The Five Hidden Costs of Offshoring Eliminated by Onshoring

The Five Hidden Costs
of Offshoring Eliminated by Onshoring

Executive Summary 1
The Hidden Cost of Crossing Borders 3
The Hidden Cost of Supplier Selection 5
The Hidden Cost of Contract Management 8
The Hidden Cost of Time 12
The Hidden Cost of Geopolitical Risk 14
Cost Elimination Through a Domestic Approach 16
Conclusion 18
Content

Executive Summary
Situation:
In the 1990’s worldwide electronics manufacturingmarket share
migrated to low cost regions, China in particular. Today 84% of PCB
manufacturing is done in Asia. But labor typically accounts for less
than 5% of product cost, and Chinese labor costs are rising at a faster
than expected rate of 15% per year, both factors contributing to a
reassessment of offshoring.
“We expect net labor costs for manufacturing in China and the U.S. to
converge by around 2015,” said Boston Consulting Group’s Harold
Sirkin. “As a result of the changing economics, you’re going to see a lot
more products ‘Made in the USA’ in the next five years.”
More companies havemoved their supply chains back into U.S.
borders due to low returns and the overwhelming complexity of
offshore operations. A recent report by the Boston Consulting Group
predicts rising wages in China -- along with a host of other factors,
including an appreciating yuan and the logistical problems of doing
business in China -- will usher in a “manufacturing renaissance” in the
U.S. over the next five years.
Problem:
When a company decides to offshore its supply chain, it is relatively
easy to assess direct costs, which are typically 15-17% of product
cost. But companies are often caught off guard by hidden costs,
which typically add 5-7% to product cost. Moving a supply chain
abroad complicates a company’s ability to manage its supply chain
dynamically and increases risks, such as intellectual property theft,
underperformance by a vendor, or a disparity between what is
negotiated and delivered. Most OEM’s choose to ignore China’s willful
environmental, labor and currency abuses. Accurate communication
(including language and cultural barriers), an understanding of the host
country’s laws and regulations, and setting up reliable management
infrastructure are all costly operations. According to leading consulting
firm Accenture:
LABOR
RATES
Costs
Hidden Costs
1
www.optimumdesign.com

Executive Summary
Many manufacturing companies that shifted production offshore “likely
did so without a complete understanding of the ‘total costs,’ and thus,
the total cost of offshoring was considerably higher than initially thought.
Part of the issue is that not all costs of offshoring roll up directly to
manufacturing; rather, they impact many areas of the enterprise.”
Overlooking or underestimating hidden costs and associated risk leads
to poor decisions.Where labor is a small portion of product cost, the
hidden costs can actually be greater than the expected labor savings.
Solution:
While a significant amount of literature dedicates itself to helping
companies manage offshore operations, solutions are often vague
and esoteric, and certainly do not guarantee cost savings or quality
improvement. Sourcing domestically or locally, on the other hand,
offers simple options that eliminate hidden costs completely, while
granting a company easy power to fix problems and make changes.
Having surveyed 287 manufacturing companies, Accenture found that
61 percent are considering moving some of their manufacturing back to
their home market. Ferreira and Heilala describe this as being a “secret
shift” and a “quiet trend.”
This paper examines five key areas of hidden cost driving many
companies to conclude that modern, efficientmanufacturing and
supply chain management are best conducted near the point of use.
“Based on Total
Cost of Ownership,
40% of American
companies have a
cost disadvantage
importing goods
from China instead
of making them
here.”
2
- According to economist Alan Beaulieu, U.S. Labor costs have
remained consistent since 2000, while China’s labor costs have risen
250%.

The Five Hidden Costs of
Crossing Borders
The Hidden Cost of Crossing
Borders
Direct costs include freight and duties. The direct cost of freight and
duties depends on many variables (the product’s type, weight, distance,
and amount) but only one variable dramatically affects the price of
overseas shipping: distance. Accordingly, shipping from China and
other East Asian countries can be expensive in both time and money. But
other costs are hidden and often not accounted for when evaluating
cross border costs:
Inventory pipeline
The lowest cost offshore sourcing models consolidate freight
shipments to lower logistics costs. This can drive unexpected delays
and often the contractor has limited ability to control delays at the
freight forwarder. Some products can be densely packed and
shipped via air at similar costs, but most products see significant cost
increases if shipped by air. Sea shipments add significant time to the
pipeline. The result is a need to carry higher levels of finished goods
inventory ‘just in case.’ Additionally, customs regulations in countries
such as China drive more frequent reconciliation of raw material
inventory with each customer than typically done in U.S. contractor
business models. This may drive higher working capital requirements.
Finally, engineering change orders can add further cost, if product
shipped before the change was implemented must be re-worked or
scrapped.
Warehousing
Is a warehouse needed? At some point in the manufacturing process
inventory must be stored awaiting sufficient volume to ship
economically. Whether a firm bears the cost indirectly through a
contract manufacturer, or pays the cost outright, warehousing cost is
inevitable.
3
1

Separation of U.S. and Foreign Products
If country content must be tracked a company will incur extra
administrative costs. This requires more work in tracking, sorting,
accurate documentation, and investment in appropriate software/
hardware to accomplish the tasks.
Import Restrictions
Accurate recordkeeping and a solid understanding of documentation
needed for U.S. Customs and Border Protection (CBP), and trade
agreements--such as The North American Free Trade Agreement
(NAFTA)--is necessary to avoid penalties and fines. In 2007, Ford
Motor Co. faced a $42 million dollar lawsuit from U.S. Customs for
insufficient records on their imports. Keeping documentation on
import-export insurance is also critical in the event of a claim.
Tariffs
Are your imports subject to special tariffs? A company must be clear
about foreign and domestic rules, especially as they vary from border
to border and are subject to change.
Travel & Staff
For travel expenses a company should account for the following: trips
per year, average stay duration, price of airfare, and room and board.
This does not include the salary of the dedicated employee, who must
cope with language and cultural barriers, and on whom a company
must rely to make accurate decisions and assessments, especially
while selecting and managing vendors.
EXPENSES
Crossing Borders
4
1

2 The Five Hidden Costs of
Supplier Selection
The Hidden Cost of Supplier
Selection
Selecting the offshoring partner is the most critical step in an
outsourcing plan. It requires significant time from qualified people to
have a successful outcome. Supplier selection typically adds 1% to the
actual cost of the product.
Bounded strategic decisions
Selecting an appropriate CM is a lengthy and complicated process that
bearsmany risks. Direct selection costs include: documenting
requirements, sending out requests for proposal (RFPs), evaluating the
responses, and negotiating a contract. This requires either training or
hiring a staff with proper knowledge and oversight skills, as well as
paying their travel expenses.Whether a company decides to hire an
offshore consultant or execute these tasks themselves,CM selection is
a delicate process that takes considerable time and planning. Risks
and costs associated with poor supplier selection aremagnified when
offshoring. The hidden risks include:
Inaccurate Proposals
A failure to account for cross cultural assessment of bounded variables
presents risks. Disparities between requirements as understood by a
vendor and what is meant by the customer are common. A foreign
CM may have false or incomplete perceptions of what they bid on due
to poor estimates, misunderstood specifications, language barriers,
and overall miscommunication.
5

Bid Abandonment
CM’s willingness to honor original bid’s varies by culture. Companies,
of course, seek CMs with the best deal. This results in a tendency
toward adverse selection of the CM most likely to have made an error.
Often, the CM is unwilling to honor a deal’s original price and structure.
Costs appear when an unhonored deal must be renegotiated or
terminated, and tensions between client and CM may rise.
Inadequate Infrastructure
China’s outsourcing infrastructure, while robust especially compared
to India, is built for high volume manufacturing. Mid and low volume
projects are typically done at smaller shops that primarily serve
as consignment subcontractors to the large EMS companies. As
a result, there is inadequate supply chain infrastructure for small to
mid range projects. China’s physical infrastructure is a work in
progress and must be assessed carefully by specific region. For
example, China has 20% of the world’s population but just 5% of the
world’s roads. China’s per capita water availability is about one-third
of what’s available to the rest of the world. With rapid growth and
industrialization, the country needs to come up with a way to increase
its water supply.
Misunderstood government laws and regulations
China is complex and often lacks predictability in its business
environment. China’s current legal and regulatory system can be
opaque, inconsistent, and arbitrary as well as constantly changing.
Implementation of Chinese law is also inconsistent. If you are not
intimately familiar with Chinese regulations for operating in China,
chances are your company will be out of Chinese compliance. And
lack of compliance with Chinese laws and regulations can be very
costly. According to the American Chinese Chamber of Commerce
(AmCham) 2010 report, China’s regulatory environment has become
the most problematic business challenge.
20%
5%
OF WORLS’S ROADS
Supplier Selection
6
2

Supplier Selection
Cultural clash
One of the least understood elements of supplier selection is a
mutual effort to overcome cultural variations. Though both parties
in a communication may be fluent in English, their use of words and
concepts may vary considerably. In Asia “yes” can simply be an
acknowledgement they heard the question, and “no” is often so
indirect an American fails to perceive it. U.S. culture places a high
value on time, Asian cultures tend not to. Both parties need to be
skilled in overcoming basic cultural expectations.
Accounting for Working Conditions
Improvements in worker safety and wages have increased the cost of
manufacturing in America. In contrast, China possesses lower
standards of safety and lower wages resulting in seemingly low
manufacturing costs. Too often companies ignore both the economic
cost and ethical implication of these lower standards
2
500
Protests
Daily
7
2011 daily average, Landesa
Survey

The Hidden Cost of Contract
Management
Managing an offshore CM, as well as their behavior, is one of the most
difficult and risky tasks for a company. Again, this endeavor requires
dedicated and skilled staffers who can maintain oversight, conduct
audits, and negotiate schedules. CM contracts are a major source of
company risk, including off balance sheet risk. It goes without saying
that a failed relationship with a vendor is costly in dollars, time, and
company resources. Contract Management issues, including quality,
travel, communications, and related factors typically contributes 7% to
product cost, but are rarely accounted for:
Enforceability of Contracts
Many portions of US contracts are not enforceable outside the US.
For example, a non-compete clause may do nothing to stop a
supplier from using a company’s tooling and equipment to develop
competing products. In China, contracts should be written in Chinese,
because the Chinese contract controls the relationship. It does not
matter what the English version says. One cannot stress enough the
difficulty in translating contracts into Chinese. It requires recognized
Chinese legal experts who speak and write Chinese at a native level to
properly construct a viable contract with a Chinese supplier. Even then,
enforcement may still be an issue.
Quality
In general, having on-site personnel or qualified third-party
inspectors/auditors to control quality is crucial. Over time, controlling
quality may become an arduous task. A supplier’s business may serve
an increased number of customers, making it more difficult to monitor
quality. In addition, suppliers may also change (without any notice) the
process by which they produce, affecting quality. Inspecting all
products before shipment is crucial. Quality defects alone can run
between 1% and 8% of product cost.
3
CONTRACT
The Hidden Costs of
Contract Management
8

The Hidden Costs of
Contract Management
Sub-Tier Supplier Management
Regardless of what the contract says, visibility into the 2nd and 3rd
tier suppliers is difficult to obtain and these suppliers are frequently
changed without notice. Ensuring quality and performance of an
unseen supply chain is difficult.
Intellectual Property
Protection of intellectual property is weak to non-existent. Even
though China has joined the WTO and agrees to abide by all world
organizational rules, in reality many laws are violated. Copyright laws
in particular are not enforced, and piracy of trademarked and
copyrighted goods is ubiquitous. Many companies will not produce
their product in Asia because they cannot protect the proprietary,
patented, or intellectual properties of a product or its manufacturing
process.
Technology Transfer
Closely related to attitudes and laws regarding intellectual property
is the use of physical assets (i.e. fixtures or molds) to subsidize a
competitors product. What a US company views as proprietary
physical assets, the CM may view as an underutilized resource that
can help it win additional business.
Miscommunication
Wage inflation in the most popular manufacturing zones often
leaves margin-challenged CM’s with limited choices for program
managers and engineers possessing the required English language
competencies. The end result can be language fluency-driven or
culture-driven communications errors, as well as a requirement for
greater travel by the U.S. project team. In a project with frequent
engineering changes, schedule variability or complex quality
requirements, mistakes can be costly.
Conflict Avoidance
Most offshore teams speak English as a second language and many
come from cultures where disagreement is considered rude. Fluency
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The Hidden Costs of
Contract Management
in multiple languages is valued and admitting that an instruction in
English wasn’t understood can cause embarrassment. In cultures
where it is rude to argue, when a project member doesn’t agree with a
customer’s request, it simply doesn’t get done.
Changes
Inevitably, changes occur in business needs and requirements. How
change is managed can vary considerably. In the US, adoption
to change is anticipated and usually covered by contract. In Asia,
adoption to change is often governed by relationship.
Underperformance
Given the potential for misunderstanding and the conflict avoidance
culture prevalent in China, often the first sign of a deteriorating
relationship is underperformance of commitments. Deliberate
underperformance can be difficult to diagnose, but any material
underperformance can quickly become a major problem given the
difficulty in changing an offshore CM relationship.
Low Ethical Standards
Offshore operations may operate with a culture of low ethical
standards, which is extremely difficult to assess. Low ethics can
compromise end customers, employees, and put the company at
financial risk.
Local Espionage Laws
China’s laws on industrial espionage provide authorities wide
discretion in deciding who to charge with espionage. Often, economic
and industrial data is considered to be state secrets. Without expert
advice and close cooperation with the government, unwittingly
violating these laws is possible.
Local Labor Law Compliance
China has many laws governing the treatment of workers, such as
minimum-wage laws and laws governing overtime and overtime pay.
As some U.S. companies have found, these laws are often ignored by
their CM’s. U.S. manufacturers can be held legally responsible for
Deliberate
underperformance can
be difficult to diagnose,
but any material
underperformance
can quickly become
a major problem
given the difficulty in
changing an offshore
CM relationship.
10
3

The Hidden Costs of
Contract Management
these violations in their supply chain. The court of public opinion
can also convict companies for these unethical working conditions.
Staff Turnover
Project teams managing offshore products tend to work longer hours.
Time differences drive conference calls outside normal work hours and
source inspection trips can consume weeks at the offshore supplier.
Besides the measurable cost of travel and any compensated overtime,
there can be higher turnover in these positions. That in turn drives
recruitment costs and inefficiencies as new hires go through a learning
curve. As the U.S. economy improves, this issue will worsen as project
personnel have more job opportunities with less stress.
11
3

The Hidden Cost of Time
For manufacturers, time is often the most critical strategic focus.
To achieve cheaper wages and products, a company may choose
to sacrifice quicker return on investment and fast time to market.
Approximately 90% of world trade is transported by ship in cargo
containers. Typical transit time between the US and China is 4-6
weeks. Effectively, manufacturing in China prohibits the use of just-in-time
inventory models and is counter to lean manufacturing.
“Let’s say you want to order a batch of widgets from amanufacturer in
China that’s charging 50 percent less than amanufacturer here in the
United States. The price may be good, but you have to wire the money
up front to pay for your order. Then you wait — up to 90 dayswhile your
product is produced and shipped across the ocean.
When you finally get the product to your customer…you then have to
wait up to 90 days before you get your money. Think about that. The
time between when you lay out your money to your manufacturer and
when you finally receive a payment from your customer can be as long
as 180 days. So, youmight wait up to 225 days before you get your
money back. That’s a long time and a serious drain on cash flow. And
that’s assuming everything goes well.”
–New York Times
Reduced Automation
Lower labor cost markets tend to minimize automation and avoid
continuous improvement initiatives because there is little cost benefit in
a low wage environment. That can translate to a greater number of
design spins in product development cycles and less schedule change
flexibility in production.
Rigid Schedules
The rise of information systems that provide real-time data on inventory
status and a focus on minimizing finished goods inventories have
increased the popularity of “just in time” (JIT) ordering. When demand
is variable the supplier must be able to rapidly support schedule change.
However, many offshore suppliers see little value in supporting variable
4
90%
WORLD TRADE
The Hidden Costs of Time
12

4 The Hidden Costs of Time
demand production because their business models are focused on high
volume production with high equipment utilization, so changeovers must
be kept to aminimum. Customers needing changes in production on
short notices are often disappointed. The cost can lead to lost
sales opportunities, finished goods inventory build up, and contractual
penalties.
Logistics Risks
Reliability and cost of transportation can be adversely impacted by lack
of availability and local cost of fuel. Delays in transportation can be
caused by lack of availability and access to port facilities, or variations
in port clearing time. There is transport risk even after leaving port: each
year approximately 10,000 cargo containers fall overboard.

The Hidden Cost of
Geopolitical Risk
As many U.S. companies look to less-developed countries (LDCs)
like China, India, and Thailand for cheap labor and lower foreign
exchange rates, they often ignore the larger political, cultural, and
economic contexts under which LDCs operate. If these contexts are
not understood properly, or at least minded, a company’s offshore
operations could be hindered or compromised.
In September 2012, Foxconn Technology, amajor electronics supplier
for companies like Apple and Dell, had to close one of its factories due
to employee riots. Analysts say that this incident and other labor
tensions in China were caused by a sudden inflation of Chinese currency,
prompting workers to demand higher wages.
Labor Unrest
Labor unrest is inevitable in such a rapidly changing environment. With
wages rising 15% annually and an emergingmiddle class clamoring for
economic recognition, labor unrest threatens to interrupt fluid supply
chain operations.
Currency manipulation
By some estimates China manipulates the yuan to devalue it by 20%.
As international political pressuremounts, China may be forced to
cease this manipulation, which will effectively increase Chinese prices
by 20% for US companies.
Political instability
The risk consultancy Maplecroft recently analyzed political stability
hazards for China. The country “is categorized as ‘extreme risk’ across
several areas,” according to Maplecroft, “including: civil and political
rights, judicial independence, democratic governance, labor rights, and
human rights violations committed by members of the security forces.
Companies which are deemed in any way to be supporting
a government or its agents in stifling democracy, liberty and human
5
15%
14
The Hidden Costs of
Geopolitical Risks

rights may suffer reputational damage, which will ultimately impact the
bottom line.
U.S. Income Inequality
Offshoring reduces domestic employment demand and therefore
domestic wages. At the same time, increasing corporate profits result
in higher compensation for executives, who are usually compensated
based on somemeasure related to profitability. The result is increasing
wages for executives and decreasingwages for workers. The
increasing income inequality creates pressure for US domestic political
solutions that may disrupt offshoring.
Natural Disasters
Natural disasters occur frequently in China, affecting more than 200
million people every year. They have become an important factor
restricting economic and social development. China is home to 5 of the
top 10 natural disasters in world history, including the top 3. China has
had 6 of the world’s top 10 deadliest floods, including the top 5. China
has also experienced 3 of the top 10 deadliest earthquakes, and 6 of the
top ten deadliest famines.
Local Judicial Instability
The local judicial climate is difficult, if not impossible, to stay informed
on. For example, in the wake of food safety violations, the China High
Court recently called for “lower courts [to] hand down the death
sentence to those found guilty of food safety violations that result in
loss of human lives.” (as reported by United Press International).
Health Environment
The health environment of China, in particular, has economic costs.
The first outbreak of SARS occurred in China, and its impact on
southern China’s economy was significant. Themore recent outbreak
of the bird flu has also had some impact, although not to the extent
of SARS. Currently companies are beginning to quantify the cost of
employees quarantined after trips to Asia.
EXECUTIVE
WAGES
WORKERS
WAGES
5 The Hidden Costs of
Geopolitical Risks
15

Eliminated Costs
Cost Elimination Through a
Domestic Approach
After decades of coping with the trial and error of offshore operations,
more and more companies are now realizing the benefits of returning
to the U.S. The five categories of hidden costs above merely hint
at the complexity a company assumes in an offshore operation; the
variables are endless. To simplify a supply chain, and therefore
eliminate associated hidden costs, a company should consider a
domestic approach.
Not only does sourcing within the U.S. eliminate overt hidden costs
- shipping, inventory holdings, specialized staff, and travel - but it
also allows for clear strategic decision making. When a contract
manufacturer is selected domestically, a company is able to determine
clearly and thoroughly on whom they can rely for the best possible
product. Details and specifications of the contract can be discussed
and conferred over in real-time and without language barriers, and
the contract manufacturer can be upfront about their own needs,
limitations, and some potential problems otherwise unseen by a client.
With higher skilled engineering and manufacturing personnel, US
companies tend to lower costs through design for manufacturing. One
advanced engineer in the U.S. using high end software tools may
accomplish more than three engineers in a lower cost labor market
using basic tools. Similarly, in production there may be greater focus
on Lean manufacturing initiatives that decrease procurement and
production cycle time
Accordingly, the new or modified product will have a shorter time
to market, giving a domestically sourced company a competitive
advantage over their offshoring competitors. While the latter waits
more time for a cheaper, less dynamic product, a company sourcing
domestically can introduce to the market a wider variety of ‘made to
measure’ products at a faster rate with lower risk.
U.S. contractors focus on logistics simplicity. At a regional level, it
isn’t unusual to see auto-replenishment ‘milk run’ deliveries for local
customers, eliminating inventory pipeline and warehousing hidden
costs. Even when working at a distance, the least expensive cross
Top factors driving
re-shoring decisions
are labor costs
(57%), quality (41%),
ease of doing
business (29%),
and proximity to
customers (28%).
16
70% claim “sourcing
in China is more
costly than it looks
on paper”.
— 17th annual ASSEMBLY
State of the Profession Survey

Eliminated Costs
country freight shipments take less time than expedited shipments
from an offshore supplier. By definition, costs associated with
product separation, duties, and compliance with import/export rules
are eliminated by onshoring. Staff expenses and stress are also
eliminated as the team deals with suppliers near their home time zone.
When managing a domestic contract, quality control, problem solving,
and general oversight is more thorough and much less expensive. A
domestic contractor can be held more accountable, as their own
business’ success is built on reputation. In addition, strategic decision-making
and management are not only simplified by a domestic
approach, but also enhanced. Given the rate of innovation, especially
within the electronics industry, new models and changes in design can
be introduced and collaborated upon with clarity and urgency.
Lastly, U.S. macro variables - cultural, political, and economic - are
more predictable. A sudden spike in foreign exchange rates, or a
change in a foreign country’s politics, could catch a company off
guard. Companies operating within the U.S. have a more intimate
sense of political and economic tides, allowing for clearer strategic
decisions. Furthermore, sourcing within the U.S. endows a company
with cultural resources otherwise absent overseas. Working with
manufacturers of the same culture fosters better collaboration and
innovation.

Conclusion
A company looking to source from abroad should pay close attention to
how well their expected savings on labor and unit prices overcome the 5
categories of hidden costs, and whether the decision to pay them is
worthwhile.
A survey of 750 senior business
executives worldwide, conducted in
late 2012 by Ernst & Young, showed
the number of executives that plan to
nearsource previously outsourced
activities will more than double in the
next three years, from 14 percent to
35 percent
A business either experiencing difficulties abroad or just starting up
can eliminate the five hidden cost categories by sourcing within the
U.S. Hidden costs are not only eliminated by this approach, but their
absence grants companies the competitive advantage of delivering
higher quality goods to the market more quickly and reliably.
SITUATION:
Onshoring is Real
PROBLEM:
Hidden Costs are Driving
SOLUTION:
Understand Your Costs
18

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Top Experts
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Optimum Design Associates Blog
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Manufacturing and Design Information

About Optimum Design Associates
Optimum Design Associates (ODA) is a leading provider of award winning printed circuit board
(PCB) layout, engineering, and in-house turnkey electronics manufacturing services (EMS).
Established in 1991, ODA continues to meet the challenge of creating complex, high-density
printed PCB layouts for some of the world’s leading high-tech original equipment manufacturers
(OEMs). ODA has offices in California and Australia. Its California facility is ITAR-registered and
certified to ISO 9001:2008.

The Five Hidden Costs of Offshoring Eliminated by Onshoring

The Five Hidden Costs of Offshoring Eliminated by Onshoring

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