1 Explain why production and logistics decisions are of central importance to many multinational businesses.
2 Explain how country differences, production technology, and product features all affect the choice of where to locate production activities.
3 Recognize how the role of foreign subsidiaries in production can be enhanced over time as they accumulate knowledge.
4 Identify the factors that influence a firm’s decision of whether to source supplies from within the company or from foreign suppliers.
5 Describe what is required to efficiently coordinate a globally dispersed production system.
opening case Making the Amazon Kindle
When online retailer Amazon.com invented its revolutionary e-book reader, the Kindle, the company had to decide where to have it made. Guiding the decision was an understanding that if the Kindle was going to be successful, it had to have that magic combination of low price, high functionality, high reliability, and design elegance. Over time, this has only become more important as competitors have emerged. These have included Sony with various readers, Barnes & Noble with its Nook, and most notably, Apple with its multipurpose iPad, which can function as a digital reader among other things. Amazon’s goal has been to aggressively reduce the price of the Kindle so that it both has an edge over competitors and it becomes feasible to have a couple lying around the house as a sort of digital library.
Amazon designed the Kindle in a lab in California, precisely because this is where the key R&D expertise was located. One of the Kindle’s key components, the “ink” (the tiny microcapsule beads used in its display) were designed and are made by E Ink, a company based in Cambridge, Massachusetts. Much of the rest of the value of the Kindle, however, is outsourced to manufacturing enterprises in Asia.
The market research firm iSuppli estimates that when it was introduced in 2009, the total manufacturing cost for the Kindle 2 ran about $185. The most expensive single component was the display, which cost about $60. Although the display used E Ink’s technology, there were no American firms with the expertise required to manufacture a bistable electrophoretic display that will show an image even when it is not drawing on battery power. This technology is central to the Kindle because it allows for very long battery life. Ultimately, Amazon contracted with a Taiwanese firm, Prime View International, to make the display. Prime View had considerable expertise in the manufacture of LCDs and was known as an efficient and reliable manufacturer. Estimates suggest that 40 to 50 percent of the value of the display is captured by E Ink, with the rest going to Prime View.
After the display, the next most expensive component is the wireless card that allows the Kindle to connect to Amazon’s digital bookstore through a wireless link. The card costs about $40. Novatel Wireless, a South Korean enterprise that has developed considerable expertise in making wireless chipsets for cell phone manufacturers, produces this component. The card includes a $13 chip that was designed by Qualcomm of San Diego. This, too, is manufactured in Asia. The brain of the Kindle is an $8.64 microprocessor chip designed by Texas-based Freescale Semiconductor. Freescale outsources its chip making to foundries in Taiwan and China. Another key component, the lithium polymer battery, costs about $7.50 and is manufactured in China. In sum, out of a total manufacturing cost of about $185, perhaps $40 to $50 is accounted for by activities undertaken in the United States by E Ink, Qualcomm, and Freescale, with the remainder being outsourced to manufacturers in Taiwan, China, and South Korea.
Sources: M. Muro, “Amazon’s Kindle: Symbol of American Decline?” Brookings Institute, February 25, 2010, www.brookings.edu; and G. P. Pisano and W. C. Shih, “Restoring American Competitiveness,” Harvard Business Review, July–August 2009, pp. 114–26.
As trade barriers fall and global markets develop, many firms increasingly confront a set of interrelated issues. First, where in the world should production activities be located? Should they be concentrated in a single country, or should they be dispersed around the globe, matching the type of activity with country differences in factor costs, tariff barriers, political risks, and the like to minimize costs and maximize value added? Second, what should be the long-term strategic role of foreign production sites? Should the firm abandon a foreign site if factor costs change, moving production to another more favorable location, or is there value to maintaining an operation at a given location even if underlying economic conditions change? Third, should the firm own foreign production activities, or is it better to outsource those activities to independent vendors? Fourth, how should a globally dispersed supply chain be managed, and what is the role of Internet-based information technology in the management of global logistics? Fifth, should the firm manage global logistics itself, or should it outsource the management to enterprises that specialize in this activity?
The example of the Amazon Kindle discussed in the opening case touches upon some of these issues. Like many modern products, different components of the Kindle are manufactured in different locations to produce a reliable low-cost product. In choosing who should make what components, Amazon was guided by the need to keep the cost of the device low so that it could price aggressively and preempt competitors in the digital reader market. For example, Amazon picked Prime View of Taiwan to make the display screen precisely because that company is among the best in the world at this kind of manufacturing. For Amazon to secure a competitive advantage against intense competition, it had to make the correct choices.
Strategy, Production, and Logistics
LEARNING OBJECTIVE 1
Explain why production and logistics decisions are of central importance to many multinational businesses.
Chapter 12 introduced the concept of the value chain and discussed a number of value creation activities, including production, marketing, logistics, R&D, human resources, and information systems. This chapter will focus on two of these activities—production and logistics—and attempt to clarify how they might be performed internationally to (1) lower the costs of value creation and (2) add value by better serving customer needs. We will discuss the contributions of information technology to these activities, which has become particularly important in the era of the Internet. The remaining chapters in this text will look at other value creation activities in this international context (marketing, R&D, and human resource management).
Activities involved in creating a product.
The procurement and physical transmission of material through the supply chain, from suppliers to customers.
In Chapter 12, we defined production as “the activities involved in creating a product.” We used the term production to denote both service and manufacturing activities, because one can produce a service or produce a physical product. Although in this chapter we focus more on the production of physical goods, we should not forget that the term can also be applied to services. This has become more evident in recent years, with the trend among U.S. firms to outsource the “production” of certain service activities to developing nations where labor costs are lower (e.g., the trend among many U.S. companies to outsource customer care services to places such as India, where English is widely spoken and labor costs are much lower). Logistics is the activity that controls the transmission of physical materials through the value chain, from procurement through production and into distribution. Production and logistics are closely linked because a firm’s ability to perform its production activities efficiently depends on a timely supply of high-quality material inputs, for which logistics is responsible.
ANOTHER PERSPECTIVE Careers in Supply Chain Management
With increased outsourcing and overseas production sites and customers, supply chain management is a growing field. The Council of Supply Chain Management Professionals (CSCMP), a professional association with more than 8,500 members worldwide, says the industry offers a promising outlook. What’s more, potential employers are everywhere—manufacturers and distributors; government agencies; consulting firms; the transport industry; universities and colleges; service firms such as banks, hospitals, and hotels; and third-party logistics providers.
For more information about the organization and careers in this field, visit the CSCMP website at www.cscmp.org and its careers site, www.careersinsupplychain.org.
The production and logistics functions of an international firm have a number of important strategic objectives.1 One is to lower costs. Dispersing production activities to various locations around the globe where each activity can be performed most efficiently can lower costs. Costs can also be cut by managing the global supply chain efficiently so as to better match supply and demand. Efficient supply chain management reduces the amount of inventory in the system and increases inventory turnover, which means the firm has to invest less working capital in inventory and is less likely to find excess inventory on hand that cannot be sold and has to be written off.
A second strategic objective shared by production and logistics is to increase product quality by eliminating defective products from both the supply chain and the manufacturing process.2 (In this context, quality means reliability, implying that the product has no defects and performs well.) The objectives of reducing costs and increasing quality are not independent of each other. As illustrated in Figure 15.1, the firm that improves its quality control will also reduce its costs of value creation. Improved quality control reduces costs by:
• Increasing productivity because time is not wasted producing poor-quality products that cannot be sold, leading to a direct reduction in unit costs.
• Lowering rework and scrap costs associated with defective products.
• Reducing the warranty costs and time associated with fixing defective products.
FIGURE 15.1 The Relationship Between Quality and Costs
Source: From “What Does Product Quality Really Mean,” by David A. Gandin, MIT Sloan Management Review, Fall 1984. Copyright © 1984 by Massachusetts Institute of Technology. All rights reserved. Distributed by Tribune Media Services.
The effect is to lower the costs of value creation by reducing both production and after-sales service costs.
The principal tool that most managers now use to increase the reliability of their product offering is the Six Sigma quality improvement methodology. The Six Sigma methodology is a direct descendant of the total quality management (TQM) philosophy that was widely adopted, first by Japanese companies and then American companies during the 1980s and early 1990s.3 The TQM philosophy was developed by a number of American consultants such as W. Edward Deming, Joseph Juran, and A. V. Feigenbaum.4 Deming identified a number of steps that should be part of any TQM program. He argued that management should embrace the philosophy that mistakes, defects, and poor-quality materials are not acceptable and should be eliminated. He suggested that the quality of supervision should be improved by allowing more time for supervisors to work with employees and by providing them with the tools they need to do the job. Deming recommended that management should create an environment in which employees will not fear reporting problems or recommending improvements. He believed that work standards should not only be defined as numbers or quotas, but should also include some notion of quality to promote the production of defect-free output. He argued that management has the responsibility to train employees in new skills to keep pace with changes in the workplace. In addition, he believed that achieving better quality requires the commitment of everyone in the company.
Total Quality Management (TQM)
Management philosophy that takes as its central focus the need to improve the quality of a company’s products and services.
Six Sigma, the modern successor to TQM, is a statistically based philosophy that aims to reduce defects, boost productivity, eliminate waste, and cut costs throughout a company. Six Sigma programs have been adopted by several major corporations, such as Motorola, General Electric, and Allied Signal. Sigma comes from the Greek letter that statisticians use to represent a standard deviation from a mean; the higher the number of “sigmas,” the smaller the number of errors. At six sigma, a production process would be 99.99966 percent accurate, creating just 3.4 defects per million units. While it is almost impossible for a company to achieve such perfection, Six Sigma quality is a goal that several strive toward. Increasingly, companies are adopting Six Sigma programs to try to boost their product quality and productivity.5
Statistically based methodology for improving product quality.
General Electric is one of the major corporations that have embraced Six Sigma. Its commitment to quality is evident in all its industries, from retail to insurance to aviation.
Certification process that requires certain quality standards must be met.
The growth of international standards has also focused greater attention on the importance of product quality. In Europe, for example, the European Union requires that the quality of a firm’s manufacturing processes and products be certified under a quality standard known as ISO 9000 before the firm is allowed access to the EU marketplace. Although the ISO 9000 certification process has proved to be somewhat bureaucratic and costly for many firms, it does focus management attention on the need to improve the quality of products and processes.6
In addition to the lowering of costs and the improvement of quality, two other objectives have particular importance in international businesses. First, production and logistics functions must be able to accommodate demands for local responsiveness. As we saw in Chapter 12, demands for local responsiveness arise from national differences in consumer tastes and preferences, infrastructure, distribution channels, and host-government demands. Demands for local responsiveness create pressures to decentralize production activities to the major national or regional markets in which the firm does business or to implement flexible manufacturing processes that enable the firm to customize the product coming out of a factory according to the market in which it is to be sold.
Second, production and logistics must be able to respond quickly to shifts in customer demand. In recent years, time-based competition has grown more important.7 When consumer demand is prone to large and unpredictable shifts, the firm that can adapt most quickly to these shifts will gain an advantage.8 As we shall see, both production and logistics play critical roles here.
• QUICK STUDY
1. What are the main strategic objectives of production and logistics?
2. How does improved product reliability reduce costs?
Where to Produce
LEARNING OBJECTIVE 2
Explain how country differences, production technology, and product features all affect the choice of where to locate production activities.
An essential decision facing an international firm is where to locate its production activities to best minimize costs and improve product quality. For the firm contemplating international production, a number of factors must be considered. These factors can be grouped under three broad headings: country factors, technological factors, and product factors.9
We reviewed country-specific factors in some detail earlier in the book. Political economy, culture, and relative factor costs differ from country to country. In Chapter 6, we saw that due to differences in factor costs, some countries have a comparative advantage for producing certain products. In Chapters 2, 3, and 4 we saw how differences in political economy and national culture influence the benefits, costs, and risks of doing business in a country. Other things being equal, a firm should locate its various manufacturing activities where the economic, political, and cultural conditions—including relative factor costs—are conducive to the performance of those activities (for an example, see the accompanying Management Focus, which looks at the Philips Electronics NV investment in China). In Chapter 12, we referred to the benefits derived from such a strategy as location economies. We argued that one result of the strategy is the creation of a global web of value creation activities.
Also important in some industries is the presence of global concentrations of activities at certain locations. In Chapter 8, we discussed the role of location externalities in influencing foreign direct investment decisions. Externalities include the presence of an appropriately skilled labor pool and supporting industries.10 Such externalities can play an important role in deciding where to locate production activities. For example, because of a cluster of semiconductor manufacturing plants in Taiwan, a pool of labor with experience in the semiconductor business has developed. In addition, the plants have attracted a number of supporting industries, such as the manufacturers of semiconductor capital equipment and silicon, which have established facilities in Taiwan to be near their customers. This implies that there are real benefits to locating in Taiwan, as opposed to another location that lacks such externalities. Other things being equal, the externalities make Taiwan an attractive location for semiconductor manufacturing facilities. The same process is now under way in two Indian cities, Hyderabad and Bangalore, where both Western and Indian information technology companies have established operations. For example, locals refer to a section of Hyderabad as “Cyberabad,” where Microsoft, IBM, Infosys, and Qualcomm (among others) have major facilities.
Of course, other things are not equal. Differences in relative factor costs, political economy, culture, and location externalities are important, but other factors also loom large. Formal and informal trade barriers obviously influence location decisions (see Chapter 7), as do transportation costs and rules and regulations regarding foreign direct investment (see Chapter 8). For example, although relative factor costs may make a country look attractive as a location for performing a manufacturing activity, regulations prohibiting foreign direct investment may eliminate this option. Similarly, a consideration of factor costs might suggest that a firm should source production of a certain component from a particular country, but trade barriers could make this uneconomical.
MANAGEMENT FOCUS Philips in China
The Dutch consumer electronics, lighting, semiconductor, and medical equipment conglomerate Philips Electronics NV has been operating factories in China since 1985, when the country first opened its markets to foreign investors. Then, China was seen as the land of unlimited demand, and Philips, like many other Western companies, dreamed of Chinese consumers snapping up its products by the millions. But the company soon found out that one of the big reasons the company liked China—the low wage rates—also meant that few Chinese workers could afford to buy the products they were producing. So Philips hit on a new strategy: Keep the factories in China, but export most of the goods to developed nations.
The company now operates more than 35 wholly owned subsidiaries and joint ventures in China. Together, they employ some 30,000 people. Philips exports nearly two-thirds of the $7 billion in products that the factories produce every year. Philips accelerated its Chinese investment in anticipation of China’s entry into the World Trade Organization. In 2003, Philips announced it would phase out production of electronic razors in the Netherlands, lay off 2,000 Dutch employees, and move production to China by 2005. A week earlier, Philips had stated it would expand capacity at its semiconductor factories in China, while phasing out production in higher-cost locations elsewhere. More recently, Philips has been investing in the production of medical equipment in China, including CT scanners and MRI machines.
The initial attractions of China to Philips included low wage rates, an educated workforce, a robust Chinese economy, a stable exchange rate that is linked to the U.S. dollar through a managed float, a rapidly expanding industrial base that includes many other Western and Chinese companies that Philips uses as suppliers, and easier access to world markets given China’s entry into the WTO. Philips has stated that ultimately its goal is to turn China into a global supply base from which the company’s products will be exported around the world. By the mid-2000s, more than 25 percent of everything Philips made worldwide came from China, and executives say the figure is rising rapidly. Several products are now made only in China. Philips is also starting to give its Chinese factories a greater role in product development. In the TV business, for example, basic development used to occur in Holland but was moved to Singapore in the early 1990s. Philips transferred TV development work to a new R&D center in Suzhou near Shanghai. Similarly, basic product development work on LCD screens for cell phones was shifted to Shanghai.
Some observers worry that Philips and companies pursuing a similar strategy might be overdoing it. Too much dependence on China could be dangerous if political, economic, or other problems disrupt production and the company’s ability to supply global markets. Some observers believe that it might be better if the manufacturing facilities of companies were more geographically diverse as a hedge against problems in China. These fears have taken on added importance recently as labor costs have accelerated in China due to labor shortages. According to some estimates, labor costs have been growing by 20 percent per year since the late 2000s. On the other hand, there is a silver lining to this cloud: Chinese consumption of many of the products that Philips makes there is now rising rapidly.
Sources: B. Einhorn, “Philips’ Expanding Asia Connections,” BusinessWeek Online, November 27, 2003; K. Leggett and P. Wonacott, “The World’s Factory: A Surge in Exports from China Jolts the Global Industry,” The Wall Street Journal, October 10, 2002, p. A1; “Philips NV: China Will Be Production Site for Electronic Razors,” The Wall Street Journal, April 8, 2003, p. B12; “Philips Plans China Expansion,” The Wall Street Journal, September 25, 2003, p. B13; M. Saunderson, “Eight Out of 10 DVD Players Will Be Made in China,” Dealerscope, July 2004, p. 28; and J. Blau, “Philips Tears Down Eindhoven R&D Fence,” Research Technology Management 50, no. 6 (2007), pp. 9–11.
Another important country factor is expected future movements in its exchange rate (see Chapters 10 and 11). Adverse changes in exchange rates can quickly alter a country’s attractiveness as a manufacturing base. Currency appreciation can transform a low-cost location into a high-cost location. Many Japanese corporations had to grapple with this problem during the 1990s and early 2000s. The relatively low value of the yen on foreign exchange markets between 1950 and 1980 helped strengthen Japan’s position as a low-cost location for manufacturing. More recently, however, the yen’s steady appreciation against the dollar increased the dollar cost of products exported from Japan, making Japan less attractive as a manufacturing location. In response, many Japanese firms moved their manufacturing offshore to lower-cost locations in East Asia.
The type of technology a firm uses to perform specific manufacturing activities can be pivotal in location decisions. For example, because of technological constraints, in some cases it is necessary to perform certain manufacturing activities in only one location and serve the world market from there. In other cases, the technology may make it feasible to perform an activity in multiple locations. Three characteristics of a manufacturing technology are of interest here: the level of fixed costs, the minimum efficient scale, and the flexibility of the technology.
As noted in Chapter 12, in some cases the fixed costs of setting up a production plant are so high that a firm must serve the world market from a single location or from a very few locations. For example, it now costs up to $5 billion to set up a state-of-the-art plant to manufacture semiconductor chips. Given this, other things being equal, serving the world market from a single plant sited at a single (optimal) location can make sense.
Conversely, a relatively low level of fixed costs can make it economical to perform a particular activity in several locations at once. This allows the firm to better accommodate demands for local responsiveness. Manufacturing in multiple locations may also help the firm avoid becoming too dependent on one location. Being too dependent on one location is particularly risky in a world of floating exchange rates. Many firms disperse their manufacturing plants to different locations as a “real hedge” against potentially adverse moves in currencies.
Minimum Efficient Scale
The concept of economies of scale tells us that as plant output expands, unit costs decrease. The reasons include the greater utilization of capital equipment and the productivity gains that come with specialization of employees within the plant.11 However, beyond a certain level of output, few additional scale economies are available. Thus, the “unit cost curve” declines with output until a certain output level is reached, at which point further increases in output realize little reduction in unit costs. The level of output at which most plant-level scale economies are exhausted is referred to as the minimum efficient scale of output. This is the scale of output a plant must operate to realize all major plant-level scale economies (see Figure 15.2).
Minimum Efficient Scale
The level of output at which most plant-level scale economies are exhausted.
FIGURE 15.2 A Typical Unit Cost Curve
The implications of this concept are as follows: The larger the minimum efficient scale of a plant relative to total global demand, the greater the argument for centralizing production in a single location or a limited number of locations. Alternatively, when the minimum efficient scale of production is low relative to global demand, it may be economical to manufacture a product at several locations. For example, the minimum efficient scale for a plant to manufacture personal computers is about 250,000 units a year, while the total global demand exceeds 35 million units a year. The low level of minimum efficient scale in relation to total global demand makes it economically feasible for a company such as Dell to assemble PCs in six locations.
As in the case of low fixed costs, the advantages of a low minimum efficient scale include allowing the firm to accommodate demands for local responsiveness or to hedge against currency risk by manufacturing the same product in several locations.
Flexible Manufacturing and Mass Customization
Central to the concept of economies of scale is the idea that the best way to achieve high efficiency, and hence low unit costs, is through the mass production of a standardized output. The trade-off implicit in this idea is between unit costs and product variety. Producing greater product variety from a factory implies shorter production runs, which in turn implies an inability to realize economies of scale. That is, wide product variety makes it difficult for a company to increase its production efficiency and thus reduce its unit costs. According to this logic, the way to increase efficiency and drive down unit costs is to limit product variety and produce a standardized product in large volumes.
This view of production efficiency has been challenged by the rise of flexible manufacturing technologies. The term flexible manufacturing technology—or lean production, as it is often called—covers a range of manufacturing technologies designed to (1) reduce setup times for complex equipment, (2) increase the utilization of individual machines through better scheduling, and (3) improve quality control at all stages of the manufacturing process.12 Flexible manufacturing technologies allow the company to produce a wider variety of end products at a unit cost that at one time could be achieved only through the mass production of a standardized output. Research suggests the adoption of flexible manufacturing technologies may actually increase efficiency and lower unit costs relative to what can be achieved by the mass production of a standardized output, while at the same time enabling the company to customize its product offering to a much greater extent than was once thought possible. The term mass customization has been coined to describe the ability of companies to use flexible manufacturing technology to reconcile two goals that were once thought to be incompatible—low cost and product customization.13 Flexible manufacturing technologies vary in their sophistication and complexity.
Flexible Manufacturing Technology (Lean Production)
Manufacturing technology designed to improve job scheduling, reduce setup time, and improve quality control.
The production of a variety of end products at a unit cost that could once be achieved only through mass production of a standardized output.
One of the most famous examples of a flexible manufacturing technology, Toyota’s production system, has been credited with making Toyota the most efficient auto company in the world. (Despite Toyota’s recent problems with sudden uncontrolled acceleration, the company continues to be an efficient producer of high-quality automobiles, according to JD Power, which produces an annual quality survey. Toyota’s Lexus models continue to top JD Power’s quality rankings.14) Toyota’s flexible manufacturing system was developed by one of the company’s engineers, Taiichi Ohno. After working at Toyota for five years and visiting Ford’s U.S. plants, Ohno became convinced that the mass production philosophy for making cars was flawed. He saw numerous problems with mass production.
First, long production runs created massive inventories that had to be stored in large warehouses. This was expensive, both because of the cost of warehousing and because inventories tied up capital in unproductive uses. Second, if the initial machine settings were wrong, long production runs resulted in the production of a large number of defects (i.e., waste). Third, the mass production system was unable to accommodate consumer preferences for product diversity.
In response, Ohno looked for ways to make shorter production runs economical. He developed a number of techniques designed to reduce setup times for production equipment (a major source of fixed costs). By using a system of levers and pulleys, he reduced the time required to change dyes on stamping equipment from a full day in 1950 to three minutes by 1971. This made small production runs economical, which allowed Toyota to respond better to consumer demands for product diversity. Small production runs also eliminated the need to hold large inventories, thereby reducing warehousing costs. Plus, small product runs and the lack of inventory meant that defective parts were produced only in small numbers and entered the assembly process immediately. This reduced waste and helped trace defects back to their source to fix the problem. In sum, these innovations enabled Toyota to produce a more diverse product range at a lower unit cost than was possible with conventional mass production.15
Flexible machine cells are another common flexible manufacturing technology. A flexible machine cell is a grouping of various types of machinery, a common materials handler, and a centralized cell controller (computer). Each cell normally contains four to six machines capable of performing a variety of operations. The typical cell is dedicated to the production of a family of parts or products. The settings on machines are computer controlled, which allows each cell to switch quickly between the production of different parts or products.
Flexible Machine Cells
Flexible manufacturing technology in which a grouping of various machine types, a common materials handler, and a centralized cell controller produce a family of products.
Improved capacity utilization and reductions in work in progress (i.e., stockpiles of partly finished products) and in waste are major efficiency benefits of flexible machine cells. Improved capacity utilization arises from the reduction in setup times and from the computer-controlled coordination of production flow between machines, which eliminates bottlenecks. The tight coordination between machines also reduces work-in-progress inventory. Reductions in waste are due to the ability of computer-controlled machinery to identify ways to transform inputs into outputs while producing a minimum of unusable waste material. While freestanding machines might be in use 50 percent of the time, the same machines when grouped into a cell can be used more than 80 percent of the time and produce the same end product with half the waste. This increases efficiency and results in lower costs.
In 2009, Ford Motor Company renovated its Louisville truck plant allowing for flexible manufacturing. What other industries could benefit from flexible manufacturing?
The effects of installing flexible manufacturing technology on a company’s cost structure can be dramatic. The Ford Motor Company has been introducing flexible manufacturing technologies into its automotive plants around the world. These new technologies should allow Ford to produce multiple models from the same line and to switch production from one model to another much more quickly than in the past, allowing Ford to take $2 billion out of its cost structure.16
Besides improving efficiency and lowering costs, flexible manufacturing technologies enable companies to customize products to the demands of small consumer groups—at a cost that at one time could be achieved only by mass-producing a standardized output. Thus, the technologies help a company achieve mass customization, which increases its customer responsiveness. Most important for international business, flexible manufacturing technologies can help a firm customize products for different national markets. The importance of this advantage cannot be overstated. When flexible manufacturing technologies are available, a firm can manufacture products customized to various national markets at a single factory sited at the optimal location. And it can do this without absorbing a significant cost penalty. Thus, firms no longer need to establish manufacturing facilities in each major national market to provide products that satisfy specific consumer tastes and preferences, part of the rationale for a localization strategy (Chapter 12).
A number of technological factors support the economic arguments for concentrating production facilities in a few choice locations or even in a single location. Other things being equal, when fixed costs are substantial, the minimum efficient scale of production is high, and/or flexible manufacturing technologies are available, the arguments for concentrating production at a few choice locations are strong. This is true even when substantial differences in consumer tastes and preferences exist between national markets because flexible manufacturing technologies allow the firm to customize products to national differences at a single facility. Alternatively, when fixed costs are low, the minimum efficient scale of production is low, and flexible manufacturing technologies are not available, the arguments for concentrating production at one or a few locations are not as compelling. In such cases, it may make more sense to manufacture in each major market in which the firm is active if this helps the firm better respond to local demands. This holds only if the increased local responsiveness more than offsets the cost disadvantages of not concentrating manufacturing. With the advent of flexible manufacturing technologies and mass customization, such a strategy is becoming less attractive. In sum, technological factors are making it feasible, and necessary, for firms to concentrate manufacturing facilities at optimal locations. Trade barriers and transportation costs are major brakes on this trend.
Two product features affect location decisions. The first is the product’s value-to-weight ratio because of its influence on transportation costs. Many electronic components and pharmaceuticals have high value-to-weight ratios; they are expensive and they do not weigh very much. Thus, even if they are shipped halfway around the world, their transportation costs account for a very small percentage of total costs. Given this, other things being equal, there is great pressure to produce these products in the optimal location and to serve the world market from there. The opposite holds for products with low value-to-weight ratios. Refined sugar, certain bulk chemicals, paint, and petroleum products all have low value-to-weight ratios; they are relatively inexpensive products that weigh a lot. Accordingly, when they are shipped long distances, transportation costs account for a large percentage of total costs. Thus, other things being equal, there is great pressure to make these products in multiple locations close to major markets to reduce transportation costs.
The other product feature that can influence location decisions is whether the product serves universal needs, needs that are the same all over the world. Examples include many industrial products (e.g., industrial electronics, steel, bulk chemicals) and modern consumer products (e.g., handheld calculators, personal computers, video game consoles). Because there are few national differences in consumer taste and preference for such products, the need for local responsiveness is reduced. This increases the attractiveness of concentrating production at an optimal location.
LOCATING PRODUCTION FACILITIES
There are two basic strategies for locating production facilities: concentrating them in a centralized location and serving the world market from there, or decentralizing them in various regional or national locations that are close to major markets. The appropriate strategic choice is determined by the various country-specific, technological, and product factors discussed in this section and summarized in Table 15.1.
TABLE 15.1 Location Strategy and Production
Concentrated Production Favored
Decentralized Production Favored
Differences in political economy
Differences in culture
Differences in factor costs
Important in industry
Not important in industry
Minimum efficient scale
Flexible manufacturing technology
Serves universal needs
As can be seen, concentration of production makes most sense when:
• Differences among countries in factor costs, political economy, and culture have a substantial impact on the costs of manufacturing in various countries.
• Trade barriers are low.
• Externalities arising from the concentration of like enterprises favor certain locations.
• Important exchange rates are expected to remain relatively stable.
• The production technology has high fixed costs and high minimum efficient scale relative to global demand, or flexible manufacturing technology exists.
• The product’s value-to-weight ratio is high.
• The product serves universal needs.
Alternatively, decentralization of production is appropriate when:
• Differences among countries in factor costs, political economy, and culture do not have a substantial impact on the costs of manufacturing in various countries.
• Trade barriers are high.
• Location externalities are not important.
• Volatility in important exchange rates is expected.
• The production technology has low fixed costs and low minimum efficient scale, and flexible manufacturing technology is not available.
• The product’s value-to-weight ratio is low.
• The product does not serve universal needs (i.e., significant differences in consumer tastes and preferences exist among nations).
In practice, location decisions are seldom clear-cut. For example, it is not unusual for differences in factor costs, technological factors, and product factors to point toward concentrated production while a combination of trade barriers and volatile exchange rates points toward decentralized production. This seems to be the case in the world automobile industry. Although the availability of flexible manufacturing and cars’ relatively high value-to-weight ratios suggest concentrated manufacturing, the combination of formal and informal trade barriers and the uncertainties of the world’s current floating exchange rate regime (see Chapter 10) have inhibited firms’ ability to pursue this strategy. For these reasons, several automobile companies have established “top-to-bottom” manufacturing operations in three major regional markets: Asia, North America, and western Europe.
ANOTHER PERSPECTIVE Nestlé Goes on Investing in Turkey
According to Nestlé Turkey’s CEO, Mr Hans Ulrich Mayer, Turkey has been a great place to invest—“Turkey has been the recipient of several Nestlé investments many times greater than we invest in other markets” reported Mayer. Nestlé has invested about 500 million USD in Turkey over the last 4 years and following its successful breakfast cereal investment in March 2011 intends to go on investing because of the strong Turkish economy compared to other European economies. Nestlé products sold in Turkey, ranging from pet food to chocolates, are manufactured in Turkey and also exported to North Africa and the Middle East.
Source: Invest in Turkey, www.spotblue.co.uk/turkey-property-news/11577/nestle-goes-on-investing-in-turkey/.
THE HIDDEN COSTS OF FOREIGN LOCATIONS
There may be some “hidden costs” to basing production in a foreign location. Numerous anecdotes suggest that high employee turnover, shoddy workmanship, poor product quality, and low productivity are significant issues in some outsourcing locations.17 Microsoft, for example, established a major facility in Hyderabad, India, for four very good reasons: (1) The wage rate of software programmers in India is one-third of that in the United States. (2) India has an excellent higher education system that graduates a lot of computer science majors every year. (3) There was already a high concentration of information technology companies and workers in Hyderabad. (4) Many of Microsoft’s highly skilled Indian employees, after spending years in the United States, wanted to return home, and Microsoft saw the Hyderabad facility as a way of holding on to this valuable human capital.
However, the company has found that the turnover rate among its Indian employees is higher than in the United States. Demand for software programmers in India is high, and many employees are prone to switch jobs to get better pay. Although Microsoft has tried to limit turnover by offering good benefits and long-term incentive pay, such as stock grants to high performers who stay with the company, many of the Indians who were hired locally apparently place little value on long-term incentives and prefer higher current pay. High employee turnover, of course, has a negative impact on productivity. One Microsoft manager in India noted that 40 percent of his core team had left within the past 12 months, making it very difficult to stay on track with development projects.18
Microsoft is not alone in experiencing this problem. The manager of an electronics company that outsourced the manufacture of wireless headsets to China noted that after four years of frustrations with late deliveries and poor quality, his company decided to move production back to the United States. In his words: “On the face of it, labor costs seemed so much lower in China that the decision to move production there was a very easy one. In retrospect, I wish we had looked much closer at productivity and workmanship. We have actually lost market share because of this decision.”19 The lesson here is that it is important to look beyond pay rates and make judgments about employee productivity before deciding whether to outsource activities to foreign locations.
• QUICK STUDY
1. Outline the main country factors that influence the location of production.
2. What technological factors influence the location of production?
3. How do product factors influence the location of production?
4. What are the possible hidden costs of locating production in a foreign nation?
The Strategic Role of a Foreign Production Site
LEARNING OBJECTIVE 3
Recognize how the role of foreign subsidiaries in production can be enhanced over time as they accumulate knowledge.
Whatever the rationale behind establishing a foreign production facility, the strategic role of foreign sites can evolve over time.20 Initially, many foreign sites are established where labor costs are low. Typically, their strategic role is to produce labor-intensive products at as low a cost as possible. For example, beginning in the 1970s, many U.S. firms in the computer and telecommunication equipment businesses established factories across Southeast Asia to manufacture electronic components, such as circuit boards and semiconductors, at the lowest possible cost. They located their factories in countries such as Malaysia, Thailand, and Singapore precisely because each of these countries offered an attractive combination of low labor costs, adequate infrastructure, and a favorable tax and trade regime. Initially, the components produced by these factories were designed elsewhere and the final product was assembled elsewhere. Over time, however, the strategic role of some of these factories has expanded; they have become important centers for the design and final assembly of products for the global marketplace. For example, Hewlett-Packard’s operation in Singapore was established as a low-cost location for the production of circuit boards, but the facility has become the center for the design and final assembly of portable ink-jet printers for the global marketplace (see the accompanying Management Focus).
Such upward migration in the strategic role of foreign production sites arises because many foreign sites upgrade their own capabilities.21 This improvement comes from two sources. First, pressure from the center to improve a site’s cost structure and/or customize a product to the demands of consumers in a particular nation can start a chain of events that ultimately leads to development of additional capabilities at that factory. For example, to meet centrally mandated directions to drive down costs, engineers at HP’s Singapore factory argued that they needed to redesign products so they could be manufactured at a lower cost. This led to the establishment of a design center in Singapore. As this design center proved its worth, HP executives realized the importance of co-locating design and manufacturing operations. They increasingly transferred more design responsibilities to the Singapore factory. In addition, the Singapore factory ultimately became the center for the design of products tailored to the needs of the Asian market. This made good strategic sense because it meant products were being designed by engineers who were close to the Asian market and probably had a good understanding of the needs of that market, as opposed to engineers located in the United States.
MANAGEMENT FOCUS Hewlett-Packard in Singapore
In the late 1960s, Hewlett-Packard was looking around Asia for a low-cost location to produce electronic components that were to be manufactured using labor-intensive processes. The company settled on Singapore, opening its first factory there in 1970. Although Singapore did not have the lowest labor costs in the region, costs were low relative to North America. Plus, Singapore had several important benefits that could not be found at many other locations in Asia. The education level of the local workforce was high. English was widely spoken. The government of Singapore seemed stable and committed to economic development, and the city-state had one of the better infrastructures in the region, including good communication and transportation networks and a rapidly developing industrial and commercial base. HP also extracted favorable terms from the Singapore government with regard to taxes, tariffs, and subsidies.
At its start, the Singapore unit manufactured only basic components. The combination of low labor costs and a favorable tax regime helped to make this plant profitable early. In 1973, HP transferred the manufacture of one of its basic handheld calculators from the United States to Singapore. The objective was to reduce manufacturing costs, which the Singapore factory was quickly able to do. Increasingly confident in the capability of the Singapore factory to handle entire products, as opposed to just components, HP’s management transferred other products to Singapore over the next few years, including keyboards, solid-state displays, and integrated circuits. However, all these products were still designed, developed, and initially produced in the United States.
The unit’s status shifted in the early 1980s when HP embarked on a worldwide campaign to boost product quality and reduce costs. HP transferred the production of its HP41C handheld calculator to Singapore. The managers in Singapore were given the goal of substantially reducing manufacturing costs. They argued that this could be achieved only if they were allowed to redesign the product so it could be manufactured at a lower overall cost. HP’s central management agreed, and 20 engineers from the Singapore facility were transferred to the United States for one year to learn how to design application-specific integrated circuits. They then brought this expertise back to Singapore and set about redesigning the HP41C.
The results were a huge success. By redesigning the product, the Singapore engineers reduced manufacturing costs for the HP41C by 50 percent. Using this newly acquired capability for product design, the Singapore facility then set about redesigning other products it produced. HP’s corporate managers were so impressed with the progress made that they transferred production of the entire calculator line to Singapore in 1983. This was followed by the partial transfer of ink-jet production to Singapore in 1984 and keyboard production in 1986. In all cases, the facility redesigned the products and often reduced unit manufacturing costs by more than 30 percent. The initial development and design of all these products, however, still occurred in the United States.
In the late 1980s and 1990s, the Singapore operation assumed added responsibilities, particularly in the ink-jet printer business. The unit was given the job of redesigning an HP ink-jet printer for the Japanese market. Although the initial product redesign was a market failure, the managers at Singapore pushed to be allowed to try again. They were given the job of redesigning HP’s DeskJet 505 printer for the Japanese market. This time, the redesigned product was a success, garnering significant sales in Japan. Emboldened by this success, the Singapore operation has continued to take on additional design responsibilities. Today, it is viewed as a “lead plant” within HP’s global network, with primary responsibility not just for manufacturing, but also for the development and design of many products targeted at the Asian market. In 2010, the role of Singapore was further enhanced when HP opened a basic research lab there. Currently, the lab is focused on developing a cloud-computing platform for enterprises.
Sources: K. Ferdows, “Making the Most of Foreign Factories,” Harvard Business Review, March–April 1997, pp. 73–88; and “Hewlett-Packard: Singapore,” Harvard Business School, Case No. 694–035.
A second source of improvement in the capabilities of a foreign site can be the increasing abundance of advanced factors of production in the nation in which the factory is located. Many nations that were considered economic backwaters a generation ago have been experiencing rapid economic development during the past 20 years. Their communication and transportation infrastructures and the education level of the population have improved. While these countries once lacked the advanced infrastructure required to support sophisticated design, development, and manufacturing operations, this is often no longer the case. This has made it much easier for factories based in these nations to take on a greater strategic role.
The flow of skills and product offerings from foreign subsidiary to home country and from foreign subsidiary to foreign subsidiary.
Because of such developments, many international businesses are moving away from a system in which their foreign facilities were viewed as nothing more than low-cost production facilities and toward one where they are viewed as globally dispersed centers of excellence.22 In this new model, foreign sites may take the lead role for the design and manufacture of products to serve important national or regional markets or even the global market. The development of such dispersed centers of excellence is consistent with the concept of a transnational strategy, introduced in Chapter 12. A major aspect of a transnational strategy is a belief in global learning—the idea that valuable knowledge does not reside just in a firm’s domestic operations; it may also be found in its foreign subsidiaries. Foreign factories that upgrade their capabilities over time are creating valuable knowledge that might benefit the whole corporation.
Managers of international businesses need to remember that foreign factories can improve their capabilities over time, and this can be of immense strategic benefit to the firm. Rather than viewing foreign factories simply as sweatshops where unskilled labor churns out low-cost goods, managers need to see them as potential centers of excellence and to encourage and foster attempts by local managers to upgrade the capabilities of their factories and, thereby, enhance their strategic standing within the corporation.
Such a process does imply that once a foreign factory has been established and valuable skills have been accumulated, it may not be wise to switch production to another location simply because some underlying variable, such as wage rates, has changed.23 HP has kept its facility in Singapore, rather than switching production to a location where wage rates are now much lower, such as Vietnam, because it recognizes that the Singapore operation has accumulated valuable skills that boost productivity and more than make up for the higher wage rates. Thus, when reviewing the location of production facilities, the international manager must consider the valuable skills that may have been accumulated at various locations and the impact of those skills on factors such as productivity and product design.