Five things you should understand before launching in China.

 

By David Alexander

 

 

You’ve just climbed in the taxi and are on the way back to your hotel after the closing dinner with the principals of your latest deal.  As the QB in the deal process you’ve spent months cultivating a relationship with the owners, convincing them that out of all the groups courting them, your firm was the best fit in terms of culture, business philosophy and opportunities for future growth.  With new resources in place, one of the first priorities identified is implementing a China strategy—something your firm could certainly make happen.  Right?

 

Firms with multiple funds under management constantly consider the idea of opening a sourcing office in China, leveraging volume across multiple companies to drive costs down and margins up.  No brainer, right?  Here are some considerations when determining if such an investment is worthwhile.

 

1.  Get to Break-Even

 

For any business of scale, it conservatively requires $1.5MM annually to operate a functioning “in-house” sourcing office in China today.  This takes into account travel, relocation costs, salaries for just one expatriate staff member and a Chinese support staff typically consisting of sourcing individuals, project engineers, Quality inspectors, supply chain coordinators and the necessary admin support.  This estimate does not even include the opportunity cost of valuable human resources and set-up dollars needed to get it up and running.  In five years this means a firm will invest $7.5MM in incremental fixed costs. 

 

Be sure to double the timeline and halve the payback.  Setting up is the easy part.  Becoming operationally efficient proves a little more elusive. Expect your operations leader to be hands-on, which could affect timelines on other domestic restructuring programs. On the ground support during the nascent phase is critical to long-term effectiveness of the Far East operation.  In reality, if your goal is to achieve 20% savings (net of working capital adjustments) on components you have to be able to push $8MM in projects through each year for years 2-5. Do you have the $40MM in transfer projects to China from US manufacturers needed to get to break-even?   If not, consider the variable cost option of a strategic sourcing partnership until such time that the in-house volume justifies the investment.

 

2.       Beware those who claim they are “China Experienced.”

 

After purchasing a valve and fitting company, you inherit “Bill” who is quick to inform you that he has traveled to China numerous times and has even learned a few words of the local tongue.  Single handedly, he’s “saved the company millions” overseeing outsourcing projects on behalf of the organization.  With more China experience than anyone in the firm, he has impressed a number of partners with his knowledge and has even volunteered to move to China to establish your operation.  Who better, right?

 

Bill might be proficient with his industry-specific knowledge of say, castings and forging suppliers, and may even have enough supply chain knowledge to be dangerous.  However, how his ability to transfer his knowledge and experience to other products and to the critical elements of managing the new sourcing office can test his learning curve (at best) and inhibit execution speed.  When you consider other daily administrative duties such as recruiting, personnel issues, financing and taxation details AND managing relationships with the Chinese and local governments, there’s hardly anytime left for sourcing!  He has also relied heavily in the past on his company’s Quality personnel as well as those extensive resources provided by the handful of suppliers he’d worked with in China.  Is Bill fully prepared and qualified to monitor these Quality details for your other operations?

 

Bill has never set up a business from scratch, let alone one in China, and probably lacks the broader business acumen to get the China sourcing company off the ground.  Does Bill understand the difference between a “Rep office” and a WOFE (Wholly Owned Foreign Enterprise) and the tax implications of each?

 

Running a China sourcing office is a broad-based leadership role and requires solid general management instincts and experience. If integrated into the business effectively, the China sourcing office will interface with all elements of your US operations.  Bill’s a great nuts & bolts guy but you need a heavy hitter.

 

 

3.       Location, Location, Location

 

Manufacturing expertise tends to cluster in China.  Should you really be in Zhejiang or is Guangdong Province better suited for your products?  You have heard that manufacturing is moving north and west in China.  Should you be going there?  What type of product categories do you anticipate supporting from your new office, now and five years from now?  What’s going on in the Mekong Delta?  This region in Southwest Vietnam where the Mekong River meets the sea via distributaries could likely be the preferred next low cost sourcing hub in Asia. Could Cambodia and Laos be additional low cost frontiers?  Many products are coming from India lately. Maybe you should have an office in Mumbai?  Did Bill sign that five-year lease yet?

 

 

4.       What does the Chinese government think about your business?

Regardless of the aforementioned, China remains the low cost factory of the world today and will continue as such for many years ahead.  Did you know however, that the Chinese government has a clever system to encourage and/or discourage different industries to manufacture in China? Big cost advantages through generous VAT rebates can still be enjoyed by companies in “encouraged” industries while VAT rebates for businesses now falling in “discouraged” categories were eliminated last year, with a generous one week notice from the central government in Beijing.

Delivering a speech to the 1st session of the 11th National People’s Congress (NPC) in March this year, Premier Wen Jiabao made known China’s determination to end its position as a global center of “smokestack industries” or those energy-intensive, polluting and resource-based ventures. As a result VAT rebates for 1,115 commodities in these sectors were ended.  Add in worldwide commodity price inflation, today’s soaring energy costs and a 15% appreciation of the Chinese RMB in the past 18 months and suddenly that 25% savings Bill got for your pipe fitting company may not be realistic across the board.

5.       Scale

 

Flash forward to year-five and let’s assume your office has developed a business rhythm.  You have a few successful projects under your belt and are finally realizing some savings on behalf of your portfolio companies, albeit not quite what you were promised.  The sourcing team is working with 20 or so decent manufacturers.  Independently though, each of your projects represent a small fraction of these factories’ overall volume since you are supporting only your U.S. businesses. You need to continuously look for opportunities to leverage scale. How can you do more business with fewer suppliers to ensure you have their ear on important schedule and quality issues?

 

 

The good news

 

PE firms with small and mid sized portfolio companies should do their homework before taking the plunge into China.  There are firms in place today who have absorbed startup costs, are highly capable and experienced in running a China office, and are staffed with experienced sourcing experts, engineers and Quality personnel.  These firms have a working knowledge of and ability to navigate China, the flexibility to respond and adapt to the changing landscape and command significant volume leverage with the factories with whom they work.  When choosing a solution, carefully consider the variable cost option and work with a team who has only your best interests at the forefront of their activities—whose success depends on your success.

 

David Alexander is President of BaySource Global®, www.baysourceglobal.com a U.S.& China based Project Management firm who oversees Strategic Sourcing Initiatives on behalf of clients worldwide.  BaySource is based in Tampa, FL and Mr. Alexander is a member of ACG.

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Making It in China

For U.S. companies working with Chinese partners, here’s a crucial bit of advice: Don’t let expectations get lost in translation
By ANDREW R. THOMAS, TIMOTHY J. WILKINSON and JON M. HAWES
May 12, 2008; Page R11

Any business relationship works best when both sides understand what the other expects. For U.S. companies working with Chinese business partners, that understanding can be particularly difficult.

The problem is that each side comes to the partnership with very different cultural and economic perspectives. Americans tend to view a business relationship as a win/win proposition — a contract between two corporate entities designed for their mutual benefit in long-term profitability and growth.

In China, personal relationships among business partners are far more important, and the benefits foreseen in entering a partnership often are broader and focused more on the near term — and not necessarily evenly balanced.

Any U.S. company that joins a Chinese partner without understanding these differences risks failure. The key to success is paying close attention to the relationship, both on a personal level and by implementing procedures to monitor the progress of the venture.

Several years ago, one of the authors of this article worked with a U.S. company in a nonexclusive partnership with a Chinese motorcycle manufacturer. That venture is a case study in the difficulties of a Chinese-American business relationship, and the importance of understanding and overcoming those difficulties.

Different Priorities

In the mid-1990s, a U.S. export-management firm established an alliance to purchase small motorcycles made in China, for sale to consumer markets in Latin America and Africa. The Chinese manufacturer agreed to produce motorcycles at its facility for export, while the U.S. company took charge of quality control, sales, distribution and after-sale service.

The basis of the relationship seemed clear enough, but from the beginning there were unstated differences in what the two sides hoped to accomplish.

The U.S. executives assumed that their Chinese partners shared their focus on ensuring long-term profitability by pleasing the venture’s distributors and customers with quality motorcycles. But from the Chinese perspective, the relationship with the U.S. firm provided multiple opportunities, some of which had nothing to do with the venture’s long-term profitability.

Think back to the mid-1990s. China was desperately short of foreign currency. So, first and foremost the Chinese saw the relationship as a source of regular inflows of U.S. dollars. In addition, the Chinese executives were more interested in the venture for what they could learn than for what they could earn — they saw the Americans primarily as teachers. The Chinese managers knew nothing about selling their motorcycles outside of China. Through their affiliation, the Americans provided the Chinese with market insights and knowledge the Chinese would never have been able to acquire on their own.

These differences in focus between the American and Chinese sides would emerge later, much to the detriment of the venture.

Since the mid-1980s, the Chinese manufacturer had been producing about 450,000 motorcycles per year, all for its domestic market, under a licensing agreement with a Japanese auto company. But the performance of the motorcycles was poor. To ensure higher quality for this new partnership’s motorcycles, the U.S. partner insisted on the use of Japanese imports for key engine components, in place of the inferior Chinese-made parts the manufacturer had been using. Both parties agreed that the U.S. partner would send an observer for the purpose of quality control, including confirmation that the Japanese components were being installed in the bikes.

The observer was a Chinese-American who had returned to China to explore newly available business opportunities. He was retained for one week each month by the U.S. company. Every time a monthly production run was scheduled, the observer would make sure that the Japanese engine parts were used on the motorcycles to be exported.

This system worked well for five years. Nearly 250,000 high-quality motorcycles were profitably produced and sold. Customers were pleased with the quality and service. But just as the Americans began to think of expanding the venture with the introduction of new product lines, a conflict arose between the two parties.

A Rift Opens

At the beginning of the sixth year, the observer representing the U.S. partner quit. The American executives chose not to replace him, assuming that after five years of high-quality production, the Chinese would continue using the Japanese parts for the export motorcycles. This decision was made without consulting the Chinese.

A few months later, the U.S. company began to receive complaints from customers about the quality of the motorcycles. The problem was the same everywhere: The engine would run well for the first 200 miles or so, then it would begin to smoke and eventually the engine would seize up, rendering the bike inoperable. It was quickly determined that the Chinese manufacturer had substituted poorly made Chinese parts for the specified higher-quality Japanese-made components.

From the American perspective, this is where the relationship went bad — when the Chinese began using inferior parts. From the Chinese perspective, however, the removal of the observer was where the problems started, because it signaled a major change in the relationship between the two companies. While the Americans had viewed this person simply as a quality-control monitor in an overseas factory, the Chinese looked upon him as the personal representative of the U.S. company within the Chinese operation. The disappearance of this person, with no explanation and no replacement, was seen as a breach in the relationship. No longer strictly bound by the terms of that relationship in their minds, the Chinese partners acted in their own self-interest, cutting costs to maximize their profits.

Frictions Worsen

Efforts to resolve the problem caused greater friction.

Confronted with several thousand motorcycles that would require replacement parts as well as major servicing in 15 countries, the U.S. partner calculated that $400,000 would be needed just to begin to deal with the problem. The Chinese manufacturer was consulted, and it was decided that customer credits should be issued to maintain the integrity of the brand. Because of stringent foreign-exchange controls in China, the U.S. partner issued the customer credits. Both parties then agreed that they would meet in Shanghai later that year to negotiate how to share these costs.

Prior to the meeting in Shanghai, the Chinese sent a fax demanding that the Americans provide comprehensive documentation for every customer complaint. The Americans objected, but the Chinese wouldn’t budge. This angered the Americans, who felt that both sides understood that the Chinese were to blame for the problem. In the end, the U.S. side compiled a report for each defective motorcycle, resulting in almost 50,000 pages of documentation.

The Americans were further distressed to learn that before any negotiations could occur, they would have to verbally present their findings on each motorcycle. The presentations were scheduled over a four-day period. On the second day, after presentations had been made for only about 200 of the motorcycles, the U.S. side decided that they had had all they could take. The two Americans stormed out of the room.

As the Americans were walking out of the building, one of the Chinese managers tracked them down. The Americans told him that if this continued, they would never buy another motorcycle from the Chinese. The ultimatum worked, at least in one sense — the Chinese executives agreed to at last begin discussing how to cover the $400,000 of customer credits.

After more than six hours of further talks, the Chinese executives offered to pay half of the $400,000. Incredulous, the Americans again staged an angry walkout. In a repeat of the day before, the English-speaking member of the Chinese team caught up with the Americans. He explained the Chinese position, saying that the Americans were one-half responsible for the defective motorcycles because they had allowed their Chinese partner to violate the arrangement by using Chinese parts.

Eventually the U.S. side agreed to split the costs evenly, but bad feelings remained on both sides. Again, the Americans had failed to appreciate the importance of personal relationships to the Chinese. Rudeness and anger are out of place in China and are considered embarrassing. By having a public tantrum, the Americans looked like barbarians in the eyes of the Chinese. In addition, the Chinese viewed the American demands as unreasonable because in their minds it was the Americans who devalued the relationship in the first place.

The problems between the U.S. and Chinese partners ultimately were resolved.

Mark Twain is quoted as having once said that “Nothing is as weak as a relationship that has not been tested under fire.” With a better understanding of Chinese thinking and with close monitoring, American companies in ventures with Chinese suppliers can keep those inevitable fires from spreading out of control.

–Dr. Thomas is an assistant professor of marketing and the associate director of the Taylor Institute for Direct Marketing at the University of Akron’s College of Business Administration, in Akron, Ohio. Dr. Wilkinson is an associate professor at the College of Business at Montana State University, Billings. Dr. Hawes is a distinguished professor of marketing and the director of the Fisher Institute for Professional Selling at the University of Akron’s College of Business Administration.