Executive Interview:  MIT's David Simchi-Levi on The Hidden Costs of Outsourcing

We spoke with Dr. David Simchi-Levi of MIT after his presentation at MIT’s “Future of Manufacturing” conference held in Cambridge.  Simchi-Levi has come to the forefront of the movement to reexamine the way we build and operate global supply chains, as well as the vital statistics surrounding the very emotional movement to bring manufacturing back to The Americas and reverse the damage  caused by the 80s stampede to outsource.  His research on what key issues remain for US industry highlights challenges long suspected as key contributing factors.  

Question:   What is holding companies back from returning manufacturing to the US?

Simchi-Levi:  We’re seeing a move in some industries from global to more regional operations. These companies are looking to make product closer to market demand, but there are four different reasons that prevent companies from moving all the way back the US:

1.        Labor cost.  Let’s look at the automotive industry, for example.  Labor cost in China is $3 to $4 per hour, Mexico about $6 or $7 per hour, but in the US, it’s $50 - $60, fully loaded, so if  you are a manufacturing company looking to return, you have to think about the challenges and the costs.  While it’s not very difficult to justify a move to Mexico, it is much more difficult to justify the move to the US.

2.       Financial incentives – Taxation makes a big impact.  The difference between taxation in the US versus other countries is such that when a company focuses on the financials, the tax structure needs to be included.

3.       How easy or difficult is it to move the supply base or the infrastructure to another location? In some industries like the PC or mobile phones, there is a lot of infrastructure in Asia that is not easy to move, and as a result, it is difficult to justify a move of manufacturing closer to market demand.    

4.       Labor skills – We lost some of the skills that we used to have, but the bigger problem is that as manufacturing  starts moving to other counties we not only lose manufacturing skills, but we also start to see the departure of product design and innovation.  The media are focused too much on manufacturing, but it’s not only about manufacturing – it’s product design and innovation as well - and all of a sudden you are left with almost nothing.  One way to think about this issue is to consider product such as PCs, mobile phone, or even the iPad. , Start breaking one such product down to its components and ask where the IP (intellectual property) is coming from.  It is mostly from the US, but now more and more of the IP is coming from Asia.    So, that is what is so dangerous about losing manufacturing. This is only the beginning, and after that you lose the capability to design products, innovate and develop IP.  One way to bring back the skills that we lost is through a change in education, with retraining initiatives and the community colleges.  So this may help change the image of what manufacturing is about.

Question:  How did we get into this position?

Simchi-Levi:  Initially the move to Asia was not only due to low labor costs, but also, unit cost and financial incentives for outsourcing to Asia through all sorts of tax breaks that corporations got from local countries. 

But what many companies did not take in account were the hidden costs of outsourcing – which includes the cost of inventory, logistics and the fact that a move to China implies a long lead time that exposes the supply chain to all sorts of disruptions and hence enormous risks...  All this was not taken into account because everybody looked at first order impact, or the costs to produce ourselves vs. outsourcing - they missed the hidden cost of outsourcing – and only now companies have started realizing that this is an enormous challenge.

The hidden cost of complexity

Here’s another example.  When times were good, companies added a lot of products to their portfolio, but there is a hidden cost to adding more complexity, the same as there are hidden costs to outsourcing.  When companies start to increase product portfolio and they add thousands of suppliers, complexity increases and as a result cost increases. For example, as product portfolio increases, forecast accuracy decreases and with it service level. To compensate for that, companies increase inventory which is both expensive and risky. At the same time, all these products compete on the same resources so manufacturing costs, set-up costs, increase. This is what I refer to when I talk about the hidden cost of complexity.  Unfortunately, when these companies look at standard costs and standard prices, they may think that all products have positive margins.  But, if they add the hidden costs, the result may be negative margins to some or all the products, and that’s important to understand.

Most companies don’t know how to measure the hidden the cost of complexity, or to go about complexity reduction.   I have worked with a number of major companies on complexity reduction, and we’ve seen incredible results.  At Dell, for example, over a period of 18 months, the number of configurations was reduced by 99% and as a result forecast accuracy increased by a factor of three and cost went down significantly.

Question:  We’ve heard that Toyota is mapping its supply chain.  What’s happening here?

 Toyota is indeed mapping their supply chain – they have done significant work on laying it all out.   And the reasons of course were the floods in Thailand and the earthquake and disruptions in Japan.   The company is still working hard to recover, and if we compare Toyota, Honda and Nissan, Toyota was the most affected by the two events - the numbers are huge.  Toyota lost 800,000 units of production from the earthquake and 200,000 from the Thailand floods, so they knew they had to look carefully at the supply chain and identify what to do. 

And what they did was to map the entire supply chain to identify at-risk suppliers.  Toyota now demands from their suppliers a two-week recovery time.  And Toyota now understands as a result of their experience in the floods, single source suppliers are not always more risky than dual source suppliers. This is true since a single source supplier may have two manufacturing facilities, so that when the facility in Thailand is down, for instance, they can switch to the second facility this supplier has without increasing response time...  On the other hand, a dual-sourcing strategy can be risky because the two supplier may depend on the same critical part provided by one manufacturer.   So what Toyota didn’t understand was the dependencies in their global supply chain.  That’s why it is absolutely essential for global operations to map out their entire supply and identify bottlenecks and dependencies.

 Now Toyota requires a two-week recovery time and with at-risk suppliers Toyota asks them to split production into multiple locations, or hold extra inventories, or both.  This is a big shift big shift from JIT. 

Note:  To read review of Simchi-Levi's latest book Operations Rules, click on title in book section, left sidebar - Blue Heron All-time Favorite!

David Simchi-Levi is a Professor of Engineering Systems at MIT and is considered one of the premier thought leaders in supply chain management. His research focuses on developing and implementing robust and efficient techniques for logistics and manufacturing systems. His books include:  Managing the Supply Chain (McGraw-Hill, 2004), The Logic of Logistics (Springer 2005), as well as the award winning Designing and Managing the Supply Chain (McGraw-Hill, 2007). His new book Operations Rules: Delivering Customer Value through Flexible Operations was published by MIT Press in September 2010.  He is the founder of LogicTools (now part of IBM), which provides software solutions and professional services for supply chain planning.

Patricia E. Moody

Blue Heron Journal

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