Rethinking the Value of Emerging Markets

The Hidden Costs of Outsourcing to Emerging Markets

As global companies tap manufacturers and suppliers in emerging markets to save money on making their products, they often aren’t taking into account the hidden costs of stretching their supply chain to immature economies. Problems can crop up when companies outsource production to far-off places without on-the-ground supervision. Outsourcing to emerging markets contributes to product recalls and poor inventory performance, finds recent research, but setting up shop in those markets helps reduce those problems.

Adams B. Steven, an assistant professor of logistics, business and public policy at the University of Maryland’s Robert H. Smith School of Business, worked with Rodrigo Britto of the Universidad de los Andes School of Management in Columbia to look at data from large public firms in the U.S. manufacturing sector from 2011 and 2012. The pair studied how entering an emerging market impacts a company’s inventory and product recalls. The researchers looked at how these things are impacted based on whether a company establishes a presence in an emerging market, outsources production there, or starts selling in emerging markets.

The research reveals that problems with inventory and quality are less prevalent when a company actually moves its operations to an emerging market. The results suggest that maintaining a physical presence in an emerging market — either through direct investment in the market or other vertical integration strategies — brings the best bang for the buck to a firm, which can reap the benefits of low production costs while keeping a close eye on quality.

The researchers find that outsourcing production to suppliers in emerging markets results in more product recalls, costing firms not just money spent on the recall process, but also the hit to future sales a brand often suffers after a recall. The findings also show that all emerging markets are not equal: Outsourcing to countries with weak legal and institutional infrastructures, where contract and quality enforcement is often lax, is much more likely to result in a recall. The researchers suggest companies should source from emerging markets, or specific regions within them, with the best infrastructures. Better yet, they find if a company sets up an outpost in emerging market, their control on the ground pays off, resulting in fewer recalls and inventory problems.

The researchers also looked at how cheaper manufacturing in emerging markets can boost a firm’s inventory stockpiles, but not necessarily to the benefit of their bottom line. Holding less in inventory can free up funds that a firm can then put to better use, ultimately improving profitability for the firm. The researchers found that having a lot of finished goods in inventory increased the frequency of recalls.

Read more: Emerging Market Presence, Inventory, and Product Recall Linkages is featured in the Journal of Operations Management.