November Insight – Outsourcing Trumps Bricks and Mortar

Intercedent believes that Made in China is here to stay.

For the past several years, Chinese manufacturing wages have increased annually at double digit rates.  Meanwhile, the strengthening currency and rising raw materials costs are steadily eroding the margins of China-based manufacturers.  Economic pressure on factory owners is intensifying and there is probably little relief in sight for many of them given that the country’s manufacturing workforce is shrinking and workers now often do not want to work in menial jobs.

Overall, the undoubtedly complex project of creating, capitalizing, and managing a factory operation is becoming less attractive to companies particularly against an economic backdrop in which domestic Chinese demand and consumption in a range of industrial sectors is not materializing as rapidly as expected, and where forecast consumer demand from the developed world - particularly the US and Europe - is unlikely to rebound rapidly to the levels seen before the 2008 crisis.

So, is this sunset for Made in China?  Definitely not, particularly when one factors in that tough business conditions in home economies are currently, in fact, driving an expansion of production outsourcing to China.  While foreign companies may be shying away from establishing their own factories, economic uncertainties at home and slimmer manufacturing margins in China are, in reality, accelerating the moves of many foreign companies towards procurement in China.  In addition, this trend is being propelled by the discovery that in many industrial sectors Chinese production capacity has recently been added to levels well in excess of what was available here 2 – 3 years ago.  Suppliers are hungry and very much willing to deal.

Procurement plays are capital non-intensive ways whereby one can get access to margins on Chinese manufactured goods.  When broken down to a minimalist form, procurement in China only involves contracts, relationships with local suppliers, management, regular visits and the flow of funds.  Goods, and the packaging they have, are not manufactured by you, not exported by you, and are, ultimately, the responsibility of the supplier if found to be defective or damaged.  Even further simplifying operations and minimizing risks, a foreign company can put on the ground a local procurement team with individual staff (purchasing managers, quality control managers etc.) by outsourcing payroll and human relations activities to an independent Chinese-based firm.  Your procurement team can be located in many places across China to service geographically disparate suppliers but, meanwhile, be employed totally in compliance with the Labor Law and other regulations.  With procurement, there is, generally speaking, no need for a foreign company to establish its own office or other expensive infrastructure in country – a huge bonus when compared to the complexity and expense of hiring a workforce and running your own factory or office.

While procurement does carry risks, in our experience there are tried and true ways to minimize them.  For example:
-to protect technology and expertise, please be sure to execute bilingual confidentiality agreements prior to starting a procurement program, particularly before handing over engineering drawings;

-understand that Chinese engineers do not always come at technical problems from the same professional prism as foreign engineers; therefore, there is a need for comprehensive face to face discussions between the two groups before a technical project or projects relating to procurement programs are kicked off;

-understand that rights arising from exclusive marketing agreements with Chinese suppliers can become valuable assets and, additionally, protect you from unwelcome competition in your markets from a former or current supplier; therefore put them in place at the beginning of the relationship;

-make sure that the product pricing for orders in the first years (one year at least) is established and recorded in writing at the beginning – there is nothing more frustrating than to have put time and effort into getting ready to produce to find that both sides are poles apart on pricing;

-understand that effective and regular communications will underpin successful procurement in China; therefore insist upon it from day one; and

-the internet and a number of software suppliers are also making it easier and more cost effective to identify and manage suppliers.

Procurement is still a very commercially viable way for foreign companies to engage in the Chinese economy.  Currently, margins may exceed those applicable where one runs one’s own plant.  As foreign direct investment in manufacturing continues to slow, there will likely be an uptick in procurement to take advantage of China’s leading export infrastructure and expertise.  For the moment, outsourcing trumps bricks and mortar.


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