Outsourcing isn’t about low labor costs anymore

Jaguar Land Rover's largest market is now China
Jaguar Land Rover’s largest market is now China

Outsourcing has traditionally been the province of Purchasing and Operations. Focused on lowering costs, these departments would generally look to a small number of low wage countries.

There are two dynamics that are causing production locations decisions to change: Increasing labor costs are making outsourcing for lower labor costs less attractive. Secondly, politicians are increasingly using their power to create jobs in their own countries regardless of the cost of labor. This is going to put new pressures on Operations and HR to manage their workforce more effectively to remain globally competitive.

How do politicians wield this power? In different ways, but each reflects a need to convert regulatory authority, purchasing power or control over natural resources into quality jobs. To understand how this works, let’s take a look at a couple of examples:

United States

In the U.S. the New York Transit authority purchased $599 million worth of trains last year from Bombardier. A Canadian company. The trains they purchased are manufactured in Bombardier’s Plattsburgh, NY facility. The state government has effectively converted purchasing power (of the rail cars) into good jobs in upstate New York.

NY Congressmen Bill Owen proudly announced the benefits of the deal:

“Bombardier and our community leaders work tirelessly to ensure that the region continues to emerge as an industry leader in the assembly and manufacture of transportation equipment.”

China

Let’s go to China to see a second powerful example of government at work. In November last year, Jaguar Land Rover announced that they were partnering with Chery, a Chinese Auto manufacturer.

“The joint venture will blend together the heritage and experience of luxury premium vehicle manufacturer Jaguar Land Rover with the intricate knowledge and understanding of Chinese customers evident at Chery,” JLR said.

Interesting comments, although it seems that Jaguar Land Rover was doing a pretty good job at understanding the market on its own as The Wall Street Journal reported yesterday that sales increased by 32% over last year on the back of a soaring Chinese market.

Maybe there is more than market knowledge being sought by JLR. The auto blog provides a little more clarity. By setting up local automotive production (which requires a joint venture in China) JLR can also avoid the 25% import tariff it currently faces on its products.

Another example of how the government can use its power, in this case the ability to tax and control company formation, to encourage the increase in skilled local jobs. But like most companies, Chery has its eyes set on more than producing cars for the Chinese market. Auto Blog continues…

“The partnership with Jaguar Land Rover signals the start of international expansion and strategic development for Chery Automobile.”

India

Every effort at creating jobs does not go so smoothly. In this case we’ll move to India. There’s a pending change in India’s regulations. The Wall Street journal reported on these draft regulations a couple of weeks ago.

The draft regulations would require that a substantial percentage of technology hardware purchased by government agencies and some companies come from India-based manufacturers. Foreign players would have to swiftly set up local factories to market their products here.”

In this case the government has the power of both regulatory control and purchasing power to create local manufacturing jobs. But it hasn’t thought through the practicality of trying to stand up an industry overnight. If you look carefully at the U.S. and Chinese examples, they started small and take place over decades. This allows companies to adjust and make changes as they learn. In this case India is going to disrupt a large market. The challenge here is that the buyers of this equipment probably still need it at competitive prices. Secondly, for manufacturers, it will take time to create the infrastructure, skilled employees and a supply base.

 

So why does this change in outsourcing strategy matter for readers of Lean Labor? It signals a shift from companies making decisions about moving production and employees overseas due to cost considerations to them making production decisions based on new revenue considerations. Previously all decisions were based on cost, delivery and quality. Now the decisions will be based on revenue opportunities with the pressure on Operations to make it profitable.

This means that the workforce and its managers are going to be under the same pressure to manufacture competitively, but now they will face the added complication of managing multiple cultures, languages, time zones, exchange rates and regulations among multiple production facilities.

What can you do to get started? From a systems, measurement and policies perspective, the companies that I’m working with are putting a repeatable plan in place to get acquired companies, jv’s or start-ups on board quickly. Policies and procedures are being standardized to a practical point. Companies recognize that a one size approach doesn’t work though and enough flexibility must be left in the system to let the local employees manage the nuances of each country and situation. More teeth are being applied to standardizing all types of data so that it can be quickly rolled up, analyzed and acted upon. Automation is being implemented to ensure administration costs don’t overwhelm smaller populations of employees.

Having a solid plan in place with documented success in other locations ensures that there is less room for the local facility to negotiate a unique environment. At the same time a well crafted plan makes sure that moral, engagement and the potential for innovation aren’t crushed.

For HR and Operations this represents an opportunity to create competitive advantage through the workforce. Those companies that can master distributed manufacturing and workforce management will have access to an increasing number of growing markets. Those that don’t will be stuck servicing larger mature markets as their competitors grow around them.

China rises to the challenge of increasing labor productivity

 

I recently returned from China where I attended my employer’s first customer event in China, KronosLive. Over 100 companies attended. They ranged from large privately held white good manufacturers, network equipment manufacturers and shoe manufacturers to many multi-national manufacturers with locations throughout China.

 

Customer panel discussing methods to increase labor productivity
Enjoying dinner, entertainment and awards ceremony

As this was a workforce management conference, the topic was of course focused on labor. Similar to my trip last year, the main topic was rising wages. To add pressure, many are facing growing payroll taxes to support an increasing array of benefits from the government as well.

 

At the conference, it was apparent that companies have mobilized with respect to workforce management. Here are two strategies that companies, both privately held and US based multi-national, spoke about during the conference.

 

Flexing of the workforce

As an increasing number of companies are working towards compliance, they realize they must become more innovative in how they flex the workforce. One company that deploys customer engineers in the field is accommodating its busy and slow periods in two ways. First it allows employees to draw on unearned vacation days. At this manufacturer of semiconductor fab equipment, the engineers might have slow periods in the beginnning of the year. If there is no work they have two choices, they can take unpaid leave or they can borrow vacation days off. They can then earn those days back as they accrue them through the rest of the year. They true up at the end of each year. The second method is overtime banking. If an employee uses their maximum overtime of 36 hours per month or would like more time off, they can bank their overtime hours and use it for paid time off later. These two techniques make sure the workforce is paid consistently throughout the year but allows the company to flex labor up and down as the workload changes.

 

Increasing the effectiveness of Operations

The second company implemented a new metric that is near and dear to my heart. They began using the Overall Labor Effectiveness metric at one of their key operations. The kpi began at 72% and is now running at 90%. They attributed the success to employees and supervisors having better knowledge about individual’s performance and visibility to all as to how the operation was performing. Even better was that the hours improvement came out of overtime so there was 150% savings in term of wage cost.

 

It became clear to me during the conference that Chinese companies realize they must change their strategy from one of purely low cost labor to survive. They are executing on one of three strategies:

 

  • They are implementing continuous improvement and automation with respect to labor to increase productivity and maintain low unit cost.
  • They are increasing the value of what they build with the same labor. Sometimes this value is delivered through value-added services other times through the complexity of what they are building.
  • They are extending globally to build global brands and take more of the profits along the supply chain that were previously spread among other participants.

 

I was pleased to see this progress for two reasons. First it means that the middle class continues to grow while people are working reasonable hours and making decent wages. This will result in growing demand for all types of goods produced globally. Secondly, it means that companies are focusing on increasing the value of their operations rather than relying on low cost labor. This is more aligned with manufacturers in developed countries who provide a living wage to production employees and should result in more balanced trade.

 

 

 

China’s GDP Dilemma

With the announcement that China GDP growth has slowed to 8.1%, the unbridled demand for labor will also cool off. It’s a tricky time for China as its previous strategy of pushing hard on the gas pedal to grow GDP at any cost won’t work any longer. Now China faces the challenge of growing its economy at moderate pace.

It is already starting to drive differently to effect this change. Currently China is now driving with two feet. One foot is tapping the brakes (by curtailing construction) and one foot is gently pressing the gas pedal (through the loosening of credit by banks).

What other avenues can China pursue to grow this now large country at a controllable pace?

There are many levers that governments have used over the years. But in China’s case, it has already pulled many of them as far as they can go. Let’s take a look at a couple of those options and why they won’t work in China right now:

Devalue its currency. As China never let the Yuan rise in value in order to fuel its growth, it is under tremendous pressure to increase the value of the yuan from other governments and even its own citizens who desire more global purchasing power. It is politically untenable to increase the valuation of the Yuan without expecting economic retaliation from other countries. This option is not available to China right now.

Transfer GDP creation to a different sector of the economy. China turbocharged construction over the last decade to fuel its fast GDP growth and is now slowing that sector down due to excess capacity in the industrial sector and an overheated residential market. Comparatively, as the US exited manufacturing, its transition was buffered by significant consumer demand for services, government subsidized healthcare and a strong housing market. This allowed much of the employee population previously employed by manufacturers to find new, albeit lower wage, work. The U.S. had a more balanced economy which allowed it more choices. China’s low wage strategy has not enriched the bulk of its population meaning that consumers cannot afford to carry the economy right away.

China can’t wholesale offshore its jobs to lower its manufacturing costs and spur demand. Its economic success is based on a promise to its citizens that it will increase their standard of living over time. Without a place for those displaced manufacturing jobs to go, the promise would be broken and instability would result. Secondly, the difference in wages in neighboring countries isn’t enough to overcome the increase in logistics costs in all but the most labor intensive industries. This was not the case in the U.S. where Chinese wages were a tiny fraction of U.S. wages and the transfer of some jobs resulted in lower cost goods for the majority of Americans.

China can’t reduce wages of its employees to spur export demand by quietly letting inflation reduce wages relative to the cost of other goods. Intentionally or not this is what occurred in the U.S. over the last several decades. Reducing wages in China overtly or passively would only reduce China’s already paltry consumer demand. This is one of the areas of GDP that China is trying to grow in order to reduce its dependence on exports. Look at the Foxconn to understand what direction wages in China are going. The U.S. transitioned to lower wages because the transfer of manufacturing jobs also lowered the cost of consumer goods. The pain while noticeable, was manageable as people reduced savings to fund current lifestyle with the expectation that the government and pensions would provide a comfortable retirement as it had for their parents. Americans are now realizing what we did to ourselves with this domestic consumption GDP strategy.

China can’t automate its way into high productivity. While there will certainly be automation projects at individual companies and it will occur over time, don’t look for a government strategy that would rapidly automate the plant floor to increase competitiveness. This is simple. While the U.S. rapidly increased productivity through automation, it was able to absorb the workforce in other industries. China can’t do the same on such a large scale.

So what options are left?

There are only three that I can see and from my observations China is pushing hard on all those levers.

Rather than export production China can export labor. This is the “government spend” component of GDP growth China is investing its treasure in building political allies and securing natural resources around the world. For example, it is investing heavily in the Bahamas by building out its infrastructure. And guess who is providing the labor for 8,000 jobs there? This is a technique used frequently by the U.S to invest in other countries for political reasons but ensures that the U.S. receives a share of the economic benefits by requiring U.S. contractors participate in the projects.

China can increase the value of what it produces to generate greater GDP. Exiting out of low value goods such as apparel production and into technology is a goal of the Chinese. This is a slow but traditional path as countries move from agriculture to industrialization. Alternative energy and automobile production are two good examples. Unfortunately this has generated some accusations from global manufacturers and technology providers that rather than develop or license technology themselves, Chinese manufacturers are counterfeiting brands and stealing intellectual property to speed up this transition. How this will play out is unknown.

Chinese production operators commute home in company supplied buses after a day's work. None have cars and many supervisors and managers carpool.

China can increase its labor productivity in its existing industry to lower its costs while increasing standard of living. I can personally vouch for this change in attitude by Chinese manufacturers. During a recent visit to China, I visited factories where young supervisors had implemented sophisticated techniques including active use of kan bans, 5S and changes in process to effect line leveling. They also exhibited a thorough understanding of how to manage constraints within production. Even the accuracy of payroll is now becoming a hot topic as labor laws are being enforced and wages rise. Increasing productivity was the secret to the U.S.’s success. The challenge is productivity gains are a slow path relative to most other methods of growth because it comes from the bottom up. The upside is productivity gains are a sustainable competitive advantage because it is extremely hard to duplicate. Whether the government will make this a formal strategy is yet to be determined.

This is an interesting inflection point for China’s economy and I look forward to seeing if China can exhibit the same tenacity and success in the next phase of its economy as it did in the last one.

Rising wages in China are a positive sign of an economy in transition

It’s not until you see the growth in retail, marvel at the rate and scope of infrastructure investment, tour the factories and meet with the people that you begin to understand the momentum and excitement that is going on in China.

The first time I visited China (1995) bicycles clogged the streets of Shanghai. I visited small appliance manufacturers where the most basic manufacturing processes were taking place.

I’ve been back several times since then and the progress is astounding. Shanghai holds its own with any modern city in the world and the streets are now full of cars.

The phenomenal growth is the result of China’s ability to execute on a number of factors well. Its fundamental basis of success through has been through the ability of the government to focus its efforts on specific areas of the economy (infrastructure and exports) combined with a willingness for its people to support shared sacrifice for a better tomorrow.

This is demonstrated by China’s low levels of consumption (estimated at 36% today by the World Bank) and high level of investment (46%).

One of the mis-perceptions I think people have of China is that the average manufacturing production worker’s wages are low but so are their living costs so they have a good quality of life.

This couldn’t be farther from the truth. China’s manufacturing boom is coming from high levels of government investment in specific segment of industry, a weak Yuan, and a prolonged sacrifice in the standard of living from millions of hard-working people.

But painful changes in several macro-economic conditions and a populace that recognizes not everyone is sharing in the sacrifice equally is forcing the government to re-calibrate its strategy:

The prolonged global slowdown has exposed a gap in China’s strategy: It can’t fix weak demand with low labor rates and a controlled currency. 

A real estate bubble is making housing very expensive, especially in the larger cities.

Unrelenting inflation in food prices.

Increasing political pressure from the U.S. to increase valuation of the Yuan.

More manufacturing jobs than people in coastal regions. It’s a rough estimate, but a common number is that there are 1.2 jobs for every person. This is driving up wages as people jump from job to job.

Rather than footnote every point. I’ll share one of my sources for Chinese economic statistics. The rest is fairly well-known.

The government recognizes decisive action must take place. In its most recent 5 year plan, it is trying to combat these issues. China wants to increase wages and benefits to level out income disparity between its wealthiest and poorest groups.

It is also trying to reduce the cost of consumption by slowly increasing the valuation of the Yuan. This will provide increased purchasing power to its people, reducing basic food costs as well as making it more attractive to purchase goods.

It hopes to not only begin to improve the quality of life for lower-income groups, but to also shed its dependency on exports and internal investments by growing the consumption component of its GDP.

The plan is good but expect the ride to be bumpy.

First, for those companies that make a living based on the advantage of having the lowest labor costs in the world. This is a challenge. FoxConn who employs 1 million people recently announced that it would begin replacing people with robots. This was reported in an aptly titled piece by The Economist:  Robots don’t complain or demand higher wages or kill themselves”

During my recent trip, I spoke to several labor intensive manufacturers who were moving out of China to the next lowest cost country such as Vietnam and Bangladesh. Others are looking to find ways to increase productivity.

That kind of response from business is a problem for China because the only thing worse than underpaying people is creating an economic situation that forces them out of a job. China is trying to transition its economy to industries that have higher economic value-add so that it can increase the standard of living without relying on low-cost labor.

The second issue for China is that people save too much. Yes, it’s great discipline. But I assure you, the Chinese have an affinity for the finer things in life just like the rest of us. The high savings rate is because there is no social safety net in terms of healthcare or retirement. The government has recognized this as well and is mulling over how to provide benefits for 1.3 Billion people so that they spend a little more now.

This all provides a little relief to the American worker. A weakening dollar, domestic wages that have stagnated and its main manufacturing rival experiencing large wage increases result in more U.S jobs. To read about the experience of one American manufacturer that moved to China, read this:

High wages causing job drain. A government forced to consider large sums of Treasure spent on healthcare and retirement benefits. Corporations making profit based decisions that cause pain among the populace. That all sounds so familiar.

Who will win the war for talent in China

While in Beijing recently I met with the head of Human Resources for an American based multi-national manufacturing company. Its division in China currently employs 5000.

We spoke on a number of topics with the war for talent being the most pressing. China’s manufacturing sector is vibrant. Companies continue to see growth from exports as well as an increasing percentage of business coming from domestic spending driven by investment in infrastructure and increasingly retail volume.

For workers in the manufacturing industry, a job with a local division of a multi-national manufacturer was once considered the best option for upwardly mobile employees. The salaries are higher, benefits are better and these divisions are in an invest-and-grow mode. English language skills improved and smart Chinese workers prospered. For private local companies it was difficult to compete.

Today, however, things are changing. The global recession has forced many multi-national companies to restrict investments and even close factories both in China and abroad. Other MNC’s found the complexity and costs of operating in China higher than expected and withdrew after a couple of years. Larger private Chinese manufacturers while not immune to the recession were not as exposed. Government stimulus also helped. As a result they were able to weather the storm more effectively.

As China’s GDP has returned to its blistering rate of growth the dynamics of attracting talent have changed.

Chinese companies are evolving from contract assembly or sewing shops that competed solely on rock bottom wages for low-skill jobs. As the skills developed by employees with previous experience in MNC’s and Joint Ventures seep into local companies, private Chinese companies are beginning to execute on their own global manufacturing goals.

Investors have also fueled this ambition as the stock market continues to launch new public companies providing early investors with a quick exit and potentially high return. This phenomenon allows Chinese companies to continue to pay less to employees but promise through stock options a large payout. For those who were working during the late 90’s in the US, it is reminiscent of the talent drain of large stable companies to small start-ups who had nothing to offer but long hours, low pay, an exciting culture with the promise of millions of dollars in a year or two.

These economic changes have made it more difficult for MNC’s to compete for the most skilled employees. The following are some observations from my discussions with mangers and employees during my trip.

 

In China, cheap labor can still be found but talent is expensive

Rising wages for unskilled production employees in coastal cities can run $3-$4 dollars an hour, up from $1 just a few years ago. For manufacturers who have based their competitive advantage on low cost labor and have not improved productivity, they are being forced to move inland where labor is less expensive (for now). At what is often estimated to be 1.2 jobs for every person in the large cities, talented employees have many more options today than even just a couple of years ago. They are job hopping every couple of years earning 20-60% pay increases.

Even the advantage of the lower cost inland cities is evaporating quickly. Because living in Beijing and Shanghai carry significant prestige, a commuter’s package to a tier 2 or tier 3 city begins shaving away at the cost advantage of these outlying cities. Add in additional freight costs and the justification to move inland can only be made through tax and land incentives.

Parental pressure on the young to earn as much as they can

China’s single child law has had a number of unintended consequences. Parents who have sacrificed to ensure a better life for their child are now demanding a return on their investment. Legally children must provide financial support to aging parents. In some families a successful child might also be pressured to support uncles and aunts as well.

This dynamic erases a traditional benefit that Western companies have long touted as a differentiator: better working conditions. Employees who have an opportunity to earn more or strike it rich with options are considered selfish by their family if they decide to earn a little less in return for better working conditions.

Broken Trust

China’s controlled economy has built in an expectation of job security. The last recession has brought about a new reality to Chinese workers. Jobs aren’t necessarily forever.

Those companies that have been forced to close their factories or moved some of them offshore now have a reputation as providing a less secure working environment.

When recruiting employees, a reputation for flexing the workforce through lay-offs reduces a company’s attractiveness compared to companies that offer steady employment.

What can companies do?

With rising wages, throwing more labor at problems is no longer a solution. As a result making better hiring decisions each hire becomes more important. As higher risk is associated with each hire, a corresponding investment in the hiring process is justified.

Second, investing in employees through training will increase the skills of second tier employees reducing reliance on the difficult to recruit superstars.

Finally, western companies continue to have a cultural advantage in managing high performance employees. This is the ability to empower and trust employees with increasing responsibility. In discussions with employees who have worked for both local and MNC companies, the empowered culture is favored by high performance employees. They appreciate a culture that allows them the freedom to make their own decisions and have responsibility (and control) over a specific area of work.

A low-cost unskilled labor manufacturing strategy is a thing of the past in China. China is no longer the low cost labor leaders and management strategies there must also change. Investing in productivity enhancing systems, continuous improvement efforts and a focus on innovating to increase the value added to products and services is the next stage of development for companies that want to succeed.