Rising Wages, Freight Killing Manufacturing's Offshore Advantage

Ann All

Back in June I wrote about the effect soaring oil prices were having on the global supply chain, noting that for many North American companies it was becoming a lot less cost effective to have goods manufactured in low-cost locations like China.


Still, I was somewhat stunned to see a McKinsey Quarterly article (free registration required) written by two consultants and a McKinsey principal that shows how rising freight costs, combined with such economic factors as wage inflation, are actually making it less expensive to manufacture some products in nearshore locations like Mexico or even in the U.S.


Consider that the average annual wage inflation in China is 19 percent (and has been since 2003), vs. 3 percent in the U.S. and 5 percent in Mexico. That alone is pretty compelling. But when logistics costs are factored in (costs of shipping materials to manufacturers and shipping finished goods to customers), the authors find it's now cheaper to make some products in Mexico (midrange servers) and others in the U.S. (midrange copier and assembled TV). It is still cheaper to manufacture some products, like high-end servers, in China.


These cost differences become even more pronounced when less obvious costs, such as carrying inventory and product returns, are included. The authors' example: In 2003, manufacturing a midrange server in Asia instead of the U.S. yielded a 60 percent savings in labor costs. They indexed the savings to $100. When total landed costs were included, however, 36 percent of those savings were offset by freight, shipping-related charges, inventory, product returns, and other hidden costs, giving Asian countries like China a $64 overall cost advantage.


The labor savings have fallen from $100 in 2003 to $45 today due to wage inflation. Freight costs have also risen by $21 and product returns by an additional $4 because of higher oil prices. The result: Former offshore savings of $64 have turned into a $16 deficit, say the authors.


These trends may cause many North American companies to reassess manufacturing models built on simple labor arbitrage. Facilities that utilize advanced automation rather than strictly manual labor could further tip the balance toward moving some manufacturing closer to home. There's a possible snag, however: a shortage of U.S. workers equipped with the kinds of skills needed to operate such systems.

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Sep 29, 2008 12:31 PM P Kuske P Kuske  says:
I too read the McKinsey article and found it interesting to hear just how close the gap had shrunk.Long term, we believe Mexico can benefit, however I don't believe American companies will flock to Mexico in droves for two important reasons. One, there continues to be rampant lawlessness along the border with the US and elsewhere, that is well reported in the American press, not to mention corruption at many levels of government. This negative publicity slows transition and companies are reluctant to put their principles and their families at risk to manage the offshore facilities on-site or remotely.Two, transferring manufacturing is logistics heavy task, whether building new manufacturing facilities or packing up and transferring the equipment from either the US or China to new facilities in Mexico takes considerable capital, and getting those goods past Homeland Security & US customs will also be a considerable obstacle that will take time desire and perseverance.The minute Mexico becomes a "hot" manufacturing outsourcing destination (hotter than it is currently) will bring with it the wage inflation we are seeing in China and India, shrinking the overall advantage to only the reduced cost of transport the mitigating factor. This is a lesson that has been learned and remembered by companies already outsourcing to Asia. Reply

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