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Monday, May 08, 2006

Good Read - The End of the Line

Originally Posted: October 9, 2005 -- 8:54 PM
Fool Boards Link: http://boards.fool.com/Message.asp?mid=23143009

A review of an interesting book on management strategies in technology and manufacturing and their potential macroeconomic impacts in a global economy.


===================

Having toiled away in the Internet era of corporate America, I've grown more puzzled over the fixation within the executive ranks at outsourcing nearly every corporate function except the executive jet and the CEO's personal wine taster. Two weeks ago, NPR aired a story with a former FEMA or GAO official who stated the response to Katrina may have been worsened by local governments outsourcing more traditional government functions to private firms. Fewer full time government employees? Fewer employees to reposition to answer phones, help street by street searches, etc. as first responders and fewer people familiar with emergency procedures and actually responsible for fulfilling emergency duties. Contractors? Not in their job description, so no responsibility.

I just picked up a new book by Barry C Lynn entitled "End of the Line – The Rise and Coming Fall of the Global Corporation" that addresses the growth of outsourcing over the past 25 years and its relationship with / effect on trade policy, economic security and military security.

The basic premise of the book is that Presidents Reagan and Clinton implemented the biggest changes that accelerated the trend towards global outsourcing. Reagan's "contribution" was appointing policy makers who agreed with the "Nexus of Contracts" theory of corporation law that basically said corporations only exist to provide an efficient method of entering contracts (the corporation as legal "person") but WITHOUT the social responsibilities of a virtual person. Ensuring corporations behaved and conducted themselves in ways beneficial to society was the responsibility of the shareholders, not the management of the corporation itself.

Clinton's "contribution" was appointing Robert Reich as Labor Secretary and adopting half of Reich's thesis within The Work of Nations in pushing NAFTA. Reich's thesis basically assumed wider global trade and labor competition were inevitable so America should embrace it to try to profit from it while ensuring American workers were properly educated / equipped for that competition. It's easy to guess which half Clinton adopted and which half he ignored.

The book addresses the growth of GE, Dell, Cisco and Wal-Mart to describe how large businesses have succeeded in completely outsourcing the majority of their physical manufacturing and supply chain operations while squeezing virtually every bit of profit from those in the middle of the chain, delivering cheaper products to the end-consumers and higher profits to the "lead company" as Lynn calls them.

The problem is that this extreme outsourcing has resulted in a manufacturing model designed to produce ultimate economic efficiency only when all things are going right, leaving entire companies and even entire industries extremely vulnerable to a single disaster. One good example from the book is TSMC (Taiwan Semiconductor Manufacturing Corporation). TSMC operates a silicon wafer fabrication plant in Taiwan that uses a highly efficient process to produce larger wafers than any other fabricator. Because Cisco, Nortel, Dell, etc. have all outsourced their manufacturing work to companies like Selectron, Flextronics, etc. who have outsourced their parts requirements to smaller companies who have outsourced their….(ad infinitum) … and the margins are so tight up and down the line, many of the suppliers way down the chain have in fact SINGLE SOURCED their wafer needs to one company who produces materials so cheaply, they cannot afford to use anyone else. The supplier?

TSMC.

If an earthquake damages the TSMC plant or destroys the airport used to fly shipments out of Taiwan and up the supply chain, every vendor up the chain will be paralyzed. Use of just in time manufacturing processes means the supply glitch could be felt literally within 4-8 hours. A fantasy? Nope. It has already happened. An earthquake on 9/21/99 affected TSMC and resulted in a week-long gap in the supply chain.

The same thing is taking place within the auto industry as well.

The book addresses other examples of the problems resulting from this management trend with:

  • GE selling RCA to Thomson SA of France

  • Boeing's efforts to launch the 7E7 and compete against Airbus


Throughout the examples, the origins of the current policies (whether through conscious political decisions or "unconscious" decisions with unexpected, unintended consequences) are discussed. At times, this part of the story gets a tad hard to follow. The author tends to refer to material two or three chapters ahead on a routine basis, as if he couldn't decide whether to organize the book in timeline order or by covering a single idea start to finish before changing topics.

Despite the occasional sequential confusion, the analysis of the impacts of this management model is interesting. Squeezing the supply chain so hard so that only the lead company rakes in profits means larger number of workers are working for more companies closer to the financial edge, posing greater risks for pensions, unemployment, etc. Having a country like America in a position where our vaunted hi-tech industry is entirely dependent on one or two firms on one island facing political uncertainty under the thumb of a potential competitor for energy and capital. Allowing our commercial airliner industry to collapse down to a single firm which now cannot produce a plane without depending on foreign operations and foreign purchases subsidized by outsourcing jobs to the foreign country's soil.

If you are interested in manufacturing, operations management, insurance or just macro level economics and trade, the book makes quite a few interesting points. If you own any stock in auto firms, consumer electronics or insurance, the book is worth reading, even if you don't agree with the author's prescriptions.


WTH




One also has to ask what this means for the profitable shell companies. The wise ones will take into account that squeezing the supply chain results in people not having the cash to by the products - a total antithesis to Henry Ford's rationale.

It sounds like this is still part of the short-term goal mentality. It will change, but how to survive the change and find the right companies to invest in is challenging. Any hints in the book?


======================

If you believe in the book's description of the problem, it raises questions in two areas, your investments and your career.

From an investment standpoint, the book makes the point that the grossly imbalanced economic incentives facing managers of the "lead companies" make it difficult for them to change course in the short term and diversify supply chains between multiple companies, countries or regions. If a company purposely widens its supply network to guard against catastrophe and increases its cost structure, its own investors and competitors will squeeze it out of existance. For an investor, the only thing to take away is to maybe look at your portfolio and diversify from a market segment standpoint (e.g. DELL + CSCO + Flextronic is NOT a diversified portfolio...) or try to find some investments that are "orthogonal" to each other from an economic or geographic standpoint.

From a career standpoint, the question's even more difficult. If you work in an operations, engineering, software development, or similiar field and want to actively DO things, it seems pretty clear you'll be doing less and less if you continue to work for "lead companies". You will instead spend more and more time managing the contractors who manage the contractors who manage the contractors that do the work. If you actually go to work for the firms accepting the outsourcing work, you're left trying to square your participation in a phenomena with which you fundamentally disagree while being part of the chain of vendors in the middle getting squeezed for every time with your paycheck on the line.

Instead of smarter / leaner, it seems to be dumber / meaner.


WTH

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