Elsevier

Omega

Volume 105, December 2021, 102500
Omega

Impact of tariffs and production cost on a multinational firm's incentive for backshoring under competition

https://doi.org/10.1016/j.omega.2021.102500Get rights and content

Abstract

We consider the effect of tariffs and production cost on a multinational firm's incentive for backshoring under competition. The multinational firm (M) can produce in a low-cost foreign country, but her products are imposed tariffs if imported. When selling to home customers, M competes with a national firm (N). To model the two competing firms’ interactions, we adopt three common game modes: M-led or N-led Stackelberg games, and a simultaneous game. Our analytical result shows that under offshoring, M’s profit can increase in the market competition when the competition is intense, and this trend is more likely to exist when the low-cost advantage of offshoring is greater, or M becomes more powerful. Second, compared with onshoring, offshoring always hurts N but benefits home customers, and it is beneficial for M only when the tariff rate is low. Third, it is more difficult to induce M to backshore by imposing tariffs when M is less powerful. Furthermore, in a model variant, we show that under offshoring, selling through an independent domestic retailer (R) is more attractive for the multinational group (G) than selling directly when the tariff rate is high, and G’s incentive for selling through R is stronger when R is more powerful.

Introduction

In past few decades, pushed by focus on core competencies and the pressure to reduce operating costs, offshore manufacturing has shown a growing trend [53]. Through offshoring, a multinational firm establishes manufacturing subsidiaries in low-cost foreign countries to provide intermediate components or final products to its retailing subsidiaries at home country. Because of its lower costs, offshoring has become a prevalent practice of global supply chains [37]. For instance, many European and U.S. firms started shifting manufacturing jobs away from their countries to wherever enjoys the low-cost advantage, such as China, Eastern Europe, Mexico, and Thailand [45]. As of 2008, more than 50% of U.S. companies have adopted offshoring strategy [36].

Due to the uneven distribution of benefits, however, “offshoring”, once recognized as a merit of outsourcing practice, has been reexamined recent years, and the upward “reshoring” tendency has raised concerns in many industries. Although consumers in developed countries now benefit from lower-cost products, many of them lose their jobs and witness their prospects for economic development dull [14]. Reshoring and backshoring have become a hot issue in business magazines. For example, the Economist [47] notes that, many well-known firms, such as Google, Ford Motor, and General Electric, are really moving some of their production facilities back to the United States (U.S.) or setting up a new capacity in the U.S. Besides, according to a survey handled by Boston Consulting Group (BCG) in 2012, 37% of U.S. manufacturing firms with annual sales over $1 billion are preparing or actively thinking about moving their production lines back to U.S. from China, and 48% of giant firms with annual sales over $10 billion prove to be reshorers [46]. For instance, in 2013, Apple publicized that it had started making the Mac Pro computers in a Texas plant [8]; Walmart commits to procure an additional $250 billion of products that are sourced, made, or grown in U.S. by 2023 [50].

The pros and cons of offshore production have been broadly debated in research literature and business media (see, e.g., [49]). Specifically, there is a discussion about reshoring to U.S., Europe, Japan, and/or other developed economies [13]. According to a recent survey by BCG, more than 30% of U.S. manufacturing executives declare that their firms are working to expand manufacturing capacity in U.S., whereas only 20% state that their firms are enlarging in China [43]. However, A.T. Kearney, a global management consulting firm, utilizes aggregate economic data to show that offshoring is indeed increasing at a higher rate than reshoring [48]. The field study by Cohen and Lee [13] indicates that outsourcing to low-cost countries maintains a preferred strategy in some industries, despite of governments’ policies and incentives to boost domestic manufacturing and/or curb outsourcing. Therefore, whether a multinational firm should employ offshoring/backshoring strategy deserves further study.

To promote “bringing manufacturing back” to home country from low-cost emerging economies, the governments of developed countries can impose trade tariffs on imported products. For example, to protect domestic producers in steel and aluminum industry, and increase regionalized production and manufacturing employment in U.S., the government imposes 232 tariffs on steel (25%) and aluminum (10%) imports [18]. In 2018, U.S. government proposed Section 301 ($50 billion in tariffs) on goods imported from China. Owing to the immediacy of these events, there are few custom-based research papers to directly address the effect of escalated tariffs and trade wars on supply chains, firms’ outputs, and profitability, except Dong and Kouvelis [18] and Nagurney et al. [39]. Dong and Kouvelis [18] discuss the effect of the additional unit cost due to imposed tariffs on two competing firms’ equilibrium total quantities under four competition structures. Nagurney et al. [39] show that when firms compete in product quality levels and quantities, the imposition of a strict quota or tariff may benefit firms but decline the welfare of consumers. Yet, the effect of tariffs on a multinational firm's incentive to reshore is unclear, especially under competition.

According to Dong and Kouvelis [18], competition exists in almost every industry and every stage of a value chain as world's markets are opened to many companies due to low trade barriers. In addition, Jung [29] also notes that the competition effect plays a vital role in firms’ global sourcing decisions. To address this issue, we incorporate the competition from a local rival firm into our model when discussing the multinational firm's trade-off between offshoring and backshoring.

There are several motivations for multinational firms to employ offshoring strategy, such as, efficiency-seeking (including lower resource costs, primarily labor costs [62], tax advantages and financial assistance for activities [34], vendors’ expertise and economies of scale [9]), flexibility-seeking (including easy adjustment of labor supply [20] and flexible supply of resources [17], resource-seeking (including quality labor [31], specialized knowledge [27]), focus on core activities [1] and quick response due to leaner organizing [15]. According to the analysis of the data on over 1600 offshoring programs, Manning et al. [31] show that cost-saving is the most predominant incentive for offshoring. For example, while Detroit Three automakers build their cars at the labor cost of $63 per hour, foreign-based automakers only spend $50 per hour or less [32]. The cost-saving effect of offshoring in some emerging economies (e.g., China) may be offset by soaring labor costs year by year, but it can also be enhanced by economies of scale and efficient collaboration in supply chain networks. In a modeling paper, Wu and Zhang [54] claim that the most frequently cited benefit of offshoring is cost savings from less expensive labor in emerging economies. In another recent work, Chen and Hu [10] also attribute the top driver of offshoring to lower labor costs in emerging economies. Hence, the low-cost advantage has been considered as the main driver for multinational firms to offshore. However, the effect of low-cost advantage on the multinational firm's profit under tariffs and competition, and its decision on sourcing strategies regarding offshoring and onshoring (or backshoring/ reshoring) requires further research.

In light of above discussions, we regard tariffs and cost efficiency as major trade-offs for a multinational firm's sourcing decision when both offshoring and onshoring options are accessible. To further advance understanding of the effect of tariffs and low-cost advantage on a multinational firm's incentive for backshoring production, we consider a multinational firm (M) that can make in a low-cost foreign country (i.e., offshoring), or produce at home country (i.e., onshoring). M’s products made in the foreign country are imposed tariff if imported and sold back to home customers. When selling to home customers, M competes with a national firm (N). To model the two competing firms’ interactions, we use three common game modes: M-led or N-led Stackelberg game, and a simultaneous game. These games can reflect firms’ relative market power: Under M-led or N-led Stackelberg games, M or N possesses a stronger power, whereas under the simultaneous game, M and N hold equal power.

This work analyzes the effect of tariffs and production cost on firms’ profits under competition and offshoring, and thus M’s incentive for backshore manufacturing. Our study offers several interesting insights. First, to protect domestic manufacturing, governments of developed countries indeed should impose trade tariffs on imported products to stop multinational firms from taking the low-cost advantage of offshoring to beat and eliminate national firms that manufacture at home countries. Second, M can use offshoring to hedge her loss due to stiff competition, and the greater cost advantage of offshoring enjoys, or the stronger power M possesses, this trend is more likely to be observed. Third, offshoring always hurts N but always benefits home customers, and the government can push M to backshore by levying sufficiently high tariffs, but it is more difficult for governments to induce a less powerful multinational firm to reshore.

To provide further interesting insights, we extend our basic model from M selling directly to M selling through an independent domestic retailer (R). We find that when the tariff rate is relatively high under offshoring, selling through R is more attractive for the multinational group (G) than selling directly, and G’s incentive for selling through R is stronger when the market power of R vis-à-vis N rises, and this is beneficial for N but is detrimental for home customers.

We also consider other variants, that is, we extend our basic model from quantity competition to price competition, from the case where customers are indifferent to firms’ products to the case where customers prefer M’s or N’s product, please see the detail of these extensions in Appendix A (See the supplementary material available online), if interested.

The rest of this study is organized as follows. Section 2 reviews the related literature. In Section 3, we introduce model settings and assumptions. In Section 4, we analyze the basic model. We extend our basic model in Section 5. We conclude this work with key insights and limitations in Section 6. All proofs are provided in Appendix B (See the supplementary material available online).

Section snippets

Literature review

Our paper falls into the field of research that considers multinational firms’ global sourcing decisions between offshoring and onshoring. Offshoring, according to Mihalache and Mihalache [35], is the transfer of business activities to foreign locations, by making use of countries’ comparative advantages, to support a national firm's present business operations. Offshoring and outsourcing are related, because both arise when firms consider shifting certain business activities from internal

Model settings and assumptions

This study considers one multinational (global) firm (labeled M) whose headquarter and sales market locate in a developed country (Home country, labeled H). To reduce production cost, M can locate her production facilities in a low-cost emerging economy (Foreign country, labeled F). However, to promote “bringing manufacturing back” to home from foreign countries, governments of developed countries might impose trade tariffs on imported products. Therefore, the multinational firm has to decide

Analysis of basic model

In this section, we first analyze the case where a multinational firm (labeled M) sets up her production facilities at home country (labeled H), that is, M adopts onshoring strategy. We then discuss the case where M locates her factory in a foreign country (labeled F), i.e., M employs offshoring strategy instead. Finally, to understand the effect of M’s sourcing strategies on herself, the national firm (labeled N), and customers, we compare the equilibrium outcomes under onshoring and

Model variant: multinational firm sells through an independent retailer

In the basic model, we study the case where the multinational firm (M) directly sells her product to end consumers. Direct selling can eliminate the intermediate link of sales and thus avoid the efficiency loss due to double marginalization effect. However, under Ad Valorem Tariff, imported products are taxed at retail prices when M adopts offshoring production and sells her products back to home consumers. To save tariff costs, M can wholesale her products to an independent retailer (labeled R

6 Conclusions

This paper investigates the effect of tariffs and production cost on a multinational firm's sourcing strategies regarding backshoring and offshoring under competition. The multinational firm (M) can position her production facilities in a low-cost foreign country (F) to reduce production cost, but her products are taxed when imported and sold back to home customers. To examine the impact of trade tariffs on national firms, we assume that when selling to home customers, M faces competition from

CRediT authorship contribution statement

Huixiao Yang: Conceptualization, Methodology, Investigation, Formal analysis, Writing – original draft, Writing – review & editing. Jinwen Ou: Conceptualization, Writing – review & editing. Xiaofeng Chen: Investigation, Formal analysis, Writing – review & editing.

Acknowledgments

The authors thank Ben Lev (Editor), and anonymous Associate Editor and reviewers for their constructive suggestions that helped to considerably improve the quality of this paper. This research was partly supported by the Natural Science Foundation of China (71802096, 71874159, 71902019, 72001092), Guangdong Basic and Applied Basic Research Foundation (2020A1515011118), Humanity and Social Science Youth foundation of Ministry of Education of China (18YJC630223, 19YJC630031), China Postdoctoral

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