The Trade War, Tariffs, and Product Development
In the wake of the escalating trade war with China, companies with global supply chains have been scrambling to understand the impact of the tariffs on operations, product strategy, product development, and alternative sourcing. By September 2018, tariffs of 10-25% were in effect on $250 billion worth of Chinese imports (almost half of China’s 2018 US import volume). China countered with tariffs on $110 billion worth of US imports to China. The US President continues to threaten to add more duties on another $325 billion of goods.
Simply put, import tariffs are adding cost to global supply chains. US manufacturing companies who’ve enjoyed longstanding relationships with China look for strategies to avoid the new costs associated with the trade war. Multinational companies are quickly adopting new strategies but there’s not a single clear direction. Should you bring manufacturing back to the US? Source from “duty-free” countries? Increase prices to your customers? Rethink product development? Utilize “tariff engineering”?
Let’s examine possible solutions to help survive the trade war.
Tariff engineering has been getting some media attention. Essentially, tariff engineering is a legitimate restructuring or reclassification of a product to achieve the cheapest duty rate.
How does it work? Imported products are given a code from the Harmonized Tariff Schedule (HTS). The HTS code will determine its duty rate. Companies should evaluate whether another HTS classification subject to less tariffs could apply. If multiple HTS classifications could apply, request a formal determination from U.S. Customs and Border Protection.
A few considerations: Consult an expert early -- preferably during the product design stage. A product development team can make necessary design modifications that enable the lower tariff. Further, avoid practicing tariff engineering with the intent of removing the alteration upon import – this is illegal and could result in penalties & fines.
Examples of Tariff Engineering
Tariff engineering is not a new practice. In the late 1800s, sugar companies used molasses to tint imported sugar. That slight color variation gave the appearance of a lower grade sugar that was subject to lower duties (the tariff code was color-based).
In a 1912 case that went all the way to the US Supreme Court (US v. Citroen), pearls were unstrung from a necklace and placed in a natural (unset) state, only to be strung on a necklace again. The unstrung pearls had a duty of 10% while a pearl necklace’s duty rate was 60%. The court upheld the 10% rate.
For years, The Ford Motor Company imported the Transit Connect as a passenger van with rear seats, rear windows, and rear seat-belts to bypass the 25% tariff on imported cargo trucks. After the trucks passed customs, Ford would remove the back seats and add a solid panel over the window. The procedure saved them millions in duties. In June 2019, a Federal Appellate Court determined that the Transit Connect was a vehicle for the transportation of cargo subject to the higher tariff.
Ever look into your Chuck Taylors and notice a layer of felt? It’s because shoe imports into the US can have a duty of up to 40% or higher, but slippers carry a duty rate of 6%. Converse sneakers (owned by Nike) designed in a layer of felt to cover more than 50% of the sole of their shoes so they could be classified as slippers.
The famed comic company, Marvel, has also taken advantage of tariff engineering. According to HTS codes, a “doll” represents a human while a “toy” represents non-humans. The Marvel team argued and won the lower duty claiming that the action figures could not be classified as dolls because they were not representative of human beings.
Redesign or Redevelop
Product development teams should work cross-functionally with other departments to leverage design and engineering tactics to circumvent tariff rates, overcome manufacturing challenges, and improve supply chains.
Sometimes it takes a small product modification to affect the tariff rate, which could save millions in duties. But, sometimes tariff engineering is not possible. This is a perfect opportunity to work with your design and engineering partner to consider different approaches to building your product and extracting costs.
If you can’t avoid the tariffs but don’t want to raise prices, consider cost reduction engineering. First, look at materials and components. You may consider using plastic instead of aluminum; opt for unpainted internal parts; integrate components sourced from a lower-cost country. If you redesign your products with new materials and/or new components, it is important to consider the product as a system and not just swap out a material or part. Keep in mind system influences and make sure all parts are compatible.
Don’t stop at traditional, component-based savings. Evaluate your products’ functionality and features that increase costs but add little value. Some user research may identify irrelevant product features that can be designed out.
Returning, establishing, or expanding domestic manufacturing is a strategy -- and potentially the intended outcome behind the new US trade policy. The US administration has incentivized manufacturers with the foreign-derived intangible income (FDII) tax deduction. FDII allows companies to claim a deduction on any income generated from goods produced in the US and sold overseas. The deduction reduces the tax rate on this income from 21% to 13% between now and 2025. Many companies are adopting this strategy. In 2018, a record 1,389 companies announced the return of nearly 150,000 jobs.
Unfortunately, for many manufacturers, the FDII tax benefits have not outweighed the lower unit costs to manufacture offshored products. Moving production out of China is difficult and time-consuming. Setting up operations in the US could take 18 months. A new factory location must be built, workers hired and trained, and new distribution channels must be planned. If you need to source parts and/or raw materials from China to support US production, you will still need to pay the penalty tariffs (unless you were one of the many who stockpiled inventories in advance).
Exploring Other Low-Cost Countries
Break out your passport; it’s time to explore other low-cost countries that are not affected by the new tax and trade policies.
Companies unable to avoid the tariffs are evaluating alternative supply chains outside of China. US computer manufacturers HP and Dell could move up to 30% of their notebook production in China to alternatives in Southeast Asia, according to the Nikkei Asian Review. Nikkei also reported that Apple is considering moving 15% to 30% of its production from China to India. In fact, Apple will pilot a production trial of its AirPods wireless earbuds in Vietnam. Nintendo is also going to transition some of its console production from China to Vietnam, according to the report.
If you’re considering this solution, it’s time to hustle. Some alternative countries that provide similar labor pricing and quality are already at capacity.
An important note: trans-shipment via another country will not help you avoid paying the tariffs. Trans-shipping via another country such as Vietnam or Singapore and declaring these places as the Country of Origin (COO) is illegal under U.S. Customs Regulations. The COO must be the place where the goods are manufactured or substantially transformed, not where they are trans-shipped.
For some, there’s good news. Your supplier or even the Chinese government may try to incentivize you to stay. Several Chinese sources have negotiated to either split the cost of increased tariffs or absorb them completely rather than losing the business. Many Chinese manufacturers assume the tariffs are temporary and are willing to take the risk.
Beijing is rolling out the proverbial red carpet for some major foreign businesses. For example, Tesla is currently moving into its new plant on the outskirts of Shanghai, where it broke ground just six months ago. The US electric-car maker likely received a discount from the local government for the land and received other monetary incentives to manufacture in China.
Where Does It End?
Experts agree that US-China trade relations had already been strained but the trade war has accelerated the problems. Many predict a truce will be called and reforms will continue. There are some indications that negotiations may lead to a reduction in tariffs. However, most companies are rethinking their reliance on a China supply chain. Until a truce is found, reshoring, re-negotiating, moving production elsewhere, redesigning, and tariff engineering are all viable ways to survive the trade war.
If you have any questions about how a product development strategy can help you get through the trade war, contact Brooks Stevens.