China offers big challenges, but huge opportunities.

Next year marks the centennial of one of the most amazing auto races ever: the Peking to Paris trial. A hearty band of wealthy European enthusiasts entered 26 motor cars, but only five vehicles set off from the Chinese capital on June 10, 1907. The 8,000-mile race forced competitors to endure harsh conditions and rugged terrain, such as muddy fields, mountains, rivers and deserts. A 45-hp chain-driven Itala won the race in 60 days-three weeks ahead of its closest competition.

Today, automakers and suppliers are flocking to China again. But, this time, the quest is for low-cost manufacturing sources and easy access to hungry new markets. Manufacturers from France, Germany, Japan, South Korea, the United States and other countries have invested billions of dollars in Chinese assembly plants.

At the same time, China's huge domestic auto industry is attempting to develop home-grown vehicles that can be cost-effectively exported to consumers in Europe and the United States. Eventually, Chinese manufacturers plan to follow in the footsteps of Japanese and Korean automakers that have successfully set up offshore plants.

"Skeptical U.S. companies should be aware that China today is not a repeat of Japan in 1950," warns Ron Harbour, president of Harbour Consulting (Troy, MI). "The Koreans learned from the Japanese and took half the time they did to catch up. The Chinese have learned from the Koreans and will cut the time in half again."

China represents a win-win for the global auto industry: a low-cost manufacturing source and a vast, fast-growing consumer market. Automakers and suppliers are scrambling to take advantage of this unique opportunity.

Although most of the news coming out of Detroit lately has been full of gloom and doom, it's exactly the opposite halfway around the world in Shanghai. For instance, Ford Motor Co. (Dearborn, MI) recently reported its biggest quarterly loss in more than 4 years. However, at the same time, the automaker announced that its sales in China rose 120 percent. While Ford is closing several factories and laying off thousands of workers in North America, the company plans to add at least 2,000 jobs in China this year.

General Motors Corp. (GM, Detroit) is also in the process of shuttering plants in North America to reduce operating costs and achieve "assembly capacity reduction." While the company's market share on its home turf has been declining, it's a totally different story in China, where GM increased its market share from 11.2 percent to 13.5 percent last year. GM expects its sales in China to increase by more than 20 percent this year. In fact, the company's China profit rose to $70 million in the first quarter of 2006 vs. $33 million in 2005.

With growth in China expected to outpace all other markets over the next decade, "there is no country that is more important for any global automaker," claims Troy Clarke, president of the company's North American operations, who until recently served as president of GM Asia Pacific.

Fast-Paced Market

China's auto industry has grown almost overnight. After being dormant for much of the 20th century, the country has become one of the world's largest markets for cars, trucks and buses. In fact, China is now the fourth largest market in terms of passenger vehicle sales, and is expected to surpass Japan by 2010 to take the No. 2 position.

John Bonnell, a partner at Automotive Resources Asia Ltd. (Bangkok, Thailand), believes that China may even catch up to Japan this year. "The industry has changed in dramatic fashion over the past 5 years," he explains. "Vehicle demand has exploded. Two key differences are the size of the market and the level of competition."

Unlike many other major automotive markets, Bonnell says China still has plenty of room for growth as consumers switch from bicycles to cars. Because of its huge population, car penetration in the country is one of the lowest in the world. Indeed, most car sales in China are to first-time buyers.

"The Chinese auto industry has seen some dramatic changes over the last 3 to 5 years, in terms of overall production expansion, price reduction, model variety and technology infusion," notes Jun Ni, Ph.D., professor of mechanical engineering and director of the S.M. Wu Manufacturing Research Center at the University of Michigan (Ann Arbor). But, to get a good perspective on current and future market conditions, Ni says it's important to take a brief history lesson.

"Starting in the early 1950s, it took 40 years to reach the annual capacity of 1 million vehicles," Ni points out. "China reached 2 million vehicles per year in 8 years, then 3 million in 2 years. It reached 4 million in 1 year, [which was only 3 years ago]. In 2005, China produced more than 5.7 million vehicles. Passenger cars accounted for 55 percent of the total market, exceeding commercial vehicles for the first time.

"These trends are astonishing," explains Ni. "The average vehicle prices have also seen a dramatic reduction over the last 3 to 5 years, partly due to World Trade Organization implementation and partly due to intense market competition. The number of vehicle models and brands has also multiplied many times over the same period.

"As the global auto industry undergoes consolidation, the Chinese [market] has experienced irrational mushroom expansion," says Ni. "These phenomenal changes have never been seen anywhere else."

Because of that dramatic growth, the Chinese auto industry is more competitive than ever. "Five years ago, the passenger car market in China was dominated by Volkswagen, which had more than 50 percent of the market," says Tianshu Xin, Asian powertrain manager in the automotive group at Global Insight (London). Most demand for cars was driven by government entities and organizations, rather than individuals.

"Today, private users are playing a more important role in the industry," explains Xin. "It has changed from a seller's market to a buyer's market. With more model offerings and dropping car prices, consumers have more choices and options."

According to R.L. Polk & Co. (Southfield, MI), there were 3.8 million new vehicle registrations in China in 2005, a 19 percent increase over 2004. And, that spectacular growth is expected to continue through the end of this decade.

"Everyone in the automotive industry is watching China for growth opportunities," says Steve Flinker, managing director of R.L. Polk's Asia Pacific division. He says the market specifically has a strong "affinity for small cars." Cars priced under $15,000 accounted for 63 percent of the market in 2005.

Popular vehicles in this segment include hatchbacks, such as the QQ from Chery Automobile Co. (Wuhu, China), and notchbacks, such as the Elantra from Hyundai Motor Co. (Seoul, South Korea), which was the top model in China last year.

The China Association of Automobile Manufacturers (Shanghai) reports that passenger car sales rose 54 percent to 1.25 million units during the first quarter of 2006. GM currently accounts for 14.2 percent of the passenger car market in China, with vehicles such as the Buick Regal and the Chevrolet Epica. Volkswagen AG (Wolfsburg, Germany) is close behind GM, with a 13.3 percent market share. Its most popular vehicles include the Bora, Golf and Polo.

The Asian market is expected to grow 10 percent to 20 percent over the next decade, while the U.S. market stagnates at 1 percent to 2 percent growth. Mustafa Mohatarem, GM's chief economist, predicts that more than 30 million vehicles will be on the road in China by 2010. Intense competition is expected to continue to drive down car prices and drive up demand.

An aggressive highway infrastructure project is also expected to spur future demand for vehicles. China currently has the second longest highway system in the world, but plans to keep building roads, tunnels and bridges until all cities with populations larger than 200,000 are linked by a continuous ribbon of asphalt and concrete. That massive project won't be completed until 2035.

Fierce Competition

Most of the world's top automakers already have assembly lines in China. However, those plants typically involve joint-ventures with government-supported domestic automakers, which adds to the overall complexity of the Chinese auto industry.

For instance, Shanghai Automotive Industry Corp. (SAIC, Shanghai) has formed relationships with GM and Volkswagen. China FAW Group Corp. (FAW, Changchun) does business with Toyota Motor Corp. (Nagoya, Japan) and Volkswagen. Dongfeng Motor Corp. (DFM, Wuhan) is a partner of Honda Motor Co. (Tokyo), Nissan Motor Co. (Tokyo) and PSA Peugeot Citroen (Paris).

Ford has been active in the country since 2001 and recently assembled its 150,000th vehicle. The automaker sold more than 220,000 vehicles in China in 2005, such as the Fiesta, Focus and Mondeo. Production volume at its Changan Ford Mazda Automobile Co. assembly plant in Chongqing has grown tenfold from an initial capacity of 20,000 units in 2003 to its present capacity of 200,000 units. Ford also operates a plant in Nanchang with Jiangling Motors Corp., and is currently building a new facility in Nanjing.

General Motors sold 665,390 vehicles in China in 2005, where its operations are among the most profitable in the company's vast portfolio. By comparison, the automaker produced almost twice that number of vehicles in the United States in 2005. This year, GM plans to sell 800,000 vehicles in China. The company has 13,000 employees in the country and has invested more than $2 billion in seven joint ventures and two wholly owned foreign enterprises. GM operates four assembly plants with its joint-venture partners, SAIC and Liuzhou Wuling Automotive Company Ltd. (Liuzhou China). It has an annual capacity of 350,000 units.

DaimlerChrysler (Auburn Hills, MI) has several joint-venture operations in China. For instance, China Motor Corp. assembles Chrysler Town & Country minivans at a plant in Yangmei. Beijing Jeep Corp., which has been around since 1983, assembles Jeep and Mitsubishi sport utility vehicles (SUVs). BeijingBenz-DaimlerChrysler Automotive Ltd. is a new operation that assembles the Chrysler 300C, in addition to Mercedes-Benz C- and E-class sedans.

Volkswagen has been active in China for more than 20 years and operates assembly plants in Changchun and Shanghai. However, its market share has shrunk from 33 percent in 2003 to less than 15 percent today. To combat those losses, Volkswagen recently announced a major restructuring of its local operations. For instance, it plans to introduce more than 10 new models catered to Chinese consumers during the next three years, such as the new Sagitar sedan. Volkswagen has an annual capacity of 900,000 units.

PSA Peugeot Citroen has also been active in China for a long time. Its DongFeng Peugeot Citroen Automobile joint venture operates an assembly plant in Wuhan. The facility is currently being enlarged to have a capacity to build 300,000 vehicles vs. 141,000 in 2005. The company recently unveiled a vehicle exclusive to China: the Citroen C-Triomphe sedan.

Honda is the largest Japanese automaker in China. It plans to sell 350,000 vehicles this year vs. 257,017 in 2005. Honda operates three assembly plants in China: Dongfeng Honda Automobile Co. (Wham), Guangzhou Honda Automobile Co. (Guangzhou) and Honda Automobile (China) Co. (Guangdong). Last year, Honda began exporting its Jazz subcompact car to Europe.

By 2008, Hyundai plans to become the first automaker to sell 1 million vehicles a year in China. It is currently building a second plant in Beijing that will have an annual production capacity of 300,000 vehicles. When the new assembly line is finished next year, Hyundai will have an annual capacity of 600,000 units in China.

Toyota has been exporting cars to China for more than 40 years, but only recently began manufacturing in that country, where it accounts for less than 5 percent of the market. But, that may soon change, as the automaker ramps up production. For instance, it recently began assembling its popular Camry sedan at a joint-venture plant it operates in Nansha with Guangzhou Automobile Group Co. (Guangzhou). The state-of-the-art plant features numerous pieces of leading-edge equipment to maintain quality standards throughout all production processes. It has an annual capacity of 100,000 units. Toyota also operates two factories with FAW in Tianjin, and plans to open a third plant there in 2007.

Supply and Demand

Suppliers are also busy setting up facilities in China. According to Neil De Koker, president of the Original Equipment Suppliers Association (Troy, MI), many auto part suppliers plan to nearly triple their share of Chinese procurement by 2010.

De Koker says just about every major manufacturer has at least one plant in the country. In fact, several assembly plants have popped up in China during the last few months alone, such as:
  • BorgWarner Inc. (Auburn Hills, MI) opened a facility in Ningbo to assemble turbochargers and transmission solenoids. The plant is the first of several operations planned for the site, which will serve as a manufacturing campus for several different divisions of the Tier One supplier. "We expect a five-fold increase in our sales in China over the next 5 years," says Tim Manganello, chairman and CEO. "[This facility ensures] that we are well-positioned to take full advantage of this growth."
  • Key Safety Systems Inc. (Sterling Heights, MI) unveiled a 240,000-square foot plant in Shanghai that has the capacity to build more than 5 million air bag modules, 2 million seat belt assemblies and 2 million steering wheels annually.
  • Trico Products (Rochester Hills, MI) opened a plant in Suzhou that can build up to 2 million wiper-blade systems annually.
  • Visteon Corp. (Van Buren Township, MI) opened a new 90,000-square meter plant in Dalian that assembles air conditioning components for a variety of automakers.

In addition, one of the auto industry's largest suppliers, Magna International Inc. (Aurora, ON), plans to build at least three more plants in China in the near future. It currently has 11 manufacturing facilities in the country.

Production equipment suppliers are also flocking to China. For instance, earlier this year, ABB Ltd. (Zurich, Switzerland) moved its robotics division headquarters from Detroit to Shanghai. According to Anders Jonsson, executive vice president, it was a strategic move because "the automotive industry still remains the largest consumer of robots today. While many of our clients in China are still international companies such as GM, Honda and Volkswagen, we are forming more and more partnerships with Chinese enterprises as they realize that the key to keep winning in the future is solid competitive strength." Jonsson claims that ABB has the largest market share in China among international robot suppliers.

ATS Automation Tooling Systems Inc. (ATS, Cambridge, ON) operates three manufacturing facilities in China. The company is currently in the process of nearly doubling the capacity of its Dongguan and Shanghai plants. "Although low-cost labor is abundant in the region, many global companies are electing to establish ‘lean automated manufacturing' processes at their production facilities in China in an effort to reduce production costs, while maintaining or enhancing product quality," says Ron Jutras, president and CEO.

Yankee Go Home?

Aside from attracting a who's who of the world's leading OEMs and suppliers, China has a huge domestic auto industry of its own. However, it is extremely fragmented, with more than 100 automakers and thousands of suppliers. Most of the automakers produce fewer than 10,000 vehicles a year. The local industry generally suffers from poor levels of quality and a lack of product development.

According to Automotive Resources' Bonnell, there are 23 Sino-foreign joint ventures and more than 30 Chinese companies offering vehicles in the region. At the same time, new domestic companies continue to enter the market. For instance, many companies that manufactured bicycles or motorcycles in the past are turning their attention to four wheels.

The supply side of the industry is even more fragmented, says Jack Perkowski, chairman and CEO of Asimco Technologies Ltd. (Beijing), the largest independent automotive components manufacturer in China. Asimco has 18 manufacturing plants in China and three in Michigan that produce a wide variety of parts, such as brake rotors, camshafts, engine blocks, manifolds and piston rings.

According to Perkowski, his company is now "focusing on bigger opportunities, with more assembly content." He claims that auto parts is a $72 billion industry in China. Perkowski also says there are approximately 20,000 suppliers in China. However, 75 percent of them are private companies that are very small and average less than $4 million in annual revenue.

By 2010, Perkowski says the playing field will be level in terms of technological capability between China-based and non-China-based suppliers. "While the technology gap is narrowing, American firms still have an advantage," he points out. Chinese suppliers especially lag behind when it comes to quality. For instance, Perkowski says Ford has 90 suppliers in China, but only 15 have achieved Q1 status.

"But, the supply base in China will get better and better over the next 5 to 10 years," predicts Perkowski. "In addition to quality, emissions is a big challenge to China's auto industry."

"We expect the industry to fragment further in the short term, as the Chinese partners of the joint ventures begin to bring to market new models developed by themselves," says Bonnell. "SAIC, FAW and DFM are all working on their own models."

For example, SAIC plans to begin exporting cars under its own brand by the end of this decade. The automaker expects to launch more than 30 models between 2007 and 2010.

"SAIC and FAW have a significant chance to be major players in the world car market," says Perkowski. "But, first they'll become formidable competitors in the truck and bus segment."

"In the longer term, which is difficult to estimate due to the lack of transparency with respect to government subsidies and other types of support, the industry will definitely consolidate," adds Bonnell. "Margins are falling, profits are falling and return on capital is also falling. The Chinese do not necessarily worry about an unhealthy industry. The Chinese would like their own auto industry, and could push for a profitless industry, which would encourage foreign companies to go home."

Indeed, the Chinese government recently announced that it is considering stricter approval requirements for new joint ventures, due to "overcapacity" in its auto industry. The controversial policy would force foreign automakers to hand over designs and production equipment to their Chinese partners.

"The biggest challenge facing the auto industry in China is its ability to develop its own products," says the University of Michigan's Ni. "Almost all vehicles produced in China are designed outside China or licensed to be produced in China through either joint-venture or license. In a few cases, vehicles are copied almost part by part."

A government mandate that takes effect this month requires all vehicles built in China to contain a certain amount of domestic parts. "If total cost of imported components accounts for 60 percent or more of a complete vehicle's retail price, it will be regarded as an import," explains Global Insight's Xin. "Vehicles that do not satisfy the new rule will be burdened with a 25 percent tariff rate instead of a 10 percent tariff rate for imported components."

Xin says it has already had a big impact on some luxury brands that have low production volumes in China. "For instance, with low demand and most parts imported to China, GM has decided to stop building Cadillacs [there] because the automaker has to pay an imported vehicle tariff [despite the fact that the cars are built in the country]," says Xin. "Some other OEMs may follow in its footsteps.

"China's government doesn't want international OEMs to make China an assembly base," Xin points out. "By doing that, the government wants to increase the technology content and competitiveness of the [local auto] industry."

Chinese Plants Are Different

Some of the newest auto plants in the world are located in China. While they often look similar to their counterparts in Europe and North America, their infrastructure is usually less advanced.

"Factories in China come in all shapes, sizes and technological degree of advancement," says Automotive Resources' Bonnell. "The joint-venture companies are a mixed bunch, some equipped with the most advanced equipment, others less so."

"Some large joint-venture firms have fairly sophisticated factories that use advanced production technologies," adds the University of Michigan's Ni. "However, the typical assembly plant in China utilizes less automation to reduce investment costs.

"Much of the subassembly work is performed by manual operations with the assistance of simple fixtures or jigs," adds Ni. "In critical operations, robots are utilized to perform painting and welding applications."

For instance, Toyota's new joint-venture factory in Nansha has more than 260 state-of-the art robots, but its level of automation is only 54 percent, which is well below the 80 percent to 90 percent that's typically found in assembly plants in Japan, Europe and North America.

The Harbin Hafei Motor Co., a small automaker that specializes in minivans, installed automated production equipment in its factory in Harbin several years ago. However, it discovered that the facility was less efficient and less flexible than an older plant located nearby, where assemblers use hammers and other hand tools.

The Chinese auto industry has historically been less automated than elsewhere in the world, since labor costs are lower. Indeed, car seats and windshields are often lifted into place by hand in China. On many assembly lines, it's not uncommon to see racks of parts pushed by hand. In fact, most assemblers in China don't even own cars.

Continental AG (Hanover, Germany) employs 1,000 workers who assemble tire sensors at a plant in Shanghai. However, the company also has a sensor plant in Ingolstadt, Germany, that is fully automated. The only difference between the two facilities is a failure rate of 2 parts per million in China vs. 0.8 in Germany.

"In general, the infrastructure in China is slightly less developed than in North America or Europe," says Andrew Booler, director of sales for the Asian region of ATS. "However, there is a wide spectrum of automotive production facilities. At one end of the spectrum, there are high-end production facilities with levels of automation similar to what would be found in North America or Europe. On the other end of the spectrum, there are facilities using very low quality or very manual production tools."

Booler says nut-running is a good example of an assembly process that is typically done manually in China, but is automated in Europe and North America. "Climate control of production facilities is starting to become more common, but is still the exception rather than the norm," he adds. "Seasonal fluctuations in temperature and humidity can cause a number of issues with critical production tools."

But, that's slowly starting to change, especially since the competition has intensified. Automakers and suppliers are being forced to improve productivity to be more price-competitive.

"In terms of productivity and efficiency, auto plants in China still lag behind those in developed countries," notes Global Insight's Xin. "Historically, low labor cost and less competition in China contributed to it. With intensified competition in the past few years, OEMs are looking at ways to improve productivity and efficiency.

"For instance, FAW is trying to establish a supply chain system including modularization and just-in-time delivery," explains Xin. "FAW aims to improve its productivity and reduce its cost in a more and more competitive market."

Piracy Problems

Foreign OEMs and suppliers are faced with a long list of challenges in China. In addition to obvious differences in language and culture, the auto industry also faces several other hurdles. For instance, Boolers says progress is often constrained by the growing gap between the demand for engineers, technicians and other individuals, and the available supply.

"The rush to China poses opportunities as well as problems," warns Wim van Acker, managing partner and director of North American operations at Roland Berger Strategy Consultants LLC (Troy, MI). For instance, he says low productivity levels remain a major issue.

"Though increasing, productivity rates in China are expected to remain far below productivity levels in most Western or even Eastern European countries for the foreseeable future," van Acker points out.

"Generally, there is still a gap in productivity and efficiency of auto plants in China compared to other regions of the world," adds Booler. "This difference is primarily due to training and lack of strong experience with modern production management and quality processes. This gap will narrow very quickly as training of workers and experience in advanced manufacturing techniques and processes, such as Six Sigma, improves."

In addition to productivity, intellectual property issues in China are a major concern for many automakers and suppliers. A recent study by Roland Berger discovered that 56 percent of all vehicles in China are equipped with counterfeit components.

"Chinese automakers are extremely weak in R&D capability," claims van Acker. "They tend to copy or buy technology instead of building up from inside.

"Industrial piracy and counterfeiting are among the major risks faced by companies doing business in China," adds Mahesh Lunani, a partner at Roland Berger. "Piracy of one kind or another is infused throughout the Chinese economy and it will likely get worse before it begins to get better. Most batteries produced in China, for example, are fake versions of established brand names."

Andreas Mai, a principal at PRTM Management Consultants (Mountain View, CA), says automotive manufacturers can take several steps to protect their product designs and production processes. For instance, he advises carefully choosing what components to outsource in China.

Mai says it's important to avoid complex, highly innovative parts. "Only source components that have reached maturity in the marketplace," he explains. "Only source components with little design know-how."

It is also important to "break up the puzzle and avoid sharing the big picture," says Mai. Automakers and suppliers should break up assemblies.

"Do not source too many components from one supplier," suggests Mai. "Piece out an assembly to multiple suppliers in different regions. Also avoid giving unnecessary specifications and drawing details."

Sidebar: China Part Sourcing

Pros and ConsAn efficient, low-cost supply chain is a competitive weapon for most manufacturers today. That's why many automakers have been buying more and more parts in China. Indeed, Ford Motor Co. (Dearborn, MI) and General Motors Corp. (Detroit) are both sourcing more than $1 billion in components from China every year.

Many auto part suppliers are also turning their sights to China. For instance, industry giant Robert Bosch GmbH (Stuttgart, Germany) plans to procure more than $1 billion in components from China by 2007.

However, many suppliers have not yet realized savings objectives from sourcing in China. A recent study conducted by the Original Equipment Suppliers Association (Troy, MI) and PRTM Management Consultants (Mountain View, CA) discovered that successful sourcing in China is not guaranteed. In fact, more than half of the companies profiled achieved less than 40 percent of their sourcing goals.

"Suppliers achieving the best results tend to have been in China the longest and learned what it takes to succeed," says Andreas Mai, a principal at PRTM. "Opportunity exists for other suppliers to learn from early movers to save money faster with less risk.

"China sourcing is not a quick fix for short-term cost targets," warns Mai. "Dealing with a 7,000-year-old culture 7,000 miles away is simply complex. Winning suppliers are those with China sourcing efforts based on a solid strategy, determined leadership, sufficient investment in a ‘Chinese Chinese' purchasing office and local technical support."

According to Mai, many successful suppliers invested more than 5 years of time and learning to successfully leverage China as an effective, low-cost source of supply.

The study also found that:
  • China sourcing requires a minimum savings of 20 percent to outweigh the increased costs of logistics, quality and intellectual property risk.
  • Savings vary widely, even within similar commodities.
  • A remote "test the waters" approach is bound to fail.
  • Highest savings were achieved by suppliers that deployed an integrated China strategy as part of Chinese market expansion or global product management.
  • Leading suppliers built a local presence and established critical mass of at least $10 million to $20 million.
  • Sustainable China sourcing results require high investment in local supplier development, in addition to technical and quality support.
  • Early adopters achieved the highest savings rates, shorter procurement lead times, and lower quality and supply chain risks. But, the learning curve was 6 to 10 years.