"Outsourcing -- Good or Evil?" ME Online Web Exclusive, March 9, 2005

for 3/09/05

Outsourcing—Good or Evil?

Exporting jobs and industries can have long-term effects on a nation's wealth.

by Hans D. Baumann

In the debate about outsourcing, most discussions center around the impact on U.S. unemployment and its social cost, but I have yet to hear arguments concerning the adverse effects outsourcing has on what I call our "national wealth."

A person has wealth if he has disposable income (compared to a poor person who has excessive credit card debt). A decrease in the national wealth manifests itself in a lowering of foreign reserves or, expressed differently, in an increase in foreign debt (that is, a trade imbalance). In the last three years, the percentage of U.S. workers employed in industrial jobs decreased from about 14 percent to 10 percent. This is a 29 percent reduction. During the same time, our trade imbalance increased from $326 billion to $489 billion, a boost of 33 percent. You may think this is coincidental, but I believe there definitely is a causal relationship.

A recent cartoon in a newspaper aptly describes what is happening: The first picture shows Chinese workers toiling to produce electronic gadgets; the last one depicts a scene from the U.S. economy: A man talks to a bank loan officer, saying, "I'd like to take out a third mortgage on my house so I can buy some more electronic gadgets."

Financing of our foreign trade balances is done by the federal government's issuing bonds, not much different from our man taking out a third mortgage.

Outsourcing, of course, is nothing new. In the early 19th century, Britain imported cotton from the United States, then spun and weaved the fabric in England, and finally exported the textiles abroad, primarily to India, then its colony. This kept about 80 percent of the monetary equivalent of these exports in the U.K. (adding to the national wealth). After a while, it occurred to the mill owners that they could grow the cotton in India and later ship the textile machines there, too, in order to save money on wages and shipping expenses. This sounded great, except now the only monetary value being repatriated to England was 15 to 20 percent of the total value of the textiles in the form of profit.

Now 80 percent of the created wealth remained in India, a great loss to the British economy resulting in unemployment and social unrest. While other exports took up some of the slack, Britain's economy started to decline after reaching an apex around 1848.

We here in the United States face similar problems. By outsourcing, we not only lose skilled labor but monetary wealth. Sure, our companies may gain temporary increases in profits, which are repatriated (if the U.S. firms are owned by domestic shareholders). Again, this is only 10 to 20 percent of the total product value. And, yes, this will create additional jobs. However, these additional jobs will be almost all in the service sector, unless completely new industries spring up, an unlikely and long-term prospect.

Service jobs as a rule don't pay as much as manufacturing jobs. They also do not create national wealth. On the contrary, they absorb wealth. For example, you have to work in a computer plant that can export its products (creating national wealth), so you will be paid and in turn pay your local attorney, who in turn pays his barber and so on. There are, of course, some exceptions, such as banks or insurance companies providing financial services abroad, but these have a relatively small impact on our economy.

I learned long ago that there are only three segments in the national economy that create national wealth: agriculture, mining (which includes oil production), and manufacturing. Manufacturing was by far our strongest exporting means. It is no accident that during the period of our strongest economic expansion, in the mid-1960s, about 26 percent of all employees worked in manufacturing jobs. In contrast, this number is now down to about 10 percent, and still falling. Farming is often cited as a sector where loss in employment had no negative effects. But automation and better fertilizers have made up for the decrease in farm labor. We still produce the same amount of food, probably more; hence there is no decrease in national wealth.

We can draw a distinction between outsourcing manufacturing jobs and service jobs (including data processing). Manufacturing jobs have by far the greatest impact on the national economy. First, we lose skills by outsourcing jobs. It will take time and money to retrain such a force at a later date. Second, we lose industrial infrastructure through the closing of U.S. factories. Third, we export capital abroad (to build manufacturing plants and duplicate patterns and tooling in China, for example). This money then becomes unavailable for U.S. economic expansion.

Service jobs don't require that much training and very little capital investment. U.S. companies derive substantial savings in wages and, perhaps even more importantly in health benefit payments, by exporting service jobs. Yet, in this case, too, we are losing national wealth by sending money abroad to pay foreign wages and salaries.

Another harmful effect of exporting jobs is loss of income by local, state, and federal governments. There are fewer payroll tax receipts and fewer contributions to Social Security and Medicare. Add to this the outgoing payments for unemployment benefits. Sales and other forms of tax revenue suffer, too.

WHAT ARE THE REAL SAVINGS?

Outsourcing services or simple assembly work offers the greatest cost saving potential for U.S. companies. There is very little capital involved and, except for training of personnel abroad and severance payments for the displaced U.S. workers, there are no major labor investments.

The picture is different when it comes to producing machined parts. The cost of direct labor for machinery production typically is 15 percent of the selling price of the product. So, even if you replace a worker in Massachusetts working for $20 an hour with a laborer, say in Poland, at $5 per hour, your savings on the bottom line will be 11.25 percent, at least on paper. The real savings will be substantially less, since you will have to buy or lease a new manufacturing plant, including expensive machinery, new patterns, and fixtures. You have to send U.S. managers abroad to manage the operation. There will be training of the new employees involving substantial travel expenses to send trainers from your plant to Poland. This training will not be easy, considering the cultural and the language barriers.

There will be loss of productivity, at least initially, and finally you have to expect at least 2 percent of shipping expenses when repatriating the foreign-made parts plus perhaps up to 5 percent import duty. This does not account for the extra inventory you have to carry to cushion for unforeseen delays in deliveries from abroad. In any case, you can forget about "ship on time."

All in all, expect a minimum of 5 percent in added overhead, shipping, and other expenses, leaving your "real" return at only about 6 percent. The tragedy is that most managers fail to see these "hidden" expenses in their overall cost calculations, since these expenses get buried in general overhead or in G&A. For example, in an April 2004 article, "Offshoring—New hope for U.S. or inevitable as death?," in InTech, the publication of the Instrumentation, Systems, and Automation Society, the author, Ellen Fussell, reported that while 92 percent of all managers cited cost reduction as their motivation for outsourcing, only 75 percent looked at supply chain cost, and a meager 34 percent considered plant or office shutdown expenses.

Some firms even go a step further and besides machining the parts also do assembly and engineering in underdeveloped countries. The only thing left within the U.S. is a bloated administration whose sole reason for existence is to reap the profits from abroad. It will take only a few years before the newly trained people, say in Taiwan, wake up and say: "What do we need the U.S. parent for? Let's start our own corporation and let's reap the profits ourselves."

DIMINISHING RETURNS

Initial savings in labor cost will diminish over time. Increasing employment in low-wage countries raises the local living standard and with it the expectations of the labor force. Eventually, demand for qualified workers can lead to bidding wars for employees by competing manufacturers, as happened in Mexico some years ago. Over time, there will be an appreciation of the foreign currency against the U.S. dollar.

Here is a case study based on my own experience. In order to reduce the cost of some stainless steel investment castings, we obtained bids from a Korean foundry. Their price was about 45 percent less than what we paid to our U.S. supplier. This was a good saving and we switched suppliers, absorbing about 5 percent ocean freight. Over the next four years, the cost from Korea slowly crept up, mostly due to the increase in the value of Korean currency. In addition, we quite often experienced serious delays in shipments. The excuse typically was: We had a fire in the foundry. The real reasons were, as I found out later, that the factory workers were striking for higher wages. These delays forced us to switch to more expensive airfreight, and to increase our inventory reserves.

Finally, the cost differential was less then 20 percent. At this time, I realized that this was not a sufficient saving to make up for the delays, the expensive shipping, and the cost of carrying extra inventory. So I switched back to our old supplier. Luckily for us, he was still in business.

The loss of generally high-paying industrial jobs will manifest itself in a decrease in domestic buying power. This in turn will have a negative effect on the gross domestic product. While some additional jobs may be created in the service sector from outsourcing-enhanced profits, those jobs are fewer in numbers and, as a rule, lower in pay than jobs in industry. The decrease in domestic buying power and the shrinking of the domestic markets may accelerate the relocation of U.S. companies abroad.

Such a trend can be reversed only by the introduction of new and proprietary industrial products here in the U.S., but that would require the construction of new factories. Unfortunately, the prospects of this happening, at least in the foreseeable future, are dim.

Outsourcing also can affect national defense. If factories that make materials for the armed forces, from uniforms to electronics, move abroad, we could be at the mercy of foreign suppliers. The recent war in Iraq is a prime example of supply problems. Such a potential lack of supplies can have a profound impact on our future foreign policy.

Hans Baumann, an ASME Fellow, operates an engineering consulting firm, H.B. Services Partners LLC, in Rye, N.Y. This article is based on an address he delivered to MBA candidates at the University of New Hampshire.