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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.

 

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