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US Trade Wars with China: Just a Distraction?

An interesting article was published in the Opinion pages of the Wall Street Journal called : The $6.50 Trade War. This is one of very few articles I have read in the Journal in recent memory that I have some real disagreement with. The editors / authors of this article describe in some detail what the best guess of industry analysts (ADBI) is regarding the cost breakdown of an Apple iPod and use that description to make the case that free trade is the answer to America’s economic woes. Their rationale is that the iPod costs about $178 to manufacture, and retails for about $299, with $75 of the remaining margin going to retailers and distributors, and the remaining $80 going to Apple. (I realize the math doesn’t quite work here, but – hey, it’s not my math.) So more than half of the retail prices is accrued to US companies.

Furthermore, since the components of products like the iPod and iPhone are frequently produced in other countries and shipped to China only for final assembly, really only a small portion of the cost of these products (they estimate $6.50 on the iPhone) is really a function of the work performed in China. The rest of the value was added in other countries, and simply shipped into China for assembly. Yet in official trade statistics, China is reflected as generating the entire $178.96 value when trade balances are analyzed and documented. Therefore, the Journal, concludes, China is unfairly criticized.

Finally, the authors close the article by asserting: “All of which illustrates the basic truth that trade has always benefited the US economy.” I’m from Missouri on this one. I have rarely seen anything as amorphous and multi-faceted as “trade” always producing the same result for anyone. There is fair trade, and there is unfair trade; asserting that the US always comes out ahead in international buying and selling just doesn’t pass the sniff test.

The authors of the Journal article say that focusing on the trade deficit and potentially launching a trade war with China is just a distraction; that what we really need are policy changes. I am seeing this differently than the WSJ authors, which as I said before, is pretty unusual. Here’s why: Back in 2006, I was interviewing C level executives of major corporations for a book I was writing on Mergers & Acquisitions. I remember clearly one interview with the CFO at a $25 billion multinational corporation, who proclaimed proudly that they had recently “repatriated” about $14 million from their newly opened manufacturing facility in China. In other words, this company had managed to bring $14 million in earnings back to their corporate coffers here in the United States. Now what he did NOT say, and I could not press him on since he was doing me the favor of granting my interview, is that in order to generate that corporate level profit, those jobs all left the United States. So without a doubt, hundreds – perhaps thousands – of US workers lost their jobs earning somewhere between $40,000 and $60,000 per year (my estimate based on 30+ years in manufacturing), and those jobs transferred to China where wages generated annual earnings for Chinese workers of around $10,000. When those corporate profits returned, it went to the US corporation and I have a high level of confidence that additional US workers were not hired with that money. Some of course went into executive bonuses. Some may also have gone into R&D, New Product Development, and so on. But the fact is that there is a big part of America that does not and will not ever be skilled, educated, and talented enough to do product design, product engineering, or executive management work. That strata of the US economy has relied for many years upon adding tangible value to manufactured products here in the United States to better their own lives, and more importantly, improve the chances for their children to do even better. Those jobs are gone, and probably gone for good.

Frankly, I don’t particularly care where the components of import trade numbers are assigned for the most part. Do I want to see a trade war with China erupt over $6.50 in value add? Of course not. Should these numbers be more accurate? Sure, I suppose so. But the bottom line for the US economy and for US manufacturing workers in particular is that our manufacturing base and the jobs associated with it are disappearing. Some of my other blog entries (notably the one entitled: Are Your Children Being Impacted by the Economic Downturn?) have already pointed out that once these jobs are lost, those fortunate enough to find replacement work experience a substantial and lasting income reduction, many of whom never fully recover to their baseline. We are creating a larger and larger percentage of the American workforce that is experiencing and will continue to experience a decline in their standard of living – as will their children and grandchildren.

So what should be done? The authors of the WSJ article say that our 112th Congress should stop focusing on launching a trade war with China and focus on:

“Policies that will help US companies better capitalize on the global economy” (tax policies, health care policies, and environmental regulation policies designed to lift some of the burden on manufacturers in the US.) I have no doubt that loosening these policies so that US manufacturers could operate more freely would help. But I am very confident that it wont be close to enough for us to regain our competitiveness.

While it may seem counterintuitive to the “free-traders” (I recall President George W. Bush describing himself that way once), I strongly believe that the increasing complexity and diffraction of supply chains being implemented to shave every dollar of cost – especially labor cost – out of these products – ultimately hurts the work force, and the consumer. Here’s why: First of all, I will offer this generalization which I know from my own experience to be true – though it varies to some degree based on products and processes. The cost of goods sold (COGS) in most manufactured products typically breaks down into these 3 broad categories: Materials (roughly 65% to 75% of cost), Overhead (roughly 15% to 35% of costs), and direct labor (roughly 5% to 10%). Where is the biggest element of cost? It is, of course material. Which elements will these policy changes most directly impact? Overhead. Which elements of cost are most directly targeted when moving US manufacturing jobs offshore? Direct Labor. Think about it.

Let’s say we have two otherwise identical companies who embark on a cost cutting mission. Company A decides to move their manufacturing from Arizona to China. They reduce their direct labor costs (10% of COGS) from 10% of COGS to 4%. If their COGS is $100, they just added $6 to their margin – a 6% improvement! Woohoo! However, those products now have to be shipped back from China to the US to sell them, adding $2 to the cost that wasn’t there before. That leaves the net savings at $4, or 4%.

The other company (Company B) decides to focus on material cost reductions – they work hard to simplify their product designs so that suppliers can produce components less expensively, negotiate with key component suppliers to co-locate and thereby reduce transportation costs, and so on.) They bring their raw material costs down by 15%. Now 15% of $70 is $15. In addition, they don’t incur any additional charge for shipping the products back from China to the US to sell them. The net cost reduction is $15, or 15%.

Comparing the two: Company A reduces cost by 4% by moving manufacturing to China, and reduces middle class manufacturing jobs in the US by 100. Company B reduces cost by 15% and retains all of the US manufacturing jobs. I vote for Company B!

Now in a less simplistic world than the one in my example (the real world), there are a LOT of moving parts, and a LOT of other factors need to be considered. Here, for purposes of illustration, I have deliberately kept things simple. For example, what if not only labor but also overhead and material costs are lower in China? What if the largest percentage of customers is in China? At what point does a company decide it’s going to move the work, and sacrifice the jobs of their US employees? In most cases, it’s the minute that company’s CFO perceives that it’s possible to improve company profit by doing so. (Sorry about the cynicism, but as I mentioned before, 30+ years of being a part of this has brought me to this point.) But the same principles of collocation, product design simplicity, process repeatability / quality, and collocated supply chains that were developed by Henry Ford and (in some dimensions) perfected by the Toyota Production System (TPS) can and should be used in partnership with US manufacturing workers to protect this important part of our employment base and our national security. It’s too easy to simply say “Everyone else is moving their operations offshore, so we should too”. It’s an intellectually lazy way out, and it sells America short; shame on those who take that approach.

What do you think America can and should do about the growing trade deficit between the US and China (or perhaps more accurately stated, between US manufacturers and non-US manufacturers)?

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