by George W. Russell
The Chinese government has unveiled an ambitious plan to upgrade the country’s manufacturing sector to industrialized-nation standards and see off competition from other Asia-Pacific locations. George W. Russell reports on how CPAs can help keep a lid on expenditures and boost efficiency.
Despite their reputation in some quarters for being repressive sweatshops, many Chinese factories compare favourably with those in industrialized nations: some boast well-equipped dormitories, with gymnasiums, multiple food outlets, karaoke rooms, and even – in the case of a very few such as Apple contractor Foxconn – employee-run radio and television stations.
Mainland manufacturing has come a long way since 1978, when then-leader Deng Xiaoping began the economic transformation of China into the “factory of the world.” It was little surprise then that, last month, China unveiled a plan to revamp and upgrade its manufacturing sector to bring it up to industrialized-nation standards within 10 years.
Under the “Made in China 2025” plan, Chinese manufacturers are expected, within a decade to have boosted productivity through innovation and created multinational companies in 10 focus areas: information technology; controls and robotics; aerospace; shipping and offshore engineering; railways; alternative energy; power equipment; new materials; biotechnology; and agricultural machinery.
The ambitious agenda comes as Chinese manufacturing enters a crucial period. Rising wages and other costs – as well as competition from neighbouring countries – have challenged the Mainland’s pre-eminence. “China’s manufacturing industry is undergoing a transformation,” says Ricky Tung, Managing Partner of Manufacturing at Deloitte China and a Hong Kong Institute of CPAs member.
Manufacturers are keen to advance modernization to the next level, data suggest. A recent KPMG survey found a majority were willing to increase research and development expenditure in order to adopt new manufacturing technologies and drive growth.
China’s manufacturing sector has been incrementally moving up the value chain for decades, while strategies such as R&D emphasis are aimed at accelerating the process. “A number of toy, textiles, consumer electronics and other labour-intensive manufacturers have already re¬located to Southeast Asian nations as the production cost in China is too high,” says Tung.
Already China’s rapidly growing infrastructure gives it an edge over rivals. Another plus is that despite rising wages, China has a skilled labour force with a wealth of experience that can help manufacturers shift towards higher-value items.
That is reflected in trade data: the value of Chinese high-tech electronics exports to the United States rose 24 percent between 2011 and 2013, while exports of lower-value clothes and footwear rose just 5 percent in the same period.
Focusing skill sets
Many Institute members work in China’s manufacturing sector, and their skills are expected to be instrumental in transforming the sector by influencing costs and productivity. “You can make operational improvements – even if that might require a one-off capital expenditure – that creates a more efficient workplace,” advises Bob Partridge, Greater China Transaction Advisory Services Leader at EY.
One operational improvement is improving utilization rates in factories. “If you drive more output, you do extract some margin improvements,” says Partridge. “Sometimes those margin improvements are just enough to offset higher costs, such as a renminbi appreciation if you’re largely doing export.”
CPAs might have little control over labour costs but can still help boost efficiency. “I face a 14-15 percent increase in labour costs every year, but I can drive more than 15 percent efficiency,” says Eric Yuen, Chief Financial Officer of Dometic Group Asia Pacific, a maker of electrical appliances and an Institute member.
As business advisers, CPAs should first look at measuring organizational efficiency, Tung at Deloitte advises. “Find out your company’s current position, benchmark best practices from local peers as well as the leading multinational corporations, then identify the key areas for improvement.”
Companies need to be responsive to marketplace changes and customer demands, Tung adds. “An increasing number of companies will put more emphasis on information technology and automation in order to shorten process and response times,” he says, adding that introducing “smart manufacturing” is the final stage for companies maximizing efficiencies.
“Smart manufacturing aims to create an agile and less labour-intensive manufacturing environment that can quickly respond to changes in the marketplace,” says Tung. “It applies IT solutions to the production process to calculate the best allocation of various resources and time and utilizing advanced technology such as sensors, controls and robotics.”
The long-term key to China’s future, say some analysts, is making better products. Yi Ping, Shanghai Partner at Strategy&, the PwC-owned consultancy, says China can no longer rely on low costs to gain competitive advantages. “In the past, China successfully used its labour cost advantage and manufacturing skills,” says Yi. “To maintain such a position, China now has to adopt different strategies in the next economic cycle.”
Making better products actually can reduce costs, argues Mark McKay, As¬sociate Dean of the School of Business at Trinity Western University in Vancouver. “This is counter-intuitive.” He recommends introducing modern methodologies such as the Lean manufacturing system, which eliminates wastage, and Six Sigma, which eliminates defects. “With these techniques, companies can improve overall productivity, which offsets future rising costs.”
There are still many obstacles to China’s manufacturing ambitions. Logistics is one area that requires streamlining. “Look at how much it costs to ship something from A to B, including cargo, financing, and administration,” says Jonathan Woetzel, Director of McKinsey & Co. in Shanghai. “In China, it’s about 12-13 percent as a share of gross domestic product. It’s 5 percent in the U.S.”
Another problem that particularly affects multinational corporations with manufacturing operations in China is that they have concentrated on higher-priced exports, leaving them ill-prepared to compete with local companies for domestic Mainland consumers as the economy rebalances away from exports.
CPAs in the front line agree, pointing to low domestic demand for the multinationals’ high-end, locally made products. “Chinese consumers are still very price-sensitive and the domestic demand for high-quality products is limited,” says Institute member George Tang, CFO of Cree, a U.S.-based maker of lighting products with extensive China operations.
More importantly, China’s manufacturing sector has had difficulties making the transition to higher-value capital goods. Machinery exports – a crucial indicator of a country’s ability to make and sell complex manufacturing products – have stagnated as a share of total exports in recent years.
“From the 1980s, there was a steady improvement in the kinds of goods China was manufacturing and exporting, as it moved away from making lower-value consumer goods to making higher-value capital goods,” Andrew Batson, Lead Analyst at GK Dragonomics in Beijing, observed in a February research note. “That transition has more or less stalled, with the composition of China’s exports today little different from what it was in 2008.”
Batson says that is “bad economic news” with serious implications for China’s future. “Making the transition to higher-value and more capital-intensive exports is part of the way that successful developing countries, like South Korea and Japan, earned their way to the high-income status they enjoy today,” he notes, adding that capital-intensive goods mean rising labour costs are less important.
China’s export advantage has also been affected by the appreciation of the renminbi. “I think 10 years ago China was the best low-cost hub,” says Partridge at EY. “But the appreciation of the renminbi means buying goods in China is not as cheap as when it was fixed at 8.277 to the U.S. dollar.” (The rate as of 31 May was 6.20 to the U.S. dollar.)
The future of China’s manufacturing sector has profound implications for Hong Kong, because of its proximity to Guangdong, where older established factories are concentrated. “The industrialization era, while providing very positive economic benefits, also created a number of challenges, such as environmental issues,” says Peter Liddell, Partner and Asia Pacific Head of Strategy and Operations at KPMG China.
The government, Liddell notes, is responding to these challenges through policies that discourage investment in “dirty” manufacturing. “New manufacturing clusters are emerging, especially in the western and northern regions,” he says. “Therefore many historical manufacturing clusters in the southern and eastern provinces will need to seek alternative industries to support local employment.”
The changes have already caught the attention of companies that sell and lease industrial property in the Pearl River Delta. “There will be less demand for small factory facilities, given the decrease in export-oriented manufacturing,” Frank Chen, Executive Director and Head of Research at CBRE China, says of China’s traditional manufacturing clusters.
The nature of manufacturers will also change, analysts predict. Tung at Deloitte forecasts that manufacturing companies will evolve away from the idea of simply providing a product. “There is an increasing demand for ‘solutions,’ which blends the concepts of ‘products’ and ‘services,’ better addressing customers’ needs.”
Meanwhile, China is expected to gradually change from a “manual” to an “automatic” manufacturing process, according to Yi at Strategy&. “The Internet and automation will be very important, covering not only the manufacturers themselves but also their suppliers, distributors and customers,” she says.
Automation will not eliminate human workers, but might mean that different skills will be sought. As Chinese manufacturing moves up the value chain, will there continue to be enough skilled workers able to keep pace? “A major issue for China is that more than 74 percent of highly skilled technicians with national certification are above 46 years old,” says Liddell. “The government has announced that it would study an incremental extension of the retirement age and [that] will help solve the labour shortage.”
The size and competitiveness of the workforce are likely to maintain China’s status, some analysts forecast. “China is likely to continue to play a major role in global manufacturing for some time,” says Paul Gillis, Professor of Practice at Peking University’s Guanghua School of Management. “The key to its continued success in manufacturing will be continuing to increase the skills of Chinese workers. China won’t be able to compete on price, but they can win on quality and efficiency.”
This article was originally published in the June 2015 edition of A Plus. The pageflip edition can be found here.
Competitors don’t have track record
When the Chao Phraya River burst its banks in October 2011, it wasn’t just flooded rice paddies that crimped Thailand’s exports. Seven industrial estates in Ayutthaya province were ravaged, severely impacting the automotive and electronics industries’ global supply chains.
The floods underscored the difficulty of diversifying manufacturing out of an increasingly expensive China and into its cheaper neighbours, such as most of the 10 members of the Association of Southeast Asian Nations.
“I think the flooding, coupled with recent political unrest, showed that while Thailand might be cheaper than China, there are other factors to consider,” says Bob Partridge, Greater China Transaction Advisory Services Leader at EY.
Another potential competitor, Vietnam, has its own issues, Partridge adds. “Vietnam might have a very low cost base, but you’ve got a limited pool of skilled labour,” he points out.
Nevertheless, the lure of lower costs amid an increasingly expensive Chinese manufacturing environment is prompting manufacturers to move some operations to both those countries, as well as to Indonesia and Myanmar.
“However, they are now faced with new challenges, including inconsistent product quality, supply variability and poor supporting infrastructure,” says Peter Liddell, Partner and Asia Pacific Head of Strategy and Operations, KPMG China.
Companies will continue to keep most of their eggs in a basket in China, Partridge adds. “I don’t think we’ve seen people shutting down plants in China and moving them,” but, he adds, companies that are adding production lines are splitting them between China and ASEAN countries.
South Asia is also offering potential competition as a manufacturing location. “Global supply chain managers are beginning to see benefits in operating within India as a regional manufacturing hub with similar demographics as China,” says Amit Kumar Sarkar, Partner at Grant Thornton in Mumbai.
Handling high-tech remains a challenge
When the global financial crisis crippled world trade, cutting the revenue and value of many multinational corporations, some Chinese manufacturing companies saw an opportunity.
Since then, they have been on an overseas acquisition spree to obtain advanced technology as well as access to new markets. “This enables Chinese manufacturers to move up the value chain and better position themselves to compete with global brands,” says Ricky Tung, Managing Partner of Manufacturing at Deloitte China and a Hong Kong Institute of CPAs member.
Mainland manufacturers are also likely to be helped by a favourable regulatory environment under the “Made in China 2025” plan to boost the high-tech sector.
Large, mostly state-owned Chinese manufacturers – with crucial government support – have had some success in making military aircraft and space exploration vehicles as well as integrated power plants. In April, railway company CSR announced it would bid to build and run the United Kingdom’s proposed London-Birmingham high-speed link.
There have also been setbacks in some sectors. “China has built a plane of its own and that by itself has fuelled tremendous investment in the aviation sector, likewise the whole push on high-speed rail,” says Bob Partridge, Greater China Transaction Advisory Services Leader at EY. “However, the public is concerned whether that’s been done with less than full regard for public safety.”
Smaller Mainland companies have also excelled in several high-tech fields, says Gordon Orr, Director at McKinsey & Co. in Shanghai. “Biotechnology, pharmaceuticals, consumer electronics, medical technology, drones, grapheme products and telecommunications equipment are just some of the sectors where aggressive Chinese midsize companies lead the way in their field,” he says.