Manufacturing Myths in Palo Alto and Pittsburgh

The transition from fields to factories has always been a mix of agony and hope. Families abandon land and traditions that often go back generations, move to cities and reset their lives from sunlight to time clocks. Mass production industries flourish for a few generations. Life is hardly a bed of roses, but it is nearly always better or people would return to the farm — and nobody returns. Factory work means educated kids, savings, medical care, and consumer goods like refrigerators and cars. Manufacturing jobs may be dangerous or tedious, but they are also deliver opportunity and hope to millions of people.

Eventually, of course, this all changes. Service industries like hospitality, health care, education, or banks grow faster than manufacturing — sometimes because they are less productive and end up employing more people. Consumers buy stuff made elsewhere. In the US at least, income disparity has increased and life experience stratified until many people — including many with low incomes — have no understanding of manufacturing or factory work.  Factories seem somehow dirty, Dickensian, and something to be avoided.

The result in the US is a schizophrenic attitude towards manufacturing. We are divided between those see no future for factories and those who believe that manufacturing is vital to our economy. It’s Palo Alto vs. Pittsburgh. Sunny Silicon Valley typically sees the future in online technologies, clean tech, or biotech and associate manufacturing with an economic time and place that is as far gone as the family farm. Pittsburgh’s workers, managers, policymakers, and professors argue passionately that the decline of the middle class and the decline of manufacturing employment are inexorably linked and urge government action to restore our competitive position.

As both a confirmed Silicon Valley technologist and a former machinist, union man, and factory worker, I understand both world views. My former colleagues at the McKinsey Global Institute have tried to shine a bit of light on the controversy with a report that details the role of manufacturing in the US and global economies (click here to download the 170 page report or its summary). I highly recommend it and relied on it for most of the data and charts that follow). The punch line: both Palo Alto and Pittsburgh have it wrong, even when their prevailing myths contain elements of past truths. Manufacturing matters, but for different reasons than either group believes.

Lets start with Silicon Valley. Palo Alto sees America through a prism coated in software and web services with an economic future built on service and information businesses. With the quaint and unprofitable exceptions of Tesla, the odd 3D printer, and notwithstanding the atonal musings of Andy Grove, we haven’t made anything in Silicon Valley since we drove out disk drives and semiconductors a generation ago. We view manufacturing as a relic of the industrial age, not as an engine of innovation. This belief is held in place by several myths, including:

1. Companies that make things have a lot in common.  

Manufacturing is not a sector: companies that make things vary enormously in the nature of their products, operations, and economics.

Some, like steel or aluminum plants, are incredibly energy intensive and heavy. Manufacturers need to be near water (for transport), raw materials, and cheap power (Alcoa chairman and former Treasury Secretary Paul O’Neill once described aluminum to me as “congealed electricity”). Labor costs are completely secondary.

Pharmaceuticals, in contrast, live or die on product development. They need access to capital, technology, and skilled researchers. A furniture maker needs semi-skilled workers and access to distribution.

It is hardly useful to talk about manufacturing as a single thing — it really isn’t. The McKinsey report tries to segment manufacturers into five groups and describe the requirements and challenges of each, illustrated on the right. The scheme illustrates fundamental differences between manufacturing sectors, although there remain enormous variation even within segments.

These groups require vastly different skills and have fared quite differently in advanced countries, with the final group, the so-called labor-intensive tradeables, not surprisingly accounting for the biggest share of job losses.

2.  Manufacturing is a commodity that contributes little to the US standard of living

Nope: manufacturing matters, just not like it used to. McKinsey found that throughout the developed world, manufacturing is declining in its share of economic activity but contributes disproportionately to a nation’s exports, productivity growth, R&D, and innovation.

As the chart on the right illustrates, manufacturing contributes to productivity growth (the basis for all increases in living standards) at about double the rate that it contributes to employment. It also produces spillover effects that are frequently not captured in data about manufacturing.

Manufacturing adds economic value, much of which is transferred to consumers in the form of lower prices (which are economically indistinguishable from a pay increase). On a value-added basis, manufacturing represents about 16% of global GDP, but accounted for 20% of the growth of global GDP in the first decade of this century.

Finally, manufacturing accounts for 77% of private sector R&D, which drives a huge share of technology innovation. It is far from clear that Silicon Valley would exist without it.

3. Our future is in knowledge-intensive services, not manufacturing.

Once again, our traditional categories are not helpful. Manufacturing frequently is a knowledge intensive business. (It surprises many people to learn, for example, there are more dollars of information than dollars of labor in a ton of US made steel).

Manufacturing is increasingly data intensive. Big Data is revolutionizing manufacturing products and processes, no less than services. Data enables manufacturers to target products to very specific markets. The “Internet of Things” relies on sensors, social data, and intelligent devices to rapidly inform how products are designed, built, and used. Huge data sets have also enabled new ways for manufacturers to gather customer insights, optimize inventory, price accurately, and manage supply chains.

This is not your father’s factory. Most US manufacturing jobs are not even in production. As the accompanying chart shows, they are service jobs linked to manufacturing or inside manufacturing companies.

4. Manufacturing depends on low cost labor, which is why it has fled overseas. 

This particular conceit is endemic in Palo Alto. McKinsey documents one possible reason: no sector, not even textiles, has shifted production overseas as fast as computers and electronics. Indeed, as the chart at the right illustrates, some manufacturing sectors have actually added jobs during the past ten years.

There is a second dimension to this myth however: that manufacturing jobs are factory jobs. As illustrated above, many jobs in manufacturing companies are service like jobs, including R&D, procurement, distribution, sales and marketing, post sales service, back office support, and management. These jobs make up between 30 and 55 percent of manufacturing employment in the US. Much of the work of manufacturing does not involve direct product fabrication, assembly, warehousing, or transportation.

The final misunderstanding is that most factory jobs are unskilled or low paying. In fact, manufacturers world wide are currently experiencing chronic skill shortages. McKinsey projects a potential shortage of more than 40 million high skilled workers around the world by 2020 — especially in China.

In short, the standard Silicon Valley view is much too narrow: manufacturing is and will remain a high value industry that contributes meaningfully to our standard of living. Manufacturing (some of it, anyway), is a competitive asset.

Move east to Pittsburgh, and you will quickly discover that a completely different manufacturing mythology prevails, focused mainly on job-creation. In these parts, the loss of manufacturing jobs is understandably considered a crisis for the US. Politicians pay homage to “good-paying manufacturing jobs” and blame the inability of a high school grad to get a factory job that supports a family, a home, and a motorboat on cheatin’ Chinese and union-bustin’ outsourcers. Dig a bit deeper, and you will discover that these beliefs are also grounded in economic myths, such as:

1. Manufacturing jobs pay more than service sector jobs.

This view often reflects the wishes of people with a history in “rust belt” manufacturing. In fact, manufacturing jobs pay very much like service jobs do — except at the very low end, where manufacturing creates far fewer minimum wage service jobs that are common in hospitality and retail.

Part of the reason for this of course, is that manufacturers can have low value work performed overseas — not an option for McDonalds, Walmart, or others who deliver services face-to-face.

As shown on the right, manufacturing creates about the same number of jobs in each pay band as do service sector jobs, except that there are fewer low-paying jobs and a few more high paying ones. An important caveat is that manufacturing company jobs may be more likely to include benefits, which are excluded from this calculation.

That all said, it is no longer given that manufacturing is a source of better paying jobs.

2. We should look to manufacturing for the jobs we need.

OK, but at least manufacturing creates decent jobs. Why not promote manufacturing to create jobs — even if they pay the same as service sector jobs?

The answer depends on your country’s stage of development, on domestic demand for manufactured goods, and on how robust your service sector is. For the US, the case for public policies favoring manufacturing is weak.

McKinsey documents what many have observed: manufacturing jobs decline once a country reaches about $7-10,000 GDP/person, as illustrated on the right. This pattern holds both across and within countries. As a result, manufacturing jobs are declining everywhere, except in the very poorest countries (even China is losing manufacturing jobs).

But all low cost labor countries do not enjoy equivalent manufacturing sectors. More important even than stage of development is the level of domestic demand for manufactured goods and the robustness of the domestic service sector. The US and the UK have such large service sectors that we derive smaller share of our GDP from manufacturing, even though in absolute terms both countries have robust manufacturing sectors.

3. Low wage nations like China are stealing our manufacturing jobs.

There are typically two parts to the belief that US jobs are flowing overseas. First is the underlying view that jobs are a zero-sum asset to be fought over like territory. This idea has political salience, but is economic nonsense. Jobs are the complex result of many things including the availability of public or private capital, legal and regulatory systems, local demand conditions, and managerial competence. Cheap Chinese labor is typically the least of it.

The other idea however, is that we can somehow return to 1950 when unionized manufacturing jobs dominated the US economy. This is no more likely than a return to small family farming (and like those who romanticize what Marx aptly termed “the isolation of rural life”, those who idealize factory work often have suspiciously clean fingernails).

As the accompanying chart shows, manufacturing as a share of economic activity is in long term secular decline in all high and middle income countries worldwide — including China. It is only growing as a share of the economy in very poor countries. As the UN has pointed out, Haiti is in desperate need of sweatshops. Vietnam and Burma are growing manufacturing’s share of economic output — often at China’s expense.

Manufacturing matters enormously, just like agriculture does. But it is not growing as a share of economic output. (McKinsey highlights one interesting exception to this rule. Sweden has maintained manufacturing as a share of its economy by targeting high growth sectors and especially by investing twice as much in training as other EU countries. Most importantly however, they devalued the krona against the Euro to make exports competitive — effectively taxing imports).

4. Companies build plants overseas in search of cheap labor

There was a time when labor costs were a determining factor in locating production facilities. This is much less true today, when location decisions are driven by many factors other than labor costs, as the chart on the right illustrates.

Depending on how a company competes and whether it is locating research, development, process development, or production facilities it’s location criteria may or may not turn on factor costs such as labor. Proximity to consumers or to talent may matter more. In some cases taxes matter. In other cases access to suppliers matter.

The rising cost of commodity inputs transportation during the past two decades has altered this calculation. Steel, for example, was about 8% iron ore cost and 81% production costs as recently as 1995. Today ore is more than 40% of the cost of a ton of steel and production costs are only 26%. Steel companies care much more about the cost of ore than the cost of labor.

Likewise transportation costs have skyrocketed with energy prices and infrastructure demands (the US grows highway use by about 3%/year and grows highways by about 1%/year. Anyone living here knows the result). Producers from P&G to Ikea and Emerson now are forced to locate plants near customers to minimize transportation costs. As a strategy for plant location decisions, labor arbitrage looks very 1980s.

5. If consumers would only buy local, we could restore our manufacturing base. 

Politicians and union leaders say this all the time and it is sheer idiocy. Most would not be caught dead in my German car, which was designed and made in Tennessee, but beam proudly at the sight of a Buick van imported from China.

High productivity manufacturing benefits consumers, as companies pass on savings to Americans in the form of lower product costs. As illustrated by the chart to the right, most consumer durables cost today about what they did in the 1980s — and quality is much higher. Economists have estimated that Walmart, Target, and Costco reduce retail prices by 1-3% each year because they pass to consumers savings extracted from manufacturers (this, by the way, is a big reason that manufacturing continues to shrink as a share of our economy. We pay less for our stuff  and more for services like education and health care.)

Americans say we believe in “Made in USA” campaigns, but as consumers, we are famously delusional. When surveyed, we profess to favor locally produced merchandize. But our wallets don’t lie: we buy high quality, low cost stuff regardless of where it comes from.

So how do we grow US manufacturing? Same as always: by creating innovative materials, processes, and products. McKinsey sees “a robust pipeline of technological innovations that suggest that this trend will continue to fuel productivity and growth in the coming decades”. Of course most innovations are hard to foresee. One reliable source of innovation turns out to be anything that reduces weight, such as nanomaterials, some biotech, light weight steels, aluminum, and carbon fiber. It turns out although we buy more stuff each year, the total weight of our purchases actually declines because nearly everything we buy, including cars and airplanes, weighs less than it used to.

Manufacturers have come to appreciate the power and the necessity of innovation. During the Clinton administration debates over CAFE standards, car company engineers soberly advised us that the theoretical limit of internal combustion engines was a 10-15% improvement over the current average of 17 miles per gallon. Today these companies have already doubled that efficiency and speak openly about doubling it again, even as they invest in non-combustion solutions that are even more efficient.

In short, manufacturing matters for different reasons than it used to. It used to be a plentiful source of unskilled jobs; today its value is as driver of innovation, productivity improvement, and consumer value. It’s an exciting part of the economy, even if it cannot solve every problem we face related to job creation and economic growth.