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The Myopia in the Executive Suite

My last post referenced a piece from the print edition of Atlantic Magazine, a long piece about guns by Jeffrey Goldberg.  But the December 2012 edition also included two fascinating pieces about the perils of offshoring.  I’ll reference just the first in this post, both in a later post.

Offshoring, to those uninitiated to the lingo, refers to the act of closing a factory in a country or similar group of nations that has a massive consumer market (such as the U.S. and Europe) and building factories in poverty-stricken nations such as China pre-2000 and still targeting sales in the nation with the massive consumer market.  I’m sure some economists would quibble with my definition, but I think more traditional depictions are lacking.  I’ve always thought offshoring made little economic sense or any sense long-term.  Looking at the model strictly as a question of inputs versus outputs, it seems incredibly inefficient.  The target market almost certainly has superior infrastructure than the recipient of offshored factories, so maintaining production quality likely will be an obstacle.  Moreover, locating production thousands of miles from the desired consumer market requires massive inputs related to distance alone, and inputs only rise with increased demand on transportation networks.  To me, offshoring seemed to fly in the face of basic economic logic.

So, does it face any other business logic?  There, I question that as well.  The only obvious reason is extreme disparity in wages between the producing nation and the target consumer.  But over time, wages will rise, especially as business follow the ‘logic of the crowd’ and prosperity follows.  At least for a little while, if Japan might serve as an instructive example.  So businesses will eventually jump from one formerly impoverished nation to the next actually impoverished nation.  All the while breeding anger and resentment, I might add.

In The Insourching Boom, Charles Fishman starts with the history beginning with the groundbreaking for GE’s Appliance Park in Louisville in 1951, which remains a centerpiece throughout the article.  A sprawling complex of six massive factories churning  out 60,000 appliances a week by the 1960s, Fishman describes a trajectory of the complex’s employment as well.  From 1955 with 16,000 employees Appliance Park climbed to a peak of 23,000 in 1973, employment plunging to 1,863 by 2011.  Fishman latches onto a 1960s theory from Harvard economist Raymond Vernon at first:

The U.S. would have an advantage making new, high-value products, Vernon wrote, because of its wealth and technological prowess; it made sense, at first, for engineers, assembly workers, and marketers to work in close proximity—to each other and to consumers—the better to get quick feedback, and to tweak product design and manufacture appropriately. As the market grew, and the product became standardized, production would spread to other rich nations, and competitors would arise. And then, eventually, as the product fully matured, its manufacture would shift from rich countries to low-wage countries. Amidst intensifying competition, cost would become the predominant concern, and because the making and marketing of the product were well understood, there would be little reason to produce it in the U.S. anymore.

Going as far as to blame business short-circuiting the cycle to explain the 2000s stunning drop in manufacturing employment:

But beginning in the late 1990s, something happened that seemed to short-circuit that cycle. Low-wage Chinese workers had by then flooded the global marketplace. (Even as recently as 2000, a typical Chinese factory worker made 52 cents an hour. You could hire 20 or 30 workers overseas for what one cost in Appliance Park.) And advances in communications and information technology, along with continuing trade liberalization, convinced many companies that they could skip to the last part of Vernon’s cycle immediately: globalized production, it appeared, had become “seamless.” There was no reason design and marketing could not take place in one country while production, from the start, happened half a world away.

You can see this shift in America’s jobs data. Manufacturing jobs peaked in 1979 at 19.6 million. They drifted down slowly for the next 20 years—over that span, the impact of offshoring and the steady adoption of labor-saving technologies was nearly offset by rising demand and the continual introduction of new goods made in America. But since 2000, these jobs have fallen precipitously. The country lost factory jobs seven times faster between 2000 and 2010 than it did between 1980 and 2000.

But as Fishman continues, he shows that Vernon’s cycle turns into an utter mess.  Using the example of a GE water heater named the GeoSpring, Fishman describes the process of bringing the production back to Appliance Park.

The GeoSpring suffered from an advanced-technology version of “IKEA Syndrome.” It was so hard to assemble that no one in the big room wanted to make it. Instead they redesigned it. The team eliminated 1 out of every 5 parts. It cut the cost of the materials by 25 percent. It eliminated the tangle of tubing that couldn’t be easily welded. By considering the workers who would have to put the water heater together—in fact, by having those workers right at the table, looking at the design as it was drawn—the team cut the work hours necessary to assemble the water heater from 10 hours in China to two hours in Louisville.

In the end, says Nolan, not one part was the same.

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. The labor required to make it went down. 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 percent. The China-made GeoSpring retailed for $1,599. The Louisville-made GeoSpring retails for $1,299.

Perhaps I’m being too hard on Fishman and Raymond Vernon.  Fishman describes a model of “designed at home, produced abroad” numerous times in his piece, but his description of the GeoSpring redesign seems to indicate the water heater was designed abroad as well.  But I also see a much larger issue.  Could a Chinese designer even contemplate what makes a good water heater, given the GeoSpring doesn’t appear to be sold to Chinese consumers?

For years, too many American companies have treated the actual manufacturing of their products as incidental—a generic, interchangeable, relatively low-value part of their business. If you spec’d the item closely enough—if you created a good design, and your drawings had precision; if you hired a cheap factory and inspected for quality—who cared what language the factory workers spoke?

This sounded good in theory. In practice, it was like writing a cookbook without ever cooking.

Lou Lenzi now heads design for all GE appliances, with a team of 25. But for years he worked for Thomson Consumer Electronics, which made small appliances—TVs, DVD players, telephones—with the GE logo on them. Thomson was an outsource shop. It designed stuff, then hired factories to make much of that stuff. Price was what mattered.

This is the beginning of the real meat.  Outsourcing and offshoring are used interchangeably, and considering the differences between the two are blurring, that’s understandable.  But “designed at home” is clearly wrong.  GE farmed that out to Thomson Consumer Electronics, and Fishman assumes that outsource shops design products in the United States before farming out the actual production.  But if price is all that matters, why hire American engineers to design anything, when Chinese, Indian and Vietnamese engineers are far cheaper?  (Especially if they still reside in their original low-wage countries).

Business practices are prone to fads, and in hindsight, the rush to offshore production 10 or 15 years ago looks a little extreme. The distance across the Pacific Ocean was as wide then as it is now, and the speed of cargo ships was just as slow. A lot of the very good reasons for bringing factories back to the U.S. today were potent arguments against offshoring in the first place.

It was important to innovate, and to protect innovations, 10 or 15 years ago. It was important to have designers, engineers, and assembly-line workers talk to each other then, too. That companies spent the past two decades ignoring those things just shows the power of price, even for people who should be able to take a broader view.

Harry Moser, an MIT-trained engineer, spent decades running a business that made machine tools. After retiring, he started an organization called the Reshoring Initiative in 2010, to help companies assess where to make their products. “The way we see it,” says Moser, “about 60 percent of the companies that offshored manufacturing didn’t really do the math. They looked only at the labor rate—they didn’t look at the hidden costs.” Moser believes that about a quarter of what’s made outside the U.S. could be more profitably made at home.“

There was a herd mentality to the offshoring,” says John Shook, a manufacturing expert and the CEO of the Lean Enterprise Institute, in Cambridge, Massachusetts. “And there was some bullshit. But it was also the inability to see the total costs—the engineers in the U.S. and factory managers in China who can’t talk to each other; the management hours and money flying to Asia to find out why the quality they wanted wasn’t being delivered. The cost of all that is huge.”

This hews increasingly toward my overall theory–that offshoring doesn’t make sense in the long term.  Fishman even includes my concern about transportation issues:

Time-to-market has also improved, greatly. It used to take five weeks to get the GeoSpring water heaters from the factory to U.S. retailers—four weeks on the boat from China and one week dockside to clear customs. Today, the water heaters—and the dishwashers and refrigerators—move straight from the manufacturing buildings to Appliance Park’s warehouse out back, from which they can be delivered to Lowe’s and Home Depot. Total time from factory to warehouse: 30 minutes.

So, where am I going with this, one might ask.  What’s the point of repeating quite a bit of Mr. Fishman’s article, when a reader could simply glean this for her or himself by reading the December issue of Atlantic Magazine?  My answer is simple: there is no excuse for bad management.

Fishman’s sources often use the phrase hidden costs to describe the perils of offshoring.  I have to question this description.  What was hidden about how poorly the GeoSpring’s design was?  The Louisville GE teams were able to reduce the materials input by 20%, the materials cost by 25%, and the labor input by 80% without much difficulty, it seems.  I would wager these costs weren’t hidden–they were completely overlooked.

I return to where I began: a theory that offshoring makes little to no sense economically.  I believe Fishman’s article presents much evidence to bolster that theory, but I believe he doesn’t adequately address another simple but daunting question–then why did it the offshoring craze occur at all?

To answer that, I turn on the language of supply-side economics.  In my opinion, the infection of freshwater/Chicago school economic rhetoric has become almost total in most mass media.  This rhetoric often has an almost universal disdain for increased labor costs, and attacks unions accordingly.  Fishman describes Appliance Park’s 1970s and 1980s moniker as “Strike City,” and approvingly describes how starting wages have crashed 37% in recent years:

Even then, changes in the global economy were coming into focus that made this more than just an exercise—changes that have continued to this day.

  • Oil prices are three times what they were in 2000, making cargo-ship fuel much more expensive now than it was then.
  • The natural-gas boom in the U.S. has dramatically lowered the cost for running something as energy-intensive as a factory here at home. (Natural gas now costs four times as much in Asia as it does in the U.S.)
  • In dollars, wages in China are some five times what they were in 2000—and they are expected to keep rising 18 percent a year.
  • American unions are changing their priorities. Appliance Park’s union was so fractious in the ’70s and ’80s that the place was known as “Strike City.” That same union agreed to a two-tier wage scale in 2005—and today, 70 percent of the jobs there are on the lower tier, which starts at just over $13.50 an hour, almost $8 less than what the starting wage used to be.
  • U.S. labor productivity has continued its long march upward, meaning that labor costs have become a smaller and smaller proportion of the total cost of finished goods. You simply can’t save much money chasing wages anymore.

So much has changed that GE executives came to believe the GeoSpring could be made profitably at Appliance Park without increasing the price of the water heater.

In deciding on five major reasons, and the author focuses first on rising worldwide energy prices.  I’ve touched on this before, but it bears repeating–transportation inputs for offshoring are MASSIVEContainer ship fuel consumption at a normal cruising speed starts at 100,000 pounds per day for smaller vessels and for behemoths the fuel burn often runs at triple or more that rate.  Fuel consumption for cargo aircraft is much greater per capita still.  Regardless of the cost of Brent crude, a single cargo vessel will burn millions of pounds of fuel to steam four weeks across the Pacific from Hong Kong or Shanghai.

The other three items, indeed most of Fishman’s piece revolves around the collapse of labor collective bargaining power in the United States in contrast to rising power and wages in China.  Strikes and the perception of high domestic wages are clearly pointed to as, to use another meaningless buzzword, “anti-competitive.”  But competitiveness is only meaningful when examined in total–what was competitive about producing the GeoSpring overseas?  Business executives and managers acquired extreme tunnel vision during the decades-long offshoring craze, to the point that lower wages became the name of the game regardless of anything else.

The offshoring craze clearly centered around searching for the lowest possible labor rates, which in Fishman’s article the author appears to point at American labor strife as the primary reason why the craze commenced.  However, this assumption that pervades supply-side economics and similar mass media rhetoric is belied by current behavior mentioned in the piece: enlisting the assistance of Appliance Park assembly line workers was instrumental in delivering the much greater efficiency generated when redesigning the GeoSpring.  Could it be that labor strife was incidental or a symptom of executive and managerial myopia–a single-minded drive to reduce labor costs regardless of the consequences to production quality, efficiency, and overall manufacturing effectiveness?  If this alternate theory is true, might this point to widespread executive and managerial incompetence?

Overall, Fishman’s piece is a fascinating look into the possible end to offshoring.  He mentions concerns about fads, and that the relentless pace of offshoring could resume anew when the economy picks up, which is certainly possible.  The same myopic forces that likely triggered the offshoring craze in the first place are still abundantly present in multinational corporations.  But two big questions remains left unasked.  Part of the decision-making about offshoring to China almost certainly revolved around getting a foothold to the domestic economy to the 1.3 billion Chinese citizens.  As China still has that massive population, are there other reasons than the great difficulties foreign businesses have trying to access the Chinese market for GE and other multinationals to consider pulling up stakes?  More to the point, some companies that offshore to China have offshored again to still-lower wage Asian nations.  What economic forces are at work that are making multinationals decide to pull production back home, to the United States?

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One thought on “The Myopia in the Executive Suite

  1. Pingback: It’s Not All Roses… (Or is it Something Else?) « In The Corner, Mumbling and Drooling

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