Offshoring: bringing retailing back into balance: over-reliance on offshoring can bash, rather than boost, retail profit margins

Frontline Solutions, July, 2004 by John Vande Vate

The Chinese have a saying, "wu ji bi 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.

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The Worst Offender: Retailing

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.