Global cost structures have manufacturers reevaluating outsourcing phenomenon.
By Eric Kulisch
Low labor and overhead costs were primary drivers for outsourcing much of U.S. manufacturing to China during the past 25 years, a development that accelerated with China’s accession to the World Trade Organization in 2001. But changes in global economics and new, sophisticated business tools for analyzing the complexities of international trade have led a growing number of companies to pull up stakes and open plants in other countries.
They realized, upon closer scrutiny, that cheaper labor was often canceled out by logistics costs, risks and operating inefficiencies.
What started as a trickle in 2008 amidst the uncertainty of the global recession, when oil prices shot up to $148 a barrel and significantly increased the cost of shipping goods, has become a steady stream of firms seeking to maintain low-cost production, increase quality control, diversify supply or speed up time to market by switching facilities to Mexico, Central America and South America — a process commonly referred to as “near-shoring.” In many instances, companies are even reopening factories in the United States.
At the same time, domestic manufacturers are being wooed by the Obama administration, which has made restoring the manufacturing sector a centerpiece of its economic and jobs policy.
Others are migrating within Asia to places like Cambodia, Sri Lanka, and Vietnam, or even to low-cost provinces in China’s interior.
More than a third of U.S. manufacturing companies with sales greater than $1 billion are planning to relocate production facilities to the United States from China or are considering it, according to a new survey of 106 executives by The Boston Consulting Group (BCG).
The response rate rose to 48 percent among executives at companies with $10 billion or more in revenues.
Alix Partners, a management consulting and corporate turnaround firm, in May released a survey in which almost half of the 116 senior manufacturing executives said their companies are considering near-shoring opportunities. Of those, about 35 percent will have completed or are in the process of moving production closer to home this year.
Another 15 percent said they will consider regional locations for production within the next year and 36 percent said they will do so within two to three years.
Analysts say there is growing evidence of manufacturers, including those from China, setting up shop in the Western Hemisphere in an effort to shorten the supply chain between the factory and U.S. consumer market. Fashion companies are among those sourcing more from Latin America, in large part so they can react more swiftly to changes in seasonal demand and end up with less obsolete merchandise. The shift in logistics patterns has implications for many foreign and U.S. ports, especially those in the U.S. South Atlantic and Gulf that originally anticipated hosting giant container vessels from Asia loaded with thousands of containers.
Some of that business might now come via smaller vessels that ply the inter-America trade lanes hauling containers with local products as well and those from Asia that are dropped off at transshipment hubs like Kingston, Jamaica; Freeport, Bahamas; and Caucedo, Dominican Republic, they say.
“We believe near-shoring/re-shoring/on-shoring trends are real and should limit growth in trans-Pacific container trade,” David Ross, transportation industry analyst with St. Louis investment bank Stifel, Nicolaus, wrote in a message to clients about the first quarter earnings of Expeditors, a major U.S. freight forwarder.
Fuel prices are still influencing companies to return production to the Americas, as well as the Caribbean. Meanwhile, rampant wage inflation in China and other countries is undercutting the original rationale for moving production offshore. And the depreciation of the U.S. dollar vis-à-vis other currencies, coupled with the wage differential with Western Europe, is so significant that many foreign companies now consider the United States a low-cost manufacturing center and are using it as an export platform.
|Sources: U.S. Department of Transportation, U.S. Census Bureau, U.S. Bureau of Economic Analysis, BCG analysis.|
Last year, the cost gap between manufacturing in the United States and a dozen other low-cost countries narrowed for the first time since 2007, according to a December study by Alix Partners. Its Outsourcing Cost Index showed that Vietnam, Russia and India have surpassed China in terms of cost-effectiveness.
Other factors causing firms to reevaluate the geographic spread of their supply chains include:
- Transportation rate volatility.
- The steady appreciation of the Chinese yuan.
- Changes in China’s value-added tax policy.
- Rising raw materials prices.
- Supply chain bottlenecks.
- The need for higher inventory levels.
- Intellectual property theft and the high cost of protecting critical information.
- Higher costs for supervision and training.
- Communication challenges.
- Extra cargo security requirements.
- Shorter product lifecycles.
- Increased U.S. regulatory scrutiny of Chinese imports for safety reasons.
- The price advantage from lower duties as the United States implements more free trade agreements.
More than 60 percent of manufacturers (287 respondents) polled in 2010 by business advisory firm Accenture said they needed to rebalance their supply footprint with demand location to provide customers better service and compete more effectively.
“Lemming-like over the last 15 years, we extended our supply chains a little too far globally in the name of low cost. We lost control in some cases over quality and service when we did that. We underestimated in some cases the value of our workers back here. And so, I think there’s a recalibration. I think you’re going to see more jobs come back to the U.S.,” James McNerney Jr., chief executive, president and chairman of Boeing, said during a Washington Post-sponsored conference on American competitiveness in mid-February.
Many manufacturing executives involved in outsourcing frequently say their companies experienced unexpected increases in total landed costs — the direct and indirect expenses required to deliver a product from an overseas location to a domestic customer.
Half of U.S. importers recently surveyed by Capital Business Credit, a non-bank provider of supply chain financing, recently said they have moved some of their manufacturing outside of China, and a third are considering relocating outside Asia because of rising costs, as well as difficulties Chinese factories face in obtaining financing.
More than 50 importers of apparel, housewares, home furnishings, fashion accessories and furniture were polled.
A third of the respondents had their eye on Vietnam, while 28 percent said the United States is their top alternative location. Pakistan (22 percent) and Bangladesh (17 percent) were also popular manufacturing choices.
Thirty-seven percent of respondents in the Alix Partners survey said the top reason for near-shoring was to achieve lower freight costs, followed by improved speed to market (31 percent), and lower inventory costs. The percentage of executives who cited advantages of dealing with factories in the same time zone dropped to 6 percent from 18 percent in last year’s survey as more emphasis was placed on the first three factors.
The Reshoring Initiative, a two-year-old coalition of 27 companies and trade associations working to bring back lost production to the United States, says the largest factors typically overlooked by companies outsourcing overseas are emergency air freight, travel and the negative impact on innovation from separating manufacturing from engineering. Hidden costs account for as much as 20 to 30 percent of a company’s total cost of foreign outsourcing, it claims.
In the BCG poll, 92 percent of executives opined that labor costs in China will continue to escalate and 70 percent agreed that “sourcing in China is more costly than it looks on paper.”
|Sources: Economist Intelligence Unit, U.S. Bureau of Economic Analysis, BCG analysis.|
U.S. Renaissance. In a separate report in March, the business strategy firm conservatively predicted that improved U.S. competitiveness, rising costs in China and increased exports to Western Europe will enable the United States to add 2 million to 3 million direct and indirect jobs in a range of industries and an estimated $100 billion in annual output, reduce unemployment by 1.5 to 2 percentage points, and lower the non-oil merchandise trade deficit by 25 to 35 percent by the end of the decade.
“Companies are realizing the economics of manufacturing are swinging in favor of the U.S., for goods to be sold both at home and to major export markets. This trend is likely to accelerate starting around 2015,” Harold L. Sirkin, a BCG senior partner said in a news release about the survey.
The United States has added almost a half million manufacturing jobs in the past two years, including 120,000 in the first quarter of 2012, according to the Commerce Department.
The BCG report, “U.S. Manufacturing Nears the Tipping Point,” identified transportation goods, appliances and electrical equipment, furniture, plastic and rubber products, machinery, fabricated metal products, and computers and electronics as prime candidates for insourcing as China’s cost advantage erodes in the near future.
The business consultant said that production of 10 percent to 30 percent of U.S. imports from China in these industry sectors — which represents about two-thirds (or $200 billion) of U.S. merchandise imports — could shift to the United States before the end of the decade because factory wages generally account for only a modest portion of total production costs.
“Not long ago, many companies regarded China as the low-cost default option for manufacturing,” BCG partner Michael Zinser said. “This survey shows that companies are coming to the conclusion surprisingly fast that the U.S. is becoming more competitive when the total costs of manufacturing are accounted for.”
Harvard professors Michael E. Porter and Jan W. Rivkin, writing in the March issue of the Harvard Business Review, said the United States has lost manufacturing because of a perceived deterioration in business essentials — simple tax structure, regulatory certainty, and availability of skilled labor — that reduced its attractiveness as a place to invest and companies making location decisions in a haphazard way without a clear understanding of the hidden costs of doing business in another country.
The professors interviewed senior executives at a dozen multinational firms who said location decisions are so complex and dynamic that they are often made on the basis of simple rules of thumb (follow the customer, focus on wage rates), rough estimates, biases against the U.S. business environment or corporate history.
“Although the best-run global firms have developed rigorous processes for location choices, such sophistication is far from universal,” they said.
The reality is that much outsourcing occurs incrementally in ways that don’t require detailed investment analysis, such as a manufacturer giving a contract for a component to an original equipment maker with partners in China, the professors said.
Location decisions are also constrained by difficulty pulling together cost data from globally dispersed operations that use different information technology and accounting systems. Decisions are skewed too because of tax breaks and other subsidies offered by governments.
“It is perhaps no surprise, then, that we found few companies revisiting old location choices to see if they had lived up to projections. This may reflect the idiosyncratic nature of location choices, in contrast to more replicable decisions such as acquisitions, where ex post assessments are relatively common. Yet retrospective analysis is critical because the impact of poor location choices can cascade over time. Location choices often build on one another, with an initial decision leading to more investments in the same location,” they wrote.
The lack of rigorous analysis applied to offshoring decisions is underscored by a 2009 survey by Archstone Consulting that showed 60 percent of manufacturers use “rudimentary total cost models” and ignore 20 percent of the cost of offshoring. (The firm polled 39 senior executives at U.S. and European manufacturing companies.)
The Reshoring Initiative has a free software tool that helps manufacturers calculate the aggregate impact of offshoring on their profitability.
Many third-party logistics companies and supply chain consultants use mathematical models and tools to help shippers get a holistic understanding of their supply networks and the financial implications of sourcing decisions. Shippers can also use global trade management software from various providers to calculate the total landed cost themselves.
“What we’re finding is that based on the labor content, the cube, weight and dollar value of the product you’re still going to have some sourcing from China, some in Central America and Latin America, and some of it stateside,” Ed Frazelle, chief executive of Logistics Resources International and founder of The Logistics Institute at Georgia Tech, said in a conference call with the American Shipper editorial staff.
Frazelle has coined the term “right sourcing” to describe the strategy for optimizing where a company procures or makes each of its products based on an integrated analysis of the tradeoffs between production, logistics, sales, and customer service across the entire system. One of the key calculations that many shippers overlook when outsourcing is inventory carrying cost, which is partly a function of shipping transit time, he said.
Making the correct sourcing decision requires companies to analyze the true costs for each product a company sells, he added. One of the metrics his firm uses to get a handle on supply chain efficiency is total supply chain cost per perfect order.
Lightweight products in which the labor content accounts for the dominant cost — such as T-shirts — may be more economical to produce in Sri Lanka or other countries in Asia. Goods that are heavy and expensive to ship — such as appliances — or have a high rate of obsolescence, high value per weight, less predictable demand pattern or require customization — think fashion apparel or laptop computers — are often better suited for production close to the home market, Frazelle said.
In his Logistics Viewpoints blog, former ARC Advisory Group director Adrian Gonzalez cautions that on-shoring involves more than simply relocating a plant to the United States. It also requires a company to develop a network of local suppliers to support the operation.
“You can bring your manufacturing operations back to the United States, but if the majority of your raw material or component suppliers are still overseas, then what are you gaining?” he wrote Feb. 22.
In addition to a better understanding of logistics costs, companies are slowly realizing that low wage rates in developing countries can be temporary, or neutralized, if more workers have to be hired because they are less productive or skilled, personnel turnover is high, raw materials are used less efficiently, and defects lead to higher scrap rates. Hourly wages for factory workers in Shanghai, for example, jumped 125 percent between 2006 and 2011, according to Porter and Rivkin.
At the same time the wage gap is narrowing because American workers continue to become more productive while their wages stagnate.
In 2000, Chinese workers averaged 52 cents an hour, 3 percent of the pay for U.S. factory workers. Since then Chinese wages and benefits have risen by double digits each year, including an average of 19 percent from 2005 to 2010. During that same period, the full labor cost for U.S. manufacturing jobs annually increased less than 4 percent, while U.S. productivity grew 2 percent per year, in part because labor unions have recognized the need to be more flexible in negotiations, BCG said.
It forecast average wages in China will increase 18 percent annually for the next four years as the Chinese labor market tightens due to economic growth and the nation’s aging workforce. Some companies have experienced wage spikes of 40 percent to 100 percent in a single year. By 2015, the average hourly cost of labor will be $4.51, it said.
In the Yangtze River Delta, where the largest concentration of manufacturers exists, average wages are expected to reach $6.31 per hour in 2015.
“That would make Chinese compensation packages equal to around 25 percent of what skilled workers earn in low-cost manufacturing states in the U.S. Take much higher U.S. worker productivity into account and wages in the Yangtze River Delta will likely exceed 60 percent of labor costs in U.S. states with low manufacturing costs. Even though our model includes aggressive forecasts of productivity growth in China of around 8.4 percent per year through 2015, these increases will not compensate for wages likely to rise twice as fast,” the BCG study said.
Average labor savings compared to the United States will only be 10 percent to 15 percent by then. Throw in annual 2.5 percent increases in transportation costs — (other analysts predict 5 percent increases in annual transpacific container rates, or more if fuel surcharges are added) — currency adjustments, and other costs, and outsourcing to China will no longer be economical, BCG predicts.
The upward direction of Chinese costs is not likely to change soon as China adjusts to becoming a more mature economy. The Alix Partners outsourcing study predicts that China will face escalating labor costs, a growing unionization movement and some labor unrest as workers push for wages and benefits comparable to those in developed economies.
Apple, for example, has recently come under fire for long hours, low pay and poor working conditions endured by workers at Chinese factories making iPhones and other popular products. The company has promised to address the situation, including lowering the amount of hours workers are required to log each week while protecting their pay. That could mean the plants will have to hire more people to do the same amount of work, raising the cost of production.
More than three-fourths of the manufacturing that migrates from China will likely shift to the United States in the next 10 years, BCG said. Most of the computer and electronics manufacturing that moves from China will go to the United States.
Mexico, however, is not expected to benefit as much from China’s manufacturing loss, the consultancy said. By the middle of the decade, Mexico will have a noticeable cost advantage in many sectors. Mexican productivity also is increasing, the peso continues to depreciate and most Mexican goods are not subject to U.S. duties.
Companies in Mexico also enjoy lower electricity prices than in China, Frank Lange, head of global strategic investment for Menlo Worldwide Logistics, wrote in a guest column for the Logistics Viewpoints blog. Electricity is 15 cents per kilowatt-hour in China compared to 9 cents per kWh in Mexico.
According to Alix Partners, Mexico is now the lowest-cost manufacturing locale in the world.
Despite these advantages, the United States’ southern neighbor doesn’t have the skilled workers able to operate the most sophisticated automated production lines, infrastructure or supplier network to absorb a big increase in production. It is also mired in a major drug war that scares off some companies, it said. And many U.S. states are offering tax breaks to companies to set up shop in their jurisdiction.
Chas Spence, who heads up the near-shoring practice at Alix Partners, said Mexico was the No. 1 destination in last year’s survey for companies opting to shorten their supply chain and that the security situation in the country had little influence on location decisions. The 5-percent job increase in the maquiladora industry — manufacturers that don’t have to pay tariffs on products exported to the United States — supports the survey’s findings, he said.
But only 50 percent of business leaders in the 2012 survey said their firms were moving to Mexico, compared to 70 percent last year. Thirty-five percent said the United States was the preferred destination, followed by 9 percent for Central America (up from 2 percent). Interest in South America and the Caribbean was unchanged from last year.
According to this year’s survey, 43 percent of the executives said they expect a modest improvement in Mexican security, while 40 percent anticipated no change and 13 percent said it would worsen.
The U.S. tire industry is an example of manufacturing that has reached the tipping point for transitioning production back to the United States. U.S. anti-dumping duties on Chinese tires, which add $11 to the cost, are set to expire this year and by 2015 a representative tire analyzed by BCG will cost only 2.5 percent more to make in the United States.
“Whatever cost savings might still be gained in China are unlikely to be worth the supply chain risks or to offset the logistical advantages of making tires closer to where cars are assembled,” the BCG report said, adding that up to 90 percent of the business will go to the United States instead of Mexico.
Re-shoring tire production makes sense because North American demand is projected to grow from 437 million tires in 2010 to 576 million in 2017, which translates into $26 billion in revenue growth. U.S. plants don’t have the capacity to meet the projected volume and factories in China will turn their attention to the rapidly growing domestic and Asian tires markets, according to BCG.
Last October, Continental announced plans to build a tire plant in South Carolina that would create 1,600 jobs. Bridgestone, Goodyear and Toyo Tires are also expanding their U.S. operations.
The United States is also poised to recapture production of large appliances, which are expensive to ship. One appliance studied by the consulting group now costs less than 2 percent more to make in the United States than in China when logistics and overhead are included. By 2015, wages and transportation costs will make it about 2 percent more expensive to make the product in China, at minimum.
BCG conservatively estimated that about half of appliance manufacturing returning to North America will end up in the United States.
When companies chase lowest-cost production they overlook the dynamics that generate productivity gains and the advantages of operating in the United States, Porter and Rivkin said.
“Productivity improvements are often rooted in investments in individuals, innovation teams, and infrastructure as well as long-term relationships with local suppliers and supporting institutions. It is difficult to cultivate such assets while moving from place to place,” the Harvard professors said.
“Also,” they added, “companies often mistakenly view circumstances in U.S. locations as fixed, failing to consider how they might upgrade the productivity of existing U.S. sites or find more appropriate sites within America. Companies move out of U.S. locations when they could improve them.”
U.S. firms, for example, can often find the conditions they are looking for within the United States, such as inexpensive electricity in Idaho and hourly rates in Mississippi and South Dakota that are a third lower than in New York and Massachusetts, according to the article.
Crocs, the Niwot, Colo.-based maker of lightweight clogs and other footwear, terminated a contract with a manufacturer in Florida three years ago as part of a restructuring to stem losses. But the company would reevaluate domestic production if costs were on par with making shoes overseas, CEO John McCarvel told USA Today in an interview published March 30.
The footwear producer also recently moved some production from China to Vietnam to take advantage of duty-free shipping to more countries and slightly lower production costs, as well as diversify its supply base, he said.
Heavy-equipment maker Caterpillar, based in Peoria, Ill., has embraced “home-shoring” for some of its operations. In February, it announced plans to build a $200 million plant in Athens, Ga., that will manufacture small track-type tractors and mini-hydraulic excavators. The company plans to shift production from Japan to place the two product lines closer to its primary customers in North America and Europe.
The manufacturer is also moving production from Japan and Illinois to an expanded hydraulic excavator facility in Victoria, Texas. Facilities in China and Japan will remain open to focus on local customers.
Last fall, Ford Motor Co. announced plans to bring back about 2,000 jobs from suppliers in Japan, Mexico and China as part of a $16 billion investment campaign.
Re-shoring decisions are also being influenced by the growth of the middle class in emerging markets. Producing goods for domestic and regional consumption has the same benefits in Asia as it does in the United States.
Spence said that if local demand for a company’s products increases and capacity is constrained it makes sense to reorient the plant that is dedicated to exports to meet Chinese, or Asian, demand and fulfill U.S. demand closer to home.
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New Industrial Policy. President Obama has made revitalizing the American manufacturing sector a top priority of his new economic blueprint for making the nation more competitive and is offering incentives to companies that invest in the United States.
In his State of the Union speech, the president proposed eliminating tax breaks for companies that outsource and using the money to cover moving expenses for companies that onshore production. He also called for a minimum tax on multinational firms so that they can’t avoid paying their “fair share” and applying the revenue towards lowering taxes for domestic companies. American manufacturers should get a larger tax cut — a 25 percent rate from the current 35 percent (28 percent for other corporations) — and high-tech manufacturers should get double the tax deduction for making products on U.S. soil, he said.
“We live in a global economy. If a company wants to do business overseas, of course it’s their right. But we shouldn’t subsidize it,” Obama said during a visit to Intel’s campus in Chandler, Ariz. “What we should do are subsidize and help and give tax breaks to companies that are investing here, that bring jobs back from overseas.”
Contentious relations between the House, Senate and White House will make it difficult to get his ideas into legislation this year.
During his speech, Obama praised Master Lock Co. for returning about 100 jobs from China since 2010 to its union factory in Milwaukee, which the company says is now running at full-capacity for the first time in 15 years.
In a news release, Master Lock said its decision to pull back jobs was partially motivated by higher labor and logistics costs in Asia and inconsistent availability of labor in the manufacturing belt of China. In addition to better cost structure, the move has also resulted in better customer service. CEO John Heppner said he would like to repatriate more jobs from overseas if economic conditions improve.
Obama also talked about increasing opportunities for technical education so companies can find skilled workers and enforcing trade rules so foreign competitors don’t gain an unfair advantage.
“We need to make it easier for American businesses to do business here in America, and we also need to make it easier for American businesses to sell our products other places in the world. I don’t want to export our jobs; I want to export our goods and our services,” Obama said, promoting his tax plan at an equipment manufacturer in Cedar Rapids, Iowa.
In March, Obama said he would create a network of up to 15 regional institutes for manufacturing innovation that would help firms with investment and other start-up needs for domestic production.
The institutes are intended to provide manufacturers with the resources to overcome the cost and risk of commercializing new products and scaling up manufacturing products and processes.
Under the program, industry, universities, community colleges, federal agencies, states and local governments will collaborate to accelerate innovation by investing in industrially-relevant manufacturing technologies with broad applications to bridge the gap between basic research and product development, share assets and ideas to help companies — especially small manufacturers — access sophisticated technology and equipment, and create a top teaching and training environment for advanced manufacturing skills.
The White House’s Council on Jobs and Competitiveness last year recommended regulatory and tax simplification, educational reform, transportation infrastructure investment, enhanced export assistance programs, aid for start-up firms, and policies to make foreign direct investment easier as ways to support home-based manufacturing and job creation.
The Jobs Council, which is chaired by General Electric’s Chairman and Chief Executive Officer Jeffrey R. Immelt, set a national goal of attracting $1 trillion of foreign direct investment during the next five years, quadruple the current amount.
Foreign direct investment in the United States reached $228 billion in 2010, up sharply from 2009, according to the Commerce Department. The department is now training its foreign commercial officers to help foreign business leaders invest in the United States, in addition to their traditional role promoting U.S. exports.
One sector that is already heavily represented by foreign manufacturers in the United States is the automobile industry.
Excess plant capacity, currency exchange rates that effectively lowered U.S. labor costs, quality and free-trade agreements have combined to make the United States a more attractive place to assemble cars for export to other countries, as well as for sale to domestic consumers, according to Cars.com.
Nissan, Toyota, Kia, BMW, Mercedes, Honda, Volkswagen, Hyundai, Subaru, and Mitsubishi all have U.S. plants.
Asked how the government could help influence repatriation decisions, 31 percent of respondents in the Alix Partners’ survey said policy changes would have no impact. A quarter said lower corporate tax rates would help, while 19 percent said they would respond favorably to easing of tariff and duty rates, 13 percent listed subsidies (including training and research assistance) and 9 percent said lower healthcare costs.
BCG warned companies to carefully analyze all the dynamics before deciding that factory relocation is the answer.
“Not long ago, too many companies rushed into China, spellbound by its cheap labor and fixed currency,” its report concluded. “Now they must avoid a wholesale withdrawal of production just because wages are rising and the yuan is appreciating against the dollar. What is required instead is a holistic, global, and long-term understanding of the total costs of making particular products for particular markets and the economic trends that will influence future costs.”