25 Sep 2023 Yuan Wise, Dollar Foolish: Trading Small Fees Now for Long-Term Savings?
Many Small-to-Medium Size Companies with an Aversion to Paying a Sourcing Fee - Never Realize Tens to Hundreds of Thousands in Savings Potential
Penny-wise and pound foolish is the old British saying. In sourcing from Mexico, this has been true for many small and medium-size companies. This article looks at the lost savings that taking a short-term approach to costs can have on a company’s long-term potential.
In this paper, we explore two companies that are examples of a growing number of businesses. Each experienced huge cost increases due to the massive spikes in ocean freight caused by the pandemic and its aftermath. Individual containers cost $10,000 to $12,000 more than planned in 2022 – per container – resulting in great consternation, loss of profitability and in some cases, even placing the company on the edge of financial collapse. Note that they paid these exorbitant penalties to continue to service their customers. These higher expenses were clearly unbudgeted as they were not anticipated by most companies in 2021 or 2022.
First, let’s back up in time for both types of companies.
Ongoing Growth for a Purchased Acquisition
One is a newly acquired company (within the last 2 years) purchased for 5 times EBITDA or roughly $1 million dollars. The product has been sourced solely from China and the previous owner did not have drawings, bills of materials, or any intellectual property for the product. Further, the owner sourced the product via an agent who would typically charge 4% of factory price for a very large customer or probably 7% for a customer of this size. Assuming the factory spend was $500,000, this agent’s fee was between $20,000 and $35,000 annually. Also, assume that the company, rather than incurring the expected logistics costs of $4,200 per container, instead spent $12,000 per container in 2022. For ten containers, this supply chain premium would have been $78,000. The specific product also has a duty of 4% and a 301 (Trump tariff) of 25%. The 29% of duties and tariffs on the $500,000 in purchases would be an ongoing annual expense of $145,000.
Now let’s contrast the above scenario with the results if the company had sourced from Mexico. First, Mexico has neither a duty nor tariff on this company’s product. Factory labor is also less expensive in Mexico compared to China.
Since the company does not have a detailed costed bill of materials (the Chinese agent did not disclose those details during due diligence and the previous owner did not have that information), without conducting negotiations, this savings potential is unknown. However, China heavily subsidizes steel manufacturing, and the steel price may be three times higher in Mexico than China. If the product weighs 40 lbs., then this cost penalty per unit would be $80. The ex-factory price in China is $500 per unit for the 1,000 units shipped in 2022. The steel premium then totals $80,000.
To summarize, the company was purchased for $1 million and generated EBITDA of $200,000. Ongoing duties and tariffs are $145,000 and the cost of the agent is $20,000 (minimum). The unbudgeted excess freight expense in 2022 was a one-time occurrence and not considered in the rest of this discussion. There is a potential cost penalty of $80,000 for steel, partially offset by lower manufacturing costs. Currently, freight from Mexico and China is nearly the same. Even with the above noted unknowns, the potential savings on an annual basis total $85,000 and these savings could be higher depending on the actual labor content.
On the cost side equation, the sourcing firm requested $50,000 plus travel expenses of maybe $5,000 to identify and competitively bid on the product. Assuming all the above to be roughly correct results in a payback of less than 1 year. Year 2 expenses are 50% of year 1. Savings are for the life of the product or the next 5- to 10-years+.
Of course, there is risk in this project as the expenses are known (fees) and the savings are projected. However, is that different from the original investment decision? Spend $1 million to return $200,000 based on historical information captured on spreadsheets during due diligence. The unknowns include:
- supply chain issues as in 2022 that adversely affected the bottom line,
- the potential of armed conflict with China over Taiwan that stops the flow of goods from Asia, and even if the above never happens,
- the business was purchased on the promise of growing the company and increasing its profitability, which remains a hopeful, but unknown prospect.
What’s Different with a Small to Mid-Size Company?
The difference in results between the above recent example and a small to mid-size company would be negligible. Things that might be different include that:
- The company may have its own teammates in China (which would be more expensive than the above scenario).
- If the product is not heavily based upon steel or aluminum, the cost penalty for materials in Mexico may be considerably lower.
- Many products imported from China have a duty (average is 2.9%) and depending on the product, a 301 tariff of up to 25%.
- Depending on proximity to a port, logistics costs may be lower from China or higher (central part of US).
The upfront costs of exploring Mexico are known and easy to dimension in a spreadsheet or compare to a budget. In contrast, the unknown savings potential can be very large and requires an investment in time and money to dimension. However, the opportunity cost of lost potential savings is a recurring loss of profits, year after year.
Lost Chance for Success in Mexico
Oftentimes, we hear from companies that they do not need to pay upfront consulting fees as they are perfectly capable of obtaining quotes from factories in Mexico. While that is certainly true, most of the time it does not result in a successful outcome.
A recent example we experienced was from a company that purchases injection molded kitchen products. The sourcing leader opened the conversation with his extensive experience in Mexico. When I asked him if his previous company purchased any product from Mexico after obtaining the factory quotes, he answered “No, Mexico is too expensive.” However, this time, he was reaching out to sourcing experts in Mexico, hoping for a better answer. We discussed the need for face-to-face interaction (boots on the ground) and the need to bring several factories into a repetitive, competitive bidding process to achieve a lower price. When I emphasized that we were an engineering-based sourcing organization and would spend real-time meeting with these factories and had to pay our team members (including their travel), and his company would pay for that process with an upfront fee, he completely reverted to his traditional American way of doing business. He stated he was receiving quotes from Mexican factories already, and there was no need to pay anyone to obtain quotes. Again, he is correct, with this being his current reality. However, his company is leaving money on the table with the resulting higher prices, which will directly result from not embracing the Mexican culture. I strongly suspect that his company will not be buying any products from Mexico six months from now, as he will again find that the prices he obtained were not competitive.
Some of Shoreview’s best clients are those that have previously tried to source products on their own and realized their efforts were not effective.
Relocating Sourcing from China to Mexico Is Complex Yet Productive for Many Companies
The US and China are now five years into the trade war. Things are not improving; geopolitical tensions continue to rise, and the risk of disruptions to the supply of product from China is ever-present. If your company is concerned about the Trade War with China and its growing aggressiveness over Taiwan, then you may want to exit China and Nearshore or Re-Shore. Given that global economics have changed, there may also be an opportunity to lower costs.
Re-Sourcing to the US (Re-Shoring) or Mexico (Near-Shoring) has difficulties and requires resources. Executive leadership will need to be more intimately involved to ensure that the change effort is appropriately staffed with those favorable to the potential of change rather than the existing managers and leaders who may resist the change because it will substantially change their roles, activities, or status within the company.
Since re-shoring and near-shoring also require far more effort, adding additional resources, either internally and/or externally, may be necessary to implement the strategy and achieve the goals. If external resources are required, the executive leadership should be diligent in selecting a consulting resource with a demonstrated track record of results and hands-on experience with resources on the ground in the target country. Shoreview Management Advisors is such an advisor and, for the last 5 years, has been Nearshoring from China to Mexico, having served many clients before the Trump Tariffs and trade war with China. Before this latest imperative, Shoreview executives had over 25 years of experience manufacturing and sourcing products in Mexico.
Contact us today if you’re serious about improving your bottom line and moving your sourcing from China to Mexico.