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What China Should Do to Curb Rising Production Costs

Apr 08, 2021

China is never one to rest on its laurels. Pressing forward at full speed with industrial automation and digital transformation of its colossal manufacturing base, the country is making an unparalleled bid to lead the world in the Fourth Industrial Revolution (Industry 4.0). While China steels itself for the age of innovation-driven manufacturing, other areas should garner equal focus, if it is to maintain its competitive edge in global manufacturing.

Years of domestic wage inflation and competitive cost structures from abroad have slowly chipped away at China’s seemingly insurmountable cost benefit in certain market segments. But labor costs are only part of the equation. The added expense of waste from production cycles, lack of investment in information technology, balkanized logistics, and an unclear financial policy – most of which China Inc. can control, erode at a manufacturer’s cost advantage. As a result, the larger question to consider is – What can China do to curb rising production costs?

The production of waste is one of the principal challenges China faces. Historically, recycling in the country has been mainly driven by the economic value of materials and not necessarily other equally important considerations. As an example, if a company uses steel in its production cycle and discovers poor quality steel or commits a mistake in production, it immediately becomes scrap and is returned to the manufacturer to be recycled. This is standard industry practice and that is usually where the story ends.

A leading practice would be to track the defective part. If one ton of scrap metal is sent for recycling what actually happens? How efficient is the recycling process? How does a company know that lesser quality metal is not mixed with higher quality to save cost? Having a digitized tracking and analysis system in place can allow the manufacturer to answer these questions, as well as force suppliers to be more efficient throughout the entire supply chain.

Using a digitized supply chain enables firms to track the entire lifecycle – from product arrival at the factory, slotting into production, through the residual waste stage. This drives efficiency by giving real time data to technicians and managers to make decisions quickly. If there is an issue, such as an improperly calibrated machine or producing too much scrap, it could be stopped and resolved before resuming production. This encourages companies to create less waste and pollution and also gives finance teams better visibility on cost effects for the company, unearthing areas of cost savings and driving margins higher.

This practice  is what far too few factories in China do. Today, much of the manufacturing traceability is still done by hand or by older systems that do not seamlessly connect with others – Enterprise Resource Planning or ERP, as a prime example.

China possesses world-class infrastructure – vast deep-water ports, newly-paved highways, the world’s largest network of high-speed trains, and ultramodern airports. Yet, despite these advantages, current delivery costs are eating at margins and trucking, including final delivery, can be challenging. Domestic logistics is balkanized, with multiple layers of players, vying for market dominance. According to Bloomberg, logistics expenses in China represent 15% of economic expansion in 2019, versus less than 10% in the U.S., a variance that stresses the urgency for China to lower the expense. Enterprising firms are relying on “ the Internet of Things” to monitor driver performance – everything from time behind the wheel and unsafe driving to preventing employee pilfering at transfer points. Ultimately, this makes logistics more efficient and reduces costs.

In instances where China still needs to rely on heavy manual labor, the government is encouraging business to move to the interior of the country, such as Shaanxi and Sichuan provinces, to buttress costs and expand capacity and supply chain ecosystems.

Yunnan province is a premier example as a new area for development endowed with lower labor costs. There are two forces at play. First, the opening up on the eastern seaboard close to ports for international shipment, and the other is proximity to raw material sources in interior provinces, such as Yunnan. The government is relying on substantial incentives for companies to move to these locations and spending vast sums of money, upgrading infrastructure so that once products are made, they can be easily shipped to port. In line with this strategy, an even more audacious plan unveiled last year seeks to transform all of Hainan province into a free trade port, thereby tapping an underused labor pool with competitive cost structures.

Robotics and automation are two areas that can curb rising costs while at the same time creating substantial productivity gains. Automation has accelerated since 2010, which marked the highest output and employment as a percentage of GDP but has been decreasing since then. With an aging population and a workforce that peaked in 2017, Beijing has to invest heavily in robotics, automation, AI, and new technologies that require less labor. Watch for this to become a dominant theme in manufacturing in China and other nations that have shrinking labor pools. A spillover effect will happen in Vietnam and then elsewhere that will drive manufacturing and supply chain efficiency first, and then help other neighbors as their labor force participation shrinks. This is an opportunity for homegrown Chinese automation and robotics companies to sell and license products worldwide. China is very much in the global driver’s seat for these technologies.

China’s manufacturing prowess is unmatched in most industries globally. While many in Washington talk about reshoring or with the new MSCA “nearshoring” to Mexico, which might be possible in some industries, challenges with labor efficiency, corruption, and the lack of raw materials in alternate manufacturing centers still make it beholden to many China related industries and materials.

One factor beyond the control of Chinese manufacturers that affects all is an appreciating currency. From May through December 2020, the RMB appreciated nearly 10% against the USD, making Chinese products less price competitive in international markets. Seeking mechanisms to blunt a strengthening RMB has become a major priority, leading firms to lock in future exchange rates and work with banks to arrange other finance management strategies. If China were to see a rapid surge or fall of the RMB, the forecasting ability of raw materials, parts, and other critical items, would be upended, bringing uncertainty into the futures market.

Ultimately, if Chinese enterprises can skillfully address issues of excess waste in production, upgrade systems in mission critical areas, improve long-haul delivery, increase investments in robotics, automation, AI, and with a supportive fiscal policy – such measures would curb rising production costs. For the foreseeable future and for many products, it is still more cost effective to buy from China than anywhere else. 

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