6. Case Examples
Global Co.: The Big Role of Small Trade-related Frictions in the Cross-border Movement of Goods
The economics of trade figure prominently in any company’s analysis of where to site production, supply and distribution facilities for goods it ships across national boundaries. For some multinational producers, especially sellers of price-sensitive and low-margin products, even small trade-related frictions within and between markets where very few formal trade barriers exist can have a disproportionately large weight in their facility-planning investments. Over the years, Bain & Co. has worked with many companies weighing the merits of trading with, or moving production to, Mexico. In doing this analysis, Bain has been able to quantify the costs of many of these relatively hidden considerations. A hypothetical company, Global Co., considering the relocation of its manufacturing capacity to Mexico, would discover that counterbalancing some of Mexico’s obvious advantages from a capital expenditures and labour cost perspective are transportation, security and infrastructure barriers tied to trade. While Mexico might have a 25% cost advantage, more than half of that advantage could be eliminated by supply chain friction costs.
Like any profit maximizing firm, Global Co. should perform a rigorous analysis about where to site production to squeeze the maximum attainable operational and distribution efficiencies available across Canada, Mexico and the US. Although all three markets are signatories of the North American Free Trade Agreement (NAFTA) that ended most formal trade barriers across the continent, the investment team has discovered that trade-related frictions should factor prominently in its calculations and will weigh heavily on the ultimate selection it makes.
Weighing the alternatives
Global Co.’s first level of analysis would likely establish Mexico as the leading choice. Capital expenditures to build the facilities might be some 10% lower in Mexico than in the US or Canada, and hourly wage rates in Mexico are only about one-fifth of those in the US. But as the investment team probes deeper into the details of the business case for producing and distributing to all of North America from a base in Mexico, a host of issues would arise that would subtly shade the company’s calculations.
Economic considerations related to product mix
The attractiveness of Mexico as a production centre would depend partly on Global Co.’s product mix. The products best suited for production in Mexico share a common profile. First, they have the highest direct and indirect labour content. Second, they are made from basic materials that can be easily sourced in Mexico. Third, because the final products will be shipped long distances, they will have the highest value-to-weight ratios. Finally, they do not need to be stored in protected warehouses or transported via insulated or refrigerated trucks that drive up the cost of handling and shipping. However, even if Global Co. has a significant subset of goods that are both high in labour content and have attractive shipping characteristics, the company would need to reckon with yet another range of costs and complexities.
Hidden costs complicate the evaluation
In helping companies dig more deeply into such issues, there are three broad categories of direct business costs and trade-related considerations which may combine to mask the true returns from investing in Mexico.
- Higher direct costs of doing business in Mexico: Partially offsetting Mexico’s top-line labour cost advantages are market-specific impacts that significantly lower – or raise – the marginal cost of siting facilities in Mexico. For one thing, Mexico’s federal and provincial governments provide fewer incentives to companies that invest in Mexico than their counterparts in the US or Canada do. Global Co. could find that the effect of this would be to increase its investment costs by 1%. Secondly, Mexican factories rely far less on automated production process than those based north of the border do. This lack of automation would require Global Co. to increase its production-line workforce and negate a big part of Mexico’s labour-cost advantage. Further adding to labour costs would be the lower productivity of Mexican hourly workers. To compensate for the reduced output, Global Co. might need to boost staffing levels by as much as 25%.
- Border administration and other trade-specific frictions: Differences in country trade rules within the North American free-trade area could have specific consequences – potentially both favourable and adverse – for Global Co.’s investment decision. For example, there could be a trade distorting subsidy in the US that makes commodity inputs more expensive there, which would weigh in favour of basing production in Mexico. That advantage would be offset somewhat by the increased costs resulting from rules affecting the transportation of goods by truck. The most onerous restrictions requiring shipments originating on the Mexican side of the border to switch drivers and cabs at border crossings in order to continue their journey into the US were lifted in 2011, nearly two decades after NAFTA’s ratification. However, Mexican trucking firms that carry cargo into the US must still purchase US insurance at the highest possible rate, putting them at a competitive disadvantage to US carriers.
- Trade-related obstacles affecting supply chain. The absence of formal trade barriers greases the wheels of cross-border commerce, but it also lays bare underlying issues that stem from added pressures increased trade imposes on Mexico’s economy. These would show up specifically in Mexico’s inadequate telecommunications and transportation infrastructure. Gaps in road and rail connections require shipments to travel extra distances. Moreover, because Mexico is a net exporter, trucks that carry full loads of goods north must return empty. Together this could push the cost of moving finished goods up by more than 3%.
Global Co. may also have difficulty finding high-quality suppliers in Mexico for key production inputs, adding perhaps 3% to the cost of each unit of finished goods. And when Global Co. looks into recruiting senior executives to run its Mexican operations, the company may find that Mexico’s shallow pool of qualified management talent would drive up the compensation costs for top roles by 8%.
Finally, Global Co. would need to factor in the higher security costs it would face in Mexico, where crime rates are higher than in the US and Canada. Both initial costs to safeguard building assets and higher ongoing operating costs to protect goods in transit could raise Global Co.’s fixed costs by 7% per year .
To compensate for the higher level of instability it would face, the company would likely require a higher internal rate of return on an investment in Mexico.
While these last obstacles associated with an expanded volume of trade are not a consequence of trade-inhibiting government regulations, their existence – and the need to remove the constraints they present – provide a reliable roadmap to guide future public and private investments needed in order to capture the full benefits of open borders.