Counting the cost

Offshore manufacturing may seem cheaper at first sight, but reality often works out differently. E&T explains how Total Landed Cost can reveal the truth.

These days, Hampshire-based radio equipment manufacturer Wood & Douglas is a staunch believer in manufacturing in Britain. The £5m business has explored offshore manufacture on three separate occasions, each time hoping to relieve pressure on its own production lines by transferring high-volume products to overseas facilities. And each time, explains managing director Alan Wood, the experience was disappointing.

"The risk that overseas suppliers might use inferior components, with the associated quality and yield problems, is simply too great," he notes. "With overseas sourcing, you have to invest a lot into making sure that you're getting what you expect, which soaks up management time and adds cost."

For much of the last 15 years, western manufacturers have increasingly been sourcing from low-cost overseas economies. First components, then sub-assemblies, and then - as at Wood & Douglas - finished products.

But now there's a backlash underway. Work once routinely sourced overseas is now coming back, prompted by manufacturers' growing realisation that the supposed cost advantages of overseas sourcing are not as clear-cut as they supposed.

"Last year there was a big movement in terms of categories that were formerly sourced from overseas starting to come home," says Patrick Furey, a senior category manager at e-sourcing specialist Ariba. "Transportation costs were high, freight routes were congested, and companies started to see that overseas sourcing made a lot less sense than before."

And the full scale of the trend is now becoming apparent, even in relatively low value-added spend categories. In a recent survey of US die casters by the North American Die Casting Association, for instance, 78 per cent of die cast suppliers reported seeing die casting parts come back from overseas suppliers during the last two quarters. Die cast components were returning to the US for three main reasons: concerns about part quality, increased customer-supplier proximity, and the hidden costs associated with overseas logistics.

"We're seeing customers take a long hard look at the products that they outsource to the Far East," adds Steve Wilkes, commercial director at Newport-based contract electronics manufacturer CEM Axiom Manufacturing Services. "Those with volatility - in either demand, design, or volume - are tending to either come home, or not be placed overseas in the first place. Companies are looking afresh at the costs of engineering support involved in Asian manufacture - and the associated travel and communications costs - and deciding to make that investment selectively."

Total Landed Cost

It's a process that a concept called Total Landed Cost aims to address. The only true test of whether an overseas-sourced item is cheaper, argue its proponents, is to compare the cost of domestic production with the total cost of bringing the same item onto home soil - the overall 'landed' cost, in other words.

"Just looking at relative labour and transportation costs is too simplistic," says Dr. Matthias Holweg, director of the Centre for Process Excellence and Innovation at Cambridge University's Judge Business School. "Five years ago, that was all many companies did - which is why so many of them had poor experiences with overseas sourcing. They were only looking at part of the picture, not all of it."

Do so, and the result can be a surprise - hence the phenomenon of work starting to trickle back to the West.

"The economics are always more marginal than people think," says Gus Desbarats, chairman of Farnham-based independent product design consultancy TheAlloy. "People forget that wage rates and taxes in countries like China and India are going up. The truth is that overseas sourcing isn't the 'no-brainer' that it was a few years ago."

So what are the costs that should be factored in to the sourcing equation? Experts such as Judge Business School's Holweg divide them into three categories: static, dynamic, and hidden. Add them together, and you've got the Total Landed Cost.

Static - or visible - costs are those that tend to be most apparent: the ex-factory gate purchase price, for instance, plus freight costs, tariffs, duties and insurance costs. Even though tariffs and duties are visible beforehand, it's worth noting that many companies fail to take them fully into account, and also overlook the fact that they may change.

Dynamic - or invisible - costs are those that stem indirectly from overseas sourcing. Supply chains are longer, so there's a need for more pipeline and safety stock inventory, for example. Longer supply chains are less responsive to fluctuations in demand, too, leading to inventory obsolescence and lost sales due to stock-outs.

Finally, manufacturers must consider the hidden - or unpredictable - costs of overseas sourcing, some of which are more obvious than others.

With the financial markets in turmoil, for instance, many manufacturers will have been caught out by the sudden depreciation of the pound. Sourcing decisions that might have made sense with £1 trading at almost $2 may make rather less sense with the pound trading at today's $1.50, for example.

Likewise, freight costs can vary widely. Last year, as the price of oil reached $147 a barrel, a study by the Canadian Imperial Bank of Commerce found that the cost of sending a 40ft container from Shanghai to the US east coast had risen from $3,000 in 2000 to $8,000 - and that if oil reached $200, a figure widely talked about at the time, then a cost of $15,000 could be expected. Freight rates to Europe, naturally, rose commensurately.

Of course, that was then - and this is now. As recession has hit, freight rates have plunged, with the Baltic Dry and Capesize, two widely-used indices of shipping costs, proceeding to fall by over 90 per cent. Around the world, hundreds of ships are laid up, including a growing mini-fleet moored near the Cornish harbour of Falmouth, taking advantage of a sheltered deep-water estuary.

The real point, though, is that freight costs can't be predicted with any accuracy - and the decision to source components or finished products from overseas in situations where the cost difference is marginal can easily be undone by freight rates moving in the wrong direction, and on a significant scale.

Intellectual property

Another hidden cost - not to say risk - is the possible loss of intellectual property rights. China, for instance, has developed a reputation for failing to stamp down on its domestic manufacturers copying designs.

It's one reason why those with intellectual property to protect are careful about how much of it they expose to Chinese suppliers or subcontract factories. Publicly-quoted technology development specialist Sagentia, for instance, has products manufactured for it in plants in mainland China, but retains prototyping and development activities in Hong Kong - a reversal of the conventional wisdom of placing such activities close to the factory floor.

In Hong Kong, says company director Tim Moore, "intellectual property protection is tried and tested, and as good as you'll find in the West." But elsewhere in China, he notes, while the legal framework has been built, it lacks trust, and there are concerns that it is difficult to use. "Locating in Hong Kong gives us security, yet we are close to Chinese manufacture," observes Moore.

Most unpredictable of all are the costs associated with risk. "Reputational risk, the risk of compromised quality, the risk of supply chain disruption - there are serious costs associated with all three, and we don't see enough companies take them into account," says Jeff Karrenbauer, president of INSIGHT, an advisory firm specialising in strategic supply chain management issues.

"In particular, companies disregarding disruption risk are playing with fire: it's not the risk of a ship being two days late, it's more the risk of port closures, border closures, and sudden industry nationalisation. Assuming that they won't happen is taking a very large gamble - and taking it without knowing the odds, or even the size of the bet."

In short, while sourcing from overseas can be cheaper than buying domestically, manufacturers need to be sure that the savings that they think they are making are genuinely finding their way to the bottom line.

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