The first step to fixing U.S. manufacturing

By Gary Pinkus, Katy George, Sree Ramaswamy

New research from the McKinsey Global Institute analyzes firm-level financial results and finds a stark contrast in performance between the biggest U.S. manufacturing multinationals and the small and midsize firms that make up most of the sector’s establishments and employment, write Gary Pinkus, Katy George, and Sree Ramaswamy in Harvard Business Review.

The decline of manufacturing has dominated the political narrative in the United States, but there are dual plotlines within this well-known story. A few outlier industries (notably pharmaceuticals, medical devices, and computers) prop up the sector’s aggregate performance; most others have experienced flat growth or outright declines in real GDP over the past two decades.

Even more striking, new research from the McKinsey Global Institute analyzes firm-level financial results and finds a stark contrast in performance between the biggest U.S. manufacturing multinationals and the small and midsize firms that make up most of the sector’s establishments and employment.

As a group, the largest U.S. firms have had the scale and resources to navigate the challenges of the past two decades successfully—and they have been posting even healthier returns than their peers in other parts of the world. In fact, MGI analysis of financial data shows that large publicly traded US manufacturing firms, most of them multinationals with revenues greater than $500 million, averaged returns on invested capital of 22% from 1997 to 2013. These returns were sustained by improvements in both profit margins and sales growth, and they were notably higher than those posted by large manufacturers headquartered in Western Europe, South Korea, Japan, and China. But while the largest US firms have seen their domestic revenues grow more than twice as fast as the sector average even in the domestic market, their smaller suppliers—the firms that provide them with the materials and components they depend on—have experienced negative growth. Some tier-one suppliers to major manufacturers are performing well, but tier-two and -three suppliers in many industries are struggling.

It’s clear why pain in the domestic supplier base matters from a policy perspective. Without the breathing room to invest in new equipment and technologies, smaller manufacturers may be up to 40% less productive than large companies—a gap so sizable that it drags down the entire sector’s performance. In some instances, the end results were firm closures and lost jobs. Many of the small and midsize manufacturers that did manage to survive kept going by cutting costs, which has led to stagnant wage growth.

But now the situation has reached such a tipping point that larger U.S. manufacturers are taking notice. They already report that the domestic supplier base is hollowed out, depriving them of the agility they need to respond quickly to new market opportunities. Some companies that built lengthy global supply chains have wound up with greater complexity and costs than they anticipated—not to mention greater exposure to a whole host of risks, including currency fluctuations, geopolitical disruption, delays, quality issues, and reputational risk. Many lack any real visibility into how their far-flung suppliers actually do business, and which smaller suppliers are strategic for the manufacturer’s core business.

Even when large U.S. manufacturers do source from domestic suppliers, they tend to regard them purely as a cost center. But taking a strictly transactional approach and keeping the relationship at an arm’s length can affect the bottom line. Past work by McKinsey found that inefficiencies in manufacturer-supplier interactions add up to roughly 5% of development, tooling, and product costs in the auto industry. These costs are significantly higher for U.S. carmakers than for their Asian counterparts, and may accumulate with each tier of the supply chain. Similar inefficiencies affect other industries as well, and they are likely to multiply as manufacturers seek to expand product portfolios and reduce turnaround times.

Over the longer term, there may be greater benefit in identifying which suppliers are core to the business and developing a tighter and more collaborative relationship with them. This isn’t just about setting benchmarks and monitoring performance; it’s about soliciting their ideas, investing in their capabilities, and building trust to create a preferred relationship. Contracts can be designed to offer suppliers additional incentives for finding efficiencies or opportunities to team up and go after new opportunities, sharing both risk and reward. Turning procurement into a source of value rather than simply a place to cut costs requires changing the goals and incentive structures of purchasing teams, but it’s a shift worth undertaking. A McKinsey survey found that companies that took a deeper and more strategic approach to supplier collaboration posted faster earnings growth than those that did not.

Large companies forming deeper alliances with key suppliers is a clear first step that can yield tangible benefits. But the challenge is bigger than that. Any long-term, strategic vision for making U.S. manufacturing more globally competitive has to involve shoring up small and midsize suppliers across entire industries. The sector as a whole needs investment, know-how, lean principles, digital readiness, and new workforce skills percolating throughout the supplier base—and the manufacturing sector is a key driver of productivity growth, R&D, and innovation for the entire US economy. Policy can help through measures like capital access programs, business accelerators, or tax incentives. But the future trajectory of U.S. manufacturing depends in no small part on whether its largest firms help to breathe new life into the broader ecosystem in which they operate.

This article originally ran in Harvard Business Review.

About the author(s)

Gary Pinkus is a managing partner for McKinsey in North America, Katy George is the managing partner of McKinsey’s mid-Atlantic office and a member of the MGI Council, and Sree Ramaswamy is a partner at the McKinsey Global Institute.