Challenges on the Road toward Reviving Manufacturing: Japanese companies lagging in localization

Faculty Fellow, RIETI

A growing number of American manufacturers are reshoring production to the United States from China and other overseas locations. General Electric Company (GE) began producing new appliances for American consumers on its factory floors in the state of Kentucky. Likewise, Ford Motor Company is planning to curtail overseas production and expand its manufacturing base in the state of Texas. Reduced production costs resulting from cheaper U.S. dollars are a big reason behind the booming production in the United States. Combined with soaring labor costs in China, the relative wage gaps between the two countries are shrinking.

Non-labor costs associated with overseas production are also on the rise. An analysis by Harvard University Professor Michael Porter et al. found that advancement in production processes have led to a decrease in the proportion of labor costs relative to total costs, highlighting the impact of the hidden costs of overseas production such as difficulties in quality management, high attrition rates, and concern over intellectual property protection. The shale gas revolution has had a significant impact as well. Following a significant decline in natural gas prices, Dow Chemical Company announced its plan to construct the world's largest ethylene plant in Texas.

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It is certainly true that the resurgence of manufacturing is occurring in the United States. This, however, does not mean that U.S. manufacturers are loosening their grip on their activities in China and other overseas locations. The ongoing process should be seen not as the reshoring of U.S. manufacturing, but as the optimization of production operations on a global scale to bring production closer to the customers.

Caterpillar Inc. is shifting some of its construction machinery production from Asia to the United States. At the same time, however, it is also enhancing its research and development (R&D) capabilities in China, gearing up its efforts to develop products that match local needs. In high-growth emerging economies, labor costs are rising with an increase in the level of income. In the long run, production costs in developed and developing countries will converge, but cross-country and cross-regional differences in languages, lifestyles, and political and economic systems will remain. Therefore, localization of production operations to match the market needs is the key to the revival of manufacturing in the era of the global economy.

It is also necessary to avoid the excessive concentration of production in emerging economies where business risks are relatively high. Technological innovation for enabling decentralized production systems is evolving as well. The widespread use of three-dimensional computer-aided design (3D CAD) models has shortened the process of product development and design. Furthermore, three-dimensional printing (3DP) can reduce the time required for pilot and small-lot production. As such, the effectiveness of localizing the entire process from product development to production in accordance with market needs is increasing.

Unlike the United States where the population is increasing, Japan has entered an era of population decline, and therefore its domestic market has limited room for growth. Expanding into the global market including rapidly growing emerging economies is the key to the revival of manufacturing in Japan.

Many Japanese companies earn more than half of their revenues from overseas operations and have far more employees overseas. Yet, in terms of organizational structure and governance, Japanese headquarters typically remain in control over group-wide operations including those of overseas subsidiaries with only very few companies implementing truly global management practice by taking advantage of overseas diversity. While the competitive advantage of decentralized production systems tailored to local market needs is increasing in manufacturing at the global level, Japanese manufacturers are lagging behind their U.S. and European counterparts in localizing overseas operations.

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In order to develop products that truly reflect the needs of the respective local markets, creative ideas with unique local tastes are indispensable. However, Japanese companies tend to pursue product development under the leadership of the headquarters in Japan. The figure shows the percentage of inventions made in China out of the total number of patents registered in China by Japanese, U.S., and European companies. Contribution of local subsidiaries of U.S. and European companies remain minimal, accounting for only a few percent of the total number of patents registered in China. However, the proportion of made-in-China patents has been on an upward trend since the mid-2000s, resulting in a widening gap between them and Japanese companies.

Meanwhile, when we look at documents cited in patent applications for inventions in China, we can see an overwhelming tendency of Japanese companies to cite patent documents filed by their Japanese headquarters, which provides a clear indication that R&D efforts undertaken by local subsidiaries are also led by the Japanese headquarters. In contrast, U.S. and European companies often cite patent documents filed by local entities--such as universities and enterprises in China--in their patent applications, reflecting their increasing collaboration with local innovation systems. In order to bring about innovation that can meet the needs of diverse markets, ideas and perspectives that are unique to respective countries or regions are indispensable. Monolithic organizations that are overwhelmingly Japanese cannot achieve that end.

What is needed to accelerate the localization of manufacturing is to transfer more authority to local subsidiaries and promote local personnel to responsible positions. Japanese companies compare poorly to their U.S. and European counterparts in terms of their reputation as employers because of their tendency to give local employees less discretion and lower chances for promotion. The vicious cycle of "head office control," "failure to foster local personnel for executive positions," and "lack of local discretion due to lack of suitable personnel" must be ended. Over a long-term horizon, it is also important to recruit foreign, new graduates as head office employees.

Figure: Percentage of made-in-China inventions out of the total number of patents registered in China by Japanese, U.S., and European companiesFigure: Percentage of made-in-China inventions out of the total number of patents registered in China by Japanese, U.S., and European companies
Source: Author's estimates based on patent data provided by the State Intellectual Property Office (SIPO) of the People's Republic of China.

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Concern over the leakage of advanced technology is often cited by Japanese companies as an obstacle to the internationalization of R&D and the pursuit of open innovation through collaboration with local companies. This is because Japanese manufacturers have yet to break out fully from their traditional product-centric model, which is to localize operations revolving around internationally competitive products.

Japanese companies rose and gained dominance in the postwar world economy with their manufacturing technologies capable of producing high-quality products at low costs. However, other countries and regions such as South Korea, Taiwan, and China are fast catching up from behind, and the product-centric model from the era of industrial economy obviously has its limitations. If Japanese manufacturing is to win in the global competition, they must reorient themselves to focus on manufacturing aligned to today's science-based economy, a new economic mechanism in which business models are developed based on scientific knowledge such as information technology (IT) and biological sciences.

In the science-based economy, the development of new technologies and products is not so much a vertically integrated process undertaken by a single company or group, but increasingly a process characterized by a horizontal division of labor between a technology platform provider and business innovators that formulate new business models on the platform in collaboration with users. A typical example of such division of labor can be observed in the development of new drugs, where biotech ventures would develop new innovative substances with therapeutic properties whereas large pharmaceutical companies would turn them into commercially marketable products.

The main thrust of manufacturing in the era of the science-based economy is not in the sell-and-go approach, a business model in which a company would sell its products and/or technologies and be done with them, but in the creation of value through customer services. Continual innovation that would improve services through interactions with customers is what counts. The rise of manufacturers in emerging economies has led to the commoditization of a wide variety of products. In the face of this new reality, Japanese companies should exert more effort on business innovation closer to their markets.

For instance, medical equipment manufacturers should focus on the development of optimal systems tailored to meet the needs of respective hospitals. Products intended for consumers should be designed in such a way to allow sufficient flexibility to fulfill the needs of diverse users. Collaboration with customer companies and consumers is crucial to achieving that end. In particular, global business operators should consider entering into strategic alliances with local partners with intimate knowledge of local markets.

In terms of government policy, appropriate amendments should be made to the Companies Act and relevant tax laws and regulations to facilitate cross-border mergers and acquisitions. And companies, for their part, need to develop open innovation strategies on a global level and put them into practice. In Japan, many companies maintain a competitive advantage by adhering to their product-centric business model. However, they need to steer the wheel toward a new strategy aligned with the needs of the era of the science-based economy.

>> Original text in Japanese

* Translated by RIETI.

December 30, 2013 Nihon Keizai Shimbun

February 12, 2014