The past two decades have witnessed a massive shift of manufacturing from the U.S. to China. Now there are signs of a reversal. What are the implications for those responsible for managing these supply chains?
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It is that time of year when we stop and reflect, creating top 10 lists for the past year, prognostications for the coming year, and step back and look at the big overarching trends. In 2012, more and more analysts and pundits pronounced the return of manufacturing onshore1
to the US or near-shore to Mexico (or the Caribbean). Is this real and lasting, what is causing it, and what does it mean for supply chain managers?
The Race to China
Starting in the 1990s and accelerating in the 2000s, there was a rush to outsource manufacturing to China and other low-cost countries. In part, it was driven by the lure of very low labor costs. But also by the promise of China and other emerging economies as markets with huge growth potential.2
There was a bit of gold rush mentality, underestimating the risks and costs. Over the past decade, a number of factors in the equation have changed:
Labor Costs—China’s labor cost advantage continues to shrink every year.3
In 2000, Chinese manufacturing wages were 52 cents/hour vs. $16.61/hr. in the US. Today, Chinese wages are about $3/hr. vs. about $20/hr. in the US. BCG4
forecasts Chinese rates will keep growing 17% annually and reach $4.41/hr. by 2015, compared to $26.06/hr. in the US.
Automation—American factories are increasingly highly automated. As a result, US manufacturing workers are approximately 10X more productive than Chinese workers, due almost entirely to the greater degree of automation in the US. Since US workers are paid less than 10X the amount Chinese
Fig. 1 - IMF Oil Price Forecast (as of 2011)
workers are paid, US workers’ productivity per dollar of labor cost is actually higher, though that advantage is partially offset by higher capital costs. Labor costs are an increasingly tinier portion of the overall cost equation in the US.
Fuel Costs—In 2000, a barrel of oil cost, on average, about $30. In 2012, the average was over $90 per barrel. This tripling raises the cost of transportation and its role in the overall cost equation, favoring manufacturing closer to the end markets, especially for heavier and bulkier goods.
Desire for Agility—The need for agility has only increased over the last decade. Product lifecycles continue to shorten. More companies are adopting a ‘fast-fashion’ model and/or demand-driven approaches. As a result, shorter lead times are sometimes worth more than lower costs.
Fig. 2 - Exchange Rate – Yuan / Dollar
Exchange Rates—The Yuan has strengthened against the dollar since the Chinese government eased its strict peg in 2005.
Realization of Risks and Challenges—Companies have experienced firsthand the difficulties of managing at a distance, especially with differences in language, culture, time zones, and legal systems. Painful experiences around quality, factory/labor conditions, Intellectual Property (IP) theft, environmental violations, and other problems have made companies think twice about their offshoring decisions.
China Is Not Going Away
There are factors on the other side of the equation that make China more attractive. There have been trillions invested in China’s infrastructure over the past decade. China’s infrastructure is largely newer, and in some dimensions better, than the US. There has been a huge build-up of manufacturing knowledge and capabilities. Some Chinese manufacturers have achieved world-class quality levels. And through painful lessons, many have learned how to meet the requirements of working with large global corporations, such as integrating with the various IT systems, following mandated processes and procedures, complying with requirements for working conditions, and so forth. So don’t expect Chinese factories to be abandoned wholesale anytime soon.
Having said that, there are signs the tide is changing and some manufacturing is returning to the US. Unfortunately, the rate of job creation is not proportional to the value of manufacturing production added, due to ever-higher levels of automation. Furthermore, the skill set required has changed—the previous skilled factory worker is being displaced by a technology worker who can keep those machines humming. In fact, many US businesses complain of shortages of workers with the right skills.
Implications for Supply Chain Professionals
These changes encourage a measured and deliberate approach to decisions about sourcing, manufacturing, and distribution locations. One important tool for making these decisions is Total Cost Sourcing, which quantifies the differences in total cost between different sources. Beyond the ‘factory gate price’ of the commodity or item, a total cost model adds up the various costs such as:
Total landed cost—transportation, duties, tariffs, broker fees, insurance, etc.
Inventory costs—less inventory is needed when the lead times are shorter
Cost of quality—higher quality reduces inspection, manufacturing, warranty/service and repair costs
Relationship costs—the costs of managing the relationship including integrating systems, communications, oversight, dealing with issues, etc.
This is just a partial list of the elements of total cost. The importance of each cost element varies tremendously depending on the product. Transportation costs are a relatively low percentage for semiconductors, but a high percentage for ore or lumber. That is why a semi-conductor factory could be on the other side of the world from the plant that uses that chip, but smelters are more likely to be built closer to the mines. And inversely, the cost of security (risk of theft) is low for ore and high for semiconductors. Therefore, the decision of which elements to include in a total cost model depends on the relative importance of each element for a particular set of products or commodities. See this article for more on Total Cost Sourcing.
Beyond the cost equation, there are other factors that can influence location decisions. As stated above, agility may be more important than cost (up to a point), leading to a decision to source near the end market. There is also some goodwill value to making things in the country where they are consumed. And there are still some local content regulations that may favor in-market production. Risks should be considered as well, including protecting your IP.
Supply Chain Network Planning and Optimization methods and tools can provide another systematic approach to making these types of decisions. This approach models the locations and attributes of a supply chain network, does ‘what-if’ for various scenarios, and compares (or has the software optimized) to find the best combination.
So where is all of this headed? Some of the factors influencing a sourcing or manufacturing location decision are harder to predict than others. For example, fuel costs may or may not rise dramatically in the coming years.5
Other factors are more predictable, such as the continual steady rise in the cost of labor in China. It is the interaction of these various factors that is key. Several years ago, when oil prices were surging, some people said, “If oil hits $150/barrel, it becomes uneconomical to source from China.” Now, because of rising labor costs, that equation has changed. Maybe, at today’s $95/barrel oil prices, it is already uneconomical for certain products.
These are complex decisions, requiring an understanding of the different factors, sensitivities, interactions, and thresholds. Those involved in making these decisions should be prepared to apply some of the analytic tools that are available. It is also important to gain a global strategic view, learning as much as you can about these various drivers and where they are headed. And then, putting it all together, be able to articulate the reasoning simply and clearly to the CEO and her or his team.
As the standard of living and wages in China and other emerging economies rise, the global economy will slowly continue to rebalance itself. A shift of manufacturing back to the US will certainly be welcome here. But it can’t be just because ‘it would be nice.’ It has to make good business sense for each business that makes that decision.
1 Taking a more global view, it’s not just about US and China, but an overall slowing in the rate of globalization and cross-border trade globally. For the past 20+ years, international trade has grown on average at 5.4%—about twice the rate of growth in global GDP—and even more during times of expansion (in 2006, global GDP grew 3.5%, while global trade grew 8%). However, that has decelerated to the point where, in 2012 (numbers are still being crunched), it looks like trade growth was only slightly higher than global GDP growth. In other words, globalization is slowing down. -- Return to article text above 2 Sourcing from a country vs. selling into a country are of course two different things. However, many firms understood that they had a better chance of selling into a country if they had a manufacturing presence there, for the foundational knowledge of the culture and environment, and also because of the advantages of local production. And some countries mandate some % of local content. -- Return to article text above 3 We see the same effect in other emerging economies, such as India, with 15%-20% annual increases in wages. At the same time, globalization has continued to put downward pressure on US cost of labor (keeping it contained), diminishing labor’s bargaining power. -- Return to article text above 4 Boston Consulting Group -- Return to article text above 5 Some forecasts of oil prices are worrying, predicting $180-$200/barrel prices by 2020. See Figure 1 above for the IMF forecast. That study is considered to be a balanced analysis and so far (albeit just one year out) their forecast has been quite accurate. -- Return to article text above
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