- The Washington Times - Saturday, May 29, 2004

Manufacturing companies realize “sourcing” in China, India, Mexico and Eastern Europe can lower production costs significantly, by as much as 75 percent in some cases. It also gives Western companies access to rapidly growing local markets. So the case for globalization is clear.

But sourcing from low-cost countries also has costs, which many companies underestimate. In fairness, getting the math right can be a challenge, since some costs are not apparent and can add up quickly. So the worst thing a business can do is rush into global expansion without realizing how much economic quicksand may lie under the surface.

The most obvious costs associated with moving manufacturing or service operations offshore are one-time setup expenses. These include the typical costs of establishing any new business, whether in Beijing or Bayonne, N.J. For example, in addition to “tooling” and training, the company must identify qualified suppliers, establish a reliable logistics chain, and bring software and networks online.

For manufacturing firms,research indicates these expenses processes typically add 10 to 40 percent to the cost of goods sold during the first year of operation, depending on the industry and its complexity. While startup costs vary, they are always considerable, no matter what the company does or in which low-cost countries (LCC) it does it.

For outsourced business services, one-time costs include identifying and training vendors, redesigning internal processes, establishing information-technology systems and other infrastructure, as well as software, network and transition costs, such as setting up and running the initial pilot program. Typically, such expenses may account for 25 to 75 percent of the entire first-year cost of operations.

Companies also must plan for the unexpected. The general principle that “if something can go wrong, it will” is doubly true for offshore operations, where things may go wrong even if they seemingly cannot. So companies must plan for this by building redundancy into the system, and probably back home.

If such redundancy is included in the initial “cost-advantage” calculation, the company may find it will take 2 to 2 years to recoup all the start-up costs associated with offshore sourcing and manufacturing.

Companies also need to include the “exit costs” associated with moving operations overseas in their cost-advantage equation. These include not only the direct cost of closing factories or shutting down lines of business, but also the costs of assisting the employees affected by the decision, including training, relocation and career counselling. Our experience indicates total legacy-related costs for most moves to low-cost countries fall in the range of $25,000 to $100,000 for each full-time employee affected by the move. That adds up quickly.

Companies also often underestimate senior management time needed to supervise a shift in sourcing; they underestimate their environmental liabilities; they underestimate the business they will lose (some of it permanently) during the transition, and they underestimate the higher costs domestic business units will bear when required to pay the full cost of services and infrastructure they previously shared with other business units.

The biggest hidden cost of all is that of managing a long and unreliable manufacturing, warehousing and delivery supply chain. This involves closely monitoring local suppliers, managing duplicate, or “buffer,” inventories, the “shrinkage” (disappearance) of product during shipping, and, most importantly, the cost of having too much of what is not selling in local markets and not enough of what is.

Then, of course, there are always currency exchange rate fluctuations, which can be highly volatile and make a seemingly brilliant business decision suddenly look foolish.

While globalization is inevitable, and companies must be as competitive as possible, moving operations and assets overseas is not without cost and risk, sometimes significant enough to turn the cost advantage into a disadvantage.

George Stalk and Dave Young are senior vice presidents of the Boston Consulting Group (BCG), in Toronto and Boston respectively. This article is adapted from the recently published BCG report, “Capturing Global Advantage: How Leading Industrial Companies Are Transforming Their Industries by Sourcing and Selling in China, India, and Other Low-Cost Countries.”

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