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strategy and business
 / Spring 2005 / Issue 38(originally published by Booz & Company)


The China Syndrome

Using this analysis, we have found, for example, 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, minimal labor requirements make China a bad bet for auto interior plastics and stamping, for example. Frequent product changes similarly rule the country out as a first choice for customized telecommunications equipment. Manufacturers in these industries would do better to consider low-labor-cost regions closer to home (such as Mexico for the U.S., or Eastern Europe for Western Europe), where they can realize a portion of the labor savings while maintaining tighter control on the supply chain.

Five Dimensions
The five-dimension analytical model readily leads procurement executives to a set of significant matters they need to consider when making sourcing decisions.

1. Manufacturing Cost. China can provide Western parts and materials buyers 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.

Chinese labor rates also 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 50 percent of the average wage in Mexico. There is still a large supply of low-cost labor throughout the country, and manufacturers in major cities (Shanghai, for example) are supported by government efforts to keep wages low by bringing additional workers to urban areas.

Nevertheless, as more and more companies purchase supplies from China, there has been wage inflation in some 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. Moving inland, though, makes shipment scheduling more difficult and often more costly, because of poor roads and the lack of developed logistics infrastructures.

These trends show how executives should evaluate manufacturing cost when making procurement decisions:

• 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 high-speed machines, the labor requirements are too low for China sourcing to be the best option.

• Real overhead savings 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. Electronic components and some lower-end steel grades are areas where local competition can lead to raw-material savings. 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.

• To gain the highest potential returns from a Chinese procurement effort, the amount of labor should be maximized. It often pays to think beyond the purchase of the part, and to include machining and assembly activities in the sourcing contract. For example, when an automotive company attempted to purchase raw aluminum castings from China, the Chinese supplier offered savings of only 1 percent over the bid of a U.S. supplier. By redoing the bid to include finished machining of the parts, the incremental labor, handling, and overhead, the automotive company realized a 15 percent total cost savings from the same supplier.

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