Managing the Reality of Offshore Assembly
Like it or not, offshore production is a fact of life in manufacturing today. Volatile economic conditions have forced manufacturers in all industries to reassess traditional business models and focus on the bottom line. In most cases, the potential benefits of offshore assembly cannot be ignored.
By shifting production to China, India, Mexico, Slovakia and other locations, manufacturers can reduce operating costs, improve return on invested capital, appease shareholders, and quickly enter and exit growing or mature markets.
"Fierce global competition is here to stay," claims John Engler, president of the National Association of Manufacturers (NAM, Washington, DC). "America's businesses and workers have no choice but to meet that competition head on."
Low-cost countries are changing the competitive landscape. "Seeking global advantage through low-cost countries is an imperative for all industrial companies," says Dave Young, senior vice president of Boston Consulting Group Inc. (Boston). "Those not yet examining [this strategy] need to begin now, and those already moving need to pick up the pace.
"The opportunities for competitive advantage are so large-and the potential missteps and penalties for inaction so costly-that all [manufacturers] must at least consider integrating low-cost countries into their strategic planning," adds Young.
Offshore production creates many new opportunities and new challenges for manufacturing engineers. However, engineers must confront two big misperceptions:
- Offshore manufacturing is always cheaper.
- Offshore manufacturing is always bad.
"To address the first myth, one needs to look at the total cost of producing, shipping and distributing, not just the unit labor cost, to determine the relative cost efficiency of in-house vs. offshore production," says Don Penkala, president of Granite Bay Consulting Inc. (Granite Bay, CA). "In my estimation, using an offshore manufacturing strategy is cheaper maybe 75 percent of the time, but certainly not 100 percent. And offshore manufacturing makes lean manufacturing virtually impossible."
Regarding the second myth, Penkala says moving manufacturing offshore is traumatic for those who lose their jobs and are unable to replace them with ones offering similar pay. "But, many studies have shown that offshoring benefits the U.S. economy as a whole, and protectionist efforts inhibit future growth in jobs and new technologies," Penkala points out. "Policies that encourage trade and improve efficiencies must be balanced with initiatives that ease the pain of displaced workers and their families."
Unfortunately, offshore assembly is not a short-term phenomenon. Today, there is more offshore activity than ever. "There has been an incredible escalation in production shifts out of the United States to both Latin America and Asia," says Kate Bronfenbrenner, Ph.D., director of labor education research at the School of Industrial and Labor Relations at Cornell University (Ithaca, NY).
"The number and extent of production shifts out of the United States have increased significantly since 2001," explains Bronfenbrenner, who recently conducted an extensive study on the subject for the U.S.-China Economic and Security Review Commission (Washington, DC). "This global race is driven by several unifying factors: The search for ever cheaper production costs; accessibility to expanding global markets; and the flexibility that comes from diverse supply chains in an ever more volatile global economic and political climate."
Sobering StatisticsBronfenbrenner's study, conducted with a colleague at the University of Massachusetts (Amherst, MA), reveals some eye-opening data and sobering statistics. For instance, between Jan. 1, 2004, and March 31, 2004, when the research was conducted, more than 130 U.S. manufacturers announced intentions to shift production outside the country.
Bronfenbrenner discovered that there were 69 announced or confirmed production shifts to Mexico, followed by 58 shifts to China; 31 to India; 39 to other Asian countries, such as Malaysia and Thailand; 35 to other Latin American and Caribbean countries, such as Brazil and Guatemala; and 23 shifts to other countries, such as Hungary and Poland. In an earlier study conducted during a similar 3-month period in 2001, Bronfenbrenner discovered that there were only 30 production shifts to Mexico, 25 to China and one to India.
A total of 48,417 jobs were shifted out of the United States to other countries during the first 3 months of 2004. Specifically, 23,396 jobs shifted to Mexico; 8,283 to China; 3,895 to India; 5,511 to other Latin American countries; 4,419 to other Asian countries; and 2,933 to all other countries.
"Not only are more companies announcing production shifts out of the United States than they did 4 years ago, but they are also shifting production to more, and often shifting production to multiple offshore and nearshore destinations at the same time," Bronfenbrenner points out. She defines "nearshore" as countries where manufacturers can keep production cross-border, but not offshore, so it can be quickly, easily and cheaply accessed through ground transportation. Mexico and other Latin American countries are considered nearshore locations for U.S. manufacturers, while Hungary, Poland, Slovenia and other Eastern European countries are nearshore spots for German manufacturers.
Nearshoring may soon become more popular in North America, because the Central American Free Trade Agreement (CAFTA) is expected to be ratified this spring. The controversial legislation, modeled after the North American Free Trade Agreement (NAFTA), would make Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua more appealing destinations for U.S. manufacturers.
"There is an increasing tendency to move production to multiple destinations in multiple countries at the same time," notes Bronfenbrenner. This simultaneously meets "the need to keep access to nearshore markets with less costly and less cumbersome shipping structures, while also gaining access to the large cost savings, market opportunities and government-supported infrastructure provided by offshore destinations in China and other Asian countries."
According to Bronfenbrenner, Texas Instruments Inc. (Dallas) is a good example of this trend. In February 2004, the company closed its leadframe facility in Attleboro, MA. The closure followed a yearlong shift of electronics manufacturing to a nearshore facility in Mexico and offshore facilities in China, Malaysia and Taiwan.
Another company that jumped on the global production bandwagon while Bronfenbrenner was conducting her research is GKN Automotive Inc. (Timberlake, NC). In March 2004, GKN, a major supplier of constant-velocity joints and other driveline components to Ford, Toyota and Volkswagen, announced that it would be shifting 3,000 jobs from high-cost facilities in the United States, Europe and Japan to Mexico, Eastern Europe and China. By 2007, the company expects that more than 50 percent of its production will take place in low-cost economies.
"One of the most troubling, but not surprising, findings is the lengths that corporations are now going to obfuscate or cover up how many jobs they are shifting from which source country to which destination countries, particularly shifts to China and India," concludes Bronfenbrenner.
Offshore Is Here to StayBoston Consulting Group also recently conducted a study that sheds some light on the offshore production trend. It predicts that industrial products will travel the path consumer goods did over the past two decades. Already, in the United States, some 70 percent of footwear, 60 percent of audio and video equipment, and 45 percent of apparel are now made offshore.
"Industrial goods sourced from low-cost countries now account for more than 10 percent of industrial consumption in the United States and, even in a flat economy, are growing at a rate of 30 percent per year," notes Dave Young. His report classifies industrial products in four categories in terms of seeking and realizing global advantage: moving early, growing fast, up-and-coming, and globalizing slowly.
According to Young, 10 percent to 15 percent of U.S. industrial operations-primarily automotive components-have been "moving early" into low-cost countries. About 15 percent to 20 percent of products, such as household appliances, motors, generators, relays and industrial controls, are "moving fast" and will account for "the next big wave of globalization."
Between 30 percent and 40 percent of industrial products, such as aerospace equipment and architectural or structural products, are "up-and-coming," but are increasing by more than 15 percent per year. Young claims that 25 percent to 30 percent of industrial items-primarily bulky, low-value products, such as truck trailers-remain relatively shielded from this trend and are considered to be "globalizing slowly."
Unfortunately, the trend toward offshore production is not even near its peak, warns Dermot Shorten, vice president of the Boston office of Booz Allen Hamilton Inc. (New York). By 2008, automotive and industrial product manufacturers will more than double their percentage of spending on components and materials in low-cost countries, he says. More than half of that spending will be earmarked for China.
"China remains one of the world's most desirable sourcing opportunities," explains Shorten, who specializes in supply chain management and manufacturing strategy. "Its wage advantages are not likely to end any time soon, and its skills as a supplier and manufacturer will only grow stronger."
Manufacturers can realize dramatic cost savings by shifting production to offshore or nearshore locations. "In general, the biggest cost savings are in labor," claims Young. "While a factory worker in the United States costs between $15 and $30 per hour, a Chinese worker makes less than $1 an hour.
"Further, the capital investment requirements for companies operating in China are 30 percent to 40 percent of what they'd be in the home country, because machinery is less expensive and because the greater availability of inexpensive labor lessens the need for machinery," adds Young. He says manufacturers can realize annual cost improvements of as much as 10 percent for products relocated to China because of expanded scale, deepening relationships with suppliers, and a competitive environment.
"And, even if labor rates increase dramatically in low-cost countries [due to growing unionization efforts or standard-of-living increases] and less dramatically in home countries, the gap in real wages may actually increase because the current base is so low [offshore]."
Unfortunately, Young says those cost savings will grow, not erode, over time. "Contrary to what some commentators have feared, the cost advantage offered by low-cost countries will persist and even expand, not evaporate as demand and modernization inflate labor and other costs," he points out. "We believe the cost gap won't narrow during the next two decades. And, in many cases, it may widen."
Low Cost Is Not Always BestFor many manufacturers, assembling products in Asia, appears to be the most direct path to dramatic cost cutting. Indeed, countries such as China offer an abundant supply of cheap labor, a pro-business environment, a productive workforce, and strong government support for manufacturing.
"China is the largest destination in terms of global production shifts," says Cornell's Bronfenbrenner. It has accounted for 33 percent of all offshore activity in the past 4 years. However, moving manufacturing operations from the United States to China does not necessarily translate into lower total product cost.
"While labor rates and material costs are easy to quantify, many other costs are not," warns Kevin Keegan, lead director of the Atlantic region communications and electronics practice at Pittiglio Rabin Todd & McGrath (PRTM, Waltham, MA). "These include the somewhat intangible-but very real-costs associated with managing cultural and language barriers, overcoming limited supply chain expertise, and coping with a supply chain rendered far less flexible because of the physical distance between the company and its manufacturing partner. In fact, the savings associated with lower labor and materials costs in China may be offset by these incremental costs."
When weighing the pros and cons of offshore production, "one needs to consider the effect on total system costs, not just the labor cost component," says Granite Bay Consulting's Penkala. "For high-volume, labor-intensive, commodity products, it is likely that offshore manufacturing will yield lower overall costs. But, this is often not the case for other types of products."
In addition, Penkala urges manufacturers to determine the relative benefits of offshore vs. lean manufacturing. "Offshore manufacturing may be able to reduce costs in the short run, but implementing lean principles has enabled many manufacturers to produce more efficiently and profitably within the United States and gain a long-term competitive advantage," notes Penkala.
When comparing the costs of in-house production vs. going offshore, Penkala recommends considering costs that are often hidden in overhead costs and ignored in many cases. "Longer lead times are often the result and can add a whole host of costs to an enterprise," he explains. Manufacturers should consider factors such as:
n Inventories. Will you need higher buffer stocks to keep from running out of stock?
n How will longer lead times impact warehousing and expediting costs, including air transportation?
n What is the potential for lost sales due to excessively long lead times or increased quality defects?
Penkala says other costs include severance pay for displaced workers; shipping costs to and from Asia, which can add 15 percent or more to the cost of a product; travel costs to establish and maintain relationships with suppliers and customers; currency fluctuations; and various administrative costs.
"All of these must be well understood before the decision is made to go offshore," warns Penkala. "Then, estimates must be made for the total system costs for offshore scenarios. The results are often surprising. Sometimes, the analysis confirms the efficiency of producing offshore. But, this analysis has resulted in some companies bringing operations back to the United States once the true costs are recognized."
For instance, in 2001, Epson Portland Inc. laid off 75 percent of the workforce at its printer cartridge plant in Hillsboro, OR, and shifted production to China. But, after looking at total delivered cost, Epson determined that tariffs, currency fluctuation, freight charges and other costs often negated offshore labor savings. The company has ramped up production at its U.S. plant again. In fact, the facility is now producing five times as many cartridges per worker as its sister plant in China.
According to Penkala, the labor cost differential between a product made in China and one produced in the United States can be a factor of 10. "But, the overall true costs are much closer," he points out. "In a study of 29 companies, we found that the true cost savings with moving production to China was between -3.7 percent-meaning that there was a 4 percent cost disadvantage-and 20.6 percent, with an average savings of 11.4 percent.
"On the surface, this looks like good news for those contemplating offshore manufacturing," says Penkala. "But, for companies that embrace lean principles, 11 percent improvements are conservative. When a company successfully adopts lean principles, annualized gains of 10 percent to 25 percent are common. So the question that must be asked is ‘What is the benefit of offshore manufacturing vs. lean manufacturing here in the United States?'"
Beware of Hidden CostsSeeking cost advantages is critical to long-term offshore success, but it can be a difficult, expensive undertaking for manufacturers. "Many companies fail to anticipate initial costs accurately," says Boston Consulting Group's Young. "But, the paradox is that if companies don't face up to these initial costs and risks, their long-term costs will devour the companies' competitive standings."
According to Young, one-time expenses to identify low-cost suppliers, establish a logistics chain and train workers typically add 10 percent to 40 percent to the cost of goods sold in the first year. "Offshore production can be fraught with risk and potential missteps," he warns. "Seeking new markets and increased capabilities via globalization can be a difficult, complex process. Manufacturers have to grapple with key strategic and tactical questions, including what kinds of operations to relocate and how."
For instance, "one might think you should relocate the manufacture of ‘sunset' products for which the market isn't growing and lowering cost is key," adds Young. "The reality is that you want to relocate the manufacture of high-growth-potential products in order to capture long-term global advantage."
Product lifecycle management plays a key role in determining what to assemble offshore. Typically, products that are mature and do not require leading-edge manufacturing capabilities are the most likely to result in near-term cost savings if moved offshore.
"These are products with clearly established manufacturing procedures that will have a much flatter learning curve when relocated to a new facility," says PRTM's Keegan. "These products also require less management attention and sustaining engineering. New products typically require numerous engineering changes, which can significantly add cost to any initial benefits gained by going offshore."
Manufacturing engineers should also carefully determine whether purchasing parts, components and materials from China or other offshore locations is the best scenario. For instance, engineers must consider transportation efficiency, lead time and scheduling stability, product design and technical capabilities.
By analyzing these variables, manufacturers can better understand their geographic sourcing options-which products are candidates for being sourced from low-cost countries and which should be purchased from more developed markets.
"Using this analysis, we have found, for example, that production tooling, such as injection-molded plastics and stamping dies, which are labor-intensive and which have long lead times, is perfect for Chinese procurement initiatives," says Booz Allen's Shorten. "By contrast, minimal labor requirements make China a bad bet for auto interior plastics and stamping. Frequent product changes similarly rule the country out as a first choice for customized telecommunications equipment.
"Manufacturers in these industries would do better to consider low-cost regions closer to home," adds Shorten, "such as Mexico for the United States or [Slovakia] for Europe, where they can realize a portion of the labor savings while maintaining tighter control on the supply chain."
More than 10 years after NAFTA was passed, Mexico continues to be the primary destination for production leaving the United States. "Certain industries remain much more likely to move production to Mexico," says Cornell's Bronfenbrenner. For instance, her study revealed that 68 percent of auto parts production shifts went to Mexico, as did 58 percent of plastic, glass and rubber production; 56 percent of appliance manufacturing; and 53 percent of industrial equipment and machinery.
One of the biggest overlooked costs of offshore manufacturing is shipping. For instance, most products manufactured in China are shipped by sea in cargo containers. This mode of transport averages $2,500 to $3,000 per container. The entire shipping process can take 4 to 6 weeks. Unexpected delays, such as bad weather or dock strikes, can increase this time considerably. In addition, a number of fees must be paid upon leaving and entering ports.
Nicholas Dewhurst, executive vice president of Boothroyd Dewhurst Inc. (Wakefield, RI), claims that shipping and logistics typically add 17 percent to the cost of offshore production. In addition, he says other hidden costs, such as travel costs or quality defects, can add 2 percent to 9 percent of the total cost.
According to Dewhurst, those costs can negate any savings accrued by low labor costs. "The other costs, both tangible and intangible, are rarely taken into consideration because they are not allocated to the actual product, but are paid for by the corporation from various other budgets," he explains. "Many companies are lured by tales of low labor costs only to find the initially estimated savings were never realized."
Don't Overlook Product DesignTraditionally, the best time to find cost reductions is during the product design stage, not during manufacturing. As a result, some experts claim that product redesign can be a cost-effective alternative to offshore production. They believe U.S. manufacturers could do a much better job of integrating cost analysis into product design.
"If rigorous cost analysis was instituted as a foundation for product design, manufacturers would be able to develop innovative products that are more economical to produce in the United States," claims Dewhurst. "It can be more advantageous for U.S. manufacturers to lower costs by redesigning products than by outsourcing production to other countries, such as China. In many instances, redesigning a product and manufacturing it in the United States is a better option for saving money.
"We know, from years of consulting with design engineers, that U.S. manufacturers have very little visibility into what their products should cost to make," adds Dewhurst. "Companies historically do a poor job of integrating cost analysis into early product design. Many companies now rushing to outsource manufacturing still do not understand that the design of the product determines the final cost.
"Outsourcing is not the first step in lowering product costs," Dewhurst points out. "Considering the competitive nature of the global economy, and the many hidden risks associated with outsourcing ventures, U.S. companies should scour product designs for efficiency before resorting to offshore production."
Dewhurst recently conducted a study that demonstrates that if companies consider the potential for design improvement, along with a realistic estimate of the full costs of outsourcing, it often makes more sense to manufacture products in the United States.
"Outsourcing to China does not yield as much savings as first appears," claims Dewhurst. "Unfortunately, many organizations focus only on labor savings without adding back external costs, such as shipping and logistics."
Everything Can't Be OffshoredSome products are simply not a good fit for offshore manufacturing. For instance:
- Products manufactured in the United States using a highly automated process may not show significant cost savings when produced overseas.
- Product weight and size can affect offshore manufacturing. Shipping by either air or sea is costly, particularly for bulky products regardless of weight.
- Products that require flexible scheduling are poor offshore candidates. Waiting 4 to 6 weeks for sea shipments is not viable.
- With new products, which undergo many engineering change orders and revisions, quality issues often arise from offshore production. Inventory in transit may need to be reworked when it arrives.
- Proprietary products protected by patents may be too risky to assemble offshore.