The Five Hidden Costs of Offshoring Eliminated by Onshoring

The Five Hidden Costsof Offshoring Eliminated by Onshoring

Executive Summary 1

The Hidden Cost of Crossing Borders

3

The Hidden Cost of Supplier Selection

5

The Hidden Cost of Contract Management

8

The Hidden Cost of Time

12

The Hidden Cost of Geopolitical Risk

14

Cost Elimination Through a Domestic Approach16Conclusion 18

Content

Executive Summary

Situation:In the 1990’s worldwide electronics manufacturing market share migrated to low cost regions, China in particular. Today 84% of PCB manufacturing is done in Asia. But labor typically accounts for less than 5% of product cost, and Chinese labor costs are rising at a faster than expected rate of 15% per year, both factors contributing to a reassessment of offshoring.

“We expect net labor costs for manufacturing in China and the U.S. to converge by around 2015,” said Boston Consulting Group’s Harold Sirkin. “As a result of the changing economics, you’re going to see a lot more products ‘Made in the USA’ in the next five years.”

More companies have moved their supply chains back into U.S. borders due to low returns and the overwhelming complexity of offshore operations. A recent report by the Boston Consulting Group predicts rising wages in China -- along with a host of other factors, including an appreciating yuan and the logistical problems of doing business in China -- will usher in a “manufacturing renaissance” in theU.S. over the next five years.

Problem:When a company decides to offshore its supply chain, it is relatively easy to assess direct costs, which are typically 15-17% of product cost. But companies are often caught off guard by hidden costs, which typically add 5-7% to product cost. Moving a supply chain abroad complicates a company’s ability to manage its supply chain dynamically and increases risks, such as intellectual property theft, underperformance by a vendor, or a disparity between what is negotiated and delivered. Most OEM’s choose to ignore China’s willful environmental, labor and currency abuses. Accurate communication (including language and cultural barriers), an understanding of the host country’s laws and regulations, and setting up reliable management infrastructure are all costly operations. According to leading consulting firm Accenture:

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Hidden Costs

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Executive Summary

Many manufacturing companies that shifted production offshore “likely did so without a complete understanding of the ‘total costs,’ and thus, the total cost of offshoring was considerably higher than initially thought. Part of the issue is that not all costs of offshoring roll up directly to manufacturing; rather, they impact many areas of the enterprise.”

Overlooking or underestimating hidden costs and associated risk leads to poor decisions. Where labor is a small portion of product cost, the hidden costs can actually be greater than the expected labor savings.

Solution:While a significant amount of literature dedicates itself to helping companies manage offshore operations, solutions are often vague and esoteric, and certainly do not guarantee cost savings or quality improvement. Sourcing domestically or locally, on the other hand, offers simple options that eliminate hidden costs completely, while granting a company easy power to fix problems and make changes.Having surveyed 287 manufacturing companies, Accenture found that 61 percent are considering moving some of their manufacturing back to their home market. Ferreira and Heilala describe this as being a “secret shift” and a “quiet trend.”

This paper examines five key areas of hidden cost driving many companies to conclude that modern, efficient manufacturing and supply chain management are best conducted near the point of use.

“Based on Total Cost of Ownership, 40% of American companies have a cost disadvantage importing goods from China instead of making them here.”


- According to economist Alan Beaulieu, U.S. Labor costs have remained consistent since 2000, while China’s labor costs have risen 250%.




The Hidden Cost of Crossing BordersDirect costs include freight and duties. The direct cost of freight and duties depends on many variables (the product’s type, weight, distance, and amount) but only one variable dramatically affects the price of overseas shipping: distance. Accordingly, shipping from China and other East Asian countries can be expensive in both time and money. But other costs are hidden and often not accounted for when evaluating cross border costs:

Inventory pipeline

The lowest cost offshore sourcing models consolidate freight shipments to lower logistics costs. This can drive unexpected delays and often the contractor has limited ability to control delays at the freight forwarder. Some products can be densely packed andshipped via air at similar costs, but most products see significant cost increases if shipped by air. Sea shipments add significant time to the pipeline. The result is a need to carry higher levels of finished goods inventory ‘just in case.’ Additionally, customs regulations in countries such as China drive more frequent reconciliation of raw material inventory with each customer than typically done in U.S. contractor business models. This may drive higher working capital requirements. Finally, engineering change orders can add further cost, if product shipped before the change was implemented must be re-worked or scrapped.

Warehousing

Is a warehouse needed? At some point in the manufacturing process inventory must be stored awaiting sufficient volume to ship economically. Whether a firm bears the cost indirectly through a contract manufacturer, or pays the cost outright, warehousing cost is inevitable.

The Five Hidden Costs ofCrossing Borders


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Separation of U.S. and Foreign Products

If country content must be tracked a company will incur extra administrative costs. This requires more work in tracking, sorting, accurate documentation, and investment in appropriate software/ hardware to accomplish the tasks.

Import Restrictions

Accurate recordkeeping and a solid understanding of documentation needed for U.S. Customs and Border Protection (CBP), and trade agreements--such as The North American Free Trade Agreement (NAFTA)--is necessary to avoid penalties and fines. In 2007, Ford Motor Co. faced a $42 million dollar lawsuit from U.S. Customs for insufficient records on their imports. Keeping documentation on import-export insurance is also critical in the event of a claim.

Tariffs

Are your imports subject to special tariffs? A company must be clear about foreign and domestic rules, especially as they vary from border to border and are subject to change.

Travel & Staff

For travel expenses a company should account for the following: tripsper year, average stay duration, price of airfare, and room and board.

This does not include the salary of the dedicated employee, who must cope with language and cultural barriers, and on whom a company must rely to make accurate decisions and assessments, especially while selecting and managing vendors.

EXPENSES

The Five Hidden Costs ofCrossing Borders


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The Hidden Cost of Supplier SelectionSelecting the offshoring partner is the most critical step in an outsourcing plan. It requires significant time from qualified people to have a successful outcome. Supplier selection typically adds 1% to the actual cost of the product.

Bounded strategic decisions

Selecting an appropriate CM is a lengthy and complicated process that bears many risks. Direct selection costs include: documenting requirements, sending out requests for proposal (RFPs), evaluating the responses, and negotiating a contract. This requires either training or hiring a staff with proper knowledge and oversight skills, as well as paying their travel expenses. Whether a company decides to hire an offshore consultant or execute these tasks themselves, CM selection is a delicate process that takes considerable time and planning. Risks and costs associated with poor supplier selection are magnified when offshoring. The hidden risks include:

Inaccurate Proposals

A failure to account for cross cultural assessment of bounded variables presents risks. Disparities between requirements as understood by a vendor and what is meant by the customer are common. A foreign CM may have false or incomplete perceptions of what they bid on due to poor estimates, misunderstood specifications, language barriers, and overall miscommunication.

2 The Five Hidden Costs ofSupplier Selection





Bid Abandonment

CM’s willingness to honor original bid’s varies by culture. Companies, of course, seek CMs with the best deal. This results in a tendency toward adverse selection of the CM most likely to have made an error. Often, the CM is unwilling to honor a deal’s original price and structure. Costs appear when an unhonored deal must be renegotiated or terminated, and tensions between client and CM may rise.

Inadequate Infrastructure

China’s outsourcing infrastructure, while robust especially compared to India, is built for high volume manufacturing. Mid and low volume projects are typically done at smaller shops that primarily serveas consignment subcontractors to the large EMS companies. As a result, there is inadequate supply chain infrastructure for small to mid range projects. China’s physical infrastructure is a work in progress and must be assessed carefully by specific region. Forexample, China has 20% of the world’s population but just 5% of the world’s roads. China’s per capita water availability is about one-third of what’s available to the rest of the world. With rapid growth and industrialization, the country needs to come up with a way to increase its water supply.

Misunderstood government laws and regulations

China is complex and often lacks predictability in its business environment. China’s current legal and regulatory system can beopaque, inconsistent, and arbitrary as well as constantly changing. Implementation of Chinese law is also inconsistent. If you are not intimately familiar with Chinese regulations for operating in China, chances are your company will be out of Chinese compliance. And lack of compliance with Chinese laws and regulations can be very costly. According to the American Chinese Chamber of Commerce (AmCham) 2010 report, China’s regulatory environment has become the most problematic business challenge.

20%

5%OF WORLS’S ROADS

The Five Hidden Costs ofSupplier Selection


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Cultural clash

One of the least understood elements of supplier selection is a mutual effort to overcome cultural variations. Though both parties in a communication may be fluent in English, their use of words and concepts may vary considerably. In Asia “yes” can simply be an acknowledgement they heard the question, and “no” is often so indirect an American fails to perceive it. U.S. culture places a high value on time, Asian cultures tend not to. Both parties need to be skilled in overcoming basic cultural expectations.

Accounting for Working Conditions

Improvements in worker safety and wages have increased the cost of manufacturing in America. In contrast, China possesses lower standards of safety and lower wages resulting in seemingly low manufacturing costs. Too often companies ignore both the economic cost and ethical implication of these lower standards

The Five Hidden Costs ofSupplier Selection

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500Protests Daily


2011 daily average, Landesa Survey




The Hidden Cost of Contract ManagementManaging an offshore CM, as well as their behavior, is one of the most difficult and risky tasks for a company. Again, this endeavor requires dedicated and skilled staffers who can maintain oversight, conduct audits, and negotiate schedules. CM contracts are a major source of company risk, including off balance sheet risk. It goes without saying that a failed relationship with a vendor is costly in dollars, time, and company resources. Contract Management issues, including quality, travel, communications, and related factors typically contributes 7% to product cost, but are rarely accounted for:

Enforceability of Contracts

Many portions of US contracts are not enforceable outside the US. For example, a non-compete clause may do nothing to stop asupplier from using a company’s tooling and equipment to develop competing products. In China, contracts should be written in Chinese, because the Chinese contract controls the relationship. It does not matter what the English version says. One cannot stress enough the difficulty in translating contracts into Chinese. It requires recognized Chinese legal experts who speak and write Chinese at a native level to properly construct a viable contract with a Chinese supplier. Even then, enforcement may still be an issue.

Quality

In general, having on-site personnel or qualified third-party inspectors/auditors to control quality is crucial. Over time, controlling quality may become an arduous task. A supplier’s business may serve an increased number of customers, making it more difficult to monitor quality. In addition, suppliers may also change (without any notice) the process by which they produce, affecting quality. Inspecting all products before shipment is crucial. Quality defects alone can run between 1% and 8% of product cost.

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CONTRACT

The Hidden Costs ofContract Management





Sub-Tier Supplier Management

Regardless of what the contract says, visibility into the 2nd and 3rd tier suppliers is difficult to obtain and these suppliers are frequently changed without notice. Ensuring quality and performance of an unseen supply chain is difficult.

Intellectual Property

Protection of intellectual property is weak to non-existent. Even though China has joined the WTO and agrees to abide by all world organizational rules, in reality many laws are violated. Copyright laws in particular are not enforced, and piracy of trademarked and copyrighted goods is ubiquitous. Many companies will not produce their product in Asia because they cannot protect the proprietary, patented, or intellectual properties of a product or its manufacturing process.

Technology Transfer

Closely related to attitudes and laws regarding intellectual property is the use of physical assets (i.e. fixtures or molds) to subsidize a competitors product. What a US company views as proprietary physical assets, the CM may view as an underutilized resource that can help it win additional business.

Miscommunication

Wage inflation in the most popular manufacturing zones often leaves margin-challenged CM’s with limited choices for program managers and engineers possessing the required English language competencies. The end result can be language fluency-driven or culture-driven communications errors, as well as a requirement for greater travel by the U.S. project team. In a project with frequent engineering changes, schedule variability or complex quality requirements, mistakes can be costly.

Conflict Avoidance

Most offshore teams speak English as a second language and manycome from cultures where disagreement is considered rude. Fluency



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in multiple languages is valued and admitting that an instruction in English wasn’t understood can cause embarrassment. In cultures where it is rude to argue, when a project member doesn’t agree with a customer’s request, it simply doesn’t get done.

Changes

Inevitably, changes occur in business needs and requirements. How change is managed can vary considerably. In the US, adoptionto change is anticipated and usually covered by contract. In Asia, adoption to change is often governed by relationship.

Underperformance

Given the potential for misunderstanding and the conflict avoidance culture prevalent in China, often the first sign of a deteriorating relationship is underperformance of commitments. Deliberate underperformance can be difficult to diagnose, but any material underperformance can quickly become a major problem given the difficulty in changing an offshore CM relationship.

Low Ethical Standards

Offshore operations may operate with a culture of low ethical standards, which is extremely difficult to assess. Low ethics can compromise end customers, employees, and put the company at financial risk.

Local Espionage Laws

China’s laws on industrial espionage provide authorities wide discretion in deciding who to charge with espionage. Often, economic and industrial data is considered to be state secrets. Without expert advice and close cooperation with the government, unwittingly violating these laws is possible.

Local Labor Law Compliance

China has many laws governing the treatment of workers, such as minimum-wage laws and laws governing overtime and overtime pay. As some U.S. companies have found, these laws are often ignored by their CM’s. U.S. manufacturers can be held legally responsible for

Deliberate underperformance can be difficult to diagnose, but any material underperformancecan quickly become a major problem given the difficulty in changing an offshore CM relationship.



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these violations in their supply chain. The court of public opinion can also convict companies for these unethical working conditions.

Staff Turnover

Project teams managing offshore products tend to work longer hours. Time differences drive conference calls outside normal work hours and source inspection trips can consume weeks at the offshore supplier. Besides the measurable cost of travel and any compensated overtime, there can be higher turnover in these positions. That in turn drives recruitment costs and inefficiencies as new hires go through a learning curve. As the U.S. economy improves, this issue will worsen as project personnel have more job opportunities with less stress.



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The Hidden Cost of TimeFor manufacturers, time is often the most critical strategic focus. To achieve cheaper wages and products, a company may choose to sacrifice quicker return on investment and fast time to market. Approximately 90% of world trade is transported by ship in cargo containers. Typical transit time between the US and China is 4-6weeks. Effectively, manufacturing in China prohibits the use of just-in-time inventory models and is counter to lean manufacturing.

“Let’s say you want to order a batch of widgets from a manufacturer in China that’s charging 50 percent less than a manufacturer here in the United States. The price may be good, but you have to wire the money up front to pay for your order. Then you wait — up to 90 days while your product is produced and shipped across the ocean.

When you finally get the product to your customer…you then have to wait up to 90 days before you get your money. Think about that. The time between when you lay out your money to your manufacturer and when you finally receive a payment from your customer can be as long as 180 days. So, you might wait up to 225 days before you get your money back. That’s a long time and a serious drain on cash flow. And that’s assuming everything goes well.”

– New York Times

Reduced Automation

Lower labor cost markets tend to minimize automation and avoid continuous improvement initiatives because there is little cost benefit in a low wage environment. That can translate to a greater number of design spins in product development cycles and less schedule change flexibility in production.

Rigid Schedules

The rise of information systems that provide real-time data on inventory status and a focus on minimizing finished goods inventories have increased the popularity of “just in time” (JIT) ordering. When demandis variable the supplier must be able to rapidly support schedule change.However, many offshore suppliers see little value in supporting variable

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90%

WORLD TRADE

The Hidden Costs of Time






demand production because their business models are focused on high volume production with high equipment utilization, so changeovers must be kept to a minimum. Customers needing changes in production on short notices are often disappointed. The cost can lead to lostsales opportunities, finished goods inventory build up, and contractualpenalties.

Logistics Risks

Reliability and cost of transportation can be adversely impacted by lack of availability and local cost of fuel. Delays in transportation can be caused by lack of availability and access to port facilities, or variations in port clearing time. There is transport risk even after leaving port: each year approximately 10,000 cargo containers fall overboard.

4 The Hidden Costs of Time




The Hidden Cost of Geopolitical RiskAs many U.S. companies look to less-developed countries (LDCs) like China, India, and Thailand for cheap labor and lower foreign exchange rates, they often ignore the larger political, cultural, and economic contexts under which LDCs operate. If these contexts are not understood properly, or at least minded, a company’s offshore operations could be hindered or compromised.

In September 2012, Foxconn Technology, a major electronics supplier for companies like Apple and Dell, had to close one of its factories due to employee riots. Analysts say that this incident and other labortensions in China were caused by a sudden inflation of Chinese currency,prompting workers to demand higher wages.

Labor Unrest

Labor unrest is inevitable in such a rapidly changing environment. With wages rising 15% annually and an emerging middle class clamoring for economic recognition, labor unrest threatens to interrupt fluid supply chain operations.

Currency manipulation

By some estimates China manipulates the yuan to devalue it by 20%. As international political pressure mounts, China may be forced to cease this manipulation, which will effectively increase Chinese prices by 20% for US companies.Political instability

The risk consultancy Maplecroft recently analyzed political stability hazards for China. The country “is categorized as ‘extreme risk’ across several areas,” according to Maplecroft, “including: civil and political rights, judicial independence, democratic governance, labor rights, and human rights violations committed by members of the security forces. Companies which are deemed in any way to be supportinga government or its agents in stifling democracy, liberty and human

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15 %


The Hidden Costs ofGeopolitical Risks




rights may suffer reputational damage, which will ultimately impact thebottom line.

U.S. Income Inequality

Offshoring reduces domestic employment demand and thereforedomestic wages. At the same time, increasing corporate profits result in higher compensation for executives, who are usually compensated based on some measure related to profitability. The result is increasing wages for executives and decreasing wages for workers. The increasing income inequality creates pressure for US domestic political solutions that may disrupt offshoring.

Natural Disasters

Natural disasters occur frequently in China, affecting more than 200 million people every year. They have become an important factor restricting economic and social development. China is home to 5 of the top 10 natural disasters in world history, including the top 3. China has had 6 of the world’s top 10 deadliest floods, including the top 5. China has also experienced 3 of the top 10 deadliest earthquakes, and 6 of the top ten deadliest famines.

Local Judicial Instability

The local judicial climate is difficult, if not impossible, to stay informed on. For example, in the wake of food safety violations, the China High Court recently called for “lower courts [to] hand down the death sentence to those found guilty of food safety violations that result in loss of human lives.” (as reported by United Press International).

Health Environment

The health environment of China, in particular, has economic costs. The first outbreak of SARS occurred in China, and its impact on southern China’s economy was significant. The more recent outbreak of the bird flu has also had some impact, although not to the extentof SARS. Currently companies are beginning to quantify the cost of employees quarantined after trips to Asia.

EXECUTIVE WAGES

WORKERS WAGES

5 The Hidden Costs ofGeopolitical Risks





Cost Elimination Through a Domestic ApproachAfter decades of coping with the trial and error of offshore operations, more and more companies are now realizing the benefits of returning to the U.S. The five categories of hidden costs above merely hintat the complexity a company assumes in an offshore operation; the variables are endless. To simplify a supply chain, and therefore eliminate associated hidden costs, a company should consider a domestic approach.

Not only does sourcing within the U.S. eliminate overt hidden costs- shipping, inventory holdings, specialized staff, and travel - but italso allows for clear strategic decision making. When a contract manufacturer is selected domestically, a company is able to determine clearly and thoroughly on whom they can rely for the best possible product. Details and specifications of the contract can be discussed and conferred over in real-time and without language barriers, andthe contract manufacturer can be upfront about their own needs, limitations, and some potential problems otherwise unseen by a client.

With higher skilled engineering and manufacturing personnel, US companies tend to lower costs through design for manufacturing. One advanced engineer in the U.S. using high end software tools may accomplish more than three engineers in a lower cost labor market using basic tools. Similarly, in production there may be greater focus on Lean manufacturing initiatives that decrease procurement and production cycle time

Accordingly, the new or modified product will have a shorter time to market, giving a domestically sourced company a competitive advantage over their offshoring competitors. While the latter waitsmore time for a cheaper, less dynamic product, a company sourcing domestically can introduce to the market a wider variety of ‘made to measure’ products at a faster rate with lower risk.

U.S. contractors focus on logistics simplicity. At a regional level, it isn’t unusual to see auto-replenishment ‘milk run’ deliveries for local customers, eliminating inventory pipeline and warehousing hidden costs. Even when working at a distance, the least expensive cross

Eliminated Costs

Top factors driving re-shoring decisions are labor costs (57%), quality (41%), ease of doing business (29%), and proximity to customers (28%).


70% claim “sourcing in China is more costly than it looks on paper”.

— 17th annual ASSEMBLY State of the Profession Survey





country freight shipments take less time than expedited shipments from an offshore supplier. By definition, costs associated with product separation, duties, and compliance with import/export rules are eliminated by onshoring. Staff expenses and stress are alsoeliminated as the team deals with suppliers near their home time zone.

When managing a domestic contract, quality control, problem solving, and general oversight is more thorough and much less expensive. A domestic contractor can be held more accountable, as their own business’ success is built on reputation. In addition, strategic decision- making and management are not only simplified by a domestic approach, but also enhanced. Given the rate of innovation, especially within the electronics industry, new models and changes in design can be introduced and collaborated upon with clarity and urgency.

Lastly, U.S. macro variables - cultural, political, and economic - are more predictable. A sudden spike in foreign exchange rates, or a change in a foreign country’s politics, could catch a company off guard. Companies operating within the U.S. have a more intimate sense of political and economic tides, allowing for clearer strategic decisions. Furthermore, sourcing within the U.S. endows a company with cultural resources otherwise absent overseas. Working with manufacturers of the same culture fosters better collaboration and innovation.

Eliminated Costs




A company looking to source from abroad should pay close attention to how well their expected savings on labor and unit prices overcome the 5 categories of hidden costs, and whether the decision to pay them is worthwhile.

A business either experiencing difficulties abroad or just starting up can eliminate the five hidden cost categories by sourcing within theU.S. Hidden costs are not only eliminated by this approach, but theirabsence grants companies the competitive advantage of delivering higher quality goods to the market more quickly and reliably.

Conclusion

A survey of 750 senior business executives worldwide, conducted in late 2012 by Ernst & Young, showed the number of executives that plan to nearsource previously outsourced activities will more than double in the next three years, from 14 percent to 35 percent

SITUATION:

Onshoring is Real

PROBLEM:

Hidden Costs are Driving

SOLUTION:

Understand Your Costs





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The Five Hidden Costs of Offshoring Eliminated by Onshoring

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