Selecting the Right Location for Outsourcing Production - A Case Study

Outsource manufacturing to the lowest cost geography - this has been the predominant theme for most electronic products OEMs over the past decade.  But what does this really mean and is it generally the right manufacturing strategy? 

Many OEM decision-makers focus great, almost exclusive attention on geographic labor cost differences and thus drive the vast majority of their manufacturing to outsourced providers in low wage rate countries.  For many products labor costs are a key consideration, but our experience shows that both the outsourcing decision and the choice of manufacturing location are often over-simplified and not subject to rigorous analysis or modeling of various options.  Strategic considerations and quantifiable costs are often neglected, leading to a higher total cost solution and potentially diminished service level to the end customer.  The challenge for most OEMs is how to properly identify, evaluate and quantify these factors and incorporate them into the decision-making model.  In the following article we discuss some of our methodology for manufacturing location selection using actual examples and real data from recent customer engagements.

Manufacturing Strategy and Location Development - The Case in Point
Riverwood Solutions was recently retained by a U.S.-based green-tech OEM serving the North American market to help them develop their manufacturing strategy.  As with many OEMs, the presumptive manufacturing strategy was to outsource all product manufacturing to China, assuming that this approach would provide them with the lowest direct product cost.  Our proposed alternative to using this sole criterion of lowest direct product cost (and the assumption that China would provide that) was to apply a broader analysis that accounted far more broadly both direct costs  and other considerations related to supply chain response time,  inventory related costs, logistics, transit time, OEM support costs, macroeconomic factors, cost variability, and customer requirements, all in the context of the specific characteristics of the product to be outsourced.  Working with our OEM client, the Riverwood team developed a set of criteria and quantifiable factors which lead to the evaluation of several suppliers and manufacturing locales including China, South East Asia, the US and Mexico, with somewhat unexpected results. 

For the ease of analysis, the various factors and cost elements to be considered were incorporated into an overarching top-level quantitative indicator of "total supply chain cost".  This metric includes not only the landed cost of finished goods, but also Inventory Related Costs (IRC) such as working capital and inventory depreciation, the costs to source and transport raw material, and the OEM's internal costs of launching, supporting and maintaining specific supply chain operations as well as other factors. Also considered were various macroeconomic and "ease of doing business" cost factors and difficult to quantify customer-specific factors.  The guidelines and basic methodology employed in this analysis are discussed below, as are the conclusions. 

Know Your Market
When developing a supply chain strategy, completing an assessment of the market to be served is a critical first step, as it helps to clarify the specific and sometime unique requirements for the optimal supply chain.  Factors such as expected order size and frequency, product design stability, expected end customer lead time, service levels and desired fill rates,  penalties, substitution effects and other issues should be modeled to calculate specific costs including transportation,  inventory related costs, and OEM support costs  for the end markets served by a specific manufacturing strategy and not just general figures.

Inventory Related Costs (IRC) - The Stealth Cost
Inventory Related Costs or IRC is a measure that seeks to holistically capture the full cost of procuring and owning inventory. Inventory related costs are often overlooked in manufacturing strategy decision and when they are considered the metric is often incorrectly calculated. This cost is generally expressed as "Total IRC %" which reflects the annualized rate or total cost of inventory as a percentage adder to direct purchase price of the raw material or finished goods. IRC is comprised of a combination of factors that when summed represent the total cost of inventory ownership.  By way of example, a 17% IRC indicates that the total cost of owning $1.00 of inventory for one year is $.17 (see below worksheet).  As IRC is a time dependent function, the longer inventory is in transit or in stock, the higher the total IRC cost in dollars.  The OEM's Weighted Average Cost of Capital (WACC) is one element of IRC and it typically determines the direct cash cost of financing inventory.  WACC is a fairly simple formula that considers the cost and weighting of all capital elements on the balance sheet to determine the average cost of capital to a given firm.
 


Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

A high WACC combined with a high average inventory value can produce significant financing costs, which also increase when financing costs accrue on that capital during long inventory transit times.  Long transit times also expose OEMs to costs when their products (or the raw material inputs) are subject to rapid inventory depreciation such as Average Selling Price (ASP) declines and/or higher levels of excess and obsolete inventory.  Additionally, costs incurred during procurement of raw materials can vary by sourcing location and commodity type procured.  Combing these factors generates IRC that is significant to the manufacturing decision and the selection of both manufacturing location and transportation mode decision.  For this specific project, the OEM client's total IRC was just over 27% which surprisingly enough is not an unusually high number for certain tech sectors. So for this specific project, sourcing with shorter transit time thus created the opportunity for significant cost savings, whereas on another recent project where the IRC was closer to 18% the sourcing economics would not be as sensitive to distant and/or transport mode.



Figure 1:  Basic Inventory Related Cost Model

Manufacturing Support Costs
Despite the conventional wisdom at some start-up product companies, outsourcing manufacturing does not eliminate all internal manufacturing related headcount and overhead costs within the product company.  Product companies still incur various support costs to communicate with, direct, and manage certain aspects of the supply chain and their outsourced manufacturing partner.  These support costs, which and are frequently overlooked, can vary significantly depending on the location, experience set, business model, IT systems, and infrastructure of the specific manufacturing partner and the sophistication and experience level of the OEM staff.  For companies with annual outsourced manufacturing spend of $25M, internal support costs  often range as high as 6% of outsourced spend.  These costs relate to ease of communications and access and include travel to the partner's facility, time out of the office, communication costs, implementation delays and other costs. Support costs are a function of a broad set of factors.  Traveling from the U.S. to Asia is not only costly, but it is also time-consuming, exhausting and often diverts resources from product enhancement activities and next generation product development.  These costs can grow exponentially in cases where the product and manufacturing processes are both in developmental stages.  Despite modern collaboration and communication tools, large time-zone disparities coupled with language differences and "cultural distance" still makes for costly and often challenging communications and remote management of offshore manufacturing partners.  A recent assessment Riverwood Solutions conducted for a specific client showed that support costs for U.S.-based OEMs are 40 percent lower when outsourcing in Mexico verses outsourcing in China.

Transportation and Logistics Costs
This is perhaps the most obvious factor to identify and quantify (other than per unit purchase price) and yet one that is rarely fully and accurately captured.  When calculating inbound freight rates, it is important to examine the product's size and absolute weight, as well as its dimensional weight.  The larger and heavier the product, the more pronounced freight's impact is on landed cost and the greater its influence on overall product cost.  Manufacturing's proximity to the end market can be a key driver of both transportation costs and IRC for some products while for others its can be insignificant, so it is critical to do the homework to understand the specific impact of freight and logistics costs. 
Manufacturing close to the target market often allows for greater use of consolidated freight movements and surface transportation, generally decreasing logistics costs without an increase in inventory or lead time.  Additionally, oil price volatility and container ship day rates fluctuations can lead to unpredictable and often excessive transportation costs that generally grow with distance.  Changes in fuel costs or extended use of expedited freight could have potentially wiped out much of the direct cost savings for our OEM client in an Asian outsourced manufacturing model whereas these factors had a less significant impact on the near-shore options modeled.

Inflation, Currency Fluctuation and Variability
Variability in manufacturing input costs are always problematic and can create cost and overhead challenges of their own.  Budgeting for production, forecasting margins, financing and reporting to investors are all negatively affected by input cost variability.  Expected labor cost inflation varies greatly between candidate outsourcing locations and is a function of government policies and demographics that impact local wage inflation as well as fiscal and monetary policy considerations that impact relative changes in currency exchange rates.  For example, between 2006 and 2012 Chinese fully loaded factory wages in some areas  grew almost 55 percent in US dollar terms, while those in Mexico remained relatively steady, growing just 3 percent in US dollar terms over the same period.  Chinese wages are still less than half of Mexican wages, but more predictable Mexican wage growth and minimal variability can bring significant advantages when budgeting and planning.


 
Figure 2:  Mexico direct labor rates for the past 6 years in US dollar terms

Corporate Social Responsibility
Outsourced manufacturing continues to come under the scrutiny of the media and the public, especially in this election year.  Actions that show a corporation behaving in a socially responsible manner can bring positive media attention to the company and sometime favorable government treatment.  Shipping product from an Asian location to the U.S. consumes more energy resources and generally has a higher carbon footprint than shipping products from Mexico to the U.S.  For some greentech customers that have a name and brand reputation based upon leading the green revolution (including our client), having a lower carbon footprint supply chain can be an important part of the decision making process. By sourcing from Mexico, our client could credit itself with running a "greener" supply chain than its competitors sourcing from Asia.  Some end customers of OEMs abide by corporate policy that gives preference to businesses with environmentally friendly operations.  Other such customers may simply feel the need for a boost of virtue by opting to purchase from a greener company, while still others give no consideration to these things at all - thus giving issues such as this consideration in a sourcing model are purely OEM dependent.

Project Findings and Conclusions
After getting past the initial manufacturing strategy predisposition of our client to "just send it all to China," our team set about developing a manufacturing strategy based on a comprehensive analysis with extensive modeling of several factors that included both easily quantifiable costs and more qualitative considerations.  From the analysis the OEM concluded that a supplier in Thailand could provide the lowest total cost solution, while second sourcing in Mexico provided a compelling value proposition that proved to be more economical (all in) than either China or the Philippines.  The key takeaway here for the reader and OEM supply chain professional is to adopt a comprehensive, analytical approach to developing a manufacturing strategy and selecting an outsourced manufacturing location.  There are many factors to consider incorporating into the analysis and they can only be chosen through a careful evaluation of the product, market and critical requirements of the OEM.


 
Figure 3:  Total product cost comparisons - Project Hyperion

Riverwood Solutions associates John Schell, Juan Francisco Fregoso, John Daker, Julio Henriquez and Xander Kameny all contributed to this project and to this article.

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