The Future of Sourcing and Manufacturing in China

The future of sourcing and manufacturing in China

February 25, 2011

CONFIDENTIAL AND PROPRIETARYAny use of this material without specific permission of McKinsey & Company is strictly prohibited

McKinsey & Company 1|

Speaker Profiles

Relevant experience Designed and guided multiple

supply chain transformations focusing on transparency and accountability in companies across Asia and Africa at McKinsey

Developed tactical execution strategy for Japan consumer electronics company to outsource supply to extended manufacturers and ODMs

Re-designed top South Korean fast moving consumer goods companys operating model with ODM suppliers increasing service levels from 95% on time delivery to continually over 98%; the best in companys 40 year history

Former Strategy, Operations and Planning VP of Global Supply Chain for leading IT company

Bill Gerhardt Senior ExpertEducationMBA, University of Texas

Relevant experience Leader of SCM practice in China Led development of low cost and

high quality modules for an automotive OEM in China through best-of-benchmarking with suppliers

Building and leading the Global Supply Chain + Procurement organization of a major Telecom vendor (9B Euro procurement volume, 7000 people in end-to-end value chain)

Successfully restructuring the industrial base in Europe and USA, with substantial shift of resources from high cost to low cost countries

Prior to joining McKinsey, acted as CIO and led the Global Supply Chain & Procurement Organization as Senior VP at Alcatel-Lucents headquarter in Paris

Martin LehnichAssociate PrincipalEducationMasters in Physics, University of Stuttgart

Relevant experience Led effort to apply lean

manufacturing principals to green-field plant design which houses three distinct manufacturing processes. Productivity increased by up to 37%, space utilization improved by up to 35%, and lead time decreased by up to 79%.

Led effort to accelerate the development and production readiness of major aerospace program in a China / MNC jointly managed facility

Conducted an in-depth product launch / ramp up process diagnostic for a leading China based automotive OEM

Prior to joining McKinsey, worked 14 years in the automotive industry, most recently as Executive Director for Lear Corporation in China

Dave Rogers Associate PrincipalEducationMBA, University of Chicago


Contents

Six factors that underpin Chinas success

Recent trends within China and Asia

Strategies to adapt to changes

Build and defend

Hunt for greener pasturesHunt for greener pastures


Coming out of the down turn, China still remains the worlds largest exporter

SOURCE: Global insights - WMM

In 2009, China exported 11% more than

the US and 23% more than Germany

0

500

1,000

1,500

2,000

FranceJapan

United Kingdom

GermanyUnited States

IndiaRussia

Brazil

China1

200908070605040302012000

Top economies total export of goods and servicesUSD Billions


China has focused on 6 key sources of competitive advantage which ensure its leadership position among all LCC sourcing alternatives

Scale

Value chain

Engineering & manufacturing capability

Rising productivity

Ease of business

Infrastructure

Sources of competitive advantage Findings for China and alternative regions

Chinas scale of production is truly global and there is no competition form any LCC alternative on this parameter

Chinas value chain maturity incentivises others to plug-in by co-locating and serves as an exit barrier for already existing plants

China ranks the highest in terms of high value-added manufacturing and is supported by growth in number of R&D facilities set up over time

While labor costs have increased, so has the productivity. But over time, this could put China at a disadvantage

China rates moderately in the index of ease of doing business, but is ahead of top contenders India and Vietnam

China rates way above India and Vietnam in all the physical infrastructure


0

200

400

600

800

1,000

1,200

1,400

1,600

07060504032002 200908

SOURCE: Global insights; McKinsey analysis

In terms of scale China dominates over India and VietnamVietnamIndiaChina

Overall export value comparison 2002-2009USD billions

CAGRPercent

China exports have grown at a faster rate from 2002-09 than both India and Vietnam

21

18

17


Favorable

Proximity to experienced supplier base

Proximity to customers

Factors China India

Facility and infrastructure

Time-to-production/market

Number of MNC local electronics component plant 990 300 Electronic component industry size ($ billion) 458 17 Size of skilled1 labor force (million) 150 103 Component local availability (%) 80 50

Energy supply

Vietnam

Number of electronics component manufacturers 3,700 500 n/a

Domestic consumer electronics2 industry size ($ billion) 71 4 n/a Export consumer electronics revenue ($ billion) 30 2 n/a Total logistic capacity (rail + air + ship; million tons) 8,460 1,463 31.1

1 High school equivalent workforce2 CE industry is the biggest customer of electronic components

SOURCE: CST interview; State Statistic Bureau of PRC; KoC; Govt. of India; NSS report, Vietnam State Statistic

China has a tightly integrated supplier base which makes relocation difficult

ELECTRONIC INDUSTRY


China exports much more complex categories in greater value thanIndia and Vietnam

SOURCE: Global insights; Bank of India, McKinsey analysis

Chinas top export industries, 2009 Indias top export industries, 2009 Vietnams top export industries, 2009Industry Industry Industry

13.0

10.5

9.0

8.5

3.0

2.0

1.0

1.0

0.5

4.5

Retail/Apparel

Consumer

Metal and Mining

Machinery and Industrial GoodsPulp and paper/Forest

Media

Chemical

Transportation equipment

Pharmaceuticals/medical

Others

43

34

23

23

14

9

7

4

1

79

Machinery and Industrial GoodsMetal and Mining

ChemicalsRetail/Apparel

Consumer

Media

Pulp and paper/Forest

Transportation equipmentPharmaceuticals/medicalOthers

575

199

156

97

72

47

47

42

20

94

Machinery & Industrial GoodsRetail/Apparel

Metal & MiningConsumer

Chemicals

Media

Transportation equipmentPharmaceuticals/medicalPulp & Paper/Forest ProductsOthers

4357

Machinery & Industrial (%)Rest of the exports (%)

18

82

24

76

USD Billion


Productivity and labor cost indices, ChinaIndex, 2000 = 100

Country-level labor productivityReal GDP at PPP1 in 2005 indexed $ per employed person

0

10

VietnamIndia

China

20100806040220000

100

200

300

400

500

Unit labor cost index2

Labor cost per hour

2010080604022000

+17%

+8%

Better

Worse

1 Purchasing Power Parity, indexed where 100 equals US performance2 Considering labor productivity improvement

SOURCE: EIU; McKinsey analysis

Productivity growth mitigates labor cost increase

McKinsey & Company 9|1 Lower rank, easier to do business in the country

SOURCE: World Bank International Finance Corporation 2010 which covered the period June 2008 through May 2009

China performs better than India and Vietnam on ease of conducting business

Registering property

Enforcing Contracts

Trading across borders

Paying taxes

Dealing with construction permits

Ease of doing business rank1

Starting a Business

China VietnamIndia

13389

169151

Employing workers

Getting credit

Protecting investors

Closing a business

116

175180 69

104140 103

9332 40

3061 30

4193 172

169130 147

9444 74

18218 32

13865 127

93

McKinsey & Company 10|SOURCE: "Logistics Infrastructure of India" by Ernst and Young; "Indian Indirect Tax Reforms" by PWC; CEIC; Deutsche Bank Research Bradsher (2006); The World Bank's Doing Business report, 2008

At a country level, China has more infrastructure capacitythan India or VietnamInfrastructure throughput/capacity vs. total GDP, Indexed vs. China

India Vietnam

71

56

53

53

41

Ports

Rail

China

Utilities

Air

Roads

48

15

68

91

75

Ports

Roads

Rail

Utilities

China

Air


Contents




Build and defend



Recently there are trends which are a cause of concern for sourcing professionals working with China


Latest headlines indicate trend is evolving

* Vietnam News Brief Service

Vietnam low cost labor has growing demand with limited supply in major cities

China returning labor patterns vary by employer

Post-Tet Labor Shortage Hits Enterprises in Vietnam*- 10 Feb 2011

Labor Recruitment Demand in Vietnam Biggest City Up 5.03% in Jan*-27 January 2011

Poor Infrastructure, Low-quality Labor Hinder FDI Inflow to Vietnam* -14 January 2011

Consumer price growth of 2010 in Vietnam was 9% on average, and the increasing living cost in big cities has led to the labor shortage problem*- Jan 2011

Bosses battle it out for workers- 14 Feb 2011China Daily Information Update

Most workers return to LG display China plants after holiday 16 February 2011 APULSE

Migrant workers setting their sights higher- 18 February 2011States News Service

Many migrant workers who returned to their hometowns for the holidays decided to stay there for a variety of reasons, including a cheaper standard of living, new prospects closer to home and wanting to be with children they had not seen for months or years


Recent changes in coastal China seem to erode its dominant position as a LCC sourceSeveral factors adversely impact Chinas over-all cost competitiveness as a LCC source

Rising labor costs

15% per annum over the last years Reports of labor shortages, especially in the

Pearl River Delta

Restrictive (domestic) trade policy

Tax policy to limit industries that are (i) highly polluting, (ii) high energy/resource usage, (iii) low value-add

Highest impact in industries like metals, glass, chemicals, plastics, timber and paper, furniture, textiles, garments

Appreciation of the RMB against other currencies 17

2623

62

INRDong USD Euro

RMB(% change vs 2005*)

*31 Jan 2005 vs 31 Jan 2011

McKinsey & Company 15|SOURCE: Lit-search;

At the same time Chinese Government is moving companies inland

~200,000 manufacturing companies moved to inland China (2009)

~1500 plants in Dongguan moved to China inland, and the number is still increasing (2010)

37.3% of Hong Kong enterprises in Pearl area plan to move all or part of their capacity to inland (2010)

~9000 labor intensive companies planned to transfer production from Guangdong province plans to inland in 3 years (2010)

Manufacturing shift

A stimulus package claimed to invest over RMB680 billion in 5-year to develop Western China (July 2010)

Taiwan enterprises invested 1.4 billion USD in Chongqin, Western China (2009)

Investment direction

Government support

General Office of the state council announced a corp. tax reduction program to encourage foreign investment for labor intensive industry in Middle-west China (April. 2010)

The growth rate dropped 35.8% on migrant labor in Guangdong province (2009)

Labor movement to China inland caused 60% of coastal companies in labor shortage (2010)

Labor migration

Inland

Coastal area


While across Asia, many LCCs seem to appear on the top 20 list on FDI confidence index

SOURCE: Internet search

FDI confidence index (top 20 countries)

1.051.061.071.081.081.081.101.131.14

1.161.211.271.281.341.341.361.401.42

1.952.20

United KingdomUnited StatesIndiaChina

RussiaBrazilAustraliaGermany

Poland

Turkey

Hong Kong

France

Hungary

JapanMexico

SingaporeSpain

ItalyThailand

Czech Republic

1.221.221.241.251.261.261.281.291.291.291.321.321.321.331.35

1.431.53

1.641.67

1.93

CanadaUnited Kingdom

United StatesIndia

Mexico

Germany

AustraliaPoland

Brazil

China

MalaysiaIndonesiaRussiaCzech RepublicRomania

Vietnam

Other Gulf StatesHong KongFrance

UAE

2005 2010


Contents




Build and defend



Business associationsintimacy with the Government can lead to value maximization

Government's aspiration Developmental focus:

Which areas/regions should receive incentives and stimulus to spur growth

Industry focus Which industry sectors are worth investing in, which would help China develop deep knowhow and skills to fuel the next stage of development

Value of understanding Government's policies

Timing and placements of investments

Identifying right sourcing strategy

Based on Chinese governments five year plans, it is possible to Identify regions under Government's

developmental focus Get clarity on tax holidays or subsidies Understand possible migration of essential

suppliers or customers to the region

Understand possible tariff and export incentive structure for various commodities and products

Evaluate the right mix of products and components to be sourced from China based on the above

Exiting certain sectors if required

In case of a clear indication that a certain sector will not be supported (low value add, energy intensive etc.), a timely decision to exit that industry can be taken

As an association, lobby closely with the Government


As an individual company, improve in-house operations and..

Impact

ELECTRONICS COMPONENTMANUFACTURER

Transformation scopeInitial situation 4-month effort focused

on one business unit Holistic, end-to-end

production system redesign examining all processes within the factory

16 team members trained in process redesign and improvement implementation

Insufficient machining capacity due to machine downtime

Quality problems drive substantial rework

Insufficient final assembly capacity due to bottlenecks

High levels of late customer deliveries

Downward pressure on margins

16 30

60 40

60

Rework Output

Final assemblyProcess 1 Process 2

Machining throughput

On-time delivery

Added 5-6 points of EBIT Rolled out end-to-end performance tracking Instilled continuous improvement mentality in

organization

CASE EXAMPLE #1: MANUFACTURING IMPROVEMENT

SOURCE: Client example, McKinsey analysis


75%

100%20%

120%

Approach to low cost designs (DtVapproach)

-25%

Chinabest practice

Vertical depth of local sour-cing(Deep localization)

Sourcing/Engineering intimacy (fast and extensive DtC)

Under-standing of true local cost structure

Leveraging local supply base

TypicalMNCssourcing cost in China

Move sourcing to China

Typical MNCssourcing cost in Europe

Percent


HI-TECH EXAMPLE

B C D E

enhance sourcing effectiveness

A1st stage localization

CASE EXAMPLE #2: SOURCING/PROCUREMENT IMPROVEMENT


Contents




Build and defend



Decision to shift base requires a structured approach

Assess destination optionsIdentify industry archetype Evaluate Go/No Go

a) Four industry archetypes or models are categorized based on their distinct set of critical success factors

To identify the right archetype(s), it may be necessary to break down the organization at BU/P&L level to understand which archetype is most suitable for each BU

b) Each archetype assigns a different importance to each source of competitive advantage

a) List out the alternative location optionsIt is important to extend this analysis from a country to a province level and if required, to the level of the actual site plan

b) Evaluate strengths that each location brings, and hence how it rates against each source of competitive advantageUnderstand the shifting nature of this analysis and test for sensitivity with time and with concerted government action

For the approach to be holistic follow three filters:

a) Based on importance of each source of competitive advantage (from step 1) and performance of each location (from step 2), work out a comparison between the options

b) Additionally, evaluate overall system risk option value of the move efforts involved

c) Conduct an NPV analysis to confirm financial viability

1 2 3

0

5

10M

L

K

P


1a There are four basic industry archetypes

Process industry

Industry Archetype Characteristics Examples Petrochemicals,

metals, chemicals etc Continuous or batch process industries, asset intensive, use less but skilled labor

Capital intensive manufacturing

Automotive, home appliances, capital equipment, hi-tech

Discrete manufacturing industries, asset intensive, Moderate use of labor with a mix of skilled and

unskilled workers

Labor intensive manufacturing

Apparel, toys, furniture, jewellery

Discrete manufacturing industries, Asset light High use of labor with majority of unskilled

workers

Knowledge industry

Pharmaceuticals, seeds/biotech, software

Discrete manufacturing industries, Usually asset light High use of labor with majority of skilled workers


Importance given to each source of competitive advantage varies with industry archetype

0

5

10M

L

K

P 0

5

10M

L

K

P 0

5

10M

L

K

P

0

5

10M

L

K

P 0

5

10M

L

K

P 0

5

10M

L

K

P

Note: M=Capital intensive manufacturing; L=Labor intensive manufacturing; K=Knowledge industries; P=Process industries

Scale1 Value chain maturity2 Capability3

Labor costs and productivity4 Ease of doing business5 Infrastructure6

1b

SOURCE: Expert Interviews, McKinsey analysis


We consider coastal China and a few fast emerging alternatives in our quest for the ideal sourcing and manufacturing destination

2a

LCCDestination Pros Cons

China (coastal)

Increasing wage costs Currency appreciation

Current incumbent with a vibrant business ecosystem Advantages in scale, value chain maturity and

infrastructure

China (Inland)

Increased logistics cost Evolving infrastructure Currency appreciation

Emerging alternative within China with lower cost of labor Tax incentives and government stimuli to aid further

development

India More difficult to transact

business Higher logistics cost

Largest scale among LCCs outside of China Strong and growing domestic economy, politically stable

Vietnam Smaller scale and lower

availability of resources Close proximity to coastal China, with similar

landed costs Very competitive cost of labor

China (coastal)China (inland)India

Vietnam

China

India

China


Coastal China wins on scale, value chain maturity and capability but Vietnam and China hinterland are better on labor costs

Scale1 Value chain maturity2 Capability3

Labor costs and productivity4 Ease of doing business5 Infrastructure6

0

5

10C (I)

I

V

C (C) 0

5

10C (I)

I

V

C (C) 0

5

10C (I)

I

V

C (C)

0

5

10C (I)

I

V

C (C) 0

5

10C (I)

I

V

C (C) 0

5

10C (I)

I

V

C (C)

Note: C(I)=China (inland); I=India; V=Vietnam; C(C)=China (coastal),

2b

SOURCE: Expert interviews, McKinsey analysis


Decision must pass filters of sector suitability, non-monetary impact and an NPV analysis before a Go/No Go verdict is reached

1 NPV takes into account future trends of costs and revenues based on sensitivities and risk in the discount rate

Relocation is an important decision and a holistic view need to be taken before execution Suitability captures medium

to long term viability and profitability

Non-monetary impact captures changes in risk, option value of maintaining presence in another market, or network and finally the resources required to make a successful transition

An NPV analysis provides the financial basis to go ahead with a decision

Suitable as per industry archetype to relocate?

How does it impact risk, option value and resource requirement?

Is NPV1 the best among all the options?

A B C


65%

India

69%

China (I)

71%

China (C )

100%

Vietnam

69%

India

71%

China (I)

74%

China (C )

100%

Vietnam

96%

India

83%

China (I)

92%

China (C )

100%

Vietnam

73%

India

87%

China (I)

72%

China (C )

100%

Vietnam

Process industry

Capital intensive manufacturing

Labor intensive manufacturing

Knowledge industry

Industry Archetype Results Inference

Scale and value chain depth are key to the success of this industry archetype, with coastal China the clear winner

Value chain depth and manufacturing capability are important and here too, coastal China is the preferred location

Labor cost is a key factor and though coastal China is the favourite, the gap can be bridged by the hinterland and Vietnam over a short period of time

While coastal China seems to be preferred, India could pose a serious threat in this category

HighMediumLow

Evaluate suitability of a region to your industry archetype


Option value

The option value of maintaining presence in an alternative location can be viewed from the following perspectives add-on value to existing investments Entry into a potential market Alternative source of production bases Network value through foot print optimization

Risk diversification

Resource requirement

Risk diversification could be a goal in itself which could help de-risk LCC sourcing from Regulatory and policy changes in the sourcing country Supply chain disruption in one region/country Macroeconomic factors like GDP growth, currency risk

Any change of location would require a re-investment in terms of identifying, qualifying and monitoring new sources or managing the new facility

A quantum of sourcing, production and quality personnel are required to make this transition which would take time to take-off and still more time to stabilize

HighLow

HighLow

HighLow

Non-cost parameters Description Rating (Example)

..consider the non-monetary impact of the decision to shift and


Labor

Material

OHLogistics

813

98 2

Material cost add

Overhead & tax savings

Labor savings

5

40

37

2010 baseline

1

Freight cost add

4

Final costs

35

44

6.5% Saving

-67

1008665

2011

-17

2010 20142012 2013

Step 1 Impact on

cost structure

Step 2 Initial

investment and

transition cost

Payback = 3.2 yrs

conduct robust financial evaluation to arrive at the decision

CASE EXAMPLE: MID SIZE AUTO COMPONENTS MANUFACTURER(Evaluating move from coastal China to Vietnam)

PERCENT



Case example 1: component supplier - electronics industry

Industry sensitivity : Electronics

Most favorable

Least favorable

Competitive analysis: LCC alternatives

HighLow

Vietnam

80%

India

76%

China (I)

84%

China (C )

100%HighLow

Risk

Option Value


NPV Analysis

GO

Best suited location

China: coastal

China: Inland India Vietnam

Capability

Scale

Infrastructure

Value chain maturity

Labor costs & Productivity

Ease of business

Scale

Capability

Infrastructure



Ease of business


Case example 2: garments producer - apparel industry

Industry sensitivity : Apparel Competitive analysis: LCC alternatives

HighLowChina: coastal

China: Inland India Vietnam

Scale

Capability

Infrastructure



Ease of business

Capability

Scale

Infrastructure



Ease of business

HighLowRisk

Option Value


NPV Analysis

GO

Best suited location

100%

India

89%

China (I)

101%

China (C ) Vietnam

113%

Most favorable

Least favorable


RECAP

There are six key sources of competitive advantage which impact a regions competitiveness Economies of scale Value chain maturity Engineering and manufacturing capability Rising labor productivity Relative ease of doing business InfrastructureFocusing on the above makes coastal China the worlds most preferred destination for sourcing and manufacturing

However, recent trends are a cause of concern to sourcing professionals working in China Rising cost of business (wages, taxes and exchange rate) Government's push to companies to move inwards Emergence of other regions as alternatives

Companies have recourse to two generic strategies

Build & defend As an association, lobby with Government, and align further investments with its policies On its own, improve manufacturing and sourcing efficiency

Hunt for greener pastures Analyse your industry type and its key drivers for being competitive Research alternative options and their performance on the six sources of competitive advantage Evaluate suitability, take cognizance of non-monetary impact and conduct financial analysis to decide Go/No Go

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The Future of Sourcing and Manufacturing in China

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