Delft University of Technology MATERIALS ENGINEERING Department Marine and Transport Technology Mekelweg 2 2628 CD Delft the Netherlands Phone +31 (0)15-2782889 Fax +31 (0)15-2781397 www.mtt.tudelft.nl
Specialization: Production Engineering and Logistics
Report number: 2013.TEL.7797
Title:
Offshoring, an exploration of
concepts, gains and risks.
Author:
T.A. Aarts
Title (in Dutch) Delokalisatie, een verkenning van concepten, winsten en risico’s
Assignment: literature Confidential: no
Initiator (university): Dr.ir. H.P.M. Veeke Supervisor: Dr.ir. H.P.M Veeke
Delft University of Technology MATERIALS ENGINEERING Department Marine and Transport Technology Mekelweg 2 2628 CD Delft the Netherlands Phone +31 (0)15-2782889 Fax +31 (0)15-2781397 www.mtt.tudelft.nl
Student: T.A. Aarts Assignment type: Literature
Supervisor (TUD): H.P.M. Veeke Creditpoints (EC): 10 Specialization: PEL
Report number: 2013.TEL.7797 Confidential: No
Subject:
Offshoring, an exploration of concepts, gains and risks.
Offshoring, moving processes of a company to a location abroad or outsourcing these processes to such locations, is an increasing trend. Transportation and communication technologies have improved in the last decades. Also, trade barriers and trading policies have improved to stimulate international trading between nations worldwide. As a result, developing countries have become increasingly interesting to invest company processes at such locations.
However, the concept of offshoring is not clearly defined in one business model. Offshoring describes a multitude of business concepts. So what does this phenomenon offshoring entail? And what
business concepts are there concerning offshoring? Also, why do companies choose to offshore their processes and what are the consequences of these choices? One understandable argument is to reduce labor costs but is this argument well founded? Is there a generic decision model to determine which processes a company can or cannot offshore? And is offshoring certain activities always the better choice?
These are all questions that come to mind when discussing offshoring. However, the general consensus is that offshoring operations is a profitable thing for a company because it reduces costs. This research aims to evaluate these questions in order to clearly define the benefits and risks
offshoring means to a company and its processes and to evaluate how companies have made or have to make these decisions.
Summary
Offshoring, moving processes of a company to an abroad location or outsourcing these processes to such locations, is an increasing trend. Transportation and communication technologies have improved in the last decades. As a result, the world is a much smaller place now. Also, trade barriers and trading policies have improved to stimulate international trading between nations worldwide. There is also an increase in the education levels of foreign labor forces along with an increase in investments of nation in technology centers. As a result, developing countries have become increasingly interesting to invest company processes at such locations.
Offshoring describes a multitude of business concepts. These can be broken down, legally and geographically, into three main concepts. Namely, offshore outsourcing where processes are outsourced to an offshore location, offshore development centers which are joint ventures and offshore captive shared services where a company moves a process to an offshore location. All three are forms of offshoring but have different consequences for a company when it wants to offshore its processes.
Most potential gains are to be made by using cheaper resources for a company, these resources include labor, infrastructure supply chain, etc. While the main argument for offshoring is labor cost, it should be noted that other resources will be affected when moving processes to an abroad location. These influences could affect the outcome of the potential gains from offshoring.
Offshoring also has a major impact in the operational activities. The production processes and the overhead processes could both be offshored. They are susceptive to similar gains when offshored. The main argument to for a company to do so is to reduce the labor costs. A company can also gain in efficiency and productivity by offshoring its inefficient tasks, when performed for lesser costs. However, not all companies active in offshoring are successful. It is shown that 17% of German companies that moved their processes to an abroad location pulled these processes back to the domestic country due to dissatisfying results. It can be stated that the action of removing its
processes from an offshore location to its domestic location is a result of overestimating its potential gains from the offshoring decision or underestimating the complexity of coordinating such a process from a distance in a different culture. As mentioned, labor costs are a major argument for offshoring but they should not be the only consideration for making an offshore decision. There are a number of hidden costs which can not be enumerated at first glance when assessing an offshoring decision. Companies should investigate such hidden costs. Also, it may not be in the best interest for a
company to decouple certain activities. If decoupling jeopardizes its core competencies a company may want to evaluate the risk associated with offshoring.
Thus, when assessing an offshoring decision a company should identify all possible hidden costs, risks and potential gains. Furthermore is should define clear metrics to evaluate such costs, risks and gains which are aligned to the company strategy before making a well founded offshoring decision.
Summary (in Dutch)
Offshoring, moving processes of a company to an abroad location or outsourcing these processes to such locations, is an increasing trend. Transportation and communication technologies have improved the last decades. As a result, the world is a much smaller place now. Also, trade barriers and trading policies have improved to stimulate international trading between nations worldwide. There is also an increase in the education levels of foreign labor forces along with an increase in investments of nation in technology centers. As a result, developing countries have become increasingly interesting to invest company processes at such locations.
Offshoring, het verplaatsen van activiteiten of processen van een bedrijf naar een buitenlandse locatie. In het Nederlands ook wel bekend als delokalisatie. Dit is een steeds groeiende trend. De transport en communicatie technologie van de afgelopen decennia zijn sterk verbeterd. Als gevolg is de wereld “gekrompen”. Daarnaast zijn er handelsovereenkomsten welke de internationale handel stimuleren. Ook is er een verbetering in de opleiding en training van de beroepsbevolking wereldwijd, gekoppeld met investeringen in technologiecentrums. Dit alles heeft als resultaat dat ontwikkelende landen interessante locaties zijn om bedrijfsprocessen daar te plaatsen.
Offshoring beschrijft meerdere bedrijfsconcepten. Deze kunnen wettelijk en geografisch uiteengezet worden als drie verschillende concepten. Offshore outsourcen waar de processen worden
geoutsourcet naar een locatie in het buitenland. Offshore ontwikkelingscentrums welke als joint ventures kunnen beschreven worden. En laatste, offshore geboeide diensten waar een bedrijf zijn processen verplaatst naar een buitenlandse locatie maar zelf eigenaar is. Alle drie zijn vormen van offshoring, of delocalisatie, maar hebben verschillende gevolgen voor een bedrijf dat overweegt zijn processen te verplaatsen.
De meeste winsten via delocaliatie zijn te behalen via het gebruik van goedkopere middelen. Dit zijn middelen als beroepsbevolking, infrastructuur, supply chain, etc. Het meest gebruikte argument om bedrijfsonderdelen, te verplaatsen naar het buitenland is om de personeelskosten te reduceren door gebruik te maken van goedkopere werkkrachten. Maar men moet de gevolgen van delocalisatie op andere middelen erkennen. Deze gevolgen kunnen de uitkomst van de potentiele winsten van delocalisatie sterk beïnvloeden.
Delocalisatie heeft grote invloed op de operationele processen binnen een berdijf. Zowel de productie processen als de overhead kunnen gedelocaliseed worden. Beide zijn vatbaar voor soortgelijke winsten wanneer deze processen worden verplaatst.
Zoals gezegd is het hoofdargument voor een bedrijf om processen te verplaatsen vanwege de arbeidskosten. Een bedrijf kan ook winst behalen door inefficiënte taken te verplaatsen welke dan
voor minder kosten uitgevoerd worden. Hierdoor vergroot een bedrijf zijn efficiëntie en productiviteit. Maar niet alle bedrijven zijn succesvol in delocalisatie. Onderzoek laat zien dat 17% van Duitse bedrijven die processen verplaats hebben naar een buitenlandse locatie deze processen binnen 5 jaar terugplaats hebben naar eigen land vanwege tegenvallende resultaten. Deze bedrijven hebben de potentiele winsten van delocalisatie overgewaardeerd of de complexiteit om dergelijke processen te coördineren in een ver land met andere cultuur onderschat. Men moet arbeidskosten ook niet als het enige argument gebruiken om te kiezen voor delocalisatie. Er zijn verscheidene verborgen kosten welke op het eerste gezicht niet toegekend worden aan processen welke bij delocalisatie onvoorzien kunnen stijgen. Bedrijven zouden verborgen kosten eerst moeten onderzoeken. Wanneer de huidige situatie goed onderzocht is kan er wellicht op de huidige locatie besparingen behaald worden. Verder is delocalisatie niet altijd in strijd met de strategie van een bedrijf om bepaalde processen te
ontkoppelen van zijn huidige locatie. Wanneer het ontkoppelen van dergelijke processen de kern competentie van berdrijven in gevaar brengt is het verstandig om het risico van delocalisatie te onderzoeken.
Oftewel, wanneer men een delocalisatie beslissing overweegt zou men eerst alle verborgen kosten, risico’s en potentiele winsten duidelijk geïdentificeerd moeten hebben. Daarboven zou het gebruik van metriek om dergelijke kosten, risico’s en winsten te onderzoeken gespecifieerd moeten worden welke overeenkomen met de strategie van het bedrijf voordat men een goed onderbouwde beslissing maakt.
List of abbreviations (if applicable)
FDI Foreign Direct Investments MNE Multi National Enterprises SME Small and Medium Enterprise WTO World Trade Organization
EU European Union
MERCOSUR Economic and political agreement among Argentina, Brazil, Bolivia, Paraguay, Uruguay, and Venezuela
NAFTA The North American Free Trade Agreement ASEAN The Association of Southeast Asian Nations IT Information Technology
FDI Foreign Direct Investment
OLI Ownership – Location - Internationalization DLE Disintegration-Location-Externalization BPO Business process outsourcing
PROPER Process Performance
Contents
Summary ... 1
Summary (in Dutch) ... 3
List of abbreviations (if applicable)... 5
1. Introduction ... 7
2. Driving forcers and theoretical motives for offshoring ... 7
2.1 Driving Forces ... 7
Economic driving forces ... 8
Political-legal conditions ... 8
Socio-demographic driving forces ... 8
Technological driving forces ... 8
2.2 Theoretical motives for offshoring... 9
The DLE advantages ... 10
3. Definition of offshoring ... 12
3.1 Offshoring concept... 12
4. Quantitative analysis of companies active in offshoring ... 14
4.1 Asset specificity ... 14
4.2 Company profile of captive offshored manufacturers ... 14
Characteristics of offshoring companies ... 14
4.3 Motives of captive offshored manufacturers ... 15
4.4 Motives of captured offshored manufactures for backshoring ... 17
Backshoring relevence ... 17
5. Offshoring concept via Delft Systems Approach ... 19
5.1 Introduction to the Delft Systems Approach ... 19
Comparing offshoring concepts through the Delft Systems Approach ... 19
5.2 Offshoring through DSA ... 20
Advantages with the use of resources ... 20
Advantages to make a product... 23
Advantages when performing the client wishes ... 24
Risks and cost considerations concerning the use of resources ... 24
Risks and cost considerations concerning to make a product and perform a client wish ... 27
6. Assessing offshoring ... 31
6.1 Assessing which processes to offshore ... 32
6.2 Assessing Offshore decision ... 33
Coherence of competitive strategy and offshoring criteria ... 34
Adequately considering internal optimization potentials ... 34
Dynamic location assessment: Thinking in scenarios ... 35
Estimating correctly ramp-up times and coordination costs ... 35
7. Closing ... 36
7.1 Define company specifics ... 36
7.2 Evaluate current organization ... 36
7.3 Assess offshore locations ... 37
1. Introduction
Internationalization of manufacturing activities via foreign direct investments (FDI’s) has been researched theoretically and empirically for the last few decades. Recent studies show that in
particular the relevance of offshoring activities to low-wage countries, in term of vertical relocation of production to a foreign location, has grown. Besides MNEs (Multi National Enterprises), more and more SMEs (Small and Medium size Enterprises) are offshoring production activities abroad to utilize competitive advantages of a more intense labor market (Kinkel & Maloca, 2009). International business theory predicts that units in the domestic country will specialize on more skill-intensive and capital-intensive activities, while foreign affiliates in low-wage countries exploit factor price
advantages of their host countries in labor-intensive production activities (Dunning, 1980) (Dunning, 1988) (Vernon, 1966) (Vernon, 1979). On the other hand, transaction cost advantages are strong arguments for concentrating production and auxiliary activities in one location (Williamson, 1985) (Williamson, 1991). Although advantages are much talked about, the risks of venturing into unknown locations is often underestimated. Also, the effects of decoupling business functions are
underappreciated. This study tries to give insights into the different offshoring concepts and elaborate on the effect of offshoring on the business model.
2. Driving forcers and theoretical motives for
offshoring
Due to the long-term impact on the competitiveness of the company, offshoring decisions are key aspects of strategic enterprise positioning (Dunning, 1988) (Ferdows, 1997) (MacCarthy &
Atthirawong, 2003) and play a crucial role for the competiveness and the labor market of the regional and national economy.
2.1
Driving Forces
Location advantages have improved considerably in the last decade. However, offshoring is a phenomenon that started in the early 1990’s. Company’s successes of the past along with the influence offshoring had on economies and the allure of low-cost labor fuel motivation in the early 2000’s to reshape business processes. Internationalization theory (Buckley & Casson, 1976) (Rugman & Hodgetts, 2000) and the eclectic paradigm of ownership, internationalization and location
advantages (OLI) (Dunning, 1980) (Dunning, 1988) are powerful frameworks to explain why
arguments for offshoring. In the last two decades these 2 arguments became more attractive and can be summarized as follows (Jahn, et al., 2006).
Economic driving forces
Wage differentials, interest rates, development of capital markets, capital costs and the emergence of technology centers. The aspect of the emergence of technology centers is particularly interesting, as these may not only make is easier for companies to find resources they require but may also be essential for innovation and thus for competitive advantage. It can already be seen that Asian economies show high rate of investments into national innovative capacity compared to Latin economies.
Political-legal conditions
Primarily labor, taxation, competition laws and trade barriers. The efforts towards a liberalization of the international trade by the WTO and the liberalization of economies by means of treaties and agreements within trade unions such as MERCOSUR, NAFTA and ASEAN as well as national laws also play an important role in shaping the condition for the rise and development of offshoring. Examples of decreasing trade barriers in developing/new industrializing countries can be seen in Figure 1
Socio-demographic driving forces
Include factors as population size, age structure, education levels and workforce motivation. The workforce in typical offshore countries has been developing in these respects during the last years. In India for example, especially in the IT sector, the workforce usually consists of very good education and English skills. Moreover, India has a very young workforce as 53% of the population is under the age of 25. In 2020, 47% of the people in this country which currently has about 1.1 billion inhabitants will be between 15 and 59 years old compared to 35% today. As a contrast, Western Europe and the USA are experiencing an increasing aging of the population thus a diminishing workforce.
Technological driving forces
Developments in telecommunications and transport logistics, in particular developments of the internet and mobile telecommunications as well as an improved transportation infrastructure. These developments make organizational and national borders less important when it comes to the decision about the location of business activities. The perception of geographic distance and transport cost have declined.
FIGURE 1. FOUR EXAMPLES OF DIMINISHING TRADE BARRIERS, SOURCE: (MCKINSEY GLOBAL INSTITUTE, 2004)
2.2
Theoretical motives for offshoring
Internationalization theory (Buckley & Casson, 1976) (Rugman & Hodgetts, 2000) and the eclectic paradigm of ownership, internationalization and location advantages (Dunning, 1980) (Dunning, 1988) are powerful frameworks to explain why companies produce internationally. Particularly
internationalization and location advantages are main arguments for offshoring production to low-wage countries. International business theory predicts that units in the home country will specialize on more skill-intensive and capital-intensive activities, while foreign affiliates in low-wage countries exploit factor price advantages of their host countries in labor-intensive production activities (Dunning, 1980) (Dunning, 1988) (Vernon, 1966) (Vernon, 1979)
John Dunning’s eclectic paradigm, meant for explaining the foreign direct investment (FDI) decisions by multinational enterprises (MNEs), since its inception in the 1970s, has spurred a prolonged
scientific conversation. This paradigm advanced the argument of
“Ownership-Location-Internationalization” (OLI) related advantages that encouraged or discouraged companies to engage in FDI. However, in the context of offshoring, ownership and internationalization advantages are somewhat less pertinent because these two are diminished through transfer and disintegration of production stages to other countries, while location advantages remain equally relevant. Therefore, a framework based on Disintegration-Location-Externalization (DLE) advantages which assumes that companies contemplate offshoring when they have disintegration advantages, location-specific resourcing benefits and externalization-based incentives (Kedia & Mulkherjee, 2009).
The DLE advantages
A configuration of DLE advantages is proposed to address the question why companies embark on the practice of offshoring.
Disintegration-related advantages
A stream of research has argued that organizations need to be more flexible, leaner and more focused on their core competencies in order to stay competitive and responsive in competitive environments. Another body of research notes that structuring of organization should be compatible with the design of its value chain. Nevertheless, both streams agree that the reconfiguration of value chain activities by disintegrating non-core activities and subsequently increasing focus on core areas will generate value for companies and customers.
Three distinct sets of advantages may arise from disintegration of value chain activities. First, it reduces the coordination costs associated with hierarchical governance. Second, it allows companies to focus on their core capabilities and reallocate valuable resources for that purpose. Third, it gives rise to modular structures that confer flexibility, speed and increased responsiveness in competitive environments. While cost-related-advantages are important, the focus lies on the increased focus and modularity-related advantages as these may influence a company’s strategy in the long run.
Advantages related to increased focus on core
Usage of outsourcing and/or offshoring as a strategic device founded in the idea that certain functions (data handling, customer relations management, information processing, etc.) are generic activities among different industries and can be decoupled from their perspective value chains. As a
consequence, companies can focus on their core competencies to develop superior capabilities in order to outcompete other companies in the same industry while externalizing the decoupled or disintegrated functions. In addition, companies can deploy their scarce resources on the areas where they posses competitive advantage.
Advantages related to modularity
The disintegrated, leaner and more modular organizational forms allows for increased flexibility which enables companies to be more responsive to market threats and opportunities, meeting external demands with greater speed.
Location-specific resourcing advantages
Kedia & Mukherjee (2009) argue that companies perceive mainly two types of advantages related to location-specific resourcing. Country level advantages related to the factors identified by Dunning’s eclectic paradigm and the human capital-specific advantages.
Country level advantages
Trade tariff barriers have been reduced to a great extent. Overall, investment-friendly policies, improved infrastructure and possession of inexpensive but increasingly qualified human capital have turned countries to appealing centers for offshoring.
Human capital-related advantages
Advantages related to human capital can be classified into three broad categories. Labor arbitrage, which is mainly associated with the cost of human capital. Knowledge arbitrage, associated with better quality stemming from superior capabilities of human capital. And time arbitrage, related to work that can be performed around the clock due to time difference in different time zones.
Externalization-related advantages
The third strand of the DLE framework is concerned with the externalization (outsource) versus internalization aspect of those activities (captive centers). Markets (externalization) and hierarchies (internalization) are alternative approaches to completing a set of transactions with economic actors choosing the structure which results in lower costs. Companies consider externalization as opposed to internalization when incentives are present in the form of co-specialization and organizational learning, The transaction costs and other risks associated with externalization are reduced and the advantages realized through co-specialization and organizational learning can be reaped when the relationship is based on mutual trust and cooperation.
Relationship capital-based advantages
Perceived benefits associated with externalization will be based on the solid foundation of relationship capital, defined as having mutual trust and shares values between the offshoring company and the provider.
Co-specialization and organizational learning-related advantages
If a markets function well for externalization, it may be beneficial for the companies to select superior external providers instead of inferior in-house activities. By utilizing physical, human, or organizational resources and capabilities, companies are able to exploit environmental opportunities, outperform rival companies and minimize the effects of threats. These providers often are specialists in certain
activities that are externalized to them. The offshoring companies benefit from their providers’ high-end skill sets, collective domain expertise, and industry-specific knowledge that results in integrated and innovative solutions. Offshoring partnerships can also create learning environments for both partners (Kedia & Lahiri, 2007). These authors observed that cumulative experience and learning scope is valued in offshoring relationships and can be potential sources of competitive advantage. In
sum, externalization generates co-specialization and co-learning benefits for client companies. Thus, this set of interrelated advantages as perceived by client companies determines offshoring activities. A summary of DLE advantages are given in the Figure 2 below.
FIGURE 2. DLE ADVANTAGES THAT SPUR THE GROWING OF, ESPECIALLY SERVICE, OFFSHORING. SOURCE: (KEDIA & MULKHERJEE, 2009)
3. Definition of offshoring
Currently, the term offshoring describes a multitude of scenarios and business models. Scholars and practitioners use the term “offshoring” as a synonym for external (offshore) outsourcing, or more specifically (external) business process outsourcing (BPO), to remote locations. But offshoring is not regarded as only external outsourcing. The term “offshoring” can be described as an abbreviation of “offshore resource using”, incorporating the aspects of (external) outsourcing and (internal) relocation of activities. In order to be aware of and able to effectively implement innovative approaches for better leveraging global cost differentials, a clear understanding of offshoring and its implications is as important for supply management practitioners as it is for academia.
Offshoring is a consequence of the international division of labor and of globalization, which induces economic activities to be relocated to regions where investments can yield the greatest returns. It should be noted that the topic of offshoring is deeply interrelated with the make-or-buy decision, as sourcing decisions in general have their origins in make/by alternatives (Culliton, 1942). The question, which processes of a company can be supplied by external providers or should be maintained in-house, is in turn related to the core competencies.
3.1
Offshoring concept
One approach classifies the term taking into account the contractual/legal dimension in combination with an “offshore” location, i.e. one that is not domestic/onshore (onsite or offsite in the same country) or nearshore (Jahn, et al., 2006). This can range from pure contract outsourcing (buy or
third-party), to joint ventures (partnership agreement) to a fully owned subsidiary (built-it or in-source) (Robinson & Kalakota, 2004). The resulting business models on the right-hand side of Figure 3, all to be regarded as types of “offshoring” , are “offshore outsourcing” (buy, offshore), “offshore development centers” (hybrid, make, offshore) and “captive shared services” (make, offshore).
FIGURE 3. DIFFERENTIATING OFFSHORING BUSINESS MODELS INCORPORATING FRAMEWORKS OF ROBINSON AND KALAKOTA (2004) AND MORSTEAD AND BLOUNT (2003). SOURCE: (JAHN, ET AL., 2006)
Firstly, “offshore outsourcing” reflects the model in which companies sell projects, outsource, to foreign companies to be executed completely offshore with low-cost of local labor.
Secondly, “offshore development centers” reflect joint ventures, which are common in the software industry but can also be found in manufacturing environments.
Thirdly, “offshore captive shared services” reflect the model where shared services are kept internally but are housed offshore (Robinson & Kalakota, 2004).
The studies by Robinson and Kalakota (2004) and Jahn, Hartmann & Bals (2006) mainly focus on the offshoring of service functions. However, the business models can easily be applied to offshore activities in manufacturing since the same legal and geographical dimensions apply.
4. Quantitative analysis of companies active in
offshoring
4.1
Asset specificity
Transaction theory can help shed light on how asset specificity, strategic importance, transaction frequency and contract length affect transaction costs and when it makes sense to produce a product/service in-house vis-à-vis through subcontracting.
Higher asset specificity is one of the factors of transaction cost theory that makes the hierarchical transactional arrangement (i.e. make) more favorable. Vice versa, lower specificity makes the market transactional arrangement (buy) more favorable. Due to improvements in infrastructure and
reductions in transport costs, goods have become available more easily. Site specificity, thus, has become less bound to locations also because technologies have become less bound to locations. Furthermore, human asset specificity has been decreasing also as earlier mentioned. Uncertainty has been decreasing as conditions in offshoring countries are becoming increasingly aligned with western standards. However, culture differences, language abilities and coordination difficulties can lead to increased transaction costs.
The lower specificity and transaction costs suggest that the “buy” option should be readily available and thus offshore outsourcing should at least be considered by companies. However, for more complex products, organizations might choose the hybrid or captive offshoring option reflecting a “make” decision that will allow them to leverage costs while securing or improving competitive positions and control (Jahn, et al., 2006).
4.2
Company profile of captive offshored manufacturers
Not only large multinational enterprises (MNE) but also small- and medium-sized companies (SMEs) engage in international production. Especially manufacturing offshoring as one mode of foreign direct investment is becoming an increasingly interesting option for companies of all sizes.
Kinkel & Maloca (2009) researched German manufacturers using the German Manufacturing Survey 2006. A survey on the diffusion of advanced production technologies and organizational concepts in German manufacturing industry carried out every 2 years. It is the only dataset in Europe which regularly enquires about trends towards offshoring and backshoring of R&D and manufacturing activities in the manufacturing industry. The dataset consist of 715 captive offshoring manufacturers.
Characteristics of offshoring companies
The analysis shows that the propensity to offshore production activities rises significantly with the size of the company, which is to be expected. Only 10% of the companies with less than 100 employees
have offshored production facilities, whereas more than 20% of medium-sized companies with 100-499 employees and more than 50% of large companies with more than 500 employees have been active in offshoring.
German vehicle manufacturers, electric manufactures and mechanical engineering companies are more active in manufacturing offshore compared to companies in other sectors.
Export-intensive companies are more active in offshoring. This is in line with theoretical expatiations of experience- or learning-based explanation models of internationalization production. It is predicted that companies internationalize like “rings in water”, where they start with activities in culturally and physically close countries whose history and traditions are known before moving to more distant markets.
Regarding complexity of the manufactures products no differences in propensity to offshore occur. Companies producing larger batches are more often active in offshoring than manufacturers of smaller batch sizes. This indicates that more standardized production processes make more attractive targets for offshoring strategies, which is in line with the expectations of product lifecycle theory (Vernon, 1966) (Vernon, 1979). This is supported by the results that companies developing their products for a standardized product program show a higher offshoring propensity compared to companies that are developing customer-specific products.
Companies with a higher percentage of capital costs at turnover, thus producing more capital-intensive, show a lower propensity to offshoring, which is in line with expectations of location theory and the eclectic paradigm. In these companies, personnel costs are less important for the efficiency and productivity of the production process. The qualifications of employees to efficiently exploit and optimize expensive production equipment are more relevant. The findings that companies with higher percentages of low qualified personnel are more active in offshoring, adds to these assumptions.
4.3
Motives of captive offshored manufacturers
Kinkel & Maloca (2009) further investigated the offshoring motives of German manufacturers. From this dataset, 715 manufacturers where sampled , the following motives for offshoring have resulted given in brackets in Figure 4.
The reduction of labor costs is the most important decision factor for offshoring production facilities. Second most important decision factor by a large margin are capacity bottlenecks followed by the opening of new market abroad, which is more of an expansion strategy then a cost reduction strategy.
FIGURE 4. MOTIVES FOR PRODUCTION OFFSHORING OVER TIME (GERMAN METAL AND ELECTRICAL INDUSTRY; WHOLE MANUFACTURING SECTOR IN BRACKETS). SOURCE: (KINKEL & MALOCA, 2009)
The high relevance of cost-oriented offshoring decisions is mirrored by the preference of targeted countries which can be seen in Figure 5. The new EU-member states have been the preferred location for more than 50% of the offshoring companies with a clear emphasis on the Check Republic (26%) and Poland (22%). China ranks third a most preferred offshoring country with 19%.
FIGURE 5. TARGET COUNTRIES OF PRODUCTION OFFSHORING AND COUNTRIES OF ORIGIN FOR BACKSHORING ACTIVITIES. SOURCE: (KINKEL & MALOCA, 2009)
4.4
Motives of captured offshored manufactures for
backshoring
Many studies into offshoring fail to take into account that offshoring aren't irrevocable processes. Backshoring activities once offshored from foreign locations to domestic locations are quite common. Backshoring is defined as re-concentrating (parts of) production from owned abroad locations as well as foreign suppliers to the domestic location (Kinkel & Maloca, 2009). Common barriers are capital and financial requirements, bureaucratic hurdles abroad, as well as lack of know-how capacity and competent personnel to cross-border management. These barriers, which are especially significant for SMEs are usually not further elaborated. It was argued that organizations unfamiliarity to
internationalization can be overcome by learning or imitating, a self-reinforcing process. Backshoring however, shows that internationalization barriers are not always easily overcome.
Reasons for failures resulting in backshoring operations stem from lack of knowledge about the foreign destinations and from lack of systematic location planning. Long physical and “mental” distances and possible opportunistic behavior of the foreign production site or supplier can make negotiations, monitoring and coordination costly. Thus, increased or increasing transaction and coordination costs can be strong arguments to re-concentrate production capacities via insourcing or backshoring.
In order to investigate backshoring trends, Kinkel & Maloca (2009) looked at 471 German manufacturing companies who participated in three survey rounds in 2006, 2003 and 2001.
Backshoring relevence
Analysis show that the majority of backshoring activities are initiated by companies that have offshored production facilities in the preceding 5 years. As shown in Figure 6, of the companies that offshored production facilities from 2000-2001, 17% of them backshored production facilities between mid 2004-mid 2006. 10% of the companies that offshored production facilities from 2002-2003 (resp. 2000-2001) have backshored activities to the domestic location in mid 2004-mid 2006 (resp. 2002-2003).
FIGURE 6. CORRELATION OF OFFSHORING AND BACKSHORING ACTIVITIES IN A PANEL ANALYSIS OF 471 GERMAN MANUFACTURING COMPANIES. SOURCE: (KINKEL & MALOCA, 2009)
Within 4-5 years every fourth to sixth offshoring activity is countered by a backshoring activity, which is a relevant ratio. Contrarily only 15% of the companies that reported backshoring activities had not
carried out offshoring activities in the preceding 4-5 years. Meaning that 85% of the companies that backshored their offshore activities did so within 4-5 years of initiating offshoring. Thus, it can be stated that backshoring serves as short-term corrections of location misjudgment or offshoring assessment rather than long-term reactions to local development trends.
From the manufacturers out of the first dataset of 715 who were active in backshoring, the following motives for backshoring have resulted given in brackets in Figure 7.
FIGURE 7. MOTIVES FOR BACKSHORING ACTIVITIES OVER TIME (GERMAN METAL AND ELECTRICAL INDUSTRY; FIGURES FOR THE WHOLE MANUFACTURING SECTOR IN BRACKETS). SOURCE: (KINKEL & MALOCA, 2009)
Flexibility and delivery ability problems are, with 72%, the foremost motive for backshoring activities. This mirrors the increase in inventory to accommodate the need for a safety buffer in case of
problems. What is notable is that this backshoring motive has gained significantly over the last 2-3 years. Quality problems are the second decisive motive for 61% of the backshoring companies. This is mirrored in increased expenses for quality securing measures, control and coordination compared to the assessed offshored decision. Followed are high coordination costs (16%), insufficient quality of infrastructure (15%) and lack of availability of qualified personnel (9%) as backshoring motives. The decreased importance of coordination costs as a motive implies that the industry has learned from the past and is able to more realistically estimate these important costs beforehand. Decreased
importance of infrastructure and availability of qualified personnel is proof of the improvements in the targeted countries.
Overall, it can be said that problems in reliable production processes at abroad location result in backshoring decisions. In Figure 5 it can also be seen that most backshoring activities originate from new EU-member states, 39%, in particular, the Czech Republic (19%), Poland (12%) and Hungary (11%). likely a result of underestimating management and control difficulty to maintain a reliable production due to relative small geographical distances and cultural differences. Notable is the low
percentage of 2% backshoring activity from China. Reasons might be the fact that offshoring engagements in China are relatively recent ones. And, due to geographical and cultural distance, bigger compared to engagements in the new EU-member states thus are more critically evaluated beforehand.
5. Offshoring concept via Delft Systems Approach
5.1
Introduction to the Delft Systems Approach
In the Delft Systems Approach a link between processes and control loops is established (in 't Veld, 2002) (Veeke, et al., 2008). In this study the models of this systems analysis are used. The Steady State model and the Process Performance Model (PROPER model). The steady-state model is an aspect model, with an apparatus for a process control and a function control. The PROPER model accommodates multiple aspect systems and a coordinating body which coordinates between the different aspect systems.
Comparing offshoring concepts through the Delft Systems Approach
Using the three concepts from Jahn, Hartmann & Bals and comparing them with the ProPer model, the boundary between internal en external becomes more clear.The PROPER models looks as follows under normal conditions where all the activities of a company are executed internally. When a customers “wants” a product, actions are performed to create an order which is used further to make the product ordered using the materials and resources available to the company. These three aspect systems are linked and coordinated to ensure that requirements and standards are met. When offshoring, parts of these aspects are moved to an external provider.
offshore outsourcing
When outsourcing, a company shifts the decision from making a product to buying the product. Therefore the model changes from a three aspect model to a single steady state model where the company only performs the action of processing the customers wishes or orders. These orders can then be shipped to the preferred outsourced partner. Afterwards the produced products are received and can be used internally or sent directly to the client. The advantage here is that the company can reduce manpower since it is only processing orders, the materials and resources needed to make the product lies at the outsourced partner, as well as most of the operational risks.
Perform
Make
Use
Materials Product
Order Handled order
Resources Used resources
Results Standards
Coordinate
Performance Requirements
FIGURE 8. PROPER MODEL SOURCE: (VEEKE, ET AL., 2008)
offshore development centers
A hybrid form of cooperating where the company offshores a part of its activities and maintains a level of involvement. Most often the labor intensive activities are offshored but the company maintains some level of management. Especially popular in software development where the grunt work is done offshore and the high value work is done internally.
offshore captive shared services
The whole activity is moved offshore. The home based company will maintain a certain level of involvement and control, mostly through monthly/quarterly data. Sometimes, management is moved offshore also instead of completely making use of a local workforce.
5.2
Offshoring through DSA
There are several advantages and risks associated with offshore outsourcing. These can be broken down following the earlier introduced PROPER model. A company utilizes resources and performs tasks in order to make a product, all need to be coordinated to ensure all company requirements are met. The following paragraph will introduce each aspect and the advantages and risks associated with that aspect.
Advantages with the use of resources
To produce a product or service a company will use resources like labor, machines, infrastructure, supply networks, energy, etc. Often, the resources are a substantial part of the costs of the product. Therefore it is an interesting aspect in order to reduce the costs. In regard to the aspect of the use of resources, three main advantages can be found.
Labor force
As mentioned in the theory in chapter 2 and found as a main reason to transfer production in chapter 3 (Kinkel & Maloca, 2009), labor cost is a main argument to move production elsewhere. Not only can the labor be cheaper offshore, but the knowledge and skills of the labor force is steadily increasing around the world. Also, the population size, age structure and workforce motivation has developed significantly in the last years. Meaning, the workforce is not only cheap, but also sufficiently educated, well motivated and abundant. Whereas in the western nations, although the workforce is well
educated, it is not very motivated to work factory jobs. And there is the problem of a declining workforce for western nations whereas the workforce for developing nations is growing (Jahn, et al., 2006). Furthermore, along with an improving education level of the workforce, the emergence of technology centers means companies are able to find suitable laborers but can also improve the innovational capacity of these companies which may be necessary as a comparative advantage. However, is this motivation well founded?
Example of cost-reduction
A simple analysis to give insights is elaborated below (Leibl, et al., 2009).
Substantial differences exists in the world, even within Europe, see Table 1. For example, hourly costs in Romania are 6% of those in Germany when Slovakia, which is geographically closer, are 14% of German costs.
Country Labor Cost in Euro per Hour
Germany 39.02 USA 31.14 United Kingdom 24.27 France 24.21 Czech Republic 6.60 Hungary 7.38 Slovakia 5.39 Romania 2.34
TABLE 1. LABOR COSTS PER HOUR IN DIFFERENT EUROPEAN COUNTRIES. SOURCE: (LEIBL, ET AL., 2009)
Calculation of labor costs
In conventional wisdom, it is necessary to transfer product development and manufacturing to low-wage countries to reduce costs, based on the notion that labor costs are a high percentage of a company’s total direct costs. For an overview of labor costs in comparison to the total direct costs a rough calculation was made.
In Figure 9, a common structure of the cost calculation process based is used (Pahl & Beitz, 1999). Production, R&D, administration, sales and special sales costs are included in total direct costs. Production costs consist of materials, labor and maintenance. Materials costs are divided into raw
materials and overhead, while labor costs consist of raw labor, overhead, and special production costs. The raw materials costs are approximately 40% of total direct costs and overhead is 4%. Raw labor costs are 10% with a labor overhead of 13%. Considering that the material overhead and the labor overhead contain 50% labor costs, that part of the labor based on the total direct cost is 9%. If the 10% raw labor costs are added, these labor costs total 19%. If the material costs and the overhead not depending on the labor are added there is the following result:
Labor [19%] + Material and non-labor-dependent costs [49%] = 68%
FIGURE 9. PRINCIPLE COST CALCULATION, BASED ON (PAHL & BEITZ, 1999)
These costs have a share of total direct costs of 19% plus 49%, in total 68%. That means that if the manufacturing plants are shifted to low cost countries, the cost savings would apply mainly to the labor cost portion of total direct costs. Materials such as steel and oil are purchased in a global
market, so these materials costs will vary only with the costs of transportation to their utilization as an input. To provide a simple example, if a manufacturing plant were shifted from France to Romania approximately 90% of the labor cost could be saved. This means that labor cost would be reduced from 19% to 2% of total direct cost. Therefore total direct costs would be decreased by about 17%. But shifts from high cost to low cost countries involve additional factors that may cause other costs to be incurred. Furthermore, when production is moved from high cost to low cost locations, it is often the case that more labor intensive production processes will be used. Greater labor intensity makes labor costs a higher portion of the direct costs. Greater labor intensity also means less production stability and higher failures rates.
Plant transfers can be justified on the basis of reduced labor costs only if in the long run the costs enumerated above fall below the current labor costs, 19% in our example, of the total direct costs.
Infrastructure
With improved transportation technologies and communication technologies the world is no longer as big as it used to be. The worldwide availability of communications means a real-time link is
established reaching every part of the planet. Especially in the IT sector, this is an important argument. Also, developing nations have reduced competition laws and trade barriers. Trade unions such as MERCOSUR, NAFTA and ASEAN as well as national laws also play an important role in shaping the condition for the rise and development of offshoring. As a result, the cost of transportation has reduced significantly. This is not only true for global transportation infrastructures but especially the infrastructure in developing nations in improving enabling mass transport of goods. Add the fact that developing nations can have advantageous laws compared to western nations, for instance tax laws or pollution laws. This legislation could mean that fewer regulations need to be followed and thus could head a savings.
Not only has the infrastructure of developing nations improved. Due to the increase in offshoring companies to these nations, suppliers of these companies also moved to such nations. As a result, the impact of moving a facility abroad to the supply chain available is lessened. It might even be an argument to move production abroad to position it closer to the suppliers and clients.
New market opportunities
Market-based view
The main argument being that potential offshore locations which are interesting supplier markets today, might become important customer markets in the future. Offshore outsourcing can be seen as a means for entering new and more attractive supplier markets. Captive offshoring companies are able to keep the offshore activities within their own value creation process and position themselves further directly within a possibly new customer market. Depending on the strategy of an organization, this can have important implications (Jahn, Hartmann, & Bals, 2006).
Advantages to make a product
The main function of a company is to make/ deliver the product the clients wants. Thus transforming the wishes of the client in a product.
As mentioned by the Disintegration-Location-Externalization framework (Kedia & Mulkherjee, 2009) there can be several advantages when disintegrating the production process. The eclectic paradigm (Dunning, 1980) (Dunning, 1988) and internationalization theory (Vernon, 1966) (Vernon, 1979) also predict this. By relocating inefficient tasks to low-cost countries the unit cost of the company’s product
falls, which can be interpreted as an improvement in productivity. Also, offshoring allows companies to move abroad less productive stages of the production process and shift corporate resources to high-productivity activities, such as product development and process innovation. Inefficient tasks aside, companies can also choose to move generic activities which are not directly involved with their core competency offshore. As a consequence, companies can focus on their core competencies to develop superior capabilities in order to outcompete other companies in the same industry while externalizing the decoupled or disintegrated functions. The remaining workforce may become more efficient, productive and add more value to the product. This can be true for all three of the offshoring models.
Advantages when performing the client wishes
A company will make a product according to the wishes of the client. This implies that these wishes be interpreted and translated correctly in order for the production process to produce the correct product in accordance with the client wishes.
In this process, the same arguments apply as mentioned in the previous paragraph. Although the goal of these processes are to ensure customer accordance, the nature of these processes are subjected to the same potential gains as mentioned before. Therefore, in the remainder of this study the advantages and risks concerning the aspects of making a product en performing the client wishes will be addressed together.
Risks and cost considerations concerning the use of resources
Labor Force
A small percentage of the selling price and yet offshoring decisions are often based entirely on labor cost because it is often the only processing cost which is quantified. However labor cost savings can be exceeded by a number of hidden costs which should already be quantified in the native facility before assessing offshoring. As mentioned in paragraph 5.2.1 in the example, labor costs can only be an argument for offshoring when all the costs are known and do not exceed the current costs. There are a number of hidden costs associated with labor costs. Namely;
Labor efficiency
The efficiency of the desired labor force is unknown and could cancel labor cost savings.
Control
It may be harder to exercise effective control and management of offshore operations because of time-zone separations, languages, cultural differences, lack of direct communications and the “out of sight, out of mind” syndrome.
Labor intensive design
When products are labor intensive it becomes an argument to move production offshore to reduce labor costs. Or, the processes that are moved offshore will be more labor intensive due to investment considerations. As a result, the labor costs increase.
Training costs
Difficult to attract, train and retain skilled workers. Further, lack of loyalty results in increased (re)training costs and wage escalations to keep valuable workers. Although there is a motivated workforce, they will only remain motivated and loyal when properly compensated.
Indirect labor support costs
Problems could arise which cannot be solved by the local workforce and high-costs or headquarter engineers need to solve them.
Travel costs
Costs such as lodging, transport, living expenses of personnel can exceed planning when problems arise and headquarter personnel has to travel to offshore locations.
Infrastucture
Although developing nations have increased their infrastructure concerning, transport,
communications and legislations. They are still not up to the level of the western nations. Thus, there are several risks and hidden costs associated with offshoring.
Structural risk
Most companies don’t worry about the behavior of providers of outsourced processes when they enter into contracts with them. Like all supply chain partners, providers can, and do, have incentives to behave in ways that reduce buyers’ financial benefits from outsourcing. Thus cause risk by deliberate attempts of vendors to exploit clients
Structural risk appears when providers alter the terms of contracts after clients have turned over processes to them. This is a result of the shift op power in the relationship between client and provider. Once companies have transferred processes to providers and terminated the processes within the company, they cannot retrieve these processes back into the organization on short notice. Providers can demand dramatic increases in prices when contracts are up for renewal. Two factors amplify these latent risks. First, when companies outsource processes that require transfer of tacit knowledge, they have to invest time and money in training providers’ employees. Second, some processes take time to stabilize when outsourced.
Buyers are not powerless. When negotiating a contract with a provider, is should specify a period after the contract expiry during which the provider must continue to offer a certain price. Although it may be difficult, companies should split business between two providers. In the event the company whishes to end relations with one provider it can transfer the process to the other provider that is already executing these processes. It will lessen time and (re)training costs compared to starting over with a new provider. Also, it provides the company with a better bargaining position when
renegotiating the contract term due to competiveness between providers. Another option is to keep residual capacity for the process at the domestic location so processes can be brought back into the company.
Supply chain costs
A qualitative study show that companies, often, only recognize the importance of reliable and well-functioning networks when they are no longer available (Kinkel & Lay, 2004). The findings show how difficult, and costly, it is to establish and develop reliable and satisfactory suppliers’ structures abroad. In almost all cases the prices for specific materials proved to be more expansive instead of cheaper compared to the supply at the domestic location. From a supplier perspective, this led to the situation where suppliers are confronted with the demand to follow important customers abroad.
For companies pursuing innovation leadership strategy, close networks to innovative suppliers as well as innovative customers are essential. They are aware that an integrated in locally concentrated technology clusters with concentrated innovation and technology push is crucial for their innovation output. Afterwards, they realize that innovative demand and supply are very important location factors for technology-driven companies. Of course, there are also risks associated with such technology clusters like revealing critical know-how for competition or scarcity of qualified personnel (Kinkel & Lay, 2004).
Shipping and expediting costs
Remote manufacturing will incur more shipping costs especially when also located far from suppliers. Costs include shipper, insurance, fees, permits, duties, tariffs, compliance to import/export restrictions etc. Also, the increased supply chain increases inventory.
Supply vulnerabilities
Moving too much production is to one part of the world can endanger world economy due to vulnerabilities in major supply.
Furthermore legislation and politics are susceptive to change and thus may these changes can increase costs in the offshored location therefore adding to the hidden costs.
Tax Breaks
Often enticing incentives compared to native or other countries but usually expire after a number of years.
Offshore savings don’s last
Rising labor costs, taxes, currency valuations, trade agreements and politics could render initial savings obsolete.
Unanticipated local costs
There may be local costs that pose ethical and legal dilemmas and cause resistance to total cost management.
Risks and cost considerations concerning to make a product and perform a
client wish
Concerning the operational risks, it is necessary to assess the codifiability of work and how precise metrics to measure process quality can be defined. Risks of long term atrophy depend on strategic considerations whether it is necessary to keep competencies and knowledge in-house (Jahn, et al., 2006).
Operational Risk
As seen in chapter 4, not all offshoring activities resulted in success. The three main reasons for returning offshored activities are disappointing results concerning the flexibility of the production, the quality of the produces products and the increase in coordination costs. In Figure 5 it can also be seen that most backshoring activities originate from new EU-member states, likely a result of
underestimating management and control difficulty to maintain a reliable production due to relative small geographical distances and cultural differences. Notable is the low percentage of 2%
backshoring activity from China. Reasons might be the fact that offshoring engagements in China are relatively recent ones. And, due to geographical and cultural distance, bigger compared to
engagements in the new EU-member states thus are more critically evaluated beforehand. Businesses can try to lower operational risk by tackling its twin causes. The first of which is an organization’s ability to codify work, as mentioned earlier. When companies document the word that employees do, describe the different situations they face and stipulate what employees responses should be in each scenario, people anywhere in the world should be able to do the job. The second is a company’s use of metrics to measure the quality of processes, also mentioned earlier. Developing effective metrics decrease operational risks due to increased visibility and control of processes. Companies should use metrics to measure the domestic processes to try and improve the quality and
efficiency before deciding to offshore them. If companies codify work and develop metrics to evaluate quality, they can contain operational risks even if work constantly moves between company’s
employees and vendors’ agents.
When companies look at the extent to which processes can be codified and measured using metrics, the processes fall into four distinct categories.
Transparent processes
Metrics to measure the work exist and can be codified. The operational risk of offshoring and outsourcing is low.
Codifiable processes
Companies have some ability to measure work and can mostly codify the work. If companies can measure the quality of the end result, the risk of offshoring or outsourcing processes becomes manageable. However if measuring results are difficult, the risk increases.
Opaque processes
Companies can codify the work but cannot measure the quality of process outputs. If companies specify how outsourcer’s agents should do their work and offer performance-based rewards and penalties to ensure quality standards, they can lower the risks of offshoring or outsourcing these processes.
Noncodifiable processes
Companies cannot easily codify work because of variation in business events and employee responses are too great to standardize. Although difficult, it may be possible to measure the quality op these processes. These processes are prone to a high degree of operational risk. If organizations do outsource them, they should closely supervise the providers’ agents.
To evaluate operational risk, companies should classify processes by how precise the metrics for quality are and the extend of work that can be codified. In Figure 10 a scheme is show how processes can be categorized by the above mentioned dimensions.
Co
dif
iab
ility
o
f w
or
k
Imprecise/subjective
Precise/objective
Ea syModerate Risk Low Risk
M
ode
ra
te High Risk Moderate Risk
Dif
fic
ul
t Highest Risk High Risk
FIGURE 10. EVALUATING OPERATIONAL RISK. SOURCE: (ARON & SINGH, 2005)
Structural risk
Most companies don’t worry about the behavior of providers when they enter into contracts with them. Structural risks arises when vendors stop investing in training or employ unqualified personnel. Lessen the efforts to maintain quality from when the contract was agreed. When companies supervise providers’ work, structural risks decreases. Businesses can now track, real time, providers’ efforts. Structural risks also decrease when companies use clear metrics to measure quality of providers’ work. Another kind of structural, companies face the risk that rivals may steal intellectual property and proprietary processes when transferring offshore.
To ascertain structural risk, companies should look at the precision of quality metrics and the extend in which processes can be monitored. Most processes fall into one of four categories as can be seen in Figure 11.
Ab
ility
to
m
onito
r w
or
k
Imprecise/subjective
Precise/objective
Ea syhigh Risk Low Risk
Dif
fic
ul
t Highest Risk High Risk
Hidden Costs
Offshoring manufacturing jeopardizes six out of eight cost reduction strategies (Anderson, 2010), namely:
1. Cost reduction by design, product development determines 80% of product costs. 2. Lean production cost reduction, possible by eliminating waste and raising productivity. 3. Overhead cost reduction, standard products can be build to-order without forecasts or
inventory and specials can be mass-customized on-demand.
4. Standardization Cost reduction, improve economies of scale and reduce material overhead of standard parts.
5. Product line rationalization cost reduction, focus on most profitable products. 6. Supply chain management cost reduction, simplify supply chain and establish partnerships
with vendors to reduce costs for inventory, forecasting and purchasing. 7. Quality cost reduction, quality costs can be up to 40% of the revenue.
8. Total cost measurement to support all cost reduction activities, quantify all associated costs in production to gain insight in potential gains like above mentioned.
80% of a product’s lifetime cumulative costs are determined by product design. Unfortunately, offshoring production compromises all future design opportunities because it prevents Concurrent Engineering teamwork which is the most promising opportunity for achieving truly low-cost products (Anderson, 2010). Concurrent Engineering is the practice of concurrently developing
products and their manufacturing processes. If existing processes are to be utilized, then the product must be designed for these processes. If new processes are to be utilized, then the product and the process must be developed concurrently.
Offshore plants often amortize their setup charges by building in batches and shipping in batches. It becomes hard to respond to volatile market conditions when much forecasted inventory is at the plant and in the increased supply chain. The potential gain are jeopardized, especially the concept of lean production, because it is increasingly difficult to pull products by costumer demand across the supply chain nor can they be built to order due to the batched production.
Quality costs can increase due to the lack of concurrent engineering. When quality is not properly designed or built in the design of the product the home office will rely on testing followed by repair and setup costs and possibly scrap costs, replacements and reshipping costs.
Further costs considerations
Technology introduction delays
New products or technologies are often introduced in the home plant first and in offshore plants later. As a result, capacity is low at the time of introduction and it will take time before the targeted capacity is reached. Also to introduce new products or technology direct at offshore locations increases risks and startup delays could sink projected savings. Also, transferring new technology offshore creates intellectual property risks.
Quality costs
Likely to rise due to new learning curves, local quality culture shortcomings, lack of skill and judgment, difficulty to implement quality improvements and produced quality defects stuck in long supply chain.
Offshore setup costs
Overhead costs may increase trying to find qualified contract manufactures. Or, costs associated with startup of new plants or product lines. Also, there are ongoing support costs for offshore operations. After having identified and considered the risks and concluding that it is too high. The hierarchical captive shared services model may be a suitable strategy as it can reduce the first three risks
considerably (Jahn, et al., 2006). Companies could take the captive offshoring option to leverage local cost differentials, while at the same time maintain control and gain insights, e.g. on process
innovation, in their foreign subsidiary and transferring this knowledge back to headquarters or other company subsidiaries.
6. Assessing offshoring
Most companies focus their efforts on choosing countries, cities and vendors on negotiating prices but they don’t spend time evaluating which processes they should offshore and which they shouldn’t. Without a standard methodology for differentiating processes, most companies find it hard to distinguish among core businesses they must control, critical processes that they might buy from in-class vendors and commodity processes they can outsource. Continuing with the toolkit of Aron & Singh (2005) which already gave insights towards risk, prioritizing risks and comparing them with company processes an organizational form for offshore activities can be chosen.
6.1
Assessing w hich processes to offshore
How crucial is each process or sub-process compared with others in creating value for the company’s customers? In relative terms, to what degree does each process enable the company to capture some of the value it has created for customers?
Rank processes by value
By ranking the processes along the dimensions of the value creation and value capture criteria, if necessary weights can be assigned to the criteria which is more important, the company is able to create a value hierarchy. The higher it ranks in the hierarchy, the more crucial it is to the company’s strategy.
Example of a hierarchy of processes is given in Figure 12 below. Executives in a company’s finance department charged with identifying business processes to offshore ranked six processes on their ability to create value for customers and on their ability to capture value of the business. They then added the value-creation ranking and the value-capture ranking together to arrive at a total for each process. When they studied the final rankings, or hierarchy, the executives agreed that they should offshore the three lowest-ranking processes and that the two highest-ranking processes were too strategic to offshore. Process Value-creation ranking Value-capture ranking Total ranking Float management for
suppliers 1 1 2 Processes the company shouldn’t offshore Working capital management 2 3 5 Cash-flow forecasting 4 2 6
Revenue and expense reporting 3 4 7 Processes the company might offshore Payment authorization 5 5 10 Invoice verification 6 6 12
FIGURE 12. CREATING A VALUE HIERARCHY OF PROCESSES, EXAMPLE. SOURCE: (ARON & SINGH, 2005)
Choosing the right organizational form
Companies should match organizational structures to their needs by considering both the structural and operational risks of offshoring processes. In general, they can use location to combat operational risk and organizational structures to respond to structural risk. When both operational and structural risks of offshoring processes are low, companies can outsource them overseas to providers. As the operational risk rises, locating processes nearer will reduce risk. If the operational risk is very high, setting up captive centers locally is often the best solution. Outsourcing is less attractive when structural risks of processes are moderate or high. Here, other forms of governance, such as joint ventures and captive centers, become better options. Figure 13 shows a schematic in which the risks reflect an organizational form.
