International Manufacturing Costs

Transcription

1 International Manufacturing Costs Erik J. de Bruijn * and Harm-Jan Steenhuis ** * Technology and Development Group, University of Twente, PO Box 217, 7500 AE Enschede, The Netherlands; e.j.debruijn@tdg.utwente.nl ** Department of Management, College of Business & Public Administration, Eastern Washington University, 668 N. Riverpoint Blvd., Spokane, WA 99202, USA Abstract This study discusses the key elements of the cost differences connected with international manufacturing. The influence of the geographical location of where to produce in international manufacturing is an important topic for managers as well as (political) policy makers. The actual decision on whether or not to become engaged in international manufacturing, and if so where to locate, is not purely an economic matter. It is essential to have complete insight into the various cost elements involved in international manufacturing in order to be able to determine an appropriate location, and to judge whether expected obtained benefits of production provide a comparative advantage. A structured approach to international manufacturing costs is explored. This approach provides a survey of the various types of cost generating stages and the type of costs typically involved in each of those stages and therefore will facilitate decision-making process by managers and public policy decision-makers. It is based on case study research in the aircraft manufacturing industry, and it enhances the understanding key determinants of the international manufacturing phenomenon. Keywords: Internationalization, manufacturing cost elements, production location. Introduction As a result of the increased globalization businesses managers are required to take into account the possibilities of international manufacturing. They are affected by international differences in costs, even in case the companies themselves are not yet involved in overseas production. Where they are involved in offshore production, it is important to determine the most appropriate location. This is to a large extent determined by the different cost structures in the various countries. It is therefore essential for business managers to develop an understanding of the different costs involved in producing abroad in order to make the best decision with regard to where to produce. Policy makers also have to deal with these cost aspects of international manufacturing. Manufacturing is a contributor to economic growth and it affects employment. Its contribution differs per nation. An overview of international manufacturing costs not only allows policy makers to assess whether or not they want to entice or defer certain manufacturing industries, it can also provide valuable insights as to how the cost structures might be changed. Policy makers who are aimed at using manufacturing industries towards economic development therefore can make better judgments when they have insight into the costs related to international manufacturing. Currently a comprehensive insight is frequently either completely lacking or at best superficial. 50

2 Although researchers have been studying international business for decades, a clear view of all the aspects the true costs of international manufacturing is lacking. This research addresses the costs of international manufacturing by combining contemporary available theories with recent findings about the gaps as a result the findings from the aircraft manufacturing industry (Steenhuis 2000). International Manufacturing Decision Making Issues Companies are forced to consider the implications of the increasingly global manufacturing world when planning their strategies. They have to determine where to produce, regardless of their historic origins. The various location options will offer different types of advantages. In several parts of the literature on strategy, the competitive advantages of nations have been indicated (Porter 1990). Elsewhere comparative advantages or even absolute advantages have been noted (Liemt 1992). Essentially, as highlighted by Kogut (Kogut 1985), these different kinds of advantages raise two principal questions for international strategy. 1. Where should the value-added chain be broken across borders? 2. In what functional activities should a firm concentrate its resources? At the policy level, a third question also becomes relevant: 3. What manufacturing activities should a nation concentrate on? The answers to these questions also have direct implications for manufacturing systems. Obtaining meaningful answers to these questions is complicated. It requires knowledge over a range of fields, including, but not limited to, international management, strategic management, operations management, and public policy. The decisions also involve choices such as make or buy. To complicate matters even more, international manufacturing can be primarily marketoriented, i.e. to serve the foreign market, or production oriented, i.e. finding the most suitable location for production. In this research, the choice has been made to particularly focus on the costs associated with in-house manufacturing in an international context to serve global markets and to employ a production perspective. Studies that examine manufacturing cost in an international context typically focus on the explanation or justification of cost differences. Two streams of literature dominate. Firstly, there is a large amount of literature on international trade, which is of particular interest to policy makers. This literature examines the phenomena of international trade, in particular intra-industry trade is an area that attracts attention, see e.g. (Ethier 1982; Hummels and Levinsohn 1995). The basic conclusions from these types of studies are that different countries offer a more or less suitable environment for production, for example based on factor endowments. Secondly, there is considerable literature that focuses on foreign direct investment. This literature is especially concerned with explaining how foreign direct investment can compete with local competitors, see e.g. (Dunning 1991; Dunning 2000; Hirsch 1976; Hymer 1976; Moon and Roehl 2001). Typically it is concluded that either market imperfections or specific ownership advantages explain the occurrence of foreign direct investment. Although trade theories do have value in determining public industrialization policy, their contribution at the company level is, at best, difficult to assess. One reason is that the empirical evidence is too aggregated. A similar observation can also be applied to foreign direct investment literature. As Swamidass and Kotabe (Swamidass and Kotabe 1993) note: One of the major hurdles to the investigation of international sourcing is data availability; data on intra- and intercompany international sourcing decisions are proprietary information that is difficult to obtain. 51

3 Although data on the amount of foreign direct investment and where these investments are made is available, see e.g. (Ferdows 1997), concrete data on the actual cost and benefits analysis are much harder to find. Another limitation of the current foreign direct investment theories is that they implicitly assume that the motives for companies to invest abroad are economic, and that manufacturing abroad is cost effective. There is, however, significant evidence that the cost can be much higher than originally expected. For example van de Ven and van Laarhoven (Ven and Laarhoven 1997) show that production in low-labor cost countries is, in many instances, not cost effective. Markides and Berg (Markides and Berg 1988) also argue that manufacturing offshore can be bad business. They argue that companies might save money on labor and materials by purchasing or manufacturing overseas, but other, not so obvious, costs may well offset the gains. Although the cost might be higher than anticipated, even to the extent that overseas production is not justifiable from an economic point of view, it still might be worthwhile for companies to locate production in other countries. One reason is that companies might be enticed by policies such as offset arrangements or counter trade. Although such arrangements might not be cost effective for the individual firm, they can be cost effective from a nation s viewpoint (Marin and Schitzer 1995). Another possible motive for the move overseas is related to control. Hymer (Hymer 1976) concluded that foreign direct investment is about control. Ietto-Gillies (Ietto- Gillies 1992) added an insight into the importance of labor for control. Transferring production activities to other countries reduces the power of unions. These arguments support the observation that the decision to manufacture in other countries is not always based on strictly economic criteria. Considerations, including strategic and political aspects, also play a key role. The existing theories on foreign direct investment and international production, which explain this phenomenon based on the assumption that it is cost effective, therefore, have severe drawbacks. Nevertheless, even in cases where financial criteria may not be completely decisive, managers need to have an accurate idea of the costs to enable them to determine whether or not the long-term added benefits outweigh costs involved. International Manufacturing Costs Eden and Miller (Eden and Miller 2001) identified four types of costs for producing overseas for the local market: Relative production costs: i.e. the net additional cost (positive or negative) involved in serving a foreign market by home country production plus exports, compared to production in the host country. Relational hazards costs: i.e. the transaction costs of negotiating, monitoring and dispute settlement faced by the multinational company if it serves the foreign market through the external market. Managing operations at a distance costs: i.e. the internal governance costs related to managing the multinational network. This includes start-up costs, on-going governance costs of managing the parent-affiliate relationship, and the exit costs. Liability of foreignness costs: this includes unfamiliarity hazards and discrimination hazards. In the context of in-house production to serve global markets, especially the relative production costs and the costs for managing operations at a distance are the most relevant ones. 52

4 Van de Ven and Laarhoven (Ven and Laarhoven 1997) identified several cost categories from a purely production perspective: Labor cost, i.e. the cost per man-hour. Labor productivity, i.e. the number of man-hours required for a specific task. Accessibility of materials, i.e. the cost of inputs. Markides and Berg (Markides and Berg 1988), in addition to the different productivity levels mentioned above, identified several other costs associated with manufacturing overseas. Their considerations, in line with van de Ven and Laarhoven, are largely whether it makes sense to produce abroad (to reduce cost) to serve the home market. They argue that overseas production faces the following costs: Larger inventories and higher administrative costs. Quality costs, because parts made overseas are less likely to meet specifications. Higher transportation costs and tariffs. Cost of training foreign workers. Longer time to get supplies from an offshore location, so companies operating abroad are slower to respond to changing market demands. Shifting some production operations overseas may prevent the company from exploiting economies of scale at home as well as abroad. Going offshore can cause underutilization of existing manufacturing and, ultimately, to plant closings or layoffs. Loss of customers who may switch to other home-based suppliers. In addition to these costs that apply once production has begun, there are the costs associated with the actual transfer of production. Teece (Teece 1976) describes technology transfer costs as the costs of transmitting and absorbing the relevant firm-, system- and industry-specific knowledge to the extent necessary for the effective transfer of the technology. Teece notes that technology is not necessarily transferred in-house (it could for example be licensed to another party) and therefore not all of the costs might be to have born by the same company. Teece continues by considering the operational level and identifies four cost groupings: Cost of the pre-engineering technological exchanges. Engineering costs associated with transferring the process design and associated process engineering in the case of process innovations, or the product design and production engineering in the case of product innovations. R&D division costs during all phases of the transfer projects, these are R&D costs associated with adapting or modifying the technology. Pre-startup training costs and the excess manufacturing costs. The latter represent the learning and debugging costs incurred during the startup phase and before the plant achieves the design performance specifications. To obtain a more structured insight into the cost factors related to international manufacturing a research study was set-up. The Research Design Because technology characteristics might play a key role, these were basically kept constant by looking at international manufacturing related to aircraft production. Aircraft production can be considered high technology, and, due to its global nature, is an excellent source for geographic comparison. The research used as a basis the activities involved in moving production activities from one location to another location in another country. The basis formed four in-depth case studies of 53

5 transferring aircraft (parts) production to different countries (U.K., Canada, Romania, The Netherlands, Germany). Four in-depth case studies were executed, involving two host companies in different countries and four home companies in three different countries (Steenhuis 2000). The field data was collected during nine months at the shopfloor in the host companies (6 months and 3 months respectively). Three cases were carried out in the first company because it allowed distinguishing between different home country environments. The fourth case was carried out in another host country to determine the difference in host country environment. Over the nine month period daily discussions with shopfloor level employees were held and in addition a number of semistructured interviews at the executive level were carried out. For the three cases carried out at the first company, frequent discussions with foreign representatives took place. The documentation that was analyzed included company records, including strategic plan, and documentation specifically related to the projects. This last group included documents such as schedules and production related information such as process specifications, quality plans, bill of materials, etc. This information obtained provided a clear understanding of the setting of the move of manufacturing technology and the production activities. The total research provided the basis for the development of a structured scheme of cost related to international manufacturing analyzed by type of activity and by technology characteristics. Structured Scheme The research approach was focused on one type of technology. Consequently, this led to a technology-oriented viewpoint on moving production to a foreign location. By breaking down a technology into its components, and subsequently examining the cost associated with the transfer of these components, a more structured scheme for examining international manufacturing cost was developed. An approach has been demonstrated by several authors, see e.g. (Laseur 1991; Ramanathan 1994), is to view manufacturing technology as consisting of at least three components: humanware, inforware, and technoware. Humanware consists of the software required for producing a product. This refers to having the right number of people with the right set of skills. Inforware covers the documentation needed for producing the product. This consists mainly of process specifications, drawings, and process planning sheets. Technoware contains the hardware, which can be divided into two groupings: the facility and the equipment. The facility refers to the buildings; the equipment refers to all the tools and machinery necessary for producing the product. In addition to these core components of technology, the inputs (supplies) to the technology, the output (the product), and the management of the production technology can be identified. The costs for international manufacturing are related to the transfer of the technology components plus the continuous usage of the technology. The entire process can be broken down into three stages. The pre-transfer stage is defined as the period during which an assessment is made as to whether or not it makes sense to transfer production activities to another country. Once this decision is made, the transfer stage can start, i.e. during which the technology is established at the new site. This stage ends once the first unit has been produced. At that point it has been proven that the product can be produced at the new site. After this continuous production occurs. An overview of the different costs is provided in table 1. (Steenhuis 2000). Pre-transfer costs These are primarily the management costs for assessing a new manufacturing location. This involves time commitment, and the collecting of the relevant information (this might include field 54

6 trips). This assessment might actually include assessment cost of multiple potential locations which eventually leads to the choice of one location. Transfer costs Humanware, i.e. costs associated with the human element of production during the transfer. This can be subdivided into two categories. Training: Training costs are the cost associated with teaching a labor force how to produce. Costs for developing a training package at the home location, and actual training costs (including transportation and accommodations for trainees in the case of training at the home location, or for trainers in the case of training at the host location). Technical assistance costs, this includes time and effort from technical people at the home location as well as at the host location (foreign expatriates) and includes transportation and accommodations. Direct labor: Direct labor costs are related to learning and productivity. When production is already established in the home country and then transferred, a loss of learning occurs, i.e. the new production plant starts at a less productive point on the learning curve. In addition, in many low-labor cost countries the productivity is lower than in high-labor cost countries. Therefore, it is possible that the unit labor cost in a low-labor cost country is actually higher because it requires more hours of work to complete the same job. Humanware Inforware Technoware Supplies related cost Product related cost Management Pre-Transfer cost Transfer cost Continuous Production Cost (compared to at home production) Cost for assessing the new location. transferring the human skills required for production. transferring (and understanding) the (technical) documentation. transferring equipment. setting-up new suppliers. quality or delivery of product from another location. managing the transfer. longerterm differences in human productivity. the longer-term differences in use of information. longerterm differences in the use of equipment. Longer-term cost differences in procurement costs. Longer-term cost differences due to market perceptions. longerterm differences in management. Table 1: International Manufacturing Cost 55

7 Inforware, i.e. the costs associated with transferring documentation so that the receiver understands its contents. This includes: Costs for developing the documentation package at home. Our research revealed that especially with products that have been produced over a long period, it might be very difficult, if not impossible, to use existing documentation because it is not up-to-date. In this situation new documentation has to be developed. Costs of transporting documentation. Translation costs, and costs of placing documentation in an information system at the host. If the manufacturing activities are outsourced, this last aspect can become quite expensive. This is especially true if the manufacturing operations of the two companies need to be integrated. In this case, the inforware needs to be aligned, i.e. the same production procedures (or alternatives might have to be separately approved) and the same methods of putting the documentation in the information system need to be used. Since some of these elements are only tacitly understood, transferring it is likely to create confusion. In our research we found for example that when a drawing was transferred, the receiver had a different method for projecting the drawing. Both parties were unaware of this, and the problem was only discovered after production problems arose late in the production process. Technoware, i.e. the costs associated with the hardware element of production. Facility costs, such as building a new factory at the host location. Preparation of equipment that needs to be shipped at the home location. Transportation costs, where equipment is shipped from one location to another. Equipment costs of a duplicate production line, or if it is decided to replace equipment by new equipment, plus the associated installation costs at the host location. Operating costs, such as energy for operating the technoware. In some countries the energy source is unreliable and therefore generators have to be purchased. Loss of economies of scale; this might be a factor if the production is split between two sites. Unbalancing cost ; if an assembly line has already been operated for a while in the home country, then its manufacturing line, due to learning, will have been optimized. That means, work packages will have been developed in such a way that each workstation takes about the same time to complete. When such a line is transferred to another location, the company faces a dilemma. If it decides to keep the workpackages the same way as at the home site, then it will have a loss of efficiency, the line will become unbalanced, because the workers will not have the same efficiency in their work as at the home site. If however, it is decided to rebalance the line, i.e. develop new workpackages, then the company has a loss of learning. Supplies, i.e. the costs associated with supplying the production line while establishing production. New (host) supplier cost. This includes costs for developing a new supplier network in the host country and, possibly, the costs associated with less reliable suppliers which will affect the quality of the product and/or the delivery schedule. Old (home) supplier costs. The costs for transportation of supplies where the home supplier network is used, and potential delays due to customs policies that may affect the production schedule. Product related, i.e. the costs associated with the products being manufactured and thus available in another country. Quality costs: lower market for the goods because of quality problems. These can be real or perceived, i.e. people assume a lower quality because goods were made in a low-labor cost country. Buffer costs; if the goal is to have one production line, then during the transfer a choice has to be made on whether to have a period of duplicate production (so that delivery schedules can 56

8 be kept) leading to duplication costs (such as a second set of equipment), or whether to build up an increased inventory to meet delivery schedules (increasing inventory costs), or to essentially wait until the new production facility is up and running (with potential loss of customers). Transportation costs; if the overseas produced goods are to be shipped back to the home country they have to be transported. In addition to the actual transportation charges there are import and export costs, and goods may be held up at customs which affects the delivery to the market. Management, i.e. the costs associated with managing the foreign production line. Communication costs for communicating between the home and the host location. This includes extra cost that might be faced due to an unreliable telecommunications infrastructure at the home or host location (repeat communications). Costs due to having less control over operations at the host location. This is due to the distances involved and might for example be due to loss of linkage between R&D and operations. Continuous production costs Humanware, i.e. costs associated with the human element of production during continuous production. This includes training costs (technical assistance) in the longer-term and direct labor costs related to a loss of learning and differences in productivity. Inforware, i.e. the costs associated with the documentation once production is established. Information system misalignment costs. Although the end of the transfer stage is defined as the completion of the first unit, this by no means implies that all documentation is understood. The research indicates that later in production mistakes are still sometimes made. This might, for example, occur when a production worker is replaced by another worker, from the same company but another division, and the new worker interprets the information differently. In addition, if production is taking place simultaneously in both countries, then information also needs to be updated simultaneously. This might be difficult due to a poor telecommunications infrastructure in the home or host country. As a result, production might be delayed or incorrect products produced over a certain time period. Technoware, i.e. the costs associated with the hardware element of production. Operating costs, such as energy for operating the technoware. In some countries the energy source is unreliable therefore generators have to be purchased. Loss of scale economies; this might be a factor if production is split between two sites. Climate related costs. Production in different climatic conditions can lead to increased equipment failure. Operating costs associated with different production/supporting function practices. A good example is the difference in culturally determined attitudes towards preventive maintenance. Some cultures are geared to only undertaking breakdown maintenance, which can result in tremendous cost differences. Unbalancing costs, already mentioned in the transfer stage also influence continuous production. Supplies, i.e. the costs associated with supplying the production line. Host supplier costs. This includes the costs of developing a new supplier network in the host country and, possibly, the costs associated with less reliable suppliers which will affect the quality of the product and/or the delivery schedule. Home supplier costs. The costs for transportation of supplies where the home supplier network is used, and potential delays due to customs policies that may affect the production schedule. To avoid delivery schedule problems the company may opt to keep maintain inventories, in which case inventory costs increase. 57

9 Product related, i.e. costs associated with the product being manufactured and thus available in another country. Long-term quality costs. A lower quality (real or perceived) can affect the demand for the product. Delivery schedule costs. If the host location is not able to meet the production deadline then the products are not available on time for the market. This can reduce customer demand. Transportation costs; if the overseas produced goods are to be shipped back to the home country. Management, i.e. the costs associated with managing the foreign production line. Communication costs for communicating between the home and the host location. Costs occurring because for having less control over operations at the host location. Conclusion Decisions with regard to international manufacturing are not purely economic. However, it is essential to have a good insight in the costs in order to be able to judge whether the benefits, either financial or of another type, outweigh the costs. There are several costs involved in international manufacturing but not all of these costs are clearly appreciated by management or public policy makers. The method of structuring the costs by taking a technology oriented viewpoint, and arranging by the activities that occur, means a structured approach which contributes in different ways: The developed scheme provides an insight into how geography shapes international business because it enables a structured comparison of costs associated with different locations to be made. It facilitates managers in thinking in a systematic way about the costs associated with international manufacturing. Despite the death of distance, because of better transportation and communication facilities there are still numerous differences between locations that lead to different cost structures. It also facilitates management decision-making on evaluating the basis factors for determining geographic configuration from a cost perspective. For policy makers an insight is provided into what the important cost factors are for manufacturing. This can be used by policy makers to investigate whether the elements are there to create hot spots for manufacturing. The relative size and the actual measure of each of these factors depends on the type of production and the actual location. In our cases clearly a factor that was underestimated in the case of production transfer between two highly industrialized countries was that the production processes set up showed significant differences. Since the design of the product is optimized with respect to the production process, transferring the production resulted in large unexpected production cost increases. In the cases of transfer between the industrially advanced countries and the industrially developing countries, the assumption that the learning curves would be identical, proved to be wrong. This resulted in large cost increases above the original estimates at the receiving companies, which had contracted cost based on the original curves. References Dunning, John H Explaining international production. London: Harper Collins Academic. 58

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