Calculating the Total Cost of Ownership for Offshoring Manufacturing

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1 Calculating the Total Cost of Ownership for Offshoring Manufacturing Is offshoring really delivering its promised savings? Many organizations are motivated to offshore because of low purchase prices that result from reduced wages and other expenses. Some leaders set up or contract overseas operations without considering the total cost of ownership associated with offshore manufacturing operations. The total cost of ownership (TCO) calculator in Figure 1, as shared by Harry Moser, chairman emeritus at GF AgieCharmilles, during an APQC/Association of Manufacturing Excellence Webinar, can help organizations make a holistic assessment of the costs of offshoring. Enterprises whether they are considering offshoring or already have offshored operations can benefit from weighing the costs and benefits of offshoring in concrete detail. In doing so, they may find that keeping operations at home or moving operations closer to home (re-shoring) is most cost effective. Figure 1 depicts the total cost of ownership calculation for manufacturing a hypothetical part in China. You can fill in columns two, three, and four based on your products and the norms/logistics associated with the country that handles the manufacturing. The assumptions that these numbers are based on are documented in Figure 2. You would need to complete a total cost calculation for both offshored and local manufacturing scenarios and then compare them as discussed at the end of this article. Total Cost of Ownership Calculation Cost Factor Part Die/Mold Explanation Per order cost factors FOB price $80 $30,000 Packaging Unsure Unsure Offshoring will typically cost more. Export packaging is more complex and has to meet both the standards of the destination country and the country of origin. On a mold, this could be $1K. Page 1 of 6

2 Cost Factor Part Die/Mold Explanation Duty 4% 8% 1. Machined parts: Automotive 2.5%. Most others 4.7%. Average 4%. 2. Stamping dies for metal: 8% Fees: % 0.71% 0.71% MPF (merchandise processing fee), HMF (harbor maintenance fee), insurance, brokerage and customs clearance Fees: flat $200 $200 Broker and customs fees Surface freight/u.s. ton $235 $235 Shanghai port to Chicago rail ramp. China typically sells FOB seaport or airport Air freight/lb. $2.14 N/A China airport to Chicago s O'Hare airport, including fuel and security surcharges Inventory en-route Rework/ quality Product liability nonrecovery risk 2% 3.30% China: Often paid on shipment. 5 week delivery. U.S.: Parts paid 50 days after receipt. 1 week delivery. 90 days/365 days = 0.25 * 8% = 2%. Dies paid 120 days after delivery: 3.3%. 2% 10% Guess. Include impact of delays, opportunity costs, etc. 0.50% 0.50% Guess. Extremely difficult to collect from Chinese vendors. 1 IP risk 2% 2% 1. Trade in counterfeit and pirated goods equals $800B/yr,2 2. Copyright and patent theft is increasingly common. 3 1 See August 1, 2007, Financial Times article by Patti Waldmeir: Made in China, but Sued in America. 2 Five to seven percent of world trade per IACC. On March 4, 2010, The Economist reported that 80 percent of counterfeiting comes from China. 3 From IW Connecting Manufacturing Leaders on April 30, 2010: "The U.S. government said Friday that the level of theft of copyrights and patents in China remains unacceptable and kept Beijing on a priority watch list for intellectual property protection. An annual report by the U.S. trade representative's office (USTR) said that China's enforcement regime remains largely ineffective and non-deterrent and that U.S. copyright industries ranging from software and movies to publishing to footwear report severe losses due to piracy in China. Page 2 of 6

3 Cost Factor Part Die/Mold Explanation Impact of manufacturing s proximity to R&D on product innovation Local U.S. transport Total: multiplier Total: add on/unit Unsure Unsure 1. Research shows that processes that are physically located closer together often produce innovations more quickly and efficiently Clustering is being proven as a more effective development and production strategy. 5 Equal Equal Equal 11.21% 24.51% $0.44 $435 Annual cost factors Travel: Annual $14,000 $14,000 2 trips/year, 1 week each. Total cost of time and travel: 2 * $7K = $14K Safety stock 0.30% 0% Proportional to the square root of delivery time. Difference: approx. 2 weeks usage. 14/365 * 8% = 0.3%. Total: multiplier 0.30% 0% Total: add on $14,000 $14,000 Onetime cost factors Prototype cost $5,000 $5,000 Higher since U.S. shop will not get production. Part: $5K. Die: $5K. 4 "Co-location synergies are more pronounced the more R&D intensive the supply chain. Much of the knowledge underlying emerging technologies is tacit in nature. Co-location synergies are critical." (Rationales and Mechanisms for Revitalizing U.S. Manufacturing R&D Strategies by Gregory Tassey, NIST.) 5 "Global sourcing mitigates disadvantages but does not create advantages. Moreover, global sourcing is normally a second-best solution compared to a cluster." (The Adam Smith Address: Location, Clusters, and the New Microeconomics of Competition by Prof. Michael Porter, HBS Jan Page 3 of 6

4 Cost Factor Part Die/Mold Explanation End-of-life inventory 17% N/A Difference: 2 month's usage = 17% of annual usage. Total: add on $168,200 $5,000 TCO grand total (current) $93.37 $47, Five-year TCO forecast Wage inflation: annual impact on purchase price Exchange rate: annual impact on purchase price Total annual change Carbon footprint 4% 4% China 10%. U.S. 2%. Difference: 8%. Use 4%, assuming wages at all levels represent 50% of cost. 2.5% 2.5% Assume 5% annual Yuan appreciation. Local costs, 50% of cost. Material cost, 50% of cost, equal worldwide. Thus 2.5%. 6.50% 6.50% U.S. electricity uses less coal. Asia: 1.5 trips across Pacific since boats return half-full. Figure 1 Assumptions for Figure 1 Total Cost Calculation Variable Parts Die/Mold Chinese unit price $80.00 $30,000 U.S. unit price $ $50,000 # units/year 12, Page 4 of 6

5 TCO, US $ Variable Parts Die/Mold Unit weight, including packaging, lbs ,000 Shipment size, units 1, Product life, yrs 5.00 N/A Vendor relationship life, years Number of shipments per year Units shipped over product life, years ,000 Figure 2 After the total cost of ownership has been calculated for both local and offshore scenarios, the TCO grand total amounts can be compared in a line graph (Figures 3 and 4). In this example, the TCO grand total for parts offshored to China is currently $93.37 (see page 4), compared to $ for U.S. manufacturing. The five-year forecast amounts at the bottom of Figure 1 can be used to estimate what the difference between could be in the future based on economic trends. Projected Total Cost of Ownership (TCO): China vs. U.S. (Parts) Year China U.S. Figure 3 Page 5 of 6

6 TCO, U.S. $ Projected Total Cost of Ownership (TCO): China vs. U.S. (Dies/Molds) 70, , , , , , , Year China U.S. Figure 4 Using the information gleaned from a thorough total cost of ownership calculation, an organization can determine if offshoring is the best option for its manufacturing processes. When making a final decision, less quantifiable gains should be considered, too. For instance, Moser argues that re-shoring bolsters local manufacturing industry, education, and employment rates and, thus, that re-shoring supports a healthy economy. For leaders that agree with Moser s premise, the larger goal of sustaining local manufacturing could play a decisive role if the costs of manufacturing overseas are about the same as local costs. That added, intangible benefits might mitigate a slight loss. Every organization should weigh the entire cost of any manufacturing arrangement before settling into new agreements or supporting old ones. The values of the organization come into play, but bottom-line savings often dictate offshoring decisions. Although offshoring is the best solution for some organizations, others will see much higher gains by manufacturing locally. The total cost calculation is a useful tool for determining the most appropriate scenario for your enterprise. ABOUT APQC APQC is the leading resource for performance analytics, best practices, process improvement, and knowledge management. The organization s research studies, benchmarking databases, and renowned Knowledge Base provide managers with intelligence to transform their organizations. A member-based nonprofit founded in 1977, APQC serves Global 1000, government, and nonprofit organizations. For information, visit or call Page 6 of 6