Analyzing the pros and cons of outsourcing to China

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To make the right decision, conduct an extensive cost analysis of your total delivered cost.

Wayne Forrest — Purchasing, 2/3/2005

If you’re considering setting up shop and outsourcing in China to reduce your sourcing costs, make sure that you first conduct a detailed cost analysis to determine that it truly will be a less expensive approach for your company.The reason: China isn’t necessarily a low-cost haven for companies looking to outsource. Two recent studies have concluded that while the cost of manufacturing products in China is less than the United States, businesses often underestimate the complexity of managing trade with China and, in some cases, companies might be better off redesigning their products and maintaining production at home.

Indeed, success in a China trade strategy requires companies to take a “true end-to-end management approach.” That’s the advice from Aberdeen Group’s China Trade Management Strategies Benchmark Report. The survey was cosponsored by technology providers E2open of Redwood City, Calif. and Manugistics Group in Rockville, Md. The survey found that 42% of respondents had order cycle times of more than 60 days. In addition, 89% of the respondents that had the highest logistics costs also had the longest order leadtimes. The report says those numbers are a “clear warning sign that price-based supplier selection is the wrong strategy in China.”

“If you just do it based on pricing negotiations and have not thought through the logistics of delivery, assurance of supply, flexibility of supply and quality, your total cost very quickly outweighs the price savings you made in the negotiations up front,” says Richard McCluney, vice president of account operations for E2open.

The survey cites four important criteria for success in China trade management: lowest total delivered cost; delivery reliability; supply chain flexibility; and regulatory compliance and risk minimization.

Yet, U.S. manufacturing—particularly in regard to China—”seems to be experiencing a lemming mentality when it comes to outsourcing,” suggests “A Case to Consider Before Outsourcing to China,” a recent study conducted by Boothroyd Dewhurst, a company that specializes in software tools that provide manufacturing assembly knowledge for the product design process.

While all companies strive to reduce manufacturing costs, the report found that few firms analyze and act on the greatest potential for cost savings—the design of products. “The part cost is about 70% of the cost of a product,” estimates Nicholas Dew-hurst, Boothroyd Dewhurst executive vice president and coauthor of the study. “If that’s true, then you’re barking up the wrong tree if you’re [only] looking at labor, which is the smallest piece of the pie.”

“When they look only to outsourcing for cost reduction, [companies] run the risk of becoming myopic in the design process,” says the study. Another common error: too often, companies look at the current design of a product and naturally—and mistakenly—assume that its redesigned predecessor will cost the same amount to produce, says Dew-hurst. “I think a lack of real involvement of the purchasing or supply chain group in that early design process has some impact on getting a full understanding of what the costs are.”

As Dewhurst explains, many companies design a product, send the plans to three suppliers for quotes and then choose the lowest bid. Not only does that “take a significant amount of time to arrive at the design,” but when you use that type of conventional process, “it is already too late [to have an impact on] the cost you want to produce it for.”

Similarly, many companies do an inadequate job of setting the initial target cost, revise design closely based on the original product and pay too much attention to what the competition is doing, says David G. Meeker, consultant with Neoteric Product Development in Acton, Mass. and coauthor of the Boothroyd Dew-hurst study. “Gone are the guys who could look at a product and, in their heads, know the process and costs of design and manufacturing and how it could be done less expensively.”

But how realistic is it to set a low cost for redesign and production?

“You have to absolutely do it, because you won’t know if you can bring a product to market and get the kind of [profit] margin that you want,” Dewhurst says. “If the market will bear a price of $100 and you have to make it for $75, the problem is this—how do you know that’s a good target? We see a lot of manufacturers arbitrarily picking numbers; they’ll set the cost at $75 and then see if they can do it.”

If the process is done correctly, Dewhurst maintains that a finished product’s time to market is shortened. “If you have a product that has 10 parts in it and you can make it with five, that’s five fewer things you have to carry through the development process.”

China connectionThe Boothroyd Dewhurst study also notes that some products are not good candidates for overseas manufacturing, whether they are redesigned or not. For example:

  • Products which utilize a highly automated process.
  • Products—which because of their weight and size—increase shipping costs by air or ocean.
  • Products which require scheduling flexibility.
  • New products which may require engineering and design changes to ensure quality.
  • Products with proprietary intellectual rights and/or patents that may be copied and marketed less expensively.

To assess the bottom line, companies must total all additional costs associated with overseas manufacturing, whether it be travel, shipping, legal, material or labor expenses. In other words, find the total lowest delivered cost of making a product.

China imperativesTo successfully do business in China, adds E2Open’s McCluney, it’s also critical to have key people in the sourcing process—perhaps Chinese-Americans—who know the local customs and can conduct accordingly.

“As the supply chain gets longer, if you don’t spend a lot of time making sure you’re making the right decisions on sourcing and trying to save a penny here and a penny there, you get a more convoluted supply chain,” he says. The most successful companies take key sourcing people and place them in cities such as Singapore and Shanghai because those are key areas for identifying good suppliers.

Common mistakes among companies attempting trade in China include assuming that supplies will sail through Customs easily and misjudging infrastructure capabilities in the Chinese market. McCluney used to work outside of Shanghai, where, at one time, roads were quick to travel. Today, getting from one place to another can take three times as long. “Because of the huge increase in traffic, you now have to rethink where you have your suppliers based,” he says. “A good assumption six months ago might not be the right thing today or in six months time.”

“If you do a lot of work up front to prequalify the supply base, then you are getting your assurances and benefits of the lower cost,” McCluney says. “If you just go for a successful price negotiation without all the other pieces, you may end up missing orders, not being able to fill orders, if demand changes, and your costs go up.”

On the horizonIf adventurous companies can find a way to handle China’s idiosyncrasies, they should do so quickly. Why? Meeker believes that the cost of doing business in China will not stay inexpensive forever, especially if and when China begins to more seriously enforce regulations that pertain to the environment, minimum wage, worker safety and the like—and have foreign manufacturers pay part of the tab.

“It’s not a stretch to think that at some point in the future—I don’t know if it is one year, five years or 10 years—China will have to do something and the costs [to do business in China] will only go up,” Meeker says.

E2open’s McCluney believes the Chinese market will “continue to grow, but I don’t think it is the be all and end all. I think the economics that make people look at China trade might work right now, but you have to reassess your strategy,” as the economic and political climates in the country change.

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