Qualityworld
Making up
After a dip at the start of the decade, UK manufacturing seems to be on the up, says economist Sukhy Ubhi. He examines how UK manufacturing has been responding to the challenges posed by globalisation and adapting to life with a stronger pound
Manufacturing experienced a sharp recession in the early years of this decade, with output falling by four per cent between 2000 and 2003. While there are many and varied reasons for the downturn, movements in the exchange rate were undoubtedly a factor. The pound strengthened substantially against its main trading partners in the late 1990s, weakening the competitiveness of UK exports. The situation was exacerbated by the 9/11 terrorist attacks, which had ripple effects on the world economy that further set back demand from key trade partners. Meanwhile, low-cost countries, such as China, India and those in Central and Eastern Europe started to become major players as sources of low cost goods.
More recently, however, manufacturing has staged a recovery, showing healthy growth in 2004, with a host of surveys suggesting a strong performance in 2006. Companies have had to restructure to reduce costs and also to look hard at the products and services they offer to the market. There is also the need to capitalise on the opportunities presented by emerging economies.
Make, do and mend
The recovery in manufacturing is illustrated by the Engineering Employers Federation (EEF)'s business trends survey of manufacturers. The quarterly survey asks 1,100 firms whether their output, orders, prices and investments have risen, fallen or remained the same over the past three months. The proportion of companies reporting rises minus the proportion reporting falls gives a percentage balance for each indicator. These balances paint a picture of recent trends. In addition, companies are asked the same questions about their prospects over the next three months, which reveals how confident firms are about the short term.
EEF's latest third quarter results were the best for nine years. Output and order balances have consistently come in above trend this year. Meanwhile, the internationally respected Chartered Institute of Purchasing Surveyors' (CIPS) manufacturing index has indicated expansion for 14 consecutive months. Between the start of 2006 and August, National Statistics have indicated that manufacturing and engineering output rose by 1.8 per cent and 2.5 per cent, respectively. So far this year, manufacturing growth has outpaced growth in the UK economy as a whole. The pick up in engineering has been widespread across all sectors and regions. Moreover, the forward-looking indicators show firms are optimistic about the prospects for the near future too. After contracting in 2005, the results are similar to those recorded in 2004, when manufacturing was expanding and engineering grew by more than four per cent. That said, it is important to keep the upturn in perspective as manufacturing output is only a little above where it was in 1997.
It is also worth noting that official figures may be overestimating the apparent fall in manufacturing. Companies have increasingly been divesting activities such as accounting and delivery services.
By focusing on core activities, some companies have reduced costs and also mitigated risks from changes in demand for their products. Interestingly, official figures have been slow to account for these changes, meaning activities that were once considered to be manufacturing are now attributed to the services sector.
For example, by outsourcing catering services, jobs are re-classed as services rather than manufacturing, though nothing material has changed. Other examples include outsourcing cleaning, or legal services. National Statistics suggests that failing to account for these changes could have led to overestimating the apparent fall in manufacturing by as much as 20 per cent.
In addition, manufacturers are starting to develop revenue streams from offering services to their customers. Rather than just selling products, innovative enterprises are looking to provide total solutions for companies' problems.
This goes well beyond simple maintenance work. It involves companies becoming close partners with their customers and developing more complex and informed relationships.
New orders
Perhaps the most obvious explanation for this change in fortunes is the strengthening world economy, which has been growing above trend since 2003. In particular, the resurgence in Europe this year has helped manufacturers to fill their order books. Importantly, Germany and France, the largest economies on the continent, have seen the pace of growth quicken. EEF's survey suggests a general pick up of export orders across the sector. As an example, the pick up in capital investment growth in Europe has benefited companies operating in the mechanical equipment industry. European growth hit a six year high in the three months leading up to June 2006, with the economy expanding by 0.9 per cent on the previous three months. This correlates with EEF's results, showing that overseas markets have become the main source of new orders. The latest export orders balance came in at +13 per cent, while domestic orders stalled at zero.
Interestingly, exports have risen despite the pound remaining strong. Figure 1 shows how export order balances and the exchange rate have evolved over the past decade. The higher the effective exchange rate index, the stronger the pound. The chart tells the story of companies' exports taking a knock when the pound grew in value by some 25 per cent in the late 1990s. Growth in export orders, however, has recently returned to healthy levels despite the currency remaining strong, indicating that manufacturing is learning to live with a strong pound.
Figure 1. Manufacturing learns to live with a strong pound. Percentage of export order balances in past three months. Sterling effective exchange rate (index 2005=100). Enlarge image
Source: EEF Business Trends survey and Bank of England
Keeping lean
Underlying this change has been a shift in business strategies. Firms have sought to reduce costs to regain competitiveness. Finding ways to cut costs is a constant issue for business. Within manufacturing, companies continually need to look to reduce waste and improve the efficiency of their processes if they are to maintain and hopefully improve their profits. However, a growing number of companies have lowered costs, not just through incremental steps, but by overhauling whole processes within their organisations. Many companies today are applying lean principles across their whole operation.
Techniques and processes need to be monitored constantly and reviewed in light of improvements in technology. The uptake of these approaches has been accelerated by the government's Manufacturing Advisory Service (MAS), launched in 2002. MAS disseminates information but also provides in-depth advice for companies. It has helped bring developments to companies that would otherwise have lagged behind their competitors abroad.
The latest MAS annual report suggests in the year to March, MAS helped raise productivity by an average of 27 per cent. It also helped companies improve in other areas, such as better on-time delivery and space utilisation. This has helped the UK close the productivity gap with Germany and narrow it with France. Companies are increasingly sourcing components from abroad rather than producing them in-house or purchasing from domestic suppliers. They are also investing in overseas production facilities, sometimes at the expense of maintaining or expanding domestic ones.
'By choosing to import components and concentrating on creating high-value goods and services, UK companies are maintaining competitiveness that keeps businesses viable'
However, this does not mean manufacturing is disappearing from the UK landscape altogether; on the contrary, by choosing to import components and concentrating on creating high-value goods and services, UK companies are maintaining competitiveness that keeps businesses viable. Nevertheless, it is clear that this adjustment has not been without difficulty, as it has forced suppliers to seek out export orders without the security of a very strong domestic market.
Energy boost
Evidence on manufacturing investment, however, is mixed. Official figures suggest it has been weak, falling by six per cent between the first and second quarters this year. In contrast, EEF's survey has seen an improvement in investment intentions since the beginning of this year.
The latest out-turn of +7 per cent was the highest level since the end of 1997.Yet, figure 2 shows that the link between strong increases in output and investment balances is weak by past standards. Output balances are near the levels seen in 1997 but investment balances are five percentage points lower than they were then.
Figure 2. Percentage of balances in output and investment plans. Shows that investment is weak by past standards. Enlarge image
Source: EEF Business Trends survey and Bank of England
There is no consensus on the causes of this apparent weakness in manufacturing investment, though a number of explanations have been put forward. An obvious link comes from falling manufacturing profitability, which has hit levels not seen since 1992, despite the increase in output and orders. The net rate of return in the second quarter was estimated at 6.1 per cent, down from a peak of 15.4 per cent in the first three months of 1997. In contrast, the net rate of return in services is much higher at 20 per cent.
Higher energy prices have also affected investment decisions. Oil prices had been relatively stable at about US$30 a barrel in 2003; now they are double this figure. This has directly affected companies in the energy-intensive industries but the effects are also felt elsewhere through higher raw materials costs, particularly in metals.
However, the main concern is that gas and electricity costs have risen faster in the UK than in the rest of Europe. With competition in international markets fierce, only a small minority of manufacturers are able to pass on higher costs to customers, leaving profit margins squeezed. Rising taxes that add to the cost of business, such as employers' National Insurance contributions and energy and environmental measures, are a further downward pressure on profitability. The need to address pension fund deficits may also be a drain on investment, though the evidence on this is mixed and may be more of a problem for smaller and medium-sized firms.
Into innovation
In addition to reducing costs, many companies are adopting strategies to restructure the mix of products and services they bring to the market. Innovation offers a route to increased profitability and reduced exposure to exchange rate movements. Manufacturing accounts for three-quarters of research and development (R&D) expenditure in the UK. But international evidence from the EU community innovation survey and the Organisation for Economic Cooperation and Development (OECD) suggests the UK's performance on innovation is average at best. The US tends to score well, as do Scandinavian countries, most notably Finland. This is based on metrics such as the number of patents and copyrights being registered.
However, measuring innovation simply by looking at R&D spending or the number of new products developed gives an incomplete picture. Besides new or improved products and processes, innovation includes activities such as managerial and organisational innovations, design and marketing, reflecting the changing nature of manufacturing and the drive towards gaining revenues by providing services. For example, by building closer relationships with clients through better after sales support, firms gain longer term custom on the maintenance and upgrades for their products.
A recent EEF survey indicates that manufacturing companies are moving in the right direction by increasing their focus on innovation. This is driven by the dual pressures of changing customer demands and rising competitive threats. Encouragingly, three-quarters of companies said that they had increased their spending on innovation over the past three years and over half planned to do so again.This increased spending is not surprising given that innovation appeared to be contributing to their bottom lines, with about four-fifths of innovators reporting improvements in areas such as productivity, turnover, market share and profitability.
Almost all companies (big and small) are collaborating on their innovation. One of the most promising findings was business links with the science base, which have traditionally been weak in the UK. The survey recorded two-fifths of companies saying they had contact with universities. Some of this reflected companies accessing specialised equipment and skills within universities rather than collaboration on high-tech projects. However, it is encouraging that there are signs of increasing dialogue between business and universities, providing a base on which to build in the future.
Government initiatives such as the R&D tax credit and technology strategy have played a part by subsidising and encouraging innovation. However, despite the attention government procurement practices have received, more than twice as many companies rated them negatively in terms of encouraging innovation. Feedback from members suggests over-specification and a lack of product awareness by officials as key problems in this area. These are issues that the government needs to address, given that the public sector spends more than £100bn each year procuring goods and services from the private sector and therefore has enormous potential to stimulate the demand for innovative solutions to its needs.
Companies also report problems with their internal capabilities to implement innovation. A key issue here was helping staff to adapt to the demands of the project. Skills shortages are increasingly a problem as the UK moves up the value-chain. The share of the workforce with little or no skills is relatively high by international standards. Higher, for example, than in the US, Germany or France. For manufacturers, a key priority is to raise the quantity of students achieving high grades in science, technology, engineering and mathematics (STEM) in schools and higher education. However, the increased demand for skills in general is not being met by supply. Issues surrounding the shortfall include the lack of qualified STEM teachers, poor careers advice - which herds students towards university when perhaps a vocational course would be more appropriate - and the poor perception of manufacturing by the younger generation.
Emerging economies
Despite the economic threats that countries such as China and India pose, it is important to recognise the rising opportunities they present. Combined, these two countries alone account for one-third of the world's population. As they continue to develop their economies, so their populations' disposable incomes will rise which translates into higher consumer spending. Moreover, investment flows are not on a one-way street from the UK to China or India.
Anecdotal evidence suggests UK companies have been slow off the mark in capitalising on opportunities abroad. In the past, EEF research highlighted companies' over-reliance on traditional markets in the EU such as Germany, France and Italy. The emerging economies in Asia and central and eastern Europe were relatively overlooked, being viewed more as threats or sources for low-cost suppliers. However, UK Trade and Investment (UKTI), the body responsible for supporting exports and inward investment, has published a new five-year strategy, with a greater focus on emerging economies. Companies need information about how businesses operate in these markets. The British consulates, for example, can offer vital networking opportunities through their contacts. In addition, travel costs can be subsidised to get UK companies talking face-to-face with prospective overseas customers.
This has the potential to make a substantial improvement to the UK's record in these markets. Overall, there is increasing evidence of manufacturing responding to the challenges posed by heightened competition. Companies that survived the sharp recession at the start of the decade are now seeing the fruits of the hard work that they have put in to reduce costs and develop new revenue streams. UK companies need to show a continuous commitment to increasing levels of skills and innovation, along with an ability to capitalise on the opportunities presented by the growth of emerging economies. Without these improvements, it will be difficult to sustain the recent rise in output or to reverse the decline in profitability. For many manufacturers, the adage that 'turnover is vanity, but profit is sanity' holds as true as ever
About EEF
EEF is the representative voice of manufacturing, engineering and technology-based businesses with a membership of 6,000 companies employing around 800,000 people. To find out more visit www.eef.org.uk
Sukhy Ubhi is an economist at EEF. He is responsible for disseminating information on key trends in manufacturing.
