Low-Cost Country Sourcing

In the mad scramble to obtain lower labor costs, American firms are once again surprised (as they had been two and three decades ago when there was a rapid outsourcing of production to Asia) to find that low-cost North American Free Trade Agreement (NAFTA) production claims are not always what they have been cracked-up to be, but that doesn’t mean there isn’t any benefits.  It’s a matter of where you go and the options you choose to get there (JV, Sheltered Workshop, or Maquilla).

However, now that the Asian mystic has worn off a bit and American companies have come to experience some down sides to doing business in China the concept of “near shoring” is back in vogue, as well as it should be.  After all, time zones are the same, the cultures are similar, etc., etc. (see the following table).

Buying the pitch with hardly a look over their shoulders, some companies have closed up shop (especially throughout the northeast) and moved just as simply as they move across the river into the next state.  However, the river they moved across was not the Hudson, or the Detroit, or the Mississippi; it was the Rio Grande.  Additionally, the state they moved into is not New Jersey, or Michigan, or Arkansas; it is Nuevo Leon, Sonora, Baja, or Chihuahua.  Mexico is a separate country, not a part of South Texas.

The reasons for such moves are familiar ones.  Typically they are what have driven corporate relocations in the past.  Corporations are purportedly driven to pursue low-cost country sourcing by; competitors relocating, an attempt to recover shrinking margins, the desire to derive some competitive advantage, fear of going to Asia, not having adequate production quantities to leverage costs, and/or plain old corporate greed.

Some of these companies fail to achieve their original expectations simply because many of these expectations are unrealistic or unattainable.

The move to Mexico is, in fact, a move to an independent and separate country with its own unique people, culture, customs, economy, ethics, and government.  Additionally, reflecting those differences is a sometimes vastly different set of laws and regulations that the relocated company must anticipate and recognize.  The corporations must also be prepared to adjust to an unfamiliar banking and currency system.  These changes and many more, can contribute to a rapid expansion of the hidden and unanticipated costs of doing business and therefore significantly increase what had been previously perceived to be the “low cost labor” of Mexico.

Having bought into either the advertised advantages of NAFTA or the opportunities that can be found in the havens known as Maquilladora programs (nicknamed Maquillas, pronounced “Ma’key-lahs”), many corporations have gone blindly into Mexico.  For some, especially those who sought to quickly match a competitor’s move or to improve profit margins without diligently completing their homework, the results have been less than satisfying.  Even for many of those who carefully planned the “simple border crossing” failed to fulfill expectations.

NAFTA binds Mexico, the United States of America, and Canada together into a North American economic union.  This union, whose regulations establish a legal “equality” among the parties, does not in fact establish a practical parity among the countries.  In a business sense, the USA and Canada are established nations with a middle-aged industrialized population with entrenched business, economic, and educational systems while Mexico is a young country (with a primarily young population) that is currently emerging from its agricultural base into this new “partnership” and is in the process of acquiring needed business and technical skills.

This does not mean that Mexicans (some would say the correct name for Mexico is “The United States of Mexico”) are unwilling or incapable of participating in modern business.  However, it does mean that the educated, but largely young population, does not know much about, nor have they practiced, many of the disciplines (such as Logistics, Distribution, and Lean Manufacturing) that the other North American trade partners have come to assume is “common knowledge.”  Many business practices are just being learned and are still in their infancy.  As a result, experienced professionals in these disciplines are not readily available to newly relocated businesses and, when they can be found, they can be a high-priced commodity.  An obvious alternative is to be prepared to locate, train, and mentor potential Mexican employees, but this should happen before a move and not after.

Many of the Mexican states, especially those along the USA border, have formed Maquilladoras (or Maquillas) designed to serve companies that have been attracted by the NAFTA treaty.  The term Maquilladora comes from the root word Maquillar, which means “to work or labor.”  Thus, a Maquilladora means a place to add labor.  By a logical extension of the meaning, a Maquilladora means a place that imports raw materials, adds labor, and exports the finished product “in bond.”

Maquillas are just one option for manufacturing in Mexico.  There are other options, such as: sheltered workshops, joint ventures, and straight subcontracting.  Each of these potential alternatives has their specific pros and cons and each should be investigated and evaluated prior to making a final decision.

Mexico has different labor cost zones.  They are called Zones A, B, and C.  Examples of “A” zones include Juarez, which is a border city in the state of Chihuahua and is adjacent to El Paso, Texas and Mexico City (the federal district) deep within the country.  These regions have the highest cost of living, and thus the highest costs of labor.  In comparison, “B” and “C” zones have less costly living expenses and therefore lower wage scales.  Examples of “A”, “B,” and “C” zones include:

A: Mexico City, Juarez, Tijuana, Nueva Laredo.

B: Monterrey, Chihuahua, Guadalajara and Monclova.

C: Chiapas, Durango, Guerro, Vera Cruz, and Tabasco.

In Mexico, a disproportionately high percentage of the direct labor employee pool is made up of young females who are typically between the ages of 17 and 24.  In the “A” zone, these young women earn about $2.00/hour.  They also receive additional annual cash benefits that approximate an additional $1.50/hour.  Employees work a 45 hour week, so the typical weekly salary is between $100 – $160.

When compared with labor costs in the U.S. and Canada, with or without benefits, these costs initially look very attractive.  However, these bastions of low labor costs have unanticipated expenses and the uninitiated planning to relocate some or all of operations into Mexico need to become known!  In fact, just the burden rate on base labor costs in Mexico approaches 50% or more.

For example, some categories of overhead costs (such as payroll taxes that include social security and other burdens such as vacations, etc.) shouldn’t surprise anybody even though the rates can be unexpectedly high.  On the other hand, there are mandated overhead expenses like groceries and clothing allowances that can, but should not, come as a surprise.

When all mandated expenses are considered (such as those listed below), the “come-on” base hourly $2.00 wage has inflated an enormous 300% to around $6.00 or $270 weekly as shown below.

• Payroll Taxes (Social Security and other regulatory payments) not including regulatory administrative costs borne by the company).
• Paid vacations.
• Vacation premiums.
• 8 paid holidays.
• Employee training programs.
• Indemnification, bonding, and termination costs.
• Major Medical and Life insurance (Federal government requirement).
• The presence of a medically qualified (doctor or nurse) on-site whenever workers are present to treat employees, spouses, and employees’ children (depends on size/number of employees).
• The serving of at least one warm meal daily (subsidized between 75 – 100% by the company) to employees.
• Provisión de Fundo de Oró (savings plan) in which the Maquilla matches the amount that the employee saves.
• Bonus pay for groceries.
• Bonus pay for perfect attendance.
• Clothing allotment for Administrative and Professional employees.
• Gasoline payments for Administrative and Professional employees.
• Commuting Expense: employee bus transportation expense between work and home.
• Scholarships for employees’ children and tuition reimbursement programs.
• Annual cost increases that averaged about 25% during 1996 to 98.  This inflation might apply only to border towns and not to the interior.
• Annual employee turnover rate in excess of 10% after an initial 40% to 50% turnover rate during the first two months of employment.  Rates might apply only to border towns, and not to the interior.

All these costs propel the basic $100 weekly wage closer to $300 and, looking forward, can be expected to increase the hourly wage to more than double within the next five years.  However, an even more alarming issue is that virtually all companies/Maquillas are advertising to hire.  This severe labor shortage along the border is causing employee turnover at an alarming rate that also negates all investment made in training of an individual.  A trained engineer, for example, can walk across the street for a 15% to 20% increase and they do in certain geographic areas!

So, while there is clearly a low cost labor advantage that should continue in the near term for companies whose operating expenses are predominately labor cost driven, the longer term prospects are less certain.  It behooves the corporation that envisions a long term relationship in the Mexican economy to immediately begin planning (while the income stream is beneficial) how it will meet and cope with increasing costs.

In addition, companies seeking lower labor costs by relocating to Mexico often also seek to escape U.S. and/or Canadian regulatory controls.  While this is possible in some instances, it should not be expected.  Additionally, it should not be taken for granted that any absence of regulation or enforcement will continue.

As noted in our discussion of labor regulations and costs, Mexican law and culture is different from the rest of North America.  However, there can be remarkable similarities, especially when protection of employees or the environment is an issue.  Often a big surprise to relocating organizations expecting welcoming arms and a laissez faire attitude are such frequently overlooked regulatory issues as seen below.

• Mexican law regarding EPA, DOT, OSHA, etc.  Copies of United States laws or equivalents are effectively in place in Mexico.  While they may be regulated slightly differently, the fundamentals of these basic laws and regulations are about the same.
• Mexican HazMat labeling, handling, and shipping laws (United States laws are copies or equivalents) also exist.

There are also a plethora of additional business issues that a company contemplating relocation should consider.  A small sampling of these includes the following below.

• Shortage of availability of trained (or when trained) experienced middle managers, supervisors, and lead people.
• Impact on customer service, and/or production and assembly schedules when JIT and similar materials management or distribution methodologies are employed.
• Probable increased investment in inventories and safety stocks that must typically be increased by a factor of two (2), three (3), or more weeks (depending on the physical location) to allow for events such as border crossing procedures and inherent delays.

Notwithstanding these issues, many companies are enjoying the benefits and advantages of working with Maquilla programs.  Some of the most successful of these companies are from other parts of the world (and are not simply NAFTA relocations).  Many have previously worked from foreign locations.  All these successful companies, whether from North America or elsewhere in the world exhibit one common attribute: they’re prepared.  They did their homework and they came to Mexico with their eyes open.  They recognized that this was not just like any other relocation, and that the differences they would encounter would be more than just a language barrier.  They recognized that Mexican culture and law is different from their home country, and that any movement into Mexico without the knowledge and desire to adjust to these differences would spell failure.

Regardless of their principal business activity, or where in the world these companies originated, the most successful companies in Mexico have many things in common, such as:

• The desire to be profitable while being a responsible and good corporate citizen.
• Respect for the Mexican people and their culture.
• The desire to learn about Mexico and become assimilated into the culture.
• A desire to learn the language and customs and to respectfully communicate with the people.
• Recognition of the need to contribute to the community and not simply capitalize on the low cost of labor.

These successful companies, in the process of assimilating into the culture, adapting to the culture, and establishing a respectful relationship with the Mexican people, entered into the mainstream community.  They recognized community and regional needs and contributed to the intellectual, economic and social growth of the community by:

• Donating books to schools.
• Building additions to schools.
• Donating used business equipment (computers, printers, etc.) and production machinery and tools to schools.
• Donating food and canned goods to shelters.
• Providing education, English classes, on the job training, etc.

This “good citizen” policy, like other aspects of corporate policy intended to influence image and employee relations, can prove to be more costly than companies anticipate in Mexico because the programs often extend beyond their usual experience in North American communities.

In summary, there are unquestionable advantages to companies seeking to benefit from the Maquilla (and other like) programs.  However, these programs should not be entered into without careful consideration.  The watch phrase is “be prepared.”  Do your homework and go in with your eyes wide open because there is more than just a language barrier.  The culture and laws are different.  You need to go into Mexico with the knowledge and desire to adjust to these differences.  Any other approach will spell failure.

Your path to business success.