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What’s Next for Manufacturing in China?

What is something you can think of that can’t successfully be outsourced in China?

Think long and hard about this. Resist the temptation to veer toward intangibles or time sensitive services with obvious geographical barriers such as a haircut or plumbing repair. What product theoretically cannot be manufactured in China? How about a portrait? I have an acquaintance that has connected with amazingly talented artists who will take a family photo and reproduce a framed, hand painted, oil on canvas likeness taken from a photograph.

It will have the same level of detail and quality as those done by artists in the U.S. costing a minimum of $1200-$2500 just for the painting itself. This does not include the frame which can be another $350-$500. The exact quality portrait from China can be delivered to your doorsteps for $450 or about a quarter or less that which someone would expect to pay here. Why is this?

If you said labor cost you are only partly correct. There are many more factors that play into “the China price” for which Westerners have had an insatiable appetite since the Wal Mart effect took hold in the early nineties. Yet now writers, politicians and economists say the tide is turning. Many assert that currency fluctuation, labor shortages near China’s coastlines, and a rising middle class, are quickly narrowing the cost gap between China and the West. They might be forgetting one thing though according to Mike Bellamy, author of The Essential Guide to China Sourcing , “there is no Next China.”

Rising Labor Costs in China

 

rising labor costs china

In a Roya Wolverson interview published in Time, May 16, 2011, Pin Li, President of the Wanxiang America Corporation stated that “rising labor costs in China will only cause inflation and not necessarily jobs returning to the U.S.” He further explained that what this means is “instead of paying $1 for latex gloves the price may rise to $2 and will still represent the lowest cost available in the world.”

In other words, assuming material costs are consistent globally, even doubling or tripling the average monthly wage of Chinese factory employees still does not bring total cost of goods in line with U.S. workers.

In a recent conversation, Bellamy, Chairman of the Advisory Board for China Sourcing Information Center begins to make the “No Next China” case with the notion that China’s economy is still vastly lopsided in its dependence on exporting. The Chinese and its neveaux riche’ have created the world’s second largest economy that many predict will be bigger than the U.S. within the next decade. The only fuel to keep this burning is the demand for cheap(er) exports. A growing middle class also means bolstered domestic consumption, particularly as brands become more prevalent with Chinese consumers. But to sustain economic growth, exports have to remain a big chunk of the equation.

A Shift By Coastal Manufacturing Regions

The question may not be so much about “Made in China” as it is “What will be Made in China?” Sure there is great capacity and infrastructure in coastal regions but there may be a shift developing with the evolution of improved skill sets and wage increases. Dr. Eric Thun , lecturer in Chinese Business Studies at the University of Oxford China Center, says “pushing manufacturing into high value-added activity is very much what the government wants. This kind of cost pressure stimulates upgrading.”

Bellamy adds, “because China’s economy is still heavily export dependent at present, over the past years there have been concerns about the China government promoting the interior too fast at the expense of the coast. This could have major side effects on the much needed revenue stream gained by supplying product to overseas buyers. But, as April data demonstrates to policy makers, the development of the interior is not having a major impact on exports. “

The Role Of Appreciation In Chinese Currency To U.S. Job Creation

Since June, 2010 when currency truly began floating, the RMB has appreciated 6% against the US dollar. Depending on whom you talk to however, the RMB is still undervalued by as much as 25%. Add to this CPI inflation and productivity growth rates (Chinese worker productivity is growing faster than U.S.) and the RMB will continue to be undervalued for five years or more.

Pin Li argues that “currency can help but it also can hurt. Structural issues are more fundamental for the U.S. and China. This is more of a political question than any economist can even measure. Politically we have to pretend it’s an issue. But the reality is that jobs from China won’t come to the U.S. They’ll go to Mexico, Korea, and Indonesia. And that means the imports that came from China will now cost more which also doesn’t solve the deficit issue.”

Bellamy claims “we can expect that the US government will probably use the April export record to put pressure on China to allow their currency to appreciate. The China government has a plan in place for a slow but steady increase as opposed to a dramatic adjustment as desired by the US. Don’t expect China to change their plan just because of this April data and any related pressure from the USA.”

China as a Market

Li’s passive reference to the deficit is interesting and should not go unnoticed. While many grip about jobs, only a small percentage of Western companies have invested in growing market share in China.

In an October 6, 2010 Bloomberg Press report it was estimated that China market was valued at $150 billion in potential goods and services or a top ten global opportunity for U.S. companies. “U.S. companies have experienced tremendous commercial success in China’s market and the prospects for future growth are significant,” said Erin Ennis, vice president of the U.S.-China Business Council.

Beijing has a $145 billion trade surplus with the U.S., more than its deficit with the next seven- largest partners combined. But is this solely due to undervalued currency and cheap labor? Could it be more the apathetic or myopic strategies of only selling into North American and European markets and not breaking from traditional business models?

Pin Li makes a bold statement when he asserts, “Firms’ access to Chinese should be their more of a concern than an unbalanced currency.”

The Next 5 Years

China remains a factory to the world. Government subsidized infrastructure has ensured overcapacity of manufacturing availability. One needs to simply travel from town to town; cranes as far as the eye can see. Staggering development continues in all sectors such as transportation, industrial, housing, recreation, hospitals, shopping centers, and resorts. Innovation and branding are now woven into the next generation’s mindset with Beijing’s full support. There is no next China. Whether as adversary, trading partner, or ally the future will depend on setting priorities and building mutual trust.

David Alexander is President of BaySource Global www.baysourceglobal.com

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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