THE BUSINESS REVIEW FOR PROCUREMENT LEADERS
Outsourcing production to China for short-term profit advantage could rebound
badly on western companies
by Roel Bellens
Consider the relationship between the following events. First, cotton from Texas is transported to China to produce T-shirts that are sold in the United States and later become second-hand clothing in Africa. Second, China is happy not only to produce the goods for consumption in the US, but also to finance the transaction. Third, within five years China will spend more on research and development than Europe.
What has all of this to do with strategic outsourcing, you may ask? The answer is: more than you think. This could even become the Achilles heel of the outsourcing movement within western economies.
In 1983, I was involved in the set-up of one of the first joint-venture projects in China on behalf of a company in the Johnson & Johnson healthcare group. At that time there was no decent commercial law structure, neither did a reliable financial environment exist. Looking back, it definitely was worth the effort because two decades and a couple of business cycles later, J&J has a solid equity joint venture with increased shareholder value.
It was risky, the venture required a substantial investment and there was a big question mark about the financial return. On the other hand, China was not only a promising commercial market that could be better served in a controlled way by setting up a joint venture, but also a threat if the output of uncontrolled production capacity came to spoil export markets.
The risk-taking attitude of J&J stands in contrast to the behaviour of companies that have only short-term efficiency in mind. In the automotive sector, for example, suppliers are not only forced to come up with lower and lower prices, but they also do not have enough breathing space to reclaim their investment. Considering the fact that an increasing portion of the investments within the automotive value chain are transferred to these suppliers, we could see more of them filing for bankruptcy. This, in turn, will have damaging effects for their customers.
The common justification for this attitude lies in the accepted division of the value chain from both an intellectual and an industrial perspective. According to this view, western companies focus on value creation through intellectual activities that are derived from research and development, marketing and branding, while China and others focus on the production of goods that are invented, marketed and branded elsewhere.
However, a couple of problems emerge. To start with, an increasing portion of western companies are investing less or not at all. Second, China - and, for that matter, India - are increasingly becoming not only industrial value creators, but also are gradually moving towards intellectual value creators because of their tendency to invest. Third, China and India are happy to acquire the shares of western companies with an upstream position in the value chain.
The "boomerang effect" resulting from the short-sighted behaviour of companies that have only cost-efficient outsourcing deals in mind will be doubled. Chinese goods will replace western goods and this process will accelerate because of the increasing standardisation of components required by buyers. Hence, supply-parts producers become end-product makers.
And, if necessary, they create new brand names too. Samsung and LG are Korean examples, but the next wave will come from China and India.
The second boomerang could be even more detrimental to the long-term survival of western firms. Through investing the rewards of their production power in the financial system, the added value of western companies will increasingly fall into the hands of East Asian shareholders.
This "double boomerang effect" can only be solved through long-term strategic thinking about value creation or value destruction within consecutive business cycles. Traditional analysis of outsourcing decisions is not only outdated but also life-threatening. And, by the way, if the cotton farmers of Texas were not subsidised against cheaper African producers, their cotton would never make it to China in the first place. This is an artificial situation that common sense would reject.
Better to use the same common sense in other relationships with China. One
of the better solutions is clearly the J&J model - namely, do not
go for short-term boosts in profit-and-loss statements, but rather long-term
shareholder-value creation. Becoming a shareholder in a Chinese company could
be a safer bet than being a buyer of its goods for short-term profit.
Roel Bellens is professor of value management and MD of Strategus in
Turnhout, Belgium (roel@strategus.be)
