April 2008

China targets the Achilles' heel of Capitalism

By Jim Pinto

China had attained pre-eminence in globalmanufacturing.

In recent years, the manufacturing sector has been growing so quickly China is set to exceed output in the U.S. manufacturing sector in the near future.

In the early 1990s, China was merely a low cost place to make labor-intensive products. Now China is advancing quickly up the value chain, adding state-of-the-art production capacity in cars, specialty steel, petrochemicals, and microchips.

Indeed, there are technically advanced manufacturing processes for which China is superior to the U.S.

With China's entry into the World Trade Organization (WTO) in 2001, the game has intensified. The country with the world's largest population is set to become an even more powerful force in global production.

Pricing asymmetry

Prices for Chinese manufactured goods are typically half of comparable U.S. and European products, and this continues to give China a strong competitive advantage, causing financial and manufacturing resource shifts.

Today's world has three business models:

  • U.S. businesses develop products with 60-70% gross profit margins, and target revenue growth of $100 million to $1 billion. U.S. investment is simply not available for products with smaller margins and markets. Because of this, products developed in the U.S. are typically technology related, more complex, and for large markets that can justify high investment and subsequent high overheads.
  • Developing countries (other than China) are growing rapidly through products that have intermediate complexity with smaller revenue growth and medium (40-50%) gross-profit margins. In India, Brazil, and other developing countries, there are exciting technology companies growing to $5-10 million within three to five years with medium complexity products, quickly developed. This level of success attracts high levels of local investment.
  • China is unique in that it is largely government controlled, with target gross-profit margins of only 5-10% (margins too small anywhere else). Therefore, even with comparable manufacturing costs, Chinese products come in at lower prices. As a result, China has become the undisputed world leader in low-price manufacturing of highvolume products.

Notice the difference between low-cost and lowprice. Please realize the profit margins discussed here are gross-profit (manufacturing cost related to net selling price) and not net-profit (after sales, development, and administrative expenses).

In the U.S, gross-profit margins of about 60% typically result in a target net pre-tax profit of 15-20%. In many other countries, a gross-profit of 40% results in net profit of 5-10%, which is acceptable. In China, the net-profit is often zero. This astounds most outside observers-how can a profit- making enterprise survive (capital and cash flow) with no profit?

The answer: In China, short- and medium-term operating deficits are acceptable since the government manipulates and controls capital. Chinese planners recognize the demand for short-term profit as the Achilles' heel of Capitalism. Their own primary objectives are rapid local employment and long-term global market share.

For America, the remedies require significant attitude shifts. Our short-term financial mind-set must change. Business needs to realize continual quarter-to-quarter increases in revenue and profits cannot continue on and on with work that is done elsewhere in the world.

Our society must recognize manufacturing and job creation are not just political or business manipulations, but the building blocks of society. It is important to keep investing in jobs, to upgrade factories, and to be competitive in global markets. Entrepreneurship and talent must be encouraged and stimulated to thrive in the manufacturing sector.

ABOUT THE AUTHOR

Jim Pinto (jim@jimpinto.com) writes a weekly column in InTech e-News (www.isa.org/link/pinto_main).