The future of sourcing and

manufacturing in China

February 25, 2011

CONFIDENTIAL AND PROPRIETARY

Any use of this material without specific permission of McKinsey & Company is strictly prohibited

Speaker Profiles
Dave Rogers

Martin Lehnich

Bill Gerhardt

Associate Principal

Associate Principal

Senior Expert

Education
MBA, University of
Chicago

Education
Masters in Physics,
University of Stuttgart

Education
MBA, University of
Texas

Relevant experience
Led effort to apply lean
manufacturing principals to greenfield plant design which houses
three distinct manufacturing
processes. Productivity increased
by up to 37%, space utilization
improved by up to 35%, and lead
time decreased by up to 79%.
Led effort to accelerate the
development and production
readiness of major aerospace
program in a China / MNC jointly
managed facility
Conducted an in-depth product
launch / ramp up process diagnostic
for a leading China based
automotive OEM
Prior to joining McKinsey, worked
14 years in the automotive industry,
most recently as Executive Director
for Lear Corporation in China

Relevant experience
Leader of SCM practice in China
Led development of low cost and
high quality modules for an
automotive OEM in China through
best-of-benchmarking with suppliers
Building and leading the Global
Supply Chain + Procurement
organization of a major Telecom
vendor (9B Euro procurement
volume, 7000 people in end-to-end
value chain)
Successfully restructuring the
industrial base in Europe and USA,
with substantial shift of resources
from high cost to low cost countries
Prior to joining McKinsey, acted as
CIO and led the Global Supply
Chain & Procurement Organization
as Senior VP at Alcatel-Lucents
headquarter in Paris

Relevant experience
Designed and guided multiple
supply chain transformations
focusing on transparency and
accountability in companies across
Asia and Africa at McKinsey
Developed tactical execution
strategy for Japan consumer
electronics company to outsource
supply to extended manufacturers
and ODMs
Re-designed top South Korean fast
moving consumer goods companys
operating model with ODM suppliers
increasing service levels from 95%
on time delivery to continually over
98%; the best in companys 40 year
history
Former Strategy, Operations and
Planning VP of Global Supply Chain
for leading IT company

McKinsey & Company

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Contents

Six factors that underpin Chinas success

Recent trends within China and Asia
Strategies to adapt to changes
Build and defend
Hunt for greener pastures

McKinsey & Company

| 2

Coming out of the down turn, China still remains the worlds
largest exporter
Top economies total export of goods and services
USD Billions

2,000
China1
United States

1,500

Germany

1,000

Japan
France
United Kingdom
Russia
India
Brazil

500

0
2000

01

02

03

04

05

06

07

08

2009

In 2009, China
exported 11% more than
the US and 23% more
than Germany

SOURCE: Global insights - WMM

McKinsey & Company

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China has focused on 6 key sources of competitive advantage which

ensure its leadership position among all LCC sourcing alternatives
Sources of competitive
advantage

Findings for China and alternative regions

Scale

Chinas scale of production is truly global and there is no competition form

any LCC alternative on this parameter

Value chain

Chinas value chain maturity incentivises others to plug-in by co-locating

and serves as an exit barrier for already existing plants

Engineering &
manufacturing
capability
Rising
productivity

Ease of
business

Infrastructure

China ranks the highest in terms of high value-added manufacturing and is

supported by growth in number of R&D facilities set up over time
While labor costs have increased, so has the productivity. But over time,
this could put China at a disadvantage
China rates moderately in the index of ease of doing business, but is ahead
of top contenders India and Vietnam

China rates way above India and Vietnam in all the physical infrastructure

McKinsey & Company

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In terms of scale China dominates over India and Vietnam

China

Overall export value comparison 2002-2009

USD billions

India

Vietnam

CAGR
Percent

1,600

21

1,400
1,200
1,000

18

800

China exports
have grown at
a faster rate
from 2002-09
than both India
and Vietnam

600
400
200

17

2002

03

04

SOURCE: Global insights; McKinsey analysis

05

06

07

08

2009

McKinsey & Company

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ELECTRONIC
INDUSTRY

China has a tightly integrated supplier base which makes

relocation difficult
Factors
Proximity to experienced supplier base

Number of electronics component manufacturers

India

Vietnam

3,700

500

Number of MNC local electronics component plant

990

300

Electronic component industry size ($ billion)

458

17

Size of skilled1 labor force (million)

150

103

80

50

71

n/a

30

n/a

8,460

1,463

31.1

Component local availability (%)

Proximity to customers
Domestic consumer electronics2 industry size ($ billion)

China

Favorable

Export consumer electronics revenue ($ billion)

Total logistic capacity (rail + air + ship; million tons)

n/a

Facility and infrastructure

Time-to-production/market
Energy supply
1 High school equivalent workforce
2 CE industry is the biggest customer of electronic components
SOURCE: CST interview; State Statistic Bureau of PRC; KoC; Govt. of India; NSS report, Vietnam State Statistic

McKinsey & Company

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China exports much more complex categories in greater value than

India and Vietnam
Machinery & Industrial (%)
USD Billion

Rest of the exports (%)

Chinas top export industries, 2009

Indias top export industries, 2009

Vietnams top export industries, 2009

Industry

Industry

Industry

Machinery & Industrial

Goods

575

Machinery and
Industrial Goods

43

Retail/Apparel

199

Metal and Mining

34

Metal & Mining

156

Chemicals

23

Retail/Apparel

13.0

Consumer

10.5

Metal and Mining

9.0

Consumer

97

Retail/Apparel

23

Machinery and
Industrial Goods

8.5

Chemicals

72

Consumer

14

Pulp and paper/Forest

3.0

Media

47

Media

Media

2.0

Transportation
equipment

47

Pulp and paper/Forest

Chemical

1.0

42

Transportation
equipment

Pharmaceuticals/medical

1.0

Pulp & Paper/Forest

Products

20

Pharmaceuticals/
medical

Transportation
equipment
Pharmaceuticals/medical

0.5

Others

94

Others

Others

4.5

57

79
18

43
82

SOURCE: Global insights; Bank of India, McKinsey analysis

24
76
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Productivity growth mitigates labor cost increase

Productivity and labor cost indices, China
Index, 2000 = 100

Country-level labor productivity

Real GDP at PPP1 in 2005 indexed $ per employed person

Labor
cost
per
hour

500

400

Better

10

China

+17%

300

Unit
labor
cost
index2

200

India
Vietnam

100

+8%
0
2000

02

04

06

08

2010

0
2000

Worse
02

04

06

08

2010

1 Purchasing Power Parity, indexed where 100 equals US performance

2 Considering labor productivity improvement
SOURCE: EIU; McKinsey analysis

McKinsey & Company

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China performs better than India and Vietnam on ease of conducting

business
China

India

Vietnam

Starting a Business

151

169

116

Dealing with
construction permits

180

175

69

Employing workers

140

104

103

Registering property

32

93

40

Getting credit

61

30

30

Protecting investors

93

41

172

Paying taxes

130

169

147

Trading across
borders

44

94

74

Enforcing Contracts

18

182

32

Closing a business

65

138

127

Ease of doing
business rank1

89

133

93

1 Lower rank, easier to do business in the country

SOURCE: World Bank International Finance Corporation 2010 which covered the period June 2008 through May 2009

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At a country level, China has more infrastructure capacity

than India or Vietnam
Infrastructure throughput/capacity vs. total GDP, Indexed vs. China

Vietnam

India

Roads

41
75

Roads
Utilities

53

Air

53

Ports

Rail

91

Utilities
Air

68
48

Ports

56

Rail

71

15

China
China
SOURCE: "Logistics Infrastructure of India" by Ernst and Young; "Indian Indirect Tax Reforms" by PWC; CEIC; Deutsche
Bank Research Bradsher (2006); The World Bank's Doing Business report, 2008

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Contents

Six factors that underpin Chinas success

Recent trends within China and Asia
Strategies to adapt to changes
Build and defend
Hunt for greener pastures

McKinsey & Company

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Recently there are trends which are a cause of concern for sourcing
professionals working with China

McKinsey & Company

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Latest headlines indicate trend is evolving

Vietnam low cost labor has growing demand with limited supply in major cities
Poor Infrastructure, Low-quality Labor
Hinder FDI Inflow to Vietnam*
-14 January 2011

Post-Tet Labor Shortage Hits

Enterprises in Vietnam*
- 10 Feb 2011

Consumer price growth of 2010 in Vietnam was 9%

on average, and the increasing living cost in big
cities has led to the labor shortage problem*
- Jan 2011

Labor Recruitment Demand in Vietnam Biggest City Up 5.03% in Jan*

-27 January 2011

China returning labor patterns vary by employer

Bosses battle it out for workers
- 14 Feb 2011
China Daily Information Update

Most workers return to LG display

China plants after holiday
16 February 2011 APULSE

Migrant workers setting their sights higher

- 18 February 2011
States News Service
Many migrant workers who returned to their
hometowns for the holidays decided to stay there for a
variety of reasons, including a cheaper standard of
living, new prospects closer to home and wanting to
be with children they had not seen for months or
years

* Vietnam News Brief Service

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Recent changes in coastal China seem to erode its dominant position

as a LCC source
Several factors adversely impact Chinas over-all cost competitiveness
as a LCC source
62

Appreciation of
the RMB against
other currencies

Dong

Rising labor
costs

Restrictive
(domestic) trade
policy

23

26

INR

USD

17

RMB
(% change
vs 2005*)

Euro

15% per annum over the last years

Tax policy to limit industries that are (i) highly polluting,

(ii) high energy/resource usage, (iii) low value-add

Highest impact in industries like metals, glass, chemicals,

plastics, timber and paper, furniture, textiles, garments

Reports of labor shortages, especially in the

Pearl River Delta

*31 Jan 2005 vs 31 Jan 2011

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At the same time Chinese Government is moving companies inland

Government
support

Manufacturing
shift

Investment
direction

Labor
migration

SOURCE: Lit-search;

General Office of the state council announced a

corp. tax reduction program to encourage foreign
investment for labor intensive industry in Middlewest China (April. 2010)

~200,000 manufacturing companies moved to

inland China (2009)

~1500 plants in Dongguan moved to China inland,

and the number is still increasing (2010)

37.3% of Hong Kong enterprises in Pearl area plan

to move all or part of their capacity to inland (2010)

~9000 labor intensive companies planned to

transfer production from Guangdong province
plans to inland in 3 years (2010)

A stimulus package claimed to invest over RMB

680 billion in 5-year to develop Western China
(July 2010)

Taiwan enterprises invested 1.4 billion USD in

Chongqin, Western China (2009)

The growth rate dropped 35.8% on migrant labor

in Guangdong province (2009)

Labor movement to China inland caused 60% of

coastal companies in labor shortage (2010)

Inland

Coastal area

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While across Asia, many LCCs seem to appear on the top 20 list on
FDI confidence index
FDI confidence index (top 20 countries)

2005

2010
2.20

China

1.95

India

1.93

China
1.67

United States

United States

1.42

India

United Kingdom

1.40

Brazil

1.64
1.53
1.43

Poland

1.36

Germany

Russia

1.34

Poland

1.35

Brazil

1.34

Australia

1.33

Australia

1.28

Mexico

1.32

Germany

1.27

Canada

1.32

United Kingdom

1.32

Hong Kong

1.21

Hungary

1.16

UAE

1.29

Czech Republic

1.14

Vietnam

1.29

Turkey

1.13

France

1.29

France

1.10

Hong Kong

1.28

Japan

1.08

Other Gulf States

1.26

Mexico

1.08

Romania

1.26

Spain

1.08

Czech Republic

1.25

Singapore

1.07

Russia

1.24

Italy

1.06

Indonesia

1.22

Thailand

1.05

Malaysia

1.22

SOURCE: Internet search

McKinsey & Company

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Contents

Six factors that underpin Chinas success

Recent trends within China and Asia
Strategies to adapt to changes
Build and defend
Hunt for greener pastures

McKinsey & Company

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As an association, lobby closely with the Government

Business associations
intimacy with the
Government can lead
to value maximization

Value of understanding Government's policies

Timing and
placements of
investments

Based on Chinese governments five year plans,

it is possible to
Identify regions under Government's
developmental focus
Get clarity on tax holidays or subsidies
Understand possible migration of essential
suppliers or customers to the region

Understand possible tariff and export incentive

structure for various commodities and products

Evaluate the right mix of products and components

to be sourced from China based on the above

In case of a clear indication that a certain sector will

not be supported (low value add, energy intensive
etc.), a timely decision to exit that industry can be
taken

Government's aspiration

Developmental focus:
Which areas/regions
should receive
incentives and stimulus
to spur growth
Industry focus Which
industry sectors are
worth investing in,
which would help China
develop deep knowhow
and skills to fuel the
next stage of
development

Identifying
right sourcing
strategy

Exiting certain
sectors if
required

McKinsey & Company

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As an individual company, improve in-house operations and..

ELECTRONICS COMPONENT
MANUFACTURER

CASE EXAMPLE #1: MANUFACTURING IMPROVEMENT

Initial situation

Transformation scope

Impact

4-month effort focused

on one business unit

Machining throughput

Holistic, end-to-end
production system
redesign examining all
processes within the
factory

Insufficient machining
capacity due to
machine downtime

Quality problems drive

substantial rework

Insufficient final
assembly capacity due
to bottlenecks

High levels of late

customer deliveries

Downward pressure
on margins

16 team members
trained in process
redesign and
improvement
implementation

16
Process 1

Process 2

Final assembly
40

60
Rework

Output

On-time delivery
60

SOURCE: Client example, McKinsey analysis

30

Added 5-6 points of EBIT

Rolled out end-to-end performance tracking
Instilled continuous improvement mentality in
organization
McKinsey & Company

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 enhance sourcing effectiveness

HI-TECH EXAMPLE

Percent
CASE EXAMPLE #2: SOURCING/PROCUREMENT IMPROVEMENT
120%
20%

-25%

100%

75%

Typical
MNCs
sourcing
cost in
Europe

Move
sourcing
to China

Typical
MNCs
sourcing
cost in
China

Leveraging Underlocal supply standing

base
of true
local cost
structure

Vertical
depth of local
sour-cing
(Deep
localization)

Sourcing/
Engineering
intimacy
(fast and
extensive
DtC)

Approach
to low cost
designs
(DtV
approach)

China
best
practice

1st stage localization

A

SOURCE: Client example, McKinsey analysis

McKinsey & Company

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Contents

Six factors that underpin Chinas success

Recent trends within China and Asia
Strategies to adapt to changes
Build and defend
Hunt
Hunt
forfor
greener
greener
pastures
pastures

McKinsey & Company

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Decision to shift base requires a structured approach

Identify industry archetype

Assess destination options

Evaluate Go/No Go

a)

List out the alternative location

options
It is important to extend this
analysis from a country to a
province level and if required, to the
level of the actual site plan

For the approach to be holistic

follow three filters:

a)

Based on importance of each

source of competitive advantage
(from step 1) and performance of
each location (from step 2), work
out a comparison between the
options

M
10
5
P

a)

Four industry archetypes or models

are categorized based on their
distinct set of critical success
factors
To identify the right archetype(s), it
may be necessary to break down
the organization at BU/P&L level to
understand which archetype is most
suitable for each BU

b)

Each archetype assigns

a different importance to each
source of competitive advantage

b)

Evaluate strengths that each

location brings, and hence how it
rates against each source of
competitive advantage
Understand the shifting nature of
this analysis and test for sensitivity
with time and with concerted
government action

b)

c)

Additionally, evaluate
overall system risk
option value of the move
efforts involved
Conduct an NPV analysis to
confirm financial viability
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1a

There are four basic industry archetypes

Industry Archetype

Characteristics

Examples

Process
industry

Continuous or batch process industries,

asset intensive,
use less but skilled labor

Capital intensive
manufacturing

Discrete manufacturing industries,

Automotive, home
appliances, capital
asset intensive,
Moderate use of labor with a mix of skilled and equipment, hi-tech
unskilled workers

Labor intensive
manufacturing

Discrete manufacturing industries,

Asset light
High use of labor with majority of unskilled
workers

Knowledge
industry

Discrete manufacturing industries,

Pharmaceuticals,
seeds/biotech,
Usually asset light
High use of labor with majority of skilled workers software

Petrochemicals,
metals, chemicals etc

Apparel, toys,
furniture, jewellery

McKinsey & Company

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1b

Importance given to each source of competitive advantage varies with

industry archetype
Scale

Value chain maturity

10

10

Labor costs and productivity

Infrastructure

10

10

10

Ease of doing business

Capability

10

Note: M=Capital intensive manufacturing; L=Labor intensive manufacturing; K=Knowledge industries; P=Process industries
SOURCE: Expert Interviews, McKinsey analysis

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2a We consider coastal China and a few fast emerging alternatives in our

quest for the ideal sourcing and manufacturing destination
China (coastal)
China (inland)
China

India

India

Vietnam

LCC
Destination Pros

Cons

China
(coastal)

Current incumbent with a vibrant business ecosystem

Advantages in scale, value chain maturity and
infrastructure

Increasing wage costs

Currency appreciation

China
(Inland)

Emerging alternative within China with lower cost of labor

Tax incentives and government stimuli to aid further
development

Increased logistics cost

Evolving infrastructure
Currency appreciation

India

Largest scale among LCCs outside of China

Strong and growing domestic economy, politically stable

Close proximity to coastal China, with similar

landed costs
Very competitive cost of labor

Vietnam

More difficult to transact

business
Higher logistics cost
Smaller scale and lower
availability of resources

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2b Coastal China wins on scale, value chain maturity and capability but
Vietnam and China hinterland are better on labor costs
1

Scale

Value chain maturity

C (I)
10

C (C)

C (C)

Infrastructure

C (I)
10

C (I)
10

5
I

C (C)

Ease of doing business

C (I)
10

Labor costs and productivity

C (C)

C (I)
10

Capability

C (I)
10

5
C (C)

C (C)

Note: C(I)=China (inland); I=India; V=Vietnam; C(C)=China (coastal),

SOURCE: Expert interviews, McKinsey analysis

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Decision must pass filters of sector suitability, non-monetary impact

and an NPV analysis before a Go/No Go verdict is reached
Relocation is an important
decision and a holistic view
need to be taken before
execution

Suitability captures medium

to long term viability and
profitability

Non-monetary impact
captures changes in risk,
option value of maintaining
presence in another market,
or network and finally the
resources required to make a
successful transition

An NPV analysis provides the

financial basis to go ahead
with a decision

A Suitable as
per industry
archetype
to relocate?

B How does it
impact risk,
option value
and resource
requirement?

C Is NPV1 the
best among all
the options?

1 NPV takes into account future trends of costs and revenues based on sensitivities and risk in the discount rate
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Evaluate suitability of a region to your industry archetype

High
Medium
Low

Industry Archetype

Results
100%

Process industry

Inference
71%

China (C ) China (I)

100%
Capital intensive
manufacturing

74%

China (C ) China (I)

100%

92%

Labor intensive
manufacturing
China (C ) China (I)
100%
Knowledge industry

72%

China (C ) China (I)

69%

65%

India

Vietnam

71%

69%

India

Vietnam

83%

96%

India

Vietnam

87%

73%

India

Vietnam

Scale and value chain depth are key to

the success of this industry archetype,
with coastal China the clear winner

Value chain depth and manufacturing

capability are important and here too,
coastal China is the preferred location

Labor cost is a key factor and though

coastal China is the favourite, the gap
can be bridged by the hinterland and
Vietnam over a short period of time

While coastal China seems to be

preferred, India could pose a serious
threat in this category

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..consider the non-monetary impact of the decision to shift and

Non-cost
parameters

Description

The option value of maintaining presence in an alternative

location can be viewed from the following perspectives
add-on value to existing investments
Entry into a potential market
Alternative source of production bases
Network value through foot print optimization

Risk diversification could be a goal in itself which could help

de-risk LCC sourcing from
Regulatory and policy changes in the sourcing country
Supply chain disruption in one region/country
Macroeconomic factors like GDP growth, currency risk

Any change of location would require a re-investment in

terms of identifying, qualifying and monitoring new sources
or managing the new facility
A quantum of sourcing, production and quality personnel
are required to make this transition which would take time
to take-off and still more time to stabilize

Option value

Risk
diversification

Resource
requirement

Rating (Example)
Low
High

Low

High

Low

High

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conduct robust financial evaluation to arrive at the decision

PERCENT
CASE EXAMPLE: MID SIZE AUTO COMPONENTS MANUFACTURER
(Evaluating move from coastal China to Vietnam)
Step 1
Impact on
cost
structure

Logistics
OH

8
44

Labor

13

40
8

Material

35

37

2010
baseline

Step 2
Initial
investment
and
transition
cost

6.5% Saving

Material
cost add

Overhead Freight
& tax
cost add
savings

Labor
savings

Final costs

Payback = 3.2 yrs

-67
2010

SOURCE: Client example, McKinsey analysis

65

86

100

2012

2013

2014

-17

2011

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Most favorable

Case example 1: component supplier - electronics industry

Least favorable

Industry sensitivity : Electronics

Competitive analysis: LCC alternatives

Low

China: China:
coastal Inland India Vietnam

High

Scale

Scale

Value chain maturity

Value chain maturity

Capability

Capability

Labor costs & Productivity

Labor costs & Productivity

Ease of business

Ease of business

Infrastructure

Infrastructure
Best suited location

100%
84%

Low

High

Risk

76%

80%
Option Value

GO
Resource
requirement

China (C )

China (I)

India

Vietnam

NPV Analysis

McKinsey & Company

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Most favorable

Case example 2: garments producer - apparel industry

Least favorable

Industry sensitivity : Apparel

Competitive analysis: LCC alternatives

Low

China: China:
coastal Inland India Vietnam

High

Scale

Scale

Value chain maturity

Value chain maturity

Capability

Capability

Labor costs & Productivity

Labor costs & Productivity

Ease of business

Ease of business

Infrastructure

Infrastructure
Best suited location

100%

101%

113%

Low

High

Risk

89%
Option Value

GO
Resource
requirement

China (C )

China (I)

India

Vietnam

NPV Analysis

McKinsey & Company

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RECAP
There are six key sources of competitive advantage which impact a regions competitiveness
Economies of scale
Value chain maturity
Engineering and manufacturing capability
Rising labor productivity
Relative ease of doing business
Infrastructure
Focusing on the above makes coastal China the worlds most preferred destination for sourcing and manufacturing
However, recent trends are a cause of concern to sourcing professionals working in China
Rising cost of business (wages, taxes and exchange rate)
Government's push to companies to move inwards
Emergence of other regions as alternatives
Companies have recourse to two generic strategies

Build & defend

As an association, lobby with Government, and align further investments with its policies
On its own, improve manufacturing and sourcing efficiency

Hunt for greener pastures

Analyse your industry type and its key drivers for being competitive
Research alternative options and their performance on the six sources of competitive advantage
Evaluate suitability, take cognizance of non-monetary impact and conduct financial analysis to decide Go/No Go

McKinsey & Company

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