Foxconn Hiring Freeze – Eventual Prelude To Launching Own Brands?

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. 

Reputation Risk, Wal-Mart, Apple and Supplier Policing

A November 2012 factory fire in Bangladesh killed more than one hundred people. It was also the latest one, in a number of fires to have ravaged textile factories there.

After the tragedy, clothes with western brands were found in the factory’s premises. One of the brands was Wal-Mart. But as it later turned out, the factory was not supposed to be making clothes for Wal-Mart.

So why was it still doing that? Welcome to the murky and complex world of contracting, sub-contracting and sub-sub-contracting.

Once a pair of jeans is outsourced to a key supplier that follows every one of Wal-Mart’s rules, that company may in turn sub-contract all or part of the jeans to someone else, who may in turn further sub-contract out some parts to a 3rd company. The challenge, of course, is, how will Wal-Mart police the 2nd and 3rd companies? At what point do the costs of oversight outweigh the cost advantage of outsourcing?

The problem for Wal-Mart is that, in terms of “reputation risk“, Wal-Mart has just too much to lose from turning a blind eye to suppliers violating its existing and published rules and policies.

So in an effort to mitigate this risk (and perhaps eliminate it altogether…if such a thing is even possible), Wal-Mart is instituting a few rules and a “zero tolerance policy” (WSJ article, behind paywall) effective March 1 for its global network of suppliers, some of which are excerpted from the WSJ article below:

• Starting March 1, Wal-Mart will employ a “zero tolerance” policy to sever ties with suppliers that subcontract work to factories without the retailer’s knowledge
• All facilities in Bangladesh must undergo a mandatory electrical and building safety review
• Factories found to have fire-safety related violations have 30 days to take corrective action before being terminated, instead of the previous requirement of six months to a year; all floors and buildings must have a secondary exit, preferably an external fire escape route

Obviously there is a cost associated with complying with these rules – both for Wal-Mart and the suppliers. But in the interest of human safety and ethics, one hopes that these rules are effective.

Before I end this post though, let me talk about Apple’s own recently disclosed problems with its suppliers. 

Just last week, word got out that Apple (thanks to its own stepped-up audits under Tim Cook(?)) discovered underage workers working in some of its suppliers’ factories, despite clear policies against it.

Again, what explains this? “Five star” showcase facilities and “shadow” factories, per an article on Qz.com:

The deal is that when a Western buyer takes business to a new factory, the boss will show off a facility where staff who seem happy with their lot are working 7-10 hour days with decent meal breaks. That is the five-star factory. And some multinationals may stop their audits right there.

These expensive showcase factories in turn sub-contract to others that are not “burdened” by the same standards and policies.

In reality, Apple found 74 child laborers in its suppliers factories (which means that there could, in theory, be more kids working in these factories) which doesn’t sound like much.

But it certainly highlights the problems Apple, Wal-Mart et al are having (and will likely continue to have) with policing their suppliers in far-flung places. One hopes that increased scrutiny results in better working conditions, even if consumers have to pay $1 more for each pair of jeans or $10 more for each iPad.

Outsourcing, Technology or Bad Luck – What’s Behind Boeing’s Dreamliner Woes?

The Boeing Dreamliner has many good things going for it. It is lighter, can travel long distances, is cheaper to operate (by 30%?), passengers are more comfortable, etc. Part of the weight reduction comes from not just cutting-edge composites in the fuselage and the body but also a bunch of innovations with electronics and associated systems to replace legacy hydraulics and pneumatics. 

A small part of that reduction in weight comes from using lithium-ion batteries, which are unfortunately prone to overheat and catch fire – which is what happened recently and grounded the entire Dreamliner fleet the world over. Before delving into that, let us take a small detour to see why the Dreamliner is such a strategic bet by Boeing on the future of flying and aviation. 

Airbus, Boeing’s principal competitor, thinks that the future of airlines and flying is a hub-and-spoke model. Gigantic aircraft fly between major population centers and airline hubs. Those hubs then ferry passengers to their final destinations on smaller planes. Its Airbus A380 is designed to ferry passengers between these mega hubs. 

Boeing on the other hand thinks that passengers will prefer flying from point A to point B and avoid the current hub-and-spoke model. So its 787 Dreamliner is designed to carry a lot of people efficiently and comfortably from one point to another that is up to 7000 miles away:

That means it (the Dreamliner) can fly nonstop routes that larger planes can’t profitably support, such as San Francisco to Manchester, England or Boston to Athens, Greece…“It’s going to be a hub-avoiding machine,” said Ernie Arvai, partner with aviation consulting firm AirInsight. “You’d pay extra not to go to (London’s) Heathrow.”

What this means is that both Boeing and Airbus have a lot riding on (in?) the 787 and the A380, respectively.

In 2011, Boeing was quite happy when, after numerous delays, the first Dreamliner was delivered to ANA (All Nippon Airways). The first commercial flight from Tokyo to Hong Kong on Oct 26, 2011 was deemed “Spectacular“. Most maiden Dreamliner flights for different airlines around the world had been garnering similar attention and praise. Ironically it was an emergency landing for an ANA Dreamliner (because of the lithium-ion battery catching fire) that triggered the current crisis, following, as it did, a battery unit catching fire in a parked Japan Airlines Dreamliner just a few days before that.

The subsequent grounding of the 787s is not good for either Boeing or various global airlines that must now use less efficient, older and more expensive (to operate) aircraft on the Dreamliner’s routes:

a. Boeing’s reputation (and the Dreamliner’s) takes a (big?) hit. So far, it hasn’t seen any massive cancellations hitting its order book, but the longer the FAA investigation and probe goes on, the higher the probability that customers balk at taking delivery of more such planes.

b. Airlines are going to lose some money, though it is possible that they may seek compensation from Boeing:

Mann estimates that airlines flying the Dreamliner will lose $2.5 million per aircraft for every month the model is out of service. ANA, which has the largest 787 fleet, with 17 currently in service, will be more severely affected. Here’s one projection, courtesy Reuters: ”Keeping the 787s on the ground could cost ANA alone more than $1.1 million a day, Mizuho Securities calculated, noting the Dreamliner was key to the airline’s growth strategy.”

Naturally, inquisitive minds want to know how Boeing and the Dreamliner got to this point. 

The three leading theories are:

a) Technology - The lightweight lithium-ion batteries used in the Dreamliners have a tendency to overheat and catch fire. But why did they use these batteries and not, say, Nickel-Cadmiums or others? Simple. Weight.

But then again, so many technologies in use by mankind today are safe only under very specific operating conditions. So as long as Boeing took adequate measures to assure that the batteries wouldn’t overheat, it would have been in the clear. Unfortunately for Boeing, that does not seem to be the case.

The latest here is that America’s FAA and Japan’s officials are pursuing slightly divergent investigative paths (while cooperating with each other though)

One facet of the effort led by experts from Tokyo appears to concentrate heavily on potential problems with the batteries themselves, while their counterparts in the U.S. seem more centered on possible hazards stemming from the manner in which the batteries interact with the plane’s novel electric grid.

It might take a while (or not) for the investigations to conclude, for the “root cause” to be identified and fixed. What must be frustrating is that in the 1.3 million hours of test flying, Boeing did not see (page 1, last paragraph) this problem even once. 

b) Outsourcing – An important sidebar for the lithium-ion technology discussion from above is that these batteries, the systems that charge the batteries and various other parts of the Dreamliner are made by a staggering array of globally dispersed suppliers.

According a CNN article, 45 companies supply the major parts and more than 100 supply the smaller ones, including the electronics. Sliced another way, 70% of the planes parts come from American suppliers and 30% from global suppliers. Now, one such supplier, the Japanese company “GS Yuasa” is under the microscope because it made the fire-catching batteries.

And this is where the outsourcing argument comes in. Those that blame aggressive and excessive outsourcing argue that while outsourcing may result in labor-cost savings in the short-term, in the long-term, outsourcing causes cost overruns, loss of design expertise and problems with quality. 

Links to various articles blaming outsourcing here, here, here (widely quoted LA Times article) and here. 

Those arguments certainly sound plausible…but it is rather difficult to blame outsourcing (only?) as the culprit. The nature of the airline industry over the last 10 – 15 years is such that global supply chains are the rule, not the exception. Suppliers in this industry include many venerable names with deep experience and expertise. Consider GS Yuasa. The company is no greenhorn. It is a 100+ year old company that has been in the battery making business for a long time (though Lithium-Ion batteries are relatively new for it). And Japanese companies in every vertical are known the world over for their QA/QC processes. 

What we can expect for sure is Boeing conducting a rigorous and thorough investigation into the outsourcing angle – not just because of the hundreds of unfulfilled Dreamliner orders but also because its operating model is at risk here. 

c) Bad Luck - Luck of course has a lot to do with this and at the same time very little to do with this. More than anything else, the timing is bad. New planes also experience many teething issues and the Dreamliner is no different…So while it still looks like Boeing has a hit on its hands with the Dreamliner, this is the kind of publicity that lingers in the public mind long after the underlying issues have long disappeared. 

If there is one thing Boeing must be happy about today, it must be diversification. Boeing’s 737 and 777 lines are “printing money” and it can’t make these planes fast enough to meet demand. Still, with its reputation, future sales and jobs at risk, it must be waiting for Dreamliners around the world to spend more time in the air and less time in their hangars. 

“Fresh” Orange Juice and Industrial Supply Chains

When is “fresh squeezed” Orange Juice not very fresh?

When the big juice companies

pasteurize, de-oil, and then strip the oxygen from their OJ before chilling it to 32°F and pumping it into million-gallon, refrigerated, epoxy resin-lined, carbon steel, aseptic storage tanks.


Then,

it often sits for as long as a year, from processing season to processing season, before being rejuvenated with the addition of specially formulated flavor packs (to ensure each brand maintains its own trademark taste), and shipped to a distribution center in Jersey City on the refrigerated box cars of the CSX “juice express

Anyway, this is not a comment about the quality of the juice or its “freshness”. Instead, it goes to illustrate the highly industrialized nature of our food supply chains. 

In the 19th century, something like this would have been unheard of.

Instead, most “perishable” foods in the US such as juices, vegetables, fruits, meat, etc., would have been consumed locally and/or quickly for the most part. Therefore it is likely that demand and supply were not evenly matched and “surplus” food (a lot of it?) would have probably decayed or have been processed into jams and such that of course couldn’t recreate the “fresh” experience.

But with advances and innovations in cooling technology, the rise of refrigerated marine shipping containers, refrigerated rail cars (cited above) and refrigerated trucking containers, most developed countries and increasingly, developing countries, are able to enjoy fresh, non-seasonal foods on a year-round basis.

Purists complain that all of this cold storage and transportation and the use of chemicals diminishes taste, at a minimum, and could cause health issues too. Sure, there is truth in this. But again, many consumers probably don’t care. Those that do either eat seasonal foods and/or minimally processed, “fresher” foods that endow those supplying those, such as Whole Foods, with pricing power. 

And so it goes.

A fascinating article about the cold-storage-supply-chains that have created entire (non-local) markets for different foods across the world (I excerpted from it, above) makes for an interesting read. [And tip of the hat to AndrewSullivan.com where I learnt about this article this morning.]

China, Comparative Advantage and Moving Up The Value Chain

The concept of Comparative Advantage helped China become the world’s manufacturing hub, but the very same thing and an evolving world may be biting parts of China – and may presumably bite its other parts in the not too distant future.

So first, what does this mean? 

In simple terms, it means that each country or region should produce, manufacture or create what it can do most “efficiently” (so using the least amount of raw materials or inputs).

In more rigorous economic terms, from an MIT article,

David Ricardo’s concept of “comparative advantage” is one of the most famous and venerable ideas in economics. Dating to 1817, Ricardo’s proposal is that countries will specialize in making the goods they can produce most efficiently — their areas of comparative advantage — and trade for goods they make less well, rather than making all kinds of products for themselves.

As a thought example, Ricardo proposed, consider cloth and wine production in England and Portugal. If English manufacturers are relatively better at making cloth than wine, and Portugal can produce wine more cheaply than England can, the two countries will specialize: England will concentrate on making cloth, Portugal will focus on making wine, and they will trade for the products they do not produce domestically. 

For the last couple of decades, as many erstwhile manufacturing hubs in the US realized, China was a prime illustration of this principle (in addition to companies’ greed, as some would argue) in action.

Because labor in China was cheap, substantially more so (anywhere from 60 to 90% cheaper than in the U.S.), many low skilled jobs and some moderately skilled ones too, migrated to China. Entire factories sprung up to make everything from toys to phones to American flags.

Now there is growing evidence that parts of China are beginning to see the other side of this economic principle in action.

China’s reliance on cheap labor has powered the country’s economy to unprecedented heights. But China’s manufacturing sector is running into problems these days: squeezed from one end by places with even lower labor costs, such as Laos and Vietnam, and yet struggling to move to higher ground making more advanced products because of competition from developed nations such as Germany and the United States.

What this means is that just like their American and Western European counterparts, Chinese companies and workers must now move up the “value chain” and begin to produce products that require high degrees of skills and are not easily transferable to lower wage countries.

The alternative is a future where other lower wage Asian countries become the world’s next generation of foundries and factories. 

Yet another alternative, which should cause substantial cheer in the American heartland if it is fully realized, is a slow and eventual return of at least some manufacturing and related jobs back to the US, as an article in The Economist noted, back in March:

Joerg Wuttke, a veteran industrialist with the EU Chamber of Commerce in China, predicts that the cost to manufacture in China could soar twofold or even threefold by 2020. AlixPartners, a consultancy, offers this intriguing extrapolation: if China’s currency and shipping costs were to rise by 5% annually and wages were to go up by 30% a year, by 2015 it would be just as cheap to make things in North America as to make them in China and ship them there… In reality, the convergence will probably be slower. But the trend is clear.

That article goes on to argue that what may prevent both alternatives from becoming reality in the near future or even for another 15-20 years, is that China provides not just cheap labor but amazingly efficient supply chain logistics as well as ecosystems of suppliers. While supply chain logistics are no doubt key, the supplier ecosystems are more key – because having other companies near by that can supply all the parts that you need does wonders to inventory management, costs and efficiencies. This is something that is difficult to reproduce elsewhere easily. 

Still, these are early warning signs. Or signs of hope. It depends on who you are and where you are.

India, Power and Growth

India’s power problems have been in the news a bit, of late. While millions of consumers and businesses have habitually suffered “power cuts”, what was different this time of course was that it was not a “scheduled” cut but a widespread outage caused by a series of issues all put together (demand, supply, quality of the distribution grid, etc.). 

The question though is, in light of India’s much vaunted role in the BRIC block, where does it go from here?

An interesting article in the Washington Post argues that from a electricity/power investment perspective, India is where China was two decades ago and where the US was in the 1950s:

Every modern, industrial society in history has gone through a 20-year period “where there was extremely large investment in the power sector, and electricity made the transition from a privilege of an urban elite to something every family would have,” Varro said. “India is right now just at that jump point.”

There are many reasons why India needs to get moving on this, but let us focus on the business aspects of that. 

In an increasingly competitive global economy where local employment, affluence and other metrics of growth and prosperity depend on the competitiveness of exports, clearly, the power situation is not helping:

(because of factories generating their own power)…The cost of fuel makes his shirts 5 percent more expensive, “which plays a major role when you are competing in the international market with Sri Lanka and China.”

But in a few years, I suspect that clothing and apparel will max out the total number of available jobs and if India is to provide jobs for the millions of youth that come of age every year, then manufacturing is the way to go. 

So at some point, India will have to figure out a way to create new labor laws (hopefully) – something that impedes manufacturing employment and growth in almost all of its states – and become a counterweight to China and other low-wage manufacturing hubs like the Philippines, Vietnam, etc. 

According to an article in The Economist, China is becoming less attractive to contract manufacturing because of rising wages and while it still retains other advantages, I can see how, in perhaps 5-10 years, as other countries catch up, non-domestic oriented manufacturing (perhaps even that too) will start to leave China for other countries. And India may have a once in a generation chance to capture some of that business and add a significant number of jobs. 

But unlike small garment manufacturers that can live with a diesel generator, manufacturing necessitates economies of scale, which in turn mean factories and foundries that consume hundreds of megawatts of power, which in turn make low-capacity generators impractical. 

The starting point of course is massive investment (private and/or public):

World Bank studies show that a lack of electric power is the biggest barrier to job growth and investment in India today and that outages are a significant drag on industrial output and retail sales. The IEA predicts that India will need a $1.6 trillion investment in power generation, transmission and distribution to keep up with the rapid pace of energy demand through 2035 and a $550 million investment in the coal, oil and gas sectors.

But India has a tendency to throw money at problems and create various laws (with low or no enforcement) that end up wasting money and increasing red tape. 

So just investment in this sector is not the answer though and unless there is a coherent policy (which produces results like the successful “golden quadrilateral“) that takes into account all the different parameters (policy, raw material necessary to sustainably grow power generation and distribution) necessary for success, things may not change much. 

Sometimes crises have a way of crystallizing action in a way that nothing else can. It remains to be seen what comes out of this one.