Chinese companies have thin margins

One aspect of Chinese business competition that Western companies often fail to grasp is the razor thin margins many companies in China live on. A Chinese boss will tend to look at the amount of money that can be made as opposed to what it represents in terms of margin.

In a nutshell, this also explains why China became a feeding ground for the mega corporations. It was a dream come true. They could dangle a huge contact with absurdly low margins and still get companies underbidding each other.

For example; Apple reportedly made 50-percent margins on its hot iPhone offering in 2011 (down from 58 percent in 2010). The company that assembles iPhones in China works on a 1.8-percent margin. With projected sales of $37 billion for the fourth quarter of this year alone, 1.8 percent means a fairly hefty $666 million for just one quarter – a tough number to sneeze at, but one which would disappear in an instant, if there was a major manufacturing flaw.

Thin margins, like thin branches, cannot take much weight, and if there is a storm, it’s not the place to have your baby’s basket hanging from. Even minor issues can become life and death struggles for these companies. Cutting costs and expenses, especially on quality and materials, becomes the only way for them to claw back.

So what do you do about it?

Recently a friend indicated that when looking for a good deal, he either sends someone, or goes himself, and takes a look at every aspect of the company they intend to do business with. This means bypassing the banquet room and the boozing and spending a little quality time on the factory floor and in the boardroom. His point is that some time checking the specs and maintenance of the machines and getting a little grease under the fingernails is going to net a lot more information than a couple of hours at a karaoke bar and 15 beers.

He also asks to see the company’s financials (having been in the unfortunate situation where a good deal never materialized because the manufacturer did not have the funds to pay for the materials). Keep in mind that small companies will pay 25- to 50-percent interest for short-term loans to buy materials, biting even further into their margins. If they refuse, or he gets even a whiff of something not right, he will ask them to create a double signature escrow account to be used only for the purchase of approved materials. In cases like this, since he can still control the funds up to the point of purchase, he will often fund the materials portion because it makes the deal more feasible and ultimately better for both sides.

Of course, if any major alarm bells go off, he is down the road to the next factory, often in the same area, to see what they have to offer.

As he says, “I have been cheated but they never got much.” For his type of business, which is heavy machinery manufacturing, it is also one of the best ways to establish a relationship. The other side sees clearly that you are interested in a real business affiliation. The fact that you seem to know your business and are checking every aspect even before making an order, will impress them. They are more likely to see this as just the beginning of an ongoing effort where he intends to be closely involved and will treat him accordingly.

He is also a great believer in working through problems rather than dumping the company, if there is a legitimate unforeseen issue. Not surprisingly, he has built a very nice supply chain for manufacturing and parts which has been beneficial to the bottom line.

But for every good supplier, there are a dozen or so rejects. Recently I went on an evaluation effort, to inspect a Chinese heavy machinery manufacturer. It began with a tour of a factory that was primitive, poorly organized and unsafe. I was then shown some pretty pictures of a new plant (to be built as soon as enough orders were placed), which was going to be the opposite. The pièce de résistance was a visit from the very drunk (at 2 p.m. in the afternoon) company chairman/party leader, who assured everyone that everything would be fine if we would just transfer some good technology to his company. This was interesting because the point of the visit was to see if they could make parts, not machines. His thought was that since he was anxious to get working right away, the joint venture details could be worked out as things went along. After 20 minutes of slurred speech and rude comments, he left. The fact that two of the people in our group were native Chinese did not seem to deter him. My guess is he must have thought that since they were with foreigners, their ability to understand Chinese was impaired. Not surprisingly, we left a short time later.

A little subsequent digging revealed that this company was famous for copying the designs of other companies, including one of Milwaukee’s leading heavy machinery companies. Interestingly, apparently when confronted about this, they pointed to the fact that due to the poor quality of their manufacturing processes, their machines were completely different and that none of the parts were even interchangeable with the original design.

In terms of their margins, it was impossible to tell, but as a State Owned Enterprise, I am sure they make their losses up on volume.

The moral of the story is that as the world gyrates on the political and economic turmoil caused by our past sins and bigger debts, there are opportunities and pitfalls everywhere. Taking advantage of the former and avoiding the latter is often about doing your homework.

Also keep in mind that despite the hype and the foreign reserves, China is not immune. China’s economy has its own deficits that will come to roost in time.

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