First Thoughts
  By Dan Gilmore - Editor-in-Chief  
  August 6, 2009  
  Supply Chain News: The True Costs of Offshoring  

Of late, I have taken a real interest in the subject of offshore manufacturing, the role of manufacturing in a national economy, and what policies, if any, should be pursued to impact how much manufacturing should be done in the US.

It started with a column I wrote a little while back called “Can - and Should - US Manufacturing Be Saved?," which generated quite a bit of reader Feedback. If you saw SCDigest’s On-Target e-magazine this week, you may also have read our story on a new report from the Milken Institute concerning the deteriorating state of manufacturing in California, not just in absolute terms with the recession and offshoring, but also on a relative basis among seven peer states that are gaining share of manufacturing output and employment at the Golden State’s expense. That report, in part, emphasized the vital role manufacturing plays in a state’s economy.

The whole question is fascinating to me because it not only obviously impacts supply chain strategy, but perhaps the economic and competitive fate of a nation. I am intrigued by the debate between those who say the natural progression of economic advancement is to shed manufacturing work, and a growing group of what are being called “manufacturing fundamentalists” who argue that the decline in manufacturing in the US or other Western countries isn’t inevitable and must be reversed to retain a country’s economic power.

More on all this over time.

Gilmore Says:

The real and often hidden costs of Asian outsourcing, Stalk says, are the long lead times.

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A couple months back, I had the pleasure of presenting at a Toronto CSCMP roundtable event, along with George Stalk, a well-known consultant from Boston Consulting Group, who among other accomplishments is the co-author of the book Competing Against Time, an excellent work I read many years ago. What’s interesting is that the principles in that book from the 1980s are as relevant today as ever – and actually impact the onshore/offshore discussion.


One of Stalks’s intriguing points: that many companies, especially those with high gross margin products, will have an “advantaged” supply chain if they move production back much nearer to the US from Asia.


This isn’t a new idea – we have covered some thoughts by Dr. David-Simchi-Levi and others before – but Stalk has some unique insights on this and done some excellent work to quantify the analysis.


It started in part, Stalk says, with $140 per barrel oil last summer, which caused many companies to relook at current or potential Asian offshore strategies.


But logistics cost increases can only have so much impact, because the cost to ship most goods by ocean simply is usually a small percent of the final retail sell price – with a curve hovering somewhere around 1%. For example, a DVD player that retails for $150 might cost $1.50 to ship via ocean to the US from China or Taiwan. That percent will obviously vary depending on the weight-to-value ratio of the product, but most goods come in somewhere near that point. It takes a dramatic increase in international logistics costs to make a meaningful impact on total cost of goods sold – though Stalk does agree that, at the time, soaring fuel costs began to “put a crack in the China sourcing strategies of many companies.”


But, the real and often hidden costs of Asian outsourcing, Stalk says, are the long lead times - inventory out-of-stocks and overstocks that naturally result, especially for products with highly variable demand – and who isn’t seeing an increase in demand variability these days?


A major challenge, of course, is actually assigning a cost to these inventory problems, which is a discipline very few companies have really yet mastered.


“A number of retailers and manufacturers – but by no means all - are well accounting for the cost of overstocks, but out-of-stocks are much harder, because it assumes you can actually calculate what demand would have been,” Stalk told me in a later conversation. He noted, however, that there are several techniques to get close to the real number by simulating demand.


The bottom line: for many types of companies, when those costs are factored in, Asian sourcing actually becomes the high cost option – and gives advantage to companies that source closer to home, often Mexico, but potentially even in the US itself.


Again, the products most sensitive to these costs are products with high gross margins (i.e., the cost of out-of-stocks is very high) and highly variable demand (i.e., out of stocks and overstocks more likely), though Stalk says even some products with lower gross margins and volatility can also benefit from such a rethinking of sourcing strategies.


For example, Stalk said he was working with a disk drive manufacturer – a product category that is certainly not high margin  – which had been making sourcing decisions more focused on cost instead of time, leading of course to Asia. But finally recognizing the inventory costs that resulted, the company has moved many manufacturing operations back to the Caribbean.


Something like t-shirts is at the other end of the spectrum – low margin, fairly steady demand. That’s clearly a category that should stay in Asia – or is it? American Apparel seems to be doing pretty well continuing to manufacture t-shirts and other apparel products in Los Angeles. At minimum, Stalk says more companies should look at air freighting product from Asia, rather than using ocean carriers. In fact, he says that Victor Fung of Li & Fung, the largest Asian sourcing firm in the world, argues the point that virtually all apparel products should go by air from Asia to the US or Europe to better synch inventory with demand – and Fung is someone who ought to know.


Clearly, there are often supply chain issues with many “near-shoring” locations (e.g., Mexico, the Caribbean), though Stalk is very bullish on Eastern Europe to support European distribution. Stalk says for domestic sourcing, it has more often, to date, been one of changing plans and maintaining US production, rather than actually moving it back.


“We’ve had more examples of companies not going, or scaling back planned moves, than actually returning manufacturing to the US,” Stalk says. But a lot more companies might make different sourcing and network decisions if they really understood the true total supply chain costs and the value of speed and flexibility.


“You have to be willing to pay more money in some supply chain steps to reduce total supply chain costs, and of course that’s where it breaks down in many companies, because some functions have to absorb those costs,” Stalk says. “It often really takes CEO leadership to cut through all that, and many CEOs of course don’t understand it.”


The bottom line, it seems to me, is that if you are moving rapidly down the path of moving to Asia to reduce costs, it’s worth perhaps taking a different look. While most everyone these days understands the need to calculate “total landed costs,” how well do most really do that – and how are the costs relative to overstocks and out-of-stocks really calculated? I have seen very few models for that. In fact, as we’ve noted before, when Dr. Don Ratcliff of Georgia Tech attempted to set up a database service relative to lead time variability, the project was largely thwarted because no one really had the data.


Finally, somewhat relevant to the discussion we had with Mark Holifield of Home Depot, Stalk says, “If you give me two merchants, one led by great merchants and mediocre supply chain talent, and another led my OK merchants and great supply chain people, the second one will always beat the first over time.”


That's some good news from those of us making our living in the supply chain.


Do you agree with Stalk’s perspective? Do companies well calculate the true cost of Asian sourcing, especially around inventory? Do more companies need to factor in the value speed and flexibility and the cost of inventory mistakes before making those decisions? Let us know your thoughts at the Feedback button below.

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