Build scale to close the competitiveness gap

Manufacturing is the largest business sector across the NAFTA region. Turns out Canadian companies are more profitable than their US counterparts.
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OK, I admit it. I’m an economist and I like statistics. They explain a lot, if the right questions are asked. But sometimes statistics can be misleading, resulting at best in some earnest head scratching, or at worst bad decisions made by businesses and governments.

Take, for example, the seemingly endless debate about why Canada’s competitive performance in manufacturing is in decline. In 2000, the United Nations ranked Canada fourth in the world in terms of manufacturing competitiveness. Since then, we have tumbled to fifteenth spot. Investments in research and development and in new machinery and equipment have fallen off dramatically. Our productivity gap with the US, not to mention Germany, Japan and South Korea, has widened. Today, after adjusting for price changes, the value of goods produced by Canadian manufacturers is running at about the same level as in 2002 and 6% lower than the peak, just before the Great Recession.

The statistics behind these trends paint a sobering picture of an important industry in trouble. They also underscore the challenges the Canadian economy is currently facing. Our fondness for borrowing on the back of inflated financial and property markets and artificially low interest rates has obscured the reality that Canada’s ability to generate wealth, earn export income and sustain well-paying jobs has been critically impaired by a sputtering manufacturing sector. The seriousness of this situation will become more apparent as interest rates climb higher.

But some perspective is in order. The view at the top is not always an accurate indicator of what’s happening at the level of each firm. In fact, when you ask a manufacturer about business, the response is usually fairly positive.

A better way of gauging how manufacturers are doing is to step into the shoes of a CFO and look at the financial statements, as well as average operating revenues and costs. The view from this angle is much more positive and instructive, especially comparing Canadian companies to their US counterparts.

Financial statistics show Canadian companies are – on the whole – more profitable than those in the US. As a percent of gross output (sales revenue plus changes in inventory valuation), overall labour costs are lower in Canada, while goods and services input costs account for exactly the same proportion of output in both countries. As a result, gross profit margins are higher in Canada. So too are before- and after-tax profit margins – although US manufacturers do enjoy a growing tax advantage.

Another remarkable observation is that over the past 15 years Canadian and US manufacturers have invested exactly the same proportion of their after-tax operating cash in R&D, new machinery and equipment.

This helps to explain why stats at a macro-level appear so dismal. Operating cash includes after-tax profits as well as depreciation and amortization costs, which are much higher in the US where operations are typically much larger. Only about 270 facilities in Canada are large enough to employ more than 500 people. There are almost 32,000 in the US.

So, what does all this tell us, apart from the fact that more economists should be reading financial statements?

It means that scale matters. Bigger companies invest more in innovation, employ more technology and benefit from greater economies of scale and production efficiencies. It also implies declining levels of investment and productivity in Canada can be attributed, at least in part, to the loss of larger manufacturing operations over the past several years.

There are lessons here for policy-makers aiming to strengthen economic performance. Any steps governments can take to reduce regulatory compliance costs, accelerate depreciation rates for tax purposes, or otherwise reduce taxes on manufacturers will increase cash flow and boost investment performance. Initiatives that aim to increase the amount of cash companies are willing to invest in innovation, such as supporting technology, production and business scale-up, or that help de-risk investment decisions – particularly for smaller companies – should be encouraged.

The lesson for manufacturers is the importance of building scale to compete, staying current with technology and capturing new market opportunities.

Jayson Myers is the CEO of Next Generation Manufacturing Canada. The award-winning business economist and advisor to private and public sector leaders was president and CEO of Canadian Manufacturers & Exporters between 2007 and 2016. E-mail jayson.myers@ngmcanada.com. Visit www.ngmcanada.com.