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Offshore Sourcing: An Optimal Operational Strategy?

Many retailers are making use of lower-priced goods offered by foreign vendors. The vendors, taking advantage of low wages in their countries, are able to undercut competitors operating in domestic markets. However, the characteristics of these consumer goods--clothing, footwear, food, drink, toys, furniture, appliances, electronics, household goods, and so on--are dynamic and complex, usually being sold in discrete seasons. Low cost, though important, is not the only purchasing criterion for either end consumers or retail buyers.

What exactly are the advantages and disadvantages of foreign imports as opposed to their domestic counterparts? What trade-offs are involved? What are the true costs? And what are the best sourcing strategies for the retail community?

STRATEGIC PURCHASING, PROCUREMENT, AND SOURCING

Purchasing and supply management has evolved from the adversarial, clerical transaction between supplier and customer into a strategic, cooperative, buyer-seller relationship. Subsequently, this evolution has led to a rise in supply base reduction strategies--a restructuring in the way companies do business with "key" suppliers in order to gain competitive advantage.

Typically, low cost seems to be the primary purchasing requirement for many businesses, with the strategic objective of a supplier relationship being cost reduction. Stuart and McCutcheon (2000) identify four primary mechanisms for achieving this objective:

1. lower production costs of suppliers;

2. improved conformance quality (consistently meeting specifications);

3. material/location substitution; and,

4. lower transaction costs, including those of incoming material inspections, vendor searches and evaluations, corrected supplier problems, and communication with suppliers.

But what other strategic objective might a firm strive for? Are these strategic supply decisions really made in full knowledge of all the cost/ benefit trade-offs involved?

Sourcing Locations and Discounts

The respondents in the study conducted for this research were divided between North American (44 percent) and U.K. (56 percent) retailers. First they were asked to confirm their sourcing locations over the previous 12 months (it should be remembered that for most firms in a consumer goods environment, sourcing is a dynamic activity that changes from season to season). The retailers also provided an indication of the average discount (percent lower unit cost) achieved from "offshore" sourcing. Table 1 on the next page details the findings.

Clearly, the cost implications of offshore sourcing are evident. For both North America and the U.K., retailer discounts of between 20 and 30 percent are attainable in Central America and Asia. This demonstrates the importance that retailers attach to low cost. But what other factors might a firm take into account when making sourcing decisions?

Sourcing Objectives

Table 2 details the main sourcing objectives for both North American and U.K. respondents. The participants ranked these objectives, which were divided between domestic and foreign (to include the advantages in each case).

For both sets of retailers, low cost is again a prime advantage in foreign sourcing. Offshore, quality ranks second for both North American and U.K. retailers. Domestic sourcing decisions are less clear. Quality, response time, design, and flexibility all have high scores. Cost, then, may not be the only sourcing aspiration; other objectives can be seen, although these clearly change from season to season.

Given that there are a number of purchasing goals, this study sought to establish what cost/ benefit trade-offs or measures might be used when assessing the advantages of foreign versus domestic supply and when making strategic purchasing decisions. To do this, two pertinent factors were analyzed: (a) the levels and types of responsiveness and flexibility available from both foreign and domestic vendors; and (b) the hidden costs associated with foreign supply and any subsequent inflexibility.

Sourcing Responsiveness and Flexibility

First, to deal with the responsiveness and flexibility retailers achieved from their suppliers in various geographic regions, the respondents supplied data for the average lead times or advance ordering times necessary for the supply of finished goods. The data were assessed by examining the "open to buy" periods involved. As can be seen from Figure 1, there is a direct relationship between this lead time (the advance ordering point) and major sales forecast error ahead of a sales season.

Figure 2 addresses responsiveness by examining the advance lead time retailers had to provide when finalizing orders with vendors in different locations. It is apparent that the longer lead times or advance ordering times required for products sourced from Asia, Africa, and Central America may prove problematic to all in the supply system.

The next two tables investigate flexibility issues. In Table 3, the respondents commented on the latitude that suppliers (in various regions) offered for volume and mix change once an order had been placed both before and, more crucially, during a sales season. Here is powerful evidence of the wider strategic sourcing debate. There are, it seems, many important issues beyond just unit item cost. The flexibility of suppliers after initial orders have been placed--in other words, once demand trends become clear--may be sought in both the volumes needed as well as the product mix. The flexibility required by a retailer will apply at both the pre- and post-season opening, though it is harder to adjust to the latter despite better-known demand trends. With domestic suppliers (suppliers to retailers in North America and the U.K.), there is generally substantial latitude for volume and mix change before the start of the sales season, whereas in Asia, Central America, and Africa vendors have little flexibility then. Similarly, during a sales season, domestic vendors offer much more flexibility than their foreign counterparts. It appears, then, that flexibility is an important objective in strategic procurement.

Table 4 shows the flexibility of vendors by region after the sales season has been completed. In other words, it shows their adaptability to deal with surpluses by way of returns, discounts and markdowns. A pattern similar to Table 3 emerges. At the end of the season, domestic suppliers seem to be more flexible than foreign ones when it comes to such negotiations.

To summarize, there seems to be something of a paradox. Table 1 shows that greater cost discounts are obviously available from foreign vendors, particularly in Asia, Central America, and Africa. However, Table 2 demonstrates that lower cost is not the only objective; quality, response time, flexibility, and design also have a strong role to play. Yet we see from Tables 3 and 4 that many offshore sources of supply fail to offer any of these advantages. Moreover, Table 1 tells us that North American retailers source 47 percent of their goods over a 12-month period from such offshore regions, and U.K. retailers 38 percent. From these findings, we are left to assume that the strategic purchasing objectives of these firms are clearly suboptimal in nearly half the North American cases and 40 percent of the U.K. cases.

Given the various advantages and disadvantages of domestic versus foreign purchasing, the next consideration must be whether they can be quantified and the various trade-offs properly assessed. We know that the unit cost of goods--the main attraction--is often lower offshore, but what are the costs of inflexibility and lack of responsiveness? What is the result when these costs are compared? Is offshore supply such an attractive option in those circumstances?

The Hidden and Inflexibility Costs of Offshore Sourcing

Many of the costs of sourcing offshore can be classified as hidden costs. The retailers in this study were asked to suggest the cost categories associated with purchasing abroad, apart from the cost of the goods themselves (see Table 5).

It would seem that the impact of these hidden costs is not insubstantial. However, it is unclear whether the respondents in fact quantify these costs or compare them with the advantages of offshore sourcing (an area for future research). In justification of the reason to import, the retailers cite the fact that low offshore prices allow sales at below traditional price points, while still giving attractive margins. Yet those margins may be substantially eroded when the hidden costs are quantified. In addition to the hidden costs, we also need to recognize the costs of using suppliers that are inflexible and unresponsive-- the inflexibility costs.

The costs of importing may well be closely linked to the type of sourcing strategy used. This research indicates that retailers' use strategies that can be classified into three generic types:

1. Offsbore, low-cost. A foreign manufacturer produces and ships 100 percent of the goods needed for a sales season prior to the start of the season. Purchasing decisions are made considerably in advance of the season, before any demand indication is known.

2. Combined. A foreign manufacturer ships a large proportion of the goods needed prior to the start of the season. The retailer then makes weekly replenishment orders from a domestic supplier. However, point of sale (PoS) information is often not shared with this domestic vendor, so supply is often shipped from its stock holding built as a buffer against uncertainty. This approach is similar to Vendor Managed Inventory (VMI), although it is suboptimal as far as the supplier--and ultimately the retailer--are concerned.

3. Domestic, responsive, and flexible. A domestic manufacturer ships a proportion (say, 40 percent) of the goods needed before the start of the sales season. Thereafter, in-season manufacturing is based on a reestimation of actual demand using PoS data provided by the retailer and a reorder using Electronic Data Interchange (EDI) to provide for a quick turnaround in manufacturing and shipping products in demand. For the retailer, this strategy results in more accurate stocking that reflects demand preferences, reduces inventory, and enhances customer service metrics.

Again, there are advantages and disadvantages associated with each of these strategies. Low unit cost is available offshore, but domestic suppliers are more flexible and responsive and are operating according to actual demand requirements. The latter, it is argued, is actually cheaper for the retailer in the long term. If the inflexibility costs could be measured properly, offshore sourcing may not be the most cost-effective strategy Further research is needed to quantify the costs of these various sourcing scenarios.

In an initial attempt to analyze the implications of the three sourcing strategies described, three retailers of apparel goods provided details of performance measurements for sourcing the same clothing item (men's denim jeans) during a single apparel season in 1999-2000. As shown in Table 6, Retailer A sourced jeans mainly from Hong Kong during the season; Retailer B used two suppliers in the season, bulk orders from Thailand, then reorders from the U.K.; and Retailer C used entirely domestic vendors with flexible and responsive operations.

The performance measurements supplied were for orders of similar size and were adjusted for exchange rates and so on. At this level we are not trying to establish any direct relationship between sourcing performance and a particular supplier and/or supplier location. We do, however, suggest that there are strong reasons for using a range of performance measures (over and above price alone) when analyzing the performance of different sourcing strategies. These different measures demonstrate the advantages and disadvantages of each source of supply and should be used in a combination, not in isolation. This is also an example of how future research might establish different types of cost measurement (including hidden and inflexibility costs) that should be a part of any sourcing calculation.

From Table 6 we can see that for the three retailers involved, the use of domestic, responsive, and flexible vendors emerged as the best sourcing strategy in all performance measures, apart from gross margin/sales. We can speculate that the underlying reason for the superior retail performance of goods sourced using such strategies is the realization that no forecasts are perfect--it is only during the sales season, when customer demand is revealed, that intelligent supply decisions can be made.

This research, then, does suggest one important finding: In nearly all performance measures, domestic, responsive, and flexible sourcing can be far more efficient and optimal than offshore supply, despite the lower unit cost of the latter. Moreover, it can be demonstrated that these domestic manufacturers can charge nearly 25 percent more per item and still prove a cheaper option for their retail customers. This is due to their flexibility and responsiveness and the savings they offer by avoiding the hidden and inflexibility costs associated with importing. The advantages associated with speed of response and flexibility will also allow a retailer (using offshore supply) to reduce price points by as much as 30 percent below that of a competitor, and still earn the same returns as the competitor.

The operational strategy of purchasing, procurement, and sourcing has assumed a great deal of importance for many companies. But those seeking low unit cost of goods from offshore sources as their principal goal could be in for a big disappointment if they fail to consider flexibility, responsiveness, and other advantages available from local suppliers.

Further research is needed to establish the exact costs of importing and to assess whether or not these are actually computed by retailers when making sourcing decisions. But this study is a first step toward an axiomatic framework, widely accepted across a number of consumer industries, that demonstrates the full implications of domestic versus offshore purchasing. Research is currently under way to develop a Total Acquisition Cost Model (TACM) that will allow the full implications of these strategic sourcing decisions to be properly analyzed and assessed using all the relevant information available. Such a model will also help domestic vendors demonstrate to their retail customers the advantages of using their flexible and responsive services, rather than continuing the current practice of relying on the somewhat inefficient use of cheap offshore sourcing.

Robert H. Lowson is the director of the Strategic Operations Management Centre, a lecturer in operations strategy. and the Leverhulme Trust Research Fellow at the University of East Anglia, Norwich, U.K.

References and Selected Bibliography

T.L. Gilreath, J.M. Reeve, and G.E. Whalen, Jr., "Time Is Money," Bobbin, March 1995, Pp. 50-55.

N.A. Hunter, R.E. King, and R.H. Lawson, The Textile/Clothing Pipeline and Quick Response Management (Manchester, UK: The Textile Institute, 2001).

R.E. King and N.A. Hunter, "Demand Re-estimation and Inventory Replenishment of Basic Apparel in a Specialty Retail Chain," The Journal of the Textile Institute, 87, 1 (1996): 31-41.

R.H. Lowson, "The Impact of Quick Response in the Textile and Clothing Industry: Analysis and Application," unpublished Ph.D. dissertation, Cardiff University, UK, 1999.

R.H. Lowson, R.E. King, and N.A. Hunter, Quick Response: Managing the Supply Chain to Meet Consumer Demand (Chichester, West Sussex, UK: Wiley, 1999).

R.H. Lowson, "Customised Operational Strategies for Retailers in Fast Moving Consumer Industries," International Journal of Retail, Distribution and Consumer Research, April 2001, pp. 201-224.

M.E. Porter, "What Is Strategy?" Harvard Business Review, November-December 1996, pp. 61-78.

F.I. Stuart and D.M. McCutcheon, "The Manager's Guide to Supply Chain Management," Business Horizons, March-April 2000, pp. 35-44.

[Graph omitted]

[Graph omitted]
Table 1

Sourcing Location, Percent of Goods Purchased Over Previous Year, and
Discount Available

                             Sourcing Locations and % of Goods Purchased
                                         Over Last 12 Months
                                                               Central
                               USA        U.K.      Europe     America

North American Retailers        52          0          1         24
Average Discount Available      --          0        5-10       20-25
(% lower cost)

U.K. Retailers                  3          34         24          0
Average Discount Available     1-5          -        10-15       --
(% lower cost)

                             Sourcing Locations and % of Goods
                               Purchased Over Last 12 Months

                               Asia       Africa      Other

North American Retailers        20          3           0
Average Discount Available    20-30       10-15         -
(% lower cost)

U.K. Retailers                  36          2           1
Average Discount Available    25-35       15-20        5-10
(% lower cost)
Table 2

Sourcing Objectives and Advantages of Domestic and Foreign Suppliers

                Domestic Sourcing        Offshore Sourcing
                Objectives & Advantages  Objectives & Advantages

North American  Quality (41%)            Lower Cost (53%)
Retailers       Response Time (30%)      Quality (27%)
                Design (15%)             Innovation (13%)
                Flexibility (8%)         Design (5%)
                Innovation (3%)          Response Time (2%)
                Cost (3%)

U.K. Retailers  Response Time (25%)      Lower Cost (66%)
                Flexibility (22%)        Quality (32%)
                Design (20%)             Design (2%)
                Innovation (18%)
                Quality (15%)
Table 3

Vendors' Latitude For Volume and Mix Change Both Before and During Sales
Season (by Geographic Region)

                              Once order is placed, what is the
                                vendor's latitude for change?
                                     Order Volume Change
                                       (% respondents)
           Sourcing Regions        None         Some

Before     North America            16           49
the start  U.K.                      9           52
of the     Europe                   29           43
sale       Central America          41           38
season     Asia                     66           22
           Africa                   58           19
           Other                    34           40

After      North America            39           33
the start  U.K.                     19           46
of the     Europe                   35           38
sale       Central America          52           33
season     Asia                     70           21
           Africa                   66           16
           Other                    32           42

            Once order is placed, what is the vendor's latitude for
                                    change?
            Order Volume                 Order Mix Change
               Change
                 (%                      (% respondents)
            respondents)
           Substantial         None         Some       Substantial

Before          35              21           49            30
the start       39              21           46            33
of the          28              37           38            25
sale            21              46           34            20
season          12              70           19            11
                23              62           20            18
                26              30           37            33

After           28              47           29            24
the start       35              28           39            33
of the          27              41           35            24
sale            15              63           30             7
season          9               86           12             2
                18              73           8             19
                26              39           37            24
Table 4

Suppliers' Latitude for Dealing with Surpluses After a Sales Season by
(Geographic Region)

                             At the end of a sales season,
                                   vendor flexibility
                              for agreeing to returns and

                              discounts, etc., for surplus
                                 goods (% respondents)
Sourcing Regions        None                 Some        Substantial

North America            24%                 54%             22%
U.K.                     11%                 70%             19%
Europe                   33%                 49%             18%
Central America          50%                 41%              9%
Asia                     73%                 23%              4%
Africa                   66%                 34%              0%
Other                    40%                 53%              7%
Table 5

The Hidden Costs of Importing

                                   Degree of Importance
Cost Categories                     (% of respondents)

Irrevocable letters of credit              15%
charges.

Delays at the port of entry                 7%

Last minute use of air freight              5%

Expensive administrative travel            11%
and quality problems

The requirement of an early                25%
commitment to manufacturing
before sales trends are clear

Limited ability to change mix or           37%
volume of orders shortly
before or during the sales season
Table 6

Retail Sourcing Performance Measurements

                                           RETAILER C
                                      Domestic, Responsive,
                                      and Flexible Strategy
                                       Retailer with mfg.
                                    operation. Large European
                                       and North American
                                     operation. Sources from
                                      contract mfrs. in UK.,
                                    N. America, Asia, Europe,
Measure                                  and C. America

Gross Margin to Sales Revenue                 0.47

Gross Margin ROI                              5.30

Inventory Turns per Sales Season              6.20

Average Inventory Carried                     1.00
During Sales Season (1)

Sales Revenue During Sales Season             1.00
(1)

Service Level (% of times customer            94.00
finds first choice of SKU)

Lost Sales (% of times customer               6.00
finds none of first choice)

Sell Through (proportion of                   90.40
season's merchandise selling at
initial set price

Sold Off (% of unwanted units                 0.90
remaining after season)

                                           RETAILER B
                                       Combined Strategy--
                                    using foreign & domestic
                                     sources in same season
                                    Independent UK. retailer.
                                      "Private" label goods,
                                      increasingly provided
                                     from Asia but reorders
                                            from UK.
Measure

Gross Margin to Sales Revenue                 0.46

Gross Margin ROI                              4.40

Inventory Turns per Sales Season              5.40

Average Inventory Carried                     1.70
During Sales Season (1)

Sales Revenue During Sales Season             0.74
(1)

Service Level (% of times customer            83.00
finds first choice of SKU)

Lost Sales (% of times customer               11.70
finds none of first choice)

Sell Through (proportion of                   81.90
season's merchandise selling at
initial set price

Sold Off (% of unwanted units                 6.80
remaining after season)

                                            RETAILER A
                                        Offshore, Low-Cost
                                             Strategy
                                       U.S.-based specialty
                                     clothing store. European
                                     & North American outlets.
                                    No mfg. capability. Sources
                                      mostly offshore (Asia &
                                         Central America)
Measure

Gross Margin to Sales Revenue                  0.59

Gross Margin ROI                               2.50

Inventory Turns per Sales Season               1.80

Average Inventory Carried                      3.43
During Sales Season (1)

Sales Revenue During Sales Season              0.59
(1)

Service Level (% of times customer             72.00
finds first choice of SKU)

Lost Sales (% of times customer                18.00
finds none of first choice)

Sell Through (proportion of                    72.90
season's merchandise selling at
initial set price

Sold Off (% of unwanted units                  16.00
remaining after season)

(1)Scaled to domestic supply = 1


RELATED ARTICLE: Research Profile

This article marks an initial milestone in a four-year empirical research study begun in 1999 of the retail consumer goods sector. It is an international initiative, covering retailers and suppliers/vendors in both North America and Europe. The overall objective of the project is a better understanding of operational strategies. It applies a working hypothesis that many of the firms involved are having to adopt new and radically different methods of operation in the face of increasingly volatile and dynamic demand patterns that mark this particular commercial setting.

In this part of the project, senior managers from 167 different retailers were identified in a number of industries forming the retail consumer goods sector, the qualifying feature being that each organization had a retailing function of some kind. The sample, though not totally random, was intended to be representative of the sectors that provide such goods normally available in a shopping mall or department store. Of the 167 mailed surveys delivered, 5 were returned as no longer operating as a retail function, and 78 were completed. This gave an adjusted return of 48% (adequate for analysis and discussion). Each of the respondents was subsequently interviewed (many more than once) in order to seek clarification and some expansion of a number of issues.
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Title Annotation:retail industry suppliers
Author:Lowson, Robert H.
Publication:Business Horizons
Article Type:Statistical Data Included
Geographic Code:1USA
Date:Nov 1, 2001
Words:3545
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