The different meanings of "yes"

Opportunities for U.S. manufacturers that go to China are twofold: cutting costs by leveraging China's cheap labor base; and selling to a huge, largely untapped, but still emerging consumer market.

A recent report from New York-based Accenture describes China as "a perfect storm of opportunity, where companies can ... combine worldwide sourcing, manufacturing, and logistics proficiencies with an ability to support growth in rapidly expanding geographic markets."

Supply chain and logistics were central pillars in the Chinese government's latest five-year plan, released in early 2006. Billions have been invested in new airports, highways, rail links, seaports, and "free-trade" zones. But how long can China continue to grow at nearly 10 percent per year without placing undue strain on its transportation and logistics infrastructure?

Even now, substantial concerns are being expressed about overcapacity, counterfeiting, a confusing and expensive regulatory patchwork, and the rising cost of managerial talent. Succeeding in this shifting landscape requires companies to take a more holistic view of China, says Jamie Bolton, a Shanghai-based managing director with Accenture's supply chain management practice.

"Companies should ask themselves what role China plays in the context of a global operations strategy, not just as a low-cost supply base," he says. In China, Accenture offers supply chain services for sourcing, procurement, fulfillment, logistics, and product lifecycle management. Its clients in China comprise about 40 percent multinational companies, and 60 percent Chinese companies—both state-owned and private.

Though Western manufacturers have been in China for more than 20 years, horror stories still abound. There's the greeting card company that was forced into bankruptcy following quality problems with its manufacturing operations in China. And the global footwear maker that discovered a major quality defect with a much-anticipated, strategically critical new line it made in China. Unfortunately, the company released more than 30,000 units into the market before spotting the problem. Markdowns of 50 percent meant a big hit to the bottom line and the brand.

The message, according to VP Stephen Hochman of Boston-based AMR Research, is to have a local presence in China. "They would have discovered the problem right on the plant floor on the third defective shoe, instead of in the North American distribution center on the 30,000th shoe," he says. "This is just one example of a company learning the fatal cost of quality in China."

Benchmark studies by AMR indicate 56 percent of companies using contract manufacturing experience no savings, or a net increase in their total supply chain costs. That's a sobering number, considering that cost reduction is the No. 1 reason manufacturers pursue the strategy. In response, many have established international procurement offices to promote effective collaboration with Chinese partners.

Atlanta-based UPS, the world's largest package delivery company, serves many manufacturers operating in China, including $76-billion Samsung America of Ridgefield Park, N.J. UPS receives purchase orders directly and manages fulfillment for the chemicals and electronics company, overseeing Chinese suppliers to ensure orders are filled and shipped on time. The network is designed so that inventory from multiple Chinese suppliers is routed and consolidated at port locations nearest to end customers, whether they be in Asia, Europe, or the U.S. As goods move between different Chinese provinces, UPS minimizes regulatory fees using its intimate knowledge of free trade zones and bonded logistics areas.

Doing business in China for more than 20 years, UPS believes its customers find benefit in its ability to streamline international supply chains. UPS operates 40 supply chain facilities in China, nine brokerage locations, and two million square feet of storage space, including four new warehouses in Shanghai. Services include inventory management, packaging, some final assembly of products, and even quality control and auditing services at Chinese plants for foreign customers.

Radial Magnets, Boca Raton, Fla., is a Web-based marketer and distributor of specialty magnets. Its products are used by many Fortune 500 clients in assembly processes, or as components in finished goods. Radial sources from many manufacturers in China.

Harold Dobson, president and chief engineer, says Radial worked with UPS on "a complete rethink of our shipping operations." The redesigned supply network shaved about five business days off Radial's product-delivery cycle. "If I'm looking at seven weeks from order to shipment, that one week can be critical—the difference between getting the order or not," says Dobson.

Goods from China arrive in California, where UPS staff breaks down the pallets and containers to ship directly to Radial's customers, skipping an unnecessary inventory step in Boca Raton. "I never have to see the original bill of lading anymore," says Dobson.

Dobson credits UPS with helping Chinese partners see past their typical "manufacture-to-order" models. "We're now setting agreements for them to carry our standard products in inventory," he explains. "That lets me order and ship with no manufacturing time."

Analysts and consultants agree success in China starts with extensive planning and analysis at home. Outsourcing decisions often are made at the board level, where China has great strategic appeal, but AMR's Hochman recommends close examination of fundamental questions like onshore versus offshore, and buy versus make. Even though labor costs in China are 10 to 15 times lower than in the U.S., going lean at in-house plants—or outsourcing to neighboring countries—can equalize the cost of goods sold (COGS) gap, notes Hochman. This is especially true where labor is only a small fraction of COGS.

In one well-publicized example, privately held New Balance, a $1.5-billion maker of athletic shoes and apparel, uses lean techniques to drive efficiency and quality at its five North American plants, which are responsible for 25 percent of overall production. New Balance is planning capacity expansion because it's able to get shoes to the U.S. market faster.

Most companies realize the logistics costs associated with doing business in China will be higher, but not all understand just how much higher. That's because they fail to foresee the need to absorb expedited freight and shipping costs, and alter raw material sourcing networks. Storage, ports processing, and customs clearance must be factored in, as well as higher costs for back-up inventory. Regulatory fees—courtesy of China's patchwork of regional trade authorities—can be surprisingly high.

Quality is another variable. No outsourcing business case would be complete without projections for higher rates of rejection, repackaging, scrap and rework, and lost sales due to out-of-stocks and slow turns. Insurance and cost-of-capital figures should be included in disaster recovery and back-up plans. Even invoicing and record-keeping costs can go up, given the technology gap. Add in the need for more travel, communication, and oversight, and it's no wonder increased supply chain costs can easily exceed expected labor-cost reductions in China.

"The difference between outsourcing promise and reality often is the difference between ad hoc and disciplined leadership," Hochman says. "The key is to avoid the 'Cross your fingers and write the check' approach and gain full visibility into downstream impact."

Following the detailed cost analysis, if going to China is the right choice, the rigorous analysis should continue in the evaluation and selection of Chinese partners. In fact, knowing your supplier may be the most critical factor for success, says David Caruso, a Boston-based manufacturing industry analyst and consultant. "The plants and facilities are hugely impressive, but underneath the shiny new surface, some Chinese companies may have only rudimentary systems for bills of material and material requirements planning [MRP], as well as limited understanding of important concepts like demand visibility."

"Even large suppliers to Western companies have limited production planning or sequencing capabilities," says Qin Deng, CEO of U.K.-based SupplyWeaver, which helps Western companies identify and manage local manufacturers and distributors in China. Part of the problem is cultural, adds Deng; many Chinese businesses are simply unable to say no.

"Their philosophy is to capture the customers and orders first, and then figure out delivery and fulfillment later," says Deng. "Western companies have to learn the different meanings of yes."

Guy Dunkerley, supply chain director for Bristan Group, a U.K.-based maker and distributor of faucets and plumbing fixtures, agrees that negotiating the knowledge gap can be very difficult. "For Chinese suppliers that in the past were measured just by their ability to fill and ship containers, it's a big shift to be measured on order detail, MRP capabilities, and the accuracy of shipping forecasts," he says.

Bristan works with several dozen manufacturers throughout China, and has been operating in China for nearly a decade. Dunkerley believes relationships are as important to doing business in China as processes or technology. In fact, a Chinese word has developed to describe the uniqueness of supply chain relationships: guan-xi.

A successful guan-xi based on a strong local presence and regular communication also reduces the risk of counterfeiting. Foreign companies should think twice before sharing intellectual property, advises Dunkerley. "Many suppliersare potential competitors, so in evaluating them, you should consider the likelihood of designs going out the back door," he says.

Rising labor costs in China's more developed coastal regions and among experienced supply chain managers won't take away China's cost advantage any time soon, though a global balancing is likely to occur as companies mature in analyzing sourcing and manufacturing options."We expect to see a gradual move toward blended global supply networks," notes AMR's Hochman. "Companies will hedge their bets between lowest labor-cost options in Asia and mid-cost choices in Mexico, the Caribbean, and Brazil."

Driving this recalibration is a much clearer understanding of outsourcing costs and the speed-to-market edge that comes with proximity to critical markets. Of course, that principle applies just as readily to emerging Asian consumer markets as it does to developed Western countries. "As economic growth in China—or India for that matter—accelerates, market access and increased sales trump cost savings on the list of source-location criteria," Hochman says. He expects to see a shift in the decision-making trends as soon as 2008.

It's an ironic turn of events for companies that survived initial horror stories. "Many manufacturers that went into China early with a traditionally myopic view of cost takeout now find themselves almost by chance with a front-row seat ticket in the world's best growth market," he says. "They are thanking their lucky stars that they just happened to be at the right place at the right time."