Globalization and the New Economy

Frugal Ron, true to his moniker, recently purchased sale priced Wrangler blue jeans at Walmart for $9.97. While this may not rate as earth shattering news, if you are willing to pay attention, blue jean shopping explains globalization, the widening income gap in the United States, the “New Economy” that revolves around adding value to goods and services and why the US’s manufacturing segment’s decline shouldn’t alarm us.

To understand all this, we need to follow the money. If we can get a reasonable idea of the manufacturing cost of these jeans, we can identify jobs we want to keep in the US and ones we are better off without.

Some background

According to the label, the recently purchased jeans were manufactured in Mexico. Frugal Ron’s previous identical jeans purchased from Walmart were manufactured in Vietnam. VF Corporation, which owns Wrangler, Lee, North Face and other brands does not own factories. They contract manufacturing to others.

Butler Consultants found the retail clothing industry had an average gross profit margin of 48.46% in 2009. Average gross profit margin is the difference between the $9.97 Frugal Ron paid for the jeans and what Walmart paid VF Corporation divided by the $9.97 purchase price. This is not all profit. It includes all the costs of owning stores and distribution besides their labor costs.

Unfortunately, neither Walmart nor VF Corporation is going to help us with their cost structures and what their margins are, so we need to make some assumptions as we follow the $9.97 spent down the retail and manufacturing chain. In a earlier career, Frugal Ron was a product manager and spent much time setting margins and pricing products. Some of that experience is applied here. The important point in this exercise is to pay attention to the big picture and not get caught up in the details of margins being plus or minus 5% from the numbers used below.

The nitty-gritty

Frugal Ron’s pair of jeans has a list price of $10.80, yet seems to have a perpetual price roll-back to $9.97. Given this and that Walmart operates on lower margins, we’ll estimate the jeans have a 40% margin at the $9.97 price. Using this assumption, Walmart paid VF Corporation $6.00 for the jeans in a container in a US point of entry such as Long Beach, California. VF Corporation designed the jeans, contracted for their production, got the jeans through customs and to a point in the US where Walmart could get them into their distribution channel. For all this, we’ll assume VF Corporation operates on a 45% margin when sourcing and adding their label to a product Walmart sells.

Frugal Ron's $9.97 Wrangler jeans
Frugal Ron’s $9.97 Wrangler jeans

Using these assumptions, VF Corporation paid $3.30 to the Mexican company that took the raw cotton and made it into Wrangler jeans. Denim jeans weigh two pounds and are all cotton. A pound of cotton is selling for $0.56 and a pair of men’s blue jeans weighs two pounds. Subtracting $1.12 material cost from the $3.30 manufacturing cost leaves us with $2.18. (We’ll include the zipper in the material cost.) The $2.18 is an estimate of the labor and factory overhead cost for the entire process of taking raw cotton and turning it into a pair of blue jeans.

Higher end and high-end jeans

Kohl’s, a mid level retailer, also sells blue jeans. One of their main line brands is Levi’s, owned by Levi Strauss and Company, a closely held family owned firm. Their Levi’s 505 Regular Jeans for Men are regularly $58.00 and on sale for $39.99. Except for some rivets, the Levi’s are almost identical to Frugal Ron’s $9.97 Wranglers.

We’ll assume Kohl’s margins are close to the industry average of 47%. We’ll also assume the Levi’s cost $3.60, or $0.30 more to manufacture than the Wranglers because of the rivets. This leaves Levi Strauss and Company with a whopping 83% margin on these jeans with essentially the same costs that VF Corporation has with the Wranglers.

Levi's $39.99 jeans
Levi’s $39.99 jeans

This trend is far more pronounced when dealing with luxury or exclusive products. At the other end from Walmart in the Madison retailing scene is Macy’s. Shopping at Macy’s, Frugal Ron is way out of his comfort zone. However, he found a pair of imported women’s “For All Mankind Mid-Rise Boot-cut Jeans”, described as “Slim Illusion Dusty Vintage Blue Wash” for $215.00. They are not on sale.

$215 For All Mankind jeans
For All Mankind’s $215 jeans

Examining the Slim Illusion Dusty Vintage Blue Wash jeans, the fabric is 95% cotton and 5% spandex. The stitching and construction look very similar to Frugal Ron’s $9.97 jeans.

Following the money, we’ll assume Macy’s is getting a 60% margin on these $215 jeans. In other words, they make $129 when they sell a pair of For All Mankind Mid-Rise Boot-cut jeans. Not much of this is going to the Macys’s sales associates. According to Glassdoor.com, average pay in Madison, Wisconsin for Sales Associates at Macy’s is $8.99/hour and $8.86 at Walmart.

The same factories in developing nations that produce Wrangler jeans also produce the $215 variety. It would be a stretch to imagine that when an order for the For All Mankind jeans comes in that the workers’ pay rises proportionately with the retail price of the jeans. More likely, For All Mankind gets their jeans manufactured for about the same assumed $3.30 that VF Corporation pays. Being generous, we’ll figure the manufacturing costs are double, or $6.60, because of the extra cost of the spandex and For All Mankind doesn’t get the economies of scale other distributors have. Using these assumptions, For All Mankind’s margin is an estimated $79.40 on each pair of jeans sold.

Where does the money go?

Following the Money, Blue Jeans
Wrangler Jeans Levis For All Mankind Jeans
Retail selling price $9.99 $39.99 $215
Retailer Walmart Kohls Macy’s
Assumed retailer margin (%) 40% 47% 60%
Assumed retailer margin ($) $4.00 $18.80 $129
Distributor VF Corporation Levi Strauss For All Mankind
Assumed distributor margin (%) 45% 83% 92%
Assumed distributor margin ($) $2.69 $17.59 $79.40
Assumed raw material and manufacturing cost $3.30 $3.60 $6.60
Material cost estimate. Cotton costs $0.56/pound. Two pounds needed to manufacture men’s blue jeans. One pound for women’s. $1.12 $1.42 $0.65
Cost to produce jeans from raw cotton $2.18 $2.18 $5.95
Manufacturing cost as a percent of retail price 22% 5% 3%

You can make different assumptions on margins and come up with different numbers than above, but the decisions and what we learn are the same. Even if the above manufacturing estimates are off by 100%, except for low-end products, production costs are an insignificant part of these products’ retail price. This goes beyond clothing and includes almost all the goods we buy.

Those who suggest a successful economy revolves around making things are just plain wrong. The real money and best jobs are in designing, developing, sourcing and marketing products.

The impact of globalization

The biggest benefits from trade are when countries with very different economies (such as the US and Indonesia) trade. No county is best at everything and markets allocate to each country what they are most efficient at.

Each country’s largest labor force segment gains the most from international trade and the smallest segment is the loser. For Indonesia, globalization and reduced trade barriers meant their huge unskilled labor force that survived on less than a dollar a day now find jobs in factories and make $2-3 per hour. On the other end of the spectrum, before trade liberalization, Indonesian engineers and architects had the local market to themselves. Now, they have to compete (usually unsuccessfully) against US, European and Japanese firms on local projects. This hasn’t been good for them.

In the US, the smaller segment of the economy is people with lower levels of education employed in manufacturing. These are the losers in globalization. The winners are the bigger segment of workers with college degrees. Whether they are engineers, bankers, lawyers, marketers or a plethora of other skilled areas, globalization made them more valuable than ever.

The Pew report called “The Rising Cost of Not Going to College” substantiates this process. Millennial college graduates (25-32 years old) earn 55% more than peer group high school graduates, the largest spread in history. While the college graduate premium over a high school diploma is $17,500 annually, a two-year technical college degree’s premium is only $2,000. Pew did not survey those without high school diplomas. We can assume they are much worse off financially. While the value of a college degree increased, the major reason for the $17,500 premium for the bachelor’s degree was the drop in the high school diploma holder’s earnings since a previous survey in 1965.

Averages often mislead. A college education doesn’t guarantee financial success. It only provides a ticket to the dance. The Pew report found 6% of millennials with college degrees are living in poverty. (Twenty-two percent of high school graduates are living in poverty.) On the other end of the spectrum, a person will be extremely well compensated if they can get customers to pay four times as much for a pair of Levi jeans at Kohl’s instead of a pair of jeans with the same utility at Walmart. And, someone who can design and market jeans that are so flattering to women’s appearance that they will pay $215 for them will be even wealthier.

Globalization provides a larger market for college graduates and the products they market. If the $215 jeans are popular in the US, they’ll be successful in Europe, Japan, China and many other countries. This makes the rich richer.

Moving away from average salary figures for college graduates, the number of US billionaires jumps every year as entrepreneurs with great ideas and vision control their own companies. Other billionaires lead publicly owned companies that make their stockholders rich. Logically, the stockholders like this and compensate their top management with stock options that increase in value with the company’s value.

The difference between struggling companies like KFC and successful ones like McDonald’s is leadership. If McDonald’s management makes their shareholders rich while KFC’s management drags their company’s profits, it is ridiculous to expect the two companies top management will have similar compensation.

We should celebrate that people can make huge amounts of money in today’s US economy and that the opportunity for someone from a poor background is as great as ever. If income inequality is a problem, it isn’t solved by preventing people from making lots of money. It’s solved by helping those at the low-end of the spectrum.

Yet at the same time, the wealthiest people are profiting from a system that allows them to maximize their opportunities at the cost of the least skilled people in the US.  Progressive tax policies can remedy some of this.

Government impacts

All this highlights two issues for government policymakers. First, how should states and the federal government take advantage of this new economy? For an example of how to do everything wrong, look to Wisconsin where voters elected the Keystone Cops of government policymaking. Wisconsin focuses job creation efforts on attracting manufacturing companies to the state. For example, the Wisconsin Economic Development Corporation gave Ashley Furniture $6 million in tax credits to keep them in Wisconsin. Over 56% of the company’s workers make less than $10.88/hour. Eight years’ of Governor Scott Walker’s focus on attracting manufacturing jobs all but guarantees the state will be an economic backwater for decades.

In contrast, the “New Economy” companies that add value to products and pay high salaries want to recruit creative people. Often, they are also looking for employees with high-end math, science and communication skills. To attract these workers, they move to states and cities that offer great schools, lots of amenities such as parks and an active social scene, public transportation and a laissez-faire attitude towards gays and alternative lifestyles. Oftentimes, great universities spin-off these types of companies.

While top-notch K-12 schools and universities are important for recruiting new economy jobs, they are essential for keeping them in the US. States like Wisconsin want to increase manufacturing jobs and look at education as a source for future tax cuts. In contrast, China would gladly send their low-end manufacturing jobs to Wisconsin. They and other nations are investing heavily in education so their citizens can get the upper level college graduate engineering and marketing  jobs. Keeping these jobs in the US is our biggest challenge going forward.

US government policy makers face a second challenge with the economic stratification globalization has caused. Not everyone wants to be or can be a college graduate. As wages for low skill jobs move lower and new more expensive housing replaces low-cost housing , more people are homeless.

At the same time, record numbers of working poor are forced onto food stamps and public assistance. The Republican solution of simply eliminating these programs without eliminating the reason they exist is unbelievably shortsighted.

Wrapping up…

The most important lesson from blue jean shopping is that manufacturing jobs are low paying and add very little value to the product. The real money is in product development and marketing. To keep high-end, value adding jobs in the US,  it is more important than ever for government to make sure each US student gets a world-class education.

We can’t waste resources trying to subsidize low paying manufacturing jobs. At the same time, government can’t ignore citizens who’ve lost in this musical chair game. The US needs major infrastructure upgrades and we have a large segment of unemployed or underemployed citizens. These are opportunities disguised as problems.

 


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