Balancing on the Rim

Like gravity, the lure of Asia’s rock-bottom costs and abundant labor force has a powerful pull. But companies need to closely examine potential pitfalls of sourcing halfway around the globe. Taking that first step into the Pacific Rim means walking a tightrope between the benefits and risks.


Rewards Without the Risk

In any discussion of business in general, and global sourcing in particular, China typically monopolizes the conversation. And no wonder; its trade statistics are staggering.

In 2004, for example, China’s exports surged 35 percent to reach $593.4 billion, according to the Beijing-based Ministry of Commerce.From January to September 2005, China’s trade with the European Union jumped 23.3 percent to $157.8 billion.

In the same time frame, China-U.S. trade reached $153.5 billion, up 25.6 percent; and its trade with Japan increased 10.5 percent to $134.5 billion. And during the first nine months of 2005, mainland China’s total exports rose 31.3 percent to $546.4 billion.

Other Pacific Rim countries, such as Singapore, Thailand, the Philippines, and Malaysia, are also hot spots for global sourcing. Exports from countries in the Association of Southeast Asian Nations (ASEAN), for example, reached $431 billion in 2003, topping the $408 billion peak in 2000.

The upward trend continued in 2004, with ASEAN-6 exports (those from Brunei Darussalam, Indonesia, Malaysia, the Philippines, Singapore, and Thailand) up 21.8 percent over 2003.

“Global sourcing has become a way of life for retailers, manufacturers, and other industries,” says Philip Toy of Mercer Management Consulting. “New sourcing locations provide a variety of products, components, technology, and repair and service options at competitive costs.”

The Cost Factor

The hourly labor costs in countries such as China and India are far less than in the United States, Europe, or even Mexico. These developing countries have improved their manufacturing capabilities, infrastructure, and technical and business skills, making them more attractive regions for global sourcing.

“In addition, stabilized political climates, reliable communications and logistics, and falling trade barriers have made it easier than ever to source from many areas of the world,” says Toy.

China exemplifies these trends. The country is well-positioned as a source for global manufacturing thanks to its scale, skills, and cost trade-offs. Compared to the rest of Asia, China offers low-cost labor at a high-quality skill level. The average monthly wage for a manufacturing worker in China is US $98 (2000-2002), compared to $1,683 in Singapore, and $1,385 in Korea.

This wage disparity is unlikely to disappear anytime soon, say George Stalk and Dave Young, senior vice presidents at the Boston Consulting Group.

“Typically, a U.S. or Western European factory worker costs an employer $15 to $30 per hour. A Chinese factory worker earns the equivalent of less than $1 per hour. If, over the next five years, wages in China increase 15 percent annually, while they increase a healthy 3 percent to 4 percent a year in the United States, by 2009, the average hourly wage will be $2 in China and $18 to $35 in the industrialized West,” write Stalk and Young in a recent Washington Post column.

“So, despite the disparity in growth rates, the hourly wage gap would widen to $16 to $33. Western countries’ government-mandated labor costs, such as workers’ compensation, make the difference greater yet,” they add.

Multinational companies continue to rush to take advantage of China’s labor cost/skill set advantage. North American multinational manufacturers, for instance, expect to increase Chinese operations by 37 percent in the next two to three years, according to Deloitte Research.

Similarly, Western European multinational companies are expected to grow by 31 percent in China in the same period.

Overlooked Risks

While cost savings are a substantial benefit driving many companies to Pacific Rim sourcing, going global means other supply chain issues take on added significance.

“Transportation time and costs, for instance, are impacted by distance and geography,” says Toy.

“Western multinationals can expect logistics-related costs to comprise 20 percent of their Chinese operations, compared with an average of 10 percent in the West,” says Udo Jung, a vice president with Boston Consulting Group.

“Transporting goods over a long distance often means switching logistics providers, and integration is not always seamless. The result is a lot of paperwork. Also, different provinces have different regulations—these ‘non-tariff trade barriers’ all add to logistics costs.”

Naturally, long-distance supplier management is challenging. Lead times, demand variability, productivity, quality, tracking, performance measurement, and problem resolution become more complex as a function of distance. To keep tabs on overseas suppliers, a company may need to hire or retrain workers, or develop a local presence where the supplier is situated.

“All too often, companies overlook these risks. They don’t calculate solving potential quality issues from a distance,” says Toy. “They don’t recognize the added length and complexity of a global supply chain means additional handoffs as well as port and mode transfers—all of which can cause disruptions.

“Instead, these companies treat global sourcing as simply an extension of their standard local sourcing and supply chain processes,” he continues. “The results can be disappointing and sometimes disastrous. A geographically extended supply chain is always complex and fragile.”

A case in point is one Class 1 railroad that recently decided to source certain rail track components from China. The railroad found a Chinese supplier offering quality product that met durability standards. So it decided to switch from its domestic supplier to the Chinese vendor.

“The first batch of product from the Chinese supplier was fine,” Toy says. “The second batch, however, was not.”

The carrier tested the product and found the properties of the metal were not the same; it no longer met the railroad’s durability requirements. The company returned the second batch, received a third batch, and found the same quality problem. The railroad then sent an inspector from a Chinese agent to the factory.

“The inspector discovered the supplier actually changed the manufacturing process without telling the railroad,” Toy says.

Fortunately, the railroad hadn’t yet switched all sourcing for the component to the Chinese manufacturer. It negotiated a deal with its U.S. vendor for increased supply, and stopped doing business with the Chinese supplier.

“The railroad’s tale of woe is not the last such story we’ll hear,” warns Toy.

When companies consider sourcing from the Pacific Rim or other low-cost areas, they must weigh the economics against the risk.

“Many companies do not assess risk in any quantifiable way,” reports David Bovet, Mercer Management Consulting.

A Portfolio Approach

Companies should adopt a “portfolio theory” approach when making sourcing decisions, Bovet advises. That means identifying, classifying, and quantifying supply chain risks associated with each approach. A company must assess the added complexities of getting goods from door to door, for example.

“Creating a portfolio starts with developing a set of alternative supply chain designs that support the business in different ways,” Bovet explains. “One design might emphasize speed to market, another may focus on manufacturing quality, and a third could hone in on cost.”

Problems can occur at almost any point in the international sourcing supply chain, which is typically fragmented across multiple parties. “Firms must weigh mode costs against reliability requirements,” Toy says.

After identifying projected returns and risks, companies can model and plot them on a spectrum. The optimal solution represents the set of options with the highest return for an acceptable level of risk.

“Portfolio modeling offers two advantages,” Bovet says. “First, it is understood and practiced by CFOs and allows supply chain executives to make the case about risk in terms senior management understands.

“Second, it focuses on the business value that supply chain management delivers—satisfied customers, capital efficiency, and low operating costs—for a given level of risk.”

Adding Value

The electronics industry is one sector familiar with balancing the risks and rewards of Asia Pacific sourcing. Many electronics companies have been offshoring production and managing Asia-based supply chains for 20 to 30 years.

Distributors such as Arrow Electronics and Avnet Inc. play a broad role in the electronics supply chain, helping companies of all sizes manage the complexities of doing business in and around Asia.

Arrow Electronics, with 2004 sales of $10.6 billion, is a global provider of products, services, and solutions to industrial and commercial users of electronic components and computer products.

Headquartered in Melville, N.Y., Arrow serves as a supply channel partner for nearly 600 suppliers and 150,000 original equipment manufacturers (OEMs), contract manufacturers, and commercial customers through a global network of more than 200 locations in 53 countries and territories.

Arrow Asia/Pacific serves 11 countries and territories in the world’s largest and fastest-growing electronic equipment manufacturing market. In 2004, this market produced more than $400 billion in electronic equipment, a production level projected to increase to more than $550 billion over the next four years.

“Arrow works with numerous suppliers and OEMs that are migrating their business to Asia,” says Paul Katz, vice president, global supply chain, Arrow. “This is not a new trend. The first wave of migration to Asia focused largely on cost reduction; the second, current wave focuses on reaching new end markets—now the primary driver for companies shifting production to the Pacific Rim.

“Take a company that makes pollution control devices for combustion engines,” he says. “China is a potentially huge market for those products, but to tap into it, companies have to manufacture in China. While companies can reduce costs by sourcing in Asia Pacific, the big driver is the sheer end-market sales potential that comes from having a presence there.”

While Arrow’s customers run the gamut in size, its core base is small- to medium-sized companies. Many are not familiar with managing logistics in Asia.

“They find the logistics industry in Asia Pacific more fragmented than in the United States,” Katz says. “The Asia Pacific logistics industry is comprised of small players that offer lower levels of supply chain support.”

That’s where Arrow comes in.

Arrow has formal relationships with a growing list of suppliers in Asia, so it can play a role in meeting bill-of-materials requirements for companies shifting manufacturing into Asia.

“This can be a complex undertaking, especially for companies moving goods into, out of, and within China. We’ve developed the logistics infrastructure, procedures, and licensing to support manufacturing in any part of Asia,” says Katz.

“Electronics suppliers and OEMs are looking for a comprehensive sourcing and supply chain plan. They don’t want to simply move production to Asia and see what happens.”

Arrow has created a set of Asia Pacific supply chain service offerings tailored to its customers’ needs and sophistication levels.

“With vendor-managed inventory programs, for example, we can manage buffer or bonded inventory out of our warehouses,” Katz explains. “Or, we can manage consignment inventory at customer locations.”

Arrow Takes a Bow

For the latter, customers manage the consignment and hold the inventory in a secure, physically segregated area. Arrow handles the material planning responsibilities, delivers inventory to this on-site area, and retains title to the inventory until disbursement. Strict controls are required to maintain visibility, align liability, and preserve inventory accuracy.

“Arrow can also manage the process of feeding production material to the customer’s production and engineering operations just-in-time,” Katz says. “Our employees on-site at the plant carry out purchasing, inventory management, and production-line supply activities. We maintain ownership of material up to the point of use or consumption.”

Phoenix-based Avnet Inc. also helps customers make the most of Pacific Rim sourcing. With more than $13 billion in revenue, 100,000 customers, and 300 suppliers, Avnet is one of the world’s largest B2B distributors of semiconductors; interconnect, passive, and electromechanical components; and enterprise network and computer equipment.

“All companies in the high-tech industry face the challenge of coordinating global supply chains,” says Greg Frazier, executive vice president, supply chain services worldwide for Avnet.

“Companies typically have made strides managing regional supply chains, but once they extend beyond individual regions, they have to deal with more constituents, time zones, communications, tariffs, and duties—all of which add complexity. It’s our job to come up with processes that allow customers to manufacture anywhere in the world and not have to worry about their supply.

“Our customers want to maintain command and control of their supply chains, but don’t want to handle the day-to-day execution. We feed them the supply chain information they need to make effective decisions,” he adds.

If an Avnet customer, for example, needs 100,000 pieces but only 50,000 are available, Avnet provides that information so the customer can make an allocation decision. Similarly, Avnet’s customers dictate which suppliers the distributor uses. If Avnet finds a $10 component priced at $5 per unit at a different supplier, however, it forwards that pricing to the customer before moving ahead.

“We have to be flexible and responsive,” Frazier says. “We own and manage inventory at customer sites at 175 locations around the world. The customer only takes ownership when it pulls the item to its manufacturing line.”

Gaining Clout

High-tech companies that use Avnet’s products take advantage of the distributor’s aggregate buying clout to secure material and components at a lower cost. And because Avnet has other outlets for inventory, if one customer doesn’t need the material, it can move to other customers.

“Our customers have no way to mitigate excess inventory, but we do. They want maximum flexibility with limited or no inventory liability,” Frazier explains. “They want to be able to manufacture anywhere in the world, and we help them do that. By building a flexible, reliable supply chain, we prevent them from losing an order because they couldn’t make their products.”

Overall, that flexibility is one main benefit companies gain through global sourcing. But it’s not the whole story.

“Companies considering Asia Pacific sourcing need to think about the whole supply network,” Katz advises. “Options for supply chain solutions in Asia are growing, but companies should look at their product volume, mix, and complexity, and the end markets they intend to serve, before setting up manufacturing locations in the region.”

Rewards Without the Risk

Pacific Rim sourcing brings substantial benefit to many companies, but also comes with risk. David Bovet and Philip Toy of Mercer Management Consulting offer the following suggestions to help companies reduce risk in Pacific Rim sourcing operations:

1) Improve demand planning with distributors and retailers by closely connecting with customers through shared demand forecasts, vendor-managed inventory, and other joint systems. The goal is to avoid being blindsided by demand shifts.

2) Manage supply proactively. Work with suppliers to create contingency plans and diversify sourcing to reduce the risk of catastrophic supply chain failure. Establish backup arrangements by qualifying additional suppliers, even without awarding them significant volume. Companies should consider awarding 10 percent to 20 percent of their needs to a second supplier that will diligently try to displace the primary supplier.

3) Extend insurance policies to cover overseas suppliers. Contingent business interruption coverage, for example, is typically limited to the United States and nearby countries. Extend it explicitly to cover major suppliers located in Asia and other low-cost regions.

4) Consider employing a major third-party logistics provider (3PL) or distributor with broad resources and experience working in Pacific Rim countries. Because top 3PLs have been doing business in the area for years, they offer robust networks and expertise.

5) All components are not created equal, so model and optimize inventory on a disaggregated basis. Modeling supply susceptibility to delays helps companies fine-tune safety stocks—which may rise for some parts or finished goods, but fall for others.

6) Increase product component standardization. The ability to mix and match components from multiple suppliers and plants allows companies such as Dell and IBM to increase supply chain flexibility. Reducing product complexity also shortens cycle times and speeds response to supply crises.

7) Create a centralized product data management system. If your supplier is the only one who knows the specifications of your products or components, during an emergency it may be time-consuming, if not impossible, to rapidly re-source products. Developing a database of products and components so substitutes can be rapidly located helps reduce the risk of disruption.

8) Raise visibility along the extended supply chain. Tracking inventory from order placement to reception at a forward distribution center or customer means inventory can effectively become part of a company’s safety stock.

9) Monitor specific warning signs. Tracking a limited number of supply chain risk indicators such as average train speed, weeks of orders outstanding, component delivery variability, and exchange rate movements provides a crucial warning as problems approach tipping point.

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