March 2007 – Low-Cost Countries: An Endangered Species?

In the past few years, many companies have rushed to identify cheaper ways of doing business by exploiting low-cost labor and other “comparative advantages” that so-called “low-cost” countries can bring. But in the future, will low-cost countries, as they are defined today, even be relevant for the same reasons why manufacturers flock to them in the current environment? 

Take the case of India. Without question, skilled Indian labor is far cheaper than labor available in the West. But middle and senior management―not to mention ex-patriot―salaries are sky rocketing. One of our colleagues just returned from a business trip to the Northern Indian city of Gurgaon where he found that a 4 bedroom townhouse was priced at close to $1,000,000—about what you’d expect to pay in most parts of downtown Chicago for a similar property. In Bangalore, skilled, senior software engineers can now demand as much as $35,000 per year (up roughly 3x compared with ten years ago). And commercial property value in the city can command square foot rental rates that are higher than that of California’s Silicon Valley. 

Amidst this significant wage and property inflation is a decrepit state-rum infrastructure where it still can cost as much or more as the United States per mile to move cargo around. In our view, it’s hard to fathom how a country with such great engineers can fail to build an efficient, national highway system. According to an article in The Economist, it takes eight days at an average speed of 6.8 miles per hour—including 32 hours of waiting at checkpoints—for a road-bound container to travel from Kolkata to Mumbai. And by the time India gets its act together and builds out a proper infrastructure and port system, middle class and working wages will look more like those in the U.S. and Mexico, making “low-cost” driven sourcing decisions irrelevant. 

India, however, is but one “low cost” destination which is becoming less interesting from a labor arbitrage perspective. We have talked to a number of U.S. manufacturers in industries ranging from automotive to industrial products who have decided to change previously made decisions to produce and or source specific parts from China. These companies have found that while China can now offer high quality and low unit costs for larger production run volume items, the total costs of doing business (including tax, tariffs, logistics and additional inventory carrying costs) can outweigh the labor advantage benefits of manufacturing or buying from the region. 

Clearly, a sea change is underway. At least as we see it, “low-cost country” based decisions are eventually going to go away completely. Given this, rather than simply, looking to play the labor arbitrage, game. U.S. manufacturers need to look to places like India and China more holistically. For example, might India make a good location to put a new design center (to take advantage of the millions of highly educated engineering graduates that the country is turning out)? Or, would it make sense to enter the Chinese market not just to reap the benefits of lower-cost export production, but also to sell ‘products to the booming middle and factory working class? 

The opportunity for U.S. manufacturers to reap the benefits of globalization and free trade are huge. But we must all think beyond simple near-term savings opportunities, instead taking a long view to support both growth and cost reduction strategies that are sustainable and lower risk.