Let’s Go Global! But Where?

 

Selecting the Best Offshoring Destination in Asia with Data Envelopment Analysis
Authored by Andry Haryanto for Prof. Lawrence M. Seiford as IOE 551 Winter 2008 Final Assignment submitted on April 21, 2008 University of Michigan Ann Arbor

 

THE TOP 10
China India Japan Hong Kong Singapore Israel Pakistan Yemen Qatar Myanmar

 

1. Problem Definition
Offshoring has been a controversial emerging trend in international business. Both local and multinational companies compete in the pursuit of global resources to gain competitive advantage. Offshoring refers to the transfer of manufacturing or service operations (outsourcing) to foreign countries. Offshoring activities traditionally intended to take advantage of a supply of skilled but relatively cheap labor, both in services and manufacturing. As customer demand extends beyond cost, companies are increasingly offshoring more knowledge-intensive non-manufacturing activities, such as software programming, market analytics, financial analysis, and product development. At the beginning of the 21st century, advances in technology for remote delivery have rapidly expanded the offshoring market. By 2005, the potential market of global outsourcing has grown to $300 billion, with only ten percent being realized.1 This leaves an ample opportunity for companies to grow and leverage global resources. As companies are increasingly catching up with this emerging trend, they are constantly trying to define a solid global strategy. Part of the global offshoring strategy is the selecting the most suitable the destination country. This project will try to answer a piece of the complex puzzle by helping companies choose the most appropriate offshore location in Asia. We will adopt the view of a home company in the United States looking for a potential offshore destination country in Asia. The potentials of countries would be judged based on their abilities to convert a set of socioeconomic indicators to financial output that measure their capabilities to add value to foreign investors. Data Envelopment Analysis was used as an aid to analyze the relative efficiencies of these countries based on multiple inputs and outputs.

2. Data
We considered 42 Asian countries in this analysis. Due to the high-volatility nature of the region, a variable for political risk was included. Afghanistan, Iraq, and North Korea were excluded because their current political situations were considered too risky to justify an investment. Most recently available data were derived from year 2006. In any case of unavailability, the most recent set or point from previous year was used as the best available proxy.

2.1 Input measures
2.1.1 Wage ($/hour) Wage was included as one of the inputs because cost reduction has been traditionally a primary driver for business offshoring. Data from Legislative Reference Bureau (2008) were utilized to compare the labor costs among countries. The wage input used is the hourly non-poverty wage for persons outside the United States with no benefit provided. 2 Data from US Import Administration were used for Kyrgyzstan and Myanmar because they better reflected the current situation based on periodical research.3 Every year, Import Administration evaluates labor cost of select foreign countries as a basis of analysis to prevent dumping from foreign countries. Page 1 of 11   

2.1.2 Political Stability Learning from the 1998 financial crash in Asia, it is important that we incorporate a measure of political risk into the model. Every year, World Bank publishes its benchmark of country governance, “Worldwide Governance Index.”4 In this analysis, we utilized a subset of the index: “Political Stability” from year 2006. The score ranges from 0 to 5, with higher values indicating better governance. 2.1.3. Education (% secondary school enrollment) Education has been becoming increasingly important as a selection criterion due to the increasing number of knowledge-intensive activities being offshored. As an indicator of general workforce education level, we utilized gross secondary school enrollment as a percentage of population in 2006. Data were obtained from World Bank’s World Development Indicators. Values from 2005 and 2004 were used for some countries as proxy values. The percentage of people in secondary education was chosen because a country with higher enrollment ratio would have a more educated workforce, thus increasing its capability in global competition. Gross enrollment ratio is the ratio of total enrollment, regardless of age, to the population of the age group that officially corresponds to the level of education shown. Secondary education completes the provision of basic education that began at the primary level, and aims at laying the foundations for lifelong learning and human development, by offering more subject- or skilloriented instruction using more specialized teachers. Percent enrollment above 100% means that there enrolled students outside the secondaryschool age. These values would be limited to 100% to keep the transformed variable consistently positive. 2.1.4 Infrastructure Infrastructure development is essential for both manufacturing and service providers. Transportation infrastructure is especially important for manufacturing supply chain and logistics. Information, technology, and communications infrastructure to support remote delivery and knowledge-intensive activities. Both transportation and IT & communication are measured from 2007-2008 Global Competitiveness Index – Second Pillar: Infrastructure.5 The GCI Infrastructure score gives an estimate of the infrastructure development in each country. It ranges from 0 to 7, with 7 being the best. Due to limited country coverage, some data points have to be obtained from a proxy. The proxy analysis was accomplished by looking for another country with similar ITC and TRANS indicators. A country not covered in GCI will be assigned the score of another country with similar ITC and TRANS scores. ITC: Information, Technology, and Communications Infrastructure (unit/100 people) There are three data sets obtained from World Bank’s World Development Indicators in 2006 (or 2005 proxy): number of broadband subscribers per 100 people, mobile and landline phone subscribers per 100 people, and number of personal computer per 100 people. The three variables are combined into ITC = (Broadband subscriber + Mobile and landline phone + PC) per 100 people.

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TRANS: Transportation Infrastructure (million ton-km/sq km) The variable TRANS was defined as the total goods transported per area of the country. TRANS = (Railway freight + Air freight + Road freight) / Area. The freight measures were obtained from World Bank’s 2005-2006 World Development Indicators.

2.2 Output measures
2.2.1 Foreign Direct Investment Inflow ($ million) FDI, Foreign Direct Investment, is investment of foreign assets into domestic structures, equipment, and organizations. It does not include foreign investment into the stock markets. Foreign direct investment is thought to be more useful to a country than investments in the equity of its companies because equity investments are potentially "hot money" which can leave at the first sign of trouble, whereas FDI is durable and generally useful whether things go well or badly.6 The FDI inflows to and outflows from a country may be useful indicators of economic health and investment appeal. Countries with major inflows probably represent growth opportunities. Countries with major outflows probably represent created wealth, or strategic positioning, or less appealing home country investments. Inflows are probably clearer indications of what is going on than outflows.7 Data of FDI inflows were primarily obtained from World Bank’s World Development Indicators. Information from other government agencies and independent organizations were used to complete the data set.8 2.2.2 Export ($ million) Since we are interested in the value-added manufacturing and service activities, data of commercial services export and manufactured goods export (as opposed to merchandise export) were obtained from World Bank’s World Development Indicators (2006 or latest). There are two variables utilized in the model: commercial services export (SEX) and manufactured goods export (MEX).

3. Variable Introduction and Transformation
Four input variables and three output variables fed into DEA model are summarized in Exhibit 1. The values of input and output variables are available in Appendix A. Exhibit 1. Description of DEA input and output variables
Variable INPUTS NONWAGE STAB EDU INFRA OUTPUTS FDI MEX SEX Unit ($/hr) _ (%) _ ($ million) ($ million) ($ million) Description Transformation of hourly wage Political stability Secondary school enrollment Infrastructure development Foreign Direct Investment Inflows Manufactured-goods export Commercial services export Transformed? Yes

Yes

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Wage was transformed because it was negatively correlated with output: an increase in wage would result in decrease of foreign investment output. This orientation was against DEA convention that input and output be positively correlated. Variable WAGE was converted to NONWAGE using the max-minus method, in which NONWAGE = max[WAGE{i}] – WAGE[i] +0.1 * max[WAGE{i]], variable i = pointer of countries. The maximum wage for this transformation is $ 13.96/hr in Qatar. FDI had to be transformed to ensure non-negative values. Japan has a negative FDI of $6,783.58 million. Therefore, a positive value of $6,783.58 million was added to every single FDI data point to maintain non-negativity.

4. Model Selection
4.1 Orientation
The problem would be defined as an output oriented problem because each country would aim to increase the amount of FDI inflow and export to make their countries more attractive to foreign investment. The rest of the inputs are measures that generally should not be decreased, if not improved: education level, infrastructure development, or political stability.

4.2 Returns to scale (RTS)
Macroeconomic variables generally follow the principle of diminishing return: in a production system with fixed and variable inputs, beyond some point, each additional unit of variable input yields less and less additional output. Therefore, variable returns to scale BCC model is preferred to constant returns to scale CCR model. The hypothesis was confirmed after running the BCC-O model. The data set indeed showed a variable returns to scale behavior because 8 out of the 12 efficient countries showed increasing RTS behavior. See Appendix B for the RTS analysis result of BCC-O model.

4.3 Non-controllable variables (NCN)
This analysis was set up as an evaluation aid for a company, not an improvement tool for local regulators. Therefore, efforts to improve the attractiveness of a country are outside the scope of the project. Please note that non-controllable variables (i.e. inputs) were not used because they would reduce the objectivity of the model by failing to include the non-controllable variables. All the inputs given here are not to be reduced, but they can be managed/controlled. Instead of being reduced, these inputs could be better leveraged/managed. Please jump to “Section 6.2 ” for more explanation.

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5. Model Progress
BCC-O models were run in three distinct configurations shown in Exhibit 2. MEXSEX configuration was used to determine the overall-efficient countries, while MEX and SEX were used to determine efficient countries in manufacturing and commercial services. Exhibit 2. BCC-O configurations to analyze different output priorities Config. INPUTS OUTPUTS MODEL MEXSEX NONWAGE, STAB, EDU, INFRA FDI, MEX, SEX BCC-O MEX NONWAGE, STAB, EDU, INFRA FDI, MEX BCC-O SEX NONWAGE, STAB, EDU, INFRA FDI, SEX BCC-O Super BCC-O was used to rank the efficient producers based on how much they affect the shape of the efficient frontier. The efficient countries with Super BCC-O scores above 1.0 were ranked based on the highest score. Those with scores of 1.0 were ranked based on FDI because it measures country attractiveness and willingness of foreign investors to permanently reside in the country. Appendix C summarizes the prioritization process of MEXSEX BCC-O analysis. Additional analyses were also performed to determine relative efficiencies of each country in response to a single input. These configurations were also run in BCC-O model and summarized in Exhibit 3. Exhibit 3. BCC-O configurations to analyze various input priorities Config. INPUTS OUTPUTS MODEL NONWAGE NONWAGE FDI, MEX, SEX BCC-O STAB STAB FDI, MEX, SEX BCC-O EDU EDU FDI, MEX, SEX BCC-O INFRA INFRA FDI, MEX, SEX BCC-O The efficiency score results of both simulation sets are summarized in Appendix D.

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6. Discussion
Countries with 1.0 score are those most efficient in leveraging their resources to satisfy demand in global competition / global offshoring market, making them the most attractive destination offshore countries for investment.

6.1 Companies choosing most attractive destination
A company might be considering different parts of its operations. Generally, these activities can be divided into two major categories: manufacturing and services. The MEXSEX configuration determines best countries in overall categories, both manufacturing and services. To choose the best offshoring destination for a specific type of operation, we used MEX for manufacturing and SEX for commercial services. The country selection in Exhibit 4 was derived from the simulation result summarized in Appendix D. The top 3 destinations were determined by ranking the Super BCC-O scores of the efficient countries, shown in Appendix E. Exhibit 4. Given the type of operations, which country should we go to? Config. W hat type of Best Destinations Top 3 Destinations operation (unordered) (best to worst) outsourced? MEXSEX General / overall China, Hong Kong, India, Israel, Japan, China, India, Japan Laos, Myanmar, Nepal, Pakistan, Qatar, Singapore, Yemen MEX Manufacturing China, Hong Kong, Israel, Japan, Laos, China, Hong Kong, Myanmar, Nepal, Pakistan, Qatar, Japan Singapore, Yemen SEX Commercial China, Hong Kong, India, Israel, Japan, China, India, Japan services Laos, Myanmar, Nepal, Qatar, Singapore, Yemen China was efficient in all three configurations because it has the highest FDI, highest manufacturing export, and second highest services export. The country also has one of the lowest labor costs, moderately stable government, moderate infrastructure, and education level (around the 75% median). Given what it has, China is extremely efficient at being the leaders in all three output dimensions. Hong Kong and Japan made it to the second and third spot in manufacturing despite their relatively high cost. India is the number two country for commercial services. India’s FDI is only number six among the pack, but it is extremely efficient in capitalizing its 54% education level to produce commercial services export at the number 3 spot. In another case, a company might have a specific concern about the condition at the destination country. In the early 2000s, a lot of manufacturing companies offshored their operations to India just to be disheartened when the total cost ownership skyrocketed due to underdeveloped land infrastructure. Derived from results in Appendix D, information in Exhibit 5 provides insights to address such specific concerns. Page 6 of 11   

Exhibit 5. If wage, politics, education, or infrastructure is important, where should we go to? Config. W hat input factor most important? Best Destinations NONWAGE Labor cost China, Hong Kong, Japan, Qatar STAB Political stability and low-volatility China, India, Japan, Nepal EDU Education of workforce China, India, Japan, Pakistan INFRA IT, communications, transportation China, Japan, Yemen infrastructure

6.2 DEA Projections as a guide to achieve efficiency
This analysis originally was only intended for a company to evaluate a country’s potential. Therefore, efforts to improve the attractiveness of a country are not the main goal of the simulation model. Nevertheless, the “Projections” of the MEXSEX overall analysis provided interesting insights for regulators in each country. The projections summarized in Exhibit 6 on the following page could guide a country how to become efficient either by reducing inputs or increasing outputs. Let us explore a few examples. Example 1: Yemen To become efficient, increase output Yemen is on the verge of being efficient because almost all of its projections are virtually zero. It has all the resources required to become an efficient country. The only homework left for regulators in Yemen is increasing manufacturing exports by 0.05 or 5%. This could be accomplished by providing economic incentives such as tax break or investment aid. Example 2: Bhutan To become efficient, increase output and better leverage the input (cannot reduce input) In order to become an efficient producer, Bhutan has to increase its wage (reduce nonwage) by 1%, reduce stability by 65%, reduce education by 7%, increase FDI by 14%, increase manufacturing export by 14%, and increase service export by 1000%. Increasing FDI and manufacturing export by 14% are practically attainable, while increasing service export by 1000% is numerically attainable but realistically requires a superhuman effort.

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Exhibit 6. Projections from MEXSEX overall analysis as a pathway to reach efficient frontier

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A negative projection in wage might be interpreted in two ways. First, in DEA language, a nonwage decrease (wage increase) would incur a “handicap advantage” that would allow Bhutan to attain a higher efficiency score with a lower output. Second, in macroeconomics, increasing wage may seem counterintuitive, but might conform to the principle of efficiency wage, in which the productivity increases as a result of wage increase. Why, then, would we possibly want to reduce education level or political stability to become efficient? We do not. Negative projections of NONWAGE, STAB, EDU, and INFRA should be interpreted as underleveraged assets of a country. Instead of reducing the inputs, thereby reducing advancement of a country, the country’s regulators should put an effort to leverage the underutilized resources to produce more output. In shot, a negative EDU projection means a country is not capitalizing enough on its intellectual capital. For Bhutan, 65% reduction projection in STAB implied that it has very good governance. The data confirmed this observation: Bhutan has the highest score of 3.80/5 in a dataset with median of 1.91/5 and minimum of 0.24/5. Bhutan could be more efficient by capitalizing more on its political stability by, for example, educating foreign investors about its superior governance, giving them incentive to increase FDI inflow to Bhutan. The other variables could also be interpreted in a similar way. A country can translate“reduce wage” as “create a culture with great work ethic so that more value is created with the same amount of pay” or “reduce infrastructure” as “reform school curriculum so that students could better perform in the global workplace”. While the data could not provide immediate improvement suggestions, one insight can be derived from Exhibit 6: a country with negative input projection should capitalize more on the corresponding input to increase the output indicators. This is an inverse interpretation of a typical DEA projection: instead of reducing the input, increase the productivity of each input to improve the output.

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7. Conclusions, limitations, and recommendations
DEA analysis with four inputs and three outputs was utilized to determine the most lucrative offshoring destination in Asia for a US company. Super BCC and FDI inflow were used to rank the efficient units. The top ten destination countries are:
Rank 1 2 3 4 5 6 7 8 9 10 Country China India Japan Hong Kong Singapore Israel Pakistan Yemen Qatar Myanmar

We were able to choose the best destination countries based on type of offshored operations (manufacturing, operations, or both) and type of macroeconomic priority (labor cost, governance, education, and infrastructure). Biased on its original purpose as an evaluation rather than improvement device, the model described here is not smart enough yet to determine feasible specific improvement steps for inefficient countries. The useful interpretations of the projections are guides to identify abundant and underutilized resources in those countries. These resources should be better utilized but not reduced due to the nature of the input. Some of the improvement suggestions, such as 1000% increase in export, were also realistically unattainable. Looking forward, a more advanced method is expected to be able to take these effects into account to transform the projection result into a quantifiable objective and impose limits to the variables to produce a realistic game plan.

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References
                                                             
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 http://www.mckinsey.com/locations/india/mckinseyonindia/pdf/NASSCOM_McKinsey_Report_2005.pdf   http://www.ci.mil.wi.us/ImageLibrary/Groups/doaPurchasing/forms/nonpovertywage.pdf   http://ia.ita.doc.gov/wages/04wages/04wages‐010907.html   http://info.worldbank.org/governance/wgi2007/home.htm   http://www.gcr.weforum.org/   http://econterms.com/glossary.cgi?action=++Search++&query=fdi   http://seekingalpha.com/article/40674‐foreign‐direct‐investment‐flows‐indicative‐of‐growth‐opportunities   http://www.adb.org/Documents/Books/Key_Indicators/2006/pdf/rt24.pdf 

3 4 5 6 7 8

   

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Appendix A. Data feed for DEA Software

 

Appendix B. RTS analysis of BCC-O model

 

Appendix C. Prioritization process of MEXSEX BCC-O analysis.

 

Appendix D. Efficiency scores of various inputs or various outputs DEA runs

 

Appendix E. Super BCC-O prioritization of MEX and SEX models

 

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