Outsourcing in Supply Chains Under Exchange Rate Risk and Competition

Offshore outsourcing refers to the practice of procuring goods or services from outside foreign suppliers rather than producing them in-house. Since outsourcing manufacturing to lower-wage countries generally reduces production costs it has been growing rapidly in the past decade. From 2000 to 2007, 70 percent of U.S. non-oil import growth was driven by imports from developing countries with imports from China alone accounting for 39 percent of the growth.

However, although offshore outsourcing can provide significant cost reduction opportunities, it also exposes supply chain firms to various risks including: foreign exchange risk, production disruption risk, quality risk, supplier default risk, etc.

Among these risks, foreign exchange risk is consistently considered to be on the list of top concerns of supply chain executives! A study by The Economist, which surveyed 500 global company executives with responsibility for risk management, showed that, in 2009, exchange rate uncertainty was ranked as the second most important risk factor next to demand uncertainty due to the economic recession. In addition, the executives ranked foreign exchange risk as their number one concern for the subsequent twelve months. In 2010, the high volatility of the euro and possible appreciation of the Chinese yuan have posed significant risks to many companies involved in offshore outsourcing and global trades.

In a recent study, completed with Professor Zugang Liu, we quantified the impact of foreign exchange rate uncertainty and competition intensity on supply chain firms who are involved in
offshore outsourcing activities. In particular, the computer-based, analytical model that we developed considers firms' decision-making regarding pricing, material procurement, offshore-outsourcing, transportation, and in-house production under competition and foreign exchange rate uncertainty. Our model allows firms to have different attitudes toward risk. Through a series of simulation examples, we were able to answer imortant questions regarding supply chain firms' pricing and outsourcing decisions, and the associated profits and risks.

The simulation results indicate that, in general, the risk-averse firm has lower profitability and lower risk than the risk-neutral firm. When the competition intensity increases, the exchange rate risks of both risk-neutral and risk-averse firms will increase, which is consistent with recent empirical findings; the profit of the risk-averse firm will always decrease; and the profits of the risk-neutral firm will decrease if exchange rate uncertainty is relatively low and will increase if exchange rate uncertainty is high.

On the other hand, when exchange rate volatility increases, the average profit of the risk-neutral firm will first increase and then become stable while the profits of risk-averse firms will always decrease. As exchange rate variability increases, the risk of the risk-neutral firm will always increase, and the risk of the risk-averse firm will increase when the firm increase prices to compensate the risks, and will decrease if the firm switches from outsourcing to in-house production.

Moreover, as the exchange rate variability becomes higher the risk-averse firm will reduce its outsourcing activities while the risk-neutral firm may increase its outsourcing activities. These results explain the phenomenon regarding how exchange rate uncertainty affects imports of developed countries.

The results in our study provide timely managerial insights for supply chain decision-makers involved in offshore outsourcing and in this highly competitive economic climate:

1. Supply chain managers should first evaluate the risk tolerance level of the firm. If the firm is more concerned about risk, it should try to differentiate its products from that of its competitors since intense competition will both reduce profitability and increase the risk.

2. They should also maintain certain in-house production capacity for operational hedging purposes when the exchange rate uncertainty is high.

3. For the firms that are not sensitive to risk, high exchange rate uncertainty may provide an opportunity for them to get an edge on the competition with more risk-averse firms. For example, when the exchange rate variability is relatively high they should expand their outsourcing operations in order to gain more market share from more risk-sensitive competitors which may help them increase average profits. However, the firms that exploit these opportunities should understand that such strategies can also cause significant risk and loss.

More background, information, and data, along with the model and computational procedure, which was utilized for the simulation examples, can be found in our paper, "Supply Chain Outsourcing Under Exchange Rate Risk and Competition," by Zugang Liu and Anna Nagurney.