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Nikotech and Cost of Goods Sold
For NikoTech, COGS increased 25% from Y1 to Y2 ($990 million to $1.239 billion). When viewed as a direct function of the top-line sales figure, which increased 23% in the same period (from $1.500 billion to $1.845 billion), this may not be a change that requires a great deal of study. COGS did outpace sales growth by 2%, but with downward pressure on pricing, as well as increased costs, this may be interpreted as a trend that the entire industry is experiencing.
Of perhaps more concern is the fact that gross profit only increased $9 million, or 2%, from Y1 to Y2. Expressed in terms of gross margin and shown in Table 14.1, there was actually a decrease of 4.3% in Y2 (from 31.3% to 27%). Given this trend, the insightful analyst will be compelled to inquire as to the real source of the increase in COGS. As asked throughout earlier discussions, was it simply a function of increased sales and incremental direct costs or were there other forces at play in the model?
Table 14.1: Y1 Versus Y2 Gross Margin
The question for managers is not only about the rate at which COGS outpaces sales. The real goal is to determine what drives the growth in COGS and what measures can be taken to level the slope of its growth line. If NikoTech does not attack this issue, at some point in the future growth in COGS will intersect with the sales line (implying a breakeven point). Beyond that moment, losses will begin to accrue and NikoTech will be out of business in short order. Hypothesizing that all of the growth in COGS is not a function of sales leads to several reasons for the real increase. Using several Six Sigma tools, the management team was able to uncover a bevy of unnecessary costs.
For example, the NikoTech plant in China historically sourced almost all of its raw materials from three major domestic suppliers that are located within 30 miles of the NikoTech facility. In the third quarter of Y1, it was announced that two of those suppliers did not renew their contracts with NikoTech for the following year, instead dedicating their capacity to other companies in the EMS field. Management did not foresee this possibility, and NikoTech's commodity managers were forced to reach non-advantageous "hurry-up" agreements with other suppliers in Asia, Eastern Europe and Mexico.
Without considering quality issues or changes in unit costs, transportation expense went up almost 40%, with the total landed cost per component dependent on the countries from which materials were sourced. Also, customs duties had to be figured into the costed bills of material, a situation that did not exist when the China plant was sourcing domestically. This change exacted additional costs that caused the Shanghai plant to be 52% over budget.
Another scenario involved the relationship between NikoTech's materials requirements planning process and the logistics function. Except for parts that cannot be exposed to salt air or humidity, company policy is to ship all internationally sourced raw materials via ocean transportation. For purposes of materials requirements planning execution, the lead times associated with ocean transportation must be considered as part of the lead time offsetting component of the overall process. Because lead time offsetting plots the issuance of raw materials purchase orders against the time needed to deliver goods to the floor, coordination between materials planning and logistics is critical to the successful operation of any plant.
NikoTech was aware of this, but because of sales growth that eclipsed the forecast, the company found itself constantly upgrading ocean shipments to airfreight. This maneuver increased per-unit transportation cost by an average of 40% across the board. Also, because buyers had no confidence in lead times, they were also upgrading shipments to airfreight just to make sure they would have raw materials on the floor. Thus, the uncertainty associated with both forecasts and lead times not only inflated inventories but compelled buyers to bring in goods they did not even need by airfreight. Net sales may have been up but, as illustrated in Figure 14.1, at a cost that caused the slope of the COGS line to be steeper than that of the sales line.
Figure 14.1: NikoTech Sales Versus Cost of Goods Sold Growth
The final example of the challenges that NikoTech faced related to COGS is probably the most disconcerting. Because the problem began upstream in the sales department, it went undetected until the Six Sigma team dug it up during a deployment process mapping exercise. It is precisely these types of phantom costs that chip away at profitability and, most dangerously, without anybody ever being aware of it.
A contract was awarded to the Hungary plant in late Y1 for the production and final distribution of routers to NikoTech's number one customer in Europe and Scandinavia. This was a new program that required drop shipments to end users, with an average gross margin of 30% over the life of the three-year contract. The plant's jubilation was short-lived, however, when it was disclosed that the gross margin was only 22%. Unable to discover why the margin was lower than budgeted, plant management accepted the "extra cost of working internationally" and went about its business. The Six Sigma team saw things a bit differently.
After considerable digging, the cause of the missing margin was traced back to the early sales negotiations that stipulated the Incoterm applicable to the contract. Because Incoterms determine at what point responsibility for logistics and related costs transfer from seller to buyer, inclusion of these costs in a target pricing exercise is fundamental to working up a profitable contract.
Because NikoTech Europe's policy had always been to sell on an ex works basis (with all logistics costs for the account of the buyer), the stipulation in the new contract for a delivered duty paid Incoterm went unnoticed. What nobody questioned was the fact that the delivered duty paid Incoterm stipulates a selling price that includes not only the price of the merchandise but also all transportation- and customs-related costs to the named place(s) listed in the contract. If a company agrees to incur those costs and does not recover them in its invoice price, those unprotected costs remain in COGS without the benefit of being offset by the total sales price. This is precisely what happened to NikoTech at the Hungary plant.
For the better part of Y2, NikoTech delivered finished goods throughout Europe and Scandinavia on a direct-to-user basis without recouping transportation- and customs-related expenses. The company was lucky in the sense that duties from Hungary into Europe and Scandinavia are either reduced or nonexistent, so it didn't have to take too big a hit on customs duties. Nevertheless, it was forced to assume all airfreight, trucking and customs clearance charges associated with getting the goods to the final users.
Once uncovered, the pricing had to be renegotiated with the client without the benefit of recovering the months of losses. Senior management was able to get an increase in price, but at a huge cost to the company from both a financial and customer goodwill perspective.
Similar to the examples discussed for R&A, the above cases clearly illustrate the direct functional relationship between COGS figures and lead time management, landed costs analysis and inventory availability. Unfortunately, whether a company is dealing with the revenue or cost side of the supply chain equation, there are many other examples that could be cited. Experience, forward thinking and contingency planning can minimize the probability of problems arising, but the key to supply chain management is the constant quest to uncover even the smallest issue before it has an impact on financial performance. To quote Machiavelli's The Prince:
When trouble is sensed well in advance it can easily be remedied; if you wait for it to show itself any medicine will be too late because the disease will have become incurable. [1]
Let's hope it's not to late for the good people at NikoTech.
[1]Niccolo Machiavelli, The Prince, Penguin Books, 1961, p. 10.
