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August 31, 2014
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Manufacturing

Time to come home?

To offshore, nearshore, or "reshore"? A total cost of ownership (TCO) analysis can answer that question. For some companies, TCO analyses are suggesting that manufacturing close to the point of consumption is the best choice.

In just the last couple of years, supply chains around the world have been shaken up by a series of unexpected events and developments. Volcanoes in Europe and South America have disrupted airfreight routes and schedules. The Japanese earthquake, tsunami, and nuclear power disaster confirmed the fragility of extended supply chains. Political instability continues to wrack the Middle East. Wages and currencies have been rising in China and other relatively low-labor-cost countries (LLCCs). Transportation costs have soared along with crude oil prices.

Those are just a few of the shocks and disruptions that are leading some companies to rethink their sourcing models. The question for many is whether to offshore (source from distant overseas suppliers), nearshore (source from suppliers located closer to end markets), or "reshore" (source within a consuming market that has lost manufacturing to lower-cost countries).

Article Figures
[Figure 1] Sample total cost of ownership (TCO) estimator (in U.S. dollars)
[Figure 1] Sample total cost of ownership (TCO) estimator (in U.S. dollars) Enlarge this image

Total cost of ownership (TCO) should be a key element in the decision to adopt new sourcing models. A TCO analysis will help to objectively identify the sources that minimize total cost, including those associated with the risk of additional supply chain shocks and disruptions. When all of the relevant costs and risks are taken into account, companies may find that manufacturing close to the point of consumption—"coming home," one might say—is the best choice.

What is TCO?
Many companies still make sourcing decisions based only on price. Others decide based on the financial concept "cost of goods sold" (CoGS), which might also include freight, duty, and packaging for large, discrete products. Landed cost generally is similar to the cost of goods sold for purchased components or products.

Total cost of ownership is much more comprehensive. It includes all of those costs as well as others that are often overlooked; for example, costs affecting cash flow, such as emergency airfreight and travel to audit a supplier. TCO also considers inventory carrying costs and predictable future costs, such as obsolete inventory.

Other costs that factor into TCO are not found in financial statements. For example, there is an "opportunity cost" associated with the inability to respond quickly enough to customers' demands for certain quantities or features. Harder to predict are risk-related costs, such as those caused by political instability or natural disasters.

These are just a few examples; the list of potentially relevant costs is long. That, and the fact that many of the costs are individually small, cannot be found in financial statements, or cannot be easily quantified by an accounting system, are among the reasons why many companies make sourcing decisions based on factors that are far easier to measure but do not provide a complete cost picture.

Why TCO is important now
Before the recent spate of supply chain shocks, many companies were comfortable making sourcing decisions based only on wage rates or purchase prices. They were willing to ignore other costs because the wage/price gap between low-cost countries and other manufacturing locations was so large. However, because they mainly compared prices and did not consider the entire cost of offshoring, that strategy may not have been as profitable as they believed.

This oversight is a common one. A 2009 survey conducted by Archstone Consulting, for example, found that 60 percent of manufacturers ignore 20 percent or more of the cost of offshoring.1 Similarly, 61 percent of respondents to a 2010 survey conducted by the global consulting firm Accenture acknowledged the need to implement TCO.2

This attitude may finally be starting to change. One indication is that IDC Manufacturing Insight analyst Simon Ellis included "a broader view of total cost" that will encourage nearshoring and reshoring in his "Top 10 Supply Chain Predictions for 2011" list. "In the context of taking a broader view of total cost, supply chain organizations will gain a new appreciation for shortening lead times through profitable proximity sourcing strategies," Ellis wrote.3

The list of supply chain "shocks" at the beginning of this article suggests why companies are increasingly interested in TCO as a tool for determining the best sourcing strategy. Clearly, the relative costs and risks of offshoring have changed, and therefore some offshoring that was profitable in the past could now be profitably reshored.

Business conditions are changing so quickly, in fact, that some long-held assumptions about low-cost sourcing are rapidly becoming obsolete. For example, companies are now questioning whether China is still the most profitable location for manufacturing. Boston Consulting Group4 and Accenture5 recently reported that net per-unit manufacturing costs in China are rapidly converging with those in some U.S. states. One reason why is that Chinese wages are rising 15 percent to 20 percent per year, but productivity remains below that in U.S. factories. In addition, the yuan is gradually appreciating (approximately 6 percent per year). It is expected to rise faster as China fights an inflation rate that is two to three times the U.S. rate and promotes a stronger currency in order to reduce the cost of imports.

It is true that raw material costs are about the same in both countries, and Chinese hourly wage rates are expected to remain far below U.S. levels for some time to come. But if companies take a total cost of ownership view that includes both direct and indirect costs and risks, then in many cases it will not make sense for them to source from China. However, China is not the only offshore manufacturing location where costs are rapidly rising, therefore those sources also merit reconsideration.

Calculating the TCO
The Reshoring Initiative, a nonprofit organization dedicated to helping companies determine the feasibility of manufacturing in their home country (primarily the United States, but the group's approach applies to any country), has developed a method for calculating the total cost of ownership. (For more information, see the sidebar "About the Reshoring Initiative.")

The Reshoring Initiative's trademarked Total Cost of Ownership Estimator software is based in part on the factors that motivated dozens of U.S. companies to successfully reshore products ranging from small consumer electronics such as earphones to larger, more labor-intensive items like water heaters and automotive components.

To determine the total cost of ownership, the user assigns a value to each factor that is relevant to the specific case, and then accumulates a single cost value for a product sourced from a particular supplier. The user then repeats the process, substituting other vendors. In this way, it is possible to readily and objectively compare the TCO for the same product from multiple vendors, whether local or offshore.

What kind of costs should a TCO calculation include? It will vary depending on the specific circumstances, but the following list, grouped by category, is a useful guide. The list begins with easily quantified, "hard cash" costs and progresses to more subjective measures. Each item also includes some observations and recommendations for comparing the costs of local and offshore sourcing. Figure 1 shows the calculations for a hypothetical example.

1. Cost of goods sold or landed cost: This includes price, packaging, duty, and planned freight, such as surface transportation, fees, and insurance. This data should be readily available, especially for items that are large or valuable enough that the various costs usually are aggregated.

2. Other "hard" costs: These include factors that affect other costs that have an immediate effect on cash flow or are calculable and highly likely to occur.

a. Carrying cost for in-transit product. Foreign and local suppliers often are paid on different schedules. For example, Chinese suppliers generally are paid prior to shipment, typically three to six weeks prior to receipt of the goods. U.S. suppliers typically are paid two to three months after the shipment date, which essentially is the same as the receipt date. In such cases, the customer's cash will be tied up for three to four months longer with an offshore source. An appropriate measure for calculating the carrying cost for this period, therefore, is the customer's cost of capital.

b. Carrying cost of inventory on-site. At the simplest level, the amount of safety stock is proportional to the square root of the lead time. If the lead time for product sourced in Asia is nine weeks and the local lead time is one week, then the safety stock for Asianmade goods will be three times higher than for locally sourced products. In addition, the amount of onsite inventory will be dramatically higher for product shipped by ocean freight from offshore than for shipments from a local, ideally just-in-time (JIT), supplier. One reason why is that offshore shipments will arrive in container loads to minimize shipping costs. If the product arrives monthly, then the cycle inventory will be one-half of a month. Additionally, extra inventory must be held to compensate for arrivals of late or defective shipments.

c. Prototype cost. Many companies prefer to source prototypes locally so their engineers and marketingorganizations can work intensively with the suppliers during product development. Local suppliers typically charge less for the prototype if they also receive the production orders.

d. End-of-life or obsolete inventory. When demand dies down or a product is revised or replaced, a company will end up holding some obsolete inventory. With an offshore source, the amount of inventory in-house, en route, and on order will be higher than it would be with a local source. Thus, companies that source offshore are likely to end up with more obsolete inventory.

e. Travel costs. The cost of travel associated with the startup of the sourcing relationship as well as for ongoing auditing and problem solving is often overlooked when companies calculate sourcing costs. Yet it can have a notable impact on a product's total cost.

Most customers visit a supplier several times year. For a local supplier, this might require a few hours or a day or two. For an Asian supplier, each trip can take a week or two and might cost US $10,000, including time and travel expenses. Offshore sources also may require more face-to-face meetings because of timezone and language differences. Alternatively, larger companies might choose to facilitate communication and oversight by employing liaison/auditors who are located close to the offshore source, and that cost also should be taken into account.

3. Potential risk-related costs: The cost impact of high-frequency risks, such as emergency airfreight, scrap, and rework, to name a few, can be calculated based on past experience with an existing supplier. New products or potential new suppliers will require estimates. Other risks tend to have a low probability but could still be devastating, so they should also be considered.

a. Rework. If an individual item or an entire lot is bad, then it must be scrapped. Does the supplier send a replacement without charge, or do you incur some cost whenever rework is required? The answer may depend on how much leverage you have with the supplier. These costs can be especially high for custom products, such as molds or dies.

b. Quality. Who pays for scrap? In addition to the cost of lost production and warranty-related payouts when the product fails, quality problems are costly in other, less tangible ways. Think of the cost impact of lost market share, permanent loss of customers, or the negative impact on brand image.

c. Product liability. How do the supplier candidates compare in terms of accessibility, willingness, and ability to pay any product-liability claims? It can be difficult to sue a foreign company for damages, and even harder to collect. A local supplier, by contrast, could have been audited to verify that it had sufficient product liability insurance.

d. Intellectual property risk. Approximately 5 percent to 7 percent of world trade consists of counterfeit or pirated goods, according to the International Anti- Counterfeiting Coalition.6 Some products, such as software, movies, and fashion accessories, are more at risk than others, a factor that should be considered in cost calculations.

e. Opportunity cost. What would be the cost of lost orders and customers when a supplier cannot respond quickly enough to changes in quantity or product specifications demanded by the market?

f. Brand image. What is the impact on brand image of the product's "country of origin" label? At a time when developed nations are continuing to experience economic instability and people are concerned about their jobs, consumers may consider buying locally made goods as a way to help the economy and their neighbors. Recent product-adulteration scandals (such as those involving pet food, medicine, milk, and drywall) have also favorably influenced consumers' attitudes toward locally made goods.

g. Economic stability of the supplier. It is much easier to investigate and find accurate information about the stability of a supplier located in the home market than it is for a supplier overseas.

h. Political stability of the source country. It's not difficult to rate the stability of countries that are already in chaos. It's much harder to correctly assess those that are making good economic progress but whose populations may be destabilizing because of changing consumer expectations and demands.

i. Exposure to another recession. The larger inventory and on-order quantities associated with offshoring represent an exposure risk if there should be another severe business downturn. Four months of inventory on hand, en route, and on order could easily turn into much more in a recession.

4. Strategic costs: There are many factors that could fall under this category. The following are just two examples of how sourcing decisions can affect product strategy and value.

a. Impact on innovation. U.S. companies in particular are frequently urged to outsource most of their manufacturing offshore and focus on innovation and marketing. However, separating manufacturing from engineering degrades the innovative effectiveness of both a company and its home country, according to Harvard Business School (HBS) professors Gary Pisano and Willy Shih.7 Similarly HBS's Michael Porter has discussed the advantage for innovation of "clustering"—having suppliers, research universities, manufacturing, and others involved in product development and production located near each other.

b. Impact on product differentiation and mass customization. Many companies in developed economies are shifting their focus from commodities to differentiated products. They often do this through mass customization, producing small quantities of products that conform to the specific desires of the market but at costs approaching those of mass production. It is easier and less costly to make the move to mass customization with short, tightly clustered supply chains.

5. Environment: This is the most subjective category. In principle, for each product source, a company should measure the "cleanliness" of the electricity generation at each location, pollution from the production process, the carbon footprint of its shipping operations, the requirements for local warehousing, how it disposes of obsolete inventory, and other activities that affect the environmental impact of its supply chain. Once the "green" impact has been quantified for each source, the next step is to apply a dollar value to that impact. A common measure is the cost per ton of carbon dioxide (CO2) produced. Whether to assign "green" costs and at what rate clearly is a corporate policy decision.

TCO applies everywhere
This article has mostly focused on the United States, but the total cost of ownership concept and methodology can help companies in any country understand and quantify the value of local sourcing.

For many products, the base price of those sourced in low-labor-cost countries will almost always be lower than the price for the same product manufactured in higher-labor-cost locations. When companies focus only on price and labor, they downgrade all other priorities. Companies that employ TCO, however, usually find that almost all of the other costs would favor production close to the end customer.

TCO helps relax some constraints on companies. Once it becomes clear that there is not much difference between the total cost of ownership for locally manufactured and offshore products, a company could decide to place more emphasis on a product-differentiation or brand-image strategy. It might pursue local cost-reduction programs, such as lean, theory of constraints (TOC), design for manufacture and assembly (DFMA), quick response manufacturing (QRM), or automation that might have seemed insufficient to close the price gap before.

Objectively re-evaluating sourcing decisions using total cost of ownership represents a strong, effective response to newly understood supply chain fragility and the changing competitiveness of lower-labor-cost countries. When companies determine that the most profitable source for many of their products is local, they will be able not only to reduce their costs but also to relax constraints on innovation and product strategies while minimizing their exposure to the shocks of local disasters and world economic crises.

Endnotes:
1. James Benes, "Made in USA: Returning Home," American Machinist, July 16, 2009.
2. Accenture, Manufacturing's Secret Shift: Gaining Competitive Advantage by Getting Closer to the Customer, March 2011.
3. Simon Ellis, "Top 10 Supply Chain Predictions for 2011," Material Handling & Logistics, February 2, 2011.
4. The Boston Consulting Group, Made in America Again: Why Manufacturing Will Return to the U.S., July 5, 2011.
5. Accenture, March 2011.
6. "Knock-offs catch on," The Economist, March 4, 2010.
7. Roger Thompson, "Why Manufacturing Matters," Working Knowledge newsletter, Harvard Business School, March 28, 2011.

Harry Moser is chief executive officer of The Reshoring Initiative.

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