Changes in China Sourcing

Many picture manufacturing in China as dominated by endless armies of workers toiling at low wages, but reality is far more complicated than that. China’s economic growth in recent decades has lifted many boats including those or many factory workers. This, combined with changes in currency and other factors, means that manufacturing in China is undergoing dramatic changes.  However, with the many advantages China offers in manufacturing, it is likely to remain a factory of the world.

When China first opened to the West, living standards were a fraction of those of the outside world. A seemingly endless pool of workers happy to work for wages others would reject and favorable investment laws made it very attractive to businesses looking to compete through lower labor costs. While issues such as bureaucracy, corruption and different attitudes toward business and quality often made conditions less than ideal, the benefits outweighed the costs for many willing to brave the risks.

In time, as the investment regions and supply chain developed, China become more attractive and accessible to the less brave. It became possible for more businesses to take advantage of what China had to offer, and the quality of the manufacturing improved as China moved up the supply chain and began to produce higher-value goods.

With this success came problems both from within China and without. With its massive trade surpluses, more nations have pushed China to lower them. In response, China begun letting its currency rise (most analysts say it was kept at an artificially low rate to make exports cheaper) and eliminating preferential tax treatment for exporters.

Within China, as living standards have risen, wages for factory workers have increased. This has been especially true in booming coastal provinces where factories often cannot find enough workers and must bid up wages. Workers have become more aggressive too and strikes have increased.

Also, trying to emulate China’s success, other nations have also created economic zones offering favorable treatment to outside investors and exporters. Furthermore, free trade deals the US made with Mexico and other nations has given those nations cost advantages as China’s expense.

In response, China has taken steps to encourage investment in less developed regions in the interior where labor is cheaper and in greater supply. It has also begun to move higher up the supply chain where labor is a smaller portion of production costs.

While some production has begun to shift away from China to cheaper regions or back to countries where the products will be marketed, China still has advantages that will keep it the world’s factory for many products. China has invested heavily in infrastructure and has developed an impressive network of suppliers. This, combined with decades of experience in Western markets, means China will continue to be very attractive as a place to manufacture, albeit production is likely to keep shifting to new areas and more to higher-end manufacturing.

Also, average wages, particularly in the less-developed regions, will remain low by Western standards for the foreseeable future.  No other nation can offer the kind of labor resources and infrastructure that China currently does. For these reasons, China will remain a manufacturing force to be reckoned with. However, exactly what kind of a force it will change into remains to be seen.

Sourcing and the Size of Production Runs

When sourcing an order with a Chinese or other overseas factory, a major decision is the size of the production run. Numerous factors need to be taken into consideration when deciding the size of an order. The following is a look at some of these factors.

The amount that can be invested in production is an obvious factor. With economies of scale, it is best the place the largest order one can afford to get the lowest unit cost. Up to a point, the larger the order the lower the unit cost. Also, shipping and other costs tend to be less when ordering in bulk. Shipping by full container gives the best rates. These factors need to be balanced with storage costs, projected sales and the amount the organization buying the product wants to invest.

One factor when deciding the size of a production run is trust in the manufacturer. Sampling is not always a clear indication of the quality of work a factory will ultimately produce. Until the manufacturer has demonstrated they produce quality work on a consistent basis, it is prudent to limit exposure in any single production run and source in smaller quantities.

Time will also dictate how large a production run should be. When time is limited, it is sometimes necessary to do a run that is smaller than would otherwise be optimal.

Setting up a production run requires time and money. Machines and parts often need to be purchased, workers trained and factory floor space set aside. If the manufacturer does not believe the order quantity will generate enough profit to make the production set-up worthwhile, they will simply refuse to take the order. Therefore, while there are a few products that can be ordered by the hundreds, the vast majority require production runs in the thousands, tens of thousands or more. Size of Production Runs

Suppliers are also often a factor. Buying on the open market is usually considerably more expensive, so materials need to be purchased in bulk from suppliers. Even if a manufacturer is willing to do a smaller run, they may have to purchase materials in much larger quantities than needed for the production run. Since manufacturers are rarely willing to store materials, any leftover materials will be considered waste and will add to unit costs.

The type of product is also a major factor to consider when deciding on the quantity of product to order. Some products, such as plastics, need molds and therefore require some of the largest production runs. Not only does the mold need to be produced, which usually requires a significant investment, but the materials for the plastic must be purchased in bulk. Furthermore, machines need to be set-up to produce the mold.

Molds and tooling are major factors in determining production runs. Since they usually require a significant investment, a larger order quantity may be needed to allocate the set-up costs over more units. If the purchaser is planning future orders to recoup these costs, they should stipulate they will own the tooling.

On the other hand, products such as bags are easier to source and their production runs tend to be less complicated to set-up. They can sometimes be ordered in much smaller quantities.

While every product is different, carefully considering these factors will help in deciding the quantity of a product to order with the factory.

VAT and China Sourcing

Since a nation’s value added tax (VAT) has a direct impact on price and profits, it is important to understand the VAT of the country where manufacturing and products are sourced. The following describes China’s VAT and how it affects China sourcing.

The mechanics of the VAT and its application to China sourcing
While VAT works differently in various countries, it is basically a tax paid on the value added to a product as it moves down the supply chain to the end user. For example, the raw materials for a widget are purchased by a manufacturer and a tax is paid. Then, when value is added to the materials by turning them into a widget, a tax is paid on the added value. Finally, a tax is paid on the additional added value of the widgets when they are sold to the final consumer.

For example, if the VAT is 10% and the manufacturer pays $50 for materials, then $5 is paid to the government. If the manufacturer then sells the widgets for $80, a total of $8 will be paid to the government ($3 additional dollars because $5 was already paid). If the widgets are next sold to the final consumer for $100, the government will have collected a total of $10 (an additional $2 since $8 has already been paid). VAT can also be viewed as a type of sales tax that is paid in part before the goods reach the final end user. Because the tax is paid periodically during the production/sales process, it is more difficult to avoid than a regular sales tax.

In China, the VAT rate is 17% on most goods. However, the government often refunds at least part of the VAT when the goods are exported. The amount refunded varies with the product, and the Chinese government uses the VAT as a tool to influence industry. Usually, the refund is highest on those goods for which the government wants to encourage production (e.g. higher value-added products) and lower or non-existent on products the government is less interested in having China manufacture. An example of this was seen in 2007 when the VAT system was changed and VAT refunds for many high-energy, high-polluting goods were greatly reduced or eliminated.

In its most simplified form, the VAT refund for an exported product works as follows. If the VAT rate is 17%, and the refund rate is 10%, and a $17 VAT is paid, then $10 would be returned to the exporter while the government would keep $7.

The importance of understanding VAT when importing
Importers who do not understand the VAT system are exposing themselves to the following potential problems and extra costs:VAT China Sourcing

  • The best pricing starts with transparency. When breaking down pricing, comparing suppliers and negotiating, it is critical to know the supplier’s true cost. Without an accurate breakdown of costs with the VAT rate clearly stated, the supplier has more room to manipulate the price.
  • Some manufacturers may not tell the purchaser about the VAT refund or they may tell the purchaser the refund was at a lower rate that they actually received and then will pocket the difference (it is also sometimes possible to negotiate the customs classification and therefore the VAT rate). To fully obtain all cost savings due through VAT refunds, every importer needs to be fully aware of the classification and rebate for the products purchased.
  • If a manufacturer lacks the proper import-export rights or VAT processing abilities, they may be forced to rely on third parties who will likely inflate the price and make the relationship with the manufacturer more complicated.
  • In a gray area of the law, some suppliers are able to avoid the VAT for smaller orders. While this will give the purchaser a lower price in the short term (although this increases the risk the goods will be trapped in China without proper documentation to export them), the importer will suddenly be hit with the tax when their business grows and the order size reaches a point where the VAT cannot be avoided. The tax increase will likely be greater than any discount from larger order quantities.

Therefore, when doing business in China or any nation with a VAT, is imperative to know the classification and VAT for every product and ask the supplier to outline their VAT policies. Doing so will enable the purchaser to avoid unexpected costs or other problems while getting the best price possible.