A few decades ago, the Asian continent was the most attractive location for offshoring due to its abundant and cheap labour supply. At that time, multinationals only considered superficial aspects when deciding on the location of their production, such as technical feasibility and labour costs. Nowadays, though, together with a growing experience in foreign markets, there has been a growing awareness from multinational companies with regard to the downsides of an extended offshore supply chain. In addition, the ongoing structural shifts in low cost regions of the world have made the location decision, which is part of the overall strategy of a firm, more complex and nuanced.
Going back home?
The range of factors that have to be taken into consideration when doing offshoring has amplified and is not restrained anymore to the mere comparison of the increase in transportation costs to the labour costs savings in foreign countries. It indeed further expands to more complex variables including higher supply chain risks, lower flexibility, higher inventory, intellectual property protection, sustainability and quality. In that framework, reshoring has become an additional option in the organization of companies’ operations. According to the Boston Consulting Group, most large American companies intend to move back some parts of their production from China, or at least consider this option. This move, backed by promising opportunities in the home country, is nevertheless accompanied by important challenges the companies would have to cope with.
When making reshoring decisions, firms have to consider the way in which they will transform their operating environment in order to sustain production over the long run. While there are economic benefits of bringing manufacturing “back home”, many significant barriers do also arise. As pointed out by AlixPartners, any sourcing change implies switching costs that must be overcome, such as exchange rates and the potential need for approval from customers or regulatory agencies.
For instance, it has been observed that some companies started to move back only the less profitable parts of their production. Many companies, such as General Electric and Apple, moved small parts of their production process back to their home country. However, it always concerned low margin products.
Offshoring and reshoring
As stated in “The Internationalisation of Firms from Exports to FDI” by ECARES, once firms paid the fixed costs of FDI in a certain country, they tend not to “reshore” in order to cover these costs and to avoid to incur them again if they were to re-offshore in the future. As these costs are quite substantial, companies need to have a sound financial system and, moreover, they need to be sure to make profits in the future in order to be able to recover these costs. Therefore, companies should make sure that this reshoring step would be the last one and that they would not offshore a second time in the future. Indeed, another relocalisation would lead to further expenses and make previous relocation expenses senseless.
Moreover, these shifting costs are quite substantial as not only production facilities need to be established in the foreign country but also some materials need to be shipped from A to B. Firms that decide to shift production back to their home country should decide on whether to transfer all existing materials from the foreign production place or rebuild them “from scratch” in their home country, with different costs associated with each strategy.
Besides, the overall vertical value chain plays a significant role in maximizing the speed and flexibility of reshoring. When it comes to specific value-added activities, firms have to localize the supply base in an optimal way. The benefits of reshoring could be curbed when firms face a limited vertical ecosystem if the home country lacks the required tooling capabilities.
Therefore, the reshoring transition requires a carefully designed project plan and good execution in order not to disrupt the company’s supply chain. Such an interruption can increase costs (through the recovery process) and decrease revenue (due to less sales), thereby reducing the firm’s profit. The challenge also includes the way firms intend to handle their inventories during the transition phase. Shareholders should therefore expect that profits in the short run may decrease as a consequence of reshoring. In the long run, though, revenues have to be high enough to recover these costs and increase profits. However, so far, no company clearly stated that reshoring has led to a substantial increase in profits, the main benefits highlighted referring mostly to qualitative issues.
Reshoring, an existential question for each company
China has often been criticised for the poor quality of its products, suggesting that firms should not have any difficulty in producing products of greater quality in their home country. However, China is also well-known for its expertise in mass manufacturing, a comparative advantage that is difficult to reproduce by American or European companies in their home market, due to cultural differences and a lack of knowledge.
Therefore, firms should keep in mind that achieving productive and qualitative manufacturing call for garnering the qualified workforce with the specific manufacturing skills. When deciding to offshore, companies move their manufacturing processes (at that time core competences) to low-cost countries and develop new ones such as distribution. In a sense, offshoring involves a complete restructuring of the company in terms of its assembly and distribution processes. By reshoring, the company has thus to redefine itself a second time.
Bringing the assembly work from abroad can turn out to be even more challenging for countries such as the US, which have offshored their manufacturing activities decades ago and largely focused on the service economy. Therefore, when reshoring, these countries not only have to make sure that they would not revamp their internal organisation but also that their output will be of a higher quality than the end-product produced in the low-cost country. The company has then two issues to face, i.e. redeveloping production capabilities “at home”, which means additional sunk costs, and hire new workers who already have the necessary skills, which might be problematic if such workers do not exist in sufficient quantity in the home labour market.
Moreover, products design has to go along with the off or re-shoring strategy of a firm. Companies have to address the automation challenge by rethinking the design of their products. As a way to tackle this issue, companies should also consider to locate their design operations closer to their manufacturing ones in order to enhance innovation, processes and results.
Reshoring in order to increase quality?
A frequent argument stressed by companies to justify their reshoring decision is the subsequent increase in product quality. This being said, it is not clear whether companies always have the right capabilities and human skills to guarantee a quality increase in the short run. In some cases, the company might just want to increase prices, not only to recover the delocalisation costs but also to make up for the higher production costs in its home country. Even though many American companies argue that consumers prefer “Made in America” products over “Made in China” ones, customers might still opt for the low price opportunity over the high quality good. On the other hand, customers might be willing to pay a premium not for the increased quality of a product but rather for the greener production process that reshoring implies. As such, a reshoring process entails an extensive cost-benefit analysis from the company that includes all the risks it needs to be aware off, including trends in consumer behaviour.
Besides the reshoring trend, a new trend of “nearshoring” can be observed (Hobson 2014), in which companies move back their production not to their home country but to neighboring countries with lower costs. For instance, many US companies decided to move their production to Mexico. In Europe, the same phenomenon can be observed as some companies moved their production to Eastern Europe. For example, when Lego faced difficulties with its Singaporean partner, it decided to move its production process to the Czech Republic.
Aside from reshoring and nearshoring, companies also may decide to move their production process to other low cost countries such as Vietnam. These countries not only have lower labour costs than China but have also largely benefited from spillover effects from China in terms of knowledge and expertise in mass manufacturing. From a regulatory perspective, governmental policies should also need to adapt somehow in order to support the reshoring trend as it may have a positive impact on employment. Therefore, the political cycle should also be considered, on top of the economic one.
To conclude, it should be emphasized that no studies have demonstrated yet that the economic benefits of reshoring outweigh its sunk costs. Reshoring should thus be considered with caution and only further analyses will show whether or not this new trend can be viewed as a success for firms and also for the national Western economies.
Cover photo credit: Michel Gagnon; http://bit.ly/1OLGVgG
Photo credit: Dustin Jed Sullivan http://bit.ly/1OLIYRJ