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Copyright 2008 © The Manufacturing Optimization Group; all rights reserved.
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Outsourcing – Panacea, Dirty Word, or Viable Option?
By James Shearer
Outsourcing – a controversial word and one increasingly in the news. The very
mention of the word can cause an emotional response. On one end of the spectrum,
the emotions can elicit a very strong belief in the right for any business to
behave in its own enlightened self-interest. On the other end there can be
equally strong beliefs that exporting jobs and technology may not be in the best
interest of our country, our economy, or perhaps even our value system.
Although “services” or components can be outsourced, for the purposes of this
article, the focus is on manufactured “finished goods” and also on outsourcing a
significant portion of current or anticipated future production. (To outsource
half a dozen minor products of relatively insignificant impact on the overall
organization is more of a routine, tactical decision than a strategic,
operational decision.)
There are numerous reasons or conditions that would cause a manufacturer to
consider outsourcing. However, they all have one simple thing in common – a need
or desire to reduce costs. Listed below are some of the reasons or conditions
that might drive a decision to outsource.
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The right to survive in today’s marketplace. Survival is a
worthwhile objective!
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The legitimate right for any company to improve its financial
performance by lowering its operating costs and improving its bottom line,
regardless of how profitable it may or may not be.
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The urgent need for a distressed company to quickly reverse
unacceptable financial performance.
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The opportunity for a company to achieve strategic cost advantages.
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To counter one or more direct competitors that may already be
outsourcing.
Regardless of the driver, today’s increasingly competitive global marketplace
puts constant, unrelenting pressure on manufacturers to produce their goods ever
more quickly and far more cost-efficiently. Any manufacturer who wants to
survive and prosper must become, if not “the low cost producer,” at least
“a low cost producer.” To not respond to this market-driven, economic
reality is to invite disaster.
When considering outsourcing, the analysis and decision process must be as
unique as the individual business making the decision. There is no simple
checklist to use in making the decision, and the owner, general manager, or
management team must conduct a very thorough, in-depth and objective analysis of
the pros and cons of the decision. The analysis should appropriately include
strategic implications, organizational implications, economics, logistics,
corporate values, the impacts (both positive and negative) on the business’s
stakeholders, and the actual implementation approach that might be used.
One way to put all the relevant information and data (which may be
conflicting in nature) into perspective is to construct a simple balance sheet.
The balance sheet would list each area being analyzed and, for each area, two
columns – one for pros and one for cons. When completed, the analysis will lead
to an informed, fact-based, objective decision, and one that will have a much
higher likelihood of producing the desired results. Let’s evaluate some of the
areas and considerations in the decision process.
Strategic Implications
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Is outsourcing consistent with the stated mission and vision of the
company?
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Is it in alignment with or in conflict with existing business
strategies?
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Faced with the possibility of very low cost offshore production,
should the strategies, mission, and vision be re-evaluated and fine-tuned or
even changed entirely?
Organizational Implications
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If a decision is made to proceed with outsourcing on some
significant scale, what will the new organizational model need to look like to
properly support the new manufacturing approach? What costs will remain and
what new costs may be added?
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What are the impacts on the existing organization? Will new
reporting relationships need to be established? Will new talents and
capabilities be required? Can existing staff be retrained or will
new/additional staff need to be added?
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There are organizational fears or concerns that could cause US-based
manufacturing companies to have a natural reluctance to outsource. These might
include:
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“We don’t know how”
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“We haven’t done it”
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“Failures we’ve heard about…”
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Fear of loss of direct control over manufacturing
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Fear of loss of manufacturing flexibility
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The concern that a specific item is simply too critical to risk
outsourcing it
(Although these fears or concerns may be legitimate, each one, if thoroughly
evaluated and analyzed, can be overcome by proper, detailed planning, including
well-thought-out contingencies.)
Economics
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First and foremost, the most common reason for outsourcing is
economic, specifically greatly reduced direct labor and overhead costs.
Although there can be exceptions, the reality is that it typically costs far
less to produce most manufactured items in countries with much lower labor and
overhead costs.
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If direct labor wages in the USA are, for example, $15.00/hour and
they are $2.00/hour in Mexico, less than $1.00/hour in India, and less than
$0.50/hour in China, there is obviously a strong financial incentive to
consider offshore production, especially in high-labor-content goods.
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There are frequently very similar if not even more savings in
offshore overhead costs. These overhead costs may include:
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Land costs (typically by lease)
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Plant / facility / office construction or lease costs
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Machinery and equipment
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Utilities
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Supervisory / management / staff salaries
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Healthcare
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Workers’ compensation
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General liability
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OSHA compliance
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Environmental compliance
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Reduced likelihood of litigation. (And the list goes on!)
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Detailed and accurate analysis of manufacturing costs, utilizing
low labor cost factories with the associated low overhead available to those
factories, needs to be undertaken.
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Firm, stable, and well-understood quotes need to be obtained
from one or more reliable offshore factories.
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At least one, and ideally several, visits should be made to
ensure the factory has been properly and thoroughly evaluated for its
ability to consistently perform the needed manufacturing tasks and
functions. (Well-constructed, well-lit, highly productive, and very
well-managed offshore factories, some with ISO 9000 series quality
certifications, do exist. On the other hand, a dirt floor, lean-to factory
in a remote village in SE Asia is probably not in your best interest!)
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Assuming the outsourcing approach ultimately leads to a significant
percentage of offshore sourcing, a new business model will need to be
developed to optimize performance under these new global logistical
strategies. An extensive, detailed analysis of this resulting business model
must be undertaken to identify and quantify all of the overheads costs that
will remain. These costs may include different staffing levels, unused
stateside plant and equipment capacity, new logistical requirements, new IT
and communications requirements, and any number of other overhead costs that
will remain or result from the new outsourcing strategy.
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If the offshore factory is located in Mexico, the logistics pipeline
(physical distance) may not be appreciably extended beyond stateside
manufacturing. If that is the case, additional on-hand stateside finished
goods inventory may not be required to ensure that adequate response time to
varying market demand is maintained. However, if the factory is located in
India or China, for example, the company must at least consider increasing
on-hand stateside warehouse stock levels of finished goods to compensate for
the extended pipeline. Since this extended pipeline can easily add several
weeks or possibly even months to transportation time, the carrying costs of
the additional on-hand inventory necessary to cover this inevitable delay must
be considered as a cost offset. (Although emergency air shipments of goods
manufactured offshore can help reduce the transportation delays, if the
products are of any reasonable size, air freight is extremely expensive and
will still have customs delays of from a few days to over a week.)
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Total delivered cost must be the basis of any product cost
comparisons. Total delivered cost is manufactured cost plus all other costs
associated with getting a product on the company’s warehouse shelves. These
additional costs must be factored into the analysis for it to be meaningful.
For example, let’s assume that a product manufactured in a company’s own
stateside factory has a manufactured cost of $2.00. If the factory is adjacent
to the warehouse, the manufactured cost will equal the total delivered cost,
in this case $2.00. However, if a company procures an equivalent product
offshore for $1.80, F.O.B. foreign factory, additional costs including ocean
freight, inland freight, customs/duties, insurance, and brokerage fees must be
added to the offshore factory cost to get a total delivered cost. Only then
can a true apples-to-apples product cost comparison be made.
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Costs of quality must be considered. If the offshore factory has
quality levels below the stateside factory, and those defective items escape
detection and make it into the stream of commerce, there is an additional cost
to the company to handle valid quality claims and returns. Furthermore, there
can be the intangible loss of customer confidence in the company’s quality.
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The company must determine if legitimate, net cost reductions from
outsourcing will be added to the company’s bottom line or passed on, in part
or in total, to the customers to protect or grow market share. (If price
concessions to customers are needed to protect market share and thus keep the
company alive, outsourcing may become an increasingly attractive way to
protect margins and ensure survival and financial viability!)
Logistics
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As previously mentioned, offshore sourcing, through increased
transportation distances, typically adds time to the delivery cycle,
potentially compromising customer service. This delay must be properly
analyzed and managed for its potential negative impact on delivery, or it must
be compensated for by increasing on-hand stateside inventory levels of
finished goods.
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Greater physical distances equate to decreased communication
effectiveness. If the factory is 500 miles away, 1500 miles away, or 12,000
miles away, the speed and effectiveness of written, verbal, and
telecommunications will be less than if the factory is 250 feet away. This
factor must be properly considered.
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By definition, offshore sourcing infers a different culture,
different rules, regulations, and laws, and a different language. These issues
can certainly be overcome but not without management effort and associated
cost.
Impact on Stakeholders (Stakeholders are those people or entities that
benefit when a company does well and suffer when a company does poorly.)
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Employees
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When a company outsources production, jobs are lost. Those
employees whose jobs are lost will have their employment terminated and
their livelihoods negatively impacted, at least until they find new jobs.
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On the other hand, those employees whose jobs are not directly
impacted by the outsourcing may well have a far healthier and more stable
employment outlook because the company may be stronger financially.
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Vendors
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If production leaves, demand for components, materials, and
perhaps services will be curtailed proportionally. Stateside vendors will
experience a reduction in the demand for their output.
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Customers
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Ideally, other than country-of-origin marking, a decision to
outsource manufactured goods should be invisible to the customer. If
anything, the customers may gain the benefit of reduced prices through
reduced manufacturing costs. This is especially true in a highly cost
competitive market.
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Some customers, especially government buyers, may have a strong
bias in favor of “Made in America.” These customers would have to reevaluate
the decision to buy from a manufacturing company that changes from domestic
to imported goods. The company should know (and confirm) the feelings of its
key customers before embarking on an outsourcing program.
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Community
-
If a company downsizes, there are usually negative impacts on the
local community. These can include a reduction in jobs, a sell-off of
residential property (and resulting reduction in real estate values), a loss
of local tax base, a reduction in community retail activity due to the
reduced workforce, and, if the company cutbacks are significant, a reduction
in the overall quality of life in the community.
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If outsourcing “saves” the company, the longer term impact on the
community will be a more stable, albeit reduced, local job market.
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Owners, Stockholders
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The most obvious impact, if an objective evaluation leads to
outsourcing, is that the company will have reduced its operating costs.
These savings can be used to maintain or grow market share through price
concessions to customers or to maintain or improve bottom line financial
results. Either one is a significant plus to those who take the risk of
investing in a manufacturing business.
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A decision to outsource is rarely popular in our society, and the
result can be unfavorable backlash at corporate management and ownership.
Corporate Values
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On one hand, surviving and making a fair and reasonable profit, thus
providing value and an acceptable return to the business owners (and corporate
stability to other stakeholders) is the fundamental pillar of our economic
system.
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On the other hand, there is perhaps the negative perception that
outsourcing is somehow un-American, unfair to long-standing loyal employees,
dangerous, or even traitorous.
Implementation Considerations
Assuming a decision is made to proceed, outsourcing should be considered from
an incremental perspective. It is not wise to “bet the company farm” on an
initial, first attempt at outsourcing a significant amount of manufacturing. The
company should consider starting slowly, perhaps with one or a few items. This
prudent, well-considered approach can allow the company to learn from inevitable
mistakes and build up knowledge, skills, capabilities and confidence as the
outsourcing effort grows. This approach also allows the company to overcome the
organizational fears outlined above.
For example, perhaps an organization would start with one relatively minor
product. The first step might be to simply subcontract the manufacturing to a
capable offshore factory that serves as a vendor. The company exercises little
control over the vendor but the risk is relatively small. Over time, as the
vendor establishes consistent performance, more items can be sourced from that
vendor.
As the company becomes more important to the vendor, it can have greater
influence (and hence greater control) on that vendor and on the company’s own
products as they are manufactured by the vendor. Eventually, as the company
gains in capabilities and confidence, it can even establish its own factories or
offshore corporations and exercise full control. Although it can take awhile
longer, and it requires a strategic perspective, this incremental approach can
provide a relatively low risk but highly effective way to implement outsourcing
as a corporate strategic imperative.
In addition to the “logistical” aspect of implementing outsourcing, there is
also a strategic market consideration. This consideration relates directly to
the amount of value added by a company that is now outsourcing a significant
portion of its production. In the act of producing goods, a manufacturer adds
useful value to the stream of commerce by transforming materials from one form
into another, more useful form. If a company ceases much of its manufacturing
activity and predominantly uses outsourced products supplied by vendors, it will
lose much of its ability to add value through the material transformation
process.
In this situation, the company must alter its business model to add value to
the distribution process rather than concentrate only on the added value during
the manufacturing process. Failure to do so will make the company vulnerable to
the fickleness of channel distribution. [Witness the impact The Home Depot ® has
had on wholesale distributors of electrical, plumbing, and irrigation products.
The traditional wholesalers, acting more or less as brokers, had very little
added value. They bought low and sold high, period. They are beginning to suffer
from the increased value (convenience, one-stop shopping, more variety, less
stock-outs, sharp pricing, attractive product presentation, financing, etc.)
that The Home Depot ® provides to professional contractors. In order to survive
and prosper, these traditional wholesale suppliers must adapt to a new business
environment and provide added value to the distribution process that may
distinguish them from the “big box supplier.”]
Summary
Outsourcing is an option or opportunity, not a dirty word and not a panacea.
It is an approach or strategy that, under certain conditions, can make the
difference between whether or not a company survives in today’s highly
competitive business climate.
The decision to outsource is a strategic consideration, perhaps one born out
of necessity. The management team owes it to all stakeholders to accurately,
thoroughly, and objectively assess all pros and cons of the outsourcing
question. Only in this way can a fact-based, intelligent, and informed
“strategic decision” be made.
The approach outlined above provides both a template and some pragmatic
considerations to ensure that the best possible management decision is made and,
if the decision is yes, that a well-considered and well-thought-out
implementation plan is used.
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