Why it's Important to Understand Total Cost of Ownership for Outsourcing Manufacturing

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Manufacturing Outsourcing

Cost estimates often don't include the intangible costs associated with business, such as the true costs of delays, defects, and deviations from standard or expected processes

by Michele Nash-Hoff

In the increasingly competitive global marketplace, manufacturers need to continually strive to reduce costs to keep or increase market share. This is one of the key factors in making the decision of whether to make parts in-house, outsource to domestic suppliers, or outsource offshore.

Even after a company makes the decision to outsource to a supplier, most don't look beyond the quoted unit price in making the decision about which supplier to select. This is especially true when comparing the quotes for domestic vs. offshore suppliers. Some companies choose to outsource offshore because the price is cheaper than a domestic supplier. They don't add in the costs for transportation, much less all of the other "hidden costs" of dealing with an offshore supplier.

In order to make the correct decision for outsourcing, a company needs to understand the concept of "Total Cost of Ownership" (TCO) for outsourcing manufacturing. What is "Total Cost of Ownership?" It is an estimate of the direct and indirect costs and benefits related to the purchase of any part, subassembly, assembly, or product. The Gartner Group (www.gartner.com) originated the concept of TCO analysis several years ago, and there are a number of different methodologies and software tools for calculating the TCO for various industries, products, and services.

Total Cost of Ownership includes much more than the purchase price of the goods paid to the supplier. For the purchase of the types of manufactured products we are considering, it should include all of the other costs associated with the purchase of the goods, such as the following:

* Geographical location

* Transportation alternatives

* Inventory costs and control

* Quality controls

* Reserve capacity

* Responsiveness

* Technological depth

The search for low cost areas for manufacturing isn't something new. Fifty years ago, northern and New England companies started moving manufacturing to the southern states. Twenty-five years ago, many West Coast manufacturers started moving high-volume production offshore to Hong Kong, Singapore, and the Philippines. "Offshoring" refers to relocating one or more processes or functions to a foreign location. The next lower cost area was Mexico, with the advent of the maquiladoras.

For the past 15 years, many manufacturers have sought to reduce costs by offshoring all or part of their manufacturing processes in China. In the last decade, outsourcing offshore has evolved from a little-used practice to a mature industry. Even conservative companies are now willing to experiment with going offshore to gain a competitive edge. The concept of globalization has become part of the fabric of today's business.

Many times, the decision to outsource offshore is based on faulty assumptions that can have unpleasant consequences. In some cases, the basis for the decision is well intentioned, such as to win new business by being close to a customer.

But, with every business decision comes an assumption, and more often than not, the related assumptions are erroneous. Here's a list of well intentioned but often-faulty assumptions:

* Longer lead times won't affect our cost calculations very much.

* Overseas suppliers have the same morals and work ethics as we do.

* Overseas laws will protect our proprietary information.

* We can teach our suppliers to reach our quality needs and to build our product reliably and efficiently.

* Communication will not be an issue given daily conference calls, the Internet, and the fact that the supplier speaks English.

* Assessment and travel costs won't change our cost calculations very much.

* The increase in delivery and quality costs won't be significantly different from our cost calculations.

* Lean manufacturing and Six Sigma methodologies can be taught to suppliers before our company's bottom line is affected.

In actuality, many case studies have shown that these assumptions were orders of magnitude off from reality. The problems with making these assumptions are the following:

* It doesn't capture a reasonable amount of variation. Each lot takes weeks more time than anticipated to get to the U.S. or customer site for evaluation.

* The overlying methods for producing product or service have gotten more complex, not less. In general, costs rise with complexity.

* The company doesn't know the hidden costs that exist (e.g., process stability, process capability over time, and potential for future deviations from the current process).

* The company loses complete control of quick changes to react to hidden costs. It's like trying to control production via remote control.

Accountants deal with hard costs, such as material costs, material overhead costs, labor costs, labor overhead costs, quality costs, outside services, sales, general and accounting costs, and profits. What they don't measure are the intangible costs associated with business, such as the true costs of delays, defects, and deviations from standard or expected processes (the three D's).

These costs are often called hidden factories because they keep everyone busy generating absolutely nothing of any tangible or openly measured value. Another way to understand these costs is that they produce results that no one, especially the customer, would want to pay for. In addition to obvious direct costs, such as additional meetings, travel, and engineering time, hidden factories also indirectly produce many forms of "soft" costs, such as loss of good will, loss of competitiveness, extended warranty costs, and legal costs.

When it comes to outsourcing, there's more to consider than the quoted price. Some outsourcing costs are less visible—or downright hidden. Here are the top hidden costs of outsourcing offshore:

* Currency fluctuations—last year's invoice of $100,000 could be $140,000 today;

* Lack of managing an offshore contract—underestimating the people, process, and technology required to manage an outsourcing contract;

* Design changes—language barriers make it difficult to get design changes understood and implemented;

* Quality problems—substitution of different or lower grade materials than specified is a common problem;

* Legal liabilities—offshore vendors refuse to participate in product warrantees or guarantees;

* Travel expenses—one or more visits to an offshore vendor can dissipate cost savings;

* Cost of transition—overlooking the time and effort required to do things in a new way. It takes from three months to a year to complete the transition to an offshore vendor;

* Poor communication—communication is extremely complex and burdensome;

* Intellectual property—foreign companies, particularly Chinese, are notorious for infringing on IP rights without legal recourse for American companies.

In the past, my experience was that once manufacturing moved out of the United States, it rarely came back. However, in the past three years, we have seen more companies coming back from doing business in China. The main problems these companies encountered were substitution of materials; inconsistent quality; stretched-out deliveries; and the inability to modify designs easily and rapidly.

There's also a growing realization that when it comes to quality and location, location may be the best guarantee of all. It's hard—very hard—to outsource quality, particularly to a distant land many miles and time zones away. A growing number of manufacturers are realizing that "you get what you pay for" from their offshore suppliers. Applying good quality principles takes money, education, and experience, many of which are in short supply in the low-wage countries capturing the majority of offshoring dollars these days.

The "desirable" locations for cheaper outsourcing will change over time just as they have in the past fifty years. The purely financial benefits of lower pricing will erode over time. The challenge for America is to keep as many companies as possible growing and prospering within the United States. As more manufacturers gain a correct understanding of the True Cost of Ownership for outsourcing manufacturing, it will help bring back and maintain more manufacturing in the United States. You can help save American manufacturing by making sure everyone in your company gains this correct understanding.

Michele Nash-Hoff is the author of Can American Manufacturing be Saved? Why We Should and How We Can (http://savingusmanufacturing.com).

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