Outsourcing Effectively

Determine whether outsourcing is a viable option for you

The global downturn's speed and severity have significant implications for the supply chains of global manufacturers. Among steelmakers, chemical players, and some high-tech companies, for instance, order books-and therefore prices-are under tremendous pressure. Output in the steel industry dropped by an unprecedented 30 percent and prices by about 50 percent from June 2008 to December 2008.

That kind of volatility wreaks havoc on traditional supply chain planning: the process for determining production levels, raw-material purchases, transport capacity, and other vital factors, largely by examining historical patterns of demand. "Every month, we produce a rolling three-year plan," said one metals executive recently, "but right now I can't see even three weeks ahead." Indeed, the forecasting challenge is particularly acute because in many upstream industrial settings, as supply partners along the chain anticipate that demand will fall, the supply chain appears to be decoupling from downstream consumption-the focus of most forecasting models.

Against this backdrop, senior executives should reconsider the implications of the "bullwhip effect," first identified in the 1960s and known to generations of business students as the "beer game." In this classic phenomenon, distortions in information snowball along the length of a company's supply chain, propelling relatively small changes in end-consumer demand into much larger and less predictable swings in demand further upstream (Exhibit 1a and Exhibit 1b).

How relevant is the bullwhip effect today? Consider the US inventory-to-sales ratio, which rose sharply from June to December 2008. Exhibit 2, bearing as close a resemblance to a pileup accident as any chart you'll ever see, emphasizes the significant reverberations, up and down the line, of cancelled orders as companies retrench.

Exhibit 2

At the end of 2008, businesses saw a sharp increase in the ratio of inventory to sales caused by-and then exacerbated by-unexpected drops in demand.

Many of the bullwhip effect's classic triggers now operate in full force. Rising commodity prices before the crisis, for example, led to the stockpiling of excess inventory. Now, falling commodity prices give customers an incentive to postpone orders and await better deals. Meanwhile, a new factor-the dash for cash-exacerbates today's difficulties: the evaporation of traditional financing channels leaves companies desperate to shed inventory, reduce working capital, and squirrel away cash. Of course, one company's working-capital reductions are another's cancelled orders.

The good news is that destocking has limits. Over an extended period, upstream orders must equal downstream ones. In the case of steel, for example, unless end-user demand drops by the same 30 percent as did output between June 2008 and December 2008-not impossible, but beyond current demand forecasts of an 8 to 10 percent reduction this year-orders must eventually rise. Yet as the bullwhip metaphor implies, the upswing could be rapid in steel or other industries that have complex, multitier supply chains. Unprepared ones could make companies neglect their customers' needs and lose share to more nimble competitors.

How should manufacturers respond? First, they must make supply chain decisions more quickly: in the face of unprecedented volatile demand, business-as-usual calendars for forecasting, budgeting, and planning won't do. Companies that adhere rigidly to unrealistic plans may find themselves sitting on piles of inventory or fighting price wars.

Some companies are establishing supply chain "war rooms" to make fast decisions across functions. Populated by leaders from production, procurement, logistics, and sales-and furnished with the latest data on purchasing, production, orders, and deliveries-these teams meet weekly or even daily to devise near-term operational plans. A chemical company that created such a team cut inventory levels by 20 percent in just ten weeks, while maintaining high levels of customer service. What's more, by speeding up decisions, the company increased the frequency but reduced the size of its orders from key suppliers. Greater cross-functional cooperation helped it not only to identify new opportunities for using out-of-spec materials (and thus inventory on hand) but also to make better-informed decisions about where and when to discount overstocked products.

As companies rethink the way they plan, they must also learn how to act on the resulting decisions more quickly and flexibly. When raw-material and transport costs and the use of equipment shift dramatically, for example, companies must be prepared to revisit well-understood trade-offs involving, say, minimum batch sizes or optimal process yields. Things can change quickly, as a plastic goods manufacturer found after working hard to reduce the raw-material content of its products. Its strategy of accepting slightly higher defect rates in return for savings on these inputs has become decidedly less advantageous as their cost plummeted.

What companies need now is the ability to deal with changing conditions by making production processes more flexible-shifting manufacturing locations quickly as shipping costs change, for example. One source of lessons on flexibility comes from the process industries, like chemicals or cement, which have long adjusted their mix of fuels (such as coal, fuel oils, or biomass) according to changing prices. Manufacturers that can adjust process yields rapidly to suit changing conditions should have a significant advantage over less flexible competitors.

More effective collaboration with key suppliers is important as well-advice that's surely relevant throughout the business cycle, but particularly now that volatility could undermine their survival. Improved collaboration need not depend on expensive integrated IT systems; in our experience, such projects generally have disappointing results. Simple moves, such as establishing direct communication from planner to planner and running forecasting processes jointly with key suppliers, can reduce "signaling" noise and raise service levels. Smaller but more frequent orders are often an easy way to reduce volatility in demand and therefore inventory levels. So is a better understanding of whether reduced demand results from destocking or from the behavior of end consumers.

Manufacturers should view today's environment as an opportunity. Now they can make changes-renegotiating contracts, consolidating manufacturing and distribution networks, launching aggressive productivity programs-that might not have been feasible earlier and may soon be difficult again. Remember, the bullwhip metaphor implies that the future upturn in demand could come rapidly, even if demand doesn't return to its level before the downturn. For many organizations, a return to growth could, paradoxically, close the window of opportunity to improve the supply chain.

About the authors

Christoph Glatzel is a principal in McKinsey's Cologne office, Stefan Helmcke is a principal in the Vienna office, and Joshua Wine is an associate principal in the Tel Aviv office.

Are you getting enough value from your business process outsourcing arrangement these days, or is the relationship beginning to go stale?

An important recent development in the health industry has been the increase in both IT outsourcing and business process outsourcing. It would be difficult to find a company anywhere in the healthcare ecosystem not using outsourcing in some form. But as with any business or IT capability, the bar of expectations keeps being raised. Outsourcing providers and their clients alike need to be looking for ways to increase the value they achieve and deliver together.

Health companies have come to expect the cost savings, improved efficiencies and decreased compliance risks that accompany a solid BPO relationship. But those benefits are just table stakes now. Use offshore labor for data entry or resolution of simple claim edits? Been there. Outsource basic back-office functionality? Done that.

Staying ahead of the game today requires working at a higher level of insight and performance. A new generation of BPO solutions is drawing on the power of the best service providers to deploy analytics that can extract actionable business insights from the immense stores of transactional data they accumulate during long-term client engagements. Health companies can use those insights to generate higher-impact business outcomes-results ranging from accelerated speed to market to enhanced innovativeness, stronger customer loyalty and top-line growth.

Embedding analytics successfully in a BPO solution depends on several factors, including ongoing alignment to business goals, having the right incentives in place and making sure the provider has sufficient visibility across an entire function or process.

Climbing the ladder
Several industry trends are leading to a new generation of health BPO solutions. One is that companies are becoming comfortable outsourcing more mission- critical functions and activities. As companies see external providers perform an increasing number of business functions better than they can themselves, they are looking for ways to leverage that success more broadly across their organizations.

Another important trend is the amount of data being generated across the healthcare ecosystem. Companies know that this data holds important keys to improving operations, developing innovative products and serving customers more effectively. But few of them have the resources or capabilities to spin their data-straw into insight-gold.

A final relevant trend is the increased sophistication and applicability of analytics solutions, and the growing realization by companies that they are not tapping into all the possibilities analytics presents them.

Many organizations are getting better at generating clean and integrated data; some others are able to define distinctive customer segments with that data. But those are only the bottom rungs of what the authors of the book Analytics at Work call the "ladder of analytical applications." As companies move up the ladder, they leverage more sophisticated analytics solutions to get greater value-applications that can help devise different responses for customer segments, predict responses more accurately, and then to actually embed different actions and corporate responses into a business process itself. Ultimately, companies can use analytics to adapt and optimize processes and respond to real-time needs.

At each rung of the analytical applications ladder, BPO presents an environment that can lead to distinctive value because BPO analytics begins on what is already a strong foundation of functional healthcare expertise, along with comprehensive data about a business process and how it is performing.

Analytics at work in healthcare
In the health industry, analytics solutions vary across marketing, clinical, operational and financial domains. In some functional domains, analytics solutions can result in continuous improvement of business processes, or even embed differentiated actions in the processes themselves. In other areas such as clinical research, analytics is more likely to provide assistance to human decision making. Here are several examples of BPO analytics solutions in the health industry at different rungs of the analytics ladder.

1. Improving data quality
One health organization found that its automated eligibility team was processing about 250,000 "fallouts" per month-system errors amounting to about 2.5 percent of overall automated enrollment volume. Average time to resolve those fallouts was five business days, a significant drag on efficiency and service.

The organization's BPO provider applied analytics to identify errors within the mass of transaction data. The team leveraged their operational expertise to segment the transactions and identify key error trends along with the system components responsible. By addressing the root causes of the fallouts through system fixes and by making changes to upstream data entry procedures, the organization eliminated 25 percent of the bad transactions at their source-about a $1 million savings.

2. Understanding and attracting customers
Another suite of solutions that moves BPO deeper in the value chain focuses on consumer analytics. Succeeding in an environment of increased consumer power and choice is a major challenge in the health industry. As a recent Accenture research report notes, there has been a "seismic shift in power to the customer" in the health insurance market and insurers "will need to invent new healthcare solutions for competitive success."

To take a more specific example, recent healthcare reforms mean that individuals will soon have the opportunity to buy health insurance through health insurance exchanges. Payer firms can use consumer analytics tools to understand and attract these customers and then target health management programs as they are enrolled. In this challenging era of healthcare, a BPO solution that can take the next step up the analytics ladder and predict a consumer's response, and also realign resources to handle customer interactions more effectively, can create a distinct competitive advantage.

3. Predicting and preventing
BPO solutions at the top rung of the analytics ladder can leverage predictive capabilities to optimize process responses continuously, in real time. One such BPO solution is designed to eliminate manual work within a health insurer's claims operation. The solution leverages machine learning to detect patterns in claims data and then take action on segmented queues of claims. The solution also goes a step further and systematically adjusts to trends in the data, predicting sources of errors and directing actions in real time, thus continuously improving the process and the benefits delivered.

A pilot of the solution was able to reduce preventable financial rework for a company from 40 percent to 50 percent of the time. The results showed that prevented errors through the predictive analytics solution would:

• Reduce administrative costs associated with claims rework by 10 percent to 20 percent.
  
  
• Reduce medical costs savings by 5 percent to 15 percent of all recoveries by preventing overpayments (e.g., paying duplicate claims).
  
  
• Improve provider and member satisfaction by increasing first-time payment accuracy.
  
  

Making BPO analytics happen
The new generation of BPO in the health industry is business-outcome driven. Thus, the most important set of questions health executives need to ask is: What are our business goals, and is the relationship with our BPO partner set up to drive those goals? Are the proper incentives in place to produce the desired outcomes? Cost savings and operational efficiencies are vital, but what else is the relationship providing in terms of helping the organization leverage information to serve customers better and drive new and innovative solutions?

Another important success factor is having access to data and workflows across an entire process. Health organizations are now becoming more comfortable with outsourcing a process from end-to-end because of the synergies that result from a holistic approach, eliminating the inefficiencies of having different parts of the same process run by different providers.

Winning the new game
BPO in the health industry is a new game with new rules. Regulatory demands on price and performance are rising, competition is increasing and companies are coping with a changing sense of who the healthcare "consumer" is.

Today's BPO market demands that providers deliver value by synthesizing massive amounts of data, analyzing it and then applying industry experience to drive improved outcomes. Organizations that get the most value from BPO choose providers that bring sophisticated analytics and industry knowledge to the relationship, and they enable their partners to go broader and deeper to deliver insights and innovative solutions.

1 Thomas H. Davenport, Jeanne G. Harris and Robert Morison, Analytics at Work: Smarter Decisions, Better Results (Harvard Business Press, 2010). (Back to .)

2 " The 7 Things Your Health Insurance Customers Are Not Telling You ," Accenture, 2011. (Back to .)

About the authors
Rich Hunter is a senior executive and the global lead for Accenture's BPO offerings in Health & Public Service.

Leana Fowler is a senior executive in Management Consulting and leads the Payment Integrity offering in Health & Public Service.

Ann Kieffaber is a senior executive and the lead for Accenture's Health Analytics offering.

Companies that successfully create and sustain value year after year are rare. Many try to, but a recent study of 2,000 companies over 10 years by our consulting firm, Bain & Co., found that only one in 10 achieved sustained, profitable growth. One activity that sets such winners apart: They often use capability sourcing in more innovative ways than their competitors.

Outsourcing and offshoring began as cost-cutting measures, but companies that create real sustained value routinely use them for far more strategic ends-to gain capabilities that they don't have in-house, or to strengthen capabilities they do have. We have found that 85% of those winners use capability-sourcing broadly and strategically for everything from developing world-class talent to bringing new products to market faster and enabling business model innovation. In other words, they've moved way beyond mere cost-cutting.

Based on our research and experience with clients, we've found that leading companies use capability-sourcing to build five strategic capabilities.

- To tap into global talent. Particularly in emerging markets, shortages of talent can impede a company's ability to grow. Texas Instruments has overcome this obstacle with an R&D center in India that has not only delivered cost savings but also nurtured a rich talent pool that has delivered an increasing stream of U.S. patents.

-To build partnerships that both capture value and reduce risk. Even though sourcing risks have increased over time, many companies continue to manage their sourcing relationships at arm's length. The reality is that they need to exert control. Companies like the toy manufacturer Hasbro accomplish this by viewing their external relations as strategic partners tightly integrated with their domestic operations or overseas subsidiaries. That's a major reason why Hasbro was largely unaffected by the toy industry's lead paint crisis in 2007. Among its sourcing safeguards, the company prequalifies and continually monitors its overseas factories to ensure that quality management systems are in place. The risk of a quality issue arising can't be totally eliminated, of course. The key is to limit potential problems and act quickly when one occurs to keep it from happening over and over again.

-To seize new local market opportunities. As new markets emerge, companies need ways to establish a presence before their competitors. AstraZeneca tapped into the booming Chinese pharmaceutical market by making large-scale, multiyear offshoring investments in everything from manufacturing to sales, partnering with local universities, government organizations and Chinese companies. As a result, AstraZeneca has become the largest pharmaceutical multinational in Chinese prescription drugs.

- To get to market faster and boost innovation. Bringing out new products ahead of competitors is critical for consumer products companies in a rapidly changing market. When Procter & Gamble outsourced some R&D activities it boosted its innovation productivity by 60%, to generate more than $10 billion in revenue from over 400 new products. Today, about half of P&G's innovation comes from external collaboration.

- To disrupt traditional business models. Since the spin-off of its contract manufacturing operations in 2000, Acer, the Taiwan-based personal computer maker, has used capability sourcing to make itself into the world's second-largest PC manufacturer. The company's executives knew it was good at branding and marketing and chose to outsource everything it had a harder time with, like manufacturing. The move led Acer to faster-growing sales and gains in market share. The company now maintains a strikingly lean and flexible operation. Its 6,800 employees represent a workforce less than a tenth the size of its largest competitor.

Being a follower has advantages in capability sourcing. Fast followers can learn from others' mistakes. There are capability sourcing models and offshore locations and vendor options today that didn't exist five or 10 years ago, providing the chance to catch up faster. We've found that building a local team offshore with an independent charter and autonomy improves a company's long-term odds of success. For example, General Electric used offshoring to develop its largest multidisciplinary, integrated R&D hub, in India. The hub supports the company globally and has fostered a large Indian talent pool with strong onsite leadership.

Our experience suggests that if a company doesn't get a return of at least 25% on its sourcing investments, it needs to carefully review and fix its current programs before moving on to new projects. Experienced practitioners should challenge the status quo. To avoid becoming complacent, even the most successful veteran outsourcers need to hold regular comprehensive reviews of their sourcing strategies and programs. For example, many companies in financial services, an industry with long experience in capability sourcing, have reevaluated their programs in the global downturn, as the relative benefits of owning and operating captive offshore centers has declined and even pioneering firms such as Citibank and American Express have sold off some of those operations.

In some instances, experienced practitioners have used outsourcing and offshoring to change the game in their industries. The semiconductor industry was redefined when companies started outsourcing manufacturing to low-cost Asian foundries. Those pioneers took off because their outsourcing strategies freed them to focus on R&D rather than pouring most of their investment into capital-intensive fabrication.

Companies also have developed repeatable formulas that apply what they've learned from their increasingly complex outsourcing and offshoring activities, sometimes by building an internal organization to manage partner relationships and transfer experience from one project to the next. Cisco Systems is expert at continuously applying its outsourcing model to new products and services with remarkable efficiency and effectiveness.

In today's uncertain business climate, adopting a strategic view of capability sourcing isn't an option. It's imperative if your company is to have any hope of leapfrogging the competition.

Published: January 11, 2011 in Knowledge@Wharton

As wages and other costs increased in recent decades, U.S.-based global manufacturers gradually opted to outsource more and more of their production to suppliers in Asia, especially China. This process may have made sense for U.S. multinationals that needed to compete with companies based in those low-cost countries -- and with multinationals from other countries doing business there. And outsourcing has indeed lowered the costs of many products.

But it has also gradually become emblematic of globalization's drawbacks, and it is widely condemned as one of the key sources of today's high unemployment rates. In last fall's U.S. Congressional elections, some candidates from both the Democratic and Republican parties attempted to attract voters by accusing their opponents of supporting policies that make it easier for companies to "ship jobs overseas" -- in other words, outsourcing.

Can the tide of outsourcing be reversed without enacting protectionist, anti-trade legislation? Is such a reversal already under way in some sectors? Or is it unrealistic to expect a reversal?

Analysts generally agree that U.S. companies -- and many of their counterparts in Europe and other developed economies -- tend to think a little harder nowadays about sending production lines to Asia. Indeed, some companies were burned after outsourcing turned out to involve all sorts of hidden costs, including quality control problems and delays that resulted from longer supply chains. Recent headlines suggest these companies may be relocating some low-cost production lines back to "near-shore" locations in Mexico or Central America. Even better for U.S. workers and trade unions, more companies may soon be persuaded to expand their workforces in the United States, rather than outsource from foreign plants. In a rare, but high-profile success story, General Electric recently announced that it would add 200 jobs at its appliance plant in Bloomington, Ind., rather than shut down the plant and move production to Mexico.

"The worldwide economic downturn and its aftermath have had a significant effect on how companies view and approach global sourcing," says a recent report by The Boston Consulting Group (BCG). The report notes that exports from low-cost countries dropped sharply during the crisis -- from $3.8 trillion in 2008 to $3 trillion in 2009 -- and have yet to recover to their pre-downturn levels. So companies are "re-thinking" their strategies to take into account the "total cost" of outsourcing production lines to Asia rather than calculating just the most obvious costs, such as wages and transportation. Under increased scrutiny are the real and potential costs involved with handling such challenges as product recalls and volatile commodity prices, among other issues, says the report.

Nevertheless, outsourcing is hardly about to disappear. According to data compiled by the Economist Intelligence Unit and BCG, exports from low-cost countries, while sharply down in 2009, were still at the third-highest level in history, exceeded only in 2007 and 2008. Moreover, says the BCG report, outsourcing is "no longer restricted to high-labor-content products such as garments, toys and shoes. Increasingly, multinationals are sourcing a wider range of products from low-cost countries to capitalize on the less expensive overhead, inputs and capital -- and for strategic reasons such as better access to supplier clusters or to consumers in emerging markets." That means the total volume of exports from low-cost countries almost certainly finished 2010 on an upward course as demand for goods from those countries continued to recover from the recession.

Many politicians may remain in the dark about the subtleties of outsourcing, but executives at leading global companies have long understood its complexities, says Mauro Guillén, a professor of international management at Wharton and director of the school's Joseph H. Lauder Institute for Management & International Studies. Knowledgeable executives reject the conventional public wisdom that outsourcing is a simple, straightforward proposition because, as the cliché goes, the world is "flat." That is an "entirely wrong" assumption, states Guillén. "The world is only flat in some places." If the world were entirely flat, it would always make sense to outsource where wages and other costs are lower -- but that is clearly not the case.

Well-managed companies with experience in non-U.S. markets have long recognized that it is "very difficult to generalize" about the virtues of outsourcing, adds Guillén, noting that what makes sense for some sectors and products just doesn't make sense for others. Fortunately, the notion that most global companies dive blindly into China "couldn't be further from the truth. Companies are much more sophisticated than that."

Astute analysis of the total costs -- including potential risks -- involved in outsourcing a production line can lead companies to make decisions that are not at all obvious at first glance. "What drives the location of outsourcing is the value-to-cost ratio," says Ravi Aron, a professor at the Johns Hopkins Carey Business School and a senior fellow at Wharton's Mack Center for Technological Innovation. If, for example, the value of a product is $100, but the cost is $4, the value-to-cost ratio is 25 to 1, high enough that you can source that product at home. "Only in such cases do you tend not to outsource" a product, Aron says. That's because doing so is not worth the risks that go along with managing any extended supply chain.

To raise the value-added side of that ratio, multinationals sometimes need to invest in upgrading their production lines in high-wage countries. For example, GE's recent decision to add 200 workers in Indiana committed the company to making $93 million in new investments in its plant, which will manufacture higher-value, more-energy-efficient refrigerators. To lower the cost side of the ratio, on the other hand, GE was promised $2.25 million in state-income tax credits and federal energy incentives of $5 million. For its part, the International Brotherhood of Electrical Workers agreed that new hires at the plant would start at $13 an hour, much lower than the $24 paid to existing workers.

Cricket, the Spanish maker of cigarette lighters, provides another case study in the subtleties of calculating the value-to-cost ratio. Cricket operates three factories -- one in Spain, one in India and a third in China. Predictably, Cricket's labor costs in Spain are much higher than in India or China, yet Cricket's per-unit production costs in Spain are actually lower than in China, says Guillén, because its Spanish plant was fully automated at significant investment cost. Why does Cricket even have a plant in China? Because when customers need to order customized lighters -- for example, lighters carrying a corporate logo -- production lines must be retooled, and it is cheaper to retool in China where the lines are not automated. "The China plant gives them flexibility," says Guillén.

Global managers have also learned over the years that products such as high-end aircraft don't lend themselves to outsourcing because they cannot be mass produced; they must be manufactured to meet unique specifications demanded by each buyer. In other cases, notes Guillén, "You want R&D to be close to the manufacturer, or you want the manufacturer to be close to the buyer" so that you can respond rapidly to changes in demand. Such considerations explain why Germany is the second-largest exporter in the world, after China, despite the fact that it has very high wages.

Two key variables that determine whether it makes sense to hand over your production line to foreign suppliers, adds Aron, are its "codifiability" and the nature of the metrics involved in the manufacturing process. "Some products do not lend themselves to being codified," and even the most exhaustive attempts to codify how they need to be manufactured won't do the job. So those kinds of products should probably not be outsourced. As for metrics, global manufacturers need to be able to provide their would-be suppliers with precise, well-defined metrics so they know exactly how to measure their performance. But for some products, notes Aron, the only possible performance metrics are too imprecise or subjective, so outsourcing again doesn't make sense.

Discussion about companies bringing overseas production back to the Americas has been exaggerated or misunderstood, says Tom Kim, Hong Kong-based transportation researcher at Goldman Sachs (Asia), adding that global companies are not bringing their production lines back to the United States despite the downturn in demand for outsourced products during the recession. Something else is happening, he says. "What we are seeing is a diversification of new sources of growth in order to help companies diversify their corporate exposure" to global risks. This trend does not involve "the displacement of their existing production from China but the expansion of their capacity into different markets outside China." In other words, rather than shut down their plants in China or sever their ties with independent Chinese contract suppliers of those goods, some global companies are also outsourcing production from countries like Cambodia, Thailand and Vietnam.

Under what conditions does "near-sourcing" to, say, Mexico, make sense? "The reason for near-sourcing is that it allows you to change your supply destinations much faster," Aron says. Adds Walter Kemmsies, chief economist of Moffatt & Nichol, a marine infrastructure engineering firm: "Those companies whose products are frequently redesigned may find that outsourcing to Asia makes less sense than to near-source to Mexico, Central America or the Caribbean."

Trade pacts, such as the Central American Free Trade Agreement (CAFTA), which gives tariff preferences to firms that export from that region, can be a key factor in making near-sourcing cost-effective. In the case of CAFTA, U.S. textile mills must first export their yarn and fabric to that region, where Central American companies then cut and sew the material into apparel, which is then shipped back to the United States for distribution to retailers. This complex supply chain makes sense only because, under CAFTA, apparel made in Central America enters the United States duty-free, so long as the yarn and fabric "originate[d] in the U.S." (Otherwise, U.S. tariffs on apparel are high.)

This sort of near-sourcing benefits both Central America and the United States. Thanks to CAFTA, the average piece of clothing imported to the United States from Central America now contains 70% U.S.-made yarn and fabric. In contrast, the average piece of clothing imported from China to the United States contains less than 1% U.S. yarn and fabric, says David Spooner, a former U.S. trade negotiator who is now an attorney at Squire, Sanders & Dempsey in Washington, D.C.

Kim of Goldman Sachs agrees that near-sourcing may work well for some global companies that want to respond quickly to changes in customer demand and that need to ship products to U.S. buyers within days, not weeks. However, he adds, China will continue to be the prime location for global companies to outsource products in a wide range of industrial sectors, despite its distance from the United States -- and even despite the fact that China's wages will continue to rise, especially along its eastern coast. Why will it be so hard to replace China in so many outsourced production lines? Kim says that China offers global manufacturers a very strong physical infrastructure, which the Chinese government has been "aggressively expanding" over the past several years. Newer outsourcing sites in Asia -- even those that pay lower wages than China -- can't offer total costs that are competitive with China's because those countries' roads, ports, bridges and other facilities are significantly inferior, leading to higher costs for critical transportation and logistics.

In addition, notes Kim, Chinese companies have been actively upgrading their technology infrastructure, implementing the latest IT platforms and applications to improve their efficiency and to lower the total cost of outsourcing, even with rising wages. A final factor, he says, is the sheer size and capability of the Chinese labor force. "It is very hard to replace China's huge pool of workers" in the much smaller nations of Southeast Asia, Latin America or elsewhere. "China's workforce is upgrading its level of skills so that it can handle the production of an ever-wider range of products."

Global companies that outsource their manufacturing processes need to weigh very different sorts of factors from those that outsource their back-office processes, known as business process outsourcing (BPO), adds Aron. When it comes to manufacturing, economies of scale are very important; if economies of scale can't be provided by a particular supplier or group of suppliers in one manufacturing site, companies need to look elsewhere. In contrast, when it comes to BPO, the ability to automate and standardize processes "is a lot more important than scale," Aron states. In the case of services, inputs, outputs and working processes are all information, "so co-location is not as important in services as it is in manufacturing."

Surveys show that BPO activity is increasing again after declining briefly in the wake of the recession. IDC, an IT research firm, estimates that worldwide revenues for BPO services were $158.2 billion in 2010, and it expects an increase of 5.4% in 2011.

However, the BPO business is also growing more competitive, and some countries have developed specialized BPO capabilities that feed off the skills of their workforces and/or the time zones in which they operate, says Aron. For example, the time zone is an important factor for BPO in such countries as Mexico, El Salvador and Chile, which compete for supplying Spanish-language call centers to customers in North America.

Even with all the new concerns, many companies don't pay enough attention to the full range of logistics challenges they face when they outsource manufacturing to suppliers in distant locations, according to George Stalk, a Toronto-based senior advisor at BCG. "People have to be careful when they go out [to Asia] about stock-outs and overstocks," says Stalk, and they must be prepared to pay the higher cost of shipping fashions, high-tech goods and other products that customers demand on short notice. Many companies "don't think about logistics" until they have a problem, he adds, and too many corporate heads of logistics are "a level or two down" from senior management, where they "don't have the throw weight" to make strategic decisions that have a major impact on profitability. Notable exceptions to that rule include apparel companies as well as supply-chain-driven companies like Wal-Mart and Dell Computer, whose logistics heads have long exercised a strong voice in senior management.

Stalk also worries that global companies could be caught unprepared for upcoming increases in logistics costs. "Companies have calculated their logistics footprint when logistics costs were going down in real terms. But now, all of these costs are beginning to reverse themselves," including rates for containers and railroads as well as oil prices. Despite the Obama administration's bold rhetoric about upgrading U.S. infrastructure, 95% of infrastructure spending in the stimulus package "was about catching up with delayed maintenance," Stalk notes. "We have no new runways, no new airports and the 'next generation' air traffic control systems are still not up. All across the board, the opportunity to get ahead of the problem has passed. The congestion costs are beginning to bite."

Published: July 17, 2013 in Knowledge@Wharton

Global companies struggle with decisions on how much to outsource. Too little means an organization may lose the pricing advantages that can come with using competitive providers worldwide. Too much -- or the wrong kind of outsourcing -- and quality and knowledge management can suffer.

A panel at a recent Wharton Global Forum in Tokyo titled, "Global Supply Chain Management: Outsourcing, Re-shoring, and Near-Shoring," looked at the reshaping of the global supply chain, and how companies choose where and whom to source from in a fast-changing environment. During the discussion, led by Wharton professor of operations and information management Morris A. Cohen, the panelists suggested that the cheapest solution is not always the best, and that the architecture of supply chains can vary widely depending on the industry and products involved.

Boeing's supply chain evolves from extensive research into customers and the environments in which they operate, said Beth Anderson, a Boeing vice president. "We go through the entire cycle of designing the airplane and designing the production system, and understanding who our customers are going to be and how we're going to support [the aircraft] once it goes into service."

Boeing's main customer base has evolved since 20 years ago, when 75% of the company's production took place in the United States and Europe, with the rest happening elsewhere. Now, just 25% of Boeing's backlog is in its traditional markets in the U.S. and Europe, with 75% in fast-growing economies like China and India. Thus, Boeing's vast supply chain is evolving to fit its changing market and advancing technologies.

Last year, the manufacturer sourced 783 million parts used to build 600 aircraft. By 2014, it will be bringing in more than one billion parts from a total of 7,500 suppliers to build 700 planes. "It's a vast supply chain and very complex," Anderson said of the 500,000 people in 73 countries engaged in helping to build Boeing products. "It [takes] really well choreographed logistics ... to bring those airplanes together." She noted that even a seemingly simple window shade is sourced from seven suppliers.

Like most manufacturers, Boeing is contending with immense competition, and that means its choice of suppliers has to enhance its competitive advantage. Ultimately, "it all comes down to safety," Anderson said. Each of Boeing's 7,500 suppliers is held to the same standards the company requires of itself. Optimizing its supply chain and other qualities such as fuel efficiency and aerodynamics enabled Boeing to gain 35% in efficiency between 1975 and 1995, but airlines are demanding still more improvements. "Our world has changed dramatically," Anderson noted. "To be competitive, we are working with our supply chain. We're looking at whom we work with, [and] how we change the engineering, the architecture."

Boeing's manufacturing processes have been in the spotlight lately because of the company's high-tech 787 Dreamliner, which suffered from delays, cost overruns and, after its launch, high-profile battery problems. Last week, an empty 787 Dreamliner caught fire while parked at London's Heathrow Airport. Boeing, along with Great Britain's Air Accidents Investigation Branch, the U.S. National Transportation Safety Board and Honeywell, maker of the emergency device located in the area where the fire appeared to be burning, is investigating the possible causes of the incident.

Ultimately, Boeing seeks to minimize risk and maximize the value of its supply chain by gauging the capability, capacity, collaboration, cash and commitment of its suppliers. It also has to work with aspiring partners in emerging markets such as China, despite potential risks from technology transfers. "It's a balancing act. We don't want to say, 'No, we're not going to share,' because we would be shutting ourselves out of the market. But we have to decide when we have to say no," Anderson noted.

Japanese aircraft maker and defense contractor Mitsubishi Heavy Industries, whose company has worked closely with Boeing on the 787 and other planes, is also balancing its domestic manufacturing base with the need to expand into global markets, said Shigefumi Tatsumi, the company's vice president and general manager for commercial aircraft. The company makes at most 50 of its best-selling aircraft in a month, with lead times that are often over a year. "We have a very flat supply chain, which is not good for the current business environment," noted Tatsumi. Key considerations are location and quality assurance.

Nissan Motors faces similar challenges, according to Vincent Cobee, corporate vice president in the automaker's Global Datsun Business Unit. Nissan's supply chain, like Boeing's, has been transformed by globalization and the emergence of newly affluent markets outside of North America, Europe and Japan. The shift of production to offshore markets to help defuse trade friction ended the traditional reliance of Japanese automakers on marketing through the big Japanese trading houses. That transition was followed by a shift toward localization across many markets.

While Nissan maintains full control over development of its vehicles, it has had to localize supply chains to reduce costs and reach its key markets. The automaker uses several different business models. The premium brand, Infiniti, is competitive with German luxury cars and developed and made in Japan. The global Nissan product is developed in Japan but localized for various markets. Finally, there is Datsun, which Cobee calls a global-local product, developed and sourced locally with Japanese expertise.

For high-tech products, supply chain logistics can be even more daunting, said Kenji Mizuno, a senior vice president in electronics maker Fujitsu's supply chain management unit. Unlike aircraft and cars, Fujitsu's products are often invisible to consumers, but there are similar pressures to ensure that goods are delivered quickly enough to meet customers' requirements. Fujitsu counts among its clients nearly half of all Fortune 500 global companies and it is the world's third-largest IT service provider, with 173,000 employees and 4.4 trillion yen in annual sales.

Rather than thousands of suppliers, Fujitsu relies on only a handful for each of the many components used in its X86 servers, which Mizuno cited as an example. It buys CPUs from Intel and AMD, and hard disc drives from Seagate and Toshiba. The realities of the supply chain, and high expectations of Fujitsu's customers, mean that Fujitsu has to source parts from suppliers that have moved offshore to China and elsewhere in Asia, and keep costs low, while providing high quality and high reliability and managing grueling time limitations.

Despite the small number of suppliers, Fujitsu must provide servers tailored to meet up to 20,000 configurations, Mizuno said. Fujitsu's solution to the dilemma of scattered suppliers and short delivery times of five or six days is to buy parts from China or from members of the Association of Southeast Asian Nations (ASEAN), ship them by sea freight and have them ready for final assembly close to its customers' locations in Japan, Europe and China. "We assemble the products, put them through long tests and deliver. This is the only scenario that allows us to make money and meet all the other requirements," Mizuno noted.

To manage its myriad supply chains, Fujitsu has opted for a "virtual global SCM" (supply chain management system) to decide who will make and deliver products. "We are doing this every day. We look at the customer orders, factory lines and parts supplies. This is the only way we can do it," Mizuno said. Tokyo Electron, which makes the chip sets used in Sony Play Stations and other devices, faces similar requirements for high reliability and quality but has a less open approach to its own supply chain, noted Akihisa Sekiguchi, the company's vice president and general manager for corporate marketing. Tokyo Electron produces mainly for export, though only eight customers account for almost all its business.

Although it is not that well-known to consumers, Tokyo Electron once was number one in the integrated circuit industry, back when Japan was the leading manufacturer of semiconductors. Now, it is at the top in Japan and number three in the world, with 12,000 employees and $5 billion to $7 billion in annual sales. The firm's manufacturing is all done in Japan, though it ships 90% of its products overseas. "Our R&D is global, but sourcing is domestic," Sekiguchi said. Keeping production onshore works for Tokyo Electron because the components needed to make its tools are made in Japan, and the country's infrastructure can support its manufacturing.

Apart from trials related to years of "endaka," or the high-valued yen, Tokyo Electron's biggest challenge came with the March 2011 earthquake and tsunami, which forced its factory in Fukushima to close for about two months. The company's workers pulled together to get production back up as soon as possible, though "it takes time to track down 4,000 or 5,000 suppliers," Sekiguchi noted. Calamities like the March 2011 disasters drove home the need to mitigate risk through multi-sourcing. But it does involve costs. "It's not an easy solution," Sekiguchi said. "IP protection is an issue. Geographic location is an issue."

Ultimately, there is no single solution that works in all cases. The question of IP protection is vital to supply chain management, Cohen noted during the panel discussion. But for companies like Boeing, the extremely high degree of regulation typically helps to prevent bogus parts from getting into the industry. "Mostly the regulators do the policing. We just ensure that all the parts have the right documentation," Anderson said.

Automakers like Nissan face much greater risks, given the prevalence of independent auto service companies in many markets. "It's very difficult to guarantee the source of the parts. Our badge is on the car no matter where the parts come from," Cobee noted. "I recommend not using an unauthorized dealer in China."

Partly out of those concerns, some consumers are choosy about the origin of the products they buy. But for IT companies like Fujitsu, although components are made in various places, from Costa Rica to Israel, "we can boast that our products are made only in Japan," said Mizuno. "The real issue is reliability and capability. We do very special tests, and sometimes many components fail. But when we deliver the finished computers, they are very high quality. That's our expertise. They are made and assembled in Japan with our technology."

Tokyo Electron, likewise, uses components from overseas but puts its products through extensive testing before they are shipped. "If components fail, they are dropped," Sekiguchi said of the tests, which extend to the "molecular level. In the semiconductor industry, we buy the product, not the location or the source."

Stretching to reach global markets involves risks, as Boeing's experience with the 787 attests. Yet, outsourcing is something Boeing will continue to do, even if the company found that it went a bit too far with the Dreamliner.

"We had an expectation that our suppliers could do the same things that we do every day. We learned that stuffing an airplane full of parts, [something that] we take for granted, is ... challenging," Anderson noted. "We'll take our expertise and start getting the next new airplane on the books. We're taking advantage of the expertise around the world. We can't believe we're the only ones who can do it." According to Tatsumi of Mitsubishi Heavy Industries, working with Boeing is an elaborate process involving hundreds of engineers and a collaboration that has to evolve as the products and market environment change.

Companies must realize that once they have opened the door to collaboration or outsourcing, though, it can never be closed, noted Nissan's Cobee. Given the huge risks of failure for products like automobiles and many other products, "you have to think about not only the benefit for tomorrow but also about whether you can sustain it." To keep a competitive edge requires constant innovation. "You have to innovate more than the others. Yes, we have the daily job of protecting IP. It doesn't take a genius to dismantle a car and reverse engineer it," Cobee said. "The only way is innovation."

The outsourcing and offshoring industry is at a turning point. What began as a small-scale sector dedicated to application development, accounting, and payroll has become, as of 2008, an $80 billion global industry, addressing a range of business processes and technology services. As the IT services and BPO industry matures, however, challenges are emerging.

Our research finds that more that 70 percent of offshore delivery centers, including both wholly owned captive operations as well as vendors, narrow their global operations to just three locations, often situated in only two countries (most frequently India, China or the Philippines). This reliance on a limited number of geographic regions-historically driven by the availability of highly skilled, low-cost labor in these areas-is exposing providers to a variety of location-specific risks. These include abrupt currency and wage fluctuations, intense competition for employees, and regulatory limits. While a narrow geographic concentration may result in lower labor costs at the outset, the overall risks are higher, according to our research. The same is true on a microlevel: our data show that when a delivery center in a large Indian city grows beyond 3,000 employees, costs spiral and performance begins to deteriorate.

Offshore service providers can mitigate these risks in the way a financial manager would-by diversifying their holdings. While diversification has long been the rule for investment decisions, outsourcing providers were under little pressure to change their lowest-cost-country approach until recently, when rising volatility in many favored offshoring markets began to impair providers' ability to predict costs and manage talent needs. As a result, many are looking to address these vulnerabilities while still reaping a cost advantage.

Offshore delivery centers can accomplish this goal by diversifying their operations in two ways: on a macrolevel, by expanding their global footprints to reduce overconcentration in any one region; and on a microlevel, by broadening the range and scale of activities conducted in any one center. The result is a network approach to offshore delivery management that features centralized global delivery hubs and decentralized local or specialized service spokes. This next-generation model not only improves overall global delivery but also brings greater predictability to cost management while fostering better coordination, flexibility, and responsiveness-characteristics that can give global companies a sharper edge in this period of rapid change. The remainder of the article and exhibits that follow illustrate the benefits inherent in moving to this new model.

The benefits of a portfolio approach

The underlying volatility of today's markets makes planning more difficult, particularly in the cost-sensitive IT and BPO service industry model. With increasing pressure on margins, service centers need to anticipate changes in costs-and avoid sharp movements in local market conditions (such as higher wages, labor shortages, and inflation). Such swings have been particularly marked in preferred offshoring destinations such as India, where the economics of doing business were significantly altered in the space of the 15 months between January 2008 and March 2009. Over that period, the rate of wage inflation fell by eight percentage points (to 4 percent), the US dollar rose 32 percent against the rupee, and employee turnover declined by 15 percent. These double-digit swings would have wreaked havoc on any cost projections and have made planning quite tricky.

Delivery centers can ease the planning burden by adding other geographies to their portfolios-ones that offer more stable economic profiles or whose market movements counteract those of the original location. Doing so allows companies to hedge their exposure to risk and makes managing costs more predictable. Such considerations form the basis of strong portfolio planning.

The following composite example illustrates how one company, based in Paris, used this strategy to its advantage (Exhibit 1). The company was looking to offshore 2,000 specialized, high-end IT jobs and initially planned on sourcing the entire project in India. It opted for an alternative scenario, however, after running the numbers as part of its due diligence. With a view to minimizing its exposure to geographic, currency, and labor issues, the company tiered the work across several locations, placing roughly two-thirds of the project in India and splitting the remaining third across three other regions. It kept 100 jobs in Lille, France, and nearshored 300 more in low-cost Romania, because of the proximity of these locations to European markets. A further 300 were placed in Egypt, where government programs have substantially broadened the talent base. The company then housed the remaining 1,300 roles in Bangalore. By diversifying in this way, the company significantly lowered its overall portfolio risk while incurring only marginally higher costs than it would have under the all-India approach.

A qualitative and quantitative advantage

In popular offshoring locations, processing centers are often pitted against one another in the war for talent-a battle that often results in higher wage and recruitment costs for delivery centers. A diversified location portfolio acts as a buffer against talent shortages while expanding access to a broader range of business, technical, functional and domain skills, languages, and other competencies. India, for instance, remains a top offshoring destination because of its reputation for low-cost, high-quality talent. Yet markets such as Egypt, South America, and Southeast Asia have been on the map for some time as viable offshoring locations. For scale-oriented delivery services, their comparable cost and risk structures make them attractive alternatives to heavily penetrated countries like India (Exhibit 2). By tapping into nontraditional destinations, companies may succeed in achieving a comparative cost advantage versus the competition. Qualitative factors-such as time zone, the suitability of the local skill base, the region's proximity to key customers, and the existence of government initiatives-also play an important role. Although Eastern European countries are more expensive, for example, they bring strong specialist talent, the requisite language skills, and excellent infrastructures; these factors may often compensate for the higher cost.

Diversifying on a microlevel

Government initiatives have enhanced the service options available for companies looking to choose an offshoring location (see sidebar, "An enhanced menu of location choices"). Some emerging markets, such as India and Malaysia, are becoming attractive R&D locales as a result of a concentration of elite universities and public-private research parks. These locations offer specialized pockets of talent and subject matter expertise. Despite these opportunities, many companies tend to focus on "transaction only" centers-those that cater to basic needs such as data entry, simple payroll processing, and account documentation. This narrow scope can cause a center's overall performance to deteriorate over time, since competitors often converge in similar markets and draw down the available talent pool.

As a result, it becomes important for companies to diversify on the microlevel as well. By expanding the range of work conducted in centers to include higher-level skills, such as market research and analytics, delivery centers can limit their exposure in any one competency and provide more attractive career choices-improving employee retention and lowering costs. Our data indicate that those outsourcers and offshorers that leverage different types of talent within an integrated service model (often called a center of excellence) can achieve cost savings of 12 to 22 percent over those of their transaction-processing-focused peers (Exhibit 3).

The limits of scale

A center's performance generally improves with scale, but there are limits. Our research into more than 80 offshore service centers in India shows there is a tipping point, after which diseconomies emerge based on the size of the available talent pool and the need to fill more seats with increasingly scarce and therefore more expensive talent.

We found that when centers in Hyderabad and Bangalore grew to around 2,000 to 3,500 seats, for instance, their cost performance began to deteriorate. To counter this, companies should assess their own performance profiles and scout new locations before their existing centers grow too large. As Exhibit 4 shows, having multiple locations versus one or two megacenters not only maintains the right cost-performance balance, but also helps to foster network effects.

A next-generation strategy for offshore operators

When a provider has only three outsourcing centers, it is easy to consider them as separate entities. Yet the use of multiple sourcing locations can create valuable network benefits in the form of improved governance, process standardization, workflow transitions, and contingency planning. When coordinated well, the whole can be greater than the sum of its parts.

One service provider, facing too narrow a concentration of geographies, skill sets, and centers, sought to create a next-generation global delivery model (Exhibit 5). Before the change, it operated a cluster of centers in India and China. These free-standing units managed everything from HR to service delivery at the center level. The result was unnecessary duplication of activity and poor coordination between locations. In addition, a few centers were highly skilled in some applications, but because competing projects stretched existing resources and slowed development time, the provider was unable to leverage and channel the right skills for the appropriate tasks. To address these issues, the provider moved to a global network approach with global operations hubs delivering finance and accounting, HR, and customer service in four locations in Asia, Eastern Europe, North America, and South America. These facilities managed global back-office functions on a centralized basis, eliminating redundancy and improving knowledge sharing across the network. At the same time, the company decentralized its software-development labs, creating a network of competence centers around the world, each specializing in a specific product line or software capability. These centers integrated a mix of high-level skills-including product R&D and system programming, along with more basic tasks-in order to boost productivity and volume.

This new structure yielded several benefits. Consolidating core operating functions eased the oversight burden, allowing management to focus its attention on high-level issues, while enabling individual centers to cooperate on day-to-day matters more directly. This new approach allowed the company to standardize processes, establish common frameworks, enforce best practices, improve delivery speed, and streamline process handovers for round-the-clock global coverage in the global operations hubs. Meanwhile, the decentralized spokes (the company's network of specialized development labs) focused on developing specialist skills to enhance innovation speed and superior project delivery for high-end IT projects. These changes combined to lower costs and improve performance.

Global service delivery for business and technology services is gradually coming of age. The operating model of service delivery centers has traditionally benefited from low labor costs at outsourcing sites concentrated in China, India, and the Philippines. But with the wider economy poised for what will likely be a sustained period of underlying market volatility, financial and structural risks are rising. As the industry matures, so too must its service model. To sustain future growth, providers need to create a network of offshore centers to diversify their risk and provide greater management flexibility.

About the authors

Matthias Daub is a consultant in McKinsey's Frankfurt office, Barnik Maitra is a consultant in the Delhi office, and Tor Mesøy is a principal in the Oslo office.