Emerging perils: offshore risks

Illustration: David Lyttleton

Following reported losses running at £16m a year, fastener manufacturer
Infast decided in 2004 to discontinue its British manufacturing operations.
Instead, the company began sourcing fasteners from low-cost countries such as
India and China. Management consultants Rossmore Group were appointed to
identify a strategy for closing the company’s two Yorkshire manufacturing plants
and transition the company to a business model based on overseas sourcing.

“We were committed to moving offshore,” says Robert Sternick, then the
company’s chief executive. “The two plants were losing money and the cost of
buying fasteners from the Far East was substantially less than we could produce
them for in Britain.” The brief to the consultants was to find the best way of
extricating the company from UK-based manufacturing, without alienating
customers, disrupting supply chains or buffeting the business’s finances any
further.

But the outcome was surprising. Instead of delivering a strategy for closing
the plants, the consultants put forward a recommendation to retain the plants.
“Lead times from the Far East were 12 to 14 weeks,” says Sternick. In addition
to the cash tied up in such long supply lines, lead times of that length would
result in a loss of flexibility and responsiveness. Worse, the variability of
shipping times meant holding even more inventory as a cushion, to avoid
disappointing customers.

Hybrid solutions
Yet, if overseas manufacturing had its drawbacks, so too did continuing to
produce in the UK – notably the mounting losses. The solution is a hybrid
approach to the manufacturing-

versus-sourcing question: sourcing high-volume products with stable demand
patterns from low-cost Far Eastern suppliers, while the UK operations would
concentrate on higher value, low-volume products where responsiveness and
flexibility was important. Instead of taking months to meet customer demand for
its manufactured-to-order custom fasteners, Infast could deliver in as little as
four weeks – sometimes even one.

It was a plan with obvious appeal. “I’m a believer in British manufacturing,”
says Sternick. “And if you do things differently and pursue innovative
strategies, then you can succeed where otherwise you wouldn’t.”

The company realised an annual saving of more than £600,000 on products
sourced overseas, while monthly losses on the retained higher value UK
manufacturing business became operational profits within six months. The
fastener operations were subsequently sold as going concerns, saving 200 British
manufacturing jobs and doubling Infast’s market value.

The fact is that the economics of sourcing from low-cost economies isn’t all
one way traffic and low-cost country sourcing can, and does, have downsides.

The dangers are clear: even as the purchasing director returns a hero from
his travels, having apparently slashed the company’s cost base, it’s the finance
director who must explain the rising inventory levels and increased working
capital requirements, as well as the fall in the share price that might follow
supply chain disruption.

Globalisation has fundamentally changed the financial characteristics of one
of the first industries to embrace it, according to a recent study by AMR
Research. Within the automotive industry, inventory as a percentage of revenue
was increasing. In fact, falling inventory turns were reversing thirty years of
rising inventory turns. And the further upstream from the vehicle assembly lines
you looked, the more marked was the phenomenon. Inventory was increasing faster
at the supplier level, where overseas operations were more prevalent.

The reversal in inventory performance wasn’t uniform in impact, though. The
firms judged by the study to be weaker performers had up to 60 days of inventory
on hand, while the stronger performers held less than 10 days of inventory.
What’s more, stronger performers accomplished the cash-to-cash cycle ten times f
aster than their weaker competitors. Some companies, in other words, had managed
to profit from globalisation while side-stepping its downsides.

Hidden costs
One common mistake, warns David Morgenstern at Ariba, is failing to adequately
calculate the ‘landed cost’ of overseas-sourced parts. “There’s a surprising
amount of purchasing ‘bad practice’ around, where companies opt for sourcing
from China without looking at the overall cost picture,” he says.

Factor in the impact of freight costs, inventory and tariffs, for example,
and the logic of sourcing large castings or sheet metal enclosures from
countries such as China, with their lower labour costs, largely disappears.
Instead, ‘near shore’ sourcing can make more sense.

Nor are all the costs entailed by global sourcing always made as explicit as
they could be, warns Raees Lakhani, client services director at Resources Global
Professionals. “Many companies overlook the land transport charges involved in
getting product to ports. Rates also vary from port to port. In China, for
example, rates out of Hong Kong and Shanghai can be more expensive than those
out of Tianjin.”

Neither is low-cost sourcing a silver bullet, adds Graham Underwood, managing
director of GFT UK. “Companies that bundle up a problem and ship it thousands of
miles are not going to solve it. They just add geographical issues, management
time and cultural differences to it,” he says.

IT systems form another hurdle, says Richard Bailon, chief executive of
British ERP vendor Exel’s China office, located in Suzhou, southern China. With
Western companies increasingly transferring information such as production
schedules, orders and shipment advices electronically, it’s tempting to think
that this will be possible with suppliers in China. But it will only be possible
if all the relevant IT systems support the Unicode character set. Users of large
enterprise systems don’t need to worry, but an assumption that Unicode is built
into a system is dangerous.

Watch the blind spot
All in all, low-cost country sourcing can comprise a troubling corporate blind
spot, says Adrian Griffiths, business development director at Vendigital.
“There’s something of a herding instinct in place,” he says. “Companies have
been going to China without doing the research necessary to know what’s the best
option.”

Quite regularly, says Griffiths, Vendigital comes across examples of
companies that have achieved reductions of 35% to 40% in the factory gate cost
of items sourced from China, only to see those savings wiped out by the costs of
managing a supply chain stretching that far. “We take companies to China all the
time,” he says. “It’s a superb location, but so much depends on what you’re
buying, the amount you’re buying, the length of the contract and where the
product is in your product lifecycle.”

Griffiths stresses that companies contemplating sourcing from overseas
locations must consider two questions. The first relates to the precise nature
of the costs that overseas sourcing is intended to reduce. Energy-intensive
items such as large castings are an example of the potential pitfalls of an ‘it
must be China’ assumption. “China’s advantage is lower labour cost, so it wins
out with products where a high proportion of the overall cost is labour,” he
says. “For energy-intensive products, it’s worth bearing in mind that a
significant proportion of Brazil’s electricity comes from hydro-electric
schemes.”

The second question is more subtle and relates to the extent to which
businesses understand that the associated ‘friction’ costs of managing a supply
chain resource decline significantly, the shorter that supply chain becomes.

Closer to home
Griffiths recommends that companies benchmark the landed cost of goods sourced
from China or India with the landed cost of goods sourced nearer to home and
then ask if the additional savings incurred by sourcing from China or India are
worth the additional hassle. “We see companies compare the UK cost to the
Chinese cost, see that China is 40% cheaper and can’t do the deal quickly
enough,” he says. “I then ask them: ‘And how much was it in Portugal?’ – and
usually, they haven’t a clue.”

Venturing overseas also involves addressing questions relating to technology
transfer. “Tensions over the pace of transfer of new technology and tools to
emerging markets are common,” says Peter Siddall, chairman of Siddall &
Company. “Deciding how much leading edge intellectual property to make available
to overseas markets can be a very genuine problem.”

Of course, there’s also the issue of theft. “Intellectual property theft is
not preventable,” says Paul Eccles, director at strategy consultants Arthur D
Little, which recently studied the success factors for automotive suppliers
looking to set up production facilities in China, based on detailed interviews
with more than 40 automotive suppliers already based in the country. Two-thirds
of these companies were reluctant to increase R&D in China due to
difficulties over intellectual property.

Minimise risk
Companies venturing into China are adopting deliberate strategies to minimise
the amount of intellectual property that they expose to the risk of theft. Take
SGAI Tech, for example, which owns four assembly plants in mainland China.

Although conventional wisdom would place prototyping and development
activities within these plants themselves, in order to be as close as possible
to the factory floor, SGAI Tech deliberately locates them in Hong Kong, explains
chief executive Tim Moore.

“In Hong Kong,” he says, “intellectual property protection is as good as
you’ll find in the West.” Elsewhere in China, he notes, that isn’t the case.
Under China’s ‘one country, two systems’ framework, intellectual property laws
in the former British colony remain close to British law, while laws on the
mainland are far more loosely defined.

On the rare occasions that any development work is carried out in China, he
adds, “We’ll do it with disparate teams who don’t know that the others exist,
with each team working on only a part of the project.” The combination of making
things difficult to copy and basing critical actions in a location where the law
offers protection has worked well, he says.

It’s not straightforward, but for companies wanting globalisation’s upside,
without its downside, such circumlocutions are increasingly the norm.