Manufacturing in Mexico suddenly has morphed from a classic supply chain dilemma to a political hot potato. We can’t do anything about the political side, but we do have a lot of experience working with clients trying to get into or get out of Mexico for manufacturing. And the potential 20% import tariff on goods made in Mexico sure does throw an extra wrench into the works. And the fallout from such a political move could potentially impact companies who manufacture in the US or Pacific Rim countries.
In Part 1 of our three-part series, we looked at Manufacturing Location Tradeoffs. Today, in Part 2, we look at Comparing Costs Between Regions, and our final installment, Part 3, will look at Alternative Manufacturing Strategies.
While ultimately one needs to compare manufacturing costs between specific factories / companies in specific locations, it is useful to under the macro issues which drive costs regionally. The cost of a product can be oversimplified to fall into three categories:
- Material cost: this includes all purchased materials, components and subsystems, and typically also includes inbound freight and duties, as well as a scrap factor
- Value add: this includes labor, both direct and indirect, as well as other overhead costs, SG&A costs and any profit margin
- Logistics: this includes not only the raw transportation costs but also any duties, warehousing, spoilage, etc.
Together these three add up to Landed Cost. Note that there are of course other more indirect costs, for example the cost of quality in terms of reverse logistics, repair and the like.
To some extent this is the easiest to quantify, and to first order these costs tend to vary relatively little region-by-region. However, especially in low to medium volumes, there can be regional cost differences to materials or components, either due to different pricing strategies and / or related to distribution or costs of doing business. And in general, there is a home-field advantage—a China-sourced part is often cheaper in China; a Mexico-sourced part is cheaper in Mexico. And, since for many products material cost dominates the total cost, small differences in material costs can swing the equation for overall product costs.
More important, however are inbound freight and duties, which can vary tremendously. Duties are not always logical—tariffs on steel, for example, often fluctuate to bizarre levels. And a trade war could really mix this all up. On the more boring side, freight costs tend to go up with distance, weight and size, and this can \skew build-vs-buy decisions on parts and subassemblies.
Specific to manufacturing in Mexico, a product with a Mexico supply chain will be more resistant to being moved than a product with a US or Asia supply chain. That said, it typically just means more work to find alternative sources. Worst case, however, in a 20% punitive tariff political situation, would tend to make this a major issue if alternative regional sources could not be found. But, unfortunately for Mexico, it is relatively rare to see a Mexico-only supply chain.
The flip side of this, however, is that products being built in Mexico using predominately foreign supply chains would be much easier to move, and have less of a cost disadvantage of moving to the US. However, in cases where the supply chain is mostly from China or other Asian sources, this might mean moving the product manufacturing to Asia instead.
Relative to the US, Mexico does enjoy a significant labor cost advantage, with raw labor rates being perhaps 20 to 30% of the US for unskilled labor and perhaps 30 to 50% for skilled labor or indirect labor. The differences increase if comparing to union labor, but that is beyond the scope of this blog series. Labor rate differential is the single biggest factor that drives manufacturing in Mexico, and it is a non-trivial advantage that has to be factored into any discussion.
Labor also factors, surprisingly heavily, into overhead, which is typically the single largest element of the value add. As mentioned above, the labor savings in Mexico for an engineer or accountant is still significant but often not as severe as for less skilled labor. This savings often is further diluted by the relative inexperience seen in such factory professionals compared to a US factory. A Mexican engineer with 2-years’ experience at half the price for a US engineer with 30-years’ experience may not be a bargain. Turnover in the professional ranks can also be much higher in Mexico, resulting in come-up-to speed costs as well.
Beyond labor, other overhead costs such as facilities, utilities etc. may or may not be cheaper in Mexico. Of course, the weightings of these factors are heavily product-dependent—an aluminum smelter is much more dependent on the cost of electricity than a factory that assembles circuit boards. Factory utilization also plays a very significant role—a full factory in the US might have lower overhead rates than a half-empty factory in Mexico.
Like overhead, SG&A is heavily impacted by administrative labor rates, but also by corporate structures. Oftentimes a Mexican subsidiary of a US company is burdened not only by its local costs but also an allocation from corporate, which might actually be higher than a US-only company due to additional multinational complexities (like dealing with those pesky tariffs)
Logistics cost vary not only based on country but also region. It might be cheaper to truck product from Juarez to Houston then from Los Angeles to Houston. That said, the paperwork and congestion from crossing an international border can add significant bureaucratic costs, and delays impact cash flow, customer satisfaction and in some cases, spoilage. If agents are used to facilitate or de-risk, their costs must be included.
Besides cash flow, transit times also have secondary issues in terms of flexibility, forecasting, and ability to respond to market changes. While the difference between Mexico and the US are slight, if Asian options are considered as a replacement for Mexico, this transit time becomes very significant, and need to be factored into the strategic decision-making process as well as the cost impact.
While not directly factored into landed cost, understanding and modelling risk is important to making strategic supply chain decisions. Risks can take many forms, from exchange rate fluctuation risk to risks of terrorism, labor unrest risks to product quality risks. Costs of mitigating risks can be tangible and calculatable, in which case they can be added into SG&A and other calculations, or they can be intangible and only weigh in at the strategic level. Each situation is different, and each company in practice has a different risk adversity profile.
While there are many ways to deal with risk, a simplistic expected-value model can often be used to do a first-order calculation, multiplying the percent chance of a risk factor occurring by the economic cost if it occurs. For example, we can model the risk of obsolete inventory in transit by multiplying the probability of a market shift that obsoletes inventory times the dollar amount of said inventory
As mentioned above, Landed Cost = Material Cost + Value Add + Logistics Cost. This is typically the best metric for comparing costs between regions, although there are of course intangibles as well as strategic implications to be weighed as well. While every situation is different, typically we see companies allowing a US solution to be a few percent higher than Mexico and a Mexico solution to be a few percentage points higher than Asia to counterbalance these intangibles as well as risk.
Our final installment will address in more detail various strategies and tactics that companies can use to mitigate risk, assess and compare options, optimize their supply chains, and make the best of what might well become a messy situation.
All for now. And remember to breath.