The process of offshoring and backshoring of manufacturing to and from low wage countries

INDEX

EXECUTIVE SUMMARY

INTRODUCTION

1. OFFSHORING AS A STRATEGIC DECISION FOR LOWERING MANUFACTURING COSTS
1.1. Definition
1.2. Evolution of Offshoring
1.3. Drivers and Reasons for Offshoring
1.4. Offshoring Failure Analysis
1.4.1. Culture
1.4.2. Political Instability
1.4.3. Legislation
1.4.4. Infrastructure
1.4.5. Supply Chain Management and Transportation Costs
1.4.6. Tariffs and non-tariff costs
1.4.7. Labour and workforce management
1.4.8. Overheads and coordination costs
1.4.9. Unit Labour Costs
1.4.10. Distance and Quality
1.4.11. Intangible reasons
1.4.12. Changing environment
1.5. Summary

2. THE BACKSHORING TRANSITION AS A RELOCATION REACTION TO A FAILED OFFSHORE PROJECT
2.1. Definition
2.2. Evolution
2.3. Drivers and Reasons for Backshoring
2.4. Bringing Production back Home Strategically
2.4.1. When to Backshore
2.4.2. One-time Transition Costs
2.4.3. Strategic Decision-Making
2.4.3.1. Product Specifications
2.4.3.2. Company Specifications
2.4.3.3. Further Potential at Offshoring Location
2.4.3.4. Base Case
2.4.3.5. Decision Questionnaire
2.4.4. Strategic Planning
2.4.4.1. Project Team
2.4.4.2. Alert Supplier
2.4.4.3. Plan and Schedule
2.4.4.4. Quick Reassignment and Recruitment of Employees
2.4.4.5. Adequate Documentation, Security Policy and Procedures
2.4.4.6. Set up of Facilities, Plant and Machines (or select Domestic Supplier)
2.4.4.7. Business Continuity
2.4.4.8. Communication Plan
2.4.4.9. Performance Expectations and Measurements
2.5. Future Outlook
2.6. Summary

3. CASE STUDY
3.1. Margarete Steiff GmbH
3.1.1. Company Overview
3.1.2. Products
3.1.3. Changes in Collectors behaviour and Retail
3.1.4. Going Offshore
3.1.5. Problems Offshore
3.1.6. Backshoring Plans and Reasons
3.1.7. Analysis of Backshoring Activity
3.2. Summary

BIBLIOGRAPHY

APPENDIX

EXECUTIVE SUMMARY

Since the beginning of globalisation in the 1970s, offshoring of manufacturing to lowwage countries has become a relevant topic in order to reduce costs. Businesses were able to lower labour costs and to stay competitive within an environment of fierce international rivalry. However, offshore engagements have been failing, because the real costs and risks of sending work overseas were not fully anticipated.

When adding up expenses for supplementary overheads, coordination and workforce management, low productivity and quality problems as well as ever increasing transportation costs at the offshore plant, the unit labour costs - ‘the value of labour needed to produce a unit of a product or a service’ (Berger 2005, p. 119) can equal those at home. Inefficiencies are further created because of political instability, insufficient law enforcement and an underdeveloped infrastructure at the overseas location. The crucial reality for companies manufacturing offshore are changing conditions, in particular in terms wages: In China the annual real wage growth between 2001 and 2007 has been 12.93 per cent (International Labour Office 2008, p. 12) and a trained middle manager in the automotive industry speaking English and Mandarin, will earn more in Shanghai than in Wolfsburg or Birmingham (De Meyer 2008).

Companies reassess their location decision, and bringing production back home is a natural phenomenon (Carmel 2007). Although reliable data is not available, an estimate of $1 gets backshored for every $10 offshored (Testa 2007) due to the lack of flexibility and ability to supply, quality issues, high cost of coordination and the lack of qualified personnel (Kinkel and Maloca 2008, pp. 5-12). One-time transition costs are decisive for the location reassessment, but even more aspects are included in the Decision Questionnaire: The specifications of the product made offshore and the characteristics of the company at home, the further potential at the offshore location as well as the financial base line, called the Base Case (Delaney et al. 2007, pp. 364-5), allow a better understanding of where a product is best made - offshore or at home. Backing out of a low-wage country needs to be well planned and scheduled for guaranteeing business continuity and a smooth transition process.

The case study about premium stuffed animal producer ‘Margarete Steiff’ incorporates the issues identified when producing offshore and the reasons for backshoring. Changes in collectors’ behaviour and retail made Steiff change its strategy. In order to reconquer the kids’ segment with a less expensive version of its products, Steiff offshore outsourced to China in 2003, but announced in mid-2008 to reintegrate its production back under their own roofs in Portugal, Tunisia and Germany within two years. Triggered by the loss of flexibility in supplying, high turnover that led to quality problems and low efficiencies combined with lengthy transportation, the toy maker decided to back out of China. Applying the Decision Questionnaire to the case of Steiff shows the company took the right decision in reintegrating the production back to its plants.

INTRODUCTION

As seen in the executive summary, offshore activities do fail, because risks and problems have not sufficiently been anticipated by companies beforehand, and backshoring transitions are being made in order to readjust and to find a new way of manufacturing in the most cost efficient and productive way possible.

Developing an understanding of the risks and issues of shifting production to low-wage regions in Asia or Eastern Europe, as well as the elements that determine a company’s decision of bringing its production back home is the thesis’s main aim. The document is structured in three parts, whereas the first chapter deals with offshoring, the middle piece with backshoring and the last part’s case study on ‘Margarete Steiff GmbH’ underlines the thesis’s theoretical parts and applies the Decision Questionnaire, developed in part two.

The thesis is structured in an explanatory manner in order to give the reader a very broad overview about an up-to-date topic: Offshoring and backshoring of manufacturing to and frpm low-wage countries and an approach of improving future backshoring location decisions.

1. OFFSHORING AS A STRATEGIC DECISION FOR LOWERING MANUFACTURING COSTS

‘ [ … ] Lower wages, a stable global economy, and rapidly growing local markets. These factors combined to make nations such as China and Malaysia favoured manufacturing locations. ’ (McKinsey 2008, p. 1)

1.1. Definition

Offshoring is a phenomenon that occurred with the emergence of globalisation and can be defined as international sourcing, which refers either to international procurement or production abroad (Spulber 2007, p. 48), done for different strategic reasons. Most commonly, relocations are accomplished in order to gain on cost advantages, especially labour costs in offshoring business processes to Third World and developing countries.

There are two main types of offshoring, as well as other hybrid business models:

1. Offshore Branch/ Affiliate (also called Offshore Insourcing or Captives, to produce
abroad but inhouse), which means that companies create a wholly owned subsidiary in another country, where they hire local labour. This approach of offshoring ‘by starting its own business in a foreign country’ (Schniederjans 2005, p. 5) is also used for entering new markets.
2. Offshore Outsourcing (to produce abroad on a B2B level, independent contractors), which can generally be seen as ‘the movement of business processes from inside the organisation to an international service provider’ (Duening 2005, p. 2), to countries like China, India, Eastern Europe or Latin

America. These fragmented companies do outsource business processes that normally do not belong to their core competencies and which other specialised businesses can accomplish better and more effectively (Kroll 2005). 3. There are other hybrid business models called Build-Operate Transfer (the benefit of a supplier who knows the market, but the advantages of control and financial benefits of a captive after takeover), Dedicated Center or Synthetic Captive (similar to outsourcing, except that the offshore supplier gives the customer greater control over the outside supplier’s choice of employees), Virtual Captive or Assisted Captive (the outsourcing arrangement covers the functions that support employees but the personnel performing services are employees of the customer) and Joint Venture (the customer and the offshore supplier jointly create a new company to provide services to the customer) (Delaney et al. 2007 Volume One, pp. 27-8).

Combining with work being done offshore can even happen unconsciously, when a U.S.based customer hiring a U.S.-based supplier engages in offshore outsourcing if the supplier has the work performed in offshore locations. Many companies have engaged in inadvertent offshore outsourcing by entering into a contract that does not restrict the location of performance (Delaney et al. 2007 Volume One, p. 19).

Companies can offshore different parts and processes of their business. The most common are information technology, software R&D, knowledge processes as well as business processes, which does include manufacturing. This work will focus on the process of relocating manufacturing which has beforehand been offshored to the international labour market and then backshored afterwards, as this is one of the processes that are most often relocated.

1.2. Evolution of Offshoring

Suzanne Berger (2005, p. 10, 96) describes in her book that tough international competition made companies look for new ways to economise costs. The opening of the world market was mainly driven by the creation of international trade agreements and zones, the sinking costs of transportation and communication as well as the accessibility of workers in developing countries. Cost of transport dropped by a third between 1960 and the millennium, due to the invention of containers and the creation of third-party logistics provider (De Meyer 2008).

With these new opportunities, corporations would notably seek savings on labour intensive processes within their business. The new ‘Lego-Model‘ (Berger 2005, p. 74) was an additional driver of bringing production offshore, which is characterised as a modular system, where corporations ‘carried out fewer and fewer of the functions in the production process within their own walls’ (ibid, p. 74).

A shift took place from products manufactured in-house in totally vertically integrated companies, to the break open of the production process into modularity. Managers now had the possibility to decide where to produce what on the international marketplace in order to get products and services with the highest quality for the lowest price, because ‘today’s standard of excellence is not just best-in-class; it’s best-in-world’ (Corbett 2004, p. 4).

Berger gives a short overview about the historical background of offshoring:

The first jobs relocated overseas in the 1970s were in industries requiring relatively low levels of skill: toys, clothing, shoes, printed circuit board assembly. By the 1980s, the increasing level of skills that could be found in a number of low-wage Southeast Asian and East Asian countries, like Taiwan, Malaysia, and South Korea, made it possible to set up more complex manufacturing operations, like the hard-disk-drive industry in Singapore. (Berger 2005, p. 117)

The phenomenon of sourcing or producing abroad is therefore nothing new, what ‘has caught everyone by surprise since the 1990s is the speed at which offshoring has taken hold’ (Scase 2007, p. 6).

1.3. Drivers and Reasons for Offshoring

One main driver of the process of modularity and the break up of the production process was competition within a marketplace becoming more and more internationally resulting in fiercer rivalry. Competition requires that today’s organisations reduce costs and improve quality to gain a competitive advantage (American Productivity & Quality Center 1997, p. 6). This is the way companies try to survive, whereas, offshoring is seen as a strategic decision of achieving this superiority.

Going abroad in order to gain a competitive advantage has four different motivations:

1. Market entry into a foreign market,
2. Induced offshoring (following ones’ clients, notably in B2B relations),
3. Access to resources that are scarce and exhausted at home,
4. Lowering the cost of production (Berger 2005, p. 113).

Less important factors are tax advantages and subsidies as well as access to innovative clusters and knowledge that make foreign production destinations more attractive. The aforementioned reasons can also be in combination with each other, for example companies seeking market entry to a low-wage country and at the same time benefiting from moderate costs of production. Often a whole bundle of motives are influential for offshoring decisions.

The new EU-members especially in Eastern Europe and Asian countries are the most popular target regions for cost driven offshoring activities. Offshoring for market and customer reasons are mainly ‘targeted at Northern America and Asia, whereas Western Europe seems to be attractive for compensating for capacity bottlenecks or as source for new technologies’ (Dachs et al. 2006, p. 1)

When offshoring for cost reasons, the predominant interest of managers to produce abroad besides low environmental standards, cheap rents and energy prices as well as tax advantages, not surprisingly, are finding workers at inexpensive wages with limited social benefits. Even in capital-intensive and highly automated industries such as the automotive sector, corporations opt for relocation, although labour costs represent an insignificant component of overall costs.

1.4. Offshoring Failure Analysis

Offshoring decisions made for market entry, following clients and to obtain access to scarce resources are less likely to fail, than offshoring implemented for lowering the costs of production. This has been proven by a Fraunhofer Institute study of offshoring operations of German organisations by Kinkel and Lay (2004). They concluded that cost driven production offshoring has a higher risk of failing and even a negative quantitative impact on employment at the home location (Kinkel and Lay 2004, pp. 9-10). Offshoring motivations other than for cost savings tend to fail less often and do not have a negative impact on employment at home.

A fundamental before considering relocating, is to reflect on the real costs of producing abroad and not only to see inexpensive labour costs as a separate factor. There is a deficiency in the analysis of the real overall costs, previous to the offshoring decision.

As described in James E. Austin’s book (1990), this analysis needs to include:

- Economic Factors (labour, capital, infrastructure, technology and natural resources)
- Political Factors (instability, ideology, institutions, international links)
- Cultural Issues (social structure & dynamics, human nature, time & space, religion, gender roles, language)
- Demographic Evolution (population growth, age structure, urbanisation, migration, health status)

Daniel F. Spulber (2007, pp. 6 - 8) defined in his book a more modern approach on the costs of doing business across international borders. He calls the four types of trade barriers ‘the four Ts’:

- Transaction costs (different cultures, different business practises, different languages, unknown markets)
- Tariffs and non-tariff costs (government trade barriers, economic nationalism, subsidies, tariffs and quotas at borders)
- Transportation costs (freight, complicated logistics and supply chains, respond to market)
- Time costs (longer cycle times with supply chains geographically dispersed, adapting to new environment, slower reaction time)

Below, the most common aspects I identified while looking at case studies and articles of why offshoring engagements failed and what risks should be examined the most thoroughly are further examined. As you can see in the graphic (figure 1) I developed, the most important factors that influence the failure of an offshoring engagement are being summarised. The reasons are listed without order, because for every company, depending on size, products and processes, the weight of each reason might be different.

Afterwards, each aspect is elaborated further in order gain a more specific insight and understanding why offshoring to low-wage countries fails.

illustration not visible in this excerpt

Figure 1

1.4.1. Culture

When analysing cultural factors for the failure of offshoring decisions in the first place, it needs to be mentioned that already communication between two persons from different cultures is more likely to fail than information exchange between people from the same culture, because the recipient will interpret and understand the sender’s message differently due to another way of thinking and seeing reality. Language problems will reinforce this condition, in spite of English being applied in business situations as a common language for communication. Many ideas and concepts are not simply translatable from one language to another and little face to face communication reinforces this problem, because nonverbal messages get lost (Phatak 1983, p. 133)

Cultural differences, including aspects like power distance, individualism, masculinity and uncertainty avoidance as described and analysed by Hofstede, have different dimensions in different countries around the globe and have an enormous negative impact if not recognised in management.

Employees on the other side of the globe have a different awareness for quality issues, urgency and the way business should be conducted. Many offshore engagements fail simply because of these cultural components.

1.4.2. Political Instability

To act on the assumption that political stability is as common as in the Western world, is a big mistake. The analysis of the political reality is as important as the calculation of the cost of labour. A repressive government hinders fruitful economic development in a dramatic way. Bribery, corrupt officials and hold-ups are part of everyday life in other parts of the world, which makes political stability become a valuable asset for making business. However, although the possibility of a war break-out is the worst case scenario, but not impossible in countries with rebellious movements and extreme poverty of some of its population.

A recent example is the death of 2,473 people in India in 2008 from acts of terrorism. Executives have been kidnapped or killed and ‘some multinationals have temporarily flown out their top expat execs out of India’ (Lakshman 2008, p. 24), because of new waves of terrorism. This unstable environment means unexpected business interruptions for some companies offshore.

1.4.3. Legislation

In different countries, different legislations are in force and therefore can have a purely negative effect on doing business with an offshoring engagement, when not considered beforehand.

A country like China does protect intellectual property (copy rights) differently as this is the case in Europe and Northern America, whereas sensitive information becomes even more vulnerable when being exposed to this environment. Therefore, in particular innovative and new products being manufactured in these countries will more likely become copied, than when being produced at home. Even if most of the countries do have laws for protecting intellectual property and businesses in general, the crucial component is the enforcement of law and the support of the government in doing so. Not only the existence, but the application of law has an enormous value for the success of offshoring activities.

When it comes to HR practises abroad, certainly, these do not resemble the ones in industrially higher developed countries. Duening (2005, p. 200) discusses, that plenty of foreign countries still haven’t created ‘laws governing matters such as workplace discrimination, sexual harassment, or privacy’ (ibid, p. 200), which can easily be respected when setting up a companies’ own facilities abroad, but will become a major issue when it comes to contracting. Sweat shop and child labour practises common in certain countries can severely ruin a good reputation of a brand, which is one of the most important intangible assets.

1.4.4. Infrastructure

Even though taxes are low and property for setting up a plant is easily and for a small amount of money accessible, this often doesn’t include the costs, which need to be invested when the infrastructure is not as sophisticated as at home. The gas and electricity grid, highway and railroad networks, telephone service, police, and other public services are often poor and unreliable. In some countries, roads simply do not exist or are in such a bad condition, that companies do need to build their own roads for the transportation of their manufactured goods as well as to supply their plant.

For the supply of electricity, power lines need to be set up at the cost of the organisation, even current generators to be installed, because interruption of production are often due to power breakdowns or shortages in developing countries (Berger 2005, p. 125).

1.4.5. Supply Chain Management and Transportation Costs

When producing abroad and not in the home market anymore, a more sophisticated supply chain management needs to be established, since the supply of the plant and the delivery of finished goods beyond international borders requires a more mature planning. Consequently, this adds up to the costs.

It needs to be considered, that long distance supply chains are more vulnerable and exact time schedules are more difficult to foresee when seafreight is the way of transporting goods to Europe or America. Not only is the time an important component of supply chains, but also an immature infrastructure as above mentioned. When a big whole in the middle of the road makes it almost impossible for the supply truck to reach the plant in time, a reality check on the infrastructure is needed. The impact of production interruptions, idle times, penalty paying or overtime, raises the overall costs dramatically.

Other costs occur for buffer stocks, the risk of obsolescence of the products, running out of stock and the costs to bear, when swings in demands and evolution in technology can less flexible be reacted to (De Meyer, Holweg 2008).

The International Labour Office (2008, p. 7) argues that energy prices have been increasing by more than a third within two years between 2005 and 2007 and oil prices continuing to increase with speed and reaching a peak in the middle of 2008, before sliding back. However, increasing demand and scarcity of oil as a resource will lead to further increase in energy prices in the long term. Bulky and heavy products are more vulnerable to fuel costs (Gandall 2008), as well as cheap goods, where transportation adds up significantly to the final price (Aeppel 2008).

Not only do the transportation costs for shipping the finished goods over the ocean to their destination have an impact on costs, but increasing oil prices have affected the price manufacturers pay for raw materials too. The costs for transportation might even be higher than the actual price for the raw material: Shipping a ton of iron from Brazil to China costs about $100, which is more expensive than the resource itself (McKinsey 2008, p. 1). This development will have an irreversible effect on long distance supply chains, international trade and offshoring decisions.

1.4.6. Tariffs and non-tariff costs

Even though in the event of globalisation, trade barriers have been going down and made international business easier, various types of tariff and non-tariff barriers to trade remain (import quotas, product standards, subsidies, voluntary export restraints, licensing). Interestingly, importing to developing countries tends to require more signatures and documents than to developed countries, which is an important time and flexibility factor adding up to the cost of manufacturing abroad (Spulber 2007, pp. 19-20).

Importing goods to OECD high income countries takes an estimated 14 days, whereas importing to the Middle East & North Africa, can take up to 43 days (see appendix 1). The physical infrastructure (port and terminal handling and inland transport) is the reason for onequarter of trade delays, whereas process costs (prearrival document preparation, customs, inspections) make up for half of the time (The World Bank and the International Finance Corporation 2006, p.54). Especially for new and innovative consumer goods, these delivery times might be too long and will make the offshoring engagements fail.

1.4.7. Labour and workforce management

The access to inexpensive and skilled workers in low-wage countries is one of the major aspects, why organisations decide to offshore parts of their business processes. Unfortunately, in most cases shifting work from a worker at home to an employee in an economically fast developing country is not as easy as it seems, even though workers might be skilled and work is basic and requires a minimum of training.

Turnover rates at offshore destinations have become an important issue. Those workers that have the greatest talents, skills and competencies will leave first, ‘since they are the most heavily recruited by the competition’ (Testa 2007). Workers will change work simply for the reason of getting paid more at another company, even though the difference in pay is minimal. There is a lack of employees with previous experience of carrying out product transitions. The workforce is in need of skills that would make new-product introduction smooth (Berger 2005, p. 234). The transfer of knowledge inherent in the human capital is a critical issue in this high speed economic environment.

Another important aspect is the difference in culture of the employees and management abroad. This becomes an important issue, if the culture of the home company is one of the most important factors of success. This can be the case, when quality and reactivity are not seen as important as in the home country, because the cultural background of the offshored destination does not see these issues as important.

In some countries like India, local employees surprisingly have a relatively high level of education, hold a high school degree or even a college diploma. However, when working with less trained and skilled workers, productivity and efficiency of the manufacturing process is more likely to suffer, which is often the case in manufacturing. The capacity of reducing waste and using resources to the fullest are less developed compared to workers in the Western World (lean production). The ability to see problems and to find solutions for the elimination of the obstacle is lower than at home. Plus, the workforce might not be able to maintain the equipment as required. The consequences can be long production downtimes, because technical support is not quickly enough available, high waste of resources and minimal learning curve effects. All these issues result in low efficiencies and low productivity compensating the savings for low cost labour.

1.4.8. Overheads and coordination costs

Most of the companies offshoring have experienced high expenses for overheads and coordination costs, for managing the manufacturing process abroad, eating up the savings on labour cost. This includes not only travel expenses for managers in order to update on the current status of the plant or to help develop the contractor to meet certain standards.