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July 1, 2005

What’s It Worth to You?

Just about everyone in the North American manufacturing supply chain agrees that high costs are one important reason why manufacturing here is at a disadvantage in global trade. A well-known 2003 study by the National Association of Manufacturers (NAM) actually put a number to the proposition, finding that U.S. manufacturers face a 22% cost disadvantage with their global competitors right out of the box.

The dilemma is, what we buy with that 22% cost disadvantage includes benefits that make the North American standard of living one of the highest and most sought-after in the world. Specifically, what we are paying for, directly or indirectly, are our justice system, our cleaner environment, our world-class healthcare system and our many economic freedoms.

COSTS ARE REAL

There's no question that the cost issue exists. The study, “How Structural Costs Imposed on U.S. Manufacturers Harm Workers and Threaten Competitiveness,” produced by The National Association of Manufacturers (NAM) and The Manufacturers Alliance/MAPI, found that U.S. regulatory costs alone, for example, run a huge $850 billion a year, with $160 billion of that cost falling squarely on manufacturing.

“Out-of-control structural costs mean shrinking margins for everyone,” says Don Wainwright, CEO of Wainwright Industries and chairman of the President's Manufacturing Council. “We have regulation coming up from the bottom and price pressures coming down from the top. I don't know what it means to raise a price.”

Those external overhead costs beyond the manufacturing sector's control offset a large part of the 54% increase in productivity the United States achieved since 1990. Most importantly, the costs study dispels the myth that most of our industrialized partners face higher costs than the United States. Removing the 22% structural disadvantage would make America more competitive than Canada, France, Germany and the United Kingdom, four of its nine largest trading partners.

So, would removing that structural disadvantage be the right thing to do? Three questions come to mind:

  1. If we had to do away with some of those things that make up our higher standard of living, what would they be? To whittle away at that 22%, what would we cut?
  2. Have American companies really done everything they can do to compensate for the disadvantage? Or are they just whining about costs that result from 200 years of a free society and a largely open market economy?
  3. Little discussed, are we measuring the right things? When we push for productivity improvements and GDP growth, are the metrics we use adequate to tell us how we are really doing vis-à-vis our foreign competitors?

WHITTLING

Asking what part of America's benefits you would alter is like asking which one of your children you would prefer not to have had so you won't have to pay college tuition.

None of us would do away with our judicial system, but NAM's cost study showed that U.S. manufacturing tort costs represent 4.5% of manufacturing output, higher than in nine countries analyzed. (See “Tort Reform,” Forward, May/June )

Everyone wants the world's best healthcare system at their disposal in their times of need. Yet at the same time, no one disagrees that healthcare costs are too high and rising at unacceptable rates—and still 45 million Americans are uninsured, 85% of them in families headed by a worker. The U.S. government provides more than $100 billion toward health insurance coverage to employers as exemptions, but two-thirds of that goes to the wealthiest one-third of American families. The U.S. Department of Health and Human Services says that reasonable reform of medical liability would save $70 billion to $126 billion annually.

High energy costs from the consumer's gas station to the factory's utility provider are causing political problems and voter disquiet across the country. Metals companies, for instance, have seen their costs increase by $5 to $9 a ton due to the cost of energy.

U.S. corporate taxes are an anchor around the ankle of American companies. The business tax structure has not been overhauled since 1986 and the general statutory tax rate on corporate profits—about 39% when you add in state taxes—is uncompetitive with our foreign trading partners. Of 20 developed countries, the U.S. had the eighth-highest tax rate on capital in 2004 (when you lump together corporate income taxes, asset-based taxes such as franchise fees and sales tax on capital components). The effective tax rate actually rose to 25% this year.

The U.S. Office of Management and Budget has an interesting, if somewhat macabre, method of measuring the cost effectiveness of regulations. Those deemed cost-effective require spending less than $7 million to save one life. Environmental regulations fail the test by, in general, costing more than $1 billion per life saved.

NAM's cost study shows that tax rates and employee benefits are the largest contributors to the excess burden—almost a third each—and Jeremy Leonard, author of the study, believes that this is where the whittling should start. “If marginal corporate tax rates, healthcare costs and litigation costs related to torts could be reduced 15%,” he says, “then the average excess cost burden could conceivably be cut in half.”

So taken one by one, the five factors making up NAM's 22% competitive disadvantage could use more than a little whittling.

STOP YOUR WHINING!

In many ways, the cost of our standard of living is simply the greens fee that must be paid by all citizens—individuals and corporations—to enjoy “life, liberty and the pursuit of happiness.” There are many things that American companies can do to improve their position against foreign competitors but, “the one thing you don't want to do is whine about it all the time,” says Wainwright.

We are, after all, still the world's largest economy and many would chide us for complaining about something that we are pretty capable of overcoming.

“The good news,” says Stephen Gold, vice president of NAM, “is it seems that while metals companies face incredible challenges internally and externally, they are at the same time becoming more productive, more innovative or changing the business model where something is happening. They're managing to at least turn things around and see business grow.”

Turning things around is certainly what U.S. Steel is about, says CEO John P. Surma, Jr. Since 2000, the company has cut its workforce by a third while increasing its raw steel capacity from 13,267 thousand tons in 2000 to 26,800 thousand tons in 2004. Overall production increased from 11,744 thousand tons to 22,951 thousand tons over the same four-year period and revenues went up from $6 billion to $14 billion. Without the workforce cuts, “I don't know how we'd compete,” Surma says. “Productivity is what really counts.”

Such labor efficiencies and the upgrading of equipment have helped lower costs for the metals industry, says Charles Bradford, president of Bradford Research. The biggest change, of course, has been the renegotiation of labor contracts led by Wilbur Ross, chairman of ISG. Even with downsizing and productivity improvements, U.S. Steel still carries labor costs of 26% of revenue compared with 15% for ISG, says Bradford.

To make up for the difference in workers' benefits, companies have gone increasingly to profit sharing. Dating back to the mid-1980s when the industry went through significant restructuring, profit sharing plans have been revamped to increase payouts and employee satisfaction. U.S. Steel, for instance, paid out $241 million in 2004, about $8,000 to $9,000 per worker, a fraction of what it would have spent on pensions. The company also participates in the Steelworkers Pension Trust with some 600 other companies, contributing 2% of gross earnings to a defined benefit pension plan for some employees.

On the plant floor, everything from lean manufacturing to just-in-time inventory, Centers of Excellence to supply chain optimization shave costs and build efficiency.

“Business models are changing, and we're finding that those companies that are surviving are not only changing their business models but also finding new ways of doing business,” NAM's Gold says. “It keeps boiling down to efficiency to be able to compete—to find new ways of doing business with much less money to compete with those overseas as well as the domestic manufacturers and suppliers.”

“Lean manufacturing is having a mindset and skill set on the floor where we can accommodate the flexible, changing needs on a day-to-day basis,” says Paul Luber, president of Jor-Mac Co., a Grafton, Wisconsin-based metal fabricator. Luber says that if businesses aren't challenged with competition, chances are they're getting lazy and doing things that don't make money.

Lean manufacturing provided one of several lifeboats to turn Jor-Mac around. Luber's company can produce a part at a lower cost than five years ago. Customer lead times have dropped by 60%, inventory has been cut by more than half and the two-hour average setups plummeted to a mere five to 10 minutes. On-time performance now sits north of 98%. While technology, new equipment and automation certainly contributed, Luber says that lean manufacturing played a significant part. The lean process begins by conducting a value stream of the shop or office, finding a better way to structure a run, implementing it, stabilizing it and then being able to reproduce the outcome consistently every time. Lean manufacturing enables Jor-Mac to supply parts to 75 customers on an as-needed basis.

“The perceived competition has been a moving target—first domestic in the Southeast, then Mexico, Japan and now the Far East—but I think those opportunities challenge you every time,” Luber says. “Innovation usually comes when there's hunger, sometimes from within, sometimes external. The juices start flowing and you come up with something that works better.”

Luber and his partners acquired the 53-year old Jor-Mac in 2000. At the time, the fabricator functioned as a job shop serving a local customer base on a spot-order basis. The new management brought focus, energy and direction to an organization using older equipment and traditional business methods. Today, its customer base is 70% Fortune 1000 companies in several regions of the United States, Mexico and Canada. Annual sales and number of employees have increased five- and three-fold respectively—to around $12 million with 100 employees. Revenue per employee jumped from $100,000 two years ago to $180,000.

HOW TO LIE WITH STATISTICS

That productivity growth is the single most important economic indicator is a truism. But how do we measure productivity?

Almost always, it's how much was produced per worker per hour. By that measure, the United States outstrips pretty much any nation out there. In the last nine years, the annual average rate of productivity improvement in the United States has been 4%, twice that of the early 1990s—all that going toward the 54% improvement that the NAM cost study shows. Although the growth in GDP per man-hour was slower—an average of 2.2% per year since 1996—the pace was faster here than in Europe.

So why are we still having so much trouble? If we're doing everything right—whittling away at the right things, sucking it up and getting on with solving our own competitive challenges, innovating like only we entrepreneurial Americans can—why are people like Nucor's director of marketing, Bob Johns (see sidebar below) still saying that the playing field isn't level and the “system discriminates against the home team?”

The problem may be that we're measuring productivity the wrong way. A better measure is total factor productivity (TFP), the efficiency with which inputs of both capital and labor are used. For instance, new and better equipment automatically boosts output per man per hour, but overall economic efficiency may not change even after you factor in the extra capital spent. A study by the United States' own Federal Reserve economists showed that, in the late 1990s, IT investment plus the TFP gains in producing IT goods accounted for 98% of the total increase in American productivity. In essence, non-IT areas of manufacturing sat on their hands—a disputable fact if you're U.S. Steel or Wainwright Industries, where layoffs and retirements have reduced headcount by 30% in the last five years. However, TFP might give a better indication of what's actually going on, why all the whittling in the world won't solve the problem.

OECD (Organisation for Economic Co-operation and Development) figures are the best measures of TFP, a much slipperier metric than man-hours. These figures show American productivity has increased by an average of only 1.2% annually since 1996. The rate is faster in France, almost even in Germany and only slightly less in the U.K.

The difference is what the OECD calls “capital deepening,” an increase in the amount of capital per worker. Across the U.S. economy, a lot of that is made up of IT equipment, an expenditure that has been dropping off since late last year. This would mean that, as measured by TFP, the growth in American labor productivity will not be sustained into the future.

Advocates of the TFP metric say that it is less distorted by national differences in measuring real output. In the U.S., for instance, software spending is a business investment whereas in Europe it counts as a business expense, excluding it from final output figures. Software spending in the United States, therefore, inflated GDP growth as compared to other countries. However, American statistics overstate the growth in capital spending as an input as well as an output. This distortion would be eliminated by using TFP calculations.

“If you don't measure it, it doesn't happen” is a favorite mantra of many in American business. However, we may have fallen in love with the measurements instead of focusing on what needs to happen to move the needle. The fog of percentages and economic charts may be clouding what American manufacturing needs to do to be more competitive. We need to get on with the twin tactics of lobbying for change and innovating for competitive advantage.

 VIEW FROM ABOVE

Canadian manufacturers face many of the same challenges as their U.S. counterparts, says Jayson Myers (right), senior vice president and chief economist at Canadian Manufacturers and Exporters (CME) in Ottawa, Canada. Rising material and energy costs plague manufacturers in Canada, but because of socialized medicine and Canada's consumer protection laws, which limit the use of civil suits in liability issues, Canadian manufacturers do not face the same health care and litigation costs as their American counterparts. However, Myers reports challenges—such as the escalating costs of materials, competition from extremely low-cost producers and the increasing value of the Canadian dollar—that force a shakeout in the metals industry right across North America.

“The industry is facing an increased demand for metals along with supply constraints, which provides a short-term cushion in terms of high pricing,” Myers says. “But that's not going to last.”

Myers predicts a tough transition for North American metals companies in the next three years as that cushion flattens and competition intensifies. An extensive restructuring in the industry will result as companies consolidate, reduce costs and develop higher-value products, likely causing closures and job losses. Companies need a global perspective, he says, not only in terms of where the competition is coming from, but also where the opportunities are for expansion, new market entry and industry consolidation.

Successful companies see themselves as delivering solutions to the customer in which metals are involved, rather than delivering metal parts,” Myers says.

THE CASE FOR INNOVATION

photo by Roger Ball

In 1990 when Michael E. Porter's book, The Competitive Advantage of Nations was published, the chapter on government policy never mentioned the cost of doing business. Given the times (the end of the Reagan-Thatcher years), Porter focused instead on the rise of market economies, the need to end subsidies and artificial props for failing industries, and government's role in developing an educated workforce.

“Ultimately,” Porter wrote 15 years ago, “nations succeed in particular industries because their home environment is the most dynamic and the most challenging, and stimulates and prods firms to upgrade and widen their advantages over time.”

No metals company has taken the need for dynamism and constant upgrades to heart as much as the No. 1 ranked company in BusinessWeek's 2005 listing of the top 50 performers: Nucor. The steelmaker recorded 82% sales growth, and earned $1.12 billion, in 2004, its most profitable year. Nucor has achieved uninterrupted, profitable quarters since the 1960s—the only steelmaker to remain profitable during the downturn of the early 2000s.

Nucor is the steel industry's lowest-cost producer based on a couple of measures including efficiency of output per unit of labor. Scrap and scrap substitutes comprise the majority of Nucor's steelmaking costs, which averaged $238/ton in 2004. Nucor and Posco in South Korea generally rank at the top in efficiency and cost ratings. Nucor emerges as the world's tenth largest steelmaker, the largest in the United States and the nation's largest recycler. What's more, the Nucor buying spree that began in 2001 and resulted in the acquisition of 10 steel plants enabled the company to gain more than 5 million tons of capacity for an average of 17¢ on the dollar, based on estimated asset value, since many acquisitions involved bankruptcy situations that sold well below replacement value.

The company that adopted the name Nucor in 1972 relocated from Arizona to the right-to-work state of North Carolina in 1966. Its 10,600 employees are non-union, giving Nucor a considerable leg up in competing with integrated mills with expensive union contracts.

Even as the company incorporated one acquisition after another, it maintained a flat organizational structure with only four management layers between the CEO and front-line workers. These two factors helped keep the company in the black all these years, says Bob Johns, Nucor's director of marketing. Its workforce practices enable the company to cope with the structural issues that are inherent in being located in the United States.

“The initiative that comes from employees not being micro-managed leads to high productivity,” Johns says. “That productivity helps offset the ‘self-inflicted' costs associated with being in the United States.”

As Nucor has grown, it has maintained the core of its culture, Johns says. This culture encompasses several characteristics:

  • Individual initiative leads to innovation and better solutions to manufacturing challenges.

  • An incentive system fosters extremely high levels of productivity.

  • Training and the overall environment help Nucor promote cross-functional cooperation and expertise.

Most of Nucor's current culture and management philosophies can be traced to Ken Iverson, who took over in 1965 as CEO when Nucor's predecessor, Nuclear Corp. of America, faced bankruptcy. He developed performance-related compensation systems based on specific goals and targets. Production employees, for example, earn weekly bonuses through a production-incentive plan based on crew performance, which promotes teamwork and productivity. With no upper caps, production payouts average 80% to 150% of base salary. Generally, two-thirds of workers' pay comes from bonuses. On average, the Nucor plant employee takes home a larger check than his unionized counterpart based on a lower hourly rate but much higher production incentives. As a result, Nucor employees produce two to five times the tonnage of their counterparts per hour. Other manager and non-production employees earn annual incentive bonuses through a performance-incentive compensation plan based on return on assets.

Nucor also has maintained a Profit Sharing and Retirement Savings Plan since the 1960s, which rewards qualified employees based on the profitability of the company. The Society for Human Resource Management reports that only 30% of its surveyed companies in 2004 maintain a profit-sharing plan. Nucor contributes a minimum of 10% of its pre-tax earnings each year after a minimum earnings threshold is attained. Nucor contributed $172.3 million in 2004—an unusually high number—based on record earnings and an extraordinary bonus of $1,000 paid to employees in July 2004 for record first-half earnings. Previous profit sharing numbers were $8.9 million in 2003 and $25.9 million in 2002.

As a result of these performance-based plans, Johns says, Nucor developed an efficiency and low-cost mentality that's ingrained in the company culture. It maintains the highest productivity, the highest-paid employees with the lowest labor costs. Each Nucor mini mill employee, for example, makes three times as many tons of steel as each employee at U.S. Steel (the largest integrated steel producer in the United States) when comparing annual tons per worker. Although Nucor's hourly wages and salaries run about 66% to 75% of the average in the industry, the rest of employees' income comes from “at risk” bonuses.

“It all comes down to productivity of quality tons produced, which does wonders for prime yields and customer service,” Johns adds. “Culture is a significant factor in what makes Nucor run.”