There’s a certain feeling in the air – call it a hunch, call it wishful thinking – that more U.S. companies are learning that the cost advantages of moving their businesses to emerging economies aren’t as clear cut as they once appeared.
Indeed, while it seemed not long ago that U.S. companies were falling over themselves to exit the country, there’s a growing realization that packing up isn’t always the right answer.
A new report from The Conference Board backs that up. The study shows that, when adjusted for low productivity, the comparative cost advantages in emerging economies, where unit labor costs in manufacturing can be 20 percent lower than in the U.S., aren’t what they’re cracked up to be.
“One critical lesson for businesses that benefit from one-time labor cost benefits when investing in ‘low-wage’ countries is that productivity gains from new technology and innovation have to keep pace with often fast-rising wages of skilled and semi-skilled workers or the ‘cost advantage’ begins to erode,” said Bart van Ark, Director of The Conference Board International economic research program.
The report also noted that during the past 12 years, the U.S. has widened its unit labor cost advantage over Europe – not as a result of lower wages, but because of higher productivity gains.
“For advanced countries, the issue is to keep labor compensation in check with productivity,” van Ark said. “This raises issues about the balance between net and gross pay, the tax base, and the cost structure of firms. But it also forces government and business to focus on exploiting knowledge creation as a means to stay at the productivity frontier, and avoid a race to the bottom in term of cost competition.”
Now, this isn’t to say offshoring is always wrong – clearly it isn’t – or that it’s going away. But the reality is you have to pick the right spot. For instance, The Conference Board study says Mexico has labor costs of 11 percent that of the U.S. But that was matched by similar gap in productivity, meaning labor costs in manufacturing were almost the same as those in the U.S.
In China and India, it’s a bit different; not surprisingly, they are by far the most competitive manufacturing nations. Labor costs are 2.5 to 3 percent of the U.S. level, and while productivity levels are well below those of the United States, they exceeded compensation levels by a substantial margin.
“These differences underscore the challenge that even very low wage countries have in fostering productivity growth that keeps pace with, or exceeds, rising wage levels to preserve their relative global competitive position,” van Ark said. “The key for emerging economies is to promote productivity through technological change and innovation to match wage increases which will undoubtedly happen in a rapidly growing economy.”
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