Opportunities for Action in Industrial Goods. Made in China: Why Industrial Goods Are Going Next

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1 Opportunities for Action in Industrial Goods Made in China: Why Industrial Goods Are Going Next

2 Made in China: Why Industrial Goods Are Going Next Shopping at Wal-Mart in the United States or at Carrefour in Europe will give you the wrong idea about where China s threat to U.S. and European manufacturing lies. Most made-in-china consumer goods on those shelves represent industries that left the United States and Europe years ago. A major study by The Boston Consulting Group, currently under way, suggests that the real contest between Western and Chinese factories is taking shape over industrial goods a $2 trillion market whose products range from small motors and oscilloscopes to locomotives. For goods such as these, the West s muchvaunted technological edge and resulting productivity advantage have kept production safe at home until recently. Today China s rapidly growing capabilities and huge scale are undermining these defenses. The cost advantages of moving production to China can amount to savings of an astonishing 20 to 35 percent with no loss of quality. Numbers like these are persuading manufacturers to transplant to China even high-performance, highly automated product lines, such as micromotors and medical-imaging machines. Many more will follow. How China Is Doing It How is China managing to compete so effectively against Western factories? Unlike Japan, which reinvented manufacturing a generation ago by introducing continuous improvement and quality programs, China is de inventing manufacturing by removing capital and reintroducing skilled manual labor on the

3 plant floor. China s low costs not only for production workers but also for plant technicians, accountants, and managers allow Western companies to rethink every business process, from how a product and its parts are designed to how they are made, tested, packaged, distributed, and even supported in the field. The results in addition to cost savings are more craft, less complexity in plant processes, and often a shorter time from design to production. And then there is the vast potential of the Chinese market. China is already becoming the world s largest market for some industrial goods, such as machine tools and power equipment. Add to these advantages the improving quality of materials and the reliability of supply chains in China including sophisticated transportation and third-party logistics and it s little wonder that some U.S. and European companies are moving entire core product lines there. But many are not. In both the U.S. and the European industrial-goods markets, China is still small fry. In the United States, China accounts for just 3 percent of industrial goods sold. Domestic production accounts for 70 percent, imports from Japan and Western Europe another 20 percent, and imports from lowwage countries, including China, just 10 percent. In Europe, China s penetration rates are even lower. In Germany, for example, imports from low-wage countries account for just 6 percent of the industrial goods market, and China s penetration is 2 percent. Why have so few industrial-goods companies thus far turned to China for manufacturing? Why Some Companies Are Holding Back Some Western companies have found China s cost advantage elusive. In a number of cases, their initial

4 approaches sending buying teams to China, armed with drawings and specs, to search for low-cost sources haven t worked out. Producers of small engines and low-end farm equipment, among others, recently explored the possibility of taking production lines to China but found that uneven quality and unreliable supply lines outweighed the advantage of lower production costs. In their view, the money they would have saved on manufacturing just wasn t worth the higher technical- and inventory-support costs, in addition to the risks. From a short-term point of view, their decision makes sense. Sourcing in China takes time. It works best for companies that are willing to invest their own knowhow and nurture their China operations over sustained periods. So far, only a limited number of foreign industrial-goods manufacturers, such as Atlas Copco in compressors and Emerson in motors, have made this kind of commitment. The lessons they are learning can be instructive. How Committed Companies See a Different China Our research shows that companies committed to large-scale manufacturing in China think about the issues differently than their less committed competitors in several important ways. Committed companies have a clearer view of the cost advantages to be gained. Companies that are committed to manufacturing in China accurately assess both the labor costs and the capital costs of their products. Accounting statements may tell a finished-equipment manufacturer that factory payroll represents only 10 percent of its costs; but in fact, when one adds in the full payroll cost of the purchased components and

5 company overhead costs, the total labor costs typically amount to 40 to 60 percent of the final product cost. In China, those labor costs are lower across the board. Production workers typically cost 5 percent of their U.S. or European counterparts, whereas experienced engineers and plant managers may cost 35 percent. But what about the difference in labor productivity? True, U.S. and European workers in capital-intensive factories can be several times more productive than their Chinese counterparts. That s because they work in plants in which complex flexible-automation and material-handling systems have replaced many factory workers. This substitution has reduced labor costs but it has substantially raised the costs of both capital and support systems. Chinese factories reverse this process by taking capital out of the production process and reintroducing a greater role for labor. Parts are designed to be made, handled, and assembled manually. This approach cuts the total capital required by as much as one-third. So although output per worker is lower in Chinese factories, the combination of lower wages and a lower capital investment typically raises the return on capital well above Western factory levels. Some manufacturers have beaten their cost-saving estimates by 15 to 20 percent and report return on invested capital of 50 percent or more at mature plants. Western companies that develop several factories in China as, for example, Kodak and Copeland have done will see more cost savings than a competitor taking its first steps, for several reasons. These companies work with and improve their local suppliers. They teach their Chinese engineers the quality disciplines. And they become skilled at hiring good people and designing effective incentives. The benefits of

6 manufacturing in China increase with scale and experience there. The more you grow, the easier it is to continue growing. Committed companies understand which products to shift to China. Counterintuitively, it usually makes more sense to send a distinctive new product line to China than an old, price-pressured one. The payoff from sending the latter to China is low. The many one-time expenses redesigning products and processes, sorting out new local suppliers, and requalifying the new finished product with customers back in home markets could wipe out any profit margin. In addition, moving existing product lines often forces companies to close down production lines in home countries a process that is painful at best, especially in Europe. In contrast, designing a new product for manufacturing in China can make a lot of sense, particularly if the company is far along on its experience curve there. For instance, Tektronix s new oscilloscope was designed by U.S.-based engineers working virtually with their China-based tooling counterparts. Because the product was designed for production in China from its inception, the company will have only one set of start-up costs and a lower capital investment to amortize. Committed companies make more realistic assessments of the risks involved. Outsiders often exaggerate China s supply-chain risks. Similarly, China s production tends to look more secure to insiders than to outsiders. For example, China demonstrated its fundamental resilience early this year when the outbreak of severe acute respiratory syndrome, or SARS, caused few supply disruptions. And Chinese authorities regard foreign-owned plants as valuable assets not to be disturbed.

7 But some risks are not exaggerated. The need to protect intellectual property rights, for example, deters many companies from taking highly proprietary processes to China. Armstrong, the world s leading floor- and ceiling-tile manufacturer, keeps some material formulas and processes in the United States. AMP, the world s leading producer of connectors, had no choice but to move to China because of the cost savings involved. So AMP conducts its proprietary inline-plating process in China in a specially designed, secure enclosure with licensed employees. Other companies accept the risk of some leakage of intellectual property in return for China s many advantages. Auto companies, for example, know that some of their technology is migrating to their Chinese joint-venture partners; but in return, they get a head start in China s exploding market. Committed companies understand the implementation challenges and how to overcome them. Many companies have been attracted to the benefits China offers but have not been able to realize them, often because of organizational barriers. These obstacles include organizational mindset, communications challenges, resource issues, the need for complex coordination, and a lack of incentives. Successful companies have overcome those barriers in a variety of ways. Their approaches tend to have two things in common. First, these companies invariably lead from the top as exemplified by Jack Welch at General Electric, among many other CEOs who have made this topic their own. Second, they set stretch targets. Cost-reduction goals of some 10 percent force the organization to consider relocating manufacturing to low-cost countries, such as China. They provide a powerful incentive to break through organizational inertia and resistance.

8 The Bottom Line Not all products will or should move to China. Products for which customer-driven innovation is frequent and critical will not go there. Nor will those that require extensive customization involving intimate user contact with the factory. In addition, a number of products may stay at home for political reasons. Some Western customers, especially publicly funded organizations, will insist on buying only goods that have been produced in their home countries. As more companies discover the advantages of manufacturing in China, the impact on Western jobs will grow, making it an increasingly potent political issue. In moving manufacturing to China, the most daunting barriers will be the customer-related and organization-related factors mentioned above, not technologyrelated ones. Production technology is often surprisingly mobile and divisible among locations. Large quantities of leading-edge medical diagnostic equipment are now being made in China. Jet aircraft engines which are already being overhauled and maintained in China will soon be manufactured there as well. There are many reasons to make more things in China. * * * Although China today has only 3 percent of the industrial goods business in the United States and even less in Europe, its shipments to those regions are growing very rapidly at more than 20 percent annually in a market that is essentially flat. Over the next several years, the pace of China s continuing penetration of Western markets will be governed not by anything as simple as wage increases or exchange-rate revaluations but by the increasing capabilities of for-

9 eign-owned and operated plants in China. Industrial goods companies that are not already sourcing and manufacturing in China should be giving this opportunity very serious consideration. Jim Hemerling Thomas Hout Jean Lebreton Jim Hemerling is a vice president and director in the Shanghai office of The Boston Consulting Group. Thomas Hout is a senior adviser in the firm s Hong Kong office. Jean Lebreton is a vice president and director in BCG s Shanghai office. This article is based on The Real Contest Between America and China, which appeared in The Asian Wall Street Journal on September 16, It is adapted with the permission of The Wall Street Journal, Dow Jones & Company, Inc. All rights reserved. You may contact the authors at: hemerling.jim@bcg.com hout.thomas@bcg.com lebreton.jean@bcg.com The Boston Consulting Group, Inc All rights reserved.

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