4.1 Kiwi Medical Devices Ltd.: Is "Right Shoring" the Right Response?

Exhausted, Michelle Ledger leaned against the “Stop” sign, stretching out her burning calve muscles. She had just finished a 90-minute, 20-kilometer run. Amazingly, she wasn’t even training for a marathon. Rather, she was burning off anxiety. Every time pressure at work ratcheted up, she turned to her favorite pastime—long-distance running. Somehow, running along Waitemata Harbour and looking to the Waitekere Range calmed her inner worries as she focused on the task du jour at work. As she began her cool-down routine, Michelle reflected on the events of the past few months.

At the forefront of her thoughts was the morning’s executive steering committee meeting. It had not gone well. Timothy Craig, CEO of Kiwi Medical Devices Ltd., had pressed Michelle for a solution to Kiwi’s eroding market share. Michelle hated having to say, “I don’t know,” but she didn’t have an answer. Worse, she had to admit she wasn’t sure when she would know. Kiwi had never “offshored” and the complexity and nuance of the analysis was daunting. Yet, despite the angst caused by Tim’s repeated, intense questioning, Michelle was certain that a wrong decision made in haste would cost far more than the uneasiness of the moment.

As Director of Operations at Kiwi, Michelle had been tasked with increasing Kiwi’s manufacturing capacity and competitive capabilities. The need to evaluate offshoring was raised by a recent market analysis, which revealed that although Kiwi retained an innovation edge over aggressive global rivals, it had lost cost and delivery advantages. As a result, competitors were taking share in markets around the world. By setting up production operations in Asia, competitors had lowered their cost structures, changing the rules of the competitive race. Michelle and her team needed to respond—and quickly. Although confident her team could help Kiwi regain its leadership position, Michelle wasn’t quite sure how Kiwi could best restructure its global operations to gain advantage.

Kiwi Medical was born in the late 1960s. The offspring of Kiwi Design & Electronics, a high-end, innovation-driven manufacturer of household appliances, Kiwi Medical came into existence as a hedge against a highly volatile appliance market. Kiwi Design had sought to find a counter-cyclical market where it could leverage its technological expertise. Heated humidification devices used in respiratory and sleep apnea applications seemed to offer a good fit from at least three perspectives.

1. The industry was underdeveloped and lacked entrenched competitors.

2. Kiwi’s technology and R&D expertise gave it a strong foundation that could be used to transform the industry and establish Kiwi as a world leader.

3. The medical device industry had strong global growth potential.

Following 30 years of solid growth and good financial performance, Kiwi Medical was spun off as an independent company in 2001 with its headquarters and manufacturing in Auckland, New Zealand.

By 2009, Kiwi Medical’s global sales had reached NZ$398 (its market capitalization was approximately NZ$1.5 billion). Kiwi sold to hospitals, long-term care facilities, and home healthcare dealers in over 120 countries worldwide. Its core products included respiratory humidifiers and neonatal care products including infant warmers and resuscitators. Kiwi had also developed a strong presence in the obstructive sleep apnea (OSA) market with a focus on continuous positive airway pressure (CPAP) therapy devices. Kiwi also manufactured and distributed the accessories needed to effectively deploy its equipment (e.g., single-use and reusable chambers as well as breathing circuits). See Figure 1 for a breakdown of sales by product group.

From 2005 to 2009, sales had grown at a solid, if not spectacular, pace of 9.5% per year (see Table 1). Kiwi attributed the sales growth to its intense focus on technological innovation and a relentless quest to expand its global market presence.

1. Product Innovation. Kiwi was dedicated to improving existing products as well as developing innovative, complementary product offerings. Indeed, a continued commitment to research and development enabled Kiwi to target new medical applications for its core technologies. From 2005 to 2009, Kiwi spent an average 6.3% of sales on product development and clinical research. By 2009, its research team of engineers, scientists, and physiologists had grown to 253 people. In 2009 alone, Kiwi had obtained 371 patents in markets around the world (79 in the US). An additional 365 patent applications had been filed (73 in the US).

2. Global Market Development. Kiwi’s largest market was North America, however, Kiwi had a very strong presence in both Asia and Europe (see Figure 2). To support its aggressive marketing initiatives, Kiwi had developed a 493-person sales, marketing, and distribution team. Direct sales offices had been established in Australia, China, the Euro zone, India, New Zealand, Scandinavia, the UK, and the US. In addition, Kiwi had developed relationships with over 90 distributors worldwide. To help support continued market expansion, Kiwi opened two new distribution centers in Canada and Japan in 2009.

Even as Kiwi chased global sales, operating costs seemed to be racing out of control—they had increased 16% per year over the past five years. Kiwi had long been proud of its New Zealand heritage. Indeed, Kiwi touted, “We manufacture, assemble, and test our complete range of products, including many components, in our custom-built facilities in New Zealand with a total area of approximately 51,000 m2.” These facilities possessed advanced manufacturing technologies and had obtained highly visible ISO9001 and ISO13485 (the international medical device) quality certifications.

Although provincial, New Zealand-based manufacturing had provided Kiwi a relative cost advantage vis-à-vis its toughest rivals in Europe, Japan, and the US. However, now that rivals had globalized their production networks, Kiwi’s limited base of operations was becoming a liability.

By most measures, 2009 had been an outstanding year for Kiwi. Operating revenue was up 28% with both product groups—respiratory (34%) and OSA (23%)—delivering strong growth. Better yet, operating profit increased by a very healthy 76%. However, a very challenging 2008 coupled with the general upward trend in operating costs led Tim Craig and the executive steering committee to initiate an in-depth analysis of competitive and market trends.

Michelle had been a member of this scanning team. To her dismay, many of the findings—especially those related to Kiwi’s more mature products in the respiratory market—had led her back to her favorite running trail along Waitemata Harbour. Nonetheless, she kept a list of the most pertinent findings posted by her office door. She had highlighted the most distressing points in red. The list included the following items that would influence Kiwi’s long-term success in the respiratory market:

• The respiratory device market was a NZ$1.4 billion market. Global demand for respiratory care devices was expected to rise 3-5% annually for the next 20 years.

• Kiwi’s share of the respiratory market was had decreased from almost 25% to 17.5 percent in the past four years. Kiwi’s market share was falling by 2% per year!

• Kiwi’s traditional competitors were headquartered in Europe, Japan, and North America. Although their historical costs had exceeded Kiwi’s, four of Kiwi’s five largest rivals had shifted manufacturing to lower-cost sites in China, Vietnam, and Indonesia. As a result, these rivals now enjoyed a 10-15% price advantage for comparable respiratory devices.

• New low-cost, but less technologically sophisticated rivals had emerged in China. These rivals could not match Kiwi’s innovation, but they put tremendous pressure on Kiwi’s more mature product line. Of note, these Chinese rivals challenged Kiwi’s value proposition. Some customers had begun to ask a threatening question, “For some applications, how much price premium is state-of-the-art technology worth?”

• Real wages in New Zealand were rising faster than in most of Europe and North America. Collective bargaining units (unions) were gaining a foothold with Kiwi’s former parent company, Kiwi Design and Electronics.

• Kiwi Breathers (the name of Kiwi’s respiratory devices) were crated and shipped airfreight in lots of five on an EXW basis to customers outside New Zealand. Kiwi Although product could be delivered to 80% of Kiwi’s global customers within 5-7 days, customers were asking for even faster responsiveness. Many customers were now ordering competing devices from more geographically proximate rivals.

• Available airfreight capacity from New Zealand was dropping. Transportation costs from New Zealand were rising faster than from North America or Europe. (Were freight rates during the 2007 oil spike a harbinger?)

The competitive marketplace was clearly more hostile, and potentially volatile, than at any time in Michelle’s nine years with Kiwi. After taking a deep dive into the facts presented by the market study, Kiwi’s management determined that it needed to reduce operating expenses by at least 3% per year over the next 5 years while offering better—that is, faster, more robust—delivery. The goal was to reverse Kiwi’s market share slide and raise operating profit by 5-8% annually. Offshoring seemed to be the only possible response. As Michelle and her team began to explore this option, they identified three separate, but related questions that needed to be answered.

• Where was the right place to set up overseas manufacturing?

• How much investment and risk was Kiwi willing to incur as it set up overseas operations?

• How should Kiwi provide logistical support for its overseas operations?

For Michelle and her team, which had become known as the “right-sourcing” team, the natural starting point in the search for a right-sourcing location was to follow the competition to Asia. However, given Kiwi’s global sales platform and customers’ desire for responsive delivery, the team decided to add Slovakia, Poland, and Mexico to the initial set of possible host countries. As the right-sourcing team met to discuss options, they began to identify potential country selection criteria. From an initial list of over thirty criteria, the team settled on the following ten criteria that appeared to best delimit Kiwi’s needs.

1. Labor costs

2. Labor skill and experience

3. Transportation costs

4. Transportation lead times to/from the factory

5. Duty rates (for incoming raw materials as well as export of finished product)

6. Political stability/corruption

7. Local taxes

8. Unions, strike risk

9. Permits and factory setup cost

10. Management relocation expense, lifestyle, and safety.

As the right-sourcing team defined the critical criteria, several countries under consideration fell off the list, leaving the team with four finalists to evaluate more closely: China, Indonesia, Mexico, and Slovakia. To help make the final decision, the team assembled a fact sheet on each country (see Table 2).

Despite the methodical approach, different members of the team adopted advocacy roles for each of the countries. Some team members felt it would be foolish to allow competitors to operate in China unimpeded. They did not want to give rivals a first-mover’s advantage in developing the Chinese market. Others noted that Kiwi’s strength was leading-edge innovation. They felt being close to developed markets of Europe and the U.S. was pivotal. Michelle could understand both arguments and hoped that rigorous analysis would provide a tipping point that all of the team could rally around.

Of course, once a country was selected, Michelle knew it would be vital to select the right city. This, decision, however, was more important and challenging for China and Mexico. After all, the options in these two countries were both greater and more diverse. In both countries, the team noted that the most important differentiation was between long-established investment zones and interior cities. The advantage of classic investment centers like China’s Guangdong province and Mexico’s border cities of Tijuana and Juarez was simplified setup and logistics. By contrast, interior cities like Chongching and Saltillo offered lower wage rates, a more-abundant and stable workforce, and better tax incentives.

From the inception of the analysis, Michelle had recognized that neither she nor anyone else on the right-sourcing team had global manufacturing experience. Even so, Michelle was not so naïve to think business the New Zealand way could be easily transferred to one of the finalist countries. She realized that regardless of country choice, navigating the politics and managing the cultural differences in the country of choice would be a real challenge. This reality increased both Kiwi’s and Michelle’s risk of failure. No wonder she spent so much time running during the past three months.

Fortunately, as the team invested in the due-diligence process, they identified opportunities to minimize Kiwi’s exposure to the uncertainties of global operations. Most importantly, they realized that going global did not mean they had to go all in. Three options for expanding capacity and improving competitiveness existed: subcontracting, shelter operations, and a wholly owned subsidiary.

Subcontracting offered the easiest and the fastest way (often as little as 30 days) to get started. Subcontracting involved finding a local manufacturer of OEM electronics that could produce to Kiwi’s design specifications. Kiwi could thus minimize investment. Although Kiwi would have to provide the specialized equipment and arrange for delivery of needed components, it would have no bricks-and-mortar responsibilities. The subcontractor would manage manufacturing and provide logistics support. Two downsides worried Michelle. Kiwi would lose some control over the production process and thus product reliability. Further, she expected that unit costs would be higher under subcontracting.

The shelter option required more time to get going than subcontracting (around 60-90 days), but compared to a wholly owned subsidiary, shelters reduced the initial investment and mitigated the learning challenges associated with new setups. A “shelter” service provider would manage the hassles of getting the business up and running. In essence, Kiwi could maintain control of the production process and product technologies without getting bogged down in administrative and legal annoyances. As the team met with several shelter service providers, five caught their attention:

1. Assistance with accounting and tax services as well as obtaining licenses and permits.

2. Help with legal and fiscal representation in the host country.

3. Provision labor procurement and HR services, including payroll and performance monitoring.

4. Sharing of expertise regarding raw materials sourcing and vendor-managed warehousing.

5. Help with customs clearance and duty-rate analysis.

Wholly owned subsidiaries offered Kiwi maximum control and they often delivered the lowest operating cost structure, but they were know-how intensive and risky. If Kiwi pursued this course, the right-sourcing team would have to find a site, manage construction of the facility, and perform all of the administrative tasks performed by the shelter service providers. Understanding the details of doing business locally was a must. So too was developing needed political and business relationships. Ownership was the preferred option for companies 1) looking to make a long-term commitment, 2) seeking to establish large-scale operations, and 3) needing high levels of technological or new-product support. The key was achieving the long-term success needed to justify the up-front capital and emotional investments.

Even as the team began to develop the country-selection criteria, Michelle realized that right sourcing demanded more than just good manufacturing decisions. The fact that several of the criteria were transport oriented underscored the need to build the right logistics infrastructure to support the overseas operation. The good news: Kiwi had a lot of exporting experience. At least here, the team would not be running completely in the dark. Still, supporting a global manufacturing operation would be more complex than anything that Kiwi had done before.

Because of time pressures and the lack of direct experience, the team decided the best option would be to outsource the logistics support to a third-party logistics (3PL) company. Such a decision fit well with Kiwi’s past behavior. Senior management at Kiwi had always emphasized that Kiwi was an R&D and manufacturing company—not a logistics provider.

To prepare for effective outsourcing, the team mapped out the basic materials flows. Mapping revealed the need to find 3PLs that could handle three distinct types of logistics: 1) inbound movement of capital equipment, 2) inbound movement of raw materials and components, and 3) outbound movement of finished goods to customers around the world. A closer inspection of the materials flow map suggested that Kiwi should evaluate the 3PLs’ ability to set up and manage an inbound cross-dock warehouse. After all, regardless of country choice, Kiwi’s primary suppliers were geographically dispersed and would be shipping product into a port of entry—probably in less-than-container-load quantities. From a cost perspective, it might make sense to consolidate these shipments at the entry point and then ship them on a truckload basis to the new factory. Based on this analysis, the right-sourcing team developed a request for information (RFI) requesting the following:

1. pricing, capacity, and lead-time information for movement of raw materials from ten international suppliers to the appropriate port of entry for each of the four country finalists,

2. pricing and timing information for movement of capital equipment from five European suppliers to each proposed site option,

3. pricing for consolidation of inbound shipments at a cross-dock warehouse,

4. pricing, capacity, and lead-time information for appropriate ground transport from port of entry to actual manufacturing site,

5. pricing, capacity, and lead-time information for appropriate ground transport from factory to airport for export shipping,

6. pricing, capacity, and lead-time information for movement of finished product to international customers by either truck or air depending on customer location,

7. pricing information for preparing all paperwork (customs clearance as well as inspection of capital equipment and raw materials) on inbound shipments to the factory,

8. pricing information for all import/export documentation related to outbound shipments of finished goods (to include in-bond documents for international shipments).

The team had just sent out the RFIs a few days earlier. The three big logistics integrators—DHL, FedEx, and UPS—had been selected as potential support team leaders because they were viewed as capable of providing one-stop shopping for Kiwi’s global needs. Although DHL had been Kiwi’s sole global 3PL for its New Zealand import/export shipments for 20+ years, the team felt it was time to verify that DHL was still capable of providing Kiwi top-notch service at world-class prices.

In addition, tailored RFIs were sent to local freight forwarders in each country to assess their ability to provide ground transport, cross docking, and customs clearance/documentation services. Kiwi wanted to make sure that it built the right relationships to get things done on the ground. Sometimes this could be done best by a local player with “good” connections.

Having run through the day’s stress, Michelle finished her cool-down routine. Suddenly, she realized that until the detailed responses to the RFIs were returned, the team could do little more than wait. The rest of the homework had been done. The right-sourcing team was closer to making more progress than she had realized. Life was good after all.

Of course, Michelle knew that this was the lull before the storm. Once the information from the 3PLs came back, a decision would need to be made. Then the real work of execution would begin. Only then would they find out whether they had truly right sourced Kiwi’s mature products, reducing freight and manufacturing costs, shortening lead times, and increasing Kiwi’s geographic reach. If they had done their job well, Kiwi would have additional capacity at its New Zealand facility to design and build the new, more-technologically sophisticated products that were the lifeblood and future of Kiwi Medical Devices Ltd.

1. Which of the four finalist countries should Michelle and the right-sourcing team select for its new right-shore facility? Or should Kiwi stop, take a deep breath, and continue its New Zealand-centric manufacturing model. Hint: a weighted-factor model might provide insight into a good choice.

2. Given Kiwi’s competitive challenge and its strategic goals, would you suggest a port-of-entry or an interior city for the new manufacturing facility? What specific factors drove your decision?

3. Which mode of entry/operation—subcontracting, shelter, or wholly owned subsidiary—would you recommend? What factors should really drive this decision?

4. What do you think of Kiwi’s decision to invite new players to bid for the logistics support business associated with the right-shore operation?