Reshoring Factors

Low labor costs, the low cost of transportation, and decreasing costs of capital, all of which once prompted companies to seek offshoring opportunities, are now receding. These factors, combined with the risks associated with foreign markets (political, foreign exchange, and intellectual property concerns), logistical considerations (reducing the length of supply chains, matching production to demand, or locating within an industrial cluster to obtain agglomeration benefits), a domestic energy boom, technological innovations, and other hidden costs have caused companies to rethink their location decisions. Michael Porter, in the Harvard Business Review, describes these factors as being, “complex, interrelated, and dynamic.” What follows is a discussion of the various factors from multiple media and consulting firm reports.

Labor Costs

The decision to offshore manufacturing activity is no longer a simple arithmetic problem based solely on which country’s labor is cheapest. As Michael Porter puts it, simply using wage rates fails to paint the entire picture:

Some hidden direct costs are becoming better known. The rush to arbitrage wage rates, for instance, is giving way to a deeper understanding of the need to take into account total wage costs. If lower-wage workers in emerging economies are less productive or less skilled, firms wind up hiring more workers. They also end up using raw material less efficiently, or experiencing lower first-pass quality levels and higher scrap rates. Both direct and indirect costs change over time, sometimes radically.

Instead of seeking out the lowest labor rates, companies now are using other direct and indirect costs to determine where to locate manufacturing activity.

Wage Rates

Bottom line, wage inflation in emerging countries and China has far outpaced the increase in US wages. The Boston Consulting Group states that between 1999 and 2006 average wages increased by 150 percent. Porter reports that between 2006 and 2011 hourly wage rates for line production workers in Shanghai rose by 125 percent. TD Economics and the Boston Consulting Group both expect growth rates for manufacturing wages in China to be 15 to 20 percent. The Boston Consulting Group states that this is a conservative estimate, and it is likely some companies will face steeper wage inflation just as Foxconn (wages doubled following a number of worker suicides) and Honda (a 47 percent in wages after its workforce went on strike) have experienced.

As described in the Economist, it’s a case of supply and demand dynamics: “China’s labour market is so overstretched that all the high-quality labour has been exhausted, you have to hire people with lesser qualifications, and then quality becomes a problem,” says Alain Deuwaerder, who recently ran a factory in Thailand for Ducati, an Italian motorbike-maker. Another European chief executive complains about the flightiness of his Chinese workforce: “If  someone on the other side of the road offers 5% more pay, they go.”

Labor Productivity

Labor productivity measures the amount of goods or services produced by one hour (or any other unit of time) of labor. This measure can be drastically different for countries, and is an important consideration in the location decision making process. TD Economics figures the unit labor cost (ULC) in China has doubled between 2001 and 2011 while the ULC in the United States rose less than 10 percent. Via GE’s experience in moving water heater production from China to the United States, Fishman highlights the advantages of higher worker productivity.

So a funny thing happened to the GeoSpring on the way from the cheap Chinese factory to the expensive Kentucky factory: The material cost went down (by 25 percent). The labor required to make it went down (from 10 to 2 hours). The quality went up. Even the energy efficiency went  up. GE wasn’t just able to hold the retail sticker to the ‘China price’. It beat that price by nearly 20% ($1,299 to $1,599).

Labor/Capital Intensity Mix

The amount of labor and capital required to produce one unit of output also plays a role in determining where a manufacturer chooses to locate its operations. Initially, the type of manufacturing jobs offshored were those that required high amounts of labor per unit of output- toys, apparel, and other textiles. This made sense since more cost savings could be realized with low wage rates. As labor needed per unit of output is reduced, the amount of capital investment (equipment/machinery) needed to produce one unit of output is increased. Because labor is a smaller portion of the costs to produce that good, the cost savings associated with cheap labor is reduced thereby diminishing or altogether removing the incentive to relocate the manufacturing process in the first place.

Nelson D. Schwartz depicts an American manufacturing atmosphere with a deepening reliance upon capital and less labor, “It’s not that manufacturing is disappearing. But nearly all of the American manufacturers that survived the lean ears of the last decade are globally competitive companies that depend on high productivity and advanced technology for their success more than masses of assembly line workers.” TD Economics would agree. Over the past 20 years, labor hours in the United States have fallen off by 33 percent while the amount of real capital in the sector increased by 44 percent, and is expected to continue due to the next factor: future technology, and in particular automation and robotics.

Future Technology (Robotics, Automation and 3D Printing)

Technological innovations are nothing new to the manufacturing sector, and the effects on reshoring are slowly coming into focus. Robots like Baxter, an American robot manufactured by Rethink Robotics and sold for $22,000 apiece, are handling more tasks once performed by humans, and deepening the divide between the labor and capital mix. According to Vivek Wadhwa, robots are already making their presence felt. For instance, Foxconn Technology Group plans to install one million robots within 3 years to replace human labor and the associated expense and demands, and the use of robots to assemble the Tesla Model S allow the manufacturing to take place in Silicon Valley. Mr. Wadhwa also discusses the impact of 3D printing on reshoring, “Even if the Chinese automate their factories with AI-powered robots and manufacture 3D printers, it will no longer make sense to ship raw materials all the way to China to have them assembled into finished products and shipped back to the U.S.”

Labor Flexibility

Labor flexibility has also been a dynamic that is tilting the playing field towards the reshoring of manufacturing activities with labor becoming increasingly flexible in developed countries while workers in Asia attain more rights. An example put forth by the Economist is the willingness of Western car manufacturing employees to work night shifts, while Kia and Hyundai employees in South Korea have succeeded in removing night shifts. Acceptance of a two-tier wage system by large labor unions in the United States allow for the overall labor costs to be more globally competitive, and is also an example of increased labor flexibility.

Transportation Costs (Volatility)

The costs of having to ship intermediate goods and finished products between points along a supply chain is an important concern for shippers, and eliminating transoceanic trips is an obvious place to begin. The volatility associated with shipping freight across oceans also causes shippers to rethink their location decisions as it causes long-term planning issues. While the BCG4 assumes an average annual increase of only 2.5 percent for transportation costs, they also point to the possibility of acute changes in the price of oil and shifts in ship and container port capacity leading to more dramatic ocean freight rate increases. Dolega summarizes the issue:

“Producing goods thousands of miles from their intended market also embodies costs. Some of these are easily quantifiable such as the cost of freight. For instance, shipping costs increased as much as tenfold between 2002 and 2008. They have since retreated to near record lows under the current global economic backdrop and the increased supply of ships commissioned during boom years. But, the inherent volatility can be costly to firms. Likewise, shipping rates are unlikely to remain at current levels and are expected to rise when global economic growth accelerates.”

Capital Interest Rates

“As we’ve all learned over the years, if you reduce the cost of capital you increase your use of fixed assets, and you take out jobs. Corporate America, seeing an ever increasing cost for its employee base and extraordinarily low interest rates, is taking every step it can possibly take to reduce employment, to build factories abroad and domestically to substitute technology and automated processes for people.”-Ken Griffin

The declining interest rates throughout the past 30 years (Figure 1) cannot be overlooked in the globalization and reshoring stories. As Carney points out, Griffin’s commentary is far from standard economic thinking. However, the continual reduction in interest rates provided multiple opportunities for corporations to refinance their long-term liabilities, as well as creating a culture during the past 30 years of business cycles encouraging the favoring of fixed over human assets.

What is interesting about the federal funds rate currently being ‘zero-bound’ is that it is at an obvious inflection point and eventually has to go up at some point in time. It may be one, two, five, or even more years out, but eventually the rates will increase. When that happens, will there be consequences in terms of how corporations split investments between its fixed assets and variable human assets? Will a rising interest rate environment (higher highs and higher lows) encourage corporations to favor human capital over technology and automation? We will have to wait and see.

Figure 1: Federal Funds Rate: 1980-2012

Source: Economic Research Division, Federal Reserve Bank of St. Louis.

The general trend for the federal funds rate between January of 1980 and August of 2012 is one of lower highs and lower lows to its current ‘zero-bound’ position.

Foreign Direct Investment

The infusion of capital via foreign direct investment (FDI) will also play a role in the reshoring trend as foreign firms attempt to gain access to US raw materials, as well as locate closer to their end consumers. Between 2000 and the third quarter of 2012, Chinese FDI in the United States totaled 593 deals to the tune of $22.6 billion. FDI is not just coming from China. Recent investments from Japan and Europe have contributed to multi-billion dollar natural gas export projects, while foreign companies in the chemical and steel industries have also posted recent FDI.

Energy Boom (an Exogenous Shock)

It has become clear to me that the responsible development of our nation’s extensive recoverable    oil and natural gas resources has the potential to be the once-in-a-lifetime economic engine that    coal was nearly 200 years ago. –U.S. Steel Chairman John Surma

The recent energy boom via innovations in horizontal fracking has not only had a profound effect on the amount of domestic production (which the International Energy Agency forecasts the United States to become the world’s number one gas producer in 2015), but also the price on domestic natural gas relative to global production which Dolega puts at “roughly one-fourth of the European equivalent, and one-sixth of Japanese LNG imports.” As Birnbaum states, cheaper energy sources are not the only way the energy boom is affecting the US manufacturing environment. “Among those most affected are energy-intensive industries such as steel and chemicals, because they use natural gas as a raw material and power source. With Europe lagging in energy production, manufacturers on the continent warn that a chain reaction could shift more and more investment to US shores.” In particular, Birnbaum mentions German chemicals giant BASF and Austrian steelmaker Voestalpine as two European companies who have placed production facilities in the United States to take advantage of the cheap natural gas.

The energy boom and accompanying technological innovations serve as an exogenous shock to the economy as a whole as investments must be made to source, refine, manufacture, and consume the new technology—or in this case the new energy source. Schoen describes the flow to the rest of the economy, “As groundbreaking on these projects gets under way, the dividends from the energy boom will flow even further—to construction companies, engineering firms, material and equipment suppliers and lenders who help finance the projects.”

These effects felt within the manufacturing sector are mirrored in the transportation sector. The prospect of utilizing a cheaper fuel source that is domestically sourced is causing transportation providers to evaluate whether or not to convert their fleets from petroleum and diesel powered engines to natural gas powered engines. Conversions have caused compounding effects as it too causes further investments to be made in plant, equipment, infrastructure, and human capital to source, refine, manufacture, and service the new technology.

Foreign Risks

The costs associated with locating production facilities in foreign countries have been considered to be hidden costs as they accumulate over time. The protection of intellectual property is, as Porter states, “significant, and often underestimated,” as companies spend financial and human resources attempting to curb the theft of intellectual property or deal with the aftermath of stolen intellectual property. Other risks include labor issues and unrest as workers in developing countries receive more rights (Foroohar sites the Apple and Foxconn relationship), supply chain disruption, trade protection actions such as increased import taxes (the BCG mentions a WTO provision and other instances), and the nationalization of local subsidiaries (while not common, this fat tail-risk can result in total loss of investment and capital).

Foreign currency exchange rate risks are also hidden costs tipping the scales in favor of the United States. Prior to 2005, the Chinese yuan was pegged to the US dollar, but as Dolega points out, a 31 percent nominal rise and 40 percent real term rise in the Chinese currency versus the US dollar since 2005 has slowly eroded the advantage of sourcing labor in China. Further appreciation in the yuan is expected in the future as Chinese officials attempt to transition the Chinese economy from that of world exporter to more consumption focused.

Supply Chain’s Influence

Considerations involving the movement of raw materials, intermediate goods, and finished products along a company’s supply chain are also playing a role in deciding where to locate manufacturing facilities.

The costs associated with financing inventory is highlighted by Dolega below:

However, perhaps more important is that distant shipping routes increase the required size of a firm’s inventories tying up valuable capital. This opportunity cost can be especially detrimental for firms that use credit to fund inventories. Credit conditions have eased somewhat since the recession but remain elevated – especially for small and medium-sized businesses. This, in effect, raises the cost of holding inventory, favoring shorter and leaner supply-chains.

By locating its production facilities in Louisville, KY versus China, GE has reduced the time-to-market considerably—what once took five weeks, now only takes 30 minutes as finished products are moved from the production facility to a warehouse where the products can be shipped to a retail location.

A second supply chain factor is the distance between the physical location of the manufacturing plant compared to R&D teams and engineering and design teams. Not only does locating the manufacturing plant close to the R&D and engineering teams increase the productivity and efficiency of the manufacturing process, but it also reduces the cost of travel in order to troubleshoot any problems that do occur and allows companies to respond quicker to changes in consumer preferences. Lastly, the impact of new technologies should not be overlooked, as highlighted by Foroohar:

The once separate steps of designing a product, making or buying parts, and then putting everything together are beginning to blend – a consequence of technologies such as additive manufacturing and 3-D printing. It means that manufacturing wants to be closer to engineering and design – a dynamic that would likely benefit the U.S., which still rules those high-end job categories.

Companies have also been able to shrink their supply chains by matching production of a market’s supply to that of its market demand. For example, instead of utilizing a single platform to manufacturing their supply and then ship globally, car companies such as Toyota, Nissan, Volkswagen, Honda, Mazda, and others have recently placed a number of new production facilities in Mexico in order to produce vehicles for the North American market thereby eliminating the need to transport the finished products across an ocean. This strategy is not limited to automobile manufacturing, nor to reshoring in the U.S. as stated by the BCG, “Given rising income levels in China and the rest of developing Asia, demand for goods in the region will increase rapidly. Multinational companies are likely to devote more of their capacity in China to serving the domestic Chinese as well as the larger Asian market, and to bring some production work for the North American market back to the US”

Land Costs

Lastly, the cost of acquiring appropriate zoned land parcels is also playing into the overall cost equation when determining where to locate. Just as in any supply-demand relationship, as the supply decreases and/or demand increases, the price increases. As the BCG reports, industrial land in China is no longer cheap ranging from $11.15 per ft2 to $21.00 per ft2, while square footage industrial property in Alabama, Tennessee, and North Carolina ranges from $1.30 to $7.43. “To secure low real-estate costs in China, companies will need to move inland. But in so doing, they will incur higher transportation costs and lost some of the benefits of being part of the industrial clusters that have grown up in the major coastal cities.”

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