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Is China in your future? - 2013-06-21 15:20:57

Grant Thornton LLP analysis of China operations

Contents
1 Introduction
2 Why manufacturers flock(ed) to China: It started with the money
3 Practices and performance: How China and U.S. plants line up
4 Does China belong in your future?
5 Considering China: 10 things to think about

Introduction
Over the past five to 10 years, a huge number of companies shifted their production to China to take advantage of lower wages, favorable tax rates and a vast market of potential consumers in Asia. A wide array of global brands established themselves in China, including computer-maker Lenovo, appliance-maker Haier and brewer Tsingtao. For a time, it seemed that China's industrial growth potential was limitless. Its gross domestic product (GDP) experienced double-digit increases year after year, reaching $4.42 trillion in 2008. The prevailing question among manufacturers was not if they should produce in China, but when.
Then came the global economic slump. Demand contracted sharply. Economic uncertainty ratcheted up. The pace of China’s industrial revolution slowed considerably. China manufacturers scaled back production schedules and procurement of raw materials, impacting suppliers in Asia and the United States. Exports fell more than 25 percent from a year ago.1 In January and February of this year, profits of China’s industrial companies fell 37 percent from the same period a year earlier, to 219.1 billion yuan (around $32.1 billion).2 Millions of factory workers were laid off as manufacturers cut production in response to the shrinking demand and growing uncertainty. Many analysts predict continued weakness in industrial profitability in the coming months.
Despite the slower pace of growth, China’s GDP still expanded nine percent in 2008.3 The country’s economy is forecast to grow in 2009, albeit at a slower pace than prior years. Many U.S. manufacturers and distributors continue to leverage the low-cost capabilities of China manufacturers by sourcing raw materials and components and/or outsourcing production of components and finished goods. Indeed, many manufacturers see China as a critical component of their supply chains, the global economic slowdown notwithstanding.
Each manufacturer must approach its China decisions on a company-by-company, supply-chain-by-supply-chain basis. At the same time, because manufacturing costs in China have risen in recent years (considering such factors as increased salaries, internal transportation costs, corporate tax rates, lease rates and environmental compliance costs), many manufacturers may prefer to look elsewhere in Asia or to keep production in their home countries. Other low-cost developing countries that may merit consideration include Vietnam and Bangladesh.

1 Nelson D. Schwartz, “Rapid declines in manufacturing spread global anxiety,” The New York Times, March 19, 2009.
2 Andrew Monahan, “Profits at Chinese companies continue to decline,” Wall Street Journal, March 30, 2009.
3 Xinhua News Agency, “China’s GDP grows 9% in 2008,” China.org.cn, Jan. 22, 2009.

Even with the recent declines in industrial profits, there still are opportunities in China for certain companies. Many forward-looking organizations continue to ask: Is China in my future?

• Should my company take advantage of China’s production capabilities? Can we build high-quality products while avoiding delays in an extended supply chain? Is the cost advantage between China and other options (including keeping work in the U.S.) still sizeable?

• Does my long-term business strategy include selling to Western and locally owned domestic companies in the Asia-Pacific region? If so, what are our manufacturing and operational strengths, and how can we differentiate ourselves from China manufacturers? What are the first steps in developing these relationships in China?

• Can we build facilities and produce in China? Can we capitalize on local pricing? Can we apply our cultural and organizational principles in a Chinese work environment?

Is China in your future? offers useful insights into China manufacturing operations and strategic considerations (go or not go, make vs. buy, supplier selections, plant expansions or closings). Based on data from the 2007 China Manufacturing Study,4 we point out both the operations capabilities and the challenges of China manufacturing.

Also included in this report is “Considering China? 10 things to think about,” which offers practical advice from Grant Thornton experts in the U.S. and China. As a global audit, tax and advisory network, Grant Thornton International Ltd member firms in mainland China and Hong Kong encompass nearly 1,700 partners and staff, providing us with an immediate perspective on the real-world issues facing U.S. manufacturers in China every day.

We hope you find this insight into the China manufacturing marketplace valuable as you evaluate whether China is — or is not — in your future. It’s our job to help you make the strategic and operational decisions that will boost your organization’s bottom line for years to come.

Grant Thornton LLP analysis of China operations
Introduction
Wally Gruenes
National managing partner, Consumer and Industrial Products,
serving manufacturers, retailers and distributors
214.561.2640
Wally.Gruenes@gt.com
Stephen Chipman
CEO, Grant Thornton
China Management Corporation
Stephen.Chipman@gt.com
4 Data analyzed in Is China in your future? are, unless otherwise footnoted, from the 2007 China Manufacturing Study by the Manufacturing Performance Institute (MPI) of 402 China plants that were either ISO 9001-certified or in the process of certification or recertification. Sixty-two percent of plants surveyed were part of private companies, 15 percent were foreign enterprises, 11 percent were joint ventures, and 11 percent were state-owned. This report also incorporates data from the 2007 IndustryWeek/MPI 2007 Census of Manufacturers of 433 U.S. plants. For most questions seeking specific numeric metrics, respondents were asked to report “Current year” and “Three years ago” figures. For this report, this data are referenced as “2007” and “2004,” respectively.Grant Thornton LLP

analysis of China operations
Why manufacturers flock(ed) to China: It started with the money
It’s hard not to focus on the factories that have closed in recent months as consumer demand has fallen. Exports have shrunk, while at the same time domestic consumption within Asia has declined sharply. But the right-sizing of manufacturing and production within China in late 2008 and early 2009 does not explain why companies headed, often in droves, to China in the first place, why many have stayed, and why newcomers continue to arrive, albeit at a slower and more cautious pace than in the past.
Clearly, most were compelled by the relative cost advantages and performance of factories in China, which earned an impressive 50 percent median return on invested capital (ROIC) in 2007. That is nearly three times higher than the median ROIC in U.S. plants (18%). Put simply, most China plants post excellent returns relative to U.S. plants.
The financial performance on plant floors in Guangzhou, Shanghai, Shenzhen and elsewhere in mainland China represents substantial cost savings for many North American manufacturers. The gross margin advantages may be impressive, but companies need to keep in mind that much of that margin is labor arbitrage. In fact, when comparing 2007 sales-per-employee productivity, the median in China is $205,200,5 nearly identical to that of U.S. manufacturers. 30% 18% 20% 25% 50% 55% Plant costs as a percentage of cost of goods sold China plantsU.S. plants Labor Overhead Materials Return on invested capital(Net operating profit after taxes ÷ by capital invested) MedianChinaU.S.50%18% Cost of goods sold as a percentage of plant revenue MedianChina plantsU.S. plants30%68%
It’s worth noting that the labor situation in China isn’t static. Changes in China’s labor laws have sought to develop more employee-friendly organizations. Employers now have greater responsibility with regard to employee overtime, layoffs and firings. Further, when times were good, workers tended to jump from company to company in search of higher wages and better benefits. Now workers are in ample supply due to the economic slowdown, so employee turnover is down substantially.
5 Figures originally in RMB and then converted for year 2007 to U.S. dollars at a Jan. 1, 2007, rate of 0.12825.
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Grant Thornton LLP analysis of China operations
Practices and performance: How China and U.S. plants line up
Especially given today’s economic environment, any decision to manufacture in China needs to be made with one’s eyes wide open to the practices common in the China manufacturing sector. Our research and the experience of Grant Thornton professionals “on the ground” in China note differences from U.S. practices in a number of areas, such as:
• customer reject rates
• on-time delivery/overall equipment effectiveness
• labor and personnel-development practices
• quality improvement practices
• strategic initiatives and inventory management techniques and
• marketing strategies.
Customer reject rates
For the most part, the plant-floor metrics of facilities in the 2007 China Manufacturing Study resemble those of Western firms. One notable exception: China represents a disadvantage in customer reject rates. China has a median 50,000 parts per million (ppm), compared to 100 ppm in the U.S.
On-time delivery/overall equipment effectiveness
China seemingly demonstrates an advantage over the U.S. in on-time delivery and overall equipment effectiveness (OEE). However, China’s median on-time delivery of 100 percent likely is a product of the local definition for “on-time” (possibly “shipped” rather than “delivered”), while China’s median OEE of 90 percent may mean that equipment is running far past its designed rate in order to keep pace with demand. Even though the operational results of China and U.S. plants are comparable, the methods and practices used to achieve them may differ significantly. For example, to reach 100 percent on-time delivery, a China plant may cover delays by throwing more manpower at its problems. To resolve quality problems, a China plant similarly may use more labor, reworking and redoing products until the outcomes are acceptable — although poor quality, as headlines over the past year clearly proclaimed, still makes its way out of China.
Practices/performance measures
China plants U.S. plants
Warranty costs (% of sales) 1.0% 0.9%
Customer reject rates (ppm) 50,000 100
Customer retention rate 95.0% 98.0%
Overall equipment effectiveness 90.0% 90.0%
Manufacturing cycle time (hours) 16 20
Customer order lead time (days) 7 11
On-time delivery rate 100.0% 96.0%
Finished product first-pass quality yield 98.0% 97.0%
Scrap and rework (% of plant sales) 2.0% 2.0%
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Labor and personnel-development practices
How do China and U.S. labor practices differ? It starts with the workforce, as there is little empowerment/self-direction among China production workers. Nearly half of all plants (47.9%) have no empowered workers and only 8.3 percent have a majority of their workforce empowered (just 28.5% of U.S. facilities had no empowered workers, and 29.7 percent reported majority empowerment). Surprisingly, this lack of empowerment is present even in plants with Western connections: joint ventures (40% have no empowered workers) and foreign enterprises (47%).
Levels of employee training vary considerably in China. More than four in 10 China plants (41%) report that they trained workers for more than 40 hours per employee per year, a world-class effort, but another 21 percent report that they trained less than 8 hours per employee. This is in contrast to 18 percent train workers for more than 40 hours and 18 percent that train workers for less than 8 hours.
Quality-improvement practices
A well-trained, empowered workforce is necessary to undertake improvement initiatives, particularly lean manufacturing and its culture of problem-solving and use of the scientific method. So it’s not surprising that lean manufacturing hasn’t taken root in China. Just 25.1 percent of China plants report using lean manufacturing (vs. 69.6% in the United States). This could represent either a great opportunity for plants to improve performance or, conversely, the inability of China’s management culture to support lean manufacturing. Even among joint ventures and foreign enterprise plants, only 34 percent and 35 percent, respectively, report deploying lean and/or the Toyota Production System (TPS).
Finally, a high percentage of China plants (81.7%) report using Total Quality Management as an improvement approach, compared with only 34.2 percent that employ this approach in the U.S. This high percentage is understandable given the China Manufacturing Study’s population of ISO-certified plants. As in any market, however, one should be cautious when evaluating the ISO certification of plants. It is important to ensure that the procedures established to achieve ISO certification are consistently followed and actually producing tangible benefits.
Grant Thornton LLP analysis of China operations81.7% 34.2% 25.1% 69.6% Improvement methodologiesChina plantsU.S. plantsTotal Quality ManagementLean manufacturing47.9% 28.5% 36.8% 27.8% 7.0% 14.0% 3.1% 11.5% 3.4% 7.2% 1.8% 11.0%Percentage of production employees that participate in empoweredor self-directed work teams China plantsU.S. plants0%1 - 25%51 - 75%26 - 50%100%76 - 99%
A well-trained, empowered workforce is necessary to undertake improvement initiatives, particularly lean manufacturing and its culture of problem-solving and use of the scientific method.
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Strategic initiatives and inventory management techniques
The pursuit of individual strategic practices and inventory management techniques among China plants are much less common than in the West. For example, more than three in four U.S. companies (77%) have a continuous improvement program, compared with less than half of China plants (48%). Forty-three percent of U.S. companies use benchmarking processes, while only 19 percent of China plants employ benchmarking.
In some instances, adoption rates for best practices are comparable to those in the United States, including customer satisfaction surveys, total productive maintenance and quality certifications.
Marketing strategy
In the area of marketing, when asked to identify their top three strategies, China plants report “high quality” as their leading strategy (cited by 83.3% of plants), despite some Western perceptions to the contrary. The majority of China plants also report low cost (56.6%) and innovation (53.9%) as key marketing strategies. In contrast, U.S. plants focus most on high quality (73.7%), service and support (55.8%), and total value (41.2%).
Given the emphasis on service, support and total value among U.S. companies, manufacturers should be wary of the large number of China plants that do not consider service and support (only 28.2% select this among the top three marketing strategies) or total value (a mere 5%) as part of their go-to-market strategies.
Grant Thornton LLP analysis of China operations
Pursuit of practices/techniques
China plants U.S. plants
Continuous improvement program 48% 77%
Kaizen events/blitzes 20% 46%
Benchmarking 19% 43%
Recycling/reuse programs 17 % 56%
Value stream mapping 9% 46%
Focus of marketing strategies (multiple responses allowed)
China plants U.S. plants
High quality 83.3% 73.7%
Low cost 56.6% 26.8%
Innovation 53.9% 26.8%
Service and support 28.2% 55.8%
Fast delivery 23.9% 32.0%
Product variety 23.2% 13.4%
Customization 17.0% 26.6%
Total value 5.0% 41.2%
The pursuit of individual strategic practices and inventory management techniques among China plants are much less common than in the West.
*Survey participants each selected three objectives to describe their marketing strategies.
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Grant Thornton LLP analysis of China operations
Does China belong in your future?
Ultimately, expanding production capabilities to China, or even sourcing components and materials there, may be a vital component of your corporate strategy.
There’s little doubt that the global economic environment has shifted since the original data from the China Manufacturing Study were gathered in 2007. Production levels have fallen markedly. Many factories have closed their doors. Consumer demand has shrunk, while global anxieties and uncertainties have heightened. But even with these market shifts, the fundamental trends, issues and advantages of operating in China remain valid today.
Your company’s strategic development and execution shape its future success. These determine whether your company will be able to succeed in the face of the unrelenting pressures facing manufacturers today. Customers demand high value at a lower price. Global competition is stiffer than ever. Clients treat every product as a commodity that can be procured from the lowest bidder. Ultimately, expanding production capabilities to China, or even sourcing components and materials there, may be a vital component of your corporate strategy.
Making sound decisions about global manufacturing and supply chain strategies requires careful analysis and considerable due diligence. In order to assist companies in navigating this difficult process, Grant Thornton advocates a Solution-ChainSM approach to manufacturing. This technique rigorously examines all the possibilities of where and how goods can be produced, while building world-class capabilities throughout the organization with the right mix of internal and external capabilities. Solution-Chain manufacturing requires you to understand that your business will function in a new way, developing measures to gauge potential operations performance, total costs (including nonoperational factors such as tax ramifications) and margins. Then, prioritize your corporate strengths and core competencies relative to your weaknesses, and make thoughtful decisions about whether certain aspects could be sourced elsewhere. This may mean exploring sourcing from China or other countries, such as Vietnam, Bangladesh, India or Mexico. By adopting a Solution-Chain approach, you will be investing in your core competencies and strengths, while at the same time establishing strategic relationships (e.g., outsourcing, joint ventures, overseas expansions) that can present opportunities for improved margins and even increased customer satisfaction.
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If you are thinking about moving operations to China, you should consider the following critical issues:
• Total costs: Do you really understand the total cost of doing business in China, and how that will change based on different scenarios (e.g., outsourcing vs. joint venturing or wholly owned manufacturing)? Have you done the math on freight costs, duties, inventory carrying costs, travel costs, etc.? And how will these costs change as China’s industry matures? How will your company take advantage of manufacturing capabilities in Asia and incorporate these benefits into a global strategy?
• Impact on your customers: How does a global manufacturing and supply chain strategy affect your customers in the Asia Pacific region and the U.S? Should your company develop separate manufacturing and supply chain strategies for the Asian market and North American markets? For North American clients, what manufacturing and supply chain strategy will assure high quality, timely and right-sized deliveries, and order flexibility?
• Risks and intangibles: What are you risking by going to China with sourcing and/or selling goods? Intellectual property? Proprietary processes? If it can be lost, assume it will be. Will your China partners be able to grow (managerial talent, skilled labor, etc.) as your firm needs? Can you ensure and document for your customers that the China goods incorporated into your products meet standards (e.g., green manufacturing and quality)?
• Business environment: Do you fully understand the China legal, regulatory and reporting environment? Do you have the skills or resources to navigate the country’s famously complex bureaucracy? Are you prepared to grapple with the challenges of transfer pricing and tax-efficient structuring to maximize the value of your company’s investment?
Despite the economic slowdown, many U.S. companies continues to leverage the low-cost capabilities of China manufacturers and other benefits of doing business there. China still may be in your future. Take the time now to make sure your company is there for the right reasons.
Grant Thornton LLP analysis of China operations
Considering China: 10 things to think about
Grant Thornton LLP routinely advises clients with established operations in China, as well as those that are considering taking the China plunge. We work hand-in-hand with Grant Thornton International Ltd member firms in mainland China and Hong Kong, to provide seamless and comprehensive advice and service to our U.S.-based clients.
Based on our collective experience, here are 10 issues we urge you to factor into your decisions involving China expansion.
1. Transfer pricing documentation – Both Chinese and U.S. tax laws require intercompany transaction documentation. New Chinese rules require specific annual reporting forms to be filed with Chinese tax authorities, and contemporaneous documentation is a mandatory obligation for taxpayers if they meet China’s documentation threshold. The overall transfer pricing audit environment has become more stringent in China, and companies should ensure compliance to avoid transfer pricing audits and subsequent adjustments/penalties.
2. Tax-efficient structuring – Investments in China may be structured in a way that aligns a company’s global tax strategy with its operational plan. Tax-efficient structuring addresses the complexities of international tax laws and may provide a reduction in total taxes paid.
3. Tax compliance – One of the major issues faced by many enterprises in China is the emphasis placed on negotiation with authorities on the tax compliance process. Successful negotiation requires a comprehensive understanding of the tax system and the ability to reach a mutual understanding with tax authorities. It also is critical to develop sound relationships with knowledgeable tax authorities.
continued >
Information pertaining to Chinese tax laws and regulations was provided byGrant Thornton China member firm.
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Grant Thornton analysis of China operations 9
4. Accounting requirements – In recognition of the changing environment (due to economic reform and the open policy), accounting laws and regulations have been formulated for enterprises with foreign investment. These accounting laws and regulations are generally close to internationally recognized accounting standards, although differences exist. Statutory audits are required for enterprises with foreign investments.
5. Incentives for business activities – Incentives are available for various business activities. Under the new tax rules, most incentives are provided to enterprises that fall within “encouraged industries,” regardless of their location or ownership by foreign enterprises. These include customs and tax incentives and other preferential treatment.
6. Due diligence – Performing due diligence in China is very different from performing due diligence in the United States. While deal-makers understand that execution takes longer in China, many still underestimate the time it takes to close a transaction. Access to information in China may be restricted or difficult to obtain, and financial and tax records may lack transparency. There may be a need to focus more on operational due diligence as opposed to traditional financial due diligence.
7. Control of foreign investments – Exchange controls are monitored by the State Administration of Foreign Exchange and the People’s Bank of China. For foreign investment enterprises and individuals, revenue and expenses in foreign currencies have to be deposited with or withdrawn from accounts with the Bank of China or another authorized bank. After-tax profits or income on foreign investment enterprises or individuals can be remitted outside mainland China, provided tax liabilities due for covered transactions are appropriately cleared.
8. Corporate governance – The Sarbanes-Oxley Act of 2002 requires U.S.-listed companies, as well as their China operations, to document and evaluate corporate governance and internal controls over financial reporting. The newly enacted Basic Standard for Enterprise Internal Control, effective July 1, 2009, will require all listed companies in China (including domestic-listed entities of foreign enterprises) to assess and report on the enterprise’s internal control system.
9. Labor Contract Law – The Labor Contract Law, effective on Jan. 1, 2008, applies to all enterprises, individually owned economic organizations and private nonenterprise work units in China. Under the Labor Contract Law, there are four types of contracts, and the contracts must be written to establish labor relationships.
10. Enterprise Bankruptcy Law – The Enterprise Bankruptcy Law, effective June 1, 2007, provides for structured regimens of bankruptcy, restructuring and conciliation applicable to any People’s Republic of China-incorporated enterprises including state-owned enterprises and foreign investment vehicles. There are specific provisions dealing with cross-border insolvency issues.
Grant Thornton LLP analysis of China operations
Considering China: 10 things to think about (continued)
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