SOURCING AND PROCUREMENT
Sourcing and procurement may relate to raw material, parts and components, or semi-finished goods, or finished goods. There are two important issues which are involved in relation to procurement and sourcing strategy:
i) Centralised (concentrated facilities) versus Decentralised (dispersed facilities) approach serving the world market. In other words, to what extent the firm will have integrated manufacturing operations?
ii) Make or buy decisions i.e., whether to buy or subcontract the needed goods, or. To manufacture within the firm’s own facilities.
Before goods can be manufactured, raw materials must be procured. Procurement of raw materials, for instance, is critical for Japan, since it purchases from abroad 100% of its uranium, bauxite, and nickel; virtually 100% of its crude oil and iron ore; 92% of its copper; 85% of its cooking coal; and 30% of its farm products. Trading companies, discussed in Block 1 and with which we hope you are familiar, came into being to acquire the raw materials that are necessary for manufacturing purposes. Procurement from abroad involves problems that are not present to the same extent in domestic sourcing; for example, problems like language, distance, currency, wars and insurrections, strikes, political problems, tariffs, etc.
The importer needs to know how to acquire goods, what duties must be paid, what special laws exist. Sometimes goods are imported into a country and are immediately exported, or are assembled into an intermediate or final product and then exported. When imported goods are exported from a bonded custom warehouse, the entire import duty paid earlier may be refunded. Likewise, when articles manufactured or produced in a country with the use of imported merchandise are exported, a substantial percentage of the duties are refunded as a drawback. In recent years, foreign trade zones (FTZs) have become very popular as an intermediate step between import and final use. We shall revert to this topic a little later.
Managers have to select the best source for the various inputs which are needed for manufacturing a product. They have to decide on the most effective means of obtaining them and have to determine the timing for acquiring them. The firm’s overall objective may be to obtain the best inputs from around the world in order to produce the components and products efficiently. Of course, the managers need to modify this objective in the light of constraints of different political and cultural environments.
Centralised versus Decentralised Approach
To procure goods for world markets, the firm may establish a centralised source or sources. This question is directly related to the firm’s desire to rationalize its production and marketing processes. The main advantages of establishing a centralised source (or sources) are:
• lower production costs through economies of scale
elimination and reduction of costly scheduling problem
• rapid start-up on new products
• reduction of inventories
However the centralised system may give rise to the following disadvantages:
• The firm may not be able to meet the host countries’ demand for local manufacturing. The firm therefore runs the risk of loosing such market.
• The firm may have to compromise with the flexibility of responding to changing market conditions and the consumer preferences.
• If production or sourcing is concentrated in one or few countries, this may make the firm vulnerable to socio-economic and political events (e.g. political uncertainty and strikes etc.) in the given country (or countries) in which major plants are located.
All the firms may not like the centralised sourcing activities. The most favourable conditions for a centralised system are where there is high relationship between the unit cost and the volume produced (the larger the volume the lower the unit cost) and where production system is using a continuous-process type of manufacturing technology (e.g. and chemicals, and petroleum). Sometimes, larger export incentives offered by a host country may also influence in favour of centralised sourcing facility. Export Process Zones (EPZs) have become major sourcing points for many U.S., European, and Japanese firms, partly because of governmental subsidies and partly because of lower labour costs. According to one study, five countries, namely Mexico, Ireland, Taiwan, Hong Kong and Singapore, accounted for 22% of 362 export plants. These along with another five countries (Canada, Belgium, Netherlands, U.K. and Italy) claim 33% of such plants. All of these countries offer substantial incentives to foreign investors.
Some manufacturers may have what is known as global sourcing strategy (a decentralised approach). For example, Nike, which is a producer of sports shoes in the United States, sources more than 90% of its production by contacting with foreign suppliers, mainly from Asia. The company has expanded beyond its home market and increased foreign sales to more than 20% of its total turnover.
It is interesting to note that India is fastly emerging a major sub-contracting source for European companies
India fast becoming a major subcontracting source for European cos
India has been steadily emerging as a subcontracting base for Europe. The European manufacturers, particularly the automobile and machinery builders, are keenly looking at India as a base for the supply of parts, subassemblies, castings, forgings and engineering components.
The recently concluded Hanover Fair ’95, the world’s largest industrial fair, has brought to the fore the almost compelling need of the European industries to source their procurement from countries outside Europe. India is being considered now as a dependable source for such manufactures.
According to Indian industry sources, Mahindra Exports Ltd. (MEL) has tied up with the world’s biggest tractor manufacturer in Germany for supply of tractor parts and components. The company has also tied up with a Spanish company which will supply MEL the tooling for component manufacturing and will buy back the production on a continuous basis.
Another Pune based company, Pratibha Founders, has received a huge order from the Netherlands for supply of aluminium castings, and the volume is so large that this company will have full capacity utilization throughout the year with this single order alone.
Due to the high cost of production and strict environmental laws, German foundries and forging shops are finding it difficult to cater to their user industries cost effectively. Controlling the costs of inputs is such an over whelming consideration today that European and American industries are willing to source their component inputs from any part of the world, where they see price advantage.
Since the volumes of orders involved are very large, even the marginal cost advantage spells big overall saving. This kind of a scenario holds precious opportunities for the Indian foundry and forging industry. The technology of most of major foundry and forging companies in India can be rated as the best among all the developing countries.
The industry already has spare capacity to undertake major jobs. Raw materials, power, skilled labour and logistics are no more a problem. With all counts in its favour, the Indian foundry and forging industry is the most ideal sub-contracting partner for European and American industries, sources here say.
The next two to three years would be very crucial for exports for India’s foundry and forging industry. During this period, if it can establish itself as a price competitive and reliable source for subcontracting, the industry’s hands will be full with business for at least a decade. Hanover Fair, the world’s biggest forum for subcontracting, has provided Indian exhibitors an opportunity to establish worldwide contacts from a single platform.
The Indo-German Chamber of Commerce had organized a joint Indian pavilion in the subcontracting sector at Han over Fair ’95 in order to help medium and small scale companies step into the export market. The IGCC has been organizing such joint participation for last three years by offering complete infrastructural support and facilities to the exhibitors. The country level participation organized by the IGCC provides the medium and small scale exhibitors a large image and helps them attract major and serious customers. The Centre for Promotion of Imports from Developing Countries (CBI), Netherlands, had also supported a group participation of 14 companies in the subcontracting sector and power transmission sector.
Reports from Beijing also indicate that the massive modernisation programme of the Chinese railways and the $20 billion three gorges multipurpose dam project have opened up possibility for Indian subcontracting jobs in China.
The Chinese authorities have already started making enquiries for Indian participation in the railway modernisation programmes, particularly for purchase of Indian rails from the Bhilai steel plant.
The world leaders in power equipment, Asea Brown Boveri (ABB) and Siemens are to take up big contract jobs in the three gorges power project which is expected to have three billion dollars foreign investment.
The project to be completed by the year 2010 is to have huge 18,200 MW of hydel power generating capacity.
A company following global sourcing global sourcing strategy may purchase its requirements from import agents, and negotiations may take place based on home country currency. This is a passive approach. A more aggressive approach may be to have its buyers traveling overseas seeking out sources of supply. Alternatively, it may have purchasing offices located in foreign countries. The personnel overseas may be responsible for quality control, product design, and for supplying materials to foreign fabricators as well as for purchasing and shipping.
The implementation of a global sourcing strategy requires appropriate organizational support, global research on supply sources and personnel experienced in many dimensions of international trade. The buyers of the company must be familiar with foreign exchange risk, tariffs, quotas, international transportation, difference in cultural environment, and many other import issues.
It should be mentioned that the choice between centralised versus decentralised sourcing is not of the either/or type. It has been observed that many firms use both the alternatives. High tariff rates, transportation cost, foreign exchange fluctuations tend to discourage centralised sourcing in certain parts of the world, and for certain products, the firm may use centralised sourcing. In other parts of the world and for other products, it may use a decentralised system. For example, Dow Chemical Company has established larger chemical manufacturing units in West Germany and the Netherlands to supply chemical and petrochemical products for entire European markets, but its consumer oriented products are manufactured in various countries to meet local demands. Such hybrid or mixed strategies involving partial rationalization of production and marketing facilities and partial local manufacturing reflect the influence of the following factors:
1) Technology : Capital intensive industry tend to provide economies of scale on much higher volume through reduction of overhead costs. Capital intensive industries through are more likely to have centralised facilities.
2) Market competitiveness: In an industry where there is a intense competition, there is considerable pressure to reduce unit costs. Consequently, production and marketing rationalization become almost a necessity.
3) Interchangeability of parts: Rationalising the production facility for manufacturing parts etc. is quite difficult unless the products are standardized. Consequently, products which are at the mature stage of their product life cycle are more likely subject to production rationalization.
4) Government demands and pressures : Many developing countries require multinational companies to manufacture locally. The objectives behind this requirement are to achieve self sufficiency and to generate economic and industrial growth. Countries such as India, Indonesia, Malaysia, Brazil and Peru have required local manufacturing, and until recently, have imposed stiff duties and penalties on goods imported from other countries. It may be pertinent to make a distinction between global sourcing strategy and a global strategy (or global logistic strategy). A multinational enterprise following the latter strategy would normally like to have the sourching for its target markets from a centralised system perspective. Rather than determining supply source independently for each market, the enterprise can seek to strengthen its competitive position by considering all the markets simultaneously and by designing a least cost supply strategy for the system as a whole. It may rationalize its manufacturing operations by having an integrated network of plants, each plant may specialize in one or more products or components, and each plant may serve a world or a regional market. Plants may also specialise by stages in the production process and can be located indifferent countries according to location advantages. Extensive trans-shipments of components and finished products between subsidiaries indifferent countries is usually the result of such global (or global logistic) strategy.
The global strategy can reduce unit cost in industries where economies of scale are significant and not fully exploited within the size of national market. Once each subsidiary no longer manufactures a full product line, the management of export activities becomes extremely important. Export orders have to be directed to centre and then allocated to the appropriate subsidiary. Needless to mention the implementation of such a strategy requires the use of export/import expertise, and this capability must be exercised includes harmony with the management of foreign production.
Source-Market Matrix
To help plan production management, the MNE following a global strategy can gainfully employ a source-market matrix. The matrix relates the supply of products of various subsidiaries to the demands for these products in various markets. Each cell in the matrix, as shown in Figure, contains information about the incremental costs of producing one extra unit output and the logistics costs of transporting that unit from one subsidiary (source) to another market.
The production costs of the various subsidiaries will differ because of country specific factors, such as local wage rates. Logistics costs may also vary because of environmental factors, such as optimal transport mode and level of tariffs. The purpose of the matrix is to provide a framework for the MNE to evaluate production and logistics costs in relationship to market demand. The usual objective of the MNE is to avoid both excess production and under production, as the former builds up inventory costs and the latter can lead to stock outs. The MNE has to optimize production by many subsidiaries across many markets. The source-market matrix is a device to focus attention on the integrated nature of its production management.
The source-market matrix shown in Figure is a simple matrix which is limited to focusing on the relationships between three nations. Some MNEs may have operations by having subsidiaries or affiliated companies in 50 or more countries. The matrix could be further sub-divided into major regions within the host nations. Each cell in the matrix is further divided into over-and-under-capacity production cost, as this will differ significantly between plants. The matrix should be updated periodically to reflect other changes in production of logistics costs in the various countries in which the MNE operates.
Sourcing Policies and Practices
One study indicates that European and Japanese companies have rationalized their production systems more than the United States companies. Japanese firms, until production systems more than the United States companies. Japanese firms, until recently, had a preference for exporting from Japan or their off-shore facilities in low wage countries. The ability of the Japanese firms to achieve economies of scale and lower unit cost largely explains their success in the international market place. Competition from the Japanese and European firms has compelled many United States firms to rationalize production and marketing systems. Nearly 40% U.S. exports and nearly 45% of their imports are intrafirms transactions.
According to statistics of the United Nations some 23% of sales by U.S. affiliates were intra company transactions. Such intracompany trade is higher in the mining and petroleum industries than in the manufacturing sector, and is more significant in the affiliates located in developing than in the developed countries. In context, European and Japanese multinational firms claim to use local inputs in large proportions in order to satisfy the host government’s demands and to grant higher degrees of autonomy to their overseas subsidiaries. This is particulary true in relation to developing countries where such demands are most intensive.
The results of the comparative study of U.S. German and Japanese multinational companies show a great deal of convergence in sourcing policies and practices of these three types of multinational companies. Approximately two thirds of the U.S., German and Japanese subsidiaries purchased more than one quarter of their requirements of raw materials, semi-finished and finished goods from their respective parent organizations. Controlling and coordinating the sourcing for the required input is perhaps the first step towards global integration. Through integrated sourcing policy the firm may indeed be able to reduce the cost and perhaps the price of the goods.
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