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An Industry in the Course of Major ChangeJuly/August 2006China-Britain Business Review

China offers some of the lowest manufacturing costs in the world but China's principal competitive advantage – low labour costs – can be quickly eroded by logistics costs that are often double to quadruple those in developed markets and where overnight deliveries can take a week to complete. Any calculation of costs needs to account for the total landed cost of ownership for procuring goods from this export juggernaut. Those procuring goods from and selling within China must make sure that they factor in the toll that logistics and handling will take on their firm's operations. Francis Bassolino and Sean Leow take a brief look at the history of this adolescent industry in China for insights into why current problems exist and how recent developments are changing the competitive landscape.

Unlike the logistics companies of today which are striving to squeeze out supply chain inefficiencies and ensure maximum profits, the importance of logistics in China was first realised as a wartime tactic to ensure survival. During the Korean War, the People's Liberation Army found that a robust logistics programme could help them withstand the constant aerial bombardments by the U.S. Some historians credit the PLA's improved logistics as a key factor in fighting the U.S. to a standstill.

Before the opening up of China’s economy in the late 1970s, the distribution of goods was centrally planned and had to flow through a rigid, state-controlled network of distributors. This top-down command and control structure led to frequent supply shortages, excessive inventory levels and low efficiency levels. Many of these historical inefficiencies haunt China’s distribution network and, as a result, the total ost of ownership in the channels is high by global standards.

As China’s attraction as a low-cost manufacturing base grew and large multinational corporations entered China in the 1980s, demand for international and interprovincial logistic providers increased. This demand, along with China’s preparation for entering the WTO, spurred the government to invest heavily in infrastructure and place logistics as a priority area for development. As the consumer goods markets began to heat up and export-manufacturers expanded their global reach, certain Chinese manufacturers, such as Haier, started to focus on how to improve their logistics and supply chain management.

China is dealing with its infrastructure shortcomings aggressively and is expected to add a quarter more roads over the next five years. It will also construct 100,000km of new rail lines, one-third of that being high-speed passenger lines. However, inefficiencies of moving goods around China linger on today. The logistics industry is extremely fragmented with more than 10,000 listed logistics providers, most of which are small and localised.

This is evidenced by that fact that there is an average of 2.3 trucks for every trucking provider. Minimal integration between various nodes in the supply chain exists and the local protectionism between regional authorities can be fierce. With limited options for nationwide trucking coverage, goods are constantly switching between trucks and subject to unnecessary handling.

Despite these deficiencies, China’s regulatory environment has been opening up and, with it, the logistics and distribution industry is undergoing immense change. Large-scale entrance of foreign players and industry consolidation are taking place and while many companies may lose out, those who strategically prepare will benefit from a rationalisation of the industry.

Fallout from consolidation

Like many of China’s fragmented industries that are undergoing major overhaul and competition from foreign entrants, China’s logistics industry is ripe for consolidation. From the three major categories of logistics players - Chinese SOEs, Chinese private companies and foreign companies - who will be forced to shut down and who will emerge as the industry leaders?

The companies with the lowest prospects for success are the small state-owned enterprises and tiny freight forwarders who took advantage of China’s patchwork transportation system and regulatory restrictions to stay in business. With infrastructure improving and the regulatory environment being liberalised, these small players will be the first to go in the continuing industry consolidation. Indeed, many of these smaller firms have already disappeared; the better companies were acquired by foreigninvested enterprises or consolidated into larger firms while many others closed shop.

The prospects for China’s larger SOEs, such as Sinotrans, COSCO and CMST, are much brighter. The Chinese government is eager to create a global leader in the logistics industry and their home country advantage allows them to mitigate local protectionism and disputes over regulations.

Pricing that is likely to be lower than many of the large foreign players and extensive transportation networks are additional advantages.

However, the learning curve for these companies will be steep as many lack experience in offering the full suite of valueadded third party logistics (‘3PL’) services. These companies will be trying to compete with global leaders that have mastered this complex service. In an effort to compete, most of the largest domestic players have already established 3PLs as separate business units within their organisation. The most advanced logistics providers are represented by joint ventures such as ST-Anda and JHJ Logistics, along with the familiar global names of FedEx, UPS, Maersk, DHL, APL Logistics, Penske and CAT Logistics.

Integrated services, such as IT capability and cost-optimisation technology, are offered by all of these providers. Foreign companies differentiate themselves with global networks, extensive 3PL experience, robust physical assets and strong brand names. Established relationships with preexisting customers add to their attraction in terms of consolidating global logistics.

Picking a long-term winner is difficult but, barring any unforeseen regulations, the best bet is on the global players who are able to identify, acquire and rationalise the best domestic players, and do it quickly. This will require a long-term, strategic outlook and the resources to implement it.

To 3PL or not to 3PL

Unless you are dealing with very high volumes, logistics should be outsourced to a reliable 3PL with a proven track record and good references Make sure the 3PL company is able to provide ‘one-stop’ logistics services so that you simplify your logistics operations under one roof Make sure your firm’s specific requirements are met by the 3PL’s service offering (i.e. warehouse is temperaturecontrolled for sensitive items; trucking service can provide delivery to second- and third-tier cities) Establish a complete list of key performance indicators to monitor the service level of the 3PL. Sample metrics include: damage rate, on-time delivery, inventory accuracy, hygiene conditions and crosscontamination rates, efficiency of locating warehoused items and service levels of delivery personnel

 

Role of the 3PL

By some estimates, logistics accounts for 40 per cent of the cost of goods sold and fourfifths of production-cycle time in China. This compares with around 10 per cent of the cost of goods sold in the US and shows the tremendous opportunity for efficiency improvements in China’s logistics industry. To facilitate greater efficiency and meet the needs of the China’s booming economy, 3PL providers will become the central players in this industry.

3PLs, by definition, offer a full range of logistics-related services that include customs clearance, warehousing, freight consolidation, inter-modal transportation and distribution. Many 3PLs also offer more sophisticated services such as ‘just-in-time’ and ‘just-in-sequence’ delivery, inventory optimisation, radio frequency identification (RFID) tracking, and a host of services to improve supply chain performance. However, in China’s adolescent 3PL industry, the top three services currently outsourced to 3PLs are still the basic needs of transportation (30 per cent), warehousing (15 per cent) and custom clearance (12 per cent).

China’s 3PL sector is currently small and penetration levels are low. Of the 19 per cent of China’s total GDP spending that is allocated to logistics, only around 5 per cent goes to 3PLs, much lower than in the US and Europe. However, as the demand for 3PLs increases in China, the market share of these full service logistics providers is forecast to increase to 20 per cent by 2010. This compares with just 2 per cent last year.

What should foreign firms consider when choosing a 3PL in China? Depending on the specific requirements of the firm, both foreign and local 3PLs offer certain advantages. In general, the advantages of a foreign 3PL are: information technology (IT) capabilities, industry experience and international networks. Those of local 3PLs are: price, local experience and familiarity with the government and regulations.

The emergence of the 3PL and China’s logistics industry will mature much the same as it has in developed markets. The difference will be in the speed that the China market plays out, as proven concepts for supply chain management and operation of 3PLs already exist.

Based in Shanghai, Francis Bassolino is managing director and Sean Leow is an associate with Alaris Consulting, an Allied Capital portfolio company that provides operational and strategic support to private equity firms and middle market companies. Contact, email: francis_bassolino@alaris.com.cn and sean_leow@alaris.com.cn

By Francis Bassolino & Sean Leow