Manufacturing and the Supply Chain

Stephen DeAngelis

May 26, 2011

In his famous book entitled Pilgrim’s Progress published in 1678, John Bunyan wrote about a swamp of despair that he described as “a very miry slough that was in the midst of the plain. … The name of the slough was ‘Despond.'” Fast forward a third of a millennium and you find another John writing, “For years, the U.S. manufacturing sector seems to have been sliding into the Slough of Despond. Companies have been eagerly outsourcing to lower-cost venues such as China, India and Mexico. And with the production go jobs.” [“Will Costs Drive Firms Home?” by John Bussey, The Wall Street Journal, 5 May 2011]. In Bunyan’s book, people who fell into the swamp “wallowed for a time, being grievously bedaubed with the dirt … and … because of the burden … began to sink in the mire.” Bussey believes there might be a way out of the slough for American manufacturers. He writes:

“A combination of forces—rapidly rising labor rates abroad, loftier materials and shipping costs, deep-discount tax incentives from U.S. states—are changing some of the calculations by which companies decide to move production abroad, or even keep what’s there now.”

Before discussing the “combination of forces” that could bring manufacturing jobs by to the U.S., Bussey reminds us that some manufacturing has never left. He writes:

“Employment at manufacturing companies in the U.S. may have dropped over the last 40 years. But those companies have gotten a lot more productive, and manufacturing output has actually risen. Companies are making — in the U.S. — more than double what they did four decades ago.”

He also notes that even though there may be forces pushing manufacturing back to U.S. shores, the manufacturing that returns will most likely produce products for domestic consumption. Hal Sirkin of the Boston Consulting Group “is increasingly likely to suggest [to his clients that] they stay at home, not for patriotic reasons but because the economics of globalisation are changing fast.” [“Moving back to America,” The Economist, 12 May 2011] The same forces that make it sensible to manufacture goods closer to home make it sensible to manufacture goods closer to foreign consumers as well. As The Economist wrote, “Many multinationals will continue to build most of their new factories in emerging markets, not to export stuff back home but because that is where demand is growing fastest.” I have argued for some time that this type of regionalization within globalization’s broader framework is likely to increase. This really shouldn’t be too surprising. Professor Pankaj Ghemawat of IESE Business School in Spain notes that “less than 1% of all American companies have any foreign operations” and “exports are equivalent to only 20% of global GDP.” [“The case against globaloney,” The Economist, 26 April 2011]. What are the “forces at work” that Bussey believes are so potent? The first force is rising global wages. He writes:

“Wage rates are soaring in China as the market for skilled workers tightens and the previously mute labor movement finds its voice and agitates for higher salaries. This is cutting into the cost advantage that cheap Chinese labor provided U.S. manufacturers. In many sectors, annual wage growth is running at 15% or more. And in higher value sectors, Chinese managers are earning as much as their Western counterparts.”

I wrote a post on this subject a little less than a year entitled The “China Price” Continues to Rise. Labor unrest and suicides at the Chinese corporate giant Foxconn prompted me to write that post. Last November Financial Times‘ columnist David Pilling added his views on the subject [“Foxconn’s milestone for a rising China price,” 17 November 2011]. Pilling wrote:

“One post-Foxconn trend tentatively surfacing is a greater tolerance for unions by Chinese authorities that have long been nervous about organized labor. … That, plus demographic changes, should mean a sustained period of higher wage inflation. … A secondary consequence could thus be a spillover of higher wages into neighboring countries. Again, there are signs this may already be happening. … A third post-Foxconn effect could be the most profound of all. If wages in China – and elsewhere in Asia – continue to rise, so will the prices of finished goods. … That would both reduce the purchasing power of American and European consumers and increase the buying power of Chinese workers. In short, it would set the scene for the rebalancing that everyone has been screaming for – only it would come via higher wages rather than a higher exchange rate.”

Bussey reports that Christian Murck, president of the American Chamber of Commerce in China, told a gathering of corporate and trade officials in Washington, “China’s low-wage advantage will disappear over the next five years.” As a result of the rising “China Price,” Murck claimed, “Supply chains are already being disrupted.” Another force that could bring some manufacturing back to the U.S. discussed by Bussey is inflation. He writes:

“The tab for energy, raw materials, real estate, shipping. All are on the rise, rapidly boosting the cost of doing business abroad. U.S. states, meanwhile, panicked as they are by the loss of jobs and their worsening budgets, are hanging out the ‘Open for Business’ shingle. While many semiconductor companies have expanded production abroad (Intel, which has big operations in the U.S. and around the world, has invested in new chip-making and assembly plants in Vietnam and China), Globalfoundries Inc., a spinoff of Advanced Micro Devices, is setting up a new shop in Malta —that would be Malta, NY.”

Bussey reports that some manufacturers have few alternatives beyond manufacturing goods in China or the U.S. because they are the only countries with the required supply base, shipping infrastructure, and skilled labor pool necessary to support a sophisticated supply chain. Bussey, like The Economist, also interviewed Harold Sirkin. He writes:

“Harold Sirkin, senior partner at Boston Consulting Group, says, … ‘China has been the default’ for production. … ‘We began hearing from our clients three years ago about problems getting the right labor pool and at the right costs.’ If current trends continue, ‘sometime around 2015 it will make more sense to put the incremental plant in the U.S. as opposed to China,’ he contends. Why not just shift that production to Vietnam, India or another low-cost locale? Companies often discover that few other locations have the supply base, shipping infrastructure, and skilled labor to pull off what China does.”

I first started writing about the importance of domestic manufacturing almost three years ago in a post entitled Reviving U.S. Manufacturing. My latest blog on the subject, entitled Can Developed Countries Increase Manufacturing?, was posted in April of this year. What will changes in the manufacturing landscape mean for the supply chain? According to the NAIOP Research Foundation, “global shifts in manufacturing, consumption trends and international competition … will shape the future of goods movement and the demand for warehouse and distribution space.” [“Report Examines Effect of Global Manufacturing, Consumption on Growth of U.S. Ports and Distribution,” Supply Chain Brain, 15 November 2010] The report notes that manufacturers often seek manufacturing sites with low work wages and benefits. Often these sites add extra distance to the supply chain and create challenges “including efforts to deliver parts for production and the delivery of the finished product.” In addition, the extra distance makes “it more difficult to retain predictability in the supply chain.” Finally, the report asserts that “managing the longer and more complex supply chain adds expense, which must be tracked to make sure it does not erase lower-cost labor benefits.”

 

When it comes to consumption trends, the report estimates “that in 2025, India and China will account for nearly 25 percent to 40 percent of the total world demand for goods and services.” This demand, of course, is tied to higher wages and workers having more discretionary money to spend on such things “as clothing, food, automobiles, phones and pharmaceuticals.” The report notes that “a new and expanding global middle class … will have a dramatic impact on the site selection process for the manufacturing facilities and distribution centers supporting the flow of goods between global production centers and consumers.” That assessment agrees with my, Bussey’s, and The Economist‘s assessment that manufacturing goods close to the market in which they will be sold makes sound economic sense.

 

Concerning competition, the report notes that this year “China is expected to out-produce the United States for the first time, producing $1.87bn in goods output while the United States is expected to produce $1.71bn in goods output.” Does that mean that the U.S. is facing a future in which it can’t compete? The answer is an ambiguous, probably not. As I pointed out in another post, Rana Foroohar reports:

“Innovation, not how cheap or expensive labor is, [is what] determines whether a country will be successful in manufacturing. Contrary to conventional wisdom, manufacturing has not become a race to the bottom. That’s why the U.S. still ranks as the fourth-most competitive nation after China, India, and South Korea, despite vastly higher labor costs. Germany, Japan, and Singapore also hold positions in the top 10. The skill levels of their workers more than offset their costs (U.S. workers are twice as productive as those in the next 10 leading manufacturing economies). Skills are particularly critical in the lucrative high-end manufacturing sector, which accounts for about half of all new innovation within an economy.” [“How to Build Again,” Newsweek, 10 July 2010]

A sliver of good news for Americans is the fact that “traditional ‘rust belt’ states have seen the largest gains in American manufacturing jobs over the past year.” [“America’s ‘rust belt’ states lead recovery,” by Ed Crooks, Financial Times, 1 May 2011]. The Economist reports that the Boston Consulting Group “predicts a “manufacturing renaissance” in America”; but the magazine’s staff remains skeptical. Nevertheless, it concludes, “Companies are thinking in more sophisticated ways about their supply chains. Bosses no longer assume that they should always make things in the country with the lowest wages. Increasingly, it makes sense to make things in a variety of places, including America.” Does that mean a lot of new manufacturing jobs are going to become available? Peter Coy writes:

“A renaissance in U.S. manufacturing output does not necessarily imply a hiring binge; efficient companies might just do more with fewer people. In fact, manufacturing employment has risen only 2 percent from its recent low, while the Federal Reserve’s index of manufacturing production is up 13 percent. That’s unfortunate because factory jobs pay better than most careers that are open to people without college degrees.” [“The Case for Making It in the USA,” Bloomberg BusinessWeek, 5 May 2011]

The bottom line is that American can compete with the world, but it has to be smart about how it goes about it. Inevitably there are going to be shifts in the supply chain. Smart companies are going look beyond day-to-day operations so that they can understand what changes are taking place and anticipate how their business might have to change as a result. If they don’t anticipate and proactively deal with change, they may well find themselves stuck in Slough of Despond.