Cheap labor is a powerful magnet when global companies are deciding where to source production. It doesn't take a complicated formula to see that China's factory wage rates are well below those of the U.S. Hence the wholesale migration of manufacturing to China and other developing countries in Asia over the past decade.

Now, though, companies are starting to deploy a broader set of criteria for determining where they should be making product and sourcing raw materials. At the same time, they're redefining what constitutes a customer. The result is likely to be a major shift in the makeup of global supply chains in the years ahead.

One thing seems certain: future sourcing decisions won't be based entirely on low labor rates. The offshoring of production to China over the last few years "got us into a whole lot of trouble," says Jim Lawton, senior vice president and general manager of supply management solutions with Dun & Bradstreet. "We can't afford not to do it," he adds. "We've just got to do it smarter than we did the last time."

What went wrong? For many sourcing executives, labor rates took precedence over a host of hidden expenses. Chief among them is what Simon Ellis, practice director for supply chain strategies with IDC Manufacturing Insights, calls "those pesky logistics costs." In a situation that now looks blindingly obvious to makers of consumer products, greater distances between factory and consumer led to longer transit times and prolonged order cycles. It became harder for suppliers to meet unexpected surges in customer demand. To guard against stockouts, companies were forced to beef up safety stocks, reversing a trend toward cost-cutting through the reduction of inventory in the pipeline. Meanwhile, regulators increased the burden on importers to monitor distant suppliers. And supply-chain risk soared.

One big factor behind the turnaround in sourcing strategy was the rise in fuel prices in 2008. As the price of oil soared, many executives began paying closer attention to that line item, says Adrian Gonzalez, director at ARC Advisory Group. Physical distance became a bigger consideration.

"A lot of the savings that companies were getting in labor were being eaten up by transportation cost," Gonzalez says, noting the need to increase buffer stocks to ensure responsiveness to demand. Then came a wave of product recalls due to quality issues - lead in toys, melamine in food - and suddenly China wasn't looking quite so attractive as a means of holding down supply chain costs.

Add to that a continuing concern over the lack of protection of intellectual property in China. The country has taken some steps to address the problem, but piracy of movies and other entertainment product is still rampant there, and U.S. companies worry about the access of Chinese suppliers to their proprietary technology. Gonzalez expects some progress as China develops its own generation of skilled engineers, many of them trained in the West. Nevertheless, "there is still some maturity that needs to take place in terms of their IP protection laws."

Even the issue of wage rates isn't as simple as it once seemed. Gonzalez points to the recent strikes in China as evidence that the country no longer can be treated solely a source of cheap labor. There have been reports of worker unrest at factories making automotive parts in Guangzhou, electronic components in Tianjin and air conditioning systems in Zhongshan, among other locations. Work stoppages were becoming increasingly common in the spring and early summer of 2010.

A New Approach

All of this suggests that supply-chain executives need to adopt a more sophisticated approach to the sourcing question. "We've been predicting now for a couple of years that companies need to think a bit more holistically about global sourcing," says Ellis. Some product categories are extremely price-sensitive and don't require short lead times. But many others call for a rethinking of basic strategy, to maintain high levels of customer service while keeping the lid on cost. Ellis is pushing the concept of "optimized sourcing," by which companies seek to align supply with projected demand growth.

Companies are searching for lower-cost alternatives to China, says Ellis. But it's not always that easy to make the change. Semiconductor manufacturers invest in foundries that are expected to be productive for 20 to 30 years. They can't just pull up roots when wage rates start to rise.

Other industries, such as apparel and consumer electronics, are more flexible. "Even with supply contracts and service-level agreements, it's not unreasonable to think that that kind of business could transition from one country to another relatively seamlessly," says Ellis.

Whether the cost and available infrastructure are comparable is another question. It would be extremely difficult to duplicate elsewhere the capabilities of a supplier like Foxconn Technology Group, which employs some 800,000 people at a city-like complex in Shenzhen. Sourcing decisions today must strike a careful balance between cost and risk, says Ellis.

He urges companies to adopt what he calls "profitable proximity," a concept whereby companies consider their total supply-chain costs while also thinking about the need for speed, lead time and the balance between supply and demand. Also of growing importance, he notes, is the issue of sustainability. Longer distances between the factory and sales floor, coupled with a last-minute reliance on airfreight for expedited shipments, add significantly to a company's carbon footprint.

That said, manufacturers are making a concerted effort to move at least some production capacity out of China. Lawton saw D&B's database of firms in Vietnam increase more than five-fold last year, and more than double in Malaysia. "That's where our customers have been leading us, to want to make investments," he says.

The next step is to acquire accurate information about suppliers in the target country. In the post-9/11 era, it has become more critical than ever to build secure supply chains. The new Importer Security Filing requirement of U.S. Customs and Border Protection, also known as the 10+2 Rule, is only the latest in a string of measures that require companies to fully vet their foreign suppliers. In addition, says Lawton, original equipment manufacturers need to know intimate details about a supplier's level of quality and financial condition. The unanticipated failure of a key supplier can seriously impact a global supply chain, especially when cost-conscious executives allow for narrow margins of error.

A further complication is the multi-tiered nature of many supply chains. Companies relying on production in China might be surprised to learn of the true source of some of their goods. For example, says Lawton, a large portion of the value-add in a given product might come from sub-Saharan Africa. "Chinese companies are looking for the best place to be doing business," he says. "In some cases, it's not in China." Still, U.S. buyers tend to take the "Made in China" label literally.

Lawton believes companies are just beginning to make progress toward adoption of a "total landed cost" approach to sourcing evaluations. During the worst of the recession, he says, many were focused exclusively on survival. Now, with modest recovery beginning to take shape, they can afford to consider factors such as quality, delivery issues, supplier solvency and the cost of keeping inventory on a ship for 30 days.

"Have I seen a dramatic increase in companies' ability to get their arms around [total landed cost]?" asks Lawton. "I'd say no. Many companies are not equipped to take into account the factors that are much more relevant.... But some have gotten smarter about it."

Deeper Into China?

One alternative is to shift production within China, from overcrowded coastal areas to inland regions. China itself is promoting this move, as it seeks to develop other parts of the country and build up infrastructure in non-urban locations. Josh Green, chief executive officer with Panjiva, calls this strategy "a short-term solution to rising wages." He points out that much of the industrial labor force in coastal China was drawn from inland areas in the first place.

"It's not as if you're really tapping a totally different labor pool by moving inward," Green says. At the same time, lengthier supply lines are boosting transportation costs.

The decision to abandon China in favor of other low-wage Asian countries has its drawbacks. Companies are likely to find lower wages in Vietnam, Indonesia and Bangladesh, to name three possibilities. But the benefits will be short-lived, says Green, because the populations of those countries aren't large enough to support an extensive network of low-cost factories.

India, with a population of more than 1.1bn, is a well-accepted location for offshore services. But it, too, offers challenges to global supply chains based on manufacturing. A high degree of bureaucracy, coupled with inadequate infrastructure for trade, results in an expensive place to do business. "Most sourcing executives I talked to are skeptical [about India]," says Green.

So what's left? Green says companies must be more innovative about the way they manufacture products, no matter where their factories are located. The search for ever-lower wages can't continue indefinitely; in its place must come efforts to boost productivity and efficiencies at the plant. In addition, companies must do a better job of achieving visibility throughout their supply chains, to match supply with demand. Experts are forever predicting an end to technological advances, Green says, but "betting against innovation tends to be wrong."

Latin America can't compete with China and other places in Asia on the basis of wage rates alone. But some experts argue that its greater proximity to western markets could be a big plus for multinationals. Tom Dinges, senior consultant with the market-research firm iSuppli, says Brazil is shaping up as a major market for foreign investment in manufacturing. The country's tangle of import regulations and tariffs virtually requires an on-the-ground presence if a company wants to sell into that market. Hewlett-Packard Co. is among the major high-tech companies to take that step, he says.

Mexico lost a significant amount of manufacturing activity when U.S. companies flocked to China. Now, it might be getting some of that business back. Dinges says companies are considering a return to the Mexican maquiladora facilities that produced a wide range of goods for the U.S. market over the past few decades.

"Industry as a whole is very migratory," he says. Electronics companies, which tend to rely on standardized equipment that can be moved around with relative ease, can shift more easily than a steel mill, say. But any transfer of production from one country to another is still a multi-year process - so don't expect Mexico and other Latin American countries to become big players in global manufacturing overnight.

Or not at all. Dinges cautions that Latin America could face the small dilemma as Eastern Europe, which served as an attractive source of low-cost labor about 10 years ago. Because the local workforce was young, and the number of plants so high, wage rates moved up quickly, dimming the region's attractiveness to producers. The same scenario could play out in areas such as Central America, where country populations are relatively small, and access both to infrastructure and basic needs such as water is limited.

Jim Kelly, chief executive officer of the management consultancy JVKellyGroup Inc., says a desire by companies to reduce supply-chain risk might drive some global businesses to Latin America. He cites a new study by AMR Research Inc. (now part of Gartner Research), which found that 45 percent of the 500-plus companies surveyed had experienced a disruption in their supply chains during the past year. Of that number, 8 percent reported a problem that cost them $5m or more.

Kelly sees agricultural production as one area that is ripe for growth in Latin America. There could even be a return of some services, particularly call centers, to the U.S. and Canada, he says. In addition, companies might choose to allocate certain discrete business processes, such as performance-metric analytics, to a local provider.

But Kelly doesn't believe that consumer products manufacturers will abandon their low-cost plants in Asia for the western hemisphere, let alone the U.S., any time soon. "Americans have given up on a lot of different industries [because] they can get it better, cheaper and faster elsewhere," he says. The lure of cost savings offered by Asian producers is still too strong to ignore.

It's Still About Cost

Jim Wetekamp, senior vice president of solution strategies with BravoSolution, agrees that companies are beginning to incorporate an array of risk-management concerns into their sourcing strategies. Nevertheless, "for the majority of our clients, the number-one consideration for outsourcing is still cost."

Wetekamp is referring to more than the hourly wage of a factory worker. He says businesses are factoring in all of the costs related to start-up and ongoing operations. Transportation and inventory carrying expense are major elements in that calculation. So is the financial stability of overseas suppliers.

China remains one of the top locations for outsourced manufacturing, even though growth there has recently slowed, Wetekamp says. Other Asian nations, including Malaysia, Thailand and Indonesia, are presenting themselves as alternatives.

Less attractive to multinationals, despite the proximity issue, are countries in the western hemisphere. Existing sourcing relationships are deep and "very sticky," Wetekamp says, adding that the business case for locating production in Latin America "is not compelling enough, from what I've seen so far."

Lawton agrees. "To some degree, [the return to the West] has been overstated," he says. "In some strategic cases, with specific components and services, you do see some of that. But it's so rare that it makes news."

In the long run, the main reason why companies will decide to remain in China is to be in a position to sell into that market. The big automakers have already established joint ventures with local manufacturers, allowing them to redistribute their brand in China, Wetekamp says. The prospect of serving a nation of more than a billion people is simply too compelling to pass up.

"For a lot of companies, the decision to manufacture overseas is really more about where the future consumer is going to be," says Gonzalez. What was once a decision based on hard costs such as labor has become a strategic move, in anticipation of a rising Chinese middle class with substantial purchasing power.

"If you want to sell a product in the largest-growing market in the world, you'd better be sourcing in that country," agrees Peter Scott, vice president of supply chain solutions with Exostar, creator of a technology platform for trading-partner collaboration. "People are using sourcing almost as a competitive weapon." This despite real concerns over IP protection and regulatory issues in China. Executives are beginning to focus on "top-line" considerations related to long-term marketing strategy.

Future sourcing strategies, then, will look a lot like present-day ones - but for an entirely different set of reasons. As they tap into new global markets, companies will still be concerned about cost, Gonzalez says. But they will also be aiming for continuous improvement of their supply chains, through the application of new technology and innovative ideas for cutting waste. In the process, rival suppliers might find themselves sharing transportation and distribution capacity, in the interest of serving a common retail customer.

The idea has been talked about for a long time, "but I get the sense that the needle has been pushed far enough so that companies are saying, 'Let's start exploring this for real,'" Gonzalez says. "That's what is going to cause the next level of efficiency."

Resource Links:

ARC Advisory Group, www.arcweb.com
BravoSolution, www.bravosolution.com
Dun & Bradstreet, www.dnb.com
Exostar, www.exostar.com
IDC Manufacturing Insights, www.idc-mi.com
iSuppli, www.isuppli.com
JVKellyGroup, www.jvkg.com
Panjiva, www.panjiva.com