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Extended supply chains have many moving parts in manufacturing and logistics that require regular maintenance.

The rush to reduce costs in manufacturing and procurement fueled a surge in outsourcing and offshoring over the last decade that has almost taken on a life of its own. The major business assumption driving this trend was that it was less expensive to purchase goods and manufacture overseas because labor and raw materials and, therefore, capital projects, cost less.

At the same time, a “me, too” mentality was taking hold – “If everyone else is doing it, it must be the right thing to do.” In fact, it was some of the early successes that may have helped drive this momentum.

Has the tide turned? Is it time to question some of those decisions?

Several factors, including rising energy costs, currency devaluation and demographic changes in the “low cost” countries, are challenging the accuracy of those earlier assumptions. Depending on the country of origin, the combined impact of these factors has escalated costs by anywhere between 10% and 40% over the past three years. A rigorous and continuing analysis of a company’s supply chain network can reveal the true costs, benefits and risks of manufacturing and distribution decisions.

The only accurate measure of success in any decision to offshore manufacturing is the total delivered cost (TDC) of the product to the final customer – not the price at which it can be purchased or the manufacturing cost in the “low cost” country. The TDC breaks down into obvious and hidden, tangible and intangible components.

One under-appreciated cost component that has recently come to the forefront is the cost of quality. In the worst-case scenarios of toys with high lead content, melamine-contaminated pet foods and chondroitin-laced Heparin, multinationals certainly got their low prices, but paid the monumental costs of widespread recalls, fines, lost customer goodwill and damage to reputation.

The debacles that result from ignoring the cost of quality are not new to this decade, nor are they limited to Chinese exports. During World War II, for example, US-made aircraft pistons for British fighters had to be scrapped because the US manufacturer used a conversion rate of 2.54 cm to 1 inch, which was not precise enough for aircraft engine tolerances, demonstrating that quality control over offshore production can be tricky at best. Today, in the aircraft industry, Boeing is purchasing a Global Aeronautica, LLC fuselage sub-assembly plant in order to regain control over the 787 Dreamliner manufacturing process. Clearly, ensuring the control of final product quality is a key factor in the outsourcing decision process – whether the source is domestic or off shore – even before the logistics factors enter the equation.

Tangible Planned Costs

In addition to quality, there are other costs, obvious and otherwise, that can be overlooked when companies are not thorough in their analysis of the TDC. Take the case of a specialty chemicals manufacturer that received an excellent price from an offshore manufacturer for a key raw material. While it accounted for ocean freight costs, it neglected to include import duties. Ultimately, its “great price” resulted in a TDC of about 15% more than its original delivered cost for local materials.

The first step to avoid this type of mistake is to perform a complete analysis of the TDC, assuming everything goes according to plan (unplanned costs will be considered below). The following table compares the most common domestic and offshore transportation costs that should be included in this type of analysis.

In addition, export taxes or tax rebates may apply, depending on the country of origin for the shipment.

Although distribution center costs are listed for both domestic and offshore manufacturing, the types and magnitudes of the costs are likely to be quite different between the two supply chains. For example, imported materials may require additional handling and processing to be re-palletized to conform to the “standard” pallet in use in the country of consumption.

The warehouse footprint and average dwell time of the material in the warehouse will typically be larger for the imported materials. Even if the order size, and thus the cycle time, of the goods are the same for both imported and domestic materials, the safety stock required to provide the same level of service can be significantly higher for the imported material. This is evident upon inspection of a simple safety stock formula for a fixed order quantity with variable lead-time:

As the lead time between ordering for replenishment and receiving increases, the required safety stock increases. Likewise, as the variability in the lead time increases, the required safety stock increases.
A thorough examination of these items should result in a good estimate of the TDC when everything goes according to plan. However, it is also important to include the costs that are incurred when things don’t follow the plan.

Unplanned Costs

When it comes to offshore manufacturing, variability is the name of the game – making profitability a moving target. Political, socioeconomic and demographic upheavals, changing marketplaces and the multitude of factors that affect transit time all raise risks and costs and reduce a manufacturer’s flexibility in terms of inventory tracking and control, warehousing, distribution and customer service.

Every risk that comes with the increased time and variability of an extended supply chain has an associated cost. Examining these costs in greater detail is the second step in the process to make a good decision.

The current US transportation-related infrastructure often causes bottlenecks leading to delays and hence lost or delayed sales and/or premium costs to expedite. Even now, US port and rail systems are overburdened with imported cargo. Staging spaces and crane capacity are inadequate, and rail and truck traffic out of ports often approaches gridlock. Further, since container ships are getting bigger, some take five or more days to unload. Those are just everyday delays and do not take into consideration the possibility of labor actions at US West Coast ports that could cause disruptions similar to the lock-out that closed ports a few years ago.

A continued focus on security has brought with it an increasing likelihood of more thorough cargo inspections at the port of entry, delaying shipments by a week or more.

The current gridlock at US West Coast ports is worsening as US export traffic increases with the weak dollar. Traditionally, ports have dealt with a ratio of about three import containers to one export container, but now that ratio is approaching 2:1 as more and more export containers take up scarce staging space, potentially holding up incoming shipments.

Stuck in all this port congestion, trucks are idling longer, triggering concerns over air quality and leading to an increase in environmental regulations. The Ports of Los Angeles, Long Beach and Oakland, for example, will levy a $35 per twenty-foot-container equivalent environmental fee to mitigate pollution.

A number of ports are developing regulations on the type of fuel ships can use while they are in port. While container ships are at sea, they burn bunker fuel. The regulations would require that they burn a low sulfur fuel when they come into ports in Europe and on the US West Coast. We can expect to see higher fuel costs as the price of bunker fuel is soars and low sulfur fuel prices are even higher with increased demand.

Weather is an uncontrollable variable that can cause substantial delays, again increasing expediting costs and revenue shortfalls. A typhoon in the Pacific Ocean could mean, at best, delays as a ship detours around the affected area. Or, in the worst case, it may cause losses as shipping containers are jettisoned or lost due to the storm.

Clearly, over the course of time some fraction of the replenishment shipments will be expedited due to unexpected surges in demand or delays in replenishment resulting from these and other causes. The costs to expedite an overseas shipment can easily be three to four times the cost of the planned mode of transport. Even a small percentage of expedites can have a material effect on the TDC. Therefore, an estimate of the number of expedites should be built into the TDC of the imported material during the initial analysis.

Out of Room in the Warehouse?

The foreseeable and unforeseeable delays of long supply chains not only increase expediting costs and revenue shortfalls, they also complicate supply chain management. One of the highest hidden costs associated with offshore manufacturing is inventory. Although logistics professionals recognize the need to add extra days of inventory to cover the “pipeline” while the material is in transit from an overseas location, they sometimes overlook the need for additional safety stock to account for the longer lead time for replenishment.

There are additional factors that also negatively affect warehousing costs. Ocean transport of containers can be extremely variable, requiring importers to plan for delays in receipt and also require them to be able to accommodate larger quantities of material in a single shipment. It is not uncommon, for example, to have two, three or even five containers arrive at the same time, even though they were all ordered one week apart. This multiplies the need for warehousing and staging space and the labor costs for marshaling and sorting the products. If extra warehousing space is not readily available, it may mean paying a premium for third-party space or last-minute arrangements.

As one manufacturer learned, equipment rentals, such as special chassis for ISO-containers, may further increase these costs. The manufacturer offshored production of a key intermediate from the US Gulf Coast to Europe and found itself in a “feast or famine” situation for months while its ISO-containers were stacking up in Europe as they got rolled from one ship to the next.

The planning horizon for overseas manufacturing is much longer, which adds uncertainties and risks and hence hidden costs. Planning under these conditions is much more problematic and challenging than for domestic manufacturing. The longer the supply chain, the more the company is at the mercy of its forecast accuracy. A longer supply chain can increase the risk of obsolescence. Mistakes are not as easy to correct in an extended supply chain as with a domestic manufacturer. The domestic supplier may be able to provide additional products in a matter of hours or days, not weeks or months. Thus, great care should be taken in the assessment of total cost of inventory (working capital, damage, obsolescence) and the facilities and costs required to manage it, both at the “average” level and during the peaks and valleys that often accompany cross-ocean supply chains.

Tracking Tribulations

Inventory management with offshore manufacturing is further complicated by having inventory in different places at different times – on the ocean, waiting for an inspection in port, moving on a train or already stored in the warehouse. All inventory must, of course, be tracked, no matter where it is. Technology can help, but only to a degree. Without sophisticated tracking processes, products being shipped from overseas tend to go into a “black hole” until they arrive at a port. It may take several days just to find out whether a container has been loaded onto a ship as scheduled or has been “rolled,” i.e., left behind because the ship left full without it. Uncertainty means risk, and hence costs.

Several transportation management systems are available to track inventory, all of which claim to provide clear line-of-sight to the inventory throughout the supply chain. However, these technologies can be difficult to implement. Moreover, they may be of limited use in inventory management because the various carriers do not abide by a single standard for communication and some carriers are spotty at best in their delivery of status messages that drive the tracking systems. Further, a number of third- and fourth-party logistics companies claim to provide visibility of shipments around the world. But these are also hampered by the lack of common standards, and sometimes they are owned by a carrier that may have difficulty obtaining information from a competitor. Adding to the challenge are the difficulties of communicating in multiple languages and across different cultures, which may lead to misunderstandings and unmet schedules. At best, tracking attempts present a fragmented picture, regardless of how “easy” electronic commerce supposedly has become. Inability to track shipments accurately calls for great flexibility, and often additional costs, in inventory. Don’t forget to include these tracking costs as part of the TDC analysis.

Costs That Change Over Time

Some companies do a thorough job of analyzing the entire cost picture initially but forget to review their calculations regularly. When this happens, they pay much more a year or so later when rapid global change has suddenly made their decision unprofitable. A profitable outsourcing decision never depends on a single number at a single moment in time, but needs to consider a range of possibilities and a range of possible futures. This is the third step in a good decision-making process.

Among the global changes that can dramatically affect manufacturing costs are currency fluctuations, demographic and socioeconomic changes and, of course, the ever-rising cost of fuel. Such changes can quickly double manufacturing and transportation costs and can erase any return on investment (ROI) from an overseas capital investment. Today, it is more critical than ever to evaluate a planned infrastructure capital investment overseas against many different futures to ensure it is robust enough to be profitable under any conditions. Once a decision is made, continued vigilance and flexibility are just as critical.

Let’s say that, to obtain a reasonable ROI, an offshore facility has to operate at reasonably full capacity for five years. What macroeconomic changes might occur in that country, and the world, during those five years that could change the facility’s profitability? India, for example, was the destination of choice for information technology-related outsourcing just a few years ago. Now, that country’s economy has grown, and these services have become much more expensive. More jobs have become available for people who used to depend on work in all-night call centers, and computer manufacturers are paying much more to retain quality personnel so they can maintain service levels for US consumers. Similarly, in China, an emerging middle class is creating a larger demand for consumer goods and skilled workers, resulting in unprecedented job hopping that makes retaining good people exceedingly difficult. Some estimates suggest China's labor-cost advantage will come to an end by 2010.

Whether companies outsource their services or manufacturing operations, they need to remain vigilant to changes in workforce demographics and salary costs. Even over as short an investment horizon as five years, the changes in developing countries can be dramatic.

Along with demographic changes, changing political and regulatory policies can have a significant impact on total delivered costs over the time horizon of an offshoring or outsourcing decision. For a number of years, many companies have taken advantage of a 17% tax rebate on products exported from China. However, based on a protest brought to the WTO for unfair trading practices, this rebate is being phased out, creating a step change increase in the cost of goods that are now sourced from China.

This kind of cost increase could be a disaster if it were not anticipated.

Components of Complex Decisions

Making the right decision under such complex conditions and evaluating it against many possible futures depends on three components: the right tools, the right data and the right methods. Tools must have the ability to:

• Calculate the total delivered cost.
• Account for all the elements of the total delivered cost, tangible and intangible.
• Allow accurate forecasting over the length – both time and distance – of the supply chain.
• Track the total cost so it can be used in decision-making.
• Model and compare the entire matrix of sourcing options for all raw materials and components used in the manufacturing process.
• Account for the extreme variability that comes with global commerce.

With a short, domestic supply chain, it is easy to take quick, corrective action if variability has been ignored in the beginning. But with a global supply chain, the next shipment may be two months away.

The data that supports decision-making covers all the cost elements: raw material, manufacturing, transportation (ocean, air and land), taxes and duties, warehousing, inventory and distribution. It also includes currency values and forecasts of changes in those values.

A common pitfall is discounting the risks of currency fluctuations, regulatory change and risks associated with transportation. Discounting risks usually results in higher costs.

Even the most capable tool and the best data, however, can lead to poor decisions if the underlying assumptions about a company’s operations are incorrect. Many companies have the best forecasting tools on the market, but their forecasts are not worth the paper they are printed on because they do not follow a disciplined forecasting process. If an accurate forecast was assumed in the TDC analysis, the inventory and expediting costs that were calculated will be significantly lower than the actual costs will be.

Once a decision is made, sensitivity analysis can help ensure it remains profitable. What would have to happen to reverse the decision? Could it happen, and is it credible? For example, if expediting 5% of all orders were to reverse the economics of the decision, is such a 5% expedite rate credible? If so, perhaps domestic manufacturing or a blended strategy would be more cost-effective. It may be efficient, for example, to obtain 90% of the products from a developing country, using an inexpensive method of transportation, while ordering the remaining 10% from a more expensive, but highly responsive domestic supplier to mitigate expediting requirements.

Think Globally

Savvy logistics professionals are analyzing the impact of all manufacturing and distribution components to determine the best sourcing matrix. They achieve a proper balance between domestic and overseas sourcing by correctly assessing supply chain cost and risk. With a short, domestic supply chain, it is usually easy to take corrective action if the unexpected happens. With a global supply chain, variability is not only more likely, but when it bites, it takes a bigger chunk out of profits. The trouble with variability is that it is an uncomfortable concept, difficult to grasp and it is hard to account for in calculations of costs and benefits. A step in the right direction is having good processes and analytical tools for supply chain analysis and forecasting. But don’t count on analytical detail and forecasting to provide the right answer automatically. Take the time to think about how a decision will operate under varying global conditions, now and in a number of possible futures. The most informed decisions will emerge from regularly-scheduled reviews, which include a combination of detailed analysis and a wide-ranging perspective of the global landscape.

Alan Kosansky is President and Ted Schaefer is Director of Logistics and Supply Chain Services with Profit Point, a company that specializes in helping businesses optimize complex processes. www.profitpt.com.