Rethinking profitable growth - the productivity imperative for foreign multinationals in china

Rethinking profitable growth Page 0

Rethinking profitable growth

September 2012

The productivity imperative for

foreign multinationals in China


A detailed look at productivity

► Rethinking profitable growth is part of a major

program of research on productivity in China

► Ernst & Young and the Economist Intelligence Unit

(EIU) surveyed C-suite and senior managers from

over 200 foreign multinational corporations in

China between March and May 2012

In the business environment that is now emerging

in China, companies have an increasingly urgent

need to raise productivity if they are to maintain

profitable growth.

Our view


Foreign multinationals remain profitable …

3%

13%

7%

49%

50%

51%

48%

39%

31%

37%

41%

9%

6%

5%

11%

Overall

Less than 5 years

5-10 years

More than 10 years

Company’s number of years in China

4%

3%

41%

53%

41%

38%

14%

7%

Services

Industrials

Negative Less than 10 percent 10 to 20 percent Over 20 percent

By sector

• 97 percent of

foreign

multinationals

reported positive

profitability

• Time in China was

a key determinant

of profitability

• Services industries

proved more

profitable,

suggesting that the

shift toward a more

services-driven

growth model has

already started to

happen

For the last full financial year, what was your company’s approximate

EBITDA margin?

Source: Ernst & Young; Economist Intelligence Unit.


… but past performance is no guarantee of future success

How does your company’s current EBITDA margin compare to two years ago?

35%

20%

27%

30%

33%

40%

45%

50%

59%

29%

45%

33%

20%

13%

28%

36%

27%

24%

36%

35%

40%

50%

53%

32%

18%

23%

18%

Overall

Healthcare

Telecommunications

Consumer goods

Retailing

Chemicals

Professional services

Information technology

Manufacturing

The margin has decreased The margin has stayed roughly the same The margin has increased

• 59 percent of respondents in the manufacturing sector reported decreasing margins compared to two years ago

• IT, professional services, and chemicals have not done well, suggesting a relative decline in overall corporate demand and in industrial activity

• Retailing is a strong performer, followed closely by consumer goods



What’s different now?

-40%

-20%

0%

20%

40%

60%

80%

100%

2007 2008 2009 2010 2011 2012

ye

ar-

on

-ye

ar

gro

wth

Europe

2007 2008 2009 2010 2011 2012

North America

-40%

-20%

0%

20%

40%

60%

80%

100%

2007 2008 2009 2010 2011 2012

ye

ar-

on

-ye

ar

gro

wth

Asia

2007 2008 2009 2010 2011 2012

Other

• China’s export growth has slowed significantly since 2010

Export growth by geography

Source: General Administration of Customs, Ernst & Young analysis.


3.5 4.1 4.1 3.3

4.8 5.8

7.2

2.7 2.1 3.5

0.5 0.3 0.3

0.3

0.2

0.2

0.2

0.1 0.2

0.2

4.3 4.7

5.6 6.5

6.3

6.8

6.9

6.8 7.0

6.9

0%

2%

4%

6%

8%

10%

12%

14%

16%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Accounting for China’s growth

Total factor productivity Labor Capital GDP growth

What’s different now?

Source: National Bureau of Statistics; Ernst & Young analysis.

• Productivity growth has

fallen

• Earlier rounds of market

liberalization and

privatization have largely

run their course

• The mass reallocation of

labor from low productivity

agriculture to higher

productivity manufacturing

is coming to an end

• The size of China’s

workforce will begin a long-

term decline from 2015

• Very rapid growth in capital

stock without productivity

growth leads to a decine in

capital efficiency, and

eventually inhibits growth


Productivity is firmly on the government agenda

12th five-year plan targets

7.0%

GDP growth

2010 2015

10.3%

Urban disposable income (CNY)

10,109

26,810 80.9

68.0

Energy consumption per GDP (TCE/CNY millions)

1.75 2.20

R&D as percentage of GDP

870

Minimum wage standard (CNY)

1,603

Service sector value-added output as percentage of GDP

43.0% 47.0%

8.33

6.91

Carbon emissions (billion tonnes) Strategic emerging industries as percentage of GDP

3.0%

8.0%

Labor

• Raise urban disposable

income

• Gradual increase in social

welfare benefits and minimum

wage

• Pressure to boost labor

productivity

Resources

• Increase carbon and energy

efficiency

• Reduce water and land use

per unit of GDP

• Pressure to boost resource

efficiency

Go

vern

men

t C

om

pan

ies

Innovation

• Movement up the value

chain for the entire

economy

• Supported by an increase

in R&D spending

• Incentives for innovation

Growth

• Lower growth, but more efficient and

sustainable

• Shift away from capital-intensive

industrial production

•

• Move to targeted, efficient growth

Source: National Bureau of Statistics; Ministry of Human Resources and Social Security; Xinhua; Reuters; Ernst & Young analysis.


91%

9%

Yes

No

Has the importance of improving productivity increased in the

past two years?

How important is increasing productivity to your company’s

performance in the next 1-3 years?

26%

58%

16%

0.5%

0%

Extremely important

Very important

Somewhat important

A little important

Not at all important

Companies overwhelmingly acknowledge the importance of productivity

• Nine out of ten respondents

said that the importance of

improving productivity has

increased in the past two

years

• 84 percent said productivity

is either “extremely” or “very”

important to business

performance in the next 1-3

years



A focus on profitable growth

47%

35%

33%

29%

24%

23%

21%

18%

16%

8%

Introduction of new and better products/services

Increased productivity

Restructuring of current operations

Hiring of new talent/management of existing talent

Increased focus on research and development

More sophisticated pricing management

Better use of outsourcing/subcontracting

Geographic expansion into new/more profitable markets

Exit from certain less attractive markets

Undertaking mergers and acquisitions

What areas could have the most impact on company profitability in the next 24 months?

• Foreign multinationals are focused capturing growth segments in the China market with targeted products

and services whilst reducing inputs for every dollar of revenue generated

Respondents were asked to choose up to three.



Companies are already feeling the pressure

• The current

environment is

characterized by rising

cost pressure,

intensifying

competition, and

continuing volatility in

global markets

• Foreign multinationals’

concerns about labor

and commodity costs

reflect what has been

happening in the

market

50%

32%

27%

27%

22%

22%

22%

21%

19%

2%

Labor costs

Exchange rate movements

Commodity costs

Cost of capital

Energy costs

Regulatory costs

Reduced demand

Other, please specify

What drivers are having the most impact on your company’s

overall cost structure and profitability?

Rising input costs


Competition from domestic

companies

Competition from foreign

companies



Companies are already feeling the pressure

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

220%

2007 2008 2009 2010 2011

Weighted cost indices, China domestic (Jan 2007=100%)

Labor Soft commodities Metals Energy

100% Labor

77% Energy

19% Metals

60% Soft commodities

Cost increases

since 2007

Source: National Bureau of Statistics; National Development and Reform Commission; United States Department of Agriculture; United States Geological

Survey; BP Statistical Review of World Energy; Ernst & Young analysis.


We expect these cost increases to continue

► The roll out of mandatory employer social welfare contributions,

accompanied by government targets to increase the minimum wage,

rising expectations from employees, and the increasing cost of living, will

undoubtedly put continuous upward pressure on labor costs

Labor

Commodities

Volatility

► The price of commodities, generally lower in China than globally, will also

continue to rise in the medium term as the Chinese government removes

administrative controls. Commodities prices are likely to remain volatile,

and will be subject to spikes and sharp corrections depending on global

conditions

► Volatility in global markets itself also imposes a significant cost upon

companies, who must hedge against uncertain movements in prices.

These costs especially impact on firms that source components and

raw materials internationally

1

2

3


43%

42%

12%

3%

1%

None or very little

Less than 33 percent

Between 33 to 66 percent

More than 66 percent

All

What percentage of rising costs do you expect your company to be able to

pass on to your customers?

Nowhere to pass on costs

95.00

100.00

105.00

110.00

115.00

2008 2009 2010 2011

Input/output price growth ratio, manufacturing

• 85 percent of

respondents expect

they can pass on at

most a third of rising

costs to the final

customer. There was

remarkably little

variation between

industries in the extent

to which they could

pass on rising costs

• In manufacturing, for

example, input prices

have consistently risen

faster than output

prices. The gap

between the two has

increased from an

average of 4.5 percent

in 2009 to 10.0 percent

in 2011


Source: National Bureau of Statistics, Ernst & Young analysis.

Rethinking profitable growth Page 13 Rethinking profitable growth Page 13

Case Study: McDonald’s Balancing rising costs and service standards

The cost of food, utilities, and occupancy all

impact McDonald’s profit in China, but it is the

cost of labor which has emerged as the

leading consideration. McDonald’s staff have

seen their real wages rise steadily throughout

the past decade, culminating in a 15-17

percent increase in 2011.

McDonald’s also monitors the external

environment to gauge customers’

expectations around level of service and at

what price points. Year-on-year, the company

is only able to recover a fraction of rising

input costs through pricing. Like many of its

competitors in the fast food industry, it has

had to keep its annual price adjustment to low

single digits.

For McDonald’s, the balance between rising costs and

maintaining standards of customer service lies in

productivity improvements.

“The main driver of success for us has always been our ability to run our

restaurants efficiently – the number of customers served per hour of labor.”

-- Dan March, CEO of McDonald’s China


Please indicate your level of agreement with the following statements.

36%

23%

19%

28%

37%

43%

21%

21%

29%

14%

16%

8%

3%

4%

2%

Strongly agree Agree Neither agree or disagree Disagree Strongly disagree

Our company’s current operating model impairs our competitiveness.

Our company’s operating model does not allow us to keep pace with rapid growth.

We need to overhaul our organizational structure in China to tap new opportunities.

Concern about operating model alignment


• 64 percent of

respondents agreed

that their company’s

operating model

impaired their

competitiveness

• Productivity should

be understood in its

widest sense –

improving

processes and

organization within

a business

• This requires a

competitive

operating model

suited to the fast

pace of the

domestic

environment in

China

Please indicate your level of agreement with the following statements.


More productivity gains will come from front office

45%

37%

23%

21%

16%

14%

6%

1%

Operations

Marketing and sales

Research and development

Finance

IT

Customer service

HR

Other, please specify

In your opinion, which functional areas in your company offer the

most scope for productivity improvements over the next 24 months?

Respondents were asked to choose up to two.

• operations (45 percent), and

marketing and sales (37

percent) are the two

functional areas that offered

the most scope for

productivity improvements

• These two areas are also

traditionally the biggest in

terms of cost, where

productivity initiatives

usually have the biggest

impact.

• many foreign multinationals

have already achieved

gains from back office

initiatives, and it seems that

they are new moving the

focus of performance

improvement programs to

the front office



Case Study: Li & Fung Moving the productivity focus to front office

Shared service center model:

centralizing finance, human

resources, and IT functions to

reduce back office costs per unit

of output.

Move the productivity

focus from back

office to sales and

marketing.

“For the next few years, technology is what we will focus on, because

outsourcing and shared services has been a model which we’ve been using

for many years. ”

-- Herman So, Executive Vice President of Finance at Li & Fung

Many support services are

concentrated in Nanjing, where

labor costs are relatively cheaper

than first tier cities like Beijing or

Shanghai.

Introduced tablet computers

to the company’s sales force

to increase their effectiveness

and efficiency.

Conduct more business

online, both for its obvious

cost advantages, and to

access the vast online

population in China.

Experiment with selling

account services to its

existing customers.


40%

39%

37%

33%

30%

30%

23%

15%

Workforce mobility tools

CRM systems

Cloud computing services

Data center capacity

Staff collaboration tools

Data analytics

Has your company adopted any of the following methods to increase

productivity?

Supply chain management systems

Enterprise resource planning tools

A failure to capitalize on information technology

• Given the potential, a

surprisingly low number of

foreign multinationals

have adopted IT initiatives

to drive productivity. More

needs to be done to

capitalize on IT

investments already

made in core business

systems such as

enterprise resource

planning

• Examples of Information

technology enabler:

Mobile internet and e-

commerce, cloud

computing, and data

analytics



Case Study: Cisco Time to capitalize on IT

The company employs common

productivity metrics globally, and

tries to limit administrative

complexity – for example by

simplifying its legal entity structure.

TelePresence is a collaboration

platform developed by Cisco to

help geographically dispersed

organizations overcome physical

barriers, and cut down on

travelling costs.

“Cisco is in the business of selling productivity tools, but we’re also a primary

user of the same technology – often before it goes to market.”

-- Michael Foy, Finance Director of Cisco China

It sees great potential in cloud

computing to raise utilization

rates while slashing IT costs by

20 percent or more.

Capitalize on IT to reduce costs and increase productivity.


Barriers to improve productivity

30%

29%

25%

25%

23%

20%

15%

14%

3%

What barriers are most likely to hamper your organization’s efforts to improve

productivity?

Shortage of labor or management talent

Inappropriate business model

Unclear accountability

Lack of communication between management

and workforce

Overly centralized control by home country

headquarters

Excessive government

regulation

Lack of access to up-to-date productivity

information

Incompatible information systems

Other




The top 5 productivity initiatives among top-performing MNCs:

49%

48%

45%

38%

33%

32%

39%

29%

24%

18%

Business unit strategy reviews

Improved people development and management

Cost reduction programs

Enterprise resource planning tools

Greater autonomy for regional or country management from

global/regional headquarters High performers Others

Has your company adopted any of the following methods to increase productivity?



Case Study: Ford Raising productivity on many fronts

“You have to look at every cost element, to pay attention to every line on the

income statement. You need to balance the global capacity to share assets,

ideas, and technologies, with an in-depth knowledge of local business and

employee practices. ”

-- John Lawler, CFO of Ford Asia-Pacific & Africa

Within each business unit and

region, Ford assesses

performance against its peers

around the world.

The company continues to invest

in training and development to

accelerate labor productivity in its

relatively young workforce.

Globally consolidated functions

work across geographies in a

matrix structure.

Raise productivity and aim

for global best practice.


Five lessons for foreign multinationals

► Companies should adopt strategic, cross-functional approaches to raise

productivity across the organization

► A strategy with focus and clarity is needed to avoid complexity and

wasted effort

► Companies should prioritize operational improvement initiatives that drive

productivity improvements and allocate resources accordingly

Productivity as a

strategic imperative

► Local autonomy needs to be balanced with a strong risk and controls

framework

► Companies should pursue opportunities for active mergers and

acquisition activities in China in order to increase local market presence

► opportunity to collaborate should be better explored

Operating model

alignment

► Prioritizing locally initiated cost management programs enables

management to deliver on bottom line commitments and retain more

control

► Processes ought to be streamlined and non-core functions outsourced,

while making sure that core information and expertise is retained

► Increase efficiency and flexibility of core business processes with

sophisticated techniques such as identifying cost drivers and using

analytics techniques to target cost areas

Proactive cost

management

1

2

3


Five lessons for foreign multinationals (continued)

► Management should do more to capitalize on information technology

investments

► Improve the level of compliance, ensuring workarounds are minimized

and all users are using the IT system as they are supposed to

► leverage the data generated by the IT system through the use of

business analytics and customer relationship management (CRM) tools

to improve their operational efficiency, more closely target customers,

and better predict outcomes and risks

Driving business value

from information

technology

► Boost the productivity of their employees through innovative ways to

incentivize staff, and transforming process flows so as to reduce physical

and technical barriers between employees

► Effective managers should possess balanced management skills and

sales ability, as well as the ability to manage every aspect of the P&L.

► The focus of training programs ought to put a greater emphasis on

productivity topics such as reengineering business processes, reducing

costs, and improving sales effectiveness

Enhancing people

development

4

5


Questions for management

► How well are you doing against industry and internal peers?

► Do you know how the major drivers of margin are trending in your industry

► What actions are you taking to boost productivity?

► Are there any short term cost reduction initiatives?

► Have you started to think about the longer term operational improvements that can be made?

► Does your company have the governance structures in place to enable productivity

improvement?

► Does your company have the capability for sustained productivity gains to match long-term

cost increases?

Appendix


Survey respondent demographics

37%

11%

24%

10%

17%

Global revenues

$500 million or less

$500 million to $1 billion

$1 billion to $5 billion

$5 billion to $10 billion

$10 billion or more

1%

27%

31%

41%

Headquarters by country

Europe

Asia-Pacific

North America

Other


Survey respondent demographics

6%

4%

6%

7%

7%

7%

7%

10%

10%

11%

11%

13%

Industry

Other

Financial services

Energy and natural resources

Construction and real estate

Telecommunications

Retailing

Professional services

Healthcare, pharmaceuticals and

biotechnology

Consumer goods

Information technology

Manufacturing

Chemicals

12%

4%

40%

4%

5%

29%

5%

Job title

Senior Vice President

Vice President

Director

CEO

President

Managing Director

Head of department

CFO/Treasurer

Board member

Head of business unit

Other C-level executive


Argentina

Australia

Brazil

Canada

France Germany

Italy

Japan

South Korea

Malaysia

Mexico

Poland

South Africa

Spain

Turkey

United Kingdom

United States

Venezuela, RB

0

10

20

30

40

50

60

70

80

90

0 50 100 150 200 250

La

bo

r p

rod

uc

tivit

y

tho

us

an

ds

US

D/w

ork

er

Capital intensity (K/L) thousands USD/worker

World technological frontier, 2010

China

Colombia

Egypt

India

Indonesia

Morocco

Peru

Romania

Thailand

Vietnam

0

1

2

3

4

5

6

7

8

0 5 10 15 20

Bangladesh

China, 2001

China, 2010

Philippines

Inset

China still has a long way to go when it comes to productivity

Source: World Bank, Ernst & Young analysis.


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© 2012 Ernst & Young (China) Advisory Limited

All Rights Reserved.

FEA no. 03002101

This presentation contains information in summary form and is therefore intended for

general guidance only. It is not intended to be a substitute for detailed research or the

exercise of professional judgment. Neither Ernst & Young (China) Advisory Limited nor

any other member of the global Ernst & Young organization can accept any

responsibility for loss occasioned to any person acting or refraining from action as a

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made to the appropriate advisor.

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