a new era for manufacturing in china _ mckinsey & company

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26/10/2013 A new era for manufacturing in China | McKinsey & Company

www.mckinsey.com/insights/manufacturing/a_new_era_for_manufacturing_in_china

The makeup of

Chinese

Sidebar

Chinas em ergenceas a manufacturing powerhouse has been astonishing. In

seventh place, trailing Italy, as recently as 1 980 , China not only overtook the

United States in 2011 to beco me the worlds largest producer of manufactured

goods but also used its huge manufacturing engineto boost living standards by

doubling the co untrys GDP per capitaover the last decade. That achievement took

the industrializing United Kingdom 1 50 years.

Today, however, China faces new challenges as economic growth slows, wages andother factor costs rise, value chains become more complex, and co nsumers grow

more sophisticated and demanding. Moreover, these pressures are rising against

the backdrop of a more fundamental macroec onomic reality: the almost inevitable

decline in the relative ro le of manufacturing in China as it gets richer.

Manufacturing growth is slowing more quickly than aggregate economic growth,

for example, and evidence suggests that the country is already losing some new

factory investments to lower-cost locations, such as Vietnam, sparking concern

about Chinas manufacturing competitiv eness.

Competitiveness, of course, is a broad term that can confuse more than clarify.

During the 19 80s, for ex ample, there was muc h hand-wringing in the United States

about dec lining manufacturing competitiv eness ver sus Japan. In the following

decade, however, those concerns faded, replaced by a focus on the failings of

Japan Inc., the SUV-fueled resurgence of the US automotive sector, and the

bo om in US high-te ch manu factur ing. I n the Unite d Stat es then, as in China t oday ,

there isnt just one manufacturing secto r; there are many, eac h with different

competitive strengths and weaknesses.

In this article, we move beyond the hyped hopes and frantic fears for Chinese

manufacturing as a whole, to gain a more balanced picture of this diverse sector.

We star t wit h a su mmary of four ke y ch alle nges that affec t different ty pes of

manufacturers in different ways and then move on to a discussion of competitive

priorities whose impo rtance again v aries for playe rs of different stripes. Despite

the variation across manufacturing subsectors, companiesChinese owned and

multinational alikecant escape the need to raise their game and mov e up the

value ch ain b y bo osting pro duc tiv ity , re fining p ro duc t-de v elo pme nt ap pro ac hes,

and taming supply-chain complexity. Those that do should prosper in the years

ahead, while those that rely on yesterdays model of rock-bottom wages and

stratospheric domestic growth rates are likely to fade.

Four challenges

For y ears, Chinas low salaries; strong supply base; high investment in port, road,

and rail infrastructure; and solid engineering and tec hnical skills provided a stro ng

platform for manufacturing ex ports. Meanwhile, a vast domestic market helped

fuel Chinas continuing transition to a co nsumption-based econo my. Today s

outlook is more mixed. Here, we review four core challenges and the types of

players particularly affected by each of them. In doing so, we draw on a set of

global manufacturing archetypes established recently by the McKinsey Global

Institute (see sidebar The makeup of Chinese manufacturing).

Rising factor costs

Rising wages and the apprec iation of the renminbi

have dampened Chinas exports in recent years and

focused global attention o n its future v iability as a

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includes:

In this series

Chinas next chapter

Chinas next chapter

Chinas rising consumer

class

Chinas urbanization

imperative

Chinas manufacturing

challenge

Chinas financial

coming-of-age

Chinas human-capital

quest

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Article | McKinsey Quarterly

A new era for manufacturing in ChinaCompanies that continue to base their manufacturing strategies solely on Chinas rock-bottom wages and

stratospheric domestic growth rates are in for a rude awakening. New challenges will require new competitive

priorities.

June 2013 | by Karel Eloot, Alan Huang, and Martin Lehnich

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manufacturing low-cost manufacturing center. Most multinationals

that produce labor-intensive goods, like textiles and

apparel, are actively seeking to diversify bey ond

China to reduc e co sts and mitigate political and

supply-chain risks. China-based processo rs of goods

such as beverages, fabricated metals, food, and tobacco are also concerned about

rising costs, including those for packaging. Ye t their regional focus makes this less

a global competitive issue and more a question of which players in the value chain

will c rea te t he m ost v alue .

Rising consumer sophistication

McKinsey researc h suggests that by 2020 , the income o f more than half of Chinasurban households, calculated on a purchasing- power-parity basis, will catapult

them into the upper middle class a category that barely existed in China in 2000

(for more, see Mapping Chinas middle c lass). The members of this group already

demand innovative products that require engineering and manufacturing

capabilities many local producers do not y et adequately possess. An ex ecutive of

a Chinese television-panel maker, for example, re cently confessed that his

company cannot fully meet the requirements of high-end customers and that the

quality of his companys flat-screen panels is exceeded by that of products from

fast-moving South Korean co mpetitors. Chinas automakers face a similar

challenge: consumers perceive their brands as lower in quality, even compared

with foreign brands asse mbled in nea rby Chines e fac to ries.

These issues confront players in a range of other sec torsfrom appliances and

chemicals to electrical and office machinery, pharmaceuticals,

telecommunications gear, and transportation equipment. What they have in

common is that they compete on the strength of their R&D, technology, and abilityto bring customers a steady stream of new products and services. Rising consumer

expectations will require even food and beverage players to raise their game on

freshness and regulatory compliance , areas where Chinas standards still lag

beh ind West ern ones.

Rising value-chain complexity

Anot her big challe nge is c oping with t he r ising v alue -ch ain c omplexity that

acco mpanies consumer gro wth. Greater affluence and rapid urbanization require

product makers to manage, make, and deliver an array of increasingly diverse and

customized products to increasingly remote locations. Between now and 2015, for

example, almost two -thirds of the growth in demand for fast-moving co nsumer

goods will come from smaller (Tier-three and Tier-four) cities, which out number

their Tier-one counterparts, suc h as Beijing or Shanghai, by a factor of 20.

Product proliferation and booming e-commerce also contribute to value-chaincomplexity. Business-to-consumer online sales in China are expected to grow by

45 percent a y ear from 2010 to 2015 . For product makers, this means smaller and

smaller lot sizes and deliveries to househo lds farther and farther out th ere.

During Chinese festival periods, the supply chains of many c ompanies already

creak under the strain of online orders. Demanding consumers c ontribute to

supply-chain headac hes, as well. Since many retailers in China accept c ash-on-

delivery payments, its not uncommon for shoppers to pit online retailers against

one another by ordering, say, three identical products from three retailersand

refusing delivery to all but the first to arrive.

Such issues are relevant for technology companies and others responding to the

Chinese co nsumers increasingly sophisticated tastes. But rising value-chain

complexity is also a worry for manufacturers of more labor-intensive goods, given

the sheer variety of products they make, and for regional processors, whose

logistics networks are affected by urbanization and booming infrastructure

development.

Heightened volatility

The uncertain global economic environment since 2008 has complicated life for

manufacturers everywhere. Those in China have arguably been the most severely

affected, given the countrys status as the workshop of the world.

In Chinas steel industry, for ex ample, annual demand growth slowed to 3 perc ent

in 2012 , after a decade of double-digit increases. The result has been lower

capacity utilization, cutthroat competition, and a 56 percent decline in average

profit margins for the industry from 201 0 to 20 12. Similarly, in Chinas massive

auto industry, annual growth rates over the past five years have varied from 7

percent to 52 percent. Appliance and electrical-machinery producers have also

experienced strong demand fluctuations, exacerbated by gyrating overseas

demand.

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Seeking purchasing

excellence in China

Sidebar

Vo lati lity at su ch lev els m akes planning d ifficu lt for China s manufac tur ers . This is

problematic for companies that routinely make large, long-lived capital

expenditures whose returns are crucial determinants of performance.

Three imperatives for Chinas manufacturers

As labor co sts r ise a nd slo wing gro wth dampens the abi lity of China s ste adily

rising industrial output to deliver regular productivity gains, manufacturers there

will ne ed t o st riv e for glo bal lev els o f ope rat ional ex ce llence . Energy effic ienc y is a

particular opportunity for many companies (see Seizing Chinas energy -efficiency

opportunity: A case study), but far from the only one. Companies hoping to

differentiate themselves beyond low-cost labor also can focus their efforts

upstream (to harness innovation and product-development efforts) ordownstream (to tame supply-chain complexity) or both, depending on the

characteristics of competition in their sectors.

1. Achieve manufacturing excellence

Lean and Six Sigma are not new to China. Plant managers in domestic and

multinational companies alike have worked hard to bring manufacturing-

excellence tools and approaches to the countrys shop floors. But for all these

efforts, significant potential remains, mainly because plant managers in China

often focus on hard technical tools at the expense of softer ones involving

mind-sets and behavior. A recent lean-manufacturing transformation at one state-

owned enterprise, for ex ample, fell far short of its efficiency targets when

managers and supervisors failed to complement the otherwise excellent technical

changes with the necessary softer skillsincluding leadershipthat would have

made the changes stick.

One factor that complicates these problems has been the breakneck development

of Chinas manufacturing secto r, which means that many wo rkers are relatively

new to the job. We have seen too many frontline managers, lacking the experience

to identify the problems inevitably associated with new plants and new ventures,

merely react to problems rather than look for their root causes. Companies facing

this problem will never get the full benefit of the productivity improvements they

expect from lean. In one auto-assembly and body-shop operation, for example,

team leaders spent as little as 5 percent o f their time on coac hing and problem

solving (best practice is about 30 percent). Improvement efforts stalled until the

company introduced standardized daily work agendas for team leaders and

supervisors, to emphasize that shift meetings were occasions for problem solving

and co achingnot firefighting.

Cultural differences also co ntinue to thwart o perational improv ements in Chinese

companies. In one auto plant, the multinational joint-venture par tner installed

v isual-performa nce bo ard s to make the stat us o f wor k pro jec ts transpar ent,assuming that the tools would be accepted as they are elsewhere in the global auto

industry. In fact, the frontline workers resisted them, interpreting the initiative as

a criticism of individual colleagues and forcing the joint ventures leaders to devise

way s to achieve th e same e ffect with out alienat ing the staff. Mo reov er, the Chines e

company s senior plant managers, while supporting the changes, were initially

uncomfortable about role-modeling the more transparent and inclusive way of

wor king. A new c ont inuo us-im pro v eme nt departm ent ev entually helped worker s

and managers alike to view greater transparency and continuous improvement as

a new way of working rather than a flavor of the month e xerc ise. The

automakers experience is not uncommon; indeed, the fact that the domestic

leaders became involved was encouragingall too often, the front line must sort

out such c hanges itself.

Finally, companies in China must aspire to extend efficiency improvements

throughout the value chain. An automotive joint venture recently began this

jou rney by working with 60 of its sup plie rs to addr ess t he 3 0 most pre ssing qua lity

problems. The company fixed them in only six months and has since prevented

their recurrence, in large part by equipping its people with assessment tools and

skills and by engaging suppliers to address prob lems at the source . A new

performance-management system helps ensure that both the automaker and its

suppliers keep up their ends of the bargain.(For more on the relationship between

purchasers and suppliers, see sidebar Seeking purchasing exce llence in China.)

2. Look upstream

For industries reliant on innovation, the triple

wham my of rising c osts, c omplexity , and

competitive pressure means that the old ways o f

deve loping products in China now risk beco ming

liabilities. Staying competitive will require domestic
http://www.mckinsey.com/insights/energy_resources_materials/seizing_chinas_energy-efficiency_opportunity


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companies and multinationals alike to change,

starting with the mind-sets and attitudes that have pervaded product-

development activities in China.

Produ ct -deve lop ment ro adb loc ks. Domestic Chinese companies must get beyond

the faster, cheaper fixatio n that has character ized their approach to R&D in

recent decades. For every world-beating Chinese innovator, we still see dozens of

smaller players struggling to dev elop the R&D pipelines that would help them grow

from scrappy upstarts into incumbents that can realize their global ambitions. The

growth of one China-based medical-device player, for example, has halved in

recent years as smaller domestic competitors copy its designs and undercut its

prices, much as the company itself copied from multinationals in earlier years. Yet

even as it wo rks now to bo ost its R&D capabilities and to generate market insightsextremely difficult tasks given the absence o f necessary skills and institutional

processesthe copying mind-set remains strong.

To some ex tent, multinationals face a mind-set challenge as well. Many invest

significantly in their China R&D units while continuing to regard them as c ost-

saving satellites of the home -office mo ther ship. Even when multinationals

establish supposedly autonomo us R&D units in China, many lack the support and

skills to become intellectual-property creators, not just consumers. The

experience of another medical-product company we studiedthis one a

multinationalhighlights the challenge.

The leaders of the multinationals China R&D group thought t hey d identified a

lucrative niche for a new, low-cost medical-diagnostic productbut were denied

funding by the head o ffice bac k home. The general manager o f the China business

fought what he thought was a shortsighted dec ision, winning permission to

proce ed if his business unit could finance the new produc t itself. His unitultimately did just that, in part by promoting the product to customers and

collec ting advance o rders. Once launched, it was highly succ essfulat first in

China but soon in other c ountries too as the c ompany s sales reps got wind of its

popularity and began offering it in their own regions.

Fast-forward about 18 months, when the company dec ided to rev ise the product.

Rather than entrust its deve lopment to the China R&D team, the c ompany assigned

it to the main R&D group at he adquarters and used the China team for suppor t. The

product flopped when new and technically elegant features and other changes

insisted on by the Western group proved too expensive for customers or

irrelevant to them.

A suc ce ss st ory .The experienc e of a global lighting manufacturer suggests ho w

some companies are overcoming the challenges. With global consumer

preferences shifting toward new applications of a decades-old technology, the

company identified a huge market opportunity in LED lighting. The market was

also hugely c ompetitiv eChinese and Taiwanese player s were piling into the

lower-end consumer segmentsso a well-designed product clearly wouldnt be

enough. Hitting a low price po int and rapidly establishing scale would also be

necessary.

The multinational briefly c onsidered using its wo rld-class global R&D unit to

develop the product. But senior executives worried that the groups insular,

engineering-centric culture would lead it to overspec the offering with costly

features. Leaving it to the co mpanys China unit, on the other hand, was too risky:

that group co uldnt generate unique customer insights and didnt have enough

experience working with supplier networks upstream or with the companys global

supply chain downstream to co mpete on cost and speed. The obvious c ompromise

combining the groups in a more traditional way by playing to the strengths of

eachmight mean suffering the usual time-zone delay s while reinforcing the silo

cultures the companys leaders wanted to break. It ultimately chose to view the

project as an ex periment for improv ing both units, so that the one in China wouldbec ome mo re independent and the effor ts bene fits c ould be leveraged glo bal ly .

To get there, company executives quickly assembled a mixed R&D team in China

comprising representatives from the marketing, procurement, supply-chain, and

quality groups. For ten weeks, the team worked closely to develop an idea-

generation and decision-making process that could not only create a winning,

scalable design but also build skills and develop processes the company could use

globally. The team collaborated to create and test customer insights,

complementing the work with teardowns of competitors products. It also

conducted shop-floor walkthroughs with suppliers and met with a variety of

manufacturing ex perts to learn how the product co uld incorporate cheaper, more

modular designs.

A set o f simple rules prov ed c rit ical to breaking old ha bit s and unlo cking go od

ideas: to ensure that the team nev er fixated on one part o f the value chain at the

5


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expense o f another, it consistently asked a handful of total-cost-of-ownership

questions when it made its most important decisions. This approach he lped spark

improv ement ideas in unusual areas, such as product packaging: the team found a

way to giv e o ne o f its pro duc ts a m or e pr ominent shelf appea rance a locally

important factor because of high levels of competitionwhile lowering logistics

and other co sts through the efficient use of materials.

As the effor t pic ked u p ste am, it bec ame popular wi th o the r manage rs in the China

busines s. The co mpany trained some o f these ev ange lists as chang e agents to

maintain momentum at the end o f the pilot. This effort ultimately helped the

company to lower the costs associated with the product line by an additional 20

percent beyond initial expectations. Further, the effort positions the company

well for futur e c ost -red uc tio n op portu nitie s that sh ould ar ise a s the ind ustr ymatures.

3. Tame supply-chain complexity

While the e ffects o f value-ch ain c omplexity vary by manu factur ing su bse ct or ,

most Chinese consumers are changing faster than supply chains are adapting.

Indeed, supply chains in the countryboth multinational and domesticare

generally set up for a low-labor-cost environment that is quickly disappearing.

Now that long cycles characterized by so-so levels of transparency and cross-

functional collaboration are proving insufficient, companies will have to start by

revisiting their demand planning. Consider the ex perience o f a large consumer-

electronics company whose processes were proving unsuited to the new demand

patterns associated with some of its high-end products. Poor or delayed forecasts

wer e dis rup ting opera tio ns and lea ding to ex ce ss inv entor ies, while als o upsetting

customers downstream.

The turning point was the companys rec ognition that its planners were applying

the same broad-brush approach to all products, regardless of their market

characteristics. In response, the companys leaders created a tiered approach to

detach planning activities for some basic appliances whose demand patterns were

well unde rstoo d (rice co okers, for ex ample) fro m pla ns for fast er-m ov ing pr oduc ts

with less cert ain de mand . Fo r th e basic pro duc ts, the co mpany dev elo ped a

streamlined, good enough planning approach . For the high-end goods, it crafted

specific plans by product line.

Its results, including an overall improvement in forecast accuracy to more than 65

percent, from 35 percent, have been impressive. Inventory fell from more than 55

days to 30 day s, and the company increased its proportion of on-time deliveries

to more than 95 percent, from 60 percent. Whats more, the changes in the

companys planning approach made the work more interesting for its employees,

as many of them subsequently received training in advanced forecasting

techniques. Consequently, employee turnover among the planning teams went

down dramaticallyfrom 50 percent before the effort to just 20 percent

afterward. In a second phase, currently under way, the c ompany ex tended this

approach for high-end products to others with similar demand characteristics.

Significantly, the c ompany is separating what had been a mo nolithic China supply

chain into nimbler splinters that can better manage complexity. Products with

steadier demand go to market in the traditional manner: via co astal distribution

centers and large drop-ship order s to retail partners. Higher-end ones travel via

smaller regional distribution centers located closer to demand inland. For some

products, this approach allows the company to experiment with postponement

strategiesfinalizing product assembly closer to demandthat help reduce costs

and inventory levels (in the case of some customers, by as much as 45 percent).

As co mpanies loo k to move th eir foo tpr ints closer t o c ustomers in Tier -thr ee and

Tier-four c ities in Chinas interior, another likely c hange will be the long-term

development of logistics hubs and assets. In this way, those companies will be

bet ter positione d to ser ve boo ming dem and fo r online pur ch ases (see Chinas e-

tail revolution). These investments are risky, and many senior executives we

know are worried about overextending their companies. Some describe what they

say is a need to go Westbut not too far West. As for do mestic Chinese

companies with global plans, they know that getting closer to customers means

Western c ustom ers as we ll. A few o f the largest white-goods make rs are t hinking

about expanding their assembly and test activities in the developed world,

bec ause th ey reco gnize that they ca n no longer ade quate ly serv e it fr om Shenzh en

and other hubs.

Chinas rise to manufacturing preeminence in recent y ears has been amazing. Yet

rising costs, more sophisticated consumers, and fundamental macroeconomic

6
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realities mean that yesterdays approaches to manufacturing are losing their

relevanc e. For Chinese-owned and multinational manufacturers alike, the

imperatives now are to boo st productivity, refine product-development

approaches, and tame supply-chain complexity. Those that do so c an create an

enduring competitive edge.

About the authors

Karel Elootis a director in McKinseys Shanghai office, where Alan Huangand Martin Lehnichare

principals.

The authors w ould like to thank She Guo, Mads Lauritzen, Gregory Otte, Gernot Strube, Min Su, and

Forrest Zhang for their contributions to this article.

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