In the trenches

With globalization driving companies to find low-cost sourcing options, many are integrating China into their supply chain. Manufacturers face a sink-or-swim global market where they must incorporate China, or another low-cost location, into their supply base to remain competitive. But a rapidly changing business environment coupled with a general level of unfamiliarity with China makes it difficult to research targeted markets or interpret findings.

Mesmerized by China's allure as the world's fastest-growing economy, some executives seem to check their common sense at the border, all too eager to try to close deals quickly.

Others misunderstand the nature of competition in China. In areas where economic growth can approach 10-15% per year, and even higher in times of high demand, any profit from a new product or innovation is quickly whittled away as thousands of entrepreneurs enter the market and vie for position. Remarkably, in many of China's industries, there is massive overcapacity. This trend drives down prices and diminishes the bargaining power of suppliers. Indeed, there is an odd dynamic of "If I build it, they will come" and "let's make as much money as we can before this product becomes a commodity."

At the same time, overcapacity provides interesting opportunities for companies looking for alternative applications for under-utilized capital equipment and management skills or the capability to access certain markets. The importance of understanding alternative applications for capital equipment and management, as well as the complicated capital structures of the enterprise cannot be overstated. Executives need people in China who can qualify the assets, validate the competence of the management and then implement the grand financial models in the context of rapidly shifting market conditions.

Regional trends
Any misunderstanding of regional trends in China can also create obstacles for companies who want to source from China. For example, the Pearl River Delta Region today faces some significant challenges. The central government recently changed the tax code to help raise income levels in rural areas. The effect on Guangdong, where most light-industrial factories are staffed by women migrating from rural areas for 3-5 year stints, is that migrant labor now finds short-term work in an unknown land less appealing. Some regions in Guangdong had to increase salaries of semi-skilled workers by 30% this year and there is still a shortage of workers.

Despite the established manufacturing base in Shenzhen-Guangzhou and the presence of many first-rate suppliers, the region has several deep-seated problems that, if not addressed by regional governments, could make it less attractive over time. The PRD growth is based on a historical anomaly: for much of the period up to the early 1990s, most trade with China went through Hong Kong. This privilege to collect a toll on all trade with China has ended; companies may now source directly from all points north and inland without passing through the hands of Hong Kong traders. In economic parlance, these channels have been disintermediated. After many years of booming growth, Guangdong has suffered a declining reputation due to corruption, poor infrastructure, pollution, crime and an unskilled workforce. In contrast, the Yangtse Delta Region (YRD)

Shanghai Jiangsu and Zhejiang boasts markedly better infrastructure, regulatory bodies, higher productivity levels, more Mandarin and English speakers and some of China's best educational institutions in hard and soft sciences. People tend to move to the YRD and stay, while in the south, it's more akin to an American college student going to Alaska for the summer to earn money in a fish cannery. Not many people stay in Alaska.

In the process of analyzing a sourcing operation, bills of material and data on every significant driver in an industry and region must be taken into account before reaching an understanding of the cost base for a typical supplier in the supply chain. This understanding is used to define a strategy to make or buy a product, merge or acquire assets. Finding the best sources of supply or determining the best location is only the beginning of the battle. Implementation can also be tricky and requires dynamic project management, which is a cutting-edge science in China. Surprisingly, there is still a dearth of good general managers who are experienced and bilingual.

Francis Bassolino is based in Shanghai and is managing director of Alaris, an Allied Capital portfolio company providing operational and strategic support to private equity firms.