Monday, August 23, 2004

As anybody who listens to the nightly news already knows, top executives of U.S. and other

Western companies are fully aware of the labor cost savings they can achieve by outsourcing to China, India, Mexico, and several Eastern European countries.

But what many people don’t yet understand — and this includes many of these same executives, as well as workers, investors, and policy makers — is that cheap labor is not the only cost advantage available in these countries.

Companies can also save money by reducing their capital investment requirements, lowering the cost of parts and components, achieving unprecedented economies of scale, and taking advantage of available government incentives.

Labor costs, of course, are the greatest source of potential savings, accounting for approximately 60 percent of the total cost advantage. A factory worker in the United States or Europe typically costs between $15 and $30 per hour. In contrast, a Chinese factory work earns less than $1 per hour, giving China a fifteenfold to thirtyfold advantage.

The cost advantages are similarly impressive in the service industries. For example, an English-speaking Indian employee typically costs 50 percent to 60 percent less than his or her U.S. or Western European counterpart. In dollars, an accounting employee might cost a business $26 to $30 per hour in the United States, while a similarly qualified worker would cost just $10 to $12 per hour in India and $15 to $18 per hour in Eastern Europe.

Lower capital investment costs account for an additional — and not insignificant — 25 percent of the typical cost advantage. Simply put, it costs much less to build and equip a factory in China and many other countries than it in the West. Some companies report saving as much as 60 percent to 70 percent. Thus, a factory that costs $50 million to build in the United States might cost as little as $15 million to $20 million in a low-cost country. Such large savings not only can help boost a company’s balance sheet, but enable the company to recover its investment faster, fueling additional —and faster — company growth.

Another source of capital investment savings is in product design. When companies move production offshore, they frequently redesign the manufacturing process itself, reducing the use of robotics and other automation and increasing the use of labor. In other words, they are able to substitute low-cost labor for high-cost equipment. One leading manufacturer of household appliances, for instance, has completely eliminated conveyor belts in its Chinese factories.

Government incentives are a third source of cost advantage. The Chinese in particular have become extraordinarily adept at using incentives to attract Western investment. So generous are tax and other incentives offered by China’s central government and Chinese provinces that several companies claim they were able to build factories virtually cost-free.

In addition, companies also can save money by sourcing needed raw materials, supplies and services locally. Firms report saving 30 percent on fabrics and 20 percent on plastics, for example.

Cost advantage also is affected by the greater economies of scale available in low-cost markets. Producing in volume almost always lowers costs, and many low-cost countries offer huge domestic markets. China is already the largest market in the world for machine tools, the second-largest market for transmission and distribution equipment and the fourth-largest market for passenger cars and trucks — and it continues growing fast.

A word of caution: Although the potential cost advantages can be enormous, companies also incur significant costs going global. Moving operations abroad or closing operations at home can be costly, and every company needs to take a realistic look at these costs before jumping in to the low-cost game.

Moving jobs overseas is something few companies relish. But many companies have no option: They must either compete with the low-cost producers or risk losing their businesses. To be competitive in the global marketplace — indeed, just to sell to Wal-Mart — they must aggressively pursue cost advantage wherever it is.

That’s the reality companies face today — a reality workers, investors, and policymakers need to understand.

George Stalk and Dave Young are senior vice presidents of the Boston Consulting Group (BCG), in Toronto and Boston respectively. This article was adapted from “Anatomy of a Cost Advantage” in a recent issue of Manufacturing Today magazine.

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