Supply Chain: Making It in China

When Arvinder Surdhar traveled to China in 1990 to form a joint venture between IBM and a Chinese manufacturing company to produce PCs, he wound up manufacturing something he hadn’t expected: cardboard boxes.

“When we opened up those first shipments from China, there was more dust in the boxes than anything else,” recalls Surdhar, who is director of global logistics for IBM’s integrated supply chain division. Many of the PCs were damaged due to problems endemic to doing business in China, problems that still plague American companies 15 years later: bumpy, dusty, overcrowded roads (and train tracks); a fractured logistics network in which shipments are loaded and unloaded at the whim of provincial border agents; overburdened ports where products languish in humid containers for weeks waiting to board a ship. “We had to come up with special shrink-wrap and unique, thicker boxes and packing materials that absorbed shock and resisted dust and humidity,” Surdhar says.

IBM’s new boxes did not wipe out the cost advantages of making PCs in a country where factory workers, truck drivers and longshoremen make one-tenth the salary of their counterparts in the United States and Europe. But they could have. According to research by consultancy Booz Allen Hamilton, the logistical costs of getting products into, around and out of China may end up outweighing the cost advantage gained by going there in the first place; if the labor costs of manufacturing the product in the West account for 25 percent or less of the total product cost, it may be to companies’ advantage to keep manufacturing in the West.

Besides logistical complications, other factors—such as inflexible production lines and limited ability for many Chinese factories to handle last-minute design changes—can also make the risk of going to China bigger than the potential savings. Broken, dusty, improperly specified or delayed PCs don’t sell, no matter how little it costs to produce them. IBM’s joint venture thrived after its initial logistical hiccups, according to Surdhar, and the joint venture eventually began making higher-end servers for IBM. (The PC part of the business was sold to Chinese giant Lenovo earlier this year.) Other companies haven’t fared so well with their joint ventures. Making sure that products built in China look, function and arrive as promised remains a tremendous challenge today.

The CIO’s Burden

The slice of that challenge that falls to CIOs—monitoring, managing, automating and feeding the Chinese supply chain with information—is the most daunting of all. Supply chain visibility is a precious commodity even in the West. In China, for all but the most advanced products, navigating the supply chain can be a matter of feeling your way through total darkness. IT, however, is not the automatic answer for lighting up the supply chain. Labor costs are so low in China that IT automation and monitoring projects may add more to costs—in terms of software, hardware and still-precious (and unreliable) bandwidth—than they save in productivity. (The median wage at a Chinese manufacturing plant is 1,000 yuan, or about $120, per month, according to a 2005 survey by The MPI Group.) Hence, some low-tech or commodity products may not be worth monitoring at all until they hit a ship in a Chinese port.

CIOs who have succeeded in China understand the country’s dramatically different cultural, political and business practices and how they affect the design and management of supply chains. They know, for example, that the Chinese government essentially becomes a third party in any dealings with local companies and can intervene, at any time, in capricious and costly ways. They realize that Chinese companies consider contracts to be starting points for developing a business relationship—and may not honor them to the letter. They understand that communism is merely a new name for a political and economic system that has stressed hierarchy and authority over independence and jurisprudence for hundreds of years.

Though neophytes assume that China will become “more Western” over time, CIOs with experience there aren’t holding their collective breath. In the meantime, these executives have developed strategies that accommodate Chinese differences without compromising the goals of low costs and high quality. They hire Chinese import/export companies to act as local ambassadors to navigate the thickets of government bureaucracy, cajole local suppliers and provide information links to their supply chains. They build their own factories in China, when possible, to instill the company’s own manufacturing and quality processes and provide more fertile ground for extending the company’s enterprise IT systems into China. And they make the necessary investments in relationship building, or guanxi, that provide the foundation for doing business in China. (For more on how to negotiate this ethical thicket, read “Bribes and Payoffs—Oh, My!” on Page 54.)

CIOs who act without this knowledge risk erasing the very cost advantages that brought their businesses to China in the first place. If they can’t provide cost-effective systems that give insight into the supply chain, “the complexity and unpredictability of China-sourced products become overwhelming,” says Beth Enslow, VP of enterprise research for Aberdeen Group.

Stepping Back in Time

When the last chunk of Pacific Cycle’s bicycle manufacturing finally packed up and went to China in 2000, Ed Matthews’ information supply chain went dark. Gone were the detailed bills of materials and dedicated EDI that Matthews, who is Pacific’s director of information systems, had with factories in the United States and Mexico that enabled Pacific to ship bikes anywhere in North America in a matter of days and change production lines for a new model in as little as two weeks.

They were replaced by paper and pen, or at best, e-mails (when they went through) and simple spreadsheets. Matthews’ step back in time is not unusual: 63 percent of companies surveyed by Aberdeen Group manage their global trade processes using paper and spreadsheets. Production schedules for Pacific’s Chinese factories are in spreadsheets that are manually adjusted to fit Pacific’s specifications and purchase orders and then manually entered into Matthews’ U.S.-based SAP ERP system.

“There is a lot of manual work at both ends of the supply chain now because the Chinese factories aren’t sophisticated enough to have the systems,” Matthews says. Consequently, he can’t track bikes in anything approaching real-time until they hit the ports on China’s eastern rim.

Matthews and other CIOs working with Chinese companies compensate with lead time. The less visibility you have in the supply chain, the more time you need to get things right. Lead time for Pacific’s bikes is now as long as 270 days, from a maximum of 60 in the old days, Matthews estimates. It’s the same thing for many companies going to China: 42 percent of companies surveyed by Aberdeen had lead times of 60 days or more.

Longer lead times also mean much higher logistics costs—especially as Pacific does business with factories farther inland. (The farther in you go, the lower the costs are, because inexpensive labor is in much greater supply in China’s vast, impoverished western interior than in its coastal areas.) Products face a long trek across China (40 percent of those surveyed by Aberdeen said their products languish for 30 days or more inside China) and the oceans (20 to 30 days) before reaching the United States. Aberdeen found that 63 percent of companies with the longest lead times were spending more than 6 percent of revenue on logistics (for high-tech companies it was as much as 9 percent) while logistics costs in many U.S.-based companies were as low as 3 percent.

Longer lead times result in higher risks for any supply chain. Inventories will need to be higher to accommodate unforeseen demand, damage to shipments and variations in quality. When working at arm’s length with many suppliers that change frequently, as Pacific’s factories do, constructing deep IT connections doesn’t make much sense, according to Matthews. “I once asked if a factory could accept EDI,” he recalls. “A message came back asking, ‘What is EDI?’”

Despite the problems, the arrangement makes sense for Pacific Cycle. Low-end bicycles are fairly bulletproof commodity products that don’t change much year-to-year. So Pacific can afford to absorb the long lead times and switch factories often. The labor savings Pacific reaps from manufacturing in China blow away the losses in supply chain flexibility, Matthews says.

Your Ambassador to China

Matthews does what he can to shorten the lead times by working closely with importer/exporters in China. He has constructed EDI connections with Pacific’s representatives in China for purchase orders and advanced shipping notices, among other notifications. The importer/exporter tracks the bikes all the way through the Port of Long Beach/Los Angeles and on to Pacific’s U.S. distribution centers.

Importer/exporters and third-party logistics providers have emerged as the linchpins of China’s supply chain. They are like local ambassadors for foreign companies. They cajole factories to perform, cut red tape with the government, and push products through customs and onto boats and airplanes.

The importance of the importer/exporters can be tied to the role that relationship—or guanxi—plays in Chinese business. Familiarity is critically important in China. Veterans of China all report the importance of direct, face-to-face dealings to building and cementing business relationships. There are the bizarre examples—IBM’s Surdhar recalls drinking a mixture of snake blood and wine to demonstrate his commitment to a Chinese supplier. And there are the mundane—meeting suppliers at the airport in the United States and never discussing business during the first meeting. Both are designed to create trust. “Dealing with anyone there you have to be patient,” says Surdhar. “That is one of biggest issues foreigners face.”

The importer/exporter is an important link between Western expectations and Chinese realities. They understand better than any foreigner the system of favors—some legal, some not—that have helped the Chinese navigate the complexities of their hierarchical and arbitrary political systems for hundreds of years.

In the United States, laws and ethical rules that govern business behavior are relatively clear and uniformly accepted. Not so in Asia. “China is a much more hierarchical society than here in the U.S.,” says Tom Stipanowich, president and CEO of the International Institute for Conflict Prevention and Resolution. “People respect authority and place much more emphasis on people’s relative positions—superior and inferior—than we do.” For thousands of years, Chinese businessmen have brought their disputes to a recognized authority figure, such as a village elder, for resolution, says Stipanowich. That tradition survives, but the number of authority figures has increased, as has the overlap in their roles: city, regional and national officials may each have different interpretations of a law written by one of China’s national ministries, for example.

“The Chinese system is arbitrary and can easily change,” says Oded Shenkar, professor of management and human resources at the Fisher College of Business at Ohio State University and author of The Chinese Century. “Anything you want to get done depends on a network of people, not a single individual.”

Determining who gets the last freight slot on a crowded ship in a Chinese port, for example, is “very much open to interpretation,” Shenkar says. Priority won’t be determined by who got there first, or who needs it the most, or even who’s willing to pay the most, but by the relationships that have accumulated over the years with the shipping company, customs agents and government officials, he says. Approval at one level does not guarantee that the next level up will not reconsider the situation.

In this environment, it shouldn’t be surprising that contracts do not carry the same weight as they do in the West. “To the Chinese, the contract is the starting point to a relationship that will evolve,” Stipanowich says. “If you’re in a relationship with them, it behooves you to appreciate that there will be some need for accommodation on the original terms of the contract.” If suppliers try to take you to the cleaners, it may be time to end the relationship, not rewrite the contract.

The Supply Chain Headache

Guanxi, however, is just the beginning of a strategy for conquering China’s mysteries. Just ask Watts Water Technologies, a global manufacturer of water valves and monitoring equipment. Watts Water has a global supply chain that includes 12 manufacturing plants in the United States and now three in China. Watts Water first entered China in 1995, when the only type of foreign investment allowed by the Chinese government was joint ventures with local companies. But that model caused problems. “The joint ventures are difficult because you essentially have two parallel management structures—yours and the local company’s—and the two are often in competition,” says Anton Ter Meulen, VP of information and strategic planning at Watts Water. “It’s hard to know who’s in charge.”

In addition, Chinese manufacturers are not comfortable with the concept of the extended supply chain—where suppliers are partners, and parts are built and ordered in advance. The Chinese business culture is almost entirely cash-based; credit and advanced purchasing are not popular concepts in a country where legal remedies are limited, Ter Meulen says. “Factories won’t do anything without a firm purchase order in hand,” he adds.

To bring the Chinese factories up to speed on its business processes and IT, Watts Water bought out its local Chinese partners three years ago (when the Chinese government relaxed the joint venture requirement) and made the factories extensions of the U.S. plants. More and more companies are choosing that option. Direct ownership has become nearly four times as popular as joint ventures, according to the State Statistical Bureau of the People’s Republic of China.

Buying factories in China made it much easier for Ter Meulen to link his company’s U.S. and Chinese supply chains. He installed Watts Water’s QAD ERP system in the Chinese factories (in a special Chinese language version that incorporates the esoteric reporting requirements of the central government) and linked them together on a single global Progress Software database. “Using our software makes it a lot easier to integrate the Chinese factories into our demand stream back here,” he says.

At the same time, Ter Meulen also used his five importer/exporters to increase supply chain flexibility with the companies supplying his factories with raw materials and parts. Watts Water convinced them—by paying an extra couple of percentage points per transaction—to act as consolidation points for inventory from the Chinese suppliers they dealt with, who, without the direct relationship to Watts Water, were completely uninterested in looking beyond the purchase orders they received and sent.

The extra margin helped create a buffer so that Watts Water could more quickly recover from unexpected demand for its Chinese-made products and components. But it still didn’t give Watts Water’s own Chinese factories and the importer/exporters what they really needed: the confidence to buy and build things in advance. So Ter Meulen built a custom demand-planning system designed to give the Chinese six months of reliable demand information in advance. With that data in hand, the Chinese factories are expected to finish the product in 42 days.

The first thing Ter Meulen discovered when he started building the demand system was how little Watts Water really knew about its own demand. “We probably didn’t have good forecasts historically—and we didn’t need them,” he says. “We could forecast four weeks out, and that was fine. Suppliers were nearby and kept raw materials on hand; we were pretty vertically integrated. But as you extend the supply chain, you have to come up with greater forecast accuracy.” The demand-planning system aggregates demand in the United States and runs it through seven algorithms to get accurate readings. The forecasts are shipped to the Chinese factories and importer/exporters each week so that everyone can make any necessary adjustments to their plans.

To increase Watts Water’s supply chain flexibility further, the company is building two distribution centers in China: one in the north and the other in the south. These centers will provide mega consolidation points for the importer/exporters. In particular, the distribution centers will make shipping more flexible than it would be from the factories or from the importer/exporters. “Shipping directly from a vendor is not as much of a benefit since that vendor typically is dealing with a smaller diversity of items and usually on a less frequent basis,” Ter Meulen says.

Ter Meulen estimates that all these strategies will bring Watts Water’s Chinese lead times down from 120 days to as little as 30, while dramatically increasing the company’s ability to recover from unexpected changes in demand. Safety stock inventory in the United States will be down, and there will be less need to create redundant manufacturing capacity in the United States to cover for problems in China.

The Shipping News

Lead times can be whittled down only so far, however. Oceans, for example, are an incontrovertible barrier to getting China supply chain turnaround times much below 30 days. IT hardware companies such as IBM and Hewlett-Packard have a special challenge. Their product lifecycles are notoriously short, and many of their products, such as servers and PCs, are heavy and bulky, meaning they cannot leapfrog China’s logistical delays by jumping onto airplanes. It would be too easy to destroy those savings by putting heavy PCs and servers onto planes. Big hardware vendors are, thus, restricted to ships, which cannot get to the United States in less than 20 days, according to Aberdeen Group, and 40 percent of survey respondents say they need 30 days to get goods to the United States.

IBM and HP have responded by breaking up the Chinese supply chain into discrete chunks. For big, complex machines that have short lifecycles or allow customers to specify their own configurations, final assembly often occurs at a plant close to the final destination in the West, to avoid trapping the entire machine on a boat for 30 days. For example, HP manufactures the cores of its servers in China—including heavy, less time-sensitive pieces such as the enclosure, wiring and power supply—then packs them together like sardines in huge shipments on cargo ships and sends them to final assembly locations in the United States and Europe. Smaller, expensive and perishable components such as memory, hard drives and microprocessors are shipped directly—often by air—to those final assembly locations.

But when you pull a supply chain apart into pieces, you need information in order to make those pieces come back together at the right time and place. Huge, diversified global suppliers such as Flextronics and Solectron have emerged to do most of the manufacturing for original equipment manufacturers like HP and IBM. With these companies, who perform the lion’s share of the Chinese supply chain for computer makers, the IT links are deep. “ERP, planning systems and EDI become important [to connect suppliers who make semifinished goods],” says Dick Conrad, senior vice president of global operations supply chain for HP. “Suppliers need to be able to share forecasts and customer orders in real-time. We all need inventory visibility and in-transit visibility so we can plan all along the supply chain.” For smaller, independent suppliers in China, HP relaxes its information connectivity requirements and offers its own systems through a supplier Web portal to exchange basic information such as delivery dates and purchase orders.

The risk of late delivery decreases in this highly connected model, but IT overhead will be much higher than under the “slow-boat from China” model. Yet overall IT costs remain low for HP, according to Gianpaolo Callioni, HP’s director of supply chain strategy and communications. HP is procuring computers in such high volumes from its major suppliers that the IT costs pale in comparison to the losses Callioni says he would incur from slow deliveries or from installing a stale microprocessor or hard drive in his machines. “Microprocessors can lose 40 to 50 percent of their value in a year,” he says.

IT’s power in China today is in linking disaggregated supply chains and finding ways to compensate for poor procurement and logistical capabilities. In other words, IT can cut lead times in some places where guanxi cannot. In sum, Chinese labor can reduce the total cost of products. And IT can reduce the risks that come with that cost reduction: lead time and supply variability. “CIOs should be part of the China decision,” says Peter Regen, vice president and partner of global visible commerce for Unisys. “That’s because they can determine the costs of those risks to justify the investment.”