Two-Source Decision: Purchase Price vs. Total Landed Cost
Your company buys a machined component from two qualified sources. Supplier A quotes $42.00 per unit FOB origin with a 12-day lead time, a 1,000-unit minimum, and freight billed at $0.09 per unit. Supplier B quotes $45.50 per unit delivered duty paid with a 32-day ocean lead time and a 5,000-unit minimum. Annual demand is stable at 60,000 units and either source can cover it. Your inventory carrying cost rate is 22% per year, applied to landed unit cost for the full pipeline exposure. Supplier B's process historically yields 1.5% rejects that must be reworked at $8.00 each; Supplier A's reject rate is 0.4%. Finance favors consolidating volume on B: fewer suppliers and more leverage at next year's negotiation.
1. Calculate the total landed cost per unit and per year for each source, and make a recommendation.
Read the worked answer
Supplier A
- Landed base: $42.00 + $0.09 = $42.09
- Rework: 0.4% x $8.00 = $0.03
- Pipeline carrying: 22% x $42.09 x (12/365) = $0.30
- Total: $42.43/unit -> $2,545,600/yr
Supplier B
- Landed base: $45.50 (freight included)
- Rework: 1.5% x $8.00 = $0.12
- Pipeline carrying: 22% x $45.50 x (32/365) = $0.88
- Total: $46.50/unit -> $2,789,900/yr
Recommendation: A, by roughly $4.07/unit or $244,000 per year. The purchase-price gap ($3.50) understates the true gap because B's 20 extra pipeline days cost about $0.57/unit in carrying cost and its reject rate costs another $0.09/unit. Note that only transit days are counted here; the longer lead time also multiplies safety stock by about 1.6x (sqrt(32/12)) if demand becomes volatile, which would widen the gap further.
2. Finance asks what B would have to do on price to win the business. Compute the break-even and interpret it.
Read the worked answer
Set B's delivered price P so that its total equals A's $42.43:
P + $0.12 + (0.22 x P x 32/365) = $42.43 P x 1.01929 = $42.31 P = $41.51
B would need to cut its delivered price by about $4.00, roughly 8.8%, to match A on landed cost. That is far beyond a normal annual concession, so the consolidation case cannot be justified on price alone. Two legitimate reasons to keep B anyway: (1) dual sourcing for supply continuity, in which case the premium is an insurance cost that should be budgeted explicitly rather than hidden; (2) a credible quality program that removes the rework penalty. If B eliminated rejects entirely, its total would fall to $46.38 and the gap would narrow only marginally - the carrying cost, not quality, is the structural problem.
3. What factors outside this calculation should drive the final sourcing decision?
Read the worked answer
- Demand variability: the calculation assumes stable demand. Real safety stock scales with the square root of lead time; at 32 days versus 12, B's buffer is materially larger and the 22% rate would apply to it.
- Cash and MOQ: B's 5,000-unit minimum is fine at 60,000 units/yr, but it locks cash and raises obsolescence exposure if the forecast is cut.
- Rework cost realism: $8.00 captures labor only. It excludes schedule disruption, expediting, and scrap at the end of the line - A's advantage may be larger than shown.
- Supply risk: single-sourcing to A removes B's ocean exposure but also removes a qualified alternate. Dual sourcing is a risk decision, not a price decision, and should be funded as such.
- Action: present the landed-cost comparison, then ask finance to state explicitly how much it is willing to pay for supply-base reduction. Do not let a purchase-price target silently override the total cost model.