You manage the operations for a department in a large retail establishment. Your

Question

You manage the operations for a department in a large retail establishment.  Your entire business rests on being able to acquire inventory for your department from your supplier when needed and at a price that allows you to make a profit.  You have been purchasing  an average of $1M annually in inventory items from a supplier that has all their manufacturing facilities in the U.S.  and your terms have been FOB destination.  However, your supplier is planning to move the manufacturing of these products to China and, at the same time, change your terms to FOB shipping.  You estimate that the shipping costs from China will run about 10% of the purchase price of the inventory.  If you agree to this switch in shipping terms, your supplier would agree to charge you 10% less for each unit of inventory that you purchase.  You and your boss have discussed the pros and cons from an operational perspective and you both feel that you will be able to get your inventory items when you need them. You must suggest whether to:

Stay with your current supplier, given what they have been proposed (manufacturing moved to China and terms changed to FOB shipping with a 10% inventory price decrease), or

Move to a different supplier that allows you to continue to purchase under your current conditions (manufacturing still in the U.S. and terms FOB destination with no change in purchase price).

Pretend that I am your boss and you are writing an e-mail to me indicating those questions that must be answered before you make a final suggestion.  The proposed 10% price reduction sounds like a great deal on the surface, but how might the change in shipping terms impact other financial results?  What changes might we need to make to accommodate a manufacturer in China?  What hidden costs might be involved if we make the changes proposed by your current supplier?

Remember that you’re trying to impress me, but that I’m also pretty busy.  Therefore, you need to make your points efficiently.  Since you’re trying to impress me, make sure that your e-mail uses proper grammar and addresses all the questions posed – otherwise I might think you don’t know what you’re talking about and will dismiss your ideas completely.

Explanation / Answer

When the US manufacturer changes the base to China, many arrangements needs to be done that will have some hidden costs that have to be cosidered.

We can discuss the main points briefly;

1. Cost : Though the cost will be reduced by 10% in basis rate, there will be additional cost involved in import duty and clearing charges in US port and the cost of local transport from US port to factory that will be added to basic cost.

2. Inventory Holding Cost: As the base is moved to China, the order needs to be made in bulk and there will be increased holding cost due to higher inventory holding.

3. Storage Cost : As the Inventory holding will be larger , there will be requirement of larger storage and insurance cost that will add to the total inventory cost.

4. Transaction currency : The transaction currency is an important factor. If the transaction currency in set in RMB , then any unfavorable USD dollar movement will cause foreign exchange loss on purchase. So to hedge the forex risk , it will be better to keep the transaction currency in USD.

5. Cost of Possible failure : If the Supply from Chian is failed or delayed , there is high chance of loss of sale and profit that has to be kept in consideration.

Keeping all these factors in mind , it is better to develop the alternate suppliers in USA who can provide FOB destination supply in smaller required quatities in time as there is no cost advantage that will result from procuring from China manufacturing facility.

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