Strategy

Sighted: The ends of the Earth

Rethinking globalization as the Thai floods affect Canada.

Fire engulfs a Japanese oil refinery following the March 2011 earthquake. (Photo: European Photopress Agency)

The monsoon season in Thailand typically runs from June to October, but this year the rains have exacted an unusually frightening toll. Starting in late July, floodwaters swamped large swaths of the Southeast Asian country, leaving hundreds of people dead and hundreds of thousands homeless.

The ramifications of the flooding are being felt far beyond Thailand’s borders and in the boardrooms of global business. Industrial parks that once cranked out semiconductors for companies like Texas Instruments, Apple and Samsung are now under water and crawling with crocodiles. Thailand produces almost 45% of the world’s computer hard drives, but that’s come to a halt as manufacturers like Toshiba and Western Digital contemplate waterlogged plants.

It’s the second natural disaster to hit global supply chains this year, after Japan’s earthquake and tsunami in March. Honda had to cut its car production in the U.S. and Canada by half for two weeks in October and November thanks to a parts shortage caused by the Thai floods. The company reported its operating profit nosedived 68% in the second quarter thanks to manufacturing interruptions due to the disasters in both Japan and Thailand. Toyota has also cut production in North America. It blamed the Japanese earthquake when its quarterly profit slid 18.5%.

Meanwhile, rising wages, increased shipping costs and land prices in China have slashed that country’s cost advantages for western manufacturers. Between 1999 and 2006, average wages in China went up 150%, and they continue to rise at an annual clip of 15% to 20% at the average Chinese factory. Last year, a strike at a Honda supplier’s plant resulted in a 47% wage increase. Foxconn, the giant electronics manufacturer that supplies Apple, Sony and other multinationals, doubled wages at its Shenzhen facility after a string of worker suicides.

With headaches like natural disasters, rising wages in China, and a financial domino effect gripping economies around the world—not to mention recession-induced protectionism like U.S. President Barack Obama’s jobs bills with their Buy American clauses—have we reached the limits of the global integration that has propelled the world economy since the end of the Cold War? Has globalization as we know it peaked?

Joy Nott, executive director of IE Canada, the national association of importers and exporters, remembers when just-in-time manufacturing was something the auto industry was just testing. Almost 30 years later, the practice of timing the arrival of inputs from suppliers to cut down or eliminate excess inventory has become the norm. “Just-in-time became the model to have, whether you were talking cars or shoelaces,” says Nott. “You didn’t want your supplies until 10 seconds before you needed it, but when you needed it, it had to be there.”

The first major challenge for the practice was 9/11. In the immediate aftermath of the terrorist attacks, when the U.S. closed its borders, many companies were forced to slow down or halt production. “Just-in-time is a valid supply-chain strategy on paper,” says Nott. “But life, with its flat tires, tsunamis and labour strikes, is not a PowerPoint slide.”

There are also signs that many companies are looking at the risks and costs involved in outsourcing and deciding that it might just be better to stay home. The Coleman Co. announced earlier this year that it’s moving production of one of its 16-quart wheeled plastic coolers from China to a factory in Wichita, Kan. Martin Franklin, CEO of Coleman’s parent, Jarden Corp., told the Wichita Eagle that he sees the end of the 30-year, one-way outflow of manufacturing from the U.S. to China. The cost-benefit calculation has changed enough for the company to bring production of some goods from China back to North America, he said. In addition to coolers, the company has brought production of its First Alert safety devices and Miken carbon-fibre baseball bats stateside.

A recent study by the Boston Consulting Group concluded that within the next five years, the total cost of production in many coastal Chinese cities will only be 10% to 15% less than in some parts of the U.S. The same study points to an emerging gulf in commercial real estate costs. China’s national average is US$10.22 per square foot of industrial space, while in states like Tennessee and North Carolina it ranges from $1.30 to $4.65. Add to that requirements in Obama’s jobs bills that all iron, steel and manufactured goods used in public buildings or public works be supplied by U.S. firms. A similar provision was included in the 2009 U.S. stimulus bill, specifying that U.S.-made steel and other manufactured goods were favoured in government-funded building projects.

Saibal Ray, a management professor at McGill University, says one of the biggest issues facing supply chains today is risk management. “Most companies are now looking at total landed cost instead of just production cost,” he says. “Your manufacturing cost could be very cheap, but with all the risks along the way, whether fuel prices or natural disasters, it might not make sense for your business to source something in Asia and ship it back here.”

But while the reaction to all these relatively recent developments may appear to be a recipe for economic contraction—a return to the protected national economies of old—it’s acting as an illusion, obscuring the real seismic shifts in global business. We’re not cutting ties, but actually becoming more interconnected. Supply chains are in fact getting longer. These changes are just the market’s way of getting better at globalization, not ­running away from it.

China’s rising wages may be making production more expensive, but decades of supplying the West with manufactured goods has also nurtured a Chinese middle class that wants to buy those baubles for itself. The United Nations Population Division and Goldman Sachs recently reported that by 2030 China would have about 1.4 ­billion members of what the World Bank defines as the middle class, compared to 365 million in the U.S. and 414 million in western Europe.

About 300 million Chinese consumers now have more disposable income than a decade ago, and western companies want a part of it. Of Nike’s 2010 earnings, 60% came from emerging markets, mostly in Asia. Coca-Cola now gets 70% of its revenues from outside of the U.S. “Originally, China was primarily a sourcing location,” says Ray. “But now it’s become the other way around. Even if China has become more expensive to produce within, companies cannot leave because they want to sell in China.”

That said, the days of China being the default for any North American company looking to outsource are over. Plenty of firms have shifted production of clothing and other products not requiring skilled labour to cheaper locations like Vietnam and Sri Lanka. Others that have moved or are considering moving some production back to North America are also keeping operations in Asia to tap that market. Last year, technology manufacturer NCR moved production of some of its automatic teller machines to a factory outside of Atlanta. But it still maintains factories in China and Hungary to handle those regions.

University of Laval management professor Yan Cimon says we’ve reached a stage where business must make a choice between optimization and robustness. “We’ve always had this fantasy of the optimal supply chain where everything arrives on time and properly built, but we have to accept and allow for more robustness,” he says. “Things like strategically designed inefficiencies where you carry more inventory to ensure more precise delivery windows. The trade-off between the two is difficult to achieve.”

The 787 Dreamliner debacle is a prime example. Billions of dollars over budget and years late, Boeing’s newest airplane was originally supposed to be a shining example of global efficiency. The company tapped suppliers from a collection of countries such as China, Italy, South Korea and Sweden, boosting the 787’s foreign content to 30%, more than any other Boeing plane. But when the parts and components began arriving at Boeing’s Seattle plant for assembly, the paper-perfect plan fell apart. Parts didn’t fit, suppliers couldn’t meet quotas and the whole operation was jammed up with delays. Boeing even spent about US$1 billion to take over its underperforming fuselage supplier, to make sure the job was done right. Company executives have since acknowledged that their aggressive outsourcing lacked the requisite communication between suppliers and management. Boeing commercial aviation chief Jim Albaugh told a group of Seattle students earlier this year that the company didn’t provide the necessary oversight. “In hindsight, we spent a lot more money in trying to recover than we ever would have spent if we tried to keep many of the key technologies closer to Boeing. The pendulum swung too far.”

Cimon says that companies are realizing how important it is, as supply chains continue to grow longer and more complicated, to closely monitor suppliers and keep in constant communication, and also keep suppliers in contact with each other, to reduce the risk of disruption. “The network model, in which suppliers are in contact with one another, is increasingly popular as managers and businesses realize they are more interdependent than they think,” he says.

Diversified supply chains also help protect against unpredictable threats like floods and ­tsunamis. IE Canada’s Nott says smart companies have their supply-chain contingency plans up and running instead of collecting dust on the shelf. That has meant complementing just-in-time production with carrying more inventory and locating auxiliary production closer to home—whether in North America or “near-shoring” (as opposed to offshoring) in places like Brazil, Argentina, Mexico or Chile (the latter two being attractive to Canadian firms thanks to existing free trade agreements).

Hal Sirkin, senior partner at the Boston Consulting Group, says globalization isn’t a linear path of either/or. Depending on the size of the business and type of product, sometimes it makes sense to outsource to China and sometimes it doesn’t. “When wages were really low in China, it made sense to make just about everything there,” says Sirkin. “Which of course caused wages to go up, and that causes a rebalancing to take place. We’re going to see that happening more and more, where the economics change. It’s part of the ­evolution of the developing world, the development of China, that the economics will change as they get wealthier.”

As a result, the ties that bind international business, supply chains and economies will only get more intertwined. “Rather than supply-driven it’s becoming more market- or demand-driven,” says Ray. “Globalization is here to stay, but it’s becoming more diverse and nuanced.”