Paper delivered to the Technology and Operations Management Faculty of Harvard Business School by Russell S Johnson (MBA '80), President of China Array Group, LLC.: October 2002.

A Framework for Investigating China's Manufacturing

A staple of the first year TOM course is the Make or Buy case, i.e. produce in-house or buy from outside. The logical extension of the buy decision becomes why and from whom? Applying this question to China provides a framework for evaluating the country's manufacturing capability.

Historical Context

Two historical factors account for China's surprisingly strong and diverse industrial foundation: economic isolation and an emphasis on military preparedness. Since 1949, China has been estranged from the West, but, of equal importance, in 1960 China essentially severed all ties with the Soviet Bloc as well. The country was left on its own to produce everything it needed. Secondly, having experienced almost continual warfare from the late 30s through the mid 50s, with particularly horrific losses in the Korean War, clearly demonstrating its military shortcomings, China's government focused every effort on building a strong military. Between 1950 and 1980 it largely succeeded. Engineers were trained on a vast scale and sent by the government to military factories located in the country's interior (to make them less vulnerable to invasion), which then received the state's highest priority for material. Significant gains were achieved in the manufacture of small arms, munitions, heavy equipment and shipbuilding with the ancillary benefit of the country's manufacturing capacity being greatly enhanced.

As with most developing countries, when China started doing business with the West in the early eighties, low technology products led the way. But, quite rapidly Western companies discovered China's well developed industrial infrastructure and started moving up the technology chain to procure such products as submersible pumps, electric motors, compressors, hand tools, automotive and tractor parts etc. Western companies realized that, with a little tweaking, Chinese factories could produce adequate quality industrial products for Western markets.

China's Advantages over Western and Emerging Economies

On a continuum of products ranging from low technology (toys) to high technology (semiconductors), China's competitive advantage lies in the middle: the vast array of industrial products that make up the bulk of the world's economy. It possesses advantages that cut two ways: a cost advantage over the West and an advantage in manufacturing capability over developing nations.

How does one determine for which products China has a competitive edge over Western manufacturers? The answer lies in a comparison of the manufacturing approaches of the US and China. In simplified terms, the contest is between the US's high tech capital equipment and China's standard machine tools and skilled, low cost labor force. Certain products obviously fit better with one approach than another: high volume goods with little labor content favor the US. Low volume goods with high labor content favor China. For example, stainless steel dairy equipment (an area in which I have been involved for over 20 years) is produced in small production runs, which limits opportunities for automation, and requires extensive hand polishing to meet FDA standards, which increases labor content, would favor the Chinese model. On the other hand, some products require a higher degree of precision than is possible using standard machine tools currently available in China, which would place them firmly inside the US model.

Cost of Capital versus Cost of Labor

What of those products that lie somewhere between an obvious fit with one model or the other: say products of mid-sized production runs requiring some manual labor? The comparison then becomes a question of the cost of capital in the US system versus the cost of labor in China.

The US System: One catch phrase of computerized manufacturing is that it eliminates setup time. A CAD drawing loaded into a computer controlled laser-cutting machine produces a perfect part immediately. While this system eliminates the setup time between drawing and part, the actual cost of setup has just been moved back one step in the process. In order to achieve the immediate drawing to part transition, a very costly and complex system has to first be implemented. The laser-cutter, a significant capital investment, must be installed and calibrated for every type and thickness of steel to be cut: a costly and time-consuming proposition. Feed racks for providing the correct raw materials must be arrayed properly, etc. Setup in such a system consists of one colossal up front task to allow the tool to quickly adapt to making several diverse parts seamlessly, as opposed to a series of small setups for each different part. To amortize the cost of the machine and its initial setup, an absorption cost is assigned to each part produced by the machine.

The Chinese System: China, on the other hand, can be view as one giant job shop. Factories rely mainly on standard machine tools (lathes, brakes, hydraulic presses etc.) and tend to have an excess capacity of such tools, which gives Chinese manufacturers an ability to react to demand by adding or subtracting operators. The machine tools are mostly fully depreciated (an understatement) or are inexpensive compared to the capital equipment deployed in the US. The cost per piece under the Chinese model is mostly labor.

Outlined below is a simplified formula for determining which products have a competitive advantage in the US versus China (assuming each system is capable of producing the required precision necessary for the product in question):

US cost per piece required to amortize capital equipment < China labor cost per piece

Operational Leverage

The above comparison can be recast in terms of operational leverage. The two systems lie at opposite ends of the spectrum, which has significant implications for the future competition between them. Operational leverage is determined by a firm's fixed costs. The higher the fixed costs, the higher the operational leverage. Viewed in the context of the above discussion, US operational leverage is high; China's is low.

A corollary to operational leverage is that, as with debt leverage, high operational leverage entails more risk and requires a certain production volume to be profitable. Therefore, the US system must utilize its capital equipment at some minimum capacity or face losses as fixed costs exceed revenues. Alternatively, the Chinese model can easily add labor (by drawing from a large underemployed pool of workers) or subtract it (due to low social costs connected to layoffs). It is the quintessential example of low operational leverage. If the market drops, the Chinese simply reduce the number of workers. If it rises, they add workers.

A caveat to the China system is that the low operational leverage model applies primarily to private companies, as opposed to SOEs (State Owned Enterprises). SOEs have substantial obligations to cover workers' housing, health care etc. and are generally restricted from making layoffs, which drive up their fixed costs and hence their operational leverage. This caveat is diminishing as the private sector expands and the state sector contracts and revamps rules covering workers' benefits.

Private Companies in China's Future

Private companies' ability to efficiently match variable costs to revenues, the very definition of low operational leverage, represents China's best hope for coping with the vagaries of future markets and for taking advantage of arising opportunities by basically flowing resources to where they are needed without huge capital investments. The transition from a state owned to a private economy has enormous implications for China's future. SOEs are no longer sustainable. The government continues to prop them up through bank financing in an effort to slow the rate of unemployment and stave off political unrest. But, the real race has become how fast the private sector can absorb workers from the failing SOEs. Which raises a most critical question regarding China's future: is China's private sector up to the task?

Private companies in China are all startups: few older than 10 years, most less than five. If these private companies are successful, then they are fast growing startups: the most difficult to manage. Additionally, they exist within a shifting legal code undefined by precedent and have few of the traditional means of financing available to them. While managers have abundant experience in manufacturing, they have virtually none in sales, distribution or finance, since the entire economy worked under a government orchestrated quota system till well into the 1980s.

Private firms' reliance on manufacturing has led to a collective strategy of competing almost exclusively on price. A strategy welcomed by western buyers, but of questionable long-term benefit to Chinese manufacturers. The easiest profits for China's nascent private companies have come from arbitrage between costs in the West versus those in China. But, who has captured the greater share of these profits: the Chinese manufacturers or the Home Depots and Wal-Marts of the world? As markets become less imperfect and arbitrage between the West and China reaches diminishing returns, Chinese manufacturers, if they continue to compete amongst themselves and do not establish their own distribution or brands, will find their profit margins continually squeezed.

Productivity: Two Moving Targets

In the late seventies, books were being written predicting Japan would surpass the US as the world's largest economy. Japan, of course, faltered, but of equal importance, is the fact that the US responded with some impressive productivity gains of its own. The same will be true in the competition between the US and China. What form will this productivity competition take in the future?

The capital intense US model will gain productivity from reduced computer costs and from the integration of its automated systems. Whereas, earlier systems had each stage of production programmed separately, firms increasingly now have the ability to program the entire production process from bill of materials to finished goods with ever decreasing human involvement. China can increase productivity rapidly and cheaply by retrofitting current machine tools with inexpensive computer technology, which has been perfected by the West over the last three decades, and by replacing antiquated tools with more up-to-date, efficient models.

Ironically, as China invests in productivity improvements, it will inevitably move toward the capital intense model of the US. Thereby, dissipating its most powerful current advantage: low cost, skilled labor. Eventually, as both sides continue to invest in capital equipment, the competition will shift to that of managing capital intense systems with the key factor for success being managerial talent, which will spur demand for MBAs. So, the story has a happy ending for B-Schools everywhere!