Chapter 16 Outline

Where to Manufacture

An essential decision facing an international firm is where to locate its manufacturing activities to achieve the twin goals of minimizing costs and improving product quality. For the firm contemplating 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.⁶

Country Factors

We reviewed country - specific factors in some detail earlier in the book and we will not dwell on them here. Political economy, culture, and relative factor costs differ from country to country. In Chapter 4, we saw that due to differences in factor costs, certain 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 performance of those activities. 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.

Of course, other things are not equal. Other country factors that impinge on location decisions include formal and informal trade barriers (see Chapter 5) and rules and regulations regarding foreign direct investment (see Chapter 7). For example, although relative factor costs may make a country look attractive as a location for performing a manufacturing activity, regulations prohibiting foreign direct investment may eliminate this option. Similarly, a consideration 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 lowcost location into a high - cost location. Many Japanese corporations had to grapple with this problem during the 1990s. 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 location. In response, many Japanese firms moved their manufacturing offshore to lowercost locations in East Asia.

Technological Factors

The technology we are concerned with in this subsection is manufacturing technology--the technology that performs specific manufacturing activities. The type of technology a firm uses in its manufacturing can be pivotal in location decisions. For example, because of technological constraints, in some cases it is feasible to perform certain manufacturing 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 locations. Three characteristics of a manufacturing technology are of interest here: the level of its fixed costs, its minimum efficient scale, and its flexibility.

Fixed Costs

As we noted in Chapter 12, in some cases the fixed costs of setting up a manufacturing 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 can cost more than $1 billion to set up a plant to manufacture semiconductor chips. Given this, serving the world market from a single plant sited at a single (optimal) location makes sense.

But a relatively low level of fixed costs can make it economical to perform a particular activity in several locations at once. One advantage of this is that the firm can better accommodate demands for local responsiveness. Manufacturing in multiple locations may also help the firm avoid becoming too dependent on one location. Being too dependent on one location is particularly risky in a world of floating exchange rates.

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.⁷ 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 at to realize all major plant - level scale economies (see Figure 16.2).

The implications of this concept are as follows: The larger the minimum efficient scale of a plant, the greater the argument for centralizing production in a single location or a limited number of locations. Alternatively, when the minimum efficient scale of production is relatively low, it may be economical to manufacture a product at several locations. As in the case of low fixed costs, the advantages are allowing the firm to accommodate demands for local responsiveness or to hedge against currency risk by manufacturing the same product in several locations.

Figure 16.2

A Typical Unit Cost Curve

Flexible Manufacturing (Lean Production)

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 one 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. Increasing product variety makes it difficult for a company to increase its manufacturing efficiency and thus reduce 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 manufacturing efficiency has been challenged by the recent rise of flexible manufacturing technologies. The term flexible manufacturing technology--or lean production as it is often called--covers a range of manufacturing technologies that are designed to (a) reduce setup times for complex equipment, (b) increase utilization of individual machines through better scheduling, and (c) improve quality control at all stages of the manufacturing process.⁸ Flexible manufacturing technologies allow a 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. The term mass customization has been coined to describe this ability.⁹ Mass customization implies that a firm may be able to customize its product range to suit the needs of different customer groups without bearing a cost penalty. Research suggests that the adoption of flexible manufacturing technologies may increase efficiency and lower unit costs relative to what can be achieved by the mass production of a standardized output.¹⁰

Flexible manufacturing technologies vary in their sophistication and complexity. One famous example of a flexible manufacturing technology, Toyota's production system, is relatively unsophisticated, but it has been credited with making Toyota the most efficient auto company in the world. 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 US plants, Ohno became convinced that the mass production philosophy for making cars was flawed. He saw numerous problems with the mass production system, including the following.

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 machine 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 production equipment (a major source of fixed costs). By using a system of levers and pulleys, he reduced the time required to change dies on stamping equipment from a full day in 1950 to 3 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. Furthermore, 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, Ohno's innovations enabled Toyota to produce a more diverse product range at a lower unit cost than was possible with conventional mass production.¹¹

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 dedicated to the production of a family of parts or products. The settings on machines are computer controlled. This allows each cell to switch quickly between the production of different parts or products.

Improved capacity utilization and reductions in work in progress and waste are major efficiency benefits of flexible machine 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 (e.g., stockpiles of partly finished products). Reductions in waste arise from the ability of computer-controlled machinery to identify how to transform inputs into outputs while producing a minimum of unusable waste material. As a consequence of all these factors, while a free-standing machine 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 efficiency benefits of installing flexible manufacturing technology can be dramatic. For example, after introduction of a flexible manufacturing system, General Electric's locomotive operations reduced the time it took to produce locomotive motor frames from 16 days to 16 hours. Similarly, after it introduced a flexible manufacturing system, Fireplace Manufacturers Inc., one of the country's largest fireplace businesses, reduced scrap left from the manufacturing process by 60 percent, increased inventory turnover threefold, and increased labor productivity by more than 30 percent.¹²

As these examples make clear, flexible manufacturing technologies can improve a company's efficiency. Not only do flexible manufacturing technologies allow companies to lower costs, but they also enable companies to customize products to the demands of small consumer groups--and to do so at a cost that at one time could be achieved only by mass producing a standardized output. Thus, they help a company increase customer responsiveness. Most important for an international business, flexible manufacturing technologies can help the firm customize products for different national markets. The importance of this advantage cannot be overstated. When flexible manufacturing technologies are available, a firm can manufacture products 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, companies no longer need to establish manufacturing facilities in each major national market to provide products that satisfy specific consumer tastes and preferences, part of the rationale for a multidomestic strategy (chapter 12).

Summary

A number of technological factors support the economic arguments for concentrating manufacturing 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, since flexible manufacturing technologies allow the firm to customize products to national differences at a single facility. Alternatively, when

• Fixed costs are low,

• The minimum efficient scale of production is low, and

• Flexible manufacturing 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 better 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, such a strategy is becoming less attractive. In sum, technological factors are making it feasible, and necessary, for firms to concentrate their manufacturing facilities at optimal locations. Trade barriers and transportation costs are probably the 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 percentage of total costs. Given this, other things being equal, there is great pressure to manufacture 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, certain bulk chemicals, paints, 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 manufacture 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 modern consumer products (e.g., handheld calculators and personal computers). Since there are few national differences in consumer taste and preference for such products, the need for local responsiveness is reduced. This increases the attractiveness of concentrating manufacturing at an optimal location.

Locating Manufacturing Facilities

There are two basic strategies for locating manufacturing facilities: concentrating them in the optimal location and serving the world market from there, and decentralizing them in various regional or national locations that are close to major markets. The appropriate strategic choice is determined by the various country, Table 16.1

Location Strategy and Manufacturing

	Favored Manufactred Strategy
	Concentrated	Decentralized
Country factors
Differences in political economy	Substantial	Few
Differences in culture	Substantial	Few
Differences in factor costs	Substantial	Few
Trade barriers	Few	Many
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

technological, and product factors we have discussed in this section, and are summarized in Table 16.1. As can be seen, concentration of manufacturing 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.

• Important exchange rates are expected to remain relatively stable.

• The production technology has high fixed costs, a high minimum efficient scale, or a flexible manufacturing technology exists.

• The product's value-to-weight ratio is high.

• The product serves universal needs.

Alternatively, decentralization of manufacturing 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.

• Volatility in important exchange rates is expected.

• The production technology has low fixed costs, 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 manufacturing while a combination of trade barriers and volatile exchange rates points toward decentralized manufacturing. This is probably the case in the world automobile industry. Although the availability of flexible manufacturing and cars' relatively high value-to-weight ratios suggest concentrated manufacturing, the combination 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, Honda is establishing "top-to-bottom" manufacturing operations in its three major markets: Japan, North America, and Western Europe. Honda can treat Western Europe as a single market because of the European Community's success in removing trade barriers and stabilizing exchange rates in the member countries.

Another auto company that treats Western Europe as a single market is Ford. Map 16.1 shows how Ford of Europe dispersed the various manufacturing activities for its Fiesta to different locations in Western Europe. (This figure shows the geographical pattern of only the network within Ford; independent component suppliers are not shown.) Some components are single sourced to take advantage of economies of scale. For example, all carburetors are supplied by the Belfast plant; all transmissions are built at Bordeaux; Basildon supplies radiator assemblies; Treforest makes spark plugs. Final assembly operations are performed at three locations: Dagenham in Great Britain, Saarlouis in Germany, and Valencia in Spain. Ford reasons that it can better customize the product to local needs by doing this. In addition, it can make up for shortfalls of production at one location by shipping cars from one of the other locations. The result is a complex network of crossborder flows of finished vehicles and components. Presumably, Ford locates the various activities in particular locations because it believes these are the most favorable locations for performing those activities.