10.10End-of-Topic Case: Total Cost of Ownership with an Environmental Twist

Beth Davis, a buyer at Bull Lawn Equipment Manufacturers, is sourcing small gas-burning engines for a new line of lawnmowers that Bull is planning to launch in 6 months. Bull, which is headquartered in Avondale, Arizona, manufactures a full line of yard equipment, including lawnmowers, weed-eaters, and leaf blowers.

Beth's annual evaluationswhich have been excellentare based on her ability to acquire components at the lowest possible purchase price. The result: Over the past decade, Beth has become a global citizen. After all, many of the parts Bull uses to assemble its products are manufactured in distant lands. Recently, senior management has increased the emphasis on driving spending down. The pressure on price was a direct result of escalating costs of services, goods, and transportation.

Although Beth understood that price was a critical "feature" in the minds of end consumers, she was bothered by the fact that Bull had never stopped to consider the environmental impact of its purchasing decisions. Personally, Beth had always been environmentally friendly. Some of her friends had called her a LOHASa term used to describe well-to-do people who pursued a Lifestyle Of Health And Sustainability. Beth recycled, carried her own shopping bags to the store, and collected old cell phones and computer equipment for remanufacturing. She had even had her residence evaluated for wasted electricity and planned to install newer windows that would help her take advantage of "natural" lighting. Beth has initiated a sustainability discussion with Bull's senior management.

Buying Small Engines

Beth's current task is to determine the total cost of ownership for a variety of small-engine suppliers located in different geographic locations. After narrowing the options, Beth sent out RFQs to 10 suppliers that she thought had the potential to provide the right engines for Bull. Three suppliersone each from China, Netherlands, and Ukraineresponded with interesting quotes. Beth's dilemma: The quotes are different enough that she cannot make a simple "apples-to-apples" comparison. She knows that purchasing from each location will incur distinct costs (e.g., committing corporate capital to hold inventory).

Beth is also considering a local supplierjust 20 miles from her manufacturing facilitythat she has done business with in the past. Not surprising, the local supplier quoted prices much higher than the three global rivals.

Key Information About the Engines

Bull's marketing group estimated demand for the engines to be 3,000 per month (36,000 per year). However, since it is a new product, marketing's committing to this forecast is hesitantat best.

As Beth compared the quotes, she jotted down some notes.

• All three suppliers will incur some costs to retool for this particular type of engine. The tooling costs are included in the quotes.

• Each supplier will package the engines differently, changing the shipping requirements. Simply put, the number of engines that fit on a shipping container varies from supplier to supplier. However, the weight of the product is consistent, causing the weight to be the restrictive shipping criteria, not the cube. Beth considered some key shipping details.

  • Product dimensions are 1.25' x 1.0' x 1.25' (approximately 1.56 total cubic feet).

  • Product weight is 45 pounds.

  • A standard 40' container holds approximately 2,400 cubic feet.

  • A standard 40' container holds approximately 45,000 pounds. (This is a maximum number. No container will be allowed to ship if it exceeds this weight.)

  • All containers ship to the Long Beach port. Product moves to Avondale plant via truck.

Supplier Information and Quotes

Supplier #1: Fujian Lijia Company

The first quote is from Fujian Lijia Company located in the Guangdong Providence in China. Fujian must pack the engines in a container and ship via inland transportation to the port of Shanghai. In Shanghai, the shipment is transferred to a container ship for steaming to Long Beach. The container then ships inland to Avondale. The quoted unit price does not include the international shipping costs, which the Bull will pay. Fujian is ISO9001: 2000 certified and comes highly recommended. The U.S. requires that any wood products transported from China must have a certified record of fumigation because of the influx of forest damaging beetles. This means the pallets must have this additional certification. Fujian has the least control over its process and products in terms of environmental impact. Site visits by others have shown serious violations of the U.S. OSHA policy (although it is not a violation in China).

• Unit Price: $42.00

• Packaging (Fumigated Wood Carton) for containerization: $2.00

• Tooling Cost (use annual rate of sale): $3,600

• Shipping Lead Time: 8 weeks

• Defect Rate: 5%

• Cost of inland transportation to port of export: $200 per container

• Cost of ocean transportation: $3,000 per container

• Freight Forwarders Fee (letter of credit, documentation, etc.): $200 per container

• Insurance is 1% the value of the shipment

Supplier #2: Zvezda (Eastern Europe)

The second quote is from Zvezda which is located in Kiev, Ukraine. Prevailing wisdom indicates that production costs in Eastern European countries are usually lower than in Western Europe. Lenient environmental regulations lower costs. Ukraine, like other countries in Eastern Europe, prides itself on continued low labor cost and an ability to sell products at much lower prices than Western rivals.

• Unit Price: $60.00

• Packaging (Heavy Cardboard Packaging) for containerization: $2.50

• Tooling Cost (use annual rate of sale): $2700

• Shipping Lead Time: 8 weeks

• Defect Rate: 3%

• Cost of inland transportation to port of export: $750 per container

• Cost of ocean transportation: $4,500

• Freight Forwarders Fee (letter of credit, documentation, etc.): $400

• Insurance is 1% of value of container

Supplier #3: Brabant Express (Western Europe)

The third quote is from Brabant Express located just outside of Amsterdam in the Netherlandsa country with stringent environmental regulations. The result: By U.S. standards these engines have the most stringent environmental criteria designed into both the product and the process. There are required surcharges for businesses that are importing products from the Netherlands. Any defects that occur have to be returned to the original manufacturer for disposal. Beth thinks that these engines may help Bull be better poised to meet the future U.S. regulations, which she is confident will increase.

• Unit Price: $85.00

• Packaging (regular weight cardboard packaging with wood corners): $1.75 per piece

• Operational Environmental Surcharge are $500 per container

• Regulatory Environmental Surcharge is $750 per container

• Tooling Cost (annual rate of sale): $4500

• Shipping Lead Time: 6 weeks

• Defect rate: less than 1%

• Cost of inland transport to port of export: $200 per container

• Cost of ocean transportation: $3500

• Freight Forwarders Fee (letter of credit, documentation, etc.): $100

• Insurance is 1% of container value

Additional Cost Information

In addition to the supplier's quote, all three suppliers must pay the following charges at the U.S. port:

• U.S. Port Handling Charges: $1,500 per container. This cost continues to increase because of increased security at the ports.

• Customs Duty: 5% of unit cost

• Customs broker fees per shipment: $500

• Transportation from Long Beach to Avondale: $1,500

• Warehousing Costs in Avondale for at least four weeks of inventory at a warehousing cost of $1.00 per cubic foot per month, to compensate for lead time uncertainty.

Beth must also calculate the costs associated with committing corporate capital for holding inventory. Bull typically uses a corporate cost of capital rate of 24%. Finally, Beth recognizes that the cost of doing business globally means she needs to consider the following.

• Cost of hedging currency broker fees = $400 per shipment

• Additional administrative time due to international shipping:

  • China: 6 hours per container at $25 per hour

  • Ukraine: 8 hours per container at $25 per hour

  • Netherlands: 3 hours per container at $25 per hour

• One international visit of 5 days per 36,000 engines (annual visit) to meet with suppliers and provide updates on performance and shipping: $9,000 per year.

Beth knows she might have missed something. After all, global business is complex. But, she thinks she is now ready to approximate the costs of buying from each supplier. As she thought about the hassle of going overseas and the potential environmental impact, Beth decided to include a column for the local supplier in her spreadsheet.

U.S. Based Supplier

• Unit Price: $120

• Packaging for short transport: $1.00 per engine

• Tooling: $900 one time charge

• Freight: $5.20 per engine

Questions

1. The spreadsheet below estimates the total cost for each supplier. Analyze each of three supplier options and compare their costs to the cost of the U.S. supplier.

2. What additional cost elements for each supplier should Beth consider? Are there other issues besides cost that Beth should evaluate?

3. Consider environmental impact of doing business with each of these suppliers. How does this impact the total cost and your decision-making?

4. Which supplier do you recommend?

5. Looking at your preferred supplier, what suggestions do you have for lowering your total costs?

6. Imagine your boss asks you to look at a 3-year contract. After some quick analysis, you determine that prices in China and Ukraine will rise even as prices in Netherlands and U.S. decrease (see the following table). You expect this lawn mower to be a big hit with sales increasing as follows:

   • Year 1: 36,000 (3,000 per month)

   • Year 2: 72,000 (6,000 per month)

   • Year 3: 108,000 (9,000 per month)

   Calculate the net present value (NPV) for each supply option using a 10% cost of capital. Which supplier would you choose now? Why?