Who’s Going The WRONG WAY?
The pursuit of being the low-cost producer has been and will continue to be the primary focus of all successful [...]
June 2 2008 by William E. Rothschild And Stephen M. Rothschild
The pursuit of being the low-cost producer has been and will continue to be the primary focus of all successful businesses. Over the past few decades, companies have targeted low-cost labor areas, with governments that were willing to sacrifice the environment and even the welfare of its people to attract investors. In the 1960s American companies moved from the unionized and high-cost Northeast and Midwest to the “right to work” south. Then it was Japan, Korea and Taiwan. But in each case, the costs increased and the journey continues.
In the 1980s the Chinese government sought to attract multinational companies via the combination of incentives and its huge, low-cost labor force. According to the Financial Times, some 30,000 South Korean companies had taken advantage of China‘s tax incentives to invest in southern China by the late 1980s, and by 2003, Korean companies had invested 41.4 percent of its investment into China. Other countries, like Japan and Taiwan, followed a similar pattern. China was clearly their preferred manufacturing nation. U.S. companies lagged but in recent years have accelerated their Chinese investments and have even been willing to transfer some of the research and development into China.
But as in the past, many companies have found that China is not as attractive and are leaving the country for other “lower cost, hungry locations.” For instance: the number of Korean companies in China has been reduced by two-thirds, from 30,000 to 10,000, and between 2003 and 2006 total investment declined from 41.4 percent to 31 percent. Japanese and Taiwanese companies are also leaving China. Why the exodus? We believe that there are four major reasons that Korean, Japanese and Taiwanese companies are leaving China: cost, security, flexibility and complexity.
The cost of doing business in China is rapidly increasing due to a number of factors, including:
Accelerating Inflationary Rates. According to the Financial Times, “The (Chinese) February inflation rate of 8.7 percent was the highest in 12 years and is expected to be deeply worrying for a government that has spent a lot of energy recently trying to talk down consumer and business concerns about inflation.”
Taxes, stricter enforcement of environmental standards and overall manufacturing cost increases. Prices for plastics, steel and other materials have climbed 30 percent or more, and electricity rates are surging, too,” reports The International Herald Tribune.
Environmental and Product Standards. We all know about the lead issue in childrens’ toys and problems with drugs being exported from China. In addition, we know that China has enormous health and safety issues. Air pollution and water pollution are common. A recent Economist article reported that in 2006, “70 percent of 2 million annual cancer deaths were pollution related.” Factories are unsafe. At some point the Chinese government will have to address these issues and stop sacrificing their own people’s lives. Since China has over a billion and half people and only a small portion pay income taxes, the best, most obvious place to get money to fund these programs is to tax foreign companies.
“Companies operating in China are required by the government to chip into a housing fund that’s available to their Chinese employees, who also make a contribution,” reports BusinessWeek magazine. “When employees are ready to buy a home, they can draw from the funds to help. About 20 percent of the multinationals currently chip in more to the housing fund than required.”
Scarcity of Talent. The International Herald Tribune reports that “despite its huge pool of unskilled rural laborers, China‘s supply of experienced, skilled talent falls far short of demand. The gap has pushed wages up by 10 percent to 15 percent a year.” China has not trained its middle and upper management to lead companies and it is now very difficult for companies to find these people. If and when they do, they must compete for them and then expect a constant turnover and need to replenish the supply. Many companies are being forced to export their management training overseas, which is costly and difficult to do.
Infrastructure. China has embarked on a very rapid, some say too rapid, building of power plants, water systems, sewerage, roads, railroads and highways, along with buildings. One of the major problems is that this construction was not centrally planned and implemented. Provinces have overbuilt and are competing among themselves. Ultimately there will be overcapacity and, even worse, much damage to the environment and physical assets of the nation. Again, the Chinese will increase the burden on its “foreign” companies.
Lack of Security
The cost of doing business in China is not just restricted to the ordinary cost of labor, materials and taxes, it must also include the violation of patents, copyrights and other intellectual properties. This is a major issue with the Chinese. China has never signed the International Copyright and Patents agreements, and does not protect copyrights or patents. A 2005 Time article called “The Idea-Stealing Factory” reported that “in a country where government-controlled companies comprise the industrial base, piracy is not derived from commercial callowness, it appears to be official policy.”
The music/entertainment/publishing industries have lost billions because their protected materials are stolen and sold at a fraction of the list price, of which they get nothing. In fact, my own last two books were translated and sold illegally in China. The CIA asserts that China has an elaborate spy system in the U.S. to steal commercial and military technologies. And a quick Goggle scan of articles about industrial espionage yields more than 15 incidences of companies either suing the Chinese for pirating or companies leaving China because of their inability to protect their patents and copyrights.
For example, Cisco Systems filed a suit against Huawei Technology of China, accusing the company of copying software and infringing patents. And former Lucent Technology scientists Hai-Lin, Kai-Xu and Young-Oing were indicted by a federal grand jury for allegedly conspiring to steal trade secrets from Lucent Technologies.
The Wall Street Journal summarizes the current situation this way: “Though China is working hard to repair its reputation as a place where theft of intellectual property is rampantï¿½ï¿½ the truth is that counterfeiting and piracy remain common.”
What’s more, since foreign companies must train their Chinese managers, professionals and workforce, they are, in essence, developing their own new competition. There have been reports of companies who built factories in China and within a few years the employees left to build a competing factory across the street. In all of the major Chinese growth areas, such as wind power, electrical systems, transportation and water purification, new Chinese companies are being formed not only to serve the Chinese markets, but to sell offshore, especially in developing nations. In fact, in March 2008 China reportedly announced that it was creating a new company to design, produce and sell jetliners big enough to carry more than 150 passengers, which could eventually pose a threat to Boeing and Airbus.
Security issues extend beyond just the loss of intellectual properties. The travel of senior management and professionals as they visit and interact with their employees in China also presents huge security issues and requires an expensive infrastructure.
A third layer of costs deals with a company’s ability to hire and fire workers to meet its strategic and financial needs and to make acquisitions or mergers if and when it makes economic sense. Both of these rights are limited in China.
A new labor law passed by China that would “substantially increase labor costs and reduce flexibility” was roundly protested by foreign companies, who warned the Chinese government that the new regulations would force them to move operations out of China. “Foreign executives said they are especially worried about the new labor regulations because their companies tend to comply with existing laws more rigorously than some of their Chinese competitors do,” reported The New York Times. “Their competitive disadvantage could increase sharply, they said, if the new rules put fresh burdens on foreign companies that their local counterparts ignore.”
Some provisions of the new law include:
- Requiring employers to provide written contracts to their workers, restrict the use of temporary laborers and make it difficult to lay off employees.
- Moving China closer to European-style labor regulations that emphasize fixed- and open-term employment contracts enforceable by law, and requiring that employees with short-term contracts become full-time employees with lifetime benefits after a short-term contract is renewed twice.
- Giving the state-run union and other employee representative groups the power to bargain with employers. When more than 50 employees are to be laid off, for example, the company must negotiate an agreement with the labor union or all employees.
Foreign companies are limited in what companies they may acquire. They are able to purchase “small Chinese companies that the central government is not interested in managing; large, state-owned enterprises that suffer from financial difficulty, provided the foreign investor agrees to restructure the purchased company, and non-majority interest in strong, successful Chinese companies, but only if there is some added benefit, such as transfer of technology, advanced management or access to foreign markets,” according to China International Business magazine. Of course, it must also be kept in mind that China is and wants to remain a Communist state and may not hesitate to nationalize companies and seize investments if they believe it is to their benefit.
Doing business in any foreign nation is complex and China is no exception. There are language, nationality and cultural differences, as well as different accounting and financial requirements. For instance:
Languages. “There are between six and 12 main regional groups of Chinese languages with 13 sublanguages.
Nationalities and Cultures. The Han Chinese are the largest ethnic group, representing 91 percent of the population, but China recognizes 55 other “nationalities” or ethnic groups.
Different Accounting and Financial Laws and Regulation.
Each country has its own unique accounting and financial laws and regulations. The Chinese accounting regulations and policies are very different from U.S. requirements and add complexity and cost to the company.
The New Frontier?
Because of increasing costs and complexity of doing business in China, the Koreans, Japanese and Taiwanese are moving to other low-cost countries, like Vietnam, Cambodia and North Korea, as well as the U.S. Going to Vietnam, Cambodia and North Korea follows the same pattern as the past. These are developing nations, with large low-wage workforces and governments willing to make major concessions to get new industry. Companies will benefit from these concessions for a few years and then experience higher wages and more government interference.
There are also many examples of companies moving into the U.S. Nissan recently opened a $1.4 billion vehicle assembly plant in Canton, Miss., expected to employ about 5,300 workers. BSH Home Appliance Corp. recently opened two plants in
New Bern, N.C., employing about 1,200 American workers. Hyundai Motors and Kia Motors recently established a joint design and technical center in Irvine, Calif.; and Ecolabels is adding 400 engineers at its research and development center in Eagan, Minn.
Why the U.S.?
The U.S. is still a very large, affluent and growing market for many of the products and services these companies provide. It has a low inflationary rate; stable government and legal system; a large skilled, highly productive workforce; and protects patents and copyrights. Pros include:
Stable wages and benefits. Wages and benefits in the U.S. become increasingly more competitive as unions and workers accept that they will not get pensions, must have their own 401(k) plans, and, in many cases, pay more toward health care.
Strong infrastructure. The U.S. has increasingly focused on improving the quality of air, water and preserving natural resources. Quality of life is far superior and, while infrastructure has been neglected, it is still competitive and will improve in time. Information/communications networks are second to none.
Abundant management and productive workforce. The university and professional schools in the U.S. are still among the best. There are an ample supply of qualified business graduates and, despite declining enrollments, science and engineering programs remain competitive and can be increased with the right incentives.
State and local governments competing for jobs and investment. Major locations in the U.S., such as Michigan, New York, Massachusetts and Connecticut, are aggressively soliciting companies to build plants in their states with tax incentives and other support.
Security. U.S. laws protect copyrights and patents. Its workforce can be more loyal to their companies than to the nation. Travel is easier, safer and not as complex. It is easier to protect facilities and key people in the U.S. than in a developing, often unfriendly country.
Stable and consistent financial requirements. The U.S. has a strong heritage of sound financial and accounting practices that are more stable and understandable than China or other developing nations.
The Right Strategy
Just because some companies have decided to de-emphasize China, seek new low-cost nations and re-invest in the U.S., doesn’t mean this is right for everyone. We counsel clients to make global decisions based on three factors: nature of market or industry, time horizon, and strategic drivers. (See “Where and How to Invest Globally,” opposite page.)
If, for example, your company participates in a commodity and highly price-competitive market and industry, clearly you must seek out the lowest-cost areas to produce or outsource your products and services. Therefore, nations eager to provide low-cost labor and ignore the environment are the places to look. This may require moving from the coastal, increasingly expensive areas to the western, rural areas of China. Or it may mean moving to Vietnam, Cambodia and North Korea. However, some American states may still be low-cost manufacturing locations. Obviously this will require careful strategic evaluations and possibly moving again in time.
Deciding when a business requires adding value and quickly adapting to change will require focusing less on lowest costs and more on the skills and responsiveness of the workforce.
Normally this would mean being close to the customer and being able to respond rapidly. In this case, you want to be near the market you are targeting. So if you are targeting China or India, it may make sense to stay in these countries and not worry as much about the increasing cost. This is the main reason so many European and Far East automobile companies are building factories in the Southern part of the United States.
Finally, technologically innovative companies must protect their patents, copyrights and intellectual properties, now and in the future. They can’t afford to lose their competitive edge and create their own competitors. In this case, I strongly recommend that companies invest first in their own countries and concentrate on their R&D and not fragment or jeopardize their technical skills.
American companies should focus on the United States, European companies on their home countries and so on. It is not the cost of labor that is key to these businesses and their ability to implement their strategies and succeed, but their ability to control and protect their “crown jewels.” Moving to nations that are not secure, even if they have low-cost technical skills, makes no strategic sense.
The message is clear. Winners are selective, adaptive and internally, strategically consistent. They have a long-term, balanced view of the world and refuse to just follow the herd, and most of all they protect their “crown jewels.”
Where and How to Invest Globally
Type of Industry/Market
Low Cost Manufacturing/Outsourcing
China, Vietnam, North Korea, Cambodia, India, selective low-cost U.S. states
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Value Added/Rapid Response
United States, China, Europe, India
Selectively in other countries, if you can protect innovations
Home country, United States, Europe, China,India
Home country is preferred
William E. Rothschild is author of “The Secret to GE’s Success” and CEO of Rothschild Strategies Unlimited LLC. His blog, strategyleader.com, assesses GE’s performance from time to time. Stephen M. Rothschild is President and CEO of Provox Technologies, in Salem, Va.