Cadalyst MCAD Tech News #122 (June 3, 2004)

2 Jun, 2004 By: Joe Greco

In the previous issue of this newsletter, I explored some of the effects that overseas outsourcing is having on workers in industrialized nations. Unemployment is not just a statistic--it causes major disruptions in the lives of those affected by it.

In this issue, I'll explore many of the frequently overlooked problems that outsourcing causes for the corporation it's supposed to benefit. This was going to be the last part of this outsourcing series, but there was so much material that I decided to move the final topic, how to be competitive without overseas outsourcing, to the next newsletter.

I had trouble deciding who I should address this article to: employees or upper management or investors. So I decided to make it as general as possible. If you're employed in manufacturing and fear that your job is being considered for outsourcing by upper management, I hope that you can take the information presented here and use it to make your point. If you are in upper management and worry that your small or midsized company will suffer because the multinational corporation you supply to is considering overseas outsourcing, by all means use this piece if it helps your cause. Investors who think a company that outsources much of its work to cheap labor markets is making the wise choice and is therefore a sound investment may want to rethink that strategy in light of the points outlined here.

QUALITY
Many of the goods produced overseas are of acceptable quality, but when problems do occur they can be disastrous simply because of the distances involved. Oversight is more difficult, so many problems don't get noticed until later in the manufacturing or assembly process. In addition, can you be sure ISO 9001 standards are being followed? Are revision histories being kept? Is data backed up and properly secured? Collaborative software helps with some of these issues, but how much time will you spend making in-person visits to ensure that both foreseen and unforeseen disasters are not just right around the corner?

Having production half a world away also makes you less responsive and flexible to customer requests. This becomes a quality issue not in terms of manufacturing (geometrical tolerances, etc.) but in terms of design quality--the robustness and usefulness of your product.

NEGATIVE PRESS
With more media outlets paying attention to outsourcing, a company's decision to move jobs overseas may generate a fair share of negative publicity. For instance, every weeknight CNN's Lou Dobbs has a segment called Exporting America, in which he lists companies known to be exporting well-paying jobs overseas. Public backlash does seem to help from time to time--when a strike was recently settled between SBC Communications and the CWA (Communications Workers of America) union, one of the reasons cited was that SBC felt that public opinion wasn't on its side. A condition of the settlement requires SBC to bring back some of its 3,000 technical support jobs that have gone overseas.

A related issue is the morale of the workers who remain. When employees feel that no matter how hard they work, their job seems doomed, they will probably lose interest in that job and/or seek employment elsewhere. Having half your workforce disgruntled and other half searching the Help Wanted ads is not the way to increase productivity.

GAINING TIME, LOSING EVERYTHING ELSE
Time differences are frequently thought of as a positive by manufacturers looking to outsource because now production can take place around the clock. Though powerful collaboration programs make this possible, there is still the issue of getting immediate answers when your overseas supplier is twelve time zones away. Other barriers, such as language differences, can result in poor communications, design errors, and unsatisfactory support. In fact, Dell recently returned some tech support jobs because of customer complaints. Most people I've spoken with in the product development business believe that in many instances round-the-clock productivity gains are quickly lost to increased time spent supervising and communicating, as well as fixing problems due to the lack thereof.

As a matter of fact, many overseas suppliers don't provide technical assistance because of these problems. If they did, the expense would make their price advantage evaporate. In addition, many suppliers in industrialized nations provide free engineering advice and design services to designers in the hope of getting the manufacturing job. However, when they see that the production will not be coming to them, they are forced to charge for design and engineering services. When this happens, the design fees can offset much of the perceived savings from outsourcing the manufacturing. Last year, Jay Dunwell, president of Wolverine Coil Spring, gave testimony before a special manufacturing panel of Congress about this very issue.

Also sometimes overlooked is how outsourcing kills your long-term relationships with suppliers. An enormous amount of value comes from working with someone you fully trust and who understands your problems. That security and knowledge is lost the moment the outsourcing decision is made. Also, the credit history that allowed you to make payments on a 30-or 60-day line of credit has to be re-established, and until (and if) it is, the new terms may be COD or wire transfer. What will these upfront payments cost you over time, especially compared with holding on to your money for a month or two longer?

FUZZY MATH
Sometimes when cost analysis is run on the financial "benefits" of overseas outsourcing, what's lacking is something accountants call activity-based accounting. This means expenses that are really variable are treated as fixed and semi-fixed costs.

For instance, let's say you discover that you can manufacture a product that costs you one dollar domestically for only 90 cents overseas. However, when its manufacturing moves abroad, your machinery is still used for other production, even if the volume may be less. If you currently allocate 15 cents per unit for equipment maintenance, that 10-cents-per-unit savings actually becomes a cost increase of five cents--in short, 5% more than if you had done nothing. Another way to look at it is if you move 30% of manufacturing operations overseas, your maintenance costs won't go down by 30%. They may actually rise. In addition, you risk losing money because shared resources are underutilized when processes such as material handling, packaging, and distribution are no longer co-located with manufacturing.

SHIPPING AND INVENTORY
Of course, most companies considering outsourcing manufacturing operations overseas have examined the increased cost of shipping, but what about other related costs? For example, most nonindustrialized nations don't have the same air transportation network as a developed country. This means while the goods may be manufactured in a fairly large city, it may not have an airport, which means your products must travel along substandard roads or on waterways, adding unseen shipping costs and delays.

Outsourcers argue that while shipping times are greater, as long as a consistent number of days can be figured in, potential problems will be minimal. The problem is that the further away something is produced, the more hands have to touch it. That leads to variability in shipping times. In addition, not only do increased security delays have be factored in, but they too are variable. The random screening of packages makes it impossible to predict which orders will be delayed at the port of departure or entry.

All these delays result in higher inventories, which also costs you money. Though low interest rates make inventory a minor problem, rates are rising and will continue to do so in the future. This issue of higher future costs was not considered by many companies who started outsourcing in the late 1990s when oil was $10 a barrel, but now they are getting hit with huge energy costs related to shipping.

Many companies have the goal of reducing their product development cycle, but longer delivery times mean that time may have to be made up elsewhere, which can cause problems. For instance, you may need to commit to starting manufacturing before sales forecasts are complete, leading to under- or over production.

CULTURAL DIFFERENCES
Cultural issues also play a part in international shipping. For instance, the Chinese New Year can delay shipment of products for weeks. Various licenses and permits may be needed for political and cultural reasons that you would never anticipate. In addition, those with experience in this area have told me about the rampant government corruption that sometimes occurs overseas, making the acquisition of such certificates much harder and more costly.

When outsourcing, cultural differences are often considered, but not fully understood. For example, negotiating styles and commercial habits differ. In some cultures, there is a reluctance to provide all the information if it appears that the project's objectives will not be met.

ISSUES AROUND THE CORNER
We talked about future price increases not being factored into cost "savings" projections. For companies that follow the lowest labor costs, betting that wages will always be low in a particular country is another example of a false projection. No matter where the jobs go, when they leave industrialized countries, domestic suppliers cut back to try to compete. Eventually, the experienced staff that provides expertise that designers require may be reduced or eliminated. In the worst case, perhaps the designers themselves will be outsourced, which is actually already happening. If this continues, when multinational manufacturing companies realize that even in their warped reality some design work needs to be located domestically, they may find only a small talent pool to draw from. This will be amplified if students continue to turn away from design and engineering for fear of not finding a job--because of outsourcing.

As less and less design and manufacturing is done here, national security may also be affected. When Magnequench, the producers of rare-earth magnets essential to the building of guidance systems, closes its doors in Indiana and moves to China, I call that a national security issue ( and http://nwitimes.com/articles/2003/09/30/business/business/9f898fd15142a5dc86256db00077cc88.txt).

Potential political instability in certain countries also must be considered. Following cheap labor to a country that could erupt in civil war may not be the best long-term strategy. Also, moving production to small countries with cheap labor may seem to make some financial sense today, but in a few years, valuable land and domestic resources may become dramatically limited, eventually raising the very costs that the move was supposed to control. One of the reasons Honda moved some of its production to the United States years ago was limited real estate and natural resources in Japan. In addition, developing countries generally don't have the core manufacturing centers that are found in industrialized countries, such as Research Triangle Park in North Carolina or Silicon Valley in California--centers that can really spark innovative business development.

Favorable exchange rates in certain countries may make outsourcing appear attractive, but future fluctuation can cause problems. For example, many of those goods manufactured in China are imported so cheaply because the Chinese government has fixed the value of its currency, the Yuan. Because of this, most economists believe that it is overvalued by as much as 40% and there is a demand for a change. Not only does this currency fixing fuel the United States' increasing trade deficit with China, but it also puts stress on their economy, including destabilizing their banking system. It's also causing the price of goods to rise. One way or another, the flood of cheap goods coming from China may become a trickle, making it much less attractive to set up manufacturing operations there. Whether all this will happen remains to be seen, but it's just another example of a factor that you can't control when you outsource production overseas. In addition, new tariffs and taxes are other unpredictable events that can make your outsourced goods suddenly not so financially attractive to the consumers they are designed to appeal to.

STEALING OF INTELLECTUAL PROPERTY
This is perhaps the most important issue from a financial standpoint, so I saved it for last. A story on "60 Minutes II" back in January asked the question: "Once the Chinese know how to make an American product, what's to stop them from copying it? The answer? Nothing at all". As companies such as Nike, Callaway, and others have discovered, intellectual property doesn't mean much in many overseas countries. In addition, when something does happen, your legal recourse may be minimal.

CAD software companies are rightfully concerned about the large amount of software piracy that goes on overseas, but they should be equally concerned about the way their software is sometimes used to reverse engineer these products.

Perhaps what's needed is an industry agreement to not sell software to overseas producers that don't respect the patents of the products they manufacture. If they are not respecting that intellectual property, they are probably not respecting the software copyright. The agreement should also extend to individual companies that tilt the playing field by not following fair labor, wage, and environmental standards.

THINK ABOUT IT
Considering everything reviewed above, are there any good reasons to outsource? If so, I'd like to hear them.

The chart that will be included when this article appears online in a few days will provide a good summary of the issues discussed here. In short, before making an outsourcing move, consider all the issues--don't just make a knee-jerk decision. Finally, look for my next newsletter, which will talk about ways to keep jobs in the industrialized countries.