April 16, 2007    Volume 14, No. 7

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Manufacturing Productivity Growth Isn't What The Government Measures: Numbers Are Inflated By Cost Reductions From Offshore Outsourcing



BY RICHARD McCORMACK
richard@manufacturingnews.com


The federal government's measure of productivity growth of the U.S. manufacturing sector during the past 15 years may be widely overstated due to outsourcing and the shift to offshore production of goods, according to a study from the Upjohn Institute for Employment Research. Productivity measures do not account for outsourcing and offshoring and are, therefore, "misleading," writes Susan Houseman in a study entitled "Outsourcing, Offshoring and Productivity Measurement in U.S. Manufacturing."

"Productivity growth is the basis for improvements in workers' standard of living," Houseman writes. "Yet, widespread improvement in American workers' wages has not accompanied the rapid growth in measured U.S. productivity. Outsourcing and offshoring may help explain some of this puzzle."

Manufacturing companies are outsourcing functions and offshoring production because of the inducement of cheaper labor and lower costs. These cost savings are then recorded as productivity improvements in the multifactor productivity calculation.

"The growth of outsourcing and offshoring in industrialized countries makes it exceedingly difficult for government statistical agencies to measure changes in the flows of inputs into the production process and hence to accurately measure productivity growth," Houseman states. "In addition, the growth of outsourcing and offshoring raises conceptual issues about what productivity statistics do and should measure, with implications for how they should be interpreted and who will benefit from measured productivity gains."

Houseman calculated that outsourcing of manufacturing services jobs accounted for about half of a percent point of the growth in manufacturing productivity between 1990 and 2000, dropping the growth rate from 3.71 percent to 3.17 percent. It's more difficult to factor in offshoring of production overseas in the manufacturing sector because the government does not track the shift of production offshore. It's also difficult to ascertain productivity growth in the overall manufacturing sector because virtually all of the gains in productivity during the 1990s were driven by the high-tech industry. That industry was a leader in shipping its work offshore.

"Foreign labor is counted as a separate input, weighted by its cost share, and hence, in as much as lower hourly foreign labor costs are not commensurately matched by lower productivity, cost savings from offshoring will be counted as productivity gains," writes Houseman. "To the extent that offshoring is an important source of measured productivity growth in the economy, productivity statistics will, in part, be capturing cost savings or gains to trade but not improvements in the output of American labor and should be interpreted with caution.

"While economic theory holds that improvement in a population's standard of living is directly tied to its productivity growth, one of the great puzzles of the American economy in recent years has been the fact that large productivity gains have not broadly benefited workers in the form of higher wages. A better understanding of what our productivity statistics actually measure potentially provides some answers to this puzzle." Houseman says that her findings provide "a direct link between productivity measurement, offshoring and inequality."

Productivity improvements from offshoring "may largely measure cost savings, not improvements to output per hour worked by American labor," she writes. "Productivity trends may be an indicator not of how productive American workers are compared to foreign workers, but rather of how cost uncompetitive they are vis--vis foreign labor. Although the productivity numbers may capture some net gains to the American economy from trade, there is no reason to believe that these gains will be broadly shared among workers. The very process of offshoring to cheap foreign labor places downward pressure on many domestic workers' wages and simultaneously increases measured productivity through cost savings."

Quotable:

"In practice, a company may lower costs by shifting to less productive but substantially lower-cost contract labor, and from the company's perspective output per worker hour would fall, but measured productivity...would rise. Such a case is nicely illustrated in a recent consulting report by McKinsey (2006), which compares the R&D costs to Cisco Systems of developing switching routers with its own U.S.-based engineers versus outsourcing the R&D development to a Chinese company, Huawei Net Engine.

"According to McKinsey's estimates, the amount of work hours required by Huawei's engineers to develop the product is roughly double that required by Cisco engineers, but because labor costs of Chinese engineers are dramatically lower than those of American engineers, McKinsey estimates that the cost [of] R&D development in China is about one-fifth that in the United States.

"If Cisco outsourced the R&D development to China and actual work hours were measured as labor input, labor and multifactor productivity would fall. However, because the Chinese contract labor is treated as a separate input and weighted by its cost share, multifactor productivity measures would increase."

-- Susan Houseman, Upjohn Institute for Employment Research, "Outsourcing, Offshoring and Productivity Measurement in U.S. Manufacturing," Revised Edition Feb. 2007



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