Executive White Paper Series

Lean Outsourcing: Ten Major Improvement Ideas

by
Terence T. Burton
President and Chief Executive Officer
The Center for Excellence in Operations, Inc. (CEO)
Bedford, NH 03110 USA

Copyright 2013 by The Center for Excellence in Operations, Inc. (CEO)

Lean Outsourcing: Ten Major Improvement Ideas

by Terence T. Burton, President
The Center for Excellence in Operations, Inc. (CEO)

Outsourcing, a popular term to describe the transfer of U.S. jobs to third world countries,
emerged significantly over the last decade or so. The original objective of outsourcing was to set
up a national presence in other countries such as China, Brazil, India, and others with high
revenue growth potential for goods and services. Today over 50%+ of revenues in many
corporations come from international markets. A major driver was also the availability of low
wage Chinese workers that literally flooded the global marketplace. What a winning strategy:
big incremental global revenues, unlimited availability of resources, significant labor cost
reductions, less government regulations, lower taxes, and huge profits - right?
Outsourcing is a dynamic process; many of the assumptions behind these initial decisions were
either incomplete and have definitely changed, or could never have been predicted up front.
Organizations that are willing to analyze and eliminate the hidden waste and associated costs in
their outsourcing process will quickly discover that there are millions of dollars in new
improvement opportunities waiting to be harvested. This article provides a proven approach to
lean outsourcing. Lean outsourcing is all about velocity improvement, quality improvement,
cost reduction, resource and logistics optimization, eliminating waste, reducing global supply
chain complexity and risk, and improving the overall customer experience to present outsourcing
approaches - and also the strategic options of modifying offshoring decisions, including a large
movement of reshoring back to the U.S. The ultimate positive and hopeful outcome of lean
outsourcing is insourcing and reshoring, as long as the data supports this option.
A Few Definitions
Before we get too far down the road, it is important to understand the distinction between several
terms being tossed around in industry and used in this article. Exhibit I provides a clarification
of the various terms used around the broader topic of outsourcing.

Outsourcing is the contracting out of an internal business operation or process to a third party organization because it offers a higher value than staffing it internally. Outsourcing involves the transfer of jobs and/or assets
to an external third party, and includes both foreign or domestic contracting. Outsourcing was and is the most
popular word to describe the mass transfer of U.S. jobs to China and other third world countries.

Insourcing is the reversal of outsourcing and includes the transfer of jobs from a domestic or foreign contractor
or supplier to the internal operations of a business. Insourcing can also include bringing a third party contractor
or consultant in to work inside a company's facility to provide talent for missing core competencies or resource
constraints. The decision to insource is made to protect proprietary technology and intellectual property,
maintain control of critical production or competencies, and minimize risk in the global supply chain.

Offshoring is the relocation by a company or segment of its operations from one country to another country. The
difference between outsourcing and offshoring is that outsourcing is either a local or international transfer of
operations to a third party contractor, where offshoring is the transfer of operations to another country - either to
the organization's resident global operations or to a third party contractor.

Inshoring is the import of foreign company operations and their respective jobs to the U.S. A good example of
inshoring is the decisions of Toyota, Honda, Mercedes Benz, and other foreign corporations to establish plants on
U.S. soil, creating thousands of direct jobs and infrastructure employment in the process.

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Reshoring
is also
viewed
the reversalinofOperations,
outsourcing and
includes
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(CEO)the transfer of operations from a foreign
location (an organization's resident global operations or a third party contractor) back to the country of origin.
Decisions to reshore are based on sound financial and economic analysis and consider the Total Cost of
Ownership (TCO). If you live in the U.S. and have been a victim of outsourcing, reshoring is interpreted as
moving jobs back to the U.S.

The History Lesson

In retrospect, many outsourcing decisions have been driven by a cursory and "lite" financial
spreadsheet analysis focused on labor and other visible P&L elements of costs. Many
organizations have followed the blind, follow-the-leader outsourcing directions of other
organizations. Several executives even mandated that they wanted X levels of outsourcing
achieved by Y date without any analysis at all. In their journey, many organizations became
confused with the difference between price and total loaded costincluding the hidden costs of
outsourcing. In the process, several organizations moved their problems 7,000 miles away under
a different roof, making problems and the cost of resolving them exponentially higher. When
your name is on the box, you ultimately own the problem and most offshore contractors are not
the most cooperative when it comes to acknowledging and resolving their own internal
performance issues. They are also opposed to accepting returns and processing credit
adjustments for their own problems. For now, the good news is that the incremental
international revenues are covering these costs and profitability probably looks like a winning
strategy. However, over 50% of outsourcing decisions need significant improvement to maintain
profitability and achieve valid long-term feasibility. The total hidden costs of outsourcing
typically fall somewhere between 14% to 60% of purchase price. In some isolated situations we
have looked at, the hidden costs are in excess of over 2X to 3X the purchase price. Think about
the implications: every sale results in giving away an additional unknown amount of money that
exceeds the profit margin; the more you sell, the higher your losses. Incremental revenue growth
is covering up the problem but it will not last forever. This is the difference between western
executives looking at the next quarter, and their eastern counterparts looking at the next quarterof-a-century.
Let's now look at the larger strategic implications of outsourcing. Outsourcing has split the
loyalty between profit-motivated corporations and country of origin interests. First of all, global
trade implies reciprocity, it is supposed to be a two way street. There has been little to no
reciprocity in outsourcing for a number of complex economic and political reasons, only the
continuous export of domestic manufacturing jobs. Corporations have also fooled themselves
into thinking that as long as the creative and innovative work was kept here, the dirty fingernails
grunt work of manufacturing could be outsourced to other countries. Organizations are learning
a very painful lesson about this logic today. Manufacturing is the incubator for technology and
innovation; it needs to be in close proximity where innovative ideas and concepts can be proven
out through pilot production, test, and worker feedback - all of which fuels a positive cycle of
innovation. This is why organizations are experiencing the pull of innovation, technology
development, product development, and software development to outsourced contractors.
Outsourcing is growing rapidly beyond a trade imbalance problem to a national security
problem. If organizations continue to hollow out their innovation, technology, development, and
manufacturing capabilities, how will the U.S. respond to a major military threat to our
homeland? If it is a Communist threat, do you think we can rely on China to make performance
military clothing, weapon systems, and other goods and services to defend our country? Sure,
this is a risk and a long shot. But basic economics 101 teaches us that if countries consume more
than they make, it translates into lower economic value-add and a lower standard of living.
Copyright 2013 by The Center for Excellence in Operations, Inc. (CEO)

Today, the U.S. is smack in the middle of this model where the largest and fastest growing career
is government entitlements, not value-producing jobs. Organizations like GE, GM, Pop
Outerwear, Lyncean Technologies, and hundreds of other companies see this wake-up call and
are leading the latest trend towards insourcing.

The Outsourcing Game is Changing Rapidly

Beyond the strategic implications, the current financial dynamics of outsourcing are also
changing rapidly. Much of the outsourcing efforts of the past decade were driven by a herd
leadership mentality, a lack of data-driven and fact-based decision making, and a lot of baloney,
period - end of story! Let's look at a few facts that were either clearly visible, coming into focus,
or are unfolding as we speak in the global economy:

Oil prices have risen by 3X since 2000, making cargo-ship fuel much more expensive
option.

Wages in China are now 5X what they were in 2000 and rising at an annualized rate of
about 20%

Many American unions have learned a painful lesson about the need to refocus their
purpose. The previous annual negotiations and strike threats in the absence of economic
reality must be replaced with more comparable global competitive strategies.

The natural-gas boom in the U.S. has dramatically lowered operating and facility costs in
the U.S.; in Asia, natural gas now costs 4X U.S. rates.

A combination of higher material content in products combined with impressive

productivity gains through continuous improvement initiatives makes chasing labor
savings the wrong game.

Much of the illusive labor savings in low cost countries is trumped by all of the hidden
waste and overhead costs that have been generated since day one to make the overall
supply chain function well.

When organizations go deep into their present outsourcing processes and practices and factor in
the above points and many other hidden opportunities, a totally different picture of success
emerges. The most common initial responses I have experienced is "This is not possible; We
wouldn't have done this if it wasn't the right thing to do; and There is something wrong with your
data." About 99% of the time, the people making these comments do not have any data of their
own to prove otherwise. In many situations a strong case can be built to return manufacturing or
some part of manufacturing to the U.S. based on a fully loaded Total Cost of Ownership (TCO)
analysis. Then there are several situations like clothing and accessories, bedding, electronics,
low end kitchen accessories, and many other products that will probably remain in China for a
long time.

Copyright 2013 by The Center for Excellence in Operations, Inc. (CEO)

So why all of a sudden is the landscape of outsourcing changing? Organizations are becoming
wise to the total cost of outsourcing but are having difficulty where to begin in terms of forward
progress. These hidden opportunities exist because people don't know what they don't know . . .
so they are not able to make the right data-driven decisions and achieve the right results. This is
not intended to be a sardonic statement; it is a fact about the nature of complex networks of
transactional processes and their hidden wastes. In all fairness, people are so wrapped up in
immediate moment firefighting and do not have the time or leadership support to break this
vicious cycle with structured, formal, and deliberate improvement. A major summary point is
that we need to improve outsourcing not because someone made a mistake - but because
outsourcing is a dynamic process where circumstances have changed dramatically over time.
The remainder of this article sheds more light on many of these hidden improvement
opportunities.

Ten Great Outsourcing Improvement Opportunities

The outsourcing process is a complex network of physical and transactional processes.
Outsourcing has added dozens of new links, touch points, people, variation, and risk to the total
supply chain. For many organizations there could be hundreds of new opportunities for
improvement depending on the size, scope, content, and geographical logistics of outsourcing
activities. This section provides ten areas that usually generate significant savings.
1. Cost of Outsourcing Strategy. This is a rationalization and reassessment of the current
outsourcing portfolio in terms of revenue topology (where and how distributed/sold) vs.
sourcing decisions (where made). In this complex and challenging global economy,
organizations must remain somewhat fluid when it comes to outsourcing strategies.
Markets shift over time, which may drive logistics and management costs up. Another
Copyright 2013 by The Center for Excellence in Operations, Inc. (CEO)

factor here is to review the outsourcing content and commitment levels to individual
country sites, and plan how to "pick-up-shop" (e.g., a segment of final assembly) and
respond to emerging market opportunities in other countries. A solid analysis of the true
facts may result in geographical adjustments in sourcing decisions and costs, and in many
cases the fully loaded cost data justifies a return of manufacturing to the U.S.
2. Cost of Management and Coordination. This is a hidden cost area that "shellshocks"
executives when the total annualized cost of management and coordination is developed.
This includes the cost of people's time and travel expenses, and any other identifiable lost
opportunities such as late new product introductions due to resources involved in
sustaining engineering, quality improvement, process improvement, or simply get new
products to work in the marketplace. These activities and their associated costs can
quickly add up to millions of dollars, and much of it is symptomatic of deeper problems
such as weak local leadership, a bad outsourcing strategy, fragmented design and
development, or poor supplier selection. Many managers have this "it comes with the
territory" attitude about these activities, but these are real unplanned and hidden costs. It
takes the right experience to identify and isolate these activity-based wastes and their
recurring root causes into various categories. However the analysis leads to real
evidence-based improvement and cost reduction.
3. Cost of Sales and Operations Planning. This is one of the most difficult activities in an
organization. Outsourcing has lengthened the pipeline, so schedule changes tend to have
a much larger impact than when we could walk out to the plant or drive down the street to
a supplier. Another complexity factor is managing multiple demand streams to a network
of outsourced contractors. One of our clients was having serious delivery performance
issues with their contractors. They reviewed their schedules with business unit leaders
and found that 40% of the demand was artificially inflated and no longer needed. When
suppliers did not deliver, business units added more to the schedule for planning fluff.
No wonder why the contractors were clogged and could not perform! And they can't
make the inventory of unneeded product that they already built via "the schedule"
disappear. A thorough understanding of the hidden costs and their root causes is the first
order of business. The goal is to get to more realistic schedules, continuous
communication, and frequent performance reviews around the true issues hiding in this
process.
4. Cost of Inventory Performance. Outsourcing definitely reduces flexibility in design
and the ability to respond to schedule changes. This usually translates to more inventory
in the global pipeline, more mismatches between supply and demand, more shrinkage,
more excess and obsolete inventory, and in general higher risks of things going wrong.
This translates into millions of dollars of negative cash flow. Additionally, think of what
happens in many organizations at the end of the month. Rather than selling the higher
margin items that were planned, they end up selling whatever is available to sell,
sometimes with negative margins plus deep discounts. Then there is the cost of lost sales
element. These hidden costs alone could add up to 10%+ of total revenues. One VP of
EMEA Sales said, "I sell hundreds of products in 32 different countries using a hundred
Copyright 2013 by The Center for Excellence in Operations, Inc. (CEO)

distributors. I can't possibly predict what I need where and by when." There were buffer
inventories staged everywhere and significant "premium" movement of product around
the supply chain. There was also additional wastes such as country conversions
repackaging of damaged product due to excess logistics. Pareto analysis was
unbelievably revealing: nearly 90% of revenues flowed through nine major country
distributors and represented about 25 SKUs. Product line analysis, rationalization, and
pruning, and a more segmented and targeted outsourcing strategy helps this situation but
the analysis is complex and emotional. One needs to evaluate options in light of many
other factors, but using real data and facts greatly helps the process.
5. Cost of Supplier Management. What are the hidden costs associated with sourcing,
developing, and maintaining a supplier relative to expected performance (i.e., process
capability, quality and reliability, capacity, flex to changers, turnover and retraining, etc.).
We mentioned the management coordination and travel costs above. A common issue in
this area is a design engineering function operating to a lowest unit cost design metric.
This leads to the selection lesser expensive through-hole vs. SMT components, selection
of cheap, substandard suppliers to meet target design cost goals. In these organizations
there exists a familiar attitude of "not my job" and "We'll worry about it later." I have
witnessed so many products released to the market where the contractor could not meet
quality and demand requirements, and in several cases - could never have met quality and
capacity requirements. The price was right and the unit design cost is on target, product
availability in a serious quandary. Beyond lost customer credibility, this has a huge
impact on lifecycle margins. Now there is an urgent need for last minute hop-scotching
from supplier to supplier to find a reliable source, often at a higher price. Add it all up it's millions of hidden costs and lost opportunities.
6.

Copyright 2013 by The Center for Excellence in Operations, Inc. (CEO)

7. Cost of Quality. This is another straight forward concept, although the hidden costs are
often difficult to quantify. The obvious costs (scrap, rework, repair, etc. can be obtained
from the financial statements. The remaining costs (i.e., prevention, detection, internal
failure, external failure) are more challenging and require assumptions and a good
activity-based approach. Total cost of quality could represent as much as 5% to 20% of
revenues, and the majority of these costs are hidden. Organizations may not like to admit
it, but there are several examples where the entire development and manufacturing
process was outsourced only to create millions of dollars of product that will never work,
and is on the top shelf in the back of a distribution center waiting to be written off.
8. Cost of Unplanned Logistics and Premium Freight. This one is straight forward. It
cost a lot of money to move product around with last minute jet trips and partial
containers (shipping "air" via air freight is expensive). Often we observe that a product
needed for a U.S. customer is in the European distribution center or vice versa. Then
there is the mismatch and movement of product from distributor to distributor, or a non
value-adding conversion process to get the right country mix of product. In one
organization, the CEO walked through the purchasing department and mentioned,
"Whatever you do, don't run out of material. Use premium freight if you need to." You
can guess the rest of the story: planners were granted permission to play it safe. Over
50% of items delivered at the receiving dock arrived via premium freight and were not
needed (were not needed yet or the demand went away). Receipt of some deliveries was
delayed for weeks as vendors called looking for payment after jumping through hoops.
An easy fix, and a $680K savings. These things probably never happens in your
organizations . . .
9. Cost of Warranty, Returns, and Allowances. Often these costs become an
institutionalized way of conducting business. For example, how does every organization
solve these problems? They allocate reserves to cover the anticipated costs . . . each year,
every year. This does not address root causes which are traceable and assignable with the
right improvement methodologies. One of our clients in the apparel industry was
experiencing $60 million in returns and allowances annually. When we raised this as a
significant opportunity we were told, "We have benchmarked our competitors and we're
actually a little better than they are." One of those old, leftover policies to satisfy the
customer. Together we created several improvement teams that analyzed and isolated
actionable root causes of returns and allowances and implemented policy changes and
other process improvements. They reduced their planned reserves by 20%, an instant
$18M positive hit to profitability. Think about the sales efforts required to create $18M
of profit.

10. Cost of Cash Flow. We mentioned earlier that outsourcing lengthens and adds
complexity and risk to the supply chain pipeline. In many situations it also increases the
cash-to-cash cycles which are proportional to the number of trading partners in the supply
chain. Then there are the currency manipulations that add additional hidden costs. One
organization had P&L, inventory, and cash flow issues (90-120 day cycle). An analysis
Copyright 2013 by The Center for Excellence in Operations, Inc. (CEO)

revealed that over 90% of a high margin product line manufactured in China (moved
there with many other products a few years earlier) was sold in the U.S. market . . .
specifically in the mid-west and west coast. Additional analysis revealed similar results
to a few other product lines. Several product lines were moved back to the U.S.,
manufactured at a lower fully loaded cost, and sent direct to customers with a net 30 day
invoice. Problem solved!
11. Cost of Unplanned and Unforeseen Risks. These costs are beyond hidden: they are
unpredictable on the surface. Deming referred to these quality costs as unknown and
unknowing. Situations like intellectual property theft, installation of bullet-proof glass in
a plant, 24 hour armed security, tsunamis, piracy and theft, drug cartel bribes, and many
other examples add irreversible costs to the outsourcing process. There is a well known
government owned building in Shanghai (Xiangyang Market ) where merchants sell
nothing but knockoff products ranging from jeans, handbags, jewelry, watches, down
parkas, high end sneakers, software, brake pads, and an endless list of fake products.
Some like knock-off products can not only result in cannibalized sales or negative brand
image, but also generate additional hidden costs like warranty and repairs by the
legitimate company. One of our clients found out that their China supplier was selling
the same parts and components to a relative that was making the identical branded
product and selling it for $600 less on the internet. They operated for about nine months
and then disappeared like a ghost when our client discovered that they were losing sales
and unknowingly handling the warranty and returns activities for them. Another client
received a call from their contractor informing them that they were closing in a week and
left their customer high and dry for product. Our client decided to reverse engineer their
product and develop a new version which is now manufacturing it in the U.S. It's too late
to Monday morning quarterback these issues, but the possibilities, risks, and
consequences should be integrated into the outsourcing strategy right up front. These
situations are game-changers because they may change the basic assumptions of
outsourcing decisions and create the feasibility of a better sourcing option - like
manufacturing in the U.S.
Mining and classifying these hidden costs is not easy; it requires a deep understanding of
improvement, multiple key business processes, activity-based management, and information
technology. The real challenge is that the outsourcing process cannot be improved through our
normal senses and approaches - we can't see a defect in real time, or feel a late shipment, or hear
a bad software design decision, or touch a contractor's un-communicated design change. The
wastes are hidden. These complex knowledge-based transactional processes include a lot of
unpredictability, professional judgments vs. hard data, a high degree of informal activities
underlying a formal process, and fuzzy cause-and-effects in space and time. The seasoned
improvement expert knows how to use the organizations integrated enterprise architecture and
other applications to trace transaction streams like a detective conducting transactional forensics
as they reconstruct the waste crime scene of the process or look for hard evidence of the
supposed problems and opportunities. Transactional forensics is a very appropriate name for this
approach: it involves setting up deliberate process experiments for transactional stream mapping
and classification to either discover the root causes and magnitudes of problems, and/or to verify
Copyright 2013 by The Center for Excellence in Operations, Inc. (CEO)

that problems have been eliminated through the right data-driven improvements and corrective
actions. On the one hand, one needs to do a thorough job of classifying and allocating hidden
costs on the right statistical basis assumptions. At the same time, one must make sure not to
double count these hidden costs.
Summary
There is a lot of gold in the outsourcing processes of most organizations, and a lot of tough work
to redefine the best data-driven and evidence-based strategies in today's global marketplace. It is
no secret that most outsourcing decisions were fueled by the expectation of huge revenue growth
and labor savings, and executed with a partial analysis of (what has turned out to be) the facts.
Some executives are reluctant to revisit their decisions of the past, because short term
performance and compensation objectives are being met, and the hidden wastes continue to be
covered up by incremental country revenues for the time being. The largest cost driver in many
products is materials, not labor - so chasing labor savings is yesterday's rain. Complacency,
postponement, or procrastination about outsourcing improvement are not winning strategies for
future success. The real winners in this game will be proactive and successful at lean
outsourcing - whether that means finding millions of dollars of new opportunities in their China
contractor relationship, reducing complexity and risk in their global supply chains, or deciding
based on all the facts to move thousands of manufacturing jobs back to the U.S.

Copyright 2013 by The Center for Excellence in Operations, Inc. (CEO)

About the Author

Terence T. Burton is President of The Center for Excellence in Operations, Inc. (CEO), a
management consulting firm with headquarters in Bedford, New Hampshire and offices in
Munich, Germany. Terry has nearly four decades of diversified experience in executive
leadership, operations, supply chain management, quality, engineering, distribution and
logistics, maintenance and repair, customer service, finance, sales and marketing, and recently
healthcare and not-for profits. Since founding CEO in 1991, Terry has become an
internationally recognized expert on strategic business improvement as a thought leader and
practitioner, with a solid reputation for delivering results. He has worked on thousands of major
improvement initiatives with over 300 clients in the Americas and Europe ranging from large
multinational Fortune 500 corporations to small and mid-sized companies. His latest book,
"Out of the Present Crisis: Rediscovering Improvement in the New Economy" was released in
June, 2012.

For additional information, visit www.ceobreakthrough.com or Amazon at http://www.amazon.com/Out-PresentCrisis-Rediscovering-Improvement/dp/1466504420

Please also feel free to contact the author directly at burton@ceobreakthrough.com

Copyright 2013 by The Center for Excellence in Operations, Inc. (CEO)