Sourcing manufacturing in low-wage economies has been conventional business wisdom for decades. But now rising costs and market volatility are causing companies to consider ‘re-shoring’ and to ask: Where should we be manufacturing?
Coming to their aid, Vlerick Business School Professor Robert Boute and Professor Jan Van Mieghem from the Kellogg School of Management have developed a model to help companies decide how much to manufacture locally or offshore, based on a formula that measures the impact of the various factors at play.
Manufacturing locally is generally more expensive, but the cost advantage of low-wage countries must be weighed against higher transport costs, and the need to keep larger stocks to enable a flexible response to demand in the face of longer delivery times.
Furthermore, as China and other so-called emerging economies ‘emerge’, wage costs have risen; while at the same time rapid technological advances in robotics and automation are reducing the need for human intervention and making wages less significant.
“Over the last few decades, companies have moved their manufacturing en masse to low-wage countries, attracted by lower wage and material costs. However, we are increasingly seeing companies reverse these decisions. Wages in these countries have risen, particularly in China, and transport has become more expensive. Furthermore, speed and flexibility are essential: many products have a shorter life cycle, demand is becoming more volatile and customers expect ever-faster lead times.” says Professor Boute.
This does not mean companies should re-shore all manufacturing. “It’s a mistake to put all your eggs in one basket. Ideally, you can combine a number of different locations or suppliers. Which then prompts the following question: ‘How much should you produce or source locally and how much elsewhere?’” says Boute.
The professors’ formula calculates the optimal split between offshored and local manufacturing taking into account:
Factor costs – variable costs such as direct material and wage costs, energy and import taxes
Capacity costs – fixed costs such as investments in machines, wage costs and other overheads that cannot be directly attributed to any one product
This approach is new, as previous models for stock optimisation only take into account factor costs and stock costs; whereas capacity costs, and especially the flexibility of that capacity, are also critical to the decision.
The formula expresses both the various different factors that help determine overall costs, and the relationship between these factors. It also shows that inflexibility in terms of capacity – the inflexibility of staff to work overtime or of machines to produce larger volumes – has the same effect as a (wage) cost disadvantage.
This last factor may partly explain why so far reshoring has been more prevalent in the US than in Europe – the rigidity of European labour markets discourage reshoring.
Boute concludes by saying: “We have succeeded in finding a simple formula that gives a nuanced picture and allows businesses to strike a well-informed balance between costs and the ability to react quickly to demand and to changes in the market.”
Source: The paper “Global Dual Sourcing and Order Smoothing: The Impact of Capacity and Lead Times” was published in Management Science, Articles in Advance, p. 1-20, 2014. You can obtain the paper from the authors.
About Robert Boute, Associate Professor in Operations Management at Vlerick Business School
About Jan A. Van Mieghem, Harold L. Stuart Distinguished Professor in Managerial Economics and Professor in Operations Management at the Kellogg School of Management