China: The Pursuit of Competitive Advantage and

Profitable Growth

THE BOSTON CONSULTING GROUP

BCG June 2003

The Boston Consulting Group in Greater China

Hong KongThe Boston Consulting Group International, GmbH34th Floor, Shell TowerTimes Square, Causeway BayHong Kong CHINATelephone: 852-2506-2111Facsimile: 852-2506-9084

ShanghaiBoston Consulting (Shanghai) Company Ltd.21st Floor, Central Plaza227, Huangpi Bei LuShanghai, 200003 CHINATelephone: 86-21-6375-8618Facsimile: 86-21-6375-8628

BeijingThe Boston Consulting Group (Beijing)Unit 902, The Exchange BeijingNo. 118 Jian Guo Lu Yi, Chao Yang DistrictBeijing, 100022 CHINATelephone: 86-10-6567-5755Facsimile: 86-10-6567-5799

TaipeiThe Boston Consulting Group (Greater China) LLCRoom 702, 23/F105, Tun-hwa S. Rd Sec 2Taipei 106, TaiwanTelephone: 8862-2755-0000 ext. 722Facsimile: 8862-2784-1632

The Boston Consulting Group is a generalmanagement consulting firm that is a global leaderin business strategy. BCG has helped companiesin every major industry and market achieve acompetitive advantage by developing andimplementing winning strategies. Founded in 1963,the firm now operates 58 offices in 36 countries.For further information, please visit our Web site atwww.bcg.com.

The Boston Consulting Group, Inc., 2003. All rights reserved.Report designed by BCG Greater China marketing team.c

2003

Contents

Foreword

Operations

Aim High, Act Fast: The China Sourcing Imperative

Consumer Markets

Breaking Out of China’s Value Trap

Catching the Wave: Marketing in China

Technology and Communications

The Dragon’s Revenge: Tough Times for Telecom

Vendors in China

Automotive

Competing to Win in China’s Fast-Growing Automotive Market

Rethinking “Made in China” Cars and Parts

Health Care

China’s Growing Drug Market: Will You Be a Contender?

0205

10

27

37

23

FOREWORD

2

For more than 20 years, China has been experiencing adramatic transformation from a centrally planned economyto a managed market economy. It is difficult to overstatethe achievements of the 1980s and 1990s, culminating inChina’s accession to the World Trade Organization (WTO)in 2001. With economic growth in the range of 7 to 8percent annually and foreign direct investment exceeding$50 billion per year, China is clearly a major force in theworld economy whose impact will only grow with time.

Much has been written about the policies that haveenabled or hindered this progress. That is not our purposehere. Instead of evaluating the Chinese political systemor the country’s macroeconomic and industrial policies,we want to share our perspectives on how to buildsustainable competitive advantage and achieve profitablegrowth within the rapidly evolving Chinese economy.

China: The Pursuit of Competitive Advantage andProfitable Growth is an anthology of articles about Chinapublished by The Boston Consulting Group over the pasttwo years and written by BCG’s leading consultantsworking in the Greater China region. These articles addresstopical business issues facing both multinational anddomestic Chinese companies in a broad range ofindustries. At the same time, they are informed by BCG’snearly 20 years’ experience working with such companieson the ground in China. Finally, they draw on thefunctional and industry expertise of BCG’s extensiveglobal network.

For both multinationals and domestic companies, Chinaoffers two major business opportunities. The first is tosell to a large and growing domestic market. In virtuallyevery industry, China represents huge growth potential.It is already a leading global economy and, if current GDPgrowth continues, it will be among the largest in the worldby 2010. China is already the number one producer inmore than 100 product categories, and it is the numberone market in many.

The second opportunity is to leverage China as a globallow-cost supply base. Exports from China have been

growing at approximately 15 percent for the past decade,driven by low labor costs but also by favorable industrialpolicies, an increasingly educated work force, the creationof more than 500 special economic zones, the wideavailability of electric power, and pragmatic, probusinessgovernment policies, including specific investment andtax incentives. As a result, exports are growing acrossthe board in textiles and apparel, electronics and homeappliances, metals and chemicals, a wide range ofindustrial goods, and, most recently, automotivecomponents. For most companies, sourcing from Chinais now an imperative.

Although China’s market is large and growing, and thelow-cost supply base continues to expand, the countryremains a challenging market for most multinationalcompanies. Each company that competes in China startsfrom a unique position and to some extent faces uniquecompetitive challenges. Still, some common challengesrun like “red threads” across sectors and companies.

Developing market insights to inform actions. Makingsense of the local market is one of the greatest challengesin China. The inherent complexity of the environment,the rapid pace of change, and the paucity of reliabledata are major challenges for leaders who believe inmaking fact-based decisions. For these very reasons,information about customers, competitors, distributors,or suppliers is fast becoming a key source of competitiveadvantage. Companies that have built successful nationaldistribution networks have had to screen literallythousands of distributors to determine how products flowand which distributors are optimally placed. Evaluatingwhich suppliers are capable of delivering quality goodsreliably with sustainable cost structures is extraordinarilytime-consuming in a market where suppliers’ capabilitiesvary by orders of magnitude. Those companies thatdevelop well-informed market insights have a resourcethat is hard to duplicate.

Competing with domestic companies. In fast-movingconsumer goods, home appliances, consumer electronics,telecommunications, and industrial goods, Chinese

FOREWORD

companies are competing successfully against globalplayers. They are now a force to be reckoned with inalmost every industry. Their success formulacombines extremely low cost structures, aggressiveadopt ion and adapta t ion of t echnology andmanagement practices, advantaged wholesaledistribution channels, and increasingly sophisticatedbranding and marketing.

Managing complexity and change. Another criticalleadership challenge in China is managing the complexitydriven by the heterogeneity of customers, suppliers,competitors, regions, and government entities. China isreally much more like the European Union than it is likethe United States. Developing a clear understanding ofthe business environment is inherently more difficult andis further exacerbated by the paucity of reliable data. Asif this weren’t daunting enough, China is also changingat a dramatic pace along many dimensions, includingapplication of the WTO agreements, customersegmentation and sophistication, modernization ofdistribution channels, emergence of strong domesticcompetition, adoption of technology, development ofregions beyond the east coast, and investments ininfrastructure.

Organizing for China. Preparing for hypergrowth,managing complexity and change, deploying resourcesto cope with a heterogeneous market, finding anddeveloping local talent, and managing the transition fromexpatriate managers those are the chief organizationalchallenges that all companies in China face today. What’smore, establishing a sourcing organization withappropriate operational linkages around the globe bringswith it an additional set of challenges, all exacerbated byfrequently complex country-and product-reportingrelationships.

Meeting expectations. In addition to all the challengesinherent to operating in China, business leadersincreasingly talk about the challenge of meetingaggressive expectations for market growth, costsavings, and, ultimately, profitability. If anything, thoseexpectations are intensifying. For many companies,China has become the panacea for profitability problemsin low-growth, high-cost home markets. Pressure frommanagement at the center is often reinforced by investment

analysts’ increased scrutiny of a company’s Chinainvestments. Thus, leaders in China find themselves undermore pressure precisely at a time when they are facingsome of their greatest challenges.

In addition to these cross-cutting themes, many of theissues that companies face in China are specific toindividual sectors of the economy. Each of the articlesin this volume has a specific functional or industryfocus.

“Aim High, Act Fast: The China Sourcing Imperative”explores the emergence of China as a leading globalproducer and exporter, and the competitive implications ofa market where now almost anything can be sourced, oftenat significant cost savings. Just as the opportunities to savemoney by sourcing in China have broadened, so too havethe strategic options that companies face what the authorscall the “Five Levels of Sourcing Advantage.” The articleoffers advice on how to determine what to source,establish the appropriate infrastructure, and overcomecommon barriers to action.

“Breaking Out of China’s Value Trap” looks at acommon situation facing many consumer-goodscompanies in China: profitability that is well belowexpectations. The article highlights how many companieshave gotten caught in the China “value trap” and describesthe collective strategies that leading companies are usingto break out of it. The authors define a success modelthat includes value pricing, economies of scale, low-costoperation, a deep understanding of Chinese consumers,and effective resource deployment.

“Catching the Wave: Marketing in China” elaborateson one of the core elements of the China success model:the need to develop deep local insight into consumerbehavior. To make investments in China pay off,companies must realize that behind the country’sexplosive growth in demand is a new generation ofconsumers. These consumers are characterized by sharplydefined but continually evolving tastes, changingworldviews, and unprecedented expectations about theirown future and that of their children. The prize for thosecompanies that develop deep consumer insights andtranslate them into the right products and services ispotentially worth more than $3 trillion annually.

3

FOREWORD

“The Dragon’s Revenge: Tough Times for TelecomVendors in China” recaps the success enjoyed byvendors in China’s fast growing telecom market but arguesthat the opportunity space is rapidly changing. Slowerrevenue growth, industry restructuring, postponementsof capital spending, and delays in the issuance of newlicenses are making the country’s domestic market farmore challenging for established equipment vendors. Thearticle explores these challenges and explains the stepsthat established players must take to succeed in the newenvironment.

“Competing to Win in China’s Fast Growing AutomotiveMarket” describes the changes occurring in China’s automarket. Rising disposable incomes are fueling dramaticgrowth and the proliferation of vehicle models. Tariffbarriers are crumbling and new-car prices are falling. Thenecessary infrastructure to support a mass market,including the availability of financing, distribution, andrepair services, is emerging. This article identifies fiverequirements for OEMs that want to win in what is fastbecoming an attractive and yet highly competitive market.

“Rethinking ‘Made in China’ Cars and Parts” attackswhat until recently was the conventional wisdom: theidea that China is not yet a competitive manufacturingand sourcing base for the automotive industry. The articlebegins by describing how Honda’s plans to build a plantin China dedicated exclusively to exports hit the industrylike a bombshell. It goes on to explore what Honda mustbelieve it can achieve in China for this plan to make sense.It also describes how China has already become animportant base for sourcing automotive parts andconcludes with five strategic levers that companies mustcommand in order to take advantage of this assemblyand sourcing opportunity.

“China’s Growing Drug Market: Will You Be aContender?” argues that although China’s 1.25 billionpeople represent significant untapped opportunity, mostglobal drug companies don’t consider the nation a priority.The article explores the powerful forces that are drivingthe transformation of health care in China and theopportunities this transformation represents forpharmaceutical companies. According to the authors,staking out a position in this frontier market requiresmultinationals to pursue two goals simultaneously: to

create the right drug portfolio for the Chinese market,drawn from their worldwide portfolios, and to build thelocal Chinese organization necessary to market and sellthese compounds.

Whether as a source for growth or a platform for low-costsourcing and production, China is an opportunity tooimportant to ignore. There are clearly many strategic,operational, and organizational challenges. But successwill come to those who take the actions necessary to turnthese challenges into sources of competitive advantageand use those advantages to achieve profitable growth.

Many people have contributed to the articles in this collection.I would especially like to thank BCG’s China-basedofficers Thomas Achhorner, Douglas Beal, GilesBrennand, Jim Hemerling, Hubert Hsu, Thomas Klotz, JeanLebreton, and David Michael as well as Zafar Momin fromBCG’s Singapore office and Immo Rupf from Paris(formerly based in Shanghai). I would also like thank ourGreater China consulting staff. We hope you enjoy thesearticles. We welcome your feedback and encourage youto contact us.

4

John WongSenior Vice President

Managing Director, BCG China

FOREWORD

OPERATIONS

or more than a decade, “Made in China” has been acompelling sourcing option. Today, in almost every

industry, it is becoming an imperative.

Consider some recent news stories: Ford announcedplans to buy $1 billion in auto components from suppliersbased in China. Wal-Mart established a sourcing division

in Shenzhen to buy directly from Chinese factories. AndPhilips Electronics’ 23 factories in China surpassed $5billion in goods produced, most of them for export. Forthose companies and many others, the story starts withcost savings on components and finished goods butthat is not where it ends. The overarching objective iscost advantage.

Aim High, Act Fast:The China Sourcing Imperative

Jim HemerlingHubert HsuPascal CotteHarold Sirkin

by

F

5

Exhibit 1. China Leads the World in Making and Consuming a Wide Array of Products

Chinaexport/worldconsumption

(% volume)

China consumption/world consumption

(% volume)

Clocks and watches

MicrowavesBicycles

Apparel1 Toys1

DVD players

Mobilephones

Leather shoes Air conditioners

Motorcycles

Televisions

CementRiceWheat

Washing machines

Refrigerators

Steel

Furniture1

Semiconductors1

Medicalequipment

Passenger cars

Leading global producer

15

10

5

0

30

70

5 10 15 20 25 30 35 40 45

SOURCES: China Statistics Yearbooks; China Economy Statistics Yearbook; World Economy Statistics Yearbook; press search.1By value, not volume.

Oil

Syntheticrubber

OPERATIONS

Of course, doing business in China, just as in otherdeveloping markets, involves significant risks andchallenges. But our experience shows that they canbe managed and overcome. In fact, the biggest riskmay lie in moving too slowly. China is alreadyh a v i n g a f u n d a m e n t a l i m p a c t o n m a n yindustries. (See Exhibit 1.) As a result, companiesthat are not yet acting or are not acting as fast astheir competitors are in danger of becomingcompetitively disadvantaged.

The Quest for Cost Savings

For many years, The Boston Consulting Group’s Chinateam has worked with and studied dozens of companiesoperating in China, and one finding is clear: a companycan now source almost anything from China. The nationhas long been the world’s leading manufacturer incategories such as air conditioners, motorcycles, andtelevisions. But in recent years the opportunity to sourcein China has expanded to include extremely high-techproducts, as well as components that are part of a morecomplex logistics pattern, such as automobile parts.Evidence is readily seen in the huge new industrial parksoutside Shanghai and Beijing. In them, Intel is makingsemiconductors, General Electric is producingsophisticated medical equipment, and Nokia is buildingnext-generation mobile phones.

For almost any company, China offers three broadopportunities for savings. The first is in labor and rawmaterials. Manufacturers in China benefit from an enormouspool of workers, flexible working conditions, and an averagehourly wage of approximately 50 cents well belowMexico’s $2.30 and even India’s 80 cents. In addition, rawand processed materials are often cheaper in China andfrequently match global standards for quality. (Forexample, General Motors recently awarded China’sBaosteel its global quality certificate.) Overall,procurement costs generally run 20 to 50 percent belowcosts for comparable goods in established markets.

The second opportunity, one that is sometimesoverlooked, is “capital avoidance” essentially, lowersetup, land, and factory expenses compared with other

locations. The reasons for these lower expenses arethreefold. First, to the extent that companies can outsourceproduct manufacturing, they can save on factory costs.Second, for products that companies do manufacturethemselves, they have the advantage in China of beingable to use more labor and less equipment. And finally,for equipment that is necessary, tooling expenses are verylow again largely because of less expensive labor.

The third opportunity, which has emerged morerecently, l ies in low-cost product design andresearch-and-development activities. China now has some2 million students studying engineering. That’s twice asmany as in the United States, available at a small fractionof the salary. According to a recent survey, a qualifiedelectrical engineer with six years of experience commandsan annual salary of about $7,000 in China and about $83,000in the United States.

Five Levels of Sourcing Advantage

As the savings opportunities in China have broadened,so too have the strategic options. Our experiencesuggests that five distinct levels of advantage areemerging in China sourcing. (See Exhibit 2.)

Level 1: Testing the Water. Many companies today stillhave not undertaken any formal initiatives in China,although they recognize the country’s importance. Anumber of them may source some basic commodities, butstrictly on a trial basis.

There is little competitive advantage, however, to movingso cautiously. One small benefit may be the chance tolearn from the mistakes and successes of other companies.But it certainly does not outweigh the opportunity cost.

Level 2: Purchasing Components or Complete Products.Wal-Mart bought $10.3 billion in goods from China in2001, accounting for 4 percent of China’s total exportsthat year. Although Wal-Mart outsources a greatervolume than almost any other multinational, its effortsrepresent the type of sourcing activity currently pursuedby most large companies in China. For example, in 2002the French retailer Carrefour sourced $1.6 billion in

6

OPERATIONS

China up 27 percent from 2001. Whether it’s $10 millionor $10 billion at issue, most companies are buying ormanufacturing basic products and components that meettheir standards at the lowest possible cost.

The advantage is a lower cost structure than that ofcompetitors that are not moving as aggressively. Inaddition, the knowledge gained from working withparticular suppliers, as well as a greater understanding ofthe overall supply base, are very valuable. However, theseadvantages can quickly be wiped out. Other than theirown internal barriers, nothing prevents competitors fromeventually achieving the same savings.

Level 3: Developing Comprehensive Sourcing. Motorolaintends to have $10 billion in accumulated purchasevolume from China and to be producing $10 billion a yearin goods there by 2006. It also intends by then to havemade investments totaling $10 billion inside China,including building a global R&D center in Beijing andhiring almost 5,000 researchers. This type of sourcingstrategy goes well beyond procuring simple commoditiesand components to include services and talent such asproduct design and engineering.

Because other companies can’t easily replicate the closerelationships with key suppliers or attract the best

designers and engineers, comprehensive sourcing locksin a competitive edge. Telecom equipment manufacturers,which have the most advanced China-based R&Dcapabilities, are finding that they can design andmanufacture more higher-value-added components inChina, thereby reducing their dependence on importsfrom high-cost countries. There are also potential time-based advantages, such as accelerating productdevelopment cycles. One global manufacturer recentlyfound that it could retool a plant in China not only for halfthe usual cost but also in half the time.

Level 4: Adopting an Integrated China Strategy. Untilvery recently, global automotive OEMs operating in China,as well as their suppliers, focused primarily on servingthe country’s domestic market. Today their position isbeginning to change. Increasingly, they see China notjust as an important market or as a principal supply basefor goods sold elsewhere, but as both. For these playersand others, operating in China demands an integratedstrategy. Each business line must be designed tooutsource components for products that will be soldabroad as well as to produce goods that will be sold tothe local market.

The advantage of an integrated strategy is additionalsynergies due to scale, so the potential savings are

7

Exhibit 2. Five Levels of Sourcing Advantage

Testing the water• Recognize China’s

potential

• May source someproducts on a trial basis

• Have no formal Chinainitiatives

• Are not yet organized forsourcing in China

Level 1

Purchasingcomponentsor completeproducts• Focus on reducing

purchasing costs

• Obtain valuableunderstanding of thesupply base

• But gain little defensibleadvantage

Level 2

Developingcomprehensivesourcing• Sourcing plan includes

- parts- products- talent/R&D

• Advantage gained from- supplier relationships- product development- proprietary tools andprocesses

- market intelligence

Level 3

Adopting anintegrated Chinastrategy• View China as both a

market and a sourcinglocation

• Leverage synergiesbetween export sourcingand domestic production- integrated capacityplanning

- flexible production

• Creating global centers ofexcellence

Level 4

Capturing globaladvantage• Exploit global synergies in

- cost structure- manufacturing strategy- supply chain

• Leverage best globalcapabilities

• Deploy high-cost assets

Level 5

SOURCES: BCG analysis.

OPERATIONS

greater. Products are designed to compete both globallyand domestically. Also, capacity planning is integrated:plants are sized to realize full economies of scale, not justfor domestic or export demand, and they are configuredto meet both local and global requirements. There may bepolitical advantages as well to competing in both realms:some China watchers argue that it is tougher to be solelyan export player because the government views suchcompanies as less committed than players that treat Chinaas an important market in its own right.

Level 5: Capturing Global Advantage. Plenty ofcompanies talk about integrating low-cost sourcing intoa business model that is truly managed across manycountries, yet only a few are indeed close to achievingthat goal. For example, Toyota, with its closely coordinatedmanufacturing and supply between regions, sourcessubassemblies from across Asia, enabling the companyto optimize manufacturing costs and just-in-time delivery.

The economics of globalization of cost structures andbusiness models will be relentless. The competitiveadvantage of a truly global business, which leveragesthe lowest costs and the best capabilities, is structural interms of both scale and locked-in relationships. But theadvantage is also based on capabilities: it is very difficultto achieve, and also very difficult for competitors toreplicate. The outcome is more growth at a local, regional,and global level.

How to Proceed

The five levels of sourcing advantage are not a ladder: acompany doesn’t necessarily move from Level 1 to Level2 to Level 3, and so on. Companies sometimes shift quicklyfrom, say, a cost-focused strategy for basic componentsto an ambitious integrated China strategy. Similarly, manycompanies that have been selling in China for some timeare now, in a sense, backing into sourcing, and they arealso beginning to manufacture for export. Examples includeSiemens, Lion Nathan beer brewers, GE Appliances, andseveral of the global automotive OEMs.

So how should you proceed? Whether the task is to builda China sourcing capability from scratch or to improve an

existing operation, our experience points to three essentialsteps.

Analyze the opportunities. Global companies couldsource almost anything from China today. But whatshould they source? Answering that question requirescompanies to get up to speed on their sourcing options.Then they should segment all the opportunities bothpotential products and potential suppliers and run allof them through a realistic feasibility screen .In addition,companies must determine the total supply-chain cost ofsecuring the potential savings. Is the potential advantagebig enough to offset the risks? Finally, companies shouldinstall a system that forces them to update their views onChina frequently, because the situation will continue tochange quickly.

Wal-Mart’s push to buy directly from Chinese factoriesis a case worth keeping in mind. With its unrivaledbargaining power, in addition to its requirements forrelatively simple products, Wal-Mart can place much ofthe burden for screening suppliers on the suppliersthemselves, asking them to provide detailed backgroundinformation and samples. Nevertheless, Wal-Mart stillrequires a staff of more than 200 to complete site visits,verify information, and implement sourcing decisions. Forother companies, the task is even more complicated. Morecomplex products especially those components that willgo into other products require considerably moredetailed assessments and demand greater interaction withsuppliers.

Establish the infrastructure. Designing and building asourcing operation is a significant undertaking. Such aneffort means creating processes and policies foreverything including supplier selection and assessment,monitoring and compliance, human rights evaluation, andrisk management. It also means developing databases totrack price quotes from suppliers; building China-specificexpertise; and acquiring and tracking important data onbenchmarks, site assessments, and supplier capabilities.Ultimately it means establishing tight links andcoordination across multiple facilities and operationsaround the world an amazingly tricky task. A systemand a team must be in place to make the right decisions

8

OPERATIONS

quickly and to execute them in a way that realizes savingsand builds momentum.

To carry out such an ambitious project, it is essential totap a leader who is both senior enough and capableenough to mobilize the organization. Also, because a greatdeal must happen outside China if a company is to besuccessful inside China, the importance of having thesupport of a strong champion at headquarters cannot beoverstated. Several multinationals in China haveconsidered following “level plus two” a rule of thumbplacing responsibility for China sourcing two levels abovewhere it would normally reside.

Overcome the barriers to action. Many executives todayare concerned about the risks of doing business in China.To be sure, China presents a number of serious challenges.For instance, a banking or other financial crisis couldupset stability. Progress in implementing World TradeOrganization concessions must be closely watched. Justas important are the substantial operational andmanagerial risks, such as sorting out currency swings,coordinating complex logistics, and identifying capableand trustworthy partners.

Trust is crucial when it comes to sharing intellectualproperty. When companies transfer expertise in productdesign overseas, they risk losing their proprietarytechnology to rivals, to employees who might defect torivals, and to local entrepreneurs who sometimes pirateeverything from cell phones to shoes, shampoo, andsoftware. Yet the companies that would seem to be mostvulnerable, such as makers of electronics or fashionaccessories, continue to expand their manufacturingoperations in China, believing that it is necessary to boosttheir overall competitiveness. As real and as serious asthese issues are, advantage comes from understandingand overcoming risks, not from avoiding them.

One of the biggest barriers of all is resistance from withinyour own company and even from your vendors. Timeand time again we have found that companies aspiring todo business in China struggle with cultural andorganizational challenges. Among them are a lack ofurgency, a “business as usual” mindset, a lack of

experience in China and with global sourcing in general,extreme organizational complexity, incomplete information,resistance from current suppliers, and difficulty in settingrealistic targets. Before a company can move forward, itmust identify and address these organizational barriers.

* * *

“Zhi xiang gao, xing dong kuai,” loosely translated, means“Aim high, act fast.” In essence, this is the imperative inChina sourcing today.

Leading companies in several industries have alreadymade big strides in China: they have begun to lock inadvantages, and they are on their way toward Level 5sourcing. However, many companies today eventhose purchasing many million dollars’ worth ofproducts from low-cost countries are already behindkey competitors in China. For them, the starting pointfor any analysis of their position can no longer simplybe “How much are we sourcing from China?” but rather“How do we catch up?”

Aim High, Act Fast

9

Jim Hemerling is a vice president and director in theShanghai office of The Boston Consulting Group.Hubert Hsu is a vice president and director in thefirm’s Hong Kong office. Pascal Cotte is a vicepresident and director in BCG’s Paris office and thefirm’s global topic leader for procurement. HaroldSirkin is a senior vice president and director inBCG’s Chicago office and head of the firm’s globalOperations practice.

You may contact the authors by e-mail at:hemerling.jim@bcg.comhsu.hubert@bcg.comcotte.pascal@bcg.comsirkin.hal@bcg.com

© The Boston Consulting Group, Inc. 2003. All rights reserved.

CONSUMER MARKETS

Breaking Out of China,sValue Trap

Hubert HsuJim Hemerling

by

hina continues to represent an enormousopportunity for consumer goods companies. With

an economy seven times larger than it was 20 years ago,the country is undergoing the greatest economicexpansion ever witnessed anytime, anywhere. It isalready the largest market for washing machines andmobile phones, the second largest for beer, and the thirdlargest for carbonated soft drinks.

That growth shows no sign of slowing as consumers’disposable incomes keep rising. With the full package ofWorld Trade Organization benefits to kick in over thenext few years, industries will continue to expand at ratesseveral times those in more developed markets. Andalthough highly regulated industries such astelecommunications and financial services must devotesignificant time and resources to cultivating and managinggovernment relationships, consumer goods companiescan spend more of their energy on business because theyare among the least regulated in China.

No wonder multinational companies are encouraged bytheir initial forays into China. But their earlysuccess often a result of skimming off the most affluentconsumers in the biggest cities can create a false senseof confidence in the sustainability of their businessmodels. Because the fastest growth in China’s high-income households is expected to come from outside thelargest urban areas, many companies are now trying topenetrate the mass market and they are counting on

those same business models to work for them there. (SeeExhibit 1.) When they expand into new locations andcategories, however, they typically run into a wall of newproblems. These problems include fragmented markets,consumers, and channels; low prices in areas beyond thelarge urban centers; different competitors in differentregions, each employing completely different go-to-marketapproaches; immature distribution infrastructures andplayers; and extraordinary strains on organizationalcapabilities and infrastructure.

C

Exhibit 1. The Fastest Growth in High-IncomeHouseholds Will Occur Outside Large Cities

SOURCES: BCG analysis; China Statistics Bureau.1Households with incomes greater than RMB 3,000 per month; approximately8.3 Renminbi equals U.S.$1.2More than 600 cities.

100

80

60

40

20

0

Number ofhouseholds1

(millions)

9.013 14.9

26.6

3.8

11.417.1

89.2

16.3

~0

Shanghai,BeijingGuangzhou

7.6%

Top 30coastal cities

12.3%

Top 20inland cities

24.6%

Rest of urbanChina2

39.1%

Rural

177%

Annual projectedgrowth

(2001-2006)

2001 2006

10

Most companies respond to these difficulties by allocatingadditional financial and human resources, only to becomeensnared in the China value trap: the more thesecompanies invest, the more they seem to lose asshareholder value drains away. Expatriate and localmanagers find themselves working harder and harder withno turnaround in sight.

We es t imate tha t more than 50 percen t o fconsumer-goods and retail multinationals are caught inthe value trap. In the beer industry, for example,international brewers have experienced annual lossesthat run into tens of millions of dollars, on top of hundredsof millions of dollars in write-offs from failed investments.Moreover, the problems occur across many sectors, suchas packaged food and beverages, personal care,household chemicals, consumer durables, and retailgroceries.

A few leading companies, however, are emerging fromthis trap with remarkable alacrity, and they are developinglarge, profitable positions across a range of markets. (See Exhibit 2.) Conventional wisdom asserts that the

key to success in China is a combination of low costs andlow prices. Of course, those advantages are crucial. But amore dynamic and sophisticated model is needed in amarket as complex and varied as China’s. The companiesthat accelerate quickly out of the trap all pay close andearly attention to scale, costs, and prices, but they alsofocus on local market insights and think creatively aboutresource deployment.

The Success Model Begins with a Virtuous Cycle

We’ve identified the collective strategies required to breakout of the value trap as the China success model. (SeeExhibit 3.) These strategies don’t work independently.Rather, their power lies in their integrated nature and theways in which they complement one another. The valuetrap, then, may be hard to avoid. But if a company preparesahead of time or changes course once it is snared, it willfind a way out. Indeed, the approach it employs will havea lasting impact on its business trajectory in both theseverity of the losses it experiences and the speed withwhich it escapes the trap. What follows is a closer look atthe components of the China success model.

SOURCE: BCG analysis.

Exhibit 2. Some Companies Escape the Value Trap Quickly, Whereas Others Remain There Indefinitely

Profitability

Some initial successSkim off the mostvaluable consumersFocus on top cities

Loss

0

Broaden ambitions tobecome a market leaderthrough heavy investments

Long-term profitablegrowth with the newbusiness models

Entry into China

Heavy losses resulting fromsustained investments

Remain in the value trapor exit China

Time

CONSUMER MARKETS

11

CONSUMER MARKETS

Value Pricing and Scale. With a national savings rate ofmore than 30 percent, China is famous for the frugality ofits citizens. To attract value-conscious shoppers,successful local companies focus on the high-volume,lower-price-point segments. Huiyuan in juices and Sanxiaoin toothbrushes, for example, price their products morethan 20 percent below those of the leading multinationalbrands and, as a result, dominate the mass market. Tocompete with these successful local players, many ofwhich have also improved their product quality andpositioning, global companies must proactively cut prices.Lower prices will help deepen penetration into the massmarket, which in turn will provide scale benefits to supportadditional pricing and value-enhancement strategies.

Tingyi, a Taiwanese company, has captured the marketfor packaged noodles by being the value and price leaderin the premium segment. Leveraging its scale, it has builtits own sales and distribution (S&D) network, whichincludes more than 300 sales offices across China, servingnearly 34,000 retailers directly. The remaining retail outletsare serviced through distributors, who provide logistics,

and wholesalers, who sell to remote locations. Thatapproach has allowed Tingyi to build strong relationshipswith its retailers and, as a result, dominate their shelves.The brand frequently commands as much as half of thetotal space allocated to the category. Having establishedits S&D system, Tingyi has now embarked on anaggressive program of value improvement (larger packagesizes), product extensions (an economy-priced noodlebrand), and category expansions (ready-to-drinkbeverages and snacks).

Low-Cost Operations. When global companies focus onvalue pricing and scale, they frequently complain aboutlow margins. Often, the problem is that they haven’t fullyexplored how truly low cost their operations could be.Most companies could significantly reduce their costs inat least three ways: by ensuring that economies of scaleare fully exploited, by localizing cost structures to benefitfrom China’s favorable factor costs, and by increasingtheir focus on the parts of the business that deliver realvalue to consumers and eliminating or reducing thosethat do not.

Exhibit 3. The China Success Model

Local marketinsights

Virtuouscycle

Effectiveresource

deployment

Flexible brandpositioning

Customizedproducts

Unique serviceexperience

Value pricing

ScaleLow-Costoperations

Adaptgo-to-market

models

Manageorganizational

complexity

Managemergers andacquisitions

SOURCE: BCG analysis.

12

Contrary to what many multinational companies claim,our experience doesn’t support the notion that localcompanies enjoy significant structural advantages. Somemay discover small advantages by locating in lower-costregions within China, but in relative terms, the savingsare small.

Most multinationals believe they can’t reduce costs bymuch more than 5 or 10 percent. We believe theopportunity is often more than 20 percent and possiblyas high as 40 percent. When lowering costs, however,such companies need to ensure that their Chineseoperations continue to leverage useful experiences andprocesses from the worldwide system, while they alsodevelop local management capabilities and a businessmodel that is relevant to serving the Chinese market. Forexample, when Colgate discovered Sanxiao’s 30 percentcost advantage in toothbrush production and realized itwould take significant time and resources to narrow thegap, it acquired the company. Now it not only owns theChinese toothbrush market with more than 50 percentvolume share but it also uses the low-cost facility as aninternational sourcing center.

Local Market Insights:Understanding the Chinese Consumer

China poses an enormous challenge to multinationalconsumer-goods and retail companies when it comes togaining insight into its local markets. The wide-rangingdifferences across the country with its 600-plus cities,seven major dialects, and 80 or so spoken “tongues,” notto mention its huge disparities in education andincome are made even more daunting by the severeinaccuracy or lack of published data. Rather than relysolely on market research, successful companies get outand talk directly with channel partners, competitors, andconsumers. They also tap into the direct experience oflocal managers, whose insights into the subtleties of locallifestyles and preferences help the companies tailorproducts to meet local demand.

Flexible Brand Positioning. Multinational companiesoften view Chinese consumers only in the context of their

global brands. Although such brands provide manyadvantages, they also bring with them many constraints,especially when it comes to positioning, icons, andmessages. Chinese consumers still admire West-ern products, but they are more inclined to shop forbrands they feel serve their specific needs. For example,Shiseido, long ago discovered that many Chineseconsumers believe that Asian skin is significantly differentfrom the skin of non-Asians. Acting on that insight, theJapanese company established an early lead in thefast-growing cosmetics categories by noting in itsadvertising that its products are designed specifically forAsians.

Customized Products. The challenge of offering localizedproducts is made harder by the fact that consumerpreferences vary considerably within China. What sellsin the chic environs of Shanghai might be rejected in ruralcommunities. That’s why Tingyi tailors its products toregional tastes, marketing sweeter flavors in Shanghaiand saltier flavors in the northeast region. Supported bya highly sophisticated regional production capability, thecompany is then able to revise its formulation continuallyin order to meet changing tastes, which brings it evencloser to consumers.

Unique Service Experience. Chinese consumers also placea high value on superior service. That is an area in whichmultinationals can gain an advantage because localcompanies often find it difficult to deliver even the mostbasic service. KFC and McDonald’s, for example,leveraged their global capabilities to deliver a consistentlyhigh-quality service experience that stands in starkcontrast to the indifferent service typical in competinglocal restaurants.

Leading Chinese companies are beginning to catch up,however, and some are offering very high standards ofservice. Haier, for example, differentiated itself from bothlocal and global competitors by offering a national24-hour hotline for its appliances. Furthermore, it extendedthe concept to its channel partners, proactively servicingretailers to support sales, promotion, and marketing.Those actions have contributed to making Haier numberone in China’s appliance market.

CONSUMER MARKETS

13

CONSUMER MARKETS

Effective Resource Deployment

In a country as vast as China, resource deployment canbe a complex issue. Like leaders in combat, businessleaders must first decide which battles to fight, the optimalconfiguration of forces to use, and how best to deploythose forces to break through competitive positions. Inshort, they must adapt their go-to-market models for eachregional market. Then they need to organize to ensurethat those resources are not overwhelmed by the ensuingcomplexity of battle. Clear lines of communication andsupply, as well as effective processes and policies, arevital to making certain that the troops at the front arealigned and equipped. Leaders must also decide whetherto align their forces with others and how to orchestratethat deployment. Mergers, acquisi t ions, andalliances together with effective integrationplans are often critical to building scale and capabilities.Although effective resource deployment can seemdifficult, many companies in China are already makinggreat progress.

Adapt Go-to-Market Models. Large cities account for arelatively small, albeit very attractive, share of the marketin most consumer categories today. What’s more, futureincome growth will be highest outside those cities. Sooneror later, most multinational companies will decide toexpand beyond their initial beachheads to tap into thevast potential of the rest of the country. (See Exhibit 4.)But once they encounter less sophisticated consumers,new competitors, immature distribution infrastructures,fragmented channels, and woefully inadequate data andinformation, just how many business models will theyneed? Clearly, one model can’t work for every area.Companies will need to customize products, distribution,advertising, and promotions. But that doesn’t mean thateach city requires its own unique model.

We recently helped one of the largest packaged-goodscompanies in China reassess its business model acrossthe more than 600 cities it served nearly every urbancenter in the country. First, we segmented the market intocity clusters with similar characteristics, winding up with

Exhibit 4. Significant Buying Power Exists Beyond the Largest Cities

But Those Markets Are Not Well Penetrated by the MultinationalsProduct sales (%)

Medium-term sales potential (%)

Toothbrushes

Food retail

Refrigerators

Shampoo/stylingproducts

High-incomehouseholds 2006

Total households2006

Top three cities (Shanghai, Beijing, Guangzhou)Next ten citiesRest of China

24 16 60

12 13 75

11 9 80

8 10 82

8 8 84

23

95

Unt

appe

d po

tent

ial

SOURCE: BCG analysis.

14

a much more manageable number. Then we devised ago-to-market model for each cluster, which includedchannel priorities, media and promotion strategies, salesforce deployment, as well as logistics models. Along theway, we identified certain regions that were simplyunprofitable to serve and devised exit strategies. Theexercise had a significant impact on the top and bottomlines, and it allowed the client to focus scarce resourceson its most important geographic markets and channels.

Huiyuan, the leading local juice company, providesanother good example. Unlike most packaged-goodscompanies, it eschews a diverse brand portfolio in favorof collecting most of its products under a single brandumbrella. That strategy simplifies marketing,advertising, and distribution; in addition, it enablesthe company to enjoy significant marketing scaleadvantages. What’s more, the approach allows Huiyuanto enter new categories such as packaged juicedrinks that it can introduce under the establishedumbrella brand and distribution network. As a result,the company has been able to achieve a profitablegrowth trajectory while maintaining its leadershipposition.

Manage Organizational Complexity. Expansion willinevitably increase organizational complexity because thenew cities that have a growing mass market will be smallerand channels and distributors more fragmented. Expandingan initial beachhead market to 10 or 20 cities typically resultsin an exponential increase in the number of staff,distributors, and customers. Left unmanaged, these factorsresult in overwhelming organizational complexity.

When, expatriate and local managers underestimate thatcomplexity as happens all too frequently they findthemselves spending more and more time on the roadworking longer and longer hours to deal with mountingoperational problems in one market after another.Companies can make this process considerably easier bycodifying standard processes and procedures using goodmanagement-information systems. In nascent Chinesemarkets, simple approaches are frequently just as effectiveas the sophisticated ones that multinationals adopt inmore developed markets.

For instance, a well-managed S&D network is critical, butChina’s market complexities cause many companies tostruggle with even modest expansions. One of the fewexceptions to this is PepsiCo’s beverage division. Thedivision realized that its core global processes could bejust as effective in China as they are elsewhere, butsuccess would depend on careful implementation.

Therefore, PepsiCo has piloted selected processes in afew key regional markets in order to customize them forChina. These sales tools are then codified in manuals andreinforced across all of the company’s teams. Globalcompanies such as PepsiCo have found that a profitablepilot can be a persuasive tool for convincing Chinesemanagers to adopt a new system.

PepsiCo’s continued success is also based on constantprocess renewal. To encourage innovation, it gives itssupervisors significant decision-making power. Twice ayear, the company organizes a national conference tobring its sales managers up to date on the latest S&Dinformation and to share local best practices. Managerialfreedom, however, is tempered by a rigorous monitoringsystem that entails regular evaluations by internal teamsas well as third parties on key performance indicators.With these strategies, PepsiCo has rapidly andeconomically built a deep and expansive S&D networkand gained significant share compared with Coca-Cola.

Manage Mergers and Acquisitions. Reluctant torelinquish any management control in this strategicallyimportant market, many companies opt for organic growthin China, despite its many often unique challenges.Yet the creative use of mergers and acquisitions can oftenbe a more effective way to escape the value trap. Ratherthan buying a local brand simply for its products andvolume, companies should consider the broader role thatthe acquired company could play. It could help establisha low-cost production base, for instance, or provide amass-market S&D system for the accelerated expansionof a global product portfolio. In addition, it could offerthe freedom to market a local brand enhanced withglobal product technologies but free from global brandrestrictions to a huge market of price-sensitive Chineseconsumers.

CONSUMER MARKETS

15

CONSUMER MARKETS

Nevertheless, mergers and acquisitions can involve risksthat are unique to China. Due diligence for even amedium-sized acquisition could (and probably should)take months to complete. What’s more, given the complexstructure of government in provincial China, it is vital touse a facilitator with solid knowledge of the region. Finally,in the postmerger integration phase, it is easy to overlookthe inherent differences in the operating models ofacquirer and target. Companies must guard against addinglayers of expenses that transform otherwise successfullow-cost businesses into general-and-administrative-loaded failures.

Realizing China’s Potential

As some nimble multinationals are proving, it is possibleto reduce the inevitable growing pains of expansion inChina and quickly return to profitability. To realize yourtrue potential in China, start by assessing yourorganization’s position today in relation to where youwant to go and how soon you need to get there.Answering the following questions will help you guidethat effort:

• Where do you stand today in relation to the valuetrap? Are you confident that your business in Chinawill be in a fundamentally more advantaged positionwithin a year?

• Have you factored in all the complexities that areinherent in your expansion plan? Have youunderestimated the challenges and investmentsrequired?

• Are you developing a suff ic ient ly deepunderstanding of the Chinese consumer in order toposition your brands and customize your productsand services?

• Do you know how to lower your operating costs by20 to 40 percent in order to support a value-pricingstrategy?

• Do you know in detail how you will adapt yourgo-to-market model as you start to expand beyondyour initial efforts?

• Do you have the right organization, performancediscipline, and processes to support your expandingbusiness model?

• How would a merger, acquisition, or alliance helpyou climb out of the value trap more quickly? Hasyour organization explored all the creative options?Are you aware of the challenges and risks inherentin the postmerger integration?

The China value trap is real. Many companies are caughtin it today and have seen significant shareholder valuedestroyed. If your company hasn’t fallen into the trapyet, chances are it will soon. And once caught, it mayseem like quicksand, because the harder you try to escape,the deeper you’ll sink. It takes vision, creative strategy,courage, and precise implementation to break out of thevalue trap. Are you prepared for the challenge?

Hubert Hsu is a vice president and director in theHong Kong office of The Boston Consulting Group.Jim Hemerling is a vice president and director in thefirm’ Shanghai office.

You may contact the authors by e-mail at:hsu.hubert@bcg.comhemerling.jim@bcg.com

© The Boston Consulting Group, Inc. 2002. All rights reserved.

16

CONSUMER MARKETS

China is expected to become the world’s largest consumermarket within the next 35 years. Thanks to the country’semerging middle class, marketers can look forward to thegreatest opportunity of their lives. If China remainspolitically stable, there will be unparalleled opportunitiesfor growth in all sectors of the consumer economy: food,d u r a b l e g o o d s , e n t e r t a i n m e n t a n d m e d i a ,telecommunications, transportation, leisure, education,and housing. (See Exhibits 1, 2, and 3.)

Deep insight into the consumer market will separatewinners from losers in those sectors. The prize potentiallyworth more than $3 trillion annually will go to productmakers and service providers that understand and targetChina’s young mothers, who make most major purchasing

decisions. To be a winner, a company must establishstrong, branded relationships with these consumers,provide the kinds of products that appeal to theiraspirations, and be willing to customize offerings to meetthe needs of a diverse market. It must also encourageretai lers to provide appropriate shelf space,merchandising, and customer support for its products.

Many outsiders are already vying for a piece of theprize and many more are expected to. Indeed, the U.S.government’s recent decision to normalize trade relationswith China, along with China’s anticipated admission tothe World Trade Organization, not only should draw morecompanies to the country but also should make it mucheasier for those companies to do business there.

To make investment in China pay off, companies must besensitive to the fact that behind the country’s explosivegrowth in demand is a new generation of consumers.These consumers are characterized by sharply definedbut continually evolving tastes, changing world-views,and unprecedented expectations about their own futureand that of their children. We believe that by plumbingthe hopes, dreams, and aspirations of this group China’snascent middle class it is possible to anticipate themarket and capture a leading position in it.

To that end, The Boston Consulting Group’s Shanghaioffice created an ad hoc consumer-research team to focuson young mothers in that city. BCG chose Shanghaibecause its population is relatively affluent, well educated,and interested in Western products. Having been wooed

17

Catching the Wave:Marketing in China

Jim HemerlingJohn WongHubert HsuAnne Beall

by

Exhibit 1. A Forecast of IncreasingPurchasing Power

Renminbiin billions

14,000

12,000

10,000

8,000

6,000

2,000

01980 1985 1990 1995 2000 2005 2010

Real GDP Real priveate consumption

SOURCES: Economist Intelligence Unit; China StatisticalYearbooks; BCG estimates.

CONSUMER MARKETS

by foreign marketers for more than a decade, citizens ofShanghai best represent how the Chinese are evolving intheir attitudes and beliefs.

To be sure, one group of consumers from one city cannottell the whole story of how to succeed as a marketer inChina. After all, the country is enormous, marked by vastdemographic, geographic, and intergenerationaldifferences. BCG’s recent experience in China has alreadyproduced a number of broad insights:

• The Chinese are still not used to having a wide rangeof consumer choices. As a result, they are very open

to fresh ideas. And because they are exposed to aconstant barrage of marketing messages trumpetingthe latest product features, they are eager toexperiment with different brands.

• Because geographic markets in China are highlylocalized each with its own retailers, middlemen, andcompetitors brands must be built region by region.

• At China’s current stage of consumer development,point-of-sale marketing and promotions can be aspotent as advertising.

• Marketers must recognize that they cannot dabblein China’s consumer markets and expect to win. Ittakes a big commitment over the long haul toimplement a regional, highly segmented marketingstrategy.

That said, much can be learned from a carefully chosengroup of surrogates, such as the women of Shanghai. Weconducted focus groups with married women betweenthe ages of 26 and 35. In the emerging middle class, theseare the consumers who determine their families’ budgetsand aspirations as well as most purchases.

The Dreams of China’s Consumers

The women we talked with are articulate, energetic, andinterested in the latest fashions, skin-care products, andbeauty aids. All work outside the home as nurses, salesassociates, accountants, office employees, or bank clerks.For the most part, they live in small, rented apartments-someold, some new-often with their in-laws, sometimes withtheir in-laws nearby. As a result of China’s stringent birth-control policy, each woman has only one child, who isoften cared for by her mother or mother-in-law while sheworks. We asked the women what makes them mostunhappy about their current lives, what goals they areworking toward, and what they dream about.

At first glance, Shanghai’s young mothers appear to belike mothers everywhere. They care about their children’seducation, their families’ standard of living, and theircountry’s economic prospects. A closer look, however,

18

Exhibit 2. Three Decades of Growth

1980-1999 Average Annual GrowthGDP: 9.4%; Private Consumption: 8.4%

25%

20

15

10

5

0

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998

2000-2010 Forecast of Average Annual GrowthGDP: 7.4%; Private Consumption: 6.6%

25%

20

15

10

5

02000 2002 2004 2006 2008 2010

GDPPrivate consumptionGDP forecastPrivate consumption forecast

SOURCES: Economist Intelligence Unit; China StatisticalYearbooks; BCG estimates.

CONSUMER MARKETS

shows significant differences. China has changedtremendously over the past 30 years, and the womenexpect to see even more change over the nextdecade particularly in terms of increasing wealth andfreedom, as well as access to a wider range of consumergoods. These changes, however, are creating tensionsbetween old and new customs, Eastern and Westernvalues, family obligations and individual freedom, the needto save and the desire to spend.

Companies that hope to secure these women and theirfamilies as customers must take such tensions into

account in all their manufacturing and marketing decisions.The women’s stories, told below in the form of threecomposite portraits, put the tensions in relief. What resultsis a valuable glimpse into the soul of China’s future andsome guidelines for marketers who want to play a part inthat future.

Jin Wang: The Traditionalist. Jin commutes 40 miles bytrain to her job as a nurse at a children’s hospital. Herhusband, Yougang, is an accountant at a large insurancecompany, where he often works late. They live with theireight-year-old daughter, Li, and Yougang’s parents in acramped two-bedroom apartment. But unlike many of hermarried friends who sometimes complain about living withtheir parents, Jin is grateful for her mother-in-law’s helpwith child-care and for the money she and Yougang saveby sharing the rent. Although she and her husband makerelatively good salaries, Jin worries about future expenses,especially spending whatever is necessary on privatetutoring, computers, and software to help her daughtersucceed in school.

On the whole, Jin feels that China’s traditional familysystem in which parents sacrifice for their children butthen are taken care of by the children in their old age isa just one. “I know the old customs are dying out, andchildren are becoming much more independent. But whowill care for the old people if the children don’t?” shewonders. “I worry that we are becoming too much likeWesterners-more interested in careers and social life thanin the life of the family.”

Jin’s approach to the consumer marketplace is conflictedfor that reason. “Of course, I would like to have morefashionable clothes and a house of my own with my ownfurniture,” she says. “But how can I justify spendingmoney for my personal pleasure when my daughter orparents might need it? I still believe firmly that the familymust come first.”

After spending money on basic education, food, clothing,and housing, Jin devotes any cash that is left over tothings that will benefit Li, such as piano lessons. Shetends to buy locally made products, saying, “You canfind clothes and cosmetics that are just as good as the

19

Exhibit 3. How the Urban Chinese HouseholdSpends Its Money

1999 Average Household Spending:4,600 Renminbi (RMB)

Miscellaneous 6%(RMB 276)

Food 43%(RMB 1,978)

Clothing 11%(RMB 506)

Householdfurnishings 8%

(RMB 506)

Health care 5%(RMB 230)

Transportation andcommunication 6%

(RMB 276)

Recreation andeducation 12%

(RMB 552)

Housing 9%(RMB 414)

2004 Average Household Spending:6,350 Renminbi (RMB)

Miscellaneous 4%(RMB 254)

Food 33%(RMB 2,095.5)

Clothing 12%(RMB 762)

Householdfurnishings 8%(RMB 508)

Health care 6%(RMB 381)

Recreation andeducation 14%

(RMB 889)

Housing 15%(RMB 952.5)

Transportation andcommunication 8%

(RMB 508)

SOURCES: Economist Intelligence Unit; China StatisticalYearbooks; BCG estimates.

CONSUMER MARKETS

imported ones.” And she does most of her shopping atbig department stores on Nanjing Road, Huai Hai Road,or Xujiahui.

Looking toward the future, Jin hopes to travel more:“There is much we’ve never seen in China. And after ourdaughter is grown, we might also travel to Asia or eventhe United States. My parents, of course, never had thechance to travel.”

There are great differences between the lives of Jin andher contemporaries and those of her parents’ generation.Still, Jin maintains that her daughter will look after herand her husband in their later years, just as she iscommitted to looking after her mother and father.

Hong Chen: The New Age Woman. Hong, an assistantmanager in a recently opened women’s clothing boutique,describes herself as a New Age woman. Her choice of theAmerican phrase is characteristic: Hong loves all thingsWestern; reads British, French, and U.S. fashionmagazines; and keeps up with the gossip aboutHollywood celebrities.

Hong believes that China is finally emerging from theDark Ages and into an era of more freedom, independence,and sophistication. She is raising her ten-year-old son,Yin, to be more confident and outwardly competitive thanshe was brought up to be, and not to display the self-effacing humility that was required of her generation.Hong’s views on child rearing have created some conflictwith her mother, who lives with Hong and her husband,Da Gang, and cares for Yin during the day. This conflict isthe chief reason why Hong has been saving to buy herown home. She estimates that she is within a year of hergoal.

Hong expects to double her salary within the next fiveyears and enjoys talking about what she will do with herincreased purchasing power. In addition to buying ahome, she looks forward to shopping for furniture andappliances, planting a garden, and even entertainingfriends at dinner parties. Although Martha Stewart ishardly a household name in Shanghai, Hong has readarticles about her and considers her a role model.

Hong expects to travel abroad within the next five years.She hopes that her home will have a large-screentelevision and a dishwasher, among other amenities. Sheis saving to buy her son the family’s first personalcomputer. “I want my son to have access to the university,”Hong says. “I want him to change our world.”

Rong Li: The Moderate. Rong, her husband, Hao, andtheir son, Jun, live by themselves in an attractiveapartment near the center of Shanghai. None of theirrelatives live nearby. When her friends speak enviouslyof her living situation, however, Rong reminds them thatthe burden of rearing Jun falls squarely on her and herhusband’s shoulders. And because she and Hao worklong hours Rong is a computer technician, and Hao isin real estate she often wishes she had the kind of helpthat other couples get from live-in parents.

Rong describes herself as a modern woman who doesn’twant to lose touch with traditional values. She enjoys herrelative freedom, and she certainly doesn’t expect to livewith her son when he marries. But she also feels that toomuch “Western-style” independence will weaken the closefamily ties that are important in her culture. “I definitely wantmy child to have everything that middle-class Westernersenjoy,” she says. “But I don’t want him to become soacquisitive that he forgets the importance of family.”

Although she admires Western technology and productquality (she is even sending Jun to learn English becauseit is “the language of computers”), she dreams of a daywhen her country will surpass the United States ineverything particularly in technology and medicine.“That’s not just patriotism,” Rong explains. “I know thatthe power and respect China would enjoy as a world leaderwould also raise my family's standard of living.”

Rong and her husband are both earning higher salariesthan they did in previous years and expect to see theirincomes grow even more. Rong’s long-term goal is to starther own business “something to do with computers.”

When we asked Rong about the kinds of things shecurrently decides to purchase and how those purchasesmight change in the future, she says that her decision-

20

making process hinges on a very complicated issue: “Ilove Western products. The quality is better, and thestyles are more fashionable. But I fear that my generation’spreference for imports will force domestic manufacturersto go bankrupt and ultimately hurt China’s economy.”

There’s also the problem of personal guilt. Rong adds,“Yesterday I bought a new outf i t and somecosmetics things I would have considered too frivolousor self-involved a few years ago. But as much as I lovethese things, my son’s education is most important tome. I still worry about not spending enough on him.” SoRong saves 20 percent of the family income to spend onher son. “We will buy Jun the things he needs to take hisplace in society: health care, books, computers, sportsequipment.”

Guidelines for Marketers

China’s young mothers are undoubtedly eager to purchaseproducts that will raise their families’ standard of living,improve their children’s chances for a good life, andenhance their own lives. But in manufacturing and marketingthese products, consumer companies should understandthe tensions that affect, and sometimes squelch, the pent-up desire to buy. They need to find ways around thecompromises these women believe they must make in orderto straddle the old ways and the new. What follows aresome do’s and don’ts for marketing in China.

Appreciate the complexities of the target audience. Thewomen we talked with referred repeatedly to thecomplicated nature of their household arrangements. In asociety where family structures range from large andextended to small and nuclear, the same household tasksmight be performed by grandmothers, mothers, aunts, oreven children depending on the family. Therefore,marketers must be able to sell the same product or serviceacross several generations and family members.

In fact, one family member may be responsible forpurchasing a product even though another one uses it.Young working mothers, for example, often purchase thehousehold cleaning goods and appliances that theirparents use in the home. As a result, the younger

purchaser might be more likely to buy a product that isthe favorite of an admired celebrity, whereas the olderperson using the product might be more interested inconvenience and effectiveness. Marketers, therefore,should take into account the needs of both the purchaserand the user. The process is analogous to marketingchildren’s books in the United States: because parentsbuy books for their children to enjoy, the bestsellersappeal to the sensibilities of both age groups.

Understand the benefits the market is seeking. Thewomen in our focus groups have many unfulfilled needs.Chief among them is the desire for an improved homeenvironment, including more living space. Therefore,products that help make a home seem less crowded orcleaner such as personal stereo systems, screens, airpurifiers, and noiseless, self-cleaning appliances arelikely to be highly appreciated. Eventually, as familiesmove to larger apartments, products that enhance thenew homes, such as appliances and furniture, and servicesthat provide home-decorating advice and cleaning willalso become important.

In addition, many of these women have very specificpersonal needs and wishes regarding fashion, cosmetics,and health care products. To overcome the conflicts thatcan dissuade consumers from purchasing such products,marketing messages should stress the benefits that theseaspirational products bring in terms of, for example,better health or general well-being. The messages shouldalso make clear that these benefits accrue not only directlyto the woman who purchases and uses the product butalso indirectly to her family.

Finally, the women in our focus groups are extremelyinterested in anything that can help their children becomesuccessful and relatively independent. Educational toysand lessons that encourage creativity and independentthought are sure to be well received.

Recognize the special importance of the brandexperience in a developing market. Don’t underestimatethe amount of time Chinese consumers spend makingpurchasing decisions for high-end or new items, such aselectronic appliances and travel packages. Consumers

CONSUMER MARKETS

21

CONSUMER MARKETS

22

typically spend a few months browsing in differentchannels to gather the most information about productfeatures and brand differences. During this process, word-of-mouth recommendations from friends who havepurchased a given product often carry much more weightthan advertising on TV or pitches from salespeople. Toget the word out on their products, companies need towork hard to convert past users into brand disciples. Thatmeans establishing and nurturing a service and marketingrelationship early with first-time purchasers.

Don’t stress foreign origins. Branding should representsuperior (not necessarily “Western”) technology anddesign. Although Western products typically representhigh quality and cutting-edge technology to Chineseconsumers, they fear that too many imported goods willput domestic companies out of business. Therefore,Chinese consumers tend to favor Chinese brands as longas they aren’t sacrificing quality or paying too much.Adroit marketers can sidestep this issue by clearlyexplaining the benefits of a product while underscoringits quality. They should establish a local manufacturingbase to secure a local connection while maintaining thebenefits of foreign technology and design. And theyshould act quickly to stave off local competitors that areemerging in numerous consumer goods sectors and usingtheir own powerful customer propositions to jockey formarket position.

Don’t underestimate how much China is changing. ThatChina has undergone a major transformation is obvious.What isn’t so obvious is the extent to which significantchanges are still to come. The women we spoke with wereextremely optimistic about the coming decade, envisioninga very different China with a much higher standard of living.In fact, they believe the economy and culture will changeso drastically that their children’s lives will be remarkablydifferent from their own so different, some parents fear,that their children will be unable to relate to them. Althoughthese fears may be exaggerated, the degree of changeexpected in the society is probably not. Therefore,marketers must not assume that they understand theessence of China’s culture. Instead, they must constantlyseek to deepen their understanding of China itsconsumers are changing as rapidly as the environment is.

Don’t discount the value of educating consumers.Although China’s consumers welcome new products andservices, Western marketers should realize that they aren’tas familiar with them as Western consumers are. In manycases, they will need to be educated to appreciate thebenefits of a particular product. For example, many of thewomen we spoke with had no understanding of orappreciation for insurance products. But after attendinga seminar on insurance, they were eager to buy theproducts. China’s consumers want to learn aboutproducts, and they bring open minds to the educationalprocess. Sophisticated marketers will seize thisopportunity and devote time and effort to educating them.

* * *Understanding the hopes and dreams of China’s emergingconsumer class will be a critical factor for success in thishuge emerging market. Developing and marketing productsand services that help resolve the tensions that accompanya society in transition will take sensitivity, flexibility, and,above all, a continuous effort to know the customer.

The stakes are very high, but so is the payoff. Futuremarketers in China should ask themselves today: Whatdo I have to do to be in the right place to meet the firstwave of increasing consumer demand? And how do Imake sure my brands will respond to this new generationof consumers?

Jim Hemerling is a vice president and director in theShanghai office of The Boston Consulting Group. JohnWong is a senior vice president and director, andHubert Hsu a vice president and director, in the firm’sHong Kong office. Anne Beall is a marketing researchconsultant in BCG’s Chicago office.

You may contact the authors by e-mail at:hemerling.jim@bcg.comwong.john@bcg.comhsu.hubert@bcg.combeall.anne@bcg.com

© The Boston Consulting Group, Inc. 2003. All rights reserved.

TECHNOLOGY AND COMMUNICATIONS

The Dragon’s Revenge:Tough Times for TelecomVendors in China

David MichaelCollins QianJoseph Wan

by

F or the past several years, the rapid development ofChina’s telecom industry has been a boon to the

world’s telecom-equipment manufacturers. Indeed, as theglobal telecom sector has sputtered, China has been theonly major market that has continued to grow. Fixed-linepenetration now at about 200 million phone lines hasdoubled since 1999. China’s mobile industry has also seenspectacular growth, with total subscribers now exceeding175 million up from 100 million two years ago. The majorequipment providers have been reaping the rewards. In2001, Motorola’s revenues in China totaled $5.6billion equal to the company’s sales in all of Europeand nearly three times its sales in Japan. Nokia had salesof about $3 billion and sold more in China than in anyother country except the United States. Alcatel hadrevenues of about $2 billion in China.

The opportunities are changing quickly, however. Severalfactors including slower revenue growth, industryrestructuring, postponements of capital spending, anddelays in the issuance of new licenses are making thecountry’s domestic market more challenging forestablished equipment vendors. This is occurring just asChina enters the World Trade Organization and asChina-based vendors increasingly vie for business in

important markets worldwide. Established players willneed to understand how to compete in this newenvironment.

A Shifting Market

China’s market is becoming tougher on a number of fronts.First, in both the fixed-line and mobile businesses, therehas been a noticeable slowdown in both revenue growthand near-term capital spending. In the fixed-line arena,for example, China Telecom, the dominant operator, spentonly about 80 percent of its capital budget during thepast two years. The company has also put a large shareof its capital expenditures on hold in the wake of a majorindustry restructuring one that has led to the spinoff ofthe northern portion of its business and the creation of anew rival operator, China Netcom Group.

Beyond the cutbacks in spending, there have been shiftsin investment priorities away from traditional networkdeployment and improvement and toward the creation ofnew services and improved customer-service capabilities.Indeed, China Telecom has already started to makeinvestments in Xiaolingtong, or “Little Smart” itslimited-mobility product that is based on the Personal

23

TECHNOLOGY AND COMMUNICATIONS

Handy-Phone System (PHS) and in systems that permithigher levels of customer service.

Mobile operators are also in the midst of rethinking theircapital-spending plans. China Mobile, the leading player,recently announced a 20 percent reduction in spendingin response to slower growth in average revenue per user.China Unicom is expected to trim its spending plans aswell. Having completed much of the initial work on thedeployment of a new network based on Code DivisionMultiple Access (CDMA) and having experienced slowmarket acceptance, the company is increasinglyconservative about new investments.

Adding to the overall market uncertainty is the delay inthe issuing of new licenses to mobile operators. Thegovernment was slated to award new licenses in 2002 butnow seems unlikely to do so until 2003 or 2004, at theearliest. The recent selloffs of China Mobile and ChinaUnicom shares, together with disappointing adoptionrates for CDMA mobile service, appear to have dissuadedregulators from introducing more competition at this time.Taken together, these developments further reduce thelikelihood that major new infrastructure investments willbe made in the near term.

Finally, there is the general impact of competition amongChina’s telecom operators and pressures from theinvestment community. Today all of China’s operatorsface some degree of competition, and all either are publiclyowned or have plans to become so within the next twoyears. These forces mean greater scrutiny on spendingand an increased focus on areas such as IT, customerservice, and branding at the expense of additionalnetwork deployment.

New Global Threats

Beyond the market and industry trends, we are alsowitnessing the rapid rise of China-based telecom-equipmentvendors. Some of these companies are already majorplayers in their home markets and have begun to pursueglobal ambitions. Four players are of particular note.

Huawei Technologies, a privately owned company thatis particularly strong in optical transmission andswitching, currently has the most visible internationalpresence. With revenues of $3.1 billion in 2001, thecompany has more than a third of China’s fixed-lineswitching business and employs more than 10,000engineers in R&D. Huawei has already establishedoverseas sales offices in Asia, Europe, and theAmericas; and although it focuses heavily on developingcountries, it has recently won contracts in Germany andSpain.

Zhongxing Telecommunication Equipment, which hadsales of $1.6 billion in 2001, is especially strong inswitching and mobile infrastructure. Like Huawei, ZTE,which is affiliated with the Chinese government, hasbegun pursuing business elsewhere, especially inemerging markets. It attracts engineering talent from allover China. ZTE and Huawei differentiate themselves fromtheir more established competitors by offering low priceson relatively mature lines of products something that isincreasingly attractive to operators worldwide. In thefuture, however, both ZTE and Huawei are likely to stressinnovation and service capability.

UTStarcom, which had revenues of $627 million in 2001,supplies network equipment and limited-mobilityhandsets for China Telecom’s PHS system. Theseproducts enable fixed-line operators to tap unusedswitching capacity for local wireless voice and dataservices. UTStarcom’s organization is unusual: althoughthe company operates primarily in mainland China, itsheadquarters are in the United States and it has receivedfunding from Japan’s Softbank. Many of its managers areveterans of Lucent and other Western vendors. Thecompany already generates about 20 percent of itsrevenue in areas outside China and aims to move moredeeply into growing markets such as India.

China Putian, a holding company owned by the Chinesegovernment, has been involved in several joint ventureswith foreign telecom-equipment suppliers, includingEricsson, Motorola, and Nokia. The company has a new,

24

well-connected CEO and a mandate from the governmentto prepare for an IPO and to expand aggressively. Putianhas already introduced three domestic mobile-handsetbrands and is in the midst of restructuring to becomemore competitive. Although its international commercialexperience is more limited than that of other domestictelecom vendors, it has the connections and the resourcesto become a significant force. It had revenues of $7.7billion in 2001.

Implications for Established Vendors

The recent developments in China’s telecom market andthe new competitiveness of Chinese vendors havedramatic implications for established equipment vendors.For companies looking to succeed in this newenvironment, there are several critical steps that must betaken.

Realign your product portfolios to target new areas ofgrowth. Telecom equipment vendors need to reassessthe near-term growth opportunities. Among the mostinteresting areas are PHS equipment and handsets,metropolitan area networks, selected elements ofnext-generation networks, and billing and customer caresystems. In the meantime, demand is weakening in otherareas, such as backbone transport and core switching.Vendors must consider the implications for adjusting theirown portfolios and decide whether and how to enter newlines of business.

Take advantage of the new regulatory environment toimprove efficiencies. Most established telecom-equipmentvendors set up their China operations based onregulations that existed a decade ago. These regulationsrequired investments to flow through joint ventures withlocal companies and put restrictions on how companies’import businesses and sales and marketing activities couldbe conducted. Today China permits more flexibility inorganizing such operations. At the same time, leadingjoint-venture partners such as Putian have started tocompete head-on with their erstwhile partners, creatingmajor conflicts. In light of these changes, foreign-based

vendors need to rethink their business configurationsand future options, as some are beginning to do. Alcatel,for example, recently bought a controlling stake in itsShanghai Bell joint venture, and Ericsson recentlyconsolidated some of its Chinese ventures. Most playersare now putting new investment into wholly ownedcompanies rather than joint ventures.

Restructure your local operations in response to thechanged economic environment. Most playersestablished their China-based organizations to capitalizeon a period of buoyant growth. However, the newenvironment requires them to have both leaner operationsand new capabilities. Successful companies will need tofind ways to cut costs significantly. They will also haveto bolster their capabilities in marketing and in sales ofnew products, and improve their relationship-managementskills in order to satisfy increasingly demandingcustomers.

Prepare for intensified global competition from China’semerging equipment vendors. Many of China’stelecom-equipment vendors pose formidable challengesfor established players: their abilities to compete should notbe underestimated. Senior managers need to determine whichvendors to fight head-on and which ones offer interestingpartnership or perhaps even acquisition opportunities.For example, both Huawei and ZTE have demonstratedthe ability to pursue multiple strategies. On the one hand,the companies are effective at licensing technologies andcooperating with competitors; on the other, they haveshown that they can attack overseas markets on theirown. Established companies need to understand how toweigh this potential threat.

* * *

China’s telecom market is undergoing sweeping changes.It will not return to the boom years of aggressive capitalspending driven by a few monopoly operators. ThoughChina’s continued economic development means thecountry will remain an important technology market formany years, the conditions for doing business will become

TECHNOLOGY AND COMMUNICATIONS

25

increasingly difficult as local equipment suppliers gainmarket experience and jockey for position. Establishedplayers seeking to secure their place in the Chinese marketwill need to understand how to compete in this newenvironment. Simultaneously, they will need to counterthe growing competitive threat that China’s domesticcompanies will pose in the global arena. Advantage willgo to players that recognize the new realities and actupon them quickly and effectively.

David Michael is a vice president and director inthe Beijing office of The Boston Consulting Group.Collins Qian is a manager in the firm’s Shanghaioffice. Joseph Wan is a manager in BCG’s Hong Kongoffice.

You may contact the authors by e-mail at:michael.david@bcg.comqian.collins@bcg.comwan.joseph@bcg.com

© The Boston Consulting Group, Inc. 2003. All rights reserved.

TECHNOLOGY AND COMMUNICATIONS

26

AUTOMOTIVE

Competing to Win in China’sFast-Growing AutomotiveMarket

Jim HemerlingZafar MominImmo Rupf

by

B y 2010, China will be one of the world’s five largestautomotive markets. Already, the jockeying for

position in this fast-growing market is intense. Virtuallyall the major original equipment manufacturers (OEMs)and global suppliers have significant investments in Chinaor are in the process of investing there. Moreover, thehuge deals with Chinese companies announced over thepast several months by Honda, Hyundai, Nissan, andToyota have further raised the stakes for all participants.(Although most OEM activity centers on China as adomestic market, farsighted companies are also investingthere as an increasingly important base for bothmanufacturing and sourcing for export. See the next articlein this volume, “Rethinking ‘Made in China’ Cars andParts,” on page 32. )

To date, the handful of OEMs that got to China first havedominated the market. The field is now crowded, however,and keen competition from the rash of relative newcomersis very likely to erode incumbents’ market share. By theend of this decade, when participants’ entry strategieshave played out, we will no doubt see some very bigwinners and some big losers.

To end up among the winners, a company will need topay particular attention to five activities: developing adeep understanding of Chinese consumers’ productrequirements, creating an economically viable distributionnetwork, delivering a superior brand experience,maintaining a lean cost structure, and establishing theright relationships with the right partners fast.

The Burgeoning Chinese Market

The Chinese car market is growing even faster thananticipated. In the first six months of 2002, 470,000 carswere sold in China more than 125,000 were sold in thefirst half of 2001, which represents a 36 percent growth indemand. Total sales for 2002 are expected to reach 1 million.We anticipate that the market will grow at 10 to 15 percentper year for the next several years, to reach annual salesof approximately 2 million cars in 2006. (See Exhibit 1.)

The engine driving this voracious appetite forautomobiles is China’s continued strong economicgrowth. In particular, sales of passenger cars are benefitingfrom rapidly rising disposable incomes (especially in

27

AUTOMOTIVE

China’s 50 largest cities); the increasing development ofinfrastructure such as roads and highways; theproliferation of vehicle models; falling new-car prices;crumbling tariff barriers; and the emerging availability ofcar financing.

Leading global OEMs and suppliers are already in Chinain force, and the more recent arrivals are investing rapidlyto ramp up their presence. Volkswagen, Citroën, and Audientered early, followed by General Motors and Honda.BMW, Fiat, Ford, Hyundai, and Peugeot are recententrants with one-factory joint ventures. Nissan’s andToyota’s recently announced megadeals with Dong FengMotor Corporation and China FAW Group Corporation,respectively, involve multiple sites, multiple products, andcooperation along the whole value chain.

Clearly, with the field already packed, the battle for sharein this high-growth market will be increasingly intense.What will it take to emerge as one of the winners?

Winning in China

Naturally, each company’s strategy for participating inChina’s automotive market will need to reflect its currentstarting point and its particular aspirations. In all cases,however, companies that end up among the winners in

this market will get there by tailoring their businesses toChina’s unique requirements. Among the many thingsthey will need to do well, the following five are criticallyimportant.

Develop a deep understanding of Chinese consumers’product requirements. Up to now, most vehicles sold inChina have been fleet and government purchases.However, consumers represented only 35 percent of autosales in 2001, and we expect that share to double by 2010.But because consumer purchases are just now attainingscale, carmakers have not yet fully understood Chineseauto buyers’ needs, wants, fears, and aspirations. Themarket segmentations that are now available are devisedprimarily on the basis of features and price points, not onconsumers’ characteristics and requirements. We do knowthat private car buyers are becoming more informed andsophisticated in terms of their requirements. We also knowthat, in addition to price (which is always a primaryconsideration), consumers consider body style, quality,reliability, brand image, and service availability in theirpurchase decisions.

In China, as in other emerging markets in Asia,carmakers have generally sold cars designed toWestern or Japanese specifications. Exceptions includethe Audi A6 and the Volkswagen Passat, which provideextra back-seat legroom in China, where buyers oftenride as passengers driven by chauffeurs. Adaptationsof this kind, which cater specifically to the preferencesof the mass market, are likely to win market share. InIndia, for example, Tata’s homegrown Indica car, fittedwith a diesel engine, has done very well; it offerscustomers a cheaper fuel alternative in a car that iscomparable in price and performance to its foreignrivals. In China, some key considerations includeproviding interiors that are ergonomically better suitedto carrying passengers, as well as suspensions thatcan handle rough roads.

The long-term winners in China will be those companiesthat make the right tradeoffs in terms of product styling,

Exhibit 1. China Is Emerging as an AttractiveAutomotive Market

Compoundannualgrowth ofpassengervehiclesales,2001-2006(%)

181614121086420

-2-4

0

Passenger vehicle sales of2 million units in 2006

Compound annual GDP growth,2001-2006 (%)

China

Global average

SOURCES: DRI; Economist Intelligence Unit; BCG analysis.

1 2 3 4 5 6 87

IndiaMexico

Chile

Czech RepublicSouth Korea

Brazil

GermanyFranceJapan

United KingdomUnited States

28

performance, features, and price to meet the needs andpreferences of consumers in each market segment andthen bundle these products with the right serviceofferings to meet customers’ cost and conveniencerequirements. Creating the right customer and products t ra tegy wil l require very careful p lanning,incorporating reliable demand forecasts, extensivequalitative and quantitative consumer research,competitive gaming, and creativity. Companies willneed not only solid market information but alsoconsiderable knowledge of competitors, suppliers,dealers, and social and political fixtures in China’svarious provinces. Understanding Chinese consumers’requirements across the full life cycle of car ownershipwill be key to delivering the right value propositionand building customer loyalty.

Create an economically viable distribution network.World-class distribution networks are already emergingin China. Most of the OEMs we talk with are planning todevelop their own proprietary, single-brand dealernetworks. Although this model may be desirable, itwon’t work for everyone. China consists of vast,relatively underdeveloped, heterogeneous regionalmarkets. Our research suggests that only a handful ofmajor players will have the volume required to supporteconomically viable networks that offer national servicecoverage.

Nonetheless, each company’s distribution network willplay a crucial role in delivering its value proposition tocustomers. Given the vast expanse of China, companieswill need to come up with innovative business modelsfor providing both geographic coverage and fullfunctionality (such as new-car sales, used-car sales,service, repair, and financing), while achieving viableeconomics and ensuring customer satisfaction. One ofthe biggest challenges will be providing service in ruralareas, such as quick-service dealers with lowerbreakeven volumes.

Deliver a superior brand experience. Branding in China,as in more established markets, will entail orchestrating

the entire purchase-ownership-repurchase continuum.Although the products themselves will remain at the coreof the brand experience, the brand wars will increasinglybe fought in the before-sales, sales, and after-salesexperiences. OEMs that have scale and margin will beable to afford to invest; others will find it extraordinarilydifficult and will have to look at creative alliances andoutsourcing arrangements, very likely in cooperation withother OEMs.

First impressions will be critically important as the marketgrows and changes. As new consumers enter the marketeach day, the oversupply of rapidly proliferating newmodels will give them considerable choice for the firsttime. Moreover, as tariffs fall and capacity from existingand new players expands, we expect to see tens ofthousands of vehicles go unsold.

Therefore, it will be a buyer’s market. Because manyChinese consumers will make their first-time car-buyingdecisions on the basis of word-of-mouth referrals fromother first-time buyers, OEMs would do well to ensure thatthese consumers enjoy a positive sales and after-salesexperience, as well as excellent product quality. Focusingon this experience will have far more impact on marketshare than will broad-based advertising or expensivebrand positioning.

Branding may become a sticky issue in the future as Chinesecar manufacturers intensify their efforts to create orstrengthen their own brands, thus complicating theirrelationships with their foreign partners. The key questionwill be whether Chinese consumers will prove more loyalto Chinese brands than to global brands for nationalisticreasons (as, for example, Korean and Japanese car buyershave been). Our view is that the winners over the long termwill be those companies, regardless of national origin, thatcan deliver a superior value proposition consistent withtheir brand positioning in the relevant customer segment.

Maintain a lean cost structure. Although 1 million passengercars will be sold in China in 2002, the market is splinteredamong multiple OEMs, brands, and models. As a result,

AUTOMOTIVE

29

players are seriously subscale and high cost relative to low-cost manufacturers in Japan, Europe, and North America.With their profitability already under pressure from pricewars and the need for continual investment, participants inChina are finding that high vehicle and distribution costspose serious challenges to their survival. Costs must bekept lean not only in plants and assets but also in distributionnetworks, overhead, and information systems. Allinfrastructure must be kept consistent in scale with the sizeand growth of local operations.

Establish the right relationships with the rightpartners—fast. A complex web of automotive jointventures is developing in China. (See Exhibit 2.) Each ofthe three largest Chinese manufacturers—ShanghaiAutomotive Industry Corporation, China FAW GroupCorporation, and Dong Feng Motor Corporation—alreadyhas two or three partners, and a host of other playershave also entered into joint ventures. Some of theseplayers will survive as independents, whereas others willbe merged into the large manufacturers (as in the case ofTianjin Automotive Industry Corporation recentlybecoming part of FAW).

Although the future is far from clear, it is certain to includejoint ventures. Thus far, the Chinese government hasshown no sign of intending to relax the 50 percent limiton foreign ownership of automotive assembly. However,Honda is now lobbying for majority control of its newplant, and it remains to be seen whether the governmentwill prove flexible on this issue for the right deal structure.

Foreign companies entering into joint ventures in Chinashould be prepared for a healthy tension betweenthemselves and their partners with respect to the scopeand pace of investment. Generally, Chinese partners prefermore and faster investments and greater technologytransfer, whereas foreign companies like tyinginvestments to revenue growth rather than overinvestinginitially and then “bleeding” for a long time.

With so many OEMs jockeying to choose the right partners,align interests, and compete for scarce resources, the jointventure arena will be a particularly ferocious battleground.Those at the top of the pecking order will have a strongadvantage. Of course, partnerships by themselves cannotensure success. In some cases, they could even becomestumbling blocks for future growth. Nevertheless, havingthe right partners and connections in China can play apivotal role in a company’s success or failure in deliveringthe right value proposition to the customer.

* * *

ShanghaiAutomotiveIndustryCorporation

ChinaFAW GroupCorporation

Dong FengMotorCorporation

BeijingAutomotiveIndustryCorporation

ShanghaiVolkswagenFAWVolkswagen

DongFengCitroën

GuangzhouHonda

Chang’anSuzuki

Dong FengNissan

Yueda KiaBeijingHyundai

Fiat Yuejin

BeijingAutomotive

Chang’anFord

HainanMazda

TianjinToyotaFAWToyota

Brilliance BMW

Other OEMs

Imports

2001 sales of passenger vehiclesVehicles

(thousands) %

361

58

54

51

43

17

6

6

5

4

0

0

150

60

815

1

1

1

0

0

0

18

7

100

SOURCES: DRI; press searches.

Exhibit 2. Car Joint Ventures Form a ComplexWeb in China

GuangzhouAutomotiveIndustryCorporation

Chang’anAutomobileGroup

BrillianceChinaAutomotiveHoldings

ShanghaiGeneralMotors

44

7

7

6

5

2

Total

AUTOMOTIVE

30

Jim Hemerling is a vice president and director in theShanghai office of The Boston Consulting Group.Zafar Momin is a vice president and director in thefirm’s Singapore office and leads the Automotivepractice in the Asia Pacific region. Immo Rupf is avice president and director in the BCG’s Paris officeand was formerly based in Shanghai.

You may contact the authors by e-mail at:hemerling.jim@bcg.commomin.zafar@bcg.comrupf.immo@bcg.com

© The Boston Consulting Group, Inc. 2003. All rights reserved.

Participation in China’s vast, fast-growing, and highlycompetitive automotive market is not for the faint of heart.But those who have the will, vision, and tenacity to tacklethe immense challenges the country presents as wellas the insight, experience, and wisdom to undertakemeticulous preparation and execution are likely to beamong the winners.

AUTOMOTIVE

31

Rethinking “Made in China”Cars and Parts

Jim HemerlingZafar MominImmo Rupf

by

hina not only represents the fastest-growing carmarket in the world, but also offers some of the

lowest labor costs, at just 3 percent of European orJapanese manufacturing wages. Moreover, China can beexpected to retain its labor cost advantage for a longtime, thanks to its enormous pool of increasingly mobileworkers, both skilled and semiskilled. (See Exhibit 1.) Todate, however, global auto OEMs and suppliers havefocused primarily on establishing positions in China’sdomestic auto market, and have paid far less attention todeveloping China as a low-cost base for assembly andsourcing for export. Until very recently, general “wisdom”had it that China just was not yet a competitivemanufacturing and sourcing base.

Today, however, that assumption is being challenged.This past July, Honda declared that it planned to build aplant in China dedicated exclusively to export, to produce50,000 cars in 2004 and ultimately 300,000 cars per year.Ford, meanwhile, has announced plans to source $1 billionworth of components from China in 2003. Other OEMsare also increasing their reliance on China-sourcedcomponents.

For both OEMs and component manufacturers, themessage is clear: you need to expand your view of China,from seeing it only as a domestic market to viewing it alsoas a base for assembly and sourcing for export. Andbecause moving from planning to assembly takes years,not months, you must start making that shift now.

China as an Assembly Base for Export

To date, China has not been considered a viable base formanufacturing cars for export. Why? Although China doeshave cheap labor, this advantage is outweighed by lowerlabor and asset productivity; expensive raw material;joint-venture-related inefficiencies; and much higher costsin the supplier base, along with quality problems andweak design and logistics capabilities. OEMs report thatcompared with best costs elsewhere in the world, Chinaoperates at a cost disadvantage of 10 to 20 percent forlarge established car ventures and up to 40 percent forsmaller operations. Although China is working to closethe gap, estimates of how long it will take to achieveparity range from five to ten years.

C

AUTOMOTIVE

32

Exhibit 1. China Is Emerging as Both an AttractiveMarket and a Low-Cost Supply BaseCompoundannualgrowth ofpassengervehiclesales,2001-2006(%)

181614121086420

-2-4

34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0

Passenger vehicle sales of2 million units in 2006

Manufacturing labor cost in 2006 ($/hour)

Germany

UnitedStates

France

United Kingdom

Japan

China

ChileCzechRepublicSouth Korea

IndiaBrazil

Mexico

Taiwan

Global average

SOURCES: DRI; Economist Intelligence Unit; BCG analysis.

In this context, Honda’s announcement that it plans tobuild a factory dedicated to exports hit the industry like abombshell. Particularly noteworthy was Honda’s claimthat it would achieve a 20 percent per vehicle costadvantage in relation to production in Japan. What mustHonda believe it can achieve in China for this plan tomake sense? First, it must believe that consumers will bewilling to buy vehicles bearing the “made in China” label,despite that label’s historical associations withinexpensive, low-quality products. Second, it must believethat it can manufacture these vehicles at an advantagedcost. Let’s examine both assumptions.

The “Made in China” Label. Because China exportsvirtually no vehicles today, to examine Honda’s firstassumption we need to look at automotive experience inother markets, as well as experience with nonautomotiveexports from China. Increasingly, global auto makers areusing plants in the developing world to make cars fortheir home markets. For example, Ford will produce itsFusion mini-SUVs for the United States in Bahia, Brazil,starting in 2004. BMW is producing 3-series sedans forJapan, Australia, and the United States in Rosslyn, SouthAfrica. Honda is about to start making the Fit compactcar for Japan in Ayutthaya, Thailand, and GM has beenproducing Opel Zafira minivans for Europe and Japan inRayong, Thailand, since 2000. Clearly, these OEMs haveconcluded that consumers in developed markets will notbe overly concerned about products manufactured inemerging-market plants.

Meanwhile, the reception given exports from China in ahost of other categories, from name-brand running shoesand clothing to high-end cameras, electronics, and medicalequipment, suggests that the “made in China” label nolonger carries the stigma of low manufacturing quality.We believe that, with the right quality control andcommunication, resistance to “made in China” vehiclesshould not pose an obstacle, particularly for entry andmid-level vehicles. Let’s not forget that not too long ago,observers expressed the same concern about vehiclesmade in Korea and earlier about vehicles made in Japan.

The Quest for Cost Advantage. To determine whethervehicles produced in China will be cost competitive, and

if so, when, we first looked at the global cost structure ofa typical passenger car and then assessed costs today inChina and what it would take for Honda to achieve a 20percent cost advantage. Having completed that analysis,we believe that achieving a cost advantage of 20 percentis feasible. How might Honda do it?

As noted above, Chinese auto plants now operate at acost disadvantage of 10 to 40 percent in relation to world-class plants. This disadvantage arises primarily from twofactors: high component costs, due to the lack ofcompetitiveness of the supply base, and low capitalproductivity most car plants in China are underutilized,producing significantly fewer vehicles per dollar ofinvested capital than their rivals elsewhere. So Hondawill need both to reduce component costs and to increasecapital productivity.

Reducing Component Costs. Most automotive suppliersin China are relatively subscale and inefficient and havelow first-pass yields. Although they have come a longway over the past decade, they still have much ground tocover. Government policy and regional protectionism haveled to a fragmented industry in which individual suppliersare tied to individual assembly plants and thus limited insize. Import tariffs on components (of approximately 30percent) and local-content requirements have furtherprotected suppliers, enabling them to pass alonginefficiencies in the form of higher prices. Althoughgovernment actions, falling tariffs, and market forces aredriving consolidation and rationalization, most OEMs inChina will continue to suffer a component-costdisadvantage in the near term.

Honda’s strategy to reduce component costs is likely torest on two pillars. The company will probably importthose parts for which China offers no structural costadvantage, such as most categories of engine and drivetrain components. Importing such parts will pose no costdisadvantage beyond freight costs, because the Chinesegovernment waives import taxes on components destinedfor reexport.

For labor-intensive parts, such as wire harnesses andradios, China’s low labor rates can give Honda a

AUTOMOTIVE

33

significant advantage, provided that productivity andquality can be brought up to competitive levels. JapaneseOEMs will no doubt require their Japanese suppliers torelocate to China, and will also develop local suppliers.Honda is already doing both.

Increasing Capital Productivity. Capital costs can destroyprofitability, particularly when plants operate below world-class volumes. Honda’s expertise in flexiblemanufacturing will be a big factor in enabling it to achievescale economies even with lower volumes. The key tooperating in China lies in achieving high levels ofutilization while optimizing the tradeoff betweenautomation and labor. In the body shop, Honda can userelatively low-tech welding lines with only limitedautomation instead of expensive welding robots. The sameapproach can be applied to the paint shop. Honda isalready familiar with such tradeoffs; in India, its assemblyline has very limited automation, and even its assemblytrack is not motorized.

Alternatively, OEMs can try to reduce the capital outlayitself. For example, Tata in India imported an old Nissanassembly line from Australia for its car venture, thussignificantly reducing its total investment in plant andmachinery.

When we combine the effects of lowering componentcosts and increasing capital productivity, it appears thata 20 percent cost advantage for car manufacturing in Chinacould be feasible in the medium term. (See Exhibit 2.) Intoday’s best cases, the cost disadvantage of carproduction in China is about 10 percent, arising from thecumulative effects of smaller-scale operations, lowutilization rates, and high component costs. Today, theseeffects outweigh China’s advantages in low labor ratesand low prices for land and commodities. However, itshould be possible to move from this disadvantagedposition, represented on the left side of Exhibit 2, to the20 percent cost advantage represented on the right side,by avoiding import duties on parts assembled intoexported vehicles, achieving an optimal mix of Chineseand non-Chinese sourcing, optimizing capital-labortradeoffs, and ensuring full facility utilization (for example,by dedicating operations to export).

In our view, the export of fully assembled vehicles fromChina is not only feasible but inevitable. Some OEMs,such as Honda, will build capacity explicitly dedicated toexports. Other OEMs that cannot find the sales volumesthey had planned for in China will be forced to export outof China to remain viable. Either way, vehicles will beexported. The only question is who will do it best, andhow soon.

China as a Base for Sourcing Parts

In contrast to the export of fully assembled vehicles fromChina, the export of components is already a reality. Howis this possible, when domestic OEMs face a costdisadvantage in components? First, OEMs looking tosource Chinese-made components for global operationscan be selective, focusing on those commodities for whichChina’s inexpensive labor and in some cases localmaterials give China a global advantage. Second,components for export benefit from a full rebate of dutiesand VAT. Third, unlike domestic assemblers, which aretied to individual suppliers and hence get average costsat best, OEMs sourcing from China can pick from amongall suppliers and get the lowest cost. And fourth, somesuppliers and regional governments are willing toprice more aggressively for export business. These factors

Exhibit 2. A 20 Percent Cost Advantage in ChinaAppears Feasible for Automotive Plants for Export

Modeled economics1

80

SOURCE: BCG estimates.1Modeled economics for hypothetical automotive plants,based on general industry knowledge and assumptions.

Typi

cal g

loba

lpl

ant

1112

7110121414

112100

Scal

e

Util

izat

ion

Com

pone

ntco

sts

Labo

r

Land

Raw

mat

eria

l

Mod

eled

dom

estic

plan

t in

Chi

na

Dut

ies

Sour

cing

Asse

t util

izat

ion

Mod

eled

exp

ort

plan

t in

Chi

na

Assets

AUTOMOTIVE

34

combine to give China an advantage in some partscategories an advantage that will only grow as therestructuring and capability upgrading proceed.

Over the long term, these advantages will help Chinaevolve into a much larger and more competitive supplybase, as global tier-one suppliers relocate capacity toChina and local competitors upgrade. In the short term,however, we believe there will be a shortage of capacity.On the supply side, numerous forces will combine toimpede the relocation of tier-one capacity to China, and itwill take time for Chinese suppliers to develop. On thedemand side, pressure is building from the rapid growthof domestic vehicle sales (at 10 to 15 percent per year)and the increased sourcing efforts in China of globalOEMs.

Because of these constraints, OEMs that want to use Chinaas a low-cost manufacturing and sourcing base in the nextfew years need to mobilize quickly. The race is on.

Exploiting the Assembly and Sourcing Opportunity

Although component supply may be constrained overthe next few years, China today offers a considerablymore developed and comprehensive assembly base thanit did just two decades ago and that base is developingfast. Back in the 1980s, companies beginning to assemblemodels such as VW’s Santana and the Peugeot 505 tookeight to ten years to be able to manufacture cars with 80percent local content. In contrast, later models such asCitroen’s Fukang and VW’s Jetta, which were introducedin the early ’90s, took just three to five years to achievethe same results. Even more recently, the Buick Regal,which started with 40 percent local content in 1999, tookonly three years to get to 80 percent.

To exploit the Chinese assembly and sourcing opportunitysuccessfully, companies must command five key strategiclevers.

Integrate China into global capacity planning. Tosucceed in China, OEMs will need to create globalproduction systems that combine China-based suppliersand assembly facilities with supply operations in other

countries. Japanese OEMs are taking the lead inincorporating China into global capacity planning for bothassembly and components, building capacity and shiftingthe supply base. Just as Toyota rationalized sourcing inASEAN, we believe it will now incorporate China in waysthat will give it a powerful additional advantage. The recentdeal with FAW Group Corporation, one of China’s top-fourcar makers, will ensure a strong partner in China with whichToyota can build a strong assembly base for the region.Looking ahead, OEMs will also need to explicitly factorpotential exports from China into their plans, building inthe flexibility required to meet variations in local andglobal standards.

Revisit the economics of assembly and componentsregularly. China’s supply base is evolving very quicklythrough rationalization, investment by global tier-one andtier-two suppliers, and the continuous improvement oflocal suppliers. In such a dynamic environment, cost,capacity, quality, and capabilities change from week toweek. Serious players must be in the market and havetheir fingers on the pulse of what is happening.

Organize for global sourcing. Realizing the sourcingopportunity in China requires tremendous leadership,from the most senior levels down and across theorganization, to mobilize the necessary resources, createthe essential capabilities, and overcome the inevitableorganizational resistance. Global companies will need toestablish organizations at the corporate center, in varioussourcing regions, and in China; to set up a sourcingcapability including processes, skills, and informationplatforms to enable global communication and decisionmaking; to forge links between this capability andsuppliers located across China; and then to manage theday-to-day execution. All of this takes a staggeringamount of effort.

Encourage your suppliers to relocate to China. Althoughsome 200 global suppliers already have operations inChina, most have focused on the domestic market. Fewhave made the tough decision to relocate large-volumefacilities for key components to China, or have madeinvestments to ensure lowest global cost. This musthappen. Japanese suppliers are already moving

AUTOMOTIVE

35

aggressively; others must step up their efforts or risklosing out to those who are committed.

Develop and secure local suppliers. Many of the leadingsuppliers exporting from China today are privateentrepreneurial companies and state-owned enterprisesthat already have state-of-the-art equipment, excellentmanufacturing processes, and strong management.Although most lack full-service supplier designcapabilities, they are eager to create those as well.Developing deep relationships with these suppliers andinvesting to improve quality, cost, design, andmanagement further—will be critical to winning the exportbattle.

* * *

The stakes in China’s burgeoning automotive market arehigh and rising fast. Participation in China not only as amarket but also as an assembly and sourcing base forglobal export raises the stakes even higher. Winning thedomestic battle is now only half the game. Success is byno means assured; but for the companies that get it right,the rewards will be tremendous.

Jim Hemerling is a vice president and director in theShanghai office of The Boston Consulting Group.Zafar Momin is a vice president and director in thefirm’s Singapore office and leads BCG’s Automotivepractice in the Asia-Pacific region. Immo Rupf is avice president and director in BCG’s Paris office andwas formerly based in Shanghai.

You may contact the authors by e-mail at:hemerling.jim@bcg.commomin.zafar@bcg.comrupf.immo@bcg.com

© The Boston Consulting Group, Inc. 2003. All rights reserved.

AUTOMOTIVE

36

China’s GrowingDrug Market:Will You Be a Contender?

John WongXudong Yin

by

ven though China’s 1.25 billion people representsignificant untapped opportunity, most global drug

companies don’t consider the nation a priority. That’sbecause few of the multinational firms that have operatedthere since the 1980s have yet realized the country’simmense potential as a drug market. Frustrated by China’scomplex regulations and distribution networks, its seeminglyunenforceable intellectual-property laws, and itscomparatively low expenditures on health care, foreign playersforesee minimal near-term success in China. They haveresponded by investing cautiously in the market—manyoverly so. Most important, these players have withheldtheir most innovative drugs from the market, fearing thatChina’s traditionally weak patent protection would exposebreakthrough drugs to copycat versions and priceerosion.

Despite the challenges, however, analysis by The BostonConsulting Group indicates that China is fast becoming amajor opportunity that pharmaceutical companies can’tignore. Indeed, by 2010 we expect the country to emergeas the fifth-largest pharmaceutical market in the world,with revenues of over $24 billion more than triple itscurrent size.1 (See the exhibit “China Will Become theFifth-Largest Pharmaceutical Market.”) Such growthwould catapult China’s market, which currently ranksseventh behind the markets of Italy and the UnitedKingdom, to a position right behind the drug markets ofFrance and Germany. Driving this growth are China’s

ongoing economic development and its recent entry intothe World Trade Organization (WTO).

The most promising opportunities will emerge in the areasof greatest unmet need: innovative ethical, or prescription,drugs and differentiated over-the-counter (OTC)products. The market for ethical drugs in China, valued at$5.8 billion in 2000, will climb to approximately $19 billionby 2010. Innovative drugs will fare particularly well,commanding 30 percent of revenues and, more important,about 70 percent of the profit generated in the ethical

EChina Will Become the Fifth-LargestPharmaceutical Market

Estimated Market Size for Ethicaland OTC Drugs (U.S.$billions)

1996 Top 11 2000 Top 10 2005 Top 10 2010 Top 10UnitedStatesJapanGermanyFranceItalyBrazilUnitedKingdomSpainSouthKoreaCanadaChina

522018108.48.2

91

6.04.5

4.34.3

UnitedStatesJapanGermanyFranceUnitedKingdomItalyChinaBrazilCanadaSpain

58171711

150

116.86.76.36.2

UnitedStatesJapanGermanyFranceUnitedKingdomItalyChinaBrazilCanadaSpain

65242116

262

151410109.8

UnitedStatesJapanGermanyFranceChinaUnitedKingdomItalyCanadaSpainBrazil

8137282424

466

23171615

SOURCE: BCG analysis.

1 All market sizes are calculated in nominal local currency at 2001 exchange rates.

37

HEALTH CARE

HEALTH CARE

38

category. The OTC market, practically nonexistent todayas defined by Western standards, will grow at a compoundannual rate of 19 percent, from about $1 billion in 2000 toabout $5.7 billion in 2010.

Best positioned to fill these needs are multinationalcompanies (MNCs), which possess superior R&Dcapabilities as well as scale and experience in marketing,distribution, and sales. But if they are to become majorplayers in China, MNCs must move forward moreaggressively as changing regulations and economicsopen the window of opportunity. That means betteranticipating the needs of the market as it evolves in orderto build true local capabilities as well as relationshipswith regulators and distributors.

The Transformation in China

Several powerful forces will converge over the next decadeto transform China’s competitive landscape. First, Chinais a rapidly developing nation with a rising gross domesticproduct. As the country and its economy modernize,demand for advanced health care will increase, and withit health-care expenditures. The population will movebeyond the basic anti-infective treatments common inChina today to embrace drugs that will improve the qualityof their lives. This latter category includes medicines thataddress chronic conditions that are widely treated inalready developed nations.

Second, although China’s rural areas will remain lessdeveloped, pockets of wealth are already emerging in urbanareas such as the Shanghai Delta and the Beijing-Tianjinand Guangdong-Pearl River Delta regions. Increasedaffluence in these areas will usher in increased demandfor and ability to pay for world-class ethical and OTCdrugs. In fact, this trend is already taking shape, asevidenced by the success of Heptodin, a treatment forhepatitis B. Although not currently covered by the state,Heptodin has become a top-selling drug in China, largelybecause patients demand it and are willing to pay for it.

Third, China’s entry into the WTO in December 2001promises to bring the country’s regulations anddistribution networks in line with world-class standards

over the next five years. Among its most importantchanges in the pharmaceutical arena, the WTO agreementspecifies that China will do the following:

Enhance its protection of intellectual property rights(IPRs). China is now obligated to enforce foreign andinternational patents in accordance with the Agreementon Trade-Related Aspects of Intellectual Property Rights(TRIPS) of 1995, the most comprehensive multilateralagreement on IPRs. TRIPS mandates that drugs receiveat least 20 years of patent protection.

Reduce import tariffs on pharmaceuticals. Within threeyears of joining the WTO, China will reduce tariffs onimported pharmaceuticals from, on average, today’s 9.6percent to 4.2 percent.

Increase foreign participation in the drug distributionindustry. China has already opened pharmaceutical retailin Beijing and Shanghai to foreign companies. Withinthree years, the nation’s retail and wholesale markets willopen entirely.

Comply fully with global regulatory standards. As aWTO member, China must guarantee efficiency andquality when licensing drug companies and approving ordenying drugs. In addition, the WTO requirestransparency from regulatory agencies; this will ensurethat companies have information about regulatorydecisions that affect drug pricing and availability.

Significant changes will sweep China in the wake of itsentry into the WTO, thereby providing foreign playerswith new opportunities in health care. We focus here onthe largest of the opportunities: branded ethical drugsand OTC products.

Delivering Innovative Ethical Drugs:From Me-Too to Breakthrough

In China today, the pharmaceutical market is awash inme-too drugs, with almost all of the approximately 6,000local manufacturers producing primarily generics andcompeting almost entirely on price. Three factors drivethis glut of undifferentiated drugs:

HEALTH CARE

• The Chinese government has concentrated initiallyon basic medical needs, such as anti-infectiveproducts.

• In doing so, it has focused the state-owned localindustry on generics and hasn’t been particularlyeffective in preventing local manufacturers frominfringing on foreign drug patents.

• At least historically, new drugs in China have beenquickly copied and their price points eroded by theresulting generics. Thus, MNCs in China have foundit difficult to justify the investments required to bringnew, innovative drugs to market.

In this environment, where as many as 40 knockoffsmay compete illegally with a patent-protected drug,enforcing the provisions of TRIPS will naturally taketime. Nonetheless, we expect that within five years,significantly enhanced intellectual-property protectionand reduced import tariffs will give MNCs a greaterincentive to introduce breakthrough drugs that addressillnesses that otherwise go untreated or are treatedinadequately by existing or generic drugs. In fact, wehave found that executives at MNCs are increasinglyforeseeing a future for innovative drugs in China. Morethan two-thirds of the 35 senior executives BCGsurveyed at multinational pharmaceutical companies saidthat they expect the WTO agreement to strengthen IPRprotection.

The shift to breakthrough drugs will be further fueledby the enormity of the opportunity: the unmet need forsophisticated drugs is vast in China, and the potentialpayoff is significant. China is, after all, a nation where100 million to 150 million people carry the hepatitis-Bvirus and where neck and head cancers are moreprevalent than anywhere else in the world. China alsohas its share of patients with chronic conditionsroutinely treated in the West, such as high bloodpressure, high cholesterol, diabetes, depression,osteoporosis, and arthritis. In addition, AIDS is justbeginning to be acknowledged in China, and demand isemerging for the pharmaceuticals used to treat thedisease and its related complications.

Differentiating OTC Products for Consumers

Like branded ethical drugs, OTC medications aresignificantly underrepresented and often misunderstoodamong the Chinese today. That’s because OTC drugstend to be dispensed and reimbursed as prescriptionmedications, are not widely available for purchase, andare not marketed. Many Chinese also have a strongattachment to traditional home remedies.

As the country phases out government reimbursementfor OTC drugs, however, consumers across the nationare likely to behave as we have already seen in China’smore affluent areas where a willingness to self-medicatewith home remedies translates quickly into demand forWestern OTC drugs. In addition, as Chinese authoritiesencourage growth in the retail pharmacy arena and openit to foreign players, consumers will gain an outlet (whichthey currently lack) for selecting and purchasing OTCdrugs on their own further accelerating the developmentof the OTC market. In this transformed environment, thekey to succeeding in the OTC sector will be a company’sability to market directly to the consumer.

To date, the prohibitive cost of establishing a strongOTC brand with consumers exacerbated by the lack ofclarity in OTC regulations as well as a general lack ofmarketing expertise in China has deterred most drugcompanies from aggressively pursuing the OTC sector.There are, of course, some notable exceptions, such asHarbin Pharmaceutical Group, Xian-Janssen, and TianjinSmith Kline & French. Eventually, however, we expectthat on the heels of China’s entry into the WTO, a handfulof large, international players will emerge to lead thissegment. Today that space remains open and up forgrabs.

Positioning for Competitive Advantagein China

In an increasingly competitive and global businessenvironment, multinational pharmaceutical companiescannot afford to ignore the real opportunities imminent inChina. To stake out a position in this frontier market,MNCs must pursue two goals simultaneously:

39

HEALTH CARE

40

Assemble and prioritize a portfolio of patented and OTCproducts tailored uniquely to the Chinese market. Thefirst step is to review your existing global portfolio ofdrugs. Your company may be able to meet the needs ofthe Chinese market simply by tweaking its current productoffering. You may, however, need to make a moresignificant investment in overhauling the portfolio, eitherby accelerating well-suited products still in the late stagesof development or by inlicensing promising drugs fromother players.

The best drugs for China will be those in therapeuticareas likely to experience the highest growth, includingmedicines for chronic diseases already treated in thedeveloped world. Following this logic, your companymight want to focus resources in the cardiovascular,central-nervous-system, and endocrine areas, addressingconditions such as heart disease, depression, anddiabetes.

Once the right mix of products has been identified,corporate and local resources should coordinate closelyto begin securing Chinese regulatory approval for theseofferings a process that could take as long as 48 months.Because we believe that the window for enhanced IPRprotection in China will begin to open in about 18 to 24months, it is critical that MNCs initiate this stepimmediately so they can best exploit the impendingopportunities.

Focus the head of Chinese operations on assessing andsharpening local capabilities in the sales, marketing,and distribution of ethical and OTC products. Yourmarketing capabilities in particular will become morecritical as self-pay patients and commercial insurersbecome more common. Of course, you should keep inmind that when it comes to consumer marketing, thesuperpowers in consumer products Procter & Gamble,for example may currently exceed pharmaceuticalcompanies in scale and skill. But MNCs in the drugindustry do not have to cede this space automatically.Certain drug players, for example, may determine that theythemselves possess superior skills that they can enhancefor greater advantage. For instance, companies such asGlaxoSmithKline and Johnson & Johnson are well

positioned to exploit their current strengths in marketingto consumers in China.

Other companies, concluding that they lack the capabilitiesrequired to succeed in China, can buy or borrow them.Some may gain the needed skills through acquisition, astrategy that is already being used frequently asconsolidation ripples through the industry. Still otherplayers may borrow the capabilities of others by opting tolicense their most promising products to companies thatalready demonstrate marketing prowess in China. Note,however, that another alternative building the requiredcapabilities from scratch will likely prove to beprohibitively expensive and take too long.

Ultimately, to accomplish both goals improving theportfolio of drugs and developing marketing and othercapabilities MNCs must build critical mass in humanresources, supporting their Chinese operations withworld-class regulatory specialists and marketers. Futurecontenders will need to staff up now to gain scientificand marketing expertise in all the therapeutic areascritical to China, including those that may not even berecognized there yet. Consider, for example, thatalthough cholesterol and obesity are not yet prevalentamong the Chinese, as the economy changes, diet andhealth trends will also change and so, too, willtreatment needs. Companies seeking to stake a claim inChina will also need to hire more systematically andtrain more intensively the human resources they deploy“on the ground.” Relying solely on a handful of Westernexpatriates or less-expensive and less-experienced localswill expose a foreign company to the high risk that itsfew key experts could be lured away.

Because none of these tasks will be easy, MNCs willalso need to engage their corporate and local leadershipin an ongoing dialogue about which expectations canbe realistically achieved and when. Previously,without such alignment, many corporate leaders enteredChina overly enthusiastic about the near-term potential.Once disappointed, many have since become tooconservative about investing in the market. In contrast,by understanding local realities, MNCs will view Chinamore accurately: as a burgeoning opportunity that will

HEALTH CARE

41

take a few years and some investment before itblossoms fully.

Over the next decade, as the pharmaceutical market inChina continues to evolve, drug regulations will becomeclearer, enforcement of IPRs more stringent, distributionsystems more efficient, and the country’s medical needsmore advanced. In concert, these factors will no doubtsweeten the attraction of China for drug companies andheighten the competition there. But most important, theywill also level the very playing field on which thecompetition plays out making victory more likely forforeign drug companies.

John Wong is a senior vice president and director inthe Hong Kong office of The Boston ConsultingGroup. Xudong Yin is a manager in the firm’s Shanghaioffice.

You may contact the authors by e-mail at:wong.john@bcg.comyin.xudong@bcg.com

© The Boston Consulting Group, Inc. 2003. All rights reserved.

THE BOSTON CONSULTING GROUP

Amsterdam

Athens

Atlanta

Auckland

Bangkok

Barcelona

Beijing

Berlin

Boston

Brussels

Budapest

Buenos Aires

Chicago

Cologne

Copenhagen

Dallas

Düsseldorf

Frankfurt

Hamburg

Helsinki

Hong Kong

Houston

Istanbul

Jakarta

Kuala Lumpur

Lisbon

London

Los Angeles

Madrid

Melbourne

Mexico City

Miami

Milan

Monterrey

Moscow

Mumbai

Munich

New Delhi

New York

Oslo

Paris

Rome

San Francisco

Santiago

São Paulo

Seoul

Shanghai

Singapore

Stockholm

Stuttgart

Sydney

Taipei

Tokyo

Toronto

Vienna

Warsaw

Washington

Zürich

www.bcg.comBCG