This article was originally published in the Spring 2012 edition of OnAnalytics, published by the Institute for Business Analytics at Indiana University’s Kelley School of Business.
This article focuses on insights from Kyle Cattani, a professor in the department of Operations and Decision Technologies. Find more information about this research in the article, “Lowest Cost May Not Lower Total Cost: Using ‘Spackling’ to Smooth Mass-Customized Production“.
The past decade has witnessed a significant shift in manufacturing from the U.S. (and other western nations) to the Far East, in search of less-expensive, efficient manufacturing. For U.S. manufacturers that produce both make-to-order (MTO) and make-to-stock (MTS) items, a typical strategy might involve a (more expensive) flexible domestic factory creating the custom products and a (less expensive) overseas facility to make the standard variants. While this setup might intuitively appear to save money by minimizing the cost of the standard items, a more profitable approach for some companies might be to maximize use of the flexible domestic factory to also produce the standard items. By creating an analytical model and applying it to a real-world test case, the researchers show how some manufacturers can actually save money by foregoing offshore production in favor of an approach they refer to as “spackling,” wherein the flexible factory’s unused production capacity is filled in with production of standard-issue items. They also analyze a third strategy – “layered spackling” – that incorporates offshore production but also makes use of the flexible factory’s downtime between custom orders.
Statement of the Problem
For many companies that offer MTO products, customers’ expected turnaround time makes domestic production necessary, as shipping costs mitigate any labor savings achieved by sourcing products overseas. With MTS versions of these products, however, products are made in advance of purchase, allowing slower, low-cost shipping to preserve the cost savings of overseas labor. Thus the traditional approach for this type of company has been to maintain two facilities, each with a different focus: a flexible, domestic plant to produce MTO items and an efficient, overseas plant to produce standard items.
This “focus” strategy, however, has its own inefficiencies. One is the unused capacity of the flexible plant, which sits idle after or-ders are filled. Another is the cost of setting up two separate plants to manufacture the same products. A third risk associated with the efficient plant is of that of inventory (over- or underproduction), whereas the flexible plant could produce stock to order.
With this study, motivated by a scenario at a messenger-bag company, Timbuk2, the researchers set out to create an assessment tool that would help the company determine whether a second plant was needed and whether greater cost savings could be achieved by spackling production either with or without the use of offshore production. They applied the model to assess whether the San Francisco-based company would benefit from moving its MTS production overseas.
Data Sources Used
The data for the empirical analysis of the model came from Timbuk2’s financial records, which the company shared with the researchers.
The researchers constructed a stylized, single-period model of costs based on a fixed expense for plant capacity, variable production expenses, costs associated with underage and overage (where appropriate), costs of opening a second plant, and a “lost-focus premium” for operating a multipurpose plant in the case of spackling.
The optimal solution for the focus case appears as a closed-form (newsvendor) explicit function, while the optimal solutions for the spackling cases are implicit functions that are easily solved numerically. The resultant equations can be used to determine optimal capacities for standard and custom products for the focus, pure spackling, or layered spackling strategies and the corresponding expected costs. The expected costs for each strategy can then allow a comparison that reveals the lowest-cost strategy.
Using the data provided by Timbuk2, the researchers performed sensitivity analyses of the relative merits of each strategy by graph-ing the expected costs for each strategy versus each of the follow-ing: unit production cost, the effect of cost efficiencies from focus, the effect of the mix of custom and standard demand, and the effect of opening costs for the efficient facility. These plots allowed the researchers to determine the thresholds at which the different strategies would emerge as the most cost effective. They followed up with a sensitivity analysis of the identified custom-standard mix threshold to test whether the threshold was robust to unit costs, horizon lengths, and demand distributions.
The results of the Timbuk2 analysis revealed that with the then-current mix of custom and standard orders, layered spackling was the most cost-effective strategy so long as unit variable costs did not increase from their current level of $14 to more than $18.1Considering the fixed labor costs of production using flexible capacity, the focus strategy would be preferable to the layered spackling strategy only if the labor costs per unit was $3.50 or less, while the current rate was $6. Interestingly, the researchers found that an increase in custom demand, which Timbuk2 anticipated, could significantly shift the balance toward pure spackling. Layered spackling was optimal under the current mix of demand of 20% custom; however, a mix of 50% custom demand would make pure spackling most cost effective.
The sensitivity analysis revealed that the demand mix threshold was robust to the unit cost of efficient production and to the horizon length considered. The researchers note that the greater the fluctuation in custom demand, the more cost effective the pure spackling strategy becomes. Variability in standard demand, how-ever, causes only a slight increase in the threshold at which pure spackling surpasses layered spackling in cost effectiveness.
The Timbuk2 data indicates that if the company anticipates reaching 50% custom orders, cost savings may be best achieved by maintaining a pure spackling strategy rather than opening an efficient facility overseas. Even if custom demand does not reach these thresholds, at the current level of unit costs a layered-spackling strategy is preferable to a focus strategy that fails to take advantage of the “free flexible capacity” provided by the flexible factory’s downtime.
This analysis has important implications for companies that pro-duce both MTO and MTS products. The Timbuk2 case demon-strates that the traditional focus strategy of using a flexible domes-tic factory for custom products and an efficient overseas factory for standard products does not always result in cost savings. While the benefits of employing efficient (overseas) production are often visible and easy to calculate, a more in-depth analysis highlights some of the more subtle benefits arising from better coordination of use of efficient capacity in conjunction with flexible capacity. In other words, if unaware of the benefits of spackling, senior man-agement could be falsely attracted by a phantom savings of lower unit costs under efficient production, and unwisely choose a focus strategy with suboptimal results.
This study serves as an example of the benefits of using analytics to model projected expenses and guide sound business decisions. By systematically addressing a number of factors involved in operating a second facility, this model overturns some commonly held assumptions about the cost savings of moving production of standard items overseas.