Recently there have been several attention grabbing headlines in the international press to the tune of —‘Homesick producers lose taste for going overseas’ and ‘Stung by soaring transport costs, factories bring jobs home again’. The past decade saw a historic combination of falling barriers to trade, low energy and transportation costs, new access to plentiful labor and relative currency stability. It was not just the multinational companies (MNCs) which exploited this trend by shifting sourcing and manufacturing to low-cost, rapidly developing economies (RDEs), but new challengers from these same RDEs also rode this wave for all it was worth capitalising on their home country’s low cost advantage.
RDEs have a labor cost advantage. The labor costs in India and China are still a fraction of the cost in the West. Simple projections show that this gap is not going to disappear in a hurry. Moreover, while labor costs are increasing, so is productivity, often at a faster pace. BCG analysis shows that in 2001, $100 would buy 354 units of productivity in India on an average. In 2008, the same $100, after accounting for wage inflation, buys 501 units (analysis based on EIU data). Similarly from 1999 through 2006, manufacturing wages in China increased by 160%, but productivity increased by 220% over that period (based on EIU data).
But RDE Challengers are shaping a new business era competing with everyone from everywhere for everything. The winners go beyond simple cost and productivity levels and use multiple strategies to build advantaged value chains.
To start with, these winners build a capital advantage on top of their labor cost advantage. They localise, adapt and de-content assets, processes and people strategies to their home environments, which can lower plant investments by anywhere from 5% to 40%. In contrast, many MNC plants in RDEs actually produce at costs comparable to or even higher than counterparts in developed countries. These plants had largely copied plant configurations from home locations to RDEs as part of global ‘one plant’ policies. Chinese company BYD has become the largest nickel cadmium battery manufacturer in the world. It started off by importing a Japanese production line without its high cost robots. It reconfigured the line to replace these robots with labor which not only allowed it to sell at 40% lower cost than the Japanese but produce small batches which the highly automated Japanese producers could not. It gained share very quickly.
Winners do not work only on fixed assets to reduce costs. They work on their products to make it simpler and more cost efficient. When Renault wanted to design a car for price sensitive customers in Eastern Europe, it knew that its engineers in France would not be able to design it — it had never designed low cost cars before. So to put together a team at Dacia, the Romanian car company which it had acquired and by adopting strategies like simplifying the product using existing parts and reducing specifications, Logan was born at a cost which was 40% of its predecessor Clio, designed and produced in France. When Renault entered into a partnership with Mahindra to introduce Logan in India, Mahindra’s engineers took this low-cost Logan and reduced the cost of introduction by a further 15% which made Carlos Ghosn, Chairman of Renault talk admiringly of the ‘frugal mind-set’ of Indian engineers.
Silicon Valley is the world’s best-known cluster, but its just one example of a general and well-documented phenomenon industrial development happens in clusters or ecosystems of interrelated and inter-dependent companies, suppliers and service providers. Many challengers understand and exploit the power of the fast emerging clusters in their countries. In just the main coastal provinces of China, dozens of industry ecosystems have taken hold. In India, pharma challengers with operations in Hyderabad or Ahmedabad or auto companies with operations in the Chennai-Bangalore belt have significant advantage over peers who are not present in these clusters. They know that by locating their operations within a cluster, they typically pay more for land and labor, but those costs are offset by the access to scale and experience. Through effective management, its possible to build supplier relationships and trust that reduce coordination costs and increase reliability.
As the working population aged in the West and their cost increased rapidly, MNCs started moving away from building super scale plants needing lots of labor. On the other hand, leaders like Johnson Electric, the global leader in micro motors, have built cost advantage on the back of a super-scale plant in China. This plant employs 30,000 workers and produces 3 million motors a day. Johnson Electric is not the only one adopting such a strategy. Reliance Industries has always believed in building its competitive advantage around super-scale operations.
Finally, the winners pinpoint their value chain and build not just a low-cost plant but a globally advantaged network. The Indian IT companies were pioneers with their global delivery model which combined the best of low cost with customer intimacy and specialised talent to give the most competitive value proposition to their customers. RDE Challengers have been amongst the first to integrate their home market plants into a global network of fungible capacity instead of operating them as stand-alone low-cost islands. They break-up their value chain and locate different parts at the right global location in terms of cost or talent and capabilities or customer intimacy. Bharat Forge derives its pre-eminent position in its industry as much from its design and engineering capability as its dual shore manufacturing strategy, which allows it to serve its global customers with both low-cost products from India and China and high complexity/technology products from its European and US operations. Johnson Electric has integrated its low cost super-scale plant in China with configuration plants in Europe and the US which supplies more complex and design-heavy products to its global customers.
The typical 25-30% cost advantage of RDE manufacturers is almost wiped off with recent increases in wages and logistics costs, and factoring in higher supply chain variability due to congestion in many ports in Europe and US. Hence some of the media hype mentioned at the beginning. Winners in the era of Globality continue to construct an advantaged value chain by adopting the rules described here and enjoy a 25-30% cost advantage over their peers who do not.
This is the end of the beginning and the beginning of next phase for global manufacturing networks, in which companies that follow these new rules will continue to reap the benefits. Simple labor cost arbitrage was never a basis for differentiation and sustainable advantage.