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Perception Vs Reality

Are the costs associated with producing apparel offshore really smaller, or do they just look that way.

By Dr. Helmut H. A. Hergeth

offshore1_785M any apparel manufacturing facilities have long been moving from the United States into the Caribbean or Mexico where costs appear to be smaller. But are they really smaller, or do they only look small seen from a distance?

The College of Textiles at North Carolina State University recently surveyed a number of companies to see how they treat overhead costs in their domestic and their offshore production.

The starting point of any cost analysis has to be a thorough documentation of the costs that occurred, an analysis of the activities that drive these costs, and, for decision making purposes, a distinction of the product-variable and product-fix costs.

The survey did not attempt to investigate the actual costs, but rather the way the costing system in the participating companies was designed. Analyzing the system can determine if the costing system can fulfill all these tasks.

We believe that any domestic and any offshore production facility will provide a thorough documentation of all costs, and we therefore did not make this part of the survey. The survey focuses on the methods of allocating overhead costs to the individual products.

For short-term decision-making purposes it is necessary to distinguish between variable and fixed costs. Costs that are directly influenced by the production level of a specific product are relevant in decisions about this product. Costs that do not change with the production or non-production of a specific product should not be considered for product decisions.

Traditionally, manufacturing costs are considered variable, and corporate overhead costs are considered fixed. Limitations of this simplification have been shown, and many of them can be overcome by using activity-based costing systems. The purpose of activity-based costing (ABC) is to identify cost drivers for all activities in a company, and then determine how far each and every product has caused an activity to be performed. The cost of each activity is then attributed to those products that actually caused it.

Offshore Overhead

The basic assumption behind the preliminary study was that most decisions for offshore production sites are driven by lower cost factors in the offshore region.

Usually a primary factor is lower labor cost; sometimes other cost factors are also in favor of the offshore site. At the same time we suspect that the overhead cost structure for offshore productions is different from a domestic production.

Some examples of overhead costs that are suspected to be different are:

- Training Costs for Labor — these are likely to be higher in the offshore regions because they are not as far along in the learning curve. Typically the costs for trainers and training sessions tend to involve time and travel from the more experienced workforce in the domestic site;

- Transportation Costs — these are typically higher for an offshore site than within the domestic market, and in some cases they are not allocated to specific products;

- Second Quality and Rework — there is a tendency for the offshore production (at least for a period of time) to have a higher percentage of second quality products and to require more rework; the rework is often done in the domestic site, especially if this is where the final quality control is located;

- Marketing — usually the marketing costs are allocated "evenly" to all products, domestic and offshore. However, this is not necessarily how the marketing moneys are spent. In some cases the longer production runs (typically moved to the offshore productions) benefit more than the shorter runs. It may be necessary to intensify marketing efforts in order to offset a perceived drop in quality when production sites change;

- Corporate or General Management — corporate management is used by either location, but typically the travel efforts of the corporate managers are due to activities away from the headquarters, e.g., the offshore production. There is also a tendency that the utilization may be higher for new ventures, e.g., the offshore production site. This would mean that moving a standard production offshore would require more attention by the corporate management than a domestic location would require; and

- Expatriate Management at the Offshore Production Site — typically there are fringe benefits or additional payments for expatriates who are temporarily located at the offshore production site. While the nominal cost of their stay at the offshore facility is usually allocated to that facility, fringe benefits and any hardship payments that are paid in the home country are often charged to the corporate headquarters and become "domestic overhead."

This means that we have some overhead costs that are either caused at the same level for products produced domestically or offshore (like marketing). And we have such overhead costs that are caused at a higher level for products at the offshore location (like coordination costs, training cost, etc.). It is worthwhile to see if such costs can be distributed accordingly with the costing systems in place. If the costing system allows this, it should be further investigated to see if it is actually done and if the costs are allocated to the correct products.


Preliminary Survey

Our survey only investigated whether it is actually possible to allocate the overhead costs according to their "regional causality." We sent out a brief questionnaire mostly to smaller companies. By addressing these smaller companies we expected a faster response and a wider range of answers. Therefore not all the results may not be completely representative for the industry as a whole. For example, only about 40 percent of the respondents either manufacture or import products from the Caribbean or from Mexico.

In all, 28 companies responded to this preliminary study. Of these companies, those with offshore activities tended to have a larger sales volume than those having domestic production only. Of the companies active abroad, 36.36 percent had a sales volume of more than $100 million, and only one company had a sales volume of less than $5 million. In contrast, 41.18 percent of the companies not active offshore had a sales volume of less than $5 million.

Figure 1 shows that the vast majority of the respondents use direct labor as the allocation key for their overhead costs. This is also true for those companies that are active offshore: 72.7 percent are using a percentage of direct labor to allocate their overhead.

Figure 2 shows that 27.3 percent of the companies that are active offshore are using the same overhead rate for their domestic as for their offshore production. Of the companies using different rates, 75 percent reported higher overhead rates for the domestic than for their offshore production.

Using the same overhead rate for domestic and offshore production (usually based on direct labor) leads to some serious problems. Usually the direct labor rate is lower in the offshore region; when we apply the same rate (i.e., percentage or multiplier) as we do in the domestic production cost calculation, we automatically assign a lower absolute cost to the offshore production.

If the absolute cost is the same for both regions, the example in Table 1 shows how the allocation to the offshore products is underestimated. The difference actually due to the labor cost differential should only be $0.40, not $1.00.

An example of this discrepancy would be marketing costs that are allocated to all products. If direct labor is used as a key, the allocation of marketing costs to offshore products is likely to be too low.


Overhead Allocation

More than 70 percent of the companies active abroad use different rates or factors for their domestic and offshore productions. Most of them use direct labor to allocate the overhead, but at different rates.

Using this differential might be seen as a corrective measure to compensate for the different labor rates, so that the absolute amount is more or less the same (assuming the overhead activities are the same for the domestic and offshore products). This is contradicted by the survey that shows 75 percent of those companies with different rates have higher domestic rates than offshore rates.

There are two possible explanations for this result. First, the companies allocate only a fraction of their corporate overhead to the offshore production — this would lead to a serious, almost intentional underestimation of offshore production costs. Or the answers are supposed to reflect not higher rates (i.e. percentage rates or multipliers), but the higher amounts of overhead cost for domestic products, as shown in Table 1.

In either case, the overhead allocation does not appear to reflect the previous suspicion that some costs occur specifically because of the offshore production, and that, therefore, the use of overhead activities for the offshore production is higher than for the domestic production. An example is management travel to coordinate the locations, specific training programs, etc.

If these costs are allocated to all products (domestic and offshore), the domestic production cost is incorrectly inflated and the offshore production cost is underestimated. This will, of course, lead to decisions based on incorrect assumptions.

The general problems of using direct labor as a key to allocating overhead costs have long been known. In the case of comparing costs of domestic and offshore production the picture gets even more distorted. It is also important to note that many overhead activities are not equally distributed between the production sites. The survey showed that most companies did not and often could not allocate overhead costs according to causality. To use cost as a basis for decisions, this would however be essential.

To recognize the true cost of offshore production, we will have to look at offshore costs just as closely as we are looking at domestic cost. Other problems with intangible costs, such as loss of market due to unreliable deliveries, will still have to be investigated.

Editor's Note: Dr. Helmut H.A. Hergeth is a professor of Textile and Apparel Management and Technology at the North Carolina State University College of Textiles, Raleigh, N.C.
January 2000