unraveling the chinese puzzle

7/29/2019 Unraveling the Chinese Puzzle

1/12

Perspective Edouard Samakh

Kaj Grichnik

Ron Haddock

Unraveling the ChinesePuzzleA Practical Approach

For Manufacturers


2/12

Booz & Company is a leading global management consulting

rm, helping the worlds top businesses, governments,and organizations.

Our founder, Edwin Booz, dened the profession when he

established the rst management consulting rm in 1914.

Today, with more than 3,300 people in 58 ofces around the

world, we bring foresight and knowledge, deep functional

expertise, and a practical approach to building capabilitiesand delivering real impact. We work closely with our clients

to create and deliver essential advantage.

For our management magazine strategy+business, visitwww.strategy-business.com.

Visit www.booz.com to learn more about Booz & Company.

CONTACT INFORMATION

LondonEdouard SamakhPrincipal

[email protected]

MunichKaj GrichnikPartner

[email protected]

ZurichRon HaddockPartner

[email protected]

Originally published as:

Unraveling the Chinese Puzzle: A Practical Approach for Manufacturers,by Kaj Grichnik, Ron Haddock, and Edouard Samakh, Booz Allen Hamilton, 2006


3/12

A leading industrial iber manuacturer whose

products are critical to automobile tires and seatbelts had traditionally had most o its actories

in Western Europe, near company headquarters.

Recently, though, the companys already low proit

margins had declined even more, by as much

as 2 percent, as revenue growth in its domestic

market slowed. And while the iber manuacturer

struggled to deal with its eroding inancial per-

ormance, it became aware o another potentially

troubling reality: More and more o its competitors

were in the process o moving their production to

low-cost countries, especially to China.

The manuacturer had been planning to make a mul-

timillion-euro investment to upgrade its European ac-

tory operations, but considering the changing business

landscape and geographic shit o manuacturing to

China, management was orced to reconsider whether

this was the right decision. A more undamental ques-

tion needed to be addressed. How would globaliza-

tion speciically, low-cost manuacturing in China impact the companys operations in Western Europe

now and in the coming years?

To help the company work through this diicult quanda-

ry, Booz Allen Hamilton conducted an exhaustive exami-

nation o its operations. Our analysis revealed that the

companys Tier One customers, which included several

European automakers, tire companies, and seat belt

manuacturers, had not been opening actories in Asia

or many o their product lines and were unlikely to do

so in the near uture. One o the reasons or this was

that just-in-time delivery requirements, combined with

high variability in product and ordering requirements,dictated that these Tier One companies stay close to

their European customer base. Additionally, rigid labor

contracts limited the degree to which they could relo-

cate actories without incurring signiicant inancial

penalties. And existing overcapacity in Western Europe

would make it prohibitively expensive to close these

plants and replace them with newer ones in low-cost

countries. Given the need or short manuacturing and

delivery lead times, i the Tier One seat belt and tire

manuacturers ultimately sought lower-cost plants, the

plants would most likely be built in Eastern Europeor in the southern United States, closer to where an

increasing number o automakers were building new

assembly capacity or established markets.

Traditional Tier Two and Tier Three suppliers in

other words, the iber company and its primary rivals

aced a dierent set o challenges. Many o these

companies, which convert yarn and other industrial

ibers into raw material or tires or into woven narrow

abric or seat belts, were deinitely China-bound (i not

history-bound). The main reason: increased competi-tion rom Asian suppliers. Moreover, many o the Tier

Two and Tier Three suppliers actories in Europe were

aging and already ully depreciated, so replacing them

would incur lower capital costs than was the case with

Tier One suppliers, and would thereore generate more

immediate and larger cost savings.

Consequently, or the oreseeable uture, pricing and

market trends in the iber manuacturers industry

would be driven by economically advantaged actories

in Asia, independent o who owned them. Our conclu-

Unraveling the Chinese PuzzleA Practical Approach for Manufacturers

1


4/12

2

sion was that i the iber manuacturer stood still and

continued to ignore the lure o China or its customers

and rivals that is, i the iber manuacturer didnt

explore a shit in its own manuacturing base to China(or other lower-cost countries) its survival might be

in doubt.

This was a disturbing inding or the iber manuacturer,

but it is one that more and more companies in Europe

are acing. To react quickly to rapidly changing

low-cost manuacturing dynamics, executives must

comprehend not only what is happening in their own

companies, but also the challenges being aced by

their customers, and the customers o their customers.

Without a broad understanding o trends across the

value chain, it is easy to get blindsided and miss nar-

row windows o opportunity to make changes beore it

is too late.

In responding to the challenges emanating rom China,

industrial-goods manuacturers typically ace several

top-level issues:

n Low-cost sourcing: To what degree can China be

used as a low-cost sourcing base or Western mar-

kets? What is the true cost dierential?

n Make versus buy: Should I source rom others or

establish my own actories in China?

n Timing: What is the value o preempting a domestic

or Asian competitor, or an Asian copycat competitor,who decides to use Chinese actories to attack my

home market with low-cost imports? What is the pen-

alty o delay?

n Growth/expansion: What is the opportunity to com-

bine a manuacturing or sourcing play in China with

the pursuit o new growth in that nations rapidly

expanding market by leveraging existing strengths

or customer relationships? What other markets and

customers in the Asia/Paciic region could also be

served rom Chinese plants?

n Regulations: What is the legal or regulatory environ-

ment? Will it allow the implementation o reliable

operations now and in the uture?

Assessing the level o opportunity or threat rom

China, or rom other low-cost countries, starts with an

analysis o a manuacturers cost structure relative

to the industry as a whole. This is especially critical

or industries or products that are driven primarily by

price-based competition. One o the most common

Source: Booz Allen Hamilton analysis

Exhibit 1Example Industry Supply Curve

Cost to Serve Germany rom Dierent Locations

Conversion +

Transport

Potential Supply into Germany (in Manufactured Units)

China Eastern Europe Western Europe

Transport Conversion

0 5,000 10,000 15,000 20,000 25,000


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3

approaches or comparing relative cost positions o

companies, or even countries, is to develop an industry

supply curve. A supply curve is based on the classic

economic notion o economies o scale and geographic

advantage, and graphically depicts the cost o providing

a product to a market rom dierent acilities and geo-

graphical locations.

As an example, Exhibit 1 (page 2) shows the cost to

manuacture a commodity product and deliver it to

Germany rom China, Eastern Europe, and Western

Europe. The idea is that in commodity industries, com-

panies with the lowest cost structure that is, those

with the bulk o their manuacturing operations on the

let side o the curve have cost structures with the

greatest advantages. When the lowest-cost capacity

is ully utilized, the next least expensive manuactur-

ing and logistics option becomes the best choice. This

process o gradual participation o increasingly higher-

cost suppliers and actories continues until ull market

demand is satisied. By extension, as demand or pric-

ing drops, the companies or countries on the right side

o the supply curve are typically the irst ones aected,

given their higher cost structures and lesser ability to

compete on the basis o cost alone.

New entrants as well as incumbents that are adding

new capacity typically do so on the let side o the sup-

ply curve, by investing in the latest technology as well

as choosing the lowest-cost geographic locations and

suppliers. As incumbents extend their manuacturing

networks into low-cost locations, they oten can elimi-

nate or at least reduce their relative output rom the

more costly right side o the supply curve, minimizing

their average cost-to-manuacture in the process.

To avoid being maneuvered into an unproitable posi-

tion on the right side o the supply curve, manuactur-

ers need to answer three key questions: What are the

economic beneits, at the dierent levels o the value

chain, o shiting manuacturing assets to China or

other low-cost countries? Looking beyond the advan-

tage o low labor costs, are there any barriers that

might prevent or argue against a shit o manuactur-

ing operations to China? And how ast will the shit to

China happen? (See Exhibit 2.)

1. What are the economic beneits, at the dierent

levels o the value chain, o shiting manuacturing

assets to China or other low-cost countries?

An assessment o the cost elements should include aholistic understanding o the key economic drivers and


Exhibit 2Framework to Assess the Impact o China on Manuacturing in the West

1. What are

the economic

benefits?

2. Are there any barriers? 3. How fast will the shift happen?

Determine cost and

revenue driversModel relocation

scenarios

Is it beneficial

for a Western

company

to shift its

manufacturing base

to China?

Map product

and process

characteristicsUnderstand key levers to

compete

Estimate market size of

different clustersEstimate impact on

sales portfolio

Analyze current and

future market situation in

ChinaAnalyze current and

future regulatory

environment

Develop entry and

footprint strategyDevelop operational

strategy

Are there

any (business)

barriers that

offset the

purely financial

benefits?

How does the demand/supply

balance in China look?

How does the regulatory

environment look?

What is the Chinese government

policy in this industry?

Western regional

competition

Global competition

(Western and Chinese)

Global market served

from China or other

low-cost country

Is there a threat

that China-based

companies wil l

compete with

Western-based

assets?

Niche

Protected

Market

Exposed

Market

Threatened

Market

Commodity


6/12

4

1. Develop a coherent manuacturing strategy. This

should include a clear mission or manuacturing that

considers how a China-based operation can be inte-

grated into a companys total supply chain. The orga-

nizational structure and leadership team that will drive

the mission, expectations o the manuacturing pro-

gram or both short- and long-term results, incentives

or the local team, and global supporting unctions all

need to be aligned. Given the rapidly changing environ-

ment in China, this manuacturing strategy must be

routinely monitored and adjusted as conditions change.

2. Determine which resources to import and which

resources to acquire locally by assessing labor costs

and needs, quality requirements or raw materials

and nished products, and availability o talent or key

management positions. Although most Chinese labor is

cheap compared with that in more developed markets,

plant management unctions may be a dierent story.

Capital can be more expensive than in the West, at

least or Western companies. And Chinese companies

usually have access to local sources o unding that

are not available to oreign-owned companies; or ex-

ample, the local Chinese banks that oten supply unds

below the true cost o capital. This can be a real

disadvantage to multinational manuacturers that are

required to meet certain hurdle rates or investment

returns.

3. Adapt management and reporting styles to theChina context. Understand the local culture and di-

erences in business practices between China and the

West. Dont simply copy the Western way o doing busi-

ness. For example, accrual accounting is less popular

in China than cash accounting. Although the benets

o accrual accounting and the practice o activity-based

costing are oten crucial or making the right business

decisions, Western companies that have acquired local

assets may need to gradually build in these processes.

And while doing so, they will have to keep the plants

operating protably using cash accounting systems.

4. Develop a culture o adaptability, fexibility, entre-

preneurship, and willingness to accept a large degree

o ambiguity. This applies not only to customers and

markets, but also to business partnerships, supplier

relationships, and local government relations. The con-

text o business in China can change rapidly, making it

essential that companies remain fexible and sensitive

to the local culture.

5. Manage communications with corporate headquar-

ters. Executives at the home oce oten have little

understanding o the situation on the ground in China

and, worse, sometimes have signicant misconcep-

tions about China. Maintaining proper communication

and linkages with global headquarters can be challeng-

ing and rustrating at times, but communication must

be appropriately handled to ensure smooth operations

and provide the China manuacturing entity with the

support and time to perorm protably.

6. Constantly update your knowledge about China,

because the competitive and regulatory environment

can change rapidly.

Six Steps to a Successul Manuacturing Entry into China


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5

how they trade o against each other. The net beneits

o these trade-os will drive the economics or the

company as a whole. Typical economic drivers to be

examined include:

n Labor: impact o low labor costs on total product

costs

n Productivity: number o units that can be produced

per person per hour

n Transportation: impact o increased logistics costs

on total product costs, including losses due to dam-

ages in transit

n Inventory: impact o increased delivery time and

potentially a greater degree o obsolescence on total

product costs

n Scale: cost advantages rom increasing the size oexisting plants

n Utilization: cost advantages rom running more vol-

ume through existing plants

n Complexity: cost impact o process complexity in the

current manuacturing network, and o linking a ar-

lung plant to the network

Exhibit 3 (page 6) provides an example o how such

an analysis might play out in a situation in which labor

costs, transportation, and capacity utilization are the

dominant issues.

In our experience, a correct interpretation o the results

is as important as getting the detailed analyses right.

For example, its essential to evaluate incremental

costs that can be squeezed out o the current manu-

acturing setup. I the cost gap with a low-cost country

can be closed by optimizing the existing manuacturing

network, this will result in a higher net product value,

as it is a less risky option than building new capacity.

I the gap cannot realistically be eliminated, then struc-

tural, low-cost-country options might be the only way tostay in the game.

2. Looking beyond the advantage o low labor costs,

are there any barriers that might prevent or argue

against a shit o manuacturing operations to China?

Although cost cutting requently (and oten misguid-

edly) outranks all other considerations in determining a

manuacturing ootprint, companies should look beyond

labor cost beneits to the bigger picture; China may not

be as advantageous as it irst seems.

Lead time impact:For products that are customized

and manuactured on a make-to-order, rather than a

make-to-stock, basis, or are part o a just-in-time supply

chain, the additional lead time involved in manuactur-

ing in China may be unacceptable. Longer lead times

should be actored into inventory costs, orecast inac-

curacies, and increased supply risks as part o an anal-

ysis o the system-wide impact. In some cases, com-

panies may have to pay additional amounts or more

rapid response rom Chinese manuacturers, even or

commodities. This too needs to be considered.

We recently witnessed a case in which a Western aero-

space manuacturer outsourced the manuacturing o

some large airplane components to an Asian company

that had proprietary composite technology, withoutrealizing that these simple parts actually needed

to be customized to the airlines requests at a late

assembly stage. The increased lead time needed to

assemble and ship these parts wreaked havoc with

the aircrats production schedule. Consequently, the

aerospace manuacturer had to establish a brand-new

plant to produce the parts in the West at great urgency

and cost.

Communications/coordination impact:When a sig-

niicant degree o codevelopment or shared R&D isrequired, its oten preerable (although not always

essential) or suppliers and customers to be located

close to each other. This can sometimes mean that

design, engineering, and actory operations should be

situated in the home country or market, to make it

easier to communicate and collaborate internally and

with suppliers and customers on complex, cross-unc-

tional issues. Although they are more diicult to quan-

tiy, the cost o lost time, cost o travel, and telecom-

munications costs all should be taken into account.

Biotechnology and other advanced technologies in par-

ticular would be hampered by large distances between

R&D and production sites.

Protection of intellectual property:Many companies

that make innovative products have been careul to

avoid China when manuacturing components with high

intellectual property content. They have a legitimate

ear that their product designs and process technolo-

gies may be stolen by unscrupulous business partners,

or even their own employees, in an environment where


8/12

6


Exhibit 3Cost Driver Analysis (Example)

0% 20% 40% 60% 80% 100%

Capacity Utilization

Capacity Utilization Curve

Capacity Utilization Analysis

Germany

CzechRepublicChina

0% 20% 40% 60% 80% 100%

UnitCosts

Process 1

Utilization

0% 20% 40% 60% 80% 100%

Utilization

0% 20% 40% 60% 80% 100%

Utilization

UnitCosts

UnitCosts

Process 2

UnitCosts

Process 3

0 100 200 400 500 600

Capacity (Packaging Units; in Millions)

Scale Curve

Scale Analysis

Germany

Czech Republic

China

0 100 200 300

Process 1

Capacity (Packaging Units)



0 50 100 150

UnitCosts

Process 2

0 20 40 60 8 0

Process 3

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5

Complexity Index

Complexity Curve

Capacity Utilization Analysis

Germany

CzechRepublic

China

0 1 2 3 4 5

ShareofSetupTime

Setup Time

Complexity Index

Complexity Index0 1 2 3 4 5

L

aborCostTotal

UnitCosts

Labor Costs

Germany

CzechRepublic

China

Analysis of Key Drivers

300

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9/12

7

intellectual property is diicult to protect owing to a

still-evolving legal system. In a recent case, General

Motors in China was unable to stop Chinese carmaker

Chery rom making an automobile that closely resem-

bled, inside and out, GMs Spark. Because o piracy

concerns, many companies are careul about restricting

who has access to what inormation in their Chinese

ventures. Some companies operating there have begun

to separate components o a project so that no single

employee or team has access to the complete set o

design and process insights and technologies.

Responsiveness to changes in design/specs:Products

requiring requent design changes are less likely to be

candidates or manuacturing in China, because trans-

mitting the new specs and reconiguring the actoryand logistics schedule can be a slow, tedious process.

An example o this is T-shirts made to represent teams

during the World Cup ootball (soccer) tournament. As

a country is successul on the ield and rises to the

top o its bracket, the demand or T-shirts displaying

its lag increases signiicantly. Clearly, manuacturing

T-shirts, or at least adding the images on the T-shirt or

sale in Europe, would be diicult to do with production

in China. The same logic applies to some components

in rapidly changing consumer or industrial products or

which supply chains may span wide distances.

As a result o this broad range o considerations,

many companies choose to locate some o their

operations in low-cost countries, while keeping other

activities closer to home. To evaluate which parts o a

companys manuacturing operations should relocate to

China, we typically divide the businesses or products

into three categories:

a) Inherently local businesses/products:This includes

businesses making products that will typically remainin the West because manuacturing costs are less

critical to total cost competitiveness, or because other

considerations outweigh costs. For many products,

transportation economics rom China are unavor-

able or capital costs ar outweigh the advantages o

low labor costs. For example, sewage tubes and tires

have unavorable transport economics (companies

pay or shipping a lot o air). And sotware has high

intellectual content, along with relatively little low-cost

labor content. Additionally, success in designing some

products requires a deep understanding o local tastes

and culture, which is best perormed by marketers and

designers in the home country who collaborate with

each other. For instance, processed ood and bever-

ages are typically local businesses.

b) Transitional businesses/products, shifting from local

to global:In these segments, much o the manuac-

turing at the industry level still remains in developed

home countries and markets, but the companies are

becoming increasingly vulnerable to price pressure

rom low-cost, China-based manuacturers. Many con-

sumer electronics products and components are in this

transitional category.

c) Global commodities:These businesses/products

have already commoditized and largely shited to

China, or are likely to do so in the near uture. Mass-

market and some higher-end textiles are in this cat-

egory, as are many white goods, toys, and consumer

durables with high labor content that are also relatively

inexpensive to ship.

3. How ast will the shit to China happen?

The third key question manuacturers should ask them-

selves to be sure they are staying on the right side o

the supply curve concerns the speed o the move to

China. Deregulation in China has continued to expandthe ield o industries in which oreign companies are

allowed to compete by selling products, taking owner-

ship stakes, or both. With Chinas relatively recent

entry into the World Trade Organization, this trend will

surely continue. (See Exhibit 4, page 8.) Indeed, or

many industries today, China is already an open market

or both manuacturing in and marketing in the country.

The Chinese government has also eased ownership

regulations to increase the ability o oreign companies

to own assets in China as the economy liberalizes.

Historically, because o Chinese laws constraining or-

eign ownership, many multinationals had to set up joint

ventures and other opportunistic partnerships with

Chinese companies. Today, wholly oreign-owned enter-

prises (WFOEs) are the preerred mode o entry into

China or the vast majority o multinational companies.

WFOEs have made it so much easier or oreign com-

panies to implement ull-ledged manuacturing opera-

tions in China that they have ballooned in popularity.

In 2004, 66 percent o oreign corporate investment

in China was in WFOEs, up rom 36 percent in 1997.


10/12

8

Meanwhile, during this same period, the amount invest-

ed in joint ventures dropped to 27 percent rom 43

percent. Vehicle assembly remains a notable exception

to the increasing openness in China. There continues

to be import duties o varying levels or components,

and vehicle manuacturers are still required to operate

through 50/50 joint ventures.

Another actor that will inluence how quickly manuac-

turing industries must relocate to China and how

much capacity they should consider relocating there

is local Chinese demand. Although the supply/

demand balance in China or products is in lux, with

requent major imbalances, overall strong growth in the

economy will continue to avor the need or increasing

capacity or virtually all industries. One related ques-

tion is, In which key industries that China is not yet a

major exporter will it become one?

For many manuacturers, China has become the 800-

pound gorilla. It dominates every conversation and

strategic plan; even when it isnt a real threat, the

ear exists that it is about to become one. As usual,

an educated analysis, diligently conducted, can make

the dierence between acting out o irrational ear and

perorming a logical assessment o risk and potential

reward.


Exhibit 4Changes in the Regulatory Framework in China

Energy

Hospitals

Insurance

AgriculturalMachinery

Pharmaceuticals

Banks

Auto

Tourism

Restricted Free

ConsumerProducts

Media

Retail andDistribution

Telecom Service

Ownership Degree of Freedom

Restricted

Free

Product Market

Degree of Freedom

From Mid-1990s to Today From Today to 2015


11/12


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