Front End I Electronic Components Supply Network
What’s all the fuss about total
acquisition cost?
Is a focus on total cost accounting helping to reverse the off-shore sourcing trend of the past twenty years? Adam Fletcher suggests it could be
T
he migration of electronic system production away from the UK to countries with lower labour and land costs started in the mid 1990s. With it went much of the associated production component sourcing opportunity. Today this trend appears to be slowing and in some cases might even have gone into reverse. The reasons behind this are many and varied but ecsn suggests that for many organisations it’s the increased use of Total Cost Accounting that may be the primary change driver.
Many organisations were seduced into
off-shore manufacturing by the lower unit pricing offered by potential suppliers particularly in Asia, exacerbated by a general disinterest in the UK manufacturing sector at all levels (remember the “Knowledge Economy” myth?). Not every manufacturer did his homework: some blindly followed the trend set by their competitors in the belief that they’d gain a competitive advantage. Unit production costs might have been appreciably lower off-shore, but manufacturers often failed to appreciate the costs associated with funding eight week’s worth of finished goods inventory while it was shipped via sea cargo half way round the world.
Financial accounting reporting The obsession with unit price reduction in the 1990s was partially cultural and partly systemic. Everyone is seduced by lower prices, however most material managers were (and are) only responsible and rewarded for the inventory until it was “pulled” from the store and into the
8 September 2012
manufacturing operation. IT systems of the time were set up to track the Cost of Goods Sold (COGS) and often failed to allocate many additional costs back to its point of origin, merely allocating them as part of the general cost of their manufacturing operation.
Whilst COGS is primarily a financial accounting reporting metric many organisations use additional internal management reporting to analyse and monitor their organisation’s performance and Total Acquisition Cost (TAC) has become increasingly important. Correctly implemented TAC enables a company to track and sum all of the costs involved in ordering and carrying (holding) inventory, including stock-out (shortage) costs. The “holding” costs includes all inventory classes (raw materials, in- process, finished goods) and a calculation of all fixed- and variable-cost elements such as buildings, people (purchasing, goods in, inspection, stores personnel), heat, light, IT, cost of money (interest), scrap, re-work etc. A “stock-out” is the cost of not having an item in inventory when required, which results in a missed sales revenue opportunity and needlessly idle resources (people, machinery etc).. Xerox Corp was amongst the first
group of organisations to be actively involved in multi-site manufacture and sourcing of electronic components and systems. Xerox realised that the unit price was only one element of the cost. Along with duty, insurance and freight they added an additional element that they referred to as the “Hurdle Rate”, which included elements like premium freight, communication and travel costs, increased
Components in Electronics
inventory holding, scrap, re-work, obsolescence, compliance monitoring, IP Protection, supply chain risk etc... Just calculating one element of the
“Hurdle Rate” the holding cost of inventory came as quite a revelation to Xerox, and may be easily ‘guesstimated’ for any other organisation using the following method:
Assuming an average “raw material” inventory value of £1,200,000 a very simple calculation is the sum of:
Warehouse Space (annual cost of leased or owned space) £100,000
Taxes (paid on inventory and warehouse space)
Insurance Obsolescence / Shrinkage
Material Handling (people, machinery)
Cost of Money (current interest rate on inventory)
£240,000 £ 30,000 £ 24,000
£ 80,000 £132,000
Total Cost £606,000
Total Cost £600,000/Average Inventory Value £1,200,000 = 50% This means that the “holding cost” for every £1 of inventory is 50p
Reducing ‘waste’
Many organisations today utilise lean manufacturing systems with the aim of reducing “waste” in the process. One of the key elements of “waste” is considered to be inventory and so great efforts are made to control both “raw materials” and “in-process” inventory. As the inventory progresses through each manufacturing process, value is “added” until it becomes a “finished good” with all the value creation processes invested in it and ready to transfer to another division of the company, a distributor or to the end customer.
Organisations who outsource the manufacturing process to a Contract Electronic Manufacturer (CEM) continue
to carry many of the same risks and costs identified in the “Hurdle Rate”. A product with a raw material cost of £1 will often have a finished goods value at a factory transfer price (the cost used to sell between divisions of a company) of £8, a wholesale price of £12 and a retail price of £25.
Unfortunately often in an Asian off-
shore manufacturing environment all the efforts to control inventory are totally negated by the fact that the majority of the finished goods have to be shipped via sea freight (airfreight is often too expensive) to the end customer, a six- to eight- week process.
The value of the finished goods inventory is at least eight to twelve times the raw material cost, yet most of the activities of the organisation have been focused on the downstream processes. It’s therefore apparent that manufacturers’ increased use of TAC (Total Acquisition Costing) is resulting in a greater focus on identifying “value add” and “waste” of resources within the organisation and as a result, some products that show only a marginal saving when manufactured off-shore are likely to be moved to a manufacturing location significantly closer to the end market. Whilst the UK may benefit from this
activity, don’t expect to see a step function increase in UK high-volume manufacturing activity in the short term. There is simply too much competition and too much market distortion as a result of governmental subsidies in other European countries. In the UK we will have to continue to invest in advanced manufacturing processes and maintain our focus on complex products where we are able to apply significant intellectual property and other added value.
ECSN |
www.ecsn-uk.org Adam Fletcher is Chairman of Afdec/ECSN
www.cieonline.co.uk
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