"We are now having offshoring discussions based on facts and figures, rather than on gut feel," says Dave Cooper, vice president of supply chain services for Solectron.

When Teradyne decided to move production of its J750 semiconductor tester to Shanghai, China, it wasn't going in cold. It had opened an office there in 2003 to support customers in the Far East.

The site initially housed applications engineering and sales for Teradyne's Connective Systems business. Six months later, the Semiconductor Test division began to ramp up production of the J750. That's when things got complicated. Instead of raking in labor-related savings, Teradyne was shelling out money to reposition its supply chain, move product more than 7,000 miles overseas, execute engineering change orders (ECOs), deal with value-added tax (VAT) bureaucracy and support the manufacturing effort from the United States.

"It wasn't an easy transition," says Scott Cameron, supply line manager for the Boston-based test equipment maker. "And it wasn't as if our other division had been there for years—it was maybe six months ahead of us. There was a very steep learning curve."

Teradyne wasn't the first, and won't be the last, electronics manufacturer to face such hurdles: The siren song of low-cost countries hasn't lost its allure. Supply chain consultancy Technology Forecasters Inc. (TFI) estimates that today more than one third of the world's outsourced electronics products are built in China. By 2007 that portion will increase to half. But recently TFI and other consultants have noticed a waning of interest in China. Two years ago, says TFI consultant Charlie Barnhart, "China was all anybody wanted to talk about." However, within the past six months, he says, interest has dropped precipitously. "Clients are still chasing lower costs, but they are willing to look at other alternatives, not just emerging locations but also ones that are already established."

Has the backlash over U.S. job losses changed corporate minds? Maybe, but that's not the reason some electronics companies are hesitating to move offshore. As it turns out, countries presumed to offer low-cost manufacturing aren't the bargain everybody thought they would be. Experience and cost modeling are illuminating the so-called hidden expenses of manufacturing overseas. "We are seeing companies take a more balanced business approach to China, rather than going there just because everybody else is," says Hal Sirkin, head of the operations practice of Boston Consulting Group (BCG). "We are now having offshoring discussions with our customers based on facts and figures, rather than on gut feel," says Dave Cooper, vice president of supply chain services for global electronics manufacturing services (EMS) provider Solectron.

Hidden costs can rapidly outweigh any labor savings. One Solectron customer saw its estimated offshore savings dwindle from $37.8 million to $7.6 million when accounting for extra carrying and ECO costs, missed sales, obsolescence, work in progress and travel to the Far East. This kind of analysis, as well as studies by TFI, BCG, McKinsey & Co. and others, contain cautionary messages for electronics manufacturers. First, ask why you are going overseas. Are real savings involved? Second, have you weighed those potential savings against complex logistics or the risk of losing your intellectual property? And finally, is your existing supply chain in order? Problems here will only be magnified if you move manufacturing overseas.

The big lure of China, of course, is the low cost of labor. But for many electronics products, labor is a very small fraction of the overall expense. On average, says Barnhart, materials account for 79 percent of the cost of manufacturing a printed circuit board assembly (PCBA)—labor and related overhead account for less than 10 percent. Electronics companies frequently underestimate the cost of managing materials flow in and out of China. "There really are no 'hidden' costs," he says, "but there are costs that just aren't well comprehended."

The potential for problems stems from as far back as the product's design. "You really can't just pick up a product that is designed in the U.S. and drop it into China," says Sirkin. If engineers in, say, Dallas spec in a part that can't be sourced in Shanghai, the supply chain can come to a complete standstill until a substitute part is found, purchase orders are processed and the substitute is delivered. New-product designs frequently run into such roadblocks.

One Solectron customer decided to move the manufacture of a relatively new product to Asia, against its EMS partner's recommendation. "The reason it didn't work is that there were a lot of engineering change orders to this product. But engineering was awake in the U.S. when manufacturing was asleep on the other side of the world, and vice versa," says Cooper, so communication regarding the changes slowed down, triggering a delay in the product introduction.

In cases such as this, companies can incur a lot of man-hour and travel expenses. If someone has to be dispatched to Asia to deal with an ECO, the average stay is a week, says Barnhart. "Depending on where you are, you can do Mexico in a day or two, but you really can't do China in a couple of days." But U.S.-based support isn't cheap either. "Your people typically don't switch their work schedule to coincide with Asian time—they work their regular workday plus whatever it takes to support Asia," says Teradyne's Cameron.

That problem is unlikely to abate soon. China currently has a shortage of the kind of experienced labor that ECO support needs, says Sirkin. "The optimum employee is a Chinese person who has worked in a Western company and understands Western culture—and there is a limited pool of that talent," he says.

But lead times are the industry's biggest problem, because missing a market window in the rapidly changing consumer electronics arena, for example, affects both revenues and reputation. "Long lead times stand out in the high-tech electronics industry, where the need to send products by sea can translate into price declines of 2 to 6 percent," says a McKinsey report. "That's a harsh penalty to pay, since almost every product now requires just hours or minutes to make." Then there are the missed market opportunities: One OEM racked up $16.1 million in lost sales under Solectron's offshoring scenario (see "A Tale of Two Strategies," below), because its product didn't reach the customer market in time.

Being on the ground in China has its challenges as well, whether they relate to logistics, the legendary Chinese bureaucracy, pricing or quality control. Some examples:

Infrastructure. The complexity of moving products in and out of China, as well as within the country, has been an eye-opener for electronics OEMs. "One of the biggest mistakes companies make is assuming that they can easily move things around inside the country," says Sirkin. "That is not true—the infrastructure is not that good," he adds, citing both asphalt and electricity as problem areas.

Companies, he says, tend to underestimate the amount and quality of the infrastructure required to run a high-volume supply chain on a day-to-daybasis. Smoothing out delivery or customs issues begins to add costs that may need to be passed on to the end customer.

Bureaucracy. Some costs are tied to China's daunting bureaucracy. For example, says Teradyne's Cameron, imported components may have to clear several layers of customs before even getting near a factory. "In general," he says, "nothing is seamless. You may think that something clears customs in Beijing and you are all set. Wrong. It then has to clear customs within a province." Both customs bodies, he says, may have separate requirements and paperwork. The company has to allocate manpower just to deal with the bureaucracy.

"We are now having offshoring discussions with our customers based on facts and figures, rather than on gut feel."—Dave Cooper, Solectron

Another black hole for manpower is China's value-added tax (VAT), which is comparable to a sales tax in the United States. Under certain circumstances, that tax can be recouped—after hours and hours of paperwork, says Cameron. Manpower and record keeping, he says, can add up to a lot of money. He cites one EMS company that maintains a staff of 20 people in China just to handle the logistics and paperwork required to move components around within the country.

Pricing. Buying components from indigenous Chinese companies can circumvent the customs problems, only to create others. Even with local sourcing, says TFI's Barnhart, component prices are not the same for all customers. "Chinese suppliers want to work only with the big, name-brand foreign OEMs," says Barnhart. "If you have a two- or three-letter ticker symbol on the NYSE, you can get incredible pricing. If you are on the NASDAQ, you might not." The most advantageous pricing, he adds, goes to indigenous Chinese OEMs.

Quality. Foreign companies should conduct very rigorous checks with indigenous suppliers, Barnhart adds. The cost of poor quality is magnified in the offshore supply chain. The problems are not always due to faulty components and shoddy workmanship—in fact, BCG's Sirkin warns against assumptions that foreign quality is bad. But a single defect can create a domino effect. Let's say a batch of boards is manufactured in China and sent to the United States. A manufacturing defect is discovered, and someone is dispatched back to Asia to find and fix the problem. In the meantime, additional batches of product have been shipped and yet other batches are still on the manufacturing line. Barnhart says this long cycle time has driven defect rates sky-high. "The first-pass failure rate of products coming out of China is more than 3 percent," says Barnhart. "In the rest of the industry, it is something like half a percent. Although that 3 percent may sound small, it is almost an order of magnitude higher than what people are used to seeing."

Businesses should do some soul-searching before moving offshore, experts say. "You really need to decide upfront where the real value of offshoring is," says Sirkin. "It can be a bad choice when your decision doesn't take into account the complications and wrinkles." First, he says, identify the issues you consider to be high-risk—delivery execution, intellectual property or materials management. Risk assessments should also include the loss of cost-competitiveness if your company does not manufacture overseas. Philips Electronics, for example, manufactures its most cost-sensitive products in China. "With these products, if we are a few cents higher than a competing bid, we can lose the business," says Robert Sayre, Philips' outsourcing manager.

If you choose to manufacture offshore, consider carefully which products to send. What part of the lifecycle is your product in? New products tend to need a lot of fine-tuning and support, and you may want your factory nearby. Solectron recommended Mexico over Asia to one customer, even though production costs in Mexico are slightly higher. "The difference was something like 6 percent," says Cooper, "but the customer's headquarters and engineering team were on the East Coast. For what it would be saving, having to send employees to Asia might not have been worth it."

Products, suggests Sirkin, should be reengineered to suit their manufacturing location. This may require simplifying them so they can be produced with more-manual operations—to take advantage of low labor costs—or changing the materials specifications so that local sources can be used. They should also be designed with IP protection in mind. One company, he says, moved everything to China except for one critical part. "The way that part was manufactured was the differentiator." Although it cost more to do so, the company maintained the production of that part in France and then shipped the device to China for final installation.

Manufacturing in Asia works best for mature products with stable, predictable demand. "If you manufacture in China and your market is North America, you are talking a three-week supply chain at least," says Sayre. "The products we make in China have a low variation in demand—they are stable—and we don't have to carry a lot of inventory there to meet sudden spikes." He also leans toward products that can source the bulk of materials locally and don't need a lot of engineering changes.

Ultimately, experts say, success depends on the right mix of products and process. When possible, source materials locally and keep the manufacturing process simple. Glitches in the supply chain are only exacerbated when your production is 7,000 miles away.

"When I hear about bad experiences overseas, I sometimes have to say, 'What did you expect?" says Barnhart. "You can't forecast on Tuesday what you want on Thursday, you build 400 different assemblies and need 87 engineering changes and you already have a contract manufacturer around the corner that can't deal with these issues. What makes you think somebody who is going to bed when you are getting up will do any better?"

Have you conisidered China and then backed away? Tell us why at feedback@eb.reedbusiness.com .

Barbara Jorgensen writes Electronic Business' monthly Supply Chain Management column but has trouble matching her family's grocery supply with demand.