Willy Shih is the Robert and Jane Cizik Professor of Management Practice at the Harvard Business School in Boston. He spent 28 years in the industry at companies like IBM and Eastman Kodak, before coming to HBS in 2007. He teaches in the MBA and Executive Education programs.
June 2013, Inside Supply Management® Vol. 24, No. 5, page 30
The rising costs of doing business in China, new natural gas and energy sources in North America, and a desire to keep R&D close to home are all factors luring manufacturing production back to the United States.
There is a lot of talk about manufacturing coming back to America. In January 2013, Wal-Mart announced its commitment to increase domestic sourcing of its products by purchasing an additional US$50 billion in U.S.-made products over the next decade. In his February 2013 State of the Union Address, President Barack Obama stated the importance of creating domestic manufacturing hubs, as it would feed innovation and create jobs for Americans. Some jobs are coming back, that is certain. But what are the factors driving this trend, and do they reflect short-term macro effects, or a longer-term structural change? How are many supply management practitioners thinking about this, and is it a sustainable long-term trend?
As long as there has been trade, we have shipped production work to lower-cost regions. A good way to think about what enables this is the economist's notion of tradability. If a product can be sold in a location that is different from where it is produced, it is deemed tradable; otherwise, it is non-tradable. Most manufactured goods are tradable, while most services are not.
The tradability of a product is determined by how much it costs to transport a good or service relative to its total value (think of it as value density) and product lifetime (whether it can spoil or lose value quickly). Things that are high-value and easy to transport, like iPads or semiconductor chips, are eminently tradable, as the transport costs are a tiny fraction of what it costs to produce them. Ready-mix cement is not tradable because it weighs a lot, and it spoils (hardens) soon after mixing and must be used within a set time frame. This also means tradability can change with transport costs and speed — think how air freight has transformed the global market for fresh fish and cut flowers.
Tradability comes with a price, and the economists think of this as coordination cost. This includes things like the time spent communicating with a remote factory and suppliers, which can account for a majority of the day for many supply chain practitioners.
Coordination costs are necessary components of total cost when manufacturing in other countries. When China opened for business in the early 1990s, many companies saw opportunity in the tremendous labor cost differentials, which was as much as 100 times lower than the wage rate (on a fully burdened basis — salary plus benefits) of developed markets. Many managers at the time (myself included) thought, "If I send the work to China, I can overcome a lot of costs just by using more labor." This was pure labor arbitrage — the cost differential justified moving the work offshore, even though the workforce might not have been as skilled.
This harkens to mechanical engineer Frederick Taylor's well-known principles of scientific management, in which we break down complex manufacturing assembly tasks into simple subtasks so that semiskilled workers can handle the work. Rather than invest in sophisticated capital equipment like robotic assembly to reduce labor content, many firms chose to offshore manual assembly. This gave them the benefit of flexibility, as people are much more flexible than hard automation. When the shift to offshoring occurred in many manufacturing industries like electronics assembly or small consumer durables, it was a combination of exploitation of labor arbitrage and the substitution of labor for capital. The latter was almost the reverse pattern from what usually happens as economies develop, where we see substitution of capital for labor.
The wave of offshoring to China and other emerging markets incurred large coordination costs and required lengthening the inventory pipeline for goods. The task was simplified thanks to low-cost air travel and vast improvements in communications and the Internet. We sent our production engineers, supply chain specialists and managers to spend weeks, months or years in Chinese factories. Low-cost ocean container shipping and airfreight expanded the tradable sector to more and more goods. The cost savings on labor were so significant that they covered the coordination costs (and risks) of the lengthened inventory pipeline. Add to that the combination of favorable costs for land acquisition to build factories, often subsidized energy or raw material costs, low construction costs and favorable tax incentives, and many companies found it irresistible to move manufacturing and manufacturing jobs to China.
But in the last five years, things have changed. Labor costs in China have risen at 20 percent or more per year, and similarly in other parts of East and Southeast Asia. Meanwhile, labor costs in the U.S. have remained flat. Fuel costs have risen dramatically, which has forced many products that have traditionally been shipped by air to switch to ocean freight, which leads to more inventories in the pipeline. And China is experiencing a massive demographic shift as a result of its one-child policy instituted decades ago: The bulge in young people joining the workforce, its "population dividend," is ending, which means it will no longer have a seemingly limitless supply of labor. Labor in China is getting harder to attract, and more expensive.
These are some of the primary reasons companies are now rethinking their sourcing and manufacturing location strategies. The rising costs in China are shifting the balance of the tradability equation. And there are other downsides that supply chain practitioners have experienced, such as the risk of intellectual property loss, or the inability to respond as quickly to rapid market shifts when manufacturing occurs far away from the end consumer.
The labor cost differential no longer overwhelms the coordination and inventory pipeline costs, and many supply managers are realizing the magnitude of the work involved and how many risks they have taken offshore. All these costs were not necessarily priced into their cost of goods calculations. And so, several major manufacturers are moving operations back to the U.S. General Electric is one high-profile example, investing a billion dollars and moving work back to its Appliance Park operations in Louisville, Kentucky. Apple has announced its intention to move some production back to the U.S., and Caterpillar is moving work to Georgia.
The trade-off between transportation cost and low inventory pipeline has been demonstrated for many years by firms like Inditex, the "fast-fashion" clothing company located in Arteixo, Galicia, Spain, and distributor for brands such as Zara. The company manufactures in high-cost Spain or Portugal, as well as Eastern Europe and North Africa, and it uses air to deliver its product to markets around the globe. Having a short pipeline (both in design and production) dramatically reduces markdowns that the retail stores might otherwise have to take because a particular style or design may not sell. In the fickle world of fashion, it really helps that you don't have a lot of inventory in the pipe if it is the wrong inventory. But the same applies in many other markets, especially as we see more desire for customization or faster overall cycle times. Short inventory pipelines translate into smaller markdowns or write-offs if you are not precisely correct on your product mix.
Another macro factor favoring American manufacturing is the revolution in hydraulic fracturing (fracking) that has opened new reserves of natural gas and oil. For industries like petrochemicals and plastics that use gas and oil as feedstocks, this has been a boon. For the first time in more than three decades, we have new petrochemical plants being built in the United States. Other industries have benefited, as well, as a large-scale switch from coal to natural gas for power generation has translated into lower electricity rates. As long as we have more natural gas than we can readily export (a problem many manufacturers would like to see continue), we will see significant production cost benefits to manufacturing in America.
These changes all point to a change in the tradability equation. It increasingly makes logical sense to produce more things in the U.S. because of the changes in labor costs, energy costs, and the proximity to R&D and the world's largest market. However, the real question is whether this trend is sustainable. Natural gas is not likely to cost one-quarter as much in the United States as it does in Germany over the longer term.
Regarding R&D, one factor many supply managers seemed to overlook during the great offshoring boom was the benefit of having manufacturing close to the centers of design and R&D. We learned from Japan in the 1980s how important this is, when companies like Toyota demonstrated how much of the innovation cycle actually occurred on the production side.
When I worked with manufacturing in the 1980s and early 1990s, my manufacturing manager took pride in engineering's close physical proximity to the production line. The tacit knowledge gained on the production line fed back into design, facilitated continuous improvement and fueled further innovations, particularly when our products were new and the production processes were still immature.
Then, in the late 1990s and 2000s, we seemed to forget. We sent our engineers over to our new overseas factories, and we trained those local workforces and suppliers to improve their products and processes. And by doing this, we were also training our future competition.
Over the next few years, American manufacturers have the opportunity to rediscover the benefits of locating production close to R&D and development, which is especially important for new technologies and processes that are just beginning to go into production. Technologies like additive manufacturing enable customization or much shorter production cycle times on tooling, so being close to both design and the marketplace will let companies be more flexible and reactive, among other benefits.
Going forward, will "Made in America" be a short-term reflection of changes in the macro environment, or will it signal a more sustained shift? We have a window of opportunity to once again prove the value of making things close to home. CEOs will always face the challenge of how to allocate global production while recognizing the importance of national markets. The opportunity for American manufacturers and supply chain practitioners is to take advantage of the current state of the tradability equation to demonstrate the value of close proximity of production locations to R&D, and show what lower coordination costs can mean for the bottom line. For American manufacturers, this is a time to rethink.
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