Will digitalisation bring the end of FDI flows in manufacturing?

Digitalisation is easily the most widely discussed topic at any business conference these days. And frankly, who hasn’t heard the prediction that just as steam engines or electricity revolutionised our economies in the past, so digitalisation will change our world in the near future?

But what exactly is this digitalisation that the Germans call 'Industry 4.0' and which, despite being told constantly that it is important, we find so hard to get our heads around?

What it means

I’ll try to define what digitalisation might mean for the way we do business (let’s face it, the jury is still out where exactly this is going), and why this might result in a significant slowing of FDI flows.

The Oxford English Dictionary defines digitisation as “the action or process of digitising; the conversion of analogue data... into digital form” and digitalisation as “the adoption or increase in use of digital or computer technology by an organisation, industry, country, etc.” So what? Why should converting data into digital form, or the use of computer technology, suddenly change everything?

Even those who see the potential of digitising information, only look at it as being merely a bit of a productivity boost, rather than a paradigm shift in 'what we do' and 'how we do it'.

All we have worried about in the past 20 years has been how we do what we do a little bit more efficiently. Hence, our lack of intuitive understanding might simply be driven by the words and concepts we use to talk about this phenomenon. So much so that Roland Berger GmbH [1] felt compelled to stress that automation is not “Industry 4.0”; it is, at best, a small part of it. And because we are still stuck in our 'maximising efficiency' logic, and all of our concepts, words and metrics are geared towards that, we largely fail to see that digitalisation is not merely making the same old processes smoother, but is in fact changing the whole logic.

Changing the rules

Looking at your children should give you a bit of an insight into this. They use social media as much more than merely a convenient way of sending messages; it has changed how they interact with their friends. Industry 4.0 is very much like that; it is changing the rules of the game.

If you happen to be the owner of a book shop you probably grasp the gravity of this digital transformation better than the rest of us. The delight in the advent of computers and online traceability of the next-day delivery of merchandise for your shop presumably quickly evaporated when you found yourself facing the new paradigm of bookselling, called Amazon.

I do not want to downplay the potential of digitalisation in terms of efficiency gains in manufacturing. Parvianinen et al [2] claimed that “by digitising information-intensive processes, costs can be cut by up to 90% and turnaround times improved by several orders of magnitude”. This admittedly is more than only a marginal efficiency improvement, and well worth pursuing.

Just the first step

But this is nothing more than a small first step. Streamlining a few internal processes, knowing where your stock is (within your own warehouse or within the supply chain) or lowering your costs, by doing more with fewer people, is not what this is all about.

Industry 4.0 will change business models (presumably yours as well). It will turn the economic rationale on which we currently operate upside down. And I’d argue that this large-scale rejigging of business processes – the coming changes in production paradigms – will up end FDI flows and trade flows as we know them.

Grand words easily spoken, you might say. But who tells us that this is not the usual hyperbole about new technology we have become so accustomed to? Let’s first look at two examples in the fashion industry – which is ahead of the game in this field – and then try to figure out the underlying effects that might hit all of us sooner or later.

The first example is the German sport shoe manufacturer Adidas, making news with its first so-called 'Speedfactory' in Ansbach, Germany (with a second planned in the US city of Atlanta, Georgia). There Adidas plans to produce made-to-order shoes in less than a day via highly automated additive manufacturing and computerised knitting processes. Instead of the traditional model of producing hundreds of thousands of identical shoes in China, shipping them to Europe and selling them in their shops, the facility manufactures bespoke shoes when they are wanted.

Admittedly, right now numerically this is merely a drop in the ocean: Speedfactories produce about 500,000 pairs of shoes a year while Adidas is selling some 300 million pairs a year. But if the concept is successful, this is a paradigm shift toward locally produced, mass-customised advanced manufacturing.

Fashion’s paradigm shift

It is a paradigm shift that another fashion company has already successfully implemented and, which on the back of this, became one of the most successful and fastest growing players of the industry: Spanish clothing retailer Zara.

While all its major competitors base their production in low labour cost countries such as China, Indonesia or Vietnam, Zara’s main facilities are in Europe. Instead of producing in bulk and shipping items to Europe, it manufactures in small lots locally. Despite paying a multiple in hourly wages, Zara continues to gain market share.

The company manages to design, manufacture and distribute new products within two weeks while competitors need up to half a year for the same turnaround. There is no excess stock in Zara’s supply chain and it is said it manages to sell about 80% to 90% of its clothes at full price while competitors often barely reach the 60% mark. On the back of this localised production strategy, Zara has grown into a multi-billion-dollar business, out-stripping its low labour cost model competitors.

Much like Zara’s competitors, the underlying logic for many manufacturing companies was to offshore production to low labour cost countries in order to reduce unit costs. Over the past two decades, this has driven unprecedented FDI inflows into eastern Europe, China and Mexico, which were acting as workbenches for Western high-income countries. But two converging effects are about to bring this to an end: the rapidly rising labour costs in developing countries and the emergence of Industry 4.0.

While investors might have somehow swallowed the often quite significant cost increases in these countries (wages in Shanghai, for example, have doubled in the past decade), it is the paradigm shift caused by Industry 4.0 – in particular, advanced manufacturing, additive manufacturing and big-data analytics – that will precipitate a reshoring of large parts of production capabilities.

Why should that be the case? Most importantly, speed. If we look at this in the context of our shoe example: so far, your favourite running shoe is manufactured in China, travels to Europe on a journey lasting weeks (maybe months) via container ships and distribution centres, and is trucked across the country to finally reach a shop near you. In order to avoid stock-outs, Adidas needs to maintain stock levels covering a months-long delivery time to get new merchandise in. 

For any business, this translates into tied-up capital, warehousing costs and the risk that this particular shoe has gone out of fashion before it even hits the store.

Being able to design and produce locally would allow Adidas to produce only what it has sold already and dispatch with the end-of-season discount frenzies in order to clear stock that has not moved. In a world that is becoming more protectionist and uncertain by the day, it can also side-step transfer pricing uncertainties, import duties and currency fluctuations. 

With the share of labour cost in the 'total cost of unit' rapidly dwindling owing to Industry 4.0/advanced manufacturing, while hourly labour costs are drastically rising in Far Eastern factories, even the initial reason for offshoring is increasingly lost. So why do we have factories thousands of miles away from where we need the product?

How FDI will change

So what does this mean for FDI flows? Arguably, the days of so-called efficiency-seeking FDI are over. With rising labour costs in eastern Europe and the Far East, the erstwhile cost advantage is rapidly dwindling. More importantly, however, customer expectations and business models are changing. Design and development cycles will be measured in weeks rather than months, and – following the just-in-time logic of the automotive industry – products will increasingly be manufactured close to market and only when they are needed.

This in turn might bring large parts of traditional FDI flows into low labour cost countries to a standstill. Only if these countries are seen as potential markets will investors continue building factories there. Consequently, the massive trade flows from East to West, those shiploads full of finished goods, will start to dry up as an increasing share of goods will be produced locally.

We are on the eve of a new era of globalisation: one that many will call de-globalisation but that in effect is only a different form of global interconnectedness. For all those in FDI, this may very well mean that the days of large-scale manufacturing projects in emerging markets are over.

Martin G Kaspar is head of business development at a German Mittelstand company within the automotive industry and a PhD candidate at Durham University in the UK.

1. Roland Berger GmbH (2016), “The Industrie 4.0 transition quantified – How the fourth industrial revolution is reshuffling the economic, social and industrial model”, Think Act Series, Roland Berger, Munich

2. Parviainen, P, Kääriäinen, J, Tihinen, M & Teppola, S, (2017), “Tackling the digitalization challenge: how to benefit from digitalization in practice”, International Journal of Information Systems and Project Management, Vol. 5, No.1, p 63-77

3. World Economic Forum (2016), “World Economic Forum White Paper, Digital Transformation of Industries, in collaboration with Accenture, Digital Enterprise”