What Outsourcing Might Really Cost

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Recently we have heard many harrowing stories about major issues in outsourcing of manufacturing. There are many raging debates about the price benefits, core competency issues, and joys of running a business (OEM) with high return-on-invested-capital and low cash-to-cash cycle times. But the stories keep mounting.

Process disabler

Recently, we have seen several OEMs present in industry forums the challenges they have been facing with their contract Manufacturers[1]. One OEM in Telco found that after they outsourced their module manufacturing to a larger, so-called more technically savy EMS, their visibility to orders, WIP, inventory liabilities, etc., was significantly reduced. Daily shift status updates were replaced by weekly MRP runs. Not only did they have more trouble promising orders and dealing with changes with their customers, they could not get a handle on how much inventory they actually had – both allocated as well as obsolescent. The expected savings from going with the large EMS – who theoretically has a bigger spend and therefore could purchase materials at better costs and terms – did not materialize.

Technology Forecaster recently published a study on the true cost of outsourcing. Technology Forecaster reports are a “must have” for electronics firms who want to successfully master the outsourcing game.
Pam Gordon, President of Technology Forecaster, reports: “Each time in the past decade when we have asked brand-name electronic product companies to rank their criteria for manufacturing outsourcing decisions, they have reported “pricing” as their dominant concern. Yet, our newest study of global contract manufacturing pricing practices indicates that many product companies’ assumptions are inaccurate. In some low cost regions, we have found six fold differences between what the product companies think they are paying for labor and what is actually being charged.

The typical error fostering this fact gap is the assumption that country by country comparisons of workers’ average hourly compensation directly correlate with total costs. In truth, an assembly worker’s compensation as a percentage of total manufacturing costs is dramatically different in various global regions. While some costs–such as equipment depreciation, building costs, and administration costs – can be roughly similar across countries, other costs (such as logistics, utilities, regulation-related costs, and other key cost categories) can be surprisingly different. Therefore, labor costs do not necessarily walk in step with hourly wage differences.”

She goes on: “Mad dashes to move manufacturing to widely recognized low cost regions can squeeze out time to evaluate additional costs incurred by the switch and hidden costs experienced in the new region.”
In addition, American and European firms suffer from the China Syndrome, an irrational fantasy that they who are now the high cost producers in most markets, can actually sell products in the China market. And after they have turned over the know-how and proprietary technologies, that somehow there will be a reward in heaven.

When ChainLink looked at the ‘books’, we found that the study costs, start-up costs, restructuring costs, etc, are not accounted for in the ‘cost of manufacturing’. So it is easy to claim lower cost, when in reality, frequently the payback period, if all goes well, is years out.

Every story has two sides

Many EMS’s are all too anxious to get contracts, so they sometimes knowingly walk into the lion’s den. Many OEMs have ignored solid manufacturing and systems improvement for many years, and eventually throw up their hands and basically dump the problem on their outsourcing partners. This old approach to outsourcing holds sway in both logistics and manufacturing. Rather than taking the work but not the plants and people, third parties absorbed all the liabilities of their customers’ sites. Both EMSs and 3PLs have been weighed down under the burden of managing multiple redundant process, system, lines, etc. In lower cost regions, the ebbs and flows in demand cause poor utilization, but also intense worker problems due to the manually intensive approach to planning and building products.

Contract Manufacturers also make the same mistakes as OEMs in regional rollouts, states Gordon: “Product companies are not the only ones to lose when decision makers rush to take advantage of regions whose full costs they do not entirely understand. Contract manufacturers end up underutilizing some facilities while simultaneously having to invest in new facilities elsewhere. In the 1990s, product company executives decided (virtually in unison) to embrace the build-in-the-customer’s-region approach to global manufacturing, which fueled an explosive expansion by the EMS industry, especially in Mexico and Eastern Europe. Then, again in unison, some executives began abandoning their commitments in these regions in favor of what they perceived as ‘lower costs’ deals in China. In response, the contract manufacturers took production away from their Mexican operations and rapidly expanded in China. This migration weakened – not strengthened – many contract manufacturers. And owing to uneven utilization of its facilities, the contractor charges back to OEMs the associated higher general and administrative, interest, and margin costs.”

Advice for brand name electronic product company executives on how to avoid costly surprises comes from the head of the new global-pricing study, Charlie Barnhart, Technology Forecasters’ senior outsourcing consultant. “Question the wisdom of summarily abandoning the build in-region strategy to chase lower cost manufacturing elsewhere. Lower purchase price doesn’t always result in lower cost of ownership, and the current trend of moving work to low cost regions, such as China, can be naive unless you have fully comprehended the long-term logistical, cultural, and geo-political realities of the region.”

[1] We will not reveal company names, since most of these firms are public and could have an adverse affect on their valuations.

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