Mastering Disruptive Change in Manufacturing

Get Ready for China’s Manufacturing Comeback Chinese manufacturers are evolving, not fading. Western competitors have no time to waste.

Get Ready for China’s Manufacturing Comeback

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Executive Summary Stories of recent setbacks for Chinese manufacturers may tempt western executives to conclude that China’s manufacturing might is fading. It’s true that rising labor costs, high staff turnover, excessive overhead, and inefficient processes are eroding China’s cost advantage over less-developed countries such as Vietnam, Myanmar, and Bangladesh. And some manufacturers are shifting low-value production to these countries, where wage rates run well below China’s. Yet this “flight from China” masks a longer-term evolution of Chinese manufacturing away from the low-cost model that made the country an industrial giant over the past quarter-century. Chinese manufacturers are moving up the value chain to capitalize on growing domestic demand for expensive consumer goods. Some are also venturing abroad to compete with western manufacturers on their home turf. And China is attacking its productivity gap with a long-range strategy centered on three levers: better education, high-value, automated manufacturing, and imported expertise. In the years to come, western manufacturers will face increasingly sophisticated Chinese rivals at home and abroad. To win, they will need to create flexible manufacturing footprints capable of responding to changes in the cost landscape, optimize productivity at their Chinese plants, and set themselves apart in the marketplace with innovation.

Rising Labor Costs and Inefficiency Undermine Chinese Productivity China rose from underdeveloped backwater to industrial juggernaut on the strength of its vast pool of low-wage workers. Labor cost advantages enabled Chinese manufacturers to take over industries ranging from consumer electronics to machine tools. But cracks have begun to appear in this model. China’s official manufacturing purchasing-managers index (PMI) fell to a three-year low last summer, dropping into contraction territory for the first time in six months. Behind the numbers are signs that China’s cost advantages are starting to slip. While wages in China remain well below those of western countries, manufacturers find far lower labor costs in Vietnam, Myanmar, Indonesia, Bangladesh, and even India (see figure 1). At the same time, high staff turnover undermines productivity in Chinese factories. In high-tech for example, many original device manufacturers (ODMs) suffer turnover rates of 15 to 20 percent per month. High turnover reflects tightening labor supply in a country where demographics favored employers for the past several decades. That’s changing, with the number of available workers expected to fall from a peak of 915 million today to 890 million in 2025 (see figure 2 on page 3).

Figure 1 China’s cost advantages are starting to slip Manufacturing labor costs per hour $, CAGR 0.2 Indonesia

2002

0.5

2015f

0.8

2019f

0.4 Vietnam

2.0 3.0 0.6 3.3

China

4.8

14.4% 9.8%

0.7 India

1.7 2.5 1.0

Philippines

2.4 3.1 27.4

United States

38.0

+2.6% 42.6

27.6 Germany

41.9

+2.9% +3.3% 52.0

+5.5%

Note: 2002 figures for Indonesia, Vietnam, and India are estimates. All figures have been converted from local currency to U.S. dollars based on either actual (for 2002) or forecast (for 2015 and 2019) exchange rates. Sources: Economist Intelligence Unit (EIU); A.T. Kearney analysis

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Figure 2 Expected workforce evolution in China Number of available workers in China Million

Forecast

1,000 800 600 400 200 0

1980

1985

1990

1995

2000

2005

2010

2015f

2020f

2025f

Sources: Allianz Demographic Pulse, United Nations Population Division; A.T. Kearney analysis

Bloated cost structures and inefficient manufacturing processes take another bite out of productivity. Chinese manufacturers are up to 70 percent less efficient than western counterparts in indirect functions such as material handling and quality assurance. Raw materials conversion rates also lag global norms: a Chinese steelmaker uses three times as much water and twice as much energy to produce a ton of steel than more efficient manufacturers in Germany. Together, these cost headwinds have pushed China’s Producer Price Index up nearly threefold since 2000, a faster rise than western countries have seen, and a sign that most Chinese companies have not been able to raise productivity enough to cover cost increases (see figure 3).

Figure 3 Producer Price Index Index (100=2000) China

Germany

United States

300 250 200 150 100 50 0

2000

2005

2010

2015f

Sources: IHS Global Insight; A.T. Kearney analysis

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As Cost Advantages Shrink, China Moves Beyond Low-End Manufacturing While the cost headwinds have hurt some Chinese manufacturers—particularly state-owned enterprises in commoditized industries—they don’t spell defeat for the country’s manufacturing sector as a whole. Private Chinese companies retain significant advantages, not least the resiliency and competitive spirit of their people. China benefits from an established industrial ecosystem comprising myriad integrated supplier networks, supported by strong education in science and technology. Lower-wage countries generally lack these attributes, putting them at a disadvantage to China in many manufacturing sectors. So for the foreseeable future China will continue to produce most of the world’s shoes, mobile phones, and hair dryers. Even as it loses share in low-value categories such as apparel, China is gaining ground in many export segments. A closer look at the “flight from China” phenomenon shows it’s more limited than it appears. Some manufacturers are building new factories elsewhere, but they’re not shuttering Chinese plants in bunches. Only a few, usually in low-value sectors, have been reduced to “zombie” status. Most factories in China have at least 20 years of useful life left, and many are increasingly being upgraded with new technology and equipment. Far more significant than the so-called flight from China is China’s flight forward from low-end manufacturing, where low costs are critical to profitability. Chinese manufacturers are moving up into segments where profits flow from high-value product features that command higher selling prices. Chinese automotive manufacturer Great Wall, for example, has boosted R&D spending to develop premium sport-utility vehicle (SUV) models that compete with international brands in the Chinese high-end market. Great Wall also is sourcing more components from domestic suppliers, reducing its reliance on imported parts. Like many Chinese manufacturers, Great Wall aims to capture the opportunity presented by expanding affluence in China, which is now the world’s second largest end market for consumer goods. With occasional help from friendly local regulators, homegrown manufacturers have the inside track on the growing Chinese consumer market.

Chinese Manufacturers Move West to Find New Markets and Expertise As Chinese manufacturers target higher-value, higher-margin products, they need advanced technical skills and innovation capabilities that are more abundant in western markets. That’s one reason why many are setting up shop abroad, particularly in the United States. Local authorities often help offset higher U.S. wages by offering generous subsidies to manufacturers. Yarn manufacturers from China and other Asian countries, for example, have opened highly automated plants in the United States that require far less labor than traditional yarn factories. The U.S. operations produce high-quality fabric that’s shipped back to Asia for the labor-intensive steps of cutting and sewing cloth into apparel. Some Asian apparel makers perform the latter operations in Mexico, so they can ship finished goods back into the United States without paying the costly duties levied on Asian imports.

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Chinese companies in a range of industries are making similar moves to tap American engineering skills and manufacturing know-how while expanding in U.S. markets. Shandon Tralin Paper Company is building a plant in Richmond, Virginia, to make household products such as napkins, tissues, and even organic fertilizer. Automotive conglomerate Wanxiang Group is building a plant in Moreno Valley, California, to rejuvenate the Fisker premium hybrid car brand. In the future, any U.S. manufacturer operating in an industry where access to American technology, talent, and markets creates a competitive advantage should expect a Chineseowned factory to appear in the neighborhood. Of course, moving to the United States is not without risks. Tax credits and subsidies go only so far in offsetting the costs of operating in the country, which are growing even higher as the dollar strengthens. But if worse comes to worst, Chinese manufacturers can pack up and head home, taking along all the strategic and technical skills they’ve acquired in the United States.

China Grabs the Productivity Levers At home, Chinese manufacturers are working to address the productivity challenges that weakened their grip on low-end sectors. Business leaders and government authorities are executing a plan focused on three main productivity levers, some of which are starting to bear fruit. Education. Education is critical to improving efficiency and quality in Chinese manufacturing. A more educated, better-trained workforce can help close the gap with western manufacturers in high-end market segments. To that end, China is increasing investment in vocational education, and Chinese companies are overhauling human resources functions to develop and manage a better-skilled, more sophisticated workforce. Rising graduation rates indicate the efforts are paying off. Upper secondary education graduation rates climbed to 59 percent in 2010, still below the Organisation for Economic Co-operation and Development (OECD) average of 81 percent but a big jump from 42 percent in 2005. High-value manufacturing. The second lever involves a fundamental shift in Chinese manufacturing, away from low-tech production of commoditized goods and toward technologically advanced manufacturing of high-value products. In these sectors, productivity levels are higher and labor represents a smaller portion of the cost equation. For example, the shift of labor-intensive auto parts production to low-wage countries such as Vietnam and Bangladesh is making room in Chinese factories for new, high-productivity operations from the west. The strategy relies on factory automation to offset rising labor costs. Automation is a focal point of the China State Council’s “Made in China 2025” strategy, which initially targets 10 key industrial sectors, including energy-efficient cars, aerospace, agricultural equipment, and medical technology. Importation of expertise. Deeper-pocketed Chinese manufacturers are bringing in expensive know-how and expertise from the outside. For example, Japanese and German Lean and Six Sigma experts are helping Chinese plants increase productivity. Combining Lean lessons with traditional Chinese discipline and eagerness to learn is already yielding big productivity gains at some manufacturers. Many also are locking in the gains by adopting Kaizen-like continuous improvement principles. Along with new productivity tools, outside experts also bring western organizational benchmarks and cost metrics that highlight opportunities to drive efficiency by trimming the excess layers of management that weigh down many Chinese manufacturers. Get Ready for China’s Manufacturing Comeback

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Overseas acquisitions and investments, meanwhile, are spurring a more systematic transfer of know-how and expertise to China. Chinese direct investment in Europe almost quadrupled to more than $100 billion in 2014 from $26 billion in 2007. In Germany alone, Chinese companies acquired 12 small- and medium-sized, highly specialized companies within the past two years. In the United States, Chinese firms have made $46 billion in investments since 2000, according to Rhodium Group. Most came in the past five years, as Chinese buyers made high-profile acquisitions such as Shuanghui Group’s purchase of Smithfield Foods and Lenovo’s buyout of Motorola Mobility. Chinese manufacturers also are building new U.S. plants, mostly in “right-to-work” states where unions have little power. Acquiring western companies and brands serves two goals, enabling Chinese firms to compete more effectively in global markets while gaining important technological capabilities. As the three levers take effect, Chinese productivity is likely to rise quickly, making China even more competitive in manufacturing. And if productivity growth falls short, Chinese officials can always further devalue the yuan. They explained their recent devaluation as a move to bring the Chinese currency in line with global financial markets. Still, the devaluation helped export-reliant Chinese manufacturers who had been pinched by unfavorable exchange rates.

Be Prepared: Competing with the New Chinese Manufacturer China’s efforts to improve productivity and move beyond a fading position of strength in low-end production make clear its intention to become an even greater force in global manufacturing. However, western companies have levers to pull, too. Three critical steps will prepare them to compete with resurgent Chinese manufacturers: • Create a flexible footprint. With global currencies, labor rates, and energy costs gyrating, it’s time for manufacturers to reassess their own footprints, as well as those of their suppliers. These reviews should ensure that products with high labor or energy content are made in areas where those factor costs are lowest. Even within China, costs can vary significantly from region to region, a fact not lost on Chinese manufacturers. Consumer electronics companies such as Wistron, Compal, and Foxconn have reaped significant productivity gains by expanding their manufacturing footprints beyond coastal manufacturing hotbeds, into regions where wages are lower (see sidebar: Moving Inland).

Moving Inland Until recently, Taiwanese OEM suppliers for the high-tech industry tended to build factories around the big ports in southeastern China, historically a more prosperous region than western China. These coastal locations afforded easy access to global shipping routes, while transportation infrastructure was largely

undeveloped elsewhere in China. But as land and air transportation to inland cities improves, manufacturers are starting to take advantage of lower wages in western provinces. Labor costs in Hubei and Szechuan can be as much as 30 percent below prevailing wages in Shanghai and Shenzhen. Helped along by subsidies from

local governments, Foxconn (which employs about 1 million people in China) and others are building huge plants in Henan and Szechuan. Many of the workers in coastal factories migrated from these populous interior provinces, and manufacturers expect them to return as job opportunities open up near their home cities.

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More important, however, is building in the flexibility to adjust your footprint in response to future global movements and cost fluctuations. In addition to traditional network optimization techniques, this requires strategic scenario planning that tests the proposed footprint under various cost and currency scenarios, and under different timelines to identify potential tipping points. For some types of manufacturing, you should also consider the benefits of reshoring (for example, to the United States or Germany) or near-shoring (for instance, to Mexico or Poland). Keeping the broader supply chain in mind will help ensure that higher transportation expenses and import duties don’t erase manufacturing cost savings. • Upgrade Chinese plants. If your Chinese plants are not merely low-cost manufacturing hubs, but strategic assets that serve the domestic or regional market, they’ll need an operational upgrade through Lean methods, smart automation, or both. Turning factories accustomed to relying on cheap labor into highly productive operations requires a major cultural shift involving significant time and investment. Chinese plant managers will need more than a manual on how things are done elsewhere in the world. They’ll need focused training, curriculum upgrades, and the assistance of experts from other parts of the world. To maximize efficiency throughout the supply chain, leading companies are not only addressing their own China plants, but also helping their strategic suppliers make the leap. Finally, product redesigns will likely be required to facilitate automation. For example, high-tech manufacturers have found that the right combination of Lean, automation, and redesign can reduce the headcount needed to make complex products such as notebook PCs by 30 to 40 percent. Chinese companies such as Haier already are moving in this direction (see sidebar: Reduced Labor Load). • Keep innovating aggressively. Despite their reputation for low-cost manufacturing of products pioneered elsewhere, Chinese companies across a variety of industries are showing innovative flair. From now on, western manufacturers will have to work harder to stay on the cutting edge. Especially in high-end markets, rapid product development will be essential to meet the rising Chinese challenge. Understand that Chinese manufacturers are no longer content to make “the cheap stuff,” and objectively assess the areas where you can maintain an advantage. A “ruthless competitor” assessment will provide valuable perspective on what a new Chinese rival could do starting from scratch in your industry, as they have done in others. Chinese hydrocolloid manufacturers, for example, met the industry’s demanding tolerance specifications five years sooner than experts thought possible. This insight can help you make the right product development investments to protect market share and margins from Chinese competitors who are on a flight forward. For some companies, such as GM, that may even mean tapping into China’s own “best and brightest” to stay ahead (see sidebar: Innovative Minds on page 8).

Reduced Labor Load Haier, founded as Qingdao Refrigerator Company in 1984, is a Chinese multinational consumer electronics and home appliances company. A strategy of combining western technologies with low labor costs made Haier a market leader

in several sectors, including white goods. Haier maintains market and cost leadership by focusing on three main pillars: automation, modularization and integration of supplier capabilities, and mass customization. This reduces Haier’s reliance on manual labor,

enabling it to move factories closer to customers. Proximity to end markets creates two important advantages: lower shipping costs for Haier’s bulky, relatively low-value goods; and shorter lead times that facilitate mass customization.

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Innovative Minds With China having passed the United States as the world’s largest car market, global automakers such as GM aim to tap local talent for innovations that will appeal to Chinese car buyers. GM recognizes that such innovations require in-country research and development, with engineering teams led by people who speak the language,

know the behavior and expectations of Chinese car buyers, and understand cultural factors that influence consumer choices. Finding talent and cultivating local innovation capabilities will require internships, special university curricula, and other programs not commonly available in China. Specific challenges include the

government’s push for electric vehicles under its Made in China 2025 strategy, which raises both technical obstacles and cultural issues. Concern over the limited driving range of electric cars is acute in China, where most people commute by public transportation and use private vehicles mainly for longer trips.

China Manufacturing 2.0: Coming Sooner Than You Think Western manufacturers should resist the temptation to write off Chinese competitors buffeted by temporary headwinds. Chinese manufacturers are evolving, not fading. Even as they lose ground in low-end sectors, they’re moving up the value chain, and moving beyond domestic markets. China has a plan to close the productivity gap, centered on a better-educated work force, high-tech manufacturing, and a worldwide search for advanced know-how. As their capabilities grow, Chinese manufacturers will challenge western rivals in new ways. Competitors who make the right adjustments and investments can meet the challenge of China Manufacturing 2.0. But there’s no time to waste—China always moves faster than others expect.

Authors Patrick Van den Bossche, partner, Washington, D.C. [email protected]

Marc Lakner, partner, Berlin [email protected]

Harald Jordan, consultant, Vienna [email protected]

The authors would like to thank Johan Gott and Alexander Rathfelder for their valuable contributions to this issue paper.

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