When offshoring, think functions not factories

Till Vestring, based in Singapore, directs Bain & Company's (www.bain.com) Asia-Pacific Industrial Practice. Ted Rouse, based in Chicago, directs Bain's Global Industrial Practice, and Uwe Reinert, based in Dusseldorf, directs the firm's European Industrial Practice.

It wasn't long ago that the survival of Continental AG, the large tire and automotive-components manufacturer based in Hanover, Germany, seemed very much in doubt. Struggling under a heavy debt load and facing relentless pressure to reduce prices, the company was widely seen as a likely takeover target. Today, however, Continental remains proudly independent. In fact, despite the general sluggishness of the car industry, the company has been thriving. Its profits are up dramatically, and its stock price has risen almost fourfold over the past three years.

Much of Continental's success can be traced to the aggressiveness and sophistication of its global supply-chain strategy. Under CEO Manfred Wennemer, the company has shifted many of its production functions to an array of low labor-cost countries, from Slovakia to China to Brazil. At the same time, it has kept other critical functions within Germany as well as inside other relatively high-cost countries like Japan. By putting the right components of its supply chain into the right places around the globe, Continental has been able to continually drive down costs while at the same time introducing a stream of technologically advanced new products.

In studying the offshoring practices of major industrial companies, we've found that Continental's highly modular approach is shared by other supply-chain leaders like General Electric, Honeywell, Siemens International, and Emerson Electric. Rather than think in terms of entire factories when they make offshoring decisions, these companies focus on individual functions and products. They optimize, in a coordinated fashion, the location of every module of their supply chain, capitalizing on regional differences not only in costs but also in skills. As a result, they've been able to move quickly and with great agility, shifting activities among a wide array of regions and countries in a way that optimizes the cost and effectiveness of their entire operating system.

Most manufacturers don't take such a modular approach. Looking to maximize their immediate cost savings, they tend to seek opportunities to close down entire factories in high-cost areas and replace them with plants in low-cost countries (LCCs). It's easy to understand the allure of such a strategy. The labor-cost savings offered by LCCs can be striking, after all. Engineering labor costs, for instance, are almost four times higher in Germany than in India, and factory labor costs in the West can be 20 or even 30 times higher than in China. In light of such enormous discrepancies, the thought of simply shutting down an operation in a high-cost country and moving it wholesale to an LCC can seem very attractive.

But transplanting entire factories is rarely the best route, even when significant improvements in cost competitiveness are critical to survival.  The cost of closing down a manufacturing facility in a high-cost country can be considerable — as much as 200,000 Euros per laborer in a country like Germany. Then you have to add in the cost of constructing a new plant in an LCC plus various hidden "legacy" costs such as those related to disrupting relations with local suppliers. The price of shifting an entire production facility is often so high that it just doesn't make economic sense. When companies realize this fact, they often end up abandoning or postponing their offshoring plans. Their ambitious plans go for naught.

That's why smart companies think in terms of functions, not factories. They realize that just by shifting certain carefully selected processes or activities, they can often approximate the savings of moving facilities without having to bear the shut-down and start-up costs. In particular, they focus on moving the most labor-intensive functions-whether simple assembly or complex engineering-while keeping highly automated functions within their traditional locations. Continental's ContiTech, for example, has shifted the making of molds for its products to the Slovakian city of Dolnè Vestenicè, but it has kept most of its highly automated production of electronic braking systems within Germany.

The modular approach has also enabled the leaders to tap into attractive foreign capabilities that go well beyond basic manufacturing functions. Recognizing that the skill levels of LCC workforces are reaching or exceeding those of the developed countries of the West, the supply-chain leaders examine specific business functions, such as finance or marketing, on a case-by-case basis, identifying those ripe for migration and sidestepping those that are not. Procter & Gamble, for instance, has its payroll done in Costa Rica, which has a large cadre of trained accountants. Boeing has a design center in Russia, a country with deep aerospace engineering skills. General Electric has built an R&D center in India with a staff of 500, about one- third of whom are PhDs. Our research shows that cost leaders are about twice as likely as cost laggards to reap benefits from shifting knowledge-intensive activities like R&D to LCCs.

Finally, in deciding which functions to move, the leaders also carefully take into account opportunities to build new markets in the host country.  Emerson, for example, does $900 million worth of manufacturing and sourcing in China, spanning a range of functions. But China is not only a key link in Emerson's global supply chain, it also accounts for more than $1 billion in annual sales of products ranging from industrial motors to network power systems. Emerson uses its operations in LCCs to gain access to and expertise in serving lucrative and rapidly growing new markets.

By placing the right functions in the right places, manufacturers can not only cut their supply-chain costs, but also strengthen their capabilities and extend their reach into attractive new markets.

Till Vestring, based in Singapore, directs Bain & Company's (www.bain.com) Asia-Pacific Industrial Practice. Ted Rouse, based in Chicago, directs Bain's Global Industrial Practice, and Uwe Reinert, based in Dusseldorf, directs the firm's European Industrial Practice.