The Beginning of the End of Outsourcing

Apple’s iPad and the Human Costs for Workers in China – NYTimes.com

In the Hutong
Working like hell
1530 hrs.

In what China-based business sustainability expert Richard Brubaker calls “the best piece to date on just how rotten [Apple’s] supply chain is,” Charles Duhigg and David Barboza of The New York Times have actually done more than that. They have written a piece that underscores the ethical risks implicit in both outsourcing and offshoring.

Control is the Issue

You could argue that this story and the reception it is getting is a function, in part, of the end of the Steve Jobs Reality Distortion Field, or, as I overheard someone say the other day in reference to Apple, “the King is Dead, the Gloves are Off.” That may be true, in part, but I think that this story is the harbinger of a wider issue plaguing the global manufacturing sector, and the challenges Apple is facing with its suppliers are simply the most visible examples.

The problem goes deeper than the conflict implicit in asking a supplier to give you the best price AND to manage its business in a way that increases its costs. The mater of working conditions is part of a bigger question about the value and importance of control over the means of production. (Don’t worry, I’m not about to go off on a Marxist tangent here. Bear with me.)

I started my career managing the output of 30-odd factories and suppliers in greater China making furniture, jewelry boxes, and small gift items for a medium-sized US importer. I learned a hell of a lot from that job, but the lesson that has stuck with me throughout my career is that you cannot change what you cannot control. We like to think that a customer like Apple would, by virtue of the size of its business, be able to strong arm its suppliers into complying with its codes of behavior, or even “incentivize” a supplier to go along by raising prices. In reality, it is nowhere near that easy. Any customer, even one the size of Apple, exerts influence over how a supplier is run, but not control. A customer can exact some concessions from a supplier on factors outside of product features and quality, but at some point, any self-respecting factory owner is going to push back and say “you may buy from me, you may be my biggest customer, but you don’t own me. I’ll give in to you on some things, but beyond that, you need to let me run my own business.”

Outsourcing and Reputation

As long as governments, NGOs, unions, activist shareholders, and bloggers aren’t looking over the customer’s shoulder, as long as the supplier is compelled to operate according to strict occupational health and safety regulations, or as long as the customer’s customers don’t care, that is an acceptable arrangement. But if the supplier operates in an environment that rewards risking health and safety, has the world watching them online, or has an activist bunch of end-users, the risks of outsourcing grows until it lands the customer and supplier in the hot water that Foxconn and Apple find themselves in today.

Barring an incident that disrupts production, the costs to Apple of its supply chain problems are in goodwill and reputation. Apple, arguably, has amassed enough goodwill and reputation to be able to afford to pay such costs for a while at least. The rest of us must live in a world where we must guard our goodwill and reputation as the corporate crown jewels, spending both with care and amassing more if possible. Indeed, if we replace “Apple” in the NYT story with Nokia, Dell, or Samsung, the report would have very real and unpleasant ramifications for any of those companies.

Apple notwithstanding, we are leaving the age when spin, messaging, great products, and generous corporate philanthropy are enough to pave over corporate practices that governments, shareholders, and consumers find objectionable. We are entering an age where the Spin Gap, the difference between a company’s reputation and the reality of its behavior, is closing, and approaching a time when behavior and reputation are essentially the same thing.

Beyond Goodwill

I tend to harp on reputation and goodwill first because these assets, always important, have become both more important and more fleeting when bad news travels at the speed of Twitter. But the problems with outsourcing and the loss of control over production goes beyond the risk to reputation posed by supplier misbehavior.

We in the west have forgotten that much of the value of our companies create happens in production. The stock market rewards companies for outsourcing their production because of a short-term focus on cost savings and on superficial measures like return on capital. But investors ignore – because they cannot see or measure – the implicit value of keeping production in house.

But, as The Economist pointed out in a superb editorial comparing the fortunes of bankrupt Kodak with those of prospering Fujifilm:

It is easy to think that companies can compete by outsourcing production and focus on developing and marketing. But many innovations bubble up from the factory floor. Even Apple, a master in outsourcing and orchestrating manufacturing, has in-house expertise and occasionally acquires certain technologies. Today, as debates rage in America over the degree to which returns on capital exceed those from actual business operations, and the relative merits of employment in manufacturing versus the services sector, the history of Kodak is more relevant than ever.

The point about innovations on the factory floor deserves some amplification. Apart from the product innovations that come from the factory floor, innovations in the production process itself can become a huge source of competitive advantage. Ford, Toyota, Hewlett-Packard, and Dell are just four companies that built their success to a great degree on innovations in the production processes.

Owning production is a hard sell to a lot of American business, not just because of Wall Street’s expectations, but because so few young Americans learn production or operations management anymore, preferring courses in finance and marketing in the hopes of getting a job in an office. That does not take away from The Economist’s point. You start outsourcing, and not only do you lose control, you mortgage your future for near-term returns.

There is no shortage of companies who, consciously or otherwise, defend their future by hanging onto their factories. Two examples off the top of my head are Boeing and Intel. Boeing got so good at manufacturing that it was able to cut an entire time-consuming step – full-size mockups – out of the development process, going straight from computer model to production on the 777 jetliner. When the company tried to go the “design and market” route with the new 787 dreamliner, they got hit with a three-year delay on their critical 787 program and, until they took back production from several contractors, they were on the verge of sacrificing expertise in a critical new skill area: manufacturing all-composite aircraft components.

Intel has always been a leader in manufacturing processes, being first in the industry to try new, expensive, and often risky technologies, working out the kinks, and sustaining leadership as a result of that expertise. Even today, Intel outsources little: the company continues to build, own, and operate manufacturing incredibly expensive manufacturing facilities – from chip fabricators to pack-and-test assembly lines – because the company understands that there is more to their business than design and marketing.

And the idea of outsourcing would be anathema to Mercedes-Benz, Fender Guitars, Microsoft, or most companies in the service industries. In all of those cases, keeping the production close is either an important part of the value delivered or the very source of  company’s differentiation.

The Vote of History

Outsourcing has saved its share of companies and returned its share of profits. But the persistent challenges encountered in its execution by one of the smartest and healthiest companies in the world is a warning: short-term expedients do not create long-term winners. Those of us who love Apple and the products it makes and who understand the nature of its relationship with its suppliers (and their own ambitions) make us worry that the company is forgetting a key source of its uniqueness.

The upshot of the above is simple: two years from now even Apple could find its reputation savaged by the perfect storm of one bad product, one down quarter, and a mishap caused by a factory it did not control; or fifteen years from now it could follow Bethlehem Steel, General Motors, and Kodak into the ignominy of Chapter 11. Either would be the ultimate result of depending on somebody else’s factory for the production of Apple devices.

What is true for Apple applies doubly for the rest of us. The factory floor matters. It’s time to take it back.

Richard Ford

David, you mentioned that owning production was a hard sell to American businesses. How coupled is this to the investment mentalities and stock market?

I ask because in the new startup that I am working with (www.skaffold.com) I have been taking a crash course in attitudes in stock markets and the like. One thing I have noticed is that dividends are seldom, if ever paid in the US. While it is sought after and preferred in Australia.

Now if investors can influence how a company deals with the issue of dividends (Apple is sitting on a huge pile of cash) can it also be said that investors, through tactic or ignorance are also effecting how these companies approach the issue of production?

David Wolf

Richard, it is very coupled. Having done investor relations work for companies using the “factory-less” model, a large cash horde and a high return on capital ratio are two measures institutions in particular use to gauge desirability of an investment. Companies will only focus on dividends when the world returns to value investing, and firms will hold onto their factories when it is obvious to shareholders that those factories are essential to the firm’s near-term returns.

Michael A. Robson

“Apple’s iPad and the Human Costs for Workers in China – NYTimes.com”

Hm. If it weren’t for Apple they’d be making less money, not more. Damn you Apple. Damn you. Why can’t HP/Dell, etc make more stuff? Oh, cuz those companies are doing that well? They don’t make phones? They only make commodity PC boxes?

Got it.

Great Example of Moral businesses.

PS. You just compared Apple to Kodak? Are you on crack?

David Wolf

PS. You just compared Apple to Kodak? Are you on crack?

No. The decisions made at Kodak that eventually caused the company’s decline were made in the late 1970s, a period during which Kodak was one of the bluest of blue chips and at the height of the company’s popularity and profitability. To have suggested then that the company would be bankrupt 35 years hence would have sounded insane. Apple may be making decisions now that contain the seeds of its own demise. This very concern is what lay at the heart of Andy Grove’s urge to stay paranoid.

Michael A. Robson

PPS. The Factory isn’t going back to the US. It’s going to Vietnam/Cambodia.
PPPS. If you think factories in Taiwan or Korea are any better, then how on Earth are HTC/Samsung products so competitively priced? Exactly. They’re all the same. Every Smartphone costs $199+Contract. Every 7″ tablet is about the same $. Every 10″ tablet costs about the same. They’re all the same. Unless you can prove that factory workers in Korea are making great money. And if they are, then Samsung are idiots for not outsourcing production to China/Indonesia/Vietnam.

David Wolf

Factories that depend on cheap or low-skilled labor working in conditions with which OSHA would be uncomfortable are not going back to the US. They’re going to Vietnam and Cambodia, as you say, and if the price of oil jumps, to Mexico and Rumania. And mass production is not coming back: as Devon Sweezy said in the Huffington Post last week, one of major reasons Apple is in China is the availability of scale, not just cheap labor. There is nothing approaching in capacity what Terry Gou has built in Dongguan alone.

The kind of manufacturing that will stay in the US is smaller-run, more localized/customized, time-sensitive and high-IP production. As some industries move to greater “mass customization,” production will fall in scale and move closer to the customer. So manufacturing will never go away in the US, it will get very different (the recent jump in 44,000 automotive jobs notwithstanding.)

Ben Shobert

David – Great post. I’m guessing you’re familiar w/ Clyde Prestowitz’s thoughts on Apple, but if not it’s worth looking at his last couple of columns about Apple’s reliance on the US government. More relevant to your post and a stronger point is what he believes US policies have resulted in, namely, that by having the locus of high-technology production taking place outside of the US, we are growing disconnected from one of the more traditional places where innovation occurs (i.e. the factory floor). I’d also double down on your comments about Boeing. In Seattle there is a growing fear that Boeing’s supply chain w/ the 787 has set in motion the inevitable Asian competitor everyone really fears … not Beijing’s AVIC but Tokyo’s Mitsubishi. We may have taken a good idea (stay close to your core competencies) too far and assumed that our companies, and perhaps even our nation, can be “systems integrators” only. I suspect we need to be a little further into the supply chain than only at this latter stage.

David Wolf

Thanks, Ben. I’ll be looking up Prestowitz’s columns. I did not even consider the policy incentives for offshoring.

And I have to agree about Mitsubishi. When I heard they were fabricating the wing assembly for the 787, I banged my head on the table, knowing that would come back to haunt the US industry somehow, possibly in the form of a Mitsu tie-up with AVIC, or worse. The implications that has on the defense side of the house are concerning as well: if Mitsubishi gets comfortable with fabrication of composite airframe components, how long before they are producing a 5th generation fighter in competition with Boeing and Lockheed? And Japan has ever been a sieve when it comes to defense technologies (see http://lubbers-line.blogspot.com/2005/10/toshiba-and-russian-espionage-again.html for links).