Deciding the operational plant location*

Considering a global value chain, companies should take every link in the chain and find the optimum location for it.

If a company that makes products requiring such components does not have a market share that is large enough to justify building a plant to make them, it is forced to outsource that component. But, if the company that has the plant is also a manufacturer of the end product, possession of the components is a strong barrier to entry to new competitors in the final product market.

However, some industries consist of independent businesses taking care of different parts of the supply chain. For example, in garment industry, various parts of the production of fabric are often done by different businesses and the garments finished in a cut, manufacture and trim plant. In this case, the garment themselves may be designed and marketed by other, totally independent businesses. And, each part of the business can be located wherever it makes most sense for the business.

Thus, businesses can find market niches at various points of the value chain and for various functions. Also, within the manufacturing part of the value chain, minimum cost operations will not always give competitive advantage because every business tries to generate some competitive advantage through differentiation.

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Thereby, according to Hill and Hult (2017), an international firm should decide where to locate its production activities to best minimize its costs and improve product quality. Thereby, firms which engage in international production have to consider several factors like country factors, technological factors and production factors.

Country Factors

This includes political and economic systems, culture and relative factor costs. In this case, in some industries, the presence of global concentrations of activities at certain locations are required.

Also, externalities can play a major role in deciding where to locate production activities. For example, due to a cluster of semi conductor manufacturing plants in Taiwan, labor with experience in the semi conductor business have developed in Taiwan.

The same has happened in Hyderabad and Bangalore, in India where both Western and Indian companies have established operations. For example, locals refer to an area of Hyderabad as Cyberabad. This is the area where Microsoft, IBM, Infosys and Qualcomm have major facilities.

However, formal and informal trade barriers influence location decisions. Also, expected future movements in its exchange rate is another key country factor to consider. That is, adverse changes in exchange rates can quickly alter a country’s attractiveness as a manufacturing base. In simple, currency appreciation can transform a low cost location into a high cost location.

For example, the relatively low value of the yen on foreign exchange markets between 1950 and 1980 helped strengthen Japan’s position as a low cost location for manufacturing. More recently, the yen’s steady appreciation against the dollar increased the dollar cost of products exported from Japan. This made Japan less attractive as a manufacturing location. Therefore, many Japanese firms moved their manufacturing offshore to lower cost locations in East Asia.

Technological factors

In this case, firms should consider three key things; fixed costs, minimum efficient scale and the flexibility of technology.

Considering fixed costs, when there is a relatively low level of fixed costs, it is much economical to perform a particular activity in several locations at once. This permits the firm to better accommodate demands for local responsiveness. This helps the firm to avoid being dependent on one single location. Specially, being dependent on one location is very risky in the presence of floating exchange rates.

Considering minimum efficient scale, the level of output at which most plant level scale economies are used is known as the minimum efficient scale of output. Therefore, this is the scale of output that a plant must operate to realize all major plant level scale of economies.

Hence, the larger the minimum efficient scale of a plant relative to global demand, the greater the better to centralize production in a single location or limited locations. For example, the low level of minimum efficient scale in relation to global demand, for PCs makes it better for companies like Dell and Lenovo to assemble PCs in multiple locations.

Flexible manufacturing and mass customization is the next technological factor to be considered. Here the trade off is between unit costs and product variety. Accordingly, the way to increase efficiency is to limit product variety and produce a standardized product in large volumes.

The above view of production efficiency has been challenged by the rise of flexible manufacturing technologies or lean production. This covers a range of manufacturing technologies designed to

  • reduce setup times for complex equipment
  • increase the utilization of individual machines through better scheduling
  • improve quality control at all stages of the manufacturing process

Thus, flexible manufacturing technologies allow the company to produce a wider variety of end products at a unit cost that could only be achieved through mass production. This indicates that mass customization is possible through flexible manufacturing technologies.

For example, Toyota’s flexible manufacturing system was developed by Ohno. The development begins with Ohno having completed 5 years at Toyota and visiting Ford’s U.S. plants.

Ohno identified several problems with mass production. First, massive inventory held up due to long production runs meant high costs for warehousing. Second, when the initial machine settings were wrong, long production runs resulted in the production of a large number of defects. Third, the mass production system was unable to accommodate consumer preferences for product diversity.

As a response to these identifications, Ohno developed a number of techniques to reduce setup times for production equipment. This made small production runs economical resulting in lower warehousing costs. Waste was also reduced. With all of these innovations, Toyota could produce a more diverse product range at a lower unit cost.

Another flexible manufacturing technology that is common is flexible machine cells. This is a grouping of various types of machinery, a common materials handler and a centralized cell controller. A typical cell is dedicated to the production of a family of parts or products. The settings on these machines are computer controlled and allows each cell to switch quickly between the production of different parts or products.

Through flexible machine cells, setup times are reduced and the production flow is coordinated by the computer. This eliminates bottlenecks and improves capacity utilization. Also, the tight coordination between machines also reduces work in progress. Adding on top of them, waste is reduced because of the ability of computer controlled machinery to identify ways to transform inputs to outputs while producing minimum waste.

Apart from improving efficiency and lowering costs, flexible manufacturing technologies enable companies to customize products to the demands of small consumer groups. Thus, mass customization can be achieved.

For example, Ford’s introduction of flexible manufacturing technologies enabled Ford to produce multiple models from the same line and to switch products from one model to another much quickly than in the past.

Production Factors

In this case, product features, locating production facilities and strategic roles for production facilities are key things to be considered.

Considering product features, first the value to weight ratio affects the location decision because of its influence on transportation costs. For example, electronic components and pharmaceuticals have high value to weight ratios. Therefore, there is high pressure to produce them in optimal locations and to serve the world from there on.

The choice of whether the product serves universal needs, also influences the location decision. If there are few national differences in consumer taste and preference for such products, the attractiveness of concentrating production at an optimal location increases.

Accordingly, for locating production facilities, a firm can either concentrate them in a centralized location and serve the world market from there, or decentralize them in various regional or national locations that are near to major markets.

The correct strategy of the two will be based on country specific, technological and product factors. Accordingly, concentration of production makes most sense in the following circumstances.

  • Differences among countries in factor costs, political economy and culture have a substantial impact on the costs of manufacturing in various countries.
  • Low trade barriers
  • Externalities arising from the concentration of entreprises favor certain locations.
  • Important exchange rates are expected to remain relatively stable.
  • Presence of high fixed costs and high minimum efficient scale relative to global demand.
  • Presence of flexible manufacturing technology.
  • High product’s value to weight ratio.
  • Product serves universal needs.

Another factor to consider in location decisions include global learning. This means that valuable knowledge does not reside in a firm’s domestic operations; it may be found in foreign subsidiaries. In simple, foreign factories upgrade their capabilities over time. This creates valuable knowledge.

These foreign factories can have a number of strategic roles like offshore factory, source factory, server factory, contributor factory, outpost factory and lead factory.

Offshore factory is a factory that is developed and set up mainly for producing component parts of finished goods at a lower cost than producing them anywhere else. In such factories, investments in technology and managerial resources should ideally be kept to a minimum, in order to achieve greater cost efficiencies. But, some strategic decisions are expected to include input from the offshore factory personnel.

Source factory is one that drives down costs in the global supply chain. In this type of factory, the managers have a say in certain decisions like purchase of raw materials and component parts. Thereby, these factories should be located where production costs are low and infrastructure is well developed. It should also be relatively easy to find a knowledgeable and skilled workforce to make the products.

A server factory is a factory which supplies a specific country or regional markets around the globe. This type of factory is usually to setup to overcome intangible and tangible barriers in the global market place. Also, managers at a server factory usually have more authority to make minor customizations to satisfy their customers.

Considering a contributor factory, this factory has more choice in terms of which suppliers to use for raw materials and component parts. This type of factory has its own infrastructure when it comes to development, engineering and production. Therefore, this type of factory is more of a standalone one.

The next type, outpost factory is an intelligence gathering unit. This is often placed near a competitor’s headquarters or main operations, near the most demanding customers or key suppliers of unique and critically important parts.

A lead factory is intended to create new processes, products and technologies that can be used throughout the global firm in all parts of the world. A lead factory should set a high bar for how the global firm wants to provide products to customers. Therefore, it should be located in an area where highly skilled employees can be found. This implies that managers and employees at the site have a direct connection to suppliers, the designs implemented and other core competencies of the firm.

Stay tuned with Zeeable for more of such updates!!

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