George Feldenkreis, chairman and CEO of Perry Ellis, an international apparel company, was born in Havana, Cuba, to Polish immigrants. But neither his natural affinity for Latin America nor his Eastern European heritage seem to influence where his company chooses to source a good deal of its products. In a keynote address at this year’s Wharton China Business Forum, Feldenkreis sang the praises of the country where, according to media reports, a full 23% of his firm’s purchases were made last year: China. Sourcing in Latin America, he noted, had been problematic due to shipping delays, and as a result, his company was increasingly turning to Asian countries like China instead.
From machine tools to computer parts to home furnishings, companies in the U.S. and Western Europe see China as the producer of choice for components or finished goods. Traditionally, the U.S. has tended to source products from its neighbors to the south, while Western European countries have turned to their Central and Eastern European counterparts. But a large, productive labor pool, low wage rates, and efficient shipping capabilities have put China on everyone’s map. Among low-cost countries, China’s industrial output is the largest — and it’s also growing the fastest.
What makes China so attractive, and how should companies choose the right sourcing locations for different parts of their value chain? Experts from Wharton and The Boston Consulting Group offer some advice for corporate decision makers.
The Case for China
The globalization of sourcing, and the move from high-cost countries to low-cost countries, is the new reality, says Jim Hemerling, a senior vice president in BCG’s Shanghai office. “There is a large amount of manufacturing still occurring in high-cost countries that will migrate to lower-cost countries. By dint of its size and growth rate, China will attract a disproportionate share of the migration.” Low-cost countries, he notes, can be split into two types. “Proximate countries are those where the wage rate is three to five times that of China, but the distance to the target country is smaller.
For products with complex logistics or less labor content, they are still advantageous. The other type of low-cost country tends to be farther away, but offers much lower costs to be competitive. These countries include China and India, and to some extent, Brazil.”
Companies look to source from low-cost countries for three reasons, notes Hemerling: “A big part of it is labor — they are looking for direct cost savings. But it’s also about talent, and about having access to the domestic market of the country they source from.”
For many firms, China’s population of 1.3 billion represents a consumer base that’s hard to pass up. When it comes to sourcing products with high labor content, China’s very low wage rate is a clear advantage. But technical skills aren’t lacking, either, says Hemerling. “China also graduates a lot of engineers and has many domestic- and overseas-trained PhDs. So companies are finding skilled people for higher-level jobs.” He cites companies like General Electric and Siemens Medical Systems, as well as mobile phone companies, that have tapped into this large talent base.
Because the Chinese economy is so large, the country also leads or nearly leads the world in consumption of a large number of products, like televisions, refrigerators, some packaged and industrial goods, steel, cement, and specialty chemicals.
“Manufacturers want to be there so that their operations can serve as a base to gain access to those domestic consumers,” says Hemerling. China’s favorable industrial policies are another factor: “The government is very responsive, the tax structure is straightforward, and there is tax relief for exported products,” says Hemerling. “More than 500 special economic zones have been [established] where the infrastructure enables quick set-up of businesses. Interest rates are low, as household savings rates are high and loans are subsidized.”
Beyond the low wage rate, the characteristics of the actual Chinese labor force are also appealing: “Firms can draw on a highly mobile, very productive and largely nonunionized labor force with a strong, disciplined work ethic,” Hemerling says.
Indeed, there is a good deal of incentive for people in rural China to seek out manufacturing jobs, says Marshall W. Meyer, professor of management and sociology at Wharton. “The rural household income is very low — about $100 a year, even though China’s GDP per capita is now around $1,000. The rural population has not seen an increase in real income since 1996, so as farm prices rise and income erodes, those people go off to cities to work in manufacturing and support their extended family for a few years.
With such a large labor pool, costs remain constant.” The discipline of the Chinese labor force, says Meyer, also has to do with the fact that the workers often have very few rights: “A factory CEO may also be party secretary, but many of those are nominal titles,” which means that protection of the workers is minimal.
East to West
For certain companies, geography matters a great deal — the less physical mileage between factory and market, the faster products can make it into consumers’ hands. “If you have a product with short lead times whose demand fluctuates greatly, proximity is a clear advantage,” says Kevin Waddell, vice president in BCG’s Warsaw office. “Getting things from countries like Poland into other areas of Europe takes less than a week, and that time is everdeclining.” Naturally, there also are fewer time zone differences and fewer cultural differences to deal with when sourcing there.
What gives these countries a disadvantage, of course, is labor cost. “The labor cost in China is $1 or $2 an hour, and the supply is vast,” says Waddell. “But a lot of people think China is a homogeneous country, a place where they can simply drop their plant, when in fact there are many regional differences. It’s harder for them to see Central Europe as one region because it is made up of so many countries.” Companies also sometimes fail to consider other factors, says Waddell. “There are inventory savings to look at, training costs, and the process by which products move from source location to end market.”
Much of the investment in Central and Eastern Europe centers on highly skilled tasks that cannot be given to just any factory worker. “We see a lot of precision machine parts, vehicle parts, and electronic equipment made here, especially things that require craft or a learning curve,” says Waddell.
Like China, countries in Central and Eastern Europe are offering investment incentives for bringing in business, but most of the activity is on a countryspecific basis. “There is not much in the way of industrial policy on a region-wide level — in other words, countries are competing with one another and with China for the business instead of asking, as a group, ‘How do we compete?’ They’re not stepping back and taking a larger view.”
South of the Border
Many of the issues facing European firms also exist for U.S. companies. Jesus de Juan, vice president at the BCG office in Monterrey, Mexico, explains why that country has been appealing to American outfits: “The Mexican economy has undergone tremendous
transformation in the last decade. Since 1994 the economy has been relatively stable, and this is the fifth year with single-digit inflation. The labor rate is one-ninth that of the U.S., so it is very competitive. It takes just two to six days for something from here to reach any mainland U.S. location by truck.”
In addition, its free trade agreement with the U.S. and Canada has done much to disentangle customs formalities. Exports make up 25 percent of the Mexican economy, of which around 80 percent are to the U.S. The country has transitioned from being a supplier of basic commodities like oil to being a source for electronics, auto components, and cars, says de Juan.
While lower-cost countries have labor advantages and require less capital investment due to the use of more simple machines, the disadvantages can be numerous, he notes. “Duties levied and managerial costs can be significant, for instance. Our time zones and seasons are symmetrical with those in the U.S., while there is many hours’ difference with China — and that can make things difficult to coordinate or communicate. So Mexico may not be more advantageous for a company, but it can be the least disadvantageous.”
Cities like Monterrey, with a modern infrastructure and frequent transportation options to the U.S., make it easier for Americans to manage the production process, says de Juan. “There are schools there like American schools, and about 15 daily flights into the U.S. — it’s easier to move your operation here, and there are managers with MBAs from top American schools.”
What’s more, says de Juan, a company’s secret sauce will generally remain secret in Mexico. “There’s no risk of losing intellectual property in Mexico, as there can be in some lower-cost countries. Other than in certain sectors such as energy and telecommunications, there are very few limitations to foreign ownership here, so you can buy out a firm and become a 100 percent owner. Repatriation of profits is also simple.” In contrast to Mexico, countries in Central America and parts of South America are not as advantageous, de Juan explains. “During the last 20 years, many Central American countries have been under dictatorships for much of the time. They also have problems with harbors and road infrastructure, so driving trailers can be a nightmare. Some of the same issues exist in South America — political instability in Venezuela, drugs in Colombia, a collapse in Argentina.” Chile, while stable and growing, has an economy largely comprised of services and natural resources, and, says de Juan, it’s too far to be of much use unless a company is shipping goods to the Pacific. The rush to China, says de Juan, is partly a fad. “Clearly the labor is cheap, and the sheer size of the Chinese domestic market is compelling. But despite the competition, Mexico is gaining market share in sourcing. Companies like Maytag, Whirlpool, and Electrolux are investing in Mexico. For bulky goods, proximity is very important. And auto component companies like coming here because the short distance makes just-in-time inventory management easier.”
BCG senior vice presidents George Stalk and Dave Young agree with de Juan that in some cases it makes sense to source production to nearby locations. In an article titled, “The Hidden Costs of Globalization,” they say, “Not all products should be outsourced to distant locations.
Products that might do better to stay home, or close to home, include certain highly complex products, products with a variety of designs and options and products likely to be in high demand one day and languish on the shelf the next. Similarly, services that require significant customization and highly responsive providers may or may not do as well abroad as at home. In taking such products and services to low-cost countries, a company could lose overall advantage in an effort to gain a narrow unit production cost advantage.”
So, where should a company be sourcing? In the final analysis, notes Hemerling, the right solution for a company may be — and is increasingly likely to be — a mix of various parts of the world. “Firms have to look at their entire supply chain. Perhaps research and development should be in one area, production of components in another, assembly in still another place. It’s not just something to be dealt with by a
procurement person — this has to be the CEO’s agenda. The global dynamic has — and will continue to have — significant organizational implications.”