Brexit, TPP, NAFTA’s evolution, China’s Belt & Road initiative (and others) are disrupting traditional WTO-based trading and offer opportunities. Both manufacturers and companies that rely on them (e.g. Apple) need to adjust to an emerging environment of volatile tariffs and non-tariff trade barriers. Along with the disruption of existing arrangements, there will be new market opportunities and supply networks to tap into, with room to build new relationships.
Manufacturing strategy is about more than cost!
Manufacturing Strategy is about what you build (versus buy), and where and how you build. In making these choices, companies must balance cost; quality; delivery speed and accuracy; and flexibility. By “flexibility” , we mean the ability to withstand exchange rate fluctuations, changes in shipping rates,operations disruptions, and changing tariffs/ non-tariff trade barriers.
Where you build can have huge implications for flexibility: choices about your manufacturing footprint (such as scale, number, location, concentration of factories) affect your ability to withstand changes in the trading environment. In particular, manufacturers with global markets may find it worthwhile to maintain production capability within multiple trading blocs, to offset the risk of higher costs or trade disruptions between blocs. Greater complexity in a set of manufacturing plants, however, can increase costs as well as reduce delivery speed & accuracy. A coherent manufacturing strategy balances these competing goals and empowers the business strategy.
In addition to focusing on independently minimizing costs at each factory, manufacturers need to start managing their manufacturing plants as a network, accepting higher costs at some in order to achieve lower production cost for the entire network, over a range of potential trade and demand scenarios. This is key to achieving manufacturing flexibility in a world of volatile trading relations.
As we’ve discussed in prior posts (https://eos-consultingllc.com/blog-entries ) , global trade relations are in flux. Long-established trade flows are being disrupted, and more disruptions threaten (e.g., BREXIT). A coherent manufacturing strategy will be critical to navigating these troubled waters.
The EU is leading a broad expansion and modernization of its already extensive PTA network with recent agreements with Vietnam, Canada, Japan and maybe soon, Argentina, Brazil, Paraguay and Uruguay (Mercosur), among the most prominent. The EU appears to be trying to build a “proprietary trading bloc” to advantage members and disadvantage outsiders. In such a trading arrangement, the bloc is dominated by a leading member, and can be used in mercantilist contests against other major economies.
Similarly, Japan has played an influential role in the revival of TPP after the U.S. withdrawal. With just the suspension of a few provisions, the TPP, presently renamed the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), will be marked this month by every one of the original 12 countries excluding the U.S. It will deliver de facto 18 new PTAs between CPTPP members — but will be dominated by the Japanese economy.
In addition to these moves by the EU and Japan, China has launched the Belt and Road Initiative (BRI), an ambitious project to improve Chinese-led regional economic integration and connectivity on a transcontinental scale. It is above and beyond typical PTAs. It includes “hard” infrastructure along six overland corridors, and the 21st Century Maritime Silk Road; “soft” infrastructure, such as the financial system, to enhance efficiency and facilitate economic flows; and policy reforms and institution-building to promote trade and foreign direct investment among the BRI countries.
Racing to keep up, other regions are also actively engaged. African countries will be signing the Continental Free Trade Agreement (CFTA) next March, expanding on the regional economic communities to liberalise trade. And in Latin America, there is an extraordinary fervor around the potential Mercosur-EU agreement and the continued strengthening of the Pacific Alliance, encompassing Colombia, Chile, Mexico and Peru, who are now negotiating “associate membership” with Australia, Canada, New Zealand and Singapore.
On a global basis, the resulting overlapping layers of trading arrangements greatly increase the complexity of production planning (among other operations) for companies operating across multiple trading blocs. And while trade within each bloc may grow, trade across proprietary trading blocs may suffer — especially if it threatens the interests of the dominant member.
For companies whose supply chains and/or production networks span trading blocs, now may be a good time to revisit your strategy (especially production strategy) as the right level of flexibility may be the key to profitability (and competitive advantage).
Richard Baldwin, President of the Centre for Economic Policy Research, has argued that “regional trade liberalisation [is sweeping] the globe like wildfire”. Preferential trade agreements (PTAs) have increased from 20 in 1990 to close to 300 today. This has become a key feature of the international trade policy landscape. The data show that Mr. Baldwin was right.
Every country in the world is party to at least one PTA, with Mongolia the last to join the pack when it signed a deal with Japan in 2016. But Brexit, the U.S. withdrawal from the Trans-Pacific Partnership (TPP), and the renegotiation of the North American Free Trade.
Agreement (NAFTA) have all been disruptive for the world trade system. These PTAs are pursued by governments in hopes they will increase productivity and benefit consumers, promote economic policy reform, underpin supply chains, and benefit regional peace and security. By boosting trade among members (at the expense of non-members) they can have positive effects on growth. But they complicate trading operations, since they add an additional overlay on top of existing trade regimes.
Back in 2016, negotiations on the TPP, encompassing the U.S., Japan and 10 other countries in the Americas and the Asia Pacific region, and on the Trade and Investment Trans-Atlantic Partnership (TTIP) between the U.S. and the European Union, was all over the headlines. These agreements covered a significant percentage of total global trade.
By 2018, the situation had dramatically changed. The U.S. withdrew from TPP, suspended TTIP negotiations, launched the renegotiation of NAFTA and initiated the revision of some specific commitments of the Korea-U.S. PTA. Meanwhile, the TPP moved on — but without the U.S., dramatically shrinking its scope.
The UK post-Brexit repositioning requires undoing a very deep trade integration scheme with the EU and agreeing on new rules of engagement for a future economic partnership, while replicating or renegotiating some 40-odd PTAs that came with EU membership – not a small task. The UK is likely to deepen trade ties with the U.S. as a hedge.
As PTAs and regional agreements overtake globe-spanning trade regimes (the WTO), companies with multinational operations must begin to build into their operations more robustness to changing trade regimes.
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Uncertainty about the future of the global economy has roiled stock markets in recent weeks (not to mention the operations of global companies), but what’s scheduled to hit in March could be worse than anything we’ve seen so far.
To start, a last minute reprieve just extended what was supposed to be a March 1 deadline in the trade war between the U.S. and China. If negotiations falter, the U.S. is planning to raise tariffs on $200 billion in Chinese imports to 25% from 10%, and China is expected to retaliate. U.S. administration officials have specified targets to be addressed, including fixing broad, longstanding problems with the Chinese economy, like its dependence on intellectual-property theft and government subsidies. As we saw with Kim Jong Un in Vietnam, the U.S. is prepared to walk away from negotiations which are not proceeding satisfactorily.
Also in March, the United Kingdom will be lurching towards the March 29 deadline to officially exit the European Union. It’s unsure whether members of parliament will approve the proposed terms, and if not, a “no deal” Brexit will be extremely disruptive. Uncertainty over the mechanisms by which the deadline might be extended will force many companies to plan for a hard Brexit.
In a worst case scenario, “markets will likely fall substantially, corporations could lay off workers and cease investing in expansion, and consumers may end up paying for both of these,” says Sam Natapoff, a former official with the U.S. Department of Commerce and New York state trade advisor.
Overall, U.S., China, and the EU are the largest economies by gross domestic product in the world; any hit to trade in any of them is going to have global repercussions.
Companies often want to know how they compare to their peers, especially when they suspect they are leading or lagging. For example, perhaps you want to know how your performance metrics compare to others’ in the industry — if yours are better than the industry norm, then you might infer you are doing things better; if worse, you might use that as internal motivation for improvement.
As an example, consider margins. Margins are a function of price paid by the customer (after all adjustments, rebates, discounts, etc. are taken into account), and the cost to produce (including overheads and cost of capital / depreciation). There are some challenges to building a set of margin data to compare to, beginning with estimating margins in the first place:
Actual price paid is surprisingly difficult to estimate, even for many companies themselves (especially those which rely on “back end money” for sales incentives) — and estimating realized prices for other companies is virtually impossible.
Actual cost to produce is also difficult to estimate for other companies (although relative costs can be estimated, with enough effort).
Margin estimates are further complicated by who pays shipping and duties — and this often varies by customer and market.
Consequently, most industry margin estimates delivered by analysts, academics or consultants are developed from aggregate financial data (as reported by public companies, at least) for companies “in the same industry.” That way, one needn’t know anything about companies’ pricing cascades, just how it all nets out. Yet SIC classes are known to be notoriously unreliable for grouping like-with-like, casting into doubt whether most groupings are actually representative of the industry in question; and there are considerable challenges in using aggregate financial data:
If you use total operating margins (for example), you have abstracted away from needing to understand competitors’ price cascades; but you don’t know what is “in” the reported operating margin. Companies report very differently (even in compliance with GAAP), and they often have good reasons to bias their reported metrics in one way or another (bonus metrics, for example).
Not only must different companies’ reporting be harmonized (usually by the reporting service, and in ways you may not agree with or even discover), but that aggregate number rolls up:
Customer types and sizes — yet customer mix varies between companies, even those in the same industry.
Product types — different types of products carry different margins, and product mix generally varies across companies in the same space.
Business models — some companies price the hardware for less, then make their margins on services and/or parts; if you look at operating margins for products only, you may be misled; yet if you look at margins in total, you may be including unrelated businesses, because…
Lines of business — firms (especially larger ones) rarely operate in the same set of businesses as all their peers — and many companies do not break out detailed metrics by line of business.
Controlling for all these factors is very difficult (if not impossible) across the broad range of companies which would be required to establish benchmarks for an “industry norm.” And the more narrowly one defines the industry, the less likely metrics are available.
So, what can you do? Pick a small number of key competitors and develop estimates for them based on a combination of their reported financials and targeted research into their particular margin drivers (product mix, customer mix, business models, etc.). This won’t be an industry benchmark (because you haven’t surveyed the industry) but it will tell you what you really need to know — which is how you might differ from key competitors. Developing this information will require some work and informed business judgment; it won’t be available in someone’s database.
Most important, if you are comparing your performance metrics to others’, you need to understand — and adjust for — how the drivers of those metrics differ between your business and theirs. Only then can you infer (for example) that your operations or pricing are better or worse than others’.
US-China trade tensions are mounting, with fears of a trade war roiling markets. Yet so far, tariffs have mostly been threatened but not yet imposed, except for some US steel, aluminum, and solar panel tariffs. It’s reminiscent of the “Phoney War” of the late 1930s, when things quieted down for awhile after the Nazi invasion of Poland.
Just as the “Phoney War” presaged major action, the current US-China trade posturing is likely to end in real and significant changes in the US-China trade relationship. In particular, US imports of Chinese industrial goods and finished products are likely to be affected — perhaps by “voluntary” export restraints similar to those the Reagan Administration negotiated with Japan. In addition, restrictions are likely to affect Chinese investment in American companies working in sensitive technologies such as AI, robotics, aircraft design, etc.
Overall, the effect will be to somewhat constrain American sourcing from Chinese companies — regardless of where they are located.
In combination with China’s eroding cost advantages, this means American companies currently sourcing from China and/or Chinese companies may need to diversify their supply bases with additional sources of cost-advantaged production. One promising option is India. Already a global source for IT services, India is rapidly building manufacturing capability. Chinese companies themselves, as they lose their cost advantages to higher labor costs, are themselves outsourcing to India, as well as Southeast Asian countries. Yet among the “MITI-V” (Malaysia, India, Thailand, Indonesia, and Vietnam), India may be the most promising candidate to be the next “factory for the world.” India has five relative advantages in the MITI-V group: massive scale; an English-speaking workforce; a proven ability to work with non-domestic customers; improving infrastructure; and a government enthusiastically pursuing industrial development (just as China’s did).
Forward-thinking leaders should be exploring supply base diversification, and considering India.
