The Haier Model: Using Rural China as a Classroom for Overseas Growth

Companies generally play in overseas markets by investing and selling in those markets. In his paper titled, “Going Out by Going In,” Marshall Meyer, emeritus management professor at Wharton, proposes an alternative. He suggests that firms in emerging markets that have found ways to successfully sell into the country’s vast and inaccessible rural market seem to develop the capability to expand in overseas markets.

According to Meyer, firms like Haier in China can “draw revenues from overseas by penetrating previously inaccessible domestic markets and then renting their distribution and service channels to foreign competitors.” In a discussion with Knowledge@Wharton, Meyer explains his argument. “You are capturing distribution and services revenues and profits, which can actually be much greater than manufacturing profits. And, in this sense, you are taking money away from your foreign competitors. It’s not acquiring revenue abroad, but it’s acquiring revenue domestically that might otherwise go to foreign competitors.” These channels could also be the prototype to enter emerging markets outside China.

An edited transcript follows.

On the title, “Going Out by Going In”:

The idea is that by going into otherwise inaccessible regions of a country, you can capture revenues from abroad. That’s an unusual idea. For companies, the paper poses both opportunities and challenges. The opportunity in China is this: you, too, can rent the Haier channel. It might be a very efficient thing to do rather than to try to establish independent distribution networks. There are costs and there are risks. But it’s an option.

For those seeking to emulate Haier in China, it’s a real challenge because the first-mover advantages are dramatic. And Haier’s market share in the countryside is very high. For companies seeking to emulate Haier outside of China, that’s where the ballgame becomes very interesting. Who will be the first, for example, to do the same? Let’s go to India. Who will be the first to do the same in other regions? Will this also be a Chinese export? Or will domestic companies, given the home advantage, figure out the path to the countryside and rent it out to others as Haier has done in China? Only time will tell.

On what inspired this research:

The idea came from meeting the team that designed the rural distribution system for the Haier group. I think I met them in Qingdao in July, 2010. But for their leader, they are all youngsters in their 20s. And they described to me how very powerful team incentives — part of the Haier management system — motivated them to rethink rural distribution in China entirely. They asked the obvious questions. What are we doing? Why are we doing it? What are the alternatives? Almost no one had asked these questions because the traditional 5,000-year-old system had hardly changed.

What they discovered through very careful analysis was that, at a certain scale, it became much more efficient to substitute a circular for a radial distribution system. Once they had that idea, the rest was easy. Implementation was not easy, of course. But, conceptually, the redesign was easy. I was totally taken with this. And I put it in my back pocket.

The idea came to fruition, however, when I went back, reread and rethought the 2008 paper I had written with the [late] Max Boisot (“Which Way through Open Door”). So, it’s a combination of two things. One is meeting the team — very, very important – and understanding their process. And then, second, being asked to rethink a paper published in 2008, really written in 2006. And that rethinking then brought the conclusions you see.

On how the research was conducted:

Well, there are two methods. Method No. 1 is boots on the ground. Quite apart from interviewing the team, I went out into the Chinese countryside and watched the distribution system, watched these teams at work. I’ve done so as recently as March. I don’t have to go very far inland. I’ll go out into the rural counties of Qingdao and Southern Jiangsu. Even the rural counties around Beijing can be very poor. I observe how the goods are distributed, how they’re sold.

I typically go back to the same sites to judge change over time. It’s the combination of repeated field observation with meeting the teams. Then, with introspection, thinking about it, that produces this result. Now, I’m going to tell you about some of the developments, about one merchant in rural Qingdao, about an hour away from the metropolitan area, whom I’ve visited now three or four times.

“The most surprising piece here … is the speed with which organizational innovation takes place. It’s almost as if the organizational chart changes every Saturday morning.”

His name is Wang. There are lots of people named Wang in China. He’s from a village near Qingdao. He’s a very plain man. Even today, in the summer, he wears sandals and not shoes. He started a small business with an investment of maybe RMB60,000 — less than $10,000 at the time. It was a town-level store where he made large appliances and small electronics goods for local residents. He’s gained enormously from this distribution system because he doesn’t have to keep much inventory, he doesn’t have to tie up money in inventory. He doesn’t have to tie up time going to the city to make the purchases.

Here’s the part I found so interesting. First of all, he doesn’t compete on price. I’ve watched customers come and go. I’ve watched him refuse to drop prices – he may add some gift but no major drop in prices. He does compete on service. Usually the deal is, “Tell you what, if you’re able to make this purchase today, I’ll put it on the back of my truck right now. We’ll take it to your house and you’ll get a free ride home.” That often clinches the deal.

Beyond this, he’s developed a network of representatives, of coordinators in the small villages. The villagers, only 10 minutes away or so, collectively make a trip to town to visit his store. And that business has grown to the point where he has opened outlets in the villages. The last time I got to see the first of them — a small room, very plain merchandise. But there you have it. He’s created a second business; he will create a third. And his business has grown dramatically as a result of the distribution information systems described in the paper.

On whether the research findings might apply to firms from other emerging markets:

There are a couple of answers. One is just arithmetic. If you have a first-mover advantage, as Haier has in China’s rural markets, then you can rent that highway — the Haier highway — out to other firms, including your direct competitors. You can extract not only highway tolls but also you can gain further revenues through providing service that foreign competitors aren’t able to provide. What you are doing is capturing at least one end of the smile curve [the value-adding potential of a chain first propounded by Acer founder Stan Shih]. You’re capturing distribution and service revenues and profits, which can actually be much greater than manufacturing profits. In this sense you’re taking money away from your foreign competitors. It’s not acquiring revenue abroad, but it’s acquiring revenue domestically that might otherwise go to foreign competitors.

Now, the larger question — it’s a trickier question — is whether the capability, the rural distribution capability at home, is transferable abroad. And, quite frankly, I don’t yet know the answer. Why is that? It’s because China’s unusual. Any country that size — China, India – is going to be unusual; it will have unique characteristics. China’s case is a little bit in contrast to India because the physical infrastructure is fairly well developed; it’s easy to roll out the trucks in a way that is efficient. Very few Chinese firms have taken advantage of these potential efficiencies. It’s the result of tradition. It’s the result of having small and fragmented markets. It takes a while before there’s breakthrough thinking about distribution in China. But once the breakthrough thinking occurs, it’s possible to actually implement this thinking, given that the asphalt’s all in place and large, efficient trucks can be moved around with a day’s worth of distribution for many, many outlets.

India could be different. That’s because my sense is that the highway system’s not as well developed. So implementation of a similar platform in India may prove difficult. That said, the success in China might motivate Haier or Haier’s competitors in India to try to do the same somehow.

“My question is whether they are going to ultimately solve the problem of enterprise reform by spinning little pieces out of large organizations and having [them] become the central economic actors in the market place of China.”

It will be interesting to see. I’m not really an expert to discuss the distribution issues in India, Latin America, and sub-Saharan Africa. My guess is that the economies, especially sub-Saharan Africa, look not only a lot like China but may also be an exaggerated version of China, where you have prosperity in the port cities and much less development in the hinterlands. The question is the role of physical infrastructure in opening distribution there. Circumvent the problems of physical infrastructure or correct those problems and then, yes, the Haier model has enormous applicability outside of the Chinese context.

On whether the Haier model can be used by online retailers:

It’s incredibly relevant for Alibaba. You probably read that Alibaba has made a $360 million investment in a joint venture with Haier [old technology]. The new technology [Alibaba] requires the old technology to move the goods. The intent of the joint venture is to open distribution for all large goods, including furniture, sold over Taobao Tmall by Alibaba into the countryside of China. The joint venture is in its early stages. Who can guess what the success will be? But, yes, it’s very, very relevant.

On Haier’s Strategy:

Is Haier’s strategy to make more refrigerators at a time when manufacturing is becoming something of a commodity? Or is their strategy to hit the two ends of the smile curve? One side is design; the other side is distribution and service. This is where the money is. Will they decide to roll up their sleeves and try to do in other countries what they’ve done in China? I don’t know the answer to that. I’ve raised the question with them. And, quite frankly, the senior managers, when they hear the question at first, almost don’t grasp it because they have so focused on China as the base of their operations.

My bet, however, is that they’ll try. They will do so in a small country. They will do so following their general model of internationalization. Remember, they were offered — they almost had the right of first refusal — Maytag in the U.S. They did not do it for many reasons. In part, they were less confident than they are now. They were smaller. But there are other reasons as well.

One of their key Western acquisitions has been Fisher & Paykel, the New Zealand-based, high-end appliance company. Great brand. But they are acquiring it in part for the technology. They have advanced technology. They are acquiring it in part because New Zealand is a small country. It may be a very good place for Haier to learn a lot more about Western markets at a lower cost.

On the Speed of Innovation:

The most surprising piece here for a person brought up in this culture is the speed with which organizational innovation takes place. It’s almost as if the organizational chart changes every Saturday morning when the senior management meets. I attempted to grasp the details. The ink is barely dry on paper and there’s Version 2, Version 3, Version 4. That’s the nature of the management process in China. And it makes research as we know it — as Western scholars know it — a little bit challenging because we want to get data. We want to get “hard” data, nail down the facts. In China, those facts are always shifting because everything’s experimental. It’s a highly decentralized system. And if you’re lucky, you’ll get a first approximation.

On future research:

I think the immediate research will be more microscopic — to go into the teams, to observe the teams even more closely and to ask a question that’s a little different from the question posed in this paper. The proposition is that a firm may effectively internationalize by developing otherwise impenetrable domestic markets, opening access to those markets to foreign companies. We can certainly observe the progress of the system, the sustainability of this system. Based on analysts’ reports, it looks like it’s doing pretty well; Haier’s performance has jumped dramatically from 2012 to 2013, at a time when its main domestic competitors haven’t done quite so well.

But there’s another issue that needs to be explored. The paper describes briefly the team structure of Haier, the so-called zi zhu jing ying ti — or self-ownership — teams that operate as if they’re standalone businesses, even though they’re very small — 12, 13 people perhaps. The question is whether these teams become even more independent of the center of Haier. Some instances: already the teams do internal M&A. One team will literally acquire another through an internal bidding process. Sometimes they do joint ventures with their distributors, with their retailers. They have partial HR function at this point. Some have begun to spin out of Haier and become totally independent, legal entities — still within the family but legally separate.

The future of Capitalism in China:

So the big question I want to research is whether this is the future of capitalism of China. Are we going to see the devolution of the firm? Our standard theories going back many years — Alfred Chandler, the historian, Oliver Williamson, the theorist of transaction-cost economics — talk about the integration of the firm from market to hierarchy. But my question is whether, in China, they’re going to ultimately solve the problem of enterprise reform by reversing this process, by going from hierarchy to market. By spinning little pieces out of large organizations — whether or not state owned; Haier is not state owned. And by having these pieces become the central economic actors in the market place of China.

I don’t know the answer, but I think it’s a fundamental question and it has to be pursued. Given China’s highly-fragmented market structure, which I don’t think will change fundamentally, despite a rail system, despite a highway system, it’s entirely possible that rather than from market to hierarchy, you’ll see China go from hierarchy to market as a solution to many, many problems.

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