Low-cost labor bears a hidden price tag. Companies that thought they were saving huge amounts of money by shifting production overseas take on a whole new level of risk within their supply chains. And when they venture into emerging economies, the problems compound.

"What they've missed is all of the complexities associated with a longer lead time," says Joe Fantasia, a director with Deloitte Consulting LLP. "The most critical is a lack of visibility into the supply chain. And with that comes a lack of information."

China has been the prime target for companies seeking cut-rate manufacturing in recent years. Now, however, there are signs of rising costs in that country, as it encounters higher prices for fuel and raw materials, as well as a growing middle class with new wage demands.

In response, multinationals are moving into less-developed nations with even cheaper workforces. Apparel companies have a long history of doing business in emerging economies such as Vietnam, Cambodia and Malaysia. But other industries are now joining their ranks, opening plants or outsourcing to producers elsewhere in Asia, Latin America and Eastern Europe.

With that decision comes the potential for additional delay in the supply chain, especially with regard to logistics processes. John Brockwell, vice president with JPMorgan Global Trade Services, illustrates the way in which additional hand-offs can erode customer responsiveness. Imagine that a retail store in the U.S. is supplied by a domestic factory, with a record of 95-percent reliability. Door-to-door delivery time might be three days. Now place that factory overseas, with trucks at both ends, an ocean voyage of nearly three weeks in between, and the requisite extra clerks or document processors. Call it a total of five hand-offs, a conservative estimate for a globalized supply chain. (A real end-to-end supply chain could have as many as 20 participants, notes Neil Smith, chief executive officer of Savi Networks.) By itself, each of those legs offers the identical reliability record of 95 percent. But when the potential for failure at each stage is factored in, the result is an abysmal 77.4-percent performance level. Not to mention the extra days of transit that were built into the model, reducing a supplier's ability to respond to changes in consumer demand.

Companies will accept the longer lead time, stretching order cycles by as much as six months, without figuring out how to solve the problems that are likely to crop up, Fantasia says. One solution is to partner with a trusted logistics service provider (LSP) with a presence in the target country, and knowledge of the local culture. Another is to implement global trade management (GTM) software that supplies two essential functions: visibility of the order throughout its lifecycle, and critical data about each country's rules on importing, exporting and customs clearance.

Even in the age of the internet, paper presents an obstacle. According to Brockwell, emerging countries often have byzantine rules for complying with customs requirements. What might take a day or less in the U.S. or other industrialized nations can stretch to nearly three weeks, with double the number of documents required. "One of the main causes of [supply chain] variability," says Brockwell, "is people just not understanding how long it's going to take to clear customs."

Reaping the Benefits

Of course, the extra time and cost of global sourcing, even with the occasional disaster, won't stop companies from seeking out new locations for low-cost labor-not when big retailers like Wal-Mart Stores demand endless concessions from suppliers in order to keep their own prices low. And many emerging nations are eager to attract foreign investment, offering substantial breaks on taxes, infrastructure and other costs of doing business locally.

Manufacturers entering an emerging market often find suppliers that are ready and eager to work with them. Some have dormant capacity that was freed up when they were dumped by a previous original equipment manufacturer (OEM), mostly likely in the automotive sector, says Jeff Pratt, leader of the U.S. supply chain practice for PricewaterhouseCoopers (PwC). He cites the case of one maker of industrial products that hopes to work with Eastern European suppliers who had previously served customers in automotive and aerospace.

A successful outsourcing strategy is about more than cost. A recent Deloitte survey of 448 companies found higher growth and better margins among those that sought to differentiate themselves through participation in emerging economies. They benefited, too, from proximity to new markets for their finished goods. Those "underserved and unserved" consumers represent a strong source of new business, if not at the level of those in developed countries, Fantasia says.

In fact, some companies use global sourcing as a means of establishing a beachhead in future markets. Accenture has been working with a North American candy manufacturer that wants to expand into emerging countries through joint ventures, says Mike Engoian, who heads up the consultancy's North American fulfillment practice. The company might export raw materials or use mixing facilities for items that the host country doesn't make, then partner with local entities to make and sell finished goods.

Making a connection with a strong local partner is one key to doing business in an emerging country, says Smith of Savi Networks. "There are so many cases where companies have tried to set up offshore operations and go solo," he says. "But the success stories have largely been around where they've partnered." That's true even in China, Smith says, where foreign companies may be tempted to go it alone because the Chinese government has relaxed some of its restrictions on wholly owned ventures. Yet they might lack a local partner's intimate knowledge of government agency requirements and customs procedures.

Work done at the earliest stage of a product's lifecycle is also finding its way overseas. According to Fantasia, about a third of companies surveyed by Deloitte were planning to locate research and development programs in emerging countries, leading to a better understanding of local cultures and allowing for the integration of business processes and infrastructure on a global basis.

Things to Remember

Still, companies setting foot on unfamiliar ground must take into account a number of factors beyond the obvious one of workers' wages. Failure to do so will have serious implications for the extended supply chain, all the way to the customer's door.

Macro-issues need to be considered at the outset. Factors tied to the global economy, such as currency and foreign-exchange trends, might be overlooked by a company whose ear is too close to the ground. For a company with production in China, whose cost of labor and raw materials might have risen anywhere from 10 to 30 percent last year, a 7.6-percent appreciation of the yuan against the dollar could be the last straw. Global supply chains must be able to withstand attacks on operating margins from many directions. Any single factor, says Brockwell, can "turn your decision [to outsource] unfavorable."

Other barriers reside within companies themselves. With the economic downturn reducing the amount of private equity available to fuel acquisitions, businesses are turning to more traditional merger deals in order to grow. That can lead to a hodgepodge of information systems that inhibit the ability of companies to forge a coherent, global supply chain. "The result is a loss of visibility, inability to synchronize the supply chain, and failure to achieve synergies laid out at the time of acquisition," says Brian Bilsback, director of operations effectiveness with PwC.

Local infrastructure in the target country is a more visible challenge, one that most companies are likely to consider if not fully understand. When it comes to the quality of roads, rails, seaports and airports, China is the poster boy for both the best and the worst. In the industrialized provinces, no country offers more modern and efficient port operations. Shipments moving in and out of China used to be routed through Hong Kong by necessity, but new container ports springing up on the mainland have made that former British colony largely irrelevant to many importers and exporters. New highways, too, promise to speed cargo between Chinese factories and the waterfront.

Further inland, it's a different story. Chinese officials have sought to relieve the pressure on such highly industrialized areas as Guangdong province and the area around Shanghai, by siting production facilities in the rural central and western portions of the country. But those interior locations don't have the same access to rapid rail and highway connections.

On the carrier side, there's no lack of providers in China. Making sure they can do the job well is another matter. "You can almost find an individual on every corner who's got a truck and is ready to haul freight," says Lonny Warner, vice president of operations for the high-tech and electronics industry with Menlo Worldwide Logistics.

Menlo employs a rigorous methodology to sort out the best candidates. "The biggest concern is not in the four walls [of a distribution center]," Warner says. "It's in the consolidation points, and getting freight to those points to achieve proper cycle time and information flow."

How FTAs Can Help

Another commonly overlooked factor in the outsourcing decision-one that's more positive in nature-is the explosion of free-trade agreements, both bilateral and multilateral. FTAs offer duty-free treatment of goods with a minimum level of local content, or produced within one of the member countries. They may also result in faster clearance of cross-border shipments. Current examples include the North American Free Trade Agreement and the pact between the European Union and Mexico. Many others remain in the proposal stage, notes Brockwell, and companies should keep tabs on their progress as a criterion for future sourcing decisions.

A good global trade management (GTM) system can help to identify opportunities available through FTAs. It can also guide companies through the maze of customs regulations that must be observed by a global trader's network of customs brokers, freight forwarders and carriers. But the ultimate responsibility for compliance rests with the shipper, Engoian says. No outsourcing arrangement can protect a company against severe penalties for trading with buyers on a denied parties list, or violating rules on import quotas or local content.

Other types of information technology address the problem of tracking shipments in remote places. Shippers complain of "black holes," where the precise location of freight can't be fixed, even in the most developed countries. The problem is exponentially worse in areas where communications structure is lacking, or operators are unaccustomed to the reporting needs of modern-day supply chains.

Conventional wisdom states that computers and the internet have made it possible to communicate from just about anywhere on the globe. Indeed, a number of developing countries have leapfrogged from virtually no telephone service to a network of cellphones and satellite links in a matter of years. But there are still gaps in many locations.

"It's much more complex than that when you're transferring or reconciling inventories, or running a smart dock, cross-dock, postponement operation or light assembly," says Warner. "You're dealing with bills of material and new SKU configurations. It's not quite as simple as firing up a PC and your mobile card."

Cargo security is another pressing issue in many developing nations. In Colombia, Savi has partnered with Emprevi, a locally based provider of logistics and security services, to track the movement of freight from in-country factories to ports of exit on a real-time basis. The program is intended to protect the goods from theft, and assure Colombian customs officials that the containers have not been loaded with illegal narcotics. According to Smith, it has saved shippers $300 per container on security and handling costs, while reducing the number of time-killing inspections by customs. In addition, data gathered by the program can potentially be tied into Savi's global network of information on shipment status.

Ocean carriers, meanwhile, are struggling to track containers and keep them from vanishing into the hinterland of developing nations for days at a time. In China, they need to make import boxes available for exports as quickly as possible, while minimizing the movement of empty containers. (The huge trade imbalance between China and the U.S., favoring Chinese exports, ensures that a large number of import boxes will enter the country empty.) Yet that goal becomes harder to achieve as international commerce moves deeper into China's interior.

International Asset Systems, a vendor of technology to monitor the status of transportation equipment, is working with logistics providers in China to fill empty inbound containers with domestic freight, bound for upriver locations, where the boxes can then be stripped and reloaded with export cargo. The program could help carriers to hold the line on freight rates by reducing the cost of moving empties, according to Phil Behenna, senior vice president of IAS.

Landed Cost Calculations

The final decision on whether and how much to outsource production to an emerging economy comes down to an assessment of its real price tag. But that's where many companies appear to be falling short. Looking only at more obvious factors, such as worker wages and transport expense, they fail to understand the concept of true landed cost. Mid-sized companies, which tend to have less experience in global markets, are especially prone to unpleasant surprises for this reason. "Just understanding what [outsourcing] does to their payment terms can be a challenge," says Brockwell. "They might get stuck with more working capital requirements."

Often a company's analysis of risk and reward will be based on the movement of freight in a perfect world. But glitches in complex, global supply chains are inevitable. And when they happen, an importer might find itself resorting to premium air freight in order to avoid an interruption of supply.

Such actions are common, especially during seasons of peak demand for transportation capacity. "The FedExes and the UPSes of the world are getting rich on expedited shipments from China," says Bilsback. In the alternative, a company will keep extra inventory close at hand, weighting down the balance sheet and boosting the risk of product obsolescence.

Aspects of landed cost include expense incurred by production, inventory carrying and logistics, Fantasia says. Additional considerations include local government policies, political stability and the risk of natural disasters. All are factors from the time an order is placed with a new supplier, to the delivery of finished product to final destination. And all are necessary for managers to make an educated "go or no-go decision" about whether to outsource.

In some cases, the evaluation will lead to a mixed strategy, combining overseas production with limited sourcing or storage closer to the customer. Either way, Fantasia cautions, "you don't want to over-engineer the problem." Senior managers should evaluate the entire supply chain without getting bogged down in decisions between port pairs, or between full containers and consolidated loads. By getting too immersed in analytics, they risk not making sound decisions at a strategic level.

Even if they feel comfortable producing in an emerging economy, companies would be wise to consider alternative sources for parts and finished goods. One PwC client suffered a year-long labor strike at a supplier's facility, barring access to its tooling for that period. Bilsback says executives need to balance their desire for lean supply chains with a well-considered risk management program.

A manufacturer might not always have the luxury of sourcing product or parts from multiple locations. It could be constrained by issues of cost, supplier quality or the availability of raw materials. But a single-source strategy requires even greater diligence, says Jon Chorley, vice president of supply chain management product strategy with Oracle Corp. "You need to understand more about the supplier," he says. "You exchange one set of challenges for another."

Engoian recommends that OEMs consider labor-hedging strategies that account for the nature of individual products. Some of Accenture's U.S.-based clients rely on overseas sources, possibly in developing countries, for basic items that can support longer and more predictable lead times. For complex goods with more volatile demand, they will source domestically, or across the border in Mexico. The split might be 70 percent overseas, where product is cheaper, and 30 percent in closer locations. Rising wages in China, along with the greater likelihood of product damage on longer routes, are additional factors that are prompting some companies to shift at least some of their production back to the Americas, Engoian says.

Companies sourcing in emerging economies will typically approach the issue of risk mitigation in one of three ways, according to Jin Whang, professor at Stanford University's Graduate School of Business and co-director of the school's Global Supply Chain Management Forum. The easiest solution is to create redundancy in the supply chain. That takes the form of extra inventory, sourcing locations, vendors or nodes in the communications network. But that approach is also the most expensive to implement.

The second technique is to prepare for disaster by learning from "near misses," Whang says. Airlines are experts in this area, but other industries can adopt the practice as well. They can look at incidents where damage to the supply chain was either avoided or contained, then apply those lessons to everyday operating strategies. Examples include a labor strike that was threatened but called off, a traffic accident in which the contents of a truck didn't escape, or a natural disaster that skirted the relevant area.

The third and most effective technique, says Whang, is to streamline the entire supply chain so that the possibility of glitches is minimized. Instead of trying to deal with problems only after they happen, he says, companies should be applying quality precepts to various stages of the chain. In the process, they will come to understand why variability arises in the first place.

Planners can also anticipate problems through strategic network modeling. Oracle is among the vendors to offer a tool for testing out various hedging strategies and assessing their impact on price and product availability, Chorley says. The software also helps companies to decide in advance how they will cope with disruptions such as supplier failure, congestion and natural disaster.

In the end, manufacturers may have no choice but to go on seeking the lowest-cost sources of production around the world. But they'll need every scrap of available information to succeed in those countries. "Most industries today are global, and most companies are outsourcing all or at least some of it to somewhere," says Morris Cohen, chairman of MCA Solutions. "The ability to manage those pieces in an integrated fashion is still a challenge."

RESOURCE LINKS:
Accenture, www.accenture.com
Deloitte, www.deloitte.com
International Asset Systems, www.interasset.com
JPMorgan Global Trade Services, www.jpmorgan.com
MCA Solutions, www.mcasolutions.com
Menlo Worldwide Logistics, www.menloworldwide.com
Oracle Corp., www.oracle.com
PricewaterhouseCoopers, www.pwc.com
Savi Networks, www.savi.com
Stanford Global Supply Chain Management Forum, www.stanford.edu/group/scforum