Operations Jul 10, 2017

How Much Does It Cost to Man­u­fac­ture Over­seas Ver­sus at Home?

A new tool helps com­pa­nies cal­cu­late whether to off­shore, man­u­fac­ture local­ly, or dual source.

Yevgenia Nayberg

Based on the research of

Robert Boute

Jan A. Van Mieghem

The cost of labor is an obvi­ous and com­pelling rea­son to send jobs over­seas. Low wages else­where are the main rea­son that about 5 mil­lion US man­u­fac­tur­ing jobs were off­shored between 2001 and 2011. About a third of them went to China.

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But do low wages trump the neg­a­tives of off­shoring, par­tic­u­lar­ly the addi­tion­al ship­ping time and asso­ci­at­ed trans­porta­tion and hid­den costs, like the over­head of man­ag­ing sup­pli­ers who are far away? 

Firms have begun ask­ing that ques­tion more often and urgent­ly as labor costs rise around the world. Wages have near­ly dou­bled in Chi­na since 2008, for exam­ple. As a result, man­u­fac­tur­ing jobs have begun to trick­le back to the US. One sur­vey in Decem­ber 2015 found that 17 per­cent of man­u­fac­tur­ing exec­u­tives were already reshoring” jobs — that is, bring­ing them back to the US. Anoth­er 37 per­cent were plan­ning or con­sid­er­ing it. 

Labor costs are rel­a­tive­ly easy to deter­mine. But the oth­er side of the equa­tion— the cost of trans­port­ing goods from fac­to­ries to the point of sale — involves trade-offs that make a reli­able cost – ben­e­fit analy­sis hard to come by. 

It’s not just about the dol­lar cost of labor,” says Jan Van Mieghem, a pro­fes­sor of oper­a­tions at the Kel­logg School. Time is mon­ey, and firms have become smarter in real­iz­ing that, well, we can go to Chi­na, but it’s going to take a longer time to get the prod­uct back here. And I will pay for that time.’” 

How much should you source local­ly ver­sus glob­al­ly? Here’s how you can find out.

For many firms, deci­sions about off­shoring, onshoring, and dual sourc­ing are not clear-cut. So the researchers are pleased to share this free ver­sion of their mod­el.

You can enter infor­ma­tion about costs and lead time for var­i­ous sourc­ing options, as well as expect­ed demand, and get an esti­mate of your total cost with 100% local sourc­ing, 100% glob­al sourc­ing, and every­thing in between. Note that the mod­el can also accom­mo­date dual-mode trans­porta­tion deci­sions, such as the opti­mal bal­ance between rail and road, or air and road, shipping.

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Van Mieghem and his coau­thor Robert Boute, of the Uni­ver­si­ty of Leu­ven, have devel­oped a for­mu­la based on a mod­el they designed that helps com­pa­nies weigh a broad range of fac­tors in decid­ing whether it makes sense to off­shore jobs, man­u­fac­ture local­ly, or do a mix of both, which is known as dual sourcing.” 

If I’m mak­ing sourc­ing deci­sions, I need to quan­ti­fy it,” Van Mieghem says of the choice between man­u­fac­tur­ing over­seas, man­u­fac­tur­ing near­by, or rely­ing on some mix of the two. This mod­el is one of the first that gives the quan­tifi­able impact.” 

Both Sides Now

Van Mieghem’s for­mu­la will be espe­cial­ly use­ful to com­pa­nies in volatile mar­kets, where demand shifts rapid­ly. These mar­kets cre­ate uncer­tain­ty and force com­pa­nies into a dilem­ma as they ana­lyze which sourc­ing approach makes sense.

You can keep a lot of prod­uct in inven­to­ry, which will cost you mon­ey,” says Van Mieghem. And you may end up hav­ing too much on hand. Or you can be more con­ser­v­a­tive and keep less in inven­to­ry. But then you run the risk that you won’t have enough on hand, and cus­tomers will go elsewhere.”

Man­u­fac­tur­ing near­by means a com­pa­ny can keep inven­to­ry lev­els low but still get goods to mar­ket quick­ly when demand spikes. But does that ben­e­fit out­weigh the cost of pay­ing high­er wages? 

The answer depends in part on the costs of ramp­ing up pro­duc­tion to meet surges in demand — known as capac­i­ty costs.” If a sup­pli­er usu­al­ly pro­duces 100 units per day, for exam­ple, and demand ris­es to 150 units per day, how quick­ly can it meet the demand for 50 addi­tion­al units, and at what cost?

In a word, how flex­i­ble is the supplier?

The more expen­sive it is to pay over­time, hire extra work­ers, run week­end shifts and extra shifts, the more inflex­i­ble you are from a capac­i­ty per­spec­tive,” Van Mieghem says.

Euro­pean economies tend to be high­ly reg­u­lat­ed and have high rates of union­iza­tion. The same is true, to a less­er extent, in some parts of the US. This inflex­i­bil­i­ty has dri­ven the off­shoring of so many jobs over the past sev­er­al decades. 

The for­mu­la devel­oped by Van Mieghem and Boute helps a firm weigh these capac­i­ty flex­i­bil­i­ty costs against the ben­e­fits of sourc­ing near­by, such as the reduc­tion in import tax­es and inven­to­ry costs. With­out the ben­e­fit of such a for­mu­la, it has been tempt­ing for deci­sion mak­ers to fix­ate on the low cost of labor abroad.

In the past, com­pa­nies kind of under­es­ti­mat­ed, or neglect­ed, the costs of the time it takes to trans­port goods, and the cost of need­ing more inven­to­ry,” Van Mieghem says. And many com­pa­nies have become more aware of this. So they’re in a mode of not rely­ing com­plete­ly on low-cost, far­away sourc­ing. They real­ize that they need some near­by sourc­ing, too.” 

Van Mieghem’s for­mu­la helps them deter­mine the right bal­ance. A firm can input its own data on wage costs and cap­i­tal invest­ments, capac­i­ty costs, lead time, and so on to deter­mine the opti­mal mix of sourc­ing abroad and near­by. Van Mieghem is now con­sult­ing with a major com­put­er com­pa­ny to apply his for­mu­la to its products. 

The for­mu­la can also be applied to ship­ping costs, help­ing a firm choose the best mix of trans­port­ing goods by ocean and by air, and it can help deter­mine the opti­mal mix of local sources, not just local and off­shore sources.

Should we keep invest­ing more and more in Asia — or should we start invest­ing more over here?”

Bring­ing It (Part­ly) Back Home

The lure of low wages is espe­cial­ly strong in the realm of com­put­ers and elec­tron­ics, an indus­try dis­tin­guished by strong com­pe­ti­tion and low prof­it margins. 

But tech­nol­o­gy firms are the clas­sic case of an indus­try that can ben­e­fit from dual sourc­ing. Demand for com­put­ers and cell phones, and the relat­ed devices and acces­sories, is high­ly volatile — mak­ing them prime can­di­dates for near­by sourc­ing. The cost of labor may be high­er, but com­pa­nies save on ship­ping. They are also able to keep inven­to­ries low while offer­ing rapid deliv­ery, which tech­nol­o­gy con­sumers tend to value.

Those advan­tages are one rea­son the US has gained some man­u­fac­tur­ing jobs in the past few years, after three decades of steady off­shoring. For exam­ple, the Chi­nese com­put­er man­u­fac­tur­er Leno­vo opened a new fac­to­ry in 2013 in North Carolina.

That state has had anoth­er recent win in terms of keep­ing sourc­ing local from a dif­fer­ent sec­tor: fur­ni­ture man­u­fac­tur­ing. It is home to near­ly 10 per­cent of all the jobs in fur­ni­ture man­u­fac­tur­ing in the US, and has begun to win back some of those jobs it lost over the past few decades. 

The industry’s strat­e­gy for doing so has involved, in part, becom­ing smarter about inven­to­ry man­age­ment and max­i­miz­ing the advan­tages of mak­ing fur­ni­ture in fac­to­ries clos­er to show­rooms. That strat­e­gy sub­stan­tial­ly reduces both the costs of stor­ing fur­ni­ture and the admin­is­tra­tive costs of track­ing it to the point of sale. 

Despite such advan­tages of man­u­fac­tur­ing near­by, the low cost of labor means that off­shoring or dual sourc­ing still makes eco­nom­ic sense for many com­pa­nies. Van Mieghem’s for­mu­la can help com­pa­nies under­stand how to plan their sourc­ing in the cur­rent mar­ket — and years down the road. It can be used as a plan­ning mod­el, to project out for the next few years what you believe should hap­pen with your glob­al foot­print. Should we keep invest­ing more and more in Asia — or should we start invest­ing more over here?” 

Featured Faculty

Jan A. Van Mieghem

Harold L. Stuart Distinguished Professor of Managerial Economics, Professor of Operations

About the Writer

Theo Anderson is a writer and editor living in Chicago.

About the Research

Boute, Robert, and Jan A. Van Mieghem. 2015. “Global Dual Sourcing and Order Smoothing: The Impact of Capacity and Lead Times.” Management Science, 61(9), 2080-2099.

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