UK: Low Cost Manufacturing – Making It Work For You

© Rossmore Group

Transferring manufacturing operations to low cost regions around the World is being considered by many businesses, due largely to the relentless pressures on margins and demands for increasing shareholder value. However, the decisions taken in principle do not necessarily deliver improvement in practice. Anticipated margins are eroded and customer service suffers, leading to loss of market share.

In considering transferring manufacturing to low cost regions, most assessments look at benefits (from the reduction in unit cost) and business transferability (from a technical perspective) but tend to overlook the issues created by an extended supply chain. The characteristics of a supply chain incorporating low cost supply sources can drive dramatic and unforeseen effects on business performance.

This paper looks at the attractions of low cost sourcing and the relationships between service level, lead time and inventory within the supply chain. It then suggests ways of making the opportunities for low cost manufacturing deliver benefit for your business.

There is no doubt that the potential savings in unit costs that can be achieved by sourcing components and products from low cost regions should be enough to make the CEO laugh all the way to the bank.

Labour costs that are around 20% of European levels are just the taster. A recent purchasing mission to China that we were involved in sought comparative prices on raw materials, parts and packaging for a specific product range. Savings of up to 90% against US costs were quoted (see figure 1).

It is easy to see how the link between 90% saving in cost and a huge improvement in profit is made, but there are three key issues to note:

Firstly, the range of savings is up to 90%, with some being only 10%. The effort involved in finding the higher level of savings may be beyond the resources of some companies. Secondly, competitiveness varies over time – can you be confident that the current savings will be at the same level in a few years time, or will you be looking at yet another move when this one has just settled down?

Thirdly, it takes no account of the other elements that make up the cost to the company, the Total Acquisition Cost (TAC). TAC recognises the additional costs involved over and above the purchase price, including procurement costs, verification costs and inventory costs. It has a strong relationship with the Service Level Model (see figure 2) which shows the cause and effect between service level, lead time and inventory.

The direct effect of trying to maintain service levels with the increased lead times that come with a geographically spread supply chain is to increase inventory. Try and fix inventory levels in this environment and the service level goes down. This is just another nail in the coffin of long lead times, which are a huge cause of waste in business.

Imagine a world-class industrial products company looking at sourcing components from the Peoples Republic of China for assembly in the UK. Let us assume the cost savings achievable are 50%. Currently the company is achieving upper decile performance for its sector, with over 99% delivery performance, less than 0.25% scrap rate and it works with 20 stockturns, equivalent to 10 day’s stock. Their customers value them for their quality, agility and dependability. What impact will the following facts have on their performance?

• The company has no facilities in China, nor does it have any experience of purchasing from the region
• Development and monitoring of production and process capability to achieve required standards will take 3 years
• It takes about 5 weeks to ship from China to the UK and up to 3 weeks to clear customs. This can vary by at least 1 week in summer and 4 weeks in winter.
• Lead times for urgent parts from China are much greater than for own manufacture in the UK
• Very simply, it would mean a major investment in developing the capability, a continuing additional cost in running a local buying office, and probably an eight times increase in stock levels. There is also a very real risk of reduced customer service levels.

The overall supply chain, from suppliers (and their suppliers), through the company operation, and to customers (and their customers) will be quite different, with extended lead times, stretched communications, higher stocks and higher risks of supply problems.

Will the CEO still be laughing all the way to the bank? Well, he could be if the whole process of designing and managing the supply chain is conducted in an objective and rational way. And that starts with understanding the operations strategy of the business.

The Operations Strategy should be developed from the market and business requirements and defines how the operations of the business are to be structured, the core activities that must be retained and the policies on make vs buy. Of particular importance to the operations strategy is the performance objectives that have to be met to succeed in the market. The balance between quality, cost, speed, dependability and flexibility must be understood. In the industrial products example above, quality, dependability and speed are the key performance objectives. So why are we focussing on cost as the prime consideration?

The operations strategy must be the starting point. If the balance of the performance objectives has now changed, update the strategy. If there is a conflict between the performance objectives and the financial need to save money, resolve the conflict before launching out into low cost manufacturing investigations. If the strategy is not aligned to low cost manufacturing, then the distortion caused by the demands of the new supply chain will create new stresses in the business.

Once you have decided that this fits with the strategy, you can start on the process of assessing the opportunity. This involves 5 stages (see figure 3).

Look at the Big Picture

Before launching out on a major analysis and design process and soaking up a lot of management time, it is well worth spending time on assessing whether or not the opportunity looks sensible. This will involve giving consideration to a number of questions, including:-

• What are we trying to do over the next 5 years? Does low cost manufacturing have a key role in that objective, or is it just a short term expedient?

• Does our operations strategy drive us to low cost manufacturing, or are we in danger of out-sourcing activities that we thought were core competencies just 12 months ago?

• What impact will it have on our customers and markets, both current and projected?

• Are we putting our intellectual property at risk or are there opportunities from technology transfer and local manufacture for emerging markets?

• How will we operate a first class design and engineering function with the factory on the other side of the World?

• Does the initial financial analysis look attractive enough to proceed?

Unless you are considering moving everything to a low cost region, you will have to decide on the right products to move and the right level (raw material, component or assembly) to move. Some of the factors that you will need to take into account are:-

Remember the performance objectives? The products where price is a key objective will be the first to be considered for transfer. Another important factor is demand volatility, both in terms of volume and lead time. A highly volatile product demand will require high levels of stock in the system and the costs of stockholding and redundant stocks could exceed the reductions in unit cost achievable.

The transfer issues depend on the stage of the product life cycle, and hence the way they are transferred and managed will differ also:-

• Ramp Up. This is the time when a new product is introduced and is characterised by unpredictable but rising demand, problem solving, improvement and design changes. The focus is on predictability.

• Volume Production. This should be characterised by more predictable volumes, more stable design and a focus on cost down

• Ramp Down. This is the long tail when a product has falling volumes, is moving into aftermarket and is made with old, potentially inefficient tooling.

Depending on exact characteristics, it is usually preferable to transfer the volume production.

Within the broad principles, there is the option for retaining some local configuration capability for urgent requirements or special customers. Figure 4 belowshows the overall life cycle and the LCM opportunity.

If a product is 80% material, with the price dictated by world commodity prices, would you transfer it to a location where labour is cheaper? Probably not. If the ratio was 80% labour, the answer would be the opposite.

Work done with other businesses shows that if the labour element is less than 20% of the COGS then the supply chain costs have the potential to eclipse the benefits for the Asia-Pacific region.

This is perhaps the most complex part of the decision making process as the number of options can be large and there is always a degree of subjectivity involved in the evaluation. The subjectivity can be minimised with detailed product data and accurate costings, but some businesses do not have this level of data.

Included in the issues to be considered are:-

Are there any fixed points that need to be taken into account, such as unique supply sources or concentrations of customer demand? It usually makes sense to do final assembly and customisation as close to the market as possible.

The ideal product for transfer to a low cost region is one with a low level of component variety which can be assembled easily and quickly into a high value, customised product close to the market. (The point of conversion of low variety components into high variety assemblies is the ‘hinge point’). The personal computer industry has recognised this strategy and manufactures high level sub assemblies in the Far East which are then assembled to specific end user orders in Europe and US.

The best option may be to transfer some of the product volume or manufacturing operations and retain some in existing locations. This is particularly attractive for assembly operations so that they can be close to market areas.

Having decided what you could transfer, the next stage considers where you should consider sourcing from. There are numerous issues to be considered here, but we will touch on 3 important ones.

There are a range of low cost regions that can be considered, all with different characteristics, strengths and weaknesses. Did you know that China has some of the lowest wage rates but a very poor logistics infrastructure, plants close to the US border in Mexico have a major problem in staff retention, you have to be prepared for low levels of literacy in Poland and that India and Columbia tie for the lowest wage costs as measured by the Big Mac index (Big Macs that can be purchased per hour of work – ref: Princeton University)

You must research the location you are considering using. Find out about its structure, culture and traditions. Recognise that you will have to learn how to do business in the chosen area – in some countries you will have to build up a personal relationship (friendship, respect and mutual trust) with suppliers before any real business relationship can be established. Talk to people who have been involved in transferring manufacturing to the location. Understand what it will take to make it work for you. And look to the medium / long term as some of today’s low cost regions may not retain that honour in the medium term.

These are two very different approaches and require careful analysis to decide which is best for a particular situation. Owned facilities (normally with a local partner) require a long term commitment and significant investment, but provide potentially better unit costs and protection of technology. The main issue with owned facilities is finding and maintaining an effective local management team.

Out-sourcing is usually quicker to set up and requires lower commitment, but it does carry a perceived risk to intellectual property and technology.

Just as you would subject a European supplier to a careful assessment of capability, so you should with one in a low cost region. In fact the assessment should be more thorough as it not quite as easy to jump on a plane to the Far East to deal with a problem as it is to get in the car and go down the road. You have to have confidence that the supply source can provide you with a quality product on time, consistently.

Having decided which products may be candidates for transfer and the supply source that provides the most attractive option for your business, you can start thinking about the new supply chain that will need to operate in this changed operation structure. The way the supply chain operates and is managed will be quite different from one that may have been characterised by local material supply, in house manufacture and assembly in one location and then shipment.

Through designing the new supply chain, you will be able to identify the changes required to your current practices and consider the impact of those changes. The re-design is also essential for the financial modelling activity that is the next stage. But don’t get into too much detail at this stage – it is the principles of operation that you need.

In designing the new supply chain, particular attention will have to be paid to:-

There are numerous cases of businesses that have transferred part of their manufacturing to a low cost region, only to find that they now have several plants that are all under-utilised and carry a major cost burden to rationalise. The role of the current facilities must be decided and the new structure used in the supply chain design.

How will the extended supply chain be managed? How will you get visibility on what is happening without the time honoured practice of walking the shop floor? Do you have the experience within the business of dealing with non-western cultures and practices? Are your information systems robust enough to cope with the new type of supply chain and the potential need for interfacing with your suppliers systems? Can those systems adapt to pull principles of replenishment?

This is the part that really determines the characteristics of the new supply chain. It starts on the demand side of the supply chain with the service level that is required. It is worth remembering that planning for a service level on delivery reliability of 100% would require infinite stock. A realistic approach is required, taking into account the responsiveness of the supply chain, the volatility of demand and therefore the probability of reasonable forecasts.

Next you have to take account of the supply side, including:-

• lead times and variances for information and/or materials to reach the supplier, for manufacture and for shipping

• order quantities. Here the concepts of economic batch quantities may still apply, driven largely by shipping costs

Once the performance parameters are known, the planning and scheduling processes can be designed in principle. These in turn will define inventory levels and requirements for the supply source.

The ability to manage the logistics – shipping, local transport, import / export, storage, etc. – will be key competencies for the new operation and the approach to logistics must be established. Fortunately, there are a number of very competent and competitive organisations that can take this on as an outsourced operation, so you do not have to build this part of the operation if you don’t want to. If you do want to retain or build this competency, then plan it carefully.

By this stage, you should be surrounded by charts, cost information, forecast volumes, quotes, guides from the countries being considered, samples of components and assemblies with 101 reasons why they can’t be transferred (black art will probably have been mentioned)….oh yes, and a memo from the CEO politely requesting a date this century when you will be getting back to him with recommendations.

It is time to evaluate the options. Firstly, you will need a supply chain model that does 2 things:-

• Models the inventory levels required to meet lead time and service level parameters
• Models the financial implications of the new supply chain. This will include the projected:-

- Savings in unit cost of manufacture

- Additional cost of operation: inventory and stockholding costs; working capital; logistics; supply chain management; systems; closure / transfer costs for current operations; etc.

- Key measures such as net margin (return on sales), return on capital employed; etc.

- Break even date when the cumulative benefits will exceed the cumulative costs

With the model, it is time to determine the projected performance for the preferred supply chain option and compare this to the current performance. You should also test the sensitivity of the projected performance to changes in the inputs: costs; service levels; etc. as this enables identification of the key performance drivers. If the preferred option does not give acceptable results, then change one driver at a time to find ways of improving benefits or reducing costs still further.

From this modelling process, and the application of a good deal of common sense to verify that the evolving option makes sense, you are in the position to put your top level transition plans together. These must be holistic, looking at the supply chain as an integrated whole, from your supplier’s supplier to your customer’s customer, and must be comprehensive so that the decisions that are made on the use of low cost sources are based on the best information available. Part way through implementation is not a good time to go to the Board with a request for increased budget due to an omission in the plan

You are now in a position to make your recommendation to your CEO. The recommendation may be one of three alternatives:-

• Yes, go ahead with the transfer as originally envisaged (and this is the likely financial impact)

• Yes, we can save money and make a better return, but by taking a different approach (and we can achieve this by transferring a different group of products / operations from the ones originally identified)

• No, the savings are more than outweighed by the additional costs and the risks to customer service (perhaps we should put our efforts and resources into improving our current operations so that we can compete effectively).

Complete the questionnaire below and then refer to the guidelines at the end of this Paper to see how ready you are to consider transferring manufacturing to a low cost region.

This is not an initiative to be taken lightly and it will be much harder than you think. Look at the example of Sony. They built up significant capacity in China but have decided to move production of camcorders that are destined for the US back to Japan. They have found that high value add products can still be best manufactured in Japan and that the supply chain is much simpler. They also have the advantage that local demand is able to absorb the capacity made available in the Chinese plant. So remember:

• Using low cost manufacturing capabilities can be highly attractive, but it is not right for every market, business and product. The opportunity for cost saving is matched by higher risks.

• Transferring operations to a low cost region will have a major impact on your business from both a financial and operational perspective, so make sure you plan and evaluate first

• Get help and advice from people who have been there, seen it and done it. This will include advice groups (e.g. DTI), other manufacturers, and consultants who have the knowledge, experience and global presence to support you