August 20, 2013    Volume 20, No. 11

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Globalization Forces Major Change In Business Classification System: One Result Will Be That Imports From Manufacturers That Have Outsourced Production Offshore Will No Longer Be Considered Imports

By Richard A. McCormack, Editor

U.S. federal agencies involved in economic data are on the verge of a major and transformative change in the way they classify companies that have outsourced their U.S. production to foreign manufacturing contractors.

The change could radically increase U.S. production statistics by classifying "factoryless goods producers" as domestic manufacturers. Companies like Apple will no longer be considered "wholesale traders," and their sales would be counted as U.S. production, even though none of their manufacturing is in the United States.

Imports by American companies that outsource their production to foreign manufacturers also would no longer be counted as imports, thereby impacting the balance of U.S. international trade accounts.

The idea is for the federal government to determine how much production has been offshored and to pinpoint the number of American companies that are linked to manufacturing, even though they don't make the products they design and sell.

The changes now being finalized by the U.S. government would be implemented in the 2017 North America Industry Classification System when factoryless goods producers will be classified as U.S. producers. The new classification system of manufacturers would introduce "significant discontinuity" to a wide range of statistics gathered by the government, say those involved.

There is disagreement on whether it is even viable to place factoryless goods producers in the category of domestic manufacturing. Adds one economic statistician: "If you start counting foreign-produced goods as U.S. production you could be introducing a huge misinterpretation of the manufacturing [data] series."

Potentially a dozen major government statistical series could be impacted by the change. Industrial production, international accounts, national income product accounts, regional accounts, producer price indexes, international prices and industrial productivity are just some of the statistical series that will undergo significant discontinuity.

"For the purpose of balance of payments, goods that are manufactured overseas for U.S. companies are not going to be considered imports any more, they are going to be just U.S. production," notes William Powers of the International Trade Commission.

Classifying U.S. factoryless goods producers that have outsourced their production overseas as U.S. "manufacturers" has been discussed for more than a decade. Economic statisticians have been perplexed by how to categorize companies that no longer manufacture the products they design. It doesn't make sense, they say, to classify Apple as a "wholesale trader."

The change in classification means that companies like Apple, Nike, Cisco, fabless semiconductor companies, and, for instance, the hundreds of American companies that design apparel and garments and have them manufactured in Bangladesh, will also be classified as manufacturers, again, with their imports measured as U.S. output.

The U.S. Economic Classification Policy Committee (ECPC), an obscure group proposing the change, believes that imports and exports "should be recorded on a strict change of ownership basis," it says. If there is no change of ownership of a product being imported, then it should not be considered an import, says the committee made up of representatives from the Bureau of Economic Analysis, the Bureau of Labor Statistics, the Census Bureau and the White House Office of Management and Budget.

Fundamental global changes in production due to outsourcing "have introduced complexities into the production of economic statistics, forcing a re-examination of traditional economic measurement concepts related to industry classification for establishments and the value of a country's outputs, and exports both within the U.S. and internationally," says Maureen Doherty of the Bureau of Labor Statistics. "Economic activity classification systems did not address how to handle the output of establishments that outsourced certain production tasks. . . [T]o the extent that production tasks were outsourced internationally, questions were raised concerning how the outsourced accounts were handled in National Accounts and Balance of Trade statistics."

U.S. statistical agencies found that the North American Industry Classification System (NAICS) did not provide a clear definition of companies that outsourced their production overseas, but that still owned the design and controlled the production and sale of goods from that foreign production. In 2008, the Economic Classification Policy Committee created a "Manufacturing Transformation Outsourcing Subcommittee" and told it to define outsourcing and identify "characteristics of establishments that outsource manufacturing transformation activities."

The committee considered numerous options on how to classify factoryless goods producers -- and it issued a Federal Register Notice in January 2009 seeking input on how it should classify these companies. Only 10 comments were received, "with a split of opinions as to how factoryless goods establishments should be classified," says Doherty.

The committee decided that all factoryless goods producers "should be classified in manufacturing, the specific industry classification based on the transformation production process used by the contractor," Doherty explains.

But the change has raised questions. Should a company be considered a factoryless goods producer if it does not own any of the materials, equipment or the processes that are used to produce their product? How about risk? Does a factoryless goods producer that shifts risk -- the need for a contract manufacturer to obtain credit in order to purchase inputs and equipment based on an order -- still control the output of an order even if there are contractual payment terms that do not provide it with ownership until delivery?

The committee came up with a concept of "economic ownership" for factoryless goods producers, describing them as owning or controlling the rights to intellectual property or design of the product being produced offshore. Factoryless goods producers can independently change the product design; they control production by controlling inputs, choosing product lines and setting output levels. They own the final product and set its price. They sell the final product or arrange for the sale of the final product. They assume entrepreneurial risk and are responsible for losses. And they can report market value of the final product -- the number of units they produce and sell and the cost of the foreign manufacturing services.

The goal was to adopt the new classification system by 2012. But the group realized that any changes had to be implemented in conjunction with the five-year Economic Census, and it wasn't possible "given the complexity of the changes . . . [and] number of difficulties related to the detailed steps that would be required to accurately measure economic activity under the new definitions," says Doherty.

The committee recommended "that full implementation of the outsourcing redefinitions should be delayed with the goal of the 2017 Economic Census." This recommendation was accepted by the Economic Classification Policy Committee and OMB in November 2010.

None of this will be easy and it might be controversial, according to those who have been following the committee's work. "The government is going to have to explain the nomenclature of who owns the materials that go into a production process and who owns the equipment," says one economic statistician. "What if the equipment is fully contracted out by the contractor? Can an American management company or an R&D company now be considered to be a manufacturing firm, even if they have never designed a manufacturing process and if they jump from one contract manufacturer to another? Try to explain that to a company in a data survey the government wants to collect."

Reclassifying to "manufacturing" the thousands of companies that are currently engaged in wholesale trade and have outsourced production could affect more than just statistics. Even OSHA could be involved: "If these American companies are classified as manufacturing companies and their [foreign] output is considered to be part of U.S. production, then why should the United States not have OSHA regulate their production in China?" asks one observer. EPA and FDA might also want to check out "American" production that is offshore.

The changes mean the federal government is going to have to start a widespread outreach program to companies and associations with the goal of them understanding "how establishments typically manage and record outsourcing activities," says Doherty. "[T]he acceptance of the concept of a factoryless goods producer will require a paradigm shift for many people and organizations. As a result, the Economic Classification Policy Committee determined that an educational outreach campaign is necessary to explain the changes prior to the publication of data based on redefinitions."

Says William Powers of the ITC: "We need to get a sense of global integration and how much there is and what our policies will actually be. We don't know the extent of this phenomenon and the ways we can measure it don't work very well. We need to have a sense of knowing how many companies are tied to U.S. manufacturing. The ECPC and the people [involved in factoryless goods classification] are not looking at this as a way to make U.S. manufacturing look better. They just want to know how much of this exists. If you can say, 'Look at how much more factoryless goods production there is in this industry versus another industry and which regions have been affected,' then you will have facts that will support one position or another [on outsourcing]. Currently with our official statistics, we don't have those facts."

With solid data on factoryless goods production, there could be a much better basis for determining if technology and productivity are the primary cause for the decline in manufacturing employment, as many economists argue, or if that decline is being driven by outsourcing. "If you have the data that comes from separating those two things, then you can start the argument by taking it well beyond anecdotes," says Powers.

But how are jobs going to be handled in the new data series, asks Manufacturing and Technology News Editor Richard McCormack. While Apple has 50,000 U.S.-based employees, its CEO has stated that there are 1.2 million people employed making Apple's products in China and elsewhere. Executives at American companies, stockholders and those who live off investment income benefit from outsourcing and factoryless goods production offshore, but how about the workers? In today's world, the only thing that matters is who has the jobs and goes home with a paycheck. If the government is so interested in factoryless goods production offshore and will classify imports as U.S. production, then why won't it ask those same companies how many people they employ in those operations offshore? And if they are classifying those companies' output as U.S. production, then why wouldn't it classify their contract workers creating that output -- such as those at Foxconn in China making all of Apple's products -- as American workers?

Powers responds: "That area has been very understudied in the global value chain literature. You can plug in the job numbers. You can plug in the input-output methods and you can plug in a job per value of output just as well as you can a dollar of value added per unit of output, but that hasn't been well studied, so it is tricky. But once these data come in, they will affect job estimates. They won't give you what you are looking for exactly, but they will give you a sense of the value of what's being done domestically and what's being done by factoryless goods producers that outsource overseas. Once you have a value, then you can answer that question."

A variety of economic papers were presented on the topic at a conference held earlier this year by the Upjohn Institute:

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