Manufacturing costs in China have dropped sharply in recent months because the Chinese currency has depreciated and prices of both raw materials and industrial inputs have tumbled. This sharp reduction has suddenly allowed Chinese manufacturers to once again compete on price, something they were unable to do when manufacturing costs were on the rise. Now, they can lower product prices and take back any business they may have lost.
But that is not a sound strategy. Instead of just trying to undercut other suppliers on price, Chinese manufacturers ought to invest the surplus in building more meaningful relationships with their Western customers and creating value that can only come from such ties.
China’s currency began to depreciate after the government decided in March 2014 to allow the renminbi (RMB) to be traded within a wider band, which means that the value of the currency can fluctuate more than it has in the past. Market forces then went to work, and the RMB’s value dropped.
To date, the Chinese currency has depreciated by 2.3 percent in 2014. The depreciation alone would make a Chinese manufacturer struggling to break even moderately profitable almost instantly.
The Chinese economy is driven by the manufacturing sector, which exports to the rest of the world. Currently, China’s export-focused manufacturing sector is largely dedicated to producing material-intensive mechanical and electronic products for the developed world. The manufacturing of some labor-intensive products, such as shoes and t-shirts, has moved to other developing countries. Approximately 60 percent of Chinese manufacturers are now in the low-labor-content category, and material cost accounts for as much as 80 percent of their total manufacturing cost.
With the slowing of the domestic economy, producer prices in China have been in deflationary territory for twenty-four consecutive months. Raw material prices in China have plummeted. The steel price is at its lowest level in twenty years and has been below 1994 levels for more than five months. Prices for other metals such as copper, aluminum, nickel, and lead have nosedived as well, while plastics prices are also on the decline.
The drop in input prices translates into greater cost savings for Chinese manufacturers because direct and indirect materials account for a larger share than labor in their cost structures. A 10 percent drop in the material cost would add 8 percent to the bottom line.
The cheaper currency, lower input costs, and potentially greater profitability, however, should not be taken as rationale for China-based manufacturers to keep competing on price in the open market. In the wake of the global financial crisis, supply surpasses demand and customers expect their suppliers to do more to earn their business. RMB depreciation and input price reduction offer an opportunity for Chinese manufacturers to move closer to their Western customers, an effort that is long overdue. Indeed, Chinese suppliers would greatly benefit from knowing their Western customers better.
Today, international travel is expensive, getting a visa is a hassle, and lives in China and the United States have little in common. As a result, person-to-person contact is limited, and some Chinese suppliers are left without a robust understanding of their customers and the world those customers inhabit.
This makes it difficult to address real customer concerns, such as whether the supplier will be able to create the aesthetic appeal and meet the hygienic standards when the products are tailored for special end customers. Other concerns of Western customers include whether Chinese manufacturers can achieve the precision in production scheduling common in high-income countries and whether their design, engineering, and financing capabilities are comparable to those of qualified suppliers in developed markets. Distant relationships between suppliers and customers also mean that coming up with creative solutions to those concerns is next to impossible.
Chinese manufacturers should strongly consider putting money aside to build customer relations. Taking a U.S. customer to a baseball game on a business trip is not such a bad idea.
China-based contract manufacturers should also invest in upgrading the way their relationships with international customers are structured. Either by chance or by design, Chinese manufacturers have typically distanced themselves from the end markets in high-income countries. Middlemen, such as sourcing companies, distributors, and import agents, separate the manufacturers from the end customers. Arms-length, contractual relationships dominate. Made-to-order setups, occasional purchase orders, short-term contracts, and non-equity and non-committal agreements are common.
Anecdotal and non-committal arrangements might have been sufficient for relatively simple products and small customers. A distributor in Miami can import many types of standardized metal tubing products without committing to any tubing manufacturer. But more complex products for larger customers higher up the food chain—an area into which China wants to move—call for different relationships. Companies making complex and highly customized products would benefit from closer, more tightly knit relationships, such as long-term supply agreements and formal alliances. A large publishing house in New York with the design for a brand new electronic reader to be used in classrooms would have to work very closely with a highly committed manufacturer for a long time before the new product reached the market.
With a closer and more formally established structure, the manufacturing of customized products as well as contracted design and engineering work can be conducted. With the help of international equity funds, a Chinese manufacturer may take an equity position in a new company that combines its interests as the supplier with those of the Western customer. The equity relationship would provide security and predictability for the two parties, whose business functions would be intricately intertwined and virtually integrated.
When costs were rising, Chinese manufacturers’ margins were squeezed and internally generated funds were drying up, so they could not afford to take these steps. With currency depreciation and input price reduction set to increase profit margins, now is a good time to invest the surplus in building closer ties with important international customers and optimizing the way relationships with these customers are structured.
It is also a good time for Chinese business executives to shed the burden of a narrative of century-old victimization under colonial rule. Indeed, today’s most successful Chinese contract manufacturers are often located in coastal provinces where European and American influence was greatest in the late imperial and early revolutionary years.
Recognizing the European heritage of business, education, and culture in China would be a healthy first step forward. It is difficult to imagine any other way, when the task facing these manufacturers is to develop globally appealing products and serve diverse customers around the world.