In 2005, China leapfrogged the UK to become the world’s fourth largest economy. Goldman Sachs has predicted that China will become the world’s largest within the next three to four decades – some think it will happen even faster. Add to this, the emergence of China as the world’s manufacturing powerhouse and the impact on global supply chains starts to become clear. So is China a threat or an opportunity – or both? How can companies take advantage of the opportunities within this country and what are the future implications?
A recent Supply Chain Trends Survey, undertaken by consulting firm PRTM, reveals that a large percentage of companies already have a footprint or connections into China; those who don’t are under increasing pressure to move Eastwards. Over 79 per cent of companies surveyed already use some form of outsourcing and 84 per cent see themselves moving to more offshore sources in the short-term. 54 per cent of all medium sized companies (e25 million – e1 billion) involved in the survey plan to expand into China over the next 12–14 months.
The most common reason why companies consider an offshore manufacturing operation is to save money. 40 per cent of respondents to the survey listed lower costs as their primary driver. With its low cost labour force, China offers a compelling cost structure. In 1990, less than 17 per cent of US imports from China were deemed ‘higher value goods’ which includes products such as electronics. By 2001, this figure had more than doubled to 36 per cent. This significant growth in its high-tech manufacturing base makes China especially attractive to European technology based companies that face constant pricing pressure. For one consumer electronics product, offshoring to China has reduced labour and component costs by approximately 20 per cent, from e82 to e66 per item. But moving operations to China doesn’t necessarily translate into lower total product cost.
Companies must approach a move into China with greater caution than for implementations in other established manufacturing economies. The challenges that exist in China are substantially more complicated than the issues encountered elsewhere in the world and therefore require careful planning to negate the risks and avoid the hazards. The key lies in retaining overall management of the global supply chain.
In order to better understand the business issues resulting from China’s emergence as a player in the global supply chain it is important to address the context within which these opportunities have developed.
Long and proud history
China has a long and proud history, occasionally overlooked by the West. It is important for Europeans to recognise the pride that the Chinese feel for their nation, particularly as it reasserts itself on the international business scene.
Now the world’s most populous country with approximately 1.3 billion people, China is growing at a phenomenal yet sustained rate. Inward investment, measured by Foreign Direct Investment (FDI), offers an idea of the investment in supplychain related infrastructure – in 2003 China was top in the world.
PRTM’s survey found that European companies have adopted one, or a combination, of two approaches towards China: Exploiting the largely untapped Chinese consumer market or outsourcing/offshoring to a low-cost manufacturing source.
Firstly, companies such as Electrolux and Siemens are addressing the Chinese market from their own in-country operations.
However the majority of European companies fall into the second category – those whose customers remain in western markets but to whom China’s low costs represents a compelling case.
So should China be part of your global supply chain? Before judging, or following this trend of moving east, it is important for companies to recognise their basis for competition. Organisations must determine whether they wish to compete on innovation, quality, service or cost? Depending on the answer, the role of China within one’s supply chain could be very different.
When it comes to product innovation and product quality, China can play a very beneficial role. Companies competing on innovation have a very short window of opportunity to profit from new products and achieving short ‘time-to-volume’ production can be a major competitive weapon. The rapid emergence of strong product development capabilities in China makes this a feasible reason for China to play a part within a global supply chain. The country has now overcome past perceptions as a supplier of ‘questionable quality’ to provide products with as good, if not higher, levels of product quality as ‘Western’ manufacturers. In fact, many premium brands and products are now associated with Chinese manufacturing operations demonstrating the country’s capacity for consistent and reliable performance.
For companies who compete on service and cost, the role of China within their supply chains can be more problematic. ‘Service’ product providers deliver competitive advantage by tailoring their offerings to meet customer specifications and have a reputation for exceptional customer loyalty and repeat sales. Our research has shown that these companies can be up to 20 per cent more profitable with 25 per cent faster topline sales growth than those who compete on different criteria. However, it’s harder to excel when you have 9,000 km or more between your manufacturing operation and your customers. As a result, companies competing on profit must be selective about which operations and products to offshore.
For those competing on cost, there are hidden considerations that can prove critical to success. While labour rates and material costs are easy to quantify, many others are not. These include costs associated with managing cultural and language barriers, overcoming limited supply chain expertise, coping with a supply chain rendered far less flexible because of the physical distance between the company and manufacturing operations. The savings may be offset by these incremental costs.
Many of the hidden costs of offshoring relate to reduced flexibility. Only a minority of companies with offshoring operations in China have products that are expensive and light enough to air freight to their final destination. The vast majority rely on the slower sea freight for delivery to Europe, with average lead-times of five to six weeks. The implications of this delivery mechanism can be the deciding factor on a move to China. For supply chains with a perfect demand / supply balance, a mere six weeks of inventory carrying costs (on average one per cent of product cost) are outweighed by the benefits of reduced labour and material costs.
The worst case scenario
However, the worst case scenario can negate these savings. Shorter product lifecycles equal higher risk when it comes to supplying demand. For example, in the fashion clothing business, a garment’s shelf life can be as short as eight to 12 weeks. Products sourced and sea freighted from China will spend over half of their shelf life somewhere mid-ocean and the supply chain has only limited, and costly, options to react to forecast inaccuracy. Companies that plan to do the bulk of their shipping via sea freight are often forced to turn to air shipments far more commonly than planned, to offset inflexibility in the supply chain. Unless a company has excellent forecasting accuracy, or a product that is easily configurable once it arrives at its destination, close attention should be paid to the assumptions made in planning transportation and logistics costs.
And there are further pitfalls. Although China is a worldclass manufacturing hub, certain cultural practices can make it difficult to embrace acknowledged concepts and techniques. China is not as experienced with modern production concepts as many people believe. Executives must find ways to address these differences if they want to meet planned corporate milestones.
There are long-standing cultural and business ideals that must be acknowledged and managed for effective supply chain and manufacturing concepts to be successful in China. A core difference between Western and Chinese principles rests in the concept of guan xi, the Chinese practice of building relationships. Under guan xi, business partners strive to support one another, largely in the spirit of ‘you scratch my back and I’ll scratch yours’. The essence of this is the swapping of favours and developing long-term mutually beneficial relationships while overlooking short-term weaknesses or vulnerabilities. For example, it is considered bad business to hold supply chain partners accountable for poor performance, as this counters the principle of guan xi; therefore factory improvements may fail to address the root cause of problems if they result in straining an established relationship.
Skills shortage
Developing a skilled workforce is another major challenge. From 1993 to 2001, China’s gross industrial output rose from e398 billion to e944 billion – however there remains a shortage in the supply of skilled employees. Factories located in China’s coastal cities attract workers from rural, agricultural villages with little exposure to manufacturing concepts or technology products. The typical Chinese company is hierarchical; decisions are made by executives and communicated to employees as pronouncements not suggestions. Therefore lower level employees do not question inefficiencies and little incentive exists for proactive decision making. Senior and midlevel managers must learn to empower the workforce to pursue efficiency.
The impact of China on the global supply chain also demands a change in mindset in the boardroom, particularly regarding the issue of workforce longevity. If companies want to exceed productivity, profit and revenue expectations, senior managers need to invest in their workforce through training and employee-retention programmes that promote long-term tenure and loyalty.
The good news is that many of these challenges can be overcome with investment planning and a step by step approach to the transition. Companies operating in China report increased satisfaction with each passing year of experience. PRTM’s Supply Chain Trends Survey reveals that only four per cent of companies with a footprint in China felt ‘very satisfied’ in the first year, increasing to almost 25 per cent by year five.
How best to tackle supplier practices and the country’s logistical infrastructure is important. Initially there may be no getting around inventory build up to ensure there is enough material in place to prevent a production shutdown. However, that inventory need not be European responsibility. Establishing a vendor-managed inventory (VMI) hub provides more control over raw materials and encourages the supplier to keep materials closer to manufacturing sites. A VMI provides a level of flexibility that may be needed in the initial stages of offshoring and outsourcing in China as trading practices, supplier reliability, product quality and predictable delivery improves.
The key to success is making sure all relevant costs and product characteristics are considered. We advise clients to learn from other’s mistakes and not to underestimate the difficulties in implementing and managing operations overseas.
For those companies who do their homework and invest time in building relationships – a long and profitable future in China awaits.
Craig Kerr and Gordon Colborn are directors at management consultancy, PRTM
Seven steps to China
To ensure cost advantage during a move to China, the following due diligence is recommended:
- Offshore outsourcing is a holistic activity – offshore related decisions are not point solutions to reduce costs in functional areas and therefore these decisions should not be made in isolation. Planned offshore transfers or outsourcing partnerships must be closely reviewed by the entire senior management team
- Consider all the costs – all potential costs must be taken into account including internal resources and skills required to ensure success. Other hidden costs commonly overlooked include travel, training of staff, system integration and collaboration. Hidden costs can add up to 15 – 24 per cent of total labour and material costs. Budget for shipping, travel, communication, obsolescence, inventory, warehousing and training – and remember – 10,000 containers from China fall overboard every year!
- If it’s broken, don’t send it outside – companies must ensure that the processes to be outsourced are stable and operate at competitive performance levels prior to the transition. Most executives find that it takes twice as long as planned to achieve a steady state of production
- Make sure products are suitable for outsourcing or offshoring – products that have complex manufacturing or troubleshooting processes are much more difficult to outsource. China is not a good option if a high level of skill is required to implement design changes
- Carefully assess the level of supply chain expertise at the site in China – it is important to understand the capabilities of the site prior to the transition, to ensure it can handle the specifics of the product, processes and volume. PRTM recommends site visits and communication with managers at the site and other customers, to understand the strengths and weaknesses of
production - Maintain control over key suppliers and technology – reviewing the logistical elements of the suppliers’ supply chain, will help to understand how performance measurements and controls are managed
- Use a structured approach for success – an effective plan should incorporate feasibility and planning; outsourcing analysis; outsourcing design; implementation and management of the operation.
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