October 21, 2020 COVID-19 and the Real Cost of Offshoring

The COVID pandemic highlights that we have fundamentally underestimated the complexity and fragility of globalisation.

COVID-19 has paralyzed huge swathes of the global economy and highlighted the uncomfortable truth that the longer our production and supply chains have become, the more vulnerable they are to unexpected shocks – be they political, economic, environmental, or biological.  We are also seeing that in the obsessive pursuit of lower production costs, we have fundamentally underestimated the complexity and fragility of globalisation and the systemic risks it entails.

It’s now clear that mass offshoring of manufacturing to China and other emerging countries was carried out without any real consideration of the risks that it entailed. The past few months have been a rude awakening and the impact of Covid-19 throughout the global economy has initiated discussions that were impossible just a few months ago as business leaders start to realize that lower cost comes at a high price – something I have been highlighting for some years.

Writing in the Financial Times in April, Beata Javorcik, chief economist at the European Bank for Reconstruction and Development, said: “The quest to find the most cost-effective suppliers has left many companies without a plan B. Businesses will be forced to rethink their global value (post -Covid) chains . . . the disadvantages of a system that requires all of its elements to work like clockwork have now been exposed.”

The importance of analysing the true costs of offshoring is paramount, too. This was the driving force behind the research that led Professor Norman Schürhoff and I to create the Cost Differential Frontier Calculator (CDF), a decision-support tool that makes it possible to see the real cost of the increase in demand-volatility exposure that comes from extending the supply chain.

This research dovetails nicely with research carried out by the Reshoring Initiative that highlights that other than labour costs, there are at least 30 other parameters that are involved in an outsourcing transaction. These include customs, translation, packaging costs, lower productivity, poor infrastructure, potential loss of intellectual property, uncertainty about the stability of the country or insufficient supervision.

When the CDF and Reshoring Initiative tools are combined, they very often reveal that responsive local production is highly competitive with that done at a distant and inflexible supplier. When the option value and extra costs are weighed in, labor cost turns out to be much less of a deciding factor than is usually assumed.

In a post-Covid world, all these factors have far greater implications when it comes to factoring the risks associated with lengthening the production chain.  We can now see why these risks have been under-appreciated, together with the challenges of integrating unexpected events and shocks into the decision-making process. In a newly politicised environment, policy makers such as U.S. trade representative, Robert Lighthizer, are arguing that governments should actively encourage supply chains to be reshored.

But there is no one size fits all solution and different companies will make different decisions about their supply chains. Clearly, it is much easier for a garment manufacturer to switch suppliers than it is for a car manufacturer with a complex and expensive network of specialist ‘just-in-time’ suppliers. Nevertheless, we are already seeing companies such as Airbus, Safran, GKN and Rolls-Royce begin to reallocate orders or take work back in-house to minimise the impact of the crisis.

But it’s not just about logistics, revenue and risk. Post-Covid, sustainability and environmental awareness will also take on an increased importance on the global political agenda

Let’s take the textile industry as an example of the transformational potential of re-shoring in this new era. Prior to the pandemic, fast-fashion was the name of the game as stores (and online vendors) flooded the market with cheap clothing produced in poor conditions in places such as China and Bangladesh. Often, however, only 10-20% of this merchandise was sold and the rest destroyed to make way for new collections – a totally absurd state of affairs both economically, socially and ecologically.

However, with a little lateral thinking, it is quite possible to chart a way to repatriate this industry to the developed world in a way that combines technology with applications of flow-based process management that is both economically and environmentally viable. Ideally, we will move toward transforming apparel creation from a manufacturing to a service operation that begins with a visit with a personal adviser (either online or in person rather like going to a hairdresser) equipped with data from a full-body scan to design a tailor-made garment. The order will then be placed with a small production facility located close enough to provide responsive service. Following principles of revenue management, customers can pay for delivery speed, which allows the production operation to organize demand into a smooth flow. Once you are ready for a new garment, the used garment can be returned to a facility where coatings can be removed and the fiber melted and spun into new fiber – thus approaching a fully circular economic model. Note that limiting production to what people actually want contributes to sustainability

Employers are also taking employee wellbeing as well as their own corporate social responsibility more seriously. Here, reshoring also makes sense from the other end of the supply chain. It’s an acknowledged fact that many factories in Asia offer sub-optimal working conditions. Equally, over-industrialization has caused damage to workers health as well as to the environment. The jobs created in our model offer employees chances to develop on many fronts – artistically, logistically, entrepreneurially, and organizationally.

Suzanne de Treville is Professor of Operations Management at the HEC Lausanne, the business school at the University in Lausanne in Switzerland. She holds a holds a DBA from Harvard Business School and is a dual US and Swiss national. The Cost-Differential Frontier (CDF) calculator she jointly developed is used by the U.S. Department of Commerce to help companies to profitably relocate their production to America.

https://hecnet.unil.ch/hec/recherche/fiche?pnom=sdetreville&dyn_lang=en

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