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October 5, 2011

When Outsourcing Backfires

Even in a slumping economy, some companies are bringing production back to home shores — even when it bumps up costs. New research delineates the tradeoffs.

Rebecca McReynolds
Topics: Management

As the global economic downturn grinds on, more companies are acknowledging that labor costs aren’t always the most important factor when deciding where to build their next factory. Organizations such as General Electric Co. and NCR Corp. have made headlines in the past year by deciding to bring some of their manufacturing back to US plants, blaming rising shipping costs and the risk of holding too much inventory as consumers become more cautious with their spending.

But that doesn’t mean the global trend of offshoring has run its course, cautions Xiaole Wu, a research fellow at Washington University in St. Louis. It just means that companies are becoming savvier in weighing all of the factors involved in their sourcing decisions, she says. “The trade-off between cost savings from outsourcing and the convenience of domestic suppliers can be quite involved and difficult to evaluate,” she says. “It appears that the cost benefits of offshoring might not be sufficient to cover the lost flexibility of domestic sourcing under many circumstances.”

Against the Tide

Firms making offshoring decisions should not simply follow the trend, she says. They need to understand multiple factors impacting their business and, just as important, what their competitors are doing. In a new paper, Wu and co-author Fuqiang Zhang, an associate professor of operations and manufacturing management at Washington University, quantified the factors that should go into any sourcing choice.

Sourcing decisions break down to three major factors: consumer demand, market size, and shifts in suppliers’ cost structure, Wu says. All things being equal, when demand is stable, most companies look for the lowest-cost option, which usually translates into offshoring. When demand fluctuates, however, as it did during the recent recession, companies need to respond faster to shifting consumer sentiments. As a result, they will move toward the flexibility and responsiveness a domestic supplier can provide, also called “backshoring.”

Firms also need to consider market size. Larger markets mean bigger orders, so big companies will tend to use low-cost sourcing whenever possible. Companies targeting smaller markets generally opt for suppliers closer to home, Wu says, because being able to respond quickly to customers outweighs additional manufacturing costs. Middle-market companies tend to diversify their sourcing strategies.

Finally, any change in supplier cost structure can tip the scale toward one option or another. Of course, when production costs rise for an offshore supplier, you would expect to find more companies leaning toward domestic sourcing. But Wu and Zhang discovered that when there is an equal cost increase for both domestic and offshore suppliers, more companies still place greater value on the advantages of domestic sources, such as shorter delivery lead times.

Putting It All in Place

At the end of the day, though, the deciding factor will come from watching the tradeoff between cost efficiency and supply flexibility. Makers of innovative products in markets where tastes change quickly will value supply flexibility and are more likely to “backshore.” But for companies that rely heavily on low manufacturing costs, backshoring will decrease, although the countries from which they source may change. Predicts Wu, “As wages increase in China and other developing economies, businesses will seek lower-cost manufacturing sites elsewhere.”

Xiaole Wu and her co-author Fuqiang Zhang, an associate professor of operations and manufacturing management at Washington University, won first prize for their paper, Efficient Supplier or Responsive Supplier? An Analysis of Sourcing Strategies, at the New Frontiers in Operations Management Conference in July 2011. The conference was cosponsored by the China Business Initiative conference, a program of the Chazen Institute.

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