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While costs have become a focal point for companies seeking to grow their margins, China's competitive position as a low-cost sourcing destination is being questioned. This article takes a closer look at the new competitive forces shaping China and other low cost countries' competitiveness and the implications for global supply chain executives.

The world that witnessed a decade of impressive growth is now a distant memory. The global financial crisis intervened and put a halt to it. Demand in developed markets plummeted before levelling out and the knock-on effects have been felt around the world. China, along with a few other countries, temporarily bucked the trend but most are seeing relatively slower growth and it seems as if this pace is set to remain in place for the foreseeable future.

Unfortunately, not only are growth prospects bleak, but for numerous countries and sectors, costs are rising faster than revenues. This is not only the case for some developed economies, such as Australia, where labour costs have grown at twice the pace of other OECD countries over the past decade, but also that of a number of so-called low cost countries (LCCs).

Of the numerous ways to counter the effects of slowing revenues and rising costs, companies are attempting to increase their productivity and efficiency as well as run cost-cutting initiatives. By targeting one's cost base, companies are searching for innovative ways to deliver the same products and services as before from a more cost-effective position.

Globalisation has created opportunities for companies to exploit cost arbitrage between geographies, with the so-called LCC phenomenon enabling constant shifts of foreign direct investment flows in manufacturing and export activities from developed to developing countries that possess a more favourable manufacturing cost profile. None is this more evident than in China, the world's largest exporter and a preferred sourcing destination for procurement managers across the globe.

However, China's rising factors of production is leading companies to identify alternative sources of supply, especially in the case of some apparel and other low-value products, where the location of factories has partially moved from China to Thailand, Indonesia, Vietnam, Bangladesh and Myanmar. There has been literature published that deals exclusively with which countries will be able to, and are challenging, China's dominance as the world's factory. In George Friedman's work "The CP16: Identifying China's Successors", he explains how several countries are already manufacturing certain categories (typically low-value and labour-intensive) more competitively than China.

This has raised some pertinent questions: Will China's higher cost profile threaten its competitive position as a low-cost sourcing destination? Is it time for global manufacturing to go somewhere else?

Assessing China's competitiveness

As reflected in the chart above, China is moving away from its position as simply a LCC into a sourcing destination which enjoys the same world-class infrastructure facilities, access to highly skilled labour force and technological innovation capabilities as the most advanced economies in the world. While labour costs are definitely lower in many other destinations, a wider set of factors must be considered when choosing an alternative location. Ease of doing business, availability of raw materials, reliability of supply, good quality products and scale are some of the competitive advantages China still enjoys that 'cheaper' alternatives do not. Companies considering alternative sources of supply may face infrastructure challenges, shortages of skills or political instability. China will continue to hold certain key advantages - robust infrastructure, advanced technology/R&D and a skilled labour force - compared to its manufacturing competitors. While China is becoming a more expensive sourcing destination, it is also more comprehensive, flexible, and more reliable than many of its counterparts. The quality/cost ratio is also rising for many manufacturers. In the meantime, smaller supply bases in LCCs may eat a part of the cake (e.g. countries specialising in one single product).

A second factor to consider when assessing China's overall competitiveness is the attractiveness of inland China. While average wages have almost doubled in China since 2007, those in central and western China are still comparable to other LCCs. Land costs show a similar picture. Hewlett-Packard for instance, recently set up factories in central and western China due to its costs advantages for exporting to Europe on express freight trains via the ancient Silk Road. They can now deliver goods to Western Europe in around three weeks (slower but cheaper than ship and air) which will also lower inventory costs and lead times. Many other companies have followed. The Chinese government is currently upgrading existing infrastructure networks to counterbalance increased inbound logistics costs. It has also announced the creation of a fourth economic hub (as it did in coastal China in the 1980s) in central China to foster further investment in manufacturing. If this initiative proves successful, China will simply become its own alternative to low cost manufacturing, or at least part of it. This advantage will not last forever but provide a solid enough case for many to make the move inland and compete.

Thirdly, as China's labour costs have increased over the last decade, so has its investment in R&D. Today, more than half of the world's Fortune 500 companies are operating factories and R&D centres in China and many aspire their China operations to become new global centres of excellence. High-tech zones with IP-designated courts in cities such as Chengdu are creating an investment environment suitable for more technologically-advanced manufacturing.

Therefore, while China might be losing a competitive edge in labour-intensive products, it is gaining new competitive advantages in high value-added products. This has huge implications for companies looking to outsource not only the manufacturing process, but also the engineering and design elements of a product or project.

China's competitive edge is not coming to an end, it is just transforming. China's higher cost profile is accelerating the pace of a transformation characterised by greater levels of value added and innovation. China has taken a new direction towards quality rather than quantity at the cheap, margins rather than volumes, and productivity rather than low labour costs.

Implications for global supply chains

How companies react to this changing competitive environment is of critical importance. While this is not an easy task, there are some aspects supply chain executives must consider when facing these
challenges, such as:

Fine-tune China procurement. For most procurement managers, China will remain central to their strategies for reasons such as scale, variety and reliability among others. However, its transformation requires a re-thinking of current category strategies. What capacity is moving out and what capabilities are being built? How are our existing suppliers adapting? In China, there are increasingly sophisticated production capabilities across mature product categories; a move towards the manufacturing of very complex components with solid in-house product design; and an emerging set of engineering capabilities serving international markets among other trends. Partnering or establishing strategic long-term relationships with large-scale, service-oriented and design-capable Chinese suppliers are some of the initiatives foreign companies are taking in order to take advantage of the increase in Chinese companies' capabilities. However, Chinese companies still have certain gaps in skills and capabilities, but what is important is how to bridge those gaps, manage the risks and play the game well.

Follow a portfolio approach. Most strategic and prudent sourcing executives are adopting a portfolio approach. This does not imply moving away from China but rather building capabilities in emerging sourcing destinations that can complement an existing Chinese supplier base. China dominates in most but not all categories. Understanding the manufacturing competitiveness and associated risks of low cost countries on a relative basis becomes essential. Specific factors such as poor infrastructure, social non-compliance or political risks may negate an otherwise appropriate portfolio. Sourcing executives are strategically matching countries with the categories and even sub categories that they are competitive in. While the right mix can increase a supply chain's complexity, it can also lower its overall cost structure and diversify its potential risks. However, with the world constantly changing, executives should try to anticipate the future direction of their chosen portfolio and be prepared for numerous possibilities.

Revisit risk management. As companies become more dependent on cost-cutting initiatives to maintain or increase their margins, managing supply chain risks becomes critical. This is especially important when those initiatives involve new (and usually riskier) sources of supply. Extended supply chains add complexity to the work of procurement managers. Enlarging one's pool of pre-qualified vendors requires more visibility. Depending on volumes and associated risks, some sort of local risk management thinking and presence is required. More frequent travelling, strategically partnering with service providers who are on the ground, making better use of technology and establishing a local presence (or a combination of the above) are some of the available options.
Cutting costs while compromising quality is not an option Finding alternatives to China is possible, but you will have to manage the risks better and probably work harder.

Develop innovative strategies. Supply chain managers are realising that exploiting cost arbitrage opportunities between geographies is becoming increasingly difficult. The fast shifting landscape of LCCs means that finding a one-stop sourcing solution is unlikely. Although China is as close as one can achieve to a one-stop sourcing location, more and more supply chains are involving a larger number of geographies. It is within this context that other costs such as inbound logistics, outbound logistics and storage are playing a greater role in the cost cutting strategies of procurement managers. This reality requires innovative supply chain organisational structures, strategies, skills and technologies in order to facilitate cost reductions and improve efficiencies across the entire supply chain.

We are entering an era where the ability of managing complexity and volatility across different stages of the supply chain and sourcing destinations will become a differentiator. New competitive forces are appearing and supply chains are being adapted to capture the advantages on offer. While companies with an existing LCC agenda are revisiting and optimising their strategies with a portfolio approach, companies with minimal exposure to LCCs will feel the pressure of rising costs more than ever and have little alternative but to begin incorporating low cost sourcing strategies.

Although China is not necessarily the right answer for all companies or product categories, it is still a focal point for most global supply chain strategies. China has preserved and is continuously creating a set of competitive sourcing factors that attract companies seeking to compete on scale, quality, technological innovation and even service delivery. Facing tight cost pressures, Chinese companies are learning the value of optimising management and processes to boost productivity, further boosting China's gradual move up the value chain.

The speed and manner in which China transforms itself will directly affect the sourcing potential of numerous countries around the world. China will not only prove to be more attractive than other countries for certain products higher up the value chain, but it will also continue to lose competitiveness to countries in lower value products. Supply chain managers able to anticipate such shifts will cope with the complexities that emerge and adapt quickly enough to create unique competitive advantages.

This article is an abbreviated version of a forthcoming white paper by The Beijing Axis, to be released in mid-October 2013. For a copy of the white paper, please contact Barbie Co at [email protected].

While costs have become a focal point for companies seeking to grow their margins, China's competitive position as a low-cost sourcing destination is being questioned. This article takes a closer look at the new competitive forces shaping China and other low cost countries' competitiveness and the implications for global supply chain executives. - See more at: http://www.thebeijingaxis.com/tca/editions/the-china-analyst-sept-2013/203-chinas-transformation-implications-for-global-supply-chains#sthash.nr3DCGGI.dpuf

While costs have become a focal point for companies seeking to grow their margins, China's competitive position as a low-cost sourcing destination is being questioned. This article takes a closer look at the new competitive forces shaping China and other low cost countries' competitiveness and the implications for global supply chain executives. - See more at: http://www.thebeijingaxis.com/tca/editions/the-china-analyst-sept-2013/203-chinas-transformation-implications-for-global-supply-chains#sthash.nr3DCGGI.dpuf

"But I gave the factory the Pantone number!"

In the trials and tribulations of China manufacturing when a buyer finds out the color of their sample, or, even worse their production is "off", this is a common exclamation.

Perhaps not completely wrong, but not completely right.

The result is a color that is deemed different from the official Pantone. Why is this?