Hedge Your Offshoring Bets

When a European or North American manufacturer thinks about offshoring a factory or function today, it often looks first to China and India. Both countries offer an attractive combination of low costs, well-developed capabilities, business-friendly regulatory environments and large domestic markets — all reinforced by their governments’ robust public relations efforts. China and India offer such desirable characteristics, in fact, that they’re rapidly becoming the default choices for low-cost offshore operations.

But for those considering offshoring, there are dangers in taking too narrow a geographical view. Every country presents a different mix of strengths and weaknesses. One country may, for instance, have very low labor costs but a high degree of political instability and a small domestic market. Another might offer a wealth of engineering talent but quickly rising labor rates. A third may have robust local markets but intrusive regulatory regimes and a weak transport infrastructure. Moreover, the cost-benefit profiles of individual countries, particularly in the developing world, can shift rapidly and unpredictably. Currency fluctuations may unexpectedly swell the costs of sourcing from one country, for instance, or a natural disaster may wreak havoc on a critical source of supplies. If a company restricts its offshore arrangements to a small number of countries, it may unwittingly be assuming far more risk than it should.

Whenever an investment program involves choices with widely divergent cost and benefit characteristics, it usually makes sense to create a portfolio that brings potential gains and risks into balance, over both the short run and the longer term. Offshoring is no different. By spreading its foreign operations and outsourcing relationships over a broader, well-balanced mix of regions and countries, a manufacturer can, quite literally, get the best of all possible worlds.

Casting a Wide Net

Our recent research into industrial offshoring confirms the wisdom of a portfolio approach. We canvassed 138 manufacturing executives in sectors ranging from automotive and chemicals to consumer products and technology. More than 80% of them said that shifting activities to low-cost countries is a high priority in their industry, and nearly two-thirds said their own companies have launched significant offshoring initiatives. But when we categorized the companies according to their respective cost positions in their industries, we found that the cost leaders — companies with the lowest cost position given comparable quality and for comparable products — tended to approach outsourcing in a way very different from the cost laggards. In particular, one-third of the laggards restricted their offshoring efforts to China and India, while 96% of the leaders were active in countries beyond those two. Nearly half of the leaders had offshore activities in three or more countries in addition to China and India, while only about a quarter of the laggards had cast their nets so broadly.

In creating their offshoring portfolios, the cost leaders take into account a wide range of decision criteria. They look at current labor rates as well as related costs such as facility construction and utilities. They look at the education and skill levels of local workers as well as their business experience. They take into account the maturity and stability of the nation’s infrastructure — transport, energy, communications, computing and so forth. They examine political characteristics, including regulatory schemes and ownership restrictions. They assess the size of the domestic market and the likely local demand for their products. And they evaluate many other factors, including currency risk, climate and weather patterns, language skills, management training and various cultural characteristics.

Equally important, the leaders look at short-and long-term trends affecting all relevant criteria. Considering that a new industrial facility may have an investment horizon of 20 to 30 years, historical trends and present conditions may often be less important than future developments. Labor costs, for instance, can change dramatically over the course of a decade, particularly given the acceleration of offshoring to low-cost countries. As demand for local labor strengthens, the price of labor goes up as well. As with any sort of arbitrage, aggressive moves to capitalize on global discrepancies in labor rates will tend to erase those discrepancies over time. To hedge against labor-cost escalation, a company may want to establish operations not only in popular areas like Asia but also in more slowly emerging areas like Africa.

The weightings given to the various short- and long-term criteria can change offshoring calculations dramatically. Take China, for instance. The country offers a huge domestic market, with a labor pool to match. Its average factory labor cost of about $1 an hour is a small fraction of the $20 to $30 an hour average in the West. But in China, companies also face political uncertainty and a lack of enforcement of property rights, risks that could come to overwhelm the benefits of low labor costs. While China may be the most attractive location for many products on a simple cost-comparison basis, a portfolio approach may mean accepting higher unit costs in other Asian countries, Eastern Europe or Latin America in order to protect against currency risks, political risks or the impact of natural catastrophes. Hungary’s labor cost, for example, is almost quadruple China’s, but because Hungary offers a highly educated work force and relatively low political risk, it can be a better bet for Western European companies looking to offshore skilled manufacturing.

Maintaining production facilities in higher-cost countries also makes sense when labor is a minor cost component or transportation costs are high, as in high-value electronics or bulky appliances. When reducing time to market or managing transport costs is critical, leaders in cost migration tend to source products and components close to the final place of assembly or sale. But if labor accounts for a high percentage of total costs and transportation costs are relatively low, most firms will need to migrate to low-cost countries to remain competitive. Prime examples include the textile industry and services such as call centers. In all situations, deciding whether to shift costs is not an all-or-nothing proposition but requires making focused decisions for each product line, while looking deeply into issues such as relative labor costs, logistics costs, customer requirements and time to market.

One company that has been particularly adept at creating a diversified offshoring portfolio is Emerson Electric Co., a $15.6 billion U.S.-based conglomerate that competes in a wide variety of industrial markets around the world. In the mid-1980s, recognizing a surge in global competition across its markets, it embarked on a strategy to methodically and progressively shift sourcing, manufacturing and engineering from its traditional bases in Western Europe and the United States to a variety of low-cost countries around the world in Asia, Latin America and Eastern Europe. It set up a major production operation in Mexico, not only for its low costs but also because the proximity of the operation to the United States helped ensure that manufacturing would be tightly coordinated with the company’s U.S. design functions. It also established production capacity throughout Asia both to tap into low costs and ensure a high degree of responsiveness to rapidly growing Asian markets. Emerson’s low-cost country footprint varies by specific business unit. It has distributed much of its engineering function, for example, across the Philippines, India and China, hedging its risks by accessing skilled labor pools in three geographically and politically distinct areas of Asia.

By 2002, low-cost countries accounted for 44% of Emerson’s total manufacturing labor cost, a fourfold rise from a decade earlier. The company also made shifts of similar magnitude in material, engineering and development costs. The success of Emerson’s long-term strategy of transferring costs to a basket of low-cost countries is clearly visible in its earnings statement, as the company’s operating margins have steadily improved in the past decade. Although it is impossible to isolate the low-cost country impact from other measures, Emerson is well known among its peers to have benefited considerably from being earlier and bolder in its pursuit of cost migration. And the company continues to pursue new cost-migration opportunities aggressively. Its ambitious targets include doubling, yet again, the proportion of its material, engineering and development costs located in what it calls “best-cost countries” by 2007.

Beyond the Routine

As Emerson and other cost-migration leaders are discovering, offshoring need not be limited to routine production and assembly jobs. With the rise of education levels in the developing world, combined with the advance of modern communications networks, “low wage” no longer translates as “low skill.” In fact, several Asian countries, such as Singapore and Taiwan, actually have higher average education levels than the United Kingdom or France.

A portfolio approach is particularly powerful when applied to skilled work, as it enables companies to capitalize on small but important variations in the training and experience of local work forces. Cost leaders, we found, examine specific functions, such as finance, information technology or marketing, on a case-by-case basis, identifying offshore locales best suited to carrying them out efficiently and effectively. The Boeing Co., for instance, has a center that does design and technical work in Russia, a country with deep aerospace engineering skills. Procter & Gamble Co. has its taxes done in Costa Rica, which has a strong cadre of workers with accounting skills. General Electric Co. has built an R&D center in India with a staff of 500, one-third of whom are locals with doctorates.

Of course, portfolio diversity can be taken too far. Many industrial companies struggle with a legacy of fragmentation in their supply chains, with subscale plants in dozens of countries, each focused primarily on local assembly. Offshoring strategies should not be allowed to perpetuate this approach. Decisions about portfolios should be highly disciplined, balancing the risk advantages of diversification with the scale advantages of consolidation. Emerson, for example, despite having a cost-migration portfolio that spans the world, concentrates its activities in four major production centers.

Achieving such a balanced portfolio requires a centralized approach to planning, with headquarters overseeing and coordinating a companywide offshoring program. Leaving offshoring decisions up to individual business units, a common practice today, particularly among cost laggards, has two big drawbacks. First, it provides no mechanism to temper risk by distributing functions across a range of countries. Second, it prevents companies from reaping savings across business units by pooling sourcing, jointly developing new suppliers or expanding economies of scale in low-cost countries. More than 80% of the cost leaders in our study pursue a companywide or centralized strategy.

Of course, creating and maintaining a strong and balanced portfolio requires more than centralized, top-down leadership. It is a major, long-term organizationwide effort, and executives need to guard against underestimating its challenges. We found that cost-migration leaders take a number of practical steps to ensure that their portfolios are constructed successfully. They establish and constantly update a detailed and robust database of current costs and other key criteria across low-cost countries and carefully set priorities for both functions and countries. For each activity to be offshored, they then require that a short list of target countries be evaluated on the basis of their long-term competitiveness as well as current costs and capabilities. Finally, once a low-cost country is selected for offshoring, the company invests upfront — well prior to having significant volumes offshored — in building its sourcing, manufacturing and engineering infrastructure and capabilities there. By taking such a methodical approach to offshoring management, companies can greatly reduce the risk while at the same time increase the potential benefits, which are enormous.