featured malpractice

This page contains a practice, from our library of over 100 business malpractices, to illustrate the very worst practices we have encountered, and which we seek to eradicate by showing you and your executive responsible for this practice how they are damaging your business. This series of articles are intended to be humorous and gross caricatures of real situations we have encountered! We are currently featuring a Procurement practice of which we thoroughly disapprove:

Malpractice M008

The Real Cost of "Off-Shoring"

(The Square Root of a Trip to Venus)

(& the further adventures of Innocence)

Preface

The purpose of this article is to explain one of procurement's, contributions to operational inefficiency by buying off-shore on the assumption that this is cheaper. It aims to show the real cost of acquisition rather than the purchase price. (It also helps to explain a more recent reverse trend to bring work back on shore.)

For the purpose of this article I am assuming you have a satisfactory (other than cost) supplier on shore, prior to the decision to buy off shore. (We have previously covered "outsourcing" in two articles: Previous Malpractice M007: The cost of the costing system and Previous Best Practice B007: Strategic Purchasing). This article also describes the real cost of importing and some potential problems associated with imports.

Our story is set in the year 2213 following the universal trade agreement with Venus. Our hero is "Innocence" (recently promoted to procurement manager in a medium sized engineering business Space Widgets Ltd. employing 200 people). Anxious to make his mark in his new appointment, Innocence had noticed a well publicised trend over the previous 20 years to import from Venus, and decided to join the bandwagon. He obviously decided to import their most expensive purchased items and seek an alternative supply in the industrial South West Province. These items were currently supplied by a large local supplier employing 2000 employees, (many of whom actually purchase the end products produced by Space Widgets), which incidentally was also part of the same group of companies.

Set up costs

He contacted a Venusian purchasing agent who said for a single fee that he could provide a suitable supplier. Innocence readily agreed and attached the drawings to a space mail and sent them to Venus. After a short interval the agent came back with the answer. He could obtain a supply for 2 DollEuroDinarRuble's each. (The DollEuroDinarRuble, or Dudu as it had come to be known in an attempt to avoid the queues which were disrupting supermarket checkouts, was now the Earth's only currency, since the trade wars of the mid 21st century. Putting this into a historical perspective the Dudu is worth approximately 1000 times the old Dollar of 2010.)

2 Dudu's was 1/10th of the current cost! Amazing! There would of course be a set up charge for tooling. There would also be a minimum order quantity of 20,000. Innocence was not too troubled about either of these at the time. In his first monthly report Innocence proudly boasted. "I can reduce our overall purchase costs by 90%!" The MD stopped him at the coffee machine the following day and patted him on the back. "Keep up the good work", he added.

This situation of course necessitated a trip to Venus to seal the deal. (A visit to Venus was on Innocence's list of 100 things to do before he retired, so he was anxious to tick this off the list and combine the trip with a spot of sightseeing.) However because his status only qualified him for economy class flights, the flight was a little arduous! The first thing that Innocence noticed on the trip was the vast distance involved in the flight and then overland on arrival. The overall travel time from home to when he wearily dropped his designer suitcase on the supplier's home town hotel bedroom floor was 29 hours at 0.25 x light speed without a break! Still he was comforted by the thought that the supplier was only a day away in the event of problems. (He only discovered later that a Venusian day was over 200 Earth days.) He was further comforted by the fact that the hotel was one of a inter-stellar chain, so he could still get his regular English beer every night. On arrival the acid rain was particularly heavy, so Innocence sought solace in the bar. It was there that he met a fellow traveller who revealed that was the MD of a Martian company who was also on a similar mission. Innocent commented on the inclement weather. His companion replied, "this is nothing, wait until you see the Venusian monsoon!" (Mars as we know is still a fairly dry planet even after the commercial exploitation of polar ice in mid 22nd century, so Innocence dismissed this criticism as gross exaggeration.) After a few beers Innocence retired to his room and collapsed onto the hover bed without taking off his spacesuit.

Fortunately the now common robot cleaners are still a rarity on Venus and Innocence was awoken with a start the following morning by the sound of the room cleaner knocking the door. Again fortunately his appointment to meet the supplier was not until midday but he was late for his pre-meeting with the agent. His mobile, knowledge-pod, phone rang. It was the agent, who arranged to join him for mid morning brunch at the hotel. He put down the phone and looked at his watch. It still said 2am!

The meetings with the agent and the supplier went well and in a couple of hours the deal had been struck. First samples were arranged for delivery by space shuttle in two month's time with full delivery to commence (subject to sample approval) in four months time by "space donkey". (A "space donkey" is a relatively slow speed but high capacity vehicle compared to a space shuttle. Innocence spent the remaining time he had allowed on visiting the "Venusian springs" a great tourist attraction. He returned on the red eye satisfied with a job well done and an excellent tick on his "100 things to do" list. He had made the trip last for two weeks!

The tooling cost was paid and Innocence waited. The samples arrived and not only was the quality good, the items were polished! Innocence gave the go ahead for full scale production. This allowed him to switch off supplies from the existing group supplier, to coincide with the new delivery from Venus. It was at this point that Innocence received a phone call from the sales director of the group sister company. "I understand you have re-sourced our supplies to Venus with immediate effect", he protested. "We have just made a large batch of these. I am going to hit you with a liability charge of 50,000Dudu! What do you want me to do with them?" Innocence, reassured by his growing confidence in his new foreign supplier, replied that he did not want them. There was a brief exchange of forthright views on Innocence's dubious parentage and the call was terminated.

Later in the week Innocence again met the MD at the coffee machine who expressed a smug concern, "it seems that you have shaken up our sister company. They have just laid off 500 people indefinitely. The redundancy bill will be enormous. Their MD is spitting blood! We are now the only profitable group company. I also managed to defend us against the invective in the subsequent call from the Chairman on the basis of our own long term survival."

The due date for the arrival of the first shipment arrived. Innocence had prudently allowed a week for the inevitable snagging problems, but that also passed by. A desperate phone call to the Venusian agent revealed that Venusian New Year had in fact delayed the shipment by 2 weeks. But as a special favour the supplier could space shuttle a few to keep them going, provided that Innocence was prepared to fund this exceptional method of shipment. With no other options available, the charge was accepted. (He also did not realise at the time that under Venusian law this was in fact creating a precedent.) Innocence gave little thought to the weight of the items at this stage.

As it transpired there were 10 shuttle shipments in the following 5 weeks. But this had nothing to do with Venusian New Year. The first partial shipment finally arrived and was rejected due to handling damage (and they were not polished). On investigation it was revealed that, whilst perfectly adequate for local delivery, the previously used packaging was totally unsuitable for space transport. Later it was also revealed by the assembly manager that the underlying quality consistency delivered by the sister company who had been making these items for several years was significantly better. Although the items were within specification they were nowhere near as consistent which caused rework and additional internal costs in assembly and slowed internal output. The assembly manager estimated that assembly cost had jumped by a factor of 50% from 2Dudu each to 3Dudu each.

It was at this point that Innocence was called into the MD's office. This had not happened before so he knew there was a problem. The MD was not prone to calling people into his office to pat them on the back. (This activity, as we have previously learned, was confined to the proximity of the coffee machine where the MD was always jovial.) The MD had received a call from their most important customer "Pan-Universal" with complaints about late delivery. The fickle finger of blame was pointing in the direction of delivery problems from Venus. This resulted in Innocence's second trip to the South West Province where he was dispatched by the MD, (whose secretary had already pre-booked the shuttle flight).

Before he left for his flight Innocence examined the small print of the Venusian contract. Although it was written in an obscure Venusian dialect he managed to make out, "Loose packing in newspaper" and no mention of quality consistency within tolerance. He knew this was going to be a difficult conversation with the supplier.

He was delighted when he returned from an intense renegotiation with the supplier with an additional cost of only 0.50Dudu per piece for improved packaging and a promise to try to improve quality consistency provided that Innocence was prepared to accept larger batches filling a "space donkey bay" (roughly the equivalent of the old 40 foot shipping containers, but slightly taller), since this was considered to be an "Economic Batch Quantity". (See Previous Malpractice M005: Economic Batch Quantity EBQ / EOQ.) After all, the cost was now still only 2.50Dudu each, compared with the previous 20Dudu. (But if you have been following this series of articles you will understand that this is an accident waiting to happen!)

Real logistics and communication costs

Unfortunately the next shipment was delayed by a paperwork cock-up at the port of embarkation. Apparently the container had mistakenly been delivered to the Rotterdam Space Hub. Innocence, in a panic, arranged for a delivery by hovercraft from Rotterdam. However the error was further compounded by the foreign hovercraft driver who having escaped from an enormous traffic jam holding pattern over the south marker of Heathrow Shuttle Port by taking a steep dive, was guided, lemming-like, by his Sat. Nav. to a bridge somewhere in South London, under which he was firmly and semi-permanently stuck. (But this is not the accident we predicted earlier, although the company's insurance premium did increase slightly. That accident comes later.)

This would not have been so bad had the shipment not already been late. The damaged goods were sorted offsite with inspection personnel diverted from other duties and the few remaining salvaged items delivered in a piecemeal fashion. The operations manager piled on the overtime in a desperate attempt to catch up, but inevitably the delays caused further customer complaints. This did not endear Innocence to the MD who inserted a regular item into the board meeting agenda regarding unreliable supplies.

Clearly the following shipment had to be pulled forward to overcome this disaster and recover the shortages scrapped in the traffic accident. The supplier (whose responsibilities ended at port of embarkation), whilst sympathetic, was having difficulty in keeping up the additional requirements. Eventually the backlog was recovered when Innocence agreed to pay for shuttle freight and excessive overtime, at the supplier, as a one off payment again.

The next (first full) delivery was due. Innocence had been reassured by the advance delivery notification from the supplier which suggested delivery on 23rd. However on the 23rd he became aware of a problem when he received an irate telephone call from the stores manager asking where all this stuff was supposed to be stored. On investigation Innocence saw a queue of traffic waiting outside goods inwards and responded, "stop squealing like a stuffed pig! Just leave it outside and get the queue cleared". To cut a long story short it took 5 hours to offload half of the space donkey bay container causing traffic chaos throughout the whole of the district. At this point the exercise was halted by the police who were unsympathetic. (It would have been halted by the stores manager anyway shortly afterwards, because he had run out of space outside the building and wanted to go home!) That would have been OK had it not rained that evening. This caused the new improved packaging, exposed to the elements, to disintegrate and stick to their contents. The chief inspector also commented on the continuing variation within tolerance (which subsequent root cause analysis revealed was due to the difficult metrology problems caused by the significant temperature fluctuation on Venus. The measuring equipment tended to melt in the Venusian day and was too cold to touch by night.)

Innocence at this point came to the inevitable conclusion that more warehousing space would be necessary to accommodate these increased loads. This clearly would have to be off-site to avoid the traffic congestion (which would cause double handling and potentially more damage). He noted that a number of logistics businesses have now incorporated this facility into their offerings, so this would be easy to arrange. He arranged a contract with an international carrier to provide daily Just in Time (JIT) supply from a distribution centre somewhere in the M1 warehouse precinct, (which now extended 35 miles along the M1 hover-way).

Real lead-time costs

Oh joy! This was the equivalent of the JIT supply they used to enjoy from their sister company. This worked fine for the first 3 months. Innocence then started to receive complaints about assembly shortages for the "JIT" supplies!? He had a heated conversation with the international carrier who blamed the supplier. In a further conversation with the Venusian supplier it transpired that in order to accommodate the 8 week space donkey and hovercraft ride that an 8 week extension of the sales forecast was necessary in order to give the supplier a chance of making what was needed. So Innocence found himself in a conversation with the Sales Director about supplying 12 week sales forecasts now, to which the sales director replied, "no chance, I do not know what we will be selling tomorrow!" Inevitably a routine forecasting process was established which now needed an additional demand planner and a super-computer software package. (They had not heard of our SSC03 Advanced Forecasting And Inventory Modelling training course, which provided a much better and cheaper solution in the good old days of the 21st century.)

This brings us to the subtitle of this article the "The Square Root of a Trip to Venus" because, as every Inventory Planning "knowledge-pod" tells you, you need to multiply the variation in lead-time by the square root of the lead-time by a safety factor in order to calculate safety stock. Whereas the safety stock held on site used to be a day's worth to accommodate a lead-time variation of +/- a day, the lead-time was now 8-10 weeks weeks (not nearly as reliable).

The new safety stock calculation suggested that it needed to be set at roughly:

a safety factor (approximately "2", Innocence determined from the knowledge-pod)

x a week (observed +/- variation in lead-time in weeks)

x the square root of 9 weeks (average observed lead-time)

= 6 weeks worth

Or 42 times more stock than was previously required (1 day vs. 6 weeks).

However that is not the end of the story. When it came to calculate the point at which orders need to be placed, because a space donkey bay container represented approximately 8 week's worth of demand, one container needed to be ordered when the reorder was triggered for 8 week's worth which means on average that stock holding would now be 6 week's worth of safety stock (from above) + 1/2 of a batch of 8 week's worth = 10 week's worth (not half a days worth)! (You will be pleased to know that we explain in more detail & significantly refine this calculation in our training.)

When Innocence did this rough calculation he suddenly realised why his warehouse space now needed to be permanently expanded by a factor of 140! However he rationalised that he was still making a killing on the purchase price. (But it did explain to him why huge warehouses were now magically appearing at every hover junction in the country and why his warehouse manager was "squealing like a stuffed pig" with some justification!)

Innocence implemented the new stock policy, which had two short term effects:

This again gave the Venusian supplier an opportunity to quote the previous precedent and demand more compensation, because this represented an enormous increase in short term requirements.
The contract with the international carrier was renegotiated to reflect the increased storage requirements and additional handling.

Meanwhile customer service continued to be problematic and the shortage situation in the shop was now causing serious disruption. Productivity had halved because the new packaging still had a tendency to stick to items!

Pan-Universal's MD asked if he could visit to try to understand the continuing late delivery issues. The subsequent meeting turned out to be a fairly uncomfortable one for Innocence. Reassurances were given, but the words, "I will believe it when donkeys can fly", rang in Innocence's ears as he left the meeting. Following the meeting he received an ultimatum from the MD.

Things settled down for a while and Innocence asked the international carrier, whilst decanting the daily delivery from the space donkey bay container, to remove the packaging. It was now early summer and Innocence was pondering on which foreign trip to tick from his list of 99 things to do before he retired when he once again received a complaint about a late delivery. He rang the Venusian supplier, who said he was struggling to obtain raw materials from Saturn because their factory had been recently damaged by an earthquake. (The Venusian supplier had apparently switched his own supplies to Saturn to save costs.) This had also been compounded by his own difficulties because the roads had been washed away by the heavier than usual Venusian monsoon acid rain.

Innocence was angry at this point but Saturn was also on his list so he acted decisively and took a super shuttle flight. To cut a long arduous journey short, Innocence rightly insisted that both Venus and Saturn suppliers held additional stock to ensure business continuity.

Innocence redid the stock calculation. Because lead-time variation had now doubled, although average lead-time had not changed, he would need to double safety stock to 12 weeks making average stock holding 16 weeks worth of demand. Again this took a while to build up. There was more shuttle freight in the process and more storage space needed at the carrier. (Innocence briefly considered the potential problem that a flight might actually be lost in space on the way from Saturn and / or Venus, but decided to ignore the possibility, since this would make the numbers look silly.) Innocence decided instead that he needed an expeditor to manage the situation. The expeditor subsequently complained that he spent half his life on Shuttle flights.

There would also be an ongoing weekly Master Production Scheduling meeting held by video conference with the Venusian supplier to improve communications. The MD sat in on the first one. The technology was marvellous! However the MD commented on the distinct lack of urgency in response to the urgent requests being placed on them. Innocence had noticed this desire on the part of suppliers (not just Venusian suppliers) in the past to have stable plans and to resist changes in demand. The MD also expressed concern about the fact that the Venusian suppliers had their feet on the board room table at the other end, and that they seemed to resist anything that would disrupt their low cost / big batch / stable plan mentality! Quite the opposite of the way that Space Widgets responded to urgent customer requests and the service they used to receive from their sister company! This cultural divide could not lead to good customer service! But because they had stock coming out of their ears what could go wrong? (See Previous Malpractice M004: Creating the wrong culture) (There were some headaches at the annual stock take, which took 7 week-ends overtime and several shuttle flights to solve, but that will be covered in a future article.)

Serenity reigned again until one eventful day approaching Christmas, when goods inwards inspection called. They had unveiled a shelf life problem. Some of these items in stock at the carrier were well out of shelf life. They were now scrapping over 20% of all deliveries on arrival and having to check every consignment. Replacement was causing the carrier to double daily deliveries. Since Innocence had previously determined that this level of stock was needed, there was no solution to the problem whilst the supplies continued to come from afar. Innocence resigned himself to the fact that there was so much fat in the warehouse this could never cause a supply problem. A procedure called "re-lifing" was introduced to check items approaching their shelf life and to reset the life if the stock had not deteriorated too far. The carrier was happy to conduct these checks for a small increase in price. (Innocence thought he was in the Dudu now, but the slow motion accident is starting to occur!)

It was about this time that the designer came to Innocence with a request for a quotation for a new component. Innocence obviously gave the problem to the Venusian agent again. The agent duly came back with a price of 4Dudu each (a slightly less advantageous price over local competition than before). The agent explained that this was due to adverse currency movement and inflation in the intervening period on Venus. Innocence accepted the quotation and ordered initial supplies. It was about this time that the contract for the original supplies also came up for renewal. Another trip was required. For the original supplies and for similar reasons this time the price was agreed at 3Dudu as a part of a 2 year contract, which was sealed with a glass of Venusian grass wine (which whilst an acquired taste, Innocence had by now become accustomed).

He returned from the trip and on his first day back in the office the designer dropped the bombshell! The new item replaced the original items and the marketing department insisted that the change needed to take place immediately (in order to counter a new threat from a competitor). He added, "we will probably need to do this again at least once a year". "Product life cycles are shortening all the time!" (There is a clear crunching sound now!)

After much protestation from the supplier, Innocence cancelled the existing contract and whilst there was a liability charge the new items started to arrive. (The train had now comprehensively hit the buffers when Innocence was hit with this new and massive Dudu liability claim!)

That was not the end of the story though. In addition there was however a quality problem with the new supplies. Innocence with a distinct feeling of déjà vu and turning to the expeditor who happened to be in the office on one of his rare visits for his annual appraisal asked, "is it groundhog day".

As ever, determined to learn from his experiences, Innocence decided to do a quick sum:

Cost of expenditure with sister company before the change of supplier:

20Dudu each x 10,000 items pa = 200,000Dudu pa

Cost to the group in the subsequent year:

	Dudu
Purchase price: 2.50Dudu each x 10,000 items pa (before latest price increase)	25,000
Agent's fees	5,000
Set up costs for tooling	1,000
Liability charge (sister company)	50,000
Increase in insurance premium	5,000
Demand planner & computer software	41,000
Redundancy costs	25,000
Air freight	20,000
Additional assembly costs 1Dudu each x 10,000pa	10,000
One off overtime backlog clearance payment to supplier (x 3)	10,000
Own company inspection overtime and overnight accommodation	5,000
Rust removal 1Dudu each x 5,000 items	5,000
International carrier DC contract (including "re-lifing" procedure)	20,000
Cash tied up by a space donkey container load. (50,000Dudu x 4% carrying costs interest)	2,000
Additional expeditor	20,000
Expeditors travel expenses	20,000
Innocence's travel Venus (5 trips)	25,000
Innocence's travel Saturn (1 trip)	5,000
Scrap due to out of shelf life 20% x 2.50Dudu = 0.50Dudu each x 2,000 pa	1,000
Obsolete stock (in house stock)	10,000
Obsolete stock (carrier stock)	35,000
Liability claim for 2 years output from Venusian supplier.3Dudu (latest price) x 20,000	60,000
Goods Inwards Inspection overtime	10,000
Video conference equipment and line rental	5,000
TOTAL :	415,000

Total cost per product:

Old method: 20Dudu each

New method: 415,000Dudu / 10,000 = 41.50Dudu each

He rationalised that perhaps he should not include the sister company's redundancy bill of 25,000Dudu (which after all was their problem) and which would make it only 39Dudu each. He also chose to ignore the cost of the additional time attached to each of the space trips spent ticking off his holiday list (which he had accidentally included in his expenses), any other hidden costs which he was not aware of, and other costs incurred on the operations manager's budget since it would be difficult for them to pin this on him! He also rationalised that many of these costs were one-off, so that in subsequent years, these costs would not be repeated, but then he recalled the designer's words, "we will probably need to do this again at least once a year". He did however muse on how much time he had spent arranging all this over the last year! At this point Innocence hid the scrap of paper in his desk draw and returned to his tick list of 98 things to do before he retired.

But it was then that Innocence actually began to realise the real cost when he was called to the MD's office again, following the cancellation of the order by Pan-Universal due to the continuing problems with unreliable supply. (Interestingly he discovered later that they had decided to buy from the same Venusian supplier who was now capable of supplying identical designs ex-stock from a warehouse somewhere in M1 warehouse precinct.) Innocence was fired! He just had time to settle the new and complicated liability claim for the massive reduction in demand for the new items from the Venus and Saturn suppliers before he emptied the contents of his desk into his designer suitcase.

That would not have been so bad, but this reduction in sales also placed the already precarious group profitability into terminal decline. (He learned much later that this also threatened his accumulated pension from the company. Because the sister company had closed, the sales from Space Widgets also further declined and the number of group employees now totalled 35!)

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What you should do instead

We do not suggest that you source all items locally, although there are obvious lead-time advantages of doing so (unless you can afford the air freight). What we suggest you do is:

Understand your own businesses critical success factors, in particular if cost reduction is an overriding need in your business. (See Six Steps to Near-Perfect Quality). For example in our line of business there are cheaper, but we do not view these as serious competitors, because we are principally selling experience, quality, independence, innovation, responsiveness. There are many reasons why people buy things. But you are very foolish if you buy from the cheapest. (We describe 8 potential critical success factors in Previous Malpractice M003: Buying Cheap)
Understand the strengths as well as the weaknesses of your current suppliers and supply chain by conducting a SWOT analysis (See Previous Techniques T013: SWOT Analysis) (You may be about to lose something you value such as lead-time or quality consistency as in our example above.)
Understand the risks (See Previous Techniques: T027: Product FMEA and T033: Process FMEA):
1. Implementation risk
2. Failure to supply
3. Intellectual property
4. Reputation
5. etc. (we supply a more comprehensive list in our P03 Service Level Agreements and S04 Strategic Capacity Management training courses)
Properly understand the total acquisition costs (wherever you source items):
1. Set up costs (& over how many items must this cost be amortised) (In our story above Innocence exchanged a variable cost for fixed set up costs which were subsequently amortised over fewer items than originally envisaged. In fact many became a recurring item of expenditure and not a one-off cost!)
2. Running costs
3. Ancillary / consequential costs
  1. Management time & dilution of management effort on critical success factors for the business!
  2. Does your method of costing actually provide you with sensible cost data and are you interpreting it correctly? (See Previous Malpractice M007: The cost of the costing system)
4. The cost of alleviating risk

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Speed of Beneficial Impact

Typically better decisions start to be made, the benefits of which occur a lead-time later.

Type of benefits of eliminating the practices and adopting the alternative approach

We would expect you to:

Make better procurement decisions

Buy better

Get more output / better productivity

Reduce risk

Reduce real costs

Create cash

Keep your existing customers!

Ease of Implementation

Easy

Prerequisites

None

We hope this will help you to persuade your Procurement Manager to correct this serious malpractice. To do this they will need to persuade their managers to understand the real cost and risks of buying off-shore, by showing them this article.

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Important message

We are currently researching the topic of malpractice and would be interested to hear your experiences (in confidence of course, and if you wish, you do not need to name your organisation)? We are also interested in collaborating in this research project with companies or government departments as fascinated by this topic as we are, and the following question:

There is no shortage of advice on best practice, in fact the opposite. Why therefore is malpractice so easy to find and what are the connections between business environment, practices (good and bad) and performance?

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Whilst great care has been taken to provide relevant, accurate, practical, advice based on our considerable process design and development experience, this will almost certainly require interpretation into the context of your unique business. Please be careful in doing so and if in doubt seek expert advice. We would welcome your feedback!

SM Thacker & Associates

Independent Best Practice Training & Consultancy

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