China Supply Chain Disruption: The Hidden Risk of China’s Growth Slowdown

Posted on November 3, 2015

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Much has been written about the economic slowdown in China and its potential effect on the world economy. All the superficial “noise” from uninformed pundits masks a potential exposure that thousands of American companies risk confronting in the next 12 to 24 months. That risk is supply chain disruption due to the inability of many Chinese suppliers to transition their businesses to a lower growth environment. It is highly likely that U.S. companies that are dependent on less sophisticated Chinese suppliers for low cost products will see delivery cycles extend unacceptably, prices increase with confusing rationale and in the worst cases – business failures of strategic supply partners. Virtually nothing has been written about this looming risk, but it is real and entirely avoidable.

On a macroeconomic level, China will remain the world’s fastest growing large market for the foreseeable future. According to the CIA World Factbook, China’s economy is already the world’s largest on a purchase price parity basis, surpassing the U.S. in 2013. According to International Monetary Fund and World Bank data, even at 6%-7% GDP growth, China will produce more new GDP than the combined total of the U.S., Germany and Japan.

These macroeconomic facts are interesting and important, but daily business operates at the microeconomic level, not at the level of GDP. Companies interact with suppliers and customers on a detailed transactional and activity level – designing, producing, and selling products and services. This is where the GDP growth slowdown will negatively affect many Chinese companies; a portion will struggle and underperform and an alarming number will probably fail in a lower growth economic environment.

The average Chinese company’s business management systems and skills are much less sophisticated than Western standards. Very few have full functional ERP systems that are routine business tools at Western companies and few Chinese manufacturers understand or use the concepts of MRP and sophisticated working capital management. Surprisingly, the vast majority of Chinese manufacturers do not even have cost accounting systems that enable them to understand SKU-level product and inventory costs, including labor, material and overhead cost contribution.

When the Chinese economy was growing at double digit rates and companies were awash in business and cash, these systemic management weaknesses were masked and companies could still succeed with loose, and in some cases nonexistent capabilities in what Western companies view as critical functional disciplines. These same sophisticated business systems and skills have taken Western companies decades to develop into an integrated business management infrastructure. They enable Western companies to operate in low growth environments, balancing operating, commercial and financial considerations. In contrast, the Chinese industrial base that serves Western export markets is only two decades old. These more complex operating skills and processes have not had time to develop, spread through the industrial base and mature. Compounding the challenge, China has not encountered a business cycle since the country started its ascendency to economic power. China enjoyed a constant upward growth curve that was impervious to the business cycles encountered elsewhere in the world. While the current China growth slowdown is not a recession, it will present Chinese manufacturers with operating challenges due to broad weaknesses and immaturity of these important processes, capabilities and management tools.

China Centric believes that over the next 12 to 24 months, a significant segment of the China manufacturing base will begin to confront business problems due to the lack of “Business 101” management functionality. Cash positions will become tighter as extended collection periods will not be covered by extraordinary sales growth. Tightening cash positions will restrict the ability to purchase raw materials. Broad material management weakness (e.g. absence of MRP and advance materials management systems) will drive material shortages and production slowdowns. The lack of working capital credit lines will further intensify the problems that will mushroom into financial difficulty. Many Chinese manufacturing companies will have no alternative but to delay shipments, others will respond by increasing prices or take other actions that will risk the value exchange with their export customers. Still others may not even survive.

To be fair, there are many Chinese companies that will thrive in this new environment and they will be able to absorb the fallout from the lower end of the supplier spectrum. The result of this shakeout will be a much stronger and robust China manufacturing sector. But the transition will be painful for foreign companies that are dependent on strategically important China supply chains that have utilized less sophisticated Chinese manufacturing partners. Having enjoyed many years of successful supply from “trusted” Chinese suppliers, most Western companies have no transparency into these systemic weaknesses and won’t know that they exist until their supply chain breaks down and they are thrust into supply crisis.

Western companies have options to mitigate this risk and control a supply chain shakeout. Assuring that a company aligns with the best supplier should not simply focus on product and price. However a large proportion of China supplier selections have focused excessively on these two factors. These are obviously important, but security of supply chain requires that suppliers have management skills and systems that are strong and robust to change with an altering business environment. Western companies need to “vet” and confirm supplier capabilities across the full range of functional disciplines including:

  • Manufacturing – actual production management;
  • Manufacturing Support Processes (production planning, materials management, supplier management;
  • Quality Management;
  • Technical Support;
  • Logistics;
  • General Management (Capitalization, Financial Strength, Credit, etc.)

Western companies can get ahead of the looming China supply chain risks by conducting supply chain assessments to gauge the severity of the exposure and make adjustments as required before supply disruptions occur. The assessment process should be structured and formal with target supplier capability attributes customized to each supply situation. The assessment process must also be unbiased, as third party assessment professionals should be engaged to provide a fresh and independent perspective. This is not to suggest that the input of the existing supply chain management professionals at a company is not important. However, the experience and comfort with the status quo can distort and overlook underlying weaknesses and exposures when past supply has been satisfactory. In our experience, an independent assessment is the fastest and most effective path to identifying supply chain risk and the development of an effective corrective action.

This looming supply chain exposure is real and has the potential of seriously impacting thousands of Western companies. It is avoidable with proactive and timely assessment and aggressive corrective action.

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