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Economic Policies Should Focus on Increasing Supply Chain Competitiveness

Sept. 13, 2015
With the vast majority of revenue flowing through supply chains, wouldn’t it make a lot of sense to base government economic policy on increasing supply chain competitiveness?

If you read my previous column you know that a pet peeve of mine involves politicians who “chase smoke stacks” and cite that as their commitment to economic development. In the best instance, this practice creates jobs through a form of what is nothing more than corporate welfare. In the worst instance, this approach provides zero sum economic impact for the country as a whole while reducing manufacturing’s contribution to society in general—in other words, it’s a major giveaway. The subject of this article will be a proposal that Next Generation Supply Management can provide real economic development through effective government/business collaboration.

Since the rant in my last article about the duplicity of politicians who chase smoke stacks gave me such a good feeling, I’ll start the argument on this subject by continuing to lay out further the economics involved when state governments throw money at manufacturers in an effort to get them to locate and/or relocate within their borders.

I’ve been in industry almost 40 years now and have seen just about everything at least once. In my experience, smoke stack chasing ramped-up in the 1980s when southern states started applying this strategy in an attempt to jump-start their manufacturing economies. Following, I’ll review two actual related case studies of this that I have personal knowledge of.

In 1988 a large multi-national OEM with a factory located in the upper-Midwest United States decided to expand a product line by opening a second manufacturing facility. Previously, the entire product line had been produced exclusively at that single, upper-Midwest plant. A Southeast U.S. site was selected based on significant financial state incentives as well as the hope for a lower wage structure. The new factory opened and the product line extension was successful, which had a positive effect on local wages. So what can be wrong with that?

The new factory was a dedicated high-volume assembly facility. The cost of goods sold (COGS) of the products produced there was comprised of approximately 80% purchased content, 15% overhead and 5% labor—a split not unusual in many new factory start-ups. The economic benefit of this plant to its new state was at most 20% based on the labor and overhead percentages unless, of course, any of the purchased content—parts and assemblies needed in the production of the products being produced—were also sourced in that state. The problem was, very little was! The OEM found that the sourcing options in that state just weren’t up to the task of providing what was needed for its new operation.

In fact, about 40% of the annual purchases made by this plant continued to be from the state where their incumbent factory was located. An “apples-to-apples” economic impact comparison, then, shows that even with all of the financial incentives the smoke stack chasing politicians had spent to get the new factory located in their state, the benefits delivered represented at most 20% of revenue generated by that plant. On the other hand, the state that had lost that new plant continued to receive 32% of revenue without having spent a single penny in incentives!

You might wonder whether over time the supply chain relocated closer to their new factory customer. For instance, what was the sourcing situation a couple of decades later? For a variety of reasons the incumbent state where the original factory is located continues to be the largest supplier to this plant while very few suppliers have set up supporting operations in the state where the new factory was sited.

Don’t think this is an outlier example. Another upper Midwest OEM I am familiar with decided to increase capacity—this time, for an existing product—by opening a new plant in a deep-South low-wage, smoke stack chasing state in 1997. Similar to the previous example, purchased content was high, i.e., it comprised 75% of the COGS for this product line; 28% of this total was sourced with suppliers from the state where the incumbent factory was located. And again, over time, the sourcing pattern was maintained, as that incumbent state continued to enjoy the bulk of the positive financial impact through their supply chain participants. The bottom line is that the incumbent state continued to benefit from the bulk of the revenue from the products from the new plant even though those products were no longer assembled in-state without having had to “buy” the business. Are there any lessons here? There sure are.

First of all, these examples re-emphasize the point made in the last column about smoke stack chasing, i.e., “all that glitters is not gold” (with apologies to JRR Tolkien). When you see a politician issue a glossy press release about how they have created jobs by attracting a new plant to the state, think again about the cost vs. benefit. You’ll probably find in “peeling back the onion” that the vast majority of the revenue generated by the new plant will not remain in the state. Instead, it will go to the states where the factory’s suppliers are located. Which begs the question even further: “Was the plant really worth all of the public money spent to attract it?”

As I stated in the last column, arguments can no longer be made that the incentives have gotten out-of-hand, relative to the payback. People used to think the use of public money to retain/attract sports teams was a good policy but, for the most part, this strategy no longer receives majority support. At some point I think that same public is going to see the parallel between the use of public monies to retain/support sports franchises vs. manufacturing and sour on the extravagant incentives politicians are offering to compete for those new factories.

Second—and the point of this article—is that with the vast majority of revenue flowing through supply chains, wouldn’t it make a lot of sense to base government economic policy on increasing supply chain competitiveness? If a nation or state can develop the infrastructure necessary for its small- and medium-sized manufacturers to successfully compete for OEM sourcing, wouldn’t that go a long ways towards ensuring that U.S. manufacturers get a lion’s share of overall global business?

I won’t go into it in detail in this column but this idea is an extension of the concept of industry clusters first advanced by Harvard Business School’s Michael Porter in the 1990s. The good news is that in recognition of the importance of supply chains to our national economy, the U.S. Department of Commerce hosted a competition for governmental “Manufacturing Community” (industry cluster) designation and in 2014 gave 12 regions such designation, with the intent that designees will be given priority to access of federal funds already slated for economic development. But is this enough? Of course it is not.

While such designations are necessary, they are not sufficient for developing the infrastructure needed to create a strong, national supply chain infrastructure. This then begs the question, “what is required?” Or, “show what stakeholder groups the program would need to include and/or address.”

First and foremost, it would need to focus on our country’s small- and medium-sized manufacturers. These firms have had to bear the brunt of the competition from the emergence of manufacturing in low-wage countries and in doing so have had to compete not only against actual foreign manufacturers, but also against their governments. Personally, I believe that if we ever reach the point in this country where individuals are unable to successfully launch “garaged-based” manufacturing start-ups, the U.S will be out of the manufacturing “game.” Why? Because these are the companies that 30 years later have the potential to employ hundreds (or thousands) of people in good-paying jobs, as previous generations have shown. It is also where the money flows. To this point, though, how many stories have you heard of this type of thing happening recently, at least outside of Silicon Valley? Small garage-shop start-ups, by the way, represent real economic development as opposed to the quick-hit glitzy type favored by many of today’s politicians.

Second, we need to involve original equipment manufacturers (OEMs) since they are the customers of supply chains. I’m sure that the previous sentence will quickly elicit negative comments of “corporate welfare” from uber free marketeers so let me try to put those to bed immediately. I personally think that the “big guys” (OEMs) do a pretty good job of taking care of themselves. And when they feel they need help, they have the lobbying wherewithal to get the support they need from our politicians. So, how would the OEMs participate? In two ways:

1) In defining supply chain capability needs. I’m talking generic—not OEM-specific—so there shouldn’t be any problem here with picking individual winners and losers. Truth be told, the vast majority of supplier metrics are common across most OEMs. What is needed here is to create a composite (and continually update) the important performance parameters necessary for suppliers to successfully compete, both now and in the future.

2) In defining how suppliers achieve performance expectations. Today, very few OEMs have an understanding of the how’s of supplier performance. As a consequence, some suppliers have learned to “game” the performance metric process such that they achieve what is considered “world-class” performance through methods that are anything but competitive. And because they do not apply competitive strategies, they focus on/blame wages as they struggle to maintain solvency. Companies like this are the first to relocate to low-wage countries, which they see as the solution to all their problems.

Finally, and foremost, we need to continue the efforts started by the U.S. Department of Commerce to align its current economic development resources with supply chain, as they did in their Manufacturing Community designation program. A lot of federal dollars are actually spent annually in support of economic development. The problem is that these programs are not currently structured nor positioned to effectively support supply chains. So I’m not talking about “new” monies needed to increase positive governmental economic impact. I’m talking about a more targeted, consolidated approach.

I’ll talk further about one way for this to happen in my next column.

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