Q & A With Barry Jaruzelski, Booz Allen Hamilton
Jaruzelski: On balance, 2007 was a solid year for industrial manufacturers, despite a slowing U.S. economy in the second half and fear of a 2008 recession. As of late November, the Dow Jones Industrial Average and the Standard & Poor’s 500 Index had both gone up four percent. Unfilled orders for U.S. manufactured goods reached their highest levels in 15 years this past fall, with export sales rising almost 14 percent for the year, according to the U.S. Bureau of Economic Analysis. However, industrial production fell by 0.5 percent in October, with U.S. capacity utilization declining to 81.7 percent from September’s 82.2 percent.
More ominously, however, global prices for essential raw materials such as copper, steel, and plastic resin resumed their upward climb following a pause in 2006, while oil prices rose nearly 50 percent between January and November. Oil prices in excess of $100 per barrel hit U.S. manufacturers especially hard, since the U.S. dollar has lost more than 25 percent of their value against the Euro since 2000. Given the enormous U.S. current account deficit, the real surprise may be that the dollar’s decline did not begin sooner. Meanwhile, credit market jitters and declining U.S. home values shook the confidence of consumers and businesses alike. With more than 70 percent of the U.S. economy being consumer driven, it is only a matter of time before consumers’ diminished net worth and their mounting concerns about the future begin to dampen the overall economy, impacting industrial production.
Q: What significant trends can industrial manufacturing expect in 2008?
Jaruzelski: The twin prospects of slow or negative economic growth coupled with the likelihood of further declines in the dollar, form the backdrop for our views about important industrial manufacturing trends in 2008. We believe the U.S. companies that will emerge as winners in the coming year will be those that best prepare for both:
- A harsh economic environment that will challenge every North American business to achieve greater end-to-end efficiencies.
- Expanding export opportunities via the cheaper dollar that will alter manufacturing strategies and global trade patterns for years to come.
Jaruzelski: The silver lining in an increasingly cloudy economic season is the incentive it provides to prepare for the next surge in growth. Well-managed companies respond to an economic slowdown by fixing inefficiencies, lowering costs, and becoming more competitive. The coming slowdown should be no different, because industrial manufacturers have ample opportunities to make themselves leaner and more globally competitive. Managing industrial companies through a period of slowing sales and rising commodity prices will be challenging because they are capital-intensive enterprises with high fixed costs. Even so, most could do a far better job of managing their operations.
Better rationalizing of product and service offerings is one area of opportunity. In the past, we have discussed what we call "smart customization"—which means responding selectively to customer demands for increased customization of products and services. Put simply, companies need to ask themselves, Is each customer really paying for all the complexity we create in our operation in order to serve that customer’s unique needs? The same principle applies when manufacturing companies provide customers with tailor-made solutions as opposed to products. By providing solutions without requiring that a customer pay for the additional expertise and service involved, manufacturers sacrifice efficiency and erode their margins, often without realizing the magnitude of the impact on customer profitability.
For example, one midsized industrial company sells only bare-bones products to a giant discount retailer, knowing that the retailer pays only rock-bottom prices. Such a policy makes sense for the largest customers that have the scale and the resources to perform machinery installation, maintenance, and other after-sales support services for themselves. By contrast, when dealing with smaller retailers, the same industrial manufacturer provides highly tailored solutions that include extended warranties and financing, for which smaller companies are willing to pay a premium.
Q: What types of opportunities might exist for manufacturers in today’s global climate?
Jaruzelski: The declining U.S. dollar has positive implications for U.S. manufacturing. U.S. exports have already strengthened as a result of the weakened currency, and the nation’s trade deficit has begun to improve as well. In 2007, Europe’s exports to China actually fell, while U.S. exports were up 15 percent. In recent years, the U.S. consumer has been the most important driver of the global economy, despite short-term fluctuations in currency values.
Given the phenomenal economic growth of India, China, and other emerging economies, the U.S. is unlikely to maintain such a central role in the future. The U.S. consumer’s diminished purchasing power, coupled with the declining dollar, points to a permanent shift in the global marketplace. For industrial manufacturers and many other sectors, globalization must now become the top priority. Currently, 45 percent of the earnings of the S&P 500 are already from non-U.S. sources, and this proportion will likely grow in coming years as exports expand. The dollar value of non-U.S. earnings will grow as well, if the greenback continues its slide, as is expected.
For years, most American manufacturers have talked about globalization as a strategic focal point, but relatively few have actually reoriented themselves to become export-driven. For many, it is now imperative to do so. As part of that reorientation, U.S. manufacturers must begin developing localized capacity to service overseas markets. A major finding of Booz Allen’s third annual analysis of the world’s 1,000 largest corporate R&D spenders has important implications for all manufacturers: The most significant differences in returns on R&D investments are based on the extent to which companies directly engage customers to develop new products. Companies that focus on obtaining direct customer insight throughout the innovation process reported more than three times higher operating income growth, 75 percent higher total shareholder return, and more than two times greater return on assets than companies less focused on direct customer input.
This year’s Global Innovation 1000 study also reinforced an important finding from last year: The relative handful of companies that we call "high-leverage innovators"—those that consistently outperform peers while simultaneously spending less on R&D as a percentage of sales—have three things in common, regardless of which industry they’re in. They share a well-integrated, end-to-end approach to innovation at each step in the process; a strong understanding of the needs and desires of customers and end-users; and transparency throughout the innovation process, so that investment decisions and assumptions can be understood, debated, and anticipated across the enterprise.
In addition, American industrial manufacturers must learn to view the domestic market in the same way that global competitors do. The declining dollar will make it easier and more attractive for foreign competitors in a widening array of product sectors to invest in U.S. operations, putting still more pressure on companies whose primary focus remains domestic. The Detroit Three U.S. auto manufacturers learned years ago that foreign auto companies could manufacture in the U.S. more profitably than they could. That same principle now applies to a growing array of companies making items such as recreational vehicles and large, hard-to-ship appliances.
Finally, globalization is increasing the burden on most companies to ensure product quality and sustainability. The lead paint found in Chinese-manufactured toys this year, along with tainted Mexican, Chinese, and Southeast Asian food exports, is making consumers in developed nations more wary of almost any product originating in distant, low-cost countries. There is also mounting concern among developed nations about the full spectrum of green issues—especially energy efficiency and carbon emissions. For example, Australia, California, and the U.S. Congress have all introduced legislation to ban the common incandescent lightbulb in favor of new, energy-efficient, compact fluorescent bulbs, and governments will soon focus on consumer appliances such as computers and televisions. It is only a matter of time before industrial products receive the kind of environmental scrutiny previously reserved for passenger vehicles.