The product supply chain from China is not what it used to be. Over the past 20 years, Chinese consumer-product manufacturers have become increasingly sophisticated and capable of taking on more "value-adding" tasks or segments of the product creation supply chain and have moved from mere manufacturers to multi-functional suppliers. In doing so, they have changed the game, taking on an array of production functions traditionally handled within "shop-by-product" companies.
This deconstruction of the manufacturing and product-development process has opened up new possibilities for product companies. However, unless there is evolution in the contracting model that takes these changes into account, product marketing (Brand) companies will increasingly face threats to their core roles and functions. For some companies, the evolution of their value chain has been subtle, while for others, the changes have been dramatic and obvious and these companies have come to well appreciate the value and the leverage that the multi-functional supplier brings to table.
The product value chain is fundamentally comprised of three players (represented in the graphic below):
Manufacturers—historically focused on the hard aspects of actual manufacture, taking orders from the product marketing companies and manufacturing the products.
Product Marketing Companies—historically focused on the more intangible upstream and downstream aspects of production such as conceiving, cultivating and launching product and Brand lines.
Product Distributors—historically focused on the last step in the product value cycle, retail or wholesale (i.e., pushing product in the last mile to end-consumers).
In fact, rather than clearly delineated players, each of these players really represent a collection of functions—of value-add activities that all combine to form the product supply chain. In one of the most significant recent developments, the roles of Chinese product manufacturers have expanded, as these manufacturers have taken on more important roles in the supply chain, even becoming potential competitors to both product marketing companies and retailers.
It is important now to look at Chinese suppliers as providers of bundles of value-adding services that must be managed through a contractual framework that effectively addresses the unique attributes of product sourcing and the Chinese manufacturing landscape—a challenge well-suited to the outsourcing contractual model. This article will look at the evolution of the Chinese supply base in the provision of Original Engineering Manufacturing (OEM) (suppliers that manufacture to designs given to them), and Original Design Manufacturing (ODM) (suppliers that develop products and designs on their own) and the new world of issues that sourcing customers around the world face with their service contracts.
The Evolving Value Chain It is helpful to explain the evolution in the value chain through a comparison of the roles of each of the key players in the consumer-product value chain over the last 20 years.
In 1990, brand companies were the key drivers of product innovation as they actively cultivated their connections with retailers and consumers to develop each new generation of product. Key functions, such as marketing, product management, product design, design engineering and manufacturing, were deemed "mission critical" strategic functions that were naturally controlled internally. Manufacturers in China did little more than fabricate toolings, inject plastic parts, source components and assemble products for their customers. The relative added-value of the manufacturer was limited and as a result their margins were thin. Retailers were primarily responsible for end-distribution and interfacing with the consumer.
"House Brands" were few and far between and were limited to opportunistic products at lower price points sourced off-the-shelf from suppliers. In summary, there was relatively little overlap in the roles and responsibilities of the different supply chain players.
The Evolving Value Chain 2010
Today, product marketing companies involve their manufacturers significantly earlier in the new product development process in order to save engineering costs and time and to provide for a more seamless transition to manufacturing. Chinese suppliers have risen to the opportunity, investing in product development engineering resources required to help their customers get products off the ground—motivated by the ability to raise their margins, notably through the avoidance of competitive bidding for new products. By getting involved earlier, Chinese suppliers "lock-in" their customers, avoid the risk of having to compete on mere lowest cost manufacturing and improve their margins by using their new-found leverage to quote on a "value-base" rather than "cost plus" basis. The integration of manufacturing suppliers into the process has helped to shorten development lead times, but early integration has left purchasing professionals without the ability to source the product with the best cost supplier.
Over the last 20 years, the confluence of three important factors has shaped the current value chain and shifted leverage away from the brand company to the supplier: (1) consolidation of the retail sector, (2) the need for brand companies to be more cost-competitive through low-cost country manufacturing, and (3) the push by Chinese suppliers to increase their margins and protect their manufacturing through the creation of more ODM products that cannot be ported to other suppliers.
First, consolidation of the retail sector in both North America and Europe has allowed retailers to increase their own margins through the development of "house brands" to supplement their own supplier's (brand companies') offerings. While initially undertaken on an opportunistic basis, the trend has become prevalent in hard lines (hardware, electronics), soft lines (clothing) and fast-moving consumer goods (groceries) product offerings, while squeezing the price points where many brand companies operate. As a result of their increased leverage through consolidation, retailers presented an attractive alternative customer base for Chinese manufacturers, allowing both the retailer and manufacturer to greatly increase their margins through the removal of the brand company intermediary.
Second, retailers have pushed their brand company suppliers to offer productivity savings and to lower their prices to consumers with products that are competitively priced against "house brand" products. Competition has further exerted pressure on the same brand companies to increase margins by lowering their manufacturing costs through shifting more and more of their manufacturing to low-cost countries.
Finally, in order to meet the needs of both retailers and brand companies, manufacturers in China have invested in human capital to increase management skills and English language capabilities, as well as investing in new critical areas such as product marketing, project management, product design and engineering, quality systems and injection-mould manufacturing. To further add value for their customers, these mostly privately held (family-run) companies have the cash to offer other services including injection-mould (production equipment) financing and product inventory and warehousing services. Successful Chinese suppliers have made these investments to stand themselves above their peers and in the process, increased their margins and have made themselves indispensable to their customers.
Look for Part 2 of this series where we'll discuss what this all means today and the role of brand companies, manufacturers and retailers.
Geof Master is a partner in Mayer Brown JSM's Business & Technology Sourcing practice. He can be reached at [email protected]
Tom Keenan is a Registered Foreign Lawyer (Victoria, Australia) of Mayer Brown JSM. He can be reached at [email protected]