TRADE DEFICITS, VAST DISTANCES BETWEEN COUNTRIES, AND CONTINUING SUPPLY CHAIN DISRUPTIONS–RECIPE FOR DISASTER?

By Jeffrey Cartwright, Shoreview Advisors | 8 min read

Supply chain disruptions not only continue to be in the business headlines, but they are causing substantial losses to profitability by large increases in product costs from both the tariffs and from the doubling and even tripling of inbound transportation costs from China. Even with the new administration, tariffs will be ongoing and the reasons for moving sourcing away from China continue to build. By now, with both Democrats and Republicans calling for taking a more aggressive stance with China over human rights or unfair competition or repatriating good manufacturing jobs back to the US, it is evident that the relationship will not materially improve any time soon. These tariffs will continue at a high level.

Today, executives must ask themselves are they willing to accept these now seemingly permanent changes to their cost structure or is it now time to reduce the risks of their supply chain including the historical quality, intellectual property, and now shipping delay issues by basing their supply chains on products sourced in another country like Mexico. Are they confident that quality, confidentiality, and their trade secrets are not being compromised?

From personal experience building large sourcing infrastructures in China for US marketers and distributors, there are good reasons for the shift in some products from the US to lower cost countries like China. There are also American executives who have moved production from the US to China for other reasons, including not clearly understanding their cost structures before, and after, an anticipated move.

In this blog, we touch on several issues leading to the current situation of too high of a percentage of U.S. companies’ goods and services being outsourced to China, without the benefits that were first offered to them. Some of these issues include:

  • Labor costs that have been escalating each year such that other countries now have much lower labor costs
  • The real costs of doing business in China.
  • Unethical behavior leading to consequences of U.S. executives being bribed into continuing to do business in China.
  • Complacency in some sourcing departments that have made declining benefits go unnoticed for far too long.
  • Not understanding the full cost structure of outsourcing (variable and fixed costs) leading to poor make vs buy decisions.

WHAT DROVE THEM THERE (TO CHINA), WON’T KEEP THEM THERE

The allure of lower labor costs was the primary reason to source products in China. While it was a compelling reason, it is not the sole reason for the massive relocation of manufacturing to China. This pursuit of substantially lower labor costs or low-cost country manufacturing is continuing and resulting in the movement of products from China to other countries, such as Vietnam and Mexico. 

The second major historical reason was the access to lower cost raw materials. While true, the reasons for this are less clear. The US has much greater availability of most raw material sources. In some cases, the US has been the source of discounted raw materials in foreign countries when US demand was insufficient to absorb domestic capacity at a high level. In those cases, some US industrial companies heavily discounted prices to China so as not to upset US market pricing. While understandable, it has also increased the cost differential between US companies and Chinese companies on a finished product manufacturing basis.

 An example is that of the price of steel in the US, which is substantially higher than China. In the early days, this was partially because excess steel was sold into China at deep discounts to keep US factories operating. Today, it is more because China has a much lower cost of steel manufacturing for various reasons including potential government subsidies and large capacity increases. The net effect of US steel tariffs is that the domestic producers raise US prices, China costs remain the same, and US companies that convert steel to finished products now have a higher product cost, making the difference with China on similar products much greater. This all leads to US companies becoming less competitive and even more products being sourced from China. 

SUCCESS BREEDS COMPLACENCY. COMPLACENCY BREEDS FAILURE.

Over time, factories in China have developed a network of sources for raw materials, components, and services that have made it easier to source from China instead of other countries, such as the US and Mexico. More specifically, in sourcing a product from Mexico or the US, the marketer/distributor must develop the sources for the raw materials that the primary factory requires for manufacturing. In China, this is typically accomplished by the factory, which makes the whole sourcing function much simpler for the US company.

Since this area has been greatly simplified by a Chinese agent, there has been a reduction in the staff resources that were required previously in the US. Rather than staying aggressive and challenging their supply chain, many companies have become overly reliant on Chinese resources. Hence, nearly any move to China resulted in a lower cost than manufacturing in the US. However, due to the hollowing out of US staff resources, companies may no longer be receiving the best deal as compared to other Chinese, Vietnamese, or Mexican factories. Nor do they have the resources to periodically review their supply chains. The result is manufacturing that could be less expensive if performed in the US or other countries does not return, even if it might be at lower cost, due to the lack of strategic review, under staffing and lower skill sets.

UNFORTUNATE REASONS WHY MANUFACTURING SHIFTED TO CHINA

The ethics of business in China and the US are sometimes very different. We read on a frequent basis about high level government executives being investigated for corruption. This is not confined to the Chinese alone. Many US executives have received personal financial inducements to source their company’s components or products from China. It is widespread in China and far more common than one would like to believe. 

SEDUCED BY THE ALLURE OF CHINA

Naiveté of the executive and lack of understanding the firm’s cost structure is another less than stellar reason why some products were outsourced to China. In this case, poor make vs buy studies decisions were made which considered only the variable costs of purchasing from China versus manufacturing in the US. What these executives failed to consider was that fixed costs are just that. Of course, one can write down plants and equipment and take the one-time adjustment to earnings and avoid the recurring fixed costs on the income statement. However, which CEO, CFO, or Operations leader volunteered to reduce his or her contribution to fixed cost by reducing their individual compensation commensurately. Fixed costs for assets should be considered as sunk costs. That is not to say, that they should not be considered as part of a future investment decision from a financing standpoint, but they are not ongoing costs per se.

The variable costs of operating a factory, such as utilities, should be considered in the analysis, but not depreciation or lease cost, which is more of a financing of the original asset than an ongoing cost that should be assigned to a product based on direct labor content of a product. Of course, in a business, over the long run all costs are variable — one can choose to close the business and eliminate the entire cost of doing business. The problem is that when the decision is made to outsource, rarely is there a complete strategic review of the business, including the subsequent impact on product costs, if the fixed cost structure is not radically addressed in the same way. 

Not only is the above treatment of fixed costs generally true, the analysis of the variable cost of importing is generally insufficient. It rarely includes the cost of the additional inventory for the 30-45 days of manufacturing lead time in China (vs the 2 weeks or so in the US) or the cost of inventory for the 25 to 30 days for transit across the Pacific Ocean or the time from port to distribution center. Nor is there consideration for the potential of air freight if there is a demanding customer or a quality issue when the product arrives. And don’t get me started on the impact a complete shutdown of the Suez Canal can have – it will take the industry many months to recover from this. It is likely that the analysis did not build in the overhead costs of travel to and from China. Then there are the intangible costs, such as the theft of intellectual property which is one of the underlying causes of the current tariff situation. 

Lastly, there is the issue that many companies jump on to the bandwagon of the latest management philosophy, in this case outsourcing. Shareholders are expecting results, and outsourcing is a convenient way of pleasing them, even if the underlying business does not materially improve. Share prices increased many times as an announcement was made about restructuring or outsourcing. My contention is that these decisions should be made on a recurring basis and if a CEO must make a major announcement (other than when first hired) about either of these, then he and his team have not been performing their job on a regular basis. 

QUO VADIS?

With the current situation of impending trade wars and the imposition of tariffs, for many companies there exists the opportunity to correct the past mistakes in previous make vs buy decisions. The gradual swell over the last few years in the consultant genre of Reshoring and the return of manufacturing to the US may be somewhat overplayed, but the underlying rationale is very much true. Labor costs in China have increased nearly 280% over the last decade, while increasing in the US only 36% (including benefits). The previous ratio of workers in China to the US was more than 12 to 1 and has now decreased to 4 to 1. While that is still a large difference, the reality is that in many products, direct labor is a relatively small portion of total costs. It is also my opinion that the average motivated US worker is far more productive than his or her Chinese counterpart, both due to his or her inherent problem-solving abilities and greater automation. Considering removal of the ocean freight, normal tariffs, inventory reduction and other costs, the equation is much more balanced. If the product in China also contained a premium for poor negotiating tactics or outright graft and corruption, then there is a great probability that moving from China to another low-cost country like Vietnam or Mexico or even to the United States would be advantageous. These countries provide greater protection of intellectual property than China. The persistent headlines provide convenient cover with investors and boards of directors for company executives to seriously re-evaluate their supply chains. 

Beyond the headlines, companies should re-evaluate their supply chains and sourcing strategies every so often, perhaps every 5 to 8 years. Becoming complacent creates opportunities for competitors. Re-sourcing, Near-Shoring, or On-Shoring are prudent strategies. When was the last time you reviewed your sourcing strategy?