Lowest Cost Isnt Always The Answer

Walk down the aisles of any western toy supersto-re, and most of the basic products will say Made in China or, perhaps, Malaysia or Indonesia. Until, that is, you reach the Lego section. Suddenly, the boxes are more likely to identify Denmark, Switzerland or the US as suppliers. It might seem logical that a global company, selling into a multitude of country markets and measuring its market share in global terms, should place production facilities wherever costs are lowest.

But life is not that simple; even in the toy sector price competition among retailers is ferocious, pressure on suppliers is intense, and manufacturing fairly unsophisticated. Lego, the Danish company, has for years concentrated its manufacturing in Europe and the US, arguing that this best satisfies design and quality requirements.

 

And Lego is not alone in seeking something other than the lowest-cost solution: in a different sector there is the recent example of Motorolas decision to set up cellular phone production facilities in Germany. According to the latest UN Conference on Trade and Development data, developed countries took almost two-thirds of foreign direct investment inflows in 1995, while developing countries accounted for less than one-third.

As Prof Gary Eppen, at the University of Chicagos Graduate Business School, puts it: The notion of cost, in the naive, low-cost sense, is only a small part of the production picture. So how does a global company structure go about organising its manufacturing network?

The decision has become more complicated over the past tow decades. On the one hand, trade barriers across much of the world have declined sharply. It is estimated, for example, that the average tariff by 1990 stood at about 7 per cent, less than one-fifth of the level four decades earlier. Simultaneously, a range of new markets has opened to foreign investment.

This has made global production much more possible. But it has also reduced the need for many overseas plants. Markets that previously demanded local production facilities can now be supplied from non-domestic sources.

Plainly, in this newly-liberalised environment, basic manufacturing costs do become more significant. In the electronics sector, for example, production facilities have been shifted, from Hong Kong and Singa-pore to Taiwan and Korea, and now to Malaysia, Indonesia and China.

But there are limits to a purely cost-driven approach. Many companies have built their current production structure through acquisitions, and so approach the issue with anything but a clean sheet.

P&G, the Cincinnati-based consumer products group, is a case in point. In the decade from 1982, it acquired 79 manufacturing plants, of which it closed just 24, leaving the company with 147 factories worldwide. In 1993 P&G decided it could afford to close 30 facilities. While the company stresses that the restructuring was partly designed to focus plants on regional brand requirements and get better value from manufacturing operations, it also acknowledges that the acquisition legacy was a big factor in the realignment.

Another problem is that costings themselves can be subject to rapid change, making todays Indonesia, for example, to-morrows Hong Kong. As Graham Perrott, London-based Price Waterhouses management consulting says, this adds a further dimension to any global companys investment decision-making. The reality is that manufacturing businesses also need to think: how quickly can I pull the plug? he suggests.

Mr Perrott says some companies have addressed this issue satisfactorily through the part configuration model. This involves selecting a number of regional manufacturing bases which are viewed as longer-term investments, and augmenting them with lower-skilled assembly plants, which can more easily be moved between markets.

The availability of suitable human capital also needs to be examined when investment decisions are being made. There may be close links between manufacturing and product innovation and if too much focus is put on low-cost assembly operations the latter tends to be undermined.

Some companies try to deal with this problem by distinguishing between different types of production facilities. For example Whirlpool, the US appliance company, owns two plants which make its microwave ovens. One in Sweden, and the other in China. The former was acquired from Philips, and is likely to continue to drive product development. The Chinese facility, added later, will manufacture competitively for Asian customers, and export into more developed markets.

Perhaps, the hottest topic is whether a global company needs to be a producer at all. There are indications that outsourcing is growing in popularity. Many argue that outsourcing gives a company more flexibility, and fits well with a global strategy. A business may be better placed to supply differentiated products into different regional markets, and it can probably adjust more swiftly to changing cost considerations since it is less constrained by physical plant.

Sceptics say that such a structure whittles away a companys research and product development capabilities, and could adversely affect its long-term ability to push new, differentiated goods into the market.

That is not the only possible pitfall. Perhaps no outsourcing exemplifies the trend better than Nike, the sports shoe group. On paper, its strategy of subcontracting the production of its shoes to local factories looks eminently sensible. But these arrangements have turned into a public relations nightmare in recent years, as campaigners have complained of sweatshop conditions in many of the Asian plants.

Last month, Nike was forced to sever contracts with four factories in Indonesia, saying that they had refused to comply with company standards for working conditions. Lack of ownership, it seems, does not bring freedom from responsibility.