Integral Logistics Management — Operations Management and Supply Chain Management Within and Across Companies

2.1.2 RoO (Rules of Origin), Value Content Requirements and Tariff-Orientation in a Global Supply Chain — Global Trading

Intended learning outcomes: Produce an overview on terms such as tariff, free trade agreement (FTA), and free trade area. Explain the concepts of rules of origin (RoO), value content, and tariff heading. Describe various scenarios for a truck manufacturer within the EU that wants to sell trucks in the NAFTA area.

Globalization trends in recent decades have exposed companies to inter­natio­nal competition and high cost pressure, but they also make savings possible through global sourcing. From the point of view of a local economy, this is not always favorable, since shifting value adding elsewhere also entails loss of jobs, which can also result in negative impacts on gross domestic product. That is why there are now increasing attempts at the political level to tie multi­national companies to the local economy, but without inhibiting trade flows between economies. Possible tools for resolving this conflict of aims are free trade agreements and free trade areas in combination with Rules of Origin (see below).

A tariff is, according to [APIC16], an official schedule of taxes and fees imposed by a country on imports or exports.

As a result of a free trade agreement (FTA), a free trade area (FTA) is a form of preferential trading area where there is fully free trade among members, but each country is free to levy different external tariffs against nonmember countries.

FTAs are used to stimulate trade among member countries and there­fore support the local companies and economies. Two of the most prominent FTAs are the European Union (EU) and the North American Free Trade Agreement (NAFTA — replaced by the USMCA agreement since July 2020) (see also Figure and [LiLi07]).

Fig.        Some of the most important FTA.

When there is no common external tariff among the member countries of an FTA, companies can enter the FTA at the lowest tariff entry point. Goods can then be shipped to the final destination within the FTA without additio­nal tariff costs. This results in tariff revenue transfer effects, since this trade deflection transfers tariff revenue to the country with the lowest external tariff within the FTA. To reduce trade deflection, Rules of Origin are used.

Rules of Origin (RoO) define the extent of a product’s local content needed to be regarded as local and therefore the prerequisites for trading goods tariff-free within the FTA. Additionally, RoO are used to induce companies from nonmember countries to shift value-adding activities toward the FTA to be able to benefit from the preferential tariff treatment.

There are two ways to treat a good as “local.” First, it can be “wholly obtained or produced,” meaning the good has been wholly grown, harvested, or extracted from the soil of the member country or has been manufactured from any of these pro­ducts. This type of RoO is not further examined here. Second, the good has gone through a “substantial local transformation.” This criterion is im­por­tant for global SCM. It has three aspects that can be used in a combination or on a stand-alone basis (see also [EsSu05]):

  • Value content (VCFTA): Value content defines, for a specific FTA, the minimum percentage of local value added that is required for the product to be considered local.
  • Change in tariff heading (CTH): This criterion is fulfilled as soon as the imported good has been processed in a way that alters the tariff code in the harmonized system (HS).
  • Technical requirements (TECH): This criterion defines a list with processes and/or inputs that are prohibited or that need to be realized within the FTA.

What is the implication of FTAs and RoO for global SCM? An opportunity occurs when the companies meet the FTA’s requirements and are allowed to trade tariff-free within the econo­mic area. In most cases, this requires an amount of value adding (VCFTA) to take place within the domestic area. The following example illustrates the issues: A truck manufacturing firm either produces trucks P (tariff code HS8701.20) completely in the EU or produces semi­finished products S of P in the EU and assembles them to finished trucks in the NAFTA. In both cases, the company ships its finished goods to its customers in the NAFTA member countries, the United States (USA), Mexico, and Canada. If the value content of the manufacturer’s products, namely, VCP,FTA or semifinished products, namely, VCS,FTA is less than the VCFTA, the company faces the tariff situation shown in Figure

Fig.        Tariffs of code HS8701.20 for shipments from one country to another, if there is no free trade agreement FTA in place or VCP,FTA< VCFTA or VCS,FTA< VCFTA (n.a. = “not applicable”).

The tariffs, which can differ depending on type of products, may have a significant impact on the cost optimal supply chain design. Figure shows a case-by-case analysis of the VCFTA threshold fulfill­ment in a sim­p­li­fied but still realistic supply chain structure for the truck manufacturer.

Fig.        Different supply chain design options regarding value content (VCFTA) fulfillment.

The truck manufacturer can either produce P wholly in the EU (scenarios I, II) or meet the VCNAFTA threshold by shifting production of P to the NAFTA regions (scenarios III, IV) and reducing value adding in the EU to production of semifinished products. To stress the influence of tariff costs, this example disregards sourcing, production, and transportation costs and the sales quantity of the destination markets.

  • In scenario I, the manufacturer produces all trucks P in the EU and then ships the finished products to the destination markets Canada, USA, and Mexico. Because of the sourcing from non-EU members and no value adding in the NAFTA, it cannot meet either the VCEC-Mexico threshold (50%) or the VCNAFTA requirements (62.5%). From a tariff perspective, the best solution would be direct shipment of P to, and payment of the external tariff of each country.
  • In scenario II, the manufacturer is able to fulfill the VCEC-Mexico (50%) by executing 50% or more of its value adding of P in the EU. It can therefore exploit the tariff-free shipment to Mexico.
  • Scenario III is possible if the manufacturer decides to produce only semifinished goods S in the EU and finished products P in the NAFTA (principle of “completely knocked down” or “semi knocked down”). This makes sense as soon as the value content of trucks P (VCP,NAFTA) becomes greater or equal to VCNAFTA (62.5%). As for the semifinished goods S, in this scenario VCS,EU is smaller than VCEC-Mexico. Therefore, it is optimal to enter the NAFTA with the semifinished goods S through the USA, which in this case is the lowest tariff entry point, assemble them to P in the USA, and distribute the finished goods P to the USA, Canada, and Mexico.
  • In scenario IV, the manufacturer allocates its value adding activities for semifinished goods S in a way that VCS,EU ≥ VCEC-Mexico, and for finished product P in a way that VCP,NAFTA ≥ VCNAFTA. From a tariff perspective, the assembly of P in Mexico would be the optimum.

There are considerable threats in a tariff-oriented supply chain. This is because the basis for the decision-making, that is, the value content of a product, the calculation method of VCFTA, and even TECH can alter rapidly. In addition, the degree of CTH can increase (here see [PlFi10]). Once a compa­ny has made long-term investments in facility locations and sourcing decisions based on an optimum tariffs scenario, it might suddenly be locked in a local supply chain (scenarios III, IV). As a consequence, it might no longer be able to compete with global competitors (scenarios I, II) due to relatively high sourcing costs. The following three scenarios have been picked out of a multitude of possibilities, in which a changing environment causes problems with VCFTA fulfillment.

  • Scenario “supplier shortfall”: When a company has decided on local sourcing to match VCFTA requirements, a shortfall by a local supplier can have a crucial impact on tariff costs. If there are no alternative local suppliers, the company will be forced to switch to a global sourcing strategy. This would decrease the amount of origi­nating materials and thus decrease the VCP,FTA of the product.
  • Scenario “increasing capacity utilization”: A problem from the perspective of the VC of the product emerges as soon as increased capacity utilization (a much desired effect) reduces the total cost per product. This could happen because of, for example, manu­facturing overheads being allocated to a greater amount of final products. As a decrease in total cost, this could cause a reduction of VCP,FTA.
  • Scenario “rise of the value content (VCFTA) requested by the govern­ment”: This kind of increase could mean that RoO requirements cannot be met. The relevance of this factor is shown by the trend of the VCFTA in the NAFTA region for light vehicles set out in NAFTA Article 403. Whereas VCNAFTA was at 50% on Jan. 1, 1994, it increa­sed to 56% on Jan. 1, 1998, and to 62.5% on Jan. 1, 2002 [Cana15]. With the new USMCA agreement, the value content increased to 75%.

The example shows that the potential benefit of a tariff-oriented supply chain structure is significant. Nevertheless, companies that seek to exploit the advantages need to be aware of the underlying risks. These risks need to be evaluated and tested before decision investments are made.

Course section 2.1: Subsections and their intended learning outcomes