Nearshoring Latin America: A Closer Look
Do the advantages of locating production near the point of consumption outweigh the region’s drawbacks?
The rising price of oil, driven by dwindling supplY and mounting demand from China and India, will kill globalization as we know it, writes Canadian economist Jeff Rubin in his 2009 book Why Your World Is About to Get a Whole Lot Smaller: Oil and the End of Globalization.
How Safe are Latin America’s Market Leaders?
A Model Concept
If oil is cheap, it doesn’t matter how far factories are from showrooms, Rubin observes. Other expenses, such as labor and taxes, determine where companies manufacture products.
If oil is expensive and scarce, however, the equation changes. Rubin believes the world has now reached this inflection point. Reports from the trenches confirm his observation.
Once far-flung supply chains are contracting. U.S. manufacturers are bringing production back—not necessarily all the way back to the United States, but to the Americas. Trade flows that were long distance, East-West oriented for nearly two decades are shifting. They’re being replaced, at least in part, by shorter, region-based trade flows—between the United States and Latin America, for example.
The price of oil isn’t the only factor driving global supply chain network design, but a major shift in supply chain network strategy is underway. A new model is emerging: a regionalized global supply chain in which goods are produced, sold, and consumed in the same geographic region.
To grasp the significance of this new trend, it helps to take a look back. In 2000, U.S. manufacturers started to move production from maquiladora plants in Mexico to Asia. First, they shifted operations to Japan, then Taiwan, China, Vietnam, Malaysia, and elsewhere. They also relocated manufacturing to Eastern European countries such as Poland and Estonia.
“Most companies decided to move production using one-dimensional reasoning, based on labor costs, which represented 70 to 80 percent of the criteria considered,” says Tom Page, director of customer solutions, international regions, UPS.
Even today, many firms still focus on transportation, labor, and currency exchange rates as key network design drivers. “They make decisions based on an arbitrage play on those three elements,” says John Ferreira of supply chain consulting firm Accenture.
“But what happens when their customers want more unique products with short cycle times and multiple reorder points?” he continues. “They need intermediate warehouses. That drives up inventory, labor, and procurement costs because they have to manage goods coming from multiple facilities.”
Companies find it difficult and expensive to address these customer requirements with global networks that have long supply lines.
“The North American market, for example, still represents a significant share of global demand for consumer and industrial products,” says Ferreira. “Many organizations serving North America from Asia have discovered that exchange rates and increased transportation and labor costs negatively impact what they once thought were good sourcing decisions.
“As they saw these costs increase and the so-called savings evaporate, they realized other unanticipated costs were associated with far-sourcing,” he adds.
Many businesses neglected to factor flexibility and agility into their outsourcing decisions. “They didn’t consider what flexibility and agility are worth, or how to quantify their value,” observes Page. “You have to ask whether being able to respond to market demand faster allows you to increase sales or improve margins. If you have ready access to product, can you sell more?”
As a result of these realizations, companies are rebalancing their physical networks to match regionalized demand. Forty-two percent of survey respondents to a 2011 study by consulting firm AlixPartners indicate they are either nearshoring currently or plan to within the next three years.
Expected Advantages of Nearshoring
Respondents to a survey by consulting firm AlixPartners cite lower freight costs as the primary advantage they expect to gain through nearshoring decisions.
Source: AlixPartners
More companies are reconfiguring their existing supply footprint and, as part of this process, bolstering capacity in Latin America, according to a 2011 Accenture study.
“A shift to onshore or nearshore manufacturing operations for producing local demand in nearby low-cost countries, such as Mexico for the United States, appears to be here to stay as manufacturers look for the next level of competitive advantage,” says Ferreira. “In the case of Mexico and Latin America, these moves serve a dual purpose: the ability to accommodate growing markets near customers there, as well as being nearshore to the large U.S.-based demand.”
HP’s Nearshoring Story
Leading companies began embracing this dual-purpose supply chain strategy some time ago. Computer manufacturer HP has a significant presence in Latin America, especially Mexico. The company runs its supply chain activities for personal computers, printers, and servers for all of Latin America out of a facility in Guadalajara.
“We also provide IT support and development from Mexico,” says Julio Acevedo, head of HP Guadalajara. “We started offering those services 10 years ago with 10 people. Today, more than 500 people work in support and development.”
The Guadalajara operation handles centralized procurement for HP, buying more than $3 billion in materials and product annually, and manages payroll, human resources, finance, and marketing support for the United States, Latin America, and other parts of the world.
HP’s Guadalajara location is part of a high-tech industry cluster of original equipment manufacturers, suppliers, contract manufacturers, and service providers. By clustering suppliers, manufacturers, and services, HP reaps the benefits of a highly qualified business ecosystem. The company leverages the strengths of the cluster—even competitors such as IBM—”to improve our service and reduce costs so we can compete against Asia,” says Acevedo.
Avnet, a $26-billion global electronics distributor based in Phoenix, Ariz., recently opened a value-added supply chain operation in Nogales, Mexico, to serve both the United States and Latin America. “We wanted proximity to our U.S. customer base, and the ability to leverage the cost model in Mexico while retaining direct control,” says Robert Brenner, Avnet’s senior vice president of logistics, warehousing, and distribution for the Americas. “We try to keep our supply chain interregional. Our philosophy is to build and ship within one region.”
Decision Points
Nearshoring manufacturing makes sense for a variety of reasons. Here are some factors currently influencing corporate leaders’ decisions.
Rising labor costs abroad. “Rising U.S. labor costs and access to the Chinese labor market were primary drivers for companies’ initial movement to China,” says Wendy Tate, assistant professor of logistics at the University of Tennessee. “Chinese wages are now climbing at 15 to 20 percent per year, however, thanks to a supply-and-demand imbalance of skilled laborers in manufacturing regions, global pressure to upgrade Chinese labor practices and wages, and increased employee demands for better pay and conditions.”
Meanwhile, flexible work rules and new government incentives in both the United States and Latin America are making these regions increasingly competitive as manufacturing source points.
Volatile, escalating energy costs. Rising energy costs may be the biggest factor pushing nearshoring. “Transportation costs are becoming prohibitive,” says Stephen Paruola, vice president, distribution and transportation, for Rainbow USA, a New York-based value retailer of women’s and children’s clothing and shoes. “Nearshoring through Mexico and Latin America will increase because of lower transport costs. There will also be more mode shifting from truck to rail intermodal in the United States.”
As transportation becomes a larger percentage of the cost of goods, companies such as Rainbow will take steps to reduce those costs. “We are a budget chain,” Paruola says. “We can’t raise our prices 20 to 30 percent to cover higher transport costs, so we have to change how we manage our supply chain to reduce those costs. That means buying more product domestically, or at least closer to home.”
Currency exchange. The value of the U.S. dollar has fallen sharply against many currencies over the past five years. With continuing signs of sluggishness, the weak dollar diminishes the cost advantages of manufacturing in low-cost countries.
Transit time. Sourcing closer to home reduces transit times, and enables manufacturers to respond more rapidly to fluctuating customer demand. Shorter transit times also reduce system-wide inventory.
Flexibility. Nearshoring gives manufacturers the ability to postpone final configuration and differentiation in the sales cycle to a point closer to consumption. Postponement carries a number of benefits.
“A product sold in clamshell packaging can ship unpackaged in bulk from Asia to Mexico, then be packaged there, close to the U.S. market,” Page notes. “This approach brings tremendous logistics value, including transportation cost savings and reduced carbon footprint.”
IP protection. Intellectual property (IP) rights protection is a significant and growing concern for companies manufacturing in Asia, where IP theft and counterfeiting, together with a lack of regulatory protection and enforcement, are widespread. The need for better IP protection and enforcement drives many nearshoring discussions.
While Latin America’s IP laws and enforcement vary by country, many nations have signed Free Trade Agreements (FTAs) with the United States, which should guarantee IP rights to foreign companies. But the FTAs are often ambiguous or incomplete on key enforcement issues that then have to be interpreted by each country’s government, leading to very different IP environments.
Quality. Manufacturing quality and vendor qualification are major issues in sourcing from other countries. “Companies have to assess the total supply base to determine whether it can support their manufacturing effectively,” says Page. “They can’t just send specs to vendors and tell them to produce the part. They must ensure vendors and all their suppliers have good quality systems in place, or risk a costly product or supply quality problem. In a complex supply chain, product or quality failures can be a nightmare.”
Available talent. “A stable work environment plays a significant role in sourcing decisions,” says Mary Anne Young, senior vice president, Caribbean and Latin America West Coast, Hamburg Süd.
Questions to ask include: How big is the current qualified labor pool? Will the operation be able to scale up over the next five to 10 years? Who is competing for the same talent? What are the strengths and weaknesses? How strong is the work ethic? Do labor laws favor workers or employers?
The labor force’s skillset is critical in supporting flexible production operations.
“The workforce and infrastructure must be flexible enough to change a production line on demand and still put out quality product,” advises Page. Cultural affinity between the United States and Latin America is an advantage in this regard.
Infrastructure. “Just because a country was known for having solid infrastructure in the past does not mean it will in the future,” says Patrick Haller of Nearshore Americas, a research organization focused on Latin America outsourcing.
For instance, Chile has traditionally been regarded as having stable infrastructure, but President Sebastián Piñera recently warned that Chile would face an energy crisis during his administration because of an estimated annual demand increase of up to seven percent.
Hamburg Süd, UPS, and other carriers and service providers track infrastructure and security improvement efforts. “If a country doesn’t maintain good roads to inland locations, its ability to grow suffers,” Young says. “Mexico and Brazil are making advances in infrastructure development.”
Natural disasters. No country is safe from nature’s wrath, but some are more susceptible to disasters than others. Chile is more prone to earthquakes than flooding, Colombia suffers from flooding and earthquakes, and drought threatens Brazil, according to disaster reduction resource Prevention Web.
How well a country is able to address risk drivers indicates its risk-governance capacities. “In general, countries with weak governance and great difficulty addressing these drivers are low- and lower-middle-income countries,” states the United Nations 2011 Global Assessment Report on Disaster Risk Reduction.
“Countries with the lowest risk-governance capacities are also experiencing conflict or political instability, and their development trajectories diverge not only from high-income countries but from successful low- and middle-income countries,” according to the report. “Some middle-income countries, such as Costa Rica and Chile, have comparatively high-risk governance capacities, so they are better equipped to respond to a natural disaster.”
Considering the full supply chain, including suppliers’ product sources, is vital to accurately assess risk. “Manufacturers need to understand where suppliers are getting their products,” says Page. “Most companies only assess risk of disruption to first-tier suppliers. But today, they need to be able to see every supplier level’s risk to determine how it changes their overall risk equation.”
Political risk and security. “With revolution after revolution in North Africa, police crackdowns in China, and uprisings in the Middle East, the global political climate does not seem welcoming for business investment,” notes Tarun George of Nearshore Americas.
Geopolitical risk must be factored into the supply chain network design decision-making process. Political risk and security issues take several forms in trade and supply chain operations.
The first is government policies and attitudes toward foreign businesses. Are foreign companies welcome to operate freely within the selected country? Does the country have a history of nationalizing private enterprises? Can the government close down an operation that is deemed contrary to its philosophy?
These are very real concerns, especially in Latin America, where some nations’ political dynamics change rapidly.
“Countries such as Venezuela and Argentina, which have a history of volatile political climates, may pose higher risk,” advises George. “Chile and Colombia, on the other hand, stand as recent examples of political stability.”
Physical security is another risk consideration. “Security problems are increasing from the Central America nations to Costa Rica because gangs and drugs are moving into these countries,” says Young. “Mexico’s problems are well-publicized, but other Latin American countries have security issues, too. Understanding how governments will address these concerns helps companies plan additional security measures.”
Trade regulations and compliance. The ease of doing business in a country is a significant factor that can quickly drive up costs. “In-country trade regulations can be vague, leaving implementation open to interpretation,” cautions Page.
“If UPS prepares a shipment using the harmonized trade schedule, makes entry, and files it, the port authority representative can reject it based on how they interpret the trade regulations,” he continues. “But a different customs agent could interpret the rule another way, and let the shipment through.
“When interpretation of laws is left up to individuals, doing business is tough,” he says.
Getting Close to Customers
The regionalization of supply chain networks makes good business sense for many reasons. “To meet demand in the Americas, it makes sense to manufacture in the Americas,” Ferreira insists. “The same goes for demand in Asia.”
But changing your supply network is a long journey.
“Building new networks, a talent pool, and an integrated supplier base takes time,” notes Mike Heilala, a senior manager with Accenture. “These are long-term decisions. In five to 10 years, where will your demand be, and how much will it grow and change?
“Bringing production back to the Americas so we can then export it halfway across the world is not what nearshoring is about,” Heilala concludes. “It’s really about getting close to customers.”
With that goal in mind, and a firm grasp on sourcing decision factors, today’s businesses can locate in the regions that best suit their needs.
How Safe are Latin America’s Market Leaders?
Argentina “Known for its bureaucratic red tape, nepotism, and an administration that seems uninterested in the professional services and sourcing industry as a whole, there is no doubt—based on the survey results—that Argentina still has an image problem,” the Nearshore Americas study states. Thirty-eight percent of respondents strongly disagree or disagree when asked if the national government is actively involved in creating a safer climate for businesses and business investment.
Argentina did score well on personal safety, with 71 percent of survey respondents rating personal safety as high or very high.
Brazil Despite ongoing violence in Rio de Janeiro, 54 percent of respondents with outsourcing interests in Brazil continue to rate personal safety at a high or very high level. “Brazil has other advantages, such as its large and scalable workforce and talented labor pool, that count for much more,” comments one industry analyst.
In terms of the role government plays in creating a safer climate, 85 percent of respondents feel that political stability and democracy in Brazil are at a high to very high level. The strong trade links and political cooperation between the United States and Brazil, particularly under the current Brazilian government, will likely make North American companies more comfortable doing business there.
Chile Chile was ranked the safest country in Latin America by a majority of survey respondents. Civil unrest or violence was rated of very low to low concern by 80 percent of respondents, while street crime/petty theft was rated very low to low by 74 percent.
Chile’s strong economy, high literacy rates, and sizeable copper wealth contribute to its positive safety ranking. Other reasons given by outsourcing buyers surveyed include the efficient courts and judicial system, uncorrupt law enforcement, and the high level of education and technological development. Respondents also have a favorable view of Chile’s government, with 73 percent rating the level of political stability as high.
Notably, Chile’s outsourcing action is largely concentrated in two cities, Santiago and Valparaiso; these rankings reflect only the situation there. Other parts of the country continue to struggle with poverty and income inequality.
Mexico The United States’ closest southern neighbor offers numerous outsourcing benefits, including time zone alignment, U.S. cultural familiarity, and a well-educated, bilingual workforce. More than 64,000 students graduate annually from Mexico’s 121 technology-focused universities—more than any other Latin American nation.
The country suffers from an image problem because of drug cartel-related violence, however, and the U.S. Department of State has advised Americans to defer non-essential travel to vast stretches of Mexico.
Yet while cities close to the border, such as Juárez, are experiencing violent disruptions, other locations, including Guadalajara and Mexico City, continue to provide some of the best sourcing alternatives to U.S. companies. Currently, Mexico has not seen a drop in investment or companies pulling out, but if the drug war continues, new business may suffer.
Business Climate Perceptions: The Government’s Role
Blue – The national government is actively involved in creating a safer climate for businesses and business investment.
Green – The country’s government is stable and democratic.
Source: Nearshore Americas
A Model Concept
The decision to nearshore manufacturing is highly complex. “A modeling tool can help evaluate the variables,” says Tom Page, director of customer solutions, international regions, UPS. “Modeling must include some understanding of currency fluctuation probability, low and high threshold, and how currency fluctuations contribute to overall sourcing decisions. It has to incorporate sensitivity to all decision factors.”
While many models are effective at quantifying the hard costs of positioning product in a market, they may not excel at calculating the value of supply chain flexibility, which could generate additional revenue and profit.
“The model should be able to assess the opportunity an investment or decision can create, and how much that opportunity is worth,” notes Page. “If you take on more cost, but can generate more revenue as a result, for example, you increase profit. But does that profit boost offset the cost of the decision?”
Even with sophisticated modeling tools, production-sourcing decisions for many products are not perfectly clear. “The fundamental concerns are reliability and consistency—how your decisions affect your ability to serve customers,” says Page. “You can have the lowest costs but fail to understand your risk exposure adequately. If an event shuts down your supply chain, all savings are destroyed by a failure to understand those risks and model their sensitivity.”