Australia Learns About Outsourcing Costs

Slowly but surely companies are beginning to realize that there is more to competitiveness than just cheap labor.

Chinese wages and salaries are a fraction of ours [Australia] and they also have lower construction and capital costs, lower compliance costs and massive economies of scale through the size of their manufacturing sector.

However, this year the first signs have also emerged of some light at the end of the tunnel for local manufacturers competing with China. If you are a buyer it may also be time to think twice before embarking on your next China sourcing project.

Heresy!  Of course not.  Those of us in the lean world have known for a long time that speed and agility trump labor cost any day.

Agility is the key to beat Chinese imports and lean manufacturing the most effective tool to achieve that agility.

Lean enables suppliers to offer faster service, better quality, smaller batch sizes and a greater degree of customisation than traditional manufacturing approaches without increasing unit costs. Lean can drive down total costs for customers by reducing inventory holding and handling costs, obsolescence and the cost of poor quality.

So how about some real analysis to put some meat on those bones?  For once, someone has actually done it.  To start with, here are the assumptions with the traditional "outsource to China" model.

Based on recent experience importing from China, the team from TXM have have calculated the relative costs to source a "typical" product over a period of five years.

For the Chinese and "typical" local suppliers the test-case assumed that products were ordered in monthly lots with a four week production lead time plus, I also allowed a delivery lead time from China of three weeks.

To reflect the problems that can occur when starting up new suppliers, the test-case allowed for two major quality issues to occur in the first year and one quality issue per year in subsequent years for both the local and Chinese suppliers. The test-case also assumed that a proportion of the stock each year would become obsolescent.

Importantly for the Chinese supplier, the test-case has included the cost of supporting the supplier in China. Often these overhead costs (e.g. the China Procurement Office) are not included in any cost comparison. Interestingly the inventory levels and holding costs are not significantly different between China and the typical local supplier. This is because the monthly order cycle and one month lead time applying in both cases have a bigger impact on inventory than shipping lead time.

Now the "lean" domestic supplier.

For the "lean" local supplier, the TXM team assumed a weekly order cycle and one week order lead time based on the supplier having more flexible production processes. This brings down all the inventory related costs in the supply chain.

In addition, it is reasonable to assume that a "lean" supplier will have better control of internal quality and therefore be less likely to send poor quality parts to the customer and have lower startup costs. Therefore it has been assumed there is one quality issue in the first year one and no major issues in subsequent years. The results of this analysis by TXM are summarised in the table.

And the result?

In this example, even though the Chinese supplier offers a 40 per cent ex-works unit cost saving at the start of the contract, over the five year period the total cost of sourcing the parts is only 1.4 per cent lower than the "typical" local supplier and the Chinese supplier actually works out more expensive than a "lean" local supplier.

It's all about total cost, which includes cost to support the offshore manufacturer in differently languages and time zones, in-transit inventories, obsolescence, less agility to rapidly introduce new designs, and training.  This is what some companies, some who don't even claim to be lean, realize.  It's how companies like American Apparel can successfully compete against sweatshops in the low margin clothing business from high cost areas like Los Angeles while paying living wages with benefits.  If they can, you can.

Comments

[Matt]

Anyone know where this study was from XTM? I've been trying to find it online and it seems to not be showing up. Would love to see the data they obtained.

[jake]

isn't it more agility (to rapidly introduce new designs)? not less?

[David Levy]

Of course many companies who outsource may ignore the hidden costs of doing so, and may find to their surprise that they are no more profitable and competitive than if they'd found a lean domestic supplier.

The comparison cited above (and many like it) assume that the only choices are "lean" on one side and "outsourced" on the other. This is a false dilemma. What happens when you compare "lean domestic" sourcing cost with "lean China" sourcing costs?

Sure you still may take a hit because of transportation costs and lead times, but there is no reason to assume that China-based production is necessarily less flexible and lean than domestic vendors.

My experience in China tells me that the China-based factory CAN be operated in a lean manner, mitigating the costs of longer transportation lead times, and not incurring the prohibitive costs associated required support functions and poor quality. If that's the case, then the cost savings associated with low-cost production will in many cases (but not always!!) will be enough to ensure profitability, even though long-distance transportation costs and transportation lead times are an offsetting factory.

This is an unpopular view in my home country (USA), but it is my experience after 20 years in greater China (8 of those running China-based factories).

[Tim McLean]

I am the author of the article cited above and the Principal of TXM Pty. Ltd. TXM is a Project Management and Lean Implementation business based in Melbourne, Australia. It is great to see the amount of discussion the article has created. You can find other articles I have written on lean topics if you go to www.txm.com.au and click on publications.

Some background to the article. Firstly, the article had two purposes.

The first was to encourage buyers of materials in China to consider the full cost of doing so, not just unit purchase costs. Buyers also need to look beyond today and allow for the fact that costs in China will increase over time. I have been actively involved in outsourcing product to China and also implementing lean in China and Australia over recent years. I do not subscribe to some of the "pollyanna" views around that you should never outsource to China. On a recent project we achieved a 75% real cost saving for equivalent quality by sourcing components from China. Our client would have jeopardised its own future if it had not gone for this option. Some its competitors already source their entire product from China. On the other hand I hear procurement guys talking about sourcing from China or other Asian countries for a 15%-25% unit cost saving. In this case, I would suggest that in the cold light of day those parts will end up costing more from China, not less.

The second purpose of the article was to try and make the point that local suppliers can compete with China, but they MUST change to do so. I get very frustrated when I talk to some local suppliers who complain about the Chinese and want some sort of government help, but are unprepared to improve the way they service their customers. The days of monthly orders, large minimum order quantities and 20 - 40 order day lead times are over (or at least they should be).

I hope this provides some background to the article. I do believe in outsourcing from low cost countries when it makes sense and when all the costs have been considered. However buyers need to beware that the "headline" cost saving is often not real. On the other hand local suppliers can bridge the competitive gap if they are prepared to become lean to take advantage of the benefits of being local.

regards
Tim McLean - Principal TXM Pty. Ltd.
www.txm.com.au