Other Voices: Is the time right for reshoring?

It’s hard not to pick up a newspaper or listen to a news report without hearing that U.S. manufacturers are reshoring production, and jobs, back to the U.S. It’s a cause we have been dedicated to at the Reshoring Initiative. There are a number of reasons why we believe that 2018 is the right for companies to re-evaluate their offshoring decisions. Among them are the reduction in U.S. corporate tax rates and regulatory costs and the approximately nine percent decline in the USD from Jan. 2017 to Jan. 2018.

Recent academic research provides useful detailed insight into how and why some organizations have reevaluated their offshoring decisions, leading to decisions to reshore. The results are generally consistent with the analyses of data collected by my organization, the Reshoring Initiative, based on a larger population of reshorers.

In a recent article entitled “Why in the world did they reshore? Examining small to medium-sized manufacturer decisions,” John V. Gray, Gökçe Esenduran, M. Johnny Rungtusanatham, and Keith Skowronski looked at four small-to-medium-size enterprises, or SMEs, with headquarters and demand in the U.S., that had moved their manufacturing operations from low-cost locations in Asia back to high-cost countries. Two of the companies are located in the Midwest and two are in the West, with product categories ranging from power transmission equipment to measuring and controlling devices, to fabricated metal products to apparel. The authors found that these reshoring decisions are driven by factors beyond changing location-related costs.

The Reshoring Initiative and John V. Gray, one of the co-authors and a professor at The Ohio State University’s Fisher College of Business, have discussed the reshoring phenomenon for years. This article is an effort to compare the results from the in-depth academic research of a small number of firms by Gray and his colleagues, and the larger-scale survey data collected by our organization. To differentiate between their work and ours, any numerical results related to the work of the Reshoring Initiative are italicized.

Lessons Learned

1. Remedying the Unintended Consequences
SMEs are correcting the unintended consequences of initial offshoring decisions originally made by managers with limited offshoring experience. Focused on finding the lowest per-unit landed cost, these decisions were often made using overly simplistic heuristics, or shortcuts, to enable decision-making. In subsequent reshoring decisions, the SME’s learned from experience and incorporated additional risk, cost and performance considerations into the decision-making process.

Negative events offshore: The SMEs made all of their reshoring decisions after experiencing negative events offshore, such as operational problems and intellectual property (IP) violations. The increased risk of these problems, and the associated potential costs, were not explicitly considered in the original offshoring decisions. Gray’s research listed 9 real world examples of negative events offshore. They included:
• The use of unapproved suppliers without notice,
• The use of unapproved and different components in final assemblies,
• Delivery of finished products that were different than the samples provided,
• Suppliers unable or refusing to correct problems,
• Repeated poor-quality products,
• Brand damage due to poor quality,
• The need for third-party quality control inspectors not originally calculated into the original cost model,
• IP theft,
• Legal costs to address IP theft not originally accounted for.

Data collected by the Reshoring Initiative data some 700 companies across the U.S. from 2007 to 2016 is consistent with the study’s detailed findings from its small sample of companies. Quality/rework/warranty was the #1 area of dissatisfaction with offshore, about 2/3 higher than #2, freight cost. IP risk was #8 but still mentioned by 10% of the companies that reshored. Other high ranked factors were: total cost, delivery and inventory.

2. Increased Awareness of Less-Quantifiable Factors

When offshoring, SME managers often employed the lowest per-unit landed cost (LPLC) heuristic and put “a strong emphasis on the quoted price.” When reshoring, SME managers consistently considered less quantifiable or less visible cost factors. Some of these examples included:
• Product quality, such as third-part inspector costs, rework of rejected products, time lost and inadequately captured opportunity costs.
• Brand damage and loss of reputation that can accompany poor product quality and loss of quality control.
• Supply chain and operational problems that are difficult to quantify such as port strikes that require “what if” advanced planning.
• Increased cost of responsiveness to market-driven product design changes due to physical distance. SMEs stated that changes offshore could take as many as 16 weeks as compared to a couple of days locally.
• Reduction of supply-demand mismatch responsiveness emerged as a key factor for design flexibility and lead-time reduction.
• Harming of R&D productivity: Firms found that as the distance from their base operations increased due to offshoring, it was more difficult to maintain the relationships required for innovation, especially for SMEs lacking globally dispersed R&D and engineering functions. In “Producing Prosperity: Why America Needs a Manufacturing Renaissance,”  Harvard Business School’s Gary P. Pisano and Willy Shih argued that innovation declines when manufacturing and engineering are separated.

In sum, decisions to reshore manufacturing operations, as compared to decisions to offshore, appear to incorporate a wider range of factors, many of which are extremely difficult to quantify.

These observations from the academic case studies are consistent with conclusions from the Reshoring Library and TCO user databases. We have found the following:
• Companies offshored primarily to reduce their product cost, making decisions based on wage rates, manufacturing cost or ex-works price.
• A combination of accumulated offshore experience and offshore costs rising relative to domestic costs has driven companies to reevaluate their offshoring decisions.
• The distribution of Chinese offshore ex-works price as a percentage of U.S. ex-works price has a mode of about 72%. Approximately 25% of the offshore work would have a lower total cost if sourced domestically. Use of TCO can justify reshoring some work, but far from all.
• It is far easier to reshore work that is outsourced offshore than in-house offshore.
3. Indifference to Environmental Concerns

Although SMEs did not take environmental impact into consideration in their decisions to reshore, they were well aware that manufacturing in the U.S. is substantially cleaner than in China.

Similarly, the Reshoring Initiative has found that green considerations were cited fifty times but came in as number eleven of the negative factors found offshore. The Initiative is developing a Corporate Social Responsibility Estimator that will help companies estimate the relative environmental impact of offshoring and reshoring

4. Governance Structure: Level of Administrative Control

Governance considers the level of administrative control of the operation that can range from complete (in-house, hierarchical governance) to intermediate (local production, close partnerships with suppliers, hybrid governance), to essentially no control (typical of offshoring, arms-length, market governance).

Offshoring and Loss of Control

Other research has shown location decisions often are conflated with governance decisions, the offshoring and reshoring decisions examined here being no exception. Partnerships typically involve extensive, often face-to-face, buyer-supplier interaction. Local production is expected to facilitate such interaction, permitting greater cooperation and collaboration between manufacturing and other functions.
• The original offshoring decisions did not appear to explicitly consider the governance implications of extending the supply chain through offshoring.
• When offshoring, the SMEs shifted governance structures toward market governance (essentially no control / arms-length). After offshoring, they visited infrequently (primarily for auditing purposes) or not at all, often relying on an intermediary, or broker, to manage the offshore supplier. Thus, what was thought of as a location decision also was a governance decision.
• When reshoring, the SMEs moved away from market governance, with half of the reshoring decisions moving to in-house production.
• Even the reshoring decisions that did not include in-house production led to increased coordination and cooperation with domestic suppliers, along with increased control.
• Related to the above two bullets, firms typically reshored in the context of rethinking their supply chain structure and competitive priorities to take advantage of the reduced geographic and organizational distance to their suppliers. Thus, the decision was intentionally not just a location decision but also a governance decision.
• Selecting local suppliers enabled higher quality control and resolution of issues as they arose.

In sum, decisions to offshore, seemingly unintentionally, shifted governance towards market. Decisions to reshore tended to, more deliberately, shift the governance structure away from market governance.

About 70% of the publicly reported reshoring is in-house by the company that decides to reshore. This statistic is likely at least partially driven by the fact that in-house reshoring typically involves a new facility, and thus is likely to be written about in the press. Conversely, a change from an offshore to an onshore supplier may be seen as just another order and is less likely to be documented.

5. Propositions based on the Research

Overall, the academic research found that SMEs, through their decision-making process, are remedying the unintended consequences of initial offshoring decisions made by managers possessing limited offshoring experience using overly simplistic heuristics. The researchers derived propositions related to SME reshoring decision-making. Here, managers at the SMEs focused on finding the lowest per-unit landed cost (the aforementioned LPLC heuristic). Focusing on cost, managers often altered not only the geographic distance, but also the governance structure away to an arms-length “market buy”, sometimes from a starting point of in-house production. This added the complexities related to outsourcing with those of offshoring. In subsequent reshoring decisions, they learned from their offshore experience and incorporated additional cost and performance considerations into the decision-making. The derived propositions are:

• Proposition 1: The more the original SME offshoring decision resulted in a move toward market governance (arms-length outsourcing), the more likely the SME is to reshore.
• Proposition 2a: When facing intense competition in per-unit landed-cost performance relative to competition in other performance dimensions, SMEs are less likely to reshore.
• Proposition 2b: When facing intense competition not directly attributable to per-unit landed costs (e.g., responsiveness), SMEs are more likely to reshore.
• Proposition 3: SMEs are less likely to reverse their reshoring decision and offshore (or vice versa) when the original decisions were made subject to the condition of high offshoring experience.
In some of the cases, managers with prior offshoring experience hired after the original offshoring decision was made were instrumental in making the case for reshoring.

The researchers also suspected managers considered per-unit landed cost the most valid cue when deciding from where to source their products, and chose the viable option with the lowest per-unit cost. Offshore operational challenges forced managers to recognize later that they had undervalued important risks and performance challenges.

The reshoring decisions were made with more analysis and included more factors. This learning through experience is consistent with the simple-rules paradigm proposed in 2011 by the researchers Bingham and Eisenhardt.

Announcements of reshoring and FDI (Foreign Direct Investment) of manufacturing jobs in 2017 totaled 169,000, bringing the total number of such manufacturing jobs announced to over 570,000 since 2010.

The rate of reshoring and FDI doubled in the fourth quarter of 2016 presumably due to anticipation of greater U.S. competitiveness following the election. The rate then increased again in the first quarter of 2017 and maintained that level throughout the year.

Trends making reshoring more attractive

At the Reshoring Initiative, we believe there are a number of trends that make reshoring today more attractive. Among them are the reduction in the corporate tax rate from 35% to 21% and the immediate expensing of most capital investments is one of the trends making reshoring more attractive.

Moreover, while regulatory reform has moderately reduced costs, it has also dramatically improved business confidence that regulations will not get worse. The USD is down nine percent against a market basket of currencies in the last year. Skilled workforce training and automation are increasing. In addition to these recent improvements in U.S. competitiveness, the long-term rise in offshore labor rates, especially in China, is closing the cost gap.
         
I conclude this article with a quote from the research team’s article:

“A strong manufacturing base is considered critical to innovation capability, and is seen as beneficial to the middle class, the economy, and national security. Commonly discussed approaches to stimulate manufacturing within a country include infrastructure investments, direct incentives, and operating cost reductions. The research suggests that aiding managers to accurately incorporate the challenges of operating offshore is worth adding to that list.”

Author’s note: For readers interested in comparing the cost of out-sourcing versus reshoring, the U.S. Department has created a resource called ACETool, which stands for Assess Costs Everywhere. The tool is designed to highlight, and in some cases, quantify the hidden costs of outsourcing manufacturing. The OpLab Cost Differential Frontier Calculator hosted by the University of Lausanne, is designed to answer the question: “How much cheaper does a long-lead-time supplier have to be to compensate for the increase in demand-volatility exposure?” Another resource is the Reshoring Initiative’s TCO Estimator. This tool sensitizes firms considering offshoring to a myriad of easily and not-so-easily quantifiable factors when comparing onshore and offshore sources.

Harry Moser is the founder and president of the Reshoring Initiative. He can be reached at [email protected].