05 October 2009

Companies from the developed world are yet to make the most of the benefits of sourcing from emerging countries, writes Jan Wuellenweber

Rising wages. Freight costs. Currency risks. Poor quality. Lax safety standards. The attractiveness of emerging countries as producers of cheap raw materials and labour has suffered a number of reversals in recent years.

Just 12 months ago, some notable companies, including major European firms, were considering reversing their previous policies and increasing sourcing in high-wage countries. More than a few economists confidently predicted the end of globalisation and offshoring.

The picture is very different today: the adoption of new production technologies has driven up efficiency and reduced unit costs in low-cost countries (LCCs). Oil prices have dropped by more than half since 2007 and the drop in demand for shipping capacity has dramatically reduced freight costs. As companies in many industries face intense pressure to reduce their own costs, the remaining problems of global sourcing - such as quality defects or product-liability risks - suddenly seem to be solvable.

Global management consultants McKinsey recently carried out an analysis of the sourcing behaviour of 100 companies worldwide, interviewing decision-makers in the automotive, engineering, consumer goods, chemicals and electronics sectors. The researchers categorised the respondents to the survey according to two criteria: the maturity of their global sourcing development and the sophistication of their approach.

This structure created three distinct groups of respondents.

While 57 per cent of the companies in the survey revealed average performance, 14 per cent were leaders compared with others in their industry, and 29 per cent were "laggards".

The survey found that global sourcing is still in its infancy. Even the most progressive companies allocated only 31 per cent of their total spend to global sourcing. At more conservative companies the figure was less than 10 per cent.

Closer examination of the findings reveals that the reasons for this limited uptake of global sourcing were not fundamental but practical in nature. The majority of companies, the survey suggests, are not correctly positioned to maximise the potential of global sourcing. Researchers identified five barriers to effective global sourcing:

1 The absence of a global procurement strategy 2 The lack of effective models to allocate responsibility and incentivise managers 3 Insufficient focus on specific regions 4 A lack of presence on the ground in discussions with potential suppliers 5 Poor talent management in LCCs.

STRATEGIC SUCCESS An effective global sourcing strategy requires the definition of demanding but realistic goals and the allocation of clear responsibilities to individual areas of the organisation. These goals can only be defined after the company has made a complete overview of all procurement options, and has an understanding of its own procurement portfolio - including cost structures.

A successful global sourcing strategy must also take into account country-specific strengths and the economic environment. A North American conglomerate, which manages the procurement of cast-iron components in accordance with country-specific resources and capacities, provides one example. Its simple cast-iron products are sourced in large quantities from China. More sophisticated products required in smaller quantities are sourced in India. The most complex designs and highest specification alloys come from Korea.

In contrast, a different economic environment has prompted a European automotive company to restructure its global purchasing strategy. After reviewing the country-specific risks associated with China and India, the group is planning to move its sourcing of cast-iron parts to Eastern Europe.

Most companies in the leaders group have such a professional LCC sourcing strategy, the survey reveals. More than two-thirds of them manage their global purchasing based on clearly analysed cost structures and potential savings. Among the laggards, only 12 per cent had any sort of formal LCC sourcing strategy.

CLEAR RESPONSIBILITIES AND INCENTIVES Global sourcing initiatives often fail due to the resistance of employees and executives - not in LCCs, but at home in their own headquarters.

This failure is not the result of a lack of insight. Even in companies with a small share of global sourcing, managers are mostly convinced of its benefits. Instead, the lack of commitment comes from an unclear allocation of responsibilities. The survey found that 86 per cent of the laggards did not have defined responsibilities, roles or ownership for their global sourcing efforts. Yet many firms could accelerate their efforts with the right incentives.

These should not be simply financial. Rather than just distributing bonuses, it would be advantageous if companies made global sourcing success a core theme on which the recognition and career advancement of employees depends.

The importance of the internal position of global sourcing can be seen in the efforts of a North American group with an international customer base.

The company's CEO planned to use a global sourcing programme as a direct response to weak stock market performance. However, the programme quickly met with resistance from staff, particularly from those in the company's production and quality management departments.

The company solved this problem with the introduction of cross-functional global sourcing teams. These teams were given a clear incentive model, with factory managers appointed as sponsors. Representatives from the critical production and quality management departments were invited to visit new suppliers in order to gain a first-hand understanding of their systems and capabilities. The company also established sourcing offices in Brazil, China, the Czech Republic and India.

The company has been transformed as a result of implementing these global sourcing initiatives.

Purchasing costs have fallen by 25 per cent and international business has expanded - more than half of its total turnover is now generated outside North America. Overall, the global sourcing initiative resulted in a significant increase in turnover, profits and market capitalisation for the company.

FOCUS ON SELECTED REGIONS A number of organisations employ a 'global shopping' approach to global sourcing: they select suppliers from a very wide - and widely dispersed - set of regions. While this approach may allow the lowest price for particular items to be identified, it fails to recognise that each new region creates additional management complexity, logistics risks, and costs.

Companies that source this way inevitably struggle to recruit management resources in the regions where they are sourcing, or gain a detailed knowledge of regional suppliers, laws, taxes and subsidies.

Only 14 per cent of the participants in the survey said they had a strategy to understand the dynamics of LCC sourcing in detail, and only 11 per cent said that they had a detailed understanding of the relevant supply base and the risk and reward balance in the countries in which they were active.

Even among the leaders group, only a few organisations in our survey had the capabilities and knowledge to differentiate various LCCs according to criteria such as country-specific strengths (raw materials, wages, the level of education), the level of development of indigenous industry (supplier performance, size of the domestic market) or the wider economic environment (availability of capital, infrastructure, country-specific risks).

A more effective strategy would be for companies to concentrate their global sourcing efforts in a small circle of selected regions, even if it means neglecting apparently cheaper offers from elsewhere. In this way, sourcing decisions can be based on extensive market knowledge, and the costly overheads required to manage global sourcing efforts is minimised.

The time when a firm from developed countries in the West could mail a few dozen LCC suppliers and wait for the responses to come flooding in are over. Today, the success of supplier selection in LCCs depends on detailed interaction between client and supplier before the tender process begins. Such interactions, whether via phone calls, personal meetings, video conferences or factory visits, help to inform the client about the supplier as well as underline the client's seriousness in the eyes of the vendor.

CLOSER COOPERATION WITH SUPPLIERS In McKinsey's survey, 80 per cent of the most successful companies indicated that they call potential suppliers and ask for information before the tendering process begins. Among less successful companies, only 47 per cent said they did this.

A precise knowledge of the supplier is also important for successful negotiations. It is essential that companies understand not only the supplier's offer, but also the intention behind it. For example, suppliers in India will often attempt to ensure their place in ongoing negotiations with an extremely favourable price, regardless of whether this price can be held. Chinese suppliers, on the other hand, expect to negotiate their prices downward and buyers should always follow this pattern when negotiating with them. Before awarding any contract, of course, buyers should also verify a supplier's performance, track record and stability.

Once relationships are established, it is important that they are maintained. The survey found 58 per cent of the global sourcing leaders maintained personal relationships with their suppliers in the form of visits or conference events. Among laggards, that figure was only 17 per cent.

Furthermore, 79 per cent of leaders track the performance of their suppliers and give them systematic and regular feedback. Half of them even carry out joint product development activities with their LCC suppliers. In contrast, just 38 per cent of laggards track performance and only 13 per cent have any joint product development activities.

LOCAL TALENT MANAGEMENT Successful global sourcing depends on the right talent, at home, on the ground in LCCs and in-house at suppliers. Therefore, the best global sourcing programmes include strategic HR management to build capabilities on the ground.

Retaining good people in LCC sourcing centres is a major challenge. Good companies take people recruited in LCCs, bring them to headquarters for training and development, then return them to their own countries where they recruit local buyers and manage procurement programmes.

Such investments are significant, but they will eventually pay for themselves in comparison with the cost of sending out expatriate staff to attempt the same jobs, often with less success.

One thing is clear: companies have not yet begun to really exploit all the potential offered by global sourcing. Far from being over, the real triumph of global sourcing is yet to come. But before they achieve this, companies will need to do their homework and change their internal structures in readiness for a new sort of purchasing process.

Jan Wuellenweber is a principal at McKinsey & Company in Cologne, Germany

SMoct2009