China Sourcing - Is it Worth it?

For one industrial manufacturer a few years ago, it seemed that purchasing components from China for export to Western markets was the right thing to do--and quickly. Some of the company's competitors, as well as manufacturers in virtually every industry, were setting up shop in China; to read about it in much of the business press, every venture paid off. The industrial manufacturer, though, discovered to its dismay that success in China is not a sure thing.

The company made some key mistakes. Enticed by attractive price quotes, the industrial manufacturer failed to make completely sure, before signing the procurement contracts, that its Chinese partners could live up to the company's technical and logistical requirements. As a result, when its Chinese suppliers struggled to meet production schedules, the manufacturer was forced to use expensive airfreight. And quality concerns arose as it became evident that suppliers lacked the skills to maintain process control and implement engineering changes. The combination of these issues eroded the expected cost savings. Ultimately, the industrial manufacturer ratcheted down its Chinese procurement effort, and management declared itself unlikely to reconsider this strategy.

As this industrial manufacturer and many other companies learned, procurement in China, when it is not well planned and carefully analyzed, can carry with it some tough lessons. Yet despite these experiences, we believe that sourcing in China, if approached with a rigorous assessment of product characteristics, can be the right answer for optimal management of the supply chain.

The China "gold rush" grew out of a dilemma. In recent years, when companies examined their P&Ls, they invariably found that purchased material was the largest line item--typically 40 to 70 percent of total cost of goods. In the face of relentless market pressure to keep prices down, procurement often became a prime target for cost reductions. But after multiple years of extracting 5 to 10 percent annually from domestic supply bases, the well, for many companies, had begun to run dry. Thus, businesses started looking to nondomestic sources to meet cost reduction demands.

Asia, especially China, appeared to be the most obvious solution. It has the cheapest labor, a pro-business environment, a productive workforce, and strong government support for keeping domestic manufacturing operations as inexpensive as possible. In short, China seems to represent the most direct path to easy cost cutting. The supply chain's headlong tilt toward Asia and China can be seen in the percentage share of supplier contracts awarded in the past six years. In 1998, at one U.S. auto manufacturer, U.S. and Canadian companies garnered 62 percent of all quotes and supplier contracts, and Asian (primarily Chinese) outfits only 4 percent (see Exhibit 1, page 2); by 2002, the two regions were just about equal, each enjoying about 30 percent of supplier contracts awarded.

This trend away from high-labor-cost nations is not even near its peak yet For most companies, over half of the spending targeted for LCCs will be earmarked for China.

No Magic Bullet

The Chinese experience can turn sour, though, when procurement managers fail to systematically assess the fit between the requirements for purchased components and the realities of the China-based supply chain. Instead, they often abandon North American and European procurement sources and make large-scale shifts to China--believing that it's a magic bullet with no downside--without fully analyzing the costs not only in labor, but in transportation efficiency, lead time and scheduling stability, product design, and local capabilities The end result can be commodities that are sourced in China, but that could more wisely be procured from another low-cost region or even domestic sources.

Each of these critical dimensions has to be examined for every prospective purchase of components and materials in order for a company to decide whether purchasing from China is the best decision. In our experience working with companies across multiple industries, applying this approach clearly singles out the best-fit candidates for Chinese sourcing (see Exhibit 3, page 3). For example, using this analysis, we have found that production tooling (such as injection-molded plastics and stamping dies, which are labor-intensive to manufacture and which have long product lead times) is perfect for Chinese procurement initiatives.

By contrast, our analyses have demonstrated that for manufacturers of other products (auto interior plastics, simple automotive stamping, and customized telecommunications electronics), China is not a fit as a primary procurement site. Such issues as minimal labor requirements (auto interior plastics and stampings), transportation economics (auto interior plastics), short lead times (customized telecom), and frequent product changes (customized telecom) rule out China as a first choice. These industries would do better to consider low-labor-cost regions closer to home (e.g., Mexico for the U.S.; Eastern Europe for Western Europe), where they can realize a portion of the labor savings while maintaining a tighter control on the supply chain.

China may be the procurement location du jour, but companies actually have three options for wage rate-driven sourcing decisions: China; "local" low-wage countries; and domestic sources, even though at first blush the last option might seem far too expensive. To help companies gain the greatest advantages when making this choice-- that is, to analytically align the overall needs of the procurement effort with the appropriate source location--we have designed a systematic approach for evaluating when to purchase from China and when another source may be the better option.

Five Factors to Examine

The model encompasses analysis of five critical dimensions:

1. Manufacturing Cost

Chinese labor rates are extremely attractive relative to those of other countries. Including hourly wage rates and benefits, Chinese wages are about 10 percent of salaries in the U.S. and Western Europe and only 50 percent of salaries in Mexico. There is still a large supply of lowcost labor throughout the country, and manufacturers in major cities (Shanghai, for example) are supported by government efforts to bring additional workers to urban areas to keep wages lower. Nevertheless, as more and more companies purchase supplies from China, there has been wage inflation in some of the large cities. As a result, labor-intensive supplier relationships, such as some automotive OEM programs, are moving inland where wages remain lower. Honda, for example, is establishing its manufacturing center, automotive assembly, and supporting component operations in Dongfeng in central China. However, moving inland makes scheduling shipments much more difficult and often increases costs, because of poor roads and the lack of developed logistics infrastructures.

China also potentially provides significant benefits in overhead and raw material costs. Total overhead rates in China vary significantly by supplier, but can be less than half of Western levels.

Key considerations

* The total labor content (direct and indirect) of a product is the primary driver for China procurement savings. For a product with a large labor component (i.e. 25 percent or more of the product cost structure), low Chinese wages represent a meaningful benefit. In these cases, the labor savings--applied labor hours multiplied by the difference in the labor rate--can be significant. But for some products, such as shoot-and-ship injection-molded plastics, for which one operator manages several highspeed machines, the labor requirements are too low for China sourcing to be the best option.
* Although overhead savings are hard to project, frequently real cost differentials can be realized in China. Local labor rates are embedded in the price of many of the goods and services that are critical components of overhead costs. And many suppliers use local machinery, which can also cost as little as half the price of imported equipment.
* Savings on raw materials in China are possible when these materials are locally sourced from competitive suppliers. Examples include electronic components and some lower-end steel grades. However, when Chinese suppliers have to import materials--such as high-quality steel alloys--there can be a significant cost penalty in a procurement agreement.
* Since Chinese labor costs are so attractive, to gain the highest potential returns from a Chinese procurement effort, the amount of labor should be maximized. This sometimes requires including machining and assembly activities, rather than just purchase of components, in the sourcing contract. For example, when an automotive supplier attempted to purchase raw aluminum castings from China, a savings of only 1 percent over buying these items in the U.S. was quoted. But by redoing the bid to include finished machining of the parts, the incremental labor, handling, and overhead (and taking into account the reduced scrap and lighter shipments), the same supplier realized a 15 percent total cost savings.

2. Transportation Efficiency

Procurement from China incurs natural transportation cost increases over more local sourcing arrangements. In China, the product needs to go from the factory to the port, onto a ship, and then to, for example, the U.S., where it is unloaded and trucked to its destination site. The cost of ocean transport alone from China to the U.S. is $2,500 to $3,000 per container. For a $12 casting, the total incremental transportation cost is $1.10. This is compared to transportation costs of $0.30 for a typical Mexican supplier shipping to the U.S. Financial assessment of China sourcing should then be made on the total landed cost of a product--which includes the manufacturing cost differential as well as the full logistics cost.

Key considerations

* Transportation efficiency is measured as the ratio of the cost of transport to the total product cost. Since ocean transportation costs are essentially a fixed cost per volume shipped, economics favor China when smaller, higher-value items are involved. For instance, thousands of small electric motors can be packed in one container, spreading the fixed costs over numerous units. Conversely, plastics and stamping assemblies for auto interiors require protective packaging that results in low packing density and fewer parts to share the burden.
* If airfreight is required--for instance, to overcome shortterm breakdowns in the supply chain or to meet faster lead time requirements when four to six weeks of ocean freight is too long--the savings generated by lower-wagerate manufacturing in China are usually eliminated. Airfreight costs about $1.51 per pound, whereas ocean transport is $0.06 per pound. Only products with very high packing density and high value per unit (for example, printed circuit boards) can support the costs associated with airfreight.
* The relevant comparison to use when analyzing which nation to procure from is simply the total freight and logistics cost incurred in each sourcing option. In the end, the buyer always pays for the freight, directly or indirectly, so the costs should always be built into the assessment.

3. Lead Time and Scheduling Stability

Ocean freight adds four to six weeks to the delivery time from China to Western markets--up to one week from inland sites to the port and an additional three to four weeks on the water. The risk of this extended supply chain to the core business needs to be incorporated into an assessment of whether China is the right location for procurement. The time delay generated by the longer supply chain significantly increases the chances of both stock-outs in the near term, and excess and obsolete inventory in the long term.

Key considerations

* To optimize shipping economics when sourcing in China, large volumes of a product--often a container load--are typically sent in each shipment. This represents multiple challenges that must be considered. Among them: More dollars are tied up in massive inventory investments, and manufactured defects spread throughout a shipment could mean thousands of useless components.
* In some cases, ocean freight lead time can make a Chinese procurement effort unfeasible. For instance, a manufacturer of telecom infrastructure seemed to be a perfect fit for China because its wiring panels required labor-intensive assembly. However, this benefit was canceled out because the manufacturer's customers often demanded a high degree of late-stage product customization and expected a rapid lead time. The manufacturer was able to charge more for these customized products and, thus, pay the slightly higher wages in Mexico and Eastern Europe for a quicker turnaround on components delivered to U.S. and Western Europe operations.

4. Product Design

Implementing engineering change orders is a significant challenge for even very mature supply chains. Engineering changes introduce instability into the supply chain in two forms: (1) The old version of the product becomes obsolete, and since much of what is sourced is components made up of additional components, this revision can create incompatibility among component parts. (2) Manufacturing (and supply) operations require time to digest new products and processes, which creates opportunities for subpar quality during that period. The long lead time and large order quantities required to do business most cheaply in China exacerbate both of these issues, as the arrival of old-version components can continue for weeks after an engineering change and it can require an equally long time to take corrective action on lower-quality parts.

Key considerations

* Products with frequent design changes (at least one per quarter) may not be suitable for Chinese procurement, because the supply chain could end up with a continuous run of obsolete inventory and in an endless ride on a learning curve. Products that are stable for at least a model year, such as automotive components, may fit better in a Chinese procurement strategy as they essentially involve a successful one-time launch rather than continual incremental changes.
* In general, China is not a good option when a high degree of skill is required to implement design changes. Chinese supply chains are challenged by the language gap, a lack of local technical capability for implementing changes correctly, and the complexities of suppliers' processes for managing launches of new products.

5. Technical Capabilities

China is not currently a viable option for highly specialized manufacturing produced on custom equipment, such as application-specific copper-wrapped coils and high-speed connector assembly. These types of processes often require specific technical knowledge of product engineering or equipment design that is not generally available among suppliers in new procurement markets such as China. By contrast, commoditized processes such as stamping, casting, and manual electronics assembly can be handled by almost all suppliers.

Key considerations

* Sourcing subcomponents in China and maintaining technology-intensive activities in more highly skilled domestic factories, in many cases, yields a better total cost return than procuring the total product. Technologydriven processes often need significant oversight to maintain process control. That frequently can be achieved only in sophisticated plants in developed countries. When factory processes get out of skew in China, yields decrease and the resulting scrap (as well as logistics costs) can quickly overshadow savings generated by lower wage rates.
* Although products made with the least complicated, most mature technologies are the best choices to source from China, the nation's suppliers continue to develop increasingly sophisticated skills. As a result, more companies are sourcing process-sensitive products, such as rubber and machined parts, from China --a good decision when other critical procurement dimensions, such as lead time, engineering changes, and labor and transportation costs, favor China.

By analyzing these five critical dimensions for each unique procurement initiative, companies can better understand their geographic sourcing options--which products are candidates to be sourced from low-cost countries and which need to be purchased from more developed markets. If a low-cost country is appropriate, assessment of lead times can help establish which commodities can be sourced from remote low-cost countries (such as China or India) and which need to be purchased more locally from Mexico or Eastern Europe. Execution of this assessment requires going beyond typical procurement piece-price analysis. It requires the involvement of engineering and manufacturing units to define the total supply chain requirements of purchased products.

Even with all of the factors that must be taken into account, China remains one of the most desirable sourcing opportunities. Its wage advantages are not likely to be eliminated anytime soon, and its skills as a supplier and manufacturer will only grow stronger. But as with any other procurement effort, obvious costs, such as labor, are not the only factors to take into account.