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The True Costs of Offshoring
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This Week's Supply Chain by the Numbers - Starbucks Goes Lean, Baxter Reduces CO2, Falling Parcel Volumes, Iron Ore Prices


Last week brought mixed results for Wall Street investors.  Our Supply Chain and Logistics stock index was evenly split.

In the software group, Ariba fell 6.9% on the heels of the release of their FY 2009 Q3 results report, while SAP was up 4.7%.  In the hardware group, both Intermec and Zebra lost a bit of ground (down 5.1% and 2.2%, respectively).  In the transportation and logistics group, Yellow Roadway fell another 12.5% following the report of a substantial 2nd quarter loss, while Canadian National climbed 6.2%.

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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 calledCan - 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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Very apropos to today’s First Thoughts column, we are printing a number of letters this week from our earlier piece on Can - and Should - US Manufacturing Be Saved? That includes our feedback of the Week from Dr. Arnold Maltz at Arizona State University, who wonders how far a pure services economy can really go.


You will find that letter and several others on this topic below, plus a hold over from last week on the supply chain of the future.

Feedback of the Week – On Should Western Manufacturing be Saved?

This issue has been front and center in my classes for some time, since some 40% of our supply chain students are non-U. S., but most of them want to stay in the U. S.  My strong preference would be to preserve and grow U. S. manufacturing, but:

I certainly agree that, in many industries, the final assembly and the supply base are long gone. Hence, bringing that “back” is going to be very difficult, no matter what.  So, if we want those products, and logistics costs go up, we will be paying more either way.  Most likely, given our demographics and apparently problematic educational system, plus the expectation of “office” work for most kids - the stuff stays overseas.  Maybe the supply chain planning and control stays here, maybe not (note that IBM’s Purchasing VP moved to China some time ago).  As an aside, the reason Mexico has not done even better in many areas is that the supply base there has not progressed enough to take on some of the manufacturing that would benefit from “near shoring.”

The even longer term question is whether a relatively pure “service” economy can continue to produce enough value to pay for the physical goods its citizens need and want.  If so, then everything is fine, although I personally expect some downward pressure on living standards (i.e., how much stuff we buy).  If the services we produce are not valuable enough to physical supply-oriented nations, then we will see adjustment, presumably via exchange rates, and a real drop in the “stuff” standard of living.

Finally, I would note that the U. S. is no longer seen as a key growth market by many companies, so we may be late to the party for innovative products and even services as the focus shifts to the Asian and South American growth areas.


As for security, our defense contractors are already looking several levels down in their bills of material to see what is no longer available at virtually any price from U. S. suppliers.  We need to stay tuned on that one.

This is a discussion I hope will continue.  I’d like to hear what everybody has to say.

Arnold Maltz
Arizona State University

More On Should Western Manufacturing Be Saved?:


Isn’t this a trend that’s been going on for quite a while? Auto manufacturing was out-sourcing to lower cost models in the 60s to Japan until their wages pretty much caught up with domestic wages and those manufacturers on-shored to the US? Most of the low-skill manufacturing jobs have been automated or off-shored, but many high-skill, hands-on jobs are still retained here. 


We saw a lot of manufacturing shift to Japan until they got too expensive, then China - where that same trend is occurring. As those economies get better and achieve parity, you’re likely to see more shifts back and forth.  BTW, in the 70s, the Defense Industrial Base was a hot topic as manufacturers and defense contractors consolidated, so this is nothing new and DOD continues to monitor their contractors. In regard to machines needing repair, once there’s enough need and enough money, you’ll see that expertise be re-created again. It all comes down to demand and what you’re willing to pay. Just as water seeks its own level, so will manufacturing, and don’t be surprised when economic parity starts pushing the level up.


Rob Williams

Think of our nation as a household with exports as income and imports as consumption.  Right, we're consuming more than we earn and funding the difference through debt. In the long term, this is unsustainable.  We have far superior productivity, but it's still impossible (in most cases) to compete with the low wages and the lack of worker and environmental protections in many other countries. We can compete more effectively by lowering wages and protections. That's a race to the bottom we don't want participate in.  The only practical solution is tariffs to help equalize costs.


Tom Kilianski

Channel Account Manager - OH/KY/MI/IN

I believe most businesses in the US are optimizing their short-term profit at the expense and future of the overall US economy. If you don't pay someone in your local economy to fix your car, then the guy who fixes cars cannot contribute as much to the local economy. It's an economic reality that if money doesn't circulate in your local economy, then your overall local economy will shrink.


The other concerning issue, as was mentioned in the article, capital is not invested in businesses with shrinking revenues. And, a lot of US companies have a lot of debt on their balance sheets. So, the ability to expand manufacturing is most likely going to happen in manufacturing economies that are growing and not US-based companies.


And, by losing talent and opportunities at the actual execution level of the supply chain, the US tends to push people toward higher education. This means that people will be managing supply chains and making decisions that really don't know how things are executed at the bottom. They will literally build and manage less competitive supply chains.  Isn't that what happened to the US automotive industry?

Alonzo Bright


On The Supply Chain of the Future:


UTi Worldwide Group has been working on the supply chain of the future and basically on the trends that will change the supply chain practices and landscape in the next 5 to 10 years. No secrets, though, neither fantastic stories about super advanced technology, but at least a good thought process based on the IBM study you mentioned. We also used a PRTM study and other material from AMR Research as input, together with internal and external meetings with UTi’s and our clients’ executives. Here are the main 8 trends we found that would make significant impact on future supply chains:

  • Flexibility & Agility to Sense & Respond to Changing Environments
  • Focus on Value Networks
  • Integrated Supply Chain View oo Improve Predictability & Reliability
  • Inventory Optimization to Free Working Capital
  • Customer Centricity to Gain Market Share
  • Sustainability as Strategic Differentiator
  • Leverage Growth from Developing Markets
  • Rebalance Supply and Demand
  • Supply Chains as Shock Absorbers


Our study is summarized in a deck explaining these trends. Just wanted to double check with you if you see any alignment of this with your analysis and, of course, we are really interested on what comes out from your research and the final product you will present at the conference.


Eduardo Vargas


Q. US truck "vehicle miles travelled' is estimated to double about every how many years?

24. Lane mile highway constuction, however, is on pace to double only every 370 years. Now you know why there is congestion...