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Tuesday, December 28, 2010

The Cost of Manufacturing Overseas

In New Zealand we are upgrading our rail system.  We have recently contracted the manufacture of new rolling stock to South Korea.  I wonder how much cheaper rail cars would have to be to make it worthwhile to buy them overseas.  Lets look at the downside of manufacturing overseas.*

*incidentally, we have an industry which says it is quite capable of building our own rolling stock. It needs some expansion and since we are planning to continue to expand rail over the coming years, this would be very worthwhile.  The present order from Korea is just the start of our need for new rolling stock.

The Primary Tax Take
First there is the primary tax take.  The rolling stock construction company and all its workers pay income tas and GST.  Some estimates are that approximately 50%* of a workers salary goes back to the government.  This increases the money available to the government to do its work.  This revenue has been lost to the New Zealand government.  Looked at another way, if the train company is a government company (SOE), which it is in New Zealand,  then the price of the rolling stock is automatically reduced by the amount of tax they rake back from it's manufacture.  Just as a thumb suck, would this be a fifth of the cost.  If so, based just on the primary tax take, you would have to be able to buy your rail cars for 80% of the  cost of manufacturing them in New Zealand to make it worthwhile to do so.

*33% income tax and 15% Sales tax (GST)

The secondary Tax Take
The carriage building company buys some parts in New Zealand and every person working to build our own rolling stock, patronizes the local retail outlets.  The parts suppliers where the company shops and the super markets, furniture stores, hardware stores etc. where the workers shop, all pay taxes.  Their employees of all these companies pay taxes.  This tax revenue is lost to the government. Incidentally, the extra revenue that super markets furniture stores etc would make from the car building company and its employees is 'on  top'.  It is after their fixed costs and hence at their marginal tax rate.

Some parts bought overseas have various taxes on them as they come through our borders.  This goes to the government.  Looked at another way, parts from overseas are tax free to an SOE and hence less expensive  than to a private business as they pass our borders.

The workers of the super markets, furniture stores etc. also shop and the companies they buy from pay taxes...........*

*The calculation is an infinite series with a finite sum. (remember year 12 math) Give it to your maths boffin.  In a back of the envelope calculation, I suspect that the secondary tax take is about equal to the primary tax take.  If my initial thumb suck is correct, just based on the primary, secondary and tertiary etc. tax take, you would have to obtain rail cars overseas for 60% of the manufactured-in-New-Zealand cost to make the purchase worthwhile.  We are now at 60% of 80% which equals 48%.

Cost of Borrowing Money
Contracting rolling stock overseas further worsens our balance of payments.  A poor balance of payments has a whole range of deleterious effects on our economy including raising our bank interest rates.  Sending our manufacturing overseas makes life more expensive for every New Zealander.

The Welfare Cost.
I don't know how many people are out of work because our rolling stock is being made overseas.  Say 50 for the sake of argument.  Jobs are not just waiting to be filled in New Zealand so these skilled people don't have suitable jobs in their professions they can go to.    We have  high unemployment so every manufacturing job we contract overseas puts people out of work.  This increases the number of people on welfare.  Various estimates put the number of secondary jobs lost for each core manufacturing job at between 2 and 5.

The Lost Technical Capacity
As new technology becomes available, it is incorporated into newly manufactured goods.  From the descriptions in the media, there are many innovations in the new rail cars.  We have given Korea the chance to keep up to date with these innovations rather than keeping our own industry at the cutting edge.  We have degraded our own capacity for future manufacture.  This cuts into our prospects for future earnings.

Lost Advertising
If we were to build our own rail cars,  tourist who ride our rail will see that our cars are 'Made In New Zealand'.  Some of these tourists will be business men.  Realizing that our rolling stock is made here, they will realize that they can get us to make similar products for them.  Seeing that the rolling stock is made in Korea, they will go to Korea.  We are showcasing another country.

The Lost People
When we send manufacturing overseas and put people out of work, we send them overseas to look for work.  This is especially so with  highly trained people who  are not hugely motivated to seek a job stocking Super Market shelves.  Many land up in Australia - others further afield.  Getting things manufactured overseas  not only exports our dollars and our technical capacity but also our best and brightest further degrading our capacity for future earnings.

I suspect I have only just touched the surface.  I'll update this blog as more disadvantages of manufacturing overseas come to mind.  Can anyone put a figure on all the above.  How much cheaper would  rail carriages have to be before it would be worthwhile to buy them overseas instead of making them in New Zealand. Would it ever be worthwhile.  We must start to look at the true costs of our actions, not just the immediate costs.  If a private company contracted manufacturing overseas, you could understand if not forgive it.  They have a very narrow focus which only looks at the immediate bottom line of their individual company.  For an SOE to do this is myopic to the point of  criminal irresponsibility.  Of course an SOE operates just like a private company unless otherwise directed by the political party in power.  The responsibility for taking a wider view rests, at present, with the National Party.

A Government Argument
One of the arguments by the government for obtaining our rolling stock overseas is that it can be produced faster than our local companies can.  This would seem to me to be a disadvantage.  We have got along with the present situation for years and now suddenly we need all this new rolling stock within, say, three years.  Nonesense.  Far better to produce a three car unit and a new locomotive, put them into service, iron out any bugs and incorporate the knowledge gained into the next units.  I understand that the first unit to arrive in New Zealand from overseas did not meet our requirements so are we now have a whole bunch of these units which need fixing because of the speed of overseas manufacture.

There is another consideration.  Suppose for the sake of the argument, we could buy all the rolling stock in the first contract off the shelf from Korea or China and they could arrive on the first ship coming our way.  I would be willing to bet that this would overwhelm our ability to absorb them and they would take a good deal of time to get into service.  How much better to put these units into service one after the other and upgrade the support service as necessary.  How much better to be able to give feed back to our own company and upgrade the units as the need becomes apparent.

Below is a reply I received from  Jim Quinn of the SOE KiwiRail.  He has kindly given permission to include his reply in this blog.  I am grateful to Mr Quinn for presenting the other side of the argument.

Thanks for your email.  I read your blog and understand your point however you seem to have ignored some basic points:
·         The gap in the price points between local build and foreign build is far more than the benefits you discuss.
·         We have never built electric multiple units in New Zealand so we have little knowledge of the complexity of the build.  Using your logic we should build cars, trucks and jumbo jets here- that debate has long been negated.
·         There would undoubtedly be some local spin off of any build but the vast majority of the parts would come from overseas if we were to build here and we simply have no scale to buy well and competitively.
·         If we were to build here we take all the warranty and cost risk in the build.  I have great faith in our capability but projects like these can go wrong & we can’t afford that risk.
·         As an SOE our responsibility is the best commercial answer.  Other people’s job is to evaluate wider benefits.  That is the appropriate split of responsibility.

The worst thing we can possibly do is create manufacturing capability here that cannot be sustained.  So long term sustainability and affordability must be our first test if not we are simply making short term bad calls and wasting money.

I have been told by an 'informed source' that in Australia the rule is 75%.  A product has to be obtainable for 75% or less of the local price or it will be sourced within Australia.

It has been brought to my attention that a study was commissioned on this subject by the RMTU (Rail and Maritime Transport Union) and the DCC (Dunedin City Council).  It was prepared by the economists, David Norman, Dr Ganesh Nana and Kel Sanderson.  To see the whole report, click here,  go to the bottom and click on the BERL report.  In summary:

1.  38 three car multiple units (114 cars)  and 13 electric locomotives are to be built in this phase of our rail improvement.  They would cost $375m to produce in New Zealand

2.  The work would employ 1270 employees for a period of 45 months or 770 employees for 69 months

3.  This would add between $232m  and  $250m to our GDP

4.  If you consider just the immediate benefits, we would have to obtain the cars for 29% less than the cost of making them in New Zealand.  If we consider the wider benefits (see the start of this blog and note that in the BERL report there are benefits I didn't think of) we would have to be able to purchase them for 62% less than the overseas cost (ie for 38% of the New Zealand cost).

5.  The BERL report only deals with the financial side of the question.  It doesn't examine the human side of the equation such as the gut wrenching decision families need to make to go overseas to seek decent employment, leaving elderly parents, friends and the environment they love in order to work in a land of floods and drought.

There is much more in the BERL report that I haven't dealt with.


andrew said...

Good points. Are there any advantages to outsourcing the production of our rolling stock?

William Hughes-Games said...

I can't think of any but would like to hear any suggestions

benkepes said...

the only benefit of outsourcing is a gain in either technology or efficiency. This was the rationale used back in the 80s for wholesale privitisation of state assets

William Hughes-Games said...

I wasn't here then but my understanding is that this privatization was not exactly a success in terms of its benefits to New Zealand

John McCaskey said...

I saw hundreds of redundant passenger carriages in the Nairobi station yard. Same guage as NZ. Do the Kenyans some aid deal and refurbish for NZ service locally