By Eric Miscoll, Publisher EMSNOW

A few weeks ago, we introduced  a series of articles describing trends we have observed as the EMS industry has evolved over the last few decades. We outlined six themes that we promised we would elaborate on over the coming weeks.

At long last, we pick up the first of those. Here’s what we said:

The China Price – Remember when Wall Street decided to ‘encourage’ all publicly held electronics OEMs to outsource their ‘dirty factories’ to China? Labor is so cheap, they said. Developed countries can become ‘service economies’. What could go wrong? We’ll explore.

If you Google China Price you’ll get a whole bunch of articles from 2004-9 where journalists with their hair on fire wrote things like this quote from Bloomberg:

The China Price. They are the three scariest words in U.S. industry. Cut your price at least 30% or lose your customers. Nearly every manufacturer is vulnerable — from furniture to networking gear. The result: A massive shift in economic power is under way.

Journalists at that time made three main arguments about why this was the inevitable result of globalization and mainly a good thing:

  • Addicted to cheap: The developed world’s consumers love getting everything cheaper.
  • Billions of Chinese consumers: Multinational businesses have to build products in China to gain access to those markets.
  • Service economy is better than manufacturing: Outsourcing manufacturing to take advantage of low labor rates won’t hurt workers because they can get better jobs in service industries.

Like most simplifications, these contained kernels of truth and a lot of complications.

We’ll address these bullets more fully in future articles, but the main fallacy of ‘the China price’ for electronics manufacturing was the idea that there were billions of workers willing and able to build complex electronic products for $1/hour and then turn around in a few years and become consumers of those products. Even if these electronics are ‘cheap’ by Western standards, you can’t buy them if you are making $1/hour. And anyway, once you learn how to make a complicated product like a cell phone, you’ll have the skills necessary to demand more than $1/hour.

In about 2004, our colleague Charlie Barnhart began compiling data about labor rates to allow OEMs to make informed decisions about their electronic manufacturing services spend. He intended to both educate and warn people that direct labor rates were not a good measure of the true costs of outsourcing to China and other so called ‘low labor cost’ regions. Charlie’s data was very accurate because it was sourced from actual quotes from his vast trusted network of managers coming out of decades in the EMS industry. These executives of public companies were getting pressure from the investment community to follow the herd and send manufacturing to the region where they could get the cheapest labor. Many of them knew that this could be catastrophic. They were hoping for some data to support a more thoughtful analysis. Indeed, some of the quotes that Charlie received from his network had to be separated from the database after a few years because the projects failed, sometimes spectacularly.

The Cost of the China Price

Instead of direct labor rates Charlie used ‘fully burdened direct labor rates’ for an expanding list of regions tracked, including China. These were specific to the EMS industry. The fully burdened rate included direct labor costs and the overheard burden assigned to it, all according to Generally Accepted Accounting Principles (GAAP).

In 2010, the average unburdened direct labor cost number for China was $1.11/hour. However the associated overhead burden in China was 960%, putting the fully burdened rate at more like $10/hour. That didn’t include the associated risk factors, such as geographic distance, miscommunications based on language, cultural and legal differences; unstable infrastructure, intellectual property theft, and so forth. Building electronic products is a complicated endeavor and the data reflected the challenges of handing over all that tribal knowledge to a group of people a half a globe away.

The warning issued by Charlie Barnhart & Associates (CBA) to its clients was that these labor prices were not going to last forever. In fact, at one point we advised that labor rates would increase at a rate of 1-1.5% per month. When making these statements in conference rooms we were often met with derision and outright scoffing: “What? There are billions of Chinese people happy to work for $1/hour.” We would point out that the Chinese government itself had already announced in its Five Year Plan that it had no intention of staying in the category of lowest global labor cost region. Chinese economists and politicians had a long range plan. Unfortunately, many executives in C-suites of the Fortune 500 were more short-sighted and not as strategic.

So what happened to the China Price? Well, it served the strategic plan of the Chinese government that operated more from an employment motive rather than the profit motive driving western companies who tried to take advantage of it. And it served this objective well…until the needs and objectives of China changed. When this happened, many western companies were left to reassess and restructure their supply solutions, while China transitioned from third world to arguably first world status.

Hopefully, western companies have learned this lesson and will not seek to replicate it in other far flung regions of the world such as India, Vietnam, or sub-Saharan Africa (which does have the lowest direct labor rates on the planet).

We believe that lessons have been learned, as we will discuss in future articles.