Eye On China

Eye On China

As China rapidly evolves into a more service-oriented economy, U.S. manufacturers need to adjust their China strategy to remain competitive.

In today's politically charged climate, few U.S. manufacturers are likely to shed any tears (at least publicly) upon hearing that China's manufacturing industry has hit a rough patch. Nevertheless, with so many U.S. companies currently using Chinese factories to take advantage of low-cost labor, and so many others seriously looking to the East for competitive reasons, the state of Chinese manufacturing in the coming years will have a profound effect -- for better or worse -- on U.S. companies.

China's manufacturing industry is going through a period that can best be described as evolutionary, according to Bradley Feuling, CEO of Shanghai-based Kong and Allan, a supply chain consulting firm. Many Chinese manufacturing companies, he explains, were launched when the Chinese government began offering a value-added tax (VAT) credit reimbursement to encourage exports. A year ago, however, China reduced or eliminated the VAT export rebates for some industries. As a result, though you don't hear it reported much in the United States, some Chinese manufacturers are operating now at a loss, and many have been severely impacted.

"A number of manufacturers and industries in China are facing very difficult times," Feuling states. "Competition has grown to a point where each manufacturer has a very small piece of a huge pie. Gaining market share means consolidation and acquisition, yet few operations have the cash to invest in purchasing other companies." The majority of owner-operated companies are unwilling to sell to other local companies, though some will sell ownership to foreign buyers for the cash inflow, he says.

See Also

How to 'China-fy' Your Manufacturing Operations

"With that being said," Feuling continues, "the manufacturing industry in China is still expanding, but in a vertical migratory path instead of horizontal. Higher value-added services are beginning to be understood -- customer service, for example, in working with foreign customers. Product or material design is another area. Supply chain operations and efficiency is a third. Companies can readily see that the future will require adjustment to remain competitive and in some cases stay alive."

End-to-end supply chain involvement is critical for U.S. manufacturers if their goal is to fully understand the cost of sourcing in China. "Sourcing accounts for more than direct cost," Feuling emphasizes. "When you buy a product, you buy the supply chain." He suggests that companies focus particularly on inventory and capacity management.

Absence Of Lean

When it comes to the current state of Chinese manufacturing efficiency, David Hemmings, president and CEO of consulting firm Pacific Rim Alliance, says, "Chinese companies, when compared to Western productivity numbers, are still very inefficient despite a great workforce ethic. It doesn't matter if wages are only $1.25 an hour if there are 2,000 extra people working to make up for their inefficiencies."

Jintian Group, an example of a modern Chinese manufacturing plant, makes equipment for the electrical and electric power industry in southern China.
From Hemmings' perspective, lean manufacturing is mostly a rumor in China. "Chinese-run companies don't have lean manufacturing, and workers won't stop production lines if they see something's wrong because the social and education system is based on Confucianism -- which emphasizes loyalty, harmony and obedience, not questioning."

As he sees it, the Chinese government does not encourage lean manufacturing because "it wants to spread the wealth and create more jobs, not less. Additionally, it wants companies to take on cost and the burden of social responsibility." The lack of lean manufacturing, he adds, is one of the reasons why only three out of the top 10 Chinese car companies are local domestic producers.

"The big competitive advantage Western manufacturing companies operating in China have over domestic factories is China's manufacturing foundation is based on heavy use of labor and less automation, while in the United States, it's heavy automation," Hemmings notes. "In Europe and the U.S., the successful companies have significantly invested in upgrading their plants."

Growing Pains

Some U.S. industries, of course, long ago moved most if not all of their production work over to China. The U.S. toy industry, which imports roughly 80% of its products from China, came under fire in 2007 when millions of Mattel-brand toys were recalled due to product defects or lead paint, but there's no evidence that any significant movement is afoot to bring that production work back to the United States, perhaps because Mattel itself ultimately shouldered the blame for the recalls. Another U.S. industry that has basically relocated to low-cost production centers like China is the apparel and footwear sector.

"China is the world leader in high-quality, high-volume footwear manufacturing," observes Mark Rave, director of logistics with California-based Ariat International Inc., a manufacturer of equestrian riding boots. "We're in China along with pretty much every other major footwear manufacturer in the world. It's one of the leading countries where we use contract manufacturing."

Although he acknowledges that China is facing some growing pains, in terms of labor shortages in certain areas as well as pollution, Rave points out that Ariat hasn't had any quality issues from its Chinese producers. In fact, from his perspective it's gotten easier to do business with China in recent years. "China has an ever-growing, highly educated middle class, and their business savvy is equal to any other place in the world now."

Jack Watts agrees. "The stereotyped images of sweat shops with dirt floors, windowless rooms with 40-watt light bulbs and workers chained to machines simply do not exist any more," says Watts, operations manager and director of manufacturing excellence for the Northwest Industrial Resource Center, a Pennsylvania-based organization that recently participated in a trade visit to China. "We saw modern, well-lit facilities and huge production areas with row after row of state-of-the-art injection molds, computer-controlled fabrication machines and other high-tech equipment."

Watts acknowledges that it's important for U.S. companies considering a Chinese manufacturing strategy to have a partner well versed in the ways of China. The trade visit he participated in, for instance, was organized by Orient Product Services, which manages and operates a large buying group for manufacturing overseas. "If you don't have someone in China working for you, you have a very high probability that you're not going to get what you want." (See also sidebar, "How to 'China-fy' Your Manufacturing Operations.")

China Is Offshoring, Too

For those U.S. companies waiting for China to start losing its cachet as a production source, Kong and Allan's Feuling doesn't offer much hope. "It's clear that China's exports to the United States are continuing to grow," he observes. "From the large multinational corporations, we don't see a major shift from China as the strongest source for lower cost production. Companies already working in China are looking at alternative strategies such as upstream supplier and supply chain development to address increasing cost factors. This will be a major focal point in the coming years. Large companies realize China is a long-term investment. This improves penetration within the local market and increased visibility and transparency." As for the small to midsized manufacturers, Feuling sees more of them are now looking at sourcing from China to remain competitive and create sales in larger-volume Western channels.

With China firmly established as the country of choice for low-cost labor, naturally enough U.S. manufacturers looking for the "next big thing" are looking closely at smaller, nearby Southeast Asian countries as sources for even lower-cost labor. "As higher wages and inflation occur in China, Vietnam, Bangladesh and Indonesia are the next primary targets for low-cost manufacturing labor," Hemmings reports. "They have young populations, eager to take their place in the world. Indonesia has great potential, but it's about eight years away; Vietnam and Bangladesh are three or four years away."

Acknowledging the emergence of alternative locations, Feuling is quick to point out, "China is still cost competitive. Raw materials, for example, are commonly cheaper in China, since other countries such as Vietnam, Malaysia and Indonesia must import the materials, increasing the costs potentially offset by lower labor costs. With a stronger established manufacturing base in China, it is easier to identify manufacturers with experience serving foreign customers than in other locations."

Somewhat paradoxically, Chinese manufacturers themselves are shifting some production work to lower-cost countries, a trend that began at least three years ago, Feuling says. This trend, though, is dependent on the product. He cites the example of the apparel industry where because of the higher labor input, other countries such as Vietnam have an advantage of as much as 20% to 30% in lower labor costs. "With the really high competition, low investment start-up cost industries, the profit margin is small and is maximized through very high volume," Feuling says. The manufacture of hand tools (hammers, screw drivers, etc.) is another product segment where the Chinese are looking elsewhere for cheaper production labor.

Know Who You're Dealing With

For U.S. manufacturers still debating whether they should move some of their production capacity over to China, Feuling says, "In some industries, now is a very strong time to enter China. As Chinese manufacturers are dealing with cost influences and the challenges of attracting new customers, strong concessions in the buyer's favor can be made, for example, lengthened payment terms."

He is quick to add, though, "For other industries, our suggestions are to thoroughly evaluate and plan before simply entering. Far too many companies move to China via personal relationships or to achieve the 'low-cost gold rush' without completely evaluating the business model. For example, Friendly's Ice Cream entered China only to realize after they had invested in a manufacturing facility that local cold chain operators couldn't deliver solid product to the customer. Every time the customer received the ice cream, it was melted."

U.S. companies no longer need to be part of a joint venture to do business in China, unless it is in a protected industry, observes Hemmings. "Additionally there is no longer a need to get the Beijing government's blessing, but working with local government is still important. You also need to be distrustful of any Chinese businessman who says he has the inside track," he adds. "Business is less and less based upon just who you know but more on what you know and what you bring to the party."

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