Contract manufacturers in China and other parts of the world (mostly Asia, but also some parts of Eastern Europe) have thrived because of an abundant supply of labor, assured supplies of electricity and transportation links.
However, as anyone with even a passing interest in global trade knows, labor costs are not static. In the beginning, they attract industry and manufacturers, but their very success attracts others to that area, driving up demand and in turn, costs. This is applicable to IT outsourcing to India (where, some estimate that in the next years wage parity will be achieved with the West) and it is applicable to contract manufacturers in China.
The WSJ ran an article (paywall) yesterday about Foxconn, the famous maker of Apple devices and provider of 1.4 million jobs, freezing new hiring after the Chinese New Year.
On the surface, Foxconn ascribes this to a much higher number of “returnees” (which in itself is interesting…so not all the workers that leave for the holiday come back to their old job? ha!) obviating the need for new hiring. It also denies what was reported in The Financial Times earlier this week:
Mr. Woo denied that the move was related to customer orders. The Financial Times reported on Wednesday that Foxconn had instituted the freeze in response to reduced orders for Apple’s iPhone 5. Apple representatives didn’t immediately respond to requests for comment.
But as the article says, while this sounds like a one-off, there could be other stronger and longer-term forces at work here, mostly to do with costs, supply, demand and a maturing business:
It also is contending with other labor challenges that China-based manufacturers face, including rising wages and increased competition in recruiting workers. Over the longer term, Foxconn has said it will pursue greater automation of its production line, which could stem employment growth.
To be sure, Foxconn is still growing and is extremely profitable. But the rate of growth is slowing. For the next year or two, I doubt if this really means much…but beyond that, I think that its competitive advantage stemming solely from what economists would call “labor arbitrage” will diminish some more and that sets the stage for Foxconn making and selling its own brands.
What does it get by making and selling its own brands? Aside from nice sounding things like freedom and control over its destiny, it gets to capture a lot more of the value created by its products.
Today, as many say, the cost of labor for each iPhone = Foxconn’s revenue for each iPhone, is between $12.50 and $30. If materials cost another $200 or so, and Apple sells each iPhone for $600 (unsubsidized carrier buying price), Apple captures more than 50% of the total selling price. Foxconn? 2 to 5%. Wouldn’t Foxconn want to be more like Apple?
Other companies out of Asia have successfully made this transition, with HTC being the most famous (in my mind) contract manufacturer (also headquartered in Taiwan, like Foxconn) that made the transition. As HTC’s own site says,
Founded in 1997, HTC built its reputation as the behind-the-scenes designer and manufacturer of many of the most popular OEM-branded mobile devices on the market. Since 2006, we have regularly introduced many critically-acclaimed mobile devices under our own brand, and our portfolio includes smartphones and tablets powered by the Android and Windows Phone operating systems.
Despite HTC’s recent stumbles, it remains a potent force in the SmartPhone industry globally. Similarly, Haier, from China, is another example. Its branded refrigerators, for example, have made some inroads into the budget refrigerator market abroad. The key to their success though hinges on innovation and marketing/brand building…Again, HTC has done both quite well and others will want to emulate it.
So, in summary, will Foxconn take the plunge and move up the value chain, eliminating its profits’ dependence on labor cost arbitrage alone? I say, yes. In 5 years, if not 10, it will get there. It must.