The China-dominated manufacturing environment

What are you doing to compete?

By William Barron

March 7, 2006

All manufacturers have to realize that what is going on in China will affect them in some way, no matter how small their business is. Protectionist policies from the U.S. government aren't on the horizon to help. Business owners and managers are negligent if they do not make an effort to understand the economic changes caused by China's movement to a market economy in some detail and then use that understanding to evaluate and likely modify their companies' business plans.

Editor's Note: This article is adapted from William Barron's presentation, "China's growing economic influence—How are you reacting?" presented at the 3rd annual STAMPING Journal® Forum, May 10-11, 2005, Troy, Ohio.

Anyone who reads the newspapers knows that manufacturing employment in the U.S. has been declining for many years. Bringing this issue closer to home is the fact that more than 350 small and midsized U.S. metal stamping companies—17 percent of the market—disappeared between 1997 and 2002. The reasons are numerous: a cyclical downturn in the economy, automation, lean manufacturing techniques, and the movement of businesses offshore, primarily to China, in recent years.

All manufacturers have to realize that what is going on in China will affect them in some way, no matter how small their business is. Protectionist policies from the U.S. government aren't on the horizon to help. Business owners and managers are negligent if they do not make an effort to understand in some detail the economic changes caused by China's movement to a market economy and then use that understanding to evaluate and likely modify their companies' business plans.

China's changing economy is a threat, but it also is an opportunity. The threat comes from:

• An 85-cents-per-hour fully loaded manufacturing cost.
• $10,000-per-year managers' and engineers' salaries.
• Little direct labor wage inflation.
• Growing technology expertise.
• World-class manufacturing quality in many industries.
• The migration of manufacturing industries to China; for example, electronics and textiles.

The opportunity for U.S. businesses comes from China having:

• One-quarter of the world's population.
• A very high economic growth rate.
• A middle class of 100 million that is growing by 1 million per year.
• A rapidly growing export market for U.S. products that is already $25 billion.
• The largest market in the world for many products (including cell phones, low-price TVs, and furniture).
• The fastest-growing world market for automotive components and assemblies.

Even Western companies that don't have the product types or resources to take advantage of the opportunities in China need to react to the threat China presents. Studying what other small and midsized businesses have done is a good way to start developing ideas and plans.

When Competitors Head to China

Many companies have seen their competitors reduce prices dramatically by moving their manufacturing operations to China. One way for these companies to react is to automate their manufacturing processes in the U.S. Automated production always can compete in price with Chinese production.

For those companies that don't have the product volume to justify automation, subcontracting high-volume orders to Chinese companies is another option. Specials and short-run orders can continue to be made in the U.S. A company does not need to be large to try this option.

How does a company decide if subcontracting is a good choice? If a product line has become a commodity—that is, there is little differentiation in the market among competing products—and price is the main competitive driver, subcontracting is a suitable option. The company's resources can be better focused on new products and services that add value for the customer.

This subcontracting also can be approached by forming a joint venture with a Chinese manufacturer. However, many companies feel that they don't have the resources to devote to the development of a China joint venture. In those cases, the company can form a partnership or a consortium in the U.S., and the consortium can be the legal entity that partners with the Chinese manufacturer. This reduces the cost and risk for any one company.

For simple stamped parts with few finishing or secondary operations that require labor, China's low labor cost doesn't provide any advantage. There is an advantage in the cost of building the stamping tooling, however. Progressive-die cost in China is at least half of what it is in the U.S.

When Customers Head to China

Many companies have lost business when their customers moved their entire manufacturing operation to China. Anyone selling to the computer, consumer electronics, clothing, or furniture industries experienced this years ago. Other industries, such as first-tier automotive suppliers, are in the process of moving some of their production there right now.

One stamping house that also designs and manufactures small assemblies of stamped parts had a primary customer base of automotive suppliers in the U.S., but these large customers were insisting that the stamping house open a facility in China to service their facilities that were already there and to ensure that this supplier was getting the best price.

The stamping house's solution was to form a joint venture in China with a Chinese stamping house to service automotive companies there and to export to the U.S. some products that required a significant amount of assembly labor. Single-piece stampings continue to be made in the U.S., as are short-run specials and prototypes. The company is beginning to source its tooling to China.

Another small stamping company in the Chicago area had a similar situation. The volume segment of its customer base moved to Asia. The company didn't have the financial or management resources to follow the business to Asia, even through subcontractors. Its solution was to change its business model to become a short-run specials and prototype shop only. It does not quote high-volume jobs because it knows it will lose the business to a Chinese supplier.

A California-based company also was too small to follow most of its customers to Asia. Its solution was to change to a business model of marketing only to markets that were staying in the U.S. For this company, this was primarily the military market, but it also targeted the medical and industrial machinery markets.

A Wealth of Opportunities

U.S. manufacturers' relationships with China don't always have to be in terms of importing, however. There are more opportunities to export to China than most people realize. Companies that make standard products based on well-known technologies can start exporting their products to China by selling through existing distribution networks, with little investment needed for sales and marketing. Some of the U.S. products that are in demand in China are construction products, capital equipment, raw materials, branded consumer products, and high-tech products.

The opportunities for companies to utilize China in their business can be summarized as follows:

• Chinese or U.S. competitors with Chinese facilities driving prices down

Niche marketers
• Make specials and prototype products in the U.S.; subcontract high-volume commodity products to China.
• Make specials and prototype products in the U.S.; establish a joint venture in China for high-volume commodity products.
• Source tooling from Chinese suppliers.
• Form a joint venture or consortium with other U.S. companies to own a Chinese facility jointly or to form a relationship with a Chinese subcontractor.

High-market-share companies
• Automate complete product line.
• Automate high-volume products; subcontract add-on product in China

• Customers relocating to China

Niche marketers
• Establish a joint venture in China to manufacture and market to U.S. transplants.
• Change business model to fast turnaround specials, prototypes, and short-run production.
• Market only to market segments remaining in the U.S.

High-market-share companies
• Establish a manufacturing presence in China, wholly owned or with a Chinese investment partner.
• Initially market to U.S. transplants in China.
• Market full-scale to transplants and Chinese companies.

• China not a threat but an opportunity
  •Initially export to U.S. transplant companies in China
  • Market full-scale across China and subcontract add-on products to fill out the product line.

It is very important when evaluating different China-related strategies to base your analysis on cash accounting, not absorption accounting. In absorption accounting, fixed costs prorated over a smaller production volume will increase unit cost in the U.S., and those numbers can dissuade a company from moving some production to a subcontractor.

A decision against outsourcing could be disastrous to a company in the long run if it is not based on accurate, unskewed numbers. Fixed costs are already paid for. Analysis of alternatives should be based on projected out-of-pocket costs.

Lessons Learned

Once a subcontracting strategy has been selected, the hard work begins: the execution of that strategy. There are many lessons to be learned from doing business in China:

• Western business logic and practices usually don't apply in China. Written contracts are not worth much. Businesspeople aren't direct in their communication. For example, they don't like to say no; saying that they will study your proposal is often their way of saying no.

In a conversation, a great deal of weight is given to a person's age and position in addition to the logic of his or her statements. And decisions aren't made quickly. Someone once said that doing business in China is like playing chess with some of the pieces moved at night when nobody is around.

• Business relationships are based on guanxi.Guanxiare close relationships that have been developed over a long period of time. When you have established guanxi with a business partner, written contracts aren't a big concern. A person wouldn't think of "losing face" in the business community by doing something to hurt someone he has such a relationship with.
  
  
• Finding senior-level managers who can communicate well with Western companies can be difficult. Because of the respect for age in China, anyone put in a senior position needs to be senior in age too. Chinese managers in that age bracket were most likely trained in government-owned companies years ago. The habits and management style they developed in those organizations are very different from the ones Western, as well as successful, independent Chinese companies, use. To overcome this problem, most Western companies have found it necessary to bring in senior managers from outside of China, usually from Taiwan.
  
  
• Intellectual property is difficult to protect. Many companies in China do not bother going to court with an intellectual property issue. They address the problem in different ways, such as by making their product in several locations or by doing final assembly in the U.S. Having guanxi with local government officials in the province or city of operation can be very beneficial in handling these issues. The local government officials will stop infringers before they can get started.
  
  
• A great deal of time is needed to select the right partners for a joint venture or marketing relationship in China. You must visit the prospective partners and understand their businesses. You can't rely on a directory or Web page. Years ago when we were looking for manufacturing partners for components in China, we found that many of the companies listed in directories were really in vastly different industries.

A few other important differences are:

• There is no uniform enforcement of any regulation. Everything is negotiable.
• A third-party inspection service often is needed to ensure good product "out of the container."
• Ocean shipping adds four to six weeks to the supply chain.
• The transportation and power-generation infrastructure in China still is poor. Staying close to a seaport city and having an in-house generator help.
• Few market statistics are available for companies that want to sell in China.
• Payment terms are much longer than in the U.S.

In China everything is possible, but nothing is easy. However, what China is doing to the world's competitive environment can't be ignored by any U.S. company.

William Barron is principal with KDC & Associates Ltd., 522 S. Northwest Highway, Suite UL-8, Barrington, IL 60010, 847-776-7407, fax 847-776-2203, bbarron@kdcconsultants.com, www.kdc-china-access.com.