Bringing Manufacturing Back Home

By F. Barry Lawrence, Ph.D. Texas A&M UniversityThe Texas Mexico (TMEX) Trade Corridor Consortium started three years ago due to some troubling issues that were adversely affecting our region. Manufacturers were leaving the US and Mexico at an alarming rate. As logisticians, we felt this could not be right since supply chain costs should easily overwhelm any labor savings. We believed that firms had not done a proper job calculating the supply chain costs. 

THE CHINA DEBACLE

The manufacturing decision to locate in China and serve North America was not a good one, the high notes are:

• Manufacturing costs were pretty much equal across the two continents with the exception of labor. Chinese labor was underestimated in terms of growing hourly costs and training expenses.
• Transportation costs were properly forecasted but most did not plan for logistics company capacity shortages and rising oil prices, which quickly made Pacific shipping very expensive.
• Expediting costs were not included, big cost.
• Inventory costs were underestimated. Major miss on this one, Chinese labor could be free and, in many cases, it still would not be justified based on inventory costs alone.

After a decade or so many businesses which jumped on the China bandwagon learned a tough lesson about attention to details and what really affects the bottom line. What's the total cost of doing business? Think total, not just labor comparisons. It takes a look at all the numbers to make the right decision. Look past labor -so many don't- and a whole lot more costs loom.

Many of the costs are driven by items not found on any ledger line. More of them should. The message becomes, "What you need to know, not what you want to hear!"

Sometimes the dollars don't get greener on the other side of the Pacific.

A decade ago, the electronics companies were the first ones to take off and run, leaving electronics focused cities like Guadalajara devastated.

What went wrong? The companies were basically looking at the location equation but either not calculating accurately or leaving things out altogether. China as an emerging country had the chance to put the land in place. They were able to match facility costs with North America without too much difficulty. The second thing that came up was transportation – this would become their "Achilles' Heel." They had to overcome transportation with labor, and they did not properly calculate transportation. The third component was labor. On labor, China looked good on the books. It looked good, but people didn't calculate it correctly.

Other factors that got left off the table included inventories, finance, taxes, security and bureaucracy. China would make sure they were competitive on taxes. So what it came down to was taking taxes and facilities out of the way. Then they let labor take on transportation. Labor won for all the wrong reasons.

The first thing concerning labor was it is one thing to say Chinese labor is going to be one-tenth of U.S. or one-fourth of Mexico. What that reasoning does not get into is you have to train them. Keep in mind that training in Mexico is going to be more expensive than training in the U.S. because you may have language barriers and differences in education levels. But it was not a major leap because the two countries culturally understand each other extremely well. There could be people coming from the southwestern United States. There is an ample supply of bilingual people from the U.S. and Mexico. It was not that hard.

In China, it was a totally different situation. You get over there and right away, how many ex-pats are you going to find who speak excellent Chinese? If you find that ex-pat is going to cost you a lot of money. The ex-pat is going to be paid a much higher amount.
If you open up in Mexico, there's a good chance multiple executives from the company have been there and know something about it. If they don't, it is not expensive to get them there. With China, you got to fly them business class. They haven't been there before. They don't know much about it. Getting people the institutional knowledge to be able to hire and lead people effectively became a huge issue with China.

The Chinese operate on a three-year contract. You don't have any middle management in China. The middle management you can find is not usually bilingual. Your ex-pat winds up with an army of translators and consultants. Those are all additional costs piled on. As you are going through the training process, one of the first things that happen because they work on a three-year contract, you get the middle manager trained, and then everyone else moving over there wants them.

So what happens is you have tremendous turnover of your middle management which is the most difficult team to train, and are the ones you are counting on to train the rest of your employees.

By the time you get over all this and you are still saving money over the U.S., you're lucky. It is very doubtful you are saving money over Mexico on labor. But labor was supposed to take care of the transportation costs.

People missed the boat on transportation costs. When it comes to transportation costs, what they did not factor in was the volatility of fuel. If everyone starts shipping all over the place and fuel costs rise with the economy, would your cost equation still be good? No one did a probability analysis and when oil went to $150 a barrel, it did not make sense to ship out of China under any circumstances.

If fuel was not enough of a problem, what about shipping capacity? If everybody's moving over to China, how much shipping capacity is there in the world to handle this? The fact of the matter is there wasn't sufficient shipping capacity to handle this situation. So shipping prices start rising due to the demand. On top of that, shipments back to China are primarily empty back haul. You run into capacity constraints; you run into logistics carriers violating their contracts because they can make more money doing something else when they want to.

Regarding inventory, nobody wants to admit how much it costs to hold it. Nobody wants to do the hard math to calculate how longer lead times and higher variability associated with those lead times affect inventory.

So starting with the first one -- holding costs of inventory – there are four categories: cost of capital; cost of storage space; cost of obsolescence and cost of insurance and taxes.

It's really easy to ignore obsolescence and assume it is going to be the same to ship it across the Pacific Ocean; think again! Insurance and taxes may be a wash, but those are small numbers. Big numbers include storage costs and, especially, the cost of capital. More often storage costs are underestimated, especially if one carries a larger inventory. Instead of the often predicted 10 percent, it is closer to 18 to 24 percent for the costs of storage of inventory.

When you move over to the cost of capital, no one wants to admit that cost into the calculation of inventory holding costs. The reason is that cost of capital for many of these firms in a non-risky environment is at least 15 to 20 percent. In a high-risk environment, like going overseas, it's got to be 25 to 40 percent! Add up the storage and capital costs with the longer lead time and then you have to explain why you are holding so much inventory. Nobody wants to do that. They'll never admit how high holding costs are.

Inventory holding costs alone tell us that serving North America from Asia is not viable.

But they didn't calculate that. They didn't want to; they did not want to admit to themselves how much shipment was going to cost. They stay there three or four years and still try to figure out why they are losing money. 

SO MANUFACTURING IS COMING HOME, RIGHT?

Well, not exactly. Mexican manufacturing is up more due to firms that are already operating in Mexico expanding their production. China got shutdown during the downturn and it has taken awhile for them to get back up and for product to make it across the ocean. But if it makes more sense to produce close to home, they'll still come home, right? The problem is that China is equidistant between the largest markets (North America and Europe) and close to the emerging ones (Asia and the Subcontinent). Any firm planning to serve those markets would not want to pull out of China. The next option is to replicate manufacturing plants in the West. That's expensive and although some will, many others may hesitate. Is there another option? 

POSTPONEMENT

Dell Computer shocked the industry with the introduction of postponement. Postponement puts off final production until the last possible time that will meet customer needs. The benefits are significant. The product is not produced until demand is well established (better forecasting) and is kept in a raw material or subassembly state until then (lower inventory value and more flexible to market shifts). Inventory value plummets and customer service levels rise.
But Dell focused on postponement in a time only sense, they did not begin manufacturing until the order was taken. Not possible in most cases. The other option is postponement in terms of place. A sub assembly or non-differentiated product can be made by a high volume, efficient factory in say Tianjin, then shipped to Panama for further value add, then shipped to the US or Mexico for final value adds before hitting its final markets in Mexico City, Dallas, or New York.

At each value add manufacturing stage, the product will gain value and, therefore, cost. The inventory holding cost will decrease for the supply chain since the product does not gain its full value until it reaches its home market. Forecasting improves as the final product will not exist until shortly before demand occurs. Further upstream, the consolidation of demand from many markets will vastly improve manufacturing's forecast. The improvements will lead to lower supply chain costs and will enable even more differentiation (selection for the consumer).

Customers in emerging markets want the same quality levels as in the developed countries. To provide this quality, manufacturers offer fewer features on product destined for emerging economies. Customers hunger for products that differentiate on features, cultural themes, regional characteristics, or technology. A solution is to make one common base product and add features as we get closer to the targeted market. The demand for differentiation is only likely to grow. The ability to differentiation nearly immediately may become the primary competitive advantage in the future. The cost of opening value add manufacturing facilities in a multitude of target markets would be prohibitive, however. Manufacturers have three options, each with their strengths and weaknesses: 

- Option one: Own the entire supply chain.

• Strength: Control your brand's representation (very important) and product design throughout the supply chain.
• Weakness: Expensive, limiting growth opportunities. Takes your eye off the ball. The most important elements to success are design (to provide exciting, differentiated products) and brand (to stay in front of your customers). Owning the entire supply chain will force the firm to fund and control so many different activities that it will be difficult to become best in class at what matters most.

- Option two: Outsource value add manufacturing to logistics firms.

• Strength: Much less expensive as the logistics providers have locations in most markets already.
• Weakness: Logistics companies are new to manufacturing (some are already investing) and may suffer some quality or design issues. Logistics companies do not have a sales and marketing presence with the manufacturer's customers and will not be able to forecast effectively or deliver valuable market intelligence making differentiation less agile. - Option three: Outsource value add manufacturing to distributors.
• Strength: Less expensive (same as logistics firms) since distributors have an even more local presence. Sales and marketing advantages since the distributor has a sales force tied to the customers. Forecasting opportunities and flexibility for product changes.
• Weakness: Manufacturers may not trust distributors since they often carry competing brands. They sometimes feel the distributor will not represent their brand or may even do damage to it. Relationships would have to be reworked with incentives for distributors to reduce their supply base and build stronger alliances with core manufacturers.

Of course, manufacturers may and probably will choose some combination of the three. Examples of each abound. Automotive distributors and dealers are increasingly adding value to cars. Distributors construct larger, more powerful units from valves and motors produced by a distance manufacturer. When you put apps on your smart phone, you become the final value add manufacturer. This traditional process is about to explode.

The final configuration is not set, however, and whoever offers the best vision will get the lion's share of this exploding business opportunity like China did when everyone wanted low cost labor. Your region needs a brand and a value proposition. If they don't think you have the vision and determination, they will simply choose a region that does. Do we have that vision?