Mexico vs. China: the EMS battle has been waged: smart outsource management involves understanding all the costs of acquisition, direct and indirect.

In a recent Forbes.com article, "Global Trade--So Much For NAFTA," (1) Mexico President Vicente Fox was quoted in reference to a question about the impact of lower costs in China as saying, "We can't compete on cheap labor anymore. Mexico has other advantages to offer ..." While this statement is undoubtedly true, both President Fox and his country have been struggling under the increasing pressure of competition from the world's most populous nation.

Whether justified, unjustified, rational or irrational, the Mexico vs. China question seems to be a moot point. The reality of the situation is that China has, and continues to be, a major factor facing the growth, stability and political realities of the United States' neighbor to the south.

Subsequent comments in the article highlight the magnitude of the issue: "Between January 2001 and December 2002, the maquiladora, or manufacture-for-export sector in Mexico, lost 230,000 jobs out of a total 1.3 million as hundreds of companies either shifted production out of Mexico or shut down completely. The North American Free Trade Agreement (NAFTA), approved a decade ago, helped raise Mexico's share of U.S. imports from 7.3% in 1993 to 11.6% in 2002. But now China, which had only 5.4% of U.S. imports in 1993, looks set to overtake Mexico this year with the second-largest share of U.S. imports, after Canada." (1)

More recently and more directly focused on the electronics manufacturing sector, a recent report (2) indicated that, when measured by value, "over 40% of all new EMS [electronics manufacturing services] contracts are going to China, and that this expansion in business was taking place almost exclusively at the expense of the North American geography's (primarily Mexico's) market share."

While the cost of both labor and certain types of materials are often lower in China than in Mexico, explaining this broad, industry-wide shifting of preference based solely on these differences is difficult. Consider that the differences in actual, total landed cost between these geographies may be small, and in many cases--as exampled in the following case studies--perhaps nonexistent or even reversed.

Choosing the Right Tack

No black box exists that helps outsourcing managers choose the most cost effective sourcing solution. The selection process entails a systematic analysis of three major cost components: direct costs of acquisition, indirect costs of acquisition and commercial business drivers such as flexibility and time to market. A rigorous analysis of all three can yield the lowest landed cost and maximize a company's profits.

Let's look at the typical cost components that drive the material price of a product (Tables 1 and 2):

* The cost of material typically represents 80 to 95% of the total product cost. Material costs in China are typically 1 to 3% lower than Mexico, especially for mechanical components such as metal and plastics.

* Value add or conversion costs are those costs involved in converting raw materials into a fully assembled and tested product ready to be delivered to the customer. These costs include material acquisition, cost of money, production loss, assembly labor and test, overhead recovery and profit.

* Material acquisition costs in Mexico are typically 1 to 2% higher than China due to higher inbound freight costs, brokerage fees and applicable duties. Duties need to be evaluated component by component.

* The cost of labor is typically higher in Mexico than China. The average labor cost per hour in Mexico is typically 3 to 4 times higher than China. To realize substantial labor cost savings in Mexico, the product needs to be more complex, having longer assembly and test times.

* The exit factory cost in China is typically 5% lower than Mexico depending on the material and labor content of the product. Another consideration is that Chinese exports are better bargains overseas because many economists believe China fixes its currency at a rate that undervalues it by as much as 40%.

* Indirect costs are typically lost in product cost analysis, and they include supplier support costs, flexibility, inventory exposure and transportation costs for moving the product back to the U.S. or close to the customer.

* Mexico's physical proximity to the U.S. is a major advantage for larger box build products with less labor content.

* The supplier support costs can be significantly higher in China than Mexico. Support costs in China may be as high as 4.5% of the cost of goods sold (COGS), as compared to 1.5% in Mexico. A visit to a China-based supplier typically takes at minimum a week. A similar visit to Mexico can be made in one to two days at substantially lower costs. Real time communication is much easier. Mexico is within one to two hours of either the West or East Coasts of the U.S.

* Mexico's physical proximity to the U.S. is a major advantage for larger box build products with less labor content. Manufacturing in China extends the supply chain, can reduce inventory velocity by 23 to 25 days and adds an additional one percent cost of money. Airfreight is an option but, as will be shown in the following case studies, is not a cost effective solution given the Mexico cost model. Supply chain velocity from Mexico can provide original equipment manufacturers (OEMs) with more flexibility and cost predictability. Shipments can be expedited out of Mexico in as little as 6 to 8 hours.

* What is the impact to quality costs? If you purchase products from China, how are quality-related defects and returns going to be managed, and, more importantly, what is the cost of this extended supply chain?

* Duties and tariffs should also be considered. NAFTA has made doing business in Mexico very attractive; no duties or taxes are levied on products produced in Mexico and delivered to the U.S. Mexico is working to make additional trade regulations even more transparent and business friendly.

* Often overlooked by OEMs is the issue of communication and language barriers. While both countries speak English, OEMs often rate Mexico more English fluent and more communication friendly. With Mexico on Central Standard Time, companies there maintain the same general business hours as their customers throughout the U.S. In comparison, OEMs doing business in China typically maintain extended business hours into the late evening hours.

* In many cases the economic advantage begins to narrow as you consider the costs of landing the product back in the U.S. Depending on the transportation method, the cost advantage may be offset as seen in the following case studies (Tables 3 and 4).

Set-Top Box Case Study

Satellite and cable set-top boxes are in demand in the U.S., growing at approximately 18% per year, according to internal Elcoteq estimates. While these products are produced in very high volumes, they are not considered commodity products. Given the physical size, weight, integration complexity and design maturity, where should this type of product be manufactured?

This case study compares the fully landed cost of building a set-top box product in Mexico vs. China. In this case study, we evaluated the total landed cost of a low-end set-top box delivered from Mexico and China to a U.S. customer. In this model the cost of material is considered to be the same in Mexico and China. Materials sourced in China are typically less expensive; as a result our strategy is to obtain the lowest possible China material cost, then compare it to material costs from other locations. We cherry pick to get the most favorable bill of material (BOM) cost. We assume that we can achieve that BOM cost anywhere in the world, plus the cost of additional transportation. This additional cost is a component of the "value add" cost, not the BOM cost. The value-add component includes the cost of material acquisition, cost of money, scrap and attrition, and assembly and test labor.

If an OEM were to evaluate just the "exit factory" costs, China would represent a compelling 5% cost reduction over Mexico. But once the indirect costs are factored in--those costs associated with shipping and importing the product back into the U.S.--the cost advantage of doing business in China is reduced to 2% based on ocean shipments and is 13% more expensive for air transportation (Table 3).

Not included in this analysis are the additional supplier support costs associated with managing a China-based supplier. As mentioned earlier, that cost is estimated to be 2 to 3% higher than Mexico.

This analysis explains why so many digital and broadband set-top boxes are being built in Mexico to support the U.S. market.

note: (table3)

The Cell Phone Case Study

Over the next five years cellular subscribers are projected at 931 million. (4) By 2007 the worldwide wireless population will exceed 2 billion subscribers. (4) These numbers are good news to carriers, cell phone OEMs, EMS companies, and original design manufacturers (ODMs). The question has become: Where is the most effective place to build and service this growing demand? The answer is complex depending on a number of cost and customer serviceability considerations.

In this case study we analyzed the cost of building a low-end mobile phone for the U.S. market. We also evaluated the cost of delivering bulk shipments against the cost of delivering retail ready products from Mexico and China.

In this model, the cost of material is considered to be the same in Mexico and China. Again, materials sourced in China are typically less expensive; as a result our strategy is to obtain the lowest possible China material cost, then compare it to material costs from other locations. We cherry pick to get the most favorable bill of material (BOM) cost. We assume that we can achieve that BOM cost anywhere in the world, plus the cost of additional transportation. This additional cost is a component of the "value add" cost, not the BOM cost. The value-add component includes the cost of material acquisition, cost of money, scrap and attrition, assembly and test labor. The cost of material acquisition in Mexico is 1 to 2% higher than China as is the cost of assembly and test labor.

Again, if an OEM were to evaluate just the exit factory costs, China would represent a compelling 6% cost reduction over Mexico. But, once the indirect costs are factored in--again, those costs associated with shipping and importing the bulk product back into the U.S.--the cost advantage of doing business in China is reduced to 0.5% based on ocean shipments and $0.16 cents more expensive for air transportation. Ocean transportation is typically not used for transporting cell phones because of short product life cycles and inventory velocity considerations.

In both cases, no import taxes or duties are levied in delivering the products back to the U.S.

As can be seen in Table 4, with landed cost at parity, Mexico becomes a more compelling location to assemble, customer configure and distribute mobile phone products to the U.S. market.

Based on the previous two case studies, what products are financially viable to build in China? A number of direct and indirect costs should be considered. High-volume, commodity-type products typically make the most sense. The higher the labor content, the more advantageous are the lower labor rates. Size and weight typically limit China to smaller high-volume, commodity-type products. The two case studies illustrate the impact of transportation cost on the total landed cost and associated business model.

With higher volume, commodity-type products migrating from Mexico to China, Mexican EMS providers are experiencing a metamorphosis. Mexican EMS companies are recreating their business model to support a more complex, low-volume, high-mix model. This model includes lower volume, high-mix products with lower complexity, larger scale systems integration and complex build to order or configure to order products.

Certainly, the electronics industry in general, and the large, multinational, market-leading OEMs in particular, have been forced to seek out every possible opportunity to address the very real challenges they have faced during the economic downturn of the past several years. Yet, one cannot help wondering if something else is going on here beyond the simple search for cost savings.

Perhaps, in North America's rush to stay ahead of the competition, it has collectively lost sight of the value of long-term strategic objectives and fallen into the very seductive trap of believing that cheap labor automatically facilitates lower selling prices, higher sales and improved profitability.

In her article, "Recheck that Price Tag: Global Manufacturing Costs Differ from Common Knowledge," (3) Pamela J. Gordon, founder and president of Technology Forecasters, Inc., cautions readers on this very point: "Each time in the past decade when we have asked brand-name electronic product companies to rank their criteria for manufacturing outsourcing decisions, they have reported 'pricing' as their dominant concern. Yet, our newest study of global contract manufacturing pricing practices indicates that many product companies' assumptions are inaccurate.

"The typical error fostering this fact gap is the assumption that country-by-country comparisons of workers' average hourly compensation directly correlate with total costs.

"Disconnects in understanding true inter-region pricing comparisons owe partly to executives' race to provide demanding customers with lower-cost products and short-term-minded investors with improved quarterly financial ratios.

"Implications of manufacturers shifting production wholesale from one locale to another to satisfy questionable cost-saving strategies extend in the long run beyond individual company or microeconomic inefficiencies. Too-swift moves affect trained workers, technical and managerial staff, specialized equipment and other strategic assets in the countries left behind. Better for business and macroeconomic health would be more accurate and holistic cost comparisons and the creation of multinational manufacturing strategies whose longer-term benefits outweigh the hurry-to-the-new-spot tactic.

"Plus, the momentum of corporate change--much like the decentralization of the 1970s, the centralization in the 1980s and divestiture/outsourcing of the 1990s--tends to sweep companies toward extremes that they eventually realize they need to moderate. Unfortunately, in the interim, profit can get swept away as well."

The real goal of outsourcing is to minimize your costs and maximize your profits--not just obtain the lowest product cost. Smart outsource management involves understanding all the costs of acquisition, direct and indirect. It means evaluating your products, the entire supply chain and all the options available, not just assuming that China will produce the lowest product cost. Smart outsourcing will minimize your costs and maximize your profits.

note: (table 4)

                              Mexico           China

Direct Costs

Material                        +                -
Cost of acquisition             +                -
Direct labor                    +                -

Indirect Costs

Transportation costs            -                +
Support costs                   -                +
Commercial business             -                +

TABLE 1: Cost comparison between Mexico
and China.

China Pros

* Localized AVL's in Asia will typically be lower,
especially if mechanicals are involved

* Lower labor costs

* Landing material is typically less expensive

China Cons

* Must carry additional inventory to buffer
transit times

* Freight costs can be prohibitive, depending
on size of product

* VAT and duties applied to product

Mexico Pros

* Lower outbound logistics

* Benefit from NAFTA (no duties and taxes)

* Higher turns due to faster transit times

Mexico Cons

* Higher material COA

* Higher component duties and taxes, especially
on mechanicals from Asia

* Higher labor costs 4X more than China

TABLE 2: Comparative analysis.

Scenario 1 = Mexico manufacturing to U.S. customer by truck

        Material        Value   Exit    Freight
                Add     Factory

500K    $82.09  $16.10  $98.19  $0.78
1 Million       $81.90  $15.36  $97.26  $0.76
2 Million       $81.39  $14.68  $96.07  $0.74

Scenario 2 = China manufacturing shipped by sea

        Material        Value   Exit    Freight
                Add     Factory

500K    $82.09  $10.68  $92.77  $2.37
1 Million       $81.90  $9.60   $91.50  $2.35
2 Million       $81.39  $8.75   $90.14  $2.33

Scenario 3 = China manufacturing shipped to U.S. by air freight

        Material        Value   Exit    Freight
                Add     Factory

500K    $82.09  $10.68  $92.77  $18.00
1 Million       $81.90  $9.26   $91.50  $18.00
2 Million       $81.39  $8.75   $90.14  $18.00

Scenario 1 = Mobile phones shipped to the U.S. in truck

        Taxes & Finance Total   Total
        Duties          VMI     Landed

500K    $0.00   $0.00   $0.78   $98.97
1 Million       $0.00   $0.00   $0.76   $98.02
2 Million       $0.00   $0.00   $1.54   $97.61

Scenario 2 = China manufacturing shipped by sea

        Taxes & Finance Total   Total
        Duties          VMI     Landed

500K    $1.67   $0.93   $4.97   $97.74
1 Million       $1.65   $0.92   $4.92   $96.42
2 Million       $1.62   $0.90   $4.85   $94.99

Scenario 3 = China manufacturing shipped to U.S. by air freight

        Taxes & Finance Total   Total
        Duties          VMI     Landed

500K    $1.67   $0.00   $19.67  $112.44
1 Million       $1.65   $0.00   $19.65  $111.15
2 Million       $1.62   $0.00   $19.62  $109.76

TABLE 3: Set-top box comparison: Mexico vs. China.

Scenario 1 = Mobile phones shipped to the U.S. in bulk

        Material        Value   Exit
                Add     Factory

Mexico by Truck $75.00  $6.90   $81.90
China by Sea    $75.00  $6.40   $81.40
China by Air    $75.00  $6.40   $81.40

Scenario 2 = Mobile phones shipped to U.S. in retail boxes

        Material        Value   Exit
                Add     Factory

Mexico by Truck $75.50  $6.90   $82.40
China by Sea    $75.50  $6.40   $81.90
China by Air    $75.50  $6.40   $81.90

Scenario 1 = Mobile phones shipped to the U.S. in bulk

        Freight Taxes & Total   Total
                Duties  VMI     Landed

Mexico by Truck $0.05   $0.00   $0.05   $81.95
China by Sea    $0.14   $0.00   $0.14   $81.54
China by Air    $0.71   $0.00   $0.71   $82.11

Scenario 2 = Mobile phones shipped to U.S. in retail boxes

        Freight Taxes & Total   Total
                Duties  VMI     Landed

Mexico by Truck $0.15   $0.00   $0.15   $82.55
China by Sea    $0.24   $0.00   $0.24   $82.14
China by Air    $1.67   $0.00   $1.67   $83.57

TABLE 4: Mobile phone cost comparison.

References

(1.) "Global Trade--So Much For NAFTA," Forbes. com. www.forbes.com.

(2.) Quarterly Forum for Electronics Manufacturing Outsourcing and Supply Chain. June 2003. Technology Forecasters, Inc.

(3.) "Recheck that Price Tag: Global Manufacturing Costs Differ from Common Knowledge." Pamela J. Gordon, Electronic Business, June 2003.

(4.) "Wireless Subscribers to Reach 2 Billion by 2007." Instat/MDR, August 6.

Bill Coker is director of sales and marketing with Elcoteq Americas, Irving, TX; email: bill.coker@ elcoteq.com. Charlie Barnhart is a senior consultant with Technology Forecasters, Inc., Alameda, CA; email: [e-mail].