By RONALD HADDOCK, MICHAEL PFITZMANN and REID WILK
From Strategy+Business (www.strategy-business.com)
The myth still persists in some quarters that smart analysts in a back room can understand bids from Chinese suppliers a continent away, despite having little contact with the companies that are being asked to produce and ship critical components and products. Indeed, many U.S. and European manufacturers send an RFP (a Request for Proposal, asking suppliers to bid on a job) to Chinese companies without ever setting foot on the mainland.
Such practices will no longer work, partly because of important structural shifts under way in China's economy, including commodity and wage inflation, the rising value of the Chinese currency, high real costs of talent due to low employee retention and the failure of many manufacturers to implement efficient and lean operational systems in their plants. Because of these factors, some 50 percent of multinational companies doing business in China think the nation's competitiveness in low-cost manufacturing is eroding, according to a new survey by Booz & Company and the American Chamber of Commerce in Shanghai. Almost one-fifth, or 17 percent, are considering -- and in some cases already pursuing -- a shift of operations to even lower-cost countries such as India, Vietnam and Thailand.
Nonetheless, the vast majority of these companies find China to be highly attractive as a growth market, thanks to its expanding economy and a middle class that continues to grow by tens of millions of people every year.
Faced with these conditions, companies will find it increasingly necessary to pursue a dual strategy of using the Chinese platform to make more sophisticated product components for export and simultaneously seeking to penetrate the domestic market. This means taking a more holistic view of how sourcing fits into a company's overall activities in China, and it requires a deeper level of management engagement. Multinationals should consider adopting the new approach to working with Chinese suppliers called knowledge-based sourcing, which significantly increases insight into the supply base through a deeper understanding of -- and two-way discussions about -- production costs, manufacturing and transportation economics, lead-time requirements, schedule stability, the likely degree of product design changes and the technical skills of the suppliers.
The use of knowledge-based sourcing in China is a controversial idea for some Western executives. In their minds, an investment of this magnitude, which can require maintaining a staff of dozens or hundreds of people in the country, could offset any possible gains from sourcing there.
It's a different game entirely for companies interested in long-term, innovation-based relationships and for retailers seeking to improve product design and quality or to secure access to unique capabilities. If top Western executives need to change their product designs in response to new tastes or market demands anywhere in the world, to what extent can they count on Chinese suppliers to understand those realities and to accommodate them if they do not have a close partnership?
Moreover, consider the costs that companies can incur if they fail to pay close attention to their suppliers. A greater upfront investment in supplier relationships reduces the risk of having to pay far more to clear up a problem after it has erupted.
When companies decide that a knowledge-based sourcing approach in China (or another low-cost country) is right for them, three imperatives are essential to successful implementation:
1. Know your suppliers inside out. This includes understanding the true cost positions of current and potential suppliers. Assess supplier performance against major cost drivers (including wages and benefits, productivity, facility and process/equipment scale and utilization, logistics and access to raw materials). Low labor costs and the ability to obtain cheap raw materials and components are just two possible elements of cost structure. To gain a true advantage, it is important to establish the ideal combination of world-class performance with location, scale, process technologies and automation, and success in execution. It will then be possible to rate potential suppliers against that ideal and determine how close a supplier from a low-cost country can come to meeting it. In some cases, it might be more advantageous to select a supplier closer to home.
2. Develop strong relationships with a small number of suppliers. Identify the suppliers that are willing to commit to a long-term relationship and to jointly creating a competitive advantage. Offer an enduring and profitable business relationship to each supplier and, in turn, demand its commitment to meeting cost, delivery, quality and, if applicable, innovation targets. This will likely require local resources dedicated to supplier development, which means working with the supplier to achieve ambitious jointly established targets.
3. Work jointly with your suppliers on continuous improvement. Focus on developing suppliers' capabilities and advancing their competitiveness over time. Set ambitious but realistic targets for better performance in cost, quality, delivery or innovation, and work with your suppliers, not against them, in achieving those goals.
The ability to adopt and use a knowledge-based sourcing approach takes on particular urgency in view of the rising currency and changing cost structure in China. Companies that want to hold their margins and maintain access to that fast-growing economy must increase the efficiency of their Chinese supply base. Even those manufacturers and retailers that choose to simply shift their supply base to a lower-cost country, such as India, Vietnam or Thailand, would do well to observe the essential truths of knowledge-based sourcing. As these emerging economies prosper, it is very likely that they will go through the same evolution that China is going through now. When that happens, the winning multinationals in those countries will be those that learned from their experiences in China and implemented best practices in sourcing from the start.
Ronald Haddock is a Booz & Company partner based in Zurich. Michael Pfitzmann is a principal with Booz & Company in Chicago. Reid Wilk is a senior executive adviser with Booz & Company based in Detroit.