What is the True Cost of Outsourcing?

What is the True Cost of Outsourcing?
November 9, 2010 Joseph Paris
Outsourcing

People are naturally seduced by a “deal”. We gravitate to signs in stores and on billboards that proclaim, 50% off” or “Buy-one Get-one”. We like to think that we are paying far less for something that we have a right to – that somehow we got the “better” of our opponent. We take a smug comfort thinking that we are so much smarter and savvy than our friends and peers.

But is it as good a deal as it looks?

As human beings, it is natural that we gravitate towards an assessment based on “cost” versus “value” because cost is far easier to evaluate and reconcile than value. We want to buy an item and it has a price associated with it – and it’s very easy and objective to compare that item-price with others.

But an evaluation of “value” is much more complex and nuanced. What, precisely, are we really buying? What are the variables involved? How can they work for or against the achievement of our goals? Are the variables themselves dependant on other variables? Which of these proposed values are really important and which are not? Each option available will affect the “total cost of ownership” and must be weighed both individually and collectively

Remember, everything has a cost, but not everything has a value in the eyes of the customer. And it is the customer that is (or should be) the driving force.

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There are countless variables which influence the supply chain – and infinite combinations of these variables involved in evaluating and comparing the “total cost of ownership”. As a result, the discussions and debate can extend far beyond the space allotted for this article – so I will focus on some of the lesser known and apparent variables.

Corporate Overhead: Many times, the actual production of a product can be delivered (all things considered) less expensively by in-sourcing. However, when the “corporate overhead burden” is applied, it makes the product look more expensive if produced internally.

I know of one French-based multi-national which was manufacturing wood flooring profitably at one of its worldwide divisions – in that the total revenue generated by the division exceeded the entire cost of the facility producing by almost 18%. But when the “corporate overhead” of 25% was added, they showed a loss of 7%. They made the decision to close the facility and “outsource” – where the product was more expensive per unit, but on which they didn’t apply the “corporate overhead”.

Did this company come out ahead or behind?

Stability: Another less tangible variable that needs proper due-diligence is the stability of the country to which you are considering outsourcing – and how fast a “business friendly country” can turn decidedly “unfriendly”. History – even very recent history – is littered with examples: the Cuban Revolution in the late 1950’s, the Iranian Revolution in 1979, Venezuela’s “nationalization” programs under Hugo Chavez, the “Drug Wars” in Mexico today – to name but a few.

What are the total “sunk costs” involved in the development of an out-sourced supply chain partner which can rapidly turn into an “abandoned investment” should such an event transpire? What would happen if a sudden and sustained disruption in the supply chain were to occur? Could the loss be afforded? Is there a credible “Plan-B” for the supplied part?

Certainly, a proper and pragmatic assessment of risk should be performed prior to making a commitment which can put a company in jeopardy.

Graft, Corruption, and Bureaucracy: Much less dramatic than a nation becoming an unstable environment in which to do business – but without a doubt more pervasive in its occurrence – are the challenges faced with the “form” of doing business in countries where the rule of law is suspect, and where the laws themselves are un-navigable.

For instance, take a bureaucracy in Poland that is in desperate and apparent need of reform – ZUS (Poland’s “Social Insurance”). On the surface – and by seeing the large number of business registered – it would appear that Poland has an unusually large percentage of entrepreneurs when compared with other countries. But a further analysis would yield a much less positive result – that many Poles create companies just so they can work. As an independent contractor, ZUS can be avoided (or greatly reduced) – even if the casual observer would not be able to tell the difference between the independent contractor and the employee by their work-tasks and responsibilities.

And several years ago in Mozambique, I experienced first-hand a country where graft and corruption was the rule, not the exception. I was driving on a dirt trail in the middle of nowhere when two soldiers brandishing AK’s came out of the bush and stopped me for “speeding”. It did not matter that there was no speed-limit posted or that the road made it impossible to speed should we even have the desire. Although only I was driving, we EACH had a choice of paying the fine then and there (about $10) or to waiting in jail to go before the judge (someday) to plead our case – we each paid the $10 without objection.

And of course, a government can make the “paperwork process” nearly impossible unless – perhaps – a “local partner” can be found.

What are the costs associated with all this? None of it adds to the per-piece cost, but all of it adds to the sunk-costs. At what point is outsourcing truly the less viable and costly alternative – the better way?

Quality: Every consumer seems to take “quality” for granted. We trust that the product we are buying is sound and will perform as advertised. We certainly don’t believe that the product can harm us – or worse. And we assume that measures to ensure the quality of the products we buy have been instilled in the fiber of the company from whom we buy.

It all works – until something goes wrong. And something ALWAYS goes wrong eventually. When this happens, the trust is broken and it will take an enormous amount of energy and resources to regain that trust. What a company does in the early hours of such a breach will determine the depth of the long-term effects.

When outsourcing, it’s a fact – the further away from the “King” the “Servants” are, the less control the King can effectively exert. To compensate for this, the company/customer must put in place measures to ensure the quality of the product being produced by the out-sourcing partner is every bit to the standards expected – even if this requires the placement of quality assurance resources at the site who are paid by the customer and who’s loyalty is to the customer. Even then, this employee should be rotated out every six-months to one-year.

What would be the cost of this breach of trust?

Intellectual Property: The real competitive advantage of many Western companies is the Intellectual Property they own; either, patents, proprietary production methods, corporate strategy, client lists – the list goes on. To many companies, this intellectual property is the only asset they own. Protection of such information cannot be understated.

Believe it or not, the world is full of people and companies who would enjoy obtaining such information for their own self-interest. We see it in pirated software, music and videos. We also see it in harder assets such as vehicles, electronics and weapons systems. Everywhere significant money can be made with less work – there will be those willing to take advantage.

If you truly believe that the intellectual property found in Volvo’s won’t easily find its way into other vehicles made by Geely Automobile in China (despite promises made) – well, you are naïve. And why should Geely benefit? They bought it fair and square.

However, it goes beyond this – beyond the usurping of knowledge by sinister outsourcing partners. I know a high-technology company which will not share some of its intellectual property with certain of its wholly-owned subsidiaries overseas for fear that the company will let it out for the gain of the overseas employees that have access.

This is either a savvy company, or it’s been burnt in the past. My bet would be that they got burnt in the past – experience is the best teacher.

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So what is a company to do? “Abandon all hope ye’ who enter here?” Hardly…

Assuming the company already builds the product internally, the VERY FIRST thing a company should do before it considers out-sourcing is to create a “Costed Value-Stream Map” whereby each and every step of the production of an item is identified and costed. Mark the steps as follows:

– Green: A necessary step in the process that adds value to the production or delivery of an item.

– Yellow: A step in the process that does not add value to the production or delivery of an item – but is necessary. Such steps might include activities related to government regulatory requirements.

– Red: A step in the process that exists, but which does not add value to the production or delivery of an item or service – and is not otherwise necessary. This can include activities which disrupt the “continuous flow” of an item or service through the process.

Once this is done, perform an analysis on what it would take to eliminate the “Red” steps and to optimize the “Green” steps (using Lean tools such as SMED) and “Yellow” steps (such as eliminating obsolete reporting and merging redundant activities).

After applying burdens (except Corporate overhead), where do you stand? Is it greater or less than outsourcing?

Now perform the same exercise with your proposed out-sourcing partner. In addition to the “landed cost” of the item including; the item, various freight charges, and customs/duties – you have to add-in; the cost of evaluation and negotiation with your new partner, the cost of ramp-up time, the cost of capital (your cash can be committed for up to 90 days), the cost/remedy of defects, the cost of inventory which may be obsolete upon arrival due to an Engineering Change Notices (ECN’s), etc…

You also have to be keen to costs which are much more volatile such as fuel costs (effects shipping and transport) and the general state of the world economy (effects shipping costs).

Add to all of this the results of a proper Risk assessment (including the items mentioned at the beginning of this article) and you are able to derive a much more comprehensive understanding of the total cost of outsourcing.

At this point of the exercise, it should be clearly and objectively apparent which solution is the better source – internal or external. And under what set of circumstances such is true.

In the end, there is no “hard and fast answer” – only a subjective decision based upon the objective assessment of a full and complete up-front assessment.

 

Paris is the Founder and Chairman of the XONITEK Group of Companies; an international management consultancy firm specializing in all disciplines related to Operational Excellence, the continuous and deliberate improvement of company performance AND the circumstances of those who work there – to pursue “Operational Excellence by Design” and not by coincidence. 

He is also the Founder of the Operational Excellence Society, with hundreds of members and several Chapters located around the world, as well as the Owner of the Operational Excellence Group on Linked-In, with over 25,000 members.

For more information on Paris, please check his Linked-In Profile at: http://de.linkedin.com/in/josephpar

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