In these trying times, many manufacturing organizations are tempted to move their operations overseas, where they can capitalize on cheap labor.  This is an idea only a bean counter could love.  Sure on paper there is a significant reduction in the cost per widget.  However, we do not live on paper, in the real world there are a lot of hidden costs your accountant never dreamed of.

First, any student of Lean knows that inventory is the enemy and to manufacture offshore means carrying plenty of inventory.  It is not unfathomable in normal times for a manufacturer in China to have over four months worth of finished goods inventory in the pipeline.  Many times a defect is not detected until the product reaches the end user (and you will have defects).  Recalling, inspecting, reworking and potentially scrapping 4 or more months worth of production could be potentially ruinous to all but the largest corporations. 

When the business cycle slows, there is always a bullwhip effect in the manufacturing sector.  Due to an over reliance on MRP software and push scheduling, it takes time for the next supplier to “catch on” that demand has slowed and to react accordingly.  The further down the supply chain you are, the more excess inventory you get caught with.  If you are already carrying four months of inventory, it is not unheard of to get caught with over a year’s worth of inventory.  In essence, your factory does not have to make widget one for over a year (what kind of line of credit would you need to pull that off?  Could you even make the interest payments?).

One other factor to consider concerning inventory.  It is widely estimated that 20-25% of your average inventory level will be written off due to damage, scrap, shrinkage and obsolescence.  If your average inventory level is 5 months worth of inventory, you can count on writing off a month’s worth of inventory each year.  If your average inventory were only 2 or 3 weeks (not unheard of in a truly lean environment) your annual write off would be 2 or 3 days worth of inventory.

According to the Harvard Business Review, there were 67,000 factories that went bankrupt in China in the first half of 2008.  From January to February 2009, there was a 10% (yes, you read that correctly) reduction in the number of suppliers supplying the North American Market.  That is truly staggering!

Additionally, emerging market infrastructure and institutions are frequently lacking.  Frequent power outages can put an unforeseen damper on productivity.  Poor roads can mean that product can get damaged in transit from the factory to the docks.  It is also not uncommon to suffer losses due to truckloads of goods being hijacked.  

Talent, or the lack of is another serious issue.  Even so called low tech industries like plastic injection molding require a high level of technical expertise.  It takes several years for a technician to become a competent molder.  Who will train and oversee the technical staff when they are going through their substantial learning curve? If you think that one of your current technical staff will relocate, they won’t, at least not for long.  Once the novelty of the new locale wears off, they will want to come home. 

Your new emerging-market workforce will have a much steeper learning curve than their domestic counterparts.  Think of it this way, if the brilliant Leonardo Da Vinci were magically transported to a 21st century driver’s education class, he would have a much more difficult time learning how to drive than the average 15 year old.  The 15 year old has witnessed the operation thousands of times and knows the basic operation of the car, how to start it, what all the pedals and gauges are for, most of the rules of the road, etc. 

In the emerging market, many of your new employees are coming straight out of the countryside, may have never seen a computer, driven a car (which is similar to driving a fork truck) or experienced any automated equipment. 

Domestically, how many times have you had a piece of equipment break down only to find that it will take you 48 hours to get the necessary parts to get it back on line?   And the equipment manufacturer is only a few towns away.  Who will repair your tools when they crash?  What will the turnaround time be?  Days? Weeks?  Can you afford this?

There are other risks that must be considered.  Exchange rates change over time which can cause the price of foreign made goods to rise and fall very rapidly in a very short period of time.  Putting on my economic professor’s hat, over time, a nation’s imports have to equal their exports.  What this means is that an export driven nation will have to become a net importer at some point in the future.  It is a fairly complex explanation and not within the scope of this paper, but suffice to say that at some  point in the future, the emerging market currency will become stronger (as more currency flows into the country), making their products more expensive in relative terms.  

Labor costs in emerging markets are sure to rise over time as well.  As and area grows economically, labor will become more scarce, driving the prevailing wages up (as well as the cost of other goods and services necessary to do business, i.e. energy and transportation).

As mentioned earlier many emerging markets lack the institutions that provide a predictable environment to do business in.  Most emerging markets will not allow you to have outright ownership of your factory, but will instead require you to have native partner, which will dilute your control of your factory.  Additionally, private property rights are arbitrarily enforced, one leader looking to attract foreign investment promised not to nationalize any businesses for at least 10 years, now there’s an incentive.  Corruption runs rampant and there is an overall lack of the rule-of-law principles that provide a fair and predictable environment necessary to confidently run a business for the long haul.

As you can see, setting up shop overseas is by no means a panacea.  There are hidden costs lurking around every corner, some that could bankrupt you in the blink of an eye. However, there is still hope.  Many companies have found that by rethinking their domestic operations, they could dramatically increase productivity, reduce cycle times and cut inventory levels to a fraction of current levels, all without having to expend significant amounts of capital.  However, most organizations lack the expertise to drive such change and many owners are reluctant to admit they need help, until it’s too late.  Don’t be that guy.

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John Channing is a Manufacturing Specialist at Dorset Partners LLC, (www.DorsetPartners.com), an advisory firm specializing in corporate turnarounds, financial restructuring, revenue revitalization and profit improvements.    The team at Dorset Partners has guided hundreds of business turnarounds in dozens of industries over the past 35 years.   Much of this knowledge is outlined in the recently published Turnaround Roadmap™ which is available as a Free download on their website.