the
China road
The outsourcing option isn't
as cheap or as easy as it looks.
Everyone
knows the cheap-imports stories: Automated plants closed. Old line producers
now distributing imports. Counterfeit imported goods. Mass layoffs as
more production moves overseas.
Any discussion about how U.S. companies are outsourcing manufacturing
quickly becomes a discussion about China. China's unusual combination
of low wages, modern technology, and an enormous internal market of more
than one billion people has forged the world's lowest-cost modern manufacturing
infrastructure.
It is easy to see that labor and materials costs are cheaper in China,
but it is harder to pin down the costs of stolen intellectual property,
complex supply chains, inflexible manufacturing schedules, and project
management overhead.
These hidden costs exist. When unmasked, they suggest that outsourcing
manufacturing to China is not always a simple decision. In fact, looking
for the quick bottom line fix often leads to disappointment.
 |
| Emerging mega-market: General Motors officially launched the Cadillac brand in China at Beijing's Imperial Ancestor Temple in June last year. |
Today's outsourcing is unlike waves of factory closings in the past.
In the 1950s and 1960s, steel, textiles, and shipbuilding began to move
overseas. In the 1970s and 1980s, consumer electronics, plastic products,
and automotive parts followed.
What's different today is that some low-wage countries have begun to add
technology to the mix at increasing rates. Over the past decade, the production
of many advanced technology products, from circuit boards to cell phones,
began to shift to such emerging Asian economies as Taiwan, Singapore,
Malaysia, and South Korea. Much of that work eventually gravitated to
China. By 1995, China was exporting more technology products to the United
States than it was importing.
Today, says outsourcing expert Ronil Hira, an assistant professor of public
policy at Rochester Institute of Technology in New York, China's technology
trickle has turned into a flood. "What are our best-selling items to China,
where we ran a $2.8 billion surplus," he asks. "Oil seeds and soybeans.
What are China's biggest selling items to us? Computers, electrical machinery,
and capital equipment, where Beijing ran a $50 billion surplus."
The emergence of China as a global market economy is an epochal event.
Unlike other low-wage countries, it has a huge and growing internal market
of 1.4 billion people—20 percent of the world's population—to
support its factories. While vast swatches of the country are undeveloped,
many areas are moving rapidly into the new century.
China's economy is huge. It has grown about 9 percent annually for the
past 15 years. At $6.4 trillion, it is nearly 60 percent as large as the
United States and almost twice as large as third-ranked Japan. It has
become the third-largest trading nation, after the United States and Germany.
Over the past decade, 120 million Chinese have moved to cities to feed
its factories.
Although the average Chinese income is equivalent to only $5,000 per person,
it is not distributed evenly. Along China's rapidly developing coast,
income is twice the countrywide average. China's middle class, more than
100 million people strong, is larger than the entire population of Germany
and somewhat smaller than that of Japan.
It has a huge appetite for consumer goods, such as cars. At five million
vehicles, it is the world's third largest auto market. General Motors
Corp. alone sold nearly half a million cars there in 2004. People who
have visited Beijing say it has gone from a city of bicycles to a city
of cars in less than five years.
Corporations from all over the world want a slice of this lucrative market.
China is happy to oblige them—with one significant condition: Companies
that build factories in China must transfer technology as part of the
deal. Most businesses, from behemoths like GM to small firms like composite
golf club maker Aldila Inc., are eager to comply.
While most of China's new factories serve the local population, many others
export. More than half of all Chinese exports to the United States are
from factories owned outright or partly by Taiwanese, Japanese, and U.S.
companies.
The result is something new under the sun: low wages and a thriving internal
market harnessed to advanced technology. Once in China, new technology
tends to move freely. Chinese enforce intellectual property restrictions
loosely if at all. As a result, even local Chinese companies can often
compete globally.
Many are no longer competing with cheap knockoffs, low-quality goods,
and labor-intensive assemblies. Instead, they are making high-definition
televisions, computer displays, third-generation cell phones, and computer
and networking hardware. Those high-tech products are growing faster than
other Chinese exports to the United States.
Chinese original device manufacturers now engineer and manufacture everything
from cell phones to PDAs for some of the world's largest c onsumer electronics
makers, according to Roger Wery, practice leader for outsourcing strategy
at global management consulting firm Pittiglio Rabin Todd & McGrath
of Mountain View, Calif. "There's not a single hour of engineering invested
in these products by Palm, Sony, Ericsson, and others. They simply put
their name on these cost-competitive entry-level products and engineer
the more advanced models themselves."
 |
| Shanghai GM began exporting a 10-seat version of Buick GL8 executive wagon to the Philippines in 2001. |
Yet China is increasingly competitive at technology's edge. In December,
for example, Huawei Technologies Co. Ltd., China's largest telecommunications
provider, signed a deal to build a third-generation mobile phone network
to Telfort BV, the Netherlands's fifth largest mobile carrier.
"Wireless was an area where the United States and Europe were leading,"
Wery said. "Korea and China have closed the gap and are priced aggressively.
If we don't have an IP lead on them, how long can we justify our cost
advantage?"
Low-cost labor and high-tech manufacturing have made China the leading destination for companies looking to cut costs by outsourcing production. In the past, RIT's Hira said, U.S. companies would have fought to protect domestic production.
Today, businesses embrace offshore outsourcing to cut costs. Some buy
from Chinese producers. Others build their own factories or joint ventures.
Even companies that want to keep manufacturing in the United States may
feel forced to look offshore to remain competitive.
If China's advantages are well understood, not all of its costs are immediately
obvious, according to Nicholas P. Dewhurst, executive vice president of
Wakefield, R.I.-based Boothroyd Dewhurst Inc. Dewhurst works with companies
that use his software to reduce manufacturing and assembly costs. Many
compete or outsource to China. "I don't believe anybody yet has a handle
on what outsourcing costs truly are," Dewhurst said.
"Let me give you an example," he said. "On the way to Cincinnati, I overheard
someone say he had just bought a set of Callaway Golf Clubs and a bag
for $250. That's a bargain because the bag alone usually goes for $350.
"There was a problem, and he sent them back to Callaway for repair," Dewhurst
said. "Callaway wouldn't touch it. It was a Chinese knockoff, copied right
down to the patent numbers. How do you, as Callaway, capture the cost
of that?"
Although Callaway was not able to verify this specific incident, a spokesman
said the company would not repair counterfeit articles. According to a
press release issued early last year. Callaway pursued enforcement actions
in 11 countries in 2003. The actions involved 37,000 individual counterfeit
products, including golf clubs, clothes, and bags. The company said one
case, which resulted in a criminal charge against a U.S. reseller, was
traced back to a supplier in China.
The cost of stolen intellectual property and lost opportunities is not
as easy to calculate as the cost of labor when deciding whether or not
to outsource. Many companies also underestimate the time and energy needed
to manage projects on the other side of the globe or to master the complex
supply chain from China.
Few hard numbers about the true cost of doing business in China are readily
available. Recently, however, firms such as Pittiglio Rabin Todd &
McGrath and supply chain consultant Aberdeen Group Inc. of Boston have
conducted studies that are examining some of these issues.
The 7,000-mile supply chain that stretches from China to the United States
is the most obvious place to dig for hidden costs.
"Logistics costs in the United States are below 3 percent of revenue,"
according to Aberdeen's senior vice president of research, Chris Jones.
"Our study found companies in China were paying from 6 to 12 percent of
revenue, depending on product and factory location.
"People sometimes don't understand all the complexity involved when going
from truck-based shipping in a single country to cross-border, multimode
logistics," Jones said. "We're talking about goods passing through the
hands of 17 to 24 different parties. They include manufacturers, crate
forwarders, consolidators, customs and regulatory agencies, carriers,
ports, and more."
It is easy to underestimate potential revenue losses when bringing products
into the United States. Last holiday season, for example, companies struggled
to bring goods to market by Christmas. For some, port backups made the
difference between full price or profit-eating markdowns.
Jones found that 42 percent of the firms he studied took more than 60
days to receive an order from China, compared with only two weeks in the
United States. Surprisingly, 89 percent of the firms with the longest
lead times also had the highest logistics costs.
"You'd think slow shipments would be cheap, but it indicates that they
don't know how to run their supply chain," Jones said. "They are the ones
paying extra for expedited shipping or writing off their Christmas revenue."
Wery at Pittiglio Rabin Todd & McGrath agrees. Companies frequently
spend more on air shipments than planned. This makes up for inflexible
supply chains that have four to five weeks of products in transit at any
given time. Importers often tie up extra money in inventory to guard against
shortages.
Extended supply chains are also slow to react to schedule changes, Wery
said. "A producer in the United States can respond within 24 hours to
changes in product mix, such as color, packaging, and delivery location,"
he said. "In Mexico, it takes about three or four days. In China, they
need five to six weeks."
That creates huge problems for companies in markets where new looks and
features count. "If you're six months behind the market leader, your revenue
potential could be cut in half," Wery said. "On paper, outsourcing saves
money, but your time to market is not guaranteed.
"Right now, we're working with a client that is doing systems engineering
in California, writing software in Russia, and manufacturing the electronics
in Malaysia. All the back-and-forth between different time zones impacts
time to market. They might have been better off spending 20 to 30 percent
more for the product and getting to market earlier."
Because the supply chain is so long and rigid, most successful practitioners
limit outsourcing to products or standard components that rarely require
changes and have established, predictable markets. Others prefer near-shoring
in places like Mexico, where they save on labor but can respond faster
to market fluctuations.
Intellectual property is a major concern for anyone who does business
in China. The Callaway golf clubs are only flotsam in a flood of knockoffs
that deluge the United States each year.
"IP is an issue in China and in the Asia Pacific region, and it's nothing
we should be shy about," said Kevin Elgood, engineering director for TRW
Automotive Holdings Corp.'s Asia Pacific Technology Center in Shanghai,
China. "They do reverse engineering and they have little regard for IP."
One of the reasons TRW established its own engineering center in China
was to give the company more control over its own and customer's intellectual
property. Even so, advanced technology development remains in the United
States; Chinese engineers adapt the designs to local markets.
This helps, but it is no sure solution, according to Wery. "If you have
engineers offshore, they become prime targets for Chinese companies seeking
to hire talent," he said. "Poaching happens, so you're never completely
protected."
Companies have other ways to protect themselves. They slice projects into
modules, retaining value-added systems engineering at home, while outsourcing
mechanical engineering, electrical engineering, and manufacturing to different
vendors. This keeps any one company from reverse engineering an entire
product.
 |
| CNC machining centers (above) at TRW's plant in Langfang. The company makes parts, including brake calipers (below) for automakers selling vehicles in China. |
 |
Other companies send out only low-value work. "Take tools and dies, for
example," said automotive analyst David Cole, chairman of the Center for
Automotive Research in Ann Arbor, Mich. "You can do the rough cut anywhere
in the world. You just pick who has the lowest price. It's the sophisticated
fitting of the dies in the plant that adds value, and you have to be on
the scene to do that."
Developed nations continue to pressure China to fully enforce patents
and other intellectual property protection. Some companies have hired
investigators to collect evidence. Even when China shuts down violators,
many simply relocate elsewhere.
It takes management time and energy to overcome offshore outsourcing's
distance and cultural barriers.
"There is a cultural difference," said Craig Hergenroether, chief information
officer of packaging equipment maker Barry-Wehmiller Cos. Inc. of St.
Louis. "We deal with brilliant people, but they'll say yes to everything.
"You'll ask them to do something you know is impossible and they'll say,
ÔOh, no problem.' Then they'll work 20-hour days, and when they
miss a deadline, they'll say they worked very hard," he said. "Experienced
companies have worked through these problems to develop better communications."
Wery agrees. Companies need a "high-touch" approach to avoid misjudging
the effects of language, culture, and time-zone challenges on product
cycles and production planning.
Many firms are unprepared for the amount of project management—including
late-night phone calls, last-minute travel, and supply chain monitoring—needed
to bring an outsourcing relationship up to speed. It may take months or
even years of heavy travel to ensure that both parties understand one
another. Even then, companies need strong, consistent internal processes
to avoid problems.
Sometimes, Chinese companies cut corners to meet price expectations of
foreign customers. "Those businesses are often very entrepreneurial and
not very mature," Wery said. "They do not have established pro- cesses,
infrastructure, training, or management. To achieve cost targets, they
need to cut corners and end up doing things you would never do in the
U.S., especially in environmental areas."
Some Western firms look the other way. Others cannot afford to. They remember
how low labor costs led to consumer boycotts against companies like Nike
and Ikea during the 1990s. They worry about consumer reaction to charges
of military-enforced labor or toxic disasters. Still, said Wery, it is
an uphill battle to impose key metrics beyond those relating to cost.
China's combination of low labor costs and modern technology—aided
by lax intellectual property enforcement—makes it a manufacturing
powerhouse. Its increasingly prosperous internal market enables efficiencies
of scale.
An outsourcing study by Pittiglio Rabin Todd & McGrath found 65 percent
of companies that outsource manufacturing offshore are satisfied with
their relationships.
Yet only 4 percent of the 150 executives surveyed were "very satisfied"
with their offshore manufacturing relationships after less than one year.
Even after five years, that figure barely doubled to 9 percent. Only after
more than five years did the number of "very satisfied" customers rise
to 23 percent.
It takes time and commitment to make Chinese manufacturing relationships
work. In some cases, they may not work at all. As companies learn the
hidden costs of outsourcing, they may find it does not yield the promised
savings. This is especially true for products that require customization,
proprietary technology, or quicker reaction to market trends.
Auto analyst Cole predicts that the flexible U.S. economy will adjust
to China just as it adjusted to Japan during the 1970s and 1980s.
"When we studied how Chinese manufacturing impacted the auto industry
in Michigan, we first saw China as a competitor," he said. "But you can't
go head-to-head with China due to labor costs. Instead, we're now looking
at China as a partner.
"The auto industry is in the middle of adopting a new business model that
involves collaborating in real time across nontraditional boundaries,"
Cole said. "This creates threats and opportunities. The threat is that
they will come after our markets. The opportunity is that China's new
wealth will create a middle class market for us."
That is, of course, classic economics: Every country benefits from free
trade. But that doesn't mean every industry and every business will benefit.
The struggle of manufacturers to bounce back from the latest recession
may be proof that a shakeout is in the works.
It is far from clear who the winners and losers will be.
|
Still Waiting for the Bounce The
United States' manufacturing trade deficit reached $401.3
billion in 2003 and grew 17 percent during the first 11 months of
2004. |
Alan S. Brown is a freelance writer and frequent
contributor to Mechanical Engineering. He lives in Dayton, N.J.
home | features | breaking news | marketplace | departments | about ME | back issues | ASME | site search
© 2005 by The American Society of Mechanical Engineers