The Perfect Economic Storm and The 100-Year Flood in Manufacturing—Part 1

By David Goodreau

July 10, 2003

Editor's note: This article discusses three of six contributing factors to the current state of manufacturing—global competition, high business costs, and supply chain management and consolidation—with a focus on California manufacturing. Part II discusses technology investment, the elimination of industrial arts programs, and the lack of industry leadership.

The manufacturing industry is in one of the worst economic slumps in history. California alone lost 167,000 manufacturing jobs between December 2000 and September 2002. Depending on the industry sector or region, this downturn began as early as late 1999 and has no immediate end in sight. This is a unique economic environment that can be likened to The 100-Year Flood caused by The Perfect Storm in terms of its destructive potential.

Why The Perfect Storm? One tumultuous economic event never would have had such lasting or dramatic effect on California's diverse manufacturing economy. However, a confluence of economic factors has created an economic flood of historic proportion.

Six major factors, when considered collectively, have devastated the California manufacturing industry and have caused fundamental changes in the sub-contractor base in the state.

1. Global Competition. Manufactured components are the core of California's economic strength. Since lower prices drive the market, component manufacturing has slowly moved from California over the last 20 years, from domestic competitors, onward to Mexico's maquiladoras, and now to Asia. Today even Mexico is losing contracts to the low-cost Asian regions.

In today's electronic age, procurement, concurrent engineering, and next-day air make international trade an attractive option to cost-conscious buyers. Foreign competitors are culturally valued and heavily subsidized by their governments to encourage investment, research, development, and training. Every year these overseas firms gain additional expertise as U.S. corporations transfer intellectual properties and skills development to these overseas firms. Factors that illustrate the trend include:

• A loss of jobs. Competition, both foreign and domestic, contributed to Los Angeles County's loss of 257,800 jobs between 1987 and 2000. The Bay Area lost 209,000 manufacturing jobs between December 2000 and September 2002.
• A growing trade deficit. The incredible rise in the trade deficit is a primary indicator of production resources shifting from North America to China. Statistics suggest Americans buy five times the amount of goods from China than the Chinese purchase from the U.S.
• An increased focus by foreign firms. In 1995, the chairman of the Asian Die and Mold Federation stated that the Asian governments desired that 80 percent of all the world's dies and molds would be made in Asia in 10 years. In the last two years, the American Mold Builders Association has lost 88 members—20 percent of its total membership with more than 50 of those companies simply closing their doors. Why? A $30,000 mold from China comes with a 3.31 percent tariff while a U.S. mold going to China has a 12-percent tariff and an additional 17-percent tax.

Of course, China is the primary example. But manufacturers in countries with weak currencies, lack of labor laws, lack of environmental laws, low wages, government-subsidized raw materials, and little or no intellectual property protection also are a threat.

2. California's High Business Costs. Between 1989 and 1993, California lost almost 1,000 manufacturing plants to foreign and domestic regions. When those facilities left California's high-cost business environment, the contracts outsourced to small manufacturers soon followed, costing jobs and revenue. Today, manufacturers find themselves in a worse economic hole than the 1992 crisis, primarily because there is little or no political will to address the issues that are crippling California's manufacturers.

And relief may be slow in coming. California is the sixth largest economy in the world and the response time to implement policy reforms is slow. From political realization and pressure to economic relief can take three to four years.

Regional individuality (geographic, politics, leadership, and industry clusters) further complicates economic recovery. For example, the major urban areas of San Francisco, Oakland, San Jose, and Los Angeles County have lost 192,000 jobs between December 2000 and September. 2002, while developing regions, such as Sacramento, Riverside, San Bernardino, Fresno, Modesto, and Stockton County, have added 75,500 jobs.

The following points highlight the high-cost of doing business in California:

• California's composite business costs are 32 percent above the national average. Only four states have higher costs.
• In a recent nationwide survey of top corporate executives, 57 percent named California as having the nation's worst business climate. Their negative rating of California was double those of the next two states, New York and Massachusetts.
• In the Annual Business Climate survey conducted by the California Chamber of Commerce and the California Business Roundtable, two-thirds of California's business leaders reported that business conditions in the state worsened in 2001.
• California's national ranking for 2002 by the Small Business Survival Committee, a Washington-based group promoting entrepreneurship, fell to 46 out of the 50 states this year, down from 44 in 2001 and 39 in 2000.
• Workers Compensation rates are expected to increase by more than 100 percent when compared to the rates of three years ago. According to the California insurance commissioner, the system is more than 10 billion dollars under-reserved.

In addition, legal costs and insurance rates are other mitigating factors.

3. Supply Chain Management/Consolidation. Consolidation trends in the aerospace and defense industry are similar to those within the subcontract chain. Fifty-three major corporations have merged into four global giants. Using California SIC codes, aerospace firms in California dropped from 1,640 in 1997 to 984 in 2000, a 65 percent decrease. An article in last year's Aviation and Space Technology reported that the industry probably will lose a large percentage of its supplier base, which will never come back

The article contained comments from various industry CEOs:

• "It's going to get worse before it gets better," said James Stanley, Alcoa Howmet Castings president and CEO.
• "I don't see any sign of recovery," said Vernon Broomall, corporate vice president of engineering, quality and technology for Vought Aircraft Industries. "As that process plays out [increasing the sophistication of their suppliers], there probably won't be a role for the mom-and-pop shops; it has gotten too expensive to deal with them. The shakeout started in the early 1990s, and chances are it will continue, given the current business climate."

As consolidation continues, it trickles down the supply chain, sucking up contracts that had traditionally flowed to the small firms. Unfortunately for these smaller firms, this is the marketplace at work, and it is creating new winners and new losers.

Similar to factory farms that have put so many family farmers out of business, these new consolidated firms are capable of efficiencies that the smaller firms can't match. The incentives for customers to continue this management track are clear:

• Reducing suppliers means sharper focus and greater opportunity for leveraging customers buying power.
• Customers obtain added flexibility through long-term purchasing agreements that lock in prices and allow for smaller lot sizes.
• Through preferred supplier programs, customers focus on the best suppliers that increase higher throughput value.

Add to these factors the high cost of investing in technology to remain competitive, the shortage of skilled labor exacerbated by the elimination of industrial arts programs, and the lack of industry leadership—all factors to be discussed in Part II of this series—and you have almost insurmountable circumstances. Each factor must be addressed if manufacturing is to recover.