This week, the New York Times provides some interesting changes on Chinese labor costs:
Bruce Rockowitz, the chief executive of Li & Fung, the largest trading company supplying Chinese consumer goods to American retail chains, said in a speech here on Tuesday that the company’s average costs for goods rose 15 percent in the first five months of this year compared with the same period last year. Executives at other consumer goods companies have encountered similar or larger increases.
All else being equal, this increase in “the China price” reduces China’s cost advantage over American or European suppliers which, one expects, would rebalance the mix between local and offshore sourcing. But how large of an impact can we expect? In other words: can we give guidance on the magnitude of this rebalancing? IF we keep everything else constant, the answer is (following Obama): Yes we can! In a theoretic model of dual sourcing from local and offshore suppliers, Gad Allon and I show that the fraction of units sourced locally is roughly inversely proportional to the square root of the offshore supplier’s cost advantage Δc (you know we’re serious when we invoke square roots and Greek letters🙂. Therefore, all else being equal, our theory suggest that
Annual change in onshoring fraction ≈ sqrt(1/annual change in Δc)
Unfortunately, knowing that China prices rose by 15% is not sufficient to estimate the annual change in Δc. The latter depends on the particular product: how its local costs change AND on the relative magnitude of local to offshore. But if you knew those numbers for your business, you could use the equation.
To illustrate, consider this simple example: Assume that company X last year sourced at $100 per unit locally and $80 per unit from China. If this year, China costs increase by 15% to $92 while all else stays the same, how should company X adjust its strategic dual sourcing allocation? All else being equal (and neglecting the second order change in the holding cost), the formula predicts that the sourcing portfolio should be rebalanced toward onshoring: compared to last year, the fraction onshore will increase by Sqrt(1/(8/20)) = sqrt(2.5) = 1.58, which means we expect onshore sourcing to increase by about 58% relative to last year!
Why does a 15% cost increase lead to a much higher change in onshoring (58% in the simple example)? The reason is that, for large volume sourcing, the majority would be offshored and only “a little flexibility is all you need” through onshoring. A small change in the majority then is reflected in a proportionally much bigger change in onshoring. (President Obama would welcome this.)
But remember: this is only an academic model focusing on certain factors–specifically, the model consider selling in one market using dual sourcing and there was a good reason that I explicitly stated “all else being equal” (ceteris paribus sounds much better!). As the NYT article points out, most businesses now sell in at least 2 markets, China being one. In addition, not everything else is equal: Clearly, if the Chinese market is destined to grow, there are many other good reasons to remain active (from a sourcing perspective) in China: local operations align with local sales and provide an operational hedge against currency and demand changes.
But, hey, notwithstanding these caveats and limitations, it’s still interesting that our model can provide guidance on important questions. It provides the stimulus to continue improving our academic research.
PS: By the way, the NYT article also gives us some stats on the famous Li & Fung:
Li & Fung handles about 4 percent of American retailers’ imports from China of virtually all kinds of consumer goods, according to investment analysts. The exception is electronics, which tend to be imported directly to the United States by other companies like Apple.