Suppliers Must Reposition Value Proposition

March 19, 2010
The days of sourcing everything in your own backyard are over as 82% of respondents to a Grant Thornton survey indicated that some portion of their supply chain is purchased internationally, up from 77% last year.

Outsourcing, off shoring, near shoring, what does it all mean? Is U.S. manufacturing being summarily dismantled and only to be rebuilt in China or India? The answers to these questions are complex and don't lend themselves to readymade sound bites. A recent survey conducted by Grant Thornton suggests that while China tries to meet demand for its own burgeoning market, it will continue to dominate as an origin for exports of manufactured goods. But that is only part of the story as suppliers reposition their value proposition amid evolving manufacturing and sourcing strategies.

For sure, the days of sourcing everything in your own backyard are over as 82% of respondents to a Grant Thornton survey indicated that some portion of their supply chain is purchased internationally, up from 77% last year. China remains the front-runner choice, with 28% sourcing from that country, up from 22% last year. What was the most interesting is only half of the firms surveyed (49%) have found international sourcing to produce a positive ROI.

This begs the question, why did the other half not find international sourcing to be profitable? Three possible reasons come to mind.

  • First, fluctuating fuel (transportation) and raw material prices increase risk of the return on investment. This risk exists even before production starts as these cost factors can change during the product planning and launch phases as well.
  • Second, quality and delivery can still be an issue. Companies are recognizing that supply chain reliability and agility are of growing importance to their business. Real costs are incurred when the supply chain breaks down or fails to function as intended. Recovery from offshore quality and delivery issues involves deploying resources overseas to fix the problem and can involve expensive air freight costs to refill pipelines.
  • Third, firms have varied levels of sophistication with regard to their sourcing criteria, approach and cost modeling. A more nuanced approach is being employed with increasing regularity in some industries though. In fact, the general trend toward using Far East manufacturing or other "low cost countries" to source the preponderance of components is being tempered by a need to provide local presence in each market. For example, more than ever before, automakers are designing and manufacturing global products yet sourcing remains "regional" through larger global suppliers.

As industries place greater importance on flexibility and an ability to react to market changes, suppliers and their supply chains will need to become more focused on supporting local operations. Thus, a migration toward globally sourcing into multiple lower cost regions can support a positive ROI while mitigating risk.

As companies begin to design and manufacture global products allowing for this regional approach to sourcing is key. Returning to the automotive example above, each of the major regional markets is structured to leverage the cost arbitrage compared to the home market. Three examples are cited below.

  • North America -- Mexico continues to dominate what would be considered the "low cost country of choice" for N.A. manufacturing. While Asia Pacific operations have increased their exports substantially over the past 5 years, Grant Thornton's analysis in the automotive space shows that the sheer number of plants and SKUs supplied by Asia Pacific operations is substantially less than Mexico. On average, Mexico operations supply more than three times as many SKUs from 50% more plants.
  • Europe -- Central/Eastern European countries such as Hungary, Poland, Russia and the Czech Republic continue to be the locations of choice for Western European manufacturing from both a plant and SKU perspective with supply percentages even greater than Mexico's support of North America.
  • Asia Pacific -- The Asia Pacific regional low cost sourcing is being dominated by China, India, Vietnam, Thailand and the Philippines. In fact, inland China is being employed as a low cost source for coastal manufacturing sites.

This sourcing approach incorporates other factors into the equation beyond the traditional definition of a total landed cost. In addition to quantifiable costs (component price including labor, overhead as well as international freight, import duties, special packaging, import-export costs, etc.) that companies evaluate when making a product sourcing decision, many companies are also quantifying supply chain risks associated with a particular region and/or country. These risk factors include but are not limited to:

  • Currency stability
  • Infrastructure needs
  • Inventory pipeline needs
  • Legislative framework and I/P protection
  • Management and workforce skills & capabilities
  • Political and/or societal stability
  • Quality control
  • Related industry or customer demand to spur and maintain competition
  • Reverse logistics requirements

When many of these factors are actually quantified in a sourcing decision, the incremental savings from sourcing to a higher risk region or country is often eliminated (especially when the principle benefit is labor arbitrage). For example, sourcing a product in Mexico versus the United States is very attractive as the wage difference between a typical U.S. worker and a Mexican worker is considerable (approx. $13/hr). The savings from the labor variance alone can often overshadow other cost considerations and risk factors. However, the labor rate difference between China and Mexico is not nearly as great (approx. $2/hr). Thus, when determining a non-domestic source for a particular component the other cost and risk factors have a growing importance as a criterion.

So what about those firms that aren't seeing a positive ROI from an international sourcing decision? Will they move product back to the home market or re-source it to a regional low cost country? In most cases the answer is no. Firms that have swung the sourcing pendulum too far in one direction will not move or re-source mass quantities of product back into a particular region -- it is costly and fraught with risk. What is a more likely scenario is they will revisit sourcing decisions on a case-by-case basis when a logical sourcing change can be made such as a new product introduction or for an engineering change.

So while China will continue to be a dominant player for manufactured goods, Mexico and Central/Eastern Europe will remain long-term partners and benefactors for their respective regions. For these reasons, we see this regional sourcing model continuing for the foreseeable future as manufacturers in mature markets leverage local international sources for cost competitiveness and market flexibility. What will be different is that these supplier firms will have a decidedly global footprint that mirrors their customer needs. Other firms will elect to reposition themselves as Tier 2 suppliers rather than scaling up to compete with these global Tier 1 suppliers.

James Ricci is a Director with Grant Thorton's Manufacturing Transaction Services group in Detroit and a Certified Supply Chain Professional. He assists companies with operational performance improvement and regularly consults on distressed and turnaround matters for manufacturing firms.

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