Economics of Gaeseong Complex
By Kwon G. Ik-whan
Lately, there have been heated debates on the utility and survivability of the Gaeseong Industrial Complex as North Korea unilaterally demanded a new contract on wage and lease.
Although it is difficult and perhaps even impossible to separate the economics of operating Gaeseong from politics ― since it was established out of a political consensus between the two Koreas rather than the economics of business ― it is imperative for all of us to assess this entire situation from a business and economics prospective.
Two critical issues that impact the competitiveness of any firms in the global market are the concept of total cost of ownership and responsiveness to customer needs. Korea, whose foreign trade dependency exceeds over 50 percent of its GDP, cannot ignore these two vital concepts in the competitive international market.
The original intent of operating Gaeseong was to take advantage of ``cheap" labor from the North, and product design, know-how and capital from the South, which is no different from any company in the world seeking business opportunities.
According to one study, materials and labor account for only 52 percent of the total cost, and the rest is down to expenses such as logistics, administration, marketing, financing, new product design, etc. ― all of which adds value to the final product in the market.
A recent report also said the total labor and logistics costs for products manufactured at Gaeseong exceeds total sales ― a negative return. In addition, the same report mentions that the productivity of North Korean labor is one-third that of South Korean, while the productivity of Chinese and Vietnamese labor is 96 percent and 85 percent, respectively, of domestic labor.
In addition, the fee for building a factory in Gaeseong was $394 per square meter compared to $122 in China and $65 in Vietnam. Currently, the total wage including benefits such as free lunches and transportation for North Korean workers is $105.50 compared to $88 for Vietnamese workers. Therefore, considering all costs (from product design to delivery to the ultimate consumers ― total cost of ownership), it appears that there is not much benefit operating at Gaeseong compared to, for example, China and Vietnam.
Then, why are more than 100 companies from South Korea still operating at Gaeseong? From a supply chain management perspective, lead-time (time taken from the factories to the final customers) is one of the most important factors in meeting customer expectations, and at the same time managing optimum inventory for any company operating in a global market.
From Gaeseong to Incheon Port in South Korea is within a day's drive by truck compared to other facilities in China and Vietnam, for example. Short lead-time assures customers that their deliveries will be in most cases assured and guaranteed. Such an assurance and short lead-time also minimize inventory stock piling (called safety-stock). Considering the 20 to 24 percent average inventory carrying cost, short lead-time and optimum (usually minimum) inventory (safety) level certainly minimize the total operating expenses.
One study indicates that customers (clients) usually value more on-time delivery than the price of products. Companies at Gaeseong certainly provide such short lead-times, thereby enhancing competitiveness in the global market.
But the uncertain and erratic behavior of North Korea, as shown lately, creates challenging tasks for entrepreneurs at Gaeseong and customers around the globe. For example, North Korea shut down the gates last April for three days during the South Korean and U.S. military exercises (logistics issue).
They detained one South Korean employee for alleged negative remarks about North Korea, a man whose whereabouts are still unknown (safety and security issue). Since many companies at Gaeseong apparently operate with just-in-time environments, any prolonged disruption of traffic between the two sides obviously impacts the production schedule and transportation plan, and subsequent lead-time.
One of the major reasons that one company recently decided to pull out of the site was an inability to meet customers' delivery times abroad. Customers, especially in this global business community, are known to be impatient (as they have alternative sources) and less sympathetic (because it is not based on a business model) toward unrelated events that disrupt their routine operations.
Of course, the North may not care about such disruptions, or perhaps their unilateral actions may have been ``designed" for such disruption to punish South Korea, as with many other similar situations in the past.
It is about time, then, for South Korea to realize that operations at Gaeseong are and should be considered and evaluated based on a more business (profit and loss) prospect than politics as a guiding strategy. Perhaps we can afford to pay the North what they want ― based on a business model only. Or at least a business model provides a framework for future negotiation. Such a framework does not work if it is based on pure politics alone.
The government task now should be to provide the current 101 companies at Gaeseong with an alternative business plan for their future. A possible closure should be part of such alternative solutions if the economics of Gaeseong operations does not warrant a sound business decision. It is our understanding that the Inter-Korea Cooperation Fund has about 1.5 trillion won, which could cover some if not all losses in case the complex is closed.
Unless the future plan is based on a sound business model, this type of uncertainty will continue and create daunting and challenging tasks for everyone, including the government.
According to a study, the loss of Gaeseong may be a temporary setback for many Korean companies currently on-site, but more so for North Korea, which pockets almost $40 million per year from its operations.
As soon as the North understands that operations at Gaeseong are based on a sound business model and less or no political cobwebs, they may and certainly hope to realize it is their loss as much as the South's if the site is closed for good.
The writer is a professor of supply chain management at St. Louis University in Missouri, and a visiting professor at the KDI School of Public Policy and Management. He is also a 2009 Fulbright specialist in Korea, and can be reached at kwoni@slu.edu.