By Theo Anderson
The cost of labor is an obvious and compelling reason to send jobs overseas. Low wages elsewhere are the main reason that about 5 million US manufacturing jobs were offshored between 2001 and 2011. About a third of them went to China.
But do low wages trump the negatives of offshoring, particularly the additional shipping time and associated transportation and hidden costs, like the overhead of managing suppliers who are far away?
Firms have begun asking that question more often and urgently as labor costs rise around the world. Wages have nearly doubled in China since 2008, for example. As a result, manufacturing jobs have begun to trickle back to the US. One surveyin December 2015 found that 17 percent of manufacturing executives were already “reshoring” jobs—that is, bringing them back to the US. Another 37 percent were planning or considering it.
Labor costs are relatively easy to determine. But the other side of the equation— the cost of transporting goods from factories to the point of sale—involves trade-offs that make a reliable cost–benefit analysis hard to come by.
“It’s not just about the dollar cost of labor,” says Jan Van Mieghem, a professor of operations at the Kellogg School. “Time is money, and firms have become smarter in realizing that, ‘well, we can go to China, but it’s going to take a longer time to get the product back here. And I will pay for that time.’”
Van Mieghem and his coauthor Robert Boute, of the University of Leuven, have developed a formula based on a model they designed that helps companies weigh a broad range of factors in deciding whether it makes sense to offshore jobs, manufacture locally, or do a mix of both, which is known as “dual sourcing.” [See sidebar to input your company’s information into a free version of the model.]
“If I’m making sourcing decisions, I need to quantify it,” Van Mieghem says of the choice between manufacturing overseas, manufacturing nearby, or relying on some mix of the two. “This model is one of the first that gives the quantifiable impact.”
Both Sides Now
Van Mieghem’s formula will be especially useful to companies in volatile markets, where demand shifts rapidly. These markets create uncertainty and force companies into a dilemma as they analyze which sourcing approach makes sense.
“You can keep a lot of product in inventory, which will cost you money,” says Van Mieghem. “And you may end up having too much on hand. Or you can be more conservative and keep less in inventory. But then you run the risk that you won’t have enough on hand, and customers will go elsewhere.”
Manufacturing nearby means a company can keep inventory levels low but still get goods to market quickly when demand spikes. But does that benefit outweigh the cost of paying higher wages?
The answer depends in part on the costs of ramping up production to meet surges in demand—known as “capacity costs.” If a supplier usually produces 100 units per day, for example, and demand rises to 150 units per day, how quickly can it meet the demand for 50 additional units, and at what cost?
In a word, how flexible is the supplier?
“The more expensive it is to pay overtime, hire extra workers, run weekend shifts and extra shifts, the more inflexible you are from a capacity perspective,” Van Mieghem says.
European economies tend to be highly regulated and have high rates of unionization. The same is true, to a lesser extent, in some parts of the US. This inflexibility has driven the offshoring of so many jobs over the past several decades.
The formula developed by Van Mieghem and Boute helps a firm weigh these capacity flexibility costs against the benefits of sourcing nearby, such as the reduction in import taxes and inventory costs. Without the benefit of such a formula, it has been tempting for decision makers to fixate on the low cost of labor abroad.
“In the past, companies kind of underestimated, or neglected, the costs of the time it takes to transport goods, and the cost of needing more inventory,” Van Mieghem says. “And many companies have become more aware of this. So they’re in a mode of not relying completely on low-cost, faraway sourcing. They realize that they need some nearby sourcing, too.”
Van Mieghem’s formula helps them determine the right balance. A firm can input its own data on wage costs and capital investments, capacity costs, lead time, and so on to determine the optimal mix of sourcing abroad and nearby. Van Mieghem is now consulting with a major computer company to apply his formula to its products.
The formula can also be applied to shipping costs, helping a firm choose the best mix of transporting goods by ocean and by air, and it can help determine the optimal mix of local sources, not just local and offshore sources.
“Should we keep investing more and more in Asia—or should we start investing more over here?”
Bringing It (Partly) Back Home
The lure of low wages is especially strong in the realm of computers and electronics, an industry distinguished by strong competition and low profit margins.
But technology firms are the classic case of an industry that can benefit from dual sourcing. Demand for computers and cell phones, and the related devices and accessories, is highly volatile—making them prime candidates for nearby sourcing. The cost of labor may be higher, but companies save on shipping. They are also able to keep inventories low while offering rapid delivery, which technology consumers tend to value.
Those advantages are one reason the US has gained some manufacturing jobs in the past few years, after three decades of steady offshoring. For example, the Chinese computer manufacturer Lenovo opened a new factory in 2013 in North Carolina.
That state has had another recent win in terms of keeping sourcing local from a different sector: furniture manufacturing. It is home to nearly 10 percent of all the jobs in furniture manufacturing in the US, and has begun to win back some of those jobs it lost over the past few decades.
The industry’s strategy for doing so has involved, in part, becoming smarter about inventory management and maximizing the advantages of making furniture in factories closer to showrooms. That strategy substantially reduces both the costs of storing furniture and the administrative costs of tracking it to the point of sale.
Despite such advantages of manufacturing nearby, the low cost of labor means that offshoring or dual sourcing still makes economic sense for many companies. Van Mieghem’s formula can help companies understand how to plan their sourcing in the current market—and years down the road. “It can be used as a planning model, to project out for the next few years what you believe should happen with your global footprint. Should we keep investing more and more in Asia—or should we start investing more over here?”
This article was originally published on Kellogg Insight. Reprinted with permission of the Kellogg School of Management.
Theo Anderson is a writer and editor living in Chicago.
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