Sourcing from China 

Part 1: Everybody's doing it

If you work for a manufacturing or retail company and have not yet moved operations beyond domestic borders, someone in your boardroom has likely asked in the past year, “Should we source from China?”

Larger companies, which profit more from cost-cutting moves because of their scale, have already made the move, with many giants such as Wal-Mart Stores, Inc., and General Electric Co. setting up purchasing centers in China to feed their global supply chains. Even companies that have decided that their existing manufacturing operations are best left untouched for now are reexamining their upstream supply chains and confronting their suppliers with price quotes from Chinese producers. If your company has never looked at the option before, now may be the time to look. And if you have looked before, it may be time to look again, since the manufacturing dynamics in China change quickly. 

The big question

The first question for the uninitiated, of course, is: “Should we go to China?” The answer depends in part on your company's products. Most analysts note that China excels at sourcing components or goods made from templates, such as furniture, toys, and consumer electronics and appliances. Telecom, biotechnology, and electronics are also emerging new strengths, and General Electric Co., Microsoft Corp., and Motorola, Inc., among others, have set up global research and development centers in China to capitalize on them.

The 1-2-3 of Sourcing

1. Pick product to source
2. Define supplier and product criteria
3. Search for suppliers
4. Research supplier qualifications
5. Evaluate samples
6. Audit factories
7. Test order
8. Choose supplier
9. Establish reliable quality control
10. Establish communications
11. Establish supply chains
12. Monitor patent protection
13. Enforce long-term cost reductions
14. Repeat as needed

The answer also depends on the level of PRC exposure your company seeks. For companies entering China only for procurement, cost advantage is still China's primary draw, but companies considering more permanent stakes may find better product quality and manufacturing flexibility, as well as growing domestic demand, to be more important. 

Part 2: Why China? 

The Positives:

• Lower labor costs
According to a Boston Consulti ng Group (BCG) outsourcing report, the average hourly pay (including benefits) of production workers in China is $0.80 versus $21.86 in the United States; given the same equipment, American workers need to be 25 times more productive than their Chinese counterparts to remain competitive. Furthermore, if PRC government reforms on labor mobility succeed huge labor surpluses in the rural areas and underemployed workers at state-owned enterprises waiting in the wings may keep manufacturing wages competitive for some time.

• Long-term flexibility in production
Companies often overlook the fact that, once Chinese workers have been well trained, substituting human hands for expensive, specialized machines can actually improve the flexibility of production lines.

Proximity to downstream manufacturers
For companies that churn out intermediate goods such as auto parts, refined chemicals, and machine tools, customers (other factories) are increasingly located in China. Paradoxically, moving operations to China nowadays can lower shipping costs in addition to lowering labor costs.

Familiarity with the PRC operating environment
Companies with longer-term plans to supply the Chinese market can start with a sourcing operation, which enables them to explore their options and lay the groundwork for a move toward local production.

• Lower capital costs
For companies that plan to set up PRC manufacturing operations, land and setup costs can be a fraction of US costs, at least in the interior provinces and outside of major cities. Companies also find that using local components often minimizes input costs.

Favorable tax structures
Foreign-invested manufacturers enjoy a tax rate of 15 percent, as opposed to 33 percent for domestic enterprises, and the government rebates up to 15 percent of value-added taxes (VAT) on exports. Though the government has plans to unify the business tax structure and phase out some of these incentives, localities are likely to continue to offer incentives to lure investors.  

Part 3: Assessing the Costs
Each company must make its own decision to move to China, and a careful cost analysis is a critical part of this decision. A China-based competitor's price, adjusted for quality and market position differentials, can serve as an initial guide. Total cost analysis will incorporate cost savings (the largest portion of which is usually cheaper labor and components) and additional costs incurred, such as the initial setup costs and higher freight costs and duty payments. A more complex model will include sensitivity analysis to anticipate different scenarios, such as a government-forced slowdown or widespread power shortages.

Choosing the right path
Perhaps the easiest way for a company to source in China is to link up with an existing supplier's operations there or to encourage an existing supplier to also make the move. This allows for Chinese production prices at a familiar level of quality control and delivery.
Another way to find partners is through industry trade fairs in China; referrals from officials in the relevant ministry or local government; discussions with the American Chamber of Commerce, the US-China Business Council (publisher of this article), the US Commercial Service, or other trade organizations. Firms can also ask existing Chinese partners about potential partners or suppliers in other product areas, keeping in mind possible biases they may have.
Companies that are understaffed or on a tight budget can turn to sourcing agents. Outside help on sourcing ranges from matchmaking to consulting on logistics and quality control. According to McKinsey Quarterly, procurement agents' fees range from 3 to 12 percent of the purchase price, depending on the level of service. Of course, careful vetting of sourcing firms is crucial.

Five Options

Think strategically and consider long-term plans before you pick your path.

Structure Pros & Cons
1. Source selective components using sourcing agent
PROS: Easy to set up
CONS: Low-cost savings; little awareness of China markets

2. Source products through representative office in China
PROS: Hands-on approach and development of local expertise lets you sleep easier at night CONS: Increased management demands

3. Establish global procurement center
PROS: Maximize savings internationally; build deep relationships with PRC suppliers
CONS: Requires good enterprise and communication systems within the company

4. Set up joint venture or wholly foreign-owned
PROS: Production with rapid response; better positioned to capitalize manufacturing enterprise in China on growing PRC strengths
CONS: Large fixed investment

5. Create full manufacturing, distribution, and sales network
PROS: In some industries, China is the major growth market
CONS: CEO or board decision; must have long-term investment and exit plans

Do due diligence

The next step is to conduct due diligence on PRC factories: Examine their financial health, production capacity, quality of goods, client references, export history, IPR performance and level of experience with Western or US companies. It is important to compile as broad a list of potential factories as possible. According to BCG's report, Carrier Corp., an air-conditioner manufacturing subsidiary of United Technologies Corp., obtained 1,600 quotes before making its first order. Product samples are the first bar—shoddy quality or unreliable delivery should eliminate candidates.

After narrowing down the field to three to five suppliers that look good on paper and produce good-quality products at a satisfactory price, a detailed factory audit in China should follow. During the inspection, it is important to bring a good translator and to take the time to understand each candidate's production process and ensure that it meets international product and labor standards.

US companies will want to ask questions such as: Does the Chinese vendor run its own compliance checks on quality control and have sufficient oversight? Is the PRC supplier likely to outsource the order? Second-degree outsourcing makes it more difficult for companies to monitor supplier quality and ensure that there are no environmental, health, safety or child labor violations in the manufacture of its goods.

The next step is for your company to make a detailed, second-level assessment that integrates buyer requirements into the evaluation; this process usually rates the candidate as a whole, including all business practices, with a specific grading scale for each set of criteria. Your company can then either choose one candidate or start a bidding process between the potential suppliers on your shortlist.


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