Apple Needs to Find Its Exit Strategy From China

Workers take photos of a car turned over after a brawl by employees at Foxconn's industrial zone in Taiyuan, capital of Northern China's Shanxi province Photograph by AP Photo

“IPhone5 Launch Causes Riots”

You’d expect to see headlines like this when consumers beat down doors and trample each other, yet these riots were in China, among workers at Foxconn, a major supplier to Apple and other U.S. companies. Shortages were already occurring in Apple’s supply chain, and the huge demand meant even higher production rates at some suppliers’ factories. Some unconfirmed reports suggested that Foxconn’s attempt to boost production by extending overtime and moving people from one location to another were significant factors contributing to the unrest and brief factory shutdown.

This issue has been percolating for quite some time, and it will require a reexamination by Apple—and plenty of other multinationals with Chinese production—of their overall supply-chain strategies. The fundamental flaw in U.S. companies’ current approach to Chinese partners seems to be a lack of understanding of “cost arbitrage,” the core of the strategy and the raison d’etre for being in China in the first place.

Two points I think warrant further scrutiny. The first is whether the decision that led Apple to move production offshore incorporated more than just cost. Or were they so enamored with the cost arbitrage that everything else was ignored? For example, Apple’s flexibility to ramp production up and down almost instantaneously was probably deemed an advantage. Beyond that, however, technology executives appear not to have calculated the true cost of that flexibility, which comes with growing labor discontent and risks to corporate reputations.

While Apple can withstand the impact of reputation risk in the short term, the Chinese labor discontent will require changes to Foxconn’s operating model, thus reducing the labor cost advantage and production flexibility. Now add the increasing cost of monitoring suppliers and of compliance overhead, and suddenly that labor cost advantage looks even more precarious. There are, of course, many other issues to consider, such as manufacturing lead time, visibility, intellectual property protection, political stability, and currency exchange issues.

The second point to think about is the temporal nature of arbitrage. By definition, arbitrage exists for only a certain period, which means it will vanish at some point. I would argue that when a corporation develops an outsourcing strategy, it should simultaneously develop an exit strategy. The labor cost advantage in China is and always was temporary, which is why we have seen many other locales (Southeast Asia, Eastern Europe, India) become supplier options as well.

The arbitrage model therefore must consider many factors beyond just labor cost. It also must monitor the exit criteria and initiate an exit strategy at the appropriate time—which will be different for every industry and for every organization within that industry, be it a leader or laggard. Yet in very few examples will you find an exit strategy being developed and agreed on at the time of the initial outsourcing decision. Does that mean the decision where to outsource is permanent? Or is the organization waiting for some external factor or disaster to force it to find an exit strategy?

While Apple will continue to dominate the headlines, this issue is not specific to Apple or to China. Companies that choose to offshore/outsource need to develop an exit decision model quickly and monitor it closely. Organizations should manage the business case for the original decision as a dynamic tool that is updated periodically. Early adopters will always reap the arbitrage advantage—and the decision to exit means that the arbitrage has shifted somewhere else.