Asset Location, Global Networks & Offshoring
Why Firms Globalize their Operation
Gloablization refers to the various processes - cultural, social, political, economic, and technology - that lead to increased interaction among disparate locations across the globe. Globalisation strongly impacts the design and management of the operational network, including the spatial spread, concentration, and integration of locations. The Boston Consulting Group’s Sirkin, Hemerling, and Bhattacharya (2008) introduced globally as “the name for a new and different global reality in which we’ll all be competing with everyone, from everywhere, for everything.” We use the term global operations, or global network, to emphasise that process flows cross national boundaries.
Supply factors behind globalization
A common reason to establish operations in other parts of the world is to cut the costs of the input supply. We illustrate how location can affect three cost components: direct cost, capital cost, and taxes. To share costs and risks, several manufacturers enter into joint venture (JV) agreements.
Technological factors behind globalisation
Some locations have developed certain specialised advantages. For example, watch manufacturers are clusters around Geneva, Switzerland. The “tie-city” of Zhengzhou, China, is home to over 1,00 tie-manufacturing companies with an annual output of 300 millions ties, or one third of the world supply. Japan and Germany are known for engineering high-precision machine tools. India has attracted offshore call centre and software engineering operations. For example, Coca-Cola has hundred of bottling plants around the globe that serve local markets in order to reduce transportation costs.
Market demand factors behind globalisation
A third reason to establish operations in other parts of the world is to improve market access and increase revenues. Purchasing power is obviously of great importance to revenue potential. Globalisation can feed upon itself. Global companies with sophisticated global networks tend to intensify competition, this forcing small companies to contemplate globalisation just to keep up.
Macroeconomic and non-market factors behind globalisation
Currency risk and political stability are important considerations in global location decisions.
Measures adopted to protect domestic economies from foreign competition can induce these competitors to set up local operations. Tariffs or duties are taxes on foreign goods, often collected by custom officers at entry point.
Many economists view protectionism as a disguised tax on consumers (who pay higher prices) and subsidy to local high-cost producers and even to foreign firms, who can command higher pricers due to quantity restrictions.
Free trade zones and bilateral or multilateral treaties to reduce, if not eliminate, protectionism also impact globalisation.
Strategic Framework for Location Decisions
A location strategy is a structured approach to identify and decide where to position assets or facilities. Location decisions are multi-faceted and often idiosyncratic. Rather than letting location decisions be guided by a single-sided interest (e.g. a myopic focus on cost), it is important to view location decisions as an integral part of operations strategy.
Start by specifying the strategic role of the location: what is the primary strategic reason for the facility’s location and what is the projected scope of its activities and capabilities.
Global assessment: Identify a set of candidate locations that are broadly aligned with the desired capabilities.
Country segmentation: Rank location candidates along the desired capability dimensions to narrow down to the set of attractive candidates.
Analyse total landed cost to further narrow set of candidates.
Select location based on strategic fit, attractiveness and total landed cost.
Update model dynamically.
1. Strategic role of location
Facility strategy to denote how the size, location, and type (or role) of individual facilities are chosen.
What is the primary strategic reason for the facility’s location?
What is the scope of its current activities and competencies?
2. Global Assessment: Identify a set of candidate locations
The second step in the location strategy makes a rough global assessment to identify a set of candidate locations that are broadly aligned with the desired capabilities.
Deloitte consultants visualized the location framework as funnel when assisting an American household products manufacturer in its search of “the next China”. The global assessment of industry presence required selecting countries with an existing supply base. It selected 20 candidate countries by assessing product-related industry presence through trade export analysis using associated standard industrial classification (SIC) codes.
3. Country segmentation: rank attractiveness
The third step in the location strategy is to rank location candidates along the desired capability dimensions to narrow down to the set of attractive candidates. Each country in the candidate set is rated along technical factors directly related to the required capabilities of the site and general business factors. Countries can then be segmented according to the relative importance that senior manager place on technical factors versus how “friendly” the country is business.
4. Total Landed Cost (TLC) Analysis
Total Landed Cost (TLC) is the total end-to-end supply chain cost-starting from origin to destination for a given service level.
Cost components in TLC: COGS and Logistics
TLC starts with the typical cost of goods sold (COGS) that includes the direct material, direct labor and overheads costs at the origin destination. The insight from TLC analysis, however derives from adding all the “hidden” supply-chain related costs that are not captured in COGs. The first additional costs are outbound freight; customs, duties and taxes; and inbound freight.
Cost components in TLC: Startup, Learning Curve and Quality control
The second set of additional costs to include in TLC are startup costs of a new location and quality control costs. Especially for offshore locations, these costs include training of the new workforce to bring them down the learning curve, supplier relationship management costs (including travel cost for manager to visit suppliers), translation costs, and other soft costs (hassle of managers getting up at 3:00 a.m. to place phone calls to their supplier) and quality control. These costs are often underestimated. In 2007 Honeywell International moved its production from Ohio to Mexico. It took 3 years for the Mexican location to get to the 2007 quality levels.
Cost components in TLC: service levels, lead-times, and inventory holding costs
The third additional costs to include in TLC are driven by service and responsiveness (lead times). To enable an apples-to-pales comparison of locations it is important to evaluate their respective TLC for the same service level. Longer lead-times increase the average in-transit (or pipeline) inventory. Little’s law directly yields.
In Transit = throughput x transportation lead time
Location Strategy based on personal factors & labour
When Harley-Davidson needed to expand capacity in the mid 1990s, it hired a consulting company to specialised in location studies. The supply factor included the ubiquitous labor considerations factors (availability, costs, qualifications, work ethic, and union friendliness), but broader non-market factors were all important. A site close to an airport with direct flights to Milwaukee, WI would have offered easy accessibility to and from headquarters. Attractiveness to live at a site was measured by the availability of local support services, such as hospitals, churches, recreational opportunities, housing, hotels, and education (measured using a five page comparative analysis of primary, secondary and college education).
High-tech and high-talent companies often locate where their employees (engineers, scientists, bankers, etc.) live or would be willing to live. This strategy may generate a virtuous cycle, as in the case of Silicon Valley and Wall Street. Sometimes, locations are strongly influenced by history or personal factors. For example, some early international partnership with the Kellogg School of Management originated from close personal relationships between the school’s deans. Another example of a company choosing its locations based on personal factors is Warren Buffett’s decision to locate his company (Berkshire Hathaway Inc.) in Omaha, NE, the town where he was born.
Geographical or spatial location analysis
A geographical or spatial analysis quantified the market supply and demand factors of the location decisions. It is part of the typical location analysis when transportation costs constitute a significant fraction of total cost. Spatial analysis starts with estimates of market demand per region (or customer density) and of the number of facilities that are needed. Potential locations are often identified by infrastructure consideration such as proximity to highways, railways, railroads, or airports, or analytical approaches such as gravity location or optimisation models, as detailed by Chopra and Meindl (2012).
Competitive analysis
When demand or customer proximity is an important source of competitive advantage, the location strategy may be more driven by competitive considerations which can result in the grouping together of competitors.
Factors favoring a centralized network
Centralization, or consolidating operations in a single location, is typically observed when “bigger is better”. Recall that economies of scale, or increasing returns to scale, stem from aggregating volumes and results in unit costs that decline in size. Aggregating volumes can yield scale economies at many stages in the value chain, including product design (of one product or re-use earlier designs), sourcing (centralized sourcing may benefit from quality discounts), capacity investment, inbound transportation (coordinated or in bulk), inventory (volume aggregation smooths and reduces cycle stock per unit), and overhead. Sometimes, centralized network networks can better guarantee consistent and uniform quality than distributed networks can. For example, FedEx and UPS use central hub-and-spoke networks for their air transport.
Factors favoring a distributed network
Distributed networks served dispersed customers over a large area.
Trade-offs and optimal area to serve per facility
To key point is that the total network cost per unit includes a set of costs that decrease and another that increase with the size of the served area. The total cost per unit thus reaches a minimum at a specific size, which is a facility’s optimal geographical coverage. This optimal size is the value-maximizing trade-off between increasing and decreasing returns, and determines the extent to which the network should be centralised or distributed.
Factors favoring standardization (“copy-exacting”)
Typically, a team of R&D engineers would optimise the process in a development facility and new set of engineers would optimise the process in a development facility and a new set of engineers would transfer and adapt the process for high-volume production. This was not the case at Intel, which adopted its Copy Exactly facility strategy. Standardising resources and processes between R&D and production facilities decreases ramp time and improves yields, which are important achievements for innovators. The Copy Exactly strategy also improves productivity by sharing learning and reinvesting the wheel. Standardisation creates economies of scale in purchasing equipment and allows centralised global sourcing.
Factors favoring localisation and tailoring
While corporate and operations manager may favor standardisation, there are benefits to tailoring resources and processes to the needs of each location. There is always a tension between standardisation and progress.
Integrated networks and network flexibility
It is useful to separate the total lead-time into production and transportation lead-times. With short transportation lead-times, market allocation can be postponed to save on transportation costs.
The evolving reasons behind offshoring
Offshoring can lead to shorter lead-times than entering in labor-intensive environments with high seasonal demand volatility.
Risk of offshoring: macroeconomic and non-market factors
Offshoring shares the risks of remote foreign operations, including:
Competitive risk: an offshoring strategy that chases low cost is easily imitated
Currency risk: illustrated by the asian financial crisis in the late 1990s
Political risks never disappear: the fear of terrorism makes it difficult to operate in certain countries. A key risk for China is how it will handle its growing divergence in wealth.
Intellectual property (IP) risk is significant in some emerging countries. A typical strategy to contain that risk is IP compartmentalisation, which breaks up a project or product into smaller parts that are executed or manufactured at different locations.
Health and environmental risk: in June 2007, the U.S. Consumer Product Safety Commission announced a voluntary recall of dozens of Thomas Railway Toys, which were manufactured China and contained potentially poisonous lead paint.
Risk of offshoring: operational factors
The longer supply chains not only incur higher costs, but also longer and more variable lead-times which reduce market responsiveness and increase inventories. Potential quality concerns only exacerbate these risks.
Factors favoring a global network and even entering (reshoring, nearshoring)
North America is also seeing an increase in restoring and near shoring - some companies are cutting back in China and heading to Mexico.
Factors that favour onshoring:
Rapid and significant increase in labor costs in the original low cost countries
High scale economies with substantial domestic markets favours entering
A competitive strategy based on speed favours domestic capacity
These may be high tariff-transportation costs relative to the production cost savings from offshoring.
Higher currency exchange rate risk typically favors the natural the natural hedge embedded in the global network
High demand volatility along with high price differences favours a global network, and even onshoring.
The progressive role of offshoring and global networks
An offshoring strategy designed to capture cost advantages seldom yields a long-term competitive advantage. Offshoring takes a new meaning when its role broadens over time from seeking a cost advantage (“offshore plant”) to developing and serving the offshore market and ultimately creating innovations for the global company. From this perspective, offshoring is just an intermediate step towards buildings and integrated global network. Given current population and growth projections, such integrated global network seems to be the natural operations strategy.
Key insights for optimal integrated global networks
For the optimisation, we just add more scenarios which can also account for dynamic evolution. The important insights are:
It is valuable to integrate global networks through flexible capacity, contingent allocations, and transshipment, especially as costs and revenues differ across locations and as demand and exchange rates become more volatile.
To be able to exploit the upside, the network news extra capacity.
The best global network configuration can be determined by optimizing the amounts and locations of capacity. The optimisation must incorporate demand and exchange rate risks in addition to costs.
Global network flexibility is valuable
While globalization improves cost and revenue potentials, it also increases the stakes and exposes the organization to more risk. Integrated networks with allocation flexibility not only provide an operational hedge against supply, demand, political, and macroeconomic risks, but they can also exploit the upside and add value.
Tailor the locations in your network
Successful global organisations tailor their networks to their strategies and local conditions. For example, while offshore textile production of basic apparel is to be expected, domestic facilities and more appropriate for Zara’s cash fashion strategy.