Global Sourcing Model Helps Companies Optimise Benefits from Free Trade Agreements

Published: November 03, 2007 in Knowledge@SMU

Free trade agreements are an important indicator of globalisation and economic interdependence between countries and across regions. Some of the more prominent FTAs include NAFTA (North American Free Trade Agreement), CEFTA (Central European Free Trade Agreement, and SAFTA (Singapore-Australia Free Trade Agreement) among others. Foreign-trade zones are another, growing mechanism through which countries are doing away with trade restrictions and creating a variety of tariff structures.

As these arrangements proliferate, companies increasingly face difficult decisions about where best to source for components and set up manufacturing bases. Many businesses, lacking sufficient knowledge about how best to exploit FTAs, only marginally benefit from these opportunities. Others are turning to academia for help. One such company, a Japanese multinational (MNC), recently commissioned a study by Brian Rodrigues, professor of operations management at the Singapore Management University, and management sciences professors Li Yanzhi and Andrew Lim, City University of Hong Kong, to help save costs and solve their supply chain issues.

Following the project, Rodrigues, Yanzhi and Lim recently published an article on “Global Sourcing Using Local Content Tariff Rules” in IEE Transactions, published by the Institute of Industrial Engineers, in which they outlined the material sourcing model they developed for companies that manufacture and export within free trade zones to optimise their manufacturing networks.

The Problem

According to Rodrigues, their client was interested in importing consumer electronics into Japan. Part of its problem was to come up with a procurement strategy to source for raw materials or semi-finished products. In a larger context, the company also wanted to expedite the flow of goods in its supply chain. The research team’s role was to help the company change its sourcing strategy and maximise benefits flowing from the Japan-Singapore Economic Partnership Agreement (JSEPA).

The JSEPA, launched in October 2000, accorded a zero-tariff rate for 94% of Singapore’s exports and an additional 4,000 products, benefiting companies in the electronics, pharmaceuticals and instrumentation sectors. According to the Ministry of Trade and Industry, the annual savings to exporters was estimated to be S$330 million.

According to Rodrigues, previous studies done on FTAs had mostly focused on national, welfare and economic perspectives. Little work has been done in the operations management literature on the impact of ROO (rules of origin) on material sourcing. ROO, a key component of FTAs, in effect determines the “nationality” of goods and prevents trade from going through the country with the lowest tariff before for transshipment to other partner countries. It specifies conditions under which a good becomes eligible for a zero-tariff rule so that only goods originating from partner countries can benefit from the FTA. For example, ROO prevent electronic products originating in Indonesia and shipped to Japan through Singapore from benefiting from the JSEPA.

The authors built upon work by Munson & Rosenblatt (1997) which studied local content rules that compel firms to purchase components from suppliers located in a single country of manufacture. Rodrigues and his team went on to develop an algorithm which would help companies to optimise sourcing strategies, taking into account tariff structures, component costs and transportation costs.

Findings

The study results showed that although total cost increases with qualifying value content (QVC), it plateaus after a certain point. QVC, the qualifying value content of the good, is typically set by trade policy designers at a range of 30% to 60% to encourage manufacturers to source product material among FTA partner countries. The research team observed that a higher QVC leads to higher costs, as expected, but the increase becomes linear when it reaches 60%. Since the cost plateaus after this point, increasing the QVC has little effect on cost. Interestingly, the QVC set for JSEPA is 60%.

In the case of FTAs where the QVC is different, Rodrigues noted, “The QVC can be changed as well. If you change the parameter, you can see the behaviour of cost in respect to that. It’s like flipping the problem backwards.”

The researchers also found, counter to conventional wisdom, that smaller batch sizes do not always translate to a lower total cost. Although it is generally accepted that using smaller batch sizes offers greater flexibility in sourcing decisions, the impact of capacity restriction and the limitations implied by uniform batch sizes means that smaller batches do not always lead to lower total cost.

Bridging the Gap

In the process of attempting to solve the Japanese client’s immediate needs, Rodriques and his team worked with a consultant to help the company more clearly define their needs and the underlying problem. “These issues don’t come out in a book. We had to work with the consultant who, in turn, had to do a lot of homework within the company before he could pinpoint the problem,” Rodrigues said. The lack of a well-defined problem led to research that broke new ground, but it also highlights the gap between industry and academia.

According to Rodrigues, their study went a lot further than what was originally anticipated. “In academia, we are usually ahead of the industry in terms of research. There has always been a gap between the two, but closing the gap does not always happen immediately.” He added that once academics develop these algorithms or models, companies can simplify and adapt these for their own use. For example, his Japanese client is now using part of the algorithm that his research team had formulated.

Commenting further on this assignment, Rodrigues emphasized that their client was an exception to the rule; many companies are not yet fully leveraging on the benefits of FTAs. “The main motivation for the MNC that approached us to do the study was to save costs and to exploit the FTA between Singapore and Japan. However, most companies use simple calculations, unlike the theoretical models that academics can produce,” he said.

Rodrigues believes the reason why some companies are not yet paying enough attention to this issue is because they think it is too complicated. “Some might not even understand how to get into a model,” he said. However, there are a growing number of companies that are becoming operation-smart, such as DHL and UPS which rely heavily on research.

He is convinced that further studies in this direction are essential and useful. “The study focuses only on one FTA, JSEPA. We could expand this research into other FTAs in China or Japan. As more countries push for FTA collaboration, there are a lot of possibilities for studying how best to optimise overlap and linterinking of FTAs as these grow more complex.”