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The true costs of sourcing from China: China isn't spelled 'cheaper,' especially when it comes to raw materials. But lower labor and overhead costs often make the decision worthwhile, though there are still a myriad of issues to understand and consider.

Manufacturing in China has become almost a "given" for many U.S.-based manufacturing companies. In reading the press, you might assume that if you are not manufacturing in China, you cannot possibly be competitive--that anything made here can be made much less expensively there. This is not always the case.

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While this article focuses on sourcing of components and sub-assemblies for use in original equipment manufacturer (OEM) manufacturing lines in North America, the issues involved are similar for other China sourcing projects. Armed with knowledge of the differences between Chinese and domestic sourcing, careful management of the issues and a great deal of patience, you can indeed realize great savings by sourcing in China. As a senior financial manager, your analysis of the following cost factors will play a major role in making it happen.

Part or Sub-Assembly Costs

The vendor's quoted purchase cost of the part or sub-assembly is the "hard" number, and the place where the savings occur. And the savings can be great.

Purchase cost is determined by raw material, labor and overhead costs. Expect raw material in China to cost as much as--if not more than--raw material purchased domestically. Savings will be realized through lower labor and overhead costs. Even though labor costs in China are rising, by 2009, labor rates in North America are expected to be roughly 20 times the rates in China, according to Boston Consulting Group's China Report. Companies will also save on overhead, everything from salaries and lease costs to utilities.

The more direct labor involved in the manufacturing process, the greater the savings. When choosing a part or sub-assembly to be manufactured in China, concentrate on labor-intensive, items, then weight these direct cost savings against the additional costs of Asian sourcing.

Freight and Duty

Most quotes from Chinese manufacturers will be FOB (freight on board) Departure Port, such as Hong Kong, Shanghai, etc. You have two choices for freight--sea and air. In almost all cases, sea freight is required. (Two notable exceptions are when your parts cannot be exposed to the environment of a long sea voyage, or when air freight is necessary to prevent a line down in manufacturing.)

The tradeoff is cost versus time. Shipping by air you can get parts in a few days, but the cost will almost always be more than the profit on the part (and possibly more than the sale price). On the other hand, shipping by sea can take up to six weeks. This requires adjustments to the way products are planned and released. With forethought and proper planning, however, this can be done very successfully.

All products coming into the U.S. are subject to duty; even duty-free products are subject to a 0.21 percent fee. Products are classified by the Harmonized Tariff Schedule (HTS). Pay close attention to the assigned HTS code: Not only does it determine your duty rate, but it will be reviewed for appropriateness when the product reaches the U.S. Any problems or questions on the part of the Customs service can hold up a shipment and delay delivery. Your freight broker or a third-party Asian sourcing company can help you determine the right HTS code for your products.

Working Capital

Sourcing in China adds complexity to the working capital analysis. Factors include credit terms, finished inventory and raw materials inventory. Most vendors require a letter of credit or cash on delivery (COD) at the beginning of a relationship. They will extend credit terms, typically net 30 days, once a history is established. But even with credit terms, you will be paying the invoice prior to receipt of product, due to the sea transit time. This will extend your cash conversion time.

Inventory factors also impact working capital differently for China-sourced products. Depending on the criticality of on-time delivery, you will need safety stock at your domestic location to accommodate shipping delays and demand fluctuations. Experience shows this can run from two to four weeks of average requirements. Working capital will also be tied up in inventory "on the water."

Finally, in cases where raw material or components (especially electronics) are unavailable or prohibitively priced in China, consider maintaining an inventory of consigned component at the Asian manufacturing location. Plan to keep a safety stock of components in China, as well as in-transit inventory to China, of five to six weeks of average requirements.

Pre-Production Support Costs

Starting up any new vendor or part production takes much time and attention to detail. Add cultural and geographic differences to that new relationship, and the costs become a significant factor.

Americans conduct business very differently from their Chinese counterparts. One style is not better than the other, just different. But this difference, if not understood, can lead to deal-ending frustration and misunderstanding.

Americans expect that the terms and obligations set forth in the purchase order and quote are understood and will be completed without fail. The Chinese don't see this process as written in stone. Items change, obligations are negotiated; it is an ongoing process. It takes more dedicated time for the North American buyer to follow these projects with Asian vendors. A great deal of patience is required, but will be well worth it.

As with any new production, your staff will need to make on-site visits to see the project to a successful completion. The number of trips will depend on the complexity and duration of the project, and on your familiarity with the vendor. But China is 8,000 miles away, and a five-day trip can run approximately $2,000 to $6,000 per person.

Language, Time and Scheduling

It is not unusual for a smaller Chinese vendor to have only one person on staff responsible for all English language communication. That person may have no manufacturing or technical experience, so be prepared to explain issues carefully and patiently. Miscommunication can lead to expensive mistakes, so it is important to have someone on your side who understands the language and can communicate directly with the vendor's staff.

With the 12-hour time difference, you may need to accommodate flexible work schedules for your own staff. And plan on an extra day or more to get answers to urgent questions. Again, patience is the key.

It can take 12 weeks from order date for a delivery of product to your door. This can vary, but the fact is that lead time, in the absence of air freight, is significantly longer than the lead time from a domestic supplier.

This mindset change is the hardest challenge for buyers new to China sourcing. It requires looking out 12 weeks and issuing firm orders for this horizon. It requires quick reactions to scheduling changes--once the parts are made and on the boat, it's too late to change them or hold them back. You must invest in managing scheduling--be sure you have dedicated adequate time, personnel and tools to the effort.

Education, Experience and Partnerships

You can manage these issues with a combination of education, experience and partnerships. Most companies don't broadcast their experiences with China sourcing, but it is possible to find case studies and talk with other companies that have successfully implemented it.

Then you must choose the right part or sub-assembly to source in China. Make sure you've done the analysis of labor savings vs. the costs described above. For a first experience, choose a part that does not have a mission-critical delivery date. You want to give yourself room to make mistakes while you learn the ropes without incurring air freight costs, letting a manufacturing line go down or missing a customer commitment.

Another option is to work with an experienced partner. These include vendor sales reps, traditional distributors and third-party Asian sourcing companies.

A vendor sales rep can assist you in communicating with the vendor and negotiating the sale. They typically have limited ability to assist you beyond the sale with quality, engineering, delivery or logistics issues. A distributor or reseller typically focuses on logistics, accepting product from the vendor and reshipping it to you. Distributors will handle customs, duty and freight issues. They generally won't intermediate between you and the vendor on issues of delivery or quality.

A third-party Asian sourcing company can assume responsibility for all of the issues described here. These full-service companies can offer the benefits of buying from a U.S. company, such as delivery FOB to a U.S. warehouse, to mitigate your Customs and working capital issues. They can take responsibility for logistics management, communications, travel and scheduling. Specialized sourcing companies may also offer engineering and quality services, and help analyze which parts and sub-assemblies are a good fit for China sourcing.

In summary, China sourcing, if done right, can deliver great cost savings on parts and sub-assemblies for North American manufacturers. Finance managers need to make sure their company takes all of the cost factors into account, rather than simply focusing on labor rates. And once starting down this path, remember that patience is the key to ultimate success.

James Carboni (jvcar@globalpointusa.com) is Senior Vice President and CFO at Global Point Technologies, which has been has been sourcing engineered components and sub-assemblies from China since 1998.

RELATED ARTICLE: takeaways

* While it's commonly believed that anything made in China will be cheaper than what can be made in North America, that isn't always true.

* With labor and overhead costs lower, they will likely justify sourcing from China, but there are a myriad of logistical and cultural issues to navigate.

* One major concern is the fact that inventory is "on the water" with sea delivery, and orders can take 12 weeks from time of order to actual delivery.

* Unlike many Westerners, the Chinese don't see the purchase order process as written in stone, and items can change and obligations can be renegotiated.
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Title Annotation:international
Author:Carboni, James
Publication:Financial Executive
Geographic Code:9CHIN
Date:Oct 1, 2005
Words:1638
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