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China’s Developing Supply Chain: The Rise of Global Manufacturing Competition

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  • China’s Developing Supply Chain: The Rise of Global Manufacturing Competition

    As originally published in Supply Chain Europe, July/August 2008:

    The gap between Chinese manufacturing cost and overseas price points is closing. With increasing input material and labor costs, companies around the globe are losing competitive advantage. Asia Pacific Directors are feeling the squeeze as P&L statements reflect declining margins.

    Currency exchange rates are one external factor increasing costs. Between May 2007 and May 2008 the Chinese RMB (CNY) appreciated by 9.69% to the British Pound, 9% to the US Dollar, and depreciated against the Euro by -4.1%. Only in the EU did products from China gain profit margin as a result. As currencies fluctuate, every global supply chain is affected.

    Other internal upstream processes in the China supply chain create costs. Consider localized transportation and inventory management. With increasing fuel prices and inefficient logistics such as routing and material handling, further profits are sacrificed. The positioning of inventory throughout the global supply chain greatly affects material flow costs as well.

    With a limited knowledge of the realities in the China supply chain, few companies have been able to adjust their global models to protect profit margins. Alternatively, companies are beginning to consider substitute manufacturing locations. In developing a long-term sustainable advantage, productivity and efficiency throughout the global supply chain will remain critical.

    Facing the Realities of the China Supply Chain
    In 2006, Hewitt Associates and the US China Business Council stated, average salaries increased by 7-9% in tier one cities. Similarly, raw material prices have risen by 10-30%. In 2007, VAT refunds were reduced or eliminated influencing export oriented businesses. This profit erosion has lead in part to the closure of over 10,000 manufacturers in Guangdong province earlier in the year. In order to establish advantages in the next wave of China’s development, greater focus will be placed specifically on the upstream China supply chain. Where do we start? One area is inventory management.

    Inventory Management in China
    When considering China’s inventory management, including raw material, work-in-process, finished goods and in-transit, opportunities for improvement are apparent. For instance, the IBM Global Business Services 2007 Mainland China Value Chain Study (IBM Institute for Business Values, October 2007) reports 66% of local Chinese companies have cash-to-cash cycles of greater than 30 days. This is compared to 60% in Europe and 59% in North America. Cash flow velocity is important for inventory management, capacity and to strengthen productivity, all which can reduce costs.

    Raw material prices are rising. In some industries, the annual increase is in excess of 50%. In China, inventory management polices are commonly the responsibility of the manufacturer, however procedural knowledge may be underdeveloped. Stock-outs and delays are frequent. This is compounded by rising prices and limited cash flow. Improved processes are needed to manage supplier selection, material handling, storage optimization, inventory accuracy, reorder point policies, and cycle and lead time considerations.

    Work-in-process inventory is viewed in a similar manner. Rarely are operational procedures audited to identify process efficiency or continuous improvement opportunities. Assembly lines for example, are commonly designed without quantitative analytics including functionality and time optimization for material flows.

    The IBM Study provides further key indicators related to finished goods inventory as well. For China’s local companies, 97% report finished goods inventory turnover of four turns or higher. This figure compares to companies in Europe at 78% or North America at 68%. Some may initially identify this as a strong metric. What we see are potential inefficiencies.

    The key piece is the denominator, inventory. Many survey respondents were export oriented. This means finished goods inventory will naturally be low. Considering lead times, this may reaffirm an ability to maintain a high supply chain service level, yet at a significant cost. By not holding finished goods in China, there is a lost opportunity of inventory balancing between a manufacturer, in-transit and a customer’s distribution location.

    Logistics, Capacity and Demand-Production Synchronization
    Connected to the discussion of lead times and inventory management are three further areas of consideration. These are logistics, capacity management and demand-production synchronization.

    As we consider the logistics industry in China, it is immediately apparent the market is highly fragmented. Some estimate over 700,000 registered third-party logistics (3PL) providers exist with an average fleet size of three trucks. According to the JLJ Group, China: Logistics and Distribution Industry (March 2007), 20% of local Chinese companies utilize 3PL outsourcing and logistics costs are 20% of the total China GDP. This compares to, for example, 9% in the United States.

    Here, it is clear, local logistics costs can be reduced. Areas such as consolidation, route optimization, cross docking and in-transit merging are developing, yet the knowledge for effectively building these models is limited. Stronger warehousing and distribution networks continue to expand as second and third-tier city investment increases. Hub and spoke designs are only starting to become defined.

    Capacity management in China is another important consideration. Differing perspectives exist. On one side, competition in many industries has created low capacity utilization for individual manufacturers. In other cases, foreign suppliers may be at near full capacity with high quality production and demand. In this case, initial capacity audits are essential for both operations and supply chain throughput.

    Capacity goes beyond production when taking into account inventory and logistics management. Production planning, new product ramp up, and expansion will face delays if capacity is not properly managed. By assessing the end-to-end supply chain, companies can mitigate the risk of capacity bottlenecks.

    Demand-production synchronization is more commonly an afterthought in low cost sourcing. For a manufacturer to accurately maintain inventory, prepare an accurate production schedule, and deliver in a required time frame, demand accuracy is critical. In most cases, overseas orders are placed or demand forecasts are adjusted without taking into account production and delivery lead times. Problems arise, costs increase, quality variability grows, and product shipment is delayed. In order to create a competitive advantage, suppliers and buyers can no longer operate in isolation. Coordination is becoming increasingly essential, bringing the world closer together.

    Comparing the China Supply Chain with Alternative Sourcing
    With the realities of the China supply chain, both local Chinese and Western companies are considering alternative low cost manufacturing countries. Locations such as Laos, India, and Vietnam, in order of export growth between 2002-2006, are becoming influential destinations. Similar to China 15 years ago, labor, overhead costs, and production volumes are critical. When analyzing substitute manufacturing locations, which direct and indirect costs may create cost prohibitive operations?

    Local logistics influence direct and indirect costs. Laos, a landlocked country, is a clear example. Although export from Laos increased by 50% year-over-year in 2006, according to the Asian Development Outlook 2007, transportation to the nearest port will traverse multiple countries. The complexities and costs undoubtedly increase. In general, inventory holding costs may be lower based on overhead and labor, yet the question again becomes lead time. Here in-transit inventory based on shipping volumes paired with lead time will influence total supply chain costs.

    Infrastructure is a key factor impacting logistics. Roads, rail, ports and airfreight capabilities all must be considered. When compared to China, many alternative sourcing locations have investment little to date in developing freight capacity. Warehousing and port authority management must be in place if inventory will be maintained locally and moved efficiently.

    Likewise, material handling is a concern. A basic understanding of packing and physical handling will be lower where investment in training has been minimal. This can influence product quality and potentially downstream production. Consider India, where multiple provincial borders may be crossed in-transit to reach a port. Each border check adds potential risk for product damage.
    Building on these foundational components, inventory management may add costs to the supply chain. Raw material procurement is importantly different. For substitute sourcing locations, raw materials will often be imported, increasing costs and upstream lead times. This regularly leads to decreased in-transit inventory operational efficiency. Demand-production synchronization again becomes a key through calculated planning, yet even greater knowledge gaps in manufacturing systems may exist.

    Technology and training investments are also important factors. What type of manufacturing capabilities do existing suppliers utilize? In China, much of the manufacturing technology may already be present, but is the same true in Vietnam? Integrated software is growing in China, although still remains fairly low. In other destinations, the reality is an even lower acceptance of systems such as EDI/INT, with the exception of India. Investing in people is important to develop leadership and managerial talent. China in most cases is farther along the project management and manufacturing operations talent development cycle.

    Lastly, capacity management and utilization in alternative sourcing locations should be a focal point. China continues to invest in significant manufacturing, storage and transportation resources. Although challenges do exist, in many cases the capacity is available although potentially constrained by inefficiencies as noted. Laos, India, and Vietnam however are in earlier stages of development and infrastructure investment. Smaller geographic and industry sizes will influence capacity, as will increasing competition. This will specifically impact all four types of available inventory capacity. Logistics capacity for example faces similar potential problems. How does the size of the transportation capacity differ and effect batch size optimization? If not properly analyzed, the complexities multiply as do the costs.

    As China’s supply chain infrastructure and knowledge base continues to develop, efficiencies in process, inventory, logistics and supply chain management will evolve. Competition and declining profit margins have brought this reality to a few select industries such as apparel and electronics. The day is approaching where many industries will be more concerned with productivity and efficiency than market share. The signs of change are apparent.

    At the same time, many countries will look to challenge China’s manufacturing foundation. Cost incentives are the initial driver. Sustainability and industry diversification will be the keys as companies migrate up the value chain. Although opinions greatly differ, Chinese manufacturing is realizing the value added mentality. What still remains to be seen are two critical and emerging components, namely service and innovation. By bringing together low cost, service and innovation we may just witness an intriguing new chapter in the China growth story.