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Manufacturing Crossroads PUBLIC ACCESS

Many U.S. Companies are Reexamining their Outsourcing Strategies. Will Production Mover Closer to Home?

Mechanical Engineering 132(06), 30-34 (Jun 01, 2010) (5 pages) doi:10.1115/1.2010-Jun-2

This article examines the American manufacturer’s outsourcing strategy to bring production closer to home. According to a survey by the international accountant firm Grant Thornton, 20% of US respondents brought sourcing closer to home in 2010, and 28% did so in 2009. The survey results show that between 1980 and 2007, China’s share of value added in global manufacturing rose from 2% to 14 %, while the United States generally held steady from its 1980s level of 22%. Nearshoring is not the same as bringing work back to the United States. Yet nearshored plants are easier to manage because they are close and share the same time zones as the United States. This makes it far easier for US managers, researchers, and engineers to interact with plants, so those functions stay in the United States. The United States retains a reputation for quality, and exports are likely to grow if the dollar remains weak.

U.S.manufacturers have taken a beating this past decade. As the economy pulls itself out of the recession, they are approaching a crossroads. Do they continue to send production offshore, or do they keep it at home and find ways to thrive in an increasingly competitive world?

The evidence points to very different conclusions. Nowhere are those contradictions better illustrated than in two stories that manufacturing consultant Chris Tsai told a Boothroyd Dewhurst forum on resurrecting U.S. manufacturing last year.

Tsai spent much of his career at Eastman Kodak, where he helped move digital camera production to China. “We started producing parts there and assembling them in U.S. factories where the intellectual property resides,” he recalled.

“The Chinese wanted to grow the service, and instead of parts they offered to sell us finished, tested components. Eventually, we would ramp up new products in U.S. factories, then move them to China. The next logical step was to ask why we needed to spend millions to move production. So we shut down our factory and moved production directly to China. That was my job as global production manager before I left.

“We’re now teaching our Chinese brethren to launch and support technology products with as little support as possible from the United States. They have the technological competency, the IP, so what's next? Designing the product? Kodak has no need in the United States for technical people or scientists. So if you look at where Kodak is going, it's becoming a marketing company.

“Where is all the value and IP created? That's in China. If my experience at Kodak is any indication, we’re on a nasty slippery slope to becoming the premier third-world country,” Tsai said. (A Kodak spokesman, Christopher Veronda, said the company uses contract manufacturers to make cameras in China, and that Rochester, N.Y., is its largest R&D center “by far.”)

Tsai also told a second story. Seven years ago, he helped an oscilloscope manufacturer move production overseas. “We had a high volume product, and we could save $600 to $700 on a $4,000 unit. It was all about the money. It was cheaper to build in Asia than the United States,” Tsai said. Soon the company was making its volume product in China and its high-end products in New York.

This story, however, had a different ending. The recession caused sales to plummet. “The company found itself with excess manufacturing capacity and high fixed costs at its New York facility,” Tsai said. “The economics had flipped on its head, and all manufacturing is coming back to the U.S.” The company was willing to pay 10 to 15 percent more to make its volume products in New York rather than try to support two manufacturing plants.

The bad news about U.S. manufacturing, encapsulated in Tsai's first story, is well known. But there is good news too. U.S. manufacturing output reached $1.6 trillion in 2008, larger than the gross domestic product of all but seven nations. While jobs declined this past decade, output continued to rise. U.S. productivity has been growing even faster. Exports are up, costs are under control, and wages, benefits, lawsuits, and even government regulations pose less of a barrier than they did even a few years ago.

Many companies have revisited their outsourcing strategies. According to a survey by the international accountant firm Grant Thornton, 20 percent of U.S. respondents brought sourcing closer to home in 2010 and 28 percent did so in 2009.

So what happens as the United States climbs out of the recession? Does production move overseas or return home? Does American manufacturing muscle bulk up or atrophy? Let's start with the bad news first.

Job losses in manufacturing have been staggering. Manufacturing employment remained stable, between 17 million and 18 million workers, for 20 years prior to the 2001 recession, when it slipped to 16 million. Instead of rebounding, though, employment plummeted until it reached 12 million workers in 2009.

Then there is China. Unlike most other developing nations, China has an enormous internal market. In exchange for market access, China demands that foreign businesses build factories in China using the latest technology—and take on Chinese partners. This combination of economies of scale and a growing class of engineers and managers weaned on Western technology, coupled with low-cost labor and government incentives, turned China into a manufacturing juggernaut.

China also undervalues its currency. This makes Chinese exports significantly cheaper. From 2005 to 2008, China let the renminbi's value rise 20 percent. This sounds like a lot, but many economists argue that it needs to appreciate another 20 to 40 percent to reflect its true value.

For proof, they could point to a 2009 International Monetary Fund estimate of what a currency could buy in its home country. Using this purchasing power parity approach, it pegged one U.S. dollar at 3.8 renminbi. The exchange rate for the past 18 months was roughly 6.8 renminbi to the dollar. This suggests that China is discounting its currency by nearly 50 percent to help exports.

When questioned about the difference, Xie Feng, China's deputy ambassador to the United States, noted that even when China allowed the renminbi to rise, the trade deficit continued to rise. He noted that China is already America's top customer for soybeans and Boeing aircraft, and that the United States could close the trade gap by selling China advanced military hardware.

The combination of low wages, good technology, and undervalued currency gave Chinese manufacturers a huge cost advantage on U.S. shores. It enabled China to vault past Germany, Japan, and the United States to become the world's largest manufactured goods exporter.

Low prices forced some U.S. factories out of business. Yet the percentage of plant closings in the United States remained fairly level between 1992 and the 2008 recession, according to a study by the Manufacturers Alliance for Productivity & Innovation, an industry research group. But starting around 2000, there was a significant decline in the number of U.S. factory openings. Apparently, many manufacturers had better bets than investing in America.

The going is tough, especially for smaller manufacturers, said Alan Tonelson, a research fellow at the U.S. Business and Industry Council, an association of privately owned manufacturers. He is the author of The Race to the Bottom: Why a Worldwide Worker Surplus and Uncontrolled Free Trade Are Sinking American Living Standards.

One of underappreciated effects of not challenging China's undervalued currency “is that it erodes manufacturing margins,” Tonelson said. “Companies need high margins to invest in equipment to stay ahead of the competition. Their margins are paper thin right now.”

Joel Popkin and Kathryn Kobe, two economists who worked on a series of papers for the National Association of Manufacturers, agree. “There's been some change in capital investment in manufacturing,” Kobe said. “It's an area of concern. One reason why is thin margins. There's a limit to how much people can protect themselves against that.”

Yet American manufacturing remains strong in many ways. While employment has fallen sharply in the past decade, output has not. And while the value of manufactured goods has not kept pace with the rest of the economy, this is not necessarily bad news. While overall U.S. prices rose 33 percent between 1995 and 2008, the price of manufactured goods declined 3 percent, according to the U.S. Bureau of Economic Analysis. In other words, more stuff and lower costs.

Since 1986, U.S. manufacturers’ labor costs have decline 40 percent when compared to 14 developed countries in Europe and Asia that are major competitors in international markets.

Source: U.S. Bureau of Labor Statistics

Grahic Jump LocationSince 1986, U.S. manufacturers’ labor costs have decline 40 percent when compared to 14 developed countries in Europe and Asia that are major competitors in international markets.Source: U.S. Bureau of Labor Statistics

Relentless pressure from imports forced prices down, especially for cars, computers, and electronics. U.S. producers also boosted productivity faster than most major competitors, according to the National Association of Manufacturers. Some gains were achieved by applying R&D, lean manufacturing, and factory automation. Other gains came by sending labor-intensive manufacturing offshore. “Some of those productivity gains were generated by layoffs, and those jobs are not going to come back,” Popkin said.

Controlling costs helped U.S. manufacturers boost exports 9 percent annually between February 2002 and July 2008. They were also helped by a weakening dollar, which fell 26 percent over the same period.

Many analysts are optimistic about the future. One is Jeremy Leonard, an economist whose October 2008 study for the Manufacturers Alliance, The Tide Is Turning, found that U.S. manufacturers had closed the competitiveness gap with other nations.

Leonard looks at what he calls “structural cost pressures” that add to the cost of manufacturing in the United States but not other countries. He found that in 2008, those additional pressures added 18 percent to the average cost of U.S. exports, but that was down from 32 percent in 2006.

U.S. manufacturers have survived a fearsome onslaught from Chinese manufacturers, fueled by low wages, undervalued currency, and good-enough technology. The survivors emerged leaner and in many ways more competitive. President Obama has called for America to double its exports.

“That's an impossible goal, especially for smaller manufacturers,” said Harry Moser, chairman emeritus of machinery manufacturer GF AgieCharmilles. “If you have only 10 or 15 guys, and you don’t have a brand or a proprietary process, you can’t compete in China. It's hard to export. But what you can do is compete with imports.”

Moser, who has been organizing “reshoring” events, admits that it will not be easy. “We import 66 percent more than we export. That says something about relative cost competitiveness,” he said. “We have pretty good anecdotal evidence that purchasing agents and supply chain managers just compare f.o.b. prices, and if they’re 20 to 30 percent lower, they buy from China.”

Moser recommends looking at total cost of ownership instead. This includes such factors as packaging, shipping, duties, inventory carrying costs, additional quality management, additional prototypes, and end-of-life obsolete inventory. He estimates that this gives U.S. factories a 24 percent home field advantage.

“We can’t reshore products that are low quality, rely on cheap labor, or have no regulatory or safety issues,” Moser said. “But if you need high quality, a short pipeline that can handle volatile demand that fluctuates month to month, or a reduced carbon footprint, we’re competitive. Instead of trying to increase exports, Obama should ask American companies to give U.S. suppliers a second chance.”

Moser held a reshoring event in May—a daylong gathering of people representing U.S. job shops and potential buyers. He is planning a second one in October.

Some manufacturing has already come home. A 2010 Grant Thornton survey of U.S. manufacturing executives found that 20 percent of respondents had brought production back to the United States and other parts of the Americas in 2009.

“Companies want their plants where their customers are, and make sourcing decisions based on that,” Steve Lyman, a Grant Thornton partner, explained. “They’re rethinking whether it makes sense to produce something in China and then incur the logistics costs to bring it to the United States.”

Manufacturers now understand how fully loaded costs—Moser's total cost of ownership—will fluctuate, Lyman said. He said an apparel company outside Atlanta had moved a couple of production facilities to China in the mid-1990s. It started reevaluating its strategy in 2008, when oil, transportation costs, raw material, and Chinese labor costs shot up.

It is now moving manufacturing for products sold in North America to Guatemala and sourcing fabric from Latin American suppliers. “The labor price may be higher, but the fully loaded price is less expensive,” Lyman said. “The China strategy sounds good, but people really needed to think about their customer base and why they go there.”

That's a very different approach from the mad rush into China during the past decade. No doubt, America's ardor with Chinese manufacturing has cooled. According to the Grant Thornton survey, 49 percent of respondents felt offshoring improved return on investment. Another 44 percent said it had no effect.

Undoubtedly, work will continue to flow to China. For certain types of labor-intensive, mass-produced products, China's cost advantages will remain attractive, even if its currency appreciates. And Chinese manufacturers are by no means standing still. Many have invested in the best technology the West and Japan have to offer. They will only get better.

Some work will move to low-wage nations in Latin America. Near-shoring is not the same as bringing work back to the United States (though three out of five companies that near-shored did just that in 2010). Yet near-shored plants are easier to manage because they are close and share the same time zones as the United States. This makes it far easier for U.S. managers, researchers, and engineers to interact with plants, so those functions stay in the States.

Closing the Gap

In The Tide is Turning, economist Jeremy Leonard identified “structural” nonmanufacturing costs that boosted the price of U.S. exports. They included employee benefits, lawsuits, regulatory compliance, taxes, and energy cost. In 2006, these costs added an estimated 32 percent to the cost of U.S. exports. By 2008, the gap had declined to 18 percent.

Benefits accounted for nearly 7.8 percentage points of the U.S. disadvantage in 2006, but only 3.6 points in 2008. Companies have reined back their contribution to retirement plans, and have asked employees to pay an increasing share of health plan costs.

What happens when employees subtract the money they now pay for benefits from slow-rising wages? Alan Tonelson, a research fellow at the U.S. Business and Industry Council, is blunt: “Relative to Europe and Japan, the United States is no longer an extremely high-labor-cost country.”

Gains were also made in tort reform. Legislation enacted in the mid-2000s moved class-action lawsuits to federal courts, instead of allowing attorneys to shop around to plaintiff-friendly jurisdictions. It also changed the formula for attorney compensation to reduce frivolous lawsuits.

Leonard estimated that regulatory compliance costs added only 1.8 percent to the cost of U.S. exports, down from 5.2 percent in 2006. One reason was that the Bush administration was less interested in regulation. In pollution control, the one area where Leonard could compare international data, costs in other countries, especially China, grew rapidly.

Taxes remain problematic. “Only Japan has a higher corporate tax rate than the United States,” Leonard noted. “It's commonly thought that the United States has so many preferences, like generous depreciation, that our effective tax rate is low. In fact, it's higher than for our nine major trading partners.”

The U.S. tax system also encourages companies to expand overseas. “Most countries only tax corporate income within their borders,” said Dmitri Shiry, a partner in the accounting firm Deloitte LLP. “We have a worldwide tax system, but only if you repatriate the earnings.”

As long as companies keep their earnings abroad, they pay no tax on them. “To the extent that non-U.S. earnings are invested outside the United States and not repatriated, they provide increased after-tax earnings for investments, acquisitions, and daily corporate business needs,” Shiry said.

U.S. manufacturers will emerge from this recession leaner than ever. Most of the jobs lost are unlikely to return. They will be replaced by outsourced (and perhaps near-shored) production that will make U.S. factories more productive and competitive than ever. The United States retains a reputation for quality, and exports are likely to grow if the dollar remains weak.

Between 1980 and 2007, China's share of value added in global manufacturing rose to 14 percent, from 2 percent, while the United State's generally held steady from its 1980 level of 22 percent.

Grahic Jump LocationBetween 1980 and 2007, China's share of value added in global manufacturing rose to 14 percent, from 2 percent, while the United State's generally held steady from its 1980 level of 22 percent.

What comes after the recession? U.S. manufacturers will continue to do what they have always done: they will keep changing. Just as Chris Tsai recounted, some will continue to send manufacturing and engineering offshore, where less buys more. Others will bring work closer to home to reduce risk.

Manufacturers will, in essence, vote with their money, just as they did when they embraced assembly lines, factory automation, lean production, and the migration of factories from the North to the South and West. The individual decisions of thousands of manufacturers will create a new paradigm that will serve until the next great challenge, when they come to a new crossroads again.

Should Manufacturers Get Special Treatment?

When manufacturers advocate policy changes, from tax breaks to tariffs on imports from currency-manipulating countries, to help them compete, W. Michael Cox, former chief economist of the Federal Reserve Bank of Dallas, disagrees. “People and companies are only as strong as they need to be,” he said, noting that protection never helped the auto industry.

According to Cox, the United States should not protect manufacturing, but should export services. After all, finance, insurance, and real estate services constituted 20 percent and professional and business services 13 percent of the U.S. gross domestic product in 2008, compared with 11.5 percent for manufacturing. The United States already runs a large service export surplus (though it is dwarfed by manufactured exports).

U.S. Business and Industry Council research fellow Alan Tonelson argued that manufacturing must be protected. “You can only create real new wealth by taking stuff that exists in nature and turning it into things people need or want to buy. Services can grease the skids, but they do not create wealth by themselves.”

Cox disagreed: “If a good produces a service, it has value. If it produces no service, it has no value. For example, I used to wear glasses and then I had laser surgery on my eyes. I traded the service provided by my glasses for the service of Lasik.”

Cox said that the United States can export engineering services around the globe. It does not really matter where the factories are, as long as U.S. engineers can reach them.

Kenneth Kraemer, former director the Center for Research on Information Technology and Organizations at the University of California, Irvine, is not sure. He surveyed 400 manufacturers. “The more a company outsourced manufacturing, the more it outsourced the physical design and development of its products,” he said.

Outsourcing benefits companies, their industries, and their products but not key sectors of the U.S. economy. As Joel Popkin, a National Association of Manufacturers economic consultant, put it: “Wherever manufacturing is, that's where R&D is too.” According to the National Science Foundation, manufacturers accounted for $190 billion of the $400 billion spent on R&D in the U.S. in 2008.

Plus, the Department of Commerce finds that every dollar spent on manufacturing generates $1.40 in other, related fields. This is because of manufacturing's backward linkages to other sectors of the economy, such as energy, raw materials, construction, and services ranging from engineering to accounting and logistics.

Copyright © 2010 by ASME
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