The trend for manufacturers to relocate operations from high to low cost economies is well established and continues to gather pace. Reports of businesses moving products or operations to Eastern Europe, Central and South America or to China are now commonplace particularly in the automotive and consumer electronics sectors.
Historically the reasons for most relocations have been tactical, either to be close to OEM customers or to take cost out of specific products. We are now, however, seeing a growing number of what we call ‘strategic migrations’ to low cost economies. These strategic migrations aim not just to reduce costs but to provide access to new markets and harness the rapidly growing local capabilities and expertise of suppliers.
A survey of leading manufacturers recently conducted by PA Consulting Group indicates that migrations are most likely to succeed where the companies concerned have recognised and addressed certain major issues. Four recurrent themes in the survey were: finding the best match of product to manufacturing location and market, adopting a flexible business model to deliver longer term benefit, integrating product and business knowledge into the local supplier base and re-engineering support processes to leverage local expertise. By focusing on these key issues companies can unlock the full value from their strategic migrations.
Despite huge challenges, the move to low-cost economies continues to gather pace. Ericsson’s plans for R&D centres in Budapest and Prague, Dyson’s transfer of vacuum cleaner manufacturing to the Far East and Dell’s relocation of desktop PC production to China are typical examples of news reports that appear almost on a daily basis. Operating in low-cost economies is prevalent within the automotive and consumer electronics industries where, from the OEMs’ perspective, if you do not have a local presence then you will not be a long term player. There are also strong signs of interest in many other industries – even within the pharmaceutical sector from manufacturers of generics and consumer products.
Several economic factors are currently reinforcing the appeal of operating in low cost economies, in addition to the perpetual drive for cost reduction in a tough climate. Saturation of traditional markets is driving companies to look for new ones and low cost economies represent major selling opportunities. One major consumer electronics company predicts 50 per cent of its future sales being in China and surrounding regions. There are powerful arguments for establishing a manufacturing facility close to these promising marketplaces rather than exporting products from a distant and higher cost economy. Other changes to the economic environment, too, are making some countries more inviting as manufacturing locations. For instance, China’s entry into the World Trade Organisation, coupled with the country's determination to be a leading player in the global economy, will make it easier and safer for overseas companies to relocate there.
Historically, manufacturing relocations have been largely tactical steps to either take advantage of lower labour costs or to meet the demands of it’s major customers, as frequently demonstrated by first tier suppliers to automotive OEMs. These tactical relocations continue to be relevant, but alongside them we increasingly see companies making more strategic decisions to extend greater parts of their operations such as product development, procurement and sales and marketing to the low cost economy.
The strategic migrations of today have more far-reaching ambitions, and seek to improve access to new markets, a developing supplier base and an untapped pool of technical expertise. Creating a local operation is essential to penetrate those new markets and to leverage local skills. A local presence can also raise visibility of company and brands, and is essential to improve knowledge of local needs and tastes in order to define any necessary adaptations of the product to the market.
Many companies that have moved manufacturing operations into low cost economies have reported major unforeseen complexities associated with relocation and the erosion of expected benefits that this has bought about. Their initiatives tended to run into problems with the operational and cultural complexities characteristic of low cost economies as well as the difficulties in obtaining reliable local supplies of materials. Confronted with problems such as these, companies often resorted to actions which increased costs and defeated the purpose of the relocation by eroding significant proportions of their expected savings.
So what can be done to manage the risk and to maximise the benefits of strategic migrations? PA has formulated some answers to this question through its experience of helping clients move operations to low cost economies – answers which we have substantiated through a survey of leading manufacturers with experience of manufacturing relocation. Our experience, reinforced by the survey responses, indicates that successful migrations must address four major issues: finding the best match of product to manufacturing location and market; adopting a flexible business model to deliver longer term benefit; integrating product and business knowledge into the local supplier base and re-engineering support processes to leverage local expertise. We examine each of these areas in turn.
Finding the best match of product to manufacturing location and market
It is not enough to carve off a convenient chunk of the manufacturing operation and relocate it: careful thought is needed as to which products offer the greatest cost reduction and market penetration potential; where these products can be made at the lowest cost and optimum proximity to target markets. In addition, companies need to evaluate which low cost countries offer the best match of technical skills and supplier capabilities to their products to determine the extent to which product development and procurement can be extended into those regions.
Some countries have an established track record in specific products and processes. One example is China, with its wealth of expertise in the manufacture of plastic parts arising from the region’s long-established toy and consumer products industries. A another example is the Czech Republic, which has a long tradition in engineering and instrument manufacture. These local capabilities can be successfully leveraged both in the short and longer term.
Understanding the capabilities of local suppliers is crucial to achieving the right match of product to location. Supplier capabilities and supply problems are by far the biggest issue for migrating businesses; as many as 80 per cent of respondents to our survey reported major difficulties with local suppliers and identified it as the single greatest barrier to further migration.
Another important option is to modify existing products to meet local market needs and buying power through re-design and value engineering. Correctly executed, this can extend the life cycle of a mature product while maintaining margins and also avoid the risk of cannibalising higher value-add markets. One PA client has recently achieved 40 to 50 per cent product cost savings from a combination of value engineering, reduced material and lower assembly costs following a relocation to Malaysia. This enabled the business not only to compete in the Far Eastern market but to source high value components at greatly reduced cost for use in products for the rest of its product portfolio.
Adopting a flexible business model to deliver long term benefit
Before embarking on migration, companies need to design and adopt a strategy for the longer term development of their overseas operation which provides the necessary flexibility to adapt to the changing environment in low cost economies. In doing so they must evaluate the possible combinations of joint venture, outsourcing, acquisition or new factory build in order to decide which provides the optimum balance of benefit versus risk and the potential for value creation into the longer term.
Sixty per cent of the companies responding to our survey had opted for a greenfield new factory build approach in order to minimise their exposure to the cultural issues associated with working in an unfamiliar country or to avoid the risks of sourcing products from unproven suppliers. This approach commits the business to a major capital investment in manufacturing capacity and management time at the point of greatest uncertainty.
Conventional wisdom that once dictated how to establish a presence in a low cost economy may no longer apply. Today’s business model needs to be flexible - a challenge when the politico-economic landscape in low-cost regions is evolving so rapidly. For example, China’s entry into the WTO is having a profound impact on its Asian neighbours who are waking up to the realisation of the huge potential market on their doorstep yet many of whom will themselves have to achieve significant productivity improvements to remain competitive in the region. This change will have both positive and negative effects on Western operators: on the one hand the quality of the supplier base will improve, but on the other these neighbours have their sights set on the same market, so increasing competition.
Integrating product and business knowledge into the local supplier base
Having identified the availability of skilled local suppliers as the key issue and main hurdle to further migration, smarter businesses are investing in local people and suppliers rather than capital assets – an approach that both reduces financial risk and improves payback from the partnership. The challenge for Western companies is to integrate their own product and business knowledge into a supplier base that already has its own knowledge and way of working while retaining the best of both. A challenge made harder by the need to persuade local suppliers to match the investment and the imperative to protect IP during the process of sharing knowledge. To maximise the return on this investment, it is important to understand local capabilities and particular cultural differences before embarking on any migration.
Different cultures have different approaches to decision-making and will be familiar with different levels of employee empowerment. There are also subtle but vital nuances of communication style – it is vital to understand the nature of these differences and not enough simply to know they exist. Cultural understanding supported by local managers instead of expatriate staff will also facilitate the creation of long-term business relationships with local partners – relationships that will allow the benefits of the investment to be realised.
A PA client, a major European toy manufacturer, had set itself a 25 per cent growth target over a period of three years. This growth was to come from products developed and manufactured in the Far East. Having performed an in-depth assessment of the local supplier base the conclusion was that the growth target could only be achieved by a major programme to raise their capabilities. This involved, typically, a one to two year investment in each supplier.
Re-engineering support processes to leverage local expertise
Because of the lower buying power of their local markets, manufacturers in low cost economies have built up substantial expertise in design for low cost manufacture and in product cost reduction. Now, too, certain countries are acquiring new specialisations that go well beyond cost reduction. Thailand, for instance, is becoming a key design centre for light commercial vehicles. This trend challenges the assumption that creative design will remain in the domain of more developed countries. Companies that spot and engage in developments like this and plan their migrations accordingly are likely to outstrip their competitors.
To leverage this expertise, business will have to examine and, to varying extents, re-engineer their existing development, procurement, sales and marketing, and even quality processes if they are to extend into distant regions with significantly different ways of doing business and still work effectively. There are huge potential benefits from this “virtual” manufacturing approach, but the greater scope increases risk.
Fifty per cent of the companies we surveyed had evidently recognised these arguments since they were either thinking about relocating significant parts of their product development and procurement processes or had already done so. However there are always decisions to be made about where the dividing line should be drawn and most of our survey respondents were of the view that the “creative design” element, for at least the time being, must be retained.
Despite the complexities and the challenges, the pace of manufacturing relocations continues to increase. Companies are now looking beyond the tactical objectives of cost reduction and seeking the greater cost and growth benefits that come from strategic migration and the extension of business processes into the low cost economies.
Our experience and the results of our survey show that addressing the four areas explored in this paper are essential to long term success. Difficult though they are to resolve, the potential benefits that result cannot be ignored. If your company passes up the benefits of strategic business migration, your competitors will not.
Tom Toth and Martin Strutt are senior consultants in the Manufacturing Industries Practice at PA Consulting Group www.paconsulting.com
