The economic case for reshoring

Dr Suzanne de Treville, professor of operations management, HEC Lausanne – the business school at the University of Lausanne – explains why just being local isn’t enough.

Dr Suzanne de Treville, HEC Lausanne, University of Lausanne
Dr Suzanne de Treville, HEC Lausanne, University of Lausanne.

As the distance between those innovating and those manufacturing grows, opportunities for incremental innovation dwindle – yet, such incremental innovation is essential to competitiveness and profitability, and local manufacturing has a key role to play in innovation.

Timbuk2, a US manufacturer of messenger bags, provides a good illustration of incremental innovation opportunities that emerge from local production. Most manufacturers of similar products transferred their production to low-wage countries many years ago.

Timbuk2, however, maintains substantial manufacturing in San Francisco, where cells of highly skilled workers produce its bags. This local production allows Timbuk2 to offer custom-made bags that are shipped to the customer the day after they are ordered. Customers pay a premium for these custom bags.

It’s clear that producing a custom-made bag to order and getting it to the customer within a couple of days of receiving the order is not possible from the other side of the world.

But, there is more to the local production – innovation link than meets the eye. The custom bags give Timbuk2 an idea of where the market is going and what customers want. This tight flow of information between customer, manufacturing, and product development has resulted in Timbuk2 gaining and retaining a leadership role in the category.

The new refurbished warehouse
If a product rarely becomes obsolete or spoils, then it’s possible to hold large inventories to cover peak demand.

What about products that have high demand volatility without needing to be made to order? For example, a product that might have a demand peak that is three times the norm for one demand period in ten?

Here, the first question to ask is whether the product can be made to stock and retain its value over a long period of time. If the product rarely becomes obsolete or spoils, then it’s possible to hold large inventories to cover peak demand.

In our experience, managers tend to be overly optimistic about the residual value of such inventories, and are often surprised when they have to scrap stocks.

When we combine exposure to demand peaks with the risk of inventory losing its value, a tool we have developed makes clear that producing locally costs less than producing offshore and incurring demand volatility risk.

To see this result, go to our cost-differential frontier tool, and enter the 86% volatility that is represented by having a demand peak that is three times normal demand for one in ten periods.

When the local, make-to-order cost is 44% of the price, and the residual value if not sold during the demand period averages 20% of the price, we see that the long-lead-time supplier needs to be 40% cheaper than the responsive supplier just to break even.

Big manufacturing firms have outperformed the FTSE 250 since 2009
Time-sensitive product needs to be produced together with a product that is not time sensitive.

If volatility is high and residual value is lower, incorporating mismatch cost into our calculations makes it obvious that producing locally is better. But, what is less obvious is that this time-sensitive product needs to be produced together with a product that is not time sensitive.

In fact, managers who see the true cost of mismatch, readily change their allocation of time-sensitive products to a local supplier, but become even more aggressive about moving time-insensitive products to the cheapest possible supplier.

The value of combining production of these two products in a single facility is far from obvious—but, it is the biggest clue to how to gain maximum profitability and competitiveness from innovation capabilities.

Being local is not sufficient to be responsive enough to both eliminate demand volatility exposure and transform the relationship into one of service plus product—much more robust than one based only on a product.

This responsiveness requires extra capacity. For example, if a normal demand for a product is 100, we might need to have a capacity of 300 to ensure that we can always deliver very quickly.

Mark Edwards considers what manufacturing operations would be like without today's modern ERP technology
Managers who see the true cost of mismatch, readily change their allocation of time-sensitive products to a local supplier.

The time-sensitive product should be one that is profitable enough to cover the fixed costs of this capacity buffer, especially when we add the service component. When the extra capacity is not needed for the time-sensitive product, it can be used to produce the time-insensitive product to stock.

Note that the only incremental cost is the variable cost, as the time-sensitive product has paid for the fixed cost already. Therefore, the local supplier becomes completely competitive with the low-labour-cost competitors even for the low-volatility product.

This surprising and counterintuitive approach to supply chain design provides a new game plan for innovation. Innovation is designing products that make the supplier able to solve the customer’s problem, not with an average solution, but with exactly the product needed combined with great service.

Reaping the benefits of innovation, and reshoring, requires that the supplier change from an arms-length manufacturer to a service provider who happens to deliver a product.