Perspective Edouard Samakh

Kaj Grichnik
Ron Haddock
Unraveling the Chinese
Puzzle
A Practical Approach
For Manufacturers
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CONTACT INFORMATION
London
Edouard Samakh
Principal
+44-20-7393-3357
edouard.samakh@booz.com
Munich
Kaj Grichnik
Partner
+49-89-54525-553
kaj.grichnik@booz.com
Zurich
Ron Haddock
Partner
+41-43-268-2132
ronald.haddock@booz.com
Originally published as:
Unraveling the Chinese Puzzle: A Practical Approach for Manufacturers,
by Kaj Grichnik, Ron Haddock, and Edouard Samakh, Booz Allen Hamilton, 2006
A leading industrial fiber manufacturer whose
products are critical to automobile tires and seat
belts had traditionally had most of its factories
in Western Europe, near company headquarters.
Recently, though, the companys already low profit
margins had declined even more, by as much
as 2 percent, as revenue growth in its domestic
market slowed. And while the fiber manufacturer
struggled to deal with its eroding financial per-
formance, it became aware of another potentially
troubling reality: More and more of its competitors
were in the process of moving their production to
low-cost countries, especially to China.
The manufacturer had been planning to make a mul-
timillion-euro investment to upgrade its European fac-
tory operations, but considering the changing business
landscape and geographic shift of manufacturing to
China, management was forced to reconsider whether
this was the right decision. A more fundamental ques-
tion needed to be addressed. How would globaliza-
tion specifically, low-cost manufacturing in China
impact the companys operations in Western Europe
now and in the coming years?
To help the company work through this difficult quanda-
ry, Booz Allen Hamilton conducted an exhaustive exami-
nation of its operations. Our analysis revealed that the
companys Tier One customers, which included several
European automakers, tire companies, and seat belt
manufacturers, had not been opening factories in Asia
for many of their product lines and were unlikely to do
so in the near future. One of the reasons for 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 factories without incurring significant financial
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 for short manufacturing and
delivery lead times, if the Tier One seat belt and tire
manufacturers ultimately sought lower-cost plants, the
plants would most likely be built in Eastern Europe
or in the southern United States, closer to where an
increasing number of automakers were building new
assembly capacity for established markets.
Traditional Tier Two and Tier Three suppliers in
other words, the fiber company and its primary rivals
faced a different set of challenges. Many of these
companies, which convert yarn and other industrial
fibers into raw material for tires or into woven narrow
fabric for seat belts, were definitely China-bound (if not
history-bound). The main reason: increased competi-
tion from Asian suppliers. Moreover, many of the Tier
Two and Tier Three suppliers factories in Europe were
aging and already fully depreciated, so replacing them
would incur lower capital costs than was the case with
Tier One suppliers, and would therefore generate more
immediate and larger cost savings.
Consequently, for the foreseeable future, pricing and
market trends in the fiber manufacturers industry
would be driven by economically advantaged factories
in Asia, independent of who owned them. Our conclu-
Unraveling the Chinese Puzzle
A Practical Approach for Manufacturers
1
2
sion was that if the fiber manufacturer stood still and
continued to ignore the lure of China for its customers
and rivals that is, if the fiber manufacturer didnt
explore a shift in its own manufacturing base to China
(or other lower-cost countries) its survival might be
in doubt.
This was a disturbing finding for the fiber manufacturer,
but it is one that more and more companies in Europe
are facing. To react quickly to rapidly changing
low-cost manufacturing dynamics, executives must
comprehend not only what is happening in their own
companies, but also the challenges being faced by
their customers, and the customers of their customers.
Without a broad understanding of trends across the
value chain, it is easy to get blindsided and miss nar-
row windows of opportunity to make changes before it
is too late.
In responding to the challenges emanating from China,
industrial-goods manufacturers typically face several
top-level issues:
n
Low-cost sourcing: To what degree can China be
used as a low-cost sourcing base for Western mar-
kets? What is the true cost differential?
n
Make versus buy: Should I source from others or
establish my own factories in China?
n
Timing: What is the value of preempting a domestic
or Asian competitor, or an Asian copycat competitor,
who decides to use Chinese factories to attack my
home market with low-cost imports? What is the pen-
alty of delay?
n
Growth/expansion: What is the opportunity to com-
bine a manufacturing or sourcing play in China with
the pursuit of new growth in that nations rapidly
expanding market by leveraging existing strengths
or customer relationships? What other markets and
customers in the Asia/Pacific region could also be
served from Chinese plants?
n
Regulations: What is the legal or regulatory environ-
ment? Will it allow the implementation of reliable
operations now and in the future?
Assessing the level of opportunity or threat from
China, or from other low-cost countries, starts with an
analysis of a manufacturers cost structure relative
to the industry as a whole. This is especially critical
for industries or products that are driven primarily by
price-based competition. One of the most common
Source: Booz Allen Hamilton analysis
Exhibit 1
Example Industry Supply Curve
Cost to Serve Germany from Different 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
3
approaches for comparing relative cost positions of
companies, or even countries, is to develop an industry
supply curve. A supply curve is based on the classic
economic notion of economies of scale and geographic
advantage, and graphically depicts the cost of providing
a product to a market from different facilities and geo-
graphical locations.
As an example, Exhibit 1 (page 2) shows the cost to
manufacture a commodity product and deliver it to
Germany from 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 of their manufacturing operations on the
left side of the curve have cost structures with the
greatest advantages. When the lowest-cost capacity
is fully utilized, the next least expensive manufactur-
ing and logistics option becomes the best choice. This
process of gradual participation of increasingly higher-
cost suppliers and factories continues until full market
demand is satisfied. By extension, as demand or pric-
ing drops, the companies or countries on the right side
of the supply curve are typically the first ones affected,
given their higher cost structures and lesser ability to
compete on the basis of cost alone.
New entrants as well as incumbents that are adding
new capacity typically do so on the left side of 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 manufacturing
networks into low-cost locations, they often can elimi-
nate or at least reduce their relative output from the
more costly right side of the supply curve, minimizing
their average cost-to-manufacture in the process.
To avoid being maneuvered into an unprofitable posi-
tion on the right side of the supply curve, manufactur-
ers need to answer three key questions: What are the
economic benefits, at the different levels of the value
chain, of shifting manufacturing assets to China or
other low-cost countries? Looking beyond the advan-
tage of low labor costs, are there any barriers that
might prevent or argue against a shift of manufactur-
ing operations to China? And how fast will the shift to
China happen? (See Exhibit 2.)
1. What are the economic benefits, at the different
levels of the value chain, of shifting manufacturing
assets to China or other low-cost countries?
An assessment of the cost elements should include a
holistic understanding of the key economic drivers and
Source: Booz Allen Hamilton analysis
Exhibit 2
Framework to Assess the Impact of China on Manufacturing 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 drivers

Model relocation
scenarios
Is it beneficial
for a Western
company
to shift its
manufacturing base
to China?

Map product
and process
characteristics

Understand key levers to

compete

Estimate market size of

different clusters

Estimate impact on
sales portfolio

Analyze current and

future market situation in
China

Analyze current and

future regulatory
environment

Develop entry and

footprint strategy

Develop 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 will
compete with
Western-based
assets?
Niche
Protected
Market
Exposed
Market
Threatened
Market
Commodity
4
1. Develop a coherent manufacturing strategy. This
should include a clear mission for manufacturing 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 of the manufacturing pro-
gram for both short- and long-term results, incentives
for the local team, and global supporting functions all
need to be aligned. Given the rapidly changing environ-
ment in China, this manufacturing 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 for raw materials
and fnished products, and availability of talent for key
management positions. Although most Chinese labor is
cheap compared with that in more developed markets,
plant management functions may be a different story.
Capital can be more expensive than in the West, at
least for Western companies. And Chinese companies
usually have access to local sources of funding that
are not available to foreign-owned companies; for ex-
ample, the local Chinese banks that often supply funds
below the true cost of capital. This can be a real
disadvantage to multinational manufacturers that are
required to meet certain hurdle rates for investment
returns.
3. Adapt management and reporting styles to the
China context. Understand the local culture and dif-
ferences in business practices between China and the
West. Dont simply copy the Western way of doing busi-
ness. For example, accrual accounting is less popular
in China than cash accounting. Although the benefts
of accrual accounting and the practice of activity-based
costing are often crucial for 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 proftably using cash accounting systems.
4. Develop a culture of adaptability, fexibility, entre-
preneurship, and willingness to accept a large degree
of ambiguity. This applies not only to customers and
markets, but also to business partnerships, supplier
relationships, and local government relations. The con-
text of 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 offce often have little
understanding of the situation on the ground in China
and, worse, sometimes have signifcant misconcep-
tions about China. Maintaining proper communication
and linkages with global headquarters can be challeng-
ing and frustrating at times, but communication must
be appropriately handled to ensure smooth operations
and provide the China manufacturing entity with the
support and time to perform proftably.
6. Constantly update your knowledge about China,
because the competitive and regulatory environment
can change rapidly.
Six Steps to a Successful Manufacturing Entry into China
5
how they trade off against each other. The net benefits
of these trade-offs will drive the economics for the
company as a whole. Typical economic drivers to be
examined include:

n
Labor: impact of low labor costs on total product
costs

n
Productivity: number of units that can be produced
per person per hour

n
Transportation: impact of increased logistics costs
on total product costs, including losses due to dam-
ages in transit

n
Inventory: impact of increased delivery time and
potentially a greater degree of obsolescence on total
product costs

n
Scale: cost advantages from increasing the size of
existing plants

n
Utilization: cost advantages from running more vol-
ume through existing plants

n
Complexity: cost impact of process complexity in the
current manufacturing network, and of linking a far-
flung plant to the network
Exhibit 3 (page 6) provides an example of 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 of the results
is as important as getting the detailed analyses right.
For example, its essential to evaluate incremental
costs that can be squeezed out of the current manu-
facturing setup. If the cost gap with a low-cost country
can be closed by optimizing the existing manufacturing
network, this will result in a higher net product value,
as it is a less risky option than building new capacity.
If the gap cannot realistically be eliminated, then struc-
tural, low-cost-country options might be the only way to
stay in the game.
2. Looking beyond the advantage of low labor costs,
are there any barriers that might prevent or argue
against a shift of manufacturing operations to China?
Although cost cutting frequently (and often misguid-
edly) outranks all other considerations in determining a
manufacturing footprint, companies should look beyond
labor cost benefits to the bigger picture; China may not
be as advantageous as it first seems.
Lead time impact: For products that are customized
and manufactured on a make-to-order, rather than a
make-to-stock, basis, or are part of a just-in-time supply
chain, the additional lead time involved in manufactur-
ing in China may be unacceptable. Longer lead times
should be factored into inventory costs, forecast inac-
curacies, and increased supply risks as part of an anal-
ysis of the system-wide impact. In some cases, com-
panies may have to pay additional amounts for more
rapid response from Chinese manufacturers, even for
commodities. This too needs to be considered.
We recently witnessed a case in which a Western aero-
space manufacturer outsourced the manufacturing of
some large airplane components to an Asian company
that had proprietary composite technology, without
realizing 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 aircrafts production schedule. Consequently, the
aerospace manufacturer 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-
nificant degree of codevelopment or shared R&D is
required, its often preferable (although not always
essential) for suppliers and customers to be located
close to each other. This can sometimes mean that
design, engineering, and factory 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-func-
tional issues. Although they are more difficult to quan-
tify, the cost of lost time, cost of 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 careful to
avoid China when manufacturing components with high
intellectual property content. They have a legitimate
fear that their product designs and process technolo-
gies may be stolen by unscrupulous business partners,
or even their own employees, in an environment where
6
Source: Booz Allen Hamilton analysis
Exhibit 3
Cost Driver Analysis (Example)
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IekhY[07dd`6aaZc=Vb^aidcVcVanh^h
0% 20% 40% 60% 80% 100%
Capacity Utilization
Capacity Utilization Curve
Capacity Utilization Analysis
Germany
Czech
Republic China
0% 20% 40% 60% 80% 100%
U
n
i
t

C
o
s
t
s
Process 1
Utilization
0% 20% 40% 60% 80% 100%
Utilization
0% 20% 40% 60% 80% 100%
Utilization
U
n
i
t

C
o
s
t
s
U
n
i
t

C
o
s
t
s
Process 2
U
n
i
t

C
o
s
t
s
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)
Capacity (Packaging Units)
Capacity (Packaging Units)
0 50 100 150
U
n
i
t

C
o
s
t
s
Process 2
0 20 40 60 80
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
Czech
Republic
China
0 1 2 3 4 5
S
h
a
r
e

o
f

S
e
t
u
p

T
i
m
e
Setup Time
Complexity Index
Complexity Index
0 1 2 3 4 5
L
a
b
o
r

C
o
s
t

T
o
t
a
l
U
n
i
t

C
o
s
t
s
Labor Costs
Germany
Czech
Republic
China
Analysis of Key Drivers
300
Add|t|ora| labor 0osts
tor late S||tts bO
labor 0osts (wages)
0||ra
labor 0osts (wages) ard
labor lroduct||t] 0||ra
0apac|t] ut|||tat|or
labor lroduct||t]
+1O
Irarsportat|or
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bu||d|rg lac|||t] 0ost
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Add|t|ora| labor 0osts
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0oub|e 0orp|e\|t]
0apac|t] bO
bu||d|rg lac|||t] 0ost
SW|tter|ard
Change in Unit Costs
Key Drivers
0apac|t]
ut|||tat|or
-60% -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60%
U
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i
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C
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s
U
n
i
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C
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U
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s
7
intellectual property is difficult to protect owing to a
still-evolving legal system. In a recent case, General
Motors in China was unable to stop Chinese carmaker
Chery from making an automobile that closely resem-
bled, inside and out, GMs Spark. Because of piracy
concerns, many companies are careful about restricting
who has access to what information in their Chinese
ventures. Some companies operating there have begun
to separate components of a project so that no single
employee or team has access to the complete set of
design and process insights and technologies.
Responsiveness to changes in design/specs: Products
requiring frequent design changes are less likely to be
candidates for manufacturing in China, because trans-
mitting the new specs and reconfiguring the factory
and logistics schedule can be a slow, tedious process.
An example of this is T-shirts made to represent teams
during the World Cup football (soccer) tournament. As
a country is successful on the field and rises to the
top of its bracket, the demand for T-shirts displaying
its flag increases significantly. Clearly, manufacturing
T-shirts, or at least adding the images on the T-shirt for
sale in Europe, would be difficult to do with production
in China. The same logic applies to some components
in rapidly changing consumer or industrial products for
which supply chains may span wide distances.
As a result of this broad range of considerations,
many companies choose to locate some of their
operations in low-cost countries, while keeping other
activities closer to home. To evaluate which parts of a
companys manufacturing 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 remain
in the West because manufacturing costs are less
critical to total cost competitiveness, or because other
considerations outweigh costs. For many products,
transportation economics from China are unfavor-
able or capital costs far outweigh the advantages of
low labor costs. For example, sewage tubes and tires
have unfavorable transport economics (companies
pay for shipping a lot of air). And software has high
intellectual content, along with relatively little low-cost
labor content. Additionally, success in designing some
products requires a deep understanding of local tastes
and culture, which is best performed by marketers and
designers in the home country who collaborate with
each other. For instance, processed food and bever-
ages are typically local businesses.
b) Transitional businesses/products, shifting from local
to global: In these segments, much of the manufac-
turing at the industry level still remains in developed
home countries and markets, but the companies are
becoming increasingly vulnerable to price pressure
from low-cost, China-based manufacturers. Many con-
sumer electronics products and components are in this
transitional category.
c) Global commodities: These businesses/products
have already commoditized and largely shifted to
China, or are likely to do so in the near future. 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 fast will the shift to China happen?
The third key question manufacturers should ask them-
selves to be sure they are staying on the right side of
the supply curve concerns the speed of the move to
China. Deregulation in China has continued to expand
the field of industries in which foreign 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, for
many industries today, China is already an open market
for both manufacturing in and marketing in the country.
The Chinese government has also eased ownership
regulations to increase the ability of foreign companies
to own assets in China as the economy liberalizes.
Historically, because of Chinese laws constraining for-
eign ownership, many multinationals had to set up joint
ventures and other opportunistic partnerships with
Chinese companies. Today, wholly foreign-owned enter-
prises (WFOEs) are the preferred mode of entry into
China for the vast majority of multinational companies.
WFOEs have made it so much easier for foreign com-
panies to implement full-fledged manufacturing opera-
tions in China that they have ballooned in popularity.
In 2004, 66 percent of foreign corporate investment
in China was in WFOEs, up from 36 percent in 1997.
8
Meanwhile, during this same period, the amount invest-
ed in joint ventures dropped to 27 percent from 43
percent. Vehicle assembly remains a notable exception
to the increasing openness in China. There continues
to be import duties of varying levels for components,
and vehicle manufacturers are still required to operate
through 50/50 joint ventures.
Another factor that will influence how quickly manufac-
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 for products is in flux, with
frequent major imbalances, overall strong growth in the
economy will continue to favor the need for increasing
capacity for 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 manufacturers, China has become the 800-
pound gorilla. It dominates every conversation and
strategic plan; even when it isnt a real threat, the
fear exists that it is about to become one. As usual,
an educated analysis, diligently conducted, can make
the difference between acting out of irrational fear and
performing a logical assessment of risk and potential
reward.
Source: Booz Allen Hamilton analysis
Exhibit 4
Changes in the Regulatory Framework in China
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<hWc[meha_d9^_dW
IekhY[07ddo6aaZc=Vb^aidcVcVanh^h
Energy
Hospitals
Insurance
Agricultural
Machinery
Pharmaceuticals
Banks
Auto
Tourism
Restricted Free
Consumer
Products
Media
Retail and
Distribution
Telecom Service
Ownership Degree of Freedom
Restricted
Free
Product Market
Degree of Freedom
From Mid-1990s to Today From Today to 2015
Asia
Beijing
Hong Kong
Mumbai
Seoul
Shanghai
Taipei
Tokyo
Australia,
New Zealand,
and
Southeast Asia
Adelaide
Auckland
Bangkok
Brisbane
Canberra
Jakarta
Kuala Lumpur
Melbourne
Sydney
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