When offshoring doesen't make sense for some

Excellent article in today's WSJ written by two McKinsey partners explaining what a firm needs to examine before outsourcing its operations.

Big companies "sending jobs overseas" is a hot topic in the presidential race. Well, here's a question for both candidates: Ever wonder why, in an age when companies are sending thousands of high-wage jobs offshore, Toyota still makes Corollas in Silicon Valley, one of the costliest places on earth?

The answer lies in a fact of business life Toyota knows well. The best supply chain is short. Sending goods 500 feet in 24 hours is better than shipping them 5,000 miles in 25 days across logistical and political boundaries.

Offshoring can make good economic sense. But it is not a panacea. Manufacturers, in particular, should study potential drawbacks before pursuing it. In our experience, many overrate the value of wage savings and underestimate the inventory, obsolescence and currency risks. Some also overlook the top-line benefits of staying close to customers. Unlike companies in service industries -- where wages are typically a higher share of costs and no physical goods change hands -- manufacturers may do better in the U.S.

To better understand the complex calculus of the offshoring decision, we've begun looking into the performance of companies in California, a good proxy for diverse, advanced manufacturing economies world-wide. We've found compelling evidence that, in certain circumstances, offshoring is the wrong choice.

One reason is wage rates. They are the heart of the offshore case, yet the importance of direct labor is falling quickly for many manufacturers and often hovers around 7% to 15% of costs of goods sold. Hence, hard goods and high-tech manufacturers often say wages are not critical determinants of their performance.

At the same time, staying at home shortens lead times and heightens responsiveness to market change. One Los Angeles maker of casual wear can fill orders of up to 160,000 units in 24 hours. How? The entire supply chain -- including weaving, dyeing and sewing -- is downtown. The company carries less than 30 days inventory and is thinking about becoming a "build-to-order" producer.

Speed like this is a competitive weapon -- and its absence can be a trap. The fashion apparel industry has spiky, unpredictable demand, and five-month lead times offshore can leave firms with too much inventory of a fading fad or too few of a hot item. For instance when a knicker craze ended before one California designer's delivery arrived from China, the firm was left with a boatload of velvet knickers that could only be sold at a large discount. With mass retailers penalizing suppliers as much as 2% per day for late orders, the cost of miscalculation can be high.

Long lead times also stand out in high-tech electronics, where on-water time can translate to price declines between 2% and 6%. It's a painful penalty to pay, since today almost every product requires just hours or minutes to manufacture. For instance, high-end telecom routers take about two hours, a car needs six hours, and an iPod roughly 30 minutes. Much of the remaining lead time for these products is waste in the form of waiting or rework.

So how should goods makers decide whether to offshore? Certainly not by starting the decision-making process with a geographic location target or wage-rate goal, as some companies seem to. Manufacturers should instead consider offshoring in the context of a broader operations strategy. They should:

• Clearly define their main competitive advantages in key product markets. This understanding should reach down to specific operating metrics, such as customer response time, product cost, or inventory. Firms should also know their tolerance for risks like supply interruptions, cost variations stemming from currency swings, and compromised process or intellectual property.

• Cut direct labor costs. When labor is 40% to 50% of a product's cost, seeking low wages is imperative. But lean manufacturing techniques regularly improve labor productivity by 30% to 50% and advanced automation yields further gains.

• Cut costs further by sourcing strategically, designing products to minimize production costs, and obtaining greater efficiencies in overhead functions. It's common to find factory-like gains in areas such as human resources, finance, and customer service centers.

Some manufacturers who take these steps will still reasonably decide to offshore. But others will try to reach the operational nirvana of a short, direct supply-chain with production sites scaled to match local market size. Getting there won't be easy, yet those who succeed will gain an edge that sets them apart from rivals.