Knowledge Wharton-2011-Outsourcing: New Pressures to Stay Home, Old Reasons to Go Abroad

January 2011 in Knowledge@Wharton
As wages and other costs increased in recent decades, U.S.-based
global manufacturers gradually opted to outsource more and more
of their production to suppliers in Asia, especially China. This
process may have made sense for U.S. multinationals that needed
to compete with companies based in those low-cost countries -- and
with multinationals from other countries doing business there. And
outsourcing has indeed lowered the costs of many products.
But it has also gradually become emblematic of globalization's
drawbacks, and it is widely condemned as one of the key sources of
today's high unemployment rates. In last fall's U.S. Congressional
elections, some candidates from both the Democratic and
Republican parties attempted to attract voters by accusing their
opponents of supporting policies that make it easier for companies
to "ship jobs overseas" -- in other words, outsourcing.
Can the tide of outsourcing be reversed without enacting protectionist, anti-trade legislation? Is such a
reversal already under way in some sectors? Or is it unrealistic to expect a reversal?
Analysts generally agree that U.S. companies -- and many of their counterparts in Europe and other
developed economies -- tend to think a little harder nowadays about sending production lines to Asia.
Indeed, some companies were burned after outsourcing turned out to involve all sorts of hidden costs,
including quality control problems and delays that resulted from longer supply chains. Recent headlines
suggest these companies may be relocating some low-cost production lines back to "near-shore" locations
in Mexico or Central America. Even better for U.S. workers and trade unions, more companies may soon
be persuaded to expand their workforces in the United States, rather than outsource from foreign plants.
In a rare, but high-profile success story, General Electric recently announced that it would add 200 jobs at
its appliance plant in Bloomington, Ind., rather than shut down the plant and move production to Mexico.
"The worldwide economic downturn and its aftermath have had a significant effect on how companies
view and approach global sourcing," says a recent report by The Boston Consulting Group (BCG). The
report notes that exports from low-cost countries dropped sharply during the crisis -- from $3.8 trillion in
2008 to $3 trillion in 2009 -- and have yet to recover to their pre-downturn levels. So companies are
"re-thinking" their strategies to take into account the "total cost" of outsourcing production lines to Asia
rather than calculating just the most obvious costs, such as wages and transportation. Under increased
scrutiny are the real and potential costs involved with handling such challenges as product recalls and
volatile commodity prices, among other issues, says the report.
Nevertheless, outsourcing is hardly about to disappear. According to data compiled by the Economist
Intelligence Unit and BCG, exports from low-cost countries, while sharply down in 2009, were still at the
third-highest level in history, exceeded only in 2007 and 2008. Moreover, says the BCG report,
outsourcing is "no longer restricted to high-labor-content products such as garments, toys and shoes.
Increasingly, multinationals are sourcing a wider range of products from low-cost countries to capitalize
on the less expensive overhead, inputs and capital -- and for strategic reasons such as better access to
supplier clusters or to consumers in emerging markets." That means the total volume of exports from
low-cost countries almost certainly finished 2010 on an upward course as demand for goods from those
countries continued to recover from the recession.
In a Not-so-flat World, a Complex Process of Analysis
Many politicians may remain in the dark about the subtleties of outsourcing, but executives at leading
global companies have long understood its complexities, says Mauro Guillén, a professor of international
management at Wharton and director of the school's Joseph H. Lauder Institute for Management &
International Studies. Knowledgeable executives reject the conventional public wisdom that outsourcing
is a simple, straightforward proposition because, as the cliché goes, the world is "flat." That is an
"entirely wrong" assumption, states Guillén. "The world is only flat in some places." If the world were
entirely flat, it would always make sense to outsource where wages and other costs are lower -- but that is
clearly not the case.
Well-managed companies with experience in non-U.S. markets have long recognized that it is "very
difficult to generalize" about the virtues of outsourcing, adds Guillén, noting that what makes sense for
some sectors and products just doesn't make sense for others. Fortunately, the notion that most global
companies dive blindly into China "couldn't be further from the truth. Companies are much more
sophisticated than that."
Astute analysis of the total costs -- including potential risks -- involved in outsourcing a production line
can lead companies to make decisions that are not at all obvious at first glance. "What drives the location
of outsourcing is the value-to-cost ratio," says Ravi Aron, a professor at the Johns Hopkins Carey
Business School and a senior fellow at Wharton's Mack Center for Technological Innovation. If, for
example, the value of a product is $100, but the cost is $4, the value-to-cost ratio is 25 to 1, high enough
that you can source that product at home. "Only in such cases do you tend not to outsource" a product,
Aron says. That's because doing so is not worth the risks that go along with managing any extended
supply chain.
To raise the value-added side of that ratio, multinationals sometimes need to invest in upgrading their
production lines in high-wage countries. For example, GE's recent decision to add 200 workers in Indiana
committed the company to making $93 million in new investments in its plant, which will manufacture
higher-value, more-energy-efficient refrigerators. To lower the cost side of the ratio, on the other hand,
GE was promised $2.25 million in state-income tax credits and federal energy incentives of $5 million.
For its part, the International Brotherhood of Electrical Workers agreed that new hires at the plant would
start at $13 an hour, much lower than the $24 paid to existing workers.
Cricket, the Spanish maker of cigarette lighters, provides another case study in the subtleties of
calculating the value-to-cost ratio. Cricket operates three factories -- one in Spain, one in India and a third
in China. Predictably, Cricket's labor costs in Spain are much higher than in India or China, yet Cricket's
per-unit production costs in Spain are actually lower than in China, says Guillén, because its Spanish
plant was fully automated at significant investment cost. Why does Cricket even have a plant in China?
Because when customers need to order customized lighters -- for example, lighters carrying a corporate
logo -- production lines must be retooled, and it is cheaper to retool in China where the lines are not
automated. "The China plant gives them flexibility," says Guillén.
Global managers have also learned over the years that products such as high-end aircraft don't lend
themselves to outsourcing because they cannot be mass produced; they must be manufactured to meet
unique specifications demanded by each buyer. In other cases, notes Guillén, "You want R&D to be close
to the manufacturer, or you want the manufacturer to be close to the buyer" so that you can respond
rapidly to changes in demand. Such considerations explain why Germany is the second-largest exporter in
the world, after China, despite the fact that it has very high wages.
Two key variables that determine whether it makes sense to hand over your production line to foreign
suppliers, adds Aron, are its "codifiability" and the nature of the metrics involved in the manufacturing
process. "Some products do not lend themselves to being codified," and even the most exhaustive
attempts to codify how they need to be manufactured won't do the job. So those kinds of products should
probably not be outsourced. As for metrics, global manufacturers need to be able to provide their
would-be suppliers with precise, well-defined metrics so they know exactly how to measure their
performance. But for some products, notes Aron, the only possible performance metrics are too imprecise
or subjective, so outsourcing again doesn't make sense.
When Near-Sourcing Makes Sense
Discussion about companies bringing overseas production back to the Americas has been exaggerated or
misunderstood, says Tom Kim, Hong Kong-based transportation researcher at Goldman Sachs (Asia),
adding that global companies are not bringing their production lines back to the United States despite the
downturn in demand for outsourced products during the recession. Something else is happening, he says.
"What we are seeing is a diversification of new sources of growth in order to help companies diversify
their corporate exposure" to global risks. This trend does not involve "the displacement of their existing
production from China but the expansion of their capacity into different markets outside China." In other
words, rather than shut down their plants in China or sever their ties with independent Chinese contract
suppliers of those goods, some global companies are also outsourcing production from countries like
Cambodia, Thailand and Vietnam.
Under what conditions does "near-sourcing" to, say, Mexico, make sense? "The reason for near-sourcing
is that it allows you to change your supply destinations much faster," Aron says. Adds Walter Kemmsies,
chief economist of Moffatt & Nichol, a marine infrastructure engineering firm: "Those companies whose
products are frequently redesigned may find that outsourcing to Asia makes less sense than to near-source
to Mexico, Central America or the Caribbean."
Trade pacts, such as the Central American Free Trade Agreement (CAFTA), which gives tariff
preferences to firms that export from that region, can be a key factor in making near-sourcing
cost-effective. In the case of CAFTA, U.S. textile mills must first export their yarn and fabric to that
region, where Central American companies then cut and sew the material into apparel, which is then
shipped back to the United States for distribution to retailers. This complex supply chain makes sense
only because, under CAFTA, apparel made in Central America enters the United States duty-free, so long
as the yarn and fabric "originate[d] in the U.S." (Otherwise, U.S. tariffs on apparel are high.)
This sort of near-sourcing benefits both Central America and the United States. Thanks to CAFTA, the
average piece of clothing imported to the United States from Central America now contains 70%
U.S.-made yarn and fabric. In contrast, the average piece of clothing imported from China to the United
States contains less than 1% U.S. yarn and fabric, says David Spooner, a former U.S. trade negotiator
who is now an attorney at Squire, Sanders & Dempsey in Washington, D.C.
Kim of Goldman Sachs agrees that near-sourcing may work well for some global companies that want to
respond quickly to changes in customer demand and that need to ship products to U.S. buyers within days,
not weeks. However, he adds, China will continue to be the prime location for global companies to
outsource products in a wide range of industrial sectors, despite its distance from the United States -- and
even despite the fact that China's wages will continue to rise, especially along its eastern coast. Why will
it be so hard to replace China in so many outsourced production lines? Kim says that China offers global
manufacturers a very strong physical infrastructure, which the Chinese government has been
"aggressively expanding" over the past several years. Newer outsourcing sites in Asia -- even those that
pay lower wages than China -- can't offer total costs that are competitive with China's because those
countries' roads, ports, bridges and other facilities are significantly inferior, leading to higher costs for
critical transportation and logistics.
In addition, notes Kim, Chinese companies have been actively upgrading their technology infrastructure,
implementing the latest IT platforms and applications to improve their efficiency and to lower the total
cost of outsourcing, even with rising wages. A final factor, he says, is the sheer size and capability of the
Chinese labor force. "It is very hard to replace China's huge pool of workers" in the much smaller nations
of Southeast Asia, Latin America or elsewhere. "China's workforce is upgrading its level of skills so that
it can handle the production of an ever-wider range of products."
Global companies that outsource their manufacturing processes need to weigh very different sorts of
factors from those that outsource their back-office processes, known as business process outsourcing
(BPO), adds Aron. When it comes to manufacturing, economies of scale are very important; if economies
of scale can't be provided by a particular supplier or group of suppliers in one manufacturing site,
companies need to look elsewhere. In contrast, when it comes to BPO, the ability to automate and
standardize processes "is a lot more important than scale," Aron states. In the case of services, inputs,
outputs and working processes are all information, "so co-location is not as important in services as it is
in manufacturing."
Surveys show that BPO activity is increasing again after declining briefly in the wake of the recession.
IDC, an IT research firm, estimates that worldwide revenues for BPO services were $158.2 billion in
2010, and it expects an increase of 5.4% in 2011.
However, the BPO business is also growing more competitive, and some countries have developed
specialized BPO capabilities that feed off the skills of their workforces and/or the time zones in which
they operate, says Aron. For example, the time zone is an important factor for BPO in such countries as
Mexico, El Salvador and Chile, which compete for supplying Spanish-language call centers to customers
in North America.
Logistics: The Potential Bottleneck
Even with all the new concerns, many companies don't pay enough attention to the full range of logistics
challenges they face when they outsource manufacturing to suppliers in distant locations, according to
George Stalk, a Toronto-based senior advisor at BCG. "People have to be careful when they go out [to
Asia] about stock-outs and overstocks," says Stalk, and they must be prepared to pay the higher cost of
shipping fashions, high-tech goods and other products that customers demand on short notice. Many
companies "don't think about logistics" until they have a problem, he adds, and too many corporate heads
of logistics are "a level or two down" from senior management, where they "don't have the throw weight"
to make strategic decisions that have a major impact on profitability. Notable exceptions to that rule
include apparel companies as well as supply-chain-driven companies like Wal-Mart and Dell Computer,
whose logistics heads have long exercised a strong voice in senior management.
Stalk also worries that global companies could be caught unprepared for upcoming increases in logistics
costs. "Companies have calculated their logistics footprint when logistics costs were going down in real
terms. But now, all of these costs are beginning to reverse themselves," including rates for containers and
railroads as well as oil prices. Despite the Obama administration's bold rhetoric about upgrading U.S.
infrastructure, 95% of infrastructure spending in the stimulus package "was about catching up with
delayed maintenance," Stalk notes. "We have no new runways, no new airports and the 'next generation'
air traffic control systems are still not up. All across the board, the opportunity to get ahead of the
problem has passed. The congestion costs are beginning to bite."

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