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(originally published by Booz & Company)


The Supply Chain Is Flat

S+B: And as supply chains change, so do the tactical models of manufacturers?
FUNG: Absolutely. Companies are moving to much more flexible manufacturing systems. John Hagel, of the Wharton School at the University of Pennsylvania, talks about companies orchestrating networks of supplies and suppliers rather than controlling everything themselves. For labor-intensive types of consumer goods, you may have to go thousands of miles away from the home base to source in countries like Bangladesh and India and China. You can offshore your operation, but how well can you manufacture in those places compared to a local guy who knows the ins and outs? Because of the distance and the difficulty of the management challenges, you’re always the most expensive manufacturer in that country. So you’re probably going to go from offshoring to outsourcing before long.

S+B: How does this network of suppliers affect trade data, such as the enormous U.S. trade deficit with China?
FUNG: The existing measurements of trade are very much antiquated. When the president of the United States says, “We’re running a trade deficit with China,” he’s working off an erroneous base for measurement. The way we determine a product’s country of origin is based on something called “major transformation,” rather than value-added processes. If the major transformation is final assembly, and that occurs in China, the product will be said to be made in China and exported back to the U.S. — even if most of the value of that product is actually manufactured in the United States. In other words, under that system of measurement, the country that gets credit for making the item may not be the one that gets the majority of the economic benefits.

For example, look at a laptop today. Chances are that the monitor is made in Taiwan, the memory is from some plant in Penang, the assembly might be in China, but “Intel Inside” is the most expensive component. Because it’s assembled in China, they slap “Made in China” on it, and it becomes part of the U.S. trade deficit with China.

S+B: How does the vast Chinese consumer market affect global sourcing and manufacturing?
FUNG: The Chinese consumer is someone the world is suddenly paying attention to. The sheer size of the market, 1.3 billion people getting middle-class status, is going to transform the world eventually. But not yet. You’re currently talking about $10 trillion in consumption for the U.S. market and $1 trillion in China — it’s one-tenth. The world has to rely on getting out of recession by having American consumers start spending again.

In China, there has always been a dichotomy between the industry that supplies the domestic markets and the industry that supplies exports, world-class products. If you were setting up a world-class factory in China, for example, you could set it up tax-free, but you couldn’t do so if it were for domestic products. Also, the export sector has been whipped into shape by companies like ours and customers around the world who demand compliance with rules or standards involving technology, speed of response, quality, health and safety, the environment, and other issues. The domestic side is not faced with the same compliance issues. So the hundreds of thousands of factories supplying the domestic market are generally of lower quality.

The big thing in China that will provide its next growth is to satisfy the local consumer by merging these two sectors. There’s resistance to this. A lot of the suppliers for the domestic market don’t want other companies to compete with them, and a lot of these domestic suppliers are owned by local governments. Eventually, though, the central government will encourage the merger of these sectors; that will create a lot of economic activity and will eliminate some of the weak players. When that happens, the domestic market in China will be supplied not only by Chinese companies but also by many more goods made around the world. Chinese consumers are like any other consumers; they just want the best product their money can buy, whether it’s from India or China or anyplace else.

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