What is the Real Cost of Offshore Manufacturing?

A few weeks ago, I had the pleasure of sitting down and speaking with a couple of gentlemen who collectively had more than 60 years’ experience in a global industry. In the early years of their business, they were able to use domestic suppliers for everything, but as competition in their space grew, prices were driven down, and they like many other original equipment manufacturers, found it necessary to source product components overseas.

During our conversation, they shared a notable nugget of information about their organization’s experience with offshore sourcing. As the company began sourcing overseas, they also started monitoring the procurement process and the associated costs for overseas and domestic suppliers. Of course, they could easily compare component pricing, shipping costs, and other readily available costs, but they also tracked the hidden costs that are often merely rolled into an organization's overhead expenses.  Things like the time their staff invested in the procurement process. The investment in increased inventory levels, which protected against longer lead times. They even considered the cost of capital for advanced payments to overseas manufacturers vs. their domestic payment terms.  They monitored every action taken from the moment the order demands were triggered until the components reached their destination.

The years of data painted a clear picture. When considering the entire buying process, they determined that overseas sourcing added, on average, 27% more to these hidden expenses. The company can now assess the offshore manufacturing costs accurately. While foreign manufacturers usually offer much better pricing, this organization can see the real costs of the offshore option by adding in the 27%.  In many cases, the overseas option still provides significant savings, but at least this organization understands their costs, and they are confident in their buying decisions.

So how should their story change how we all look at offshore manufacturing?  Glad you ask.  Their story peeked my curiosity. As a bit of a self-proclaimed “Biznologist,” and no, that is not a word, but maybe it should be. I define “biznologist” as someone who is a business geek and loves to study business models, strategy, behavior, … someone who likes peeling back the layers of business. In my 30 plus years of business analysis, I have spoken to a number of representative companies who source products outside of the US.  They all share some form of this assertion, “you cannot compete without low-cost overseas manufacturing.” They also admit to not knowing the hidden costs associated with the practice. They merely focus on the product costs, shipping costs, and lead times.

My thought processes led me to break down each phase of the buying process, discover the typical issues associated with each, and compare the pros and cons of domestics and offshore options. I also assumed the years of data collected by this respected organization provided enough evidence to reasonably conclude the additional hidden costs of 27% would be in the range of statistical norms. If your company has data that validates or refutes their findings, I would love to hear from you.  For now, I will assume this case falls within the normal statistical range and is not an outlier.  

After considerable research and thought, my conclusion was that there are several areas we should consider when evaluating offshore manufacturing, and any or all of them may add hidden costs to the procurement process. Of course, the specific costs associated with each area may differ from one organization to the other, but it will be helpful to consider each area as you make sourcing choices.

Intellectual Property (IP) Concerns – This topic undoubtedly deserves much more attention, but here we will just provide a 30 thousand foot view. Is your product significantly superior to similar products? If so, will your product sales be depressed by a knockoff? Obviously, if your product offers excellent product benefits, you should be able to charge a premium price for the product.  So, protecting your IP may be more important than reducing your manufacturing costs.  Since IP concerns increase drastically with offshore manufacturing, you will have to weigh the risk and decide which direction is more palatable and which strategy fits your product and organizational goals.

Cost of inventory – to get significant price breaks, will you have to order 3, 6 or 12 months’ supply? Consider the costs associated with the capital investment made in inventory; additional space required for storage, and even the human capital necessary to warehouse and manage the product. We often absorb these costs into our overhead, but if we estimate the additional warehouse square footage and workforce needed to maintain the excess inventory, we can then apply it to the costs of the products represented. The numbers can be staggering, and there may be a better solution.

Cost of Inventory management – because of longer lead times for overseas manufacturing, do you have to increase your inventory levels to protect against “out of stock” items?  Most companies wrestle with inventory levels.  The fluctuations in demand, coupled with raw material availability, manufacturing delays, damaged goods, deficient goods … all make it challenging to manage lean inventory levels. Since the cost of missed sales opportunities is too costly to measure adequately, most companies err on the side of too much product. So, consider how you may utilize a domestic supplier to help. Can they act as a more agile primary, or secondary supplier, allowing you to reduce inventory levels, warehouse size, and staff while preserving your ability to fill orders as customers expect?    

Time Zone Inefficiencies – managing manufacturing projects on the other side of the world has challenges. Often time we are forced to schedule conference calls late at night.   When we communicate via email, it is usually several hours before the recipient sees it, and their response often comes in the middle of the night. You then get it and respond when they are asleep. An inefficient communication cycle like this can slow the production process down considerably.  The only way to avoid delays is to make sure someone is available 24/7 from both companies. Of course, many companies hire employees and base them in the manufacturer’s country to manage production. Others outsource the work to a broker. In every case, there are added costs to the process, and they must be considered part of the cost of your offshore program.

Additional time required to Manage Manufacturing – coupled with the time zone delays and extra time invested after hours, is the added time needed to communicate clearly. A five-minute production discussion with a colleague can become an hour-long conversation with someone speaking English as a second language. Some companies address this by hiring a bilingual employee, and it can be a cost-effective option if you have a steady flow of manufacturing projects.  Again, consider the costs.

Product Damage or Loss in Transition – most domestic manufacturers, own the product until you receive it in your warehouse. Most overseas manufacturers work differently. Ownership of the product transfers when it leaves their plant, so any damages or missing product during transition becomes your responsibility. There are typically options available for recouping the loss but do not expect anything to happen quickly. Not to mention, if you need the inventory, you have to jump through hoops to get more on the way. We have to think about such issues and consider their associated risk and costs.   

Advanced payment requirements – unless you have a long-standing, trusted relationship with your overseas manufacturer, you will be required to pay in advance for your goods. 
In most cases, offshore manufacturers will not ship product until payment is received. In cases where you transport goods via the water, your payment is processed 30 days or more before you get your product. As you know, there is a cost to paying 30 days before you have the product, especially when compared to 30-day terms with a domestic manufacturer. There is a minimum of a 60-day difference between the two options.  If you are paying from existing cash-flow, it may not be too bad. If not, add the costs of capital for at least the 60 days. You may want to track your payment date and received dates to determine precisely how many days of the capital cost to add. It may not seem like it is worth monitoring, but as you combine all the possible added expenditures, it may tell a compelling story.  

The Risk when Initially Sourcing – the costs incurred while getting your overseas program started can be staggering. The search for the right manufacturer, and learning the ins and out of the process will be costly, even if you hire someone with good experience. Most companies address this by hiring a consultant, or a broker to assist in the process. We rarely consider the ROI of transitioning from Domestic to overseas manufacturing, but the time/labor costs are usually significant.  

Lastly, Insufficient Legal Recourse is one of the most significant risks to consider. What are your options, if things go wrong? Whether you are dealing with a domestic or offshore manufacturer, something will eventually go south. Most of the time a reasonable and equitable solution can be found, and you move on. Unfortunately, there are instances when things do not go well, and a realistic solution seems tenuous at best. In such cases, US companies doing business overseas will often elect to write off the loss and sever their relationship with the overseas manufacturer. There are no good legal options available and cutting ties, while justifiable, creates additional expenses. You have to locate and onboard a new manufacturer.  How long will it take to groom the new team? Do I have enough supply to get through the re-start phase? Do you have a secondary supplier, overseas, or domestically? If not, it is a worthwhile pursuit.

There is a lot to consider when sourcing manufacturing partners and this article only scratches the surface, but I hope it may inspire you to take a fresh look at the real costs and potential risk.