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Article | McKinsey Quarterly

A new era for manufacturing in China

Companies that continue to base their manufacturing strategies solely on Chinas rock-bottom wages and stratospheric domestic growth rates are in for a rude awakening. New challenges will require new competitive priorities.
June 2013 | by Karel Eloot, Alan Huang, and Martin Lehnich

Chinas em ergence as a manufacturing powerhouse has been astonishing. In sev enth place, trailing Italy , as recently as 1 980, China not only ov ertook the United States in 201 1 to become the worlds largest producer of manufactured goods but also used its huge manufacturing engine to boost liv ing standards by doubling the country s GDP per capita ov er the last decade. That achiev ement took the industrializing United Kingdom 1 50 y ears. Today , howev er, China faces new challenges as economic growth slows, wages and other factor costs rise, v alue chains become more complex , and consumers grow more sophisticated and demanding. Moreov er, these pressures are rising against the backdrop of a more fundamental macroeconomic reality : the almost inev itable decline in the relativ e role of manufacturing in China as it gets richer. Manufacturing growth is slowing more quickly than aggregate economic growth, for ex ample, and ev idence suggests that the country is already losing some new factory inv estments to lower-cost locations, such as V ietnam, sparking concern about Chinas manufacturing competitiv eness.
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Competitiv eness, of course, is a broad term that can confuse more than clarify . During the 1 980s, for ex ample, there was much hand-wringing in the United States about declining manufacturing competitiv eness v ersus Japan. In the following decade, howev er, those concerns faded, replaced by a focus on the failings of Japan Inc., the SUV -fueled resurgence of the US automotiv e sector, and the boom in US high-tech manufacturing. In the United States then, as in China today , there isnt just one manufacturing sector; there are many , each with different competitiv e strengths and weaknesses. In this article, we mov e bey ond the hy ped hopes and frantic fears for Chinese manufacturing as a whole, to gain a more balanced picture of this div erse sector. We start with a summary of four key challenges that affect different ty pes of manufacturers in different way s and then mov e on to a discussion of competitiv e priorities whose importance again v aries for play ers of different stripes. Despite the v ariation across manufacturing subsectors, companiesChinese owned and multinational alikecant escape the need to raise their game and mov e up the v alue chain by boosting productiv ity , refining product-dev elopment approaches, and taming supply -chain complex ity . Those that do should prosper in the y ears ahead, while those that rely on y esterday s model of rock-bottom wages and stratospheric domestic growth rates are likely to fade.

McKinsey Quarterly

Four challenges
For y ears, Chinas low salaries; strong supply base; high inv estment in port, road, and rail infrastructure; and solid engineering and technical skills prov ided a strong platform for manufacturing ex ports. Meanwhile, a v ast domestic market helped fuel Chinas continuing transition to a consumption-based economy . Today s outlook is more mix ed. Here, we rev iew four core challenges and the ty pes of play ers particularly affected by each of them. In doing so, we draw on a set of global manufacturing archety pes established recently by the McKinsey Global Institute (see sidebar The makeup of Chinese manufacturing).
Rising factor costs
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The makeup of Chinese

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Rising wages and the appreciation of the renminbi hav e dampened Chinas ex ports in recent y ears and focused global attention on its future v iability as a

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low-cost manufacturing center. Most multinationals that produce labor-intensiv e goods, like tex tiles and apparel, are activ ely seeking to div ersify bey ond China to reduce costs and mitigate political and supply -chain risks. China-based processors of goods such as bev erages, fabricated metals, food, and tobacco are also concerned about rising costs, including those for packaging. Y et their regional focus makes this less a global competitiv e issue and more a question of which play ers in the v alue chain will create the most v alue. manufacturing
Rising consumer sophistication

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McKinsey research suggests that by 2020, the income of more than half of Chinas urban households, calculated on a purchasing- power-parity basis, will catapult them into the upper middle class a category that barely ex isted in China in 2000 (for more, see Mapping Chinas middle class). The members of this group already demand innov ativ e products that require engineering and manufacturing capabilities many local producers do not y et adequately possess. An ex ecutiv e of a Chinese telev ision-panel maker, for ex ample, recently confessed that his company cannot fully meet the requirements of high-end customers and that the quality of his company s flat-screen panels is ex ceeded by that of products from fast-mov ing South Korean competitors. Chinas automakers face a similar challenge: consumers perceiv e their brands as lower in quality , ev en compared with foreign brands assembled in nearby Chinese factories. These issues confront play ers in a range of other sectorsfrom appliances and chemicals to electrical and office machinery , pharmaceuticals, telecommunications gear, and transportation equipment. What they hav e in common is that they compete on the strength of their R&D, technology , and ability to bring customers a steady stream of new products and serv ices. Rising consumer ex pectations will require ev en food and bev erage play ers to raise their game on freshness and regulatory compliance, areas where Chinas standards still lag behind Western ones.
Rising value-chain complexity

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Another big challenge is coping with the rising v alue-chain complex ity that accompanies consumer growth. Greater affluence and rapid urbanization require product makers to manage, make, and deliv er an array of increasingly div erse and customized products to increasingly remote locations. Between now and 201 5, for ex ample, almost two-thirds of the growth in demand for fast-mov ing consumer goods will come from smaller (Tier-three and Tier-four) cities, which outnumber their Tier-one counterparts, such as Beijing or Shanghai, by a factor of 20. Product proliferation and booming e-commerce also contribute to v alue-chain complex ity . Business-to-consumer online sales in China are ex pected to grow by 45 percent a y ear from 201 0 to 201 5. For product makers, this means smaller and smaller lot sizes and deliv eries to households farther and farther out there. During Chinese festiv al periods, the supply chains of many companies already creak under the strain of online orders. Demanding consumers contribute to supply -chain headaches, as well. Since many retailers in China accept cash-ondeliv ery pay ments, its not uncommon for shoppers to pit online retailers against one another by ordering, say , three identical products from three retailersand refusing deliv ery to all but the first to arriv e. Such issues are relev ant for technology companies and others responding to the Chinese consumers increasingly sophisticated tastes. But rising v alue-chain complex ity is also a worry for manufacturers of more labor-intensiv e goods, giv en the sheer v ariety of products they make, and for regional processors, whose logistics networks are affected by urbanization and booming infrastructure dev elopment.
Heightened volatility

The uncertain global economic env ironment since 2008 has complicated life for manufacturers ev ery where. Those in China hav e arguably been the most sev erely affected, giv en the country s status as the workshop of the world. In Chinas steel industry , for ex ample, annual demand growth slowed to 3 percent in 201 2, after a decade of double-digit increases. The result has been lower capacity utilization, cutthroat competition, and a 56 percent decline in av erage profit margins for the industry from 201 0 to 201 2. Similarly , in Chinas massiv e auto industry , annual growth rates ov er the past fiv e y ears hav e v aried from 7 percent to 52 percent. Appliance and electrical-machinery producers hav e also ex perienced strong demand fluctuations, ex acerbated by gy rating ov erseas demand.
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V olatility at such lev els makes planning difficult for Chinas manufacturers. This is problematic for companies that routinely make large, long-liv ed capital ex penditures whose returns are crucial determinants of performance.

Three imperatives for Chinas manufacturers

As labor costs rise and slowing growth dampens the ability of Chinas steadily rising industrial output to deliv er regular productiv ity gains, manufacturers there will need to striv e for global lev els of operational ex cellence. Energy efficiency is a particular opportunity for many companies (see Seizing Chinas energy -efficiency opportunity : A case study ), but far from the only one. Companies hoping to differentiate themselv es bey ond low-cost labor also can focus their efforts upstream (to harness innov ation and product-dev elopment efforts) or downstream (to tame supply -chain complex ity ) or both, depending on the characteristics of competition in their sectors.
1. Achieve manufacturing excellence

Lean and Six Sigma are not new to China. Plant managers in domestic and multinational companies alike hav e worked hard to bring manufacturingex cellence tools and approaches to the country s shop floors. But for all these efforts, significant potential remains, mainly because plant managers in China often focus on hard technical tools at the ex pense of softer ones inv olv ing mind-sets and behav ior. A recent lean-manufacturing transformation at one stateowned enterprise, for ex ample, fell far short of its efficiency targets when managers and superv isors failed to complement the otherwise ex cellent technical changes with the necessary softer skillsincluding leadershipthat would hav e made the changes stick. One factor that complicates these problems has been the breakneck dev elopment of Chinas manufacturing sector, which means that many workers are relativ ely new to the job. We hav e seen too many frontline managers, lacking the ex perience to identify the problems inev itably associated with new plants and new v entures, merely react to problems rather than look for their root causes. Companies facing this problem will nev er get the full benefit of the productiv ity improv ements they ex pect from lean. In one auto-assembly and body -shop operation, for ex ample, team leaders spent as little as 5 percent of their time on coaching and problem solv ing (best practice is about 30 percent). Improv ement efforts stalled until the company introduced standardized daily work agendas for team leaders and superv isors, to emphasize that shift meetings were occasions for problem solv ing and coachingnot firefighting. Cultural differences also continue to thwart operational improv ements in Chinese companies. In one auto plant, the multinational joint-v enture partner installed v isual-performance boards to make the status of work projects transparent, assuming that the tools would be accepted as they are elsewhere in the global auto industry . In fact, the frontline workers resisted them, interpreting the initiativ e as a criticism of indiv idual colleagues and forcing the joint v entures leaders to dev ise way s to achiev e the same effect without alienating the staff. Moreov er, the Chinese company s senior plant managers, while supporting the changes, were initially uncomfortable about role-modeling the more transparent and inclusiv e way of working. A new continuous-improv ement department ev entually helped workers and managers alike to v iew greater transparency and continuous improv ement as a new way of working rather than a flav or of the month ex ercise. The automakers ex perience is not uncommon; indeed, the fact that the domestic leaders became inv olv ed was encouragingall too often, the front line must sort out such changes itself. Finally , companies in China must aspire to ex tend efficiency improv ements throughout the v alue chain. An automotiv e joint v enture recently began this journey by working with 60 of its suppliers to address the 30 most pressing quality problems. The company fix ed them in only six months and has since prev ented their recurrence, in large part by equipping its people with assessment tools and skills and by engaging suppliers to address problems at the source. A new performance-management sy stem helps ensure that both the automaker and its suppliers keep up their ends of the bargain.(For more on the relationship between purchasers and suppliers, see sidebar Seeking purchasing ex cellence in China.)
2. Look upstream

Sidebar
Seeking purchasing excellence in China

For industries reliant on innov ation, the triple whammy of rising costs, complex ity , and competitiv e pressure means that the old way s of dev eloping products in China now risk becoming liabilities. Stay ing competitiv e will require domestic

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companies and multinationals alike to change, starting with the mind-sets and attitudes that hav e perv aded productdev elopment activ ities in China. Product-development roadblocks. Domestic Chinese companies must get bey ond the faster, cheaper fix ation that has characterized their approach to R&D in recent decades. For ev ery world-beating Chinese innov ator, we still see dozens of smaller play ers struggling to dev elop the R&D pipelines that would help them grow from scrappy upstarts into incumbents that can realize their global ambitions. The growth of one China-based medical-dev ice play er, for ex ample, has halv ed in recent y ears as smaller domestic competitors copy its designs and undercut its prices, much as the company itself copied from multinationals in earlier y ears. Y et ev en as it works now to boost its R&D capabilities and to generate market insights ex tremely difficult tasks giv en the absence of necessary skills and institutional processesthe copy ing mind-set remains strong. To some ex tent, multinationals face a mind-set challenge as well. Many inv est significantly in their China R&D units while continuing to regard them as costsav ing satellites of the home-office mother ship. Ev en when multinationals establish supposedly autonomous R&D units in China, many lack the support and skills to become intellectual-property creators, not just consumers. The ex perience of another medical-product company we studiedthis one a multinationalhighlights the challenge. The leaders of the multinationals China R&D group thought they d identified a lucrativ e niche for a new, low-cost medical-diagnostic productbut were denied funding by the head office back home. The general manager of the China business fought what he thought was a shortsighted decision, winning permission to proceed if his business unit could finance the new product itself. His unit ultimately did just that, in part by promoting the product to customers and collecting adv ance orders. Once launched, it was highly successfulat first in China but soon in other countries too as the company s sales reps got wind of its popularity and began offering it in their own regions. Fast-forward about 1 8 months, when the company decided to rev ise the product. Rather than entrust its dev elopment to the China R&D team, the company assigned it to the main R&D group at headquarters and used the China team for support. The product flopped when new and technically elegant features and other changes insisted on by the Western group prov ed too ex pensiv e for customers or irrelev ant to them. A success story. The ex perience of a global lighting manufacturer suggests how some companies are ov ercoming the challenges. With global consumer preferences shifting toward new applications of a decades-old technology , the company identified a huge market opportunity in LED lighting. The market was also hugely competitiv eChinese and Taiwanese play ers were piling into the lower-end consumer segmentsso a well-designed product clearly wouldnt be enough. Hitting a low price point and rapidly establishing scale would also be necessary . The multinational briefly considered using its world-class global R&D unit to dev elop the product. But senior ex ecutiv es worried that the groups insular, engineering-centric culture would lead it to ov erspec the offering with costly features. Leav ing it to the company s China unit, on the other hand, was too risky : that group couldnt generate unique customer insights and didnt hav e enough ex perience working with supplier networks upstream or with the company s global supply chain downstream to compete on cost and speed. The obv ious compromise combining the groups in a more traditional way by play ing to the strengths of eachmight mean suffering the usual time-zone delay s while reinforcing the silo cultures the company s leaders wanted to break. It ultimately chose to v iew the project as an ex periment for improv ing both units, so that the one in China would become more independent and the efforts benefits could be lev eraged globally . To get there, company ex ecutiv es quickly assembled a mix ed R&D team in China comprising representativ es from the marketing, procurement, supply -chain, and quality groups. For ten weeks, the team worked closely to dev elop an ideageneration and decision-making process that could not only create a winning, scalable design but also build skills and dev elop processes the company could use globally . The team collaborated to create and test customer insights, complementing the work with teardowns of competitors products. It also conducted shop-floor walkthroughs with suppliers and met with a v ariety of manufacturing ex perts to learn how the product could incorporate cheaper, more modular designs. A set of simple rules prov ed critical to breaking old habits and unlocking good ideas: to ensure that the team nev er fix ated on one part of the v alue chain at the
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ex pense of another, it consistently asked a handful of total-cost-of-ownership questions when it made its most important decisions. This approach helped spark improv ement ideas in unusual areas, such as product packaging: the team found a way to giv e one of its products a more prominent shelf appearancea locally important factor because of high lev els of competitionwhile lowering logistics and other costs through the efficient use of materials. As the effort picked up steam, it became popular with other managers in the China business. The company trained some of these ev angelists as change agents to maintain momentum at the end of the pilot. This effort ultimately helped the company to lower the costs associated with the product line by an additional 20 percent bey ond initial ex pectations. Further, the effort positions the company well for future cost-reduction opportunities that should arise as the industry matures.
3. Tame supply-chain complexity

While the effects of v alue-chain complex ity v ary by manufacturing subsector, most Chinese consumers are changing faster than supply chains are adapting. Indeed, supply chains in the country both multinational and domesticare generally set up for a low-labor-cost env ironment that is quickly disappearing. Now that long cy cles characterized by so-so lev els of transparency and crossfunctional collaboration are prov ing insufficient, companies will hav e to start by rev isiting their demand planning. Consider the ex perience of a large consumerelectronics company whose processes were prov ing unsuited to the new demand patterns associated with some of its high-end products. Poor or delay ed forecasts were disrupting operations and leading to ex cess inv entories, while also upsetting customers downstream. The turning point was the company s recognition that its planners were apply ing the same broad-brush approach to all products, regardless of their market characteristics. In response, the company s leaders created a tiered approach to detach planning activ ities for some basic appliances whose demand patterns were well understood (rice cookers, for ex ample) from plans for faster-mov ing products with less certain demand. For the basic products, the company dev eloped a streamlined, good enough planning approach. For the high-end goods, it crafted specific plans by product line. Its results, including an ov erall improv ement in forecast accuracy to more than 65 percent, from 35 percent, hav e been impressiv e. Inv entory fell from more than 55 day s to 30 day s, and the company increased its proportion of on-time deliv eries to more than 95 percent, from 60 percent. Whats more, the changes in the company s planning approach made the work more interesting for its employ ees, as many of them subsequently receiv ed training in adv anced forecasting techniques. Consequently , employ ee turnov er among the planning teams went down dramatically from 50 percent before the effort to just 20 percent afterward. In a second phase, currently under way , the company ex tended this approach for high-end products to others with similar demand characteristics. Significantly , the company is separating what had been a monolithic China supply chain into nimbler splinters that can better manage complex ity . Products with steadier demand go to market in the traditional manner: v ia coastal distribution centers and large drop-ship orders to retail partners. Higher-end ones trav el v ia smaller regional distribution centers located closer to demand inland. For some products, this approach allows the company to ex periment with postponement strategiesfinalizing product assembly closer to demandthat help reduce costs and inv entory lev els (in the case of some customers, by as much as 45 percent).
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As companies look to mov e their footprints closer to customers in Tier-three and Tier-four cities in Chinas interior, another likely change will be the long-term dev elopment of logistics hubs and assets. In this way , those companies will be better positioned to serv e booming demand for online purchases (see Chinas etail rev olution). These inv estments are risky , and many senior ex ecutiv es we know are worried about ov erex tending their companies. Some describe what they say is a need to go Westbut not too far West. As for domestic Chinese companies with global plans, they know that getting closer to customers means Western customers as well. A few of the largest white-goods makers are thinking about ex panding their assembly and test activ ities in the dev eloped world, because they recognize that they can no longer adequately serv e it from Shenzhen and other hubs.

Chinas rise to manufacturing preeminence in recent y ears has been amazing. Y et rising costs, more sophisticated consumers, and fundamental macroeconomic

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realities mean that y esterday s approaches to manufacturing are losing their relev ance. For Chinese-owned and multinational manufacturers alike, the imperativ es now are to boost productiv ity , refine product-dev elopment approaches, and tame supply -chain complex ity . Those that do so can create an enduring competitiv e edge.
About the authors Karel Eloot is a director in McKinseys Shanghai office, w here Alan Huang and Martin Lehnich are principals. The authors w ould like to thank She Guo, Mads Lauritzen, Gregory Otte, Gernot Strube, Min Su, and Forrest Zhang for their contributions to this article.

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