The Chinese have a saying, "wu jí bì f?n," which translates roughly to "When the pendulum reaches one extreme, it must swing back the other way." Recently, the pendulum appears to be reaching an extreme on the issue of offshoring,
the practice of moving work to countries with low wage rates. And it will continue
as long as savings from lower wage rates outweigh the additional supply chain
costs engendered by the added time and distance to market. In many cases, companies
seem to be using offshoring beyond the point that makes economic sense.

Evidence of these excesses is most apparent in retailing, an industry that
represents 40% of the U.S. economy and is the nation's largest employer. For
example, Wal-Mart's "everyday low prices" have squeezed other retailers' margins
and driven them to seek lower initial costs, or first costs, from their suppliers.
As a result, over the past three decades the numbers of consumer goods imported
from distant, low-cost sources have grown substantially, which has helped to
drive the trade balance from around a $1 billion surplus in 1973 to a deficit
of $500 billion in 2003. Over the same period, markdowns at general merchandise
retail department stores have grown from single digits to over 30% of sales
today. Although lost sales from out-of-stock merchandise are harder to quantify,
it's reasonable to assume that such losses have grown similarly.

These numbers suggest that U.S. retailers and their suppliers have not adequately
balanced labor costs against other supply chain costs. Rather, they are concentrating
on trying to lower the first costs they pay for goods-an effort that is indirectly
hurting their profit margins.

The real question for retailers is not whether offshoring is ethically or
politically correct. Instead, they need to ask whether they are correctly balancing
the impact of offshoring on cost and revenue in making sourcing decisions

The Notion of Total Delivered Cost
By
relying on traditional notions of total delivered cost, retailers sometimes
fail to account for the impact that off-shore manufacturing has on revenues,
given extended time and distance to market. This impact is further magnified
by the phenomenon of SKU proliferation resulting from consumer demand for greater
product variety.

In its 1998 annual report, the Federal Reserve of Dallas estimated that the
number of running-shoe styles rose from about five in the early 1970s to about
285 in the late 1990s. The most astounding examples of SKU proliferation come
from manufacturers who use mass customization as a key market strategy. The
same Federal Reserve report estimated that Dell offered consumers more than
16 million combinations of computers, and BMW claims that it produces more
than 1017 variations of its 7 Series automobile.

The increased product variety makes forecasting more complex, if not impossible,
and also makes offshore manufacturing even more difficult to manage. BMW, for
example, is adept at forecasting overall demand for its 7 Series but could
not estimate sales for each of the 1017 different combinations. Instead, manufacturers
like Dell and BMW understand the cost implication of time to market and work
hard to shorten the order-to-delivery cycle through such strategies ad postponement.

Knowing When to Stay Home

The key to effective sourcing decisions relies on the manufacturer's ability
to balance longer lead time against lower first costs. Savvy supply chain management
can help retailers deal with margin squeeze and the demand for product variety
through a combination of strategies that may include, but is not limited to,
offshoring.

Two retailers are frequently cited for their success in sourcing for maximum
profitability: World Co. Ltd. of Japan and Zara, owned by Inditex and headquartered
in Spain. Both have maintained margins by developing their supply chains to
reduce lead times and trim the product cycle time from the six-months-out approach
of traditional fashion retailers to as short as six weeks.

At World Co., supply chain speed comes
from careful planning, information systems that permit continuous forecast
updating, and production processes that can respond rapidly to change. One
factor in the speed of this supply chain is the company's decision to maintain
domestic production. Although the cost of labor in domestic factories is
significantly higher than that of overseas counterparts, World Co. can respond
more quickly to the frequent changes of the fashion world.

In Europe, Zara has achieved similar success
by continuously tracking customer preferences so that it can revise products
throughout their life cycles. Zara offers considerably more products than
similar companies. It produces about 11,000 distinct items annually compared
with 2,000 to 4,000 items for its key competitors. The company can design
a new product and have finished goods in its stores in four to five weeks;
it can modify existing items in as little as two weeks. Shortening the product
life cycle means greater success in meeting consumer preferences.

Zara's speed is the result of a combination
of elements, including manufacturing its more fashion-sensitive items locally.
Because these are the riskiest items, they are also produced in smaller quantities
so that they can be reordered more frequently on the basis of sales. A full
40% of Zara's finished garments are manufactured in Spain, and two-thirds
of the remaining items are sourced from nearby European countries and North
Africa.

In the case of World and Zara, proximity
between manufacturing and retail outlets is important in achieving a competitive
advantage that translates into stronger profits. Still, outsourcing to a
more distant location can and does have a place in retailing, even in the
rarified world of high fashion.

Deciding by Demand

Sourcing decisions should reflect the uncertainty
in demand for the product. Higher volume items with predictable demand can be
sourced further from their outlets than lower volume, high-risk products.

In short, a pair of standard work boots
does not require the same design flexibility as a pair of Manolo Blahnik
sandals, nor does it command the same price point. It's the kind of item
that can be off-shored for maximum cost efficiency because style is not likely
to change markedly over time.

Splitting the Difference

Another approach to economic sourcing is to
segment the manufacturing process, sourcing basic production processes further
from the retailer and putting the finishing touches on products at locations
closer to their outlets.

For example, Li & Fung (which derives
75% of its turnover from the apparel industry) sets up and manages supply
chains for such clients as Kohl's, Reebok, Disney, and Meijer, in which a
single product is assembled from components sourced from several locations.
By creating flexible supply networks, these organizations can allow for this
kind of integrated sourcing, including the ability to redeploy raw materials
as needed and reduce lead times in response to market changes.

The Bottom Line

No one solution works in every situation.
Cutting first costs may look like a sure way to bolster margins, but the added
lead time often leaves too much or too little inventory, sacrificing profits
to markdowns or lost sales. As retailers increasingly share the cost of discounting
and overstocking, there is some hope that suppliers will do a better job of balancing
the cost/revenue tradeoff. But until retailers incorporate the value of speed
and proximity into their commercial terms, suppliers' options will remain limited.
For now, offshoring is but one in a portfolio of strategies for maintaining margin
and profitability. Perhaps as suppliers start to shoulder more of the costs of
discounting and overstocking, they will find ways to negotiate commercial terms
that better reflect the impact of time to market and help drive the pendulum
back toward balance.