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7/29/2019 Unraveling the Chinese Puzzle
1/12
Perspective Edouard Samakh
Kaj Grichnik
Ron Haddock
Unraveling the ChinesePuzzleA Practical Approach
For Manufacturers
7/29/2019 Unraveling the Chinese Puzzle
2/12
Booz & Company is a leading global management consulting
rm, helping the worlds top businesses, governments,and organizations.
Our founder, Edwin Booz, dened the profession when he
established the rst management consulting rm in 1914.
Today, with more than 3,300 people in 58 ofces around the
world, we bring foresight and knowledge, deep functional
expertise, and a practical approach to building capabilitiesand delivering real impact. We work closely with our clients
to create and deliver essential advantage.
For our management magazine strategy+business, visitwww.strategy-business.com.
Visit www.booz.com to learn more about Booz & Company.
CONTACT INFORMATION
LondonEdouard SamakhPrincipal
+44-20-7393-3357edouard.samakh@booz.com
MunichKaj GrichnikPartner
+49-89-54525-553kaj.grichnik@booz.com
ZurichRon HaddockPartner
+41-43-268-2132ronald.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
7/29/2019 Unraveling the Chinese Puzzle
3/12
A leading industrial iber manuacturer whose
products are critical to automobile tires and seatbelts had traditionally had most o its actories
in Western Europe, near company headquarters.
Recently, though, the companys already low proit
margins had declined even more, by as much
as 2 percent, as revenue growth in its domestic
market slowed. And while the iber manuacturer
struggled to deal with its eroding inancial per-
ormance, it became aware o another potentially
troubling reality: More and more o its competitors
were in the process o moving their production to
low-cost countries, especially to China.
The manuacturer had been planning to make a mul-
timillion-euro investment to upgrade its European ac-
tory operations, but considering the changing business
landscape and geographic shit o manuacturing to
China, management was orced to reconsider whether
this was the right decision. A more undamental ques-
tion needed to be addressed. How would globaliza-
tion speciically, low-cost manuacturing in China impact the companys operations in Western Europe
now and in the coming years?
To help the company work through this diicult quanda-
ry, Booz Allen Hamilton conducted an exhaustive exami-
nation o its operations. Our analysis revealed that the
companys Tier One customers, which included several
European automakers, tire companies, and seat belt
manuacturers, had not been opening actories in Asia
or many o their product lines and were unlikely to do
so in the near uture. One o the reasons or 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 actories without incurring signiicant inancial
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 or short manuacturing and
delivery lead times, i the Tier One seat belt and tire
manuacturers ultimately sought lower-cost plants, the
plants would most likely be built in Eastern Europeor in the southern United States, closer to where an
increasing number o automakers were building new
assembly capacity or established markets.
Traditional Tier Two and Tier Three suppliers in
other words, the iber company and its primary rivals
aced a dierent set o challenges. Many o these
companies, which convert yarn and other industrial
ibers into raw material or tires or into woven narrow
abric or seat belts, were deinitely China-bound (i not
history-bound). The main reason: increased competi-tion rom Asian suppliers. Moreover, many o the Tier
Two and Tier Three suppliers actories in Europe were
aging and already ully depreciated, so replacing them
would incur lower capital costs than was the case with
Tier One suppliers, and would thereore generate more
immediate and larger cost savings.
Consequently, or the oreseeable uture, pricing and
market trends in the iber manuacturers industry
would be driven by economically advantaged actories
in Asia, independent o who owned them. Our conclu-
Unraveling the Chinese PuzzleA Practical Approach for Manufacturers
1
7/29/2019 Unraveling the Chinese Puzzle
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2
sion was that i the iber manuacturer stood still and
continued to ignore the lure o China or its customers
and rivals that is, i the iber manuacturer didnt
explore a shit in its own manuacturing base to China(or other lower-cost countries) its survival might be
in doubt.
This was a disturbing inding or the iber manuacturer,
but it is one that more and more companies in Europe
are acing. To react quickly to rapidly changing
low-cost manuacturing dynamics, executives must
comprehend not only what is happening in their own
companies, but also the challenges being aced by
their customers, and the customers o their customers.
Without a broad understanding o trends across the
value chain, it is easy to get blindsided and miss nar-
row windows o opportunity to make changes beore it
is too late.
In responding to the challenges emanating rom China,
industrial-goods manuacturers typically ace several
top-level issues:
n Low-cost sourcing: To what degree can China be
used as a low-cost sourcing base or Western mar-
kets? What is the true cost dierential?
n Make versus buy: Should I source rom others or
establish my own actories in China?
n Timing: What is the value o preempting a domestic
or Asian competitor, or an Asian copycat competitor,who decides to use Chinese actories to attack my
home market with low-cost imports? What is the pen-
alty o delay?
n Growth/expansion: What is the opportunity to com-
bine a manuacturing or sourcing play in China with
the pursuit o new growth in that nations rapidly
expanding market by leveraging existing strengths
or customer relationships? What other markets and
customers in the Asia/Paciic region could also be
served rom Chinese plants?
n Regulations: What is the legal or regulatory environ-
ment? Will it allow the implementation o reliable
operations now and in the uture?
Assessing the level o opportunity or threat rom
China, or rom other low-cost countries, starts with an
analysis o a manuacturers cost structure relative
to the industry as a whole. This is especially critical
or industries or products that are driven primarily by
price-based competition. One o the most common
Source: Booz Allen Hamilton analysis
Exhibit 1Example Industry Supply Curve
Cost to Serve Germany rom Dierent 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
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3
approaches or comparing relative cost positions o
companies, or even countries, is to develop an industry
supply curve. A supply curve is based on the classic
economic notion o economies o scale and geographic
advantage, and graphically depicts the cost o providing
a product to a market rom dierent acilities and geo-
graphical locations.
As an example, Exhibit 1 (page 2) shows the cost to
manuacture a commodity product and deliver it to
Germany rom 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 o their manuacturing operations on the
let side o the curve have cost structures with the
greatest advantages. When the lowest-cost capacity
is ully utilized, the next least expensive manuactur-
ing and logistics option becomes the best choice. This
process o gradual participation o increasingly higher-
cost suppliers and actories continues until ull market
demand is satisied. By extension, as demand or pric-
ing drops, the companies or countries on the right side
o the supply curve are typically the irst ones aected,
given their higher cost structures and lesser ability to
compete on the basis o cost alone.
New entrants as well as incumbents that are adding
new capacity typically do so on the let side o 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 manuacturing
networks into low-cost locations, they oten can elimi-
nate or at least reduce their relative output rom the
more costly right side o the supply curve, minimizing
their average cost-to-manuacture in the process.
To avoid being maneuvered into an unproitable posi-
tion on the right side o the supply curve, manuactur-
ers need to answer three key questions: What are the
economic beneits, at the dierent levels o the value
chain, o shiting manuacturing assets to China or
other low-cost countries? Looking beyond the advan-
tage o low labor costs, are there any barriers that
might prevent or argue against a shit o manuactur-
ing operations to China? And how ast will the shit to
China happen? (See Exhibit 2.)
1. What are the economic beneits, at the dierent
levels o the value chain, o shiting manuacturing
assets to China or other low-cost countries?
An assessment o the cost elements should include aholistic understanding o the key economic drivers and
Source: Booz Allen Hamilton analysis
Exhibit 2Framework to Assess the Impact o China on Manuacturing 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 driversModel relocation
scenarios
Is it beneficial
for a Western
company
to shift its
manufacturing base
to China?
Map product
and process
characteristicsUnderstand key levers to
compete
Estimate market size of
different clustersEstimate impact on
sales portfolio
Analyze current and
future market situation in
ChinaAnalyze current and
future regulatory
environment
Develop entry and
footprint strategyDevelop 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 wil l
compete with
Western-based
assets?
Niche
Protected
Market
Exposed
Market
Threatened
Market
Commodity
7/29/2019 Unraveling the Chinese Puzzle
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4
1. Develop a coherent manuacturing strategy. This
should include a clear mission or manuacturing 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 o the manuacturing pro-
gram or both short- and long-term results, incentives
or the local team, and global supporting unctions all
need to be aligned. Given the rapidly changing environ-
ment in China, this manuacturing 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 or raw materials
and nished products, and availability o talent or key
management positions. Although most Chinese labor is
cheap compared with that in more developed markets,
plant management unctions may be a dierent story.
Capital can be more expensive than in the West, at
least or Western companies. And Chinese companies
usually have access to local sources o unding that
are not available to oreign-owned companies; or ex-
ample, the local Chinese banks that oten supply unds
below the true cost o capital. This can be a real
disadvantage to multinational manuacturers that are
required to meet certain hurdle rates or investment
returns.
3. Adapt management and reporting styles to theChina context. Understand the local culture and di-
erences in business practices between China and the
West. Dont simply copy the Western way o doing busi-
ness. For example, accrual accounting is less popular
in China than cash accounting. Although the benets
o accrual accounting and the practice o activity-based
costing are oten crucial or 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 protably using cash accounting systems.
4. Develop a culture o adaptability, fexibility, entre-
preneurship, and willingness to accept a large degree
o ambiguity. This applies not only to customers and
markets, but also to business partnerships, supplier
relationships, and local government relations. The con-
text o 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 oce oten have little
understanding o the situation on the ground in China
and, worse, sometimes have signicant misconcep-
tions about China. Maintaining proper communication
and linkages with global headquarters can be challeng-
ing and rustrating at times, but communication must
be appropriately handled to ensure smooth operations
and provide the China manuacturing entity with the
support and time to perorm protably.
6. Constantly update your knowledge about China,
because the competitive and regulatory environment
can change rapidly.
Six Steps to a Successul Manuacturing Entry into China
7/29/2019 Unraveling the Chinese Puzzle
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5
how they trade o against each other. The net beneits
o these trade-os will drive the economics or the
company as a whole. Typical economic drivers to be
examined include:
n Labor: impact o low labor costs on total product
costs
n Productivity: number o units that can be produced
per person per hour
n Transportation: impact o increased logistics costs
on total product costs, including losses due to dam-
ages in transit
n Inventory: impact o increased delivery time and
potentially a greater degree o obsolescence on total
product costs
n Scale: cost advantages rom increasing the size oexisting plants
n Utilization: cost advantages rom running more vol-
ume through existing plants
n Complexity: cost impact o process complexity in the
current manuacturing network, and o linking a ar-
lung plant to the network
Exhibit 3 (page 6) provides an example o 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 o the results
is as important as getting the detailed analyses right.
For example, its essential to evaluate incremental
costs that can be squeezed out o the current manu-
acturing setup. I the cost gap with a low-cost country
can be closed by optimizing the existing manuacturing
network, this will result in a higher net product value,
as it is a less risky option than building new capacity.
I the gap cannot realistically be eliminated, then struc-
tural, low-cost-country options might be the only way tostay in the game.
2. Looking beyond the advantage o low labor costs,
are there any barriers that might prevent or argue
against a shit o manuacturing operations to China?
Although cost cutting requently (and oten misguid-
edly) outranks all other considerations in determining a
manuacturing ootprint, companies should look beyond
labor cost beneits to the bigger picture; China may not
be as advantageous as it irst seems.
Lead time impact:For products that are customized
and manuactured on a make-to-order, rather than a
make-to-stock, basis, or are part o a just-in-time supply
chain, the additional lead time involved in manuactur-
ing in China may be unacceptable. Longer lead times
should be actored into inventory costs, orecast inac-
curacies, and increased supply risks as part o an anal-
ysis o the system-wide impact. In some cases, com-
panies may have to pay additional amounts or more
rapid response rom Chinese manuacturers, even or
commodities. This too needs to be considered.
We recently witnessed a case in which a Western aero-
space manuacturer outsourced the manuacturing o
some large airplane components to an Asian company
that had proprietary composite technology, withoutrealizing 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 aircrats production schedule. Consequently, the
aerospace manuacturer 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-
niicant degree o codevelopment or shared R&D isrequired, its oten preerable (although not always
essential) or suppliers and customers to be located
close to each other. This can sometimes mean that
design, engineering, and actory 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-unc-
tional issues. Although they are more diicult to quan-
tiy, the cost o lost time, cost o 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 careul to
avoid China when manuacturing components with high
intellectual property content. They have a legitimate
ear that their product designs and process technolo-
gies may be stolen by unscrupulous business partners,
or even their own employees, in an environment where
7/29/2019 Unraveling the Chinese Puzzle
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6
Source: Booz Allen Hamilton analysis
Exhibit 3Cost Driver Analysis (Example)
0% 20% 40% 60% 80% 100%
Capacity Utilization
Capacity Utilization Curve
Capacity Utilization Analysis
Germany
CzechRepublicChina
0% 20% 40% 60% 80% 100%
UnitCosts
Process 1
Utilization
0% 20% 40% 60% 80% 100%
Utilization
0% 20% 40% 60% 80% 100%
Utilization
UnitCosts
UnitCosts
Process 2
UnitCosts
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
UnitCosts
Process 2
0 20 40 60 8 0
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
CzechRepublic
China
0 1 2 3 4 5
ShareofSetupTime
Setup Time
Complexity Index
Complexity Index0 1 2 3 4 5
L
aborCostTotal
UnitCosts
Labor Costs
Germany
CzechRepublic
China
Analysis of Key Drivers
300
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7/29/2019 Unraveling the Chinese Puzzle
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7
intellectual property is diicult to protect owing to a
still-evolving legal system. In a recent case, General
Motors in China was unable to stop Chinese carmaker
Chery rom making an automobile that closely resem-
bled, inside and out, GMs Spark. Because o piracy
concerns, many companies are careul about restricting
who has access to what inormation in their Chinese
ventures. Some companies operating there have begun
to separate components o a project so that no single
employee or team has access to the complete set o
design and process insights and technologies.
Responsiveness to changes in design/specs:Products
requiring requent design changes are less likely to be
candidates or manuacturing in China, because trans-
mitting the new specs and reconiguring the actoryand logistics schedule can be a slow, tedious process.
An example o this is T-shirts made to represent teams
during the World Cup ootball (soccer) tournament. As
a country is successul on the ield and rises to the
top o its bracket, the demand or T-shirts displaying
its lag increases signiicantly. Clearly, manuacturing
T-shirts, or at least adding the images on the T-shirt or
sale in Europe, would be diicult to do with production
in China. The same logic applies to some components
in rapidly changing consumer or industrial products or
which supply chains may span wide distances.
As a result o this broad range o considerations,
many companies choose to locate some o their
operations in low-cost countries, while keeping other
activities closer to home. To evaluate which parts o a
companys manuacturing 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 remainin the West because manuacturing costs are less
critical to total cost competitiveness, or because other
considerations outweigh costs. For many products,
transportation economics rom China are unavor-
able or capital costs ar outweigh the advantages o
low labor costs. For example, sewage tubes and tires
have unavorable transport economics (companies
pay or shipping a lot o air). And sotware has high
intellectual content, along with relatively little low-cost
labor content. Additionally, success in designing some
products requires a deep understanding o local tastes
and culture, which is best perormed by marketers and
designers in the home country who collaborate with
each other. For instance, processed ood and bever-
ages are typically local businesses.
b) Transitional businesses/products, shifting from local
to global:In these segments, much o the manuac-
turing at the industry level still remains in developed
home countries and markets, but the companies are
becoming increasingly vulnerable to price pressure
rom low-cost, China-based manuacturers. Many con-
sumer electronics products and components are in this
transitional category.
c) Global commodities:These businesses/products
have already commoditized and largely shited to
China, or are likely to do so in the near uture. 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 ast will the shit to China happen?
The third key question manuacturers should ask them-
selves to be sure they are staying on the right side o
the supply curve concerns the speed o the move to
China. Deregulation in China has continued to expandthe ield o industries in which oreign 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, or
many industries today, China is already an open market
or both manuacturing in and marketing in the country.
The Chinese government has also eased ownership
regulations to increase the ability o oreign companies
to own assets in China as the economy liberalizes.
Historically, because o Chinese laws constraining or-
eign ownership, many multinationals had to set up joint
ventures and other opportunistic partnerships with
Chinese companies. Today, wholly oreign-owned enter-
prises (WFOEs) are the preerred mode o entry into
China or the vast majority o multinational companies.
WFOEs have made it so much easier or oreign com-
panies to implement ull-ledged manuacturing opera-
tions in China that they have ballooned in popularity.
In 2004, 66 percent o oreign corporate investment
in China was in WFOEs, up rom 36 percent in 1997.
7/29/2019 Unraveling the Chinese Puzzle
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8
Meanwhile, during this same period, the amount invest-
ed in joint ventures dropped to 27 percent rom 43
percent. Vehicle assembly remains a notable exception
to the increasing openness in China. There continues
to be import duties o varying levels or components,
and vehicle manuacturers are still required to operate
through 50/50 joint ventures.
Another actor that will inluence how quickly manuac-
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 or products is in lux, with
requent major imbalances, overall strong growth in the
economy will continue to avor the need or increasing
capacity or 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 manuacturers, China has become the 800-
pound gorilla. It dominates every conversation and
strategic plan; even when it isnt a real threat, the
ear exists that it is about to become one. As usual,
an educated analysis, diligently conducted, can make
the dierence between acting out o irrational ear and
perorming a logical assessment o risk and potential
reward.
Source: Booz Allen Hamilton analysis
Exhibit 4Changes in the Regulatory Framework in China
Energy
Hospitals
Insurance
AgriculturalMachinery
Pharmaceuticals
Banks
Auto
Tourism
Restricted Free
ConsumerProducts
Media
Retail andDistribution
Telecom Service
Ownership Degree of Freedom
Restricted
Free
Product Market
Degree of Freedom
From Mid-1990s to Today From Today to 2015
7/29/2019 Unraveling the Chinese Puzzle
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Asia
BeijingHong KongMumbaiSeoulShanghaiTaipeiTokyo
Australia,
New Zealand,andSoutheast Asia
AdelaideAucklandBangkokBrisbaneCanberraJakartaKuala LumpurMelbourneSydney
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2006 Booz & Company Inc.
The most recent list of our ofce addresses and telephone numbers
can be found on our Web site, www.booz.com.
Europe
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Buenos AiresRio de JaneiroSantiagoSo Paulo
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