Relieving the pain of being slapped by the “invisible hand.”

It’s no secret US-based electronics manufacturers are facing challenges of historic proportions. Some analysts speculate the falling dollar will make these companies acquisition targets for foreign-owned corporations, which may see this situation as an opportunity to buy capacity to build electronics for the US market. A quick look at the Industry News section of this publication illustrates this trend.

According to buyusa.gov, a government-hosted Website, foreign direct investment (FDI) benefits the US economy by creating jobs, boosting wages, helping US companies penetrate international markets and strengthening domestic manufacturing. In addition, according to the site, FDI brings in new research, technology and skills, and contributes to productivity and tax revenue. The site supplies statistics that support these statements.

Is this a bad thing?

Some of these statements seem questionable when one examines the domestic economy. The starting hourly wage for autoworkers under the recently negotiated General Motors contract is half what it was 10 years ago, which surely must be attributed to the effect of Japanese automakers’ US manufacturing operations. Motorola’s PCS division seemingly did everything right by capturing a large share of the Asian cellphone market as an early entrant. It has been doing business in mainland China for decades. Yet that once-proud company’s stock fell 39% on the latest management restructuring, and the company is considering selling the PCS division. If FDI helps US companies penetrate international markets, why is our trade deficit so high?

The US has been shifting to a services-based economy for 40 years. The question then is, Can a services economy create real wealth for its citizens? What kind of services are we talking about? Well, banking and finance, for one. At this writing, JP Morgan was negotiating to acquire rival Bear Stearns for a rock-bottom price, and the Fed was acquiring billions of dollars of bad loans. Much of the wealth created in that industry seems to be evaporating.

Another area of our new services economy is insurance underwriting, including health insurance. I have a law degree, but dealing with health insurance has become such a formidable task – with so many third parties offering “value-added services” – I typically don’t get all the benefits I’m entitled to because I just don’t have time to fill out all the forms. We have created many jobs for those who read and file these forms. Yet in discussions with doctors, nurses and other care providers – the people who actually determine the quality of health care – job satisfaction is at an all-time low and many are leaving the profession.

Are we going to be happy living in a services economy? I’m not sure.

A manufacturing and engineering-based economy contributes real, foundational value. There’s no way around that. We need to quit thinking, then, that the value of a US-based multinational’s overseas operation benefits our economy. It is misleading to count products manufactured outside of the US by a US-based MNC as contributing to US GDP. This accounting masks the erosion of US manufacturing and materials technology competitiveness. Paul Craig Roberts, former assistant US Secretary of the Treasury for Economic Policy, sounds a more realistic stance:

Economic theory assumes that capitalists pursuing their individual interests are led to benefit the general welfare of their society by an invisible hand. But offshoring, or the pursuit of absolute advantage, breaks the connection between the profit motive and the general welfare. The beneficiaries … are the corporations’ shareholders and top executives and the foreign country, the GDP of which rises when its labor is substituted for the corporations’ home labor. Every time a corporation offshores its production, it converts domestic GDP into imports. The home economy loses GDP to the foreign country that gains it.

Innovation in marketing and software alone will not sustain the electronics industry. The Department of Defense is awaking to the unintended consequences surrounding electronics manufacturing offshoring. Small US manufacturers are not able to invest in materials R&D or manufacturing technologies necessary for advanced PCBs, leading to a recent DoD decision to extend to assemblies a program designed for ICs. A task force report to Congress requested in July 2006 explains, “Ensuring a supply of trusted integrated circuits is necessary, but it is not sufficient to remove risks and vulnerabilities associated with populated printed circuit assemblies. Extending the Defense Trusted Integrated Circuit Strategy to include printed circuit boards (and possibly printed circuit board mounted components) could mitigate the risks posed by tampering and counterfeiting ... While the DoD has not experienced specific disruptions to date, the globalization trend beginning in the 1990s has increased this vulnerability,” the report concludes.

The next wave of outsourcing is upon us, as medical device, aerospace, industrial and security electronics OEMs consider the make or buy decision. Many are succumbing to the lure of low labor-cost geographies. Let’s take a closer look at the financial fundamentals of these low-volume, high-mix boards and replace the knee-jerk chase for low labor rates with a more rational, data-driven approach that considers total costs.

According to our research, these products are not good candidates for low-cost labor regions because, among other reasons, the labor rate is such a small percentage of the total cost of manufacturing. Yet despite this, some of these programs are slated for low labor-cost geographies, including China. Companies are sourcing components in one geography, populating boards in another, and assembling them in yet another before shipping them for use to yet another region.

Our research demonstrates conclusively that, on a fully burdened basis, the overall total costs of doing business this way far exceed any savings. For OEMs in the medical, industrial and aerospace industries in particular, where complicated, high-mix products in low-to-medium volume create high upfront costs, the internal costs to manage these outsourcing programs exceed the cost of the program itself (sans material). Our research demonstrates, in the vast majority of cases, it is cheaper to employ a regional strategy to keep manufacturing in the same geography as the end-customer.

We reviewed hundreds of quotations, including those from low-labor cost regions. In some instances, these quotes come in very low for artificial reasons, including government subsidies. In these instances, the normal principles of free-market economics do not apply. Does it make sense from a risk-management standpoint for an OEM to take advantage of these probably temporary, and at the least, highly unpredictable short-price advantages? In our experience, the risks far outweigh the benefits, and those companies attempting to exploit these prices regret the decision in the long run.

In addition to these risks, well-documented and publicized issues involving counterfeiting should be taken seriously. There are multiple levels of vulnerability here. The components themselves may be counterfeit, or knockoff materials were used to make them. In addition, for OEMs, there is also the greater risk the manufacturer will overrun production and then re-label and sell the product to the domestic market. These are not isolated incidents and are difficult to police from outside the country. It can’t be emphasized enough that laws and assumptions we have about intellectual property are simply not shared in some other geographies.

We recommend a different approach founded in more traditional and comprehensive principles of business accounting and encourage OEMs and their EMS providers to take a second look at their strategies – if for no other reason than to avoid a sudden slap by an invisible hand.

Jennifer Read is principal and co-founder of Charlie Barnhart and Associates (charliebarnhart.com); jennifer@charliebarnhart.com.