October 2003 | Commentary | Viewpoint

Evaluating the True Cost of Overseas Manufacturing

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United States manufacturing continues to decline. Since 1970, manufacturing employment has dropped 22 percent—nearly nine percent of that drop in the last 10 years alone. Low-cost labor from Asia and Latin America has created extreme price pressure, and manufacturers are especially hard hit, experiencing brand erosion due to private label growth of major retailers. Many firms have responded by outsourcing certain product lines to these lower- cost regions. But does this strategy still make sense?

U.S. firms have always struggled with the decision to shift production outside the United States due to the political and public relations implications. They are bombarded with boycott threats and "Made in America" chants from lobbyists and protesters trying to influence their decision.

While the financial rewards may appear beneficial, this may not be the case any longer. Global instability is increasing the risk of doing business overseas. Heightened security risks are driving unexpected surcharges to shipments and increasing replenishment lead times. Volatility in interest and currency rates is increasing the cost of global sourcing.

Overseas and Over Budget

It's not just instability or rising costs driving firms to question overseas strategies; it's also decisions based upon faulty analysis. Whether contemplating outsourced manufacturing or re-evaluating existing strategies, be aware of three common mistakes that lead to flawed analysis:

1. Total landed cost is a simple concept that most people understand yet still do not follow. The problem? As firms manufacture overseas, they not only face additional costs for international shipments, but also incur inter-facility costs to ship product from ports to regional manufacturing and distribution points—a cost most firms fail to consider. To ensure your analysis is based on total costs, you must consider all costs to the customer, including changes in inbound, outbound, and especially inter-facility logistics costs.

2. Activity based costs. While most firms consider variable costs when choosing to outsource to a global company, they often make a decision based on standard product cost and not true cost behavior.

For example, standard product cost indicates you can manufacture a product for one dollar domestically or source it in Asia for 90 cents. Sound like a bargain? Not exactly. When you shift production volume to an overseas supplier, not all variable costs disappear.

Why? Because some "variable" costs are actually fixed. If you currently allocate 15 cents per unit for equipment maintenance, this cost won't disappear when volume declines because the line is still used for other production. So when absorbing the maintenance cost, your 10-cents-per-unit savings becomes an actual cost increase of five cents—five percent more than if you had done nothing.

3. Pipeline inventory. When a company goes from domestic ground transportation to international ocean—where the average shipment involves 27 different parties—it substantially increases the variability in its lead time. As a result, you need to determine safety stock increases on the combination of lead time and lead time variability.

The Bottom Line

To ensure your analysis is complete and will result in cost savings, as your firm evaluates an outsourced manufacturing opportunity you need to:

Evaluate your decision holistically. Your firm needs to factor total supply chain cost from raw materials to end customers. This includes evaluating the ripple effect on existing manufacturing and distribution infrastructure that results from reduced asset utilization and increased inventories.

Continuously analyze strategies. To avoid outsourcing programs that promise savings but don't deliver, re-evaluate your strategy on a periodic basis.

Consider an investment. Setting up your own operation or even a joint venture will force you to manage the operation holistically—trading off international allocations against domestic capabilities, thus driving greater efficiencies from your overseas operation.

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