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July 1, 2010

SUDDENLY LOW COST

Who'da thunk it? The U.S. becomes a low-cost producer.

Looking for the least-expensive place to make a stainless steel, anodized aluminum, high-end electronic parts or even Frisbees? Check out the United States.

How about automated teller machines, earthmovers, ready-to-assemble home and office furniture, or water heaters? A variety of manufacturers, from NCR and Caterpillar, to Wham-O and General Electric, have turned their backs to a surprising extent on China and other supposed low-cost countries. They have either brought manufacturing facilities back to the States, or decided they can be more competitive by staying and expanding production in America.

The crux of their thinking is not simply low price, although that remains, of course, a critically important factor in the simplistic offshoring approach of some manufacturers. Rather, the most important concept now is total cost of production—with those costs measured in terms of wasted time, inflexibility, shipping costs, management attention, political uncertainty, intellectual property theft, quality standards and all the other serious issues that have dogged companies that sought supposed “low-cost” havens in Asia. In the world of economic cycles, the pendulum is swinging once again in favor of the “all-in” winner: the skilled, fast, reliable and extremely efficient companies of North America.

There was a time, not 10 years ago, when hardly anyone would have believed it. China, with its pennies-a-day laborers, and India with an almost-as-inexpensive work force, one that even speaks English, were the almost faddish, low-priced spread for a range of manufacturers. You could make a finished product in China, they would say, for what the raw materials would cost in Ohio. And by the middle of the last decade, the store shelves of America were packed with goods “Made in China.” Even our bridges, tunnels, buildings and electronics were all-too-often made with materials that arrived by boat from Asia.

The result, as we know, was a continuing loss of factories and manufacturing jobs and an ongoing trade deficit. Last year alone, says the U.S. Bureau of Labor Statistics, “The manufacturing sector accounted for 36% of all mass layoff events and 43% of initial claims filed.” The bureau said that for the year, “the total numbers of mass layoff events, at 28,030, and initial claims, at 2,796,456, reached their highest annual levels on record.” And this only continued an ominous trend. The U.S. Census Bureau, for instance, reports that between 2002 and 2007, even before the recession dug its teeth into the economy, 1.3 million manufacturing jobs had been lost and nearly 57,000 “manufacturing establishments” as the agency calls them, had been closed.

OUR PRODUCTIVITY GROWS

And yet, the BLS also reports that, in part because of those layoffs, first quarter productivity increased 3.6% over the same period last year, the sharpest boost since 1962. Last year, productivity was up a remarkable 3.7% over the year before.

That is only part of the reason that a surprising number of companies are now rethinking, adjusting and reversing their offshore manufacturing strategies. Caterpillar and General Electric are only the most prominent examples of large companies that have announced they intend to bring at least some of their manufacturing back to the states. NCR has said it will be making its most sophisticated automated teller machines in Georgia instead of China, where they have been made for the last three years. ThyssenKrupp Stainless USA president and CEO Ulrich Albrecht-Frueh told Forward magazine in March that making stainless steel in Alabama is now just good business. “If you look at the main costs, the true costs of operations all over the world, we have an advantage here from energy costs, some advantage from personnel costs and reduced risk from transportation and inventory costs,” Albrecht-Frueh said. “On hot band, for example, we will probably save more than 10% over the average from elsewhere in the world.”

But we are not talking just sophisticated processes or high-tech stuff here. Wham-O is moving production of its Frisbees and Hula Hoops from China to California. There are no good numbers to quantify the strength of the wave of manufacturing back to these shores, but there is enough to have coined new terminology for it. You will read more about “re-shoring” and “back-shoring” in the months and years ahead.

All of which is great for American manufacturing, the economy and its workers. But why now? Chinese workers, for one thing, got tired of working for a bowl of rice a day. A March JPMorgan Chase Bank, Hong Kong, study saw China’s “monthly wage growth averaging 14.8% since 2000.” Guangdong Province increased its minimum wage by 21% beginning May 1, bringing it to 1,030 yuan, or $150 per month, “not including benefits, overtime, board and meal allowances,” says Xinhua, the official China news agency. Not much by North American standards, but more than previously.

THE DIFFERENCE BETWEEN THEN AND NOW

“You have to contrast everything from around 2002 or 2003, when the big rush to China began,” says Taymur Ahmad, vice president of operations for MOREY Corporation in Woodridge, Illinois.

MOREY makes sophisticated, often custom-designed electronic parts, controls and systems. MOREY is shifting much of its manufacturing out of China, says Ahmad. “Before I joined this company, I was in charge of putting a billion-dollar facility in Shanghai for Phillips, so I know there was a huge draw,” says Ahmad. “It did make sense in 2003 and 2004. Things were different. We didn’t know about logistics costs and 26-week lead times. But now in 2010, the equation has changed completely.”

“We have seen fuel costs triple, and labor costs over there increase 50%,” Ahmad said. “And there is our currency to consider. The exchange between the renminbi and the dollar has continued to weaken, and every economist agrees that the renminbi will now be valued upwards, perhaps by as much as 10% to 20%. So you lose 20% of any cost gain. Yes, it has only changed less than 3% recently, but we are sure it will change in the future.”

More than that, Ahmad explains, the reasons to re-shore and to stay here often vary depending on the manufacturer. “If you are making any kind of electronic devices, the supply chain is volatile,” he says. “The demand is up and down. The orders can be 20,000 and then nothing. We still get some things from China. But they have put everyone on allocation, because they need the materials for their own economy. And that makes sense for them, but it leaves us high and dry.”

Last year, MOREY’s business was down 50% compared to the year before. “But our work began picking up a month and a half ago. All our customers have given us order increases,” Ahmad said in a May interview. “And we have added 60 to 70 people to our base of 600 or so. But we are being careful; when our business was down, we went lean and learned how to do things with fewer people.”

Ahmad’s story is familiar to Stephen Maurer, a managing director of AlixPartners LLP, a management consulting firm headquartered in Southfield, Michigan, with 14 offices around the world. AlixPartners issues an annual ranking of countries based on their relative competitiveness. Maurer’s expertise is international operations improvement, product development, manufacturing and supply chain management.

“In ’05 and a bit after, there was a lot of momentum and people were jumping on the bandwagon to go to China,” he recalls. “There was a lot of cheap labor, shipping costs were relatively low, and of course there were raw materials advantages, too. And this huge potential market. But in other cases it just was maybe a bit rushed and premature. If you have a product that is less sensitive to these factors, a high technology, niche product with substantial margins, you have to look really hard at moving now to be sure it makes sense.”

You don’t have to convince Mike Campagna, president and COO of Aurora, Illinois-based Peerless Industries Inc., one of the country’s largest manufacturers of audiovisual mounts and brackets. “About five years ago when everyone else was rushing to China, we were buying all our aluminum die cast products out of there,” he says. “We are metal benders and couldn’t source them in the U.S. at a competitive price. Eventually roughly 30% of our product was out of China.”

Source: Brad Coulter, O'Keefe & Associates

THE PROBLEMS: SPEED AND THEFT

But at the same time, Peerless was having trouble getting that product as quickly as it needed it. “So we began looking at the freight costs, and warehouse costs were getting expensive. When we started picking apart the costs, we started to realize that we could, on a competitive basis, make all our stuff here in the U.S.”

“We wanted to continue to manufacture it,” Campagna says, “so we invested in die cast equipment and brought the whole thing back.” Campagna found an ideal building on 24 acres at “a great price” in Aurora, Illinois and gradually shut down his less efficient, four-building plant in Melrose Park. “We are hiring now, because we were up 5% in the first two months of the year and that has continued,” he said. “We bottomed out last February at 303 employees and are now back up to 457. These are mostly manufacturing and skills jobs, like quality engineers and designers.”

In China, Campagna says, “We had some issues with patent infringement. The Chinese companies were stealing our designs. So we thought we could do it here without all that.”

Newark, Ohio-based Anomatic Corp. was concerned about its designs as well, after opening an anodized aluminum manufacturing plant in China three years ago. Anomatic makes anodized products for a variety of industries, including personal care and electronics.

But it keeps its sophisticated tools and designs at home, developing them in Connecticut and shipping to China only the “plain vanilla” machinery, as Scott Rusch, Anomatic’s executive vice president and CFO puts it.

Raw material quality and availability, among other things, have kept Anomatic expanding in the U.S. more than overseas.

“We can’t get the quality of the aluminum we need in China, so we have to bring it in from the U.S.,” he says. “That’s why we are sourcing more and expanding here. For example, in our metal forming area we’ve expanded by about 25% in both capacity and the number of employees.”

“Doing business in China has its challenges,” he says. “One of the key ones is getting and keeping a trained work force. As we teach them the skills, they tend to look around and move away to other jobs. Retaining good employees can be a problem.”

CUSTOMERS WANT U.S. PRODUCTS

Besides, Rusch says, “customers are now asking for products to be made here. In the personal care industry, as new projects come up we see that clients are frequently looking to source more items here than from China. Companies here want to reduce their carbon footprint, which involves shortening lines of supply, and reducing freight and shipping, so all of those things have created the move to put more production back in the U.S.”

Electronics parts maker MOREY became concerned, not only about quality issues in China, but also that the length of its supply chain was slowing its response time to a range of crucial customer issues. “You know the quality issues from dog food to baby milk to toys,” says MOREY’s Ahmad. “Their quality is different. We expect our things to work 100% of the time. But not in China. They expect one-tenth the quality.”

“But it is the recovery from quality problems that is so important to us. Here within minutes we know if there is a failure and what we are going to do about it. There is no language barrier or time difference. We are on it, real time.”

“If you are used to and need a 24-hour response cycle, you cannot do that from China without huge costs,” Ahmad says. “We realized that it was just very difficult to have six weeks of inventory on boats all the time.”

One of MOREY’s newer clients, NetworkFleet, Inc., appreciates that quality control and response time. The company makes and sells GPS tracking systems for companies that manage fleets of vehicles, and had plenty of bids from overseas manufacturers who beat MOREY’s FOB prices. “But we needed to look at total costs,” says Diego Borrego, founder and vice president of product engineering. “We need a steady flow of high-quality product and the capability to make changes on a three- to six-month design cycle. I can’t afford to have six months of inventory sitting on a boat. We’ve got to be able to call them one day and say, ‘We’ve got to make this change. ’We need a lean manufacturer with just-in-time capabilities who can react to my needs and manage change very quickly.”

THE MOVE TO PROXIMITY MANUFACTURING

The manufacturing consultants we interviewed all agreed that because of changing freight, energy, labor, tariff and other cost structures, an increasing number of manufacturers want to locate closer to their clients’ assembly and delivery points. Proximity manufacturing, as this is called, has a lot of things going for it as the global economy recovers from recession. Just-in-time delivery of high-quality goods will become even more necessary, the consultants and manufacturers say, especially for the sort of high-value-added products that are, and increasingly will be, a U.S. strength.

“Companies have different market sensitivities, types of products or product life cycles that may not lend themselves to a long supply chain,” says Michael L. Hetzel, vice president for the Americas at McHenry, Illinois-based consultant Pro QC International. “Take cell phones. Initially, cell phone users were few, the phones were expensive and could be produced anywhere. Then they became a commodity and cost reduction became a key factor with offshoring as the result. As a mass-produced retail product, retailers would order them a million units at a time and they all looked alike and mostly did the same thing. So it made sense to bring in a shipment from China. But now we have mass customization that has fragmented inventory, as well as evolving technology leading to shortened product life cycles. So to manage an inventory that was previously a million phones, you might have 200 variable SKUs in that population which increases inventory volume requirements. You need large inventories to buffer the long distance supply chain and those larger inventories become more costly and problematic.”

You also need to consider the costs of government regulations and approvals, and finding good suppliers. “If you need FDA approvals, for instance, and other certifications of suppliers and materials, moving things can be hard. It can be hard to get new suppliers qualified,” says Maurer.

MISTAKEN TRANSFERS TO ASIA

That’s easy to understand. But how, then, did coming back really make sense for Wham-O and its Frisbees? Wham-O’s President Kyle Aguilar says it was because of high freight and increasing labor costs. Maurer says the Frisbee “is probably exactly the sort of thing that should never have gone over there in the first place. That is made with an injection molding machine that you can buy for the same price, wherever. And there is not much labor in it. It’s made with a big machine that sits there and chunks out Frisbees all day long. It is a low-value product that takes up a lot of space and does not require a lot of labor. And it is relatively expensive to ship because it is light. Containers are getting back to $3,000 a load, for instance, and if you are making integrated circuits, you can put millions of dollars worth in a single container, so the cost per unit comes way down. But if you are bringing back $5,000 worth of Frisbees, they may fill a whole container.” Frisbee, though, may be something of a special case in the low-end toy market, which is generally more labor intensive and as such still features a lot of “Made in China” labels.

“Those that tend to get the most benefit of domestic sourcing is the high-mix, low-volume stuff,” says Harry Moser, chairman emeritus of Agie Charmilles LLC, a machine tool supplier. He is working with the National Tooling and Machining Association and the Precision Metalforming Association to bring more manufacturing back to the U.S. “If you are making a million of one thing, it may make some sense to go to China. All you have to do is get one part right and you have a single set of setup costs. But if you are making three each of a thousand parts, you’ve got 1,000 parts to get right. So anything with high mix and low volume, anything where you need a high degree of accuracy, where intellectual property protection is a consideration, or where you have safety concerns, are likely candidates to be brought back here or to stay here.

“If you are making buckles for parachutes, you do not want to get them from China,” says Moser. “If one fails, you want them to have come from a reputable company in Cleveland that has product liability insurance and where you have a chance of collecting on any claim you might have. Also, if a product is made from sophisticated material, something that is not produced in China, where you have some risk of having inferior materials substituted, you do not want that made in China or any other so-called low-cost producer,” says Moser. “Or for things that may enjoy what is called a clustering effect, when a company and its vendors being close together can share ideas, react quickly, make improvements quickly, can innovate and optimize and control the outcome in a number of ways, that is much easier to do when they are close together.”

TOTAL COST OF PRODUCTION

Not only are there a large number of frequently overlooked factors to consider in the offshoring equation, but also it is extremely hard and meticulous work to assess them accurately. “It takes a lot of management time to figure out overseas sources,” says Brad Coulter, a director at O’Keefe & Associates, a financial consulting and turnaround management firm just outside Detroit, Michigan. “And there are a lot of questions. Is your intellectual property going to go out the door? Will the overseas supplier find a better offer and shut off your business? It is often hard to guarantee the contracts. And corruption is always in play. Your purchasing guys and sales people may be getting incentives under the table.”

“This is not insurmountable, by any means, for a large company. But the smaller ones may not realize what they are getting into,” Coulter says. “Any time you lengthen the supply chain you get all kinds of unanticipated risks, port strikes, port congestion, customs and valuation issues, shipping accidents and breakage.”

Moser and many others point out that much of this becomes startlingly clear when costs are analyzed fully and accurately. “They may look only at FOB prices and not the Total Cost of Ownership,” Moser says. “Total Cost of Ownership includes all of the costs and opportunities that influence the bottom line of the company rather than just the FOB costs, most of which are not captured by a classic accounting system but are clearly in the overheard.”

“Nothing gets more valuable on a boat,” says Hetzel. “U.S. manufacturing executives are sadly, and too frequently, uninformed about implications of supply chain architecture. And it’s not just purchasing, but throughout the company. These decisions are relegated to executives in isolated departments who don’t talk to one another in order to fully rationalize the supply chain architecture.”

“They are not considering this as an integrated cost problem,” he said. “The fragmented nature of today’s corporate structure works against re-shoring. But once we start looking at real total costs, and particularly when companies re-integrate their departments, the re-shoring trend will accelerate tremendously. It is just good business.”

At the same time, the globalization of world trade seems unlikely to stop. Companies that can manufacture and sell their products into the world’s markets may find that it makes more sense to shorten their supply lines and produce goods as close to their overseas end markets as possible. Moser, for example, says, “If they are making it in China and assembling it there and/or selling it there, they are not going to bring it back here unless they are having horrible problems. We know that.”

And of course there will still be companies that find the economics of offshoring irresistible and the search for the lowest-cost producer imperative.

“There are always going to be low-cost countries and they are getting better all the time, acquiring skills and adapting to training,” says Maurer at AlixPartners. “Look at China, which is now getting more expensive. But India is still cheap. And if the barrier is just transportation costs, the cost from Mexico may not be different than it is from different parts of the U.S. For those products where it does make sense you can be at a big disadvantage if you don’t relocate.”

In fact, the AlixPartners 2010 survey of the world’s most competitive economies shows Mexico in first place for the second year in a row. The United States actually dropped in competitiveness from fifth in 2008 to eighth in 2009. China slipped from fourth to sixth in the same period. After Mexico, in 2009, the most competitive economies were India, Vietnam, Russia, Romania, China, South Korea and the U.S. in that order, says AlixPartners.

“We are seeing more of a movement to Mexico,” says Maurer. “This is muddied a little by some of the safety and stability questions. But right now Mexico is very cost effective for us. I’ve got three clients right now, an auto parts supplier, a recreational durable goods maker and a consumer products company, and all three are looking to rebalance their manufacturing networks, and all three are looking at moving a portion into Mexico.”

But as Maurer concedes, the AlixPartners survey, which ranks countries according to seven different cost factors from raw materials and labor, to freight, duties and exchange rates, does not try to calculate the costs of the corruption or intellectual property problems that are often rampant in low-cost economies. “That’s true,” said Maurer, “the costs of corruption and copyright infringement are not in here. We wanted to focus on core economic factors. But those definitely have to be part of the decision [making] process.”

Hopefully, that decision-making process will become more intelligent and sophisticated. When North American companies accurately calculate the total cost of ownership of products they are thinking of producing offshore, these shores may, indeed, continue to look more inviting. But the global manufacturing environment is only going to get tougher and more competitive. That means those venerable factors, quality and service, reliability and value, will become even more important in the decision matrix.

“The message for those who want to stay or come back is: You have to be world class if want to do that,” Maurer says. “You can’t be mediocre and high cost. You have got to have a differentiated product and superior operations and execution or you can’t overcome the fundamental economic advantage.”

THE CATCH FOR CANADA

We can, it seems, look forward to more manufacturers bringing operations back to the United States. For Canadian factories, the story and the problems are a bit different. Certainly what is good for the U.S. manufacturers and economy is good for Canada. Half of Canadian exports are U.S. imports. To the extent there is any off-shoring in Canada, says Statistics Canada, that movement is to this country. But, the Canadian agency’s most recent study, just as the recession stranglehold began, showed that “material and services off-shoring have no effect on employment in Canadian industries.” The recession, however, has kicked Canada hard. “In 2009, manufacturing production fell 14.4% and export volumes declined by 14.6%,” says the Canadian Manufacturers & Exporters. “More than 180,000 jobs were lost in Canada’s manufacturing sector last year. Manufacturing employment has fallen by 420,000 or approximately 20% since 2005.”

Ominously for Canada’s manufacturers, the studies also show that they produce less and at higher costs than the Americans. And a weakening U.S. dollar only compounds this problem.

“This will continue to make Canadian products more expensive in relation to goods and services from the U.S. or other countries whose currencies are tied to the U.S. dollar,” says the Canadian Manufacturers & Exporters in its March “Roadmap to Recovery” report. “For Canadian companies pricing their products in U.S. or other foreign currencies, the appreciation of the Canadian dollar acts like a price cut on their export sales, diminishing profits, cash flow, investment and employment opportunities. The outlook is for further appreciation of the Canadian dollar in 2010.”

There is no mystery here. As long as Canada’s chief consumer remains just south of its border, Canadian manufacturers will have to become more globally competitive and at the same time find new opportunities in the United States. Off-shoring is the least of their problems.