Manufacturing in the US has changed dramatically over the past few decades. Part of this change includes an exodus of manufacturing to countries featuring both lower labor rates and fewer restrictive demands on work environment and employee benefits. While recently there has been a resurgence of manufacturing in the US, many companies still view overseas manufacturing beneficial to compete in the global market.
Today’s expanded global economy utilizes improved communication technologies making it easy to do business with companies across the globe. The global economy mandates a product made in Asia has to be competitive in the US and vice versa.
Some of the changes in manufacturing strategies have been described by reduction of labor cost and overhead through outsourcing, concentration on core competency, management in supply chain of materials, transition to lean manufacturing methods, establishment of cellular manufacturing cells, etc. Despite the fact that US labor rates and overhead rates are still greater than many countries, the question is whether or not this outsourcing strategy is the best option today; the dynamics of the global economy has changed and tradeoffs do indeed exist. Vertical integration, and other simple strategies, can play a key role in being competitive in a global market.
While vertical integration is the subject of this article, it cannot be discussed without the understanding of manufacturing processes. These processes can be broken into two groups: lean manufacturing and batch system manufacturing. The pros and cons of these manufacturing methods will be discussed.
Three primary factors affect the cost of producing goods: labor, materials, and overhead. The cost of labor varies throughout different parts of the world and in the US; related, is the material supply chain and overhead to support production of these goods. Having a low-cost source of labor is usually associated with having a low-cost source of materials. Material suppliers can supply goods and services easily when their customers are local to the prime manufacturer. Overhead can be burdensome for the US manufacturer trying to manage overseas production; however, this constraint is countered by less restrictive compliance to manufacturing regulations.
The manufacturing exodus was stimulated by the financial metric of quarterly profits, simply put: a company is considered doing well when the quarterly profits are up and is considered doing poorly when the quarterly profits are down. Investments to improve production processes often take more than one quarter to achieve any return on investment (ROI) giving poor motivation to make any investment at all. Outsourcing supporting operations, or focus on core competencies, overcomes this constraint. Reducing internal labor and minimizing the need for investment can appear very attractive especially if the metric and window of opportunity are measured within a quarter time frame.
Lean manufacturing methods evolved to show profitability quicker, with less inventory, and with less manufacturing goods in process. Lean manufacturing entails making each good in an uninterrupted flow, rather than as part of unfinished batches. The objective is to produce goods only what a customer orders and to reduce investment in inventory. There are many definitions and levels to lean manufacturing, but in principal, the goal is to eliminate waste – wherever it may be in the manufacturing process. If there is a step in the manufacturing process that creates waste, the goal is to identify the problem and find ameliorate measures.
One step of the manufacturing process is the movement of materials. Cellular manufacturing methods, based upon the principles of group technology, takes advantage of the similarity between parts through standardization and common processing. Manufacturing production cells surround inventory and production equipment around the work area to minimize material flow. This reduces the distance traveled by materials, inventory, and cumulative lead times.
How much inventory a manufacture carries is dependent on the business model. Purchasing materials for manufacturing, eliminating the step of inventorying for future manufacturing, is titled Just-In-Time (JIT) for manufacturing. The principal of JIT is a subset and further refinement of Lean Manufacturing.
Batch process manufacturing predates lean manufacturing with its goals being based more on minimizing labor in the manufacturing process rather than optimization of inventory, goods in process, and physical plant layouts. Manufacturing products using a batch process optimizes the use of tooling and reduces the learning curve in that particular manufacturing step. Successfully implemented, a production worker uses a particular tool or performs an activity as many times as possible before changing the manufacturing task. When compared to manufacturing cells, there may be more manufacturing goods in process resulting in more inventory required to produce a given product. While there might be more waste of work in process and inventory carried, it does allow better optimization of the flow of manufactured goods from a labor perspective.
Batch process manufacturing is not a natural way to perform assembly and requires considerable training to perfect. The reduction in manufacturing times can be tremendous because the operator does not have to frequently switch tooling and constantly learn new manufacturing steps.
In a global market, where labor and overhead is the weak link in the manufacturing process, optimizing labor resources can be the key to making products more profitable.
Broadening the manufacturing base to ancillary processes, or manufacturing goods outside core competencies, can have multiple benefits. The concept is not new and can be challenging to implement, but the benefits can be rewarding. Besides the obvious benefit of capitalizing on the profits from outsourced manufacturers and obtaining better control of the supply chain, manufacturing ancillary goods broadens the understanding of how that good should be manufactured. Without such knowledge, costs are passed along to the primary manufacturer without understanding ways for improvement.
Taking on the challenge of manufacturing ancillary goods is often associated with lower initial yields, which contradicts lean manufacturing principals, but if there is persistence to address and overcome issues and willingness to continue to make improvements, it is possible to manufacture ancillary goods just as well as an outsourced supplier. The long term benefit, besides cost, is enabling improvements in design through understanding, control over the end product, reduced administration costs of supply chain management, and reduced shipping costs. Vertical integration can fall within the principals of lean manufacturing as long as there is an understanding that the path to success may take a little longer.
Selection of ancillary products is an important business decision. If the ancillary product is labor intensive and “cannot” be tooled with machinery, most likely, that ancillary product will be a poor target for vertical integration. The tradeoff between outsourced profit margins versus internal cost of labor, overhead, and investment should be the deciding factor. A 12 to 18-month period for ROI is a good figure-of-merit.
Executing a plan for vertical integration can be difficult when quarterly profits are the key metric for profitability and defining a successful company. Smart investment in tooling, training, and inventory are all required to succeed at this endeavor. A focus on JIT manufacturing methods can hinder successful implementation of vertical integration because manufacturing is broken into more fundamental components. Surrounding a manufacturing cell with materials is often not possible when goods must be manufactured using very different processes.
Vertical integration requires smart investment in inventory. Outsourced manufacturers generally purchase inventory to support current orders. While agreements can be made to divide inventory between multiple production orders, such as holding inventory between different customers and/or over future orders, these business arrangements can be overly burdensome to the outsourced manufacturer. Agreement to purchase materials, staged for future production based on market projections, can be accomplished usually at the risk to the primary manufacturing. In doing so, materials can be blanket ordered taking advantage of volume pricing, reduced administration cost, and reduced shipping cost. Vertical integration takes advantage of better inventory purchasing, but in general requires larger inventory levels. Inventory in a vertically integration operation consists more of unfinished goods rather than partially or fully completed goods.
To illustrate the benefits of vertical integration, the author would like to express his experience with just one of many steps taken to vertically integrate manufacturing processes in his company Magna-Power Electronics.
Magna-Power Electronics manufactures large DC power supplies. Most manufacturers in this industry outsource most of the product’s components and perform final product assembly utilizing these components. The basic components consist of metal products, electronic printed circuit board assemblies, switchgear, power electronic assemblies, wire harnesses, and magnetic components. Typically, manufacturing cells are created by surrounding these purchased components in a work area to assemble a final product. One component, heat sinks, is used in virtually every assembly. Heat sinks, which provide thermal management for power semiconductors, are one of the more expensive components used in the product and one that was found difficult in manage in the supply chain. After numerous and various procurement problems, these components were chosen as the target for vertical integration
Extrusions, aluminum sheets, metal shears, and a computer numerical control (CNC) milling machine were purchased to initiate the manufacturing process. Over the course of a year, the volume of outsourced heat sinks decreased and the volume of internally manufactured heat sinks increased. The cost of heat sinks used in the vertically integrated product decreased by a factor of five after one year.
Being more competitive in a global market, sales increased along with the need for more manufactured goods. Understanding of heat sink technology enabled expansion of the product line with better thermal management, lowered manufacturing costs, allowed for product improvements, and improved control of previous outsourced heat sink components. Today, the company has six high-speed CNC machines and other cost reducing equipment to manufacture heat sinks with the highest quality. Reinvesting profits from heat sink manufacturing, the business model for vertically integration was later expanded to nearly all manufacturing operations in the company.
While there are compelling arguments for vertical integration and the return to batch system manufacturing methods, the major drawback is the metric of profitability over a quarter period. Privately held companies can easily get past this point, but larger corporations with numerous investors, concerned with growth and short term profitability, are constrained by this metric. Expanding the vision to longer term ROI, accepting lower yields during the learning phase, and making a commitment to overcoming obstacles are the ingredients for increasing levels of vertical integration and lowering long term US manufacturing costs.
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