Some Chinese suppliers, saddled with meeting low costs and codes of conduct, have formed off-the-books “shadow” companies.

Sometimes what’s right in front of your nose is hardest to recognize. As a person close to me said recently, “Why don’t we have any traditions in our family? We just keep doing the same things over and over.” So it is with the concept of Virtue. Many did not appreciate the importance of good character until they realized it was missing in certain parts of society: e.g., Wall Street, corporate executive suites, Capitol Hill. Perhaps we thought business success depended on a glitzy advertising campaign or leveraging the power of Internet social networking more than on honesty, integrity and good stewardship of resources. The recent global economic crisis may bring us back to the basics of good business practices, which we would argue come down to an avoidance of the pitfalls of the Seven Deadly Sins of Outsourcing.

This month’s focus is the third of the SALIGIA1 traits: “Luxuria” or lust. While the common interpretation focuses on the carnal, in outsourcing it translates to “lavishness,” or lust for power or recognition through insistence on the outward trappings of luxury. The corresponding virtue is Chastity, or in business terms “conservation.” In the high-flying days of ancient history – some 18 months ago – corporate executives were expected to fly in private jets, get multimillion-dollar bonuses, golden parachutes, and so forth. These were the marks of power, the well-deserved accolades that went with the position. This sense permeated corporate culture and even at the middle management level, the customer-supplier relationship often involved expensive offerings, such as tickets to sporting events, expensive meals, entertainment, and $300 bottles of wine.

But there is no such thing as a free lunch. These expenses ultimately hurt the bottom line because they add no value to the enterprise. In retrospect, looking at the history of the outsourcing of electronics manufacturing, it is clear much of the outsourcing dividend has been squandered frivolously because of the lavishness of individuals who misused their power and were impatient to cash out.

Once upon a time, Wall Street investors conceived of the idea of manipulating an electronics company’s balance sheet by creating a separate entity to perform the expensive, complicated and unglamorous tasks relating to the manufacturing of the products. This would permit the electronics OEM to focus on its “core competency” of product development and marketing – the creative stuff – and relegate the smelly and mundane costs of manufacturing to another corporate entity. Once that expense was off the OEM’s books, the capital generated would be unleashed for even more creative and productivity-enhancing electronics products that would ultimately Save the World. (Remember those arguments?) This was the outsourcing dividend.

We were involved in many such discussions in the 1980s and 90s. The electronics manufacturing services industry was born during these times. Like the sculptor Pygmalion, the OEM executive team and its investment colleagues on Wall Street fell in love with their creations, hoping and praying they would come alive. The theory stated that entities solely devoted to manufacturing could achieve economies-of-scale that ultimately would drive down costs and create new efficiencies. But the theory was never really put into practice because of the shortsighted, next-quarter’s-earnings perspective of Wall Street.. They never gave it a chance.

Here’s a story that may sound familiar. It involves an extremely well known electronics OEM. This company sold its manufacturing facilities to one of the newly created EMS companies, which it then required to drastically reduce the salaries of its workers – the OEM’s former employees – to artificially and unrealistically cut the costs of services they had contracted for with the EMS. This action satisfied the demands of Wall Street to generate the target capital returns in the shortest period of time. The EMS company, predictably, experienced 100% turnover in six months. So the OEM complained about the poor level of service. Then the OEM had a change of CEO, and the new exec broke its contract with the US EMS companies, sending manufacturing overseas to low-labor-cost regions. The EMS lost the income it needed to get established and attract new customers to become a sustainable business.

This scenario played out in other companies across market segments as the industry matured. Low-labor cost regions were accustomed to making low-tech products such as garments and shoes. The foreign governments in the region, intent on capturing foreign direct investment, assured global OEMs they would be able to build electronics for the same price as sewing t-shirts. Defying common sense, C-level executives and their Wall Street advisors, driven by Luxuria, moved entire electronics manufacturing programs to facilities 12 time zones away. Managers got used to team calls in the wee hours to quench the predictable fires that raged when product quality suffered. Consumers got used to electronics that were defective out of the box, but so cheap it wasn’t worth trying to get the manufacturer to fix them.

But even in China, there is no such thing as a free lunch. OEMs began to suspect the “China Price” meant human rights violations, and the industry adopted a righteous-sounding Supplier Code of Conduct to ensure that electronics were not made by children or slaves.

Now, we know that Luxuria speaks Mandarin and Hindi, as we learn it is as easy to cook the books in Asian countries as in the West. But what did we expect? Reports have emerged that Chinese suppliers, finding it impossible to satisfy both the cost-cutting requirements of these global companies – and their codes of conduct, have created one company that plays by the rules and an entire shadow company that operates off-the-books, where they are free to employ children and enforce 100-hour workweeks. And this is just one of many creative bookkeeping maneuvers being reported as the global economic crisis unfolds. Many of us in the industry have been suspicious about some of these companies for quite a while.

The US consumer has awakened from this binge with a debt-laden hangover. Twenty-five million Chinese migrant workers are looking for jobs. The outsourcing dividend has for all intents and purposes been squandered.
The good news is it looks like Virtue and self-denial will soon be in fashion again. Sanity and good sense may yet return to the electronics manufacturing industry.

References

1. Jennifer Read, “Why Pride and Outsourcing Don’t Mix,” Circuits Assembly, December 2007, circuitsassembly.com/cms/content/view/7532/209/.

Charlie Barnhart is cofounder and principal of Charlie Barnhart & Associates (charliebarnhart.com); charlie@charliebarnhart.com.