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The Trade Agreement

Independent of the WTO, another driver of changing supply chain dynamics is the trade agreement. The countries of the world are picking sides, and the more astute organizations will not only react to change but either directly or through industry associations put themselves in a position to influence the content of these trade agreements. Whether one focuses on the ramifications of the European Common Market, the North American Free Trade Agreement (NAFTA), the Association of Southeast Asian Nations (ASEAN) or Mercosur, the implications for supply chains are apparent. Depending on the level of cooperation among participating countries, membership may imply important responsibilities like the free movement of goods, services and people amongst member states, a common external tariff or tariff-free trade between countries. At a minimum, countries are interested in building trade with each other but, more precisely, stimulating commerce within the confines of their own borders. Table 4.1 provides a sample of major trade pacts around the world and the magnitude of each.

Table 4.1: Major Trade Agreements and Unions

Because trade agreements are preferential by nature, it is important to understand two supply-chain-related considerations that encourage a local market presence: substantial transformation and local content. Originally a customs-related term, substantial transformation addresses the importation of raw materials that are manufactured or assembled into a new, or "substantially transformed," product. Local content rules, on the other hand, dictate that a certain percentage (35% in many cases) of the value of component parts and labor be of domestic origin. Needless to say, although beneficial for participating countries and companies, the supply chain ramifications can be intimidating.

Substantial Transformation

A good example of substantial transformation is the importation of plastic casing, circuitry and wiring from Asia into Mexico for manufacture into desktop computers. Taken individually, the ad valorem duty amount associated with each product and its country of origin normally would have to be paid. Under export-oriented programs designed by the Mexican government (Maquiladora or Pitex, for example), the raw materials can be temporarily imported free of duty and assembled into a computer, an entirely "transformed" product that qualities as Mexican country of origin. From there, the Mexican company qualifies for NAFTA origin, reducing or entirely eliminating the amount of duty paid upon export to the United States or Canada.

Although the above arrangement is appealing at a macro level, the amount of expertise required to execute on the operational model is an entirely different story. For example, the documentation aspect of managing an export program requires error-free compliance. A company operating under this type of regimen in any country has to substantiate not only the value and origin of all its raw material imports but also the value, destination and proof of export of all of its finished goods. As is the case in most government-sponsored export programs, the inability to produce this documentation can result in exclusion from the program, assessment of duties or punitive fines and, in the worst of cases, potential loss of operating rights.

Additionally, the logistics of importing raw materials into Mexico from Asia are different than for direct Asian imports into the United States. The routings are different, flight and sailing availability varies and transportation costs can be higher. This means that lead times will be longer and cost of goods sold models will change accordingly. Apart from inbound logistics considerations, the nature of the customs infrastructure with its demanding procedures puts extra pressure on an already challenged supply chain.

The point is that Mexico is an ideal example of a country that is committed to participating in world trade. However, in order to enjoy the intended benefits of any export program or trade agreement, companies have to abide by the rules, with supply chain execution as close to 100% accurate as possible. If not, processes will be suboptimized and, as a direct result, margins depleted or consumed entirely.

Local Content

Local content rules are similar to substantial transformation in that they encourage a local presence, or at least domestic participation, in the production process. Designed to stimulate domestic activity in the form of job creation, local content rules apply to a combination of the amount of domestically sourced materials and local labor. Although many organizations still operate via agreements with external suppliers or representatives, local content rules have pushed the larger players into markets as commercial entities.

This rule changes the nature of supply chains due to the fact that companies must seek domestic suppliers for key components as well as have assembly/ manufacturing operations to qualify for local labor input. Much like substantial transformation, this must fit into a company's strategy as it not only wants to qualify for country of origin status where it is operating but also seeks to gain the benefits of selling competitively within the trade block(s) to which the host country is party.

A brief return to the auto industry provides a relevant example of this phenomenon. As auto suppliers began to understand what local content rules meant to their operations, they quickly figured out that the presence of an assembly operation in foreign countries would not permit them to reach the content threshold. For this reason, many manufacturers established engine plants along with aggressive local supplier campaigns to quality for the coveted country of origin status. [2]

Local content changes the supply side of the equation as well. Whereas companies may have accumulated experience in exporting from their home countries, they probably lack the experience necessary to comply with the export laws of their host governments. Many countries, for example, still require customs clearance for exports. While an archaic practice, non-compliance with local regulations will freeze exports for weeks at a time. As countries expand over seas to benefit from trade agreements or country of origin rules, they should staff their operations with locals who possess the requisite level of knowledge to expedite the movement of goods.

[2]An example of local content rules can be found in the Japanese auto industry in the United Kingdom during the Thatcher administration. James P. Womack, Daniel T. Jones, and Daniel Roos, The Machine That Changed the World: The Story of Lean Production, Harper Perennial, 1990, p. 254.