0
A comparative study of
location theory and
reshoring: missing elements
in theories on sourcing
options?
This master thesis aims to explain location theory and reshoring. It wil study at what points the concepts are complimentary and at what points they differ. Assumed is that the concepts correlate in the fact that they do not include factors
originating from the demand side of the economy. An argument will be made to support the inclusion of factors from the demand side of the economy in concepts and theories on sourcing options .
Willem van Houten
Pop Dijkemaweg 1A, 9731BA Groningen S1884867
w.van.houten@student.rug.nl +31628306540
1
DECLARATION BY CANDIDATE
I hereby declare that this thesis, “A comparative study of location theory and reshoring: missing elements in theories on sourcing options?“, is my own work and my own effort and that it has not been accepted anywhere else for the award of any other degree or diploma. Where sources of information have been used, they have been acknowledged.
Name: Willem van Houten
Signature:
2
Table of contents:
Introduction 3
Chapter 1: Theoretical framework 6
Location theory 7
Revival of location theory 10
Labor 11
Governments 13
Chapter 2: Reshoring 15
Reshoring trends 18
Total Cost of Ownership 21
Labor 22
Energy 26
Land & Physical location 28
Governments 33
Transportation 39
Market size 40
Chapter 3: PR & Brand image 43
Conclusion 47
Bibliography 50
3
Introduction
This thesis will study the differences and correlations of location theory and reshoring. I will study which parts of the concepts can be beneficial to one another when analyzing an optimal framework of sourcing options for production locations. In addition, I will argue that the aforementioned concepts focus too much on the costs of the production process and have no scope for changing factors of the demand side when different sourcing options are being considered. However, firstly the concepts that will be used in the thesis will be introduced. After these are familiar to the reader, the exact methodology will be described at the start of chapter 1.
The label ‘’Made in America’’ has always had a big impact on consumers. In the 1990’s and early 2000’s there was a reduced interest in products manufactured ‘’back home’’ (White, 2013). However, from 2005 onwards, the interest of consumers in manufactured goods made in the U.S. has been on the rise (Gross, 2012). This trend can be linked to an emerging process known as reshoring. This term is used to describe a trend in which manufacturing that was outsourced decades ago from the U.S. to new markets like China is now returning. The number of companies that choose to reshore their manufacturing is expanding (White, 2013). The movement surrounding reshoring has a sense of restoring the U.S. to the manufacturing state it once was. Big concerns like Apple and Walmart have recently reshored parts of their production and there are numerous examples of smaller American labels that have become interested in reshoring and rediscovering the economic potential of producing goods in the U.S. (Michaels, 2013). Consequently, the number of companies contemplating reshoring is increasing rapidly.
4
Reshoring is a fascinating trend that could have major effects on the global economy. The potential magnitude of reshoring over the coming years and the influence it could have on Western economies make it a highly interesting subject. However, as reshoring is a fairly new concept, it is not well understood and the academic literature discussing it is limited in nature, relying mostly on reports in newspapers or data gathered by private initiatives to develop theories.
The momentum of reshoring is on the rise. However, the fundamental concepts underlying reshoring are not the most innovative phenomena within international economics. There are existing theories to explain why manufacturers set their facilities up at particular locations that have been around for centuries. Reshoring builds on these theories and applies it to what is actually happening in contemporary sourcing options.
The relevant question with regards to location theory at hand is: To what extent does location theory provide for a thorough and complete analysis of locational choice? There will always be discrepancies between different locations in terms of the costs for different production factors for instance. However, the ideal situation is to limit these costs to the amount that it would cost for a business to relocate itself. Therefore, information and analytical tools are necessary to optimize the facts that influence the decisions related to location. Consequently, location theory should keep up with contemporary trends that effect manufacturing locations around the world. The practice of reshoring will be used to test what drives this process and to what extent the factors of importance of reshoring should have their place within location theory. This implies that it is assumed that reshoring and location theory are built upon differing factors.
I intend to show that the focus within location theory of the direct costs of the production process cannot on their own account for the gathering momentum behind reshoring. Furthermore, the assertion is that if brands marketer their relocated production in the US, it will bring extra revenues sparked by the American public preference to buy American. Further, I aim to demonstrate that the direct advantage of the amount of sales should for this reason should also be seen as a major factor that drives businesses to relocate production facilities back to the U.S.
5
aims to give an all-encompassing tool for relocating manufacturing processes. I believe there is an overriding discrepancy that could not fully include all factors of optimum locations within both location theory and reshoring. In this lies the relevance of this research. Both an old and more recent theory/practice have a strong focus for material ‘’supply side’’ factors while the immaterial ‘’demand side’’ is not highlighted enough. I will try to fill this discrepancy with the power that consumer based favorism has: A strong sense of supporting your own local companies by purchasing products manufactured in the home country to an extent that can no longer be accounted for by basic economic laws of price and product.
While location theory provides a theoretical framework for understanding firms’ choices with regard to selecting the optimal locations for manufacturing, reshoring is the term used to describe and explain the trend in which jobs that were outsourced decades ago from the U.S. to new markets like China are now returning. Similar to location theory, reshoring aims to provide a coherent set of factors that push to choose for an optimal location. Indeed, reshoring is closely related to location theory and one could even go as far as saying that reshoring is just a strand within the wider spectrum of location theory, although some advocates of reshoring might not be overly excited with this notion.
Location theory states the importance of mostly ‘’classical’’ economic drivers of relocation of manufacturing. The phenomena of reshoring will be used to exemplify the changes that could occur with respect to location theory. Classical location theorists like Weber, Hoover and Isard argued that there are no differentials in production costs. Following that reasoning, Moses argued that the optimum location for production is the point where costs of transportation, raw materials and final product are the lowest (Moses, 1957: 265). This reasoning now seems overly simplistic and location theory developed some relevant factors to consider, which are often quiet specific due to the long academic history of location theory.
6
Chapter 1
Theoretical framework
The aim of this thesis is to analyze reshoring versus location theory and demonstrate that there are factors of importance that are not covered by either of the concepts since both reshoring and location theory focus on the supply side of production processes. Both concepts will be studied at length in order to understand the similarities and correlations between the two. In addition, the advantages and disadvantages that location theory and reshoring can have on each other will be evaluated.
Assuming that both the concepts do not provide for a method in which sourcing options of production processes are properly analyzed, this thesis will aim to add the missing link. By recognizing the importance of the demand side of the production location, especially with the practice of reshoring, I aim to demonstrate that reshoring and location theory should be more open towards the influence of the demand side of the economy.
To combine these research topics I will use the following research question: To what extent does a comparative study on location theory and reshoring overlooks influences from the demand side of the economy that are of major importance to sourcing options of production facilities?
In order to discuss these topics, I will first focus on location theory and reference reshoring to demonstrate the differences and correlations between the concepts. The aim is to find out about the important facets of location theory and to determine to what extent location theory prioritizes the cost of the production process to analyze the feasibility of production locations.
7
knowledge of location theory from the first chapter, location theory will be included when it is deemed relevant.
Thirdly, I will focus on the argument of the prioritization of both concepts on the supply side of economics. Assumed is that both location theory and reshoring do not leave room for the effect that a shifting production location can have on the consumer (i.e. the demand side). I will argue that factors driven by the consumers desire for products to be ‘’Made in America’’ can have a big impact of reshoring production back to the U.S. Therefore, the last chapter will be devoted to the consequences on the public relations and the brand image of a company that may follow from a shift in production location.
Location theory
The basic principle underpinning location theory is that production locations shift based on decision maker’s desire to hold on to the rudimentary notion of economists that the ultimate goal is to source manufacturing to those locations that will enable businesses to maximize profits. The way this is calculated within location theory is by focusing on the production process itself. According to location theorists, this is the best way to calculate where a product should be manufactured in order to maximize a company’s profits. This idea assumes that firms are rational actors that have a shared goal of profit maximization and leaves little room to account for immaterial factors such as brand image and preferences of consumers besides the classical criteria like price and quality. The focus within choosing the optimal location for different branches is often analyzed by a sector specific approach, calculating what a specific set of tasks will cost at a given location. An example of this is the calculation of the cost of a manufactured product by a per-unit analysis of the production process. Within location theory, this is a much-used way of determining the costs of having the manufacturing process at a particular location.
8
Indirectly, bad press that follows from these instances show that there comes more to the analysis of sourcing options than simply calculating the lowest production cost per unit.
Later on in this research, a discussion about the contemporary concerns that influence the manufacturing location of consumer goods in the U.S. will follow. However, it is clear that reshoring is concerned with the cost of production factors as well but also includes ‘’indirect costs’’ of the production process. The presumed discrepancy between location theory will be tested against those factors that stimulate the practice of reshoring. Furthermore, it is presumed that the positive effects on the brand image that result from a changing production location are an another important factor driving businesses to reshore their manufacturing processes, even though this is not a factor of discussion within reshoring.
Location theory revolves around who produces what goods and services in which location and more specifically, why a particular location is chosen (Feinberg, 2007: 1). Fundamentally, the choice on which this is based will derive from market distortions. In a perfect market without trade barriers, location theory would be less interesting, since different location will converge and transportation and locating a production facility near consumers will be the most important facets. Since tariff reform and the equalization of production costs across the globe will not, in the near future, provide a level playing field businesses can, or at least think they can, reap the benefits of these market imperfections (Jovanovic, 2003: 24). This ‘’market seeking’’ will result in a drive to seek the optimal location for industries. However, nearly all location theorists believe the following four elements are decisive in deciding the overall optimal location: Labor, natural resource seeking, efficiency seeking and strategic asset seeking (Mataloni, 2010: 156). In this section, I will give an overview of the contemporary situation and the development of location theory.
9
Nowadays location theory is still applied to analyze the optimal location for firms. New factors have become more relevant since Weber’s main claim. However, by utilizing location theory researchers continue to search for the factors influencing international firms where to locate their production process. Location theory can thus be viewed from two perspectives, the government perspective and the business perspective. The relationship between the two can be difficult. Governments desperate of FDI can easily be persuaded to implement very liberal economic standards, while the influence of big firms can be great. The logical consequence is that a ‘’race to the bottom’’ could occur.
Traditional microeconomic location theory focusing on the interrelationships between production function models and the costs of transporting goods became largely out of fashion during the latter because more aggregate levels of analysis, which emphasized the institutional and systemic changes within the production sectors, tended to dominate literature.
For industries interested in optimizing their revenues and minimizing the cost of production location, the proximity of the market is an important factor. As described in the introduction, other factors like PR-related issues and property rights play a big role for industries (McCann & Sheppard 2003: 651). However, within the development of location theory, these factors are not predominant at all.
Since the studies of classical location theorists like Weber, a lot has changed. Weber based his notion of industries preferring a certain production location due to the minimization of transportation costs, raw materials and thus final product. However, nowadays a more all-encompassing view of location theory includes a broader range of factors.
10
worsened image of brands with production facilities in countries that are known for unsatisfactory working conditions. The concerns of human right groups and the media about safety incidents, long working hours and dire working conditions in Apple factories resulted in a shift of part of the production back to the U.S.
Revival of location theory
11
main types of clusters. Possibly, there is an overlap between the three types of cluster in the real world. However, it is clear it gives an idea to the extent in which clusters provide for sharing, matching and learning possibilities between firms.
Overall, it is supported that urban clusters of industries are associated with more knowledge flows between industries. Especially innovations by one firm have a big chance of being followed by the next within clusters (Baptista, 2000: 521).
Firms in non-urban clusters, most closely associated with the industrial complex described in annex 1, tend to increase in productivity when it is located in a region with other plants in the same industry (Moretti, 2004: 661). Studies on the productivity of agglomerations show that urban clusters benefit more from the proximity of other firms than cluster type: Industrial complex. The main reason for this is that within urban clusters the physical space of the cluster is smaller and the amount spent on innovation is greater (Audretsch & Feldman, 1996: 636). Within the industrial complex production makes up a big share of the activity of a firm. Thus, the learning and sharing of innovations does not travel as fast as it does within urban clusters. Since this thesis revolves around the manufacturing industries, which most closely relate to the industrial complex, the assumption is that it is beneficial for these firms to cluster. However, not as beneficial as it is within urban clusters.
Labor
12
Mataloni acknowledges the important role for governments in stimulating manufacturing to come back ‘’home’’. A skilled work force, industrial agglomeration and an extensive transportation infrastructure are factors of importance in which governments can play a major role. (Mataloni, 2011: 154).
To give an unsatisfying start, there is no unanimity in studies with respect to the role of labor cost in attracting FDI (Demrehan & Masca, 2008: 360). As with real estate prices, labor costs are a very flexible production factor. Many factors, intra-firm or external, matter when it comes to the analysis of the cost per-unit of a certain production process. For instance, unlike energy prices, the specific production process of every firm influences the cost of labor per unit. Although prices may vary from time to time there is not, at least not yet, such a thing as more productive energy. Prices in both countries can be put next to each other. Therefore, a trend of rising energy prices in China and declining energy prices in the U.S., due to new developments like the discovery of gas fields, could have an important influence on choosing a production location. The fragility of energy prices make it difficult to be a key factor in location theory. However, from the nature of energy as a production factor it follows that energy, as a drive within reshoring could hardly be a factor of importance to the refinement of location theory.
Evidently, location theory and reshoring both have a high interest in the cost of labor at different locations. In addition, reshoring could take advantage of a few of the tools that location theorists use.
13
The degree of which these can be used in a production facility indicate the possibility to enhance the process and make it less labor intensive. As was discussed before, the labor intensity of a production process is critical in the consideration to shift the production location. The categorization of Autor, Levy and Murhane proves effective since it fits to most manufacturing processes and is able to incorporate the fluctuation within manufacturing.
Governments
Even though, most importance in this thesis will be attached to a business perspective, there must also be minimal knowledge about the role of governments within theories about production locations, since its influence on the attractiveness of certain production locations can be very relevant. Furthermore, most factors that are important to businesses when analyzing changing production location are strongly influenced by governments. The main reasons for governments to have an interest is the attraction of Foreign Direct Investment (FDI) is to collect tax revenues and to create employment. This is important in relation to location theory. Governments could do their upmost best to provide for the best conditions in order to attract as much FDI and international trade as they can. Most governments believe that a liberal economic policy will stimulate the influx of FDI. Governments often think this will generate output, employment and foreign exchange by fostering learning and technological capacities (Nagesh, 2008: 43). The competing efforts of governments in order to attract FDI could offer opportunities for a bigger manufacturing industry. In addition, it can also result in altering the proportionality of the factors that are considered to be important to location theorists. Therefore, there could be major implications on the locations that industries choose for their production facilities.
With respect to reshoring this is no different. Of course, the prices of production factors are not all easily changeable by the government. However, the extent to which governments make it lucrative to reshore is of great importance to companies. In addition, the concept of reshoring might equip governments with the adequate tools and knowledge to attract FDI.
14
Another global trend towards liberalization has opened up many countries to FDI. The important global economic institutions, like the WTO and the World Bank, have stimulated this and this has Of course, it should not be assumed that countries simply lower their trade and investment barriers in order to have foreign companies producing in a particular host country. In relation to the issue of labor within a firm, there is also a major influence from governments. The institutionalization of unions and the political pressure, or even political power that unions exert could stimulate that firm’s prefer one location to another.
Governments in search of FDI should protect companies, not only for physical theft, unrest and harm but also guarantee a powerful regime regarding the protection of property rights, intellectual properties and contract enforcement (Javorcik & Spatareanu, 2005: 22).
For countries known for political tension and conflict situation, it is very difficult to attract FDI. Instances of expropriating FDI after a new regime is in place are well known. This makes it even tougher for unstable countries to advance their economies.
15
Chapter 2
Reshoring practice
In this chapter, the practice and concept of reshoring will be discussed. After an introduction of reshoring, the different factors of importance to reshoring will be analyzed. Labor will be the focus since this is the most important issue in reshoring. In addition, when companies outsourced production towards China low labor costs were often the main reason for offshoring as well. It may be inherent to a rather new phenomenon like reshoring that data sources are limited; there is until now just a limited number of firms that have reshored their production. I will focus on data from American companies that reshored manufacturing back to the U.S. since the trend is much bigger in the U.S. than in other parts of the Western world that have been dealing with outsourcing and offshoring a few decades ago. This difference comes from the different production factors and the costs thereof. Mainly labor and energy costs are much higher in Europe. Consequently, the reshoring potential in Europe is much lower than in the U.S.
Besides the obvious differences in transportation costs, energy costs and labor costs that come into play between different companies when they decide to reshore the production process, there are factors within these categories that are less clear than the absolute amount companies pay for international shipping. These factors, both material and immaterial will be used to subdivide reshoring practice into coherent entities. For instance, during the period of transportation companies have a lot of money tied up in big shipments. At this point, the investment is not making any returns and is just floating around.
16
In case of American companies, the image of a brand does not only work in promoting its American heritage and production. In addition, there is also bad press that could be avoided. For instance, Apple was struck by this when media covered the working conditions in the factories of Apple in China. This produced major damage to the image of Apple. Even for companies that respect labor laws, there could be a negative spillover. The image of unsatisfactory working conditions could trickle down from companies with weak regulations on labor and environmental standards to companies that do safeguard these issues.
The manufacturing sector in the U.S. is on the rebound. More and more companies see the benefits of producing in the U.S. In addition, new ways of calculating the cost of ownership of manufacturing have made clear that there are more costs attached to producing in China than companies were used to think. Reshoring theorist’s claim that this mistake was made when companies offshored production as well. These theorists believe that companies now see the real costs of production to China and see the advantage of producing in the U.S. Already in 2012, 14% out of 200 companies which were surveyed were reshoring manufacturing back to the U.S. (Simchi-Levi, 2012: 11). In this chapter, I will shed light on those companies that engage in reshoring and find out about the reasons why they do this. In addition, I will refer back to location theory every now and then to highlight the differences and correlations between reshoring as it happens in the real world and location theory.
17
Reshoring experts aim to provide an approach for companies to analyze which production is most optimally done at which industrial location. The general trend is that during recent years a growing number of companies that have offshored some branches of its business process to China are relocating to the U.S. Note that there is more to it than just the economic rationale it proclaims. Especially in the U.S., the sentiment of reclaiming the former position as a strong manufacturing state has a lot of pride attached to it. National symbols are often displayed when reshoring is mentioned, and the readers of literature by reshoring advocates should bear in mind that patriotic notions could push more rational economic factors to the background.
18
Reshoring trends
The rise of companies that decide to reshore is caused by multiple factors. Besides material factors that will be discussed later on, an important aspect is the way sourcing options are calculated. This will be analyzed in the next section. Later on, I will depart from reshoring and add factors that are related to branding and images. The assumption is that the positive influences of reshoring on the perception of a product as American will result in a higher demand. Reshoring tools, such as the TCO, aim to offer an all-encompassing way of calculating the real costs of sourcing. However, it does not shed light on the fluctuations on the demand side that are caused by reshoring.
Now a discussion on the general and global trends vis-à-vis reshoring will follow. During the early nineties, many considered outsourcing to be a major threat to the U.S. and its position as manufacturing state. Big businesses made a strategic evaluation and a substantial amount of companies decided to relocate manufacturing to China. Until the early 2000’s, companies that were outsourcing manufacturing to China were on the rise. However, around mid-2000 the tables turned. By 2010 the flow of jobs at production sites between the U.S. and China was even while ten years earlier 150,000 of those jobs went to China with only 2,000 coming back to the U.S. (Sirkin, et al., 2012).
19
The advantage of the proximity of businesses in agglomerations and clusters, as discussed in the chapter on location theory, could be bigger than concluded in the previous chapter. It was claimed that urban clusters have higher information and knowledge spillovers within location theory. Relating to reshoring, part of the success of manufacturers depends on the R&D department, especially for products that often need to be innovated. Therefore, to put it slightly paradoxically, the relatively high spillover of information and knowledge within the urban cluster could ‘’spillover’’ to the manufacturing facility. Consequently, reshoring shows that theories on clustering within location theory are open to multiple interpretations.
Wages in China rose 13.8% on average from the end of the 1990’s onwards (Hongbin et al., 2013). This huge rise contributed heavily to reshoring. This is also relevant for other ‘’cheap labor’’ markets. China was one of the first outsourcing locations and is developed the furthest in this process. Therefore, companies with manufacturing locations in China serve as a good example of reshoring since the prices of production factors have been on the rise for a relatively long time. The Chinese government undertook measures to keep production in China cheap. However, the expansion of the economy could not be stopped from tickling down all layers of the population, of urban, suburban, agricultural and industrial workers (Hongbin et al., 2013).
Consequently, in the long run it can be costly to shift production to low wage countries. The example of the development of wages in China illustrates that the investment of outsourcing can only be spread over 20 to 30 years. Moreover, the costs that will arise from shifting production once again should not be forgotten. Therefore, it may be more profitable in the long run to locate the production facilities in a stable home market, instead of taking the risk to keep changing production locations, which might only be profitable in the short run and will therefore force companies to change production locations once again.
20
reshoring theorists, there was also peer pressure and an inclination to outsource manufacturing since many companies did it.
Even though reshoring claims to have a more all-encompassing framework for analyzing which manufacturing locations are potentially the most profitable, a bandwagon effect could also appear with reshoring. To prevent this danger of a trend taking over from the numbers, reshoring theorists attach great importance to the TCO calculator. This concept will be explained later on.
Reshoring cannot be viewed as a golden egg that will revitalize American manufacturing. It is a very delicate matter that only pays off if its tools are used in a way that takes into account company specific factors. Each business has to bear with the specificities of its sector and product, which exert influence on the advantages and disadvantages of reshoring. One of the most direct and ‘’location theory driven’’ is the price of production factors and the labor intensity required for a product. The reshoring practice of, for instance, General Electric shows this differential pattern of reshoring. General Electric moved the production of fridges, heaters and washing machines back to the U.S. while the production of the numerous other products was kept abroad. Reshoring can be profitable to certain companies, when executed under the right circumstances. As mentioned, it is very product specific to calculate under which circumstances it is profitable for a business to reshore their manufacturing back to the U.S. Moreover, for the majority of consumer goods in the home market it will take a long time before reshoring is profitable. The aforementioned labor intensity of a certain product is key to the possible profitability of reshoring. Furthermore, an all-encompassing way of analyzing the potential feasibility of reshoring has been developed and can be used in a company specific framework.
21
TCO
The concept of the TCO was briefly embarked on during the section on location theory. Some of the major differences between location theory and reshoring have been discussed. Moreover, according to reshoring theorists, the indirect advantages which are only visible if there is a broader scope than just the production process itself, make shifting location profitable in the long run. The TCO is a device that can be used to counter the underestimations that are not uncommon when companies (consider to) shift manufacturing locations.
According to the Reshoring Initiative, most companies make sourcing decisions solely based on the price of the production factors. This will result in a 20 to 30 percent miscalculation of actual offshoring and sourcing costs. In addition, this fits the manner in which location theorists calculate the price per unit.
Within location theory, notions on the cost of ownership are based on the purchase costs and the costs of running the production process. The TCO incorporates not only the aforementioned factors that are not directly visible as being part of the price of production factors. It aims to combine all substantial costs for installing, deploying, operating, upgrading and maintaining the same assets. The difference between the two ways of calculating cost can be quiet large especially if costs are spread over a long period of manufacturing at a certain location (Schmidt, 2015).
Similar to location theory the TCO includes the purchase costs and the operational and maintenance costs. Nevertheless, TCO incorporates many other factors that are described as hidden costs. In annex 2, you will find the factors that are considered to be hidden costs, according to reshoring theorists. These are the factors that make up for the big difference in costs per unit calculated by focusing on the production process itself and incorporating hidden costs.
22
risks, corporate strategy and other external and internal business considerations. Moreover, the TCO is supposed to incorporate the hidden costs that are not taken into account by location theory, which almost solely focuses on the production process itself. These hidden costs are lingual barriers, time differences, telecommunications etc. Reshoring is already a big departure from location theory since it not only focuses on the production process itself and the per-unit price, it incorporates all managerial, communicational and other issues that are not visible in the production process itself.
A survey by Archstone established that in 2009 60% of companies used the direct costs of production like labor costs, land prices and the costs for raw materials. These are the same factors, which are used in location theory to compare and calculate the costs of different production locations. In 2012, the number of companies using TCO rose to about 65% (Archstone, cited in Benes, 2009)
Labor
During the timeframe that offshoring lured for many companies in the U.S., low labor costs were the main reason for relocating manufacturing to China. Many experts at the time were convinced that due to the high degree of specialization at big companies, laborers overseas could easily execute the routine tasks for lower wages (Grossman, 2006: 1979). In general, this proved to be correct for the early years of outsourcing. However, the number of companies that offshored manufacturing rose. Naturally, the demand for labor got more pressing, which caused the price of labor to rise. Some literature on offshoring claimed the major shift of companies would make wages in different areas in the world come to an equibrilerium, or at least to a point at which it would no longer be profitable for some industries to keep manufacturing abroad. However, governments still influence the price of production factors in a major way and therefore this theory will not hold in the near future. Especially the Chinese government heavily influences the cost of labor, as described in the section on Governments.
23
within those production processes in which higher skilled labor is necessary, this is a lot less likely, especially if a production process does not require a high degree of labor intensity.
The division of the five types of labor tasks by Autor, Levy & Murnane, used within location theory, sets a clear method that can be helpful for reshoring as well. Non-routine tasks require more expertise; laborers have to have qualifications to execute these tasks. Laborers capable of executing these tasks are not abundant in many low wage countries. This provides for the opportunity to profit from labor productivity much more than with routine tasks. Since the labor productivity in the U.S is higher than in China, I believe that there is a huge reshoring opportunity within those production facilities in which predominantly non-routine tasks are executed in a situation where other production factors are relatively more necessitated in the production factors than labor is. Therefore, it is likely that the shift of manufacturing jobs towards ‘’new’’ low-cost countries will mostly exist of routine task jobs.
One thing that is quite save to state is that the competitiveness of China as a cheap production location is eroding. Not only compared to the West but also in comparison with low-cost countries nearby China. China has reaped the fruits for being the World’s largest supplier of low-skilled and low-cost labor. However, this has set in motion a rise of GDP that in time will seep through to the laborers. China is now at a turning point and decision makers in China should answer the question what function the country wants to fulfill in the world economy. As it is unlikely that laborers would accept a negative impact on their wages China should look at other drivers that can yield a competitive advantage, such as labor productivity and education. Whereas location theory focuses solely on the labor and other direct costs to the product process, reshoring theorists are well aware of the division within labor and the diverging tasks in which the U.S. possesses a competitive advantage towards providers of low cost labor like China.
24
manufacturing to be reshored while other facets are still more efficiently produced in low-wage countries (IM4 blue paper, 2014).
What makes this even more difficult is the fact that economies, levels of education and technological knowledge are changing. The mismatch between employers and workers is a concern for employers, policy-makers and employees and is costly for the three of them (Scarpatta, 2014: 7). For reshoring theorists this is also a major concern. I will discuss this in more detail later on. The enormous costs attached to shifting production locations imply that some mismatch between the labor force of a country and the type of labor that manufacturers in that country demand cannot be avoided. Businesses simply cannot shift parts of their production as minor changes in production factors appear. However, as stated in the introduction, when cost reduction resulting from reshoring is not likely to exceed the cost of moving production facilities back home, a near-equilibrium can be found.
The issue of labor intensity of a product was already briefly embarked upon above. The degree of labor intensity necessary to manufacture a product is of a big importance when it comes to the cost of labor in different locations. During my conference call with Reshoring Initiative’s president Harry Moser, he stated that the point at which it is profitable to shift the manufacturing process back to the West depends on the extent to which the production requires labor vis-á-vis capital to produce a unit. In those sectors that are relatively driven by technology the labor productivity of a ‘’more expensive’’ worker in the West can easily compete with a less expensive and less productive worker in the East (Moser, 2014).
25
production factor is the availability of a skilled workforce that fits the need of manufacturing facilities that consider to reshore their facilities. Moreover, the availability of the right mix of labor for a certain product is important. Reshoring theorists do not specify this point any further. However, the categorization of Autor, Levy & Murnane offers a practical way to test the availability of a matching workforce and thereby provides in a way to study the possible feasibility of reshoring in practice.
This especially holds in relation to labor intensity. If there are more skilled labor tasks within a production process this means the abundance of laborers does not necessarily make a particular production location more attractive. However, the non-routine tasks and expert jobs, which are necessitated within most low labor intensity manufacturing locations, can make the difference to make it worthwhile to reshore. This ultimately boils down to the same point claimed by Moser, a skilled workforce is necessary. However, the categorization by Autor, Levy & Murnane makes the issue of a matching workforce much more specific.
26
In the early years, when outsourcing was on the rise, wages in China were considered to be low compared to the labor productivity. Inspired by global labor laws and the growing demand for higher wages, the competitive advantage of Chinese labor shrunk (Warner & Zhu, 2012: 291). This meant that cheap labor was harder to find in China. The rise of wages was not the only cause of this. In addition, investments to improve working conditions also began to form a costly factor for firms that outsourced manufacturing processes. The attentive reader would note that this so called advantage of lower abidance to labor rights was previously in this thesis said to be bad for publicity and that these could contradict each other. I believe this trend shows more correspondence instead of contradictions: the more U.S. consumers got concerned with working conditions and labor rights in offshore production locations abroad, the more this was reflecting the image of brands in the U.S. who were responsible for this. Therefore, I believe the effect is two-sided. On the demand side of a production chain, there can be negative publicity that derives from bad working condition, on the supply side factories are pushed by the Chinese government and to a lesser extent by their consumers to provide for safer working conditions. Either way, production will get more costly. Compared to the situation in the early years of outsourcing, with less media coverage of working conditions in manufacturing locations abroad and low costs to fulfill the necessary working conditions, this possibility for cost reduction is now long gone. Nowadays, concerns for labor rights force businesses to either invest or to take the risk of getting bad media coverage that could affect the demand for the product.
Energy
The fact that the nature of energy does not leave much room for in-depth analysis that has effects on what are the most optimal production locations, have already been discussed. For instance, it is not as multilayered as labor is. The most important factor is simply the energy prices and the direction in which these energy prices are expected to be heading.
27
When studying the trends in energy prices, energy prices should be considered a factor that increases reshoring potential. Since the beginning of this millennium oil prices in China tripled. However, economic instability in China has put downward pressure on the oil price. On 20 July 2015, a liter of oil costs 0,32$ more in China than in the U.S. (Global Petrol Prices, 2015).
Note that the slowing down of the Chinese economies has a positive effect on the price of natural gas, not only in China itself but also on the price of natural gas worldwide. Nevertheless, natural gas is at least a third cheaper in the U.S. compared to China (Johnson, 2015).
Electricity prices in China are around two-thirds of what they are in the U.S. (IEA non-member state reports, 2014). However, there is a trend towards an equilibrium. In annex 3, you will find that the prices of electricity in China have been on the rise the past decade. In the beginning of the 1990’s, when production facilities started to shift to China, electricity prices in China rose dramatically by almost 300%. The initial competitive advantage with respect to electricity was therefore swiftly reduced. In the U.S. prices have never risen that dramatically; over the last decade there has been a rise of about 30% (U.S. Energy Information Administration, 2014). Recently the recession has had negative effects on the demand of electricity of both consumers and businesses. Overall, the U.S. has a competitive advantage vis-à-vis the pricing of energy. The enormous demand for energy in China in the past decades has resulted in a tremendous grow of the energy prices. Similar to the other natural resources, the hampering of the Chinese economy has a negative effect on the electricity prices in China. The more stable economic development of the U.S. has not influenced energy prices in any major way as it did in China.
28
Land & physical location
In this section, not only the cost of land will be discussed. In addition, the costs that result from the physical location of production facilities will be included.Of course, the main factors which are discussed in other sections will be left out. Therefore, I will focus on those factors that closely relate to the physical location of a manufacturing facility. An important part within this section will be on the on the relation between the research and development department and the manufacturing location. This is important because the geographical differences between these two will result in long transportation costs, which make the implementation of innovations more difficult.
29
One factor that derives from the aforementioned argument are the enormous expenses that are tied up with having huge supplies stuck on the ocean for a long period. Indirectly this will result in reduced opportunities for rapid innovation since the process of implementing innovations and receiving the first shipments of newly innovated product takes much time. R&D departments are often situated in the U.S. and have to take long routes of communication to get through to the production facilities in China. If these different facets of businesses were to be located nearby each other, the cost of implementing innovations would be a lot lower. A high adequacy to respond can be a big advantage of reshoring. Nevertheless, the proximity of the R&D department specifically is seldom mentioned in reshoring literature as a reason for reshoring.
Location theory claims that the optimal production location is the location where transportation costs are at its lowest. In addition, location theorists heavily focus on the direct costs of the production process. In addition, land is more expensive in China and labor costs are higher. These factors could make it profitable to source manufacturing outside these regions. Note that within the expensive areas, like the coastal region, demand would be high since that is the region where most of the money is earned and spent.
Classical location theory states there are historical factors that have made it necessary for companies to specialize in the proximity to other companies. Specialization was deemed key to the efficiency of a company. Alongside a deepening degree of specialization, a geographic concentration was claimed to be necessary for the coordination of the economy as a whole. Long distance communication was ve expensive in the old days and therefore cheaper production factors elsewhere did not lure as much as they do nowadays. Literature on offshoring often claims that due to the revolution in the IT sector, it is possible to communicate for relatively low cost over long distances which make it unessential to keep different sectors within a company operating in proximity to each other (Grossman, 2006: 1982). The renewed interest by reshoring experts in the advantages of having different sections of a company located closer to each other in order to aid responsiveness to customer demands can be linked back to the classical location theory.
30
opened up their businesses overseas (Van Den Bossche et al., 2014: 28). Again, the product and sector of a particular company are decisive factors here. Manufacturers that produce a rare product will have more difficulties in finding suppliers in a new location than those manufacturers with a common product.
There are also big changes within China itself. Many industries are relocating from the coastal areas towards locations inland. The coastal areas do have some major advantages: transportation costs are lower, the infrastructure is much more advanced, governments are more cooperative towards international firms and the labor force is better educated (Chang et al., 2013: 58). However, the one thing that makes in-land locations more attractive is the abundant supply of low wage labor. The importance of low labor costs is once again stressed since many firms are currently moving their production facilities towards more inland regions. Generally, if a production facility is further away from the coastal region it will mean a big rise in the transportation costs that will arise from getting the products to a place from which they can efficiently be transported to the U.S.
The rising prices of production locations in the coastal regions are a consequence of the rising demand by foreign companies. At first, these companies saw opportunities in the coastal regions for its proximity to major transportation networks and low labor costs. However, when progressively more foreign companies located in this area these advantages diminished.
Annex 4 shows the differential path of GDP growth due to incoming FDI and the higher demand for potential industrial locations. Similar to the increasing costs of labor in China the rapid economic growth is a major factor in the deteriorating competitiveness of China as ‘’the world’s manufacturer’’. The stable economic development of the U.S. during the 1990’s and the beginning of this millennium are a big advantage, not only regarding costs of labor, but also regarding land prices. Compared to China the development of the U.S. has been steady. This constitutes to be a big advantage for companies.
31
prices of land in the coastal areas of China. Note that China’s growth was very unusual in both length and extent, so the chance that similar factors might come up in the U.S. is rather small. The results and theories that go with businesses and production facilities within agglomerations and clusters have been mentioned before. From that section, it can be derived that industrial agglomerations tend to be concentrated in the more expensive regions or in regions that quickly develop itself to an expensive region, which will be densely populated by businesses. In the section on location theory it was concluded that the advantages that companies can derive from clustering, which are information and knowledge spillovers, are most effective in those industries and sectors that have to be innovative towards the development of new products. For businesses with a low elasticity to product-innovation, there is not much to gain by locating in a cluster. Companies that have been successfully producing and selling a similar product as neighboring businesses within a cluster for decades cannot have a big advantage from spillovers if the demand for the product has not changed either. For those brands that derive their unique and competitive position from their innovative research and development, the potential profitability of being located in an industrial agglomeration is much higher. The demand for Apple products is an example in this respect. Apple is reshoring parts of its production to the U.S. (Regalado, 2013). The company did not choose to relocate manufacturing of Mac notebooks back to Silicon Valley itself. Nevertheless, the proximity of the R&D department and the manufacturing facility reduced communication difficulties and payed off since the spillovers of the R&D department could be implemented easier and faster to the manufacturing facilities.
32
The aspect that shows a different pattern between the two locations is the extent in which businesses locate their staff, which can act on information and knowledge spillovers adequately. Although this thesis revolves around the manufacturing locations of firms, I believe it is important to devote some attention to R&D facilities, especially for companies that manufacture products that require continuing innovations.
Moser states that many businesses keep R&D facilities close to the U.S. in order to follow those innovations necessary to keep U.S. consumers interested in their products (Moser, 2013). Those companies with manufacturing locations in the industrial agglomeration of China have little advantage of information and knowledge spillovers if the R&D facilities of the firms are located in the U.S. In this case, it is not necessarily a beneficial move to locate within an industrial agglomeration in China since land prices are higher and the knowledge spillovers do not necessarily correlate with the home market.
As was briefly mentioned in the introduction of this section, it is not only more complicated to communicate with the huge geographical and cultural differences, different time zones, costly visits, and digital communication, it also gets increasingly more difficult to correlate innovations with the manufacturing process. Therefore, the geographical distance between the two will result in a slow adoption of innovations since the time of transportation will delay R&D from making swift changes to a product. The proximity of R&D and the production facility could also be beneficial to the issue of Intellectual Property Rights (IPR). The risks of patents and IPR being infringed upon are much lower if the R&D department is close to the production location (Ludwig & Spiegel 2014: 47). More detail on this will follow later in this thesis when government’s regulations will be discussed.
The importance that agglomerations and clusters can have on reshoring should not be minimized. Note that within reshoring there is not that much attention for a company’s surroundings. The TCO calculator for instance measures the total costs within the company itself. It does not shed any light on the influence of clusters and neighboring companies. As opposed to location theory which has grown in popularity due to a focus on agglomerations and clusters.
33
want to add that this does not hold for all manufactured products. However, for those companies that are able to differentiate in their products to meet changing demands it offers a potential gain. With respect to reshoring the enormous distance between manufacturing locations and R&D facilities could draw progressively more manufacturers back to the U.S. When the products remains the same, and other factors are not integrated, it does not matter that much where a product is being made as long as the quality remains the same. At least as long as different factors like brand image are not taken into account.
Looking at products that are dependable on the degree of innovation, the location of R&D facilities should preferably be nearby the market in which it wants to sell its products. Companies have to cope adequately with the demands of consumers in order to sell products. The rapid reaction of the R&D department to the demands of consumers could be essential. However, this reaction takes lots of time if communication has to go across the Pacific first. In addition, the period of transportation adds up to the amount of time that it takes product innovations to be implemented.
Government
According to a survey by the MIT forum for Supply Chain Innovation the top five incentives offered by the U.S. government to attract companies are, in order of importance, corporate tax reduction, tax credits, R&D incentives, education & skill-related trainings and a better infrastructure (Simchi-Levi, 2012). I will give some attention to the tax policies and the effects these policies can have on companies that consider reshoring. Also in this section, there is no focus on the demand side of reshoring production to the U.S. I will highlight the instances which the shift of the production location could have an influence on the demand side.
34
of innovations of foreign owned enterprises. In the U.S., protection of IPR is much better safeguarded. Therefore, it is a factor within reshoring literature.
Governments have a broad influence so not all topics that governments touch upon will be discussed in this section. For instance, the educational and skill related issues are discussed in the section concerning labor and wage related issues. The type of infrastructure and the costs which are associated with transporting manufactured goods across the networks of infrastructure in both China and the U.S., will be discussed in this section. In addition, the direct attempts of the U.S. government to stimulate reshoring will be discussed.
Contrary to the welcoming approach of the U.S. towards businesses that consider reshoring, Chinese governments are putting progressively more pressure on big businesses. In general, the governmental involvement with (foreign) businesses in China is much greater than in the U.S. The scope of sectors in which Chinese local governments have a substantial say does not limit itself to customs, the approval of FDI and tax policies. Local governments in China have a big say in real estate, human resources and marketing of foreign businesses (Huang & Walton, 2012). Foreign businesses try to manage these relations. However, this will put constraints on the manufacturing process. Not only manufacturing is influenced, the Chinese bureaucracy also tends to put constraints on communication departments. Large foreign companies even devote a separate office to governmental affairs; this is quite costly.
Unlike the practice of reshoring, location theory mainly focuses on the tax regime of countries and the attraction of FDI (Feinberg, 2007: 4). In addition, location theory draws a lot of attention to the position of tax havens like Ireland, the Netherlands and the Cayman Islands.
35
suicides supposedly caused by heavy workloads can have a huge impact. This occurred in factories that made parts for Apple products and it caused wages to double in some of the manufacturing locations (Economist, 2013). The influence of the Chinese government will result in higher labor costs either way. On the one hand, companies can choose to minimize the workload or increase wages to avoid local governments stepping in, or it can neglect to do this and take the risks that governments step in and demand changes.
Rising labor costs in China are a focus point for reshoring. However, note that there is also an advantage of rising wages in China, even for American manufacturers. The differential consequences that firms attach to the deteriorating competitive advantage of China should be analyzed thoroughly, since there is the demand side of the economy as well. Therefore, it could be sensible to locate production facilities nearby upcoming markets. With wages rising, the demand for products are likely to increase. Moreover, the importance of these markets does not necessarily lie with the supply side. However, it could have advantages to the demand side. Both the concept of reshoring and location theory do not focus on these points.
It seems like the Chinese government is putting more severe constraints upon manufacturing locations which are owned by foreign companies. While this can be considered to be the practice of reshoring, it contradicts the rationale of location theorists who claim that governments will comply with the demands of businesses bringing in FDI. The governmental influence on foreign companies does not seem to be in decline. This gives companies which are considering reshoring, an extra reason to do so.
The U.S. government seems to embrace reshoring. Nevertheless, Harry Moser told me during an interview that the government is not getting into the fundamentals. One of his greatest concerns is the adequate training and education of a skilled workforce. He claims that the government only focuses on the direct attraction of more production facilities. In addition, he claims that the government of the U.S. is neglecting the long-term effects. If progressively more businesses relocate their manufacturing back to the U.S. the demand on the workforce will increase. Moser thinks that the government should influence the educational system in order to create a better match between employers and employees.
36
entire industry. Consequently, the company investing in innovative research is not being rewarded for its behavior and thus it is incentivized to reduce its investment in innovations (Fan, Gillan & Yu 2013: 211). Stronger intellectual property rights will spark investments since the company that puts in the effort will also reaps the fruits. There is a consistent line in company data that shows the link between a strong intellectual property rights regime, the attraction of FDI and the amounts spent on R&D (Ang, Cheng & Wu 2009: 11). Location theory does give some attention to the protection of intellectual property rights. For reshoring the degree of unionization, contract enforcement, trade policies and environmental regulations are important factors to the TCO. In annex 5, you will find a chart that shows the importance that firms attach to different drivers of the relocation of their businesses. The importance of a solid IPR regime to companies is clear. Innovative companies need a firm protection of IPR. The range of arguments in favor of reshoring is quiet large.
The elasticity between patenting and R&D in China is quiet low. This could indicate there is not much R&D happening within companies in China or that firms in China are less keen on requesting patents on innovative products (Hu & Jefferson 2009: 60). Another explanation could be that patenting laws are not functioning well and companies choose not to request IPR for that reason. Nevertheless, during the last decade China has grown to be one of the top information and high technology producers of the world. Especially in the high-tech sector, the importance of innovations and knowledge is highly important. Yang et al. conclude that innovation will be positively influenced in developing countries if the adherence and enforcement of IPR is getting stronger.
37
these is high as well. This increases the overall acceptance of this process and thus weakens the IPR regime in China. Especially for companies from the U.S that thrive on innovative research, the weak protection of patents can be costly.
Foreign-owned company’s apply for less patents than their Chinese counterparts do. The main reason is that the R&D offices are back in the U.S. and most of the patents are requested in the U.S. However, due to the fact that production facilities are located in China, the techniques and innovations are at risk, since the incentive of piracy is relatively high in China. This could give companies the incentive to locate the production facilities nearby the R&D facilities. The difficult position of patenting in China could have a stimulating effect on the number of companies that consider reshoring manufacturing.
Government officials even state that the lack of an effective IPR regime in China is one of the major drawbacks of manufacturing in China, according to companies. Reports on IPR infringements of U.S. companies in China are most common in the high-tech manufacturing sector. Even though some sectors appear to be untouched by the IPR infringements in China, U.S. companies reported to have lost $48 billion due to the IPR infringements. Most of these were copyright infringements or acts of piracy as I mentioned before. These infringements happened while U.S. companies invested $4.8 billion to counter IPR infringements in China (Okun et al. 2011: 14).
The lack of a effective IPR regime in China may be explained by the lack of experience of the Chinese. The U.S. have decades of experience with legal development and institution building supported by stable political and economic factors (Landry 2008: 2). Another factor I think might be of great importance is the foundation of the international IPR regime. This regime is mainly influenced by Western and Liberal ideals. Therefore, the U.S. were already equipped with an effective IPR regime, which provided a strong fundament for the international IPR regime of the WTO.
38
were met. Nevertheless, many advanced countries were worried about the enforcement of the IPR regime in China (Yang et all, 2011).
39
Transportation
When many U.S. firms decided to outsource manufacturing, the fuel prices were just a fraction of what they are nowadays. During the heydays of outsourcing and offshoring, around the turn of the century, the technological development in telecommunications and falling prices in transportation were a major draw for Western companies to relocate manufacturing facilities to China. Managers wanted to use the momentum of ‘’the death of distance’’ as it was called. Nowadays the tables have turned. ‘’Cheap labor’’ has evolved in an increasing cost post and transportation across the globe was getting more costly mainly due to rising fuel prices. The assumption of cheap transportation around the world had to be revised due to the rising cost of fuel and other sources of energy. If companies that are contemplating reshoring are calculating their cost, per-unit product the (increasing) cost of transportation will not be integrated.
In annex 6, the rising cost of fuel is visible, with exception to the downfall during the recession. Not only does it show an overall rise of costs. An increasing uncertainty of the fuel/oil market is making transportation an unreliable debit item. This makes it increasingly difficult for companies to get a grip on the amount of money it will take to transport products to the domestic market. Not only the aforementioned production side of importance. Firms with dynamic production and demand cycles lose much more by inventories stuck at the ocean for transport. Products, like electronic appliances, with a high level of demand variability can be subject to the rapidly changing wishes of customers. Therefore, the proximity of the production location can offer many advantages when it comes a quick reaction to the demand of customer. This argument is two-sided; on the one hand, R&D facilities can rapidly install product innovations, and on the other hand the time of transportation is brought to the minimum.
40
During the heydays of offshoring it was possible for companies to ship products and communicate overseas for relatively low cost (Kahai, Tejinder & Kahai, 2011: 117). However, this does not have to mean that relocating manufacturing overseas is the most beneficial option for every company. We mentioned the danger of bandwagoning before, the process in which decision takers are overshadowed by the momentum of, in this case offshoring, and thereby do not see the possible dangers anymore. This factor is more psychological than economic. However, it is taken up within reshoring as well. Whereas location theory solely focuses on economic factors, it claims that decision makers should make their decision based on these economic factors. However, it is plausible that there will always be space for some degree of imperfect information. Therefore, I believe it makes an economic approach sounder if it has tools to moderate the problems that might occur in the world of business itself but are hardly to be seen in the theories surrounding the practice of business decisions.
Market size/new markets
An important aspect that relates to the previous section on PR-related issues is the size, demand and the potential of the home market. For those products that are in high demand in the home market, it seems more sensible to reshore the manufacturing. Similar to location theory the proximity to consumers is an important factor. Firms can only reap the fruits of reshoring if most of the demand is in the market where manufacturing is located. We have learned that R&D facilities should be located in the region where most of the sales of the firm are originating. If this is the case for manufacturing as well, intra firm communication and coordination benefits greatly. As I did with other factors, we should examine the possibilities for future demands too. If the proportion of ‘’foreign’’ demands in new and upcoming markets is expected to rise the costs for transportation to these markets and the advantage of R&D-manufacturing proximity is partly lost.
Location theory acknowledges the strong influence of market sizes on industrial locations. Early theorists put a firm belief in the proximity of the consumer base. Of course, this has to do with the developments in transportation.
