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Go Direct, Young Man

Despite the headaches, more companies are turning to do-it-yourself sourcing.
Don Durfee, CFO Magazine
June 1, 2005

Generally speaking, office-supply retailer Staples is not known for selling its own merchandise. Instead, the company has built a nice business selling such well-known brands as 3M, Avery, and Panasonic. So what are managers at the $14.4 billion (in revenues) company doing overseeing a network of far-flung factories that churn out pens, paper, and a host of other products?

Eliminating the middleman, as it happens.

As part of the Framingham, Massachusetts-based company's strategy of building its own line of products, the retailer is now purchasing goods directly from cross-border suppliers and manufacturers. Toward that, the company has employees flying in to such remote locales as Indonesia and Vietnam. Those workers haggle with local producers, audit quality and labor practices, and figure out how to ship merchandise to the company's 1,600 stores. Says Paul Gaffney, Staples's executive vice president of supply chain: "What started as a fledgling purchasing operation mostly handled by others has matured into a true Asian-based sourcing organization."

Direct sourcing is not new. Multinational giants like Chrysler and Colgate-Palmolive have been doing it for decades. But now the urge to purge go-betweens is catching on with retailers and smaller manufacturers. In the past, such companies relied almost exclusively on agents to procure products.

Indeed, many retailers, ranging from Target to Federated Stores, are looking to buy more without agents. Even companies that have been sourcing direct for years are pushing the direct approach to new levels. Hewlett-Packard, for one, not only purchases computers and monitors directly from its contract manufacturers, but it also sources parts and materials on behalf of those manufacturers.

Big Savings on Moldy Sneakers
Not surprisingly, cost is driving the switch to direct sourcing. This is particularly true in the retail sector, where cutthroat pricing from the competition (aka Wal-Mart) is forcing rivals to focus on high-margin, private-label goods and wring new savings out of procurement. By sourcing goods directly, Gaffney says, Staples is shaving about 10 percent off the net average cost of its house-brand products. "Whenever you can eliminate folks who along the way have to make their own profit," he says, "you can save money."

You can also save some aggravation. Shipping goods from China to North America by boat takes three-and-a-half weeks (air cargo is faster, but prohibitively expensive). Hence, there's no time for corrections if problems with a product aren't discovered until delivery. Notes Paula Rosenblum, director of retail research with Aberdeen Group: "With direct sourcing, you don't want to wait for your shipment to get here to discover that the canvas sneakers you ordered are moldy."

The desire for greater control is behind the sourcing strategy at Pacific Alliance Manufacturing Group, which makes such brands as Nicole Miller and Gloria Vanderbilt Knits. CFO Jake Pleeter says that while the company still uses buying agents, it now works more closely and consistently with a smaller number of factories. "We have worked hard to take factories, teach them best practices, and then give them enough volume so they're captive to us instead of handling work for 10 other manufacturers."

The approach helps speed up turnaround, too. Pleeter recalls one case in which Pacific Alliance contracted with a factory, only to find that the factory owner set aside Pacific Alliance's goods when he received a better price from a rival. "A lot of these guys are transactional," says the CFO. "It's much better if you have a long-term partnership."

The gains from direct sourcing come at a price, however. A company must find qualified factories, solicit bids, place orders, inspect the factories, monitor quality, and handle logistics, customs, and duties—no small checklist. Determining the true cost of those activities can also prove tricky. "Even experienced buyers like automotive companies still struggle to quantify the total cost of sourcing directly," says Pierre Mitchell of the Hackett Group. While the purchase price of an item may look great, Mitchell warns that the true cost may be much higher. "You have to add freight, tax, duties, cost-of-inventory, quality issues, and executives' time."

Where's the Patio Furniture
Many companies are finding that their existing technology does not account for these hidden costs. Foreign sourcing is often managed with ERP (enterprise resource planning) systems that are better suited to domestic procurement than cross-border orders. In fact, many older sourcing programs were never designed to factor in currency fluctuations, customs duties, or additional bank processing fees. Hence, much of the accounting for those items gets done manually.

That was the case at Ocean State Job Lot (OSJ), a privately held deep-discounter operating in New England. Recently, the company doubled its imports but found that its IT systems couldn't handle several aspects of the import process. For one thing, the software had no container track-and-trace function, making it difficult to determine whether an order of patio furniture was still in a warehouse in China or steaming across the Pacific.

The system did not automate bids from suppliers either, forcing OSJ to resort to faxes and manila folders. And calculating the landed cost (the total cost of an order, including freight charges) meant using spreadsheets. "We found ourselves with some big holes to fill," says John Conforti, the company's CFO.

Ocean State, along with a growing number of other companies, purchased new software to fill some of those holes. The applications, offered by vendors such as Ariba, TradeStone Software, and New Generation Computing, are essentially sourcing programs updated to meet the complexities of international trade. Some of the packages also include product life-cycle management technology — software that helps companies integrate product-development efforts, supplier management, and logistics.

Warrendale, Pennsylvania-based American Eagle Outfitters Inc. is using software from TradeStone to help mesh all the links in the retailer's extended supply chain. The $1.9 billion (in revenues) company operates in an especially unpredictable corner of the clothing industry—apparel for 15-to-25-year-olds. To keep pace with such competitors as The Gap and Abercrombie & Fitch, American Eagle offers 10 new lines of private-label clothing each year. With that schedule, CFO Laura Weil says, the retailer "needs to deliver new merchandise to our stores every six weeks."

American Eagle's shoes, shirts, and jewelry arrive from factories around the world. It sources 20 percent directly from plants in Mexico and the rest from 47 other countries (with the help of Li & Fung, a Hong Kong­based trading company). Previously, the clothing retailer handled each part of the process — design, sourcing, planning, merchandising, and logistics — independently, using Excel and other software. Now those tasks are all performed using one Web-based program.

As a result, managers at the retailer know where products are in the supply chain. Further, the software has helped the company better estimate costs and shrink parts of the purchasing process. For example, when the company's New York­based design team finishes plans for a polo shirt, the software sends the specifications to multiple factories or trading companies, along with requests for quotes. Bids usually come in the next morning. Previously, the process took several days, and involved E-mails, faxes and phone calls.

The technology should make it easier for American Eagle to expand its use of direct sourcing. "If we decide to go to new countries and work directly with vendors," says CIO Michael Rempell, "we'll be able to do it much quicker with this infrastructure in place."

Spanning the Globe
Even with improved software, the move to direct sourcing adds complexity to an already complex setup. For many companies, supply chains now extend across the globe and involve several tiers of suppliers. And the changing rules of cross-border trade — such as the lifting of worldwide textile quotas this past January (see "Material Event," at the end of this article) — mean that no supply chain remains stable for long.

But the savings are hard to resist. "In our industry, the price pressure keeps rising each year," comments Pleeter of Pacific Alliance. "If an agent adds value, like product development or quality control, we don't mind paying for that. Otherwise, we'll go direct."

Don Durfee is research editor at CFO.

Material Event
The lifting of textile quotas has retailers rethinking their supply-chain strategies.

While direct sourcing offers substantial benefits, it can also be a pain. Dealing with local suppliers is just part of the problem; businesses must also contend with a welter of ever-changing trade rules.

The latest change: the expiration in January of quotas on textiles. Since the early 1970s, the United States, Canada, and the European Union have set limits on how much fabric and clothing they will import from various countries. The cap often forced apparel importers to pick suppliers based on the quota status of the suppliers’ home countries, rather than price. That has produced supply chains that extend around the planet, to such unlikely places as Cambodia and Lesotho.

The biggest beneficiary of the quota expiration? No surprise there: since January, clothing imports from China have surged. During the first three months of the year, textile imports from the People’s Republic of China shot up 63 percent. In certain categories, the increases have been dramatic. Cotton-trouser imports from China, for instance, have skyrocketed — up an astronomical 1,521 percent.

Predictably, members of the U.S. textile industry (and their allies in Congress) are not thrilled by the flood of cheap Chinese textiles onto the market. Under the terms of China’s admission to the World Trade Organization, member countries are allowed to impose restrictions on textile and apparel imports from the middle kingdom if those imports threaten to "disrupt markets." The European Union, for example, is currently contemplating reimposing restrictions on some Chinese textiles.

This uncertainty is bad news for U.S. apparel retailers, many of which are scrambling to set up purchasing offices in China and find local suppliers on the mainland. The scrambling is understandable. Research by Bain & Co. shows that textile buyers save between 5 and 15 percent by switching to Chinese producers.

Ironically, companies that haven't been sourcing directly in Asia may have the easiest time of it in China. American Eagle Outfitters Inc., for example, does its Asian sourcing through a trading company. CFO Laura Weil says the move into China will be relatively simple since the company is unencumbered by close ties to other Asian factories. "We're lucky we haven't made any commitments," states Weil. :The world order is changing, and it's now a lot easier for us to go directly to factories since we don't have [existing] relationships."

That world order is changing. As of press time, it appeared that the Bush Administration was leaning toward reimposing textile quotas. —D.D.