Finding Profitable Proximity

Low labor costs and stable oil prices have driven the move to offshore production in industries as diverse as textiles and high technology products for almost 30 years. Since then, it has become an almost universally accepted article of faith that manufacturing in low-labor cost (LLC) countries and shipping to demand markets is the smart way to do business.

That might be true if fuel prices never increased and drove up shipping costs. Or if wages never rose in overseas labor markets and eroded cost advantages. Or if political upheaval and natural disasters never interrupted the flow of parts and finished goods.

Those factors can undermine a production strategy based solely on low labor costs in distant regions. When is it smarter to move production into a higher-cost area to moderate other factors? In other words, what is the "profitable proximity" of supply in relation to demand when all factors are considered?

In recent years, moving to distant-shore production has been little more than following the leader or acting on relative costing, and not fully inclusive costing. If you haven't evaluated your complete cost-to-serve expense structure in at least the last two years, you can't know for sure whether your supply chain strategy is still working for you.

Determining your production site's profitability starts with truly understanding your location-based costs. Most companies don't do a good job of fully considering all of their cost factors. They're basing their supply chain models on inaccurate and/or incomplete information. Labor, quality, materials, and shipping are the obvious cost factors, but supply chains often harbor hidden pockets of cost that should weigh heavily in offshoring decisions.

The first step in finding those hidden pockets and accurately figuring your costs is choosing the right metric. The most inclusive calculation of production costs is "cost to serve." It encompasses all of the expenses of moving an individual product to an individual customer, and not just the obvious costs such as production and transportation.

Difficult customers, for example, have to be figured into your costs because they are more expensive to manage than easy customers. If they forecast carelessly, constantly forcing you to ship extra product on short notice, they drain your staff and might upset your manufacturing and distribution schedules. Even if you pass along the obvious costs -- the product, the shipping -- they're costing you in lost opportunity and productivity.

Size also matters. If you are treating a national retailer that moves several thousand units per day the same as a local store that moves two units, you are absorbing much higher costs on the smaller customer.

Maintaining inventory is a big expense that's not often fully accounted for. Poor forecasting can force companies to carry products in inventory for too long. In extreme cases, products in inventory can become obsolete and must be written off.

Examining your inventory management should lead to a review of your product portfolio. Are products in inventory for too long because items in your portfolio compete? A cost-to-serve analysis can reveal redundancies and conflicts in your portfolio and help you reduce it to a more manageable size.

These are examples of costs that might be hiding between the lines of your balance sheet. Different industries will have different hidden costs, and they can also vary by company. The trick is to know where to look for them and make sure they're incorporated into your cost-to-serve calculations. That yields an accurate baseline for evaluating your supply chain options.

The final piece to applying a cost-to-serve methodology is considering advanced enabling technologies to help you quickly perform "what if" analyses on the factors that affect your supply chain decisions. Mining cost data quickly and creating a series of scenarios based on changing factors builds agility into your supply chain decision making.

What do you do if oil goes to $130 per barrel and your transportation costs spike? If you're still costing your products based on limited factors, you might get lucky and make the right decisions about modifying your supply chain. Don't trust to luck. Cost-to-serve analysis enables you to make informed decisions based on concrete analysis.

In this scenario, a steep oil increase prompts you to reconsider your entire supply chain. Does a low-cost labor strategy still fit your needs? For instance, if you produce a low-labor product, the gain that you originally made from outsourcing was probably small to begin with. A major increase in related expenses could wipe it out entirely and actually start eating into your profit margin.

You might decide to blunt a sudden spike in transportation costs by shifting production to a region with higher labor costs that's closer to your demand market. However, does doing that make some of your higher-maintenance customer segments unprofitable? Could you keep those customer segments profitable if you kept production for them in a distant LLC and opted for a lower-cost transportation option? Or, maybe the answer is postponement: manufacturing base-level products in LLC locations but customizing them nearer to the demand to dilute your inventory risks.

Using cost-to-serve and a business intelligence system to answer questions like these is the essence of profitable proximity. Low labor costs are not the sole measure of a solid supply chain strategy. Neither are transportation costs, quality, protecting intellectual property -- add as many factors as you need. The point is to weigh them all in relation to current business conditions and not to be bound by decisions made in different times.

This article initially appeared in the December issue of Supply Chain Velocity digital magazine. Click here to read other articles in the package.