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Sourcing from Eastern Europe or China: A Comparison for Aspiring MNCs

Published: 
9 May 2017

An ASEAN sourcing comparison between China and Eastern Europe is not a simple calculus. A case based analysis of the current state of affairs highlights the various considerations.

For the past several decades, China has represented a lucrative option for multinationals to outsource manufacturing for high value added, labour intensive products due to low labour costs and a high standard of productivity. European and North American firms have located many of their production facilities in China, especially Eastern China as they attempt to service the Chinese and the ASEAN markets. But is this still a wise strategy? The following is a case based analysis of the current state of affairs.

The subject of this analysis is a German-based company that produces high-tech spare parts for gas and steam turbines for power plants in their production sites in Slovakia and China. Forced by cost pressures, and due to OEM customer requirements, the outsourcing of manufacturing to Eastern Europe was inevitable. Nevertheless, the close distance and low trade barriers in the European Economic Zone simplified the essential support from the headquarters. But the European market was not where the manufacturing growth and demand were. As markets developed in the emerging world, especially in China and Southeast Asia, the firm’s orientation turned more global. Soon, it became clear that growth in China was only possible with a local firm. Finding reliable local partners who were necessary to start operations constituted a major challenge in the beginning.

As China represented the fastest growing economy in the world over the last two decades, the need for power represented attractive opportunities for the power plant business. In the early days of the venture, improving skilled labour and infrastructure led to increased efficiency in operating processes and falling cost curves. However, in recent years, the firm has begun to experience enhanced red tape that has hampered the ease of doing business, especially when it comes to cross-border operations. The increasing administrative efforts and operating costs have led management to question if these drawbacks outweigh the locational advantages when supplying ASEAN. Recent improvements in Eastern European infrastructure and logistics capabilities increased the need for scrutiny of these long held assumptions.  In this article we analysed the essential cost factors, direct and indirect, faced by a European-based MNC, to provide better insights and support for such decisions.

Suppliers

In analysing producer needs, the availability of goods and the number of suppliers play a key role. When there is a need for specialised, high-tech pre-products, firms in China have to establish their plants in more developed economic zones which lead to higher land and wage costs. Alternatively, if these products have to be imported from foreign countries due to a lack of local availability, import duties become an important concern. The variety, and reliance on domestic suppliers is relatively lower than in the European Union. In China, for many products, the anti-dumping clause is invalidated from the European Union for example. Moreover, the most favoured nation clause is also not applicable. Consequently, depending on the country of origin, the costs of imported intermediate products can command a premium of up to, or in excess of, 100%. In addition, the lead time these products need to actually get to the factories and passing border customs involves further time. In contrast, the access of Eastern European countries to the European Union brings along access to a broad range of specialised or unspecialised goods. Furthermore, the lack of customs within the European Union also reduces the administrative effort and leads to shorter lead times.    

Manufacturing Process

For manufacturing, it is important to know the role that labour plays in the value adding process and the cost structure. Over the last ten years, we observed that wages have increased much less in Eastern Europe than in China. In Eastern Europe, the wages have increased roughly 25% in the last ten years. In contrast, wage levels in China have increased by 150%.[1] Ten years ago the costs for higher skilled blue-collar labour in Eastern Europe was around 110% higher than in China, nowadays this figure has decreased to under 50%.[2] It is important to note that, within Eastern Europe you still face different stages of development. More developed countries like the Czech Republic or Slovakia provide higher skilled labour and much better infrastructure than some of the less developed countries like Romania or Belarus.

As Eastern Europe approximates Western European labour laws, the flexibility has been reduced. Concepts such as parental leave for fathers, strict 40-hour work weeks, four weeks of yearly holiday and multi-year severance considerations have changed the employment landscape and limited flexibility to ramp up and ramp down for cyclical products.  Normally, such developments would sway a firm towards China as a production hub. A major advantage of Chinese blue-collar workers has been the flexibility in severance policies, working hours and unionisation. But, the latest generation of blue-collar workers in China has also changed compared to their predecessors.  They are better educated in health and legal issues, collect greater overtime pay, and therefore focus more on their work-life balance. But still working overtime is seen as normal and holidays, except for Chinese New Year, are more or less optional. In the end, the flexibility compared to Eastern European countries, is greater.

Products

Unlike labour costs, the protection of intellectual property rights in choosing a source of production tends to favour Eastern Europe. Eastern European members of the European Union have mostly harmonised their rights for intellectual property with EU standards providing greater certainty. In China, the protection of intellectual property rights is still in transition and remains highly cost intensive to maintain. Moreover, it lacks quality controls to affect either the supply of primary products, including raw materials, or finished goods of the companies. This quality control shortcoming can be related to the brief history of manufacturing higher quality products. Therefore, when the quality of materials and semi-finished goods play a significant role, purchase from foreign countries is sometimes unavoidable. The management and overall understanding of quality standards will need some time in the future to meet European standards. An option is to outsource quality control to foreign experts, but that results in a relatively strong increase of costs.

 

 

LOGISTICS

A major factor that has an influence on logistics costs is the state of infrastructure. Since the financial crisis in 2008, China set about heavily investing in roads, ports, railways and airports. In order to go more West, China extended its railway system massively and therefore transportation opportunities for companies in the domestic area improved. In addition, this provided possibilities to shift businesses from the more industrialised, but more cost intensive eastern zone, into the west (as per government development policy). This western rail expansion and connection with the west has limited China’s problems around port congestion. As the establishment of new and capacity of existing ports did not grow relative with the amounts of transported goods, it resulted in an increase of lead times and greater inefficiency. But Eastern Europe faces several obstacles as well in the shipping industry. Most of the ports in Europe have limited remaining capacity and their expansion is restricted by strict environmental rules. This leads to more strained processes and requires therefore somewhat higher costs. The advantage of Eastern Europe is more the short and developed access to the highly developed infrastructure in Western Europe. Through the improvement of roads and railways, mainly subsidised by the European Union, even less developed areas in Eastern Europe enjoy good access to transportation and thus enhanced efficiency of land transportation. Overall, due mainly to the efficiency of domestic logistics to the port of shipment, Eastern Europe shows greater speed and lower costs than China.

GOVERNMENT-DUTIES-TAXES

When exporting products from China to ASEAN, due to the ASEAN-China Free Trade Agreement (ACFTA), no export tariffs are added. Nevertheless, for certain product categories the goods and service tax (GST) is not reimbursed. As this tax is 17%, it can in effect be equated with an export tariff. When manufacturers want to collect these rebates, they have to show the GST amount they paid for purchased products and prove that they exported the finished products. Depending on the product categories that China wants to encourage, the rebates can vary between 0% and 17%. A local company is required to register with the local tax authorities in order to be eligible to claim the rebates.

In contrast, Eastern European countries impose no duties for exporting products from the European Union. All exported products are free of duty. What is important to mention is that for almost all members of ASEAN import tariffs are applicable on entry to ASEAN states. In addition, several free trade agreements of the individual states with the European Union have been established. This can reduce the costs for imports from the EU to below that of China.

The major influencers from the government´s side are taxes and tax-related incentives. In 2008, the Chinese government lowered the corporate tax rate from 33% to 25%. Afterwards, they continued more strongly with incentives for high-tech companies in research & development and information technology. By fulfilling certain requirements the corporate tax rates can be reduced to 15%.

However, within the last decade, the classifications for these sectors have become stricter and more tightly controlled. The company has to be registered for at least a year and operate within China. The intellectual property rights for the products have to be in fields supported by the state and the high-tech related operations have to contribute a minimum 60 percent of total income. This means that firms which conduct their main R&D outside of China will face problems in lowering their corporate tax rates.

In Slovakia, for example, incentives regarding the corporate tax do not exist. The current corporate tax rate amounts to 22%. Incentives for R&D can only be granted when applying for the Horizon 2020 programme, which is financed by EU funds. But this programme requires that a minimum of three independent entities work together on a R&D project and therefore it is not really attractive for an individual company. This weakness can be traced back to the fact that Eastern European countries are still dependent on funds from the European Union.   

ADMINISTRATION

A significant factor that differentiates China from the Eastern European countries is the time difference, especially for communication with ASEAN members, China is almost in the same time zone, whereas the difference with Eastern European countries can be up to seven hours. Financial quantification of this factor is almost impossible but has a major effect on doing business. As an example, the abovementioned regulations regarding tax rebates require a high degree of administrative effort. In order to claim these rebates 1) all products or raw materials need a certificate that states the country of origin. 2) China´s foreign exchange department is extremely strict in currencies for imports and exports. When a Chinese branch or company wants to sell goods or services between two foreign countries, every transaction has to pass through the China based company and has to be converted into the local currency first. It is not possible to exchange a foreign currency for another foreign currency. This of course slows down the efficiency and increases administrative effort. 3) The third reason that administrative effort is so high is the lack of digitisation. Recently, many administrative authorities in China started digitalisation by employing modern information technology software. But there is still a tremendous way to go.  By comparison, in Eastern Europe the high knowledge of engineering provided a better base for implementation of IT. The proximity to a highly developed Western Europe gave Eastern European countries a blueprint for faster development and integration of IT services.

CONCLUSION: ALL THINGS NOT BEING EQUAL

An ASEAN sourcing comparison between China and Eastern Europe is not a simple calculus. There are four main issues that have to be kept in mind. 1) First of course is costs. Currently labour in China remains about 50% cheaper than in Eastern Europe. However, if we look at the stronger required administrative effort and the export tax applicable on many finished products, the transportation costs, and some of the raw material costs, the overall manufacturing costs have reached an almost even level in both zones. And, in our case we found the net cost to be several percent lower in Eastern Europe as the transportation savings to ASEAN were significantly lower. 2) Possibly the most important aspect to keep in mind is quality. As a supplier to others, quality will define you. The understanding of quality standards in Europe is higher and therefore will more likely lead to a higher quality of outputs for high-tech products. The quality standard appreciation in China, in relative terms, is lower. 3) The third factor to keep in mind is administrative compliance and effort to do business. The learning curve in China is still steep and expensive.  4) The fourth consideration is timing and flexibility. Due to lower labour costs, the number of staff in Chinese manufacturing is 25% higher than in Eastern Europe. This reduces the manufacturing time and increases flexibility for last-minute changes. Additionally, despite customs issues, transportation time is more than 50% shorter than the shipping from Europe. Depending on the demand of the client, these can be essential criteria for the decision on where to source the products from.

 

Moritz Arnold is a student in the Masters of Management programme at Singapore Management University.
Pannapachr Itthiopassagul is Assistant Professor of Marketing at Thammasat Business School.


Sources

  • Amador, J., & Cabral, S. (2016). Global value chains: a survey of drivers and measures. Journal of Economic Surveys30(2), 278-301.
  • Ellram, L. M., Tate, W. L., & Petersen, K. J. (2013). Offshoring and reshoring: an update on the manufacturing location decision. Journal of Supply Chain Management49(2), 14-22.
  • Huttenczapski, F., Kosinski, J., & Waddell, K. (2006). Sourcing in Central and Eastern Europe: An Overlooked Opportunity. Retrieved May23, 2007.

 

[1] China Average Yearly Wages, Trading Economics, http://www.tradingeconomics.com/china/wages, accessed 22 April 2017.

[2] Slovakia Average Yearly Wages, Trading Economics, http://www.tradingeconomics.com/slovakia/wages, accessed 22 April 2017.

 

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