When American businesses outsource their engineering, especially to lower cost offshore service providers, are those companies increasing current profits at a significant future cost?
Businesses continually look for ways to reduce their costs to enhance profits. Large corporations reward their executives and managers when they find ways to reduce costs and maximize profits. For publically traded companies, positive movement of the stock price is a significant measure of such successes. Even so, decisions that affect stock price often have a very short-term focus.
Is there a significant long-term impact when companies focus on immediate profit and stock price movement? Is all cost reduction equal and is maximized short term profit good for US businesses and the US economy? Does offshoring hurt US national and local community interests? Let’s explore some ideas.
We participate in a world economy.
The US economy is not isolated. Whether consumer products or high tech, complex
systems, US businesses and consumers purchase and sell in a global market place. Developing economies such as India and China are the home to talented and intellectual resources. Many of these individuals have been trained at US universities and other quality engineering colleges.
Let’s consider India. As a developing economy, there is a large disparity between the wages of an Indian engineer and his or her US counterpart.
There is also a wide gap between the Indian and the US standard of living. Engineering bill rates (fully burdened rates) in developing countries are often lower than the pay rate for a US engineer. As a business person, the decision would appear to be a no-brainer. Send at least the lower value engineering to the Indian work force. Perhaps this is a good decision. But what happens when we consider more sophisticated engineering or more complex systems?
Offshoring Engineering – How it plays out
Let’s look at a simplified view of aircraft engineering outsourcing. The following table provides some notional thoughts to promote discussion and stimulate thought. Cost numbers are representative but are not factual. The table assumes the outsource engineering originates from a large OEM:
|Type Work||Offshore cost (bill rate)||US burdened Rates||Oversight by OEM||OEM special training||Best Case Delta Cost internal vs external (negative = savings)|
|Entry level engineering and simple design and drafting||$35.00/hour||$75.00/hour||Same for either||None – Considered industry best practice||=$35.00-$75.00
|Higher end complex system design||$35.00/hour||$90.00/hour||1 OEM leader for 3 designers
$90.00/3 = $30.00/hr
|Special training required||=35+30-90 =
|Complex structural analysis||$35.00/hour||$120.00/hour||1 OEM leader for 3 designers
|Special training required||35+40-120 =
Short term – Financial benefits and increased workload capacity – The chart above shows that the OEM receives a positive dollar per hour return for all engineering outsourced, with a range of savings is $25.00 and $45.00 per hour. However, this example discounts several costs that are not captured and are often overlooked. In any purchase agreement, there is always an administrative charge to manage the contract. There is also a management tax that applies to all work accomplished on a project.
This management tax may be the same for the internal and external (outsourced) labor. Arguably, there will be a cost increase for communication difficulties that usually occur between persons that speak different native languages. Communication issues are also magnified by cultural differences. These costs are difficult to quantify.
For more complex engineering, there is also a cost of providing special training and analytical tools that are necessary to provide a solution equivalent to the internal resources. These costs are not easily quantified and will vary depending on the complexity of the outsourced intellectual property, training requirements, and account practices within a company.
It is quite possible that the short-term financial benefit in our example may range from negligible to negative. However, clearly there is a benefit of increased capability in terms of labor capacity.
In sum, though the short-term cost benefit is negligible, the added engineering capacity is a benefit.
Overall benefits to the global community – Does outsourcing and offshoring of engineering have significant positive impact to the greater global community? When work is moved from one place to another, the receiving community will enjoy both tangible and intangible benefits. Tangible benefits include higher value jobs, increased revenues, more educational opportunities, and potential community stability. Less tangible benefits include a greater awareness of differing cultures, diversity of knowledge, and increased opportunity for new business development.
Continuing our look at the aircraft industry, the market for commercial aircraft is global and is rapidly expanding in countries like China and India. By placing work into countries like India and China, this can provide opportunity to further sell airplanes in those countries. Added jobs stimulate the economy, the increased revenues may enable funding to purchase more aircraft.
When a company like Boeing or Airbus develops a presence in a country, each company brings a part of their business and social culture. This promotes cross cultural learning. Overall, this has a positive impact.
However, what happens in the communities where employers have relocated jobs to offshore sources seeking the promise of cheaper labor? In the case of US engineering, there have been long standing reports that the engineering work force is retiring without replacements ready to fill those roles. In the US, there has been an increased focus on STEM education with a focus on getting children interested in engineering. Fortunately, the latest enrollment reports indicate that the US engineering student population is increasing. If the US work force isn’t available, then the impact to the local community will not be immediate when work moves overseas. It’s been said that a rising tide raises all ships. This is only true in the harbor that experiences the high tide.
When the tide rises in one port, it recedes in another. If the local supply is not sufficient to fill the needs, is offshoring engineering is a good thing for the local community? Perhaps out of necessity, offshoring is required to fill the demand, at least for the immediate short term. Keeping with the rising tide analogy, once the foreign harbor is full, the only way the tide will come back to the US harbor is if it leaves the foreign port. Once the foreign supplier has created the capability to perform the work, though, it is unlikely that the work will come back. As indicated earlier, when long term costs are considered, the economic benefits of offshoring may not be there. Once the capability is built offshore, the costs of moving the work back may be prohibitive. The strongest short-term business benefit of offshoring is added capacity.
Up to this point, most of the discussion has focused on short term impact and benefits. Let’s look at the longer term. And let’s focus on the long term impacts to outsourcing, particularly outsourcing offshore, and the impact on the local community.
Long Term Impacts to the company – Overall the long term impact to the OEM can be positive and negative, mostly defined by the long term company objectives. Depending on the company desires to be a “transnational company” versus a “national” or more specifically a “US company”, the focus of their national interests, business development, and corporate expansion will be very different. For argument of this article, we will assume that the company desires to do business internationally but intends to have its corporate identity in the US. We will assume that the leadership of the company desires to improve the standard of living for its local employees as well as be a responsible global citizen, fully recognizing that we are all participants in the world community and economy. It would be short-sighted to suggest that outsourcing and offshoring are simple decisions. There are many factors to consider when deciding where to accomplish engineering. This article considers two important factors that have long term negative impacts: enabling the competition and the loss of home grown capability.
Building the competition – Outsourcing and offshoring engineering usually begins with lower value work. The enticement of lower engineering costs and increased capacity make outsourcing and offshoring attractive. As time progresses and relationships are established, the natural next step for an emerging engineering supplier is to increase the capability and value of the work outsourced. This is a double edged sword. Why? Let’s explore:
Capability increases in the supplier, but decreases in the OEM – As more work is outsourced, the OEM supplier learns and develops strength in performance of the engineering task. In time the OEM builds a reliance on the supplier. Remember the rising tide analogy? As the tide comes into the supplier’s harbor, it goes out from the OEM. The intoxication of the perceived initial lower cost services gives way to sobering reality of price increases as the supplier becomes more valuable to the OEM. Meanwhile, the engineering jobs are less available in the local community, primarily because the entry level work was outsourced and the career path for high end engineering doesn’t look promising.
Price increases at the supplier – Eventually, the supplier will raise their prices. And, as the supplier becomes more necessary to the OEM, they are able to get these increases. The laws of supply and demand drive the price. Further, the emerging work force is not satisfied with “below market” wages. As the OEM’s local supply of engineering talent decreases, the increases in foreign bill rates are more attractive than investing in the development of the local work force. This is the spiral toward increased supplier dependence. On one hand, this is great for the supplier’s local economy and should increase the standard of living in the developing country. However, the OEM now has much more reliance on the supplier.
The birth of competition – Eventually, the supplier will no longer be satisfied with a sub-ordinate role to the OEM and will consider launching their own products. A great example is the Mitsubishi Regional Jet (MRJ). Mitsubishi is a company with a long aircraft history. However, post WWII, Mitsubishi has been in an OEM supplier role for large aircraft components until the recent development of the MRJ. Did participation in the OEM design process enable Mitsubishi to launch their own product?
Arguably, lessons learned through the Boeing and Airbus development programs enabled Mitsubishi to develop their own products. In a similar situation, China recently developed the C919 aircraft, a direct competitor to the Boeing 737 and Airbus A320. Will similar product launches occur in India? Bear in mind that both Boeing and Airbus anticipate a large new aircraft market in Asia. As this market develops, there is a strong chance new OEMs will find ways to compete with Boeing and Airbus, hence the pie will be split more than two ways.
Long Term Impacts to the local community – In South Carolina, residents have firsthand experience in the loss of an entire industry segment to offshoring. When the textile industry moved overseas, factories closed and some communities have never recovered. Some companies like Milliken developed different products and expanded to other industries. With the loss of the textile business, the South Carolina Department of Commerce has increased focus on recruiting advanced manufacturing into the state.
The recruitment of BMW, Michelin, Boeing, Volvo, and Mercedes is the fruit of their labor. There is no question that this is good for the local economy. Manufacturing is what made America a world economic power, and the strength of US engineering ingenuity is what enabled the US manufacturing industry to succeed. What is the long term impact to the community when engineering is sent off shore?
Loss of innovation, creativity, and leadership – A strength of our business and social culture has been our ability to lead technologically and to develop products. Entrepreneurship in the US is strong. American ingenuity and innovation put the first man on the moon. Fortunately, enrollment in engineering continues to grow in the US. With the increased focus on STEM education, more students are choosing engineering as a career path. With the worldwide demand for engineering still rising, good jobs are available in the US. However, will this trend continue if we send engineering jobs overseas?
Loss of high paying jobs – Engineering is one of the few college disciplines where a graduate with a four-year degree can find a great job and progress well in their career. Many other career choices require students to receive master’s degrees in order to compete in the job market. As engineering jobs move overseas, the local economy loses the benefit of these tax payers and consumers. Engineering jobs have historically paid very well. Engineering innovation drives manufacturing. High value manufacturing also pays well. Engineering work in the US is a benefit to the local community and helps to maintain the US standard of living.
What are the alternatives?
Responsible global citizenship for US companies – There are alternatives that will allow a US company to participate in the world economy while providing opportunities for the domestic workforce. These alternatives, if done correctly, will generate modest returns for the corporation, provide opportunities within the world market, and protect US long-term interests. The Japanese and German automakers have figured this out. Here are some ways in which US companies might do the same:
Establish an offshore manufacturing as opposed to engineering presence – Allow the global economy to participate in manufacture of goods while keeping the design of these goods domestic. BMW produces over 400,000 vehicles in Spartanburg, South Carolina. Local manufacturers (tool makers, component suppliers, support vendors, and so forth) all participate in the process. This provides jobs for the local economy. Engineers participate in the design of manufacturing support systems. However, the high value engineering (the automotive design) remains in Germany.
Retain engineering and protect intellectual property and development processes – Both German and Japanese automobile manufacturers produce vehicles in the US. The engineering for the product remains in the OEM. Procurement of support systems and parts is by specification. Product development and engineering design are enabled by strong processes that stimulate disciplined creativity.
The OEMs, like Boeing and Airbus have unique recipes for developing airplanes. These technologies include the product development process, engineering analysis methods, techniques or developing new airplane configurations, and proprietary aerodynamic codes. All of these are what separate them from the competition.
The BMW design process, similarly, allows them to create “the ultimate driving machine”. Tools and processes for efficiently accomplishing these tasks are what separate the good from the great. When this technology is shared with suppliers, essentially the OEM is teaching the supplier how to compete with them. The OEM should retain the “secret sauce” within the walls of their own company.
There is no doubt that we need to participate in a world economy. We need to sell and purchase products within the global market. US companies need to be competitive in this market. However, it is short-sighted to make decisions on immediate value alone. We need to keep an eye on the future as we take care of the present. What do you think? Will offshoring engineering come back to haunt us?
About the Author:
Paul V. Kumler, P.E. is president of KTM Solutions, an engineering company that services the aerospace and large-scale manufacturing industries. In addition to aero structures engineering services, KTM Solutions designs and builds tooling supporting a broad clientele and various industries. The company is headquartered in Greer, South Carolina with remote offices in Charleston, South Carolina. Mr. Kumler serves in several volunteer roles including the SC Aerospace Advisory Board. Mr. Kumler, a professional engineer, is licensed in Louisiana, South Carolina, Texas and Washington. He is married to Ginger A. Kumler and has two grown children and two grand children.