Calculating the true cost of production and profit of our product lines can be complicated in diversified businesses. A business plan that demonstrates that one product line should be moved overseas can trigger a cascade of products moving overseas, and the true profitability comes into question.
The topic of U.S. business migrating overseas to countries exercising dubious fair trade practices, and the U.S. public resurrecting an interest in “buying American” has been at the heart of many interesting discussions and articles this year. At the same time, U.S. industry still struggles to reduce overheads and remain “in the black” while competing with industry in lower-cost countries. As much as it may not be appealing to consider moving production overseas, for some of us it might seem like there is little choice.
I would like to offer up one case study, based on my own observations, as well as those of friends and colleagues, that might provide some insight into oversights or miscalculations that occur when making the assessment and decision to move production overseas. Because one business experienced what I will describe, it does not mean that all businesses do, but the trap was so easy to fall into, and so difficult to stop, that I suspect it may be more common than businesses would like to admit.
Imagine a business that manufactures consumer products that are sold, primarily, through retail stores and also through specialty stores and service providers. Some products are relatively low-volume for specialty markets and others are produced and sold on a scale of 120,000 units a day. It’s a healthy business, typical of many U.S. corporations in its behavior and practices, and it competes with others in the same market.
At the time this case study story begins, production takes place in a handful of U.S. manufacturing facilities, and two or three sizeable plants in Mexico. Recent experiments in outsourcing and production to Chinese plants have provided some confidence that production in China is viable and potentially profitable. (We are going back six or eight years in time here, but I observe that some of the challenges still occur as businesses engage overseas production partners.)
Recent consolidations in the product portfolio and some minor design updates drove an increase in demand and volume for what was already the highest-volume product. A business assessment and plan demonstrated that sharing production of the product line between Mexico, where it was already produced, and China, would enable the necessary increase in production volume and also open up margins slightly. It was a very compelling proposal and it was accepted.
Risks were assessed and a migration plan was assembled and, over a time period of about a year, production began in China, then increased in China, and eventually reduced in Mexico. Meanwhile, one of the U.S. plants was still producing the short-order, low volume, high-mix or high-complexity orders that are difficult to satisfy from plants where high-volume, highly-standardized production processes were the focus and international borders and customs, not to mention shipping times over the Pacific, slowed down delivery.
The plan accounted for and calculated the increase in product inventory and shipping costs because of transportation across the Pacific and the risk mitigation plan accounted for and expected some production delivery and quality challenges as the bugs of the new system and relationships were worked out. I believe it even attempted to account for customer perceptions concerning the “made in China” label on the box for a product where some of the consumers and specialty services still valued “made in America.”
It was a fairly solid and well-advised plan, as far as such business strategies go, and as the bugs of the system were worked through, it proved to be very viable. I’m not convinced that it proved to be as profitable as the business plan predicted, but it was profitable enough that it was not regretted or second-guessed. Actually, I believe the fact that it fell slightly short of the profitability expected caused some of the phenomenon we are about to reveal and discuss in an effort to re-capture some of the profits missed.
It was a good plan, but there were a number of events that unfolded that were not considered or predicted by the plan, nor do I think that one would necessarily expect them to be unless the planners had experienced them before. This is why I want to share them here, so we can all get a glimpse and see if the same phenomena might not be triggered by our own adjustments in business strategy.
Once production in China had ramped up, the plant in Mexico, with its somewhat reduced contribution to production volumes began to leverage for more work. There is a popular metric among corporate businesses that is used to assess the efficiency of various production facilities called “Utilization.” With the reduced output from the Mexico plant, the Utilization metric for that plant had fallen off. They wanted their number back, and the corporate leaders also expected better numbers.
Without going through the details and arguments, the U.S. plant fulfilling the specialty-order elements of the product line lost its production as that too was moved to Mexico. That wasn’t enough, though to re-set the Mexico plant’s Utilization and they continued to leverage for more.
The U.S. plant specialized in production of high-complexity, difficult assembly products and product elements. It left the higher-volume, highly standardized production to Mexico, and now China. However, there was one product line that had over the years, become un-profitable.
This product was of extreme complexity and difficulty to produce, and two versions of it were produced and sold under two brand names owned by the business. It pulled through other, more profitable product sales so it was still determined to be necessary. The business needed it to be profitably produced again.
An engineering re-design enabled the two branded elements to be produced on the same manufacturing line, which dramatically reduced production costs. It also made it easier to move the product to Mexico as production of various products shifted around from one plant to another as plants competed for more work and better utilization numbers and product managers strove to increase margins for their product lines.
Here is where the unpredicted phenomenon becomes apparent and also unstoppable. The plant in the U.S. has now lost two production lines to Mexico. As much as the workforce was reduced, the general overhead for the plant didn’t change very much. That overhead was now allocated to the remaining product lines produced at the U.S. plant. Do you see where this is going?
Pretty soon, the solution to improving margins and reducing the cost of production for the lines in the U.S. plant was to move them to Mexico. Every time one product was moved, the remaining ones suddenly became more expensive to produce because of their increased share in the overhead and became candidates for migration. By the way, the same phenomenon was happening between the Mexico plants and the Chinese plants as the Chinese manufacturers demonstrated increased capability.
Here’s the mistake in the business plan. The allocation of overhead to each product line that moved suddenly improved, but the overhead itself was still there! It didn’t change except for a miniscule amount as a few people changed and labor costs were reduced. The business still had basically the same amount of overhead, but the product lines themselves appeared to be more profitable.
Now, let’s observe the other phenomena that weren’t considered part of the plan, the part that is an oversight perhaps no one could be expected to predict. Returned product became a noticeable drain. Not all returns were a result of necessarily defective product and could be re-packaged and re-used. Unfortunately, all returned product had to be sent to Mexico for allocation, since none of the U.S. plants handled the products any more, and China was too far away. Also unfortunately, because of trade disagreements between China and Mexico, products produced in China, could not be re-packaged or re-used in Mexico, they had to be recycled or scrapped.
I estimated once that the business could have saved between ½ and 1-million dollars a year by simply scrapping returned product at the retail stores and never shipping them to Mexico. For various reasons, my proposal was not carried out.
Inventory levels for migrated products increased more than predicted. In part it was a mitigation plan for the fact that special-order elements were no longer built to order but had to be built when production schedules of high-volume stuff would allow. In part it was to provide a buffer for the extended shipping times from producers to distributors and customers.
What’s more, those inventories started to bite in bigger ways than just by freezing potential cash. Inventory from China cannot be stored in Mexico (practically) so Chinese inventory typically was consumed first, before Mexico inventory. However, there are tax penalties in Mexico for keeping inventory too long. The business began disposing of unused inventory to avoid penalties, or paying penalties. I know that wasn’t part of the plan.
It got worse when sales volumes dropped starting in 2008, along with most consumer sales. Suddenly the volumes that justified the overseas solution no longer occurred, but the overhead still did.
Today, some of the U.S. facilities the company once operated are closed. Some are nearly empty and still on the books because it would cost more to close them than to keep them (closing a plant is not always a simple thing). It has become standard for the business to begin production of new products in either Mexico or China, because there is little choice. The skills and capital to manufacture something in the U.S., for this business, is virtually gone.
I’m offering only a taste of the logistical, brand perception, and quality perception challenges that occurred as a result migrating production to Mexico and China. There were many more.
I won’t say that engaging China to manufacture product was a bad idea, or that it was wrong for this company. I am saying, though, that not all of the costs of doing so were accounted and the long-term impact to the business of a singular decision to move a single product was not perceived or considered. I know that the profitability that was expected was not achieved because of the unperceived costs and desire to realize that missed profitability perpetuated or drove the continued migration and the exacerbation of the uncalculated costs.
I often wondered if it would be possible to untangle all of the complex interactions and effects and reverse engineer the business strategy to see if it was truly profitable, or if continued production in the U.S. might have been practical and profitable. I was discouraged from trying. The decisions had been made, they weren’t reversible, and it wouldn’t do to try and find fault.
If your business is exploring options to remain “in the black” and taking production overseas is one of those options, take some lessons from the case study I offered. Make sure that the examination of the costs and benefits of overseas production includes the back-end of the product life cycle, including returns and disposition. Also, make sure that your plan considers possible reductions in volume as well as business growth.
If your business experiences competition between manufacturing plants for metrics and work, and/or divides product line responsibility between product managers, then it will be especially prone to business plans and proposals that look very good for a product line, but fail to account for how those decisions will affect other product lines. Be sure that business plans, proposals, and strategies account for the whole business impact and not just how one product line will benefit.
Also, competition between product lines and plants makes a business especially vulnerable to the cascade effect I described. Once one product migrates overseas it might be all but impossible to close the spill gate and prevent every product from following suit. It can be a one-way movement for the entire business with little or no chance of ever returning.
We must do what is right for our businesses, our employees, our communities, and our shareholders. Sometimes that might mean migrating a product or a few products to lower-cost regions. If we must, we must. Be aware of the un-predicted, and un-perceived challenges, expenses, behaviors, and phenomena that result from those business decisions. Do not make the decision without calculating those impacts on the long-term vision and profit plan. Let the tale above help you consider the decision with greater wisdom.
Stay wise, friends.