Evaluating the Effectiveness and Efficiency of Global Sourcing Strategies: A Conceptual Note

Eui Hong1 and Matthias Holweg

University of Cambridge

Corresponding author:

Dr Eui Hong Judge Institute of Management University of Cambridge Cambridge CB2 1AG, UK Tel: +44 1223 765 463 Email: e.hong@jims.cam.ac.uk

- Structured Abstract Evaluating the Effectiveness and Efficiency of Global Sourcing Strategies: A Conceptual Note
Purpose While the global sourcing phenomenon has received considerable attention in the recent manufacturing strategy debate, a structured approach towards assessing either the operational efficiency or cost effectiveness of such strategies is still elusive a gap this conceptual paper aims to address. Design / methodology / approach Exploring the theoretical and methodological approaches adopted, and key variables considered by previous studies into the global sourcing phenomenon, an assessment framework for six basic sourcing strategies is developed. Findings Synthesising the literature, six distinct network configurations are defined based on three key variables: the locus of the manufacturer, the locus of the suppliers, and the market served by the manufacturer. Based on these configurations, the operational and financial assessments were derived, which aim at guiding future empirical studies into global sourcing. Research limitations / implications The study provides a review of the existing literature only and hence does not present an application of the proposed frameworks. Nonetheless this conceptual work aims at

guiding future research in developing holistic assessments of global supply chain strategies an area which clearly requires both further analytical and empirical analyses.
Practical implications At present, global sourcing decisions are often solely made on unit cost calculations based on the assumption of static demand. This approach does not only omit the additional supply chain costs incurred due to reduced flexibility and inefficiencies in responding to demand changes, but it neither considers additional risks such as currency fluctuations or political instability. This paper provides a holistic framework to both academe and industry capable of capturing not only the operational, but also the tactical and strategic issues. Originality / value In addition to the existing literature on global sourcing, the underlying paper provides a concise definition of the basic supply chain configurations where to date often conflicting definitions are being used, and a guideline for a comprehensive analysis of the operational and financial implications of global sourcing strategies that represent a critical gap in the literature.

Evaluating the Effectiveness and Efficiency of Global Sourcing Strategies: A Conceptual Note

Abstract The globalisation phenomenon has induced a considerable shift in manufacturing and supply chain strategies across many industry sectors. In a quest for cost efficiency, manufacturers and service operators alike are considering the relocation of their operations to, and the sourcing of components from, low-labour cost countries. While the underlying trend towards offshoring and global sourcing has been widely discussed, the underlying concepts such as international sourcing, outsourcing, and offshoring are often used interchangeably, and the discussion still lacks a concise framework required for a comprehensive analysis of the wider supply chain implications. Reviewing the existing contributions, we synthesise six generic global sourcing and manufacturing strategies and define their respective key characteristics and motivations. We further elaborate on the operational, tactical and strategic issues as well as the static, dynamic, and hidden costs that need to be considered when analysing the operational effectiveness and cost efficiency of global sourcing and manufacturing strategies.

Keywords: global sourcing, offshoring, outsourcing, manufacturing strategy.

A Shift in Manufacturing Strategy?

As the start of the second industrial century few issues have been as fiercely

discussed as the globalisation phenomenon. At a time where the industrialisation is making rapid progress in countries such as China and India, companies in the industrialised world are experiencing increasing pressure to offshore manufacturing and service operations to (relatively) low-labour cost countries, in order to achieve a cost advantage in their respective domestic and foreign markets. The economic impact of such practices is under great dispute, whereby advocates claim that offshoring has a positive impact on national productivity due to the access to cheaper services and products, whereas opponents refer to the adversarial impacts of the resulting unemployment disputing the theorem that workers in the industrialised countries will be able to transfer to higher, more value-added activities once the basic manufacturing operations have been relocated (Krugman and Venables, 1996; Mankiw, 2004). Apart from this wider economic debate, the phenomenon has had considerable impact on the strategic design of manufacturing networks, i.e. the location decision of manufacturing facilities, and the sourcing strategy for supplying the materials and components for these facilities. In terms of competitiveness, relocating manufacturing operations to lower labour cost countries, or to source components from these regions has a strong rationale. In the automotive industry for example, US manufacturers and component suppliers have migrated to Mexico, whereas their European counterparts have been moving to Eastern Europe (and with the expansion of the European Union in 2004 even further East beyond the Euro-zone), which enables them to harness the lower labour cost while incurring only a limited penalty on logistics and coordination cost. With reduced trade barriers and well-developed logistics networks the competition has a more global character, and the sourcing content of manufactured products reflect this trend. For example, in the production of American car, 30% of the cars value originates in Korea, 17.5% in Japan, 7.5% in Germany, 4% in Taiwan and Singapore, 2.5% in the UK, and 1.5% in Ireland and Barbados and only 37% of the production value is generated in the U.S. (Antrs and Helpman, 2004).

Yet despite the apparent move towards sourcing both components and finished vehicles from low-labour cost countries, the automotive industry marks an interesting case. Here, as in many other sectors, China, India and Latin America are being seen as a major market opportunity in an otherwise stagnant industry. With growing internal demand, the establishment of manufacturing facilities in these countries are part of the global manufacturing presence of the vehicle manufacturers. Some manufacturers, such as Volkswagen for example which has topped the rankings as what of the leading 50 foreign firms in China for nine consecutive years has been present in China since 1985, and plans to invest a further $1.7 billion in the Asia-Pacific region by 2010, the majority of which in China (Zhang, 2001).
3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000 0
1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Units

South America

Korea

China

India

South Africa

Figure 1: Evolution of Car Production in Selected Newly Industrialised Countries and Regions. Annual Production for 1971-2003.

Figure 1 shows the development of production output in selected countries and regions, which mark a stark contrast to the stagnant or declining markets in the established regions of North America, Europe and Japan. The figure clearly shows the distinct phases of manufacturing capacity expansion in South Korea from 1985 onwards, in South America, and to a lesser extent, in India from 1990 onwards, and in China from 2000 onwards. Table 1 further elaborates on the relative growth of the

manufacturing base in Newly-industrialised countries (NIC) 2 , compared to the industrialised countries (IC)3. As can be seen, the slow market dynamics in Europe, North America and Japan are clearly reflected in the dynamics of global manufacturing. While the global car production increased considerably over the last three decades, more than half of this growth is accounted for by NIC production volume, which increased by a factor of seven over the period analysed.
1971 World Car Production [in million units] % of World Car Production Industrialised Countries % of Growth (based on previous period) % of World Car Production % of Growth (based on previous period) 26.45
90.85%

1980 28.61
89.90%

1990 36.27
87.84%

1995 36.07
81.98%

1997 38.45
73.44%

2000 41.23
74.85%

2001 39.97
75.27%

2002 41.22
72.26%

2003 41.78
70.12%

---

7.03%

23.87%

-7.19%

-4.5%

9.28%

-4.28%

0.83%

-1.62%

5.14%

7.65%

8.66%

15.05%

17.31%

17.22%

18.00%

21.36%

23.45%

Newly Industrialised Countries

---

61.03%

43.38%

72.93%

22.6%

6.19%

-0.08%

24.61%

11.3%

Table I: The Evolution of Global Automobile Manufacturing

However, counter to common perception, this trend towards distributed manufacturing does not represent a trend towards greater global sourcing per se. While the global automotive industry has indeed experienced a considerable trend towards establishing a global manufacturing presence, as shown in Table 1, the vehicles produced in these newly industrialised countries are indeed to serve local rather than export demand4 - a conclusion also supported by Sturgeon and Florida (2000) in their report on globalisation in the automotive industry.

We define Newly Industrialised Countries (NIC) as Brazil, Argentina, Mexico, South Korea, South Africa, Australia, Malaysia, China, Taiwan, and India. Industrialised Countries (IC) include Western Europe, USA, Canada and Japan. The only noticeable exceptions to date are Mexico, which largely produces vehicles for export to the United States and to some extent for Europe (VW Puebla), and South Africa, which produces righthand drive versions of the Mercedes C-Class, BMW 3-series and VW Golf for export to the UK, Japan and Australasia. From Brazil, the Volkswagen Fox has been exported to Europe since 2005, alongside engines for the BMW Mini. From India, Tata exports the City Rover to Europe, and Honda is 6

3 4

In turn, this shift in manufacturing strategy has resulted in considerable changes in the industrial landscape in the Industrialised Countries. In Europe for example, senior executives have argued that Toyotas plant in Valenciennes, France, which was opened in 2001 to meet the strong European demand in the small car segment, which was commented to be one of last volume plant to be established in Western Europe5. And indeed, the subsequently opened Toyota-PSA joint venture was established in Kolin, Czech Republic in 2004 marking a further development of the considerable automotive manufacturing base in Eastern Europe6. A further parallel development, however, casts a different picture on the establishment of this global automotive manufacturing presence. While in the first instance vehicle manufacturers asked suppliers to join them when establishing greenfield sites in NIC, more recently Western vehicle manufacturers have been pushing their suppliers to establish component factories in China, in order to re-export parts to the US or Europe at a lower unit cost (US Department of Commerce, 2004). Despite the reduction in component import, China is still a large net importer. In 2004, $11.27bn worth of components were imported, largely supplied by Japan ($3.9bn), Germany ($3.02bn) and Korea ($1.16bn), while American suppliers accounted for only $490.1m (Webb, 2004). Thus, as the automotive industry example illustrates, what is commonly referred to as global sourcing or globalisation should at least from a supply chain perspective in fact be seen as a continuum of strategies that ranges from simply sourcing components from abroad, to establishing globally distributed manufacturing networks. As a result, the relevant literature is quite diverse. The issues encompassed in establishing and managing international operations for example have been a subject of academic studies since the 1960s (Hall, 1960; Skinner, 1964). In reviewing the existing contribution specifically discussing global sourcing issues, it further
considering exporting the Jazz model from China to Europe. In comparison the exports from Japan, South Korea, and to a lesser extent Malaysia (Proton), the exports from Asia and South America to Europe and the US are insignificant.
5

Referring comment made by the chairmen of Peugeot-Citroean, Jean-Martin Folz, and Renaults President, Louis Schweitzer, cited in Driving out to the East, The Economist, May 3rd 2005. Current assembly plant+s in Eastern Europe include: Audi (Gyr, Hungary), Fiat (Tyly, Poland), VW/ Skoda (Bratislava, Slovakian Republic; Kvasiny, Mlada Boleslav and Vrchlabi, Czech Republic; Poznan, Poland), Renault/Dacia (Pitesti, Romania; Novo Mesto, Slovenia), Suzuki (Esztergom, Hungary) and Daewoo/FSO (Warsaw, Poland). 7

transpired that definitions are often overlapping, and that key terms are not conclusively defined. Also, the operational and strategic implications of global sourcing strategies are not as well researched as we had expected. The objective on this note is thus threefold: first, to define the strategic choices at hand when designing global manufacturing and supply networks; second, to review the theoretical and methodological approaches that have been adopted by previous studies, and third, to develop a framework that would allow for an evaluation of the effectiveness and cost efficiency of global sourcing and manufacturing settings. The paper is structured accordingly, and concludes with a framework aimed at evaluating the operational, tactical and strategic aspects of global sourcing and manufacturing strategies, as well as assessing their financial viability.

2
2.1

Defining the Sourcing Strategy Continuum

Global Sourcing as part of the Manufacturing Strategy Skinner proposed manufacturing strategy as a process to help firms define the

manufacturing capabilities needed to support their corporate strategy. He argued that an appropriate manufacturing strategy could provide a competitive advantage in terms of cost, delivery, quality, innovation, and flexibility, and the location of the manufacturing location has a strong implication on these, primarily on cost, delivery and flexibility (Skinner, 1964, 1969). The global sourcing concerns issues central to any manufacturing strategy: what are the key elements of a manufacturing strategy, where to locate factories, where to source components and how to configure products, are strongly impacted any globalisation effort (Hill, 1985). Slack and Lewis (2002) characterise the location decision in two dimensions; namely the objectives of the location decision and the number of location options available. For example, an attractive location for high-contact operations such as retailing will be a busy yet expensive area, while less contact-prone operations such as an electronics manufacturer are relatively invariant to location, yet very sensitive to operational cost. Costs, however, will vary with location, and the optimal location for such a manufacturer will be the determined by cost minimisation rather than revenue maximisation. The second dimension is concerned with the number of locations at
8

hand. The number of possible sites for an electronics manufacturer for example are relatively large, and the decision process involves narrowing the number of options down to a smaller representative number, which can be systematically evaluated against a common set of criteria. Here, the logistics infrastructure, currency and political risks will be particular concern when considering offshore locations.

2.2

The Rationale for Global Sourcing Although sourcing strategies have been widely discussed in the operations

management literature, global sourcing has not been as well defined as the respective debate would suggest. Most commonly, the definition by Monzka and Trent is quoted, yet in many cases overlapping or even contradicting definitions are used (Monczka and Trent, 1991). In this literature, global sourcing is seen as an evolution of an international sourcing strategy, thus adding the time dimension to the phenomenon as key distinguishing factor. In this section we aim to reconcile the distinction between these two core concepts. Also, outsourcing, which in occasions has been mentioned in conjunction with global sourcing and offshoring, is indeed a different concept. Outsourcing generally relates to the buying of services or products that do not represent core competencies. These may well be locally sourced, as in the case of the auto industry where modules and systems are outsourced to local supplier parks, or sourced from abroad. Outsourcing can thus be an instigator of global sourcing, but does not necessarily require the adoption of an international sourcing strategy. In addition to the often quoted labour cost advantages that drive global sourcing, reduced trade barriers (such as through the Mercorsur, the European Union, or Chinas membership in the WTO) and a general reduction of transport cost are further key enablers. Crafts and Venables (2001) indicate that deep-sea shipping costs fell by about 83% between 1750 and 1990, and that the decrease was owed to the substantial improvement in sailing ships. Similarly, the real costs of airfreight have fallen by 75% between 1940 and 1980, and the share of airfreight in international trade from the U.S. to other countries has increased to about 50%.

2.3

Global Sourcing, International Sourcing or simply Offshoring? Sourcing has received attention among scholars as it is one of key drivers for

manufacturing companies competitiveness. Zenz (1994) defines sourcing as the strategic philosophy of selecting vendors in a manner that makes them an integral part of the buying firm for a particular component or part they are to supply. From this definition, sourcing can be interpreted as a strategic decision of a manufacturing company to build up close relationship with its suppliers for improving competitive advantages, a notion discussed at length with respect to the distinction between adversarial and collaborative supplier relations (Merli, 1991; Lamming, 1993; Hines, 1994; MacBeth and Ferguson, 1994; Helper and Sako, 1998). Global sourcing can be defined best as an evolution of an international sourcing strategy, which Monczka and Trent (1991) discuss as a four-phased development process. In the first stage, Domestic purchasing only, firms purchase from domestic suppliers or distributors that are involved in foreign sourcing. In this stage, firms have little need for international sourcing information and lack sophisticated international data networks. Phase 2 is called foreign buying based on need, whereby a lack of suitable domestic supplier exists, or competitors are gaining an advantage due to foreign sourcing. To remain competitive in cost and quality, domestic firms are reactively driven to seek foreign sources, but international procurement during this phase is usually limited or performed on an ad hoc basis. Foreign buying as part of the procurement strategy marks the third phase, which represents a realisation that a focused international procurement strategy results in significant performance gains. Firms shift from phase 2 to 3 because of lower purchase prices and other significant performance improvements derived form foreign sourcing; top management commitment is seen as critical at this point. The final phase represents the true global sourcing effort, as opposed to basic international buying, and thus the most sophisticated development of a global procurement strategy. Operating at this level requires procurement, manufacturing, and technology groups to work together to establish the best possible worldwide supply network, and to develop optimal supplier capabilities. Full organisational and informational system integration is seen as crucial. According to Monczka and Trent (1991), international sourcing suggests that firms are buying from foreign suppliers, however, there is a lack of coordination of
10

requirements between worldwide business units. Global sourcing, on the other hand, refers to the integration and coordination of procurement requirements across worldwide business units, looking at common items, processes, technologies, and suppliers. The factors described by Monczka and Trent (1991) are found in other global sourcing studies (Fawcett and Birou, 1992; Handfield, 1994), which identify distinct cost, quality and technology objectives that drive a firms global sourcing efforts. Using Monczka and Trents (1991) four-phase model, Bozareth et al. (1998) examine procurement strategy-related performance differences between firms. Similarly, Petersen et al. (2000) present key factors and benefits of a successful global sourcing based on a global sourcing strategy effectiveness model, which is also founded on Monczka and Trents (1991) study. The characteristic differences between global sourcing and international sourcing are further employed in other studies including Murphy and Daley (1994), Liu and McGoldrick (1996), Narasimhan and Das (2000) and Ettlie and Sethuraman (2002) to differentiate sourcing strategies. In general, international sourcing can be defined as the acquisition of raw materials components and subassemblies from international sources for use in fabrication, assembly or for resale, regardless of whether the import source is internal or external to the company (Kotabe and Omura, 1989). Liu and McGoldirck (1996) further distinguish international sourcing from traditional importing. International sourcing implies that retailers tend to be more proactive in the acquisition of sources of supply and their own strategies dominate in the decision making as to where, when, what, how much, and from whom to buy. In the case of traditional importing, retailers often play a passive role in obtaining merchandise, with suppliers taking the initiative in providing the goods. Offshoring on the other hand is the creative and careful leveraging of new and available pools of skilled labour abroad, while exploiting communication technologies to link these to domestic demand (Venkatraman, 2004). Companies that are considering offshore sourcing will investigate which of their processes are locationindependent and where those processes would best be located. According to Bronfenbrenner and Luce (2004), for example, the number and extent of production shifts out of the United States has increased significantly since 2001, as companies are
11

shifting production to multiple offshore and nearshore destinations at the same time. In that sense, offshoring refers primarily to decisions related to manufacturing rather than sourcing strategy, although the former will have secondary effects on the sourcing of components and materials.

2.4

A Reconciliation of Concepts Most papers contrast global sourcing with international sourcing, as discussed

above, but in order to get a holistic understanding of a companys manufacturing and sourcing strategy, one needs to consider two strategic choices a company has to make: where to locate its manufacturing operations, and where to source its components. Each decision has very different implications for the configuration of the respective supply chain. More specifically, a manufacturer can either locally source (by using suppliers in the same region or country), source internationally (from suppliers located outside of the region), or source globally (by having the same supplier supplying each manufacturing facility, for example, regardless where it is located). Thus, if the manufacturer decides to offshore its operations, this would mean to locate the manufacturing facilities abroad, and to re-import its goods. If the manufacturer establishes plants abroad to satisfy local demand in the respective market however this would be part of a global manufacturing strategy, whereby a local presence in a foreign market is the key rationale. The following table 2 outlines the resulting supply chain network configurations.

12

Description Network Configuration 1 Local manufacture Traditional Export International Sourcing

Locus of Manufacturer

Locus of Supplier Domestic

Locus of Demand Domestic

Products are made locally, with Domestic local parts, to meet local demand Local products are exported to foreign markets Domestic

2 3

Domestic or Abroad Abroad, based on needs

Abroad Domestic and Abroad

Products are made locally, with Domestic parts sourced from abroad with procurement based on specific needs, to satisfy local or foreign demand Products are made with parts sourced from abroad as part of a global procurement strategy, to satisfy local demand or foreign demand. Products are made abroad, and then are re-imported to meet domestic demand. Products are made abroad to meet demand in the respective foreign market. Domestic or Abroad

Global Sourcing

Abroad, as part of procureme nt strategy Domestic or Abroad Domestic or Abroad

Domestic and Abroad

Offshoring

Abroad

Domestic

Global Manufacturing

Abroad

Abroad

Table II: Possible Supply Chain Network Configurations

In the following we will explore the theoretical and methodological approaches that have been used in the study of the different strategies identified above.

13

3
3.1

Theoretical and Methodological Approaches

Transaction Cost Economics The transactional cost economics (TCE) school has been widely used in

management research, and seems particularly suited to the analysis and evaluation of global sourcing and manufacturing strategies. For example, Dunning (1980) evaluated the significance of ownership and location specific variables in international production. He investigated that the basic incentive of a firm to internalise its capital, technology, management skills itself to produce goods rather than externalise their use by engaging in portfolio investment, licensing and so on. It was to avoid the disadvantages of external mechanisms and market imperfections, which arises whenever negotiation or transaction costs are high. TCE has further been adopted by studies into the automobile industry, where empirical analyses have shown that the greater the engineering effort needed to develop a particular automobile component, the more likely a company will internalise production. Monteverde and Teece (1982) for example found a positive relationship between engineering effort and the likelihood of internalisation in their analysis of GM and Fords component procurement policies. Similarly, Masten et al. (1989) found that Chrysler, Ford and GM were more likely to produce in-house parts that required specific design or manufacturing expertise. O'hUallachain and Wasserman (1999) give an example of vertical integration in Brazilian automobile component suppliers due to the lack of confidence in the engineering and management abilities of local suppliers. Any governance structure that increases or decreases the cost of global sourcing, which by its nature is more difficult than sourcing in the region or a particular country, can be explained by TCE. Ettlie and Sethuraman (2002) set their research hypothesis to show the relationship between TCE and global sourcing as the more vertically integrated a firm is, the lower the proportion of global sourcing will be, and the test result indicated that the less vertically integrated firms were more likely to use overseas sources of supply. Hill (1990) on the other hand has challenged TCEs basic assumption of the risk of opportunism and the resulting hierarchical governance structure when highly specific assets are involved in the transactions. He claimed that hierarchies have proved to be an imperfect solution to the problem of structuring exchanges that
14

involve specific assets alone. Murray (2001) also presents an example, which contradicts standard TCE notions, whereby high level of asset specificity among Japanese subcontractors and the asset specificity involved in what have resulted in increasing cooperation among suppliers and customers rather than causing opportunistic behaviour.

3.2

Product Life Cycle A second theory closely related to global sourcing and manufacturing is the life

cycle theory, as the decision where to manufacture products varies considerably over its life span. Nokia, the Finnish mobile phone manufacturer for example will manufacture the early series of its products in Finland at product launch, and once established, will hand volume production to contract manufacturers located in the Baltic and in China, and at the end of the life span (in some cases) even taking production back in-house as they become close to withdrawing the product from the market. Vernon (1966) has made the most compelling extension of product life cycle (PLC) model to explain international investment and international trade. He divided the location of production into three groups as the (in his view) most advanced country (United States), other advanced countries, and less developed countries based on each groups average income, labour cost, and innovativeness of the product. As innovative products become more standard and as the demand for a product expands and the competition becomes more intensive between manufacturers, the location of production moves from United States to less developed countries via other advanced countries such as Europe. If economies of scale are being fully exploited at one location, the principal differences between any two locations are likely to be labour costs. And if labour cost differences are large enough to offset transport costs, then exports back to the United States may become a possibility as well. Kotabe et al. (1998) also investigated the implications of the PLC as one of the determinants in the sourcing strategy of service firms. Rapid technological change and short product life cycle are regarded as the most salient factors in proactive behaviour by multinational service firms. As a service matures, the industry structure may resemble that of perfect competition with many suppliers and buyers. Therefore,
15

mature services are prime candidates for foreign sourcing based on the competitive cost. A short life cycle is pointed to as one of the motivators of global sourcing (Bozarth et al., 1998). Shorting PLCs are making it increasingly critical that domestic suppliers are able to deliver the required components and materials quickly regardless of their location. Swamidass and Kotabe (1993) point to a different effect of the PLC on a firms sourcing strategy. A multinational firm in a developed nation may not want to manufacture a new product in another developed nation, for fear of disclosing its technology to potential competitors. The experiences of Western car manufacturers in China are good examples of how intellectual property rights (in the form of component and vehicle design) can be compromised in foreign markets, and it was not until Chinas entry to the WTO that manufacturers decide to build recent vehicles in China. Volkswagen for example has been produced the Santana in China since 1985, and only recently started manufacturing the current Golf and Passat models. Therefore, the effect of the PLC on the sourcing decisions of multinational manufacturers is likely to depend on the age of the technology involved, economies of scale relating to the component, the maturity of the product, the degree of standardisation of the product and uncertainties associated with external procurement. Kogut (1984) pointed out four fundamental impairments of international product life cycle model in four fundamental ways in his study, which examines how a company can compete in different strategic groups across countries. Firstly, he argues that the PLC model neglects the important profit-signalling impact that an initial entry has upon competitors. Competition enters not because of gaming considerations, but because of the pursuit of profit under conditions of imperfect information. Secondly, the model fails to predict when and where investments are made overseas. Thirdly, the PLC model best suits the U.S. pattern of foreign investment, but is not well documented for explaining the history of early European investment. Fourthly, the model explains only the initial investments abroad, and not subsequent further investments undertaken in the same market. To address issues that arise from the strategic make-or-buy and supplier location decisions, Antrs and Helpman (2004) developed a theoretical model that

16

describes an equilibrium under which a manufacturer with different productivity levels would choose different ownership structures and sourcing locations. Lastly, Handfield (1994) surveyed purchasing managers of U.S. manufacturing companies to investigate the tactical and strategic issues regarding reason for adopting global sourcing, his findings suggest contrary examples to Vernons PLC model. According to his findings, critical items for growth products are sourced more frequently from international suppliers, whereas buyers in mature industries tend to rely more on domestic suppliers.

3.3

Supply Chain Implications The complex nature of a global sourcing strategy spawns many barriers to its

successful execution. In particular logistics, inventory management and geographical distance to the customer, among others, are major operational problems identified by both U.S. and foreign multinational companies engaging in international sourcing (Kotabe, 1998). Murphy and Daley (1994) designed an exploratory study to present purchasing managers perceptions concerning selected logistics issues under global sourcing conditions. The results of the survey show that the large majority of respondents utilise more than one transport modes, with air and water being the most used modes. The two most important modal selection factors in international sourcing are the required delivery date and the cost of transportation, while a large number of firms use both international freight forwarders and customs-house brokers (CHB) in their global sourcing practices. The logistical implications of global sourcing have also been studied from an economic geography perspective, which formalises the implication of transport cost reductions for the location of economic activity. Puga (2002) showed that increasing returns on scale and transport costs encourage firms to locate close to large markets, i.e., in areas of high market potential allowing firms to concentrate and take advantage of agglomeration economies. However, as transport cost falls, proximity becomes less important, and peripheral regions with their lower prices for local factors and lower competition may gain in attractiveness for firm location.

17

Glaeser and Kohlhase (2004) present similar evidence in their empirical study of regional economics and transport costs. As the costs of moving goods declined by over 90 percent over the twentieth century, they argue there is little reason for cities to be near natural resources or natural transport hubs for being easily supplied with goods. According to the result of the study, the movement away from the hinterland should best be understood as a flight from natural resources towards consumer preferences. Holl (2004) included transport infrastructure in the logistics issues related to the location of manufacturing firms. Firms that locate close to new motorways can benefit from accessibility advantages in addition to those captured by the market potential measure through easy access to flows of potential clients and suppliers. A possible effect of the new transport infrastructure is a densification of firms in the vicinity of the infrastructure. Another important logistics issue in global sourcing is compatibility of JIT sourcing and global sourcing (Fawcett and Birou, 1992; Das and Handfield, 1997). The key conflict here is that of buyer-supplier proximity, since JIT sourcing places emphasis on the delivery of small quantities in frequent intervals, whereas the large distance of global sources invariably commands transportation in large batches (full container load, for example). The required proximity is seldom attainable for globally sourced items, which are characterised by longer, less reliable international supply lines (Fawcett and Birou, 1992). Vickery (1989) also investigated the practices of three US companies in reconciling JIT demands with those of global sourcing. In his view, the key success factors for achieving global JIT sourcing include: improved logistical and production planning and scheduling by the buyer; implementation of effective buyer-seller communication links with proactive utilisation of time zone differences; the development of buyer-seller long term relationships with consequent volume and logistical economies; and expeditious clearance and movement through customs. Lowson (2002) is one of the few researchers to propose approach to quantify the cost of sourcing. He proposes a Total Acquisition Cost Model (TACM) that can be used to quantify the supply system costs associated with sourcing strategies, thereby allowing to compare the inflexibility costs of offshore procurement versus domestic, responsive and flexible supply. The inflexibility cost involves issues such as longer lead-times and a general lack of flexibility as part of a response to demand
18

changes from customers. This study shows how factors such lead-time, inventory, customer service level and vendor performance might be used to assess certain elements of a sourcing operations strategy by checking quantified LISP (Lead-time for supply; inventory at a particular supply pipeline stage; customer service level; vendor performance which involves supplier service level and vendor process time) performance scores of different types of sourcing strategies. Flexibility of the supply chain has been an issue in many studies (Fisher, 1997; Gilmore and Pine, 1997; Lummus et al., 2003), since understanding supply chain flexibility is important for several reasons: firstly, increasing demand of mass customisation requires supply chains to meet individual customer needs without adding significant cost (Holweg and Pil, 2001). Secondly, in many innovative industries including apparel and electronic industries, uncertainty of demand is very high, and creating a responsive supply chain is one method of reducing uncertainty. Thirdly, the ever-changing environment in which companies find themselves require rapid new product introduction, quick response to customer requirements in all parts of the world, and fast turn-around on customer orders to thus maximise the speed of response to any changes in the market place.

3.4

Empirical Studies An Overview Several studies have investigated the global sourcing concepts and their

implications empirically, thereby providing an important counterbalance to the theoretical and analytical contributions discussed above. For example, Petersen et al. (2000) surveyed 72 companies located in the U.S. that undertook global procurement in some form. Their key findings suggest that companies must proactively manage their global sourcing strategies to ensure the effectiveness in terms of quality improvement (such as material defect rates), on-time delivery, and price/cost benefits. They identify top management commitment, international language capabilities, global sourcing structures and processes, and global sourcing business capabilities as key success factors. To overcome increasing customisation pressures faced by manufacturing firms, Narasimhan and Das (2000) emphasise the importance of manufacturing flexibility and suggested using sourcing practices as an alternative strategy for obtaining
19

manufacturing flexibilities. An empirical test was conducted to investigate the relationship between manufacturing flexibility (including modification flexibility, delivery flexibility and volume flexibility), and sourcing practices such as supplier modification capabilities, supplier responsiveness, supplier input during the design process and purchasing integration. A statistically significant find was that sourcing practices did have a positive influence on the development of manufacturing flexibility, which given the logistics lead-times involved might be seen as a tautology. However, it is also empirical proof that a static, unit-cost based assessment of global sourcing is too restrictive, as strategic flexibility in the supply chain might be lost. Global sourcing strategies have also been prominent in the clothing industry. Cho and Kang (2001) empirically proved that for US clothing retailers the type and degree of benefits obtained, as well as the challenges accompanied with, global sourcing differ significantly by product type and import volume. As the apparel industry is highly labour intensive, results have shown that India or China provided significantly higher cost competitiveness (accessing lower priced goods, obtaining better value for money and enhancing competitive position) than those that bought from Taiwan or Korea. However, firms that sourced from India or China perceived more problems in logistics (inventory management, border-crossing procedures and transportation delays) than Taiwan or Korea, as one would expect from a theoretical perspective.

Assessing the Operational Efficiency of Global Sourcing

As we discussed in section 2, there is a great diversity of strategies related to

global sourcing, and previous studies discussed in section 3 have highlighted the important aspects of global sourcing and manufacturing strategies that need to be considered when analysing their operational effectiveness. A significant conceptual problem arises though, as previous studies have shown that there are operational as well as strategic elements to global sourcing, so any evaluation needs to consider these at times contradicting objectives. In table 4 we propose a set of key issues and variables that need to be considered when assessing global sourcing strategies, as well as their classification into operational, tactical and strategic dimensions.

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Time Locus of Mfg and supply operations Operational (day to day management)

Key Issues Labour cost Production & logistics lead times Product quality Customisation of products

Variables Delivery lead time against customer order Transportation needs (how often do you need airfreight) Search and coordination cost Transportation cost Other indirect cost (travel, set-up, extraneous payments such as bribes etc.) Purchase / unit costs Tax regime Duties and tariffs Degree of product customisation to local or customer needs Cultural, language, skill differences Political risks Market growth Labour cost Product life cycle Transaction costs

Tactical (1-2 years horizon)

Flexible configuration and local presence to gauge customer needs Need to provide appropriate product variety and innovation Location of manufacturing operation Sourcing decisions Outsourcing of operations and services

Strategic (5 years horizon)

Table III: A Conceptual Framework for the Operational Assessment of Global Sourcing

At the strategic level of global sourcing, strategy decisions prescribe a set of locations where facilities are to be located, production technologies to be employed at each facility, and which components and products to be outsourced from those facilities. The variables that need to be considered in deciding where to locate facilities are mainly political risks and economical parameters such as exchange rate, market growth rate and labour cost. The stage of component or product maturity would affect the sourcing strategy as mature products and components are prime candidates for global sourcing from low labour cost countries. The strategic level involves a long planning horizon and decision-makers usually do not have enough information to specify all variables with the required certainty. At the tactical stage firms consider the network that connects the suppliers of raw materials, the plants that manufacture both intermediate and finished products, the distribution channels, and the various needs of customers. When products are assembled at different locations globally and customised in order to satisfy unique customer demands, a variety of factors become important that would not be
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considered in a domestic sourcing strategy. The degree of product configuration will vary according to the respective market needs, so a global operation might well have to cater to several markets needs. Other tactical issues to consider are corporate tax rates, duties as well as tariffs between countries both for finished products and components. Lastly, cultural issues, language, and skill differences are also significant and must be accounted for in the assessment of the sourcing strategy. The operational level is concerned with day-to-day planning and execution decisions, such as production scheduling, the delivery of final goods to customers, and coordinating the logistics network. Although changes in the variables discussed under the tactical and strategic banner above will have impact on the operational level, here routine execution is the key concern, and factors such as exchange rates and labour cost can be treated as temporarily fixed parameters. While a discussion of each dimension in isolation will yield relevant results, we argue that only when all dimensions are considered in combination, a holistic operational assessment of a global sourcing strategy become possible. For example, the operational cost of a given location might be very low in comparison to other locations, yet if strategic indicators such as political risk or customs clearance are unstable, the source might not be suitable in the long run. Or, while the production cost might be low when sourcing from this particular location, the customers demand customised products, and thus the set-up might not be sustainable even if the cost structure seems advantageous. The financial evaluation, i.e. the cost effectiveness, is a very different discussion to the operational variables discussed above, and will be further elaborated in the following section.

Assessing the Cost Effectiveness of Global Sourcing

The main driver for global sourcing and manufacturing has been the labour

cost differential across countries, as Slack and Lewis (2002) point out. They refer to the cost of resources such as labour, transportation and energy, as the reasons that organisations move their location. With regards to labour, two factors can influence the cost: first, the productivity of labour employed, which on international level is often inversely related to labour costs. This means that generally the average amount produced by each individual employed in a given unit of time is greater in countries
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with higher labour costs, which happens at least partly because in countries with high labour costs there is more incentive to invest in productivity-enhancing technology. This effect goes some way in offsetting the large international variations in labour costs. The second factor is the rate of exchange of countries currencies. Exchange rates may swing considerably over time, as discussed above, and this in turn changes relative labour costs. These adjustments may exert a major influence on the decision of where to locate, especially in industries where labour costs are a high proportion of total costs. Transportation costs are clearly spatially variable because the resources need to be transported from the origin to the manufacturing point, and also products need to be transported from the manufacturing points to customers. Proximity to sources of supply dominates location decisions where the cost of transporting input materials is high. Proximity to customers, on the other hand, dominates location decisions where the transportation of products and services to customers is expensive or impossible. Those companies whose manufacturing processes use large amounts of energy may be influenced in their location by the availability of relatively inexpensive energy. Despite the obvious advantages of lower labour costs, there are considerable risks involved. These include currency and political risk, as well as customs and trade policies, as well as legal issues with regards to the ownership of the manufacturing facilities. Furthermore, the loss of supply chain responsiveness in terms of being able to react to shifts in demand, or the introduction of new products, is a direct function of the logistics lead-time. It seems questionable whether these additional, hidden supply chain costs are always considered when companies assess their global sourcing strategy. In fact, in our view, the cost assessment of global manufacturing and sourcing strategies needs to consider several dimensions to it. At prima facie, the costs can be evaluated by comparing the purchase price abroad, plus the transportation cost per unit. While this static perspective might be widely used, in particular by management accountants assessing the financial viability of global sourcing ventures, it omits the dynamic dimension. The assumption underlying this static cost is that demand is stable, and does not vary. However, as customer demand always fluctuates to a certain degree, additional pipeline and safety stock will be required to counter this effect and ensure uninterrupted supply. Also, the ability to introduce new products is seriously hampered, as the length of the logistics pipeline
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will be the minimum time span required to introduce new products. In case of quality problems, the cost of expensive expedited shipments will be required, and the cost of warranty claims will initially be high as the new facility or supplier be will climbing the learning curve. Additional costs accrue from the overhead costs allocated to production in the high-wage location, which commonly remain when production is transferred to a foreign location. Also, the cost of engineering visits or even resident engineers to set up the process to ensure quality levels is generally not factored into the equation. Furthermore, the cost of senior executive visits to set up the operation or to straighten out relationships with managers and suppliers operating in a different business environment, which may also include bribes, which is still common practice in many countries. Operationally, the cost of out-of-stocks and lost sales caused by long lead times to obtain the part are also critical, as is the cost for obsolete materials that have been ordered to a long-range (yet incorrect) forecast to counter the long lead-times. Lastly, there is a potential cost associated with losing the intellectual property rights (IPR) and technology to a contract manufacturer in the low-cost location, who might well turn into a competitor in that very market. In conclusion, we have identified three levels of cost that need to be considered when analysing the cost efficiency of global sourcing and manufacturing strategies, as shown in table 5: static cost, which are largely based on standard cost accounting procedures (labour cost + material + logistics = parts price), whereas dynamic cost consider the complications of dealing with demand fluctuation in the target market, or any other kind of uncertainty in the supply chain (which generally result in additional buffer stock in the system that were not factored into the static analysis). Third, there are hidden cost associated with global sourcing and manufacturing, resulting from currency fluctuations to the cost of engineering support and the strategic risk of losing knowledge/technology to future competitors.

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Static Cost 1. Purchase price ex factory gate

Dynamic Cost 1. Increased pipeline and safety stock due to demand volatility

Hidden Cost 1. Currency fluctuations, in particular for artificially pegged currencies 2. Remaining overhead at the headquarters (Purchasing, technical assistance, R&D, product development) 3. The loss of intellectual property to contract manufacturers 4. Legal risks in terms of ownership of facilities and market access 5. The strategic risk of political instability and change

2. Transportation cost per unit, assuming no unexpected delays of quality problems

2. Inventory obsolescence due to long logistics lead-times, e.g. in case of quality problems

3. Customs and duty to clear one unit for export

3. Engineering time needed to address quality and warranty issues 4. Expedited shipments, e.g. air freight, to ensure uninterrupted supply 5. Cost of lost sales and stock-outs, as the supply chain is unresponsive

Table IV: A Framework for Financial Assessment of Global Sourcing

Conclusion
Increasing competition is forcing manufacturers to source abroad and/or to

relocate their operations to low-cost locations. While this development marks a considerable shift in supply chain strategy for most companies, the phenomenon is not new, and the implications of international production and sourcing have been discussed for more than 40 years (Skinner, 1964). Nonetheless, the past decade has seen a particular rise of globalisation across all industry sectors, with direct consequences for the configuration and performance of the respective supply chain networks. The purpose of this note was to define a framework how to evaluate both the operational efficiency and cost effectiveness of global sourcing strategies, an area which to date has not been satisfactorily addressed in our view.

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Based on the review of previous contributions we identified six distinct network configurations of sourcing types regarding locus of manufacturer, supplier, and the market. These six strategies are local manufacture, export, international sourcing, global sourcing, offshoring, and global manufacturing. Based on these strategies, we developed a theoretical framework how to assess these strategies. In the operational assessment, strategic, tactical and operational variables are considered, whereas in the cost assessment static, dynamic and hidden costs are considered. In our experience, global sourcing and manufacturing decisions are often made on the sole basis of static cost, thereby neglecting the adverse impact of demand fluctuations and other disruptions. Global supply chains are by definition long and prone to dynamic distortions, which clearly need to be considered in their evaluation, alongside strategic risks such as currency fluctuations and the loss of intellectual property. This note has proposed two frameworks to assess the operational effectiveness and the cost efficiency of global sourcing, yet we have not been able to present empirical evidence to quantify the operational or cost impact of each variable. Nonetheless it is hoped that this note will guide future researchers in developing holistic assessments of global supply chains, an area which clearly requires both more analytical and empirical analysis.

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