China Business

China Outsourcing, Yes Or No?

International Manufacturing Lawyers

A Mexican client that does outsource manufacturing for U.S. and European companies recommended I read an article in the Harvard Business School’s newsletter, Working Knowledge, entitled, Making the Cost Migration Decision. The article is on making the decision on “what, how, and where” to secure product from and move production overseas. The article was written by Till Vestring, who directs Bain’s Asia-Pacific Industrial Practice from Singapore, Ted Rouse, who directs Bain’s Global Industrial Practice from Chicago, and Uwe Reinert, who directs Bain’s European Industrial Practice from Dusseldorf, Germany. It provides a very good overview of the basic decisions companies must make regarding outsourcing their production to China or to anywhere else.

The article begins by recognizing the difficulties companies face in determining “which links in their supply chain — from materials supply to research and engineering to manufacturing and assembly — are best suited to relocation” and the need to “weigh the various risks and benefits presented by different regions and countries. Based on a recent Bain survey, the authors conclude it is no longer a question of “whether to move costs to low-labor-cost countries (LCCs) — that’s now a given — but what to move, where to move, and how to move.” At the same time, however, many managers lack a framework for making these decisions.

St. Louis-based Emerson Electric is held out as an exemplar of a company that successfully outsourced.  n the mid-1990s, Emerson, a large conglomerate that competes in a wide variety of industrial markets around the world, began shifting “sourcing, manufacturing, and engineering from its traditional bases in Western Europe and North America to LCCs.” By 2002, 44 percent of Emerson’s total manufacturing costs were in LCCs and had made similar shifts in “material costs as well as engineering and development costs.” This increased outsourcing has been good for Emerson:

The success of Emerson’s long-term strategy of transferring costs to LCCs is clearly visible in its earnings statement; the company’s operating margins have steadily improved in the past decade. Emerson continues to pursue new cost-migration opportunities aggressively. Its ambitious targets include doubling, yet again, the proportion of its material and engineering and development costs located in what it calls “best-cost countries” by 2007.

Emerson’s decisions on whether to migrate its production overseas “is not an all-or-nothing proposition; it requires a careful analysis of each product line, focusing on issues such as relative labor costs, logistics costs, customer requirements, and time to market.”  Before outsourcing, the company analyzed the prospective gains available, recognizing that the need to move to LCCs varies across industries and product categories. “Where labor accounts for a high percentage of total costs and transportation costs are relatively low, the cost-migration imperative is strongest. The inverse is also true: maintaining production facilities in high-cost countries can make sense when labor is a minor cost component or transportation costs are high, as in high-value electronics or bulky appliances.”

In determining what to move, the article advocates thinking in terms of “functions,” not factories. The low labor costs in LCCs can be so striking as to tempt companies to “shut down an operation in a high-cost country and move it wholesale.” But this is not necessarily the way to go as the shut-down costs in a high cost country, coupled with the costs of constructing a new plant in an LCC can be huge. Smart companies “realize that just by shifting certain carefully selected processes or activities, they often can approximate the savings of moving facilities without having to bear the shutdown and start-up costs.”

The LCCs make sense for much more than just basic manufacturing processes:

Companies that understand that “low-wage” no longer translates as “low-skill” take a broad approach to cost migration. They examine specific functions, such as finance or marketing, and components on a case-by-case basis, identifying those ripe for migration and sidestepping those that are not. Boeing, for instance, has a center that does design and technical work in Russia, a country with deep aerospace-engineering skills. Procter & Gamble has its payroll done in Costa Rica. General Electric has built an R&D center in India with a staff of 500, one-third of whom are PhDs. Our research shows that cost leaders are about twice as likely as cost laggards to reap benefits from shifting or adding knowledge-intensive activities such as R&D to LCCs.

The article also points out that in deciding which functions to move, the leading companies also consider the opportunities to build new markets in the host country. For instance, though Emerson spends $900 million annually on China manufacturing and sourcing, China accounts for more than $1 billion in annual sales. General Electric (GE) is now also selling more in China than it is sourcing. Both of these companies are in China as much to do business in China as for producing their products there.

China and India have been the leading countries for cost migration as both offer “an attractive combination of low costs, well-developed capabilities, business-friendly regulatory environments, and large domestic markets.” But the cost leaders in the Bain survey recognize that every LCC “has its own risk-and-benefit profile and that these profiles can and will change over time.”

What I most liked about this article was the obvious: that each company needs to consider its own products and its own situation in making any product outsourcing decision. Our international manufacturing lawyers are often contacted by companies that have decided to move their production to China and when we ask them why, they say that they can have their product made for x dollars less than in the United States. But when we explain the various “hidden costs” and risks inherent in doing business in China or with China, they all of a sudden realize that outsourcing their production does not in fact make sense. I guess my point here is that the decision on whether to outsourcing your manufacturing is a lot more complicated and company and product specific than many realize.
What are you seeing out there?

3 responses to “China Outsourcing, Yes Or No?”

  1. Outsourcing in China: Five Legal Basics For Reducing Risk
    In response to yesterday’s post containing outsourcing tips from a business perspective a reader sent me an e-mail asking what to look out for on the legal side. Fortunately, I was able to find a short article fellow blogger Steve

  2. While there are many legal challenges facing outsourcing companies, this sector is still seeing tremendous growth. More startup Chinese outsourcing vendors are providing superb service and quality to overseas clients. With the rise of chinse universities comes the rise of skilled labor. Most startup vendor software developers now are fluent in English and can provide end to end support to the customer without the need for translation. Outsourcing will continue to grow and bring in more revenue each year.

  3. Mr. Wong —
    Thanks for checking in and thanks for providing the perspective of a China IT outsourcing company. This article was really much more focused on outsourcing manufacturing to China, not IT, but I generally agree with you that IT outsourcing in China will increase. However, I do not see this increase as being wholly problem free as the counterfeiting of software in China has and will continue to scare companies away. Also, my sources in the business tell me of very real concerns about the depth of the IT workforce in China.

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