When the economy went south, so did a lot of manufacturing jobs—mainly to Latin America and the Caribbean. Before that, hundreds of thousands of jobs had already migrated east, to low-wage Asian countries. Nike now manufactures its apparel at 800 facilities in over 50 countries. HP outsources 100 percent of its consumer PC production to global partners. The money saved on labor costs offsets higher transportation and other expenses, making the vendors more competitive in a cutthroat marketplace.
Except it doesn't. All too often, companies are discovering that their total costs do not drop when they move production offshore. Part of it is volatility in currency rates and security-related surcharges, which are pushing up costs and increasing replenishment lead times. Late last year, for example, U.S. Customs introduced the 24-hour rule, which requires shippers or their agents to transmit a detailed description of the contents of each U.S.-bound sea container 24 hours prior to loading Though designed to increase security, the rule will have other repercussions as well. The majority of global shippers responding to a survey conducted by BDP International in February said the rule would have a moderate to extreme impact on their costs. In response, a third are adding extra cycle times to their supply chains rather than risk delays or fines.
But these global developments aren't solely responsible for cost surprises. Much of the time, faulty analysis is to blame. What follows is a description of three common mistakes:
1 . Overlooking key costs. Total delivered cost is the total cost for shipping product from origin to final destination, including product acquisition, transportation and handling fees, duties, tariffs and all accessorial charges. That sounds straightf orward enough, yet companies often fail to factor in the costs of moving goods beyond the port (or point at which product enters the distribution network ).
One company that outsourced manufacturing to Asia, for example, neglected to factor in the price of hauling the goods to Eastern markets, where demand was heaviest, from the West Coast port of entry. Breaking down and redistributing shipments to Eastern facilities and then to customers increased its costs by millions. Don't fall into this tra p—make sure your analysis includes the cost of transporting products not just to the port but to the customer. That means evaluating the changes in inbound, outbound, and especially interfacility logistics costs that will occur as sourcing points are changed.
2. Failure to distinguish between arbitrary and fixed costs. Many manufacturers use variable activity- based costing to determine if they should move a portion of production overseas. But too often companies make their decisions based upon standard product costing and not true cost behavior. That's a mistake. Accounting standards categorize certain costs as variable on an arbitrary allocation scheme when they are actually fixed overhead. As a result, "paper costs" may decrease, but actual operating expenses go up.
For example, say standard costing indicates you can manufacture a product for $1 domestically or source it in Asia for $0.90. It may sound like a bargain, but it's not. When you shift production volume to an overseas supplier, not all variable costs disappear. That's because some "variable" costs are actually fixed costs. For example, costs associated with production supervisors, schedulers, engineers and facility maintenance and repair are rarely eliminated just because some production has been moved offshore. So if you currently allocate $0.15 per unit for these costs, they won't disappear when volume declines. The line—and the associated management, support and maintenance requirements—is still needed for other production. After factoring in these true activity-based costs, this $0.10 a unit savings actually becomes a cost increase of $0.05.
3. Overlooking costs associated with pipeline inventory. All companies expect to increase inventory when they move production overseas to offset longer lead times for replenishments. But often, companies forget to factor in the lead time variability associated with these longer shipments—a number that substantially increases safety stock requirements as well.
Consider this example. A company is considering outsourcing a domestically supplied product with a week-long average lead time and average variability of two days. Due to the lengthy transit times and uncertainty associated with ocean shipping, the overseas source would triple the lead time to three weeks and increase the variability by four days. Seems like a modest increase? It's not. In order for this company to maintain the same service levels, it would have to increase its safety stock by 97 percent on top of tripling in-transit inventories and, most likely, increasing cycle stocks.What appears to be insignificant variability amounts to a huge impact on carrying costs.And if the company had just based its decision on lead time alone—failing to factor in an increase in variability—the inventory requirement would appear to only grow by 13 percent, a hugely misleading number.
A jump in inventory associated with a decision to move production overseas can represent a huge hit to the balance sheet and inventory turns. As a result, today's managers need to determine safety stock increases on the combination of lead time and lead time variability. In general, the greater the average demand, the greater the influence of lead time variability on safety stock levels. The greater the variability of demand, the greater the influence on lead times. In all situations, but especia ly when high-value or highly seasonal products are considered for outsourcing, companies must carefully examine the tradeoffs between increased inventory carrying costs and faster, more reliable modes of transportation.
To ensure that the analysis regarding global supply chain opportunities is complete and will result in cost savings, companies need to:
1. Evaluate the decision holistically. Managers need to consider total supply chain costs—from raw materials to end customers. This includes evaluating the ripple effect on existing manufacturing and distribution infrastructure that results from decreased asset utilization and increased inventories. These strategies must also be evaluated against opportunities that could make domestic operations more attractive, like investment in more efficient equipment or technology, relocation to cheaper domestic markets or adopting an outsourced component strategy.
2. Continuously analyze strategies. To avoid outsourcing programs that promise savi n gs but don't del iver, com p a n i e s need to re-evaluate their strategy on a periodic basis. As product volumes and costs fluctuate, managers should make sure their previous assumptions still hold true under these new conditions. Significant shifts in currency exchange rates, cost of capital or even transportation costs can quickly make existing operating models obsolete. Continuous analysis and the agility to adapt to changing market conditions can ensure market leadership.
3. Consider an investment. If you're outsourcing a core product and the cost advantage is real, consider setting up your own operation or even a joint venture. This strategy will accomplish two things. First, it will force you to manage the operation holistically—trading off international allocations against domestic capabilities. Second, it will give your company an incentive to invest in capital equipment and technologies, which can drive even greater efficiencies in an overseas operation.
The Supply Chain Leadership series is directed by Karl Manrodt, Ph.D., is assistant professor of logistics at Georgia Southern University. Mary Collins Holcomb, Ph.D., is associate professor of logistics at the University of Tennessee. Comments or questions on this series can be addressed to firstname.lastname@example.org or email@example.com