By Peter Duncan

"The China Price" - the three words according to Business Week that strike fear in U.S. industry. Business in China and other "off-shore" countries is the rage, capturing the headlines of magazines and newspapers across the United States from the Wall Street Journal to the Washington Post. Outsourcing of labor to China or other low wage countries is a hot button among senior managers, and whether it is good or bad for the United States became a debate topic in the recent presidential election. Consumers celebrate the low prices of goods from Asia with one of the biggest buying sprees on record. Economists blame China for the imbalance of trade that contributes to the devaluation of the dollar, and manufacturers bemoan China's consumption for the rise in the price of steel and other commodities. Lenovo, a Chinese company, buys IBM's PC business for $1.75 billion. In short, the relationship between US business and China is hotter than a dot-com stock in the year 2000!

There is not doubt that there is a massive shift of economic power underway, but as with other bubbles, the feeding frenzy that whips up many a passion, tends to also drive markets and pundits to over-react. In the 1980's it was the juggernaut called "Japan" that was destined to undercut every American manufacturer with lower costs and higher quality. The powerful Japanese stock market and currency led many to fear the Japanese would own more Manhattan real estate than Americans. Twenty years later American continues to fret, but not of an immanent hostile take over by "Japan, Inc.", but rather what can America do to help stimulate the lagging economy of a major trading partner. As a popular song from the 1960's reminds us, "What goes up, must come down…"

If the first lesson is not to over-react, the second lesson is to recognize that there is, in fact, a long-term transition going on in the world economy. This transition did not begin last year, or even last decade. It began much closer to the dawn of industrialization and it continues today. Doing business in China is just the latest phase, which like earlier stages, captures a lot of attention as it causes immediate and painful dislocations at the point of impact, but in the perspective of history it can be seen as a small part of greater forces at work.

Been A Long Time Coming

Even before the industrial revolution transformed the world from an agrarian economy to one based on the production and trade of manufactured goods, economic beings sought "value". The quest to get more of a commodity for equal or less cost is at the heart of profit producing business. It is this pressure that sparked the mass production factories in the northern and eastern United States in the 19th century displacing many local artisans and craftsmen. Relentless application of automation and energy resources has in pushed productivity for the past 100 years. And it is the same pressure that attracted businesses to the lower wages and operating costs in the southern states in the mid-20th century. As the technology of computing and telecommunication reduced the cost of doing business in remote areas, the lower wages induced many businesses to move manufacturing operations to Mexico, Malaysia, the Philippines or other "off shore" areas at the end of the 20th Century. "Off-shoring" of jobs, both in manufacturing and services, has being going on at an increasing pace for at least three decades. The push to China and other Asian countries, while the biggest and most significant by far, is only part of a century old trend.

Is it Good or Bad?

How you react to the prospect of Chinese business depends a lot on where you stand. If you want to purchase a fairly generic product, the prices you get from China can offer a tremendous cost savings. The first furniture companies to begin outsourcing the carving and production of dining room chairs in China were able to reap significant cost advantage over competitors who struggled to find sufficient skilled domestic labor and who found they had to pay significantly higher wages for lower quality work from what labor they could find. The consumer who bought the dining set with outsourced chairs was also pleased with the better product at lower prices. The 55 year old furniture maker who lost her job overseas, however, is not so enamored by this offshore movement of work. And the community that depends on furniture manufacturing for its wage base is particularly despondent as it loses the $15-20 per hour jobs that keep its labor force off the welfare roles and pay the wages which provide the tax base enabling services such as education to train the next generation of workers.

On a political and social stage we shouldn't minimize the impact of China. It is and will continue to create significant disruptions in established economies. For those affected it will be difficult, very difficult. Whole industries and communities may find their labor base moving elsewhere. This can devastate communities for a generation, or more. The rapid transfer of the textile business to the south left many New England mill towns wallowing in depression. On a local scale the pain was severe, but in terms of the national economy the lower costs enabled a higher lifestyle for a nation of consumers who now had more affordable clothing and carpets. Those who believe all politics is "local" would try to erect barriers to this sort of job movement, but any such impediments will only be temporary dikes against the relentless tide. Eventually, the tide does turn, as it did in New England when the "Massachusetts Miracle" brought the return of good paying high-tech jobs in the 1980's and 1990's- many of which operated out of the same mill buildings abandoned a generation before.

Sparing communities from this sort of devastation is beyond the scope of this writing, but it is quite possible to address how an individual company might respond to the opportunity to outsource work to China.

Do You Want to Go Offshore?

Establishing outsourcing operations in China, or any other remote location is a significant commitment. The degree of urgency and the advantage to be gained will be different for different industries. In some cases, such as injection molding of inexpensive plastic toys it is almost mandatory to be sourcing offshore. In other situations where the product commands a high margin or quality, delivery or customization is more important than low price, going offshore may be the "wrong" way to go.

The decision to go offshore should begin with your strategy. If you are in the business of offering everyday low prices for relatively long runs of generic goods, then you will want to be able to shop for the lowest price, which may well be found off shore and may vary from vendor to vendor and country to country. If your strategy revolves around higher quality or branding and the product requires some learning to be able to produce it successfully, then you may be still consider going off shore, but you would be better off with a deeper, more trusted relationship with a smaller set of more established vendors. Where your strategy depends on customization, high service or operational flexibility, you may find the costs of going off shore are higher than the advantages.

The bicycle industry provides an interesting example of successes and failures in outsourcing manufacturing. American icon, Schwinn Bicycle, was the dominant manufacturer of bicycles from the 1940's through the 1970's. While its innovative products, such as the "Sting Ray" were important, much of Schwinn's success came serving a network of small independent dealers, according to Washington Post writer, Griff Witte (Dec. 3, 2004). But two major changes hit the bike market in the 1980's and Schwinn was slow to adapt its strategy. The rise of mass merchant retail stores created a demand for a lower price point product and emergence of new specialty-niche markets, such as mountain bikes, demanded different products for new high-end consumers.

Loyalty to its independent dealer channel slowed Schwinn's entry in to the "big box" retail market. When it did try to enter this lower cost channel, the found its product was not competitive with foreign offerings. Rather than assessing its strategy, it appears that Schwinn tried to compete by purchasing foreign made components to assemble in the USA. This made the Schwinn product the same as the lower cost imports simultaneously undercutting the Schwinn brand and validating the technology of its suppliers such as Giant Bicycle. To further reduce costs Schwinn closed its Midwest assembly line and opened a new plant in Mississippi, but even this move was not sufficient to beat the costs coming from Asia. Attempts to purchase offshore product and sell under the Schwinn brand also failed and Schwinn went out of business in 1993 selling its brand to Pacific Cycle. Pacific Cycle now runs a successful business selling imported bicycles to mass merchants under the Schwinn brand.

Meanwhile, as the jogging baby boomers began to seek lower stress alternatives to running, Cannondale and Trek developed innovative road racing and mountain bikes to supply this rapidly growing market. Carving out a smaller volume, but high margin position these two companies have continued to grow with manufacturing in the United States. By creating innovative product that commands a selling price as much as ten times what a Schwinn or other import bike might command, these niche players have developed a strategy that is less vulnerable to "the China price". Witte reports, this premium brand position has also allowed Trek to import some higher end bikes and sell them at strong margin to its entry level customers. Schwinn might have been able to execute a strategy like this, but as is too often the case when confronted with vigorous competition, it failed to make a clear move to either the commodity market or the specialty-niche market.

The U.S. bicycle market today is three times the size it was in the early 1970's. Many new consumers have come into the market bringing different needs and preferences than consumers from earlier decades. The lesson from the bicycle industry is that there are many ways to be successful - some include outsourcing and some don't. Finding or sustaining a successful business depends more on a well conceived, well executed strategy than on a single decision around outsourcing and competition from China. Before you consider a decision to outsource, be sure you have established a clear strategy, and then make the outsourcing decisions in the context of supporting that strategy.

Right today, wrong tomorrow

The "gold rush" mentality created by tales of savings from doing business in China and fueled by the popular press has created a situation that is very dynamic - what is "right" today, may not be optimal tomorrow. Capacity and capabilities are changing by the day in China, India and other "offshore" countries. Intermediaries are popping up to lower the transaction cost of doing business in remote areas. There is constant change in laws, financing, logistics and politics. It is this relentless mutation that raises so much uncertainty and renders decision making so challenging. Couple this with the fact that there is not one "silver bullet" answer, and the outsourcing question can become daunting, indeed.

Under these conditions there is no substitute for formulating operating assumptions and then reviewing them frequently. You need to have a sound and dynamic strategy process attuned to the pace of change in your industry. For those industries in the midst of this transition, the fundamental assumptions underpinning your strategy can completely change over the course of six months.

For some companies the right answer might be to be a "shopper" outsourcing components to the lowest cost vendor. This tactic is often advantageous early in the move to outsourcing as it is difficult to determine the "best" vendor without considerable experience in the off shore market. What looks like a good deal may turn out to have substantial hidden expense when all of the transaction costs are considered. When evaluating the cost of moving offshore it is important to try to capture not only direct costs, but also "transactional costs" such as lead time, inventory levels, inventory obsolescence, transport costs, expedited transport costs and travel or local management costs. Retaining a flexible posture and refraining from over-investing in "fixed" assets is probably the more prudent course in the early stage of a transition to offshore sourcing.

As markets mature and the volatility subsides, it often becomes important to establish tighter and more exclusive relationships with offshore suppliers. When the advantage of playing the spot market dwindles, then hooking up with a strong partner who can support your strategic direction over a longer time rises in priority. Establishing those relationships before your competitors do can provide a key source of advantage. But jumping on this too soon can also be an expensive mistake, as you become saddled with a particular situation while nimble competition is free to seek better deals.

Offshore supplier relations can range from preferred vendor situations to wholly owned subsidiaries. There is often a trade off between degree of control and the total cost of goods from a supplier. Lowest cost is often found by shopping for excess capacity. This capacity, however, comes at the expense of control over such things as schedule, lot size or quality. In more mature markets where these things become more important, a company can gain greater control by deepening their relationship with the supplier. Becoming their most important customer by taking up 50% of their capacity increases your control. Having a substantial in-country purchasing and quality team increases your visibility and control. Investing in a JV or wholly owned subsidiary offers even more control. But each of these comes at an increased cost.

A time of transition, by definition, is a time of volatility. Understanding your industry and timing the degree and type of outsourcing is important to success. Profit oriented businesses will often seek to improve their situation by finding lower cost suppliers or moving to lower cost labor areas. But there are costs in these transitions and a business needs to have a good understanding of its markets and sound strategy to help it be neither too far ahead or too far behind the move to China or other off shore source of supply.

The Big Picture: Strategic Focus and Competencies

Though China and other countries are growing fast, America remains the biggest consumer market in the world. Selling to Americans requires a deep understanding of what it is that the culture values. This is particularly true at the specialty end of the market.

Products by themselves are difficult to sustain, because most things, especially physical products can be copied with relative ease. Product focused companies frequently rely on having a strategic competency around the production of that product. There was a time when a production oriented competency could produce a long term advantage, but this is increasingly difficult to sustain.

On the other hand, some of the most successful new companies have a markets and customers focus. Amazon has evolved from selling books to being the place you go to shop on line. The success of e-bay is not about the technology or the products, but about the relationships the service creates among its users. Southwest Airlines wins not because it flies planes well, but because it has a very clear profile of its customer and optimizes its offering to satisfy them.

More often than not a "service" business starts with a group of customers it wants to serve. As the American economy transitions from a manufacturing economy to a service economy, you can expect the number of "market/customer" focused companies to increase. A markets and customers focused company often builds strategic competencies around things like "best total knowledge of user" or "creating brand loyalty". Even those companies that will continue to provide goods may have a "markets/customers" focus and consider manufacturing just one more "service" they bring to their customer.

In the ever evolving economy, companies will identify their strategic focus and the competencies they need to build to support it. Astute companies should nurture and grow these strategic competencies to world class strength and consider outsourcing all other activities to world class partners - many of which will be "off shore." The trend since the beginning of the industrial revolution has been toward increasing focus with an accompanying strength in more specialized strategic competencies. Together these two complementary strategic practices tend to enable companies to weather many challenges, especially those related to transitions in the economy brought on by lower cost labor available in other parts of the world.

After China

For some industries the disruptions of China have passed - like the disruptions of automation in the 60's, Japan in the 80's, or total quality in the 90's. For others they are in the middle of the turmoil, or it lies ahead. But eventually this phase will run its course and there will be a time when we look back on the rush to China like we do the gold rush of 1849 - a big deal at the time, but less significant in the context of history.

It is hard to predict the next big thing that will hit the world economy. Whatever it is, it will create a bubble, a wave that will disrupt established value and ways of doing business. Those who are prepared, with a robust strategy process, will survive. And many will prosper by seizing the opportunity created by the changes. Companies that are working their assumptions and actively managing their strategies have a better shot at identifying these changes in their environment and making the "right moves" - doing those things that are right for them in their circumstances.

It is easy to be fearful of big change, especially if you are successful today, because change disrupts the very model that has brought you success. The new world order requires hard work to understand it and figure out how to profit from the change. But change is a coming - at a faster and faster pace as each development builds exponentially on the previous one.

For more information, contact

For more, click here for a free subscription to Course and Direction.

© Copyright 2008 Center for Simplified Strategic Planning