In just a short space of years, China has become the primary manufacturing base for a very wide range of products, often produced according to the specifications of Western companies who market them under their own brands.
But as China continues to move through the changes at a concertinaed pace, the question is whether the outsourcing approach of these international brands is merely creating a massive wave of future competitors.
The acronym at the heart of the problem is OEM, standing for "original equipment manufacturer," and it means that you (the OEM manufacturer) make it, and I put my brand on it and sell it to consumers who think that I made it.
Over the past 20 years, China has established itself as the most efficient low-cost OEM manufacturing base in the world, and jobs continue to disappear from cities around the world into this employment black hole on the eastern edge of the Asian landmass.
It is a temptation that is difficult to resist as every company fights to reduce costs and stay competitive in a global marketplace. Governments are conflicted about how to handle it. They want to preserve local jobs, but they are also committed to defending the efficiency of local businesses. Not wholly compatible aims.
Some Western companies, of course, have been built on the efficiency and flexibility provided by OEM manufacturing. And that is fine, as long as they retain a technological and marketing lead over the nameless and faceless companies somewhere in China that are producing the goods in their name.
But for companies that have a technological and marketing lead today, the question is whether they can hold on to it indefinitely.
OEM manufacturing is a major contributor to the Chinese economy, according to Morgan Stanley Hong Kong, which estimates that it accounted for two-thirds of China's exports in 2003 – roughly US$300 billion.
A vast range of the products used around the world every day are produced in this way, and it could be that already a majority of the products we have before us are not actually manufactured by the companies that brand and market them.
Apple, Hewlett-Packard, Canon, Epson, Sony and Bosch are just some of the thousands of companies that outsource production to third party-producers. Automobiles, computers and appliances are produced largely of parts produced by other companies, and those other companies are increasingly based in China.
The question is: how long before these OEM manufacturers start doing their own research and development work, designing their own packaging and taking their products to market under their own names?
The answer is: it's already happening.
When Cisco filed suit against Chinese OEM producer Huawei last year for allegedly copying source code, command line interface and other portions of its IOS software, observers broke into two camps.
Those sympathetic to Cisco had little doubt that the US firm's intellectual property rights had been violated by the Chinese upstart. Those of the other camp saw a US software giant trying to clip the wings of a future competitor.
Shenzhen-based Huawei countered Cisco's allegations by saying that its Shenzhen operations had in excess of 10,000 engineers working on research and development, 40% of which had master's degrees or higher. Huawei also noted that R&D funds spent in China go further than in the US due to lower salaries for engineers and researchers.
China's engineers are not as numerous as its factory workers, but Huawei's case highlights a salient point: China is brimming with highly trained engineers and researchers whose growing numbers have sent wages down in the last couple of years. In other words, R&D help is getting easier to find and more affordable.
And China's investment in research and development is growing along with its economy. In 2002 China spent RMB 128 billion (US$15.5 billion) on research and development, not an impressive number, but it is nearly double 1999's R&D investment of RMB 67.8 billion. If the current upward trend in Mainland R&D investment holds for several years, China could conceivably be pouring hundreds of billions of dollars into research and development like the US.
Poor judgment on the part of some foreign companies regarding protection of proprietary designs or technology is giving Chinese OEM manufacturers a helping hand up the food chain. This is but one manifestation of the wider trend of emphasizing short-term cost cutting without buttressing oneself against future Chinese competition.
"I have lost a lot of faith in brands," said one European logistics executive in Guangdong province who asked not to be named. "These OEM companies are now doing their own products and designs. It is no longer just a matter of manufacturing."
"I see reps from shoes and furniture name brands in Europe, and they clearly see China just as a low-cost production outsource. I want to say to them: don't you realize these Chinese companies are going to be your big competitors, and it was you that made it possible for them to get there? You have put your key competences in their hands!"
The business of logistics is a good indicator of the trend. It used to be that logistics companies sought business from the companies in the home markets which generated the orders for goods to be shipped from China. Increasingly, logistics companies gain their business by going out and signing deals with the Chinese manufacturers themselves.
However, some analysts see China's intensely competitive market environment as slowing down the ability of China's OEM manufacturers to brand, market and innovate on the level necessary to compete globally.
Morgan Stanley Hong Kong's Chief Asia Economist Andy Xie predicted that China's OEM manufacturers will not be able to realize their global brand dreams for another 15 to 20 years.
"I think that China's profit margins in general are pretty low in the local market, so the financial resources for developing brands and proprietary technologies are really very thin," Xie said.
Xie said the environment for brand-building and innovation enjoyed by other East Asian manufacturers during their respective country?s developmental phases is not in the cards for Chinese OEM manufacturers.
"This is very different from Japan or South Korea's situation, where the master market is protected to give local producers higher margins so they can put all this money into branding and technology development," he said.
"China doesn't have that, so Chinese domestic prices are very low and determined by fierce competition. I think that China's migration to brands is a long, long time away."
Xie said that China must wait for domestic product prices to rise in order for Chinese companies to record higher margins, which will facilitate the development of brands and new or advanced technologies. "But whether the prices rise depends on when Chinese consumers become rich," Xie added. "That's a long-term process."
Xie said that a good yardstick for the future of Chinese OEM manufacturers was across the Taiwan Strait.
"Look at Taiwan. It still has not broken through the OEM model. We saw a company like [Taiwan-based] Acer try to do that. I think that Acer is not successful – it's just hanging in there. I think China is far behind Taiwan in terms of the conditions for moving into global brands."
OEM work in Greater China began in the early 1980s with Hong Kong manufacturers taking orders from foreign companies across the Chinese border to be fulfilled. It started with simple items such as jeans and bags. Taiwan, which by the early 1990s was the world's largest producer of computers and accessories, started moving production into the Mainland. Western companies piggy-backed on this production outsource system created by Hong Kong and Taiwan companies. China OEM production now includes anything up to and beyond laptop computers and complex automobile parts.
China has many advantages in the battle for manufacturing orders. Its workers are cheap, in plentiful supply and hard-working. A worker in a Shenzhen clothing factory earns a monthly wage of around RMB 600 (US$72) a month, along with free dormitory accommodation, and there is a queue of applicants for such jobs that stretch way round the corner.
But it is not only the low labor costs that attract orders. The overall quality and stability of production (there are exceptions to every rule) is generally accepted and appreciated by clients.
One company that has managed to use a reputation for consistent quality in its OEM production to develop its own business is Guangdong Galanz. Located in the Pearl River Delta, Guangdong province's manufacturing hotbed, Galanz is the world's largest manufacturer of microwave ovens by quantity. It also produces other appliances such as toasters and rice cookers.
Galanz has become one of China's OEM giants. Its clients include General Electric and Sunbeam. In 2002, the company recorded US$1 billion in revenues and manufactured 40% of the microwave ovens sold in Europe.
Chinese companies which have grown fat on an OEM diet include TCL Group, Hisense and Galanz. They produce mobile phones, televisions, "white goods" and every other appliance imaginable and tend to be concentrated in the coastal cities of Guangdong, Fujian and Zhejiang provinces. The best of the OEM manufacturers are often private companies.
Galanz spokeswoman, You Limin, said that OEM manufacturing is a major contributor to company revenue, representing approximately two-thirds of total production for export.
Galanz's strategy in the late 1990s, according to You, was to position itself as a global manufacturing center for home appliances, primarily through OEM manufacturing. The company then shifted gears to develop what it describes as its "two leg" strategy, one leg being OEM manufacturing for foreign multinationals and the other being production of its own brands for the Chinese market and foreign markets with low barriers to entry.
Galanz's development plan is in harmony with Xie's assessment of the options before Chinese OEM manufacturers: "Right now the model that makes sense is to take other people's technology and make stuff cheap."
By restructuring themselves to meet the demanding requirements of foreign manufacturers, Chinese OEM producers have indirectly (or directly) picked up the basics of efficient production. Otherwise they would not be able to turn out batch after batch of product that meets the requirements of the foreign buyers. Nor would they be able to survive the intense competition in the OEM and domestic sectors as in the case of Galanz.
Galanz isn't the only Chinese OEM manufacturer that is using its OEM business to drive its development plan. In the mobile phone area, there are similar-minded companies such as Ningbo Bird, Hisense and TCL.
In the computer manufacturing sector, Legend holds approximately one-quarter of the Mainland computer market. Beijing-based Legend established a joint research and development center with Intel in Shenzhen last year.
Go into a factory that is engaged in OEM production, and next to the displays showing the goods they have manufactured for well-known brand names, one can often find goods they have produced themselves, which are often similar in style and quality.
Chinese goods and brands today have the same reputation that Japanese and Korean goods did 30 or 20 years ago – cheap and possibly short on quality. But Japan and Korea both moved through that phase and emerged with brands such as Lexus and Samsung which could beat all-comers in terms of quality and design, let alone on cost.
China is still behind on R&D. But there is a big incentive for Chinese firms to transcend their OEM status and take their own brands directly to market in the United States, Europe and elsewhere to reap higher margins.
Will Chinese companies be able to compete effectively with regards to innovation? Some analysts believe that China's lack of emphasis on creativity and questioning in the classroom translates into an innovation-impaired workforce. Others say this is less of a cultural problem for China than it is for Japan and that the Chinese mind in the end will be able to effectively combine attention to detail with innovative creativity.
As for branding, many a foreign consumer has heard of China's boom in the manufacturing sector, particularly in computers, televisions and appliances. Yet it is safe to say that most of these same people cannot name more than one or two top Chinese brands, if that.
Being unrecognized outside of China is not necessarily a problem for Chinese brands, as they enjoy the advantage of name recognition in their growing and dynamic home market.
Beijing is pushing companies, including the major OEM manufacturers, to look outward as part of their business development strategies. The central government has just announced an overhaul in its export promotion strategy that will focus on Chinese branding of exported goods. Government and business leaders alike are keen for China to develop its own "super brands" to rival the success of Japan's Panasonic and Sony, and South Korea's Samsung and LG.
What is the answer? One may be for Western companies to look at investing in their OEM partners, partly to slow down the process of the OEM producers moving beyond passive manufacturing outsource to total brand management.
"Foreign brands should buy into these Chinese companies and become the distribution channel for Chinese brands as well," said one European logistics expert. "It may be a marketing alliance as well. But the foreign firms need to have interaction with the Chinese companies in some way other than supplier/vendor relationship at present. They have only a short window of opportunity."
The difficult part for Chinese companies is marketing and distribution.
"I have seen cases of traders handing name lists and marketing materials to their supplier Chinese companies," said the logistics expert. "This is suicide. The marketing and distribution information must be kept from the Chinese production companies."
It would also allow the foreign companies to benefit from the vitality of the Chinese companies as they work persistently over the next decade to take over the world.
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