The End of Outsourcing?
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by Chip Krakoff

Foxconn International Holdings, the world’s largest contract manufacturer of electronic components, made notorious last year by a rash of employee suicides at its Chinese factories, recently published its half-yearly financial results, which showed that its annual labor costs per employee have risen by a third over the past year, to $2,900.

Foxconn, 71% owned by Hon Hai Precision Industry of Taipei, and which also assembles products for Sony, Dell, and Hewlett Packard, employs an estimated 400,000 people at its two factories in Shenzhen (Hon Hai, with 800,000 employees, is the 10th-largest employer in the world). These people, most of them young, many of them women, work 11-hour shifts, seven days a week. According to the New York Times, Mr. Ma Xiangqiang, a 19-year-old Foxconn employee who jumped to his death from a Foxconn dormitory in January 2010, had worked 286 hours in the month prior to his suicide, including 112 hours of overtime, more than three times the legal limit. By all accounts, Foxconn is not a fun place to work, combining some of the worst features of military service, summer camp, and prison, but the problems facing Foxconn are far from unique.

Coastal China is in many ways a victim of its own success. China’s explosive industrial growth of the past 30 years, much of it concentrated in the Pearl River Delta in Guangdong Province, adjacent to Hong Kong, has lifted hundreds of millions of people out of abject poverty and introduced many of them to the temptations of consumerism. Rising living standards have been accompanied by increased awareness of the world and demands for more personal freedom. Workers no longer accept unremitting drudgery as an inevitable norm. Foxconn has responded in two ways: one, by increasing salaries, and the other, by setting up factories in Western China, where wages are lower and labor militancy so far nonexistent. China’s government has encouraged companies to set up factories in the interior, partly to reduce the strain on coastal cities’ infrastructure, but also to dissipate the kind of worker discontent that could quickly turn political. These are at most temporary expedients. Neither is a solution to the rising cost of doing business in China. Western China may offer lower wages, but the additional cost of moving components and assembled units thousands of miles within China may negate any labor cost savings. More fundamentally, Foxconn’s travails call into question the sustainability of China’s current export-dominated economic model.

It’s a fair bet that logistics – transporting the many components that go into an iPhone or an iPad and then getting the finished product to market – accounts for a much higher proportion of the final cost than the assembly work itself, which most analysts estimate at less than one per cent of the retail price. As the cost of Chinese assembly rises and the negative publicity associated with worker suicides and sweatshop working conditions intensifies, a company like Apple or HP might start to question whether assembling its products in China makes sense. With overtime and bonuses, a worker in a Chinese electronics factory can earn $500 a month. This is a lot less than the $3,000 or so a U.S. worker might get, but then Chinese manufacturing labor is far less productive. Shifting iPad assembly from China to the U.S. might raise unit costs by a few pennies, a small price to pay for greater control over their supply chains, while moving it to, say, Mexico, might even reduce the cost. No wonder the Financial Times said that “Hon Hai and its offshoots are looking like relics from another era.” No wonder, too, that Foxconn has reportedly been considering a $12 billion investment in Brazil, where import duties have raised the cost of an entry-level iPad 2 to nearly $1,000, as compared to around $400 in the U.S. The higher cost of Brazilian labor is insignificant compared to the savings in import duties, and a Brazilian-made iPad, just like a Brazilian-made Ford Fiesta, can also sell for a competitive price in the U.S. or Europe.

If China is no longer the cheapest place to manufacture or, as seems to be the case with Foxconn’s factories, its cost advantages are outweighed by other considerations, where does this leave Chinese manufacturing and the Chinese economic model? China continues to excel at making products like shoes and T-shirts, for which labor represents a much bigger share of the cost than for an iPad. But even in these product groups, a combination of lower labor costs and special trade preferences has caused a lot of production to shift to places like Vietnam, Bangladesh, Nicaragua, and Haiti. At some point, however, the world will run out of cheaper manufacturing locations. Once Vietnam and Haiti accede to the ranks of middle-income countries, where will the sweatshops move? Burundi? Somalia? It seems unlikely.

These developments prove only that present trends never continue indefinitely. The current fear of an unstoppable Chinese manufacturing juggernaut, which will end up like the victor in a game of Monopoly, owning all the money and all the property and manufacturing everything the rest of the world consumes, is no more valid than the old fear of an unstoppable Japan.

These developments also indicate that the doctrine of comparative advantage – the one economic theory that is neither obvious nor trivial – will reassert itself. Even if China had an absolute cost advantage in manufacturing of every imaginable product, which it clearly has not, it would still make sense for it to specialize in production of goods or services in which it is relatively more efficient. This mix of goods and services will change over time. China is likely to remain a formidable exporting power, but as its economy matures and its labor costs rise, its exports will shift from cheap, labor-intensive manufactures to goods and services containing higher added value, following a similar trajectory to that of Japan, Taiwan, and South Korea. More cars and flat panel displays and fewer T-shirts.

Does this mean an end to outsourcing? Not at all. But what is outsourced, and from where, will continue to change. Expect China, just now starting to export cars, to be building car factories in the United States 15 or 20 years from now. Expect Apple to shift assembly of its iPads from China back to the U.S. or perhaps to Mexico, where it can shorten its supply chain and better control quality. For now, your undershorts and T-shirts will continue to be made in Haiti or wherever else labor is cheapest and trade preferences greatest. For just about everything else, all bets are off.

Posted 10-03-2011 3:07 PM by Charles Krakoff