Offshoring More Costly Than Many Companies Think

Using a new finance tool, an MIT professor shows how the mismatch costs that result from extending the supply chain may well be higher than the lower cost offered by the offshore supplier, leading to reduced profits.

CAMBRIDGE, Mass. — In the last 20 years, a massive wave of companies have offshored manufacturing jobs from the U.S. and Europe to developing countries in search of lower costs. However, research by MIT Sloan School of Management Visiting Prof. Suzanne de Treville finds that it’s often more costly than companies think to offshore. Using a new finance tool, she shows how the mismatch costs that result from extending the supply chain may well be higher than the lower cost offered by the offshore supplier, leading to reduced profits.

“This research makes an important contribution to the current search for ways to encourage manufacturing in developed countries, where workers earn a living wage,” says de Treville. “The Obama administration in the U.S. and many European governments are committed to supporting local manufacturing jobs, but the perception remains — when the mismatch costs aren’t entered into the calculations — that manufacturing locally results in companies either losing money or in governments needing to subsidize. Our results show that there are a lot more options for competitive local manufacturing than most people realize.”

To explain how this works, she gives the example of a typical offshore supplier. That supplier offers a substantially lower price than a local manufacturer that produces to order. Extending the supply chain in this way increases the time between order and delivery, often to several months. As a result, the buyer must place the order based on a forecast. As the lead time gets longer, the range of demand levels that must be considered becomes wider. The order quantity must also take into consideration the possibility that actual demand will be several times the forecast. This leads to costly stock outs or overstocks, she says.

“Companies are aware of these mismatch costs, which have long been recognized as substantial. However, up until now managers have lacked a tool to calculate the mismatch cost and make a direct comparison between it and the cost reduction,” observes de Treville.

Her tool provides this missing information. Take, for example, a jacket that sells for $100. It costs $44 to manufacture locally to order, and has a salvage value of $20 if not sold during the season. The offshore manufacturer offers to make the jacket at a cost of $31, which appears to be a compelling 30% cost reduction relative to the local manufacturer. Demand for the jacket for a given style, color, and size might peak at four times forecast one time in 10. This estimate of the demand peak allows a company to roughly calculate demand-volatility exposure and thus the mismatch cost.

The tool shows that the cost differential required to compensate for that mismatch cost is around 40%, so the 30% cost differential is “far from sufficient,” she notes. “Further, this mismatch cost assumes that there is no supply risk, no loss of innovation from separating production and R&D by 12 time zones, no increase in supply-chain management costs, and no loss of intellectual property.”

De Treville says, “Managers are typically amazed by how much money is being left on the table with distant manufacturing. This $44 local manufacturing cost is often enough to pay a middle-class manufacturing wage to workers. Our results help managers know where local manufacturing makes sense, and to regain their hope that local manufacturing is a realistic option. This information is also useful to policymakers in developed countries, as it provides support for local manufacturing and the middle-class jobs it can create.”

Suzanne de Treville is a visiting professor at the MIT Sloan School of Management from the University of Lausanne.

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