Dragons at your door: How Chinese Cost Innovation is Disrupting Global Competition Ming Zeng and Peter J. Williamson (2007)

INTRODUCTION

Chinese tool of competition is ‘Cost Innovation’, firstly by offering high technology at lower cost,

secondly by offering a wide array of choices (more variety), and thirdly by providing specialty products at

dramatically low prices (greater customization). They are redefining ‘value for money’. The companies

enter as niche and then blow up the market one after another, as demonstrated by Chinese International

Marine Containers, as the world’s largest container maker (its business slogan reads ‘learn, improve,

disrupt’). Most Chinese MNCs expand to global markets only after building strong positions

domestically, where the global players are caught unprepared. Chinese companies do this by finding the

‘loose brick’ in the incumbents’ strategy. These things could be regulations, business models, standards;

and then Chinese companies aggressively squeeze cost out of the current operations and cross the value

chain, which incumbents can’t match even after locating their production to China. Chinese firms then

move up-market to carve out a position of more sophisticated products. Cost innovation refers to both at

process and product/ component level, and continuous improvement on bought-out foreign technologies.

Further, companies like CIMC also exploited the 1997 Asian Crisis to buy out ailing Asian companies,

and its low-cost strategy resulted in subsequent exists of incumbents.

Interesting, it’s witnessed that the incumbent’s approach of moving up the market to avoid Chinese

competition is a recipe for disaster. Through continuous improvement on imported technologies, cost

squeeze outs, and investment in building R&D capabilities, Chinese companies push the incumbents first

from low-end of the market, and then from the high-end. These companies are able to spread their fixed

cost across the market categories. The graduation could be traced as: Volume Value Technical

sophistication R&D capability. Chinese companies are offering product differentiation in terms of

application of high technology to everyday products and offering a wide product lines, customization, and

specialty products- all at low cost. Chinese companies are different from Japanese or Koreans on accounts

of: 1) painful restricting that China has undergone since economic liberalization of 1978; 2) these

companies are experiencing a far more globalized world, with modular supply chains and where

economies are far more open; 3) opening early with massive FDI, trade flows, and membership of WTO

in 2001 making local firms compete with MNCs early on; 4) massive reverse migration of Chinese from

west and other Asian countries to start technology companies; and 5) huge, diverse and rapidly growing

domestic market.

DISRUPTING GLOBAL COMPETITION

Some of the unique advantages available to Chinese companies are:

Access to low-cost talent at all skill levels: Significant movement from agriculture base; children

from rural areas joining the workforce; graduates from large state ran universities; low wage rates

and inflation are well exploited by Chinese companies than foreign companies

Access to state’s assets and intellectual property at a discount: Access to state’s assets without

paying the full value in an open market; state’s drive to increase utilization of its assets formerly

underutilized in central planning age, e.g. Lenovo was founded by members of Institute of

Computing Technology, CAS in 1984, and was given full access to its science and technology

resources- an example of “state-owned, non-government run enterprises”, hence not wise to

classify Chinese companies into public or private.

Exceptional management autonomy: Greater separation between ownership and control,

whereby management is not constrained by stakeholders, giving them ability to take risk and set

long-term goals

Strong incentives to succeed; Management handsomely rewarded for financial performance,

whereby technologists are getting personally very rich in China.

However, some of the challenges faced by Chinese players include limited knowledge of potential

customers and markets overseas, weak distribution and brands, paucity of proprietary technology, limited

breadth of capabilities, and lack of management depth (p.40).

Some of the global trends acting in favor of Chinese companies include: growing popularity of

outsourcing amongst western companies (ability to get a foot in the door, esp. in auto parts),

modularization of products and services across industries (breaking of value chain, making incumbents

vulnerable, esp. in mobile phones), growing codification of global knowledge and increase

communication access (tacit become explicit), concentration and internationalization of retailing (the

Wal-Mart- Haier case, large retailers working directly with Chinese makers), more fluid international

markets for talent and professional services (availability of expats), and an open market for corporate

control (Chinese going about M&As). These features have helped Chinese companies to introduce

‘disruptions’ in terms of 1) high technology at low cost; 2) variety and customization at low cost; and 3)

specialty products at low cost.

COST INNOVATION

Focus on cost makes sense because it firstly helps unlock a huge local demand where prices are driven

below standards; secondly, by accessing low cost labor across spectrum, it helps Chinese play to their

advantage; and thirdly, it helps challenge the orthodoxies of global competition.

Some of the enablers for delivering high-technology at low-cost (offering latest technology to mass

market) are:

Leveraging low-cost R&D into the mass market: Chinese engineers and scientists are cheaper

than western counterparts, e.g. Dawning Supercomputer that produces affordable High

Performance Computing, another spinoff from CAS- Institute of Computing Technology, by

focusing on interacting between processors to get maximum yield, using clustering approach.

They jump the technology trajectory by focusing on the most neglected dimension of

performance; and then using high-technology to create less and not more sophisticated products

Betting on low-cost, disruptive technologies: Adopting alternate, emerging technologies;

leapfrogging; e.g. using direct digital radiography in place of chemically processing X-ray

images, acquired by Chinese Aerospace Science and Technology Corporation from Russian

Academy of Sciences- creating Zhongxing Medical.

Riding the open-architecture wave: Protection on proprietary designed systems is getting lost;

allowing mix-and-match of technologies/ components; Taknova creating an all-digital machine

for ultrasound scanning, building processing units on general-purpose chips; Neusoft in MRI and

Digital- X-Ray equipments; low maintenance cost

Chinese companies are able to deliver ‘variety at low cost’ by adopting the means of:

Cost innovation through process flexibility: For e.g. BYD in rechargeable battery market, a

market which was occupied by Sanyo and Toshiba. The company entered the market by betting

on inferior Ni-Cad battery technology, when Japanese moved to Li-Ion batteries. By manually

performing parts of the production process, BYD setup an assembly line at about 1/8th the cost of

Japanese competitors. This lowered the manufacturing cost, and offered much needed flexibility

to the company. After becoming a preferred supplier to several large companies, BYD moved to

Li-Ion batteries for cell phones. The key was again substitute labor for automation, and retaining

flexibility. Another example is Chint, a maker of heavy electric machinery. These companies

plow-back the savings into building process R&D capabilities

Recombinative innovation: Creating new, improved models by recombining existing ideas and

technologies in novel ways. Not trapped by ‘not invented here’ syndrome. Haier created a

washing machine combining the best of the world requirements from US, European and Asian

markets, including need for speed, water consumption and electronic control.

Some mechanisms to bring ‘specialty products at low cost’ include:

Transforming the economies of specialty products: They first identify a niche market inside

China and use their low cost to attract it, and reduce the breakeven, and build further low cost

specialty products, leveraging the R&D to get into adjacent market. These companies lower the

breakeven cost by sharing R&D across multiple specialty areas. E.g. Shinco created a profit out

of specialty market of VCDs, which was ignored by Samsung, Sony and Philips by doing low

R&D investment and not creating a new product. The company reaped its R&D investments to

get into VCD and then DVD players.

Hopping from specialty to specialty: The low breakeven points achieved by low cost R&D and

product development allows the Chinese companies to spiral into a series of specialty product

categories, while leveraging common R&D infrastructure.

LOOSE BRICKS

Chinese companies do not come from a position of resource advantage, but rather by targeting those

markets where existing players are potentially most vulnerable. Huawei used the ‘pressure point’

principle to expand strategically into areas where existing players are weak and chipping away at adjacent

area to enter into a new market. Incumbents lose share in one segment to Chinese competitors, and then

the collapse is near- it’s like knocking down few loose bricks and the wall collapses under its own weight.

The loose bricks share two features: the segment provides a potentially low source of competitive

advantage, and where incumbents aren’t capable to mounting a response. These loose bricks include: low-

end segments (by offering value for money and not just low-cost; e.g. Haier in mini-refrigerator in US

market for storing wines or with locks); peripheral geographic markets (e.g. African countries; e.g. Lifan

in motorcycles market, or Chery in cars); troublesome customers (demanding unique product variants;

e.g. Haier in customized refrigerators; Galanz in small sized microwaves; Hisense in TVs for African

market); idiosyncratic customers (getting into niche markets, and exploring sales to move laterally). In

some cases, Chinese companies even go ahead to create a niche, say in the case of TV for kid’s room

created by Haier (Frog Prince TV), whereby unlocking latent demands.

Huawei used the ‘loose brick’ strategy of targeting a series of peripheral markets and troubled customers

to get the foothold, and then moving upwards. It first served Hong Kong’s Hutchison Telecom on number

portability, followed by Motorola in Vietnam, and later persevered in Russian and African markets (based

on its capabilities of serving large dispersed population, and keeping capital costs low). The company has

been successful in serving customers with limited purchasing power and unique demands, hence helping

it build new capabilities where incumbents show little interest.

Huawei service slogan is ‘around the world close to you’. Once established in the periphery (Africa, Latin

America, and Asia), such companies quickly move to the core markets (Europe and US), by gaining

experience, volume and track record. Huawei spent close to $12 million every year in brand building

through participation in trade shows. Firms, like Huawei, have used the virtuous cost-scale-learning cycle

to move up the experience curve.

THE WEAK LINK

The dragon multinationals have their limitations too, consequently slowing down the cost innovation

driven growth of these companies. Some of the limiting factors are:

Limited size of Chinese and developing markets: Imposing limits on volume scale and

experience building before venturing out; e.g. investment banking sector; low-cost advantage

can’t be build at such low volumes

Immature industries: Where a dominant technology/ logic has not yet emerged; cost advantage

difficult to achieve in fast moving technology lifecycle; trapped by proprietary technologies.

Systemic business: Industries requiring systemic management of large, invisible value chains;

e.g. FMCG or pharmaceutical industry; where Chinese companies can’t easily ‘slice and dice’ the

value chain

Intangible assets: Brand, proprietary technology, and experience, which is slow and costly to

build; e.g. retailing industry

Hence, the Chinese strategy is least susceptible to disrupt industries where global gateways are narrow,

and impediments to cost innovation are high. However, future trends favor Chinese competitors on

account of ability to acquire foreign companies and using China’s purchasing clout to create a ‘demand

wedge’ as an alternative way to pry open global markets (e.g. by insisting foreign companies to actively

transfer core technologies to Chinese partners; e.g. in constriction of Three Gorges Dam, or aircraft

manufacturing). Further, Chinese market is growing in size (e.g. in automobile industry), and increased

product modularization.

YOUR RESPONSE

Haier’s bid for Maytag in 2005 shows the vulnerability of western business model to onslaught of

Chinese cost-innovators. Western companies make the mistake of innovation to ‘making sophisticated

products’; while for Eastern companies, innovation means ‘value for money’. Companies can’t think of

China as a source of cheap labor and huge market alone, China is also a source of deadly competition.

The application of cost innovation has moved from manufacturing, to engineering, design and even R&D,

services, distribution and brand building. Some of the suggestions for the western incumbents include:

Using cost innovation to beat dragons at their own game

Giving a global mandate for certain products to Chinese subsidiary

Allying with the dragons to strengthen their global competitiveness

However, the most formidable response would be to change the mindset about innovation, from

sophistication to that of creating appropriate value.