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Miltary/Gov Spending II - Made in China

My previous posting sang the praises of military spending and government spending to create the foundation for technological entrepreneurship. In Part II, I'd like to point out the downside of military and government spending, based on some investigation I've done recently.

I've been working on next generation stethoscope design. Given that the country was in a deep recession with significant job losses, I thought it would be a great time to do manufacturing in the US rather than China. Manufacturers would be hungry for business so we'd get competitive pricing, and we'd be creating jobs at home. What I discovered shocked me.

Manufacturing in China doesn't save money in all areas. Shipping is expensive, travel is costly, logistics is generally more complex, there's an environmental cost to transportation, language barriers slow down communication, and so on. One can pay a significant premium for American made goods and still come out ahead. So there are many ways in which Chinese manufacturers are uncompetitive against American producers.

With that in mind, along with creating jobs at home, I headed off to explore the possibility of domestic manufacturing. After a few visits, a pattern emerged. Almost every factory I visited was doing either military components or very expensive medical devices such as implants. Military hardware is paid by taxpayers. Implants are almost completely paid for by the government, since they're used almost exclusively for Medicare patients. I don't claim that my sampling of manufacturers was scientific, but those that I visited were almost completely reliant on direct or indirect government spending in markets with little or no competition and steep margins.

When I showed these companies what I was developing, they were initially very interested. "We do a lot of medical devices" they'd say. Then I'd say something that took all the oxygen out of the room, "Doctors and nurses have to pay for stethoscopes out of their own pockets. So this isn't your typical high-margin medical device. It's more like a consumer product." The interest would visibly drain from their faces.

One company offered to help figure out some design challenges on a mechanical component. Their service was impeccable and I celebrated the fact that I could drive to this factory rather than fly to China to solve a design problem. Then they told me that a Navy contract had just come in to produce parts out of some exotic material. They promised that they'd get back to me in two weeks rather than one week. That was six months ago and I'm still waiting for a response. Their Navy contract just evaporated their interest in our project.

I don't blame companies for focusing on high-margin customers. But I do think that this is a significant reason that American manufacturing became uncompetitive. It seems to be a version of the Innovator's Dilemma, as described by Clayton Christensen at Harvard Business School:

IF a company is producing high-end products, it makes no sense to cannibalize its margins and its own product line by making low-end products, especially if those low-end products don't meet their customers' needs. So the cheap and simple products, call them "junk", went to hungry, unsophisticated manufacturers in China, and Americans logically keep the good business.

Here's where the Innovator's Dilemma comes in. The cheap junk will get more sophisticated and what was "junk" is now "hi-tech". It made "sense" to turn down a deal to make cheap toys or devices. But toys turn into smart toys, and smart toys turn into small computers, and small computers turn into laptops, netbooks, GPS navigators, cellphones, smart phones and tablets. The "junk" manufacturer is now making some pretty cool stuff.

To make things worse, the high end products are made in small quantities and don't justify robotics manufacturing. The "junk", as it became more sophisticated, required high speed robotic manufacturing and pretty soon the low-cost consumer product producers had far more sophisticated factories, as I discovered.

While Chinese factories have high-speed automation because they're producing millions of products a month on their production lines, the American factories I visited had slow, out of date machinery that's adequate to produce the low-volume products produced in the US. So the Chinese even have a cost advantage on production lines that require almost no workers at all.

This is a point that's lost in the emotional debate about off-shore production. Chinese manufacturing isn't merely about masses of cheap labor. Most electronic devices are produced by robotic systems with sophisticated automated test systems to ensure quality control. The machinery for mechanical parts is precision equipment made in Japan or Switzerland. Yes, the final assembly is done by hand and the labor is cheaper, but American factories now lag behind Chinese competitors in many technological areas. It's not just about cheap labor at this point.

American manufacturing could well rebound in the future. For now, the main reason for its decline is quite simple - lack of interest in producing most products we buy. There are a few high-margin markets that are simply too seductive. The rest have left for Asia.

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