Jul 26, 2010 3:00 AM AWST

Thin ice: Examining the facts behind Foxconn, Apple and the "crisis" facing the EMS market

Suicides. Spreading strikes. Militaristically zealous management and aggressive security guards. Pay raises and suicide contracts. These recent dramatic headlines have shoved Foxconn, the trade name of Taiwan-based Hon Hai, from relative anonymity straight into the unwelcome limelight, dragging its big-name customers like Apple, Dell and Sony along behind it. But while the glare of publicity may be bright, it has blinded many to the real story, which is about much more than suicides at a single electronics company in Southern China. While the shrill voices of daily news have been pointing fingers at individual players, the issues, real and illusory, at Foxconn are symptomatic of the dynamic, pressured relationships between all the usually anonymous EMS providers and their brand-name customers, their employees, governments and society at large.

Myth: Foxconn is the Bad Guy

Before looking at the wider issues, we should consider what is actually happening at Foxconn, and clear up a wide array of misunderstandings intensified by headline hype.

Foxconn is the largest electronic manufacturing services (EMS) provider in the world, more than twice the size of its' next-largest competitor Quanta, and with more than 300,000 employees at their Longhua and Shenzhen campuses alone. It is also notorious for an aggressive management style. "They come in like an occupation army, said one former Foxconn manager. "That approach served them well in the past, but i think they'll have to change now.

But whether management changes or not, Foxconn is hardly the only EMS firm that manages "aggressively, and while many have criticized Foxconn's on-site factory work environment, Foxconn actually offers working conditions similar to those at the other leading EMS players, and substantially better than those at many of their suppliers. One insider noted that while the company is aggressive in their business approach, they also provide their workers with swimming pools, exercise rooms and on-site counseling centers for staff. One supplier to Apple said that, in their experience, Foxconn is far from a sweatshop, and actually provides a better environment than many Chinese companies. For example Wintek, one of Foxconn's suppliers, was accused earlier this year of not protecting its workers against the toxic chemical nhexane, which is used to clean Apple components. Many employees subsequently exhibited extensive damage to their peripheral nervous system and spinal cord, causing to muscular weakness, atrophy and in some cases, paralysis.

Another misleading assertion is the link between the suicides and overtime. "in my three years of interviewing migrant workers ...I found that the greatest pressure comes more from interpersonal and emotional concerns than factory conditions, said Leslie T.Chang, author of Factory Girls: From Village to City in a Changing China, in a recent report for research house CLSA. "Laboring long hours is the reason they come to the city in the first place. According to other sources, most factory workers actually expect the ability to apply for overtime work, as this is how they make extra money on top of their base monthly salary - which averages around RMB900. Factories that do not offer overtime have a hard time filling spaces on their factory floor. While some argue that the only reason workers want overtime is because they are underpaid, the counterargument is that many of the migrant workers have one goal: to save as much as humanly possible in as short a period of time, and send it home.

Behind the Suicides

However, the 10 disturbing suicides plus three attempts that have been reported do not express a sense of worker satisfaction, and to outsiders the tragedies suggest an even darker corner in Foxconn's closet. The first suicide reported was a result of one worker being accused of stealing an iPod and then being interrogated in a small room for hours. The interrogation, and the worker's ensuing deadly leap from the roof, enraged the public. Unfortunately, the same Spartan management style that brought Foxconn to dominance was ill suited to coping with ensuing employee dissatisfaction and media coverage. Eventually compensation was granted to the worker's family. The suicides kept coming, but seemingly spawned by dissatisfaction in the given worker's personal life - although one worker referred to the prospect of generous compensation from Foxconn in his final letter.

In any population of 300,000 young people in urban China, one should statistically expect at least as many suicides per year as seen at Foxconn recently. Factory workers are overwhelmingly younger than 25, and the suicide rate among Chinese youth (similar to youth everywhere) is higher than the overall average. Many U.S.universities would be ecstatic if their suicide rates fell to levels as low as those at Foxconn China.

Even a concentration of suicides at a single manufacturer may not be the manufacturer's fault. Aggressive media coverage tends to exacerbate the globally well-documented "Werther effect of suicide clusters. "Reports from other countries have identified suicide clusters in schools, military units and other closed communities similar to the 'company town' environment at Foxconn, said Michael Phillips, director of the Shanghai Suicide Research and Prevention Center at the Shanghai Mental Health Center, in a recent opinion piece for the Asian Wall Street Journal. "This is most common in adolescents and young adults [all the recent suicides have been in their teens or early 20s] and there is always a contagion element to clusters because the individuals know each other or have been exposed to prior suicides by personal communication, the media or the internet.

Myth: The Apple's Gone Bad

While Foxconn has already caught its share of the heat, some reporters are already looking up the value chain at Foxconn's corporate customers. This involves Apple in particular, as the company has also been getting a lot of flack in this media blitz for lying down on CSR and for the fact that it seems to have little knowledge about the actions of its suppliers. In February 2010, a CSR investigation (initiated by Apple) discovered child labor in its suppliers' factories. While by the time the workers were discovered, they were legally of working age the revelation, in combination with the Foxconn scandal, has rattled Apple's image with Western consumers and made some observers wonder whether it is losing control of its supply chain.

That's extremely unlikely. Rather, the media feeding frenzy grows because Apple, like Foxconn, represents an easy target. In Apple's case, it's in part the extreme of secrecy and detail orientation in product development, though the resulting product design has created millions of devoted Apple fans the world over. A supply chain manager at a competitor in the mobile device sector says that they do think Apple is on the extreme side when it comes to their outsourcing strategy. But the difference is of degree, not of kind. "Apple is well aware of Foxconn's practices and is attentive to the world at large, says one former Apple supply chain manager. "Apple pushes Foxconn to improve the working environment.

In 2007, three academics writing for the Personal Computing industry Center took apart an iPod to gain a clearer understanding of Apple's sourcing and supply chain, and to understand which parts of the value chain were delivering the most profit. In Who Captures Value in a Global innovation System? The case of Apple's iPod, the authors revealed that the iPod, like virtually every other consumer electronics product available today, is a combination of many companies' efforts. Toshiba makes the hard drive (themselves outsourcing some components), the most expensive component in the iPod. Broadcomm, inventec and Samsumg all contribute components as well. Foxconn manages the overall upstream supply chain, assembles and delivers to distribution points, and then supports after-sale service. Nothing in this model suggests anything extraordinary, though the report does note that "Apple is particularly sensitive about its supply base.

A Problem of Cost

Looking beyond Apple and Foxconn, what substantial supply chain issues really lurk behind the stories? Rather than media hype and speculation, supply chain managers should be paying attention to how the manufacturing environment in China is changing. A primary issue is increasing labor costs. Manufacturing job growth in China has accelerated rapidly again this year, and seems to have recovered almost entirely from the 2008/2009 downturn. Rising demand for manufacturing labor, rising minimum wages and an increased sense of worth on the part of potential laborers have all put strong upward pressure on labor costs. In late May, headlines covering a strike at a Honda-owned parts factory in Foshan (near Shenzhen) began to appear alongside the Foxconn stories. The Honda employees won about a 25% wage increase. At the same time, workers struck at a Japanese-owned manufacturing facility in Xi'an and at a Taiwanese-owned facility near Shanghai. Nearly concurrently, Foxconn announced a pay raise of over 30-50% for its Shenzhen plant, bringing the base salary of its workers from RMB900 to RMB1200-2000. Numerous provincial governments subsequently announced they would raise local minimum wage levels. For companies operating in China, labor costs are going up.

Business as Usual

The EMS companies survive on relatively small margins. Can they survive in a more expensive environment? One supply chain manager at a leading EMS player says that the strikes at Honda and in Xi'an are more worrisome than the over-reported situation at Foxconn. The macro factors driving increased negotiating power on the part of employees will continue to nudge labor costs up for manufacturers. However, since labor costs are not yet a major component of overall costs, manufacturers have some room to manage labor cost increases.

Manufacturing wages have also been climbing roughly in line with GDP in China for at least a decade, yet manufacturers have survived. "A sample of 120 Taiwan tech vendors shows remarkably steady margins, on an aggregate, through many years of wage hikes, says Bhavtosh Vajpayee, head of technology research for CLSA. "Despite a decade of wage inflation, China or India will remain preferred outsourcing destinations for hardware and services. Demand volatility and non-labor input costs have a much stronger influence on margins.

Arthur Kroeber, head of the research house Dragonomics, also says that since workers in China aren't permitted to independently organize and there are still so many of them, China won't see a paradigm shift soon.

"China's massive underclass of workers is often seen as a source of social unrest, but in reality [these workers] are a force for stability, says Chang in her CLSA report. "Repeated predictions of rising unrest - during an Asia-wide recession in the late 1990s and again in the recent global economic down - turn - have not come to pass."

Customer Distancing

The other issue is the demand side. Will the recent media frenzy negatively impact Foxconn's relationship with its customers, namely Apple, and shift the power relationship between the brands and their suppliers? As mud drips off of Foxconn onto Apple and Dell, will the brands try to distance themselves?

As a rule, during initial stages of discussions between brands and EMS players, the negotiation advantage tilts towards brands, due in part to overcapacity in the EMS space and the lower barrier to entry. A sales representative for one of the leading EMS says that he as seen a lot of desperation among the EMS players recently. "Last year, we were at the final stage of negotiation for a big project, and we'd already accepted terms that would have cut our margin to 1%, he said. "Then the brand rep said we would be required to pay a multi-million contract signing fee. The sales representative's company walked away from the deal, but their competitor took it anyway. "They are losing money, he continued. "How long can this go on?

Forward looking prospects

However, no substantial change is likely in the short term. Once a relationship is established between an EMS supplier and a brand, savvy EMS players are able to make the relationship sticky - meaning the cost of shifting suppliers becomes intolerably high so that the EMS player's negotiating power increases. "[Our major customer] may press us for a few more pennies off the price, said one EMS development manager. "But we counter by saying we'll grant the discount if they give us a larger piece of the service contract. Foxconn is exceptionally good at being sticky - few of the insiders we spoke to felt that Foxconn is at any risk of losing substantial business as a result of the recent media attention, because their highprofile and highly demanding brand customers have come to rely so deeply on Foxconn's partnership - going far beyond product production and covering virtually all of the value chain: from cooperation in R&D to retail distribution and after-market services.

At the same time, the increase in labor costs is also manageable. Historically, Taiwanese tech-sector companies have been able to maintain their margins over time because they are constantly on top of their pricing. While the Shenzhen site will be more expensive to operate, Foxconn, along with competitors Quanta and Wistron, are already developing other manufacturing sites in western China.
Foxconn will likely downsize dramatically in Shenzhen and Longhua, moving the mass production work farther north and west, while the more detailed finishing and export work will stay on the coast. Not only are labor costs less out west, but land prices are also cheaper, as local governments are very keen to give large employers a break to attract them to their town.

While reaching global markets from Chongqing and other inland locations may be marginally more expensive, the move to the inland provinces also puts EMS providers closer to some of China's large and fast-growing domestic markets.

Foxconn and their figurehead Guo have also proven their ability to evolve fast. In late May, the company took the unprecedented step of inviting six buses full of journalists for a tour of their Longhua facility. For a company that is famously secretive and protective of their customers' products, the media bus tour reflects on the likely speed with which they're going to transform what they're doing in Longhua.

While discussion, concessions and media hype may continue for some time, the relationships between the brands and the EMS will not likely stray greatly from their current course. The recent incidents at Foxconn and Honda, and countless others that are happening around the country, though less reported, are merely smaller symptoms of an epoch-level transition in the global economy and supply chains. The major forces affecting the China supply chain will remain as they've been for some time: steadily rising wages and more demanding employees here; contract manufactures moving up the value chain, and brands eager to hand over more of it to the manufacturers, world-wide; and consolidation of the manufacturers, because of the paramount importance of economies of scale. Supply chain leaders will do well to remain focused on the global tides affecting supply chain management, and to ignore the regularly appearing froth on the waves.

EMS Branding Risk?

In some peoples mind, these brand names have outsourced too many secrets, and face having their name brand technology used for by and EMS trying to break into the retail market. Early in the last decade, Flextronics famously decided against developing an own-branded product in the mobile device sector, believing that they'd risk too much by going into
competition with their competitors. "Foxconn will never do what HTC and such have done, said one ex-Foxconn employee. "To launch their own brand doesn't make sense. An ex-Apple manager echoes that Foxconn will not betray its customers and in fact is in line with Apple's business strategy. "i believe Foxconn is the right partner for Apple, said the manager. "They have the same concept for supply chain management. Apple wants to move to online business, while Foxconn wants to continue their vertical integration.
The bottom line is that branded products produce more margin than unbranded ones; services and solutions produce more margin than hardware. The zeal for margin will keep brands and their EMS suppliers on the battlefield, though sometimes fighting in league with one another.