An economist is someone who knows the price of everything and the value of nothing.
Old joke based on Oscar Wilde’s quip about a cynic.
Yesterday I noted how conventional cost accounting inexorably focuses attention of executives on increasing short-term profits by cutting costs. The same thing happens in economics. Take a recent economic study that set out to shed light on role of Chinese businesses vis-à-vis American consumers. Galina Hale and Bart Hobijn, two economists from the Federal Reserve Bank of San Francisco, did a study showing that only 2.7 percent of U.S. consumers purchases have the "Made in China" label. Moreover, only 1.2% actually reflects the cost of the imported goods. Thus, on average, of every dollar spent on an item labeled “Made in China,” 55 cents go for services produced in the United States. So the study trumpets the finding that China has only a tiny sliver of the U.S. economy. So no problem, right? Well, not exactly. The tiny sliver happens to be the sliver that matters. What economists miss is what is happening behind the numbers of dollars in the real economy of people.
How whole industries disappear
Take the story of Dell Computer [DELL] and its Taiwanese electronics manufacturer. The story is told in the brilliant book by Clayton Christensen, Jerome Grossman and Jason Hwang, The Innovator's Prescription :
ASUSTeK started out making the simple circuit boards within a Dell computer. Then ASUSTeK came to Dell with an interesting value proposition: ‘We’ve been doing a good job making these little boards. Why don’t you let us make the motherboard for you? Circuit manufacturing isn’t your core competence anyway and we could do it for 20% less.’
Dell accepted the proposal because from a perspective of making money, it made sense: Dell’s revenues were unaffected and its profits improved significantly. On successive occasions, ASUSTeK came back and took over the motherboard, the assembly of the computer, the management of the supply chain and the design of the computer. In each case Dell accepted the proposal because from a perspective of making money, it made sense: Dell’s revenues were unaffected and its profits improved significantly. However the next time, ASUSTeK came back, it wasn’t to talk to Dell. It was to talk to Best Buy and other retailers to tell them that they could offer them their own brand or any brand PC for 20% lower cost. As The Innovator’s Prescription concludes:
Bingo. One company gone, another has taken its place. There’s no stupidity in the story. The managers in both companies did exactly what business school professors and the best management consultants would tell them to do—improve profitability by focuson on those activities that are profitable and by getting out of activities that are less profitable.
Amazon couldn’t make a Kindle here if it wanted to
Decades of outsourcing manufacturing has left US industry without the means to invent the next generation of high-tech products that are key to rebuilding its economy, as noted by Garry Pisano and Willy Shih in a classic article Thus in “Restoring American Competitiveness” (Harvard Business Review, July-August 2009) The US has lost or is on the verge of losing its ability to develop and manufacture a slew of high-tech products. Amazon’s Kindle 2 couldn’t be made in the US, even if Amazon wanted to:
- The flex circuit connectors are made in China because the US supplier base migrated to Asia.
- The electrophoretic display is made in Taiwan because the expertise developed from producting flat-panel LCDs migrated to Asia with semiconductor manufacturing.
- The highly polished injection-molded case is made in China because the US supplier base eroded as the manufacture of toys, consumer electronics and computers migrated to China.
- The wireless card is made in South Korea because that country became a center for making mobile phone components and handsets.
- The controller board is made in China because US companies long ago transferred manufacture of printed circuit boards to Asia.
- The Lithium polymer battery is made in China because battery development and manufacturing migrated to China along with the development and manufacture of consumer electronics and notebook computers.
An exception is Apple [AAPL], which “has been able to preserve a first-rate design capability in the States so far by remaining deeply involved in the selection of components, in industrial design, in software development, and in the articulation of the concept of its products and how they address users’ needs.”
A chain reaction of decline
Pisano and Shih continue:
“So the decline of manufacturing in a region sets of a chain reaction. Once manufacturing is outsourced, process-engineering expertise can’t be maintained, since it depends on daily interactions with manufacturing. Without process-engineering capabilities, companies find it increasingly difficult to conduct advanced research on next-generation process technologies. Without the ability to develop such new processes, they find they can no longer develop new products. In the long term, then, an economy that lacks an infrastructure for advanced process engineering and manufacturing will lose its ability to innovate.”
The lithium battery for GM’s [GM] Chevy Volt is being manufactured in South Korea. Making it in the US wasn’t feasible: rechargeable batter manufacturing left the US long ago. Some efforts are being made to resurrect rechargeable battery manufacture in the US, such as the GE-backed [GE] A123Systems, but it’s difficult to go it alone when much of the expertise is now in Asia. In the same way that cost accounting and short-term corporate profits don’t reflect the true health of corporations, the economists’ reckoning of the impact of outsourcing production overseas misses the point. Americans are left with shipping the goods, selling the goods, marketing the goods. But the country is no longer to compete in the key task of actually making the goods.
Pisano and Shih have a frighteningly long list of industries of industries that are “already lost” to the USA:
“Fabless chips”; compact fluorescent lighting; LCDs for monitors, TVs and handheld devices like mobile phones; electrophoretic displays; lithium ion, lithium polymer and NiMH batteries; advanced rechargeable batteries for hybrid vehicles; crystalline and polycrystalline silicon solar cells, inverters and power semiconductors for solar panels; desktop, notebook and netbook PCs; low-end servers; hard-disk drives; consumer networking gear such as routers, access points, and home set-top boxes; advanced composite used in sporting goods and other consumer gear; advanced ceramics and integrated circuit packaging.
Their list of industries “at risk” is even longer and more worrisome.
What’s to be done?
With such a complex societal problem, it’s hard not to start from Albert Einstein’s insight: “The significant problems that we have cannot be solved at the same level of thinking with which we created them.” Many actors will have to play a role.
- Company leaders: Business leaders need to recommit themselves to continuous innovation and the values and practices that are necessary to accomplish that. i.e radical management. As Pisano and Shih write: “Whether you’re the US firm IBM [IBM] with a major research laboratory in Switzerland or the Swiss company Novartis [NYSE:NVS] operating in the biotech commons in the Boston area, sacrificing such a commons for short-term cost benefits is a risky proposition.”
- Accountants: Accountants need to get beyond the mental prison of cost accounting and embrace the thinking in throughput accounting that puts the emphasis on how companies can add new value, rather than just cutting costs.
- Management theorists and consultants: stop rearranging deck chairs on the Titanic of traditional management (e.g. by finding new and ingenious ways to cut costs) and start understanding and disseminating management theory that is fit for the 21st Century.
- Investors: Investors need to realize that the companies of the future are those that practice continuous innovation as Apple [AAPL], Amazon [AMZN] and Salesforce [CRM], as compared to companies practicing traditional management, such Wal-Mart [WMT], Cisco [CSCO] OR GE [GE]. Investors need to realize that short-term financial gains are ephemeral: the companies that will generate real value are those that do what is necessary to continuously innovate.
- Government: Government has a role to play in protecting and promoting fields of expertise or what Pisano and Shih call “the industrial commons”. Thus: “Government-sponsored endeavors that have made a huge difference in the past three decades include DARPA’s VLSI chip development program and Strategic Computing Initiative; the DOD’s and NASA’s support of supercomputers and of NSFNET (an important contributor to the Internet); and the DOD’s support of the Global Positioning System, to mention a handful.”
- Politicians: At a time of poisonously divisive political debate, in which candidates recite anti-government mantras and call for “getting government out of the way of the private sector”, it is time for serious politicians to step up and examine which parts of the private sector are fostering, and which parts are destroying, the economy of the country. They must stop embodying e.e. cummings definition of a politician as “an ass upon which everyone has sat except a man.”
- Economists: Economists need to realize that merely adding up the numbers is not enough. They have to look at the meaning behind the numbers. When they trumpet their finding that “Chinese goods are less than 1% of the U.S. economy”, it’s akin to saying “we kept the house but gave away the keys.”
_________________ Steve Denning’s most recent book is: The Leader’s Guide to Radical Management (Jossey-Bass, 2010). Follow Steve Denning on Twitter @stevedenning Join the Zurich Gathering For C-Suite Leaders with Steve Denning Zurich Sep 12, 2011 And join the Jossey-Bass webinar series, “Why Management Still Matters“: Sep 22-Oct 20, 2011: To register, go here use discount code JBMSD