Last Breath for Western European Supply Chains?

The European Union (EU) celebrated its 50th anniversary this year. What began as a free trade agreement for coal and steel between six Western European nations with the 1950 Paris Treaty has now become an elaborate — not to say complex — political and economical union of 27 countries. With a gross domestic product equivalent to that of the United States ($13 trillion) and one-and-a-half times as many people (460 million) in a much more concentrated area, the EU is a very attractive marketplace for businesses trading goods on a global scale.

However, the disparity and overall complexity of this market (not to mention the 15 different currencies, 24 official languages, 27 value-added tax, or VAT, regimes and other rather original pieces of legislation) create a unique business environment. As with most economic zones — such as the North American Free Trade Agreement (NAFTA), the Association of Southeast Asian Nations (ASEAN) or South America's Mercosur — it is also a place where it is somewhat easier to trade from within. Nevertheless, as reaffirmed by its leaders on April 30 at the EU/US Summit in Washington, the European Union remains committed to free trade and simplifying exchanges with its world partners.

Production Exile

In this context, the last few decades have brought rapid changes to the European economic system as a large number of well-established industries delocalized part or all of their production to lower-cost economies. Most Western European carmakers set up production lines in some of the freshly independent former Soviet satellite countries, such as Poland, the Czech Republic, Slovakia or Hungary, while textile manufacturers chose to move to Northern African countries like Algeria and Morocco, or Asian countries such as India, China, Thailand or the Philippines.

Following this path to some extent, many other industries either supporting these industries or independent of them (e.g. electronics, IT, business/customer services) also displaced or developed their manufacturing base outside of the European region. In some cases, these transitions left behind only niche-market players and rare exceptions, not to mention social and political disarray.

The direct impact of this migration was an increase in the distance between the producers and their market, adding to the process a number of intermediaries, thus increasing transit time and inflating inventory levels in the supply chain. As a result, the logistics and inventory carrying costs grew significantly, amplifying or adding new risks to the equation: oil and currency fluctuations, supply shortage or inventory excess and obsolescence, as well as intellectual property (IP) issues.

After years of searching for lower production costs, manufacturing companies began to focus on "total landed cost." The overall management of the supply chain and costs associated with it took center stage, leading a large number of companies to transfer, or consider the transfer of, "in-region" assembly, configuration and distribution activities to Central and Eastern European countries. Countries such as Poland, the Czech Republic, Hungary or new EU members Bulgaria and Romania are proving very successful in attracting such business.

An Attractive Proposition

This trend is significant. Rare are the companies in the top five of their respective industries that do not have a footprint in, and/or their products destined for, the Europe, Middle East, Africa (EMEA) market flowing through one of the locations mentioned above. Providers of supply chain outsourcing services have seen recent growth in volume and expect to see more growth potential as most executive surveys highlight companies' intentions to hop on the bandwagon. And why shouldn't they? Eastern Europe has a lot to offer, including:

• Labor rates for basic skills at approximately one-quarter of Western country rates.
• Highly educated work forces that are by no means lagging behind Western standards (as is often wrongly assumed).
• Dedicated, multilingual and readily available young populations (e.g., Poland still runs an unemployment rate of 15 percent, approximately twice the EU average).
• Governments open to the market system and ready to offer incentives.
• A central position within the extended EU and overall continent.

In light of these convincing reasons to set up operations in Eastern Europe, one might wonder if there are any reasons left to maintain any part of the supply chain in Western Europe.

A Logistics Challenge

Although the arguments in favor of Eastern Europe are compelling, the news is not all bad for Western Europe. First of all, a victim of its recent success, Eastern Europe is facing serious capacity issues, with road infrastructure that is inadequate to cope with the extra traffic generated as a result of recent development. The best logistics locations (around capital cities or in industrial regions such as Prague or Budapest) — already occupied by the first movers — are showing signs of overheated economies, with skills shortages, earnings and property prices growing much faster than the EU average.

With the notable exception of Poland, these countries also either are landlocked (e.g., the Czech Republic or Hungary) or have limited maritime access for container ships (e.g., Bulgaria or Romania, through the Black Sea). This is much to these countries' disadvantage when more than 90 percent of goods imported into Europe travel by sea and currently arrive through Rotterdam (Holland), Hamburg (Germany) or Antwerp (Belgium) for at least half their total volumes. Thus shipping a container to Czech Republic or Hungary can prove up to 30 percent more expensive than going through the Netherlands, Germany, Belgium, Spain, the United Kingdom or France.

For faster moving goods being shipped via air, the balance would again be much more in favor of Western countries, as more than half the volume of European air cargo flows through Frankfurt, Paris or Schiphol. Even though airports in areas such as Vienna and Prague are competing to become the next European cargo hub for Central Europe and are growing apace, it will be years before they can rival their Western European counterparts in terms of throughput, lanes and management of future larger cargo aircrafts.

Development Issues

Most Eastern European democracies are no more than 15 years old, and importers share a common concern about security. Even though this controversial argument is often abused by Western competition, it is valid in certain cases as, for example, when trading highly valuable products. While significant progress has been made in this area, theft and corruption are still a reality. Where the majority of Western nations would score around seven or eight on the Corruption Perception Index published by Transparency International, the vast majority of Eastern countries are still below the average of five points.

Qualified workers remain another concern. If the potential labor cost differentials are certainly attractive eastwards, it should also be said that these tend to decline as qualification and responsibility levels increase. As elsewhere, skills come at a price, and in fast growing economies, demand tends to be greater than the amount of skills available. Managers are also mobile and well aware of the earnings of their Western counterparts. Therefore, average salary differences between East and West managers tend to be much smaller than those of unqualified workers (if not much superior compared to the West in terms of purchase power parity).

An Uneven Distribution of Purchase Power

More importantly, from a market standpoint, even though Eastern European consumption is starting to show some interesting potential, purchase power is still unevenly distributed in favor of the West. To take the hi-tech/consumer electronic industry as an example, it is very common to observe a multi-tier distribution profile as follows:

• Tier 1 — the United Kingdom — Ireland, Germany — Austria and France (60 to 80 million inhabitants each) — is usually the destination for more than 55 percent of total European volumes (i.e., 17-20 percent each). It is also the primary market for new product introduction and a very sensitive market for localized products (e.g., French- or German-language packaging).
• Tier 2 — Italy, Spain, Portugal and the Benelux countries (Belgium, the Netherlands and Luxemburg) — comes next, grabbing a significant piece of the cake (25 percent in total, or about 8 percent each).
• Tier 3 — Switzerland and the Nordics (Norway, Sweden, Finland and Denmark) — would account for another 10 percent of that European volume (5 percent each). It also brings mild distribution challenges with regard to customs (Switzerland and Norway are not EU members) and access (heavy good vehicle traffic restrictions in Switzerland and no ground access to most of the Nordics).
• Tier 4 — consisting of all remaining EU and non-EU countries of the European continent — accounts for the remaining 10 percent of volume.

If this "average pan-European outbound volume profile" only represents a specific industry in 2005-2006, it no doubt demonstrates how consumption of some products can be concentrated in Western Europe (Tiers 1, 2 and 3 total up to 90 percent of Europe's volumes). For this reason, attention should obviously be paid to distribution costs that are likely to soar together with lead times when locating facilities in Eastern Europe.

A Labor versus Logistics Cost Tradeoff?

At the end of the day, it seems that most European supply chain location decisions are based on a tradeoff between labor costs and inbound/outbound freight costs (some would even include inventory carrying costs in relation to the extra inbound lead time of three to five days and outbound of one to three days from East to West). As the need for in-region configuration increases and more supply chain decision-makers opt for postponement strategies (i.e., increased labor content), the balance often falls in favor of Eastern Europe — and rightly so from a total cost perspective. However, based on observations around the consumer electronics and communication segments, some additional elements are worth considering in relation to these costs drivers beyond the pure cost aspects of the business.

Indeed the question, "Does my business require a supply chain element in Western or Eastern Europe?" might just be misleading and missing the point. As most companies grow and products develop through different stages, with different product characteristics, distributed via different channels, a more appropriate question could be, "What piece of my supply chain should be located in Eastern and/or Western Europe, and when?" Following are a few considerations to help executives in answering that question:

• Product lifecycle (see Fig. 1): Time-to-market and availability are often critical to achieve initial growth in market share. Therefore, a Western location — close to primary, early-adopters and less price-sensitive markets — is the most appropriate choice. As a product becomes more commoditized and volume grows exponentially, the benefits of an Eastern solution might become more apparent.
• Product lines and characteristics: What is right for a particular product range or product line in a company's portfolio might not be right for all others. The higher the value (i.e., purchase power, risk of shrinkage), the shorter the lifecycle (air freight, critical time-to-market), and the lower the configuration requirement (e.g., pure cross-docking of finish goods), the more appropriate a Western location becomes.
• Distributions channels: Different customer types also have different ways to trade and different expectations driving different logistics costs. It is difficult to put a price on the logistics aspect as there is no real basis for comparison. However, it is a fact that the lower the number of units per shipment (e.g., business-to-consumer) and the faster the delivery (as with e-business), the higher the correlation between distance and freight costs.

The Best Solution?

Things are changing — and changing very fast — but as consumption will tend to level, so will living standards and labor rates. The unknown is how quickly the EU will be able to overcome the infrastructure deficit. Far from attempting to suggest any one best way of designing pan-European supply chain solutions, this article is intended to help decision-makers looking to optimize their revenue to build some level of flexibility in alignment with their strategic objectives. Doing so will most likely involve — either in sequence (transitional models) or in parallel (hybrid models) — an East-West collaboration.