Chapter 12

Global Production, Outsourcing, and

Logistics

Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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What Are The Main Production Issues For Firms?

International firms must answer five interrelated questions

1. Where should production activities be located? 2. What should be the long-term strategic role of foreign

production sites? 3. Should the firm own foreign production activities or

outsource those activities to independent vendors? 4. How should a globally dispersed supply chain be managed,

and what is the role of Internet-based information technology in the management of global logistics?

5. Should the firm manage global logistics itself, or should it outsource the management to enterprises that specialize in this activity?

Where should a firm locate its production activities?

In today’s global world, the answer to this question could be anywhere.

Should all production be located in a single market, or is there a reason to locate different activities in different places?

What’s the long term strategic role of foreign production sites?

What factors might cause a firm to make changes in its strategy?

Should the firm outsource, or handle activities in-house?

Firms also need to decide how to manage a globally dispersed supply chain, and what the role of Internet-based information technology should be in the management of global logistics.

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How Are Strategy, Production, And Logistics Related?

Production - activities involved in creating a product Logistics - procurement and physical transmission of

material through the supply chain, from suppliers to customers

Questions: How can production and logistics 1. Lower the costs of value creation?

disperse production to the most efficient locations manage the global supply chain efficiently to better match supply

and demand

2. Add value by better serving customer needs? eliminate defective products from the supply chain and the

manufacturing process

Let’s look at two activities in the value added chain -- production and logistics.

How can these two activities can be conducted internationally to not only lower the costs of value creation, but also to add value by better serving customer needs?

Remember that production refers to activities involved in creating a product, and that logistics refers to the procurement and physical transmission of material through the supply chain from the supplier to the customer.

The production and logistics functions of a firm have two main strategic objectives. First, to lower costs, and second, to eliminate defective products from the supply chain and the manufacturing process.

Keep in mind that these two objectives are interrelated, so for example, a firm that improves quality control will also reduce the cost of value creation.

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How Can Quality Be Improved?

Most firms use the Six Sigma program - a direct descendant of total quality management (TQM) aims to reduce defects, boost productivity, eliminate

waste, and cut costs throughout the company

In the European Union, firms must meet ISO 9000 standards before gaining access to the European marketplace

Improved quality reduces costs

How do companies boost product quality?

The main technique that’s used today is the Six Sigma program which focuses on reducing defects, boosting productivity, eliminating waste, and cutting costs throughout the company.

Companies like Motorola and General Electric use this program.

You may already be familiar with the Six Sigma program or its predecessor, total quality management or TQM. TQM was popular in the 1980s and early 1990s.

In addition to Six Sigma and TQM, many countries have set quality guidelines.

The European Union for example, has established a quality standard called ISO 9000, and requires all firms to meet its standards before they’re given access to the European market.

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How Can Quality Be Improved?The Relationship Between Quality and Costs

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Where Should Production Be Located?

Firms should locate production so that production and logistics can be locally

responsive production and logistics can respond quickly

to shifts in customer demand Firms should consider1. Country factors2. Technological factors3. Product factors

Now let’s get back to the question we asked at the start of this discussion-- where should firms produce?

Well, firms want to locate production so that they are to be able to accommodate demands for local responsiveness and to be able to respond quickly to shifts in customer demand.

As you’ll recall from the Opening Case for example, several global automakers like Hyundai have been shifting production to India to take advantage of the country’s low cost labor force. We say there are three factors that might affect the choice of production location, country factors, technological factors, and product factors.

Let’s talk about each one.

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Country FactorsManufacturing should be located where economic,

political, and cultural conditions are most conducive to the performance of that activity

Firms should consider the availability of skilled labor and supporting

industries formal and informal trade barriers expectations about future exchange rate changes transportation costsregulations affecting FDI

You’ll probably recall from our discussions in earlier chapters, that a firm should locate its manufacturing activities where economic and cultural conditions, including relative factor costs, are most conducive to the performance of that activity.

In other words, a firm should produce its product where ever it makes the most sense.

There are several country factors that influence the decision of where to produce.

For example, for a location to even be a possibility, skilled labor and supporting industries must be available.

Regulations on FDI and trade can significantly affect the attractiveness of a country as a production location.

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In addition, expectations about the future value of a currency can also influence the decision of where to produce.

Transportation costs are another factor to consider.

China has proved to be a successful production location for the Dutch firm, Phillips NV. In fact, Phillips wants to eventually use China as a global supply base!

You can learn more about Phillips’ plans in the Management Focus in your text.

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Technological Factors

Firms should consider 1. The level of fixed costs

if fixed costs are high, produce in a single location or a few locations

when fixed costs are low, multiple production plants may be possible – allows firms to respond to local demands

2. The minimum efficient scale when minimum efficient scale (the level of output at which

most plant-level scale economies are exhausted) is high, choose centralized production in a single location or a limited number of locations

when minimum efficient scale is low, respond to local market demands and hedge against currency risk by operating in multiple locations

Technology is another factor to consider when making location decisions.

In particular, we need to look at the level of fixed costs involved, the minimum efficient scale of the technology, and the flexibility of the technology. Let’s look at each one more closely beginning with the level of fixed costs.

Sometimes, the fixed costs of setting up a manufacturing plant are so high, a firm needs to serve the world market from just a few locations or even from a single location.

It costs more than a billion dollars to set up a semi-conductor plant for example, so a semi-conductor producer is unlikely to establish multiple plants.

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Keep in mind of course, that the opposite is also true.

If fixed costs are low, multiple locations might make sense.

How does minimum efficient scale affect the choice of production location?

Well, we say that the larger the minimum efficient scale of a plant, the more likely a firm will centralize production in a single location or produce in just a few locations.

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Technological Factors

3. The flexibility of the technology flexible manufacturing technology or lean

production reduces set up times for complex equipment increases the utilization of individual machines through

better scheduling improves quality control at all stages of the manufacturing

process Flexible manufacturing allows firms to produce a wide

variety of end products at a relatively low unit cost Mass customization Flexible machine cells

How do new technologies influence the decision of where to locate production?

Well, you probably already know that to achieve economies of scale and the costs savings associated with them, firms need to mass produce standardized products.

We typically think that firms that produce a greater variety of products have shorter production runs.

However, these traditional practices are changing. Today, flexible manufacturing, which is also called lean production, is changing the way companies produce, allowing them to challenge the traditional rules of production.

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These new technologies are designed to reduce set up times for complex equipment, increase the utilization of individual machines through better scheduling, and improve quality control at all stages of the manufacturing process.

Why is flexible manufacturing so important?

Flexible manufacturing allows companies to produce a wide variety of products at a unit cost that would normally be associated with mass production of a standardized product!

Mass customization implies that a firm can customize its product line to meet the needs of different customers without additional costs.

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Another common flexible manufacturing technology involves flexible machine cells. This type of technology groups various types of machinery, a common materials handler, and a centralized cell controller.

Firms that use flexible manufacturing technologies have a competitive advantage over those that don’t because they can customize their products to meet the needs of different national markets.

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Technological Factors

Production should be concentrated in a few locations when fixed costs are substantial the minimum efficient scale of production is high flexible manufacturing technologies are available

Production in multiple locations makes sense whenboth fixed costs and the minimum efficient scale of

production are relatively lowappropriate flexible manufacturing technologies are not

available

So, should a firm operate multiple production facilities or concentrate production in a few locations?

Firms should concentrate production in a few locations when they have substantial fixed costs, when the minimum efficient scale of production is high, and when flexible manufacturing is an option.

Establishing multiple production locations can make sense when both fixed costs and minimum efficient scale of production are relatively low, and when flexible manufacturing isn’t a good alternative.

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Product Factors Two product factors impact location decisions1. The product's value-to-weight ratio

If the value-to-weight ratio is high, produce the product in a single location and export to other parts of the world

If the value-to-weight ratio is low, there is greater pressure to manufacture the product in multiple locations across the world

2. Whether the product serves universal needs When products serve universal needs, the need for

local responsiveness falls, and concentrating manufacturing in a central location makes sense

How does the product affect the decision of where to locate production?

Well, there are two important factors to consider.

The first is the product’s value-to-weight ratio.

If the value-to-weight ratio is high like it might be with a pharmaceutical product, then it makes sense to produce the product in a single location and export it to other parts of the world.

You know, for example, that it doesn’t cost as much to ship prescription pain killers as it costs to ship a car, so centralized production makes sense.

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In contrast, when the value-to-weight ratio is low like it is with paint or a car, there is more pressure to manufacture the product in multiple locations around the world.

The second product factor to consider is whether the product serves universal needs, or needs that are the same everywhere.

When there are few differences in consumer tastes and preferences, the need to be locally responsive is reduced, and centralized manufacturing makes sense.

So, for example, a firm might produce calculators or video game consoles at a single location because they can be produced in bulk.

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Locating Production Facilities

There are two basic strategies for locating manufacturing facilities

1. Concentrating them in the optimal location and serving the world market from there

2. Decentralizing them in various regional or national locations that are close to major markets

So, we say that there are two basic alternatives for locating production activities. A firm can set up facilities in a single, optimal location and serve the world market from there, or a firm can decentralize production into various regional or national locations.

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How Are Location, Strategy, And Production Related?

Location, Strategy, and Production

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Strategic Role Of Foreign Factories

The strategic role of foreign factories and the strategic advantage of a particular location can change over time factories established to take advantage of low cost labor can

evolve into facilities with advanced design capabilities as governmental regulations change and/or countries upgrade

their factors of production the strategic advantage of a particular location can change

Improvement in a facility comes from 1. Pressure to lower costs or respond to local markets

2. An increase in the availability of advanced factors of production

Does the attractiveness of a production location change over time?

The answer to this question is yes!

The strategic role of foreign factories, and the strategic advantage of foreign factories can change over time.

A foreign factory that was initially established to make a standard product to serve a local market, or to take advantage of low cost inputs, can evolve into a facility with advanced design capabilities.

Hewlett Packard, for example, initially located it production in Singapore to take advantage of low costs there, but today, the facility is an important center for designing and assembling portable ink jet printers.

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You can learn more about Hewlett Packard’s operations in the Management Focus in your text.

Keep in mind that as government regulations change, or as countries upgrade their factors of production, the strategic advantage of a particular location can change. Just think about some of the changes that have been going on in many developing countries in the last twenty years or so.

Countries that had been economic backwaters just a generation ago are now thriving economies with improved communication and transportation infrastructures.

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Strategic Role Of Foreign Factories

Many companies now see foreign factories as globally dispersed centers of excellence excellence in different locations worldwide, supports the development of a transnational strategy a focus of a transnational strategy is global learning -

the idea that valuable knowledge does not reside just in a firm’s domestic operations, it may also can be found in foreign subsidiariesimplies that firms are less likely to switch

production to new locations simply because some underlying variable like wage rates has changed

Once consequence of these changes is that as the strategic role of a factory is upgraded, and a firm develops centers of excellence around the world, a transnational strategy becomes possible.

So, instead of simply thinking of foreign factories as low cost manufacturing facilities, they become vital components in the firm’s strategy.

Recall from the Opening Case for example, that Hyundai is adding R&D to its operations in India, making the location an even more important component in its overall strategy.

Remember also, that an important component of the transnational strategy is the notion of global learning, or the idea that valuable knowledge doesn’t just reside at a firm’s domestic operations, it can also be found in a firm’s foreign subsidiaries.

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Should A Firm Outsource Production?

Should a firm make or buy the component parts to go into its final product?

Make-or-buy decisions (decisions about whether to perform a certain value creation activity in-house or outsource it to another firm) are important to a firm’s manufacturing strategy service firms also face make-or-buy decisionsdecisions involving international markets are more

complex than those involving domestic markets

Now, let’s move on to outsourcing.

Should an international business make or buy the component parts to go into their final product?

The decision of whether to perform an activity in-house or outsource it to another firm, called the make- or- buy decision, is an important factor in many firms’ manufacturing strategies.

Toyota for example, actually produces less than 30 percent of the value of its cars.

The rest is outsourced to other companies.

Nike and Reebok actually outsource all production activities!

Keep in mind that like so many other things, make-or-buy decisions are more complex when they involve international markets than when they involve domestic markets.

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The Advantages of Make Vertical integration - making component parts in-house is

attractive because 1. Lowers costs - manufacturing in-house makes sense if a

firm is more efficient at that production activity than any other enterprise,

2. Facilitates investments in highly specialized assets - - in-house production makes sense when substantial investments in specialized assets (assets whose value is contingent upon a particular relationship persisting) are required to manufacture a component

3. Protects proprietary technology – in-house production makes sense when component parts contain proprietary technology (to maintain control over the technology)

4. Improving Scheduling in-house production can make planning, coordination, and scheduling of adjacent processes easier

What are the advantages of make?

Making components in-house, or vertical integration as it’s also known, has several advantages.

It’s associated with lower costs, it facilitates investments in specialized assets, it protects proprietary technology, and it facilitates the scheduling of adjacent processes.

Let’s look at each of these more closely, beginning with lowering costs.

If a firm is already the most efficient producer of certain products, it doesn’t make sense to outsource to a less efficient producer. The firm can lower costs by continuing to manufacture the product in-house.

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Boeing for example, keeps large systems integration activities in-house because it’s more efficient at this activity than any other firm.

Second, making components in-house also facilitates investments in specialized assets. When a firm has to invest in specialized assets, or assets whose value is contingent upon a particular relationship persisting, internal production makes sense.

So, if Nissan develops a new fuel injection system that it believes will be an important competitive advantage, but that requires specialized assets, Nissan will probably choose to produce the system in-house.

Because the system is unique to Nissan vehicles, it’s not worth it for an outside supplier to make the investments that would be needed.

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From Nissan’s, perspective, it wouldn’t be strategically desirable to use an outside supplier because since the supplier would have to make the special investments, Nissan would be more or less tied to that supplier, and couldn’t take advantage of changes in the market.

Third, making a product in-house can help protect proprietary assets.

A firm that outsources something that contains proprietary information runs the risk of losing control over that information.

Boeing for example, manufactures its own cockpits so that it doesn’t give away proprietary information to competitors.

Finally, firms that manufacture in-house also have more control over the planning, coordination, and scheduling or adjacent processes.

For firms with just-in time inventory systems, this can be a real advantage.

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The Advantages of Buy Buying component parts from independent suppliers

(outsourcing) is attractive because1. Gives the firm greater flexibility

Outsourcing provides flexibility to switch orders between suppliers as circumstances dictate

important when changes in exchange rates and trade barriers alter the attractiveness of various supply sources over time

2. Helps drive down the firm's cost structure Firms that outsource can

avoids challenges of coordination and control of additional subunits avoids the lack of incentive associated with internal suppliers avoids the difficulties with setting appropriate transfer prices

3. Helps the firm capture orders from international customers can help firms gain orders from suppliers’ countries

Why should a firm outsource or buy components?

Buying parts from independent suppliers gives a firm greater flexibility, helps drive down the firm’s cost structure, and helps the firm capture orders from international customers.

Let’s look at each of these beginning with the greater flexibility associated with buying.

Maintaining strategic flexibility is a key advantage of going the buy path.

By buying parts from outside suppliers firms can switch orders between suppliers as circumstances change.

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Having strategic flexibility can be especially important when exchange rate movements, political situations, or trade barriers alter the attractiveness of suppliers.

Second, by outsourcing, firms have lower costs because they can avoid the challenges involved in coordinating and controlling the additional activities that would be involved in making the components.

Firms can also lower costs when they avoid the lack of incentive that often comes with internal suppliers.

Because internal suppliers have a captive customer, they often don’t share the same drive to improve quality and lower prices that independent suppliers have.

In addition, it can be difficult to decide how to set transfer prices when products are made in-house.

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A number of factors like exchange rates changes, and the ignorance of headquarters about local conditions, affect how prices should be set, and because of the complexity, internal suppliers located in other countries might choose the easy path of simply passing on cost increases rather than trying to find ways to reduce them.

Finally, by outsourcing, firms can capture more orders from a country.

Boeing was able to get a large order from Air India for example, but agreed to shift some subcontracting work to Indian suppliers.

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Managing a Global Supply Chain

Logistics encompasses the activities necessary to get materials to a manufacturing facility, through the manufacturing process, and out through a distribution system to the end user

The goal is tomanage a global supply chain at the lowest possible cost and

in a way that best serves customer needsestablish a competitive advantage through superior customer

service

Efficient logistics can have a major impact upon a firm's bottom line

Now, let’s move on to discuss how to manage the global supply chain.

Logistics refers to the activities necessary to get materials to a manufacturing facility, through the manufacturing process, and out through the distribution system to the end user.

As you’ve probably guessed, when it comes to international logistics, firms have to deal with complications like distance, time, exchange rates, and customs barriers.

Sometimes, we think of logistics only as an afterthought, but an efficient logistics system can have a significant impact on the firm’s bottom line.

Even a small reduction in materials costs can add up to huge savings!

The goal then, is to manage the global supply chain so that costs are at their minimum, but customer needs are still met.

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The Role Of Just-In-Time Inventory

Just-in-time (JIT) systems economize on inventory holding costs by having materials arrive at a manufacturing plant just in time to enter the production process

JIT systemsgenerate major cost savings from reduced warehousing

and inventory holding costs can help the firm spot defective parts and take them out

of the manufacturing process to boost product qualityBut, a JIT system leaves the firm with no buffer

stock of inventory to meet unexpected demand or supply changes

How can a just-in-time system help a firm as it manage its global supply system?

Many firms have turned to just-in-time or JIT systems as a way to reduce inventory costs.

The basic idea behind a just-in-time system is that inventory holding costs are minimized by having materials arrive just as they’re to enter the production process.

This system was pioneered in Japan during the 1950s and 1960s.

Because inventory turnover is speeded up, firms can reduce warehouse and inventory holding costs.

Another benefit of the just-in-time system is that because parts are used right away, defective parts can be immediately spotted and fixed, before additional defective parts are made.

Remember though, that since a just-in-time system runs without any buffer stock, a firm is vulnerable to disruptions in supply, and also can’t immediately respond to sudden surges in demand.

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The Role Of Information Technology And The Internet

Web-based information systems play a crucial role in materials managementallow firms to optimize production scheduling

according to when components are expected to arrive

Electronic Data Interchange (EDI) facilitates the tracking of inputsallows the firm to optimize its production schedule lets the firm and its suppliers communicate in real timeeliminates the flow of paperwork between the firm and

its suppliers

How can the Internet and other information technology help in the materials management process?

Well, modern materials management depends on web based information to track parts around the world.

Firms can use systems like electronic data interchange, or EDI, to track inputs, optimize productions schedules, communicate with suppliers in real time, and reduce the amount of paperwork with suppliers.

The benefits of these technologies are so important, that firms that don’t take advantage of them often find themselves at a competitive disadvantage.

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