OFFSHORE MANUFACTURING "TO SAVE COST"

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Copyright 8 2014 by Dr. David M. Anderson, P.E., fASME, CMC

Offshoring Article is below

Offshoring manufacturing for cost  will not result in a net cost savings because of hidden overhead costs and because it inhibits, compromises, or thwarts 6 out of the 8 cost reduction strategies presented on the home page: Half Cost Product Strategy

Offshoring manufacturing separates manufacturing from engineering and thus thwarts Concurrent Engineering and compromises the 80% of the cost determined by the design.  Further, transferring, supporting, and dealing with quality problems of remote manufacturing absorbs many resources in engineering (in one case, 75%), manufacturing, and purchasing whose time would be better spent developing low-cost products.  See Cost Reduction by Design summary and the article Design for Manufacturability

Offshoring manufacturing to distant contract manufacturers increases the delivery time, which makes it hard to pull parts just-in-time.  Further, parts may be batched for shipping, which is opposed to the one piece flow aspects of Lean Production.  Finally, offshoring manufacturing removes production from the control of the OEM manufacturer.  All of these effects conspire to:

If all 8 cost reduction strategies are implemented, the cost savings will be much greater than appeared possible through offshoring.

OFFSHORING ARTICLE

From the book "Build-to-Order & Mass Customization,"   Copyright 8 2008 by Dr. David M. Anderson

Many companies are moving manufacturing operations overseas or outsource to foreign countries because they think it will save cost. And their primitive cost systems make such a move appear to be justified. If all they quantify is parts and labor, then moving to a A low labor rate@ country labor will appear to lower labor cost. Since no other costs are quantified, it is a A case closed@ decision.

However, when measured on a total cost basis, manufacturing offshore for sale in the U.S. rarely results in a net cost savings, considering differences in labor efficiency and all the costs of shipping, quality, inventory, communications, travel, training, transferring products, support, and complete sets of equipment needed for any manufacture. Further, offshore manufacturing compromises 5 out of the 8 cost reduction strategies presented on the home page: Half Cost Product Strategy.

Nokia builds most of its phones in its own factories in the U.S., Germany, and at its headquarters in Finland, where average wages are 30 times more than those in A low-cost@ regions. And yet, in 2003, its production costs have declined to an average of $114 per handset, compared to Motorola= s $131. Nokia can manufacture its low-end handsets in these A expensive locations@ for only $70, matching the best of the Asian manufactures.1  This is because, despite the higher labor costs, the total cost is less for reasons that will be discussed for the rest of this article.

The following discussion addresses issues affecting companies who move or expand their manufacturing operations offshore to build products for U.S. consumption. With the exception of startup issues, most of these issues also apply to outsourcing production overseas.
 

Total Cost Considerations for Offshore Manufacturing

Labor=s percentage of the selling price is much smaller than people perceive because total cost is rarely quantified well. But, just because labor is quantified, it should not dominate manufacturing strategies. Ironically, trying to reduce a small percent of total cost can raise the following other costs even more.

Labor efficiency alone might cancel out labor rate savings, for instance if labor cost is one third but labor productivity is also one third. Unfortunately, cost systems will immediately recognize the labor cost savings but not the productivity drop, unless it can be quantified and factored into the decision making process.

Labor-intensive designs. Many decisions to move to production to low-labor-rate are based on labor-intensive designs. However, Design for Manufacturability (DFM) can reduce labor content to the point where moving to low-labor-rate areas can no longer justified, even with primitive cost systems.

Shipping and expediting. Remote manufacturing will incur more shipping cost than manufacturing closer to customers and suppliers. In addition to the cost paid to the shipper itself, there are also costs of shipping insurance and other costs for fees, permits, duties, tariffs, compliance with import/export restrictions, and so forth. Longer shipping A pipelines@ increase carrying costs for inventory in the pipeline and queuing up at both ends at the seaport docks and at factory shipping and receiving departments. In addition, greater distances slow responsiveness and make it harder to implement lean production, build-to-order, and mass customization. Even if a mass-producer doesn= t have variety challenges, it may still have trouble responding to variations in demand and have to resort to expensive expediting to compensate for the lag between increasing customer demand and when products finally arrive from stepped up production. Although the business case for offshore manufacturing is typically based exclusively on ground shipping, even occasional expedited air freight can seriously erode the viability of the offshore justification. Although not planned, expensive expediting may be required because of demand volatility or shipping disruptions.

Further, greater distances between headquarters and manufacturing result in less control. Greater distances between engineering and manufacturing compromise concurrent engineering.

Training costs may exceed projections especially if it is difficult to attract and retain workers with adequate skills. For instance, many companies that open factories in Singapore are surprised at the lack of loyalty and resulting high turnover, which, in turn, further increases recruitment and training costs in addition to the wage escalation necessary to retain valuable employees in such an environment.

Quality costs may also rise, sometimes catastrophically, because of difficulty establishing a six sigma quality culture, learning curves, and the long A pipeline@ to the ultimate users which delay discovery of recurring defects (see more on the general quality discussion below).

Capacity. Needing more capacity is often the catalyst for adding a new overseas plant, but capacity can be improved in existing plants by improving equipment utilization and freeing up floor space with Lean Production programs that reduce inventory, batches, and setup time. By contrast, adding an overseas plant for capacity is a slow and inefficient way to add capacity, because of the above issues in general and the following ones in particular.

Utilization of equipment may be way below optimal levels since every plant needs a compete set of equipment, whether or not justified based on capacity needs. If a company has standardized on million dollar assembly equipment or testers (which is common for printed circuit boards), then it will need complete sets of these million dollar machines in every plant, regardless of how well they are utilized.

Automation may be hard to justify when the A nominal@ labor rate is low, especially when non-labor costs are not quantified. Insufficient CNC automation diminishes both quality and flexibility, which, in turn, diminishes responsiveness.

Cheap labor doesn=t stay that way. One of the ironies of moving production overseas for the cheap labor is that the labor advantage doesn= t last very long, due to rising labor cost, taxes, and local currency valuations, among other factors like changing trade agreements and local government desires force outsourcers to move A up the food chain@ (see comments on tax breaks below). Cross-border factories in Mexico were hot a few years, but 350 maquiladora plants have closed down since 2001.2  Robert Berges, director of Latin American Strategies for Merrill Lynch, after writing two reports on the China threat to Mexico concluded that, A Mexico= s natural advantage as a manufacturing center for North America is dissipating quickly.@3

And the production that has moved to Asia still keeps moving. Shanghai is already becoming an increasingly more expensive place to do business, so companies chasing the lowest cost manufacturing location are advised to look into rural China.4  But a cautionary tale about going too far afield was told at an internal conference of a large multinational company: because of the company= s strict low-bidding policy, one division was forced to accept the bid of a supplier in a remote area of China where, in the words of the division= s supply chain manager, A the last western person to come through there was Marco Polo!@

Moving production to chase cheap labor or opening a plant overseas is, as will be discussed in the next several points, an expensive way to A save@ money, especially if the company is moving its own manufacturing facilities.

Plant start-up costs must be taken into account and amortized over the expected life of the plant. Just the process of starting up the plant will involve a team of ex-patriots living on expense accounts for months. New (maybe redundant) infrastructures may have to be installed for personnel, purchasing, customs, legal, and other administrative functions.

Transfer costs must be applied to every product transferred, including tooling tear-down, packaging, shipping, tooling reinstallation, documentation translation, and travel for people who may have to personally supervise the transfer at both ends.

Support costs add overhead cost to find and qualify outsourcers or arrange the startup of new manufacturing plants. Support costs continue for the ongoing administration of off-shore arrangements. These headquarters expenses are rarely subtracted from the computes savings of offshore manufacture.

Travel costs are usually end up being higher than anticipated, especially if the plant is in an A attractive@ area. Travel to plants greater than nine hours away may need to be increased to compensate for communication difficulties cause by out-of-phase work schedules.

Communication costs may be more than anticipated, especially if there is a burst of intercontinental communication for the short time that out-of-phase plants are both working.

Unanticipated/hidden costs may offset much of the expected cost savings of overseas manufacturing. Local fees, licenses, and permits may be anticipated, but in many counties, especially in Asia, it is common to have to make payments for bribes, kickbacks, favors, and protection. Having to hide such payments may create resistance to total cost measurements, which seeks to quantify and categorize all expenses, and, in extreme cases, this could encourage accounting fraud and violations of laws or company policies that forbid such payments.

Tax breaks are often cited as an enticing incentive to move manufacturing overseas. These tax breaks can be so intoxicating that they override appropriate cautions, as exemplified by the following true story: One Fortune 50 company was going through the decision making process to select a location for a new offshore plant. One slide had list of candidate countries; someone noted that there was one country being considered he never heard of. The response was, A For those tax breaks, we will find it!@ However, tax breaks probably will not make up for the above mentioned increase in total cost and, furthermore, they usually expire after so many years unless the company A ups the ante@ and increases the commitment, for instance, by moving engineering there too.

Some home countries do not tax companies on profits made from overseas manufacturing as long as the profit does not come into the country. So, in order to keep avoiding taxes, companies reinvest the money overseas, thus increasing their commitments overseas.

The most subjective aspect about tax breaks deals with focus, the importance of which is emphasized throughout these cost reduction strategies. Going for tax breaks focuses on protecting profits instead of generating profits. And often the wrong focus can compromise the right focus, as all these points illustrate.

Overhead allocation downward spiral. The actual total cost of overseas manufacturing will probably be higher than anticipated because of the above issues. Total cost measurements would predict this and prevent unwise decisions. However, without total cost measurements, these decisions may be made based on A back of the envelope@ estimates of labor cost A savings.@

Nevertheless, even if not quantified, all the above mentioned A extra@ costs must be paid and usually end up in a big bucket called overhead. As mentioned in the Total Cost article, most overhead allocation algorithms are arbitrary, and when companies have overseas plants, they will B knowingly or unknowingly B shelter these plants from all the unanticipated overhead they generate because (a) they are not quantified or (b) allocating these expenses appropriately would reveal the overseas plant was a bad decision.

So the allocation on the overseas plant is arbitrarily set to correspond to a level that supports the original business plan, realistic or not. But, someone must A pay the piper,@ usually the home country operations, whose overhead must then go up. That accelerates the transfer of more products overseas, maybe even creating demand for more plants as existing ones struggle to accept all the transfers. As domestic plants lose more products, they become less efficient, operating at partial capacity, and then their overhead rises from their own transfer-induced inefficiencies, thus causing even more transfers and eventually forcing domestic plant closures. Continuing this pattern results in a downward spiral (some companies call this the death spiral) until there is no domestic production left to absorb the excess overhead. By the time all production moves overseas, all the excess costs of overseas production will be known, but by then it might be too late to make up for the competitive disadvantages caused by excessive costs and other considerations discussed next.
 

Competitive Considerations for Offshore Manufacturing

Product delivery. As with outsourced overseas production, internal production far from customers slows delivery to customers and makes Lean Production, Build-to-Order and Mass Customization more difficult, maybe impossible, to implement. In addition to shipping time, more delays may be caused as shipments are batched to fill shipping containers. Delays may also be caused by slower production due to lower productivity, quality problems, or other unanticipated problems caused by overseas manufacturing.

Primitive transportation infrastructures, such as poor roads, air, and rail service can further delay both incoming parts and outgoing products. Recently, cross-border shipments into the U.S. have been delayed by security checks.

Parts delivery. Too much distance from suppliers can slow down responsiveness and make it difficult to pull parts and materials from suppliers. Vendors need to be close to Engineering to help design products. Vendors need to be close to manufacturing for quick deliveries and optimal interactions.

Supply Vulnerabilities. Jeffrey E. Garten, Dean of the Yale School of Management, raised the issue of the vulnerabilities of moving too much production to one country, in this case, China. His concern was that the world economy is becoming A dangerously vulnerable to a major supply disruption cause by war, terrorism, social unrest, or a natural disaster.@ 5

Quality. Quality may suffer if the new plant has not established an effective quality culture. Japanese A transplant@ factories in the United States often spend up to a year training workers before the plant opens. Quality problems are more of a concern when quality is not a inherent element of the local culture. High turnover can also cause quality problems and limit effects of training efforts. Even with the optimum quality culture in place, starting up any new plant has a certain A learning curve@ phase, which also applies every time another product is transferred. Quality may also suffer if recurring defects are produced overseas and not detected until hundreds of defective products are discovered at the end of the long transcontinental A pipeline.@

Design Competitiveness. Separating engineering from manufacturing discourages interaction between engineering and manufacturing and makes it difficult for manufacturing people to participate on product development teams, which is one of the keys to Design for Manufacturability and Concurrent Engineering.

Control. It may be harder to exercise effective control of overseas operations because of time zone separations, languages, cultural differences, lack of face-to-face communications, and the A out of sight; out of mind@ syndrome.

Communications. Communications may be less than optimal due to different languages, communication equipment, and time zones, which, if over nine hours, means the plant and home office may never be working at the same time.

Local cultural differences may create unexpected problems related to quality, deliveries, holidays, communications, and treatment of local workers, which has tripped up many companies lately.

Technology introduction delays. New manufacturing technologies are usually introduced in the home plants first and overseas plants last. Such implementation delays may defer realizing technology benefits and temporarily make new technology plants incompatible with old technology plants.

Customs and regulations. There may be unanticipated difficulties with customs and regulations from both the home and overseas countries. One high tech company located their A high volume@ circuit board assembly factory in Singapore, but later found out that U.S. national security restrictions prohibited the latest microprocessors from being shipped in or out of the plant. Trade wars can disrupt or penalize overseas production and shipping.

Liability. American companies now face liability risks based on actions of their overseas joint-venture partners. Unocal has encountered legal problems for alleged human-rights violations committed by the government of Myanmar (Burma), its partner in the Yadana gas field in southern Myanmar.6

Strategic focus. Setting up and operating overseas manufacturing plants consumes a lot of effort and may distract companies from other improvement programs, such as those recommended in this cost reduction strategy.
 

When Offshore Manufacturing Does Make Sense

The preceding discussion addresses the problems of locating production overseas to save cost on parts or products shipped back to the home country.

On the other hand, overseas manufacturing does make sense when those factories are close to customers and sources of supply, as is the case with A transplant@ automobile factories set up in the U.S. by Japanese, European, and Korean automobile companies. In fact, the American automobile industry has been transformed by these transplant factories who now even design products in America for American tastes.7

This corresponds with the philosophy of Build-to-Order which is local production for local consumption. This author predicts that this will reshape world trade, as will be discussed next.

 

WORLD TRADE IN THE ERA OF BUILD-TO-ORDER AND MASS CUSTOMIZATION

The role of distance has a crippling effect on customer responsiveness at the distribution end of the supply chain. Even if the materials end of the supply chain is tightly coupled with close proximity and one-piece flow based on pull signals, the operation will probably not be able to provide the optimal customer responsiveness if finished products have to be shipped across oceans. Shipping delays will cause a significant competitive disadvantage for any company trying to take advantage of the strengths of Build-to-Order and Mass Customization. This is especially true for markets that require fast responses: rapid replenishment of lean retailing stores; individually mass-customized goods; internet sales; and on-demand part manufacturer for BTO assemblers.

Build-to-order and mass customization will favor local procurement, local production, and local distribution to ensure speed throughout the entire supply and distribution chains. And, as pointed out through this book, supply chain speed is what allows the company to build products on-demand and ship them to customers or stores as fast as the batch manufacturer can ship forecasted inventory, but without the costs of inventory or the outage vulnerabilities of forecasting.

Thus, as build-to-order and mass customization grow, exporting should diminish in both directions. In developed countries, the mass marketers who mass-produced products overseas will gradually evolve or be replaced by companies who build mass-customized and standard products on-demand for quick shipment to domestic customers.

Developing countries will be able to raise themselves above the low status of being the A cheap labor@ provider with all of its problems of workplace abuses, A sweat shop@ allegations, and population dislocations and disruptions. In fact, the current form of A globalization@ has not helped many poor countries, according Joseph Stiglitz, author of Globalization and Its Discontents.

In its place, developing countries will to evolve to the dignified status of designing products suitable for their own cultures, building them in local plants by a proud local workforce, and distributing mass-customized or standard products quickly to local consumers. And in both developed and developing countries, companies, and ultimately consumers, will benefit from avoiding the costs of transoceanic shipping, inventory, obsolescence, tariffs, and duties plus minimizing macroeconomic problems of international currency fluctuations and balance of trade deficits.

Endnotes/References (See Below)

ABOUT THE AUTHOR

The above article is derived from Chapter 6, “Outsourcing vs Integration” in Dr. Anderson’s book, Build-to-Order & Mass Customization; The Ultimate Supply Chain Management and Lean Manufacturing Strategy for Low-Cost On-Demand Production without Forecasts or Inventory.

Dr. Anderson offers consulting and seminars on Build-to-Order and also consulting and seminars on Design for Manufacturability & concurrent Engineering, which shows how to develop low-cost products.

For more information call or e-mail:

Dr. David M. Anderson, P.E., fASME, CMC
www.HalfCostProducts.com
phone: 1-805-924-0100
fax: 1-805-924-0200

e-mail: anderson@build-to-order-consulting.com
 

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ENDNOTES/REFERENCES

1. David Pringle, “How Nokia Thrives by Breaking the Rules,” The Wall Street Journal, Jan. 3, 2003.

2. Geri Smith, “The Decline of the Maquiladora,” Business Week, April 29, 2002, p. 59.

3. Geri Smith, “Wasting Away; Despite SARS, Mexico is still losing export ground to China,” Business Week, June 2, 2003, pages 42 - 44.

4. John S. McClenahen, “Waking up to a New World,” (first of a seven-part series on Manufacturing’s Global Future), Industry Week, June 2003, pages 22 - 26.

5.  Jeffery E. Garten, “When Everything is Made in China,” Business Week, June 17, 2002.

6.  Peter Waldman, “Unocal to Face Trial Over Link to Forced Labor,” Wall Street Journal, June 12, 2002.

7. Joann Muller, Kathleen Kerwin, and David Welch, “The New American Auto Industry,” Cover Story, Business Week, July 15, 2002, pp. 98- 106.

8.  Joseph E. Stiglitz, Globalization and Its Discontents, (2002, W.W. Norton), 282 pages; Book review by Michael J. Mandel, “Where Global Markets are Going Wrong,” Business Week, June 17, 2002, p. 17.