The Rational Outsourcing Blog

Monday, November 06, 2006

Interesting push for considering the Total Cost while outsourcing

I am about to quote widely from two anti-outsourcing tirades. While I usually prefer not to link to extreme views, these two posts between them make a very important point: labor cost is only a small component of the total cost of ownership and if you make outsourcing decisions based on labor costs, you are setting yourself up for failure. If we are truly going to be rational about outsourcing, we need to acknowledge and learn from the truth embedded in the most extreme views. [Not that these posts are even close to being the most extreme views on this topic.]

The first post by Bill Waddell at makes the point that companies do not have a clear sense of what their true cost is because they do not sufficiently account for factors such as the cost of lead time, quality, inventory carrying costs, supply chain risk, etc. I would tend to agree. In fact, in the Business Process Outsourcing space, I have often met customers whose cost of correcting errors is three times their outsourcing cost, yet they focus more on the labor cost differential than the error rate differential between their in-house operations and outsourcing vendors.

I have a better idea: How about if manufacturers figure out what their cost really is first. Forget about the cost of lead time and quality. Most companies have no idea what it costs to take widget materials A,B,C and D; put them together into sub-widgets E and F; slap those together into a final widget G; then put that into a cardboard box. Never mind the higher level questions of how long it takes or how many they get right.

When companies cannot figure out the cost of running and taking care of the widget making machines, or the cost of moving widget parts around their factories, the esoteric costs of such matters as lead time are the least of their worries. In most cases, 'cost' means the number they get when they add up the 2/3 or so of the direct labor time they can track plus the invoice price of the materials, then multiply the labor number by about six or seven and call that the cost of a widget. That number is about as accurate as calculating the temperature by looking at a lake and deciding that, since the lake isn't frozen it must be greater than 32 degrees, and it's not boiling so it has to be less than 212, so the temperature must be exactly in the middle - 122 degrees. Precisely 122 point 0, in fact.

For a company to take a manufactured cost that includes a 40-50% wildassguess factor and compare that to an fob Guangdong price, then decide to close a factory and throw people out of work based on the comparison is somewhere between insane and criminal. Deciding to outsource because the cost just couldn't be reduced any more, when the company never had a clue what the cost was to begin with is equally absurd.

The second post, by Kevin Meyer at makes the point that companies can save much more money by eliminating waste than by reducing labor costs via outsourcing. Once again, I tend to agree that this lesson applies to Business Process Outsourcing as well. For example, at the Total cost of errors site we highlighted one company where a 0.1 percentage point change in error rates had the same bottom line impact as a 30% reduction in labor costs due to outsourcing. [The full case study is available at]
But the bottom line is that there are really only two justifiable reasons to outsource, especially globally: to access unique capabilities and to be closer to the customer. Labor cost is not one of them. In the traditional financial world, labor cost happens to be one of the most controllable, therefore it's easy to go a few thousand miles away to save a few bucks an hour. But what about the total supply chain cost? How much cash is being chewed up in inventory on the high seas? What happens if a quality problem is found after a boatload of parts has already set sail? What is your new customer lead time? Not to mention intellectual property issues and the rapidly-rising labor costs in some outsourcing havens like China that is already forcing some companies to globetrot to another low labor cost location.

A 20% "labor penalty" is nothing compared to the internal process and methods waste at most manufacturing companies. Take the time to really use lean methods to streamline how the operation runs. Focus on one piece flow, respect your employees, and develop a high performance workforce... you usually get what you pay for. The savings from even a first-pass lean waste reduction kaizen or value stream mapping exercise will often be twice the cost of the labor of the process.

It works. That's why truly lean companies, such as Danaher, Parker-Hannifin, American Apparel, and others are building more plants in the U.S., to compete globally.

While I agree with several points raised by these authors, I do believe at least in the case of Business Process Outsourcing, the better outsourcing vendors are adopting lean practices and six sigma far more aggressively than their customers. Eventually, if the outsourcing vendors deliver truly lean processes that US companies still struggle to match, then the outsourcing vendors’ labor cost advantages will only be further enhanced by the additional financial benefits of the lean processes adopted by them. That day is not here today, but if American companies do not aggressively start improving the overall cost of their processes, soon the Indian firms will be by far the world experts in business process quality and innovation.

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