by Kevin Leung

The primary objective, when deciding whether or not to outsource the procurement, production and logistics functions, is to increase profitability. The decision to outsource affects the costs, responsiveness, risk tolerance, and strategy of the firm. These components form a framework for understanding firms who would consider using a company like Li & Fung, a global supply chain manager.

Cost Impact: Fixed and Variable Costs

Fixed-costs include substantial capital investments in property, plant, equipment and supply-chain resources necessary to manufacture goods. A firm unable to secure financing or wishes to minimize debt would see contract manufacturing as an attractive strategy versus investing in manufacturing capabilities.
Variable costs including raw material, labor, utilities, and logistics can also be reduced by using a firm such as LF who can leverage purchasing power on raw materials. Low-cost countries also have lower labor and energy costs, further reducing unit costs for the customer. Furthermore, inventory holding costs can be minimized if purchases are made on Net 30/60/90 payment terms because less capital is tied up in inventory/WIP. A start-up apparel company like Everlane has invested its money into design and marketing. They rely on manufacturers in China to produce their garments worldwide, minimizing fixed and variable costs.

Responsiveness:

Firms that need to react to fast-changing customer trends would use LF because they would gain access to a broader supply-base. For example, if apparel trends change, a company can just cut a purchase order to LF who would be responsible for sourcing the new product from beginning to end. This allows for quicker response versus investing in new PPE in-house. Contract manufacturers also insulate the company from variability in demand. Hiring/firing workers to account for swings in demand can be a costly process. By using LF, they no longer need to account for these variables and the complexities of mitigating the impact of the bullwhip effect in-house. Lastly, LF’s global footprint and freight consolidation services allow it to ship its customers’ goods around the world faster than if the customer were to manufacture in their home country.

Risk:

A company manufacturing goods in-house is essentially single-sourced to itself. Any political, environmental or economic catastrophe can potentially stop production and jeopardize a company. LF reduces risk by dual-sourcing or shifting output from between suppliers if adverse external factors occur, thus ensuring continuity of supply for its customers. Furthermore, a company using LF can negotiate INCOTERMs that are more favorable to risk reduction such as CIF, which holds the seller responsible for insurance, or DDP, which holds the seller accountable from origin to final destination.

Strategy:

Porter’s Five Forces indicates that a firm’s competitiveness is affected by a lack of purchasing power. This occurs when a company produces low volumes and cannot leverage volume discounts or when a company is not the dominant consumer of raw materials for the supplier. I experienced this first hand at United Technologies where I procured monoammonium phosphate (MAP), a raw material used in the production of fire-extinguishing powder. The primary consumer of MAP is the massive fertilizer industry, and we were a relatively small consumer and thus, yielded little purchasing power. Companies in similar positions can improve their purchasing power through LF who would aggregate demand for raw materials from different customers to leverage volume discounts with its tier two suppliers.

Lastly, companies with a competitive advantage in design/marketing would primarily invest their resources in these areas. They may lack the expertise required to run a production facility and thus, would rely on a partner for manufacturing. As LF have moved up the value-chain to offer value-added design services, their customer base may shift their specialization solely to marketing activities.