Who isn't sourcing goods in China these days? Just about every manufacturer and retailer in the world is buying some or all of its products and components from low-cost producers in China. Despite the well-documented logistics difficulties of importing from China, it has indeed become the factory floor for the world's largest companies.

As important as sourcing from China has become to the supply chain strategies for many large companies, it pales by comparison to the opportunities-and the challenges-of setting up full-blown operations within China. With an economy that has been growing at more than 9 percent annually for nearly 20 years, China is going to be the world's largest consumer and industrial market in a few years. And with foreign investment that tops $50bn year after year, China already has become a supply chain hub covering the entire Pacific Rim and beyond.

Global manufacturers and retailers have long wanted to operate within China, if only to position themselves for serving China's 1.2 billion people. But setting up and managing an entire supply chain centered in China has proven to be a frustrating experience since the 1970s when China began opening its doors to foreigners. Faced with an unfathomable communist bureaucracy, the conflicting policies and regulations of various ministries, foreign investment restrictions, and a hopelessly inadequate infrastructure for transportation, utilities and technology, operating within China has been anything but a hospitable place to do business for the world's multinational companies (MNCs).

According to Steven H. Ganster, managing director of Technomic Asia, a Shanghai-based strategy firm, nearly all MNCs that have attempted to invest in China have had similar problems and have made the same blunders. Most of these mistakes stem from not understanding the business realities of China, failing to perform basic due diligence and expecting wildly unrealistic success in too short a time frame.

Ganster's firm has assisted over 140 multinational firms with their China growth strategies, including General Motors, 3M and PPG Industries. He traces these mistakes back to the late 1980s and early 1990s when a gold-rush mentality about investing in China spread among the world's MNCs.

"CEOs would fly into Hong Kong in their corporate jets, announce a sure-fire joint venture with some unknown Chinese company and then leave a small group of managers behind to make these plans work," says Ganster. "There was never any chance of success."

Fundamental issues such as marketing, logistics, supply chain management were never seriously considered. Since investments could then be made only through joint ventures with selected domestic Chinese companies, many of which were state-owned enterprises (SOEs), no due diligence of these partners was done. The focus was solely on first mover advantage to gain access to China's huge population.

"Companies left their common business sense at the border," says Ganster. "They assumed that their partner knew all about local marketing, logistics, etc. They forgot that China is a centrally planned economy that ignored such things as marketing. It was about meeting production quotas handed down from the government and little else. These Chinese partners primarily contributed bad facilities, poor management and lots of debt. As a result, the latter half of the 1990s was about getting out of the bad ventures."

Since China's entry into the World Trade Organization in December 2001, rationality has begun to return to the MNCs. They are now allowed to operate in China as wholly foreign owed enterprises (WFOEs) if they choose. The Chinese government has increasingly relaxed rules for domestic market access. Foreign companies that previously had operations in Hong Kong, including nearly all of the global third-party logistics providers, are now allowed to locate wholly owned operations anywhere in the country. As a result of these changes, MNCs are setting up operations in China based on sound supply chain networking principles, not on speculation.                                                                    
Ganster says that foreign investment in China is now typified by a migration cycle led by large MNCs seeking to set up entirely new supply chains in China. He says one of his clients, General Motors, is a leading example of how MNCs are importing their entire supply chains into China. To be competitive for the domestic Chinese market, GM needs local production that is high quality, dependable and low cost. It turned to its traditional tier-one suppliers like Delphi and asked them to set up manufacturing operations in China to serve the GM plants. That migration is well under way, and tier-one suppliers are bringing more of their production to China in order to serve GM with the same manufacturing logistics they provide elsewhere. According to Ganster, the next phase, and the most risky, is just beginning. The tier ones are now telling their tier-two and tier-three suppliers that they have to be in China to supply them on a local basis.

"These suppliers are often new to international markets and have no experience operating in a place like China," he says. "These companies have to make a strategic decision of whether or not to invest in China, and there is no clear choice. The risks are high for either alternative."

On the one hand, a supplier that chooses not to invest in China will lose the business from a major customer that is most certainly going to ramp up global production from its emerging Chinese operation. When that customer adds new capacity elsewhere in the world, the new supplier will have a preferred position.

"The biggest fear for the U.S. supplier is that a Chinese supplier will gain a foothold with their traditional customers, and that local Chinese supplier will soon become a global supplier," says Ganster. "The downside to a supplier refusing to go to China could be very significant."

On the other hand, the economic environment for new entrants to the Chinese markets is far from hospitable. Competition within China is super-heated thanks to the WTO agreement that has allowed hundreds of foreign companies to take on local Chinese SOEs. Most of the SOEs are simply not competitive because of poor procedures, lack of technology and staggering debt loads.

"The government wants to get out of these businesses, so they are closing them down or forcing them to privatize," he says. "But this transformation is causing unemployment in certain areas, and that scares the government."

To avoid social unrest, foreign investment is welcome at all but the highest level of the industrial hierarchy. Provincial and local governments-not Beijing-are orchestrating policies to create jobs in their regions and to make local industries competitive. These foreign companies set up supply chains made up of other foreign suppliers.

"Nanking, just west of Shanghai, is the Detroit of China," says Ganster. "The automotive OEMs and tier ones use their leverage with the local government officials to help their suppliers to set up operations there. It is a form of the classic Chinese practice of guangxi, which means using connections and relationship to make things happen."

But investing in China, even to serve a large, familiar customer, does not guarantee financial success. Overcapacity already exists in many industries. And prices are continuing to drop, which is causing extreme cost pressures that companies new to China are ill prepared to deal with.
"The stress on these companies is tremendous," says Ganster. "They are being pressured to come to China before the economics are really favorable. The supplier has to make the call of whether this move is important enough for the long-term relationships and business opportunity weighed against the risk."

The Japanese Model
It's no coincidence that this group approach to setting up operations is very similar to the classic Japanese keiretsu supply chain model where manufacturers and suppliers tightly integrate their operations and closely coordinate their responsibilities and interests. The large Japanese MNCs were among the first foreigners to invest in production and facilities and sourcing hubs. In keeping with the keiretsu model, these Japanese manufacturers and retailers have included their traditional suppliers and service providers in their Chinese supply chains. Toyota, Mitsubishi, Sony and all of the other well-known Japanese MNCs have adopted a similar model for their Chinese operations. One additional element for the success of the Japanese companies has been inclusion of a Japanese 3PL to manage logistics for all trading partners in the supply chain.

Nippon Express, or Nittsu, as it is called in Japan, was one of the first 3PLs to enter China. It serves a vital role in supporting the logistics needs of many of Japan's large corporations there-from energy to automotive to consumer goods. It has 67 warehouses, freight depots and other logistics facilities throughout China.

"We often provide logistics to every company in the supply chain," says Ron Sullo, senior manager of business development for Nippon Express USA. "We have developed an extensive logistics network in China, and that serves as the supply chain lifeline for both large and small customers there."

According to Sullo, Nippon Express provides in-country logistics as well as export and import services.

"We often act as the trading company for a Japanese buyer sourcing from a Chinese manufacturer, in which case we do the logistics as well as customs, forwarding, license, and international transportation."

The key benefit global 3PLs bring to MNCs is a network of warehouses, distribution centers and other facilities that provide a built-in logistics backbone for their customers. And the 3PLs must constantly grow these networks to meet clients' increasing needs.

For example, Nippon Express recently acquired a majority interest in Mitsubishi's logistics operations in China, including 33 freight depots and DCs and a large trucking fleet. The additions will give Nippon Express's network an even greater in-county logistics support capability for the Japanese companies and other MNCs in China. These clients can grow their exports from their Chinese factories.

According to Hitoshi Uchidate, director of Nippon Express in Shanghai, this export traffic for Japanese companies operating in China remains the 3PLs' primary business, but manufacturing logistics is becoming nearly as important. Manufacturing operations consume all of the space available in most factories, so there is a huge demand for adjacent warehousing space to store raw materials and end-of-the-line production.
"The MNCs in China are eager to outsource their logistics," says Uchidate. "The factories have just enough room for the manufacturing, so the 3PLs do the rest."

The primary tasks of Nippon Express for its manufacturing customers include sequential delivery of components to the production line and managing suppliers.

"We make certain that suppliers are meeting their forecasts and that materials arrive on the production line," says Uchidate. "After the goods are produced, we put them into our DC, and then perform labeling, consolidation, and whatever else is needed to export them."

According to Uchidate, little of the production from these factories is now gong to the domestic market, but that is going to change in the very near future.

"The network we are building to support the export market will soon serve the domestic market," says Uchidate. "We don't want to be viewed as a threat to the domestic companies. We will know when the time is right to compete in the domestic market."

Strategic Growth
There are other successful models for operating in China. For example, Caterpillar, the $30bn manufacturer of construction and mining equipment, started selling its products in China in 1975. In the 1980s, it began licensing the manufacture of certain Caterpillar products to Chinese companies. Caterpillar's expansion in China accelerated in the early 1990s with a more aggressive local production strategy. Today, Caterpillar operates 10 facilities-both joint venture and wholly owned businesses-and employs approximately 2,000 people. Caterpillar sells its products through a network of five independent Caterpillar dealers in China. It's most recent investment is a minority interest in Shandong SEM Machinery Co., one of China's key wheel loader manufacturers. Caterpillar has the option to purchase the remaining equity after two years.

"China is a very strategic market for Caterpillar because of the huge infrastructure projects throughout the country," says Bill Gordon, director of supply chain strategy design and transportation for Caterpillar Logistics Services based in Shanghai. "Just as Caterpillar has the right products to support these rebuilding projects, Cat Logistics provides the right services to support the products that our parent company is selling in China."

Caterpillar's service parts business has always been supported from Cat Logistics' DC in Singapore, but that is about to change. The 3PL is building a 20,000-square-meter DC outside Shanghai that is to be the base for supporting the service parts business of Caterpillar as well as other Cat Logistics customers in China. This new DC will be in a logistics park being developed by the Shanghai Lingang Economic Development Company (Lingang Group). It will be the world's largest industrial park. Caterpillar will also locate its remanufacturing services center in the Lingang park.

Shanghai is the ideal DC location for Caterpillar Logistics, Gordon says. The nearby port allows easy importing of parts from the U.S., Japan and Europe. The industrial park also represents a potential source of 3PL business when Cat Logistics expands operations beyond the parent company.

"We selected this site using supply chain network design tools to identify the location and the optimal distribution network," he says, adding that the tools Cat Logistics used are a combination of i2 Technologies software and Caterpillar proprietary tools. "We will be using these same logistics network planning tools for new clients."

The Lingang location is a so-called bonded logistics park, which provides many of the same benefits of a free trade zone, but it provides more flexibility because the entire facility does not have to be in bond.

"You can have bonded and non-bonded operations under the same roof," says Gordon, adding that multiple customers can operate out of the same bonded facility as well, which is important for a 3PL. "A bonded facility requires you to work very closely with Customs, but the flexibility you gain is worth the effort."

Caterpillar Logistics was first established in China as a joint venture with one of its own dealers that had been in the Shanghai area.

"We have been able to leverage the knowledge that our dealer had developed over its years in China," says Gordon. "It has given us a head start in understanding the challenges they have had to deal with. The joint venture has greatly shortened our learning curve."

Cat Logistics has not served other customers in China, but it is preparing to work with many of the global companies that it serves elsewhere, including automotive OEMs, industrial equipment manufacturers and telecommunications hardware customers.

"We are strong in service parts and manufacturing logistics, where we handle all aspects of inbound components right to the production line," says Gordon. Transportation management is likely to become a big part of the 3PL's business, he says. Although most economic activity in China has been concentrated on the Eastern seaboard, especially around Shanghai and south to Shenzhen and Hong Kong, there is a major government initiative to move more manufacturing into the hinterland where transportation services are still quite immature.

Besides basic transportation infrastructure problems in many parts of the country, there are regulatory issues involved with trucking across provinces and the need to find reliable carriers.

"The transportation modeling is especially important because of the constraints that exist with the current infrastructure," says Gordon. "With the i2 tools we use and the experience we are developing, we will be able to provide our clients with the best transportation management services among the 3PLs operating over here."

A Retail Revolution
Among the most recent success stories are the large, global retailers that have been able to tap into the needs of China's blossoming middle-class. Retailers such as Wal-Mart and Carrefour are rapidly building superstores, much to the delight of consumers and to the chagrin of established merchants completely unfamiliar with this type of retailing. Wal-Mart alone has 48 supercenters throughout the country. Carrefour projects that it will have 61 large stores there by the end of the year. In the face of traditional Chinese retailing typified by small stores, no merchandising and inefficient echelons of distributors, these large retailers have been able to transplant their concept of well-stocked superstores replenished through a captive distribution system.

One of the secrets to their success in bringing this new model to China has been the use of 3PLs to manage the distribution process.

"These retailers are focusing their efforts on expanding their businesses," says John Hafferty, UPS Supply Chain Solutions vice president for Asia operations. "They are contracting with suppliers and quality manufacturers and they are using 3PLs to handle their entire supply chains. They are not making large direct investment in plants and facilities."

It's a business model built on outsourcing, so they can move quickly and limit the time and investment of holding inventory. The 3PL must provide the distribution network to support these operations all over the country.

UPS SCS services now has 33 facilities in its network, and will soon have 43. The facilities vary in size and type depending on the area. Its three largest DCs are in Shenzhen, Shanghai and soon in Panging. Besides handling outbound exports, these DCs handle small parts logistics for domestic customers. Its other facilities are freight hubs, cross-dock facilities and warehouses.

"We are building a network that will serve logistics needs of all types of customers across China," says Hafferty.

While much is made of the problems with China's freight infrastructure, Hafferty says that the intercity highway system between major cities has developed rapidly to the point that it is similar to the U.S. interstate system. UPS SCS contracts with local truckers to provide the line haul movements from DCs to the stores in major cities.

"We have had no problems with the highways, carriers or related regulatory issues," says Hafferty.

In China, businesses need an operating license for every type of business activity. The MNCs have little interest in obtaining licenses for operating transportation and logistics. "They are looking for 3PLs like us to set up the networks to manage the distribution."

Most of the global 3PLs in China have the added advantage of being able to operate anywhere, not just in Customs-controlled areas near the ports. Last year, China enacted the Closer Economic Partnership Agreement (CEPA) that gives special market access to Hong Kong-based businesses. Since most of the world's largest 3PLs have long-standing operations in Hong Kong they now are able to operate anywhere they wish in China.

The large retailers and other companies that UPS SCS counts as customers in China are very dependent on information, so they are looking for systems that can link them with suppliers. UPS SCS provides web-based tools such as Supplier Management that even small suppliers can access with a browser to receive purchase orders and share information with upstream customers worldwide.

At the same time, these systems provide the large retailers with reliable visibility into inventory while it is still in the hands of the supplier, carrier or UPS itself.

"We provide the technology connections to the entire supply chain in China," says Hafferty. "The retailers can see where the goods are and when they will arrive."

Another growing business for UPS SCS, as well as other 3PLs in China, is in repair of high-tech products, mainly from Japan and Korea. The technology companies not only manufacture and export new products, but they increasingly are moving into the repair-and-replace market.

"This is great business for a 3PL because we can manage logistics flows in both directions," says Hafferty.

Much of the repair takes place in 3PL distribution facilities in bonded logistics parks. When the work is done and the items shipped out, there is no value-added tax, which can be quite high in China.

Conclusion
Setting up manufacturing or retail distribution in China is by no means risk-free, but it is far easier and safer than it was just a few years ago because the government now is eager for more foreign investment. Entering the market with trusted supply chain partners makes all of the difference. However, fundamental logistics hurdles still exist, which is one reason why most MNCs rely so heavily on experienced 3PLs to manage all of their logistics and transportation.

Logistics costs in China can be 25 to 30 percent of overall product costs. According to Robert Spira, a transportation lawyer with Benesch, Friedlander, Coplan & Arnoff LLP in Cleveland, which advises companies on Chinese business and logistics issues, overall logistics costs in China are 19 percent of gross domestic product, compared to just 7 percent in the U.S.

"The inefficient logistics system is a function of geographic barriers in China that can make the movement of goods difficult," says Spira. "The system is a victim of political barriers created by multiple bureaucracies. The result is a highly fragmented, underdeveloped logistics industry where inefficiency is the norm rather than exception."

Moving goods from Chungking, China's main manufacturing city in the west, 3,000 kilometers east to a port city such as Shanghai, can take four days by truck or 10 days by rail. The government is devoting enormous resources to building highways, as well as rail and inland waterways.

Regardless of these difficulties, no one doubts the eventual rewards for those companies that persevere.

"Today, China is the factory for the world," says Nippon Express's Uchidate. "We all know that tomorrow China will be the biggest market in the world, so we must be there ready to compete."