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The Case for China
The globalization of sourcing, and the move from high-cost
countries to low-cost countries, is the new reality, says
Jim Hemerling, a senior vice president in BCG’s Shanghai
office. “There is a large amount of manufacturing still
occurring in high-cost countries that will migrate to
lower-cost countries. By dint of its size and growth rate,
China will attract a disproportionate share of the
migration.” Low-cost countries, he notes, can be split into
two types. “Proximate countries are those where the wage
rate is three to five times that of China, but the distance
to the target country is smaller.
For products with complex logistics or less labor content,
they are still advantageous. The other type of low-cost
country tends to be farther away, but offers much lower
costs to be competitive. These countries include China and
India, and to some extent, Brazil.”
Companies look to source from low-cost countries for three
reasons, notes Hemerling: “A big part of it is labor — they
are looking for direct cost savings. But it’s also about
talent, and about having access to the domestic market of
the country they source from.”
For many firms, China’s population of 1.3 billion represents
a consumer base that’s hard to pass up. When it comes to
sourcing products with high labor content, China’s very low
wage rate is a clear advantage. But technical skills aren’t
lacking, either, says Hemerling. “China also graduates a lot
of engineers and has many domestic- and overseas-trained
PhDs. So companies are finding skilled people for
higher-level jobs.” He cites companies like General Electric
and Siemens Medical Systems, as well as mobile phone
companies, that have tapped into this large talent base.
Because the Chinese economy is so large, the country also
leads or nearly leads the world in consumption of a large
number of products, like televisions, refrigerators, some
packaged and industrial goods, steel, cement, and specialty
chemicals.
“Manufacturers want to be there so that their operations can
serve as a base to gain access to those domestic consumers,”
says Hemerling. China’s favorable industrial policies are
another factor: “The government is very responsive, the tax
structure is straightforward, and there is tax relief for
exported products,” says Hemerling. “More than 500 special
economic zones have been [established] where the
infrastructure enables quick set-up of businesses. Interest
rates are low, as household savings rates are high and loans
are subsidized.”
Beyond the low wage rate, the characteristics of the actual
Chinese labor force are also appealing: “Firms can draw on a
highly mobile, very productive and largely nonunionized
labor force with a strong, disciplined work ethic,”
Hemerling says.
Indeed, there is a good deal of incentive for people in
rural China to seek out manufacturing jobs, says Marshall W.
Meyer, professor of management and sociology at Wharton.
“The rural household income is very low — about $100 a year,
even though China’s GDP per capita is now around $1,000. The
rural population has not seen an increase in real income
since 1996, so as farm prices rise and income erodes, those
people go off to cities to work in manufacturing and support
their extended family for a few years.
With such a large labor pool, costs remain constant.” The
discipline of the Chinese labor force, says Meyer, also has
to do with the fact that the workers often have very few
rights: “A factory CEO may also be party secretary, but many
of those are nominal titles,” which means that protection of
the workers is minimal.
East to West
For certain companies, geography matters a great deal — the
less physical mileage between factory and market, the faster
products can make it into consumers’ hands. “If you have a
product with short lead times whose demand fluctuates
greatly, proximity is a clear advantage,” says Kevin
Waddell, vice president in BCG’s Warsaw office. “Getting
things from countries like Poland into other areas of Europe
takes less than a week, and that time is everdeclining.”
Naturally, there also are fewer time zone differences and
fewer cultural differences to deal with when sourcing there.
What gives these countries a disadvantage, of course, is
labor cost. “The labor cost in China is $1 or $2 an hour,
and the supply is vast,” says Waddell. “But a lot of people
think China is a homogeneous country, a place where they can
simply drop their plant, when in fact there are many
regional differences. It’s harder for them to see Central
Europe as one region because it is made up of so many
countries.” Companies also sometimes fail to consider other
factors, says Waddell. “There are inventory savings to look
at, training costs, and the process by which products move
from source location to end market.”
Much of the investment in Central and Eastern Europe centers
on highly skilled tasks that cannot be given to just any
factory worker. “We see a lot of precision machine parts,
vehicle parts, and electronic equipment made here,
especially things that require craft or a learning curve,”
says Waddell.
Like China, countries in Central and Eastern Europe are
offering investment incentives for bringing in business, but
most of the activity is on a countryspecific basis. “There
is not much in the way of industrial policy on a region-wide
level — in other words, countries are competing with one
another and with China for the business instead of asking,
as a group, ‘How do we compete?’ They’re not stepping back
and taking a larger view.”
South of the Border
Many of the issues facing European firms also exist for U.S.
companies. Jesus de Juan, vice president at the BCG office
in Monterrey, Mexico, explains why that country has been
appealing to American outfits: “The Mexican economy has
undergone tremendous transformation in the last decade.
Since 1994 the economy has been relatively stable, and this
is the fifth year with single-digit inflation. The labor
rate is one-ninth that of the U.S., so it is very
competitive. It takes just two to six days for something
from here to reach any mainland U.S. location by truck.”
In addition, its free trade agreement with the U.S. and
Canada has done much to disentangle customs formalities.
Exports make up 25 percent of the Mexican economy, of which
around 80 percent are to the U.S. The country has
transitioned from being a supplier of basic commodities like
oil to being a source for electronics, auto components, and
cars, says de Juan.
While lower-cost countries have labor advantages and require
less capital investment due to the use of more simple
machines, the disadvantages can be numerous, he notes.
“Duties levied and managerial costs can be significant, for
instance. Our time zones and seasons are symmetrical with
those in the U.S., while there is many hours’ difference
with China — and that can make things difficult to
coordinate or communicate. So Mexico may not be more
advantageous for a company, but it can be the least
disadvantageous.”
Cities like Monterrey, with a modern infrastructure and
frequent transportation options to the U.S., make it easier
for Americans to manage the production process, says de
Juan. “There are schools there like American schools, and
about 15 daily flights into the U.S. — it’s easier to move
your operation here, and there are managers with MBAs from
top American schools.”
What’s more, says de Juan, a company’s secret sauce will
generally remain secret in Mexico. “There’s no risk of
losing intellectual property in Mexico, as there can be in
some lower-cost countries. Other than in certain sectors
such as energy and telecommunications, there are very few
limitations to foreign ownership here, so you can buy out a
firm and become a 100 percent owner. Repatriation of profits
is also simple.” In contrast to Mexico, countries in Central
America and parts of South America are not as advantageous,
de Juan explains. “During the last 20 years, many Central
American countries have been under dictatorships for much of
the time. They also have problems with harbors and road
infrastructure, so driving trailers can be a nightmare. Some
of the same issues exist in South America — political
instability in Venezuela, drugs in Colombia, a collapse in
Argentina.” Chile, while stable and growing, has an economy
largely comprised of services and natural resources, and,
says de Juan, it’s too far to be of much use unless a
company is shipping goods to the Pacific. The rush to China,
says de Juan, is partly a fad. “Clearly the labor is cheap,
and the sheer size of the Chinese domestic market is
compelling. But despite the competition, Mexico is gaining
market share in sourcing. Companies like Maytag, Whirlpool,
and Electrolux are investing in Mexico. For bulky goods,
proximity is very important. And auto component companies
like coming here because the short distance makes
just-in-time inventory management easier.”
BCG senior vice presidents George Stalk and Dave Young agree
with de Juan that in some cases it makes sense to source
production to nearby locations. In an article titled, “The
Hidden Costs of Globalization,” they say, “Not all products
should be outsourced to distant locations.
Products that might do better to stay home, or close to
home, include certain highly complex products, products with
a variety of designs and options and products likely to be
in high demand one day and languish on the shelf the next.
Similarly, services that require significant customization
and highly responsive providers may or may not do as well
abroad as at home. In taking such products and services to
low-cost countries, a company could lose overall advantage
in an effort to gain a narrow unit production cost
advantage.”
So, where should a company be sourcing? In the final
analysis, notes Hemerling, the right solution for a company
may be — and is increasingly likely to be — a mix of various
parts of the world. “Firms have to look at their entire
supply chain. Perhaps research and development should be in
one area, production of components in another, assembly in
still another place. It’s not just something to be dealt
with by a
procurement person — this has to be the CEO’s agenda. The
global dynamic has — and will continue to have — significant
organizational implications.”
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