Purchases
From Off-Shore Sources
"Total Landed Cost"
INTRODUCTION
This is a copy of a speech presented by Dr. LeRoy H. Graw,
CPP, CPPM, C.P.M., CPCM, at an educational conference in
Anaheim , California in May 1995. The speech was published
in Presentations - 80th International Purchasing Conference,
Anaheim , California , 1995. Much of the seminar material
is extracted from Dr. Graw's book entitled: "Cost and
Price Analysis: Tools to Improve Profit Margins", Van
Nostrand-Reinhold, (1994).
BACKGROUND
Buyers from off-shore sources should be very much concerned
with their ability to determine the "Total Landed Cost" of
the off-shore items. Monczka and Giunipero (1990, Pg 43)
refer to the process of arriving at "The Total Landed
Cost" as the "Total Cost Sourcing Evaluation Model".
The off-shore buyer has a multitude of cost factors to add
to the off-shore basic purchase price in order to get to "the
bottom line" price. Most quotations in off-shore purchasing
are obtained on a Cost Plus Insurance and Freight (CIF) basis,
which guarantees inclusion of the marine insurance and transportation
(to the U.S. Port) in the contract price. There are many
other costs in an off-shore transaction, some readily apparent
and some "hidden" to the buyer, all of which must
either be included in the contract price or added to that
price in order to arrive at a the "Total Landed Cost".
The buyer must be adept at evaluating all these different
categories of costs not commonly found in a domestic transaction.
If something is "missed", the buyer may ultimately
pay more than a reasonable domestic price for the same or
similar items. The problem is complicated by the fact that
several of the elements of cost must be estimated. This raises
the possibility that estimates prepared (necessarily) on
a pre-contract basis may later turn into costs substantially
higher or lower than the original estimates.
Composition of "Total Landed Cost"
In addition to the basic item purchase price, the ultimate
cost of delivering the goods to the buyer's facility will
generally include:
1. Costs of assists, if any are required.
2. Escalation cost, if permitted by the purchase order terms.
3. Cost of special, export packaging appropriate to the
item.
4. Transportation from the seller's facility to the port..
5. Port handling costs (wharfage, loading, warehousing,
freight forwarding, etc.) at the port of debarkation.
6. Export processing fees assessed by the exporter's government.
7. Certificate of inspection at the port of debarkation.
8. Ocean shipping costs.
9. Marine insurance premiums.
10. Port handling costs (wharfage, unloading, and warehousing,
etc) at the U.S. Port of entry.
11. Customshouse broker fees.
12. Customs duties (depending on the item and country of
origin).
13. Inland transportation costs (including demurrage, if
appropriate).
14. Financing charges, including bank charges for processing
documents and issuance of a letter of credit.
15. Costs of foreign exchange conversion, as appropriate.
16. Hedging (forward or futures contracts, or purchase of
currency or commodity futures).
For a CIF shipment, items 1, 2, 3, 4, 5, 6, 8, and 9 will
be included in the CIF contract price. Item #7 is normally
discretionary on the part of the buyer. The contract for
Certificate of Inspection services is generally between the
buyer and the inspection firm, for obvious conflict of interest
reasons. Separate buyer contracts are also necessary for
the customs broker, for a transportation common or contract
carrier within the U.S. , for the bank letter of credit,
and for the hedging transaction. More contracts necessitate
more contracting time by the buyer. (And legal fees, if the
firm uses outside counsel).
Different INCOTERMS (International Chamber of Commerce Terms)
than CIF call for different allocations of cost between the
buyer and seller. They also involve a different allocation
of responsibilities for handling the different aspects of
the international transaction. A summary of the principal
INCOTERMS and their respective allocations of responsibilities
and costs is shown in this chart.
Importers must, in addition, contemplate other costs of
buying off-shore. These costs are often difficult to trace
or allocate directly to the items being purchased. Most importers
account for these costs in their overhead, making it difficult
for them to determine a true "Total Landed Cost" for
their foreign purchases. These costs generally are almost
always estimated on an incremental basis. Monczka and Giunipero
(1990, Pg 47) refer to these costs as additional inventory
carrying costs and extra communication and documentation
costs.
Inventory carrying costs are those costs which are incurred
when holding inventory. Monczka and Giunipero (1990, Pg 47)
assert that they generally include "interest rate foregone
by investing funds; insurance; property taxes; storage; and
obsolescence". One must assume that interest rate foregone
means interest/investment income foregone, which can be determined
(computed) by multiplying inventory investment times the
firm's cost of capital.
Most firms find these costs to be substantial. They generally
find that buying off-shore requires a higher level of inventory.
Additional inventory carrying costs for off-shore purchases
can generally be determined by computing estimated carrying
costs for domestic items, by computing the equivalent carrying
costs for off-shore items, and then subtracting one from
the other.
Communication and documentation costs increase due to time
and distance separation from the off-shore supplier. Such
costs could include:
1. Telecommunication expenses
2. Travel, lodging, meals, and miscellaneous expenses for
trips to supplier countries.
3. Metrication (English to metric conversion) costs.
4. Increased costs of postage and correspondence.
5. Translation expenses whenever the off-shore supplier
insists that the contract be written in the supplier's native
language
6. Increased contract administration and legal time (Contracts
with off-shore suppliers often require time and effort of
higher level personnel not generally involved with domestic
transactions).
Typical Example
Let us take a typical off-shore transaction, in this case
for a particular printed circuit board built to buyer specification.
Assume the contract is for 10,000 units per month for a period
of 12 months from a firm in Taiwan . Terms are CIF, Port
of Los Angeles , and the purchasing lead-time from Taiwan
is 15 weeks. Assume that the buyer must provide buyer-provided
material (assists) amounting to $6,000.
TOTAL PURCHASE PRICE PER MONTH:
Direct cost of manufacturing $ 30 x 10,000 Units $300,000
Export packaging $ 1 x 10,000 Units 10,000
Transportation to Port of Debarkation $200/Container x 6
Containers 1,200
Freight Forwarder's Fee (By competitive supplier contract)
100
Ocean Shipping $2,300/Container x 6 Containers 13,800
Marine Insurance ($0.50 per hundred $)($32.67)(10,000) 1,663
Total CIF Purchase Price per Month $326,763
Total Annual Purchase Price W/Assists: $326,763 x 12 = $3,921,156
+ $6,000 $3,927,156
ADDITIONAL COSTS PER MONTH :
Port of Entry (POE) Terminal and Handling $700/Container
$ 4,200
Custom's Duties (4% of Unit Cost) ($32.67)(10,000)(4%) 13,068
Inland Transportation-POE to Facility ($20.00/100#)(15#/Unit)(10,000)
30,000
Customs Broker Fees (According to competitive contract)
200
Additional Inventory Carrying Costs
Warehousing, insurance, & taxes ($2/c.ft./month)(10,000
c. ft)(.5 months) 10,000
Interest/investment capital foregone ($32.76)(10,000)((20%)
65,340
Bank fees for forward contract 1,000
Additional contract administration costs 5 hrs x $30/hr
150
Additional legal costs 16.34 hrs x $200/hr 3267
Additional communication costs (10 long distance calls)
200
Total Additional Costs Per Month $127,425
Total Annual Additional Costs: $1,529,100
ANNUAL "TOTAL LANDED COST" $5,456,256
Against this "Total Landed Cost", the buyer must
compare his/her best domestic quotation. Here too the buyer
must make sure the costs for the domestic purchase are fairly
and correctly determined. In this age of "Just-In-Time" purchasing
the "Total Landed Cost" for domestic purchases
should include little, if any, inventory carrying cost and
few, if any, additional administrative costs. The buyer must,
however, make sure costs of transportation are added to an
F.O.B. Origin quotation in order to make it equivalent to
the off-shore "Total Landed Cost".
Use of Estimates in Making a Decision
Let's assume the lowest domestic quotation (transportation
included) for the circuit board is $5,099,487. To this amount
must be added the "assists" of $6,000. The total
domestic cost then is $5,105,487. The buyer must ask the
question: "Is the $350,769 differential sufficient justification
for me to go off-shore?" If the domestic supplier is
the "incumbent" supplier with which the firm has
had a long-standing relationship, the answer to that question
may be "no". If this is a new item for which there
is no existing domestic supplier, the answer may or may not
be "yes". Many firms consider the degree of confidence
in the estimated international sourcing costs, the firm's
level of experience in off-shore sourcing compared with its
level of experience in domestic sourcing, as well as its
experience with a particular off-shore supplier in assessing
whether a particular differential should dictate its decision.
Many firms require a projected differential in order to accept
an offer from an off-shore supplier. In the instant case,
the difference between the domestic cost and the off-shore
cost is only 6.5%. The buyer would need a high degree of
confidence in his estimate of "Total Landed Cost",
in his/her ability to effect an efficient international purchase,
and in his/her off-shore supplier's ability to delivery a
high quality product on time before he/she decided to go
off-shore in the instant case.
Planning For Contingencies
Estimators commonly refer to some costs as "Known-Knowns",
some costs as "Known-Unknowns", and other costs "Unknown-Unknowns".
The costs we have considered up to this point fit the category
of "Known-Knowns" (those for which we have firm
quotations or factual information in hand), or "Known-Unknowns" (those
for which we don't have firm quotations and hence must estimate).
Other costs which could materialize in the future which we
can't really estimate with any degree of certitude would
fit the definition of "Unknown-Unknowns". One of
these "Unknown-Unknowns" is the increased risk
of buyer-supplier disputes and the resultant costs of mediation,
arbitration, and/or litigation.
There are potentially several different laws available for
application to a typical international transaction. One of
these laws is the Convention on Contracts for the International
Sale of Goods (CISG). This convention is considered equivalent
to (but different from) the Uniform Commercial Code, and
can be made applicable to the transaction if both parties
agree, if even one (or both) of the affected countries has
not ratified the convention. Another law which can potentially
be applied is the law of the exporter while a third potential
law is that of the importer (the law of the state where the
importer conducts his/her business). The contract terms must
be very specific on which laws and which legal forum will
apply. Different laws and forums can have different cost
impacts on the cost of litigation and the amount of the judgements
made.
Many firm find that alternate dispute resolution (ADR) using
some type of mediation or arbitration is preferred to working
things out in a court of law. There are a plethora of rules
and procedures available for use in international mediation
and arbitration. Although the International Chamber of Commerce
rules for arbitration are, perhaps, most well known, there
are many others. The rules and how the body will be constituted
may differ from organization to organization. Different rules
and makeup can arrive at different consequences, some less
favorable than others.
Those who believe they can avoid any mention of litigation
in their off-shore contracts should be advised that such
is not the case. Even if arbitration is upheld as a method
of dispute resolution, there must be a legal forum available
to interpret whether or not arbitration is applicable as
well as to enforce the judgements of the arbitration body.
SUMMARY
Buyers from off-shore sources should be very much concerned
with their ability to determine the "Total Landed Cost" of
the off-shore items. The off-shore buyer has a multitude
of cost factors to add to the off-shore basic purchase price
in order to get to "the bottom line" price. Most
quotations in off-shore purchasing are obtained on a Cost
Plus Insurance and Freight (CIF) basis, which guarantees
inclusion of the marine insurance and transportation (to
the U.S. Port) in the contract price. There are many other
costs in an off-shore transaction, some readily apparent
and some "hidden" to the buyer, all of which must
either be included in the contract price or added to that
price in order to arrive at a the "Total Landed Cost".
The buyer must be adept at evaluating all these different
categories of costs not commonly found in a domestic transaction.
If something is "missed", the buyer may ultimately
pay more than a rr than the original estimates.
In addition to the basic item purchase price, the ultimate
cost of delivering the goods to the buyer's facility will
generally include costs of assists, if any are required;
escalation cost, if permitted by the purchase order terms;
cost of special, export packaging appropriate to the item;
transportation from the seller's facility to the port; port
handling costs (wharfage, loading, warehousing, freight forwarding,
etc.) at the port of debarkation; export processing fees
assessed by the exporter's government; certificate of inspection
at the port of debarkation; ocean shipping costs; marine
insurance premiums; port handling costs (wharfage, unloading,
and warehousing, etc) at the U.S. Port of entry; customshouse
broker fees; customs duties (depending on the item and country
of origin); inland transportation costs (including demurrage,
if appropriate); financing charges, including bank charges
for processing documents and issuance of a letter of credit;
costs of foreign exchange conversion, as appropriate; hedging
(forward or futures contracts, or purchase of currency or
commodity futures).
Different INCOTERMS (International Chamber of Commerce Terms)
than CIF call for different allocations of cost between the
buyer and seller. They also involve a different allocation
of responsibilities for handling the different aspects of
the international transaction. A summary of the principal
INCOTERMS and their respective allocations of responsibilities
and costs has been provided.
Importers must, in addition, contemplate other costs of
buying off-shore. These costs are often difficult to trace
or allocate directly to the items being purchased. Most importers
account for these costs in their overhead, making it difficult
for them to determine a true "Total Landed Cost" for
their foreign purchases. These costs generally are almost
always estimated on an incremental basis. These costs can
be said to fall into two major categories: additional inventory
carrying costs and extra communication and documentation
costs.
Other costs which could materialize in the future which
we can't really estimate with any degree of certitude would
fit the definition of "Unknown-Unknowns". One of
these "Unknown-Unknowns" is the increased risk
of buyer-supplier disputes and the resultant costs of mediation,
arbitration, and/or litigation.
Importers must know their anticipated "Total Landed
Cost" if they intend to prosper and remain in business
for any length of time.