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Low Labor Wage Issues in Moving Manufacturing Outside of America

26/10/2011

The low wages offered by many countries like China, Mexico, India and others are considered as one of the main reason for the decline of manufacturing in America. I agree that they do have a significant role to play in shifting manufacturing from America to many of these and other low wage countries. However, as discussed earlier this is not the only reason albeit a significant one. Lets take a closer look at these.

Many of my accounting friends may disagree but generally it is difficult to calculate the exact labor cost that goes into the manufacturing cost of a product for our discussion purposes. For example, do we include the cost of product designers and supply chain managers? To simplify the discussion let’s consider just the labor cost accrued within the four walls of a plant. This would include people working on receiving and shipping docks, on machines, testing, quality controls etc as well as the direct plant management like shift supervisers.

From the past experience, I have seen these costs range anywhere from 10% for a highly automated plants like chip making to 30% or so for a high manual content products like making a shirt or a shoe. of course the exact number varies with the products made, skill level of the work force involved, worker productivity and currency exchange rate among other things. For this discussion let’s assume that the range of 10-30% works for most of the products.

There are numerous organizations (like Bureau of Labor Statistics) who collect a lot of data and do a ton of analysis of various cost factors. You can draw a fairly decent picture of various cost scenarios. One thing is for certain that lower the skills required the lower the wages whether it is in US or in China or anywhere else. The salaries for unskilled factory workers could be as low as few hundred dollars per month in countries like India and China. The number is even lower in countries which are further down the economic developemnt ladder.

It is not uncommon to find a labor cost saving in the range of 75-90% for unskilled work force and 40-60% for skilled work force when compared to the salaries in US and other developed countries like Japan and Germany. This is a wide range but then we are talking in general range of numbers and not for a specific situation in a specific country.

So what is the potential for manufacturing cost saving by moving the manufacturing to a low wage location?

For a low complexity, high manual content product like garments, It is conceivable to achieve a manufacturing labor cost saving of approximately 25% (or more). For an average complexity, average manual content product like simple electronic products a saving of 15 to 25% is reasonably achieved. For highly complex, low manual operation manufacturing operations like IC chip the saving can at best be in single digits.

Once again these are fairly general numbers and for a specific product and a country and the manufacturing process involved they could vary tremendously. The numbers above are just what I have observed in the past.

As you can see that for many of the products just the saving in manufacturing labor cost may not be sufficient to move a plant away from US (or to loacte a new one). The risks and added supply chain costs may not justify such an action. There has to be more to this labor cost equation than just the savings from making the final product.

If you look at the savings on manufacturing cost recursively down the bill of material (or the components that make up the product), you can see that labor cost savings could accrue quite nicely if a company could source much of the needed components from the same general geography and reduce the cost of inbound logistics as well. For example consider you are assembling a computer in China, there is a potential for labor cost savings at the final assembly line. However, if you could also source the components like hard drives and mother boards which also have labor cost saving during their manufacturing (or assembly) step, the savings add up quickly.

So, I believe it is not the cost savings, in the manufacturing plant for the final product, alone but the accrued labor cost savings with sourcing and inbound logistics that matters. The total supply chain cost. This is one of the reason why we see many of the manufacturing plants move to China even though many other countries have much lower labor cost and are closer to us geographically.

It is the total manufacturing eco-system that matters!

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Intellectual Property Risks in Moving Manufacturing Outside of America

25/10/2011

This is probably the least understood risk that a manufacturing company faces when locating the plant, or outsourcing, outside of America. Most of the developing countries while boost many of the low wage benefits of locating the plant there also lack strong intellectual property laws. A manufacturer, who has achieved certain degree of sophistication in producing technologically complex products or manufacturing processes, this could be a substantial risk. Need less to say that these intellectual property risks do not apply to a manufacturer who is making technologically simple products or uses simple or well known manufacturing or supply chain processes.

This risk could stem from multiple sources. Some structural and some operational.

Consider a case where the country (you want to locate the plant to) requires joint-ownership with a local company. Irrespective of which company owns what percentage of the shares, a transfer of technology takes place naturally. In more cases than the other this technology transfer would be from US company to the local partner. In essence, you are creating your competitor. It may not be immediate but a strong possibility exists for that in future.

In another case, a competitor could easily break away your work force that you have trained and create a competing product. Often at a lower price point as they do not have to invest in R&D. This easily happens when the local laws may not as strong as at home. You may be thinking that people can easily copy the product anyway so what is the problem. Well, there is more than just the product design. It’s manufacturing processes, plant layout, organizational structure, quality control, supply chain know how etc. that would be hard to copy if the competition can not get hold of your trained work force.

It’s hard to avoid the loss of intellectual property when you are locating the plant in many of the low wage countries. You may none-the-less want to locate the plant there for other strategic reasons like capturing the local demand.

So, what can be done?

There are no 100% good strategies. However, you could take some precautionary measures like manufacturing only the products which are near the end of their technology life-cycle or shifting only a part of manufacturing and not the whole product or shift manufacturing for the products or components where you can leverage local technologies.

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Impediments to Manufacturing in America: Impact of Laws and Regulations

24/10/2011

This is a one sensitive topic. People have strong feelings on either side of the issues whether or not you believe in the regulations. I will try to stay clear of feeling based discussion and attempt to paint a picture of how manufacturing company CEOs look at the regulations and how it affects their decision to locate a plant.

There are many kind of laws and regulations that directly (and some indirectly) affect a manufacturing operations. It would be nearly impossible to look at all laws and regulations across various industries. That may take volumes of paper and ink. Let me focus on one of them as it relates to manufacturing – environment impacts.

Let’s take a slight diversion for the moment and consider why do these laws exist or created (and evolved) in the first place.

A company (manufacturing or otherwise) is focused on maximizing the shareholder return. They focus on obtaining their productive assets like plant at the least cost possible. Read lower fix cost or investment required. For ongoing cost (most variable) companies would love to minimize operating costs while maintaining (or even enhance) the productivity. This is the best scenario for a company.

What is this the best scenario for the society at large? It depends. It depends on the quality of life a society wants to have for its members or citizens. Given the difference in socio-economic condition of various societies (or countries in this case) they may put a different value on various constituent parts like economic growth, quality of environment, health and safety of its workers. Whether or not they get it right is a different question. And I am sure many societies do not (or at least not optimally).

Take for example, acceptable air quality may be different in different countries. The graph below shows the Carbon Dioxide emissions by country (Check out the complete table at Wikipedia). It is interesting to note that top 10 countries have a lion’s share of CO2 emission. Some more interesting analysis can be done here like CO2 emissions by GDP, population etc. But, that is for another day.

co2-by-country

The point to note is that the environmental concerns vary from one to another location. The cost for manufacturing a product could be different from one location to another. Similar arguments can be made for other environmental issues and issues like health and safety.

For some of the industries these differing costs present an arbitrage opportunity that may be significant. Which in turn may affect the decision of where to locate the manufacturing plant. I do not want to argue whether regulations are good or bad. When it comes to manufacturing companies they simply have a cost associated with them.

Societies have to strike a balance between what is good for them. Moreover, realize that everything changes and the policy makers have to continue to strike that elusive balance. One thing for sure that the lower the cost of regulations more a company is willing to locate the plant their all else being equal.

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Impediments to Manufacturing in America: Shifting Global Middle Class Consumption

23/10/2011

As we discussed earlier, the logistics cost (both inbound and outbound) plays a significant role in deciding where to locate a manufacturing plant. All else being equal, closer a plant is to the sources of both raw material and the customer the lower the total logistics cost. It may not always be possible to get both raw material and customers in same location. A trade-off between various supply chain costs gets into play.

A second issue related to servicing the customer is the level of service a manufacturer can provide. Think of delivery lead time, product availability (on shelf or warehouse), servicing the product and returns among others. If they can accomplish this with low inventory and personnel cost the better.

It would make sense that US manufacturers would be inclined to locate the plants closer to their customers. This is especially true if they can not leverage the natural competitive advantages of locating a plant in US.

So, has the global demand pattern changed in last few decades? If so, how? Is the demand more global today or less? How is it expected to change going forward?

These are some really hard questions. Depending upon how you look at the question the answers may be even more difficult. Predicting a global consumer base is somewhat easier than predicting the demand for cars say in Peru or Botswana. I came across a study by OECD on Emerging Middle Class in Developing Countries. Look at the growth of middle class consumption levels globally.

oecd-global-middle-class-consumption

As you can see from this graph, Asia is expected to grow significantly in middle class consumption. Hence, a natural next marketplace for US manufacturers. The same report also, predicts the spending level by various geographies.

spending-by-geographies

Once again, Asia Pacific region is expected to more than double in demand over coming two decades. A strong incentive for manufacturers to be in Asia Pacific region to effectively compete. Further more, India and China stand out as two countries with most growth in customer base.

Impact of Geographies

From a manufacturing company CEOs perspective Asia Pacific region is the next frontier. If they can manufacture the products in that region and serve the customer base effectively they have a winning strategy at hand. But can they? Do other supply chain factors support this strategy? The short answer is yes!

Many countries in Asia Pacific region boost low labor costs, low regulations, availability of raw material and components, reasonably trained work force, favorable currency exchange rates and business friendly government among other things. We can go through a detailed supply chain analysis but you can see that many of the factors are stacked in favor of locating the plant in Asia.

So, are we doomed when it comes to locating the plants in America? Not really. On a product-by-product basis it may still be profitable to manufacture in America and export to Asian countries. Technologically complex products that require highly skilled labor is a good example of such a situation. Can you imagine, swiss made mechanical watches, that sell for thousands of dollars, manufactured in China? Unlikely! However, supplying cotton shirts to India from US may not be such a good idea.

Then there are other regions of the world like South and Central America. Our own backyard, may be a ripe market for export of US made products in decades ahead.

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Why Do Companies Put A Manufacturing Plant Outside The USA?

22/10/2011

This is probably one of the most popular question in the mind of the millions. From policy makers, economists to factory workers who lost their jobs as the manufacturing plants move outside the US, everyone has an opinion. The popular sound bites tend to blame the cheap labor or the corporate greed or China.

Here, I want to present the equation that goes into a manufacturing company CEOs mind when thinking of where to locate the plant. The pros and cons of whether to locate it in US or locations beyond our borders. Remember the governing rule is maximizing shareholder returns.

The advantages of locating a plant in another country

The most obvious and most talked about advantage is a cheaper labor force. However, this is only one of the considerations. There are many situations when a company chooses to locate a plant outside of US even if the labor cost is higher. Think of the reverse case of foreign car companies producing cars here for example.

Let’s look at some of the key reasons for putting a plant beyond our borders.

Labor cost

This is one of the key advantages of locating a plant in geographies where the labor cost is substantially cheaper. The cost of labor is weighed against availability of skilled work force, productivity level and expected wage inflation among other factors. You may be surprised but the cost of some of the skilled (especially managerial) work force in developing countries could be competitive to wages in developed countries. Also, just because a country has large population does not mean that it may have qualified workers. Training cost could also be a deterrent except in case of products with high percentage of manual operations.

From my past experiences, a typical industrial product (or a component) may have labor cost as 15 to 30% of the total product cost. If a company could reduce the per unit labor cost from $60/hour to $15/hour; it stands to save approximately 75% on labor cost. In this example the total cost of product could approximately drop by 10% to 25%. A substantial saving especially as the amount of manual operations required to make the product increase.

Environmental regulations

This is a rather sensitive topic. Most manufacturing plants have environmental impact. Small or Large depends upon the type of product and the technologies used among other things. Consider for example making steel or cement, it has far more impact on environment than say making chips for your mouth or for your computer.

Not all countries have the same environmental laws. Many developing countries, at this point in their economic development stage, have (or have not come around to it) some what more lenient view of environmental impacts. This creates an arbitrage opportunity for companies.

By the way, It is not only limited to environmental regulations but to many other regulations like work place safety.

Proximity to customers

The closer you are to your customers the lower your outbound supply chain costs and higher the ability to react to fluctuating market demand. Given that in last 25 years or so many more people (India, China, Brazil, Russia…) have attained purchasing power it makes sense to locate a plant closer to them. Especially if you combine it with some of the other benefits.

Access to raw material/components

Just as we have raw material advantage in some cases, other countries have it in other cases. Moreover, many countries such as China have developed an eco-system where many of the components for making the finished products are available easily and cost effectively. This is one of the reason many of your electronic products are made in China or Taiwan.

The eco-system advantage can be developed (or enhanced) in US with a focused and conscious effort by policy makers.

Tax benefits

I referred to this briefly in my article on taxing the profits. Simply stated, more geographies a manufacturing company operates in more the opportunities for optimizing the overall tax burden. A company can choose to take part of the profit at different stages of production in different geography and lower the overall tax burden. This would be nearly impossible to achieve if all the operations of a company were located in one country with the demand also in the same country.

Note that companies, that export substantial amount their products, can also achieve better tax structure in the outbound supply chain even if the plant was located in US.

The disadvantages of locating a plant in another country

As they say there is always another side to the coin. Decision to locate a plant outside of US comes with its own set of risks and costs. A CEO has to balance these two not only for the initial location of the plant but for ongoing operations through out the life of the plant. After all, moving a running plant to different location is not a trivial task.

Here are some of the key factors that weigh against putting a plant outside of our borders.

Increased logistics cost

Moving a product across countries and oceans is far more expensive than moving the products across the state line. The cost quickly adds up if what you are moving is bulky or requires special handling like freezers. A perishable (limited shelf life) product adds its own set of complexity and logistics cost.

Another issue is the availability of shipping vessels. We all know that US imports lot more from China than exports. That means we have lot more vessels coming from China than going there. These ship owners have to recoup the cost some how. A wild guess would be shipping from China to US should be more expensive than the other way around.

Higher inventories

When a company manufactures products far away from the customer base, as in the case of locating a plant outside of US for fulfilling the domestic demand, the required inventory levels go up. Especially if you want to maintain your customer service levels. Two reasons for this;

  1. Longer lead (transportation) time,
  2. and bigger lot sizes.
After all you can’t afford to move a small quantity of product frequently in most cases. An interesting observation, my iMac seem to have come directly from Taiwan. One piece at a time. Oh well, for a high-value-low-density product and the presence of global logistics companies like UPS, DHL etc the inventory equation is getting redefined.

Currency risks

A typical manufacturing plant has a life span of 30 years or more. The currencies while on the other hand fluctuate minute by minute. Over a long period the effect of currency exchange rate could be devastating. Take a look at the change in Euro or Yen over last decade or so. Even Yuan is appreciating against dollar since last few years.

Currency risk is hard to predict. A company can at best create and evaluate scenarios and try to maintain a profitable operations over a wide range of exchange rates.

Management complexity

If you think that managing manufacturing operations in one location is hard think about adding a whole new set of headaches. From cultural issues to accounting to human resource policies to regulations, and the list goes on, it substantially increases the managerial efforts (read overhead costs). Add the time zone difference and travel requirements and the cost and time quickly adds up.

In conclusion

Decision to locate a manufacturing plant outside of US is not a trivial undertaking for any company. In the discussion above I have barely started to scratch the surface of the issues involved. The benefits must significantly outweigh the initial and ongoing costs with a significant margin for error. Hope, I managed to shed some light that it’s not just the cheap labor that matters in making the decision whether or not to locate the manufacturing plant in America.

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Manufacturing in America – Supply Chain Flows

20/10/2011

At the beginning of these articles on manufacturing in America, I presented a simple model of supply chain. It served it’s purpose for the last few articles but it’s now time to complicate things a bit. Let’s start adding various other flows to the model like information and financial. Also making the material flow bi-directional. After all when you return the sweater to the store that your aunt gave you for Christmas it triggers a flow of material in other direction. Here is a simple graphics depicting various supply chain flows:

supply-chain-flow

One of the flow that I have deliberately ignored is the “service.” This is not to say that the services are not important in a supply chain. They are. However, I think that many aspects of the “services” can be understood within the context of the decisions we make about strategic and operational issues in a supply chain.

You may be wondering why complicate the model. Well, as the discussion progresses we need something more to refer to. I will try to make this point more clear with the examples below.

Consider a manufacturer making and supplying widgets to 10 stores in the city. For the sake of simplicity let’s assume that the plant and warehouse are located in the same city. It is in the best interest of both the manufacturer and the stores to minimize the total inventory. This is the inventory in the warehouse, in-transit and in the stores. If the manufacturer has ongoing visibility into the selling pattern of the stores he can deploy advance inventory management techniques like “vendor managed” as opposed to sending a truck every other day to these stores only to be returned back as they did not sell enough in last few days. A good information flow paired with good supply chain decision making mechanism has tremendous potential to lower, for example, inventory levels across the chain. Thus the lower total cost and high availability of products on the shelf. Yes, there are free lunches in this world.

Further improvements can be achieved by combining the information flow with the financial flows. For example, efficiently managing the account receivables and payable with the 10 fictitious stores above. This reduces the capital requirement per unit of production (or sale) enhancing the ability of manufacturer to expand the business.

So, what happens when a manufacturer decides to locate the plant outside of US to satisfy the domestic demand. A company may achieve lower labor cost (to be discussed later in a separate article) but various supply chain costs go up. Consider our widget manufacturer above, now he has to import the widgets from say China. A long journey resulting in increased inbound transportation cost and higher inventory level. After all you can’t get a shipment everyday for most of the products. The advantages gained by an improved information flow are reduced and the cash-to-cash cycle now much longer.

In the coming articles I will discuss various trade-offs between material, information and financial flows in a supply chain with manufacturing in US and outside of US. In many situation you will see that the cost savings due to cheaper labor may not be sufficient to offset the supply chain savings by locating the plant in US. A further incentive for CEOs to evaluate their supply chain for potential for lowering the cost structure.

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