Hidden Offshoring Costs

According to a post by Steve Denning at the Forbes web site, a disease has been gnawing at the economy for decades: flawed offshoring decisions. He says offshoring is not some menial matter to be left to accountants in the backroom, or high-priced consultants armed with spreadsheets, promising quick profits. It raises mission-critical issues potentially affecting the survival of entire firms, whole industries, and ultimately the economy.

The article says the decline of manufacturing in a region sets off a chain reaction. Once manufacturing is outsourced, process-engineering expertise can’t be maintained, since it depends on daily interactions with manufacturing. Without process-engineering capabilities, companies find it increasingly difficult to conduct advanced research on next-generation process technologies. Without the ability to develop such new processes, they find they can no longer develop new products. In the long term, an economy that lacks an infrastructure for advanced process engineering and manufacturing loses its ability to innovate.

Denning says these issues should be a wakeup call to every CEO whose firm or whose suppliers have been or will be involved in offshoring. Every CEO must learn the following seven lessons.

1. Use the right metrics to evaluate offshoring

In analyzing offshoring, firms must get beyond rudimentary cost calculations focused on short-term profit, such as the cost of labor or the ex-factory cost, and incorporate the total cost and risk of extended international supply chains. Denning says it can be easily done with the help of a free analytical tool at the Reshoring Initiative website that enables companies to calculate the full risks and costs of offshoring.

The Estimator tool poses a series of questions. What’s the price of the part from each of the destinations? How far is it away? How often are you going to travel to see the supplier? How much intellectual property risk is there? How long do you think you are going to make it? It uses the answers to calculate twenty-five different costs. When they are added up, that’s the Total Cost of Ownership.

Most companies tend to make their sourcing decisions based on the wage rate or the ex-works price or the landed cost, and leave out another twenty cost categories. The Estimator tool makes it easy for the company to calculate the other twenty costs.

Often firms find the offshoring price is perhaps 30 percent less than the US price, but all these other costs add up to more than 30 percent. If they are willing to recognize all of them, then they can see that it may be profitable to bring the work back.

2. Review whether earlier outsourcing decisions made sense

The author discusses Boeing’s current problems and points out they should have been anticipated based on the perilous offshoring course on which Boeing embarked.

What was Boeing thinking when they opted to embrace such extensive offshoring? “Many companies that offshored manufacturing didn’t really do the math,” according to Harry Moser, an MIT-trained engineer and founder of the Reshoring Initiative. He says a study by the consulting company, Archstone, shows that 60 percent of offshoring decisions used only rudimentary cost calculations, maybe just price or labor costs rather than something holistic like total cost. Most of the true risks and cost of offshoring were hidden.

For many companies, it’s time to redo the math, and then verify whether they still have the expertise to bring manufacturing back.

3. Don’t outsource mission-critical components

“Boeing has acknowledged, says Moser, “that its biggest problem was in outsourcing not only manufacturing but also a lot of the engineering. There were multiple tiers of outsourced companies who were supposed to be making their designs consistent so that the parts fit together. And they didn’t fit together. If Boeing had taken full responsibility for the engineering and then had jobbed the parts out and gotten them made to print, their problems would have been a lot less severe. It seems like they had this brilliant idea of outsourcing a lot of engineering with the manufacturing. There’s almost nothing as complicated as a Dreamliner.”

“For example, an iPhone isn’t nearly as complicated. The downside risk isn’t as great. Apple has succeeded with outsourcing almost everything to Foxconn, mainly because they first completely manufacture the new product in the US. They make sure it’s right, while Foxconn is working in parallel with them, developing their tooling and whatever. So Apple has a finished product and they say to Foxconn: make it just like this! What Apple has done has worked amazingly well, because they have the capability to do the perfect prototype here, before it gets offshored to Foxconn. Most companies don’t have that.”

“Thus Boeing didn’t have a finished product. So there were all kinds of risks of things not coming together. The tendency is too often for companies to try to do the engineering over here and the manufacturing over there. Eventually the innovation declines and the risk increases.”

4. Bring some manufacturing back

According to Denning’s post, when the total costs are included, around 25 percent of manufacturing that is currently outsourced could be profitably brought home, if the manufacturing expertise still exists. Looking ahead, changes in relative economics are likely to increase that percentage.

It is important to take into account rapid changes in relative costs. Oil prices are three times what they were in 2000. Natural gas in the US is a quarter of what it is in Asia. Chinese wages are five times what they were in 2000 and are expected to keep rising rapidly. And in any event, labor is a steadily decreasing percentage of the cost of manufacturing.

Moser calculates that at least 50,000 manufacturing jobs have recently been “reshored” in the last three years. When companies see that it could be profitable to bring manufacturing back, they will need to ensure that they either have or can rebuild the necessary expertise – sometimes a daunting challenge.

5. Adequately assess the risk factors of offshoring

In Boeing’s case, the article notes, it didn’t help that the outsourcing plan included skipping the detailed blueprints the company would have normally prepared, and allowing vendors to come up with their own. Delivered components arrived with instructions and notes written in Chinese, Italian, and other languages. And, they decided to build the airplane out of plastic along with other novel materials and technologies, so it would have been a big experiment even if Boeing approached manufacturing like it always had.

Clearly firms have underestimated the risk of having extended international supply chains. Moser says the Estimator tool assigns no factor values apart from freight. The user assigns all the factors. The user answers questions about the delivery time and the price. That enables the Estimator’s algorithm to assess the inventory and the inventory carrying costs. There is also a section on opportunity cost. If the firm will lose orders because it can’t deliver, then you put a value on that. There are sections on natural disaster risk and political risk. Instead of having one size fit all, the Estimator lets you adapt for each product, each market, and make a more holistic and informed decision.

6. Adequately value the role of innovation

Denning says much of the offshoring that has taken place has assumed that the outsourced items are “little do-hickeys” with low value and so didn’t really matter much in the overall scheme of things. The little do-hickeys are worth pennies or less and have next-to-no margin. While those “little do-hickeys” might seem cheap in themselves, the lessons to be learned in improving their manufacture in the end can turn out to be highly valuable. (In cost accounting and economics, which usually don’t explicitly value knowledge, this loss is invisible and so doesn’t get taken into account.)

The opportunity cost of lost innovation can be significant. Thus when GE decided to bring manufacturing of its innovative GeoSpring water heater back from the “cheap” Chinese factory to the “expensive” Kentucky factory, the cost of production went down. The material cost went down. The labor required to make it went down. The quality went up. Even the energy efficiency went up. GE wasn’t just able to hold the retail sticker to the ‘China price.’ It beat that price by nearly 20 percent.

What is only now dawning on the smart American companies, Lou Lenzi, head of design for GE appliances says, is that when you outsource the making of the products, “your whole business goes with the outsourcing.”

7. Get to the root of the problem: maximizing shareholder value

While several decades of outsourcing were under way, why didn’t these smart managers think about the importance of innovating and protecting intellectual property? Why didn’t these well-educated managers realize that it was important to have designers, engineers, and assembly-line workers talk to each other? Why didn’t these MBA graduates realize that outsourcing might be mortgaging the future of their firms?

When managers manage with a spreadsheet rather than real-world knowledge about what is actually going on in the factory and what were its possibilities, they overlook hidden costs of the erosion of skills, the loss of quality, and constraints on innovation. They also missed the potential added value to customers that could be generated by designing and manufacturing things differently. They also missed the costs and risks of an international supply chain, which is increasingly out of step with the shorter, faster product cycles.

Why did all these smart, highly educated people make all these mistakes? The root cause of these errors is a focus on the dumbest idea in the world: maximizing shareholder value. Focusing on short-term shareholder value ended up destroying vast quantities of long-term shareholder value.
A focus on maximizing shareholder value leads the firm to do things that detract from maximizing long-term shareholder value, such as offshoring, favoring cost-cutting over innovation, and pursuit of “corner cutting” and “bad profits” that destroy brand equity.

Summary

The errors of offshoring are thus not isolated events. They are the result of the underlying philosophy of shareholder value, rather than the true purpose of every firm: create value for customers. The resurrection of American manufacturing will require more than simply bringing back production to America. Global manufacturing is at the cusp of a massive transformation as the new economics of energy and labor plays out and a set of new technologies-robotics, artificial intelligence, 3D printing, and nanotechnology-are advancing rapidly.

Together these developments will spark a radical transformation of manufacturing around the world over the next decade. The winners in the rapidly changing world of manufacturing will be those firms that have mastered the agility needed to generate rapid and continuous customer-based innovation.

Success in this new world of manufacturing will require a radically different kind of management from the hierarchical bureaucracy focused on shareholder value that is now prevalent. It will require a different goal (adding value for customers), a different role for managers (enabling self-organizing teams), a different way of coordinating work (dynamic linking), different values (continuous improvement and radical transparency), and different communications (horizontal conversations). Merely shifting the locus of production is not enough. Companies need systemic change – a new management paradigm.

References

This newsletter article was edited from a post titled “The Boeing Debacle: Seven Lessons Every CEO Must Learn” by Steve Denning at the Forbes web site.

You may also want to read about the Reshoring Initiative at their web site.

You can learn about the Total Cost of Ownership Estimator, a complimentary tool provided by the Reshoring Initiative, at this web page.