Global Business Assignment!

After you have read this chapter you should be able to:

1 Explain why production and logistics decisions are of central importance to many multinational businesses. 2 Explain how country differences, production technology, and product features all affect the choice of where to locate production

activities.

3 Recognize how the role of foreign subsidiaries in production can be enhanced over time as they accumulate knowledge. 4 Identify the factors that influence a firm’s decision of whether to source supplies from within the company or from foreign suppliers. 5 Describe what is required to efficiently coordinate a globally dispersed production system.

L E

A R

N IN

G O

B J E

C T

IV E

S

part 5 Competing in a Global Marketplace

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opening case

India is well on its way to becoming a small-car manufacturing hub for some of the world’s largest automobile companies. Between 2003 and 2008 automobile exports from India increased fivefold to about 250,000 cars a year. Despite a global economic slowdown, exports are predicted to increase, reaching half a million vehicles a year by 2012. The leading Indian exporter is the Korean company Hyundai, which committed early to the Indian market. Hyundai began production in India in 1998, when consumers were only purchasing 300,000 cars a year, despite the country’s population of almost 1 billion people. Hyundai invested in a plant in the southern city of Chennai with the capacity to turn out 100,000 cheap small cars a year. It had to train most of the workers, often giving them two years of on-the-job training before hiring them full time. Soon Hyundai’s early investments were paying off, as Indian’s emerging middle class snapped up its cars. Still the company had excess capacity, so it turned its attention to exports. By 2004, Hyundai was the country’s largest automobile exporter, shipping 70,000 cars a year overseas. Things have only improved for Hyundai since then. By 2008 Hyundai was making 500,000 cars a year in India and exporting over a third of them. Its smallest car, the i10, is now produced only in India and shipped mainly to Europe. The company plans to expand its Indian manufacturing capacity to 650,000, and ship up to half of its output overseas. Hyundai is now considering selling its Indian-made cars in the United States as well as in Europe. Hyundai’s success has not gone unnoticed. Suzuki and Nissan have also been investing aggressively in Indian automobile factories. Suzuki exported about 50,000 cars from India in 2007 and hopes to increase that to 200,000 by 2010. Nissan also has big plans for India. It has invested some $1.1 billion in a new factory close to Hyundai’s in Chennai. Completed in 2010, the fac- tory has the capacity to make some 400,000 cars a year, about half of

Global Production, Outsourcing, and Logistics

14 c h a p t e r

The Rise of the Indian Automobile Industry

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468 Part Five Competing in a Global Marketplace

which will be exported. Ford, BMW, GM, and Toyota are also building, or planning to build, cars in India. A notable local competitor is Tata Motors, which launched a low-cost “people’s car,” priced at $2,500, for the Indian market in 2009. For all of these companies, India has several attractions. The rapidly develop- ing country has a potentially large domestic market. Also, labor costs are low compared to many other nations. Nissan, for example, notes that wage rates in India will be one-tenth of those in its Japanese factories. Plus, as Hyundai has shown, productivity is high and Indian workers can produce quality automo- biles. Hyundai’s executives claim that its Indian cars are of comparable quality to those produced in Korea. Nissan’s goal is to use the same highly efficient flexible manufacturing processes in India as it uses in Japan. Before it starts production, Nissan plans to send Indian workers to its Japanese factories for training on manufacturing processes and quality control. India produces a large number of engineers every year, providing the pro- fessional skill base for designing cars and managing complex manufacturing facilities. Nissan intends to draw on this talent to design a low-cost small car to compete with Tata. According to Nissan executives, the great advantage of India’s engineers is that they are less likely to have the preconceptions of automobile engineers in developed nations, are more likely to “think outside of the box,” and thus may be better equipped to handle the challenges of designing an ultra-low-cost small car. Establishing manufacturing facilities in India does have problems, how- ever. Nissan executives note that basic infrastructure is still lacking, roads are poor, and often clogged with everything from taxis and motorbikes to bullocks and carts, making the Japanese practice of just-in-time delivery hard to implement. It is also proving challenging to find local parts suppliers that can attain the same high-quality standards as those Nissan follows else- where in the world. Nissan’s strategy has been to work with promising local companies, helping them to raise their standards. For example, under the guidance of engineers from Nissan, the Indian parts supplier Capro, which makes body panels, has built a new factory near Nissan’s Chennai facility, using the latest Japanese equipment. Workers there have also been trained in the Japanese practice of kaizen, or continuous process improvement. While it is still early, observers see the potential for Chennai to develop into the Detroit of India, with a cluster of automobile companies and parts suppliers working in the region producing high-quality, low-cost small cars that will not only sell well in the rapidly expanding Indian market, but could also sell well worldwide.

Sources: E. Bellman, “India Cranks Out Small Cars for Export,” The Wall Street Journal, October 6, 2008, p. A1; N. Lakshman, “India’s Car Market Offers No Relief for Automakers,” BusinessWeek Online, December 23, 2008; and M. Fackler, “In India, a New Detroit,” The New York Times, June 26, 2008, pp. C1, C4.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 469

Introduction As trade barriers fall and global markets develop, many firms increasingly confront a set of interrelated issues. First, where in the world should production activities be lo- cated? Should they be concentrated in a single country, or should they be dispersed around the globe, matching the type of activity with country differences in factor costs, tariff barriers, political risks, and the like to minimize costs and maximize value added? Second, what should be the long-term strategic role of foreign production sites? Should the firm abandon a foreign site if factor costs change, moving production to another more favorable location, or is there value to maintaining an operation at a given location even if underlying economic conditions change? Third, should the firm own foreign production activities, or is it better to outsource those activities to inde- pendent vendors? Fourth, how should a globally dispersed supply chain be managed, and what is the role of Internet-based information technology in the management of global logistics? Fifth, should the firm manage global logistics itself, or should it out- source the management to enterprises that specialize in this activity? The rise of the Indian automobile industry touches on some of these issues, since the industry is being driven by investment from foreign companies such as Hyundai and Nissan. These companies clearly see India, and particularly the region around the southern city of Chennai, as an emerging global center for the manufacture of low- cost small cars. In Nissan’s view, for example, not only does India’s own rapidly grow- ing domestic market make local production attractive, but also the combination of low labor costs, high quality, good engineering talent, and the beginnings of a network of local suppliers makes Chennai a good global hub for designing, manufacturing, and then exporting low-cost small cars to other markets around the globe. From a strategic perspective, the goal of companies such as Nissan and Hyundai is to turn their Chennai factories into important components of their global manufacturing system.

Strategy, Production, and Logistics In Chapter 11, we introduced the concept of the value chain and discussed a number of value creation activities, including production, marketing, logistics, R&D, human resources, and information systems. In this chapter, we will focus on two of these activities— production and logistics —and attempt to clarify how they might be per- formed internationally to (1) lower the costs of value creation and (2) add value by better serving customer needs. We will discuss the contributions of information tech- nology to these activities, which has become particularly important in the era of the Internet. In later chapters, we will look at other value creation activities in this inter- national context (marketing, R&D, and human resource management). In Chapter 11, we defined production as “the activities involved in creating a prod- uct.” We used the term production to denote both service and manufacturing activities, since one can produce a service or produce a physical product. Although in this chapter we focus more on the production of physical goods, one should not forget that the term can also be applied to services. This has become more evident in recent years with the trend among U.S. firms to outsource the “production” of certain service activities to developing nations where labor costs are lower (for example, the trend among many U.S. companies to outsource customer care services to places such as India, where English is widely spoken and labor costs are much lower). Logistics is the activity that controls the transmission of physical materials through the value chain, from procure- ment through production and into distribution. Production and logistics are closely linked since a firm’s ability to perform its production activities efficiently depends on a timely supply of high-quality material inputs, for which logistics is responsible.

LEARNING OBJECTIVE 1 Explain why production and

logistics decisions are of central importance to many

multinational businesses.

Logistics The procurement and physical transmission of material through the supply chain, from suppliers to customers.

Production Activities involved in creating a product.

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470 Part Five Competing in a Global Marketplace

The production and logistics functions of an international firm have a number of important stra- tegic objectives. 1 One is to lower costs. Dispersing production activities to various locations around the globe where each activity can be performed most efficiently can lower costs. Costs can also be cut by managing the global supply chain efficiently so as to better match supply and demand. Efficient supply chain management reduces the amount of inventory in the system and increases inventory turnover, which means the firm has to invest less working capital in inventory and is less likely to find excess inventory on hand that cannot be sold and has to be written off.

A second strategic objective shared by produc- tion and logistics is to increase product quality by eliminating defective products from both the sup- ply chain and the manufacturing process. 2 (In this context, quality means reliability, implying that the

product has no defects and performs well.) The objectives of reducing costs and increasing quality are not independent of each other. As illustrated in Figure 14.1, the firm that improves its quality control will also reduce its costs of value creation. Improved quality control reduces costs by:

• Increasing productivity because time is not wasted producing poor-quality products that cannot be sold, leading to a direct reduction in unit costs.

• Lowering rework and scrap costs associated with defective products. • Reducing the warranty costs and time associated with fixing defective products.

The effect is to lower the costs of value creation by reducing both production and after-sales service costs. The principal tool that most managers now use to increase the reliability of their product offering is the Six Sigma quality improvement methodology. The Six Sigma methodology is a direct descendant of the total quality management (TQM) philoso- phy that was widely adopted, first by Japanese companies and then American companies

Another Per spect i ve

Careers in Supply Chain Management With increased outsourcing and overseas production sites and customers, supply chain management is a growing field. The Council of Supply Chain Management Profes- sionals (CSCMP), a professional association with more than 8,500 members worldwide, says the industry offers a promising outlook. What’s more, potential employers are everywhere—manufacturers and distributors; government agencies; consulting firms; the transport industry; universi- ties and colleges; service firms such as banks, hospitals, and hotels; and third-party logistics providers. For more information about the organization and careers in this field, visit the CSCMP Web site at www.cscmp.org and its careers site, www.careersinsupplychain.org.

Improves performance

reliability

Lowers rework and scrap costs

Lowers manufacturing

costs

Increases profits

Increases productivity

Lowers warranty

costs

Lowers service costs

figure 14.1

The Relationship between Quality

and Costs

Total Quality Management

(TQM) Management philosophy

that takes as its central focus the need to

improve the quality of a company’s products and

services.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 471

during the 1980s and early 1990s. 3 The TQM philosophy was developed by a number of American consultants such as W. Edward Deming, Joseph Juran, and A. V. Feigenbaum. 4 Deming identified a number of steps that should be part of any TQM program. He ar- gued that management should embrace the philosophy that mistakes, defects, and poor- quality materials are not acceptable and should be eliminated. He suggested that the quality of supervision should be improved by allowing more time for supervisors to work with employees and by providing them with the tools they need to do the job. Deming recommended that management should create an environment in which em- ployees will not fear reporting problems or recommending improvements. He believed that work standards should not only be defined as numbers or quotas, but should also include some notion of quality to promote the production of defect-free output. He ar- gued that management has the responsibility to train employees in new skills to keep pace with changes in the workplace. In addition, he believed that achieving better quality requires the commitment of everyone in the company. Six Sigma, the modern successor to TQM, is a statistically based philosophy that aims to reduce defects, boost productivity, eliminate waste, and cut costs throughout a company. Six Sigma programs have been adopted by several major corporations, such as Motorola, General Electric, and Allied Signal. Sigma comes from the Greek letter that statisticians use to represent a standard deviation from a mean, the higher the number of “sigmas” the smaller the number of errors. At six sigma, a production pro- cess would be 99.99966 percent accurate, creating just 3.4 defects per million units. While it is almost impossible for a company to achieve such perfection, Six Sigma quality is a goal that several strive toward. Increasingly, companies are adopting Six Sigma programs to try to boost their product quality and productivity. 5 The growth of international standards has also focused greater attention on the importance of product quality. In Europe, for example, the European Union requires that the quality of a firm’s manufacturing processes and products be certified under a quality standard known as ISO 9000 before the firm is allowed access to the EU mar- ketplace. Although the ISO 9000 certification process has proved to be somewhat bu- reaucratic and costly for many firms, it does focus management attention on the need to improve the quality of products and processes. 6

Six Sigma Statistically based methodology for improving product quality.

ISO 9000 Certification process that requires certain quality standards must be met.

Motorola uses the Six Sigma philosophy, which aims to reduce defects, boost productivity, eliminate waste, and cut costs throughout the company.

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472 Part Five Competing in a Global Marketplace

In addition to the lowering of costs and the improvement of quality, two other objec- tives have particular importance in international businesses. First, production and logis- tics functions must be able to accommodate demands for local responsiveness. As we saw in Chapter 12, demands for local responsiveness arise from national differences in con- sumer tastes and preferences, infrastructure, distribution channels, and host-government demands. Demands for local responsiveness create pressures to decentralize production activities to the major national or regional markets in which the firm does business or to implement flexible manufacturing processes that enable the firm to customize the prod- uct coming out of a factory according to the market in which it is to be sold. Second, production and logistics must be able to respond quickly to shifts in cus- tomer demand. In recent years, time-based competition has grown more important. 7 When consumer demand is prone to large and unpredictable shifts, the firm that can adapt most quickly to these shifts will gain an advantage. 8 As we shall see, both pro- duction and logistics play critical roles here.

Where to Produce An essential decision facing an international firm is where to locate its production ac- tivities to best minimize costs and improve product quality. For the firm contemplat- ing international production, a number of factors must be considered. These factors can be grouped under three broad headings: country factors, technological factors, and product factors. 9

COUNTRY FACTORS We reviewed country-specific factors in some detail ear- lier in the book. Political economy, culture, and relative factor costs differ from coun- try to country. In Chapter 5, we saw that due to differences in factor costs, some countries have a comparative advantage for producing certain products. In Chapters 2 and 3, we saw how differences in political economy and national culture influence the benefits, costs, and risks of doing business in a country. Other things being equal, a firm should locate its various manufacturing activities where the economic, political, and cultural conditions, including relative factor costs, are conducive to the perfor- mance of those activities (for an example, see the accompanying Management Focus, which looks at the Philips NV investment in China). In Chapter 12, we referred to the benefits derived from such a strategy as location economies. We argued that one result of the strategy is the creation of a global web of value creation activities. Also important in some industries is the presence of global concentrations of activities at certain locations. In Chapter 7, we discussed the role of location externalities in influ- encing foreign direct investment decisions. Externalities include the presence of an ap- propriately skilled labor pool and supporting industries. 10 Such externalities can play an important role in deciding where to locate manufacturing activities. For example, because of a cluster of semiconductor manufacturing plants in Taiwan, a pool of labor with experi- ence in the semiconductor business has developed. In addition, the plants have attracted a number of supporting industries, such as the manufacturers of semiconductor capital equipment and silicon, which have established facilities in Taiwan to be near their cus- tomers. This implies that there are real benefits to locating in Taiwan, as opposed to an- other location that lacks such externalities. Other things being equal, the externalities make Taiwan an attractive location for semiconductor manufacturing facilities. Of course, other things are not equal. Differences in relative factor costs, political economy, culture, and location externalities are important, but other factors also loom large. Formal and informal trade barriers obviously influence location decisions (see Chapter 6), as do transportation costs and rules and regulations regarding foreign direct investment (see Chapter 7). For example, although relative factor costs may make a

LEARNING OBJECTIVE 2 Explain how country differences, production technology, and product features all affect the choice of where to locate production activities.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 473

country look attractive as a location for performing a manufacturing activity, regulations prohibiting foreign direct investment may eliminate this option. Similarly, a consider- ation of factor costs might suggest that a firm should source production of a certain component from a particular country, but trade barriers could make this uneconomical. Another country factor is expected future movements in its exchange rate (see Chapters 9 and 10). Adverse changes in exchange rates can quickly alter a country’s attractiveness as a manufacturing base. Currency appreciation can transform a

Management FOCUS

Philips in China

The Dutch consumer electronics, lighting, semiconductor, and medical equipment conglomerate Philips NV has been operating factories in China since 1985 when the country first opened its markets to foreign investors. Then China was seen as the land of unlimited demand, and Philips, like many other Western companies, dreamed of Chinese con- sumers snapping up its products by the millions. But the company soon found out that one of the big reasons the company liked China—the low wage rates—also meant that few Chinese workers could afford to buy the products they were producing. Chinese wage rates are currently one-third of those in Mexico and Hungary, and 5 percent of those in the United States or Japan. So Philips hit on a new strategy; keep the factories in China but export most of the goods to the United States and elsewhere. By the mid-2000s, Philips had invested over $2.5 billion in China. The company now operates 25 wholly owned sub- sidiaries and joint ventures in China. Together they employ some 30,000 people. Philips exports nearly two-thirds of the $7 billion in products that the factories produce every year. Philips accelerated its Chinese investment in antici- pation of China’s entry into the World Trade Organization. The company plans to move even more production to China in the future. In 2003, Philips announced it would phase out production of electronic razors in the Netherlands, lay off 2,000 Dutch employees, and move production to China by 2005. A week earlier, Philips had stated it would expand capacity at its semiconductor factories in China, while phasing out production in higher-cost locations elsewhere. The attractions of China to Philips include low wage rates, an educated workforce, a robust Chinese economy, a stable exchange rate that is pegged to the U.S. dollar, a rapidly expanding industrial base that includes many other Western and Chinese companies that Philips uses as sup- pliers, and easier access to world markets given China’s entry into the WTO. Philips has stated that ultimately its goal is to turn China into a global supply base from which the company’s products will be exported around the world. By the mid-2000s more than 25 percent of every- thing Philips made worldwide came from China, and

executives say the figure is rising rapidly. Several prod- ucts, such as CD and DVD players, are now made only in China. Philips is also starting to give its Chinese factories a greater role in product development. In the TV business, for example, basic development used to occur in Holland but was moved to Singapore in the early 1990s. Now Phil- ips is transferring TV development work to a new R&D center in Suzhou near Shanghai. Similarly, basic product development work on LCD screens for cell phones was recently shifted to Shanghai. Philips is hardly alone in this process. By the mid-2000s more than half of all exports from China came from foreign manufacturers or their joint ventures in China. China was the source of more than 80 percent of the DVD players sold worldwide, 50 percent of the cameras, 40 percent of all mi- crowave ovens, 30 percent of the air conditioners, 25 percent of the washing machines, and 20 percent of all refrigerators. Some observers worry that Philips and companies pur- suing a similar strategy might be overdoing it. Too much dependence on China could be dangerous if political, eco- nomic, or other problems disrupt production and the com- pany’s ability to supply global markets. Some observers believe that it might be better if the manufacturing facili- ties of companies were more geographically diverse as a hedge against problems in China. The fears of the critics were given some substance in early 2003 when an out- break of the pneumonia-like SARS (severe acute respira- tory syndrome) virus in China resulted in the temporary shutdown of several plants operated by foreign compa- nies and disrupted their global supply chains. Although Philips was not directly affected, it did restrict travel by its managers and engineers to its Chinese plants.

Sources: B. Einhorn. “Philips’ Expanding Asia Connections,” BusinessWeek Online, November 27, 2003; K. Leggett and P. Wonacott, “The World’s Factory: A Surge in Exports from China Jolts the Global Industry,” The Wall Street Journal, October 10, 2002, p. A1; “Philips NV: China Will Be Production Site for Electronic Razors,” The Wall Street Journal, April 8, 2003, p. B12; “Philips Plans China Expansion,” The Wall Street Journal, September 25, 2003, p. B13; M. Saunderson, “Eight out of 10 DVD Players Will Be Made in China,” Dealerscope, July 2004, p. 28; and J. Blau, “Philips Tears Down Eindhoven R&D Fence,” Research Technology Management 50, no. 6 (2007), pp. 9–11.

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474 Part Five Competing in a Global Marketplace

low-cost location into a high-cost location. Many Japanese corporations had to grap- ple with this problem during the 1990s and early 2000s. The relatively low value of the yen on foreign exchange markets between 1950 and 1980 helped strengthen Japan’s position as a low-cost location for manufacturing. Between 1980 and the mid-1990s, however, the yen’s steady appreciation against the dollar increased the dollar cost of products exported from Japan, making Japan less attractive as a manufacturing loca- tion. In response, many Japanese firms moved their manufacturing offshore to lower- cost locations in East Asia.

TECHNOLOGICAL FACTORS The type of technology a firm uses to perform specific manufacturing activities can be pivotal in location decisions. For example, be- cause of technological constraints, in some cases it is necessary to perform certain man- ufacturing activities in only one location and serve the world market from there. In other cases, the technology may make it feasible to perform an activity in multiple loca- tions. Three characteristics of a manufacturing technology are of interest here: the level of fixed costs, the minimum efficient scale, and the flexibility of the technology.

Fixed Costs As we noted in Chapter 11, in some cases the fixed costs of setting up a production plant are so high that a firm must serve the world market from a single location or from a very few locations. For example, it now costs more than $1 billion to set up a state-of-the-art plant to manufacture semiconductor chips. Given this, other things being equal, serving the world market from a single plant sited at a single (optimal) location can make sense. Conversely, a relatively low level of fixed costs can make it economical to perform a particular activity in several locations at once. This allows the firm to better accom- modate demands for local responsiveness. Manufacturing in multiple locations may also help the firm avoid becoming too dependent on one location. Being too depen- dent on one location is particularly risky in a world of floating exchange rates. Many firms disperse their manufacturing plants to different locations as a “real hedge” against potentially adverse moves in currencies.

Minimum Efficient Scale The concept of economies of scale tells us that as plant output expands, unit costs decrease. The reasons include the greater utilization of capital equipment and the productivity gains that come with specialization of employees within the plant. 11 However, beyond a certain level of output, few additional scale economies are available. Thus, the “unit cost curve” declines with output until a certain output level is reached, at which point further increases in output realize little reduction in unit costs. The level of output at which most plant-level scale economies are exhausted is referred to as the minimum efficient scale of output. This is the scale of output a plant must operate to realize all major plant-level scale economies (see Figure 14.2). The implications of this concept are as follows: The larger the minimum efficient scale of a plant relative to total global demand, the greater the argument for centraliz- ing production in a single location or a limited number of locations. Alternatively, when the minimum efficient scale of production is low relative to global demand, it may be economical to manufacture a product at several locations. For example, the minimum efficient scale for a plant to manufacture personal computers is about 250,000 units a year, while the total global demand exceeds 35 million units a year. The low level of minimum efficient scale in relation to total global demand makes it economically fea- sible for a company such as Dell to manufacture PCs in six locations. As in the case of low fixed costs, the advantages of a low minimum efficient scale include allowing the firm to accommodate demands for local responsiveness or to hedge against currency risk by manufacturing the same product in several locations.

Minimum Efficient Scale

The level of output at which most plant-level

scale economies are exhausted.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 475

Flexible Manufacturing and Mass Customization Central to the concept of economies of scale is the idea that the best way to achieve high efficiency, and hence low unit costs, is through the mass production of a standardized output. The trade-off implicit in this idea is between unit costs and product variety. Producing greater product variety from a factory implies shorter production runs, which in turn implies an inability to realize economies of scale. That is, wide product variety makes it difficult for a company to increase its production efficiency and thus re- duce its unit costs. According to this logic, the way to increase efficiency and drive down unit costs is to limit product variety and produce a standardized product in large volumes. This view of production efficiency has been challenged by the rise of flexible manufacturing technologies. The term flexible manufacturing technology —or lean production, as it is often called—covers a range of manufacturing technolo- gies designed to (1) reduce setup times for complex equipment, (2) increase the utilization of individual machines through better scheduling, and (3) improve qual- ity control at all stages of the manufacturing process. 12 Flexible manufacturing technologies allow the company to produce a wider variety of end products at a unit cost that at one time could be achieved only through the mass production of a standardized output. Research suggests the adoption of flexible manufacturing technologies may actually increase efficiency and lower unit costs relative to what can be achieved by the mass production of a standard- ized output, while at the same time enabling the company to customize its product offering to a much greater extent than was once thought possible. The term mass customization has been coined to describe the ability of companies to use flexible manufacturing technology to reconcile two goals that were once thought to be incompatible—low cost and product customization. 13 Flexible manu- facturing technologies vary in their sophistication and complexity.

Volume

Un it

co st

s

Minimum efficient scale

14.2 figure

A Typical Unit-Cost Curve

Flexible Manufacturing Technology (Lean Production) Manufacturing technology designed to improve job scheduling, reduce setup time, and improve quality control.

Mass Customization The production of a variety of end products at a unit cost that could once be achieved only through mass production of a standardized output.

Ford Motor Co. uses flexible manufacturing technology at its Louisville, Kentucky, assembly plant.

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476 Part Five Competing in a Global Marketplace

One of the most famous examples of a flexible manufacturing technology, Toyota’s production system, has been credited with making Toyota the most efficient auto com- pany in the world. (Despite Toyota’s recent problems with sudden uncontrolled acceleration, the company continues to be an efficient producer of high-quality automo- biles, according to J.D. Power and Associates, which produces an annual quality survey. Indeed, Toyota’s Lexus models continue to top J.D. Power’s quality rankings.) 14 Toyota’s flexible manufacturing system was developed by one of the company’s engineers, Ohno Taiichi. After working at Toyota for five years and visiting Ford’s U.S. plants, Ohno became convinced that the mass production philosophy for making cars was flawed. He saw numerous problems with mass production.

First, long production runs created massive inventories that had to be stored in large warehouses. This was expensive, both because of the cost of warehousing and because inventories tied up capital in unproductive uses. Second, if the initial ma- chine settings were wrong, long production runs resulted in the production of a large number of defects (i.e., waste). Third, the mass production system was unable to accommodate consumer preferences for product diversity. In response, Ohno looked for ways to make shorter production runs economical. He developed a number of techniques designed to reduce setup times for produc- tion equipment (a major source of fixed costs). By using a system of levers and pul- leys, he reduced the time required to change dies on stamping equipment from a full day in 1950 to three minutes by 1971. This made small production runs economical, which allowed Toyota to respond better to consumer demands for product diversity. Small production runs also eliminated the need to hold large inventories, thereby reducing warehousing costs. Plus, small product runs and the lack of inventory meant that defective parts were produced only in small numbers and entered the assembly process immediately. This reduced waste and helped trace defects back to their source to fix the problem. In sum, these innovations enabled Toyota to produce a more diverse product range at a lower unit cost than was possible with conven- tional mass production. 15 Flexible machine cells are another common flexible manufacturing technology. A flexible machine cell is a grouping of various types of machinery, a common materials handler, and a centralized cell controller (computer). Each cell normally contains four to six machines capable of performing a variety of operations. The typical cell is dedi- cated to the production of a family of parts or products. The settings on machines are computer controlled, which allows each cell to switch quickly between the production of different parts or products. Improved capacity utilization and reductions in work in progress (that is, stockpiles of partly finished products) and in waste are major efficiency benefits of flexible ma- chine cells. Improved capacity utilization arises from the reduction in setup times and from the computer-controlled coordination of production flow between machines, which eliminates bottlenecks. The tight coordination between machines also reduces work-in-progress inventory. Reductions in waste are due to the ability of computer- controlled machinery to identify ways to transform inputs into outputs while produc- ing a minimum of unusable waste material. While freestanding machines might be in use 50 percent of the time, the same machines when grouped into a cell can be used more than 80 percent of the time and produce the same end product with half the waste. This increases efficiency and results in lower costs. The effects of installing flexible manufacturing technology on a company’s cost struc- ture can be dramatic. Ford Motor Co. has been introducing flexible manufacturing tech- nologies into its automotive plants around the world. These new technologies should allow Ford to produce multiple models from the same line and to switch production

Flexible Machine Cells

Flexible manufacturing technology in which a

grouping of various machine types, a common

materials handler, and a centralized cell controller

produce a family of products.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 477

from one model to another much more quickly than in the past, allowing Ford to take $2 billion out of its cost structure. 16 Besides improving efficiency and lowering costs, flexible manufacturing technolo- gies also enable companies to customize products to the demands of small consumer groups—at a cost that at one time could be achieved only by mass-producing a stan- dardized output. Thus, the technologies help a company achieve mass customization, which increases its customer responsiveness. Most important for international busi- ness, flexible manufacturing technologies can help a firm to customize products for different national markets. The importance of this advantage cannot be overstated. When flexible manufacturing technologies are available, a firm can manufacture prod- ucts customized to various national markets at a single factory sited at the optimal location. And it can do this without absorbing a significant cost penalty. Thus, firms no longer need to establish manufacturing facilities in each major national market to pro- vide products that satisfy specific consumer tastes and preferences, part of the ratio- nale for a localization strategy (see Chapter 11).

Summary A number of technological factors support the economic arguments for concentrating production facilities in a few choice locations or even in a single location. Other things being equal, when fixed costs are substantial, the minimum efficient scale of production is high, and/or flexible manufacturing technologies are available, the arguments for concentrating production at a few choice locations are strong. This is true even when substantial differences in consumer tastes and preferences exist between national markets, because flexible manufacturing technologies allow the firm to cus- tomize products to national differences at a single facility. Alternatively, when fixed costs are low, the minimum efficient scale of production is low, and flexible manufactur- ing technologies are not available, the arguments for concentrating production at one or a few locations are not as compelling. In such cases, it may make more sense to manufacture in each major market in which the firm is active if this helps the firm bet- ter respond to local demands. This holds only if the increased local responsiveness more than offsets the cost disadvantages of not concentrating manufacturing. With the advent of flexible manufacturing technologies and mass customization, such a strategy is becoming less attractive. In sum, technological factors are making it feasible, and necessary, for firms to concentrate manufacturing facilities at optimal locations. Trade barriers and transportation costs are major brakes on this trend.

PRODUCT FACTORS Two product features affect location decisions. The first is the product’s value-to-weight ratio because of its influence on transportation costs. Many electronic components and pharmaceuticals have high value-to-weight ratios; they are expensive and they do not weigh very much. Thus, even if they are shipped halfway around the world, their transportation costs account for a very small percent- age of total costs. Given this, other things being equal, there is great pressure to pro- duce these products in the optimal location and to serve the world market from there. The opposite holds for products with low value-to-weight ratios. Refined sugar, cer- tain bulk chemicals, paint, and petroleum products all have low value-to-weight ratios; they are relatively inexpensive products that weigh a lot. Accordingly, when they are shipped long distances, transportation costs account for a large percentage of total costs. Thus, other things being equal, there is great pressure to make these products in multiple locations close to major markets to reduce transportation costs. The other product feature that can influence location decisions is whether the product serves universal needs, needs that are the same all over the world. Examples include many industrial products (e.g., industrial electronics, steel, bulk chemicals) and

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478 Part Five Competing in a Global Marketplace

modern consumer products (e.g., handheld calculators, personal computers, video game consoles). Because there are few national differences in consumer taste and pref- erence for such products, the need for local responsiveness is reduced. This increases the attractiveness of concentrating production at an optimal location.

LOCATING PRODUCTION FACILITIES There are two basic strategies for locating production facilities: concentrating them in a centralized location and serving the world market from there, or decentralizing them in various regional or national locations that are close to major markets. The appropriate strategic choice is deter- mined by the various country-specific, technological, and product factors we have discussed in this section and are summarized in Table 14.1. As can be seen, concentration of production makes most sense when:

• Differences between countries in factor costs, political economy, and culture have a substantial impact on the costs of manufacturing in various countries.

• Trade barriers are low. • Externalities arising from the concentration of like enterprises favor certain

locations. • Important exchange rates are expected to remain relatively stable. • The production technology has high fixed costs and high minimum efficient scale

relative to global demand, or flexible manufacturing technology exists. • The product’s value-to-weight ratio is high. • The product serves universal needs.

Alternatively, decentralization of production is appropriate when:

• Differences between countries in factor costs, political economy, and culture do not have a substantial impact on the costs of manufacturing in various countries.

• Trade barriers are high.

Concentrated Decentralized Production Production Favored Favored

Country factors

Difference in political economy Substantial Few

Difference in culture Substantial Few

Difference in factor costs Substantial Few

Trade barriers Few Substantial

Location externalities Important in industry Not important in industry

Exchange rates Stable Volatile

Technological factors

Fixed costs High Low

Minimum efficient scale High Low

Flexible manufacturing technology Available Not available

Product factors

Value-to-weight ratio High Low

Serves universal needs Yes No

table 14.1

Location Strategy and Production

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Chapter Fourteen Global Production, Outsourcing, and Logistics 479

• Location externalities are not important. • Volatility in important exchange rates is expected. • The production technology has low fixed costs and low minimum efficient scale,

and flexible manufacturing technology is not available. • The product’s value-to-weight ratio is low. • The product does not serve universal needs (that is, significant differences in

consumer tastes and preferences exist between nations).

In practice, location decisions are seldom clear cut. For example, it is not unusual for differences in factor costs, technological factors, and product factors to point toward concentrated production while a combination of trade barriers and volatile exchange rates points toward decentralized production. This seems to be the case in the world automobile industry. Although the availability of flexible manufacturing and cars’ rela- tively high value-to-weight ratios suggest concentrated manufacturing, the combina- tion of formal and informal trade barriers and the uncertainties of the world’s current floating exchange rate regime (see Chapter 10) have inhibited firms’ ability to pursue this strategy. For these reasons, several automobile companies have established “top- to-bottom” manufacturing operations in three major regional markets: Asia, North America, and Western Europe.

The Strategic Role of Foreign Factories Whatever the rationale behind establishing a foreign production facility, the strategic role of foreign factories can evolve over time. 17 Initially, many foreign factories are established where labor costs are low. Their strategic role typically is to produce labor- intensive products at as low a cost as possible. For example, beginning in the 1970s, many U.S. firms in the computer and telecommunication equipment businesses estab- lished factories across Southeast Asia to manufacture electronic components, such as circuit boards and semiconductors, at the lowest possible cost. They located their fac- tories in countries such as Malaysia, Thailand, and Singapore precisely because each of these countries offered an attractive combination of low labor costs, adequate infra- structure, and favorable tax and trade regime. Initially, the components produced by these factories were designed elsewhere and the final product was assembled else- where. Over time, however, the strategic role of some of these factories has expanded; they have become important centers for the design and final assembly of products for the global marketplace. For example, Hewlett-Packard’s operation in Singapore was established as a low-cost location for the production of circuit boards, but the facility has become the center for the design and final assembly of portable ink-jet printers for the global marketplace (see the accompanying Management Focus). A similar process seems to be occurring at some of the factories that Philips has established in China (see the Management Focus on Philips) and may now be starting to happen in India with regard to the production of small cars (see the opening case). Such upward migration in the strategic role of foreign factories arises because many foreign factories upgrade their own capabilities. 18 This improvement comes from two sources. First, pressure from the center to improve a factory’s cost structure and/or cus- tomize a product to the demands of consumers in a particular nation can start a chain of events that ultimately leads to development of additional capabilities at that factory. For example, to meet centrally mandated directions to drive down costs, engineers at HP’s Singapore factory argued that they needed to redesign products so they could be manu- factured at a lower cost. This led to the establishment of a design center in Singapore. As this design center proved its worth, HP executives realized the importance of co-locating design and manufacturing operations. They increasingly transferred more design

LEARNING OBJECTIVE 3 Recognize how the role

of foreign subsidiaries in production can be enhanced over time as they accumulate

knowledge.

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480 Part Five Competing in a Global Marketplace

responsibilities to the Singapore factory. In addition, the Singapore factory ultimately became the center for the design of products tailored to the needs of the Asian market. This made good strategic sense because it meant products were being designed by engi- neers who were close to the Asian market and probably had a good understanding of the needs of that market, as opposed to engineers located in the United States. A second source of improvement in the capabilities of a foreign factory can be the increasing abundance of advanced factors of production in the nation in which the factory is located. Many nations that were considered economic backwaters a generation

Management FOCUS

Hewlett-Packard in Singapore

In the late 1960s, Hewlett-Packard was looking around Asia for a low-cost location to produce electronic compo- nents that were to be manufactured using labor-intensive processes. The company looked at several Asian locations and eventually settled on Singapore, opening its first fac- tory there in 1970. Although Singapore did not have the lowest labor costs in the region, costs were low relative to North America. Plus, the Singapore location had several important benefits that could not be found at many other locations in Asia. The education level of the local work- force was high. English was widely spoken. The govern- ment of Singapore seemed stable and committed to economic development, and the city-state had one of the better infrastructures in the region, including good commu- nication and transportation networks and a rapidly devel- oping industrial and commercial base. HP also extracted favorable terms from the Singapore government with re- gard to taxes, tariffs, and subsidies. At its start, the plant manufactured only basic compo- nents. The combination of low labor costs and a favorable tax regime helped to make this plant profitable early. In 1973, HP transferred the manufacture of one of its basic handheld calculators from the United States to Singapore. The objective was to reduce manufacturing costs, which the Singapore factory was quickly able to do. Increasingly confident in the capability of the Singapore factory to han- dle entire products, as opposed to just components, HP’s management transferred other products to Singapore over the next few years including keyboards, solid-state dis- plays, and integrated circuits. However, all these products were still designed, developed, and initially produced in the United States. The plant’s status shifted in the early 1980s when HP em- barked on a worldwide campaign to boost product quality and reduce costs. HP transferred the production of its HP41C handheld calculator to Singapore. The managers at the Singapore plant were given the goal of substantially reducing manufacturing costs. They argued that this could

be achieved only if they were allowed to redesign the product so it could be manufactured at a lower overall cost. HP’s central management agreed, and 20 engineers from the Singapore facility were transferred to the United States for one year to learn how to design application- specific integrated circuits. They then brought this expertise back to Singapore and set about redesigning the HP41C. The results were a huge success. By redesigning the product, the Singapore engineers reduced manufacturing costs for the HP41C by 50 percent. Using this newly ac- quired capability for product design, the Singapore facility then set about redesigning other products it produced. HP’s corporate managers were so impressed with the progress made at the factory that they transferred produc- tion of the entire calculator line to Singapore in 1983. This was followed by the partial transfer of ink-jet production to Singapore in 1984 and keyboard production in 1986. In all cases, the facility redesigned the products and often re- duced unit manufacturing costs by more than 30 percent. The initial development and design of all these products, however, still occurred in the United States. In the late 1980s and 1990s, the Singapore plant assumed added responsibilities, particularly in the ink-jet printer business. The factory was given the job of redesigning an HP ink-jet printer for the Japanese market. Although the initial product redesign was a market failure, the managers at Singapore pushed to be allowed to try again. They were given the job of redesigning HP’s DeskJet 505 printer for the Japanese market. This time the redesigned product was a success, garnering significant sales in Japan. Em- boldened by this success, the plant has continued to take on additional design responsibilities. Today, it is viewed as a “lead plant” within HP’s global network, with primary responsibility not just for manufacturing, but also for the development and design of a family of small ink-jet printers targeted at the Asian market.

Sources: K. Ferdows, “Making the Most of Foreign Factories,” Harvard Business Review, March–April 1997, pp. 73–88; and “Hewlett-Packard: Singapore,” Harvard Business School Case No. 694–035.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 481

ago have been experiencing rapid economic development during the past 20 years. Their communication and transportation infrastructures and the education level of the population have improved. While these countries once lacked the advanced infrastruc- ture required to support sophisticated design, development, and manufacturing opera- tions, this is often no longer the case. This has made it much easier for factories based in these nations to take on a greater strategic role. Because of such developments, many international businesses are moving away from a system in which their foreign factories were viewed as nothing more than low-cost manufacturing facilities and toward one where foreign factories are viewed as globally dispersed centers of excellence. 19 In this new model, foreign factories take the lead role for the design and manufacture of products to serve important national or regional mar- kets or even the global market. The development of such dispersed centers of excellence is consistent with the concept of a transnational strategy, introduced in Chapter 12. A major aspect of a transnational strategy is a belief in global learning —the idea that valuable knowledge does not reside just in a firm’s domestic operations; it may also be found in its foreign subsidiaries. Foreign factories that upgrade their capabilities over time are creating valuable knowledge that might benefit the whole corporation. Managers of international businesses need to remember that foreign factories can improve their capabilities over time, and this can be of immense strategic benefit to the firm. Rather than viewing foreign factories simply as sweatshops where unskilled labor churns out low-cost goods, managers need to see them as potential centers of excellence and to encourage and foster attempts by local managers to upgrade the capabilities of their factories and, thereby, enhance their strategic standing within the corporation. Such a process does imply that once a foreign factory has been established and valuable skills have been accumulated, it may not be wise to switch production to another location simply because some underlying variable, such as wage rates, has changed. 20 HP has kept its facility in Singapore, rather than switching production to a location where wage rates are now much lower, such as Vietnam, because it recognizes that the Singapore factory has accumulated valuable skills that more than make up for the higher wage rates. Thus, when reviewing the location of production facilities, the international manager must con- sider the valuable skills that may have been accumulated at various locations, and the impact of those skills on factors such as productivity and product design.

Outsourcing Production: Make-or-Buy Decisions International businesses frequently face make-or-buy decisions, decisions about whether they should perform a certain value creation activity themselves or outsource it to another entity. 21 Historically, most outsourcing decisions have involved the man- ufacture of physical products. Most manufacturing firms have done their own final assembly, but have had to decide whether to vertically integrate and manufacture their own component parts or outsource the production of such parts, purchasing them from independent suppliers. Such make-or-buy decisions are an important aspect of the strategy of many firms. In the automobile industry, for example, the typical car contains more than 10,000 components, so automobile firms constantly face make-or- buy decisions. Toyota produces less than 30 percent of the value of cars that roll off its assembly lines. The remaining 70 percent, mainly accounted for by component parts and complex subassemblies, comes from independent suppliers. In the athletic shoe industry, the make-or-buy issue has been taken to an extreme with companies such as Nike and Reebok having no involvement in manufacturing; all production has been outsourced, primarily to manufacturers based in low-wage countries.

LEARNING OBJECTIVE 4 Identify the factors that

influence a firm’s decision of whether to source

supplies from within the company or from foreign

suppliers.

Make-or-Buy Decisions Whether a firm should make or buy component parts.

Global Learning The flow of skills and product offerings from foreign subsidiary to home country and from foreign subsidiary and foreign subsidiary.

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In recent years, the outsourcing decision has gone beyond the manufacture of physical products to em- brace the production of service activities. For exam- ple, many U.S.-based companies, from credit card issuers to computer companies, have outsourced their customer call centers to India. They are “buy- ing” the customer call center function, while “mak- ing” other parts of the product in house. Similarly, many information technology companies have been outsourcing some parts of the software development process, such as testing computer code written in the United States, to independent providers based in India. Such companies are “making” (writing) most of the code in-house, but “buying,” or outsourcing, part of the production process—testing—to independent companies. India is often the focus of such out- sourcing because English is widely spoken there; the nation has a well-educated workforce, particularly in engineering fields; and the pay is much lower than in the United States (a call center worker in India earns about $200 to $300 a month, about one-tenth of the comparable U.S. wage). 22

Outsourcing decisions pose plenty of problems for purely domestic businesses but even more prob- lems for international businesses. These decisions in the international arena are complicated by the vola- tility of countries’ political economies, exchange rate

movements, changes in relative factor costs, and the like. In this section, we examine the arguments for making products in-house and for buying them, and we consider the trade-offs involved in such a decision. Then we discuss strategic alliances as an alternative to producing all or part of a product within the company.

THE ADVANTAGES OF MAKE The arguments that support making all or part of a product in-house—vertical integration—are fourfold. Vertical integration

may be associated with lower costs, facilitate invest- ments in highly specialized assets, protect propri- etary product technology, and ease the scheduling of adjacent processes.

Lowering Costs It may pay a firm to continue manufacturing a product or component part in- house if the firm is more efficient at that produc- tion activity than any other enterprise.

Facilitating Specialized Investments Some times firms have to invest in specialized assets in order to do business with another enterprise. 23 A specialized asset is an asset whose value is contin- gent upon a particular relationship persisting. For example, imagine Ford of Europe has developed a new, high-performance, high-quality, and uniquely designed fuel-injection system. The increased fuel

Nike relies on outsourcing to manufacture its products. The company has received worldwide criticism for turning its back on social responsibility for the sake of profit.

Another Per spect i ve

Outsourcing: A Strategy for the Future Although many American workers take a negative view of outsourcing because it typically means a loss of jobs stateside, outsourcing can be a useful strategy for manag- ing quality and controlling costs. In addition, some other perspectives add to the strategic role that outsourcing de- cisions play in today’s business environment. For a devel- oping country, outsourcing provides a way to “get into the game.” For a global organization, outsourcing creates an opportunity to build a presence in a future market while it’s still developing. Establishing an early presence may lead to first-mover advantages, creating brand loyalty in consumers and providing valuable market knowledge for the producer.

Specialized Asset An asset designed to

perform a specific task, whose value is

significantly reduced in its next-best use.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 483

efficiency will help sell Ford cars. Ford must decide whether to make the system in-house or to contract out the manufacturing to an independent supplier. Manufac- turing these uniquely designed systems requires investments in equipment that can be used only for this purpose; it cannot be used to make fuel injection systems for any other auto firm. Thus, investment in this equipment constitutes an investment in spe- cialized assets. When, as in this situation, one firm must invest in specialized assets to supply another, mutual dependency is created. In such circumstances, each party might fear the other will abuse the relationship by seeking more favorable terms . To appreciate this, let us first examine this situation from the perspective of an inde- pendent supplier who has been asked by Ford to make this investment. The supplier might reason that once it has made the investment, it will become dependent on Ford for business since Ford is the only possible customer for the output of this equipment. The supplier perceives this as putting Ford in a strong bargaining position and worries that once the specialized investment has been made, Ford might use this to squeeze down prices for the systems. Given this risk, the supplier declines to make the invest- ment in specialized equipment. Now take the position of Ford. Ford might reason that if it contracts out production of these systems to an independent supplier, it might become too dependent on that supplier for a vital input. Because specialized equipment is required to produce the fuel injection systems, Ford cannot easily switch its orders to other suppliers who lack that equipment. (It would face high switching costs.) Ford perceives this as increasing the bargaining power of the supplier and worries that the supplier might use its bar- gaining strength to demand higher prices. Thus, the mutual dependency that outsourcing would create makes Ford nervous and scares away potential suppliers. The problem here is lack of trust. Neither party completely trusts the other to play fair. Consequently, Ford might reason that the only safe way to get the new fuel injection systems is to manufacture them itself. It may be unable to persuade any independent supplier to manufacture them. Thus, Ford de- cides to make rather than buy. In general, we can predict that when substantial investments in specialized assets are required to manufacture a component, the firm will prefer to make the component internally rather than contract it out to a supplier. Substantial empirical evidence sup- ports this prediction. 24

Protecting Proprietary Product Technology Proprietary product technology is unique to a firm. If it enables the firm to produce a product containing superior features, proprietary technology can give the firm a competitive advantage. The firm would not want competitors to get this technology. If the firm outsources the produc- tion of entire products or components containing proprietary technology, it runs the risk that those suppliers will expropriate the technology for their own use or that they will sell it to the firm’s competitors. Thus, to maintain control over its technology, the firm might prefer to make such products or component parts in-house.

Improving Scheduling Another argument for producing all or part of a product in-house is that production cost savings result because it makes planning, coordina- tion, and scheduling of adjacent processes easier. 25 This is particularly important in firms with just-in-time inventory systems (discussed later in the chapter). In the 1920s, for example, Ford profited from tight coordination and scheduling made possible by backward vertical integration into steel foundries, iron ore shipping, and mining. De- liveries at Ford’s foundries on the Great Lakes were coordinated so well that ore was turned into engine blocks within 24 hours. This substantially reduced Ford’s produc- tion costs by eliminating the need to hold excessive ore inventories.

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484 Part Five Competing in a Global Marketplace

For international businesses that source worldwide, scheduling problems can be exacerbated by the time and distance between the firm and its suppliers. This is true whether the firms use their own subunits as suppliers or use independent suppliers. However, ownership of upstream production facilities is not the issue here. By using information technology, firms can attain tight coordination between different stages in the production process.

THE ADVANTAGES OF BUY Buying component parts, or an entire product, from independent suppliers can give the firm greater flexibility, can help drive down the firm’s cost structure, and may help the firm capture orders from international customers.

Strategic Flexibility The great advantage of buying component parts, or even an entire product, from independent suppliers is that the firm can maintain its flexibility, switching orders between suppliers as circumstances dictate. This is particularly important internationally, where changes in exchange rates and trade barriers can alter the attractiveness of supply sources. One year Hong Kong might offer the lowest cost for a particular component, and the next year, Mexico may. Many firms source the same products from suppliers based in two countries, primarily as a hedge against adverse movements in factor costs, exchange rates, and the like. Sourcing products from independent suppliers can also be advantageous when the optimal location for manufacturing a product is beset by political risks. Under such circumstances, foreign direct investment to establish a component manufacturing operation in that country would expose the firm to political risks. The firm can avoid many of these risks by buying from an independent supplier in that country, thereby maintaining the flexibility to switch sourcing to another country if a war, revolution, or other political change alters that country’s attractiveness as a supply source. However, maintaining strategic flexibility has its downside. If a supplier perceives the firm will change suppliers in response to changes in exchange rates, trade barriers, or general political circumstances, that supplier might not be willing to make invest- ments in specialized plants and equipment that would ultimately benefit the firm.

Lower Costs Although making a product or component part in-house—vertical integration—is often undertaken to lower costs, it may have the opposite effect. When this is the case, outsourcing may lower the firm’s cost structure. Making all or part of a product in-house increases an organization’s scope, and the resulting increase in orga- nizational complexity can raise a firm’s cost structure. There are three reasons for this. First, the greater the number of subunits in an organization, the more problems coordinating and controlling those units. Coordinating and controlling subunits re- quire top management to process large amounts of information about subunit activi- ties. The greater the number of subunits, the more information top management must process and the harder it is to do well. Theoretically, when the firm becomes involved in too many activities, headquarters management will be unable to effectively control all of them, and the resulting inefficiencies will more than offset any advantages de- rived from vertical integration. 26 This can be particularly serious in an international business, where the problem of controlling subunits is exacerbated by distance and differences in time, language, and culture. Second, the firm that vertically integrates into component part manufacture may find that because its internal suppliers have a captive customer in the firm, they lack an incentive to reduce costs. The fact that they do not have to compete for orders with other suppliers may result in high operating costs. The managers of the supply opera- tion may be tempted to pass on cost increases to other parts of the firm in the form of higher transfer prices, rather than looking for ways to reduce those costs.

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Third, vertically integrated firms have to determine appropriate prices for goods transferred to subunits within the firm. This is a challenge in any firm, but it is even more complex in international businesses. Different tax regimes, exchange rate move- ments, and headquarters’ ignorance about local conditions all increase the complexity of transfer pricing decisions. This complexity enhances internal suppliers’ ability to manipulate transfer prices to their advantage, passing cost increases downstream rather than looking for ways to reduce costs. The firm that buys its components from independent suppliers can avoid all these problems and the associated costs. The firm that sources from independent suppliers has fewer subunits to control. The incentive problems that occur with internal suppli- ers do not arise when independent suppliers are used. Independent suppliers know they must continue to be efficient if they are to win business from the firm. Also, be- cause independent suppliers’ prices are set by market forces, the transfer pricing prob- lem does not exist. In sum, the bureaucratic inefficiencies and resulting costs that can arise when firms vertically integrate backward and produce their own components are avoided by buying component parts from independent suppliers.

Offsets Another reason for outsourcing some manufacturing to independent suppli- ers based in other countries is that it may help the firm capture more orders from that country. Offsets are common in the commercial aerospace industry. For example, before Air India places a large order with Boeing, the Indian government might ask Boeing to push some subcontracting work toward Indian manufacturers. This is not unusual in international business. Representatives of the U.S. government have repeatedly urged Japanese automobile companies to purchase more component parts from U.S. suppliers to partially offset the large volume of automobile exports from Japan to the United States.

TRADE-OFFS Clearly there are trade-offs in make-or-buy decisions. The bene- fits of making all or part of a product in-house seem to be greatest when highly spe- cialized assets are involved, when vertical integration is necessary for protecting proprietary technology, or when the firm is simply more efficient than external suppli- ers at performing a particular activity. When these conditions are not present, the risk of strategic inflexibility and organizational problems suggest it may be better to con- tract out some or all production to independent suppliers. Because issues of strategic flexibility and organizational control loom even larger for international businesses than purely domestic ones, an international business should be particularly wary of vertical integration into component part manufacture. In addition, some outsourcing in the form of offsets may help a firm gain larger orders in the future.

STRATEGIC ALLIANCES WITH SUPPLIERS Several international busi- nesses have tried to reap some benefits of vertical integration without the associated organizational problems by entering strategic alliances with essential suppliers. For example, there was an alliance between Kodak and Canon, under which Canon built photocopiers for sale by Kodak; an alliance between Microsoft and Flextronics, under which Flextronics built the Xbox for Microsoft; and an alliance between Boeing and several Japanese companies to build its jet aircraft, including the 787. By these alliances, Kodak, Microsoft, and Boeing have committed themselves to long-term relationships with these suppliers, which have encouraged the suppliers to undertake specialized investments. Strategic alliances build trust between the firm and its suppliers. Trust is built when a firm makes a credible commitment to continue pur- chasing from a supplier on reasonable terms. For example, the firm may invest money in a supplier—perhaps by taking a minority shareholding—to signal its intention to build a productive, mutually beneficial long-term relationship.

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486 Part Five Competing in a Global Marketplace

This kind of arrangement between the firm and its parts suppliers was pioneered in Japan by large auto companies such as Toyota. Many Japanese automakers have coop- erative relationships with their suppliers that go back decades. In these relationships, the auto companies and their suppliers collaborate on ways to increase value added by, for example, implementing just-in-time inventory systems or cooperating in the de- sign of component parts to improve quality and reduce assembly costs. These relation- ships have been formalized when the auto firms acquired minority shareholdings in many of their essential suppliers to symbolize their desire for long-term cooperative relationships with them. At the same time, the relationship between the firm and each essential supplier remains market mediated and terminable if the supplier fails to per- form. By pursuing such a strategy, the Japanese automakers capture many of the ben- efits of vertical integration, particularly those arising from investments in specialized assets, without suffering the organizational problems that come with formal vertical integration. The parts suppliers also benefit from these relationships because they grow with the firm they supply and share in its success. 27 The adoption of just-in-time inventory systems (JIT), computer-aided design (CAD), and computer-aided manufacturing (CAM) over the past two decades seem to have increased pressures for firms to establish long-term relationships with their sup- pliers. JIT, CAD, and CAM systems all rely on close links between firms and their suppliers supported by substantial specialized investment in equipment and informa- tion systems hardware. To get a supplier to agree to adopt such systems, a firm must make a credible commitment to an enduring relationship with the supplier—it must build trust with the supplier. It can do this within the framework of a strategic alliance. Alliances are not all good. Like formal vertical integration, a firm that enters long- term alliances may limit its strategic flexibility by the commitments it makes to its al- liance partners. As we saw in Chapter 12 when we considered alliances between competitors, a firm that allies itself with another firm risks giving away key techno- logical know-how to a potential competitor.

Managing a Global Supply Chain Logistics encompasses the activities necessary to get materials from suppliers to a man- ufacturing facility, through the manufacturing process, and out through a distribution system to the end user. 28 In the international business, the logistics function manages the global supply chain. The twin objectives of logistics are to manage a firm’s global supply chain at the lowest possible cost and in a way that best serves customer needs, thereby lowering the costs of value creation and helping the firm establish a competi- tive advantage through superior customer service. The potential for reducing costs through more efficient logistics is enormous. For the typical manufacturing enterprise, material costs account for between 50 and 70 percent of revenues, depending on the industry. Even a small reduction in these costs can have a substantial impact on profitability. According to one estimate, for a firm with revenues of $1 million, a return on investment rate of 5 percent, and mate- rials costs that are 50 percent of sales revenues, a $15,000 increase in total profits could be achieved either by increasing sales revenues 30 percent or by reducing mate- rials costs by 3 percent. 29 In a saturated market, it would be much easier to reduce materials costs by 3 percent than to increase sales revenues by 30 percent.

THE ROLE OF JUST-IN-TIME INVENTORY Pioneered by Japanese firms during that country’s remarkable economic transformation during the 1960s and 1970s, just-in-time inventory systems now play a major role in most manufac- turing firms. The basic philosophy behind just-in-time ( JIT) inventory systems is

LEARNING OBJECTIVE 5 Describe what is required to efficiently coordinate a globally dispersed production system.

Just-in-Time ( JIT) Inventory Logistics system designed to deliver parts to a production process as they are needed, not before.

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to economize on inventory holding costs by having materials arrive at a manufacturing plant just in time to enter the production process and not before. The major cost saving comes from speeding up inventory turnover. This reduces inventory holding costs, such as warehousing and storage costs. It means the company can reduce the amount of working capital it needs to finance inventory, freeing capital for other uses and/or lowering the total capital requirements of the enterprise. Other things being equal, this will boost the company’s profitability as measured by return on capital invested. It also means the com- pany is less likely to have excess unsold inventory that it has to write off against earnings or price low to sell. In addition to the cost benefits, JIT systems can also help firms improve product quality. Under a JIT system, parts enter the manufacturing process immediately; they are not warehoused. This allows defective inputs to be spotted right away. The problem can then be traced to the supply source and fixed before more defective parts are produced. Under a more traditional system, warehousing parts for weeks before they are used allows many defective parts to be produced before a problem is recognized. The drawback of a JIT system is that it leaves a firm without a buffer stock of in- ventory. Although buffer stocks are expensive to store, they can help a firm respond quickly to increases in demand and tide a firm over shortages brought about by dis- ruption among suppliers. Such a disruption occurred after the September 11, 2001, attacks on the World Trade Center, when the subsequent shutdown of international air travel and shipping left many firms that relied upon globally dispersed suppliers and tightly managed “just-in-time” supply chains without a buffer stock of inventory. A less pronounced but similar situation occurred again in April 2003 when the outbreak of pneumonia-like SARS (severe acute respiratory syndrome) virus in China resulted in the temporary shutdown of several plants operated by foreign companies and dis- rupted their global supply chains. Similarly, in late 2004, record imports into the United States left several major West Coast shipping ports clogged with too many ships from Asia that could not be unloaded fast enough, and disrupted the finely tuned supply chains of several major U.S. enterprises. 30 There are ways of reducing the risks associated with a global supply chain that op- erates on just-in-time principles. To reduce the risks associated with depending on one supplier for an important input, some firms source these inputs from several suppliers located in different countries. While this does not help in the case of an event with global ramifications, such as September 11, 2001, it does help manage country-specific supply disruptions, which are more common.

THE ROLE OF INFORMATION TECHNOLOGY AND THE INTERNET Web-based information systems play a crucial role in modern materials management. By tracking component parts as they make their way across the globe toward an as- sembly plant, information systems enable a firm to optimize its production scheduling according to when components are expected to arrive. By locating component parts in the supply chain precisely, good information systems allow the firm to accelerate

Another Per spect i ve

Logistics in the Service Sector: Global Account Management Like manufacturers, professional service firms have also been learning how to better manage their delivery on a global basis. For example, some global accounting firms are dealing with other global firms in a new way, using one supplier for all their accounting-related needs around the world. The traditional approach involved the development of market-specific relationships, so the same multinational client would have 5 to 20 individual accounting relationships, one in each major market for each company division. Under a global account manage- ment approach, one relationship has a global span—and one contract. Such logistics allow for more effective rela- tionship management, a better sense of what the client needs, more product extension opportunities, and better pricing and economies.

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488 Part Five Competing in a Global Marketplace

production when needed by pulling key components out of the regular supply chain and having them flown to the manufacturing plant. Firms now typically use electronic data interchange (EDI) via the Internet to coor- dinate the flow of materials into manufacturing, through manufacturing, and out to customers. Sometimes customers also are integrated into the system. These electronic links are then used to place orders with suppliers, to register parts leaving a supplier, to track them as they travel toward a manufacturing plant, and to register their arrival. Suppliers typically use an EDI link to send invoices to the purchasing firm. One con- sequence of an EDI system is that suppliers, shippers, and the purchasing firm can communicate with each other with no time delay, which increases the flexibility and responsiveness of the whole global supply system. A second consequence is that much of the paperwork between suppliers, shippers, and the purchasing firm is eliminated. Good EDI systems can help a firm decentralize materials management decisions to the plant level by giving corporate-level managers the information they need for coor- dinating and controlling decentralized materials management groups. Before the emergence of the Internet as a major communication medium, firms and their suppliers normally had to purchase expensive proprietary software solutions to im- plement EDI systems. The ubiquity of the Internet and the availability of Web-based applications have made most of these proprietary solutions obsolete. Less expensive Web-based systems that are much easier to install and manage now dominate the market for global supply chain management software. These Web-based systems have trans- formed the management of globally dispersed supply chains, allowing even small firms to achieve a much better balance between supply and demand, thereby reducing the inven- tory in their systems and reaping the associated economic benefits. With many firms now using these systems, those that do not will find themselves at a competitive disadvantage.

production, p. 469 logistics, p. 469 total quality management (TQM), p. 470 Six Sigma, p. 471 ISO 9000, p. 471

minimum efficient scale, p. 474 flexible manufacturing technology (lean production), p. 475 mass customization, p. 475 flexible machine cells, p. 476 global learning, p. 481

make-or-buy decisions, p. 481 specialized asset, p. 482 just-in-time inventory, p. 486

Key Terms

Summary This chapter explained how efficient production and logistics functions can improve an interna- tional business’s competitive position by lowering the costs of value creation and by performing value creation activities in such ways that customer service is enhanced and value added is maximized. We looked closely at three issues central to inter- national production and logistics: where to pro- duce, what to make and what to buy, and how to coordinate a globally dispersed manufacturing and

supply system. The chapter made the following points:

1. The choice of an optimal production location must consider country factors, technological factors, and product factors.

2. Country factors include the influence of factor costs, political economy, and national culture on production costs, along with the presence of location externalities.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 489

3. Technological factors include the fixed costs of setting up production facilities, the minimum efficient scale of production, and the availability of flexible manufacturing technologies that allow for mass customization.

4. Product factors include the value-to-weight ratio of the product and whether the product serves universal needs.

5. Location strategies either concentrate or decentralize manufacturing. The choice should be made in light of country, technological, and product factors. All location decisions involve trade-offs.

6. Foreign factories can improve their capabilities over time, and this can be of immense strategic benefit to the firm. Managers need to view foreign factories as potential centers of excellence and to encourage and foster attempts by local managers to upgrade factory capabilities.

7. An essential issue in many international businesses is determining which component parts should be manufactured in-house and which should be outsourced to independent suppliers.

8. Making components in-house facilitates investments in specialized assets and helps the firm protect its proprietary technology. It may improve scheduling between adjacent stages in the value chain, also. In-house production also makes sense if the firm is an efficient, low-cost producer of a technology.

9. Buying components from independent suppliers facilitates strategic flexibility and helps the firm avoid the organizational problems associated with extensive vertical integration. Outsourcing might also be employed as part of an “offset” policy, which is

designed to win more orders for the firm from a country by pushing some subcontracting work to that country.

10. Several firms have tried to attain the benefits of vertical integration and avoid its associated organizational problems by entering long-term strategic alliances with essential suppliers.

11. Although alliances with suppliers can give a firm the benefits of vertical integration without dispensing entirely with the benefits of a market relationship, alliances have drawbacks. The firm that enters a strategic alliance may find its strategic flexibility limited by commitments to alliance partners.

12. Logistics encompasses all the activities that move materials to a production facility, through the production process, and out through a distribution system to the end user. The logistics function is complicated in an international business by distance, time, exchange rates, custom barriers, and other things.

13. Just-in-time systems generate major cost savings from reducing warehousing and inventory holding costs and from reducing the need to write off excess inventory. In addition, JIT systems help the firm spot defective parts and remove them from the manufacturing process quickly, thereby improving product quality.

14. Information technology, particularly Internet- based electronic data interchange, plays a major role in materials management. EDI facilitates the tracking of inputs, allows the firm to optimize its production schedule, lets the firm and its suppliers communicate in real time, and eliminates the flow of paperwork between a firm and its suppliers.

Critical Thinking and Discussion Questions 1. An electronics firm is considering how best to

supply the world market for microprocessors used in consumer and industrial electronic products. A manufacturing plant costs about $500 million to construct and requires a highly skilled workforce. The total value of the world market for this product over the next 10 years is estimated to be between $10 billion and $15 billion. The tariffs

prevailing in this industry are currently low. Should the firm adopt a concentrated or decentralized manufacturing strategy? What kind of location(s) should the firm favor for its plant(s)?

2. A chemical firm is considering how best to supply the world market for sulfuric acid. A manufacturing plant costs about $20 million to

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490 Part Five Competing in a Global Marketplace

construct and requires a moderately skilled workforce. The total value of the world market for this product over the next 10 years is estimated to be between $20 billion and $30 billion. The tariffs prevailing in this industry are moderate. Should the firm favor concentrated manufacturing or decentralized manufacturing? What kind of location(s) should the firm seek for its plant(s)?

3. A firm must decide whether to make a component part in-house or to contract it out to an independent supplier. Manufacturing the part requires a nonrecoverable investment in specialized assets. The most efficient suppliers are located in countries with currencies that many foreign exchange analysts expect to appreciate substantially over the next decade. What are the pros and cons of (a) manufacturing

the component in-house and (b) outsourcing manufacturing to an independent supplier? Which option would you recommend? Why?

4. Reread the Management Focus on Philips in China then answer the following questions:

a. What are the benefits to Philips of shifting so much of its global production to China?

b. What are the risks associated with a heavy concentration of manufacturing assets in China?

c. What strategies might Philips adopt to maximize the benefits and mitigate the risks associated with moving so much product?

5. Explain how an efficient logistics function can help an international business compete more effectively in the global marketplace.

Use the globalEDGE Resource Desk (http://global EDGE.msu.edu/resourcedesk/) to complete the following exercises:

1. You work for a company whose manufacturing operations require a highly skilled labor force. Some executives have recently decided to open a production plant in Europe to serve that market because the high cost of transporting the products from your U.S. plant are making your company’s products less attractive for consumers. Using the Chartbook of International Labor Comparisons, compare the attractiveness of

producing in Spain, Italy, and Portugal based both on labor market indicators and on competitiveness indicators for manufacturing. Prepare an executive summary recommending where your company should produce.

2. The International Association of Outsourcing Professionals (IAOP) ranks the world’s best global outsourcing service providers. What are the criteria used to rank companies? Identify the 10 best companies. What are the key strengths for each company? Do you notice any trends in the information you have gathered?

Research Task http://globalEDGE.msu.edu

Building the Boeing 787

Boeing’s newest commercial jet aircraft, the wide-bodied 787 jet, is a bold bet on the future of both airline travel and plane making. Designed to fly long-haul point-to-point routes, the 250-seat 787 is made largely out of composite materials, such as carbon fibers, rather than traditional materials such as aluminum. Some 80 percent of the 787 by volume is composite materials, making the plane 20 percent lighter than a tradi- tional aircraft of the same size, which translates into a big

saving in jet fuel consumption and costs. The 787 is also packed full of other design innovations, including larger win- dows, greater headroom, and state-of-the-art electronics on the flight deck and in the passenger compartment. To reduce the risks associated with this technological gam- ble, Boeing outsourced an unprecedented 70 percent of the content of the 787 to other manufacturers, most of them based in other nations. In contrast, 50 percent of the Boeing 777 was

closing case

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Chapter Fourteen Global Production, Outsourcing, and Logistics 491

outsourced, 30 percent of the 767, and only 5 percent of the 707. The idea was that in return for a share of the work, partners would contribute toward the estimated $8 billion in develop- ment costs for the 787. In addition, by outsourcing, Boeing be- lieved it could tap into the expertise of the most efficient producers, wherever they might be located, thereby driving down the costs of making the plane. Furthermore, Boeing be- lieved that outsourcing some work to foreign countries would help it garner sales in those countries. Boeing’s role in the en- tire process was to design the plane, market and sell it, and undertake final assembly in its Everett plant in Washington State. Boeing also believed that by outsourcing the design of so many components, it could cut the time to develop this air- craft to four years from the six that is normal in the industry. Some 17 partners in 10 countries were selected to pro- duce major parts of the aircraft. The rear fuselage was to be made by Vought Aircraft Industries in South Carolina, Alenia Aeronautical of Italy was to make the middle fuselage sec- tions and horizontal tailpieces. Three Japanese companies, Fuji, Kawasaki, and Mitsubishi, were to produce the planes wing. The nose section was to be made by Toronto-based Onex Corporation. All of these bulky pieces were to be shipped to Everett for final assembly aboard a fleet of three modified Boeing 747 freighters call “Dreamlifters.” Until late 2007, the strategy seemed to be working remark- ably well. Boeing had booked orders for more than 770 aircraft, worth more than $100 billion, making the 787 the most success- ful aircraft launch in the history of commercial aviation. But behind the scenes, cracks were appearing in Boeing’s globally dispersed supply chain. In mid-2007, Boeing admitted the 787 might be a few months late due to problems with the supply of special fasteners for the fuselage. As it turned out, the prob- lems were much more serious. By early 2008 Boeing was ad- mitting to a delay of up to 12 months in the delivery of the first 787, an additional $2 billion in development costs, and was fac- ing the possibility of having to pay millions in penalty clause payments for late delivery to its leading customers. The core issue was that several key partners had not been able to meets Boeing’s delivery schedules. To make composite parts, for example, Italy’s Alenia had to build a new factory, but the site that it chose was a 300-year-old olive grove, and it faced months of haggling with local authorities and had to agree to replant the trees elsewhere before it could break ground. To compound problems, its first fuselage sections delivered to Boeing did not meet the required quality standards. Then when parts did arrive at Everett, Boeing

found that many components had not been installed in the fu- selages (as required), and that assembly instructions were available only in Italian. Other problems arose because sev- eral partners themselves outsourced mission critical design work to other enterprises. Vought, for example, outsourced the design and building of floor pieces for which it was re- sponsible to an Israeli company. In turn, the Israeli company had trouble meeting Boeing’s exacting quality standards. However, because it was reporting to Vought, not Boeing, ex- ecutives at Boeing did not learn of this until it had already become a serious bottleneck. Upon learning of the issue, Boeing rapidly dispatched engineers to Israel to work with the company, but by now several months had been lost. Boeing also subsequently acquired Vought in 2009, bringing the supplier in-house. Despite all of these issues, Boeing remains committed to its outsourcing program. However, the company has learned that if it is going to outsource work to foreign suppliers, much closer manage- ment oversight and coordination is required. The company has also indicated that as valuable as outsourcing can be, it probably went too far with the 787. Going forward, Boeing has signaled that it will not outsource key components that are seen as a source of Boeing’s competitive advantage (wings, in particular, are often mentioned as a component that may not be outsourced for future aircraft models).

Sources: J. L. Lunsford, “Jet Blues,” The Wall Street Journal , December 7, 2007, p. A1; J. Gapper, “A Clever Way to Build a Boeing,” Financial Times , July 9, 2007, p. 11; J. Teresko, “The Boeing 787: A Matter of Materials,” Industry Week , December 2007, pp. 34–39; and P. Sanders, “Boeing Takes Control of Plants,” The Wall Street Journal , December 23, 2009, p. B2.

Case Discussion Questions 1. What are the benefits to Boeing of outsourcing so much

work on the 787 to foreign suppliers? What are the potential risks? Do the benefits outweigh the risks?

2. In 2007 and 2008 Boeing ran into several publicized issues with regard to its management of a globally dispersed supply chain? What are the causes of these problems? What can a company such as Boeing do to make sure such problems do not occur in the future?

3. Some critics have claimed that by outsourcing so much work, Boeing has been exporting American jobs overseas. Is this criticism fair? How should the company respond to such criticisms?

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