Assessing a Country as a Production Location (Edexcel A-Level Business): Revision Notes

Assessing a Country as a Production Location

When businesses expand globally, they must carefully evaluate potential locations for their production facilities. This is a major strategic decision involving significant financial commitment and long-term consequences. Unlike simply exporting to a new market, establishing production abroad requires substantial investment in factories, equipment, and infrastructure.

Businesses like Jaguar Land Rover, Renault, and Dyson have all established production facilities overseas. In 2014, JLR opened its first Chinese factory in Jiangsu, partnering with Chery Automobile. This decision was driven by strong sales growth in China (which represented 25% of JLR's total sales) and the need to avoid Chinese import duties. The \£1 billion investment demonstrates the scale of commitment required when locating production internationally.

According to a 2014 report by Cushman & Wakefield, Malaysia ranked as the most attractive manufacturing location globally. The ranking considered three weighted factors: costs (40%), risks (20%), and conditions (40%). Asian countries dominated the top rankings due to their competitive production costs and relatively low risk profiles.

Key factors to consider

Costs of production

Production costs are often the primary driver of location decisions. Businesses seek competitive advantages by minimizing costs, particularly in labour-intensive industries. Main production costs include labour, energy, raw materials, and land.

Labour costs vary significantly across countries. For example, when Dyson relocated production from the UK to Malaysia in 2003, wages in Malaysia were \£3 per hour compared with \£9 in the UK—a 30% reduction in production costs. This contributed to profits more than doubling from \£18 million to \£40 million within one year.

Energy costs increasingly influence location decisions. In 2014, BASF (the world's largest chemical producer) expanded in the USA rather than Germany because US natural gas prices were approximately one-quarter of European prices, thanks to the growing shale gas industry. Energy-intensive industries like steel and chemical production are particularly sensitive to these cost differences.

Skills and availability of labour force

While low labour costs attract businesses, the quality of human capital is equally important. Businesses cannot afford the consequences of poor-quality output due to inadequate skills or training.

Skill levels matter: A business must verify that the local workforce possesses the necessary skills to maintain quality standards. In countries where labour is cheaper, workers may be unskilled or poorly educated, requiring substantial investment in training. This additional cost can offset initial wage savings.

The chart shows that improving quality of outputs is the primary reason for reshoring for both SMEs and large companies. Other significant factors include delivery certainty, reduced logistics costs, and shorter delivery times.

Labour availability: Businesses must ensure sufficient workers are available near the production site, both immediately and for future expansion. In 2014, some businesses faced recruitment difficulties in China due to the country's one-child policy, which created a worker shortage. Additionally, many workers increasingly prefer not to work in factories, especially for exporters with more demanding quality standards.

Infrastructure

Infrastructure quality is critical for supporting large-scale production facilities. Poor infrastructure can increase costs, cause delays, and limit operational effectiveness. Businesses should evaluate several key infrastructure categories:

Transport infrastructure:

• Roads: Poorly constructed or inadequately maintained roads (sometimes unsealed in developing countries) slow transportation of finished goods and raw materials. Natural disasters like flooding can disrupt supply chains.
• Railways: Undeveloped or non-existent railway networks create problems for transporting bulky or heavy goods in large quantities.
• Ports and airports: Modern facilities are essential for shipping goods internationally and enabling business personnel to travel efficiently.

Digital infrastructure:

• Broadband networks: Access to fast, reliable broadband is increasingly vital for business operations. Some countries have slow or unreliable networks that can hamper productivity.

Commercial services: Businesses need access to supporting services including printers, IT support, banks, insurance providers, advertising agencies, cleaners, maintenance companies, and component manufacturers. Some countries cannot guarantee these facilities, which may prove prohibitive for certain businesses.

Before selecting an overseas location, businesses should identify their specific infrastructure requirements and determine whether potential countries can meet them both currently and in the future.

Location in a trade bloc

Locating production facilities inside a trade bloc enables businesses to avoid trade barriers such as tariffs and quotas. Output from a factory located within a trade bloc can be sold to any member country without attracting tariffs, making products more price-competitive.

Government incentives

Governments actively compete to attract foreign direct investment (FDI) because of its benefits, including employment creation, income generation, technology transfer, and economic development. They offer various incentives to make their countries attractive production locations.

Financial incentives include:

• Tax breaks: Reduced or zero tax rates for initial periods
• Lower corporation tax rates: Ongoing reduced tax rates
• Interest-free loans: Government-backed financing
• Cheap land and preferential premises rates: Reduced property costs

Tax policy importance: According to 2014 PwC research, approximately 63% of 1,344 surveyed CEOs worldwide considered tax policy an important location factor. Recognizing this, the UK government lowered corporation tax to 20% in April 2015—the lowest rate in the G20 (the 20 most advanced economies).

Developing country incentives: Governments in Kenya, Tanzania, Uganda, and Rwanda offer extensive tax incentives including corporation tax holidays and reductions in VAT and customs duties to attract international investment.

Ease of doing business

The commercial environment—often called the 'ease of doing business'—varies significantly across countries. Operating in countries with excessive restrictions or bureaucracy creates frustration and increases costs. Key considerations include:

Business operational factors:

• Starting and closing businesses
• Contract enforcement efficiency
• Bureaucracy levels (e.g., obtaining construction permits)
• Trade credit availability
• Tax collection efficiency
• Insolvency resolution processes

Political stability

Political instability makes some countries too dangerous or financially risky for business operations. Examples of regions often avoided due to political tensions include Libya, Yemen, Ukraine, Syria, Pakistan, Iraq, Afghanistan, Somalia, and parts of Latin America.

Natural resources

Some business activities require proximity to specific natural resources, constraining location choices.

Mining operations: Mines can only be established where proven mineral deposits exist. Until 2014, when commodity prices were high, Africa attracted significant mining investment. For example, Rio Tinto acquired a Mozambique coal mining project for $2.7 billion in 2011. However, falling commodity prices subsequently reduced foreign business interest in the region.

Resource-intensive production: Businesses using substantial natural resources locate near their sources. Steel producers, for example, may site plants near iron ore or coal mines because transporting these bulky, heavy materials is expensive.

Likely return on investment

Businesses evaluate multiple location options before making final decisions. SWOT analysis and PESTLE analysis help assess location suitability, while quantitative techniques evaluate financial costs and benefits.

Quantitative methods for location assessment

Businesses use three main investment appraisal techniques to evaluate potential locations financially: payback method, average rate of return, and discounted cash flow.

Payback method

The payback method calculates how long it takes to recoup the initial investment.

$\text{Payback period} = \frac{\text{Initial investment}}{\text{Annual cash savings}}$

Location A: $\text{Payback} = \frac{\text{£12 million}}{\text{£3 million per year}} = 4 \text{ years}$

Location B: $\text{Payback} = \frac{\text{£15 million}}{\text{£5 million per year}} = 3 \text{ years}$

Conclusion: Location B is preferred as it recovers the investment one year faster.

Average rate of return (ARR)

The ARR method divides the net return by the initial investment, expressed as a percentage.

$\text{ARR} = \frac{\left(\frac{\text{Net return}}{\text{Total cash flow}}\right)}{\text{Number of years}} \times 100\%$

Discounted cash flow (DCF)

The DCF method recognizes that future cash flows are worth less than current cash flows. Money available in the future must be discounted back to present value, just as invested money grows through compound interest.

Using a 15% discount rate, future cash flows are adjusted to their present value. The discount factor decreases the further into the future the cash flow occurs.

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