purchasing managers’ opinions on whether a product should be purchased from a low cost country are much diversified. The original answers from respondents show that some purchasers provide strong support while some others are rather conservative. This is a signal that Low Cost Country Sourcing, as new purchasing practice, is not widely accepted by purchasers in the company. Therefore, it is important to find out what is hindering the progress and provide a solution. Kamann and Bakker (2004,2007) did a long term research to study how does a new purchasing practice spread in a company, and why does this process differs between different companies. A framework called contagion process is proposed and there are many factors influencing this contagion process. Firstly, purchaser’s personal trajectory together with various networks that they have been through contributes to the way that the purchaser believes how purchasing practice should be organized. Secondly, due to corporate culture or tradition, a company has its own way of ―getting things done‖, which is a process of social negotiation, and everybody comply with this social order. This way of doing business is defined as Socially Negotiated Order (SNO). Therefore, even if the purchaser has his/her own opinion on purchasing practice in some cases, they need to follow the SNO. However, there are exceptions. The purchasing function has different social status in companies. Normally companies in fashion industry of trading business pay more attention to the voice of purchasing, but in other industries, purchaser still does not have high weight in management decisions. The social status of different functions in companies is defined as Negotiated Social Order (NSO). If a purchaser could gain higher status in the NSO in a company, he/she can pervade the management in order to put his opinion towards organizing purchasing into business practice, in order to influence the SNO.

The Application of Total Cost of Ownership on Low Cost Country Sourcing: evidence from case study and the future research direction

The Application of Total Cost of Ownership on Low Cost Country

Sourcing: evidence from case study and the future research direction

Abstract

Acknowledgement

Table of Contents

Introduction

Chapter1 Decision making

process for Low Cost Country Sourcing based on Total Cost of Ownership: a

case study in European plastic pipe and fitting industry

1.1 Introduction

1.2 Theoretical Framework

1.3 The Case

1.4 Product selection for LCCS

1.5 Low cost country selection

1.6 Sustainability of low cost country sourcing

1.7 Discussion of results