Do “Lean Math” to Calculate the True Cost of Offshoring

(LEI: Cambridge, MA) -- Before offshoring work to low-wage countries, senior managers should use “lean math” to calculate the true total cost of relocating, according to management expert James P. Womack, Ph.D., founder and chairman of the Lean Enterprise Institute (LEI). 

Companies usually compare piece-price costs for a product or service with corresponding costs in a low-wage country, then add in the cost of slow freight, usually boat, when deciding whether or not to outsource, explains Womack. “This is mass production math and it is no longer realistic,” he says. 

Senior managers should perform a more accurate analysis of total costs, which Womack calls “lean math” because it's based on contemporary lean management thinking. A lean math cost analysis includes:

• Costs of additional inventory of goods shipped over long distances from the low-wage location to customers.
• Costs of additional safety stocks to ensure uninterrupted supply over long distances from the low-wage country.
• Costs of expensive expedited shipments from the low-wage supplier.
• Costs of lost sales caused by stock-outs due to longer lead times caused by longer distances.
• Cost of warranty claims if the new supplier has a long learning curve.
• Costs of engineer visits to help the new supplier get the product or service right.
• Costs of senior executive visits to establish or correct relationships with new suppliers.
• Overhead costs allocated to operations remaining in the high-wage location, which usually don't disappear when products or services are outsourced.

“This is becoming quite a list,” Womack says “and note that these additional costs are hardly ever visible to senior managers or purchasing executives who relocate production or services to a low-wage country based simply on piece-price plus slow freight. The reason is that these additional costs are paid by different functions in the company because they are allocated on a budget basis not a product-line basis.”  

The list also should include currency and country risks, plus the danger that the new supplier will become unstable or a competitor. “Because these risks are hard to calculate precisely, senior managers tend to assume they are zero when, in reality, they can be substantial,” he says.  

An analysis of total costs is no guarantee that companies will not have to relocate. For example, companies selling mature products in high-growth, low-wage markets such as China or India, will almost certainly need to locate most or all of their production there for these markets. In addition, the lowest total costs for supplying mature products to high-cost markets such as North America, Europe, and Japan are likely to be in nearby low-wage countries within the region of sale. (For instance, Mexico for the United States, Poland for Germany, and China for Japan.)  

However, for customized or new products and services within the United States, Europe, or Japan total costs are likely to be lower within these markets because proximity to design centers, logistics networks, and customers offset high labor costs.  

“The point is that offshoring is not the first line of defense for producers in high-wage countries,” Womack says. “Rather, senior managers must get truly serious about using lean principals and tools to improve the design, quality, cost, and delivery of the product or service in question, then implement lean management to sustain the gains.”