Mistake?
Pro: Labor Rates
Con: Transportation
     & Customs
Con: Political Risk
Con: Currency Risk
Con: Control Risk
Con: Piracy Risk
Con: Inventory Risk
Con: Obsolescence
Summary

Moving Overseas a Mistake?

Many U.S. companies are considering moving their manufacturing overseas to take advantage of low labor rates in countries such as China, Hong Kong, Singapore, Taiwan, South Korea, Maylasia, Indonesia and India.

Case Study:
"MRA Digital will stop outsourcing to China"

Other companies are considering moving closer to home, in Mexico, where wages are a bit higher, but they can import their products duty-free under NAFTA. For example, in May 2002, Honeywell, Inc., wrote letters to many of its machine shop suppliers, suggesting they move operations to Monterrey, Nuevo Leon, Mexico, as a way to reduce their prices back to Honeywell. The U.S. Department of Commerce, International Trade Administration, reports that 2002 U.S. exports of machine tools and metal forming equipment to Mexico totaled over $1 billion, and are expected to grow five percent in 2003. Monterrey, the "Industrial Heart of Mexico," has 13,000 manufacturers, who are buying up U.S. machine tools and taking over U.S. machining activity.

Are these companies making a big mistake?

In most cases, yes, they are making a mistake. The mistake is not necessarily just manufacturing overseas; rather, it is manufacturing products in one country for distribution in a different market. For example, manufacturing high-tech microphones in China for sale and use in the U.S. may incur both real and intangible costs that are not part of the traditional labor + transportation + duties equation. Recognizing all the intangible costs may change this equation significantly. Japanese and German car makers recognize many of these issues when they decide to invest billions in U.S. plants, building products in the U.S. for sale to U.S. customers.

The additional intangible costs are political, control and currency risks, and lack of protection for intellectual property. Additional real costs are incresased inventories and delays in time-to-market. These costs are hard to see and harder to measure, but they are real, and they can affect a company's bottom line.

There is an alternative. Manufacturers can compete with low-cost foreign labor by increasing their productivity. Lean manufacturing is a collection of techniques to improve manufacturing productivity, and overcome the apparent short-term cost advantage of overseas manufacturers.

Here are some of the pros and cons of overseas manufacturing:

Pro: Lower Labor Rates

Yes, labor rates are much lower. According to one manufacturer, while Mexico's minimum wage is about US$0.50/hour, the actual labor costs in Mexico are about half of U.S. labor costs. Supervisors in Mexico earn about US$23,000 per year.

Moreover, some temporary incentive subsidies may be available, in the form of abatements on taxes, permits, licenses and training. For example, the State of Coahuila offers no payroll tax for the first year, and will cover payroll during a 90-day training period.

Asian labor costs are even lower

• One report puts the cost of educated professionals in China at 10 percent of comparable professionals in the U.S.
• Northeastern University Prof. F. Gerard Adams reports that per capita income in China is a mere US$780 (exchange rate basis), compared to US$30,600 in the U.S.
• Printed circuit board industry trade magazine CircuiTree reports that Microsoft found labor costs in China to be US$1/hour, compared to US$3/hour in Hungary.
• The same article reports direct hourly rates for China at US$0.85, compared to the U.S. at US$9.60 (see table at right).
• The official People's Daily quotes a senior Chinese researcher from the Chinese Institute of Industrial Economics, Academy of Social Sciences: "He said the statistics also show average labor costs of industries in China are only five percent of those in developed countries like the United States, Japan and Germany."

Productivity in companies in developing countries is typically measurably lower than in the U.S., which tends to raise overall labor costs relative to straight wage rate differences. Firms owned by foreign companies may be more productive than locally-owned firms, but evidence is scant; moreover, cultural differences present barriers to instituting modern high-productivity manufacturing processes. Anecdotes about rising productivity in Asia are not clearly supported empirically.

A manufacturer can save maybe about 80-85% of direct labor costs moving to China, and about 40-45% of labor costs moving to Mexico.

Labor costs are typically about 30% of total costs, for products produced in the U.S. Thus, labor savings on their face can save a manufacturer 24-26% of total production cost in China, and about 12-14% of total production cost in Mexico. But labor costs are not the entire issue! The manufacturer still has to get the product to market, reliably over the entire product life cycle.

Con: Transportation & Customs

Air freight costs from China are can run abut $350/lb. on FedEx; even with corporate discounts, this type of shipping would be used only for high-value, low-weight goods such as electronics. Shipping costs from Mexico are much lower.

Ocean shipping is much less expensive, but true economies require a full container-load. A partial container presents more difficult logistics. The highest cost of ocean shipping from China is the several weeks spent in transit. During this time, if the manufacturer has accepted delivery in China, the shipment may be a finished goods inventory asset on the manufacturer's balance sheet. A high level of assets drives down the company's return on investment. Alternatively, if the manufacturer has not accepted delivery in China, the shipment is a current encumbered liability while in transit. A high level of current liabilities strains the company's free cash flow and working capital, and may require additional short-term debt. Lots of other evils may befall this inventory as well, discussed in more detail below.

Other costs of international shipping include commissions, customs duties, demurrage, dryage, fees, insurance and licenses. The rules for these costs are very complex, and amounts are highly variable, as different local officials may interpret rules differently. Complexity and variability also open the door to local corruption, which can lead to both financial and legal costs.

Shipments from Mexico do not incur duties, under NAFTA rules. They are subject to other fees and costs, like other international shipments. Because of its closer proximity, shipping from Mexico—typically by truck or rail—does not burden the balance sheet for such a long time. A new land-based border crossing at Santa Teresa, NM, is fed by the new Samalayuca Bypass highway in Mexico, and features automated customs clearing and expedited truck/rail/air intermodal handling. Typically, Mexico shipments require only days, rather than weeks.

Domestic shipping rules are also very complex, but they are well-documented and much less subject to local variability and corruption.

Con: Political Risk

An intangible cost--but very much real--is the political risk of manufacturing in other countries. Political risk is the probability that the local government may change the rules, making manufacturing more expensive or more difficult.

Political risk tends to be lower in democracies like Mexico, India and the Philippines, and higher in totalitarian dictatorships like China, but both provide different types of risk. While dictators tend to stay in office longer than heads of democratic states, they are more subject to radical changes in policy that can whipsaw manufacturing companies. These policies include nationalization of factories, or changes in labor rules, payroll taxes, business taxes, environmental regulations, tariffs and duties and a host of other ways government policies affect business. The Cultural Revolution and Tiananmen Square are examples of radical policy changes without regime changes.

Regime changes can also be traumatic for business in a democratic environment. Uncertainty caused by the unprecedented election of President Vicente Fox in Mexico caused temporary disruption before he took office and articulated an industrial policy. Revolutionaries in the Mexican State of Chiapas—not a major business center—engaged battles with federal troops. In the Philippines, seven coup attempts followed the election of President Corazon Aquino; the December 1989 attempted coup, suppressed with help from U.S. air support, was concentrated in the business haven of Makati, and cost the local economy US$1.5 billion.

Political unrest can also be costly for business. China has been plagued by repeated waves of labor demonstrations, involving over 10,000 protesters at a time, in 1999 and 2002. Issues include non-payment of wages, layoffs, contract disputes and conditions. An estimated 120,000 disputes in 1999 included demonstrations, strikes and violent confrontations with police.

Global anti-U.S. sentiment can be another manifestation of political unrest. In many cases, demonstrations target embassies; in other cases, vandalism targets are U.S. business assets or symbols, such as local Coca-Cola bottling plants or Marriott hotel.

Terrorism is a more extreme form of anti-U.S. sentiment. To date, actual attacks on U.S. business assets and symbols overseas have been few, but terrorism has become a way of daily life in many parts of the world, including some global manufacturing centers.

The probability of a political shut-down is typically small, but the effect can be serious for a manufacturer who has delivery and cash flow obligations. When political unrest strikes a U.S. manufacturer abroad, the effect is typically a complete shutdown until civil order is restored. In some cases, the shutdown may last mere days; in other cases, months may wear into years. While vandalism damage may be insurable, business losses from a shut-down is not. Many manufacturers do not consider political risk in evaluating a move overseas, and are surprised when they occur.

Con: Currency Risk

U.S. companies that have their products manufactured overseas typically pay for those products with foreign exchange, the currency of the country from which they are purchasing the goods. They may buy foreign currencies in open markets, usually through international banks.

Most currencies fluctuate in open markets. For these currencies, the exchange rate—the price of one currency expressed in terms of another currency—is determined by the relative supply and demand for the two currencies. Supply and demand vary according to the health of the country's economy and its balance of payments. The more a country exports, the more of its currency overseas customers must acquire to pay for those exports; demand for the currency is high and its price—expressed in other currencies—goes up. Consequently, the cost of that country's export products increases—even though the price remains the same—just due to the change in exchange rates. For example, in 2003, the Mexican Peso (MXN, or MX$) traded between a low of US$0.0890 in early March, 2003, and a high of US$0.0989 in early May, 2003, a change of over 11% in just over two months. It was US$0.0921 in late August, 2003.

Note the key phrase, "...expressed in other currencies..." In normal practice, foreign exchange markets express the prices of only two currencies in terms of other currencies: the Great Britain Pound Sterling (GBP, £) and the Euro (EUR, €), which are normally expressed in US dollars (USD, US$). For example, the GBP recently traded at US$2.60, or £1,00 cost US$2.60; the EUR recently traded at US$1.16, or €1,00 cost US$1.16.

Most other currencies are normally expressed in terms of how many units of the currency are exchanged for US$1.00. For example, the Japanese Yen (JPY, ¥) recently traded at ¥110, or ¥110 for US$1.00. In these cases, when the demand for a currency increases, the price of the currency—expressed in terms of the number of units trading for US$1.00—goes down. The actual cost of the currency to the buyer goes up, because now US$1.00 will buy fewer JPY or other currency. This seeming inverse relationship is why, when the number price of JPY appears to go down (fewer JPY per USD), the currency is actually becoming more expensive.

Some countries peg their currencies to a specific value, usually in terms of the USD. In these countries—particularly in the less-developed world—the government buys or sells its own currency and other currencies, offsetting market fluctuations, in order to maintain an exchange rate within a very narrow band, relative to the currency to which it is pegged. For example, the Chinese Yuan (CNY, 元) is pegged to the USD within a band between CNY 8.2760 and CNY 8.2800 per US$1.00.

Countries that peg their currencies bring two types of risk to businesses:

First, they may change the peg suddenly, without warning; uncertainty and unpredictability are always business hazards, even when they work in your favor.

Second, the change may be in an unfavorable direction. Currencies that are pegged to the USD, like the CNY, will fluctuate in parallel to the USD relative to all other currencies, reflecting changes in the demand and supply for USD, which are mostly influenced by U.S. business cycles. To the degree that the economy underlying a pegged currency fluctuates in a different way than the U.S. economy fluctuates, the pegged currency will become out of balance with its own underlying economy.

For example, the U.S. has had a balance of payments deficit for many years; imports exceed exports, and U.S. investments in foreign countries exceed investments in the U.S. economy by foreigners. As a result, the rest of the world has an ever-growing supply of USD, and the value of USD generally trends downward, relative to most other major currencies (this trend is somewhat offset by the world's confidence in the safety of the USD; many foreign investors are content to hold USD because of its lack of political and economic risk).

China, on the other hand, has a balance of payments surplus. It exports more than it imports, and foreigners (including U.S. investors) invest more in China than China invests in the rest of the world. Consequently, the world's demand for CNY is ever-growing, and if market forces were in operation, the value of the CNY would tend to increase. But the CNY is pegged to the USD, so market forces do not operate; instead, the value of the CNY relative to other currencies generally trends downward, along with the USD. The CNY has therefore become severely undervalued relative to other currencies, including the USD. Some economists estimate the CNY is undervalued between 15% and 40%.

An undervalued currency gives China a significant advantage in world markets, and is one reason why its labor costs are so low. Its exports are relatively cheaper than they otherwise would be, and foreign goods are relatively more expensive. But this currency advantage is artificial; it results from government intervention. It is a form of government subsidy to Chinese exporters. Japan intervened in currency markets in an attempt to offset the undervalued CNY relative to the JPY. Other countries whose currencies float in world markets are also concerned. Politically, many U.S. companies, industry groups, labor unions and Members of Congress advocate the U.S. to pressure China to revalue its currency higher, more closely reflecting market conditions, but the U.S. government has resisted a China policy change.

China has so far resisted revaluation, saying only that it is considering widening the CNY trading band. But if China should relent, the change will no doubt be sudden and cause an immediate increase in the real cost of all goods manufactured in China.

Con: Control Risk

An essential task of any manager is to control the processes on which the company depends. Even when processes are outsourced to other firms, the manager must visit the contractor, review materials sources and specifications, evaluate compliance with production processes, ensure that products are made to specifications and ensure compliance with local laws and regulations. This review process can happen only with on-site inspection.

On-site inspections at overseas locations is more difficult and more costly than at domestic locations. Travel costs and travel time, coping with local transportation, food, customs, language barriers and post-return recovery time are some of the additional costs of controlling overseas manufacturing processes.

External forces occasionally prevent or make these overseas inspections more difficult. A local coup or terror attack, effective or not, can disrupt carefully planned activities. Kidnap for ransom, a profitable business in Mexico, Brazil, Columbia and some other countries, can disrupt entire lives, even with "K&R" insurance.

A recent unanticipated control risk was Severe Acute Respiratory Syndrome (SARS). Travel advisories announced by the World Health Organization and the Center for Disease Control led many U.S. companies to suspend travel to mainland China for two months, including Dell, Eastman Kodak, Intel, Microchip Technologies and Wal-Mart. This disease even shut down business travel to Toronto, Ontario, Canada, for several weeks.

Con: Piracy Risk

Product piracy practices vary throughout the world, and are highest in Vietnam, China and Indonesia. A study for the Business Software Association estimates that the world-wide piracy rate—business software installed without a license as a percentage of total software installed in a country—was 39% in 2002.

Enforcement: Notable police actions to stop CD and DVD counterfeiting have occurred in a Philippines factory and a London factory full of Asian counterfiet products. The U.S. Customs & Border Protection agency names China as the top source for intellectual property rights seizures in 2002, representing nearly half of all IPR seizures. Taiwan, Hong Kong, Pakistan and Korea round out the top five sources, accounting for 84% of all IPR seizures.

Some of the most disturbing stories, however, involve piracy of other manufactured goods. One U.S. CEO attending a Beijing trade show reported finding a product exactly like his proprietary product for sale at a booth. The only difference was the name plate. Upon further investigation, the CEO discovered that the manufacturer he had contracted to make his product was using its third shift to make the product under a different brand name. It was not a knock-off; it was not a copy; it was exactly the same product, with a different name plate.

Trust: Any time a company exposes its intellectual property to another source, it incurrs risk; consequently, prudent managers disclose intellectual property only to trusted parties. Countries that have clearly demonstrated their untrustworthiness in terms of software and entertainment assets do not have the cultural or enforced legal recognition of intellectual property ownership that makes them trustworthy partners.

Con: Inventory Risk

Inventory is inherently evil, and nearly all businesses should strive to maintain as little of it as possible. Inventory adds only to costs; it does not add to value. Costs of inventory include:

• Capital: Inventory ties up capital, typically borrowed at 10-15% annual interest.
• Space: Inventory takes up space, which costs 40-80¢ per square foot each month. Eliminating inventory can allow a company to allocate the space to higher and more profitable uses.
• Safety: Wnen inventory spills out onto walkways, or gets stacked too high, it creates a safety hazard and causes injuries and lost time.
• Quality: Inventory is subject to dings, spoilage and shrinkage, leading to increased scrap and rework.
• Material Change: Materials stored in inventory get old and spoil, rust, temper, cure or age, leading to increased scrap, longer processing times or refinishing.
• Transactions: Accounting for inventory and the transactions in and out of inventory storage adds to back office accounting cost. Time wasted rummaging through inventory for materials, parts or products increases as inventory increases.
• Obsolescence: Things change, and materials, parts and products in inventory may no longer be useful to a new product line, customer, government regulation or business model. Obsolescence not only adds to scrap, but wastes the investment in producing the part or product in the first place.

Inventory carrying costs are typically about 20-25% of the value of the inventory. Few business actually calculate their total inventory costs, because the costs are hidden in overhead cost categories, like interest, rent, accounting, etc. But when companeis reduce their inventory, they discover that their productivity and quality increase, while down-time, scrap and back-office workloads decrease.

Overseas manufacturing increases inventory of products destined for domestic markets. Most of this inventory increase is due to the time spent in transit. Ocean shipping typically takes weeks just in transit, and even more time is spent in docks, loading, inspections, unloading, storage, customs, reloading for overland transportation etc.

Finished goods are the most expensive inventory, because they have the most investment tied up in materials, parts, labor, machine time, etc. Moreover, finished goods are also more likely to suffer damage if dropped in all the loading or unloading, and are more likely to be stolen by any of the multiple hands that cover the goods in the international shipping system.

Inventory reduces return on investment. Return on investment may be measured many ways, such as return on assets, return on equity or return on invested capital. In all of these measures, the numerator has to do with earnings, and the denominator includes a measure of assets. Inventory is an asset. Any company that can maintain the same level of earnings while reducing its assets will increase its return on investment significantly: reducing the denominator by half doubles the return.

Producing goods close to their ultimate markets minimizes shipping and handling of finished goods, eliminates the waste of international logistics, reduces inventories and increases return on investment. For products sold in the U.S., inventory will be minimized by domestic manufacturers and maximized by Asian manufacturers. Mexican manufacturers will create inventory between those two extremes.

Con: Obsolescence Risk

A particular type of inventory cost—obsolescence—is potentially particularly costly when manufacturing overseas. The long logistics chain of manufacturing overseas, communications difficulties, cultural differences and governmental regulations all converge to increase obsolescence risk.

Time-to-market can be much higher for manufacturing new products overseas. Even with Internet, e-mail and ftp communications, communicating designs and specifications can be more cumbersome due to language difficulties and manufacturing customs and standards. Long logistics lines then add even more weeks to time-to-market.

Design changes can take even longer getting to market. Whenever a design change is required, three-to-six weeks of old-design products are already in transit. Bringing the design change to the market will either be delayed until the old designs are sold, or the old designs will be scrapped or reworked. Contrary to common belief, design changes represent a significant risk to overseas manufacturers because they are quite common and are not always subject to long-term planning. Major causes of design changes include:

• Customer style and taste seem to change more quickly due to global television and other media. Agile companies can change products to respond to market opportunities, but companies with long logistics lines cannot.
• Product upgrades are routinely necessary to meet competitors' product advances. Product upgrade cycles tend to shorten as an industry matures and stronger competitors vie for market share.
• Defect correction occurs in any industry, as consumer use and complaints generate data about the actual performance of products in the field. Virtually any product may be recalled, including automotive parts, appliances, child safety seats, clothing, drugs, electronics, environmental controls, foodstuffs, furniture, household or outdoor products, lighting, medical devices, sports equipment, toys, etc.
• Packaging changes happen all the time, primarily because of changes in marketing; for example, a marketing campaign may want to emphasize a new entertainment tie-in, or emphasize a differentiation feature, or meet a new market opportunity. If the new packaging is just for temporary use, old packaging may be warehoused for later use, but this approach just adds to inventory.
• Regulatory changes may affect a product directly, or just its packaging. Labeling requirements change all the time, and vary all over the world. For example, U.S. nutritional information requirements change from time-to-time; country-of-origin labeling (COOL) requirements, generally applied to agricultural products, especially beef, are mandatory in Europe, New Zealand and Argentina, and discussed regularly in the U.S. and Japan; similar COOL regulations are proposed for recreational boats. Labeling requirements are ever-evolving.

Change is a normal part of business, but global integration and a speedup in communications technology and transportation now give a competitive advantage to the agile company that can turn on a dime in response to change. A company tied to long logistics lines and implicit large inventories cannot change quickly.

Summary

A key principle is to manufacture products near their markets. Manufacturing overseas may be the best solution if the products will be sold overseas. But for products to be sold in the U.S., manufacturing closer to home is generally a better solution.

Manufacturers can save a significant amount of labor cost by moving operations overseas. But the cost savings in labor are illusory: labor is typically not the most significant factor in a product's cost, rarely more than 30% of total cost.

Direct costs offset labor savings. Increased direct costs include customs, duties, fees, insurance, intermodal handling, licenses and transportation.

Too often, a manufacturer looks only at the labor + transportation + duty equation. In many cases, that equation will tell the manufacturer that overseas manufacturing is the cheapest solution. But that equation does not tell the full story. Overseas manufacturing also incurs some more intangible costs, intangible but nonetheless real. These intangibles most often take the form of risk.

Political risk is like a natural disaster, an earthquake, tornado or hurricane; it happens infrequently, but it can be devastating when it occurs. Political risks include radical regime change, anti-U.S. sentiment and even terrorism.

Currency risks can be intangible, in terms of the uncertainty of an exchange-rate change, or they can be real, in case of revaluation. Managers can hedge against currency fluctuations over the short run (months), but long-term investments—and the entire product cost structure—can be significantly wiped out in a currency revaluation.

Management control is significantly eroded when manufacturing is a long way distant from the market. Management cannot be two places at once; with overseas manufacturing, management is either paying attention to its market, or to its operations, but not both. The trick for successful companies, though, is to manage both at once.

Intellectual property is an intangible asset, but it may be the most valuable asset that many companies have. Protecting intellectual property is virtually impossible in some parts of the world; their cultures do not necessarily respect intellectual property rights, and their governments are reluctant or unable to enforce the laws they have.

Inventory, and all of its costs, are necessarily increased when manufacturing overseas, just due to the difficulties of long logistics lines. Inventory carrying costs are real, but they are generally absorbed in fixed cost categories, so the impact of inventory on operating expenses is hidden. Inventory adds cost but not value, and by definition reduces return on investment. Every military commander knows the dangers of long supply lines, and managers should recognize those same dangers in their logistics decisions.

Time-to-market is more important in today's world of global media than it was just two decades ago. Being first in a market can be a competitive advantage that cannot be overcome; by the time competitors catch up, the market has moved on to other products, and the competitor is stuck with obsolete inventory. Overseas manufacturing virtually always lengthens time-to-market, reduces a company's agility and becomes a competitive disadvantage.

Moving manufacturing operations overseas can be the right solution when markets are also overseas, but it is rarely the right decision when serving domestic markets.

Q: So how can companies keep their manufacturing operations at home and still compete with the price leaders who absorb the overseas risks?

A: They improve their productivity, by implementing lean manufacturing techniques.

A lean manufacturer will absorb higher hourly costs for labor, but will invest fewer labor hours in each product, because of higher productivity. A lean manufacturer will avoid the extra transportation, handling and duties costs. A lean manufacturer will not suffer political, currency or control risks, and will protect its intellectual property. A lean manufacturer will keep inventory to a rock-bottom minimum, and will be able to respond to market conditions in real time.

Many manufacturers find that they can beat lower overseas costs with increased productivity. Explore lean manufacturing alternatives before committing to long-term risks overseas.