Outsourcing: Hedge The Low-Wage Wager

June 11, 2006
Manufacturers are still chasing cheap labor around the world. But they'd be well advised not to place all their outsourcing bet on it.

Low wage rates, particularly in such highly publicized places as China and India, continue to drive decisions about where U.S.-based manufacturers locate their production facilities. Indeed, lower wage rates in China make that Asian nation more attractive to U.S. manufacturers than Mexico and other Latin American countries, where better-developed logistics and infrastructure seemingly would provide a competitive edge, reveals a recent Lehigh University study on global sourcing. By one estimate, even after doubling between 2002 and 2005, the average manufacturing wage in China was only 60 U.S. cents an hour, compared with $2.46 an hour in Mexico. Ask companies what's the greatest pressure they're under and they "always tell us" cost reduction, states Robert Trent, an associate professor of management at Lehigh.

Yet, U.S. manufacturers -- large, small and in-between -- that let labor costs alone drive their production location decisions could be headed down the wrong road, perhaps even toward a dead end. "Just chasing low-cost labor is not Nirvana," stresses Anand Sharma, CEO and co-founder of TBM Consulting in Durham, N.C.

The theory of comparative advantage, one of the classic principles of economics, suggests somewhere there'll always be a low-cost location for manufacturing. If it's not China or India, it could be Thailand, Vietnam or Bangladesh. Eventually, it could be somewhere in Africa, ventures one analyst. Actually, it's already Vietnam, where Intel Corp. is building a $300 million semiconductor assembly and test facility in Ho Chi Minh City, notes Lehigh's Trent.

"Nike originally offshored manufacture of athletic shoes to Japan," says Ig Horstmann, a professor of business economics at the University of Toronto's Rotman School of Management. "When labor costs rose there, it moved to [South] Korea and Taiwan. When labor costs rose in Korea and Taiwan, Nike moved to China," he observes. "Being flexible and prepared to move to other regions and countries is part of the strategy for successful offshoring in industries that are largely cost driven."

See Also...

Outsourcing's Next Steps
Outsourcing: Learning To Let Go
Outsoucing: Supply-Chain Stretch
More Than Costs

Nevertheless, at least in India and China, the situation is quite a bit more complicated.

For example, "it would not be easy" to shift computer software programming from India, which has relatively low labor costs and high-quality software engineers, to a country that had only lower labor costs, contends Hongxin John Zhao, an assistant professor of international business at St. Louis University's Cook School of Business. Successful overseas outsourcing depends not only on labor cost, but on labor quality as well, he says.

Although China and India remain among the world's low-cost production locations, a labor shortage exists in China and wage rates are rising there and in India. What's more, the cost of technical and professional people to support low-cost manufacturing is rising "at least three to five times per year" faster than the rate for production workers, figures TBM's Sharma. Paying between 80% and 100% of the U.S. cost for "qualified, experienced technical and professional people" in China is not unusual, he claims.

"A good number of U.S. companies who five years ago set up operations and manufacturing in Shanghai or in Shenzhen or Guangzhou are actually contemplating moving to the interior, moving to what are called second- or third-tier cities where there's less competition for these individuals [and] where there isn't the churn that occurs because so many companies are chasing a limited number of qualified individuals," says George Fifield, Beijing-based senior client partner and head of the Asia/Pacific industrial practice for Los Angeles-based Korn/Ferry International, a firm that recruits upper-middle and senior-level managers in China.

The rising wage rate for blue-collar and white-collar manufacturing workers in China is causing "some movement [and] some concern," acknowledges Steven H. Ganster, managing director of Technomic Asia, a Shanghai-based market consulting firm. "But I would hesitate to say it's causing a wholesale shift in the movement of manufacturing," he states.

"You really have to look at total cost," Ganster emphasizes. And on that basis, he believes China will continue to have a competitive advantage over a place such as the U.S. Gulf Coast. The reason: lower costs in China for land, construction, equipment, taxes and environmental protection. What's more, he claims, the costs of power and transport within China are likely to come down, and higher productivity and better practices will work to lower the cost of manufacturing in the Middle Kingdom.

At the same time, China is no longer just a production platform for components or an assembly line for goods that are shipped back to the U.S. "Part of what's happened in the last couple of years . . . is that companies have recognized that they need to be in China to manufacture for the domestic market," says Korn/Ferry's Fifield. And that, predictably, promises to intensify the competition for managers and technical people as well as production workers. "The issue is not [the] supply of educated Chinese. The issue is the right type of education," explains Fifield. "A lot of the education here [in China] is memory; it's not problem solving. It's rote memory, and that doesn't suit itself real well to a lot of the issues that manufacturers have here," he states. Initial design, product improvement, manufacturability and better process flow are among the issues he says manufacturers confront in their China operations.

Ask These Questions

For Harry Wallaesa, president and CEO of The W Group, a technology management consulting firm in Malvern, Pa., a successful outsourcing strategy begins with three basic questions: What work needs to be done? Who needs to do it? and Where does the work need to be done? "If you can answer those questions and you can take a look at those questions from the dimensions of process, economics, organization and technology, then you're going to be able to come up with a pretty good strategy," he says. Production, not responsibility, is what's being outsourced, stresses Richard Kleinert, a Los Angeles-based principal at Deloitte Consulting LLP. "There is a major managerial task involved with managing outsourced or offshore arrangements," he states. "It cannot be overlooked."

For example, low-cost overseas production is far from the whole business story for manufacturers seeking to grow their U.S. markets, says TBM's Sharma. Key to such growth are responsiveness and reliability, customer closeness, and agility. "If you are connecting with the customer, you can identify their special needs, you can customize products to their needs, and if you are flexible, if you are lean, you can do that very fast," he states.

"I'm not saying that having a global presence -- having a global footprint -- is not key. But just chasing low-cost labor is not the right strategy," Sharma emphasizes. "You see [companies] that have gone to China. And now [companies in China] are going to India and Vietnam," he relates. "But what you forget are the costs of start-up, the costs of disruption, the costs of moving, and the costs of inconvenience to your customers and to your employees -- which sometimes are higher than the labor [cost] advantage you get."

In short, what makes sense to Sharma is a strategy that is both short-term and long-term, that combines seeking short-term labor cost savings while pursuing long-term market development among the 95% of the world's population that is outside the U.S.

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