Cost increases in China - action importers can take

Implications: The automotive sector tends to get more than its fair share of commentary. While the impact on autoparts is significant, in terms of materials, labour and currency dynamics, other industries are also affected, which don't always have the leverage of a major automotive producer in the USA. How can the smaller buyers of specialist products cope with the somewhat alarming changes underway, and get a real perspective on the future. What steps can importers in USA and Europe take to manage the increases, and adjust their business model?

Analysis: Automotive, furnishings, and general engineering components are seeing China costs rise at an unprecedented rate. Cost increases are driven by the RMB's rise against the US$, steel and other material costs, and labour cost increases in certain areas. Freight costs have also contributed to total landed cost, simply to a lack of capacity and containers. Add to this the additional oil premiums that shipping lines add, and the net result is a dramatic increase in total cost of ownership.

Knee-jerk reaction is to get out of China and look for alternative developing economies. The truth is that there is still nowhere with China's capability, for most technically complex electronic or engineered products. Regional economies such as Vietnam are promising in market niches, but lack the port resources we now take for granted in Yantian and lack the diaspora of Taiwanese and Hong Kong involvement in being the catalyst in making things happen, in terms of finance and know how.

Let's look at the components of the cost increases. Materials, particularly steel hikes have been largely cost driven, as a result of ore prices and energy inputs. they are also a global phenomenon and shifting the origin of steel supply will not therefore solve the problem, as all markets advance. Price increases are going through the supply chain at different speeds and should align. Steel production is also notorious in the lead time it takes to adjust supply volumes. Oversupply inevitably follows a period of shortages.

Labour cost is increasing in the southern areas of China and other developed coastal regions, due to shortages and also improved working conditions being imposed by government. This is perceived with mixed  feelings, as workers gain more protection, better physical conditions and an assured maximum working week. The smart companies in China have already reached these standards so will be less affected. The ones who have failed to develop conditions for their workforce will feel this, and inevitably these will be the smaller players. The danger here is the numbers of companies cited as closing in southern China.

Currency appreciation of around 16% is a problem. It has been on the cards for a long time and the USA has been demanding this for years. Perhaps this is the single most important factor which will realign costs.

So what can be done to mitigate these increases and remain competitive?

Material cost differentials will harmonise, so the answer is not necessarily in shifting location solely because of this.

Understanding the real cost structure of your suppliers is a key step in determining a course of action. Labour costs are a relatively small part of most Chinese manufacturers costs, even with the increases.  Many second and third tier suppliers are also frequently underdeveloped and there is increasing scope for process development, and room for improving efficiency levels in most organisations. Low labour costs have been a characteristic for so long that there has been no incentive to look at manning levels and automation.

Know your supplier. Insist on understanding cost structures, and accessing core cost data, on the basis that this is a win win approach. Most suppliers agree when they realise you are serious and the approach is constructive.

Know your supply chain. Most buyers struggle to keep up with what is happening in the China supply chain. The task is daunting, and internal human resources are rarely available to allocate to assess changes and developments in the system, due to the sheer size of the supplier base. Invest in garnering information which is relevant for your industry in terms of cost inputs to suppliers and regional variations. Intelligence gathering is essential.

Initiate value engineering and cost reduction programmes with vendors to raise productivity, and share the results. Joint initiatives will almost certainly succeed as there is so much room for improvement in terms of eliminating waste, reducing inventory, and increasing velocity. the returns will be far greater than in western economies, yet this is frequently neglected. Expect an increase in demand for professional expertise in this sector.

RMB appreciation only really applies to materials, costs and added value indigenous to China. They do not apply to imported raw materials. If your steel in coming in from overseas, priced in US$, then the actual cost remains the same. Chinese factories need to be reminded of this occasionally.

Reverting to domestic production could be an option, if after real analysis you find the cost differentials of options are reducing. Hybrid models can address this, by mixing import and locally made parts, and reducing reliance on those parts where cost increases are most severe.

Bear in mind that the growth of the Middle East and Eastern Europe is taking up some of the capacity being left in China as the US and Europeean orders fall. The freight element of the total cost to Middle East is a lot lower than to the USA. This tends to put the USA buyers in less of a negotiation position than they might imagine. Also understand the scale of the rebuilding of the devastated areas of Sichuan province. This all tends to suggest that China's growth is unlikely to fall as significantly as we are witnessing in the EU and USA.