Lessons from China: The Importance of Knowledge-based Sourcing in Low-cost Countries

For years, it has been clear to practitioners that sourcing from China and other low-cost countries (LCCs) requires a rigorous and thorough approach, particularly when companies are seeking complex products. Strategy& has developed an new approach to working with LCC suppliers that we call knowledge-based sourcing, which significantly increases companies' insight into their supply bases. In addition to understanding their suppliers' production costs, companies that practice knowledge-based sourcing carefully assess manufacturing and transportation economics, lead-time requirements, schedule stability, the likely degree of product design changes, and the technical skills of the suppliers.

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Perspective

Ronald Haddock Reid Wilk Michael Pfitzmann

Lessons from China The Importance of Knowledge-based Sourcing in Low-cost Countries

This report was originally published before March 31, 2014, when Booz & Company became Strategy&, part of the PwC network of firms. For more information visit www.strategyand.pwc.com.

Contact Information Chicago Michael Pfitzmann Principal +1-312-578-4606 [email protected] Detroit Reid Wilk Senior Executive Advisor +1-248-680-3104 [email protected] Zurich Ronald Haddock Partner +41-43-268-2132 [email protected]

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Introduction

One major auto-related manufacturer based in the United States recently learned a painful lesson in China. Top management was in a hurry to drive down the cost of parts, which was no surprise in light of the problems hampering the U.S. automotive industry. But the company went about finding Chinese suppliers in a decidedly old-fashioned way: It sent out requests for proposals (RFPs) to dozens of parts suppliers that it did not know. Many suppliers submitted bids for the work, but as is typically the case with such bids, they did not include essential information, such as a supplier’s capacity to fill the company’s orders on a timely basis, its ability to deliver high-quality parts, or its cost basis for making the parts. Without this information, it was impossible for the company to make sound selection decisions, and the effort eventually failed.
Compare that with the experience of a top U.S. retailer, which over the years had built a broad supply base in China, doing business with hundreds of companies. To seize an advantage over its U.S. competitors, the retailer decided to narrow this supply base— limiting the companies from which it purchased items to those that it most trusted and sharing more extensive information with the chosen companies to ensure deeper relationships. In so doing, the retailer was able to benefit from supplier expertise, and it achieved a 33 to 50 percent advantage over its competitors in terms of the time needed to introduce new products to the American market. For years, it has been clear to practitioners that sourcing from China and other low-cost countries (LCCs) requires a rigorous and thorough approach, particularly when companies are seeking more highly engineered or otherwise complex products, for which the ability to understand nuances in suppliers’ capabilities or to influence design or production is required. Nevertheless, the myth that bids from Chinese or other suppliers can be fully understood by smart analysts in a back room a continent away still persists in some quarters. Many U.S. and European manufacturers still send RFPs to Chinese suppliers without ever setting foot on the mainland.

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China’s Changing Realities

Such practices will no longer work, partly because of important structural shifts under way in China’s economy and its competitiveness compared with other LCCs. According to a new survey by Booz & Company and the American Chamber of Commerce in Shanghai, some 50 percent of multinational companies doing business in China think the nation’s competitiveness in low-cost manufacturing is eroding. Almost a fifth, or 17 percent, are considering—and in some cases already pursuing—a shift of operations to even lower-cost countries such as India, Vietnam, and Thailand. At the same time, the vast majority of these companies find China to be highly attractive as a growth market, thanks to its expanding economy and a middle class that continues to grow by tens of millions of people every year. The primary reasons for China’s declining competitiveness in manufacturing are commodity and wage inflation, the rising value of the Chinese currency, high real costs of talent due to low employee retention, and the failure of many manufacturers to implement efficient and lean operational systems in their plants.

As a result of these pressures, companies will find it increasingly necessary to pursue a dual strategy of using the Chinese platform for making more sophisticated product components for export and simultaneously seeking to penetrate the domestic market. This means taking a more holistic view of how sourcing fits into a company’s overall activities in China, and it requires a deeper level of management engagement. Other pressures are mounting as well. The problems in supply chains in China—particularly the use of lowquality, dangerous materials and the prevalence of shoddy workmanship— that have affected manufacturers of products as varied as toys, pet food, and medicines have demonstrated that Western companies must have deeper footprints on the mainland. And it is becoming increasingly evident that the best techniques for protecting one’s intellectual property in China, in the absence of effective governmental agreements, center on having one’s own employees monitoring the competitive landscape. Companies including the General Motors Corporation and Cisco Systems Inc. have been stung by the emergence of copycat products from rivals operating seemingly right under their noses.

Some 50 percent of multinational companies doing business in China think the nation’s competitiveness in low-cost manufacturing is eroding.

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The Knowledgebased Sourcing Choice

For all these reasons, multinationals should consider adopting the new approach to working with LCC suppliers that we call knowledge-based sourcing, which significantly increases companies’ insight into their supply bases. In addition to understanding their suppliers’ production costs, companies that practice knowledgebased sourcing carefully assess manufacturing and transportation economics, lead-time requirements, schedule stability, the likely degree of product design changes, and the technical skills of the suppliers. The use of knowledge-based sourcing in China is a controversial idea for some Western CEOs and chief procurement officers. In their minds, an investment of this magnitude, which can require maintaining a staff of dozens or hundreds of people in China, could offset any possible gains from sourcing there. Wal-Mart seems to adhere to this view. It requires its suppliers to participate in an annual bidding process that consistently awards contracts to the lowest bidder (even as, critics allege, the quality of its products declines). That serves the purpose of driving the price down with each passing year, and that, not devel-

oping strategic supplier relationships, is Wal-Mart’s primary motivation. But it’s a different game entirely for companies interested in long-term, innovation-based relationships and for retailers seeking to improve product design and quality or to secure access to unique capabilities. If top Western executives need to change their product designs in response to new tastes or market demands anywhere in the world, to what extent can they count on Chinese suppliers to understand those realities and to accommodate them if they do not have a close partnership? Moreover, consider the costs that companies can incur if they fail to pay close attention to their suppliers. Mattel Inc., for instance, was forced to recall more than 20 million toys— mostly because of lead paint—that had been sold from November 2006 through August 2007. What Mattel and other companies learned from this experience was the importance of having the right people and processes in place from the outset; in other words, a greater up-front investment in supplier relationships diminishes the risk of having to pay far more to

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put out the fire after a problem has erupted. Of course, a company contemplating sourcing in China could conclude that the nature and scope of its buying is so limited that it does not make economic sense to build a knowledge-based sourcing system. For a company that sources such a low volume of products from China that the cost benefit of “better sourcing” is not offset by the cost of a team that can manage it, the answer may be outsourcing to one of the many Chinese sourcing and logistics companies that essentially help businesses gain the insight to better manage knowledge-based sourcing. Li & Fung Ltd., a Hong Kong–based company, has been one of the pioneers in this area. Implementation of a knowledge-

based sourcing strategy is made a bit more complicated by local conditions in China that managers must take into account as they determine how deeply to embed this approach into their companies’ operations. One variable is supplier base maturity. Some industries today have very sophisticated suppliers and supply bases in China, while others are still quite primitive. The maturity level is driven by historical factors, such as how long a specific industry has been using Chinese suppliers and the magnitude of the cost advantage that Chinese suppliers have offered over the industry’s previously established or domestic supply base. One of the earliest industries that set up shop in China was electronics, and today much of that sector’s global supply chain resides there,

driven by outsourcing from Hong Kong, Taiwan, the United States, Europe, Japan, and South Korea. The auto industry made its first major foray into China in the 1980s and 1990s, when Japanese manufacturers extended their supply base into the country well ahead of U.S. and European vehicle manufacturers. As a result of these early activities, Chinese electronics suppliers are in fact world class, and auto suppliers are rapidly moving in this direction. By contrast, major oil and gas companies have only recently begun to establish bona fide sourcing teams in China. A second key variable in a company’s decision of how deeply to embed a knowledge-based sourcing strategy is China’s importance to the company globally. Different CEOs view China from different perspectives. Some

Some industries today have very sophisticated suppliers and supply bases in China, while others are still quite primitive.

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Practical Steps toward Implementing Knowledge-based Sourcing in China • Agree on the mind-set you will employ. Is China a new center of global competitive advantage or is it merely a low-value-added low-cost country? • Develop a vision for how the supply base will evolve over time, recognizing that your company may well need to play a central role in shaping this supply base rather than simply segmenting it and developing approaches to suppliers. • Segment your supply-side needs and develop a supply base strategy that defines roles, relationships, and commitments by commodity category, supplier relationship, and other factors. Which commodities and suppliers are truly strategic? Which are or should be purely transactional? • Develop a forward-looking knowledge development strategy across commodities and suppliers, defining which knowledge should be developed internally, which should be outsourced to third parties such as Li & Fung, and which should be developed by your suppliers. see it as a center of gravity for their global supply base; others perceive it, correctly in some cases, as just another sourcing location. Companies that consider China to be a new location for developing global competitive advantage across operations—for example, in product development as well as in marketing, sales, and aftermarket services—experience the role of the supply base in one way; companies that are sourcing limited, low-value-added, semi-processed materials or components experience it in a substantially different way. Where China is central to global strategy and involved in potentially highly profitable activities, the expectations for the supply base and supplier capabilities will necessarily be elevated. • Recruit a team (using as many locals as possible) that has the mind-set, experience, and commitment to implement your tailored approach. This typically involves people with specific technical skills as well as business development skills. In some cases, significant efforts may have to be put toward building supplier capabilities, including joint investments and the insertion of professionals who can think across this range of requirements.

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Three Knowledgebased Sourcing Imperatives

When companies decide that a knowledge-based sourcing approach in China (or another LCC) is right for them, they must invest in developing strong relationships with potential and existing suppliers. Knowledgebased sourcing is more resource intensive at the outset, but its ability to drive down costs and improve quality over the long run repays that investment many times over. Particularly in China and other LCCs, there is wisdom, and profit, in the knowledge gained. In the changing Chinese environment, three imperatives are essential to implementation of a knowledge-based sourcing strategy: 1. Know your suppliers inside out. Understand current and potential suppliers’ true cost positions. We have heard of many cases in which a supplier in China or another LCC did not understand its own costs. It won work from major manufacturers and retailers only to discover that it was losing money by fulfilling its contracts. Not surprisingly, these relationships fell into crisis. Visit suppliers and see their technical capabilities and capacity with your own eyes. This includes their machinery and equipment, their process technologies, the number and qualifications of their employees, and the like. A bid is no guarantee of a supplier’s willingness and ability to meet current volume and quality requirements or its future competitiveness.

Assess supplier performance against major cost drivers (including wages and benefits, productivity, facility and process/equipment scale and utilization, logistics, and access to raw materials). Low labor costs and the ability to obtain cheap raw materials and components are just two possible elements of cost structure. To gain true advantage, it is important to establish the ideal combination of world-class performance with location, scale, process technologies and automation, and success in execution. It will then be possible to rate potential suppliers against that ideal and determine how close a supplier from an LCC can come to meeting it. In some cases, it might be more advantageous to select a supplier closer to home. 2. Develop strong relationships with fewer suppliers. Identify a few suppliers that are willing to commit to a long-term relationship and to jointly creating a competitive advantage. Offer an enduring and profitable business relationship to each supplier and, in turn, demand its commitment to meeting cost, delivery, quality, and, if applicable, innovation targets. This will likely require local resources dedicated to supplier development, which means working with the supplier to achieve ambitious jointly established targets. To avoid fragmentation of the supply base, stop bidding out each part and dropping suppliers anytime another

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company offers a better deal. It is difficult for suppliers to develop the right capabilities, make customerspecific investments, and work together well if they’re not confident of continuity. Beware of the risks of a large supply base into which you have little insight and over which you have little control. The dangers include divisive conflicts within the supplier’s leadership team, financial problems, shifts in the supplier’s strategy or customer base, and deteriorating performance. These problems could go unnoticed until crucial shipments are missed, costs mysteriously escalate, or quality suddenly nose-dives. Avoid the transactional costs associated with managing many suppliers. Each supplier, particularly one far away from a customer’s locations, requires valuable and often expensive resources in purchasing, engineering, and other functions to manage purchasing orders and financial transactions, to review and discuss quality and delivery performance, and to work on innovation and product design changes. The larger the supply base, the more resources are required

to manage transactions, control supplier performance, and address issues in the relationships. These resources could be better spent on valuable activities such as working on an innovative or lower-cost product design. 3. Work jointly with your suppliers on continuous improvement. Focus on developing suppliers’ capabilities and advancing their competitiveness over time. Set ambitious but realistic targets for better performance in cost, quality, delivery, or innovation, and work with your suppliers, not against them, in achieving those goals. Successful continuous improvement requires agreed-on objectives, transparency of current and anticipated costs and processes, and the sharing of improvement ideas. Large customers often have internal knowledge about advanced concepts such as lean manufacturing that many low-cost suppliers have not yet developed. Improving low-cost suppliers’ capabilities in that regard can create a big payoff for both parties. If you have a smaller, more dedicated supply base, you can afford to invest in relationships and ensure a higher level of coordination in the entire supply chain.

General Motors’ sourcing program in China reflects both the demands and the benefits of knowledge-based sourcing. GM is very active in China; the company has a joint venture in Shanghai with the SAIC Motor Corporation and sells a million vehicles a year in China, making it the number one player in the market. GM also purchases US$2 billion worth of parts each year from Chinese manufacturers to ship to its plants in Asia and North America. In 2007, the automaker bought many different types of components in China to fill its North American assembly needs, led by aluminum wheels, chromed parts, and electronics such as radios, according to Bo Andersson, GM’s group vice president of global purchasing and supply chain. In addition to staff assigned to the joint venture with SAIC, Andersson has put in place a veritable knowledge-based sourcing blitz, with 250 GM purchasing professionals in China working with suppliers to monitor and upgrade their capabilities, as well as to build strong relationships that can redound to GM’s advantage. “We now have a third of our people in Beijing, a third in Shanghai, and

Beware of the risks of a large supply chain into which you have little insight and over which you have little control.

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a third in Guangzhou,” Andersson says. “But we’re moving much, much more into the countryside.” This move deeper into China’s mainland is part of an effort to seek new Chinese suppliers and reduce GM’s dependence on large multinational suppliers, which charge standardized global prices that are higher than Chinabased prices. Andersson and his purchasing team are trying to find more people like Jiang Yintai, president and owner of Shanghai Daimay Automotive Interior Company. Currently, GM buys more than 5 million sun visors a year from Daimay. “It’s a privately held company, and Jiang loves our business,” says Andersson. “He helped us to go from 100-plus sun visor families to just four. He’s now making steering

wheels for us, and he’s doing the same type of transformation.” GM’s goal is to find more of these local entrepreneurs and take an active hand in the evolution of their businesses. “It may take us 10 years to develop them, but we’d rather do that and have loyal suppliers forever,” Andersson explains. “Our strategy is based on the fact that we are willing to do a lot of work with people who have the right mind-set and the right culture and the right cost structure, versus just sourcing from China. What we’re doing is much more difficult, but the payoff is much better and the loyalty from these suppliers is very different.” Other Western companies have also shifted their focus in China from traditional practices to knowledge-based

sourcing. Like GM, one Tier One automotive supplier based in Europe began its effort to cultivate a robust Chinese supply base by establishing a strong supplier development team in that nation. This team assists new Chinese suppliers as they develop their capabilities to meet contract requirements, and helps existing preferred suppliers evolve into full-fledged partners. The Tier One supplier also invested in several development centers in China. These centers support both the company’s own local production and its supply base to optimize designs to suit the local market. One surprising gain: The centers have helped suppliers reduce costs by replacing raw materials formerly imported from the U.S., Europe, and Japan with domestically sourced raw materials.

GM’s goal is to find more local entrepreneurs and take an active hand in the evolution of their businesses.

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A Mind-set of Long-term Commitment

As GM and the Tier One supplier have discovered, knowledge-based sourcing places a high premium on identifying the right supplier and building an enduring relationship. It’s not quite as complex or as time-consuming as finding a full-fledged joint venture partner, but it does take more time than simply calling for bids. There are no shortcuts in this kind of relationship building. The mind-set of knowledge-based sourcing is also different from the shotgun RFP approach in this respect: Companies should work closely with suppliers, so closely that they might even jointly accept responsibility for a supplier meeting its cost and delivery performance targets. There should be no uncertainty and absolutely no surprises. The old mentality was simply to tell LCC suppliers, “Just meet your deadlines. We don’t care how you do it or what kinds of parts and materials you use.” That approach, of course, is no longer wise. A crucial aspect of a positive supplier relationship is mutual commitment. As GM found with Daimay, it is important for purchasing managers to educate suppliers about how they want to do business and to spend time

with suppliers to gear them up. If the two parties can achieve a mutuality of purpose, over time, the company can truly leverage the relationship and help the supplier develop and expand its business. If a company doesn’t demonstrate this type of deep commitment, the supplier’s inclination is to do the bare minimum necessary to get the business. The ability to adopt and use a knowledge-based sourcing approach takes on particular urgency in view of the rising currency and cost structure in China. Companies that want to hold their margins and maintain access to that fast-growing economy must increase the efficiency of their Chinese supply base. Even those manufacturers and retailers that choose to simply shift their supply base to a lower-cost country, such as India, Vietnam, or Thailand, would do well to observe the essential truths of knowledgebased sourcing. As these emerging economies prosper, it is very likely that they will go through the same evolution that China is now. When that happens, the winning multinationals in those countries will be those that learned from their experience in China and implemented best practices in sourcing from the start.

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