Naked Capitalism on the Fallacy of Outsourcing

The Corporate Illogic of Outsourcing and Offshoring

Posted on July 8, 2014 by

You must go, now, and read a critically important piece questioning the logic of sending American manufacturing jobs offshore. It’s titled Losing Sparta (hat tip Dikaios Logos) by Ester Kaplan in VQR. We have written regularly about how we have been repeatedly told by managers and executives that the case for offshoring was often not compelling, particularly when risks, such as higher financing and shipping costs, exposure to foreign exchange losses, and inventory risk were included. This makes perfect sense when you consider that for most manufactured goods, factory labor is a mere 10-15% of total wholesale cost, and any savings in factory labor will be offset by higher shipping and greater managerial costs (more coordination, performed by much more highly paid workers). It is thus more accurate to regard a lot of offshoring as not being about cost savings, but a transfer from ordinary workers to managers and executives.

The article focuses on a world class manufacturing plant in Sparta, Tennessee, owned by Phillips that made florescent light bulbs. The workers were highly dedicated and strived to implement continued improvements in productivity. Factory pay was $13 to $15 an hour, which were good wages for that area, particularly since it included several weeks of vacation and excellent health care benefits. From the story:

Employees stuck around for years, knew their jobs inside and out, and had a rare esprit de corps. When they faced tight deadlines, fabricators would volunteer to come in as early as 4 or 5 a.m. so they could get a head start before the paint crew arrived at six. In December 2009 the Sparta facility was named by Industry​Week as a Best Plant of the year, one of the top ten in North America. In the months that followed, it won Best Plant within Philips’s global lighting division as well as the firm’s global “Lean Challenge.” That summer, plant managers invited state officials and legislators to Sparta to celebrate.

Yet Phillips decided to shutter the plant in 2010. It was impossible to get a straight answer out of Phillips and the explanations offered for moving production to Monterrey, Mexico, did not add up. And the article points to the broader mythology, that if Americans only compete better, worker will do better. Sparta, and overall statistics show that to be a myth. One of the most striking and often-shown charts is how productivity gains stopped being shared with workers around 1976.

But why shutter a plant that continued to wring more and more performance out of its workers? Consider:

This “engaged workforce,” in the words of IndustryWeek, had hiked production on some lines by more than 60 percent, cut changeover time between small orders by 90 percent, and reduced the number of defective parts by 95 percent, making the plant one of the most productive in America.

And Phillips, like many manufacturers in the US, was profitable and its returns were increasing. And a team that tried to buy the factory developed a compelling analysis that the Sparta plant would be cheaper than the Monterrey operation, meaning that if a third party funded, it, it would steal business from Phillips:

Once it was clear that Philips was determined to close the plant, [plant managers Lisa] Norris, [Dave] Uhrik, and a lean-​operations expert named Nicole Belitz pulled together a detailed proposal to buy it. They knew the numbers better than anyone, and calculated that the plant, which operated at extremely healthy margins, could be solidly profitable on its own.

Team Sparta, as they dubbed themselves, did the math, calculating the full cost to Philips of moving production to Mexico, and concluded that Philips would be dramatically increasing customer lead times, which would likely reduce its market share. The team also projected that Philips would have to rely more on distribution centers, raising warehousing costs; that the firm would be shipping fixtures longer distances on worse roads, meaning higher transportation costs and more breakage; that it would be using less automation and end up with more defects; not to mention the estimated $30 million it would cost to excavate those massive machines and rebuild them in Monterrey. Factoring in those costs, Team Sparta was convinced that the local plant could sell fixtures to Philips for less than it would cost Philips to make them in Mexico and still clear at least $1 million in annual profits.

Uhrik and Norris had no equity of their own and would need at least $12 million in start-​up capital to take over the plant, a seemingly quixotic quest. But the business case was so impressive that when they brought their plan to First National Bank in Knoxville, its investment group jumped in with $4 million. “We were able to show very healthy margins, and that moving to Mexico would hurt turnaround and logistics costs,” Norris recalls, “and show that in a consumer-​driven market, where a contractor suddenly needs thirty-​five troffer lights and he wants it next week, the Philips model was questionable.” The Tennessee Valley Authority and the USDA’s Rural Economic Development Loan and Grant program each independently reviewed the plan and together committed to another $3.75 million. After yet another review, this one by White County’s Local Industrial Board, the county commissioners, including Bailey, offered to come up with the rest by putting a $5 million bond on the ballot…

As I combed through the Team Sparta business plan, I became skeptical about whether this kind of granular analysis was ever performed by the Philips executives who decided to move the plant to Monterrey. Norris was in regular contact with Philips’s North American headquarters, and she certainly saw no evidence of it. This begged a larger question: How many of those 70,000 American plants offshored in recent decades, those millions of American jobs lost, had been the result not of a ruthless commitment to the bottom line, but of a colossal failure of due diligence?

And the article earlier came up with a best guess as to Phillip’s rationale:

But Lisa Norris’s take seemed the most persuasive: Philips’s model is to concentrate production, and so the particulars of how well a given plant performs—​even if it’s Philips’s best-​performing plant worldwide—​don’t matter. “There’s a momentum that gets in place when people say we’re going to close these plants, and it becomes a point of weakness for anyone to stand up and say, ‘No,’” she told me one evening. “No one feels strong enough to do that. Because they feel like it’s showing some sort of human weakness, that they’re making an emotional decision—​when in fact, there’s a business decision there. And so it gains a sort of momentum in an emperor-has-no-clothes sort of way. And so people are compelled to do the wrong things. And then you start adding incentives based on the execution of those plans and now you’ve got everybody marching straight off a cliff.”

I’ve had executives attest to variants of this behavior, that they offshored even though it was not particularly good for the company because Wall Street wanted it and doing so popped the stock. One can similarly imagine that the simple minded story that Phillips was “concentrating manufacturing” would sound great at investor presentations and never got scrutinized once it became a pillar of the professed strategy.

There’s much more good reporting in this compelling, if sad case about how soi disant business leaders throw loyal, skilled workers on the dust heap with no thought and not even a real commercial justification. Confirming our dim view:

A 2012 study by Michael E. Porter and Jan W. Rivkin of Harvard Business School, based on interviews with 1,767 executives involved in location decisions over the previous year, confirms Bronfenbrenner’s view. Porter and Rivkin found that “rigorous processes for location choices” are “far from universal” and that such decision-​making processes “have lagged behind those for virtually all other major investment decisions.” They found that companies often underestimate the hidden costs of offshoring, overlook the advantages of a US location and “fall prey to biases that work against the U.S.”

So workers are correct to see the treatment of workers in class warfare terms. It may take a long time to come to pass, but this level of irresponsibility among what passes for our elites is sowing the seeds for widespread upheaval.

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One response to “Naked Capitalism on the Fallacy of Outsourcing

  1. This is what GE did under Jack Welch. Their operations never ran well in Juarez City. All in the name of union-busting; ideological decisions. Thousands of US workers lost their jobs and whole communities suffered. But Jack Welch got his golden parachute and NY City apartment.

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