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The case for "profitable proximity"
The current myopic pursuit of "low-cost country sourcing" as a primary cost-mitigation strategy is coming to an end. One reason for this change is that most projections of global consumer demand show a significant amount of future demand growth coming from today's low-cost regions—a shift that moves those regions from the category of low-cost countries to one of emerging markets. It's a change that will bring increased expectations in these countries for a "globally fair" wage, which will raise the cost of goods produced there. Companies that sell to emerging markets will need to better balance cost and service, and that will force many of them to take a more strategic, customer-oriented view of global network design and sourcing.
But there's another reason low-cost country sourcing is beginning to fall out of favor. Low-cost manufacturing may initially prove seductive, but a "total supply chain cost" perspective offers a far more sensible approach to making sourcing decisions. While looking at total cost hardly amounts to a new concept, all too often businesses do not take this view, and as a result their sourcing is suboptimal.
[Figure 1] Profitable proximity decision space Enlarge this image
[Figure 2] Profitable proximity optimization Enlarge this image
In today's economy, a total-cost perspective has become more important than ever— particularly as skyrocketing energy costs have pushed up transportation, logistics, and distribution expenses as a percentage of total cost. As these costs rise, they could eclipse the gains made from the lower cost of manufacturing goods overseas.
A third reason is that sourcing strategies today must take into account how quickly suppliers can deliver parts and materials to the manufacturer. Sometimes sourcing from a low-cost country just doesn't make sense, for example, if lead-time constraints offset any cost advantages. Indeed, for some categories lead-time considerations may actually be a higher priority than cost—or at the very least, they have to be considered as part of the broader cost equation.
A wise sourcing strategy, therefore, will consider total costs and lead times as well as balance supply with demand to create a globally distributed supply network that best meets the company's business objectives. For some companies, this may mean that the most profitable source will be close to home.
At Manufacturing Insights, we have dubbed this strategic approach "profitable proximity sourcing." This concept resonates with manufacturers because effective business-continuity planning, global supply network design, and finding the right balance of cost, quality, and lead time all remain challenges for them. They are under pressure to achieve greater efficiency and sustainability. Throw in growing global demand and diversifying customer and consumer preferences that are increasing supply chain complexity, and you have a recipe for instability. With its focus on balancing cost and service, profitable proximity sourcing provides manufactures with a way to deal with these challenges.
Trends affect sourcing decisions
At the end of each calendar year, Manufacturing Insights issues predictions on key business trends for the following year. One of the predictions for 2008 was that more companies would adopt profitable proximity sourcing rather than focus mostly on lowcost manufacturing. The predictions noted a number of other factors that have an increased bearing on the sourcing decisions that companies are making:
1. Companies today recognize that the supply chain is the essential ingredient for global competition. Managers are expected to consider the supply chain in broader business decisions, especially the cost pressures involved in sourcing and transportation. They will likely increase their use of software applications, such as supply chain execution systems, as a way to manage those costs. On top of that, there is a reduced tolerance for supply chain waste and clear evidence that supply chain involvement in new product development and introduction can both speed up the process and reduce rework.
2. Risk management is the key to becoming global. Risk management becomes a priority as companies struggle to move beyond multiregional operations to truly global supply networks. It will allow companies to better balance the trade-offs inherent in such strategies as low-cost country sourcing, profitable proximity, and extended supply networks.
3. A renewed focus on the basics raises the profile of lean, Six Sigma, and other quality controls within the supply chain. As companies impose these controls, they still will have to balance cost and productivity with customer service.
4. Your supplier's problems become your own, especially when they are related to sustainability. This requires that suppliers include environmental factors and regulatory compliance in their operational metrics. The pervasiveness of sustainability discussions and its elevation to a C-level concern mean that customers are increasingly demanding visibility into not only their own operations but also those of their suppliers and their suppliers' suppliers.
Whether they are concerned about managing supply network risk and business continuity, quality and reliability, or sustainability, companies are re-evaluating their supply network strategy to reflect total business cost. And the concept of total supply chain costs is a key driver for adoption of a profitable proximity sourcing strategy.
The modern supply chain architecture
Establishing a coherent sourcing strategy can be difficult. The current generation of supply chain organizations manages an unparalleled level of complexity. Cost and a continuing re-evaluation of core competencies have resulted in distributed supply networks that can be five or six suppliers deep, with both global- trade and distributed-control challenges. Customer differentiation and consumer preferences have driven up the number of product ranges, stockkeeping units (SKUs), and configuration variants. Meanwhile, expectations about on-time delivery, delivery frequency, inventory levels and turns, and service performance as measured against the perfect order have gotten more stringent. At the same time, more and richer data about supply chain performance have become available. As a result, companies are struggling to identify which data are useful, how to collect and analyze that data, and what the resulting information can be used for in short-, medium-, and long-term supply chain operations.
In Figure 1, we graphically present the modern supply chain that operates in this environment. From one perspective, we show the horizontal, extended supply chain, where supply networks interact with the manufacturer to provide products to customers and consumers. From a second perspective, we show the manufacturer's supply chain vertically by process and application area.
The figure also highlights the "profitable proximity decision space," or those areas most responsible for addressing global sourcing strategies: network design and planning. It is here that we have the strategic discussions about network sourcing and the trade-offs between optimizing manufacturing cost (low-cost country sourcing) and optimizing total cost and lead time (profitable proximity). Indeed, we view network design and planning as the overarching business processes for the modern supply chain. It is in these processes that companies consider issues that affect risk management and business continuity. As more companies develop distributed, global supply networks, it becomes increasingly important for them to be clear about how they will assess and manage the related risks.
These strategic design discussions require the modern supply chain to be prepared to handle the proliferation of data. For this reason, the signal repositories shown in Figure 1 will play an important role in the modern supply chain. Although most of the conversations around data have focused on the demand side, we believe the supply side also is an important and proliferating source of data (and data complexity), particularly with the growth of distributed supply networks and the corresponding control challenges.
Companies are increasingly looking for a "one-stop shop" data repository where they can collect and hold externally sourced data elements for short- or longerterm analysis. Figure 1 differentiates a "supply signal repository" from a "demand signal repository" for graphical purposes, although it is likely that both groups of data will reside in the same database (ideally an enterprise-level data repository).
Why adopt profitable proximity sourcing?
Once they have the ability to see and manage supply-side data, most companies will start to recognize the value of profitable proximity as a sourcing strategy. Data analysis will show distribution costs growing as a percentage of total costs, making low-cost manufacturing a secondary consideration for many companies. Indeed, as energy costs climb and the execution aspects of supply chain management represent a greater percentage of the costs of goods sold, we expect to see "optimizing transportation costs" play a larger role in the network decision process. Companies will recognize that their sourcing decisions must give the most weight to the concept of total costs.
It should be noted that the term "total supply chain cost" includes not just total landed cost but also the inventory holding cost and the cost of obsolescence (something we call "lead-time cost"). This also can influence a company's decision to adopt a profitable proximity sourcing strategy. For example, a company can continue to source from low-cost countries as long as the costs of inventory and obsolescence buffers, which are required to compensate for longer lead times, remain within acceptable limits. But if the transportation cost goes up, then the total landed cost and inventory holding cost also will go up. Hence, at some point it becomes more profitable to source locally— even at a slightly higher landed cost—because the shorter lead time will allow for lower inventory and obsolescence costs. The lower inventory level also will limit the specific risk of obsolescence and increase flexibility.
As companies take a total cost view, the importance of collaborative supply and demand planning/forecasting becomes even greater. That's because efficient demand planning/forecasting will be required to determine the optimum inventory buffer, which in turn will determine the trade-off between sourcing cost and inventory holding cost.
But total cost concerns are not the only factors driving companies to look beyond low-cost country sourcing. In some instances, speed of delivery becomes an important factor. When considered together, concerns about cost and speed can push companies to consider a profitable proximity approach.
Lastly, another key reason for companies to consider profitable proximity as a sourcing strategy is the evolving nature of global demand. Most forecasts of consumer demand show massive growth in emerging regions. In many cases, those regions include the very same countries that make up the low-cost sourcing base of today. As consumerism takes hold in more countries around the globe, there will be more regional and local markets for companies to serve. No longer will they simply be looking for the most cost-effective way to make and provide products to customers in North America and Western Europe. Instead, they will need a sourcing strategy and supply network that works for customers around the globe.
External factors to consider
It is important to point out that profitable proximity sourcing does not preclude low-cost country sourcing. It's possible that in some instances, low-cost country sourcing may be encouraged as part of a diversified sourcing portfolio. In Figure 2, we illustrate the "tug of war" that goes on within profitable proximity, as well as the external factors that influence the strategy. Although the predominant trade-offs—cost, lead time, and proximity to demand (demand/supply balanced sourcing)—are shown within the central bubble— it is worth a quick discussion of some of those external factors:
- Sustainability continues to grow as a factor in sourcing decisions, particularly as concerns about climate change escalate and environmental regulations proliferate. A strategic sourcing strategy will have to consider its environmental impact. We believe that sustainability is now a critical input to network sourcing decisions, as it is expected to quickly become both cost-justifiable and a key corporate differentiator.
- Quality and brand equity remain high on business scorecards. The challenges of maintaining acceptable quality standards (that is, balancing the manufacturing cost of quality with warranty expenses) and preventing counterfeiting (protecting intellectual property) are causing some companies to rethink how and where they source. Although difficult to quantify, the risk to intellectual property from counterfeiting and the potential for product quality problems need to be considered when formulating any strategic sourcing strategy. More specifically, these concerns also must be considered in the opportunity- cost discussion and analysis when evaluating a profitable proximity sourcing strategy.
- Risk management, or business-continuity planning, is a hot topic in supply chain management in 2008. We are seeing more and more companies add metrics like "time to recovery" to their corporate scorecards in an effort to better measure the cost of protracted service failures. Time to recovery becomes central to balancing cost and lead-time optimization and should be a key input to the sourcing strategy.
- Inventory optimization is already a standard component of the total cost equation, but the availability of sophisticated, multiechelon (components, work-in-process, finished goods) planning tools has allowed companies to take a broader perspective on the cost of inventory and how it can be optimized across distributed supply networks. We now see companies using these tools in the network planning process, not just as an optimization engine for an already established network.
- Portfolio differentiation becomes relevant as demand diversifies geographically and demand for product types that are individualized for a particular region and/or nation grows. Coordinating the supply of regional or national variants with corresponding demand may seem like an obvious requirement, but optimizing this balance can be tricky and needs to be part of the strategic sourcing process.
- Expertise/talent turns out to be an important consideration that relates strongly to both product quality and business-continuity planning, yet it is often overlooked in the pursuit of low cost. We include it here simply as a reminder that reliability and consistency are as important as cost.
Pioneers in profitable proximity
We are already beginning to see certain industries adopt sourcing strategies that embrace many of the concepts of profitable proximity. One is the apparel industry, which has taken a "dual network" approach to product sourcing and is, in effect, using a portfolio approach for balancing cost against lead time. Established, consistent products, such as men's jeans, are sourced from low-cost regions, and although lead times are long, the predictable nature of demand keeps supply risk low and costs down. Seasonal or fashion products, such as women's summer dresses, are sourced locally, and although costs are higher, lead times are short, allowing the supply network to react more quickly to unpredictable demand.
Even the technology industries, longtime users of low-cost country sourcing, are starting to consider profitable proximity concepts. For technology companies, the cost to manufacture components, work-inprocess, and finished goods makes up most of their total cost, while transportation expenses generally are low. However, to compensate for longer lead times, they have begun adopting practices that are compatible with a profitable proximity strategy, such as reusing parts, postponing final configuration, and implementing creative "merge in transit" programs.
The consumer packaged-goods industry, which historically has not adopted low-cost country sourcing to a great degree, is closest to embracing the profitable proximity concept. Certainly there are exceptions—toothbrushes, for example—where the majority of finished goods are imported. But given the less significant contribution of manufacturing cost to the total cost of consumer goods, this industry tends to use local sourcing to match supply to demand. With distribution costs representing an increasingly large portion of total cost, this is unlikely to change anytime soon.
Given the inexorable rise in energy costs, other industries will have little choice but to consider sourcing closer to their key customer markets. As a result, many companies may re-examine the United States and North America as sourcing locations, particularly because of the current weakness in the U.S. dollar. Making sourcing network decisions based on currency exchange rates may seem to be an ill-conceived strategy driven by short-term considerations, but it is just one factor that may contribute to a potential resurgence in manufacturing in North America in some circumstances and industries.
Companies should make that decision, however, after thoroughly examining and carefully considering their total supply chain costs and lead-time factors in their sourcing calculations. Such an examination will lead them to embrace the concept of profitable proximity sourcing as a way to serve consumers in different regions of the world while at same time balancing total costs with shorter, adequate lead times for product delivery.
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