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.

There are 2 comments in this article:

  1. 25/10/2011Ben Benjabutr says:

    Hi, I’m Ben from Supply Chain Operations. I believe you add one of my articles to various categories in Business Exchange. I’m glad you find it useful and thanks a lot for passing it around!

    I’m seen lots of retailers in UK switching from overseas sourcing to local sourcing. The reason is that economy is still not very good and demand fluctuation is pretty high. Local sourcing can cope with thing like this better than overseas sourcing.

  2. 9/12/2014Intellectual Property Risks in Moving Manufacturing Outside of America - Mani Agrawal says:

    […] 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 […]

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