Each company has the same fundamental question – what is our core strategy? This question is most often based on the personal values of the founders and should be based on its value proposition and corporate vision.
The initial need of any company are the same – survive. It is making it past this first initial step that is so difficult for most businesses. It is common for businesses to take a significant loss for the first year to a few years, and provided the business survives this crucial period, the next steps, the future development of the company, can be taken into consideration.
The absolute goal of any company is the same – profitability – but how is this done? What is the advantage one company has over its direct competition?
Profit is a very simple formula: the total revenue – total cost = profit. It is possible to increase the profit margin by increasing the revenue or reducing the total cost.
Recognize this immediately – increasing the total income of a business is not the purpose of this particular piece.
Instead, Sourcing Nova is going share how a reasonable procurement plan from Chinese manufacturers can reduce your total cost and then provide the opportunity to increase a competitive advantage. Please keep reading to learn the fine details.
The leverage effect of procurement costs on financial indicators
A business that carefully watches the procurement process and costs of their products is certain to raise the profit margin. In cases where procurement costs represent the majority of sales, it makes sense that procurement costs have a leverage effect on the impact of corporate performance and financial indicators.
There are differences between the specific industries due to proportions of procurement costs and sales, and thus, the reduction of procurement costs will vary accordingly. In other words, the relationship between procurement cost and performance is different in each industry and must be treated differently as well.
To explain a bit further, procurement costs may account for a small proportion of sales (as an example, less than 30 percent), so reducing procurement costs will have a negligible impact on profit margins. On the other hand, if the purchase costs accounts for a significant amount of sales (for example, greater than or equal to 50 percent) then the purchase price has a much more direct impact on profit margins and financial indicators.
Those who perhaps are not mindful of what Sourcing Nova means at this point, here is a simple and price-based “cost benefit model” to explain.
The purchase cost of products of an e-seller accounts for 50 percent of the total revenue. Net profits before necessary taxes is 10 percent, $100.00. Take sales into consideration, the profit is $10.00, purchase cost is $50.00 and other costs are $40.00 (All prices are in U.S. dollars).
Let’s assume that all costs and expenses will change along with the selling price. The company wants a 10 percent higher profit margin, going from $10.00 to $11.00. What are the different options available?
- Method 1: Increase the sales by 10 percent to $110.00. The pre-tax profit is $11.00, purchase cost is $55.00 and other costs are $44.00.
- Method 2: The product purchase cost is reduced by $1.00. The pre-tax profit remains $11.00. There is no need to increase sales and related costs.
Method one needs to increase sales 10 percent for 10 percent better profit. Method two needs to reduce purchase costs by two percent for the same goal of better profit.
It should be apparent – Method 2 is much easier to do.
Remarks: Sales, purchase costs, and profit units are all in U.S. dollars
It is important to keep in mind that cost composition for any seller will be different and divided among the following: procurement, labor, marketing, logistics and after-sales. The individual cost that is the highest among these is the target for getting a better profit margin. If the purchase cost of a particular product is not over 20 percent of the total sale, lowering this cost will have very little effect on the profit margin. The better places to look are in the logistics and after-sales. Products coming from top manufacturers mean better customer satisfaction and lower after-sales costs. This is the product sourcing plan that Sourcing Nova recommends for the discerning buyer.
The purchase cost is not equal to the product purchase price
This formula: purchase cost ≠ product purchase price is important
There are multiple factors that are pushing many businesses into strict survival mode: the economic recession, pandemic and the trade war. On the manufacturer’s end: rising raw material costs, insufficient energy supplies and rising labor costs.
This means a cost-competitive advantage is absolute for a company to survive. Some companies look to procurement costs on prices of products, avoiding Chinese manufacturers for other countries like Vietnam, India and the like, countries not affected by the trade war. All this does is accelerate the death spiral into bankruptcy of small to medium-sized businesses, and most companies have recognized this, moving their supply chains back into China. Sourcing Nova has a substantial list of companies making this move.
China procurement VS Vietnam and India – what is the difference?
China’s exceptionally strong manufacturing industry, industry cluster and access to raw materials has crushed underdeveloped countries like Vietnam and India when looking at volume and quality of products.
It is true that China’s labor costs are higher. Laws of economy point to as a country develops more and more, labor costs increase. China’s economy has grown steadily, whereas Vietnam and India have economies that fluctuate more than a roller coaster. It is impossible to make predictions on whether or not the economy will soar like an eagle or plummet like a rock.
This does not mean India and Vietnam do not have some manufacturing advantages – cheap labor and low technology mean certain industrial products perfect for special climate conditions.
The two countries are also following China’s footsteps with reform – moving away from cheap labor for meager processing fees. This is not an easy path – full of twists, turns and no visible end.
The Chinese people have certainly worked hard through growing pains within a change in economic structure, with industry and intelligence on their side, to become a well-developed, 1st world country. The trends internationally within political and economic spheres are much different than they were 30 years ago. India’s politics and rigid caste system has held the country down from concentrating people within the country to do most of the important work necessary to move forward. The small land area and population of Vietnam are also significant drawbacks in terms of global layout in the supply chain.
Objective laws cannot be arbitrarily changed based on what the people want. The Sino-U.S. trade war has pushed for global reorganization of the supply chain, but the trade war is man-made. Being man-made means non-conformity to the objective laws of economic development. Given time, the impact of the trade war will level off after parties have played their hands and come to a fair compromise.
China’s manufacturing supply chain is the direct result of decades of accumulation in the same way that India’s IT technology outsourcing is the direct result of decades of accumulation. China would struggle to outpace India in IT outsourcing, just as India would struggle to outpace China in manufacturing outsourcing.
Purchase cost control is a systematic control process
Working towards increasing profits via controling purchasing costs is not a one time, one shot reduction of prices and pricing but a systematic process. The act of reducing costs is a risky undertaking, including quality, technical and timely supply deliveries.
A business who lacks a systematic and strategic cost management system with the sole pursuit of lowered purchase prices will inevitably push manufacturers to reducing their costs – even at the risk of product safety. As these discoveries are made by customers, the damage to the company’s name and brand will far exceed any “benefits” from the “price reduction.” Even if the company works diligently to make up for mistakes made, the effects will be irreparable and leads to the ultimate downfall of the business.
Consequences: The pursuit of low-priced materials often becomes the source of a sharp increase in total operating costs of the business.
Purchase cost formula
Looking from the inside of Sourcing Nova’s structure for product sourcing, the procurement cost equation looks like this:
procurement cost = product price + order processing cost + procurement management cost
Here is the breakdown of each of the factors into the procurement cost.
The product price is the one given by the supplier. This includes the total cost and profit to make the products. Their cost includes: raw materials they find and use, R&D, production, manufacturing, warehousing, logistics, labor and their profit margins.
Supplier price composition
The supplier price is the cost of the complete purchase of products and can be divided into three main sections:
- Direct materials – Prices of main and auxiliary materials, loss rates during processing and defective material rates
- Direct labor – The salaries of the product sourcing staff of the company, material processing fees and the salary of the quality inspector of the supplier’s company.
- Administrative – These are the “incidentals of the busines.” Warehouse management, transportation, office space, rent, sales management, after-sales service, utilities and the like. In the case of the manufacturer’s requested profit, there is a dedicated blog post on that very topic. Read that particular blog here.
Order processing cost
Order processing is also referred to as the transaction cost, the handover between the upstream and downstream of the supply chain. This includes the cost of identifying, analyzing, costs of finding and negotiating with the manufacturer, contract cost, sample testing and inspection.
Procurement management cost
This is the comprehensive operating costs of the purchasing enterprise. This includes repairs and answering customer complaints.
It is Sourcing Nova’s goals that this composition helps to adopt a rational approach for price negotiation with suppliers in the future and lock prices within an acceptable range for the buyer.
Conclusion: For every buyer, no matter the size of the company, there are procurement costs of several different and interwoven parts. It is not the sole responsibility of purchasing but R&D, purchasing, warehousing, finance, sales and customer service. Each of these work together when it comes to the determination of the price, R&D, quality, craftsmanship, transportation and utilization of the products and costs. It is the complete buy in, joint effort of each department and assumption of corresponding responsibilities that the total procurement cost can be systematically and effectively controlled and maintained.
Complete calculation method of purchase cost
This is the calculation most buyers use as a metric to determine the purchase cost. Sourcing Nova has previously discussed the leverage effect on the purchase price for the final profit margin of the business. Keep in mind, this is a simplified purchasing cost calcuation model. The actual purchasing behavior in reality is much more complicated and diverse.
Price is only one variable in the purchased product cost. There are other variables that go into the cost purchase – this means the purchase cost needs to be understood in a comprehensive way. There is a delicate balance between the purchase price and other factors. This is why blindly lowering the purchase price of a supplier is not the best direction to move for the best possible price.
When a purchase price is pushed entirely too low, the quality of the product will go down. At the same time, the defective product rate will increase. New defective products increase the total cost of the products.
The lower pricing may also push the buyer into needing greater capital for a third-party inspection company for quality checks. Again, this raises the order processing cost of the product purchase.
There is another variable to take into account, and this is the most important variable of them all – the customer satisfaction. If customer satisfaction is low, it often requires additional manpower and capital to process returns and exchanges for the dissatisfied customer. It is the same as increasing the procedure management cost.
Many less expensive manufacturers are farther away from ports of export. This means paying for transportation costs across China, and again, this will raise the logistics portion of the overall product cost.
These are simple explanations and only a portion of the different possibilities. An experienced buyer always looks at the total cost of the products instead of the one-sided view of the manufacturer’s product pricing. It is true the high-quality manufacturers will have a higher per-unit product cost, but this is offset by the quality (assistance with after-sales and/or inspection costs), greater production capacity (assistance with shortening delivery periods) and better proximity to port cities (assistance with reduction of logistics costs) and better technological innovation (assistance with reduction in R&D costs). Sourcing Nova is committed to the global buyer and matching them to the top Chinese manufacturers. The goal is a successful business over a long term.
Sourcing Nova is dedicated to helping you get the best possible products, at the best possible price from the best possible manufacturers. We specifically seek out and partner with manufacturers of OEM products for large companies across the world. We want your costs as low as possible and will work with you every step of the way. What can we find for you today?