Fight the flight to China with lean math. (CEO Journal).

I recently received a letter from my friend Jim. In it he discussed the idea of lean math, posing some provocative questions and interesting answers. I thought you'd benefit from his ideas, so I'm repeating his message here.

Many in U.S. manufacturing are asking this seemingly simple question: as a manufacturer in a high-wage country, can you ever be lean enough that you don't need to relocate your operations (or your supply chain) to China?

China has an enormous labor pool in its coastal development zones (with 300 million additional migrants to these areas expected in the next ten years), so it is conceivable that labor costs may stay at their current low levels for decades. Further, labor comprises a large fraction of the cost of metal castings. No matter how much cost a firm removes by getting lean, costs in China will always be much lower, right?

Not so, says Jim. Not if you "do the math" correctly. And to him that means doing lean math.

Here are the items he includes in his lean math calculation:

* start with the piece part cost for an item where you are;

* compare this with the piece part cost for the same item in China;

* add the cost of slow freight to get it to your customer.

Realistic Calculations

The above constitutes the entire math that a majority of purchasing departments seem to perform in their outsourcing calculations. But to get to lean math, you need to add the following to make the calculation more realistic:

* the overhead costs allocated to production in the high-wage location, which usually don't disappear when production is transferred (instead, they are re-allocated to the products and processes which remain in the U.S., raising their apparent cost);

* the cost of the additional inventory in transit over long distances from the low-wage location to the customer;

* the cost of additional safety stocks to ensure uninterrupted supply;

* the cost of expensive expedited shipments (most purchasing departments typically assume there won't be any expediting costs when we all know that there always are);

* the cost of warranty claims if the new facility or supplier has a long learning curve;

* the cost of engineer visits or resident engineers to get the process right so the product is made to the correct specification with acceptable quality;

* the cost of senior executive visits to set up the operation or to straighten out relationships (including all manner of payments and considerations, depending on local business practices);

* the cost of out-of-stocks and lost sales caused by long lead times to obtain the part;

* the cost of remaindered goods or of scrapped stocks ordered to a long-range forecast and never actually needed.

Unfortunately, these additional costs are hardly ever visible to the folks in senior management or purchasing who relocate production of an item in a low-wage country based only on piece-part price plus slow freight. However lean math requires adding three more costs to be complete:

* currency risks, which can strike quite suddenly when the currency of either the supplying or receiving country shifts;

* country risks (such as SARS, a shortage of production capacity, or a potential U.S. backlash against trade deficits and loss of manufacturing jobs);

* connectivity costs incurred in managing product hand-offs and information flows in highly complex supply chains across long distances in countries with different business practices.

Analyzing Potential Costs

While these costs can be difficult to estimate, they can potentially be very large. These risks are avoided if products are sourced close to the customer rather than across the globe.

After doing the lean math, will it show that OEM's should always source castings in the U.S.? Absolutely not. For example, if a firm is planning to sell within a foreign country, they should locate production over there because lean math works in the opposite direction too.

Lean math suggests that sourcing offshore should not be the OEM's first line of defense for cost reduction and business performance improvement. Rather firms should be serious about a lean transformation throughout the end product's value stream. For foundries and their CEOs, this suggests a new approach to sales and marketing, and a business strategy rooted in a common desire to radically improve business performance by transforming the entire value chain and, moreover, the common knowledge that foreign foundries cannot provide that same support.