Description
The document describes Off shoring of US automobile companies to China and Latin American countries: A Producers Equilibrium
Project Report
Offshoring of US Auto Companies to China & Latin American countries : Producer’s Equillibrium
Table of Contents: Abstract Introduction What is off shoring? Advantages and Disadvantages of off shoring Cost Curve Analysis Oligopoly Analysis Demand Supply Analysis Conclusion 2 3 6 8 10 12 14 15
2
ABSTRACT The industry and businesses are growing at a very fast pace. Industry dynamics are much stronger and effervescent now than in any of the previous decades. The present economic, social and political scenario around the world has changed the way business houses carry out their various functions. One major change that has particularly taken place in the way businesses function is that of “OFFSHORING”. Off shoring of business processes to countries which are cheaper has been a topic of major debate around the world. It is an issue that has fuelled varied sentiments in different countries. The reduction in production costs as a result of off shoring gives the companies a comparative advantage which forms the basis for off shoring. This report talks about off shoring of automotive components by US companies to China & Latin America providing insight into the subject while discussing the impacts of such off shoring on the automobile markets. The report also discusses the advantages that a company derives from outsourcing its manufacturing processes along with the benefits to economies in which off shoring takes place. Through this report we intend to explain the reasons for outsourcing, the scenario of US Auto industry, the market structure of this industry and the implications of off shoring.
3
INTRODUCTION
Off shoring is the practice of having all or components of a process performed in a foreign country to take advantage of labor cost arbitrage. It is a type of outsourcing. Off shoring simply means having the outsourced business functions done in another country. The intense competitive pressures in the automobile industry, especially in the US and Europe, have created a set of enabling factors, or drivers that are forcing OEMs and ancillaries to explore outsourcing and off shoring options.
•
Rising costs. Increasing labor costs, especially in North America, are resulting in a surge in overall costs. Shorter product cycles. Growing pressure on auto companies to launch new models and variants within a short span of time. Dropping profitability. New and emerging players are adding fresh capacity, which is, in turn, leading to price competition and hence affecting profitability of companies.
•
•
•
Expansion of capabilities and winning non-domestic business. Stagnant growth in home markets is forcing players to focus on expanding capacities and capabilities in emerging markets. Given the cost advantages, many of these centers are being leveraged to serve other markets.
T
4
The Off shoring Chain in automotive outsourcing
Various automotive original equipment manufacturers (OEMs) and Tier I suppliers have started off shoring design and engineering services to China and Latin America. Typically, OEMs outsource design and manufacturing of certain components or systems to their Tier I suppliers. Both, OEMs and ancillaries, establish offshore captive centers, some of whom are involved in high-end design and engineering services. In addition, the OEMs and Tier I suppliers tend to offshore low-end services to third party providers initially, before moving up to high-end services. An oligopoly describes a market situation in which there are limited or few sellers. Each seller knows that the other seller or sellers will react to its changes in prices and also quantities. This can cause a type of chain reaction in a market situation. In the world market there are oligopolies in steel production, automobiles, semi-conductor manufacturing, cigarettes, cereals, and also in telecommunications. It is characterized by: • • • Small number of large firms dominate the industry High degree of interdependence High barriers to entry that restrict new firms to enter the industry e.g. control of technology 5
• • •
Price stability within the markets Goods are highly differentiated or standardized Non price competitive e.g. free deliveries and installation, extended warranties Restricted information.
Automobile industry is largely believed to follow the oligopolistic market structure. this makes the industry having a strong price dynamics and a complicated price setting mechanism. In such a scenario reducing costs and streamlining operations by off shoring gives a company a strong advantage as would be discussed in our report.
6
WHAT IS OFF SHORING?
The process of relocation of business from one country to another is known as off shoring. This includes any business process such as production, manufacturing, or services. Off shoring is a type of outsourcing. Off shoring simply means having the outsourced business functions done in another country. The most important factor why work is off shored is to reduce labor expenses. The other reasons for off shoring are strategic. They are to enter new markets, to tap currently unavailable domestic talent or to overcome regulations that prevent specific domestic activities. The economic logic is to reduce costs. If some people can use some of their skills more cheaply than others, those people have the comparative advantage. The idea is that countries should freely trade the items that cost the least for them to produce. There are 3 types of off shoring: • Production Off shoring Production off shoring of established products involves relocation of physical manufacturing processes to a lower-cost destination. Product design, research and the development process that leads to new products, are relatively difficult to offshore. This is because research and development to improve products and create new reference designs requires a skill set that is harder to obtain in regions with cheap labor. For this reason, in many cases only the manufacturing will be off shored by a company wishing to reduce costs.
7
•
Services Off shoring The growth of services off shoring is linked to the availability of large amounts of reliable and affordable communication infrastructure following the telecommunication and Internet expansion. Coupled with the digitization of many services, it was possible to shift the actual production location of services to low cost countries in a manner theoretically transparent to end-users.
•
Innovation Off shoring Once companies are comfortable with services offerings and started realizing the cost savings, many high-tech product companies started using developing countries for innovating products
8
ADVANTAGES (http://www.article99.com/employment/outsourcing/article.php?art=6102) 1. Reduces the cost of production and services:
One of the main factors that contribute toward a company's business success is the cost of production and operation. Offshore outsourcing, refined over a period of time is one of the factors that have succeeded in reducing the cost of producing goods and services very effectively. The benefit of off shoring is the savings in operating costs which in turn contributes towards the company's sustenance and growth. Companies usually sustain themselves and grow through innovation. Lowering operating costs means they have more money to invest in innovation, resulting in a stabilized domestic workforce. 2. Creates new service lines: Through off shoring, the companies in the service sectors are able to create new service lines due to availability of funds as a result of off shoring. New services increase customer satisfaction and become new revenue streams, as well as growth paths for companies. Off shoring in a sense improves the stature of the company in so many different ways. 3. Company growth: Off shoring helps the company expands its reach and thereby helping the company grow. The geographical nature of off shoring comes along with its own share of advantages that practically outweighs the negatives. Off shoring gets the company closer to its global customers, and thereby providing appropriate services to its regional market and ensuring faster problem handling. The personnel in the relevant locations have a better understanding of customers' needs, regulatory compliances and regional preferences, and can better market the product or provide the services.
4.
Round The Clock Operation:
9
Off shoring alleviates problems created by time differences, enabling companies to support customers in a virtual round the clock (24-7) operation. For companies with constrained resources, off shoring offers better utilization of the multiple time zones.
DISADVANTAGES (http://www.articlesbase.com/law-articles/offshore-company-formation-avantagesdisadvantages-388027.html) 1. Appraisals and Financing: The offshore concept provides you with privacy, but the major drawback to this benefit is that it also makes it difficult for the potential financial partners or investors to determine what your business is actually worth. In addition to this, lenders are more likely to be hesitant in approving or granting financial assistance to a business that is out of their "reach". 2. Limitations: Some offshore companies may be limited in their activities due to restrictions that are placed on them by the United States as well as other jurisdictions. Trade benefits that are designed to help US companies may not be available to you due to your offshore registration. Again, research this issue as it can be a drawback depending on your industry. 3. Perception: As was mentioned above, the offshore concept is not always held in the highest regard due to the media only reporting bad cases so incorporate with care and privacy.
10
COST CURVE ANALYSIS The cost curve analysis is based on the assumption that the quantity produced by the firm remains constant. The producer would like to keep the quantity produced same in order to keep the demand high and thus the market price remains constant. Consider the cost curve given below in the short run condition. In the short run the one of the input parameters i.e. Capital remains constant and the other input parameter i.e. Labour varies.
However in the diagram shown above both the parameters i.e. Labour and Capital vary to give rise to a new Isocost line for the Isoquant for producing quantity q. This shows that not only does amount of labour employed change the capital used is also changing. However, as the amount of labour employed increases due to decreased cost of labour, the amount of machinery set up for 11
production does not decrease. In this case since the cost of obtaining land, machinery and permissions reduces, the infrastructure remaining constant the cost incurred for the infrastructure reduces. Hence the capital remains constant in terms of deployment of infrastructure. The produced would not increase the infrastructure setup with increase in the number of labour appointed in order to get optimum utilization of the capital employed. Thus it is seen that the Iso cost line becomes flatter thus using more labour and less of capital keeping the quantity produced constant. Thus it can be seen that the cost of production reduces due to Offshoring and thus benefits the producer by increasing the profit margins. It is also possible for the producer to expand its market in the developing countries by reducing the cost and passing on the benefits to the consumers.
12
US AUTO MARKET: OLIGOPOLISTIC MARKET STRUCTURE Oligopoly is a market structure where only a few firms account for most or all of the total production. These firms earn substantial profits over the long run because barriers to entry make it difficult for new firms to enter. The US automobile market is thus an example of an oligopolistic market structure. Few big companies like General Motors, Ford, Toyota, Honda etc are the prominent players. The large scale economies involved in production makes entry difficult for new players.
Because trust among firms tends to be fragile, oligopolistic firms have a strong desire for price stability. Price rigidity is a characteristic of this market structure. As shown in the diagram above the X axis denotes the quantity of automobiles traded in the market and Y axis represents their market price. The equilibrium price is P and the corresponding quantity is Q. At this price level, the profit maximization condition of marginal cost being equal to marginal revenue is satisfied. The resultant marginal cost curve in US is shown by the curve MCUS. At prices above P, the demand curve is very elastic. This shows that 13
if a firm tries to increase the price of its car even slightly, then other firms would not follow suit and there would be a considerable decrease in its demand as the consumers would shift to other models. The demand curve for price below P is comparatively less elastic. Thus if it were to decrease its price, the resultant increase in demand would be very less. This is because other firms would also lower the price of their cars, to avoid being left out. If the automobile firms decide to outsource to China or other Latin American countries, they gain by way of lowered costs. Firstly, the fixed cost of setting up a new plant is far less than that in US. In addition, the labor costs are also very low. This reduced fixed and variable costs cause the marginal costs to reduce, as shown by the MCChina curve in the above diagram. Even after the shift in curve the profit maximization condition of marginal cost being equal to marginal revenue is satisfied and thus the price continues to remain at P. This is due to the kinked nature of demand curve. The reduction in total costs is nothing but the gain thanks to off shoring. The different car models compete with each other on non price parameters like comfort, mileage, style etc. In the long run, other firms would realize the benefits of off shoring and emulate the same. It will result in decreasing costs for all firms, which they might then pass on to consumers to further boost demand. Thus in the long run there might be decrease in prices of automobiles due to off shoring.
14
DEMAND SUPPLY SCENARIO IN THE LONG RUN Assumptions: • • The cost benefit gained by producers through off shoring is passed on to consumers. The price of the product is determined by market forces.
Let us assume the firm is operating at price P1 and quantity Q1 (equilibrium - point of intersection between the demand curve and supply curve (black)). In the long run, the producers are able to pass the cost reduction benefit to the consumers, as a result, the price decreases to P2 at the same quantity. The company is then in a position to expand its operations and arrive at a new equilibrium, with quantity Q3 at price P3. This basically shows that in the long run, off shoring benefits can not only be passed to consumers, but also be used to expand operations.
15
doc_583521156.doc
The document describes Off shoring of US automobile companies to China and Latin American countries: A Producers Equilibrium
Project Report
Offshoring of US Auto Companies to China & Latin American countries : Producer’s Equillibrium
Table of Contents: Abstract Introduction What is off shoring? Advantages and Disadvantages of off shoring Cost Curve Analysis Oligopoly Analysis Demand Supply Analysis Conclusion 2 3 6 8 10 12 14 15
2
ABSTRACT The industry and businesses are growing at a very fast pace. Industry dynamics are much stronger and effervescent now than in any of the previous decades. The present economic, social and political scenario around the world has changed the way business houses carry out their various functions. One major change that has particularly taken place in the way businesses function is that of “OFFSHORING”. Off shoring of business processes to countries which are cheaper has been a topic of major debate around the world. It is an issue that has fuelled varied sentiments in different countries. The reduction in production costs as a result of off shoring gives the companies a comparative advantage which forms the basis for off shoring. This report talks about off shoring of automotive components by US companies to China & Latin America providing insight into the subject while discussing the impacts of such off shoring on the automobile markets. The report also discusses the advantages that a company derives from outsourcing its manufacturing processes along with the benefits to economies in which off shoring takes place. Through this report we intend to explain the reasons for outsourcing, the scenario of US Auto industry, the market structure of this industry and the implications of off shoring.
3
INTRODUCTION
Off shoring is the practice of having all or components of a process performed in a foreign country to take advantage of labor cost arbitrage. It is a type of outsourcing. Off shoring simply means having the outsourced business functions done in another country. The intense competitive pressures in the automobile industry, especially in the US and Europe, have created a set of enabling factors, or drivers that are forcing OEMs and ancillaries to explore outsourcing and off shoring options.
•
Rising costs. Increasing labor costs, especially in North America, are resulting in a surge in overall costs. Shorter product cycles. Growing pressure on auto companies to launch new models and variants within a short span of time. Dropping profitability. New and emerging players are adding fresh capacity, which is, in turn, leading to price competition and hence affecting profitability of companies.
•
•
•
Expansion of capabilities and winning non-domestic business. Stagnant growth in home markets is forcing players to focus on expanding capacities and capabilities in emerging markets. Given the cost advantages, many of these centers are being leveraged to serve other markets.
T
4
The Off shoring Chain in automotive outsourcing
Various automotive original equipment manufacturers (OEMs) and Tier I suppliers have started off shoring design and engineering services to China and Latin America. Typically, OEMs outsource design and manufacturing of certain components or systems to their Tier I suppliers. Both, OEMs and ancillaries, establish offshore captive centers, some of whom are involved in high-end design and engineering services. In addition, the OEMs and Tier I suppliers tend to offshore low-end services to third party providers initially, before moving up to high-end services. An oligopoly describes a market situation in which there are limited or few sellers. Each seller knows that the other seller or sellers will react to its changes in prices and also quantities. This can cause a type of chain reaction in a market situation. In the world market there are oligopolies in steel production, automobiles, semi-conductor manufacturing, cigarettes, cereals, and also in telecommunications. It is characterized by: • • • Small number of large firms dominate the industry High degree of interdependence High barriers to entry that restrict new firms to enter the industry e.g. control of technology 5
• • •
Price stability within the markets Goods are highly differentiated or standardized Non price competitive e.g. free deliveries and installation, extended warranties Restricted information.
Automobile industry is largely believed to follow the oligopolistic market structure. this makes the industry having a strong price dynamics and a complicated price setting mechanism. In such a scenario reducing costs and streamlining operations by off shoring gives a company a strong advantage as would be discussed in our report.
6
WHAT IS OFF SHORING?
The process of relocation of business from one country to another is known as off shoring. This includes any business process such as production, manufacturing, or services. Off shoring is a type of outsourcing. Off shoring simply means having the outsourced business functions done in another country. The most important factor why work is off shored is to reduce labor expenses. The other reasons for off shoring are strategic. They are to enter new markets, to tap currently unavailable domestic talent or to overcome regulations that prevent specific domestic activities. The economic logic is to reduce costs. If some people can use some of their skills more cheaply than others, those people have the comparative advantage. The idea is that countries should freely trade the items that cost the least for them to produce. There are 3 types of off shoring: • Production Off shoring Production off shoring of established products involves relocation of physical manufacturing processes to a lower-cost destination. Product design, research and the development process that leads to new products, are relatively difficult to offshore. This is because research and development to improve products and create new reference designs requires a skill set that is harder to obtain in regions with cheap labor. For this reason, in many cases only the manufacturing will be off shored by a company wishing to reduce costs.
7
•
Services Off shoring The growth of services off shoring is linked to the availability of large amounts of reliable and affordable communication infrastructure following the telecommunication and Internet expansion. Coupled with the digitization of many services, it was possible to shift the actual production location of services to low cost countries in a manner theoretically transparent to end-users.
•
Innovation Off shoring Once companies are comfortable with services offerings and started realizing the cost savings, many high-tech product companies started using developing countries for innovating products
8
ADVANTAGES (http://www.article99.com/employment/outsourcing/article.php?art=6102) 1. Reduces the cost of production and services:
One of the main factors that contribute toward a company's business success is the cost of production and operation. Offshore outsourcing, refined over a period of time is one of the factors that have succeeded in reducing the cost of producing goods and services very effectively. The benefit of off shoring is the savings in operating costs which in turn contributes towards the company's sustenance and growth. Companies usually sustain themselves and grow through innovation. Lowering operating costs means they have more money to invest in innovation, resulting in a stabilized domestic workforce. 2. Creates new service lines: Through off shoring, the companies in the service sectors are able to create new service lines due to availability of funds as a result of off shoring. New services increase customer satisfaction and become new revenue streams, as well as growth paths for companies. Off shoring in a sense improves the stature of the company in so many different ways. 3. Company growth: Off shoring helps the company expands its reach and thereby helping the company grow. The geographical nature of off shoring comes along with its own share of advantages that practically outweighs the negatives. Off shoring gets the company closer to its global customers, and thereby providing appropriate services to its regional market and ensuring faster problem handling. The personnel in the relevant locations have a better understanding of customers' needs, regulatory compliances and regional preferences, and can better market the product or provide the services.
4.
Round The Clock Operation:
9
Off shoring alleviates problems created by time differences, enabling companies to support customers in a virtual round the clock (24-7) operation. For companies with constrained resources, off shoring offers better utilization of the multiple time zones.
DISADVANTAGES (http://www.articlesbase.com/law-articles/offshore-company-formation-avantagesdisadvantages-388027.html) 1. Appraisals and Financing: The offshore concept provides you with privacy, but the major drawback to this benefit is that it also makes it difficult for the potential financial partners or investors to determine what your business is actually worth. In addition to this, lenders are more likely to be hesitant in approving or granting financial assistance to a business that is out of their "reach". 2. Limitations: Some offshore companies may be limited in their activities due to restrictions that are placed on them by the United States as well as other jurisdictions. Trade benefits that are designed to help US companies may not be available to you due to your offshore registration. Again, research this issue as it can be a drawback depending on your industry. 3. Perception: As was mentioned above, the offshore concept is not always held in the highest regard due to the media only reporting bad cases so incorporate with care and privacy.
10
COST CURVE ANALYSIS The cost curve analysis is based on the assumption that the quantity produced by the firm remains constant. The producer would like to keep the quantity produced same in order to keep the demand high and thus the market price remains constant. Consider the cost curve given below in the short run condition. In the short run the one of the input parameters i.e. Capital remains constant and the other input parameter i.e. Labour varies.
However in the diagram shown above both the parameters i.e. Labour and Capital vary to give rise to a new Isocost line for the Isoquant for producing quantity q. This shows that not only does amount of labour employed change the capital used is also changing. However, as the amount of labour employed increases due to decreased cost of labour, the amount of machinery set up for 11
production does not decrease. In this case since the cost of obtaining land, machinery and permissions reduces, the infrastructure remaining constant the cost incurred for the infrastructure reduces. Hence the capital remains constant in terms of deployment of infrastructure. The produced would not increase the infrastructure setup with increase in the number of labour appointed in order to get optimum utilization of the capital employed. Thus it is seen that the Iso cost line becomes flatter thus using more labour and less of capital keeping the quantity produced constant. Thus it can be seen that the cost of production reduces due to Offshoring and thus benefits the producer by increasing the profit margins. It is also possible for the producer to expand its market in the developing countries by reducing the cost and passing on the benefits to the consumers.
12
US AUTO MARKET: OLIGOPOLISTIC MARKET STRUCTURE Oligopoly is a market structure where only a few firms account for most or all of the total production. These firms earn substantial profits over the long run because barriers to entry make it difficult for new firms to enter. The US automobile market is thus an example of an oligopolistic market structure. Few big companies like General Motors, Ford, Toyota, Honda etc are the prominent players. The large scale economies involved in production makes entry difficult for new players.
Because trust among firms tends to be fragile, oligopolistic firms have a strong desire for price stability. Price rigidity is a characteristic of this market structure. As shown in the diagram above the X axis denotes the quantity of automobiles traded in the market and Y axis represents their market price. The equilibrium price is P and the corresponding quantity is Q. At this price level, the profit maximization condition of marginal cost being equal to marginal revenue is satisfied. The resultant marginal cost curve in US is shown by the curve MCUS. At prices above P, the demand curve is very elastic. This shows that 13
if a firm tries to increase the price of its car even slightly, then other firms would not follow suit and there would be a considerable decrease in its demand as the consumers would shift to other models. The demand curve for price below P is comparatively less elastic. Thus if it were to decrease its price, the resultant increase in demand would be very less. This is because other firms would also lower the price of their cars, to avoid being left out. If the automobile firms decide to outsource to China or other Latin American countries, they gain by way of lowered costs. Firstly, the fixed cost of setting up a new plant is far less than that in US. In addition, the labor costs are also very low. This reduced fixed and variable costs cause the marginal costs to reduce, as shown by the MCChina curve in the above diagram. Even after the shift in curve the profit maximization condition of marginal cost being equal to marginal revenue is satisfied and thus the price continues to remain at P. This is due to the kinked nature of demand curve. The reduction in total costs is nothing but the gain thanks to off shoring. The different car models compete with each other on non price parameters like comfort, mileage, style etc. In the long run, other firms would realize the benefits of off shoring and emulate the same. It will result in decreasing costs for all firms, which they might then pass on to consumers to further boost demand. Thus in the long run there might be decrease in prices of automobiles due to off shoring.
14
DEMAND SUPPLY SCENARIO IN THE LONG RUN Assumptions: • • The cost benefit gained by producers through off shoring is passed on to consumers. The price of the product is determined by market forces.
Let us assume the firm is operating at price P1 and quantity Q1 (equilibrium - point of intersection between the demand curve and supply curve (black)). In the long run, the producers are able to pass the cost reduction benefit to the consumers, as a result, the price decreases to P2 at the same quantity. The company is then in a position to expand its operations and arrive at a new equilibrium, with quantity Q3 at price P3. This basically shows that in the long run, off shoring benefits can not only be passed to consumers, but also be used to expand operations.
15
doc_583521156.doc