Question

Many companies choose to manufacture their products in countries where workers are paid lower wages than in the United States. Which variable costs decrease and which ones increase as a result of this decision? Why do companies make this choice? Consider what you know about the relationship of costs to profits as you formulate your answer.

Short answer

Labor costs decrease; transportation costs increase. Companies aim to maximize profit margins by reducing production costs.

Step-by-step solution

Understand the Context

Manufacturing in countries with lower wages affects various aspects of production costs. Companies often face the decision to relocate manufacturing to optimize costs and influence their profit margins.

Identify Decreasing Variable Costs

When manufacturing in countries with lower wages, labor costs—one of the primary variable costs—significantly decrease. This reduction occurs because companies pay less for the same work compared to higher-wage countries.

Identify Increasing Variable Costs

Variable costs that may increase include transportation and shipping costs, as products need to be transported to different markets, often across lengthy distances. Additionally, companies might face increased costs related to managing international logistics and overseeing the supply chain.

Analyze the Profit Motive

The choice to manufacture in lower-wage countries is driven by the goal to reduce overall production costs and thereby increase profit margins. Reduced labor costs overshadow increased transportation costs, leading to increased profitability.

Relate Costs and Profits

By lowering labor costs, companies can reduce their cost of goods sold, which directly impacts their gross profit positively. Companies make this choice primarily to increase their profitability through decreased production costs.

Key concepts

International Manufacturing

When businesses choose to manufacture their products internationally, especially in countries with lower labor costs, they embark on a journey of intricate decisions. One of the main attractions is the potential to significantly lower their production expenses. International manufacturing offers access to a global workforce, often at a fraction of the cost compared to domestic production in higher-wage countries like the United States.
This choice can allow companies to achieve economies of scale, meaning they can produce larger quantities of goods at a lower cost per unit. However, venturing into international manufacturing also comes with its challenges. Companies must navigate different standards, cultural differences, and logistics.
The decision isn't solely about reducing costs but also about managing risk and ensuring quality. Some risks involve currency fluctuations and international regulations, which can affect overall profitability. Therefore, thorough market research and strategic planning are crucial when moving into international manufacturing.

Profit Margins

Profit margins represent the difference between how much a company earns from its sales and the costs involved in producing goods—expressed as a percentage. Increasing profit margins is a key motivator for companies considering international manufacturing. When manufacturing abroad, companies often see a significant drop in labor costs, one of the largest components of production expenses.
This decrease in variable costs means companies can sell their products at competitive prices while still maintaining or enlarging their profit margins.
However, while cutting down on costs is beneficial, ensuring that the quality of the product remains high is just as important. A drop in product quality can lead to a poor market reputation and ultimately affect sales, negating any benefits earned from lower manufacturing costs. It's the balance between cost efficiency and maintaining value that defines successful management of profit margins.

Labor Costs

In manufacturing, labor costs are a significant component of variable costs. Lower labor costs can dramatically reduce overall production expenses. This is perhaps the most compelling reason companies look overseas for manufacturing.
In many developing countries, the cost of labor is significantly lower than in developed countries such as the United States. Here, labor is abundant, and the competitive environment often drives down wage expectations, allowing companies to save massively.
However, there is more to consider than just the paycheck. Workforce skill level, labor laws, and work culture can vary widely between countries. Companies must ensure that the cost savings in wages do not negatively impact productivity and product quality.

• Ensure workers are skilled and reliable.
• Understand local labor laws to avoid penalties.
• Adapt to different work cultures to maintain productivity.

It's not just about cheap labor but getting the most value from that labor.

Supply Chain Management

Supply chain management in the context of international manufacturing involves many layers of complexity. It is the system that coordinates the movement of products from conception, through production, to the consumer's hands.
When outsourcing to countries with lower labor costs, supply chain management has to adapt to longer logistical processes. Businesses face the challenge of transporting goods across continents, which increases transportation costs and sometimes affects the speed of delivery.
Efficient supply chain management is crucial to counterbalance these increased costs. This can involve choosing reliable shipping partners, optimizing inventory management, and using technology for real-time tracking of goods.

• Good communication across the supply chain is essential.
• Technology can aid in smooth operations.
• Choosing the right partners can mitigate many logistical issues.

Conducting thorough risk assessments and having contingency plans can help maintain a robust and responsive supply chain.