The concept that as plant output expands, unit costs decrease, is known as:

chapter 15 Global Production, Outsourcing, and Logistics

LEARNING OBJECTIVES

1 Explain why production and logistics decisions are of central importance to many multinational businesses.

2 Explain how country differences, production technology, and product features all affect the choice of where to locate production activities.

3 Recognize how the role of foreign subsidiaries in production can be enhanced over time as they accumulate knowledge.

4 Identify the factors that influence a firm's decision of whether to source supplies from within the company or from foreign suppliers.

5 Describe what is required to efficiently coordinate a globally dispersed production system.

opening case Making the Amazon Kindle

When online retailer Amazon.com invented its revolutionary e-book reader, the Kindle, the company had to decide where to have it made. Guiding the decision was an understanding that if the Kindle was going to be successful, it had to have that magic combination of low price, high functionality, high reliability, and design elegance. Over time, this has only become more important as competitors have emerged. These have included Sony with various readers, Barnes & Noble with its Nook, and most notably, Apple with its multipurpose iPad, which can function as a digital reader among other things. Amazon's goal has been to aggressively reduce the price of the Kindle so that it both has an edge over competitors and it becomes feasible to have a couple lying around the house as a sort of digital library.

Amazon designed the Kindle in a lab in California, precisely because this is where the key R&D expertise was located. One of the Kindle's key components, the “ink” (the tiny microcapsule beads used in its display) were designed and are made by E Ink, a company based in Cambridge, Massachusetts. Much of the rest of the value of the Kindle, however, is outsourced to manufacturing enterprises in Asia.

The market research firm iSuppli estimates that when it was introduced in 2009, the total manufacturing cost for the Kindle 2 ran about $185. The most expensive single component was the display, which cost about $60. Although the display used E Ink's technology, there were no American firms with the expertise required to manufacture a bistable electrophoretic display that will show an image even when it is not drawing on battery power. This technology is central to the Kindle because it allows for very long battery life. Ultimately, Amazon contracted with a Taiwanese firm, Prime View International, to make the display. Prime View had considerable expertise in the manufacture of LCDs and was known as an efficient and reliable manufacturer. Estimates suggest that 40 to 50 percent of the value of the display is captured by E Ink, with the rest going to Prime View.

After the display, the next most expensive component is the wireless card that allows the Kindle to connect to Amazon's digital bookstore through a wireless link. The card costs about $40. Novatel Wireless, a South Korean enterprise that has developed considerable expertise in making wireless chipsets for cell phone manufacturers, produces this component. The card includes a $13 chip that was designed by Qualcomm of San Diego. This, too, is manufactured in Asia. The brain of the Kindle is an $8.64 microprocessor chip designed by Texas-based Freescale Semiconductor. Freescale outsources its chip making to foundries in Taiwan and China. Another key component, the lithium polymer battery, costs about $7.50 and is manufactured in China. In sum, out of a total manufacturing cost of about $185, perhaps $40 to $50 is accounted for by activities undertaken in the United States by E Ink, Qualcomm, and Freescale, with the remainder being outsourced to manufacturers in Taiwan, China, and South Korea.

  Sources: M. Muro, “Amazon's Kindle: Symbol of American Decline?” Brookings Institute, February 25, 2010, www.brookings.edu; and G. P. Pisano and W. C. Shih, “Restoring American Competitiveness,” Harvard Business Review, July–August 2009, pp. 114–26.

Introduction

As trade barriers fall and global markets develop, many firms increasingly confront a set of interrelated issues. First, where in the world should production activities be located? Should they be concentrated in a single country, or should they be dispersed around the globe, matching the type of activity with country differences in factor costs, tariff barriers, political risks, and the like to minimize costs and maximize value added? Second, what should be the long-term strategic role of foreign production sites? Should the firm abandon a foreign site if factor costs change, moving production to another more favorable location, or is there value to maintaining an operation at a given location even if underlying economic conditions change? Third, should the firm own foreign production activities, or is it better to outsource those activities to independent vendors? Fourth, how should a globally dispersed supply chain be managed, and what is the role of Internet-based information technology in the management of global logistics? Fifth, should the firm manage global logistics itself, or should it outsource the management to enterprises that specialize in this activity?

The example of the Amazon Kindle discussed in the opening case touches upon some of these issues. Like many modern products, different components of the Kindle are manufactured in different locations to produce a reliable low-cost product. In choosing who should make what components, Amazon was guided by the need to keep the cost of the device low so that it could price aggressively and preempt competitors in the digital reader market. For example, Amazon picked Prime View of Taiwan to make the display screen precisely because that company is among the best in the world at this kind of manufacturing. For Amazon to secure a competitive advantage against intense competition, it had to make the correct choices.

Strategy, Production, and Logistics

LEARNING OBJECTIVE 1

Explain why production and logistics decisions are of central importance to many multinational businesses.

Chapter 12 introduced the concept of the value chain and discussed a number of value creation activities, including production, marketing, logistics, R&D, human resources, and information systems. This chapter will focus on two of these activities—production and logistics—and attempt to clarify how they might be performed internationally to (1) lower the costs of value creation and (2) add value by better serving customer needs. We will discuss the contributions of information technology to these activities, which has become particularly important in the era of the Internet. The remaining chapters in this text will look at other value creation activities in this international context (marketing, R&D, and human resource management).

Production

Activities involved in creating a product.

Logistics

The procurement and physical transmission of material through the supply chain, from suppliers to customers.

In Chapter 12, we defined production as “the activities involved in creating a product.” We used the term production to denote both service and manufacturing activities, because one can produce a service or produce a physical product. Although in this chapter we focus more on the production of physical goods, we should not forget that the term can also be applied to services. This has become more evident in recent years, with the trend among U.S. firms to outsource the “production” of certain service activities to developing nations where labor costs are lower (e.g., the trend among many U.S. companies to outsource customer care services to places such as India, where English is widely spoken and labor costs are much lower). Logistics is the activity that controls the transmission of physical materials through the value chain, from procurement through production and into distribution. Production and logistics are closely linked because a firm's ability to perform its production activities efficiently depends on a timely supply of high-quality material inputs, for which logistics is responsible.

ANOTHER PERSPECTIVE Careers in Supply Chain Management

With increased outsourcing and overseas production sites and customers, supply chain management is a growing field. The Council of Supply Chain Management Professionals (CSCMP), a professional association with more than 8,500 members worldwide, says the industry offers a promising outlook. What's more, potential employers are everywhere—manufacturers and distributors; government agencies; consulting firms; the transport industry; universities and colleges; service firms such as banks, hospitals, and hotels; and third-party logistics providers.

For more information about the organization and careers in this field, visit the CSCMP website at www.cscmp.org and its careers site, www.careersinsupplychain.org.

The production and logistics functions of an international firm have a number of important strategic objectives.1 One is to lower costs. Dispersing production activities to various locations around the globe where each activity can be performed most efficiently can lower costs. Costs can also be cut by managing the global supply chain efficiently so as to better match supply and demand. Efficient supply chain management reduces the amount of inventory in the system and increases inventory turnover, which means the firm has to invest less working capital in inventory and is less likely to find excess inventory on hand that cannot be sold and has to be written off.

A second strategic objective shared by production and logistics is to increase product quality by eliminating defective products from both the supply chain and the manufacturing process.2 (In this context, quality means reliability, implying that the product has no defects and performs well.) The objectives of reducing costs and increasing quality are not independent of each other. As illustrated in Figure 15.1, the firm that improves its quality control will also reduce its costs of value creation. Improved quality control reduces costs by:

• Increasing productivity because time is not wasted producing poor-quality products that cannot be sold, leading to a direct reduction in unit costs.

• Lowering rework and scrap costs associated with defective products.

• Reducing the warranty costs and time associated with fixing defective products.

FIGURE 15.1 The Relationship Between Quality and Costs

Source: From “What Does Product Quality Really Mean,” by David A. Gandin, MIT Sloan Management Review, Fall 1984. Copyright © 1984 by Massachusetts Institute of Technology. All rights reserved. Distributed by Tribune Media Services.

The effect is to lower the costs of value creation by reducing both production and after-sales service costs.

The principal tool that most managers now use to increase the reliability of their product offering is the Six Sigma quality improvement methodology. The Six Sigma methodology is a direct descendant of the total quality management (TQM) philosophy that was widely adopted, first by Japanese companies and then American companies during the 1980s and early 1990s.3 The TQM philosophy was developed by a number of American consultants such as W. Edward Deming, Joseph Juran, and A. V. Feigenbaum.4 Deming identified a number of steps that should be part of any TQM program. He argued that management should embrace the philosophy that mistakes, defects, and poor-quality materials are not acceptable and should be eliminated. He suggested that the quality of supervision should be improved by allowing more time for supervisors to work with employees and by providing them with the tools they need to do the job. Deming recommended that management should create an environment in which employees will not fear reporting problems or recommending improvements. He believed that work standards should not only be defined as numbers or quotas, but should also include some notion of quality to promote the production of defect-free output. He argued that management has the responsibility to train employees in new skills to keep pace with changes in the workplace. In addition, he believed that achieving better quality requires the commitment of everyone in the company.

Total Quality Management (TQM)

Management philosophy that takes as its central focus the need to improve the quality of a company's products and services.

Six Sigma, the modern successor to TQM, is a statistically based philosophy that aims to reduce defects, boost productivity, eliminate waste, and cut costs throughout a company. Six Sigma programs have been adopted by several major corporations, such as Motorola, General Electric, and Allied Signal. Sigma comes from the Greek letter that statisticians use to represent a standard deviation from a mean; the higher the number of “sigmas,” the smaller the number of errors. At six sigma, a production process would be 99.99966 percent accurate, creating just 3.4 defects per million units. While it is almost impossible for a company to achieve such perfection, Six Sigma quality is a goal that several strive toward. Increasingly, companies are adopting Six Sigma programs to try to boost their product quality and productivity.5

Six Sigma

Statistically based methodology for improving product quality.

General Electric is one of the major corporations that have embraced Six Sigma. Its commitment to quality is evident in all its industries, from retail to insurance to aviation.

ISO 9000

Certification process that requires certain quality standards must be met.

The growth of international standards has also focused greater attention on the importance of product quality. In Europe, for example, the European Union requires that the quality of a firm's manufacturing processes and products be certified under a quality standard known as ISO 9000 before the firm is allowed access to the EU marketplace. Although the ISO 9000 certification process has proved to be somewhat bureaucratic and costly for many firms, it does focus management attention on the need to improve the quality of products and processes.6

In addition to the lowering of costs and the improvement of quality, two other objectives have particular importance in international businesses. First, production and logistics functions must be able to accommodate demands for local responsiveness. As we saw in Chapter 12, demands for local responsiveness arise from national differences in consumer tastes and preferences, infrastructure, distribution channels, and host-government demands. Demands for local responsiveness create pressures to decentralize production activities to the major national or regional markets in which the firm does business or to implement flexible manufacturing processes that enable the firm to customize the product coming out of a factory according to the market in which it is to be sold.

Second, production and logistics must be able to respond quickly to shifts in customer demand. In recent years, time-based competition has grown more important.7 When consumer demand is prone to large and unpredictable shifts, the firm that can adapt most quickly to these shifts will gain an advantage.8 As we shall see, both production and logistics play critical roles here.

• QUICK STUDY

1. What are the main strategic objectives of production and logistics?

2. How does improved product reliability reduce costs?

Where to Produce

LEARNING OBJECTIVE 2

Explain how country differences, production technology, and product features all affect the choice of where to locate production activities.

An essential decision facing an international firm is where to locate its production activities to best minimize costs and improve product quality. For the firm contemplating international production, a number of factors must be considered. These factors can be grouped under three broad headings: country factors, technological factors, and product factors.9

COUNTRY FACTORS

We reviewed country-specific factors in some detail earlier in the book. Political economy, culture, and relative factor costs differ from country to country. In Chapter 6, we saw that due to differences in factor costs, some countries have a comparative advantage for producing certain products. In Chapters 2, 3, and 4 we saw how differences in political economy and national culture influence the benefits, costs, and risks of doing business in a country. Other things being equal, a firm should locate its various manufacturing activities where the economic, political, and cultural conditions—including relative factor costs—are conducive to the performance of those activities (for an example, see the accompanying Management Focus, which looks at the Philips Electronics NV investment in China). In Chapter 12, we referred to the benefits derived from such a strategy as location economies. We argued that one result of the strategy is the creation of a global web of value creation activities.

Also important in some industries is the presence of global concentrations of activities at certain locations. In Chapter 8, we discussed the role of location externalities in influencing foreign direct investment decisions. Externalities include the presence of an appropriately skilled labor pool and supporting industries.10 Such externalities can play an important role in deciding where to locate production activities. For example, because of a cluster of semiconductor manufacturing plants in Taiwan, a pool of labor with experience in the semiconductor business has developed. In addition, the plants have attracted a number of supporting industries, such as the manufacturers of semiconductor capital equipment and silicon, which have established facilities in Taiwan to be near their customers. This implies that there are real benefits to locating in Taiwan, as opposed to another location that lacks such externalities. Other things being equal, the externalities make Taiwan an attractive location for semiconductor manufacturing facilities. The same process is now under way in two Indian cities, Hyderabad and Bangalore, where both Western and Indian information technology companies have established operations. For example, locals refer to a section of Hyderabad as “Cyberabad,” where Microsoft, IBM, Infosys, and Qualcomm (among others) have major facilities.

Of course, other things are not equal. Differences in relative factor costs, political economy, culture, and location externalities are important, but other factors also loom large. Formal and informal trade barriers obviously influence location decisions (see Chapter 7), as do transportation costs and rules and regulations regarding foreign direct investment (see Chapter 8). For example, although relative factor costs may make a country look attractive as a location for performing a manufacturing activity, regulations prohibiting foreign direct investment may eliminate this option. Similarly, a consideration of factor costs might suggest that a firm should source production of a certain component from a particular country, but trade barriers could make this uneconomical.

MANAGEMENT FOCUS Philips in China

The Dutch consumer electronics, lighting, semiconductor, and medical equipment conglomerate Philips Electronics NV has been operating factories in China since 1985, when the country first opened its markets to foreign investors. Then, China was seen as the land of unlimited demand, and Philips, like many other Western companies, dreamed of Chinese consumers snapping up its products by the millions. But the company soon found out that one of the big reasons the company liked China—the low wage rates—also meant that few Chinese workers could afford to buy the products they were producing. So Philips hit on a new strategy: Keep the factories in China, but export most of the goods to developed nations.

The company now operates more than 35 wholly owned subsidiaries and joint ventures in China. Together, they employ some 30,000 people. Philips exports nearly two-thirds of the $7 billion in products that the factories produce every year. Philips accelerated its Chinese investment in anticipation of China's entry into the World Trade Organization. In 2003, Philips announced it would phase out production of electronic razors in the Netherlands, lay off 2,000 Dutch employees, and move production to China by 2005. A week earlier, Philips had stated it would expand capacity at its semiconductor factories in China, while phasing out production in higher-cost locations elsewhere. More recently, Philips has been investing in the production of medical equipment in China, including CT scanners and MRI machines.

The initial attractions of China to Philips included low wage rates, an educated workforce, a robust Chinese economy, a stable exchange rate that is linked to the U.S. dollar through a managed float, a rapidly expanding industrial base that includes many other Western and Chinese companies that Philips uses as suppliers, and easier access to world markets given China's entry into the WTO. Philips has stated that ultimately its goal is to turn China into a global supply base from which the company's products will be exported around the world. By the mid-2000s, more than 25 percent of everything Philips made worldwide came from China, and executives say the figure is rising rapidly. Several products are now made only in China. Philips is also starting to give its Chinese factories a greater role in product development. In the TV business, for example, basic development used to occur in Holland but was moved to Singapore in the early 1990s. Philips transferred TV development work to a new R&D center in Suzhou near Shanghai. Similarly, basic product development work on LCD screens for cell phones was shifted to Shanghai.

Some observers worry that Philips and companies pursuing a similar strategy might be overdoing it. Too much dependence on China could be dangerous if political, economic, or other problems disrupt production and the company's ability to supply global markets. Some observers believe that it might be better if the manufacturing facilities of companies were more geographically diverse as a hedge against problems in China. These fears have taken on added importance recently as labor costs have accelerated in China due to labor shortages. According to some estimates, labor costs have been growing by 20 percent per year since the late 2000s. On the other hand, there is a silver lining to this cloud: Chinese consumption of many of the products that Philips makes there is now rising rapidly.

  Sources: B. Einhorn, “Philips' Expanding Asia Connections,” BusinessWeek Online, November 27, 2003; K. Leggett and P. Wonacott, “The World's Factory: A Surge in Exports from China Jolts the Global Industry,” The Wall Street Journal, October 10, 2002, p. A1; “Philips NV: China Will Be Production Site for Electronic Razors,” The Wall Street Journal, April 8, 2003, p. B12; “Philips Plans China Expansion,” The Wall Street Journal, September 25, 2003, p. B13; M. Saunderson, “Eight Out of 10 DVD Players Will Be Made in China,” Dealerscope, July 2004, p. 28; and J. Blau, “Philips Tears Down Eindhoven R&D Fence,” Research Technology Management 50, no. 6 (2007), pp. 9–11.

Another important country factor is expected future movements in its exchange rate (see Chapters 10 and 11). Adverse changes in exchange rates can quickly alter a country's attractiveness as a manufacturing base. Currency appreciation can transform a low-cost location into a high-cost location. Many Japanese corporations had to grapple with this problem during the 1990s and early 2000s. The relatively low value of the yen on foreign exchange markets between 1950 and 1980 helped strengthen Japan's position as a low-cost location for manufacturing. More recently, however, the yen's steady appreciation against the dollar increased the dollar cost of products exported from Japan, making Japan less attractive as a manufacturing location. In response, many Japanese firms moved their manufacturing offshore to lower-cost locations in East Asia.

TECHNOLOGICAL FACTORS

The type of technology a firm uses to perform specific manufacturing activities can be pivotal in location decisions. For example, because of technological constraints, in some cases it is necessary to perform certain manufacturing activities in only one location and serve the world market from there. In other cases, the technology may make it feasible to perform an activity in multiple locations. Three characteristics of a manufacturing technology are of interest here: the level of fixed costs, the minimum efficient scale, and the flexibility of the technology.

Fixed Costs

As noted in Chapter 12, in some cases the fixed costs of setting up a production plant are so high that a firm must serve the world market from a single location or from a very few locations. For example, it now costs up to $5 billion to set up a state-of-the-art plant to manufacture semiconductor chips. Given this, other things being equal, serving the world market from a single plant sited at a single (optimal) location can make sense.

Conversely, a relatively low level of fixed costs can make it economical to perform a particular activity in several locations at once. This allows the firm to better accommodate demands for local responsiveness. Manufacturing in multiple locations may also help the firm avoid becoming too dependent on one location. Being too dependent on one location is particularly risky in a world of floating exchange rates. Many firms disperse their manufacturing plants to different locations as a “real hedge” against potentially adverse moves in currencies.

Minimum Efficient Scale

The concept of economies of scale tells us that as plant output expands, unit costs decrease. The reasons include the greater utilization of capital equipment and the productivity gains that come with specialization of employees within the plant.11 However, beyond a certain level of output, few additional scale economies are available. Thus, the “unit cost curve” declines with output until a certain output level is reached, at which point further increases in output realize little reduction in unit costs. The level of output at which most plant-level scale economies are exhausted is referred to as the minimum efficient scale of output. This is the scale of output a plant must operate to realize all major plant-level scale economies (see Figure 15.2).

Minimum Efficient Scale

The level of output at which most plant-level scale economies are exhausted.

FIGURE 15.2 A Typical Unit Cost Curve

The implications of this concept are as follows: The larger the minimum efficient scale of a plant relative to total global demand, the greater the argument for centralizing production in a single location or a limited number of locations. Alternatively, when the minimum efficient scale of production is low relative to global demand, it may be economical to manufacture a product at several locations. For example, the minimum efficient scale for a plant to manufacture personal computers is about 250,000 units a year, while the total global demand exceeds 35 million units a year. The low level of minimum efficient scale in relation to total global demand makes it economically feasible for a company such as Dell to assemble PCs in six locations.

As in the case of low fixed costs, the advantages of a low minimum efficient scale include allowing the firm to accommodate demands for local responsiveness or to hedge against currency risk by manufacturing the same product in several locations.

Flexible Manufacturing and Mass Customization

Central to the concept of economies of scale is the idea that the best way to achieve high efficiency, and hence low unit costs, is through the mass production of a standardized output. The trade-off implicit in this idea is between unit costs and product variety. Producing greater product variety from a factory implies shorter production runs, which in turn implies an inability to realize economies of scale. That is, wide product variety makes it difficult for a company to increase its production efficiency and thus reduce its unit costs. According to this logic, the way to increase efficiency and drive down unit costs is to limit product variety and produce a standardized product in large volumes.