Outsourcing Manufacturing – Make Sure YOU Understand the Total Costs

In the increasingly competitive global marketplace, manufacturers need to continually strive to reduce costs to keep or increase market share. This is one of the key factors in making the decision of whether to make parts in-house, outsource to domestic suppliers, or outsource offshore.

Even after a company makes the decision to outsource to a supplier, most don’t look beyond the quoted unit price in making the decision about which supplier to select. This is especially true when comparing the quotes for domestic vs. offshore suppliers. Some companies choose to outsource offshore because the price is cheaper than a domestic supplier. They don’t add in the costs for   transportation , much less all of the other “hidden costs” of dealing with an offshore supplier.

In order to make the correct decision for outsourcing, a company needs to understand the concept of “total cost of ownership” for outsourcing manufacturing.

What is “Total Cost of Ownership?” It is an estimate of the direct and indirect costs and benefits related to the purchase of any part, subassembly, assembly, or product. The Gartner Group originated the concept of (TCO) analysis several years ago, and there are a number of different methodologies and software tools for calculating the TCO for various industries, products, and services.

Total Cost of Ownership includes much more than the purchase price of the goods paid to the supplier. For the purchase the types of manufactured products we are considering, it should include all of the other costs associated with the purchase of the goods, such as:

· Geographical location

·  Transportation  alternatives

· Inventory costs and control

· Quality controls

· Reserve capacity

· Responsiveness

· Technological depth

The search for low cost areas for manufacturing isn’t something new. Fifty years ago, northern and New England companies started moving manufacturing to the southern states. Twenty-five years ago, many West Coast manufacturers started moving high-volume production to Hong Kong, Singapore, and the Philippines. The next lower cost area was Mexico with the advent of the maquiladoras in Mexico.

“Offshoring” refers to relocating one or more processes or functions to a foreign location. For the past 15 years, many manufacturers have sought to reduce costs by offshoring all or part of their manufacturing processes in China. In the last decade, outsourcing offshore has evolved from a little-used practice to a mature industry. Even conservative companies are now willing to experiment with going offshore to gain a competitive edge. The concept of globalization has become part of the fabric of today’s business.

Many times, the decision to outsource offshore is based on faulty assumptions that can have unpleasant consequences. In some cases, the basis for the decision is well intentioned, such as to win new business by being close to a customer.

But, with every business decision comes an assumption, and more often than not, the related assumptions are erroneous. Here’s a list of well intentioned but often-faulty assumptions:

· Longer lead times won’t affect our cost calculations very much.

· Overseas suppliers have the same morals and work ethics as we do.

· Overseas laws will protect our proprietary information.

· We can teach our suppliers to reach our quality needs and to build our product reliably and efficiently.

· Communication will not be an issue given daily conference calls, the Internet, and the fact that the supplier speaks English.

· Assessment and travel costs won’t change our cost calculations very much.

· The increase in delivery and quality costs won’t be significantly different than our cost calculations.

· Lean manufacturing and Six Sigma methodologies can be taught to suppliers before our company’s bottom line is affected.

In actuality, many case studies have shown that these assumptions were orders of magnitude off from reality. The problems with making these assumptions are:

· It doesn’t capture a reasonable amount of variation. Each lot takes weeks more time than anticipated to get to the U.S. or customer site for evaluation.

· The overlying methods for producing product or service have gotten more complex, not less. In general, costs rise with complexity.

· The company doesn’t know how many or even most of the hidden costs that exist (i.e., process stability, process capability over time, potential for future deviations from the current process).

· The company loses complete control of quick changes to react to hidden costs. It’s like trying to control production via remote control.

· The company is making wrong assumptions.

Hidden Costs Grow Geometrically

Accountants deal with hard costs such as material costs, material overhead costs, labor costs, labor overhead costs, quality costs, outside services, sales, general and accounting costs, profits, etc. What they don’t measure are the intangible costs associated with business such as the true costs of delay, defects, and deviations from standard or expected processes (the three D’s).

These costs are often called hidden factories because they keep everyone busy generating absolutely nothing of any tangible or openly measured value. Another way to understand these costs is that they produce results that no one, especially the customer would want to pay for. In addition to obvious direct costs – such as additional meetings, travel, and engineering time – hidden factories also indirectly produce many forms of “soft” costs, such as loss of good will, loss of competitiveness, extended warranty costs, and legal costs.

When it comes to outsourcing, there’s more to consider than the quoted price. Some outsourcing costs are less visible – or downright hidden. Here are the top hidden costs of outsourcing offshore:

· Currency Fluctuations – last year’s invoice of $100,000 could be $140,000 today.

· Lack of Managing an Offshore Contract – underestimating the people, process, and technology required to manage an outsourcing contract.

· Design changes – language barriers make it difficult to get design changes understood and implemented

· Quality problems – substitution of lower grade or different materials than specified is a common problem

· Legal liabilities – offshore vendors refuse to participate in product warranties or guarantees

· Travel Expenses – one or more visits to an offshore vendor can dissipate cost savings

· Cost of Transition – overlooking the time and effort required to do things in a new way. It takes from three months to a year to complete the transition to an offshore vendor.

· Poor Communication – communication is extremely complex and burdensome.

· Intellectual Property – foreign companies, particularly Chinese, are notorious for infringing on IP rights without legal recourse for American companies

In the past, my experience was that once manufacturing moved out of the United States, it rarely came back. However, in the past two years, we have seeing more companies coming back from doing business in China. The main problems these companies encountered were:

· Substitution of materials

· Inconsistent quality

· Stretched out deliveries

· Communication problems

· Inability to modify designs easily and rapidly

· Unfavorable purchase order and credit terms

Quality/Substitution of Materials:

In late 2007, SeaBotix Inc., a San Diego-based manufacturer of miniature underwater vehicles, told me that their Chinese molder was substituting 10 percent glass-filled ABS (a plastic material used in injection molding) for the specified 30 percent glass-filled ABS. The vendor claimed that the parts were made in the specified material, but an independent lab test confirmed that they weren’t. The 10 percent glass-filled material caused the parts to shrink more in molding so that the parts were smaller, didn’t fit mating parts properly, and were not as strong. After their Chinese vendor refused to take the parts back or give credit for the defective parts, SeaBotix decided to bring their tools back to the United States and sourced them at a molder in southern California.

Don Rodocker, president, SeaBotix, said, “The Chinese tooling was one-third the cost of tooling in the U. S., the delivery was one-third the time quoted by U. S. companies, and the piece part price was one-third the quoted U. S. price, but each time we reordered the parts, the Chinese molder increased the price until they were three times the price we could get the parts molded for in San Diego. We would probably go to a Chinese toolmaker in the future for the molds, but would bring the molds back to the States to be run.”

Cost of Inventory

In 2002, Vaniman Manufacturing, which makes dental equipment in Fallbrook, California, shifted most of their sheet metal fabrication offshore to China to save money (a 50 percent cost reduction in piece price). However, they were required to purchase significantly larger lots of parts resulting in a higher cost for the larger inventory. In turn, the larger inventory required more storage space. In addition,  transportation  costs for shipping from overseas were higher. These additional costs and other “soft” costs, such as travel expenses to visit vendors and communication costs, make up what are referred to as the Total Cost of Ownership.

After realizing that these additional costs were eating up the cost savings in the piece pricing, this company brought their sheet metal back to a local supplier in the fourth quarter of 2007. Don Vaniman, who heads the company, cited several reasons for his move: shipping delays, security hassles, and poor quality control. “If you order a thousand widgets in four shipments, three shipments might be all right, but the fourth might be totally wrong.” Vaniman said, “In the U.S., a supplier would jump through hoops to fix that kind of problem, but in China, it could take six months to work out the details.”

Vaniman said that the local supplier was able to nearly match the Chinese costs by developing more efficient and creative production techniques, using recyclable packaging for parts delivery, and utilizing larger lot sizes, delivered on a just-in-time schedule. Vaniman was able to significantly reduce their inventory and the space required for inventory, due to smaller lot sizes being delivered just in time.

In addition, rising costs in China erased much of the price gap. Vaniman said that six years ago, the cost of producing its parts in the U.S. was as much as 50 percent higher than in China. Now it’s only five percent higher – a premium that he’s happy to pay.

These stories from San Diego County are just a microcosm of what’s happening nationwide.

Intellectual Property Theft

There is increasing wariness by upper management of companies regarding sourcing in China, especially with regard to sourcing all the component parts and/or subassemblies for a product because China doesn’t honor U.S. patents. They have heard about companies that have sourced a product in China only to have a product identical to theirs appear on the market, made by a Chinese company at a much lower price. Companies that haven’t paid attention to this danger and sourced their whole product in China have suffered the consequences.

There’s also a growing realization that when it comes to quality and location, location may be the best guarantee of all. It’s hard, very hard, to outsource quality, particularly to a distant land many miles and time zones away. Many companies are returning their call centers to the U.S. because of customer complaints, and I believe that a growing number of manufacturers will realize that “you get what you pay for” from their offshore suppliers. Applying good quality principles takes money, education, and experience, many of which are in short supply in the low-wage countries capturing the majority of offshoring dollars these days.

“Made-in-China” Becoming Undesirable:

As toys, electronics, pharmaceuticals, and other goods manufactured in China have been and are being recalled month after month due to contamination, inferior and/or poisonous materials, the loss of consumer confidence in all China-made products is serving as a wake-up call to every company sourcing in China. Tainted, defective, and poor-quality products have made many consumers leery of buying goods produced in China and have awakened people to the seriousness of the offshore manufacturing issue.

Advantages of Sourcing Domestically

More and more companies are realizing that there are worthwhile advantages to sourcing in the United States. The main ones are:

· Ease of communication – same language

· Same or close time zone

· Flexible delivery – Just-in-time or Kan Ban

· Rapid turnaround for tooling or prototypes

· Many reliable choices for  transportation 

· Smoother design changes – easier to make changes understood and more willingness to make changes

· Lower cost of inventory from lower minimum buys

· Consistent higher quality – materials and dimensions match specifications

· Lower Travel Expenses

· No Intellectual Property Infringement

· More favorable Purchase Order and Credit Terms

“Outsourcing Offshore” will Continue

There is no question that “outsourcing offshore” will continue for the next ten to twenty years, especially for the multinational countries that have products to sell within the countries in which they set up manufacturing operations. In fact, manufacturing products locally for consumption within a foreign country will be crucial to profitability as  transportation  costs continue to increase.

The “desirable” locations for cheaper outsourcing will change over time just as they have in the past fifty years. The purely financial benefits of lower pricing will erode over time. The challenge for America is to keep as many companies as possible growing and prospering within the United States. A correct understanding of the True Cost of Ownership for outsourcing manufacturing will help bring back and maintain more manufacturing in the United States.

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