The changing nature of manufacturing

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The McKinsey Global Institute has released a new report: Manufacturing the future: The next era of global growth and innovation. (See also Neil Irwin's summary in the Washington Post: "American manufacturing is coming back. Manufacturing jobs aren't.")

This is the the latest in a long series, by many authors, of important reports on manufacturing. The McKinsey report reiterates and reinforces much of the recent work on why manufacturing matters to the U.S. economy -- the contribution to GDP, productivity, exports, R&D and innovation, etc. More importantly, the report makes two point that often gets overlooked in the discussion, especially the policy discussion.

The first concerns the differences within the manufacturing sector:

In order to craft effective business and policy strategies in manufacturing, it is important to start with an understanding of the fundamental differences between manufacturing industries.

They segment the manufacturing sector into five groups:
 •  Global innovation for local markets such as chemicals (including pharmaceuticals); automobiles; other transportation equipment; and machinery, equipment, and appliances.
 •  Regional processing industries such as food processing and other industries that locate close to demand and sources of raw materials.
 •  Energy and resource-intensive commodities such as basic metals.
 •  Global technology industries such as computers and electronics.
 •  Labor intensive tradables such as apparel manufacturing.

We find this segmentation a helpful way to see the global nature of different industries, anticipate where manufacturing activities are most likely to take place, and understand the role of innovation in various industries. For companies, the segmentation helps to explain the evolution of different parts of their operations, from individual business units to various stages of their supply chains. The segmentation can also clarify the differences between segments of the same industry--why suppliers of automotive electronic components respond to very different dynamics than suppliers of mechanical parts, for example. The framework also helps explain why the needs and factors of success vary even within the same industry; the carmaker that emphasizes its technological edge and precision engineering has very different requirements than the producer of low-cost models.

The second is a point I have made over and over again: The distinction between manufacturing and services has blurred.

Manufacturing has always included a range of activities in addition to production. Over time, service-like activities--such as R&D, marketing and sales, and customer support--have become a larger share of what manufacturing companies do. More than 34 percent of US manufacturing employment is in such service-like occupations today, up from about 32 percent in 2002. Depending on the segment, 30 to 55 percent of manufacturing jobs in advanced economies are service-type functions (Exhibit E5), and service inputs make up 20 to 25 percent of manufacturing output.
Manufacturing companies rely on a multitude of service providers to produce their goods. These include telecom and travel services to connect workers in global production networks, logistics providers, banks, and IT service providers. We estimate that 4.7 million US service sector jobs depend on business from manufacturers. If we count those and one million primary resources jobs related to manufacturing (e.g., iron ore mining), total manufacturing-related employment in the United States would be 17.2 million, versus 11.5 million in official data in 2010. Including outsourced services, we find that services jobs in US manufacturing related employment now exceed production jobs--8.9 million in services versus 7.3 million in production.
Just as manufacturing creates demand for services inputs, services also create demand for manufactured goods. For every dollar of output, US manufacturers use 19 cents of service inputs, creating $900 billion a year in demand for services, while services create $1.4 trillion in US manufacturing demand. In China manufacturing creates $500 billion in services demand, and services demand $600 billion a year in manufactured goods. And while manufacturing drives more than 80 percent of exports in Germany, services and manufacturing contribute nearly equal shares of value added to the country's total exports.

The report sees manufacturing facing a new set of challenges and opportunities:

Some forces are already being felt: the shift of global demand toward developing economies, the proliferation of products to meet fragmenting customer demand, the growing importance of value-added services, and rising wages in low-cost locations. Other trends are now becoming more pronounced, such as a growing scarcity of technical talent to develop and run manufacturing tools and systems, and the use of greater intelligence in product design and manufacturing to boost resource efficiency and track activity in supply chains.
...
A rich pipeline of innovations promises to create additional demand and drive further productivity gains across manufacturing industries and geographies. New technologies are increasing the importance of information, resource efficiency, and scale variations in manufacturing. These innovations include new materials such as carbon fiber components and nanotechnology, advanced robotics and 3-D printing, and new information technologies that can generate new forms of intelligence, such as big data and the use of data-gathering sensors in production machinery and in logistics (the so-called Internet of Things).

The report contains a number of insights for company managers and public policy makers. From my perspective, the conclusions on policy are the most relevant:

As manufacturing evolves, policy makers must adjust their expectations and look at manufacturing not as a source of mass employment in traditional production work but as a critical driver of innovation, productivity, and competitiveness. Policies aimed at promoting the health of manufacturing industries also must incorporate the crucial contributions that service employees, services suppliers, and collaborators make. Take exports: between 2000 and 2011, services exports grew slightly faster than goods exports in most advanced economies. In addition, services such as training and maintenance are a growing complement to equipment and machinery exports.
Policy needs to be grounded in a thorough understanding of the diverse industry segments in a national or regional economy and the wider trends that are affecting manufacturing industries.

When it comes to policy prescriptions they have the following advice:
As policy makers develop new approaches to support manufacturing, they need to consider the full policy tool kit.

Unfortunately, they shy away from the difficult policy task:

We do not attempt to settle the questions about what constitutes appropriate policy--or whether policy interventions are even warranted. We do provide policy makers a framework and approach for designing and implementing effective manufacturing strategies for today's environment, with examples of how nations have reinvented manufacturing sector strategy.

They do reiterate many of the existing policy perceptions: R&D and innovation -- including technology commercialization, standard setting and overcoming the "valley of death"; education and skill development; and reducing regulatory barriers.

Probably their most important recommendation is this: Work with trends, not against them
One of those trends is the shifting nature of production and the increasing irrelevancy of the dichotomy between manufacturing and services -- as the report points out. As we pointed out in our Policy Brief--Intellectual Capital and Revitalizing Manufacturing, manufacturing is an knowledge and intangible asset based activity with a emphasis on "production" beyond "manufacturing." We need policies (as outlined in the Working Paper) that recognize that fact.

The McKinsey report is a useful addition to the policy debate. However, much still needs to be done. Let us hope that policy makers will look carefully at the report and continue the development of a 21st Century "production" strategy fitting to the I-Cubed Economy.

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