A tier is a price for absorbing something

The easiest saving in the industry, and why it usually is not one

Marchbanks Sourcing takes 5.5% of FOB. On this order that is USD 36,418.80 for a company that owns no machines, holds no stock and takes no title.

So Verrick's owner makes the proposal every factory owner makes eventually. Deal with us direct. We will give you 3% off the FOB and you keep the rest of the commission. We both win.

It sounds obviously right. Do the arithmetic instead, because the arithmetic says something more useful than yes or no. It says at what quantity the answer changes.

Cost the functions, not the opinion

Start by listing what Marchbanks does on this order. Then price each item at what Halvedge would have to spend to get the same thing done without it. Every rate below is Halvedge's own internal figure for this invented market.

The last two lines are the interesting ones, and we will come back to them.

The last one is worth working out now. With the agent in place, Marchbanks pays Verrick and then waits for Halvedge. Direct, Verrick waits 60 days from the bill of lading for USD 662,160. Verrick's own bank prices its working capital at 14.5% a year, which is Verrick's quoted figure and nobody else's. So: USD 8.90 a piece, times 14.5%, times 60, divided by 365, is USD 0.2121 a piece, or USD 15,780.24 on the order.

Add the eight lines: USD 37,373.32 to replace a commission of USD 36,418.80.

The commission is 97.4% of what the functions cost to replace. It looked like pure margin, and it is very close to break-even.

The quantity is the whole answer

That result is not a fact about buying agents. It is a fact about this quantity. The reason is that the cost structure on the two sides is different in kind.

• Commission is purely variable. USD 0.4895 every piece, from the first to the millionth.
• Replacement is mostly fixed. The travel, the merchandiser's hours, the courier account and the credit line cost the same whether the order is 14,000 pieces or 220,000. Only the freight, the credit and the claims move with volume.

Split the replacement into the two shapes and it becomes a formula you can run on your own business.

• Fixed per order: USD 10,697 — merchandiser hours, travel, courier, credit instrument.
• Inspection: USD 380 a man-day, at four man-days plus one for each 25,000 pieces.
• Variable per piece: USD 0.3228 — freight consolidation 0.09, credit 0.2121, claims 0.0207.

Now run three quantities.

Set the two expressions equal and the crossover sits just above 82,400 pieces. At that quantity the commission is USD 40,334.80 and the direct route is USD 40,335.72, a difference of under a dollar.

HV-3110 at 74,400 pieces is 90.3% of the way to that line. It is on the wrong side of it, and only just.

So the honest answer to the factory's proposal is neither yes nor no. It is: not on this order, and yes on the programme. Halvedge places three styles a year with Verrick. Take them together and the quantity clears 82,400 comfortably, the fixed cost is spread over three orders instead of one, and direct becomes the cheaper structure by a wide margin.

What the factory did not count

Go back to the table and notice which lines Halvedge pays and which lines somebody else pays.

Verrick offered 3% off FOB, which is USD 0.267 a piece, or USD 19,864.80 across the order. It also inherits USD 17,320.32 of cost that Marchbanks had been carrying, and that appears on no invoice anywhere.

Add them: USD 37,185.12, against a profit on this order of USD 35,756.64.

Verrick's own proposal turns a profitable order into a loss of USD 1,428.48. It gives away 104.0% of its profit. And it does so believing it is capturing a commission that was never its to capture, because the commission was Halvedge's cost, not Verrick's. Removing it saves Halvedge, not Verrick.

Halvedge, meanwhile, saves the whole USD 36,418.80, spends USD 20,053.00, and is handed a further USD 19,864.80 of discount. That is USD 36,230.60 better off on one order, on a proposal the factory brought to it.

The rule underneath it

An intermediary's price is not payment for its effort. It is payment for a bundle, and the bundle holds three kinds of thing: work somebody must now do, cash somebody must now find, and losses somebody must now absorb.

When you remove the tier, all three are still there. The work gets re-homed loudly, because someone notices there is nobody to do it. The cash and the losses get re-homed quietly, because nobody sends an invoice for them.

Act as an analyst who has no view on intermediaries and reports arithmetic. I am considering removing a tier from my chain, or paying a premium to shorten it. Case A, removing an intermediary: the intermediary is [NAME AND WHAT IT IS], its charge is [RATE AND BASIS], my order quantity [NUMBER], my unit price [AMOUNT]. What it currently does, one a line, with what it would cost me to do instead: [FUNCTION, MY REPLACEMENT COST, AND WHETHER THAT COST IS FIXED PER ORDER OR VARIES WITH QUANTITY]. Also state, separately: the payment days it currently absorbs and whose working capital would fund them instead, at [PERCENT A YEAR]; the claims it currently settles at its own cost, [AMOUNT AN ORDER]; and any consolidation, freight or volume benefit that disappears with it, [AMOUNT PER PIECE]. Case B, paying for a shorter chain: the premium is [AMOUNT PER PIECE], the supplier owns these stages [LIST] and subcontracts these [LIST], my style's operations are [LIST], and my own fault history over the last [NUMBER] orders is [FOR EACH FAULT: WHICH STAGE, WHAT IT COST, HOW MANY DAYS IT TOOK TO RESOLVE]. Do the following. For case A, split the replacement into a fixed cost per order, a stepped cost, and a variable cost per piece; give me the total at my quantity; and SOLVE for the break-even quantity at which removing the tier stops costing money and starts saving it. Then run it at half and at three times my quantity. Then split the replacement cost into what lands on the buyer and what lands quietly on the supplier, and say which party each line actually falls on in a direct arrangement. For case B, work out the premium on my order, the cost of the delay the shorter chain would avoid, the probability of that delay from my own fault history, and then RE-COMPUTE the probability using only the faults that occurred in stages the supplier actually owns. State both figures and the gap between them. Finally, for both cases, name the two or three contract terms that would buy most of the benefit without the structural change, and price them. Show every calculation.

Lesson 5 asks the same question one tier further up. When a buyer chooses between a group that owns the whole chain and a factory that coordinates one, what is it actually paying the difference for?