Should you outsource to China?

You may not be making a profitable decision

Just sub-contracting manufacture to China is not the answer. In time, you will find that Chinese companies have reverse-engineered and redesigned your product and are taking your markets. Not only that but outsourcing decisions are often flawed because of the traditional works costing, rather than by accurate value stream costing.

Most companies cost their manufacturing incorrectly which makes outsourcing look profitable when in reality it’s more profitable to retain manufacture in-house. The article from Brian Maskell below explains:

So how should you calculate manufacture cost?

 - from information by Brian Maskell

The problem with current accounting systems

Traditional cost and management accounting methods actively work against this and lead to bad decisions for pricing, margins, make or buy, and other key issues. They were designed for traditional mass production and job-shop manufacturing, with measurements such as labour efficiency, machine utilisation, overhead absorption, and variance analyses. Traditional costing systems are also wasteful, time-consuming and expensive. They have to be replaced by methods that actively support low waste operation.

The important accounting aspects

It is the business management system that shows you the financial impact of changes. It uses performance measurements that motivate and enhance actions at all levels. These are visual, focused on the value stream, designed to prompt continuous improvement, support work-teams, and provide fast effective feedback.

Your performance measures become the primary mechanisms of control as processes are brought under control. You eliminate the need for cost accounting and inventory control, which are traditionally needed because processes are out of control.

It does not cut costs but turns waste into available capacity. The financial impact comes as you make strategic decisions on how to use this capacity, and from the cash flow of reduced inventory.

You cost the value stream to eliminate wasteful transactions associated with traditional cost accounting. In return you get timely understandable information.

You make decisions on the profitability and contribution margin of value stream: pricing, profitability, make or buy, new product introduction, product and customer rationalisation. QFD and target costing drives the business by customer value not cost. You don’t need to know the cost of a product because all decisions are made by assessing the profitability of the whole value stream, not of individual products or product families. Understand the flow of material, information, and cash through the value stream and the bottlenecks or obstacles to flow.

The best way to reduce cost is to increase sales. Use value stream cost analysis to understand where you expend cost with where you create value for the customer and where capacity is available. Use Kaizens to align value and cost through the entire value stream from sales and marketing through product design to shop floor operations. The team studies the customers needs and develops action plans to increase customer value and profitability. These action plans include changes in sales and marketing, product design changes, operational process improvements, and improved administration.

How standard costing can lead to poor decisions

You need accurate and valid financial information when making important decisions. But you can’t do this by using standard costs. It is harmful, misleading, and leads to poor decision-making. Use value stream costing instead. Calculate the costs and profitability of the value stream as a whole, not for the individual products within the value stream. Up-to-date information is thereby available on the total costs and profitability of each value stream. For example:

1. The sales enquiry and the response

Company A manufactures hydraulic equipment. The company received a request for XJ2 valves that they have been manufacturing for many years. It is small and simple to manufacture. The customer, a large distributor in East Anglia, wanted to order 3,000 a month, for years into the future at a target price of £45 per unit. The standard cost for an XJ2 is:

Labour time to make an XJ2 750 seconds
Labour cost per hour £ 24.73
Labour cost per unit £ 5.15
Overhead rate 290% 
Overhead cost £ 14.94
Material costs for XJ2 £ 22.33
Standard cost XJ2 £ 42.42

Because the customer was firm on the £45 price, the order was declined because the profit margin was less than 6%, outside the company’s 15% minimum margin rule with a cost of £42.42.

2. The inevitable outsourcing proposal

But the sales people were not to be deterred in their quest for a profitable sale. They bought some time from the customer and worked on finding an alternative source. They found a supplier in the Far East that could provide the valve at a significantly lower price than the standard cost:

Price to the customer £ 45.00
Cost from the Far Eastern supplier £ 30.00
Overhead for incoming logistics 7.50% 
Total inbound cost £ 32.25
Monthly revenue for 3,000 units £ 135,000.00
Monthly cost for 3,000 units £ 96,750.00
Monthly profit £ 38,250.00
Profit margin 28.33% 

The sales people told the customer they were happy to meet their price and set about ordering 30,000 units to be made and shipped to the UK from the Far East.

3. The real costs and the sensible decision

But the financial controller was not satisfied with the outsourcing decision. The plant had been on a lean journey and he had become a lean leader. He had seen the value stream go from being a long-lead-time, high WIP, traditional production process to truly lean-focused flow. They were still a long way from being really lean - but they had made some progress. The controller reckoned that their value stream could compete with any company in the world. He also disliked the idea of huge inventories and complexity that would come from sourcing overseas. It was the opposite of lean thinking.

So he examined the costs using the value stream costing information reported to the value stream manager each week. Working with the production management team, he found that the additional volume to support the 3,000 units-a-month order would need two more people and two more machines. He worked out how the value stream costs and profitability would change if they added these additional costs and revenues.

Current state Incremental
Value stream
with new order
Current monthly revenue £ 1,042,631 £ 135,000 £ 1,177,631
Material costs £ 424,763 £ 66,990 £ 491,753
Production employee costs £ 100,464 £ 7,728 £ 108,192
Support employee costs £ 208,652 £ 208,652
Machine costs £ 9,858 £ 939 £ 10,797
Other value stream costs £ 73,115 £ 73,115
Profit £ 225,779 £ 285,122
Return on sales 21.65%  24.21% 

The plant controller then summarized the three approaches; standard cost, outsourcing, or making in house.

- no order
- take the order
- take the order
Current monthly revenue £ 1,042,631 £ 1,177,631 £ 1,177,631
Material costs £ 424,763 £ 514,763 £ 491,753
Production employee costs £ 100,464 £ 100,464 £ 108,192
Support employee costs £ 208,652 £ 208,652 £ 208,652
Machine costs £ 9,858 £ 9,858 £ 10,797
Other value stream costs £ 73,115 £ 79,865 £ 73,115
Profit £ 225,779 £ 264,029 £ 285,122
Return on sales 21.65%  22.42%  24.21% 

Clearly the best course of action was to make the product in-house rather than outsource it. If they made the product in-house, it would make more money and improve profitability. And the company would save itself the problems and additional costs of sourcing from a supplier halfway across the world.

4. the company’s conclusion

After seeing this example, senior management concluded:

  1. Making an important decision using a standard cost is misleading and wrong. That you can outsource an item for less than the current standard cost is meaningless.
  2. The team did not abandon the idea of sourcing from overseas, but it was recognized that these decisions must be made using valid and reliable financial information.
  3. Valid and reliable financial information comes from up-to-date value stream direct costs and profitability. These are real numbers, not artificial accounting concepts.
  4. Few people in the company really understood the standard costing system, and using it led to serious mistakes. Value stream costing is simple, readily understandable, and gives information that can be used reliably for decision-making.
©2014 - Dr C B Mynott (Managing Director) TICS Limited