Rationale behind re-shoring business activities: a business case

Rationale behind re-shoring business activities: a business case

A much heard statement in the media nowadays is that the US is steadily losing ground to emerging and developing economies if it comes to locating manufacturing business activities. In contrast, we also saw increasing anecdotal evidence of a trend which is called “re-shoring”, which involves a re-migration of business activities back to the US from overseas locations. This fourth chapter in the series on US competitiveness will take a closer look into the total cost of producing overseas versus producing domestically, and tries to highlight hidden costs of relocating overseas, often ignored by internationally operating companies.

By means of a real business case, we present all relevant cost drivers that should be considered to arrive at accurate financial scenarios for making a strategic decision to relocate overseas or to expand domestically. Any financial base case analysis of the impact of offshoring manufacturing activities must take into account all the costs associated with an offshore initiative. The Total Cost to Ownership approach (TCO) analyzes the entire cost a company incurs when producing or purchasing a particular manufactured part overseas. The TCO approach consists of the following key components:

  • Raw material Costs
  • Packaging Costs
  • Transportation Costs
  • Customs and Duties Fees
  • Inventory Costs
  • Lead times and local warehousing Costs
  • Quality control Costs
  • Travel Costs
  • Training and Productivity
  • IP Risks
  • Exchange Rate Fluctuations
  • Inflation Rates

 

In practice, corporate decision makers often ignore important cost drivers as listed above, and focus only on the labor cost differential between the US and emerging economies such as China, Vietnam and India. Indeed, in that case China’s labor cost of 2,80 USD per hour versus 25 USD per hour in the US would eliminate all manufacturing activities in the US. However, there is a growing trend of re-shoring business activities from offshore bac to the US, and by means of a case study we will highlight the ratio behind this trend.

5.1 Business Case

Company – XYZ – is productive in the automotive industry and is a first tier supplier to OEM automotive manufacturers. It produces high-technology braking and gearing systems, for which it also uses its own software systems, fully integrated with their “hardware” products.

For their supplies of specific steel products, they are depending on several suppliers that are located globally. The board of directors is following a vertical integration strategy to allow for further growth of the company. One strategic question is to source the steel from third parties or produce and process the steel for their products internally. Second important question is where to locate the steel processing plant. Would it be more beneficial to locate the steel plant overseas and potentially benefit from lower cost levels, or does it make more sense to keep it close to the other facilities located in the US, to minimize lead times and minimize transport costs?

We will apply the TCO approach to these two strategic questions and try to provide a fact based answer to both questions.

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Now let’s consider a unit price of one component steel of $100 versus $70 in China. The reason why packaging costs is typically higher in China, is because of export packaging is much more complex and has to meet specific standards of the countries of destination and origin. An important cost driver here are the import and export duties for this product (i.e. 4% for steel parts), and the associated fixed (Broker and Customs Fees) and handling fees. Given the nature of the product (i.e. weight / value ratio) we furthermore assume that all supplies are shipped per surface freight. Adding all costs for the US and China we have a total Cost of Goods Sold (CoGS) of $101 compared to $75,09.

This case study demonstrates that off-shored production may mean “cheaper price”, but not necessarily “lower Total Cost of Ownership”, as will be demonstrated further below. Sourcing or producing locally means long lead times, transit and warehousing issues, urgent matters which requires traveling, and other hard costs. The next page shows a summary of the different cost drivers for this particular case study.

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A carrying charge is the cost of storing a physical commodity, such as grain or metals, over a period of time. The carrying charge includes insurance, storage and interest on the invested funds as well as other incidental costs. When producing locally we assume no transit carrying costs, while the cost for inventory on-site are significantly lower in the US with 100% Just-in-Time solutions, compared to China with average lead times of 45 – 60 days. In addition, long lead times require local warehousing stock for continuous delivery with coordination costs to place and pick the right products for the right shipments.

The prototype costs, including industrial design, are also generally higher offshored compared to the US, with local US firms adding a risk premium to compensate for not getting the production.

One straightforward cost driver frequently underestimated is the travel cost back and forth. En economy class fare from the US to China easily amounts US1,500 per tickets, with business class tickets 3 – 4 times more expensive, and this is even without any accommodation costs. In addition, factor in the time and expenses necessary to visit several suppliers and then audit at least one or more to finally select one.

If all hard costs are factored in, the price difference decreases to $16, still in favor of the scenario to start production in China. Undeniably for different products and commodities, China or any other emerging economy might be an interesting sourcing or production destination taking into account hard cost figures only. Yet, per definition there are also business risks involved in producing overseas. One of the major concerns relates to the protection of intellectual property protection, with relatively poor enforcement regimes in many emerging economies. One other aspect that relates to several major concerns is the quality levels of producing or sourcing overseas.

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There are daily examples of shipments being delayed due to difficult logistics, strikes or customs issues. Additional costs are necessary to get the supplies in time, and avoid capacity constraints at the other production plants or delivery expectations with final customers.

Moreover, there are higher risks with working with overseas suppliers due to the fact that they will incorporate rapidly rising cost levels to you as customer, face language and cultural barriers and increasingly, behave opportunistically. Opportunistic behavior frequently occurs with local overseas suppliers breaching contracts when they negotiate a better deal with competing firms. Quantifying these risk levels based on estimates found in international business literature, results in a further reduction of the cost differential between the US and China (i.e. $108,17 and $96,50 respectively).

In relation to some of the business risks, there may also be strategic reasons for senior management to keep production in close geographical proximity with R&D departments. There is much debate on the advantages of face-to-face meetings, with personal interaction, superior to conference or video calls. Physical distance is considered a negative indicator for the impact on innovation and the extent to which one is able to differentiate production or adjust production due to changed customer demand.

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When we include these strategic cost differentials we arrive at a total cost of ownership of $108,17 compared to $97,20 in China. In other words, the US is facing a cost disadvantage of 11,3% for this particular part compared to China.

Is this sufficient reason to move production to China, and what about forecasting trends? Skilled wages in low labor cost countries have been rising at about 10% per year vs. 2% in the U.S. Recent major labor strikes in China have resulted in wage increases of 24% to 100% annually. Transportation costs are rising again as oil prices increase and OEMs who have sourced work overseas continue to report problems with quality, counterfeiting and intellectual property violations. In addition, China’s currency is appreciating against the US Dollar(on average 5%), which will further increase local product prices denoted in USD. By forecasting the annual cost increases based on the yearly impact of wage inflation and the appreciation of the Chinese Yuan, we can model the cost of ownership for a longer period.

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A 5-year forecast model in this case study shows that the total cost of ownership will be eliminated in the medium to long run (i.e. 5 year time span).

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Source: Reshoringmfg.com 2011 and Investment Consulting Associates

This is perfectly in line with Boston Consulting Group’s recent study showing that after adjustments are made to account for American workers’ relatively higher productivity, wage rates in Chinese cities such as Shanghai and Tianjin are expected to be about only 30 percent cheaper than rates in low-cost U.S. states. And since wage rates account for 20 to 30 percent of a product’s total cost, manufacturing in China will be only 10 to 15 percent cheaper than in the U.S.—even before inventory and shipping costs are considered. After those costs are factored in, the total cost advantage will drop to single digits or be erased entirely.