This is Naked Capitalism fundraising week. 160 donors have already invested in our efforts to shed light on the dark and seamy corners of finance. Join us and participate via our Tip Jar or read about why we’re doing this fundraiser and other ways to donate on our kickoff post.
Readers may know that I have strong feelings about offshoring. There is plenty of evidence that the case for offshoring and outsourcing are considerably overdone. First, direct factory labor is only a small part of the total wholesale cost of manufactured goods, typically 10% to 15%. While offshoring clearly reduces those costs, there are offsets: increased managerial/coordination cost, greater transport and inventory financing costs. I’ve had some executives in different lines of business tell me their company decided to outsource/offshore despite the fact that the business case was not compelling. Second, offshoring increases risk, particularly the risk of getting stuck with inventory you can’t sell.
This VoxEU article does a nice job of looking at the tradeoffs between cost savings and customer responsiveness.
By Xiaole Wu, Ph.D candidate in Operations & Supply Chain Management, and Fuqiang Zhang, Associate Professor of Operations & Manufacturing Management, Olin Business School, Washington University. Cross posted from VoxEU
As the global economic downturn grinds on, more companies are acknowledging that labour costs aren’t always the most important factor when deciding where to build their next factory. This column argues that, in times of recession, some companies find that bringing their business home can give them a competitive edge.
While politicians argue strategies to create jobs in the faltering global economy, the debate around offshoring has intensified. Once considered a clear competitive advantage in the fast-changing global market, manufacturers rushed to replace domestic labour forces with lower-cost workers in emerging markets. By 2002–03, about a quarter to half of the manufacturing companies in Western Europe were involved in offshore production (Dachs et al 2006). And by 2008, more than 50% of US companies had a corporate offshoring strategy (Minter 2009).
Recently, though, many of the perceived offshoring advantages have been called into question. First, the sourcing costs from emerging economies have been rising rapidly. For example, as of mid-2010, many Chinese firms were facing labour shortages and were forced to boost wages to attract qualified workers (Plunkett Research 2010). Second, the global commodity price index has risen significantly (Archstone Consulting 2009). This has led to more expensive transportation costs, particularly as a result of higher oil prices, as well as higher production costs. Third, the economic recession that started at the end of 2007 has had a severe impact on the market. Consumers are more cautious in spending, and firms are seeking new strategies to retain customers (Dodes 2011).
So it should not come as a surprise that more US manufacturers are ‘reshoring’, ’onshoring’ and ‘backshoring’. General Electric announced last year that it is moving some of its appliance manufacturing from China to Louisville, Kentucky. NCR Corp. is pulling all of its ATM machine production from China, India, and Hungary back to a facility in Columbus, Georgia, in order to customise products and get them to clients faster. In their announcements, these firms emphasised that by being closer to the market, they can better understand the market and are able to respond quickly to market changes.
As these industry examples illustrate, the tradeoff between cost and flexibility can be quite involved and difficult to evaluate. It now appears that the labour-cost benefits gained from offshoring might not be sufficient to cover the lost flexibility under many circumstances. So before making any sourcing decisions, firms at the crossroads need to understand the business environment as well as the competitor’s sourcing strategy. The purpose of our recent paper (Wu and Zhang 2011) is to investigate the underlying factors that affect the sourcing trend and provide insights to firms on strategic sourcing decisions in a competitive setting.
Our paper studies a two-stage sourcing game in which competing firms could choose between sourcing internationally (call this the efficient sourcing strategy due to low production costs) and sourcing domestically (call this the responsive sourcing strategy due to short lead times). We first identify the point of equilibrium between the two sourcing strategies. Then we examine how that equilibrium shifts based on key parameters. We find three key factors that influence a shift from efficient sourcing to responsive sourcing: consumer demand, market size, and supplier costs.
All things being equal, when demand is relatively stable, most companies look for the lowest cost option, which usually translates to offshoring. As demand fluctuates, though, as in the recent recession, companies need to respond faster to shifting consumer sentiments.
Onshore suppliers give companies greater flexibility because they don’t have to deal with overseas transportation, which means they can place orders much closer to the selling season. As a result the firm can have a better forecast of demand information. It also gives the firm more time to understand the needs of the customer and integrate the updated product specification required by the customer into the production at the last minute.
Because the major benefit of sourcing from a responsive, or onshore, supplier is to obtain more accurate demand information, that advantage disappears when there is no demand uncertainty. At that point, the competitive advantage rests solely on cost efficiency. This implies that for products with highly predictable demand, offshoring is still a useful strategy.
After that, firms need to consider market size. Companies targeting smaller markets need to stick closer to home because competition is more intense and the firms’ selling quantities are low. That makes accurate demand information more valuable because being able to respond quickly to their customers outweighs additional manufacturing costs. This may partly explain why the backshoring phenomenon became prominent during the recent recession.
Middle-market companies can benefit from diversifying their sourcing strategies by balancing the lower cost of offshoring with the increased flexibility of using domestic, or onshore, suppliers to fill short-term needs. Larger markets, though, mean bigger orders, so companies will use efficient, or low-cost, sourcing whenever possible.
Finally, any change in supplier costs can affect sourcing decisions. Naturally, when an offshore supplier’s price rises you would expect to find more companies preferring the convenience of domestic suppliers. What we found, though, is that when there is an equal cost increase for both domestic and offshore suppliers, more companies still place greater value on being able to respond quickly to their clients. The rising cost of commodities and the commensurate increase in backshoring by US companies is an example of this phenomenon.
Makers of innovative products in markets where tastes change quickly will value supply flexibility and are more likely to “backshore”. But for companies that rely heavily on low manufacturing costs, backshoring will decrease, although the countries from which they source may change. As wages increase in China and other developing economies, businesses will seek lower-cost manufacturing sites elsewhere.