Important facts to consider when entering the China market

If you work for a manufacturing company or retail company and have not yet moved operations beyond domestic borders, someone in your company has likely asked in the past year, Should we source from China?

The big question for the uninitiated is of course is: Should we go into China?  The answer depends in part on your company’s products.  Most analysts note that China excels at sourcing components or goods made on templates, such as furniture, toys, and consumer electronics and appliances.

The answer also depends on the level of PRC exposure your company seeks.  For companies entering China only for procurement, cost advantage is still China’s primary draw, but companies considering permanent stakes may find better product quality and manufacturing flexibility, as well as growing domestic demand, to be more important.  Depending on these factors, here’s what sourcing from China can offer your company.

Lower labour costs

According to a Boston Consulting Group (BCG) report the average hourly pay (including benefits) of production workers in China is approximately 20 times less than other developed western countries.  As a result a countries such as the United States need to be 25 times more productive than their Chinese counterparts to remain competitive.

Long-term flexibility in production

Companies often overlook the fact that, once Chinese workers have been well trained, substituting human hands for expensive, specialized machines can actually improve the flexibility of production lines.

Proximity to downstream manufacturers

Moving operations to China can also mean lower transport especially shipping.  The main reason for this is that when high-tech or heavy industry type companies (eg. auto companies, chemical companies, etc) move into a particular area they will often find similar companies operating there.  Sub-contracting and sourcing for products and materials becomes much more easier.  And with customers also located nearby shipping costs is further reduced.

Familiarity with the PRC operating environment

Companies with long-term plans to supply the Chinese market can start with a sourcing operation, which enables them to explore their options and lay the groundwork for a move towards local production. 

Lower capital costs

For companies that plan to set up manufacturing operations in China, land and set up costs can be a fraction of the cost of most western developed countries.  Furthermore, companies that use and source for local components and materials obtain further cost reductions.

Favourable tax structures

Foreign-invested companies enjoy a more favourable tax rate as compared to their domestic counterparts.  On top of that Government rebates of value-added-taxes on exports are also favourable.  Though government has plans to unify the business tax structure and phase out some of these incentives, localities are likely to continue to offer incentives to lure investors. 

Despite the numerous advantages and favourable conditions, setting up operations in China does have its difficulties.  Namely, China is well known to have a tough environment for logistics and intellectual property rights (IPR) protection and as a lackluster enforcer of legal contracts.  The following are some of the difficulties which any company setting up operations can experience:

Initial start up time

Getting a sourcing operation up and running may take longer than you anticipate, depending on the complexity of your product and your supplier’s abilities.   Finding a new supplier almost always requires new molds or new lines and plenty of quality control.

A weak intellectual property regime

Foreign companies will find IPR protection a major concern for the foreseeable future, despite reassurances mad from the Chinese authorities.

Increased management complexity

Adding an overseas branch or supply relationship requires stronger communication, stringent quality control monitoring, and a redesign of operations to adjust to different comparative advantages.  The sheer geographical distance and cultural differences causes some companies to hesitate.

Longer and more complex supply chains

Delayed delivery if consumer goods to US and European consumers is a risk unless companies manage their supply chains properly.

Energy shortages, environmental disasters and other operational hiccups

China is prone to power shortages which can cripple operations.  PRC producers have borne the brunt of the power outages; some have been forced to operate only on the graveyard shift.  Natural disasters such as the recent Taiwan earthquake, which affected Internet lines and cables had an adverse effect on the communications links between companies in China and their respective overseas head offices.

Decommissioning of local assets

Companies may find that closing factories in the US and Europe and laying off workers necessary and normal if sourcing adds excess capacity and returns to local assets are low.  Such actions in China are treated differently and penalties are unique to individual companies but usually entail financial, social and sometimes political costs. 

Other trends have added to the appeal of China as an operating and sourcing destination.  First, as more foreign companies move to China, their high-quality production values becomes a challenge to the local companies. They are able to compete not only on price but on quality and service.  Second, as the Chinese consumer market grows enough to support major industries, companies are establishing their presence in hitherto unexplored product lines and supply chains.  For example, retailers and product assemblers are joining component makers in China making diversification an advantageous option to grow and expand.  Lastly, the PRC government seems to have convinced the business community that it is serious about building an investment-friendly framework for foreign companies to enter into.  Transparent licensing and registration laws, China’s strenuous efforts to be recognized as a market economy and the Chinese government’s embrace of private entrepreneurs offer some comfort to those who are thinking about taking the plunge. 

Before taking the plunge two major factors would need to be considered.

Assessing the costs:

Each company must make it own decision to move to China, and a careful cost analysis is a critical part of this decision.  Total cost analysis will incorporate cost savings (the largest portion of which is usually cheap labour and components) and additional cost incurred, such as the initial set up costs and higher freight costs and duty payments.

Choosing the right path:

Perhaps the easiest way for a company to source in China is to link up with an existing supplier’s operations there or to encourage an existing supplier to also make the move.  This allows for Chinese production prices at a familiar level of quality control and delivery.  Another way to find potential partners is through contacts and referrals from officials in the relevant industry and ministry.  But whoever you choose to go into business with, proper due diligence of your intended partner’s financial health is a prerequisite.

Finally, companies already in China cannot and should not afford to be complacent.  China is evolving and changing day-to-day.  With this change, the demand for goods and services increases for greater choice.  Manufacturing companies especially need to be ready to respond to these changes quickly and meet demand.  Companies need to diversify and should plan annual reviews of their product lines to see if sourcing, production, or logistic operations need to be modified.  Staying fresh and ahead of the game is key to surviving in China.

This article was created on: 2011.02.28