Viewed broadly, the survey revealed a shift in the “duality strategy” in China, in which China serves as a hub for both domestic markets and exports to the Asia-Pacific region and beyond. While the number of survey respondents citing access to the growing China market as their primary strategy increased markedly, those planning to supply Asian markets from China declined.

In addition, there was a dramatic increase in this year’s survey in the number of companies planning to expand manufacturing operations to lower cost regions within China and also to other emerging Asian nations like India and Vietnam. In both instances, companies are seeking cost reductions in labor, land, logistics and taxation.

A BULLISH OUTLOOK WITH A FEW DARK CLOUDS

This survey of 202 foreign-invested manufacturing companies in China with nearly 1,500 plants was conducted in December 2009. The study demonstrated a clear desire by respondents to extend their Chinese operations to serve the nation’s vast market. Nearly 83 percent of the companies surveyed – up from 71 percent two years ago – said that their primary motive for locating manufacturing operations in China was to provide products or materials for the Chinese marketplace.

While positive overall, these responses were tinged with a degree of caution. In 2009, the costs of labor and logistics, as well as labor availability, were viewed as less competitive in China than they were in 2008. Mindful of rising costs in the more well-developed areas in Southern and Eastern China, 28 percent of companies – compared to 17 percent in 2008 – indicated that they had concrete plans to move or expand manufacturing capacity within China in the next 5 years; another 14 percent of respondents, compared to only 3 percent the year before, said that they would move both within China and to other countries. Cities in Southwest and Central China, including Chongqing, Chengdu, Wuhan and Zhengzhou were among the favorites, chosen because they were seen as more cost competitive with better labor availability and tax benefits than other places in the country.

Although China has weathered the worldwide recession remarkably well, the overall average Earnings Before Interest and Tax (EBIT) margin shrank in 2009 among those surveyed to 8.3 percent from 15 percent the year before. Diminished demand, due to the economic downturn, along with wage and material price increases, surfaced as a top concern for companies doing business in China. Still, 61 percent of respondents said the business climate in 2009 could have been worse had the Chinese government not implemented a RMB4 trillion (US$586 billion) stimulus package in late 2008 designed to buttress areas critical to the economy such as rural infrastructure, transportation, health, education, environment and industry.

GREATER ATTENTION TO BEST PRACTICES

Given the global economic downturn, we asked companies about the strategies they used to address earnings shortfalls as well as the sharp drop in exports. Exploring opportunities in the Chinese domestic market was the number one strategy. However, we also learned that companies are increasingly interested in implementing sophisticated long-term strategies to enhance product competitiveness and supply chain efficiency. This is likely the result of a growing awareness that many Chinese companies, operating in their home environments, are nimble rivals with the potential to outpace less than lean competitors. Also high on the list of improvements preferred by surveyed companies were upgrading product design and building partnerships with key suppliers from a smaller supply base.

In an attempt to delve more deeply into concerns about reduced profitability, we asked manufacturers to list the actions they were taking to alleviate the impact of rising costs in China. Once again, respondents indicated that they were turning to more sophisticated best practices. Nearly 22 percent of companies indicated that they were enhancing internal cost control systems, while slightly smaller groups said that they were improving productivity (17 percent); implementing lean manufacturing (17 percent); applying energy saving measures (16 percent); and switching to alternative, low-cost raw materials (15 percent).

LEAN MANUFACTURING TAKES HOLD

In last year’s survey, we reported on initial signs that multinationals in China were upgrading their manufacturing processes to develop and capture economies of scale and scope and, in doing so, controlling costs. We applauded this trend and warned that to be in a strong position to profit from sales in China, manufacturers must view China less as a low cost country and more as a competitive manufacturing and sales environment. The global recession punctuated the importance of this advice: China was one of the few profitable regions for many multinationals in 2009, clearly demonstrating the China market’s importance to company growth prospects.

Compared to last year’s survey results, there was even stronger evidence that companies are actively pursuing manufacturing improvement initiatives. Nearly 70 percent of respondents, up from 56 percent in 2008 said that they had begun efforts to upgrade purchasing and purchasing quality; 69 percent, up from 64 percent, have taken steps to modernize manufacturing process technology; and 62 percent, up from 47 percent, were realigning their manufacturing footprint.

Moreover, lean manufacturing approaches, largely ignored by both multinationals and domestic Chinese manufacturers in the initial race to transform China into a manufacturing haven, are more and more in evidence. This year, more than 10 percent of the companies surveyed compared to 8.5 percent in 2008, installed Enterprise Resource Planning (ERP) and Manufacturing Resource Planning (MRP) systems, while 9.6 percent, double from the year before, have adopted Six Sigma quality control and lean manufacturing methodologies.

Among those who have implemented lean manufacturing techniques in 2009, product flow and site layout optimization and ERP/MRP systems produced the most satisfactory results. Moreover, product flow and site layout optimization, as well as advanced demand/capacity planning, were the most popular options for accelerated adoption. Meanwhile, implementation of expensive and resource-intensive techniques such as ERP/MRP appears to have tapered this year, likely due to financial constraints as a result of the global economic crisis.

It is important to note that implementing sophisticated and modern manufacturing approaches require diligent management of the new processes and painstaking integration of the equipment and systems into the culture and operations of the organization.

LABOR CHALLENGES RETURN

2009 saw a temporary reprieve from the steadily increasing cost and limited availability of labor for manufacturers in China. The global economic crisis dramatically reduced export demand from the West resulting in layoffs and a softer labor market. By December of 2009, however, China's economy had returned to growth levels seen prior to the economic downturn and today, human capital challenges are as severe as they have ever been.

The Labor Contract Law, which took effect in January 2008, set forth the legal rights and responsibilities of employers, employees and labor unions, and strengthened the legal mechanisms for protecting employees’ rights. And while the longer term impact of the law on labor costs in China is yet to be seen, 78 percent of respondents in this year’s survey reported an increase in costs.

Whether due to evolving government policy or the rapid pace of China’s economic development, China’s labor market is changing. In the past 12 months, China has gone from having an excess of workers to a greatly tightened job market as the pace of economic growth in China and around the world picks up. However, survey results indicate that most companies appear to be adjusting well and are shifting strategies in an attempt to take advantage of the new labor landscape. Manufacturers are choosing to broaden their value propositions for workers, which has the advantage of strengthening employee recruitment and retention – a major concern of surveyed companies. A strong majority, 79 percent of respondents, said that they are providing more training and career development assistance to employees rather than relying on compensation to attract and retain workers.

Other companies confronting labor challenges have focused on operational improvements. More than half of those surveyed said that they were simplifying processes and almost one-third are increasing automation to foster greater efficiency.

GREEN REVOLUTION

Much has been made of China’s environmental problems – air pollution, lack of clean water, minimal regulations and substantial carbon footprint, among other issues. Perhaps not enough has been said about the significant steps taken by China to address this issue such as higher factory emission standards, an emphasis on developing renewable energy technologies and stricter oversight of potential polluters.

Western multinationals have a strong record of bringing best-practice environmental standards to China and this year’s survey results bear this out. We asked companies to comment on their sustainability strategies and the resulting benefits. Three-quarters of respondents said that they were adopting green technology in their China operations and 60 percent anticipate savings to operations from their green investment. The number one priority was to increase energy efficiency (86 percent),followed by conserving or recycling water (83 percent). A majority of multinationals (58 percent) are selling services into the Chinese market that benefit the environment or that are produced and distributed in ways that are environmentally sound.

Still, despite their good intentions, companies have not yet shown that they are willing to take the appropriate steps to safeguard critical resources. While nearly 80 percent have analyzed their energy usage in order to improve efficiency, fewer than 50 percent of respondents said that they have defined their water footprint. Unlike in other markets, it is difficult to price green products competitively in China. Only 30 percent of respondents said that they could demand higher prices for green products and services in China, compared to 46 percent of companies that said they do so in other markets around the world.

NEW HORIZONS

While China, particularly East China, remains extremely attractive to foreign manufacturers as an investment destination, increasing costs and labor availability are driving companies to consider other options for their lower cost, export-driven operations.

In 2009, approximately twice the percentage of companies considered relocation or expansion plans for their manufacturing operations than in 2008 – both within and outside of China. For those considering plans to relocate or expand outside of China, more than half said they would stay within Asia, identifying India and Vietnam as their top choices on the continent. Latin America and Eastern Europe ranked a distant second and third.

However, companies must balance the savings in cost against forfeiting the advantages that China offers relative to other low-cost countries. These include increasingly strong supply chain and logistics capabilities, a growing consumer market, an improved operating and regulatory environment, and access to technology. In addition, although factories in China are generally still in the early stages of implementing innovative manufacturing practices, these lean techniques and processes are even less prevalent in surrounding low-cost countries.

CONCLUSION

China remains an extraordinarily attractive country in which to establish and expand manufacturing operations. However, in 2009 there was a definite shift in the duality strategy that so many multinationals have adopted as companies increasingly viewed access to the local Chinese market as more important than sourcing from a low cost country.

This changing landscape offers substantial opportunities for multinationals but they must be proactive and diligent about taking advantage of them. To benefit most from China’s domestic market, companies must continue to improve their sales and marketing capabilities as well as transfer world-class manufacturing practices – lean techniques, footprint optimization, demand and capacity planning and the like – to their Chinese operations.

In addition, companies will need to revisit their talent acquisition development programs. The emphasis should be on creating a workforce that is loyal, productive and highly skilled. This could be difficult and costly in the early stages, but well worth the effort. In the end, investing in a company’s workforce in China will pay dividends in quality and output gains.

Most of all, companies must avoid complacency when addressing the global cost competitiveness of their operations. As labor and material costs rise, companies will increasingly seek options within and outside of China to cut operating costs. However, choosing the right site requires a careful analysis of local conditions to determine whether lower cost locations fit the company’s needs and strategies in terms of infrastructure, distance from markets, level of worker abilities and demographics.

We hope that this study offers a roadmap for foreign-invested manufacturers as they navigate China’s ever-changing commercial business environment.

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