Responding to Cost Increases in China

Nov. 19, 2008
Cost increases in China are not temporary

It's a tough time to be in the manufacturing business. Consumers are spending less, the cost of manufacturing is increasing, and financing your way through these difficult times is practically impossible. At Panjiva, we call this state of affairs, "The Great Squeeze" -- because companies are finding themselves squeezed by several forces ostensibly beyond their control. Undoubtedly, some companies will not survive The Great Squeeze -- most likely those that employ the Deer in Headlights strategy: doing nothing in the face of danger. In contrast, survivors will take aggressive action to address the manageable aspects of The Great Squeeze. This article will explore one of these manageable aspects -- the increasing cost of manufacturing, particularly in China.

Cost Increases in China are Not Temporary

By now, most supply chain managers are quite familiar with the story that ends in higher manufacturing costs. Because everyone decided to manufacture in China, the demand for labor increased, leading to rising wages, which forced factories to raise their prices (i.e., your costs). The good news is that you're not alone in confronting rising costs in China. In fact, the rising cost of doing business in China is the most common complaint I hear from sourcing executives. And, there are actions you can take to keep costs under control. I'll come back to this in a moment, but, first, let me address a very dangerous line of thinking -- that price increases in China are temporary.

A common misconception is that the Chinese authorities will likely take action if the cost of doing business in China continues to rise. Many think (or hope) that the government will work to keep wages and prices under control in an effort to maintain the growth of their existing export industries.

However, evidence suggests the Chinese authorities are tolerating -- and, in some cases, encouraging -- these increases. Authorities have raised the minimum wage repeatedly, ostensibly so that people can cope with the rising cost of living associated with food and fuel. Moreover, Chinese authorities have been taking significant steps to encourage unionization. Why would Chinese authorities be comfortable with these steps which will ultimately result in higher costs of doing business? David Barboza, a New York Times reporter, offered a convincing explanation when he wrote that the authorities are "no longer content to be the home of low-skilled, low-cost, low-margin manufacturing" and are trying to move Chinese companies "up the value chain" ("China's Ambition Soars to High-Tech Industry," New York Times, August 1, 2008. Bottom line: don't bet against continued increases in the cost of doing business in China.

Strategies for Containing Costs

So if you are convinced, as I am, that cost increases in China are not temporary, there are several options available, each with its pros and cons, to address this aspect of the Great Squeeze. Determining which is right for your business requires a thorough understanding of the pros and cons of each -- as well as an honest assessment of your company's specific circumstances. First, let's review the options:

  1. Identify the "New China" for Your Industry
    There is no shortage of countries seeking to be the "New China," by offering lower wage labor. Which countries should be on your short list? The answer is industry specific, because a low-cost labor pool is only valuable to you if it has the skills you require. For example, in the apparel industry, Vietnam and Cambodia are two frequently evaluated options.
  2. China is the New China
    Increases in wages have been most significant in the Southern and coastal regions of China. In Northern and inland China, there remains a vast pool of low wage labor. Many companies are looking to suppliers in these regions as an option for keeping costs under control.
  3. Leverage Your Suppliers' Networks
    Your suppliers in Southern China are just as concerned as you are about rising costs. In an effort to keep costs under control, they are likely working with -- or currently searching for -- subcontracting partners in other regions within China or outside of the country. Therefore, you may be able to work through your existing suppliers to keep costs down.

Choosing the Strategy that's Right for You

Which strategy is right for you? It depends on how large the resources at your disposal are, and how quickly you need to lower costs.

The first strategy -- looking to new geographies -- requires a significant financial and research investment. First, you'll need to get to know the customs and regulations that come with doing business in the new geography. Second, suppliers in new geographies will not have the same capabilities as the suppliers you've used to-date. So you'll need to work with these new suppliers to build their capabilities and have patience when the inevitable hiccups occur. You will likely not see the benefits of working in these new geographies for some time. Therefore, this strategy is best left to bigger companies who have ample resources and the patience to wait for the payoff.

The second strategy -- looking to new regions in China -- requires the same type of investment, in terms of money and time, with one exception -- there is no learning curve for customs and regulations. However, you will want to investigate the administrative landscape in new geographies, because government authorities are offering lots of incentives to companies that venture into new regions within China. Again, this strategy is best left to bigger companies.

The third strategy -- leveraging your existing suppliers' networks -- requires two things to be true. First, your suppliers need to be resourceful and connected. Second, you need to be comfortable with your suppliers working with subcontractors. A lot of big companies are rightly concerned about the risks that come with subcontracting (for instance, the risk that subcontractors will not live up to the company's standards for social responsibility), and so this strategy may not be appropriate for them. However, leveraging your suppliers' networks requires very little in the way of resources and therefore may be perfect for smaller organizations.

Each strategy requires something from you: at a minimum, flexibility, and, in two cases, significant investment of money and time. However, the good news is this -- there is an alternative to the Deer in Headlights strategy. You CAN control costs and, in so doing, help your company avoid death via The Great Squeeze.

Josh Green is CEO of Panjiva which is an online resource for sourcing executives to gain credible and valuable knowledge about suppliers and manufacturers around the world. By providing the most comprehensive data in an easy to use format, Panjiva informs the decisions that facilitate doing business globally.

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