U.S. Factories: Falling Behind

Why America's old-line industries are trailing in the global productivity stakes

In many ways, the last few years should have been a golden era for American manufacturers. Since 1997, the productivity of U.S. factories has soared, rising at a 4.6% annual average rate. That's the fastest sustained rise in manufacturing productivity in at least 40 years, and well ahead of the 1960s heyday of U.S. industrial prowess.

Yet despite these gains, the U.S. factory sector all but imploded. Domestic factory output is still down 2% from its 2000 peak, while imported goods are up 8%. Some 3 million factory jobs -- one in every six -- have been lost since the last peak in mid-2000. And while the manufacturing sector is finally expanding and hiring again -- up 37,000 jobs since January -- no one expects domestic manufacturers to ever recover the ground lost to overseas competitors.

Economists, business leaders, and politicians give all sorts of reasons for the dire state of U.S. manufacturing: Competition from low-wage offshore factories, an excessively strong U.S. dollar, high corporate taxes, and the rising bill for employee and retiree benefits.

But there's a more surprising explanation for why U.S. manufacturers have fared so poorly. Fact is, as fast as American factories have improved productivity and cut costs, foreign competitors in Asia and Europe have charged ahead even faster. Especially outside of the high-tech and auto sectors, investment and innovation has languished in many old-line industries, turning much of manufacturing into a technological backwater. "Everybody's talking about high rates of growth in productivity," says Barry P. Bosworth, a senior fellow in economic studies at the Brookings Institution. "But it's in two areas: high technology and services. The rest of the goods-producing industries have not shared in this."

Instead, many manufacturers shifted to an end-game strategy in the second half of the 1990s. Rightly or wrongly, they skimped on capital spending and innovation, assessing that the payoff just wasn't there. Between 1995 and 2001, when the most recent data ends, the stock of equipment and software used by manufacturers increased by only 19%. That's far smaller than the 43% increase in the rest of the private sector. And while manufacturers spent $109 billion of their own funds on research and development in 2001, some 67% of that was in high tech, pharmaceuticals, medical equipment, or autos. On average, other manufacturing industries devoted less than 2% of domestic sales to R&D.

As a result, U.S. factories haven't kept up with foreign rivals. The labor cost of a unit of factory output fell at a 0.4% annual rate from 1997 to 2002 (the most recent year for comparative data). That's an excellent number, historically -- but unfortunately, production costs were falling even faster in countries such as Japan, Korea, Taiwan, and even France (chart). And while the Bureau of Labor Statistics doesn't track Chinese manufacturing, the odds are that factory costs are falling faster in that country as well.

Innovation has enabled some parts of U.S. manufacturing to boost productivity and continue expanding their output in the face of foreign competition. Manufacturers of info-tech equipment -- such as computers and networking gear -- have turned out average annual productivity gains in excess of 30% since 1997. And in the auto industry -- which has maintained its heavy investment in R&D -- output per worker rose at a more than 4% annual rate from 1997 to 2003.

INNOVATION RUT

But these two high-productivity sectors -- high tech and automobiles -- account for pretty much the entire increase in U.S. manufacturing output since the middle of the 1990s. For example, since 1997 total manufacturing output is up by 19%, according to the Federal Reserve. Take out autos and high-tech, and output in the rest of manufacturing has only grown by less than 1% over the past seven years -- a paltry gain.

The problem is that many of the biggest old-line industries still suffer from slow productivity growth. From 1997 to 2003, output per worker grew at less than 2.5% per year in such industries as furniture, food processing, paper products, printing, primary metals, and machinery.

After 100 years of technological refinement, it may be that all the innovation has been wrung out of many industries. "With 19th and 20th century technologies, almost by definition, most of the innovative sources of productivity -- the use of technology to improve the inherent performance of the products -- have been discovered," observes Adrian T. Dillon, formerly CFO of Eaton Corp. (ETN ), a large manufacturer of industrial and automotive components, and now CFO of Agilent Technologies Inc. (A ), a maker of testing gear.

The aluminum industry offers but one example of this innovation rut. Since aluminum was first refined in 1886, metallurgists have slashed the amount of electricity needed to turn bauxite into the lightweight metal, yet "the process is basically the same today as they developed in the late 1800s," says Richard B. Evans, executive vice-president of Alcan Inc. (AL ), the world's No. 2 producer. That helps explain why productivity in the industry was virtually flat throughout the 1990s.

In addition, some U.S. companies have chosen not to develop fully new technologies that might have the potential to cut labor costs. For example, robotics was once hailed as a way of replacing expensive factory workers with machines. In fact, the auto industry invested heavily in robots to do welding and spray-paint vehicles.

However, the spread of robots slowed in the 1980s because they were judged too unreliable and too expensive for more dexterous tasks, such as installing wiring. "Humans do it better," says John Paul MacDuffie, a management professor at the Wharton Business School at the University of Pennsylvania.

Nor has information technology turned out to be a panacea. Certainly, computers can help manufacturers greatly cut inventories and tighten supply chains. But the gains they achieve are matched -- and sometimes even topped -- by foreign factories that have access to the same state-of-the-art hardware and software.

Consider Banta Corp. (BN ), a $1.4-billion printing company in Menasha, Wis. In 2000, 70 employees produced by hand 360,000 page plates a year at its book-printing plant. By 2003, all the input material was received in digital form and assembled on Macintosh G3 computers, enabling 50 employees to produce 454,000 plates. That's an 80% increase in output per worker, or about 25% per year.

Yet when it comes to the all-important, capital-intensive step of actually printing the book, Banta has been able to boost productivity by 5% a year by installing new faster and wider presses. The rub? Chinese printers are buying the same $12-million machines, blunting any competitive edge Banta had hoped to achieve.

Or look at Smurfit-Stone Container Corp.'s (SSCC ) mill in Uncasville, Conn. General Manager Paul Hayes is proud of his cramped factory, which dates back to 1910 and employs 107 people to spin out 450 tons of brawny brown paper every day. That's 12.5% more than it made 15 years ago, with the same headcount.

But the heart of the factory -- the mulching, rolling, and drying machines that turn a liquid mash of old boxes into material for new ones -- is growing outdated largely because the Chicago-based company hasn't installed new processing equipment in Uncasville in those 15 years. Indeed, capital investment at the mill came to only $1 million last year. Meanwhile, over the past few years, papermakers overseas have invested generously in the latest automated machinery.

It becomes a vicious cycle. With few prospects for big returns, it's hard for many manufacturers to justify money for new equipment. That, of course, means they're hamstrung as they try to lift productivity, which makes them an even poorer prospect for further investment.

Instead, many factory-sector executives say their best hope is to hunt for nickel-and-dime savings. For example, Wilbur L. Ross Jr., chairman and CEO of WL Ross & Co., a private investment bank in New York, assembled International Steel Group Inc. (ISG ), now the nation's second-biggest integrated steelmaker, from bankrupt mills. After its initial public offering last December, ISG earned $70.9 million in the first quarter, on sales of $1.8 billion.

Ross's secret? By picking out the best factories and squeezing out labor costs, Ross hopes ISG can compete with overseas steelmakers -- without much new equipment. "The lack of capital hinders productivity," says Ross. "But the capital markets are doing their job, sorting out where to get the best rate of return."

SYMPTOMATIC RELIEF

For now, the cyclical revival in U.S. manufacturing is relieving some gloom. "We are on the way to a much better supply-demand balance," says J. Pedro Reinhard, CFO at Dow Chemical Co. (DOW ). Thanks goes in part to the slumping dollar, which makes imports more costly and U.S. goods cheaper overseas. Jobs are returning, too. The National Association of Manufacturers (NAM) predicts that factory payrolls will grow by 250,000 by yearend.

Over the long haul, though, this upturn looks more like an anesthetic than a cure. The sector's share of gross domestic product slipped to 13.9% in 2002, from 16.6% in 1997 and 18.7% in 1987. And while the data isn't yet available, it was undoubtedly lower in 2003, says NAM Chief Economist David Huether.

Still, it's far too pessimistic to write off American manufacturing. As the high-tech industry showed in the 1990s, a burst of innovation can keep U.S. manufacturers at the forefront of the global economy. And as the auto industry has proven, sustained spending on R&D and capital equipment -- along with a willingness to learn from foreign rivals -- can help U.S. manufacturers compete. But the prognosis for most manufacturers is not encouraging. In a world where productivity and investment are key, many of the country's oldest factories just can't measure up.

By Michael Arndt in Chicago and Adam Aston in New York

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