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.

12 comments on “Finding Profitable Proximity

  1. Himanshugupta
    December 25, 2012

    Douglas, outsourcing is the theme of the season. As more and more companies are announcing to pull in manufacturing back so there are many theories on the probable reason. The most logical being financial. Most of the factors to decide on local manufacturing are easy as shipping, material cost, tax benefit, labour cost but how one calculate factors such as customer preference, technology transfer, knowledge transfer etc.

  2. Taimoor Zubar
    December 25, 2012

    @Himanshugupta: I agree. There are lots of factors which may influence the company's decision to outsource but unfortunately most of them are unknown and only time will tell how they turn out to be. Companies can only make their decisions on the basis of speculated outcomes.

  3. prabhakar_deosthali
    December 26, 2012

    One of the most important aspect to study before deciding on the outsourcing is to know the local culture of the people at the location of outsourcing. Understanding the local people and their culture is very important because they are going to be your work force at the outsourced destination. Effective rapport with them will go a long way in establishing your manufacturing base. Else the local management may take you for a ride.

    This is over and above the bare cost calculations which you may do to see the profitability of doing manufacturing overseas.


  4. Himanshugupta
    December 27, 2012

    @Prabhakar, i think that the knowledge of local cuture is nice but not necessary. Company can hire cross-cultural manager for that. But knowing how to keep employee happy and keeping the cost low is for sure tricky. Also knowing how to get things done from people and politician is something more important.

  5. Mr. Roques
    December 28, 2012

    How important is it to have similar industries close? Would it be the same to move to China than to some other country (when costs are the same)?

  6. _hm
    December 28, 2012

    It is difficult to find products made in USA, Japan, Germany or like. I try to find similar products and purchase them immediately. e.g. Braun Shaving machine, Braun tooth brush, few Mytag appliances and some garments. Keeping production locally can also have more customers and good profitibility.


  7. itguyphil
    December 29, 2012

    Now that I think about 'outsourcing' more, is it possible that these companies will bring the manufacturing back on shore but outsource the other operations?

    Sort of a logistcal flip to meet the PR hype going on in the US now.

  8. hash.era
    December 30, 2012

    Mr.Roques: I feel moving to the sub continent would be much more profitable. Especially to a country like India would be ideal if allowed.

  9. Taimoor Zubar
    December 30, 2012

    @_hm: High quality products are in demand but unfortunately there's only a small portion of people who are willing to pay a premium price for the high quality. The bulk of the consumers go for low price products which may not offer the best quality. This has been the trend with almost all electronic products lately. So I don't think a high cost, high quality strategy will be very profitable.

    January 1, 2013

    How can one put a cost on the political and social economic benefits of manufacturing locally.  Much pressure is being exerted “morally” on companies to do the right thing for their country and not always chase the cheapest solution.  How is a cost assigned to this?

  11. Mr. Roques
    January 10, 2013

    Is it always based on lower salaries? but what about trained HR (that has already been trained by another company in the area), that should count for something? What about easier communication (another country in the western hemisphere)?

  12. hash.era
    January 25, 2013

    Mr.Roques: Yes those two points do count too but higher perception is on salaries for sure.

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.