- By Morris Bocian

In recent years, procurement has taken on strategic importance for companies and the trend indicates procurement will assume greater significance in years to come. Companies doing business in low wage, low tax countries continue to challenge the way U.S. companies operate, often changing the business model.

For many U.S. businesses, this change might mean outsourcing; for other companies it might mean owning a facility located offshore. In either situation the primary purpose is to reduce costs, generally by 20 percent to 40 percent or more.

If outsourcing or off-shoring isn’t done properly there may be no savings, especially if the company is not proactive! If companies fail to do the following, outsourcing and off-shoring costs can exceed its benefits:

• Allocate the appropriate resources
• Conduct sufficient due diligence on your sourcing partner
• Understand your outsourcing partner’s limitations
• Establish a local presence
• Establish processes
• Monitor and continuously product test
• Create accountability
• Understanding cultural difference
• Eliminate language barriers
• Protect its intellectual property

Many multi-national companies found out that when these costs are added to the formula, the cost savings may not be as significant as originally anticipated.

In order to achieve cost savings let us focus on the:

• Product
• Process
• Location

Product:

Does the company you are buying from have the technical and practical capabilities to produce the product on time and as specified? What part of the product is labor, materials etc. If your product is 10 percent labor the savings could be significantly less than if the product were 70 percent labor if production off-shored to a low labor cost country.

Since many outsourced products have varying degrees of complexity, look at the components to determine if a component should be outsourced, instead of the product itself. For example, Cretan product components may require a high degree of skilled labor, while the balance of the product requires light assembly by unskilled or even automated labor. It might be appropriate to outsource the skilled labor portion offshore, while keeping the balance of the production process closer to home.

Similarly, if the finished product is bulky or perishable, can you process portions of it offshore (for example, the non-perishable part) and add the perishable part once the ingredients are at the U.S. facility? This would extend the product’s shelf life. A shorter shelf life might mean more spoilage and spoilage is a cost. You need to make sure the costs do not eat up the savings.

If your product is bulky, will it be cheaper to manufacture the components offshore and assemble the product domestically, especially if the product is assembled robotically or with a minimum amount of labor?

If your product has a relatively short shelf life (such as a fashion product or high tech) or a it is a product with a highly variable demand, sourcing from far away may require you to carry significantly more inventory and a potential for a larger amount of obsolete items in your inventory. Large multinationals that deal in high volumes, and generally have an ability to finance inventory. But obsolescence risk has reduced some of the benefits of outsourcing for many multi-national companies. If you operate a small or mid-sized business, you need to at least recognize this risk and include it in your cost benefit analysis.

If you produce your product offshore and your costs are; 70 percent labor, 20 percent materials and 10 percent shipping to your warehouse and if you are paying $1.00 per hour labor instead of $10.00 per hour, you could have a competitive advantage. But this is true if you have a high enough volume to offset your indirect costs. If you have too low of a sales volume, you might not recoup your costs.

Another consideration is environmental risk Can you leverage differences in environmental laws so as to mitigate risk and your company’s liability?

Processes:

The quality of the end product can be a major risk, especially since it is your reputation on the line and a major blunder can be extremely damaging. A large company may offshore thousands of items, so if there is a problem with one, two or three items at any point in time it might damage their reputation, but presumably they are adequately diversified to recover. If a small business outsources offshore 10 out of the 20 products with its brand and there is a problem with one of them, it could devastate that small business.

There is also a capital/labor trade-off. In other words, the cheaper the labor, the lower your capital investment. So for example, if you decide you want to own a facility in a low wage country, you do not want to use a carbon copy of a U.S. facility. The foreign facility shouldn’t be as automated, to take advantage of lower wages. Many auto manufactures made that mistake, when they duplicated their American facilities. Why would you design an assembly line that was designed based on an average of $50.00 per hour (in the U.S.) when your cost of labor in offshore is expected to be $2.00 per hour (in China)?

You might even want to reengineer your product so you take advantage of the low cost skilled labor. For example, a product might be hand crafted and might either command a higher price or alternatively differentiate your product.

Right Location:

The lowest direct costs countries are not always the best choice. For example, shipping delays are being created as our ports reach capacity utilization. If you are supplying your product to a major retailer and the products need to be at your customer’s warehouse by a certain date (i.e. for the Christmas season) and there are delays caused by these constraints, it could damage your reputation, hurt your company’s selling season etc. However, if instead of outsourcing to the Pacific Rim, you decided to outsource to Mexico, your goods would not be tied up at a port, since your product would be trucked over the border, not shipped.

Lowest cost countries do not always make sense, especially for smaller and mid-sized businesses. There is a substantial investment of time, effort, due diligence, setting up a local presence, etc. When you amortize these “start-up” costs and factor into your new business model, your added costs for a local presence, costs to transport goods, brand risk, obsolescence risk, added costs for carrying more inventories etc., staying local might be the best solution until you reach the volumes needed to justify the decision.

On a positive note, the location of where you outsource may impact your opportunity. It might open up markets you didn’t have before. It could cause awareness of your product and brand in an untapped market area. If you are stimulating the local economy by “right-sizing” the number of employees you hire (employing considerably more people than you would if the facility were located in the United States) would the locals have sufficient funds to buy your product?

Off-shoring often creates opportunities for subsidies or streamlining so that a building application takes weeks, not months or years (as in the U.S.). When Liz Claiborne started manufacturing in China, the company was able to fast track production. Certain countries will bend over backwards in order to enable their citizens to become employed.

We cannot have a discussion about outsourcing without mentioning political and legal risks. Even though certain countries might have cheap labor, it might not make sense if foreign companies are treated unfairly in their legal system. You might feel that by partnering you may be insulated from unfair treatment, and you might be right as long as your relationship with your partner works. If it doesn’t work you could be on your own. You probably do not want to outsource to countries where the risk of social or political instability is high.

Tax Advantages:

Before a company decides to own its facility offshore the executives should have extensive discussions with their U.S. tax accountant and their counterpart in the foreign country. Off-shoring often creates opportunities for tax planning and potentially significant tax savings if you are off-shoring to a low tax rate country.

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