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The China Road PUBLIC ACCESS

The Outsourcing Option isn’t a Cheap or as Easy it Looks.

[+] Author Notes

Alan S. Brown is a freelance writer and frequent contributor to Mechanical Engineering. He lives in Day ton. N.J.

Mechanical Engineering 127(03), 36-40 (Mar 01, 2005) (5 pages) doi:10.1115/1.2005-MAR-3

This article highlights China’s unusual combination of low wages, modern technology, and an enormous potential of internal market. It is easy to see that labor and materials costs are cheaper in China, but it is harder to pin down the costs of stolen intellectual property, complex supply chains, inflexible manufacturing schedules, and project management overhead. Low-cost labor and high-tech manufacturing have made China the leading destination for companies looking to cut costs by outsourcing production. China’s combination of low labor costs and modern technology-aided by lax intellectual property enforcement makes it a manufacturing powerhouse. It’s increasingly prosperous internal market enables efficiencies of scale. It takes time and commitment to make Chinese manufacturing relationships work. In some cases, they may not work at all. As companies learn the hidden costs of outsourcing, they may find it does not yield the promised savings. This is especially true for products that require customization, proprietary technology, or quicker reaction to market trends.

Everyone knows the cheap-imports stories: Automated plants closed. Old line producers now distributing imports. Counterfeit imported goods. Mass layoffs as more production moves overseas.

Any discussion about how U.S. companies are outsourcing manufacturing quickly becomes a discussion about China. China’s unusual combination of low wages, modern technology, and an enormous internal market of more than one billion people has forged the world’s lowest-cost modern manufacturing infrastructure.

It is easy to see that labor and materials costs are cheaper in China, but it is harder to pin down the costs of stolen intellectual property, complex supply chains, inflexible manufacturing schedules, and project management overhead.

These hidden costs exist. When unmasked, they suggest that outsourcing manufacturing to China is not always a simple decision. In fact, looking for the quick bottom line fix often leads to disappointment.

Today’s outsourcing is unlike waves of factory closings in the past. In the 1950s and 1960s, steel, textiles, and shipbuilding began to move overseas. In the 1970s and 1980s, consumer electronics, plastic products, and automotive parts followed.

Alan S. Brown is a freelance writer and frequent contributor to Mechanical Engineering. He lives in Dayton, N.J.

What’s different today is that some low-wage countries have begun to add technology to the mix at increasing rates. Over the past decade, the production of many advanced technology products, from circuit boards to cell phones, began to shift to such emerging Asian economies as Taiwan, Singapore, Malaysia, and South Korea. Much of that work eventually gravitated to China. By 1995, China was exporting more technology products to the United States than it was importing.

Today, says outsourcing expert Ronil Hira, an assistant professor of public policy at Rochester Institute of Technology in New York, China’s technology trickle has turned into a flood. “What are our best-selling items to China, where we ran a $2.8 billion surplus,” he asks. “Oil seeds and soybeans. What are China’s biggest selling items to us? Computers, electrical machinery, and capital equipment, where Beijing ran a $50 billion surplus.”

The emergence of China as a global market economy is an epochal event. Unlike other low-wage countries, it has a huge and growing internal market of 1.4 billion people— 20 percent of the world’s population—to support its factories. While vast swatches of the country are undeveloped, many areas are moving rapidly into the new century.

China’s economy is huge. It has grown about 9 percent annually for the past 15 years. At $6.4 trillion, it is nearly 60 percent as large as the United States and almost twice as large as third-ranked Japan. It has become the third-largest trading nation, after the United States and Germany. Over the past decade, 120 million Chinese have moved to cities to feed its factories.

Although the average Chinese income is equivalent to only $5,000 per person, it is not distributed evenly. Along China’s rapidly developing coast, income is twice the countrywide average. China’s middle class, more than 100 million people strong, is larger than the entire population of Germany and somewhat smaller than that of Japan.

It has a huge appetite for consumer goods, such as cars. At five million vehicles, it is the world’s third largest auto market. General Motors Corp. alone sold nearly half a million cars there in 2004. People who have visited Beijing say it has gone from a city of bicycles to a city of cars in less than five years.

Corporations from all over the world want a slice of this lucrative market. China is happy to oblige them—with one significant condition: Companies that build factories in China must transfer technology as part of the deal. Most businesses, from behemoths like GM to small firms like composite golf club maker Aldila Inc., are eager to comply.

While most of Chinas new factories serve the local population, many others export. More than half of all Chinese exports to the United States are from factories owned outright or pardy by Taiwanese, Japanese, and U.S. companies.

The result is something new under the sun: low wages and a thriving internal market harnessed to advanced technology. Once in China, new technology tends to move freely. Chinese enforce intellectual property restrictions loosely if at all. As a result, even local Chinese companies can often compete globally.

Many are no longer competing with cheap knockoffs, low-quality goods, and labor-intensive assemblies. Instead, they are making high-definition televisions, computer displays, third-generation cell phones, and computer and net-working hardware. Those high-tech products are growing faster than other Chinese exports to the United States.

Emerging mega-market: General Motors officially launched the Cadillac brand in China at Beijing’s Imperial Ancestor Temple in June last year.

Chinese original device manufacturers now engineer and manufacture everything from cell phones to PDAs for some of the world’s largest c onsumer electronics makers, according to Roger Wery, practice leader for outsourcing strategy at global management consulting firm Pittiglio Rabin Todd & McGrath of Mountain View, Calif. “There’s not a single hour of engineering invested in these products by Palm, Sony, Ericsson, and others. They simply put their name on these cost-competitive entry-level products and engineer the more advanced models themselves.”

Yet China is increasingly competitive at technology’s edge. In December, for example, Huawei Technologies Co. Ltd., China’s largest telecommunications provider, signed a deal to build a third-generation mobile phone network to Telfort BV, the Netherlands’s fifth largest mobile carrier.

“Wireless was an area where the United States and Europe were leading,” Wery said. “Korea and China have closed the gap and are priced aggressively. If we don’t have an IP lead on them, how long can we justify our cost advantage?”

Low-cost labor and high-tech manufacturing have made China the leading destination for companies looking to cut costs by outsourcing production. In the past, RIT’s Hira said, U.S. companies would have fought to protect domestic production. Today, businesses embrace offshore outsourcing to cut costs. Some buy from Chinese producers. Others build their own factories or joint ventures. Even companies that want to keep manufacturing in the United States may feel forced to look offshore to remain competitive.

Shanghai GM began exporting a 10-seat version of Buick GL8 executive wagon to the Philippines in 2001.

Grahic Jump LocationShanghai GM began exporting a 10-seat version of Buick GL8 executive wagon to the Philippines in 2001.

If China’s advantages are well understood, not all of its costs are immediately obvious, according to Nicholas P. Dewhurst, executive vice president of Wakefield, R.I.-based Boothroyd Dewhurst Inc. Dewhurst works with companies that use his software to reduce manufacturing and assembly costs. Many compete or outsource to China. “I don’t believe anybody yet has a handle on what outsourcing costs truly are,” Dewhurst said.

“Let me give you an example,” he said. “On the way to Cincinnati, I overheard someone say he had just bought a set of Callaway Golf Clubs and a bag for $250. That’s a bargain because the bag alone usually goes for $350.

“There was a problem, and he sent them back to Callaway for repair,” Dewhurst said. “Callaway wouldn’t touch it. It was a Chinese knockoff, copied right down to the patent numbers. How do you, as Callaway, capture the cost of that?”

Although Callaway was not able to verify this specific incident, a spokesman said the company would not repair counterfeit articles. According to a press release issued early last year. Callaway pursued enforcement actions in 11 countries in 2003. The actions involved 37,000 individual counterfeit products, including golf clubs, clothes, and bags. The company said one case, which resulted in a criminal charge against a U.S. reseller, was traced back to a supplier in China.

The cost of stolen intellectual property and lost opportunities is not as easy to calculate as the cost of labor when deciding whether or not to outsource. Many companies also underestimate the time and energy needed to manage projects on the other side of the globe or to master the complex supply chain from China.

Few hard numbers about the true cost of doing business in China are readily available. Recently, however, firms such as Pittiglio Rabin Todd & McGrath and supply chain consultant Aberdeen Group Inc. of Boston have conducted studies that are examining some of these issues.

The 7,000-mile supply chain that stretches from China to the United States is the most obvious place to dig for hidden costs.

“Logistics costs in the United States are below 3 percent of revenue,” according to Aberdeen’s senior vice president of research, Chris Jones. “Our study found companies in China were paying from 6 to 12 percent of revenue, depending on product and factory location.

“People sometimes don’t understand all the complexity involved when going from truck-based shipping in a single country to cross-border, multimode logistics,” Jones said. “We’re talking about goods passing through the hands of 17 to 24 different parties. They include manufacturers, crate forwarders, consolidators, customs and regulatory agencies, carriers, ports, and more.”

It is easy to underestimate potential revenue losses when bringing products into the United States. Last holiday season, for example, companies struggled to bring goods to market by Christmas. For some, port backups made the difference between full price or profit-eating markdowns.

Jones found that 42 percent of the firms he studied took more than 60 days to receive an order from China, compared with only two weeks in the United States. Surprisingly, 89 percent of the firms with the longest lead times also had the highest logistics costs.

“You’d think slow shipments would be cheap, but it indicates that they don’t know how to run their supply chain,” Jones said. “They are the ones paying extra for expedited shipping or writing off their Christmas revenue.”

Wery at Pittiglio Rabin Todd & McGrath agrees. Companies frequently spend more on air shipments than planned. This makes up for inflexible supply chains that have four to five weeks of products in transit at any given time. Importers often tie up extra money in inventory to guard against shortages.

Extended supply chains are also slow to react to schedule changes, Wery said. “A producer in the United States can respond within 24 hours to changes in product mix, such as color, packaging, and delivery location,” he said. “In Mexico, it takes about three or four days. In China, they need five to six weeks.”

That creates huge problems for companies in markets where new looks and features count. “If you’re six months behind the market leader, your revenue potential could be cut in half,” Wery said. “On paper, outsourcing saves money, but your time to market is not guaranteed.

“Right now, we’re working with a client that is doing systems engineering in California, writing software in Russia, and manufacturing the electronics in Malaysia. All the back-and-forth between different time zones impacts time to market. They might have been better off spending 20 to 30 percent more for the product and getting to market earlier.”

Because the supply chain is so long and rigid, most successful practitioners limit outsourcing to products or standard components that rarely require changes and have established, predictable markets. Others prefer nearshoring in places like Mexico, where they save on labor but can respond faster to market fluctuations.

Intellectual property is a major concern for anyone who does business in China. The Callaway golf clubs are only flotsam in a flood of knockoffs that deluge the United States each year.

“IP is an issue in China and in the Asia Pacific region, and it’s nothing we should be shy about,” said Kevin El-good, engineering director for TRW Automotive Holdings Corp.’s Asia Pacific Technology Center in Shanghai, China. “They do reverse engineering and they have little regard for IP.”

One of the reasons TRW established its own engineering center in China was to give the company more control over its own and customer’s intellectual property. Even so, advanced technology development remains in the United States; Chinese engineers adapt the designs to local markets.

This helps, but it is no sure solution, according to Wery. “If you have engineers offshore, they become prime targets for Chinese companies seeking to hire talent,” he said. “Poaching happens, so you’re never completely protected.”

Companies have other ways to protect themselves. They slice projects into modules, retaining value-added systems engineering at home, while outsourcing mechanical engineering, electrical engineering, and manufacturing to different vendors. This keeps any one company from reverse engineering an entire product.

Other companies send out only low-value work. “Take tools and dies, for example,” said automotive analyst David Cole, chairman of the Center for Automotive Research in Ann Arbor, Mich. “You can do the rough cut anywhere in the world. You just pick who has the lowest price. It’s the sophisticated fitting of the dies in the plant that adds value, and you have to be on the scene to do that.”

Developed nations continue to pressure China to fully enforce patents and other intellectual property protection. Some companies have hired investigators to collect evidence. Even when China shuts down violators, many simply relocate elsewhere.

It takes management time and energy to overcome offshore outsourcing’s distance and cultural barriers.

“There is a cultural difference,” said Craig Hergen-roether, chief information officer of packaging equipment maker Barry-Wehmiller Cos. Inc. of St. Louis. “We deal with brilliant people, but they’ll say yes to everything.

Still waiting for the Bounce

The United States' manufacturing trade deficit reached $401.3 billion in 2003 and grew 17 percent during the first 11 months of 2004. At the same time, U.S. manufacturing output rose only 7 percent in the three years since the end of the 2ÜÜ1 recession. That’s about half the bounce following the 1991 recession, and far below the 20 to 30 percent rebounds that followed the recessions of the 1960s, 1970s, and 1980s.

Meanwhile, manufacturing employment, which reached 17.2 million in 2000, fell to 14.4 million by 2004. Although the U.S. economy created 2.1 million jobs last year, only 76,000 of them—less than one out of every 25—were in manufacturing. Unemployment rates among engineers are the highest in modern times.

Some economists claim that a more robust recovery will ignite a manufacturing boom. It will certainly help. Yet, if the past is any guide, an economy that grew 4.4 percent and generated 2.1 million jobs should have jump-started manufacturing.

Is outsourcing causing a fundamental shift in manufacturing? A recent study for the U.S.-China Economic and Security Review Commission, which monitors China trade for Congress, finds the United States lost 1.5 million jobs to China between 1989 and 2003. Initially, the greatest impact came in low-tech industries like apparel and shoes. Today, the greatest rate of loss is occurring in industries once considered relatively immune, such as electronics, computers, and communications equipment.

This echoes an earlier study completed by the commission in mid-2004. It found the pace of job shifts overseas has picked up over the past three years. It estimates that as many as 406,GOO jobs may have left the United States in 20G4, about double the number in 2001. About one-quarter of them went to China.

“You’ll ask them to do something you know is impossible and they’ll say, ‘Oh, no problem.’ Then they’ll work 20-hour days, and when they miss a deadline, they’ll say they worked very hard,” he said. “Experienced companies have worked through these problems to develop better communications.”

Wery agrees. Companies need a “high-touch” approach to avoid misjudging the effects of language, culture, and time-zone challenges on product cycles and production planning.

Many firms are unprepared for the amount of project management—including late-night phone calls, lastminute travel, and supply chain monitoring—needed to bring an outsourcing relationship up to speed. It may take months or even years of heavy travel to ensure that both parties understand one another. Even then, companies need strong, consistent internal processes to avoid problems.

Sometimes, Chinese companies cut corners to meet price expectations of foreign customers. “Those businesses are often very entrepreneurial and not very mature,” Wery said. “They do not have established processes, infrastructure, training, or management. To achieve cost targets, they need to cut corners and end up doing things you would never do in the U.S., especially in environmental areas.”

Some Western firms look the other way. Others cannot afford to. They remember how low labor costs led to consumer boycotts against companies like Nike and Ikea during the 1990s. They worry about consumer reaction to charges of military-enforced labor or toxic disasters. Still, said Wery, it is an uphill battle to impose key metrics beyond those relating to cost.

China’s combination of low labor costs and modern technology—aided by lax intellectual property enforcement— makes it a manufacturing powerhouse. Its increasingly prosperous internal market enables efficiencies of scale.

An outsourcing study by Pittiglio Rabin Todd & McGrath found 65 percent of companies that outsource manufacturing offshore are satisfied with their relationships.

Yet only 4 percent of the 150 executives surveyed were “very satisfied” with their offshore manufacturing relationships after less than one year. Even after five years, that figure barely doubled to 9 percent. Only after more than five years did the number of “very satisfied” customers rise to 23 percent.

It takes time and commitment to make Chinese manufacturing relationships work. In some cases, they may not work at all. As companies learn the hidden costs of outsourcing, they may find it does not yield the promised savings. This is especially true for products that require customization, proprietary technology, or quicker reaction to market trends.

CNC machining centers (left) at TRW’s plant in Langfang. The company makes parts, including brake calipers (right) for automakers selling vehicles in China.

Grahic Jump LocationCNC machining centers (left) at TRW’s plant in Langfang. The company makes parts, including brake calipers (right) for automakers selling vehicles in China.

Auto analyst Cole predicts that the flexible U.S. economy will adjust to China just as it adjusted to Japan during the 1970s and 1980s.

“When we studied how Chinese manufacturing impacted the auto industry in Michigan, we first saw China as a competitor,” he said. “But you can’t go head-to-head with China due to labor costs. Instead, we’re now looking at China as a partner.

“The auto industry is in the middle of adopting a new business model that involves collaborating in real time across nontraditional boundaries,” Cole said. “This creates threats and opportunities. The threat is that they will come after our markets. The opportunity is that China’s new wealth will create a middle class market for us.”

That is, of course, classic economics: Every country benefits from free trade. But that doesn’t mean every industry and every business will benefit. The struggle of manufacturers to bounce back from the latest recession may be proof that a shakeout is in the works.

It is far from clear who the winners and losers will be.

Copyright © 2005 by ASME
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