OUTSOURCING TO CHINA

Transportation and Infrastructure Challenges

During Outsourcing Operations to China

Date: 10/15/2009
Bhavin Gandhi
Morrison University
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Abstract

Lots of senior executives at multinational corporations (MNCs) all over the world are focusing

more of their time and their companies’ resources on countries like India and China. In years to

come, MNCs will face new challenges in their China operations: nurturing the growing number

of more educated and experienced Chinese managers and leveraging their China operations in

a way that contributes to their global competitive advantage.

Twenty years ago it was widely believed that companies that wanted to source products from

China were best off focusing on simple, labor-intensive products such as shoes, toys and clothes.

Today, however, high-tech companies such as Dell, IBM, Philips, Samsung and Nokia are

turning to China to source parts and products that demand sophisticated technology and

considerable R&D. With increase in complexity of business, challenges in China’s operations

are also increasing. This paper will focus on infrastructure challenges that a company might

face during its operations in China.

A decade ago multinational firms operating in China had to carry higher levels of inventory

than comparable firms in the U.S. or Western Europe because the logistical challenge of moving

goods around the country was enormous. Today, while matters have improved, gaps still persist

in China as transportation capabilities lag behind the hectic pace set by the manufacturing

sector.

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This paper will elaborate on both of these issues. This paper will explain some basic problems

in establishing an outsourcing center in China. And this paper will emphasis on existing

transportation challenges in China.

OUTSOURCING TO CHINA

As economy evolves in China with growing larger, more complex and more competitive

business operations; senior executives at multinational corporations (MNCs) in the U.S, Europe

and Asia are focusing more of their time and their companies’ resources on China. In years to

come, MNCs will face new challenges in their China operations: nurturing the growing number

of more educated and experienced Chinese managers and leveraging their China operations in a

way that contributes to their global competitive advantage().

In past years, the typical general manager in China was assigned the relatively

straightforward task of either selling his multinational’s products in that country or helping the

parent firm establish operations to leverage China’s strength as a low-cost producer. But the

demand in China managers has become more multifaceted now days. Government or MNCs

have either addressed or resolved some of the issues of outsourcing in China; but managers in

China still have to address significant growth in demand in China and all of the challenges

inherent in competing against foreign and domestic companies in what is already a vast, difficult

market.

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1. Infrastructure Challenges in China

Twenty years ago it was widely believed that companies that wanted to import their

products or outsource their operations to China were best off focusing on simple, labor-intensive

products such as shoes, toys and clothes. That was true and it helped drive tremendous success

for companies such as Procter & Gamble and Caterpillar(), which targeted these product

categories. Today, however, the sourcing landscape in China has changed. High-tech companies

such as Dell, IBM, Philips, Samsung and Nokia are turning to China to source parts and

products that demand sophisticated technology and considerable R&D.

Sourcing in China started with low-tech products but it has evolved beyond that. Now, in

addition to traditional products, another huge area is consumer electronics. The next big wave

will be industrial goods and services, with companies like Dell, HP, Siemens and Honeywell

leading the way.

According to figures announced in January 2009 by the Beijing-based Ministry of

Commerce, China’s exports surged 35% last year to reach $593.4 billion. Technology exports

have begun to command a growing share of these exports: They accounted for 27% in 2004,

compared with 23% in 2003(). According to a Bloomberg report, exports of technology products

rose 72% to $45.4 billion. This rise in exports is putting tremendous pressure on the existing

infrastructure in China. Now, we will look at those challenges in detail.

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1.1. Cost Challenges in China

China’s advantage over western suppliers does not just stem from low labor costs. Other

necessities for business like land, buildings and machinery are less expensive, too. Everything is

cheaper in China. If you set up a metal processing plant or textile plant, the investment required

is a lot lower than for equivalent facilities in other developed countries like U.S. or European

Union, anywhere from 20% to 80% less. And if you use local machinery — say, a metal-

stamping press made in China — your supplier passes on his cost advantage. It is 30% to 40%

cheaper than what you might get from a U.S. or Japanese manufacturer. Constructing an

aluminum smelter, which could cost $1 billion to $2 billion in the U.S, costs half that in China().

Due to lower wages, companies can deploy workers where, in the West, they might have

opted for machines. For example, take packaging - which in the U.S. and Europe is typically

done mechanically. In China, one might go back to a formula from the 60s of buying some basic

equipment and have 30 or 40 people wrapping by hand. In fact, that would be the cheapest way

in China instead of importing/buying those costlier packaging machines. This factor can create

challenging situations for international managers, forcing them to relearn labor-intensive

production techniques that are already obsolete in the West, but which are necessary to keep

costs competitive in China().

MNCs must understand that, though they will eventually save money in the long run by

outsourcing their operations to China, they can face big startup costs as they begin sourcing in

China. International Game Technology (IGT), largest manufacturer of slot machines for

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gambling machines, took more than 2 years to establish their R&D Department in China. IGT

had to bring their senior people and put them on the ground of China for more than 3-4 months

to just establish their Product Assurance (PA) department in China. Establishing their PA

Department in China, it cost them 20% more than their expected budget. Hence, putting this

experience in to simple words, one would rather say that until one's engineering, manufacturing

and purchasing folks have been to China, it is hard to even estimate startup cost of opening an

outsourcing center in China.

1.2. Struggle in Electricity

Sourcing from China also means exposing a company’s supply chain to disruptions that

are uncommon in the U.S. and Europe. Electricity is a huge problem in China right now. One

can have chronic shortages(). Hence in crunch time, it is not certain that your outsourcing center

is going to have power. So things may not run as smoothly in China as compared to U.S. or

Europe.

China’s economy has grown faster than its electrical grid and generation capacity, so

demand for electricity has outstripped supply. The government is working to bring more

generation capacity online, and the problem should be resolved within a few years(). Until then,

foreign multinationals should investigate the local energy situation before opening their

outsourcing center in China. The other solution to this problem can be - supplemental

generators. But before they go with this route, they have to estimate the cost of electricity used

through generators over period of 5-10 years, which is very hard to estimate.

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1.3. Copyrights Issues in China

Another risk while opening an outsourcing center in China is lack of enforcement of laws

protecting intellectual property(). One can simply put "copying is rampant in China". And while

a copycat probably would be unable to export knockoff products, such goods could be sold into

the Chinese domestic market, which is huge and growing. MNCs, therefore, need to be careful

about which technologies they share with their Chinese center. If a technology is especially

crucial to a company’s mission, it might best be kept in-house, even if production occurs in

China.

China’s record in the area of protecting one's intellectual property has been poor, and

companies contemplating setting up R&D facilities have been leery about reaping short-term

gains but long term losses, as they, in effect, train their own competitors to innovate in ways that

are quickly used against them().

The idea that China, as its own companies continue to grow and innovate, will rapidly

develop its own interest in enforcing patent law is one reason to be hopeful. But till then

companies should be more precautious regarding their intellectual properties, if they have their

outsourcing center in China.

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1.4. Communication Challenges in China

One’s biggest challenge in doing business in China is communication. It is hard to do

quality communication with Chinese people. Most Westerners think that most Chinese speak

English well. That is a big misunderstanding. The person who works in overseas marketing

does, but the engineers and quality control people don't. Most of the Westerners make their

presentations, unaware that they are not being understood 100 percent.

As you might know, Asians say "Yes" to almost everything. But the "Yes" can mean a

hundred things other than what we mean by "Yes" in the West. This phenomenon can invite

major problems. Also in the West, one likes to hear from his/her supplier every four hours when

there is a problem. They want their questions answered at once: “What are you doing to solve

the problem?”, “When is it going to be fixed?” etc. Most of North American and European

suppliers respond quickly. If they don't have the answer, they'll call or e-mail to let you know

that they are working on it. Typically, Asian suppliers will not do the same. If they don't have

the answer, you won't hear from them. They will avoid the conversation and are unlikely to even

send an e-mail confirming that they received your enquiry. Is this an avoidance tactic? Usually,

it's not. Asians do not like to respond until they have a complete answer. That would mean loss

of face. They think, "How will you be able to trust me in the future if I give you an inaccurate

response now?"().

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Challenges like these can create major problems while working with/in China. To

overcome few communication challenges one need to take following things in to

consideration().

➢ Do all the people in your firm who interact with your Chinese center know how to

communicate clearly with Asians?

➢ Do they know how to avoid getting the answer "Yes" to every question?

➢ Do they know the right questions to ask to elicit the required information?

➢ Hire quality managers who are technically skilled and who can communicate well in

Asian language.

➢ Set the expectation with China resources so that, if a problem occurs, they should let you

know right away, and that it's okay to respond without full details.

2. Transportation Challenges in China

Executives at Germany’s auto companies were flustered. They knew that China is among

the world’s fastest growing markets for vehicles — likely in a few years to overtake Japan as the

second largest after the U.S. Their efforts to tap its potential, however, were being constantly

stymied by factors such as variations in regional tariffs among the country’s 27 provinces and

the inability of local suppliers to meet quality standards for components. In the spring of 2004,

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Volkswagen, Audi, DaimlerChrysler and BMW chose to take matters into their own hands.

Recognizing that these problems were too massive to tackle individually, the companies formed

a joint logistics partnership called “Coreteam” to deal with logistics and supply chain issues. As

a BMW executive told a reporter, though the German automakers competed with one another, it

also made sense for them to collaborate and exploit synergies when they could().

The experience of the German auto companies serves as a metaphor for the logistics

challenge that confronts global organizations seeking to do business in and with China. One can

agree that China’s logistics sectors are much greater than they were in the past. Chinese shippers

are maturing, and big western firms such as UPS and DHL have begun to ramp up their

activities in China. Western entrepreneurs also have jumped in to fill gaps between the

manufacturing and retail sectors. Even so, China’s booming economy continues to outstrip the

growth of its logistics capabilities. China is growing so fast that, in some regions, it is straining

the capacity of its roads, railways and ports and testing the limits of its still young shipping

companies(). The bottom line implication: As companies draw up operations plans for China,

they need to place much greater emphasis on logistics than they might in a developed country.

The efficient distribution of goods and finished products is one of the biggest challenges

associated with China’s rapid growth. Greater strain has been placed on its transportation,

storage and distribution networks().

The growth of the logistic sector has been fuelled by rising demand for products and

services. China’s spending on logistics reached RMB 3.8 trillion in 2006 (USD 506 billion),

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having grown by 13.5 percent over the previous year. Market grew by a further 11 percent in

2007 to reach RMB 4.23 trillion().

Transportation accounts for the largest component of total logistics costs, with around 55

percent (RMB 2.1 trillion), followed by inventory storage costs (RMB 1.2 trillion) and

management costs (RMB 500 billion). These logistics numbers may be large, but they reveal one

of the key problems with the sector. As a percentage of GDP, logistics costs are over 18 percent,

and have been around this level since 2001. This is high as compared to other developed

countries, where logistics costs are typically below 10 percent of GDP. This high figure suggests

some operational inefficiency exist throughout the market(). Now let us examine each

component in China’s transportation system.

2.1. Air freight

Although China’s airfreight sector is constrained by inadequate infrastructure, its

development has been rapid. TI (U.K. -based research firm Transport Intelligence) projects

annual growth of 10 to 15 percent (assuming that road and rail remain substandard), with much

higher growth rates for services catering to high-value products such as electronics and

pharmaceuticals().

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China also boasts the second-largest domestic airfreight market in the world after the

United States. According to Boeing’s World Air Cargo Forecast, the market has grown at more

than 20 percent annually since 1991().

Airports are seeing rapid expansion in three principal economic areas: the Yangtze River

Delta (YRD), the Pearl River Delta (PRD), and the capital city of Beijing. Expansion in the PRD

is so significant that it threatens to cut into the volumes handled by Hong Kong, the world’s

largest air cargo airport.

2.2. Express package

China’s express parcel industry is creating a new history for China. With 40 percent

growth compounded annually, China’s express parcel industry has broken all the records. Now

permitted to buy domestic companies outright, growth in this industry is going to increase

beyond anyone’s imagination. UPS already acquired the rest of its venture with Sinotrans while

FedEx bought its joint venture from DTW. Arrival of foreign players has stirred up domestic

competition—for better and for worse().

2.3. Logistics outsourcing

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The big change in logistic outsourcing is the widespread recognition of the capabilities of

China’s homegrown companies for domestic logistics work. According to TI’s survey of

logistics in China, most of the western manufacturers and retailers are willing to look at Chinese

firms instead of multinational providers.

Most of China’s third party logistics providers (3PL) are clustered in the three main

economic regions. The sector remains heavily dominated by state-owned enterprises (SOEs)

such as COSCO and Sinotrans. Large SOEs will seek partnerships with foreign-owned

companies, but privately held operators, with their reputations for agility, flexibility and

entrepreneurial capabilities, are more likely to become acquisition targets().

2.4. Rail

Rail was the main form of transportation under the old communist model, but it has not

adapted to the new Chinese economy, says TI. It is primarily geared to moving bulk

commodities long distances. In theory, it should also have strong capability to move containers

from ports to inland cities. But it is a gross understatement to say that China’s railroads have a

chronic lack of capacity; they would need to double capacity just to cope with current demand.

China’s government has planned to make major investments in their rail infrastructure

according to their next five-year plan. According to China Logistics 2006, the Chinese

government’s long-term objective is to expand the network to around 100,000 kilometers, three

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times the current rate of track-laying, during the next five year(). The quality of infrastructure

will also have to be improved; only 30 percent of the system is electrified today.

Privatization may help for this initiative. Government of China can establish joint

ventures with companies like Sinotrans and COSCO, and develop more sophisticated

infrastructure for rail system in China.

2.5. Roads

Until the late '90s, much of China had rudimentary road system. The best network was

concentrated around coastal cities, and even there roads were variable in quality. From 2004,

there has been vast investment in road building, but the bias toward the eastern coastal cities has

increased().

The many internal barriers imposed by local governments, a situation that magnifies the

economic isolation of one region from each other, also limit development of road services in

China. Internal customs and policing barriers often favor certain transport activities and

organizations.

Since 1996, about two-thirds of government expenditure on infrastructure has been

invested in the road network. The program is scheduled to last until 2015, when the network

should reach about 35,000 km of toll highways(). Private-sector participation is being

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increasingly sought for road construction. But the needs will continue to outpace the road

network’s capacity for years.

2.6. Bureaucracy

The Chinese transportation and logistics market is one of the most highly regulated in the

world, according to TI. However, it is slowly opening up to outside competition, and this

process has been facilitated by China’s 2001 accession to the World Trade Organization.

TI notes that in addition to the regulations that control foreign access to the Chinese

market, there are other controls that constrain both foreign and domestic operators. For example,

the number of freight trucks is controlled through a permit system. Local or regional authorities

award permits, and restrictions are imposed on carriers from outside of the region. In addition,

there are myriad regulatory bodies, including China’s Ministry of Communications, the Ministry

of Foreign Trade, and the China State Post Bureau. Thus, getting the green light for any logistics

project in China still relies heavily on the strength of contacts within China’s bureaucracy().

There is much more to China’s fast-paced logistics story. This is just one angle of the

story. But for all its challenges, the China story is one that more and more U.S. and European

managers are finding that they simply cannot ignore. Of course MNCs like Wipro, TCS and

Infosys, which provides I.T. related services, would hardly have any effect on its operations by

transpiration barrier in their China; due to their core nature of the business. But MNCs who want

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to establish their manufacturing plant in China should analyze the existing condition of

transportation channels before thinking of opening their manufacturing plant in China.

Of course, there is much more to China’s fast-paced logistics story. But for all its

challenges, the China story is one that more and more U.S. and European managers are finding

that they simply cannot ignore. No doubt there will be other trade and political delegations to

petition for concessions on exchange rates or greenhouse-gas controls. But as long as there is a

Yuan to be made, the trucks will keep rolling, however slowly and inefficiently, all across

China.

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