By Brian J. Hogan
There's an old pop song that includes the lines:
"Those faraway places with their strange-sounding names, are calling, calling, me."
These days, quite a few manufacturing engineers and managers are very aware of the call of faraway places. It seems that you can build everything from aircraft to plastic buckets in Asia using skilled labor that costs less per day than lunch at a fast-food joint.
Everyone has heard about the benefits of manufacturing in countries that have low-cost labor. What about the other side of the coin? What are the costs, and the risks, of going offshore?
First, let's make clear what's under discussion. Outsourcing isn't offshoring. If you decide to hire a landscaping company to take care of the grounds around your plant, instead of maintaining an in-house crew for that job, you are outsourcing. If you have a contractor handle your payroll, instead of paying someone on-staff to do it, that's outsourcing. When Toyota builds a plant in Indiana to produce light trucks for the US market, or Ford puts money into its Jaguar operations in the UK, that's neither outsourcing nor offshoring. Offshoring means buying from a vendor in a low-labor-cost country instead of a vendor in the US or some other high-wage country, or establishing a manufacturing operation in a low-labor-cost country that replaces a facility you were running in the US or another high-wage country.
The hot low-cost country of the moment, of course, is China. A recent study authored by Nicholas P. Dewhurst, executive vice president of Boothroyd Dewhurst Inc. (Wakefield, RI) and David G. Meeker, consultant, Neoteric Product Development (Acton, MA), looks at the hidden costs of going to China. They make the point that there's more to be considered than the cost of hourly labor when making this decision. (A similar analysis can be applied to other low-cost countries.) According to the authors, the most dangerous part of this trend is that offshoring is often done with little or no understanding of its true costs.
What follows are some extensive, lightly edited excerpts from their report, which is entitled Improved Process Design Practices Would Make US Manufacturing More Cost Effective.
If you take a careful look and calculate the total cost of offshore outsourcing, the answer may be surprising. Oftentimes the cost benefits are calculated solely on the basis of the incredibly low labor cost. Other costs, both tangible and intangible, are rarely taken into consideration, because they are not allocated to the actual product but are paid for from various other budgets.
Labor rates for mainland China are not easy to pin down. They vary widely from region to region and for urban and rural workers. Rates may range from as little as $0.33/hr to $3 or $4/hr. China has many laws governing the treatment of workers, such as minimum-wage laws and laws governing overtime and overtime pay. As a matter of practice, however, these laws are ignored. US manufacturers should understand that their outsourcing contracts may not accurately represent actual working conditions in China.
The news is filled with stories of US manufacturing jobs outsourced to low-wage countries. Many companies are lured by tales of low labor cost and decide to transition their products to China, only to find the initially estimated savings were never realized. Before deciding to source overseas, a firm should analyze the total cost of offshore manufacturing.
Beyond the cost of production, one of the biggest costs is shipping to and from Asia. A firm can ship either by air or by sea. Most products shipped by sea are packed into cargo containers. These containers are loaded onto ships and spend approximately three weeks on the high seas before arriving at port. Regardless of how full the container is, the cost remains the same. The trick is to pack the container as full as possible in order to lower the cost per unit for shipping.
Container cost averages approximately $2600 for shipping and duty. This figure excludes the cost of transport to and from the port in China, and to customers or distributors within the US. The additional cost of these two land transports often equals the cost of shipping the product by sea. Proper analysis should include an estimate for the cost of inventory carry while in transit.
From land shipping in China through land ship in the US and unload, the entire process can take 4 to 6 weeks. Unexpected delays, such as the West Coast dock strike of 2002, can increase this time considerably. Issues involving Homeland Security affect shipping schedules, and these costs continue to unfold. Another important issue that many manufacturers encounter is discovering too late that the product, once it's on the ocean, has to be reworked. Products can't just be shipped back. In addition, a number of fees must be paid upon leaving and entering ports, depending on the port of origin and arrival.
Another cost not routinely recognized is that many Asian companies demand payment when the door on the container closes. The US firm then carries four weeks of inventory that it cannot sell. The firm must also insure the cargo against loss. Every year approximately 10,000 containers fall overboard.
About 90% of world trade moves by ship. With that much traffic, there is a serious risk of collision. In 2003, there were 445 attacks on commercial ships by pirates. Many attacks go unreported because shipping companies don't want their insurance rates to rise.
Firms may also ship a product by air. Products with small footprints that are lightweight can be shipped by air cost effectively. For these packages, costs range from $2 to $2.50/lb. Products packaged in large corrugated boxes, however, are expensive to ship by air, and the number that an airplane can carry is limited. Shipping by sea remains the most viable method for transit. Shipping and logistics add 17% to the product's cost.
Travel to Asia is difficult. The 20+ hours of travel is tiring, so representatives of US companies tend to maximize their stay and accomplish as much as possible while there. The average stay is a week to ten days. Typically, starting a relationship with a vendor and launching a product requires at least three trips to Asia. Most companies allow business-class travel for such long trips. Maintaining the relationship requires frequent in-person contact. We estimate that as much as 1% is added to product cost as a result of travel communication and lost time.
There are many ways to start manufacturing in China, such as working with a US third party who runs a factory for you, entering a joint relationship with a supplier, or selecting a vendor to manufacture your product. Vendor selection is the most critical step in your outsourcing plans, and takes a lot of time and effort. A high degree of due diligence is required to make sure the company that you select can do the manufacturing job. Multiple RFQs must be sent to several vendors and their responses evaluated. These costs can run from 0.2 - 2% of product cost.
Your product's manufacturing quality requires constant vigilance. Because payment is often based on the number of units completed, any unit finished is a good unit. Our experience is that these quality defects can run between 1 - 8% of product cost. In our later analysis, we assumed an average impact of poor quality cost of 4%.
When compared to other costs associated with outsourcing, material costs overseas generally are not significantly different than here in the US. Certain types of materials are not available in overseas markets, however, and must be exported from the US to the offshore supplier to produce the parts. It's imperative to recognize the source of all materials, and any extra export costs, before beginning offshore manufacture.
A full analysis measures opportunity costs and side effects from a proposed project. In addition to the costs we've identified above, a number of others exist. Naturally, costs depend upon the product and industry structure. The list below details a few but is not all-inclusive:
- Legal Issues
- Cost of additional paperwork
- Cost of employee morale
- Cultural/communication difficulties
- Training costs
- Underestimation of startup costs
- Increasing labor costs once a vendor relationship is established
- Cost of transition
- Cost of layoffs and severance.
Manufacturing in China prevents the use of just-in-time inventory methods, and runs counter to lean manufacturing. Because of the long shipping times, schedules are rigid and companies are less able to respond to changes in market demand.
Upper and lower bounds should be placed upon any cost estimates for producing in Asia. These should include some allowance for catastrophic events such as shipping accidents. In addition, the health environment of China, in particular, has economic costs. The first outbreak of SARS occurred in China, and its impact on southern China's economy was significant. The more recent outbreak of the bird flu has also had some impact, although not to the extent of SARS. Currently companies are beginning to quantify the cost of employees quarantined after trips to Asia.
If outsourcing to China should fail, and this has happened, the cost associated with bringing a project back to the US is high. Typically, products that are outsourced do not have best-in-class design. Cheaper manufacturing rates make it possible to take a poor design and make it economically manufacturable. But how can such a product now be brought back to the US and produced competitively? The design must be reworked from scratch, reducing parts and materials to compensate for higher labor rates.
Conservatively, this final category of miscellaneous costs of outsourcing to Asia adds 1% to the product cost. We believe the actual figure could be much higher, given that every product has a unique set of external costs. We underestimate the costs involved for the purpose of presenting our argument. The likelihood that the real costs will be higher makes the argument more compelling. Together the aforementioned costs, both tangible and intangible, sum to 24% of total product cost (see Table 2).
Cliff Waldman, an economist, works for Manufacturer's Alliance/MAPI (Arlington, VA). He points out that "China's labor costs are no longer the cheapest in the world. Other costs, such as land and raw materials are cheaper. But is labor cheaper on a skill-adjusted basis than in the US? Yes."
He observes that no firm will move production to China to gain only a small advantage. "At what point do you move [i.e. decide to offshore in China]? There's no survey data, but a differential of 25 - 30% seems to make sense for most companies. The US doesn't build plants in China that often. For US companies, it's overwhelmingly a subcontracting operation."
Aside from the economic costs, there are other risks to consider in lower-wage countries, particularly in China. "Political risk exists," remarks Waldman. "The Chinese situation is iffy. There can be social issues if the economy of China slows. There are significant health issues. AIDS is going to be an explosive issue in China. Legal issues exist in China--laws are on the books, but enforcement is very lax. Also, China has an aging population, and the working age group is decreasing in size. Bets on China are long-term bets and must be considered as such.
"India, another offshoring candidate, has a disastrous legal system," observes Waldman. "And in India there's a weather risk. About 60% of the population depends upon agriculture. The monsoons have been inadequate, and agricultural problems produce a big impact on India."
The automotive industry in China is the subject of The Rush to China, a report prepared by the Global Automotive Center of Ernst & Young LLP (Troy, MI). This document points out some of the pitfalls that await the unwary in that country. Observations in the report also apply to companies outside the automotive industry.
According to The Rush to China, access to a potential vendor or partner's financial information, for example, is limited, and the integrity of financial statements can be poor. Investors or would-be partners need to determine the integrity of financial statements.
To illustrate how Chinese accounting systems work, the Ernst & Young report explains that if a customer has a balance of $1000 outstanding, including $1 less than 30 days old and $999 that's more than three years old, many Chinese companies will report the balance as less than 30 days old. In many Chinese firms, revenue is based on invoice dates rather than product-acceptance or service-delivery dates. To determine a potential partner or vendor's liquidity, US companies need to understand the Chinese firm's revenue-recognition practices. Financial experience in Chinese industry is a must, according to Ernst & Young.
When intellectual property (IP) is involved, great care needs to be taken. According to The Rush to China, foreign companies operating in China need to protect their IP, and anticipate that their worst fears may be realized. You must be cautious and attentive to the process of registering your IP, especially how and where it's registered. Also, remember that even if your IP is well protected in China, it may surface somewhere else--perhaps India or Russia. Chinese companies deal with partners around the world. Take only the minimum IP to China that you truly need.
On the whole, the risks of offshoring are not emphasized in most media. There are business reasons for offshoring production to China, but not all products are suitable for that approach.
Dewhurst and Meeker point out that some products are just not a good fit for offshore manufacturing. Here's an excerpted and lightly edited checklist from their report of the types of products they believe are not suitable for offshoring:
- Products manufactured in the US or other high-wage countries using a highly automated process may not show significant cost savings when produced overseas.
- Product weight and size can affect offshore manufacturing.
- Products that require scheduling flexibility are poor candidates.
- With newly developed products that undergo many engineering change orders and revisions, quality issues may arise. Also, inventory on the water may need to be reworked when it arrives.
- By offshoring, firms with products protected by patents risk losing proprietary information.
- Firms that use expensive production equipment will find depreciation is the same worldwide.
Dewhurst and Meeker say that cost-benefit analysis sometimes shows a compelling case for keeping manufacturing jobs in the US. This conclusion rests on two fundamental assumptions that companies may have overlooked:
- It's possible to redesign products to reduce part count and cost and
- It's necessary to account for all the additional costs associated with offshore manufacturing and to apply those additional costs to the product.
"Much study is still needed to determine the comparative benefits of offshoring the manufacture of products to China versus redesigning products and manufacturing them here. Good thinking on this topic will cross over and integrate disciplines such as product design, industrial and manufacturing engineering, procurement, operations management, product costing, and corporate finance and accounting," say Dewhurst and Meeker.