Viewpoint -- China's Different Cost Perspective

April 7, 2008
To have any chance of long term success, a company's managers in China must have the same cost perspective as their Chinese customers and competitors.

2002 was an inflection point in China. The country joined the World Trade Organization late in 2001, signaling to foreign investors and companies that China would not reverse its economic reform program, and at the same time, telling Chinese companies that they would no longer be protected from foreign competition. Every metric for China moved into the fast line. The country's economy has grown at double-digit rates every year since, and exports that stood at $325 billion in 2002, quadrupled to more than $1.2 trillion by 2007.

China's cost competitiveness on global markets has understandably raised serious concerns about the future of manufacturing in developed countries. Evidence of this can be found in the December 6, 2004 edition of BusinessWeek called "The China Price" -- the three scariest words in U.S. industry. Everywhere I go, people ask: "How can the Chinese make things so cheaply?"

I'm not an economist, but I never bought the pat answer given by politicians, that China's costs are low because its currency is undervalued. If 50%t of a manufacturer's costs in China are labor, and 50% are raw materials, a 40% increase in the value of the yuan will increase the price of the company's labor on world markets. But, won't the company's raw material costs also be 40% lower?

Apart from theory, the numbers also don't support the notion that a revalued yuan would provide a quick fix. In the 1980s, Japan was in the same place as China is today. Exports to the U.S. were increasing; Japan's trade surplus with the U.S. was growing; and politicians were screaming about the currency. From 1985 to 1988, the number of yen that could be bought with one U.S. dollar dropped from 250 to 121 in three short years, a 50% appreciation. Yet, exports from Japan to the U.S. increased from $69 billion to $90 billion during that period. The yen continued to appreciate over the next 12 years, with the exchange rate falling to 100 yen to the dollar by 2000. Exports continued to rise and reached $146 billion by the end of the last century.

Experience so far with China is following a similar pattern. China dropped the dollar peg in July 2005 and began allowing the yuan to float within a narrow band. Since then, the yuan has appreciated by about 15% , with the exchange rate dropping from 8.3 yuan to the dollar then to 7.0 today. What have China's exports to the U.S. done since? They have increased by over 40% from $163 billion in 2005 to $233 billion last year. In both cases, American imports haven't decreased when the currencies of its major suppliers have appreciated. American consumers have just ended up paying more for the goods they purchased.

My experience in China suggests that the answer is much more fundamental--the Chinese look at money differently. hey have a completely different, and lower, cost perspective. To illustrate this point, I always carry with me two bills. One is an RMB100 bill, and the other, a $100 bill. When Americans look at a RMB100 bill, they instinctively divide by 8 and really see $12.50. However, when the Chinese, no matter how wealthy, look at the same RMB100 bill they see what Americans see when they look at a $100 bill. In other words, the two bills are treated the same, despite their very different values. A $100 bill is the largest unit of currency you can get in the United States. An RMB 100 bill is the highest in China. If you try to pay for your groceries in the U.S. with a $100 bill, the cashier will put it under a light to see if it's counterfeit. If you pay in China with an RMB 100 bill, the cashier will do the same.

How does that make a difference? Let's take a U.S. company that is setting up a factory in China in competition with a Chinese company building a similar factory in the same city. The U.S. company asks Joe Smith, its facility planner, to come to China and oversee the project. The Chinese company asks its Mr. Zhou (also pronounced "Joe") to do the same. When Joe Smith looks at the first input priced at RMB100, he automatically divides by eight and thinks to himself: "$12.50, that's 30% cheaper than I can buy it at home, buy it." Mr. Zhou, however, looks at that same input, sees the equivalent of $100 and says, "RMB100 -- that's too expensive"; and negotiates it down by 30%.

The result: two companies making the same product in the same city in China, and one is lower cost than the other--even before all of the other inputs that go into making a product are considered. This fundamentally different cost perspective is what drives China's cost competitiveness, and it will be here for many years to come.

What can companies in countries with higher cost structures do to compete with Chinese factories? The first step is to recognize that a Chinese factory's competitiveness is due largely to its lower cost perspective, and that there are no silver bullets. The second is to use this information to redefine its competitive strategies. If those strategies include manufacturing in China and selling to the China market, then companies need to develop and empower local management teams. The reason is simple. To have any chance of long term success, a company's managers in China must have the same cost perspective as their Chinese customers and competitors.

Jack Perkowski is the CEO of ASIMCO and the author of Managing the Dragon.

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