8.5 Locating Value-Added Activities

The search for growth is a primary driver of manufacturing relocation.KPMG (2009). Emerging economies have significantly higher trend rates of growth than mature economies. This is the inevitable result of the arrival of large-scale capital investment in low-wage and low-cost economies.

This phenomenon is clearly evident in the automotive industry—an industry challenged by low sales growth and declining margins in mature markets. The world’s automotive assemblers want to capture market share in the fastest growing markets of the near future, and they want their chosen suppliers to be with them. Suppliers, for their part, also want to be part of the growth story, serving not only their traditional global Original Equipment Manufacturer OEM customers but also the emerging local automakers that are capturing new markets with low cost and often innovative products, such as China’s Chery Auto and India’s Tata Motors.

Reducing cost is a second powerful driver of manufacturing relocation. A recent survey by KPMG Peat Marwick showed that among companies that are primarily motivated by costs to invest in new markets, the opportunity to lower material costs is considered marginally more important than labor or capital costs.KPMG (2009). This somewhat surprising result reflects the fact that companies still find that the costs of internationally traded raw materials and partially processed commodities, such as automotive steel, remain cheaper in some lower-cost economies. The same survey showed that even if costs can be reduced, companies remain concerned about the cost of complexity that may be introduced when operations become distributed over several locations that may be separated by large distances and may be in numerous jurisdictions. The companies interviewed also cited a wide range of other cost drivers of relocation. These include government incentives, regional interest rates, wages, and trade agreements.

The relative importance of a third driver—innovation—is increasing as the center of gravity of global business activity continues to shift eastward. In the automobile industry, for example, a vehicle manufactured today has, on average, 10 times the number of electronic functions of a vehicle manufactured 10 years ago. But while innovation has intensified, the sales volume to support the costs of this product innovation has failed to materialize. Price and income trends mean that sales volumes are unlikely to be rebuilt in the developed industrial markets; on the contrary, they are likely to fall further. In these markets, the average price of a new car has doubled over the last 20 years, but average incomes have only risen by 50%, and this price-income gap continues to widen, implying further falls in sales volumes if costs cannot be cut.

These trends are driving a multidirectional globalization of innovation in the supplier industry. Established companies in the automotive triad need both to cut the costs of innovation and find new sources of technology and process innovation. Suppliers in emerging economies need to acquire, rather than just develop, technologies and R&D skills in order to gain the innovation critical mass that will allow them to compete as global suppliers.

Companies participating in the KPMG’s Supplier Survey divide roughly equally between those who believe that R&D should be located close to production and those who are happy with geographically separated R&D and production. These responses suggest that a minority of companies plan to relocate R&D to emerging markets, despite cost pressures.

Companies who believe that R&D should be located close to production tend not to be planning R&D relocations. They believe that R&D for process improvement is more important than R&D for application engineering, and their R&D centers are most likely to be located in Western Europe and Asia, followed by North America. In contrast, companies willing to operate R&D centers remote from production are predisposed to relocating production facilities, although most of these companies say that innovation is a less important criterion than cost, growth, or risk.

These primary drivers—the need to find growth, to reduce costs, and to facilitate innovation—must be balanced by a company’s capacity to manage risks. Yet, in many cases, the upside and downside of all these factors may be more subtle or less clear than companies commonly suppose. Where markets offer the promise of growth, companies should consider how consistent that growth would be over the term of the investment. They might consider whether it is necessary to locate in a given economy, or even region, to access the expected growth. Where companies seek to reduce costs, they should also consider whether direct cost reductions in areas like labor and raw materials are accompanied by indirect cost increases in areas like logistics and quality assurance. Where companies seek to facilitate innovation, they should consider whether risks and costs are best balanced by a conservative strategy of centralized R&D or a radical strategy of globally distributed R&D. And, in seeking to manage risks, companies need to understand that globalized operations may offer risk mitigation opportunities through the hedging of production, currency exposure and raw materials sourcing, as well as the increased risk challenges inherent in global operations.

Minicase: Nestlé Adapts Its Business Model to Target the Global Halal Food MarketAris (2006, December 18).

In 2006, the Malaysian operations of the world’s biggest food company played a leading role as Nestlé began to target the fast-growing halal food business. Its annual turnover of $73 billion (in 2005) dwarfed that of its nearest rivals, notably Kraft Foods, PepsiCo, Unilever, and Coca-Cola, whose sales ranged from $20 billion to $35 billion. Nevertheless, Nestlé was positioning itself to grow its food business even further.

With a market share of only 2% of the global food industry, Nestlé had ample room for growth. The halal segment, where it was well ahead of its major competitors in terms of market share and preparation, looked particularly promising. Worth $150 billion and with Muslims forming about 25% of the world’s population and having higher per capita income growth, Nestlé estimated that the halal food business would grow to $500 billion by 2010. Nestlé’s 2006 sales of halal products were in the region of $6 billion.

The strategic importance of this segment of the market was clearly highlighted at Nestlé’s product exhibition center on the sixth floor of its headquarters in Vevey, Switzerland. In a special corner for halal food exhibits, posters displayed such messages as “As disposable incomes of Muslim countries increase, global halal food sales will skyrocket”; “In Europe, many supermarkets are selling halal products”; and “Worldwide, halal food sales exceed $150 billion.”

Growth was expected to come from not only large, populated Muslim countries like Indonesia, Bangladesh, Pakistan, and the Middle East but also non-Muslim countries with a large number of Muslims, like India and the Muslim belt of North Africa, and in cities such as London.

There were a number of factors Nestlé believed would drive growth. One was an increasing demand for products that follow Islamic law. Another was the growing divide between the West and the Islamic world. One implication of the latter was an expected increase in trade between Muslim countries—halal food products would be strong beneficiaries. Third, Muslim governments were widely expected to launch initiatives to encourage private-sector participation in expanding the halal food business. In the case of Malaysia, for example, the government had initiated an ambitious plan to turn the country into the world’s premier halal hub. Finally, the international Muslim community was getting closer to standardizing and harmonizing matters pertaining to halal food manufacturing practices, certification, and product labeling.

To capitalize on these opportunities, Nestlé was prepared to make significant changes to its business model. First, it designated its Malaysian operations to take the lead. Nestlé had begun producing halal food in Malaysia in the 1970s. That was the decade when the company established a halal committee comprising Muslim senior executives of various disciplines from the operational-factory side and the corporate level. In the 1990s, the committee became more structured, and a halal policy was established. In 1995, Nestlé Malaysia took the halal initiative to the global platform within the Nestlé Group. Two years later, Nestlé Malaysia, in collaboration with the Nestlé Group, established internal guidelines with input from Jakim (the Department of Islamic Development in Malaysia) to define what constituted halal food and how to manage its production and supply.

Second, working with the international Muslim community and governments, it had 75 of its 487 factories in 84 countries certified halal. Sixty-six were in Asia and the Middle East, seven were in Europe, and two were in the Americas. All eight of Nestlé’s Malaysian factories were halal-certified, producing more than 300 products. The big items were powdered Milo beverage, Nescafé, Maggi noodles, sauces, and culinary mixes. The Malaysian operation was also the regional producer for Milo, Kit Kat chocolate, and infant cereals.

Third, at the retail level, Nestlé worked with the United Kingdom’s largest supermarket chain, Tesco, to promote halal food products as a specialty category. Tesco had agreed to create halal corners in 40 stores in the United Kingdom, with the potential for expanding that number to 500 stores. Nestlé was finalizing a list of products, including those made by its Malaysian factories, to be featured in this section of the supermarket.

Finally, to help the Malaysian government reach its target, Nestlé conducted a mentoring program for small- and medium-scale enterprises in the food industry to improve their standards with regard to hygiene and food safety. All these preparations were about to pay a dividend.