An “Outsourced” Airline – Will It Fly?

 

Deny-NAI

In a globalized economy, companies source individual parts of their product or service from whichever country or company offers the lowest cost, best quality, etc. This is what manufacturers, retailers, IT companies and others have been doing for the last couple of decades. Consumers get cheap(er) products, supply chains mature and local jobs disappear.

And now, an airline trying to do the same thing, is running into a lot of opposition from the international Air Line Pilots Association. Among other things, it took out a full page in the Washington Post recently (because…a lot of lawmakers and policy types who ultimately they need to influence live in the DC area. I guess.) that I included above.

Their core argument, as Claire Zillman writes in Fortune Magazine, is this:

“At bottom, [Norwegian] seek[s] to establish a new flag of convenience in Ireland to avoid Norway’s labor laws and lower labor costs,” Delta Air Lines (DAL), United Airlines (UAL), and American Airlines (AAL) said in a joint letter to the Transportation Department.

“That’s why we’re calling it Walmarting,” says Edward Wytkind, president of the Transportation Trades Department of the AFL-CIO, which represents airline industry unions. “This could dumb down labor standards to the point where it’s hard to make a living wage in the airline industry.”

It will be interesting to see who wins. My money, in this case, is on the airline pilots association who will likely make the case to regulators and lawmakers that this model raises huge safety concerns and lack of accountability.

But if they don’t win the argument, (as the pilots fear?) will we start to see US airlines, especially the ones like Spirit, adopt the same business model?

Commoditized Orchids and Efficient Supply Chains

Efficient supply chains tend to drive down prices for many things we use on a day to day basis. Nowhere are the effects (benefits, if you ask consumers) of this more apparent than with digital cameras, Plasma TVs, laptops and such. 

A slighly more non-obvious example of these supply chains in action is the now highly commoditized global (rare) orchid market, says Eva Dou, on The WSJ, in an article (paywall) that illuminates this area in some detail.

An excerpt:

A custard-yellow orchid dubbed P. Golden Emperor ‘Sweet’ changed hands between Taiwan breeders in 1978 for $100,000. Now, orchids roll out of greenhouses in Taiwan and onto the shelves of retailers like Lowe’s for as little as $5.48.

As with flat-panel TVs and laptops, the once-rare orchid has become a mass-market commodity. Orchids now are the best-selling potted flower in the U.S., with annual sales exceeding the poinsettia, according to the U.S. Department of Agriculture.

Behind the shift are the entrepreneurs of Taiwan, who have brought to orchid-breeding the energy and methods applied to making consumer electronics.

One result is familiar to many electronics makers: While global orchid sales are rising, profit margins are thinning.

Airbus To Fly Against The Law Of Large Numbers

Profit margins are tricky things.

When a company is small, it is (relatively) easy to increase margins (again, relatively speaking). But as companies grow big, moving the margin percentage needle by 1 or even 2 points is a pretty big deal. And in automotive, aerospace and other such industries (click that to see operating and net margins broken down by industry, based on a database of 6177 firms – as of Jan 2013), I have to imagine that it is nothing short of a herculean task. 

Consider then what Airbus wants to do:

Airbus is on track to more than double its profit margin by 2015 through greater efficiency and revamped management, Chief Executive Fabrice Brégier said.

Mr. Brégier, who took over as CEO last June after five years as chief operating officer, said in an interview that he has been working to shake up the way Airbus builds planes, by giving factory managers more autonomy and instilling “a more entrepreneurial spirit” throughout the company.

Pretty amazing and downright impressive, that goal.

The rest of the article I excerpted from (written by Daniel Michaels, on The WSJ) offers additional details.

Containers – As Global Trade Accelerators and Enablers

A long time ago, ships were loaded the same way cars are, today, after a Costco shopping trip.

You put in the large items first and then try to squeeze in the smaller items around the larger ones. Or something like that. 

But containerization changed everything, argues an article in The Economist:

It was the brainchild of Malcom McLean, an American trucking magnate. He reckoned that big savings could be had by packing goods in uniform containers that could easily be moved between lorry and ship. When he tallied the costs from the inaugural journey of his first prototype container ship in 1956, he found that they came in at just $0.16 per tonne to load—compared with $5.83 per tonne for loose cargo on a standard ship. Containerisation quickly conquered the world: between 1966 and 1983 the share of countries with container ports rose from about 1% to nearly 90%, coinciding with a take-off in global trade (see chart).

The macro effects?

The results are striking. In a set of 22 industrialised countries containerisation explains a 320% rise in bilateral trade over the first five years after adoption and 790% over 20 years. By comparison, a bilateral free-trade agreement raises trade by 45% over 20 years and GATT membership adds 285%.

Read the full article for a fascinating look at why and how this came to be (reduced costs are not the only reason for the revolution).

Foxconn Hiring Freeze – Eventual Prelude To Launching Own Brands?

foxconn

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

3-pairs-of-jeans

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.

 

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