1.21.2008

Failing to Grasp the True Costs of Outsourcing

A private equity fund manager with a background in manufacturing is trying to raise awareness about how many companies fail to analyze the true costs of outsourcing. Unfortunately, his own analysis stops short of telling manufacturers what they really need to hear.

Michael Marks manages equity fund Bigfoot Capital. In
commentary published on Forbes.com, Marks says he is “surprised by the naivete of many sophisticated executives” concerning outsourcing.

Recently, I asked associates in one of my portfolio companies to prepare an analysis of the costs of building our product in Mexico vs. the U.S. To my surprise (shock?), the analysis consisted of taking the labor hours required to build the product, and multiplying those hours by the direct labor costs in the two countries. That was it! No analysis of overhead costs, transportation costs, labor efficiencies, power costs, average hours worked, overtime policies. And subsequently I had similar conversations with other very sophisticated executives that confirmed the need to write this particular column.

Marks then offers his own analysis of manufacturing costs based not only on labor costs, but on factory general and administrative expenses, manufacturing overhead, freight in (meaning the cost of transporting materials from suppliers), scrap, cost of materials and real estate costs.

He looked at four locations: San Jose, Calif.; Guadalajara, Mexico; Eastern Europe (Hungary, Czech Republic, Romania); and Shenzhen, China. He says his figures are “based on thousands of projects, mostly electronic or mechanical, over a period of years and a variety of locations in these countries. They are also generalized (each particular product has its nuances) but the numbers should serve to make the point.”

Marks then concludes that the full factory level costs for a product with material cost of $100 are $127.20 in California, $113.40 in Eastern Europe, $110 in Mexico and $98.90 in China.

Near the end of his column, Marks casually comments

As a final thought, these costs are at the factory location, and don't take into account the cost of freight to the customer's location. That cost can be substantial, and has been increasing quickly with the increase in the cost of oil. So transporting Chinese-made goods to the U.S. costs more, and for some products, makes moving manufacturing back to the U.S. or at least to Mexico more reasonable.

Duh!

Marks has his heart in the right place. But he would have done a much greater service for his readers by factoring in that “cost of freight to the customer’s location.” And he should have discussed in some detail issues of time to market, ability to respond quickly to market changes, quality and all those other pesky problems that can arise when you move your manufacturing several thousand miles away.

Transportation is waste. Transportation across thousands of miles is a big waste. That reality deserves more than a brief mention that it wasn’t taken into account.

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