In previous commentaries penned on Supply Chain Matters, I have noted the implications of increased labor activism and subsequent raising wage rates within mainland China. Even last week, the financial news media continued noting incidents of new work stoppages occurring within China’s automotive plants, now involving Japanese brand Toyota as well as Honda.  Much financial media and blogosphere commentary revolves around the recent decision from the government of China allowing the Chinese yuan to “tolerate a gradual appreciation” within currency markets.  The combination of these two significant developments has caused some to declare that the era of cheap manufacturing in China is coming to an end.

My view is that it is too early to be making such broad reaching statements, or more importantly, significantly altering supply chain strategy.  Both developments, in my view, are driven by pragmatic business and political considerations.  The raised labor activism and consequent wage hikes are driven by the reality that workers within China’s major Pearl and Yangtze River coastal manufacturing regions are becoming more frustrated with their economic plight, and the government of China, thus far, is de-facto not interfering with this new wave of labor activism. Foxconn, China’s largest manufacturing employer’s recent announcement of doubling base pay for employees was the benchmark event that has led to more demands for wage increases in other industries.  The real question, however, is when or if these increases will be passed on to major manufacturing-driven customers.

The long awaited government decision to allow the Chinese currency to appreciate against major currencies such as the U.S. dollar was a political decision, timed to come out just prior to this weekend’s G-20 Economic summit meeting.  Many long-time political observers have noted that the word “gradual” is the operative word, and note China’s senior economic leaders have managed to allow the yuan to appreciate no more than a certain percentage in any given year, and that will most likely continue.

More important to the currency decision is the potential that foreign imports, such as consumer electronics, could become more attractive within China’s huge market. Additionally, as noted, the very goods that U.S. and Europe based firms manufacture in China might now become more affordable for China’s evolving middle class consumers.

Thus, in supply chain strategy context, both developments should be evaluated in the primary context of future product demand within China’s internal market, and secondarily, any impact that may come in the overall cost of manufacturing.  A recent Financial Times article (free preview account may be required) makes the observation that the increased pay raises will only accelerate a move of manufacturing from the coastal region to other interior regions.  For instance, Chongqing is becoming the new base for the electronics industry.  Foxconn is reported to be in talks with the local government in Zhengzhou, the capital of Henan province, to build its next mega-plant in that region.  If other component suppliers continue to shift their manufacturing to the interior regions, than a new manufacturing hub will be created.

My advice to manufacturers is to continue to monitor developments, but also differentiate supply chain strategy within China on the basis of first supporting China’s internal market potential, and second, as a hub of competitive manufacturing cost.  It’s apparent that China’s desire to be a world leader in more high technology areas such as autos, electronics, information technology and alternative energy manufacturing will continue, and a more pronounced shift within manufacturing toward the interior regions will occur.

As always, the notions of manufacturing cost are a tradeoff of direct labor vs. material cost.  The combined occurrence of increased labor activism and a floating Chinese currency should be viewed on long-term impact to material cost.

What’s your view?

Bob Ferrari

David Dayton is the owner and manager of Silk Road International, an international procurement and project management company that helps clients find the right factories in Asia along with coordinating production, logistics and quality control needs for clients.

David pens a blog of the same name, which provides a perspective representing his 20 years of experience working with manufacturing companies in Asia.  The Silk Road International blog is listed on our Blogroll, and is a site I visit for insights on supply chain issues within China.

David recently penned a series, Chinese Culture for the Frustrated Foreign Buyer, which I highly recommend for reading by sourcing and procurement professionals with activities within China. I’ll warn you up-front that series is rather long on content, but the observations and insights are truly candid and insightful, and may help you to overcome frustrations as an outsider doing business within China.

I learned a lot from reading the entire piece, but I will tease my readers by calling attention to a few worthy insights from David:

Insight 5. The rules in China work for only one party, and that party ain’t you.

“First, it is not unique to China that laws favor the locals.  Don’t complain about the fact that the field is tilted against you—it is.  Deal with it.  Second, unless you’re a big deal (e.g. you are spending 6 figures per order) you’re not going to get any special attention, so take your ego down a couple notches before you start working here—…”

Insight 7. “We just don’t really work like that.”

“The reality of contracts (even the good Chinese ones) is that no one but you has ever read them.  When contracts are broken in China (and court is not an option) your going to just hear “well, we don’t really work like that in China” or something similar. “

Insight 9.  If you’re not here, it doesn’t matter what you want or what you say.

… “Learn this now: there is no such thing as potential when you’re manufacturing in China.  There is no future, only now.  No one feeds their family on potential.  Just think about how may hundreds of clients tell your supplier the exact same thing every week?”

You will find David’s posting very educational and perhaps helpful.

Bob Ferrari

While searching China’s Xinhua News Agency site to secure references to my previous posting related to the after effects of the tainted milk scandal, I came across a rather interesting article that provides some indication of the changing winds of outsourcing manufacturing within China.

The article, Toy exports slump with higher costs in Southern China, notes that China’s major toy manufacturing province, Guangdong, is experiencing a slump in toy exports to Europe and the U.S. amid rising costs. 

The cost of manufacturing toys in southern China has increased an average of 25 percent, while overall export demand has remained slack due to the effects of the world economy and keen competition. Both the EU and the U.S. have adopted more stringent standards on imported toys, and that has required Chinese producers to spend 15 percent more on higher quality raw materials as well as much more time on product inspection and quality needs. Labor and transportation costs within China have also risen.

In the first ten months of 2009, exports to Europe, Hong Kong and the U.S. have dropped 10.9 percent, 12 percent, and 15.2 percent respectively, which indicates that the bulk of toy purchases have already been consummated to stock for the upcoming holiday buying season and declining export volume for 2009 is a certainty.

 Toy manufacturing represents the most margin sensitive aspect of manufacturing sourcing and in fact it was the toy industry that led the first wave of production outsourcing within China’s Guangdong province.  Since that time, the obvious need for higher quality and safety standards are driving these same brand owners to source their production in more interior regions of China, or within other evolving low-cost manufacturing regions. In essence, the trends noted should not be a total surprise.

This trending in the toy industry is however another indicator of the changing winds for global outsourcing or near shoring.  The singular notion of savings in direct labor costs can no longer justify an outsourcing decision. The added factors of market acceptance of quality, more stringent regulatory compliance, transportation and landed cost factors now play a more significant aspect to the overall sourcing decision.

The latest and most timely reminder of for increased quality and safety concerns stems from this weeks highly publicized product recall of infant cribs, the largest in U.S. history,.  Over 2.1 million drop-side infant cribs, manufactured from January 1993 to October 2009 are being recalled because of potential hardware breakage leading to infant safety concerns or potential death from suffocation.  The affected cribs were noted as being manufactured in Canada, China, and Indonesia.

The takeaway is that sourcing decisions are no longer static, and sourcing professionals need many more strategic skills and information sources to make the most intelligent and timely sourcing decisions.

 Bob Ferrari

In late September of 2008, the incidents of Chinese milk and powdered milk products laced with the chemical melamine became very public, and the outrage within China and other countries was highly charged.  Six infants died and more than 300,000 children were made ill, some seriously, as result of digesting tainted milk and milk powdered products.

At the time of the incident, I penned a Supply Chain Matters commentary expressing my personal outrage and calling for Chinese officials to once and for all crackdown on these scurrilous practices which had a previous history in other product areas as well.  As more and more information began to leak out regarding the incident, it became apparent that Sanlu Group, China’s largest producer of infant formula, was aware of the magnitude of the problem as far back as August, but neglected to make full disclosure due to the sensitivity for the upcoming Olympic games being held in China at the time. Other milk producers were also impacted, and brands such as Fonterra and Nestle were dragged into the effects of the scandal.

It’s a little over a year since these incidents and we can now observe the after effects.  China‘s Xinhua New Agency reported today that two people have been executed for their involvement in the scandal.  One, a Chinese farmer, was convicted of endangering public safety by dangerous means by producing more than 770 tonnes of melamine-laced milk.  Another, a major distributor of milk to Sanlu Group, was convicted of selling more than 900 tonnes of milk tainted with protein powder.  Both were executed.  The former board chairwoman of the Sanlu Group was convicted of manufacturing and selling fake or substandard products and was sentenced to life in prison.  All together, according to Xinghua, three individuals were jailed for life, and 15 were imprisoned for terms ranging from two to fifteen years in prison. One received a suspended death sentence.

I also came across a related news article from July which noted that Chinese dairy farmers in the home province of Sanlu Group were just getting on their feet as a result of the backlash from the incident.  An official of the Hebei Food Industry Association was quoted as indicating that the market has recovered to 70 percent of pre-scandal milk consumption. Market prices of raw milk which plummeted to 1.6 yuan ($0.23 USD) in December of 2008, had bounced back to 2.6 yuan per kg. by July, but diary farmers were still economically suffering. In all, the Hebei provincial government had to provide 40 million yuan in direct subsidies and 60 million yuan in low-interest loans to help diary farmers survive the crisis. Nationwide, the Chinese Ministry of Agriculture found that 3908 of that country’s 20,393 total milk collection stations, roughly 20 percent, to be defective and were shut down.

The consumers of China, the Chinese dairy industry, and the unscrupulous individuals involved have all paid a price as a result of China’s tainted milk scandal. China’s quick actions in response to this unfortunate and tragic incident are commendable. While exercising the death penalty in so short a time can be viewed as extreme, it certainly leaves little doubt of China’s intent to send a message that its tolerance for profit over the safety of consumers is waning.

We trust that China’s producers and governmental oversight agencies have learned from this incident, and will restore consumer trust in Chinese branded products.  Time and continued diligence will provide the real answer.

Bob Ferrari

I had the opportunity to recently read the book Poorly Made in China, by Paul Midler.  Mr. Midler returned to China in 2001 after receiving his MBA from Wharton.  Having language skills in both Mandarin and English, and observing the ongoing boom in China’s manufacturing sector, he decided to become an export manufacturing representative. The book outlines many of his project experiences as a go-between among Chinese manufacturers and their U.S. and European based customers.

In November of last year, I recommended that readers take-in a very insightful blog posting on Silk Road International that described Chinese supplier business practices.  The Midler book takes David Dayton’s observations even further.  Midler comments on how companies would contact him typically after their supplier relationships began to fall apart around product quality or cost.  As Mr. Midler phrases in his book: “Trouble was my business.”  He cites the term “quality fade”, and a Chinese manufacturing culture that inserts many unannounced changes in product composition or manufacturing processes, without awareness by respective customers.  Having authored many postings on Supply Chain Matters that related to product counterfeiting or product safety issues that were traced to China, Chapter 9, which is titled The China Game, provides some eye opening observations.  A significant excerpt from this chapter reads as follows:

“An importer should have been rewarded for uncovering quality problems, but it was almost never the case.  Factories did not see an attention to quality as something that would improve their business prospects, but merely as a barrier to increased profitability.”

There are many other commentaries regarding the lack of openness concerning both sides, the Chinese manufacturer and non-Chinese importer.  Another quote from the book reflects:

 ”Chinese manufacturers were good at keeping costs low- it was their true competitive advantage- but importers (also) saw an advantage in not knowing all of their supplier’s little secrets.”

Of course, it would be unfair to label all manufacturers in China with these observations. But the fact that these occurrences occur should be a cause for continued concern for all.

If you are at all involved with overseeing the sourcing of suppliers or production facilities in China, or with managing any of the aspects of supplier risk, I highly recommend you read this book. 

Consumers who continually demand and expect the cheapest price for products should also take the time to read about the implications of low-cost products from a quality as well as a safety perspective.

This book broadened my perspectives on the challenges of insuring quality products from certain manufacturers in China. It is a cause for continued concern.

Bob Ferrari