manufacturing future drivers of the china automotive...

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Future drivers of theChina automotiveindustry.

Manufacturing


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Dear Automotive News Europe Congress Attendee,

Greetings from Deloitte and welcome to what is annually one of most important automotive conferencesin Europe. We know how important conferences like this one are for gaining new perspectives,networking with fellow industry executives and exchanging of new ideas to address the industry’s mostpressing issues. This is why Deloitte is very proud to be the lead sponsor for this year’s Automotive NewsChina Conference in November. We cordially invite you to attend what should be a great conference onChina’s automotive industry.

Deloitte has more than 4,500 people in 10 cities throughout China. We know this market, its fast pace ofgrowth and know what it takes to achieve profitabilityable growth in China’s fast growing market.

We have attached two recent reports that Deloitte prepared on the China’s automotive market whichthat provide our insights to the challenges and opportunities faced by multi-nationals and Chinesedomestic companies.

The first report, “Sustainable Strategies for China’s Automotive Industry: Something Old, SomethingNew”, provides multi-nationals with two strategic concepts that are very relevant – one an old idea thatwe believe can be executed more effectively to drive additional impact; and the other, a new conceptthat is especially well-suited to the complexities and uncertainties in the China market.

The second report, “Export Readiness of China’s Automotive Industry: The “Ins” and “Outs” ofManagement Issues” provides the key findings of our executive survey and insights into the automotiveexport challenges and opportunities of domestic Chinese manufacturers.

We hope you find both of these reports interesting and enlightening. We believe that there are significantopportunities for both multi-national automotive companies and domestic Chinese automotivecompanies doing business in China. We hope you’ll consider joining us in Shanghai this November so wecan all discuss the opportunities and challenges of China’s automotive market.

Steve Laughman Ted LeeGlobal Automotive Leader Leader of Automotive IndustryDeloitte & Touche LLP Manufacturing Group, China

Deloitte Touche Tohmatsu


ContentsSustainable strategies for China’s automotive industry: 1Something old, something new

Export readiness of China’s automotive industry: 8The “ins” and “outs” of management issues

Contacts 25

About Deloitte 26


For further information visit www.deloitte.com/manufacturing

Member of Deloitte Touche Tohmatsu.©2006 Deloitte Touche Tohmatsu. All rights reserved.

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Sustainable strategies forChina’s automotiveindustry


Something old: sourcingfrom suppliers in ChinaSourcing from low cost suppliers in China is certainly not a new idea. All global OEMs source from Chinato some extent. However, progress in the auto industry has been slow. Recent trade statistics show thatof the US$750 billion in exports from China, only about 0.3% are in auto OEM components – severelyunderperforming the potential.

With the savings potential of 10% - 40% or more on landed cost for simple components with highlabour content, why has the progress been so slow? It has been slow because it is not easy. Companieswanting to leverage low cost sourcing in China face a number of key challenges, including:

Cost base vs. capabilities: In many cases, the better the cost savings opportunity, the more immaturethe supplier.

Diligence: Reliable information about suppliers is lacking, and thus it is difficult to determine which areworth the development investment.

Programme skills: Ability to meet the demands of international procurement ranges from fair to verypoor.

Research & development: R&D capability is limited, and what does exist may be focused on reverseengineering to learn from competitors.

Compliance: It can be difficult to establish the compliance monitoring, mentoring and controls essentialfor a sustainable procurement relationship.

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So, how can global OEMs succeed in the face of these challenges? Our work with automotive clientssuggests five major focus areas:

1. You are transforming your supply chain – not just switching suppliers – and transformationsrequire active, ongoing leadership: Recognise that switching toChinese sources represents asignificant change in the way you do business. Costs will be lower, but supplier development andmanagement more complex, and risk will be higher. Expect debates over risk-reward tradeoffs. Youwill need extensive senior leadership – without it, these debates and issues will “freeze” theorganisation, and there will be little, if any, progress.

2. Carefully select suitable products: Start with simple, labour-intensive products. As internal expertiseand supplier capability grow, move to more complex commodities. The initial buy is the beginning of apotential long term supplier relationship and investment in supplier development. Do not miss theopportunity by aiming too high.

3. Deploy significant procurement resources in China – do not try to run your China sourcingremotely: There is a lot to be done and you need to locate staff in China for supplier validation,integration, monitoring and development. OEMs that try to cut corners here have not been successful.They do not gain a deep understanding of the supply base and they do not develop supplierrelationships and capability to the full potential. Those that do focus resources here will be able tobuild key capabilities such as lean manufacturing in their supply base yielding significant competitiveadvantages.

4. Supplier capability – and therefore your risk – varies immensely in China: Make sure youconduct financial, operational, technical and social responsibility due diligence including site-visitevaluations. Recognise that reliable data will be difficult to get and you will have to be creative whenvalidating and cross-referencing it. Local resources are an absolute must here.

5. Manage, assess and monitor the impact on the supply chain, not just the “piece price”:Whilst low-cost country sourcing programmes deliver reductions in total landed cost, they can alsocause longer lead times, reduce delivery reliability, and require greater inventories. This needs to beaddressed to avoid problems that undermine the price advantage.

In summary, sourcing from China and other low-cost countries is a strategy, not a tactic. Give it thecommitment and attention it deserves and you will gain both short-term wins and long-term sustainableimprovements.

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Something new: StrategicFlexibility in the Chineseautomotive marketThose responsible for China strategic planning in global OEMs have a tough, and some would sayunenviable job. There are always uncertainties about the development of markets - demand growth,pricing and costs, competitor initiatives, etc. China presents additional, less predictable factors such asauto industry and exchange rate policies. Add to that the sheer size of the China market, and theseuncertainties drive scenarios with quite different outcomes and significantly different strategicimplications.

Nonetheless, there are strong pressures to make investments in key long lead time areas such as plant,product, and dealers. Board expectations about China exacerbate this challenge. China is either near or atthe top of the agenda, and regardless of uncertainties, decisive action is what is wanted.

What should executives do? One way to address the problem of uncertainties is to invest and cover allplausible eventualities; yet few companies can amass the resources without spreading too thin. A secondway is to invest in a superior job of predicting the future; however, studies show that even the mostthoroughly conducted forecasts usually turn out to be at least somewhat off, and they can be woefullywrong. A third is to push ahead with the expectation that the company will be agile enough to react towhatever surprises emerge; but true agility is easier said than done – especially in China – due to the scaleand long lead times involved. Overall, none of these approaches is entirely satisfactory.

To cope with this type of dilemma, Deloitte has developed and successfully applied a framework calledStrategic Flexibility1, which enables a company to compete effectively today while preparing for anuncertain tomorrow without either over-committing to one vision of the future or simply hoping for thebest.

Strategic Flexibility involves using scenarios to anticipate alternative future business environments,defining a core strategy that includes actions that will be appropriate regardless of which scenario thefuture most resembles, and applying real options concepts to make contingent arrangements forelements of the strategy that may or may not be needed. It is applying real options thinking that makesStrategic Flexibility both truly strategic and truly flexible.

The basic structure of an option – a contract which gives the right but not the obligation to purchase anunderlying asset at a pre-determined price in the future – can be applied to real assets – hence the name“real options.” Acquiring a real option can involve leasing a piece of property, buying a small share ofanother company, or funding the initial stages of an R&D project. The option price is the cost ofobtaining the asset with the ability to alter the level of commitment. Exercising the option – if desired –requires additional investment to buy the property, gain control of the other company, or commercialisethe new technology. If the assets are not needed, the company walks away with far less downside than ifthey had made a full commitment upfront.

1 For more information on Strategic Flexibility, see Deloitte publications:•Deloitte Research, Performance Amid Uncertainty in Global Manufacturing: Competing Today and Positioning for Tomorrow•Deloitte Research, Managing Amid Uncertainty: New Thinking on How to Win in a Volatile World

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Applying the Strategic Flexibility approach involves four steps – anticipate, formulate, accumulate andoperate:

• Anticipate: Identify the drivers of change and define different ways they might evolve and interact overa period of time such as five to ten years. That usually results in four or five scenarios that capture therange of most-plausible futures.

• Formulate: Define the optimum strategy for each of the individual scenarios. Then merge these plansinto a single strategy that includes two components – “core” elements (initiatives that show up on the“to-do lists” for most or all of the scenarios), and “contingent” elements (initiatives that are neededunder the circumstances of just one or two scenarios).

• Accumulate: Acquire any assets and capabilities needed to execute the core elements of the strategy.Conventional scenario-based strategy methods often stop with that. But here there is more. The nextstep is to make limited commitments with regard to those assets and capabilities that will be essential ifcertain circumstances emerge. This may also involve converting fixed commitments the company haspreviously made to more flexible arrangements. These flexible commitments are the “real options” thatprovide the right but not the obligation to move in a particular direction.

• Operate: Implement the strategy. Put the core elements of the strategy fully into effect immediately.With respect to the contingent elements, monitor the business environment and either preserve,exercise, or abandon the real options depending on whether unfolding events make it more or lesslikely the conditions that make them valuable will materialise.

Anticipate• Identify drivers of change

• Define the range ofpossible futures

• Build scenarios

Formulate• Develop an optimal strategy

for each scenario

• Compare optimal strategies to define “core” and “contingent” elements

Anticipate

Formulate

Accumulate

Operate

Operate• Implement

the corestrategy

• Monitor theenvironment

• Exercise or abandonoptions as appropriate

Accumulate• Acquire those

capabilities needed toimplement the coreelements

• Take real options oncapabilities neededforcontingent elements

Strategic Flexibility: Prepare for a future youcannot predict

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Now let’s see how this might work. If an auto company adopts the Strategic Flexibility approach for itsbusiness in China, what might be included in the plan?

First, let’s consider some potential scenarios for, say, the next 5 years. The ones below are quitesimple – many other factors could and should be considered when developing an actual corporatestrategy. However, they serve to demonstrate the key concepts:

Automobile market development: Illustrativescenarios

Exports save the day Everybody wins

Price war Giant panda

Exp

ort

mar

ket

com

pet

itiv

enes

s

Domestic market development

High

LowWeak Robust

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• “Price war”: Due to weak economicconditions in China and globally, thedomestic market is stagnant orgrowing slowly and exports are notcompetitive. The government places astrong focus on consolidating theindustry; no new licences are issued.Continued real price decline and verypoor industry profitability.

• “Exports save the day”: Domesticmarket is stagnant or growing slowlydue to slow income growth and limitedavailability of credit. However, globaleconomic growth, China exchangerates, cost structure and deliveredquality lead to strong export marketwhich absorbs the majority of excess

capacity. New licences are limited but available if vehicle design, research and development, engineplant and other key activities are localised. Local prices continue to decline but losses are offset byexport gains.

• “Giant panda”: Disposable income increases and domestic market grows at a high rate. Export marketremains limited due to high landed cost compared to alternative sources and poor quality perceptions.Prices stabilise and continued efficiency improvements lead to improved profits. New licences are madeavailable for enterprises or vehicles that “raise the bar” in the local market.

• “Everybody wins”: Both domestic and export markets flourish. Capacity utilisation is high. Newlicences are issued with very few restrictions or limitations. Profits are superior to levels in other topglobal markets.


Now let’s take these scenarios and explore two examples of how real options could be applied to strategyformulation:

• Production capacity: This is one of the easiest type of “real options” to “buy” because it is aquestion of magnitude rather than a “yes or no” decision. When building or expanding a facility, it ispossible to leave open floor space, position walls, and take other steps in designing the powerhouse,paint shop, general assembly areas, etc. so these facilities are expandable in the future. It might also benecessary to buy an option on adjacent land. Building in this flexibility definitely adds cost to the initialfacility – and often damages the economics of the specific vehicle programme(s) the plant is being builtfor. Consequently, some companies are unwilling to “buy” these options. However, the “option price”should not burden the economics of the current programme. It should be seen as a cost of retainingflexibility in the China – and global – strategies.

• Positioning a global export programme in China: This issue is more difficult because for mostOEMs it is a “go/no go” decision, not a matter of degree as the decision above. The nature of theoption here could be to hold open for as long as possible the production location(s) of the new vehicle.If common processes exist across plants, the OEM could move forward with many long lead timeitems – e.g., concept design, presses, tooling, etc – while still keeping the final location decision open.An option on a site and potentially some investment in site improvements might be appropriate. Inaddition, it may be necessary to “reserve” capacity with partners and key suppliers – and/or to offerthem part of the opportunity independent of the final production site choice.

These illustrative examples demonstrate the application of the Strategic Flexibility approach in the autoindustry context in China. They also provide a contrast with approaches that try to cover every future,predict the single right future, wait and deal with inflections as they occur, or hold off preparationswaiting for evidence of future outcomes. Finally, we hope they give a sense of the type of dialogue thatmanagement should be having about the range of potential future scenarios, and the core andcontingent strategies to respond to these scenarios.

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3 6

Export readiness ofChina’s automotiveindustry


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Deloitte's Global Manufacturing Industry Group serves 88% of the manufacturng companiesas well as 33 of the 37 automotive companies on the Global Fortune 500 and rgularly conductsand publishes new research. In early 2006, Dloitte China's Manufacturing Industry Groupsurveyed senior executives of automotive companies in China. The survey aims to see howautomotive companies are responding to the opportunities and challenges in the exportmarket, especially in light of the promulgation of the Policy for Development of AutomobileIndustry issued by the National Development and Reform Commission in 2004 whichencouragers the growth of Chinese automobile exports into international market.

The observations and findings of Deloitte China’s 2006 Automotive Industry Survey onExports are presented in Sections I to V below. In Section VI, we explore the implications ofthese trends and discuss several management strategies companies can adopt to improve theircompetitiveness in the export environment.

Deloitte's Global Manufacturing Industry Group serves 88% of themanufacturing companies as well as 33 of the 37 automotive companies on theFortune Global 500, and regularly conducts and publishes new research. Inearly 2006, Deloitte China's Manufacturing Industry Group surveyed seniorexecutives of automotive companies in China. The survey aims to see howautomotive companies are responding to the opportunities and challenges inthe export market, especially in light of the promulgation of the Policy forDevelopment of Automobile Industry issued by the National Development andReform Commission in 2004 which encourages the growth of Chineseautomotive exports into international market.

The observations and findings of Deloitte China's 2006 Automotive IndustrySurvey on Exports are presented in Sections 1 to 5 below. In Section 6,we explore the implications of these trends and discuss several managementstrategies companies can adopt to improve their competitiveness in the exportenvironment.


In 2005, the total export value of automotive products and export volume of vehicles from Chinaexceeded the corresponding imports into China for the first time. This achievement was not only amilestone for the Chinese automotive industry, it also demonstrated China's ambition to become a leaderin the global automotive market.

Overseas demand for Chinese vehicles has been growing, especially for light weight trucks. Domesticallyproduced luxury vehicles are gradually replacing certain imported ones. Furthermore, domestic brandsthat were formerly considered lacking competitiveness have gradually entered the international market.Ambitious Chinese automotive companies are proactively planning to expand overseas by exporting tomainstream automotive markets in Europe and North America.

The increasing number of international parts and component manufacturers entering or expanding inChina fueled the growth of both the domestic market size and export volume. And, these internationalmanufacturers have enhanced and improved the industry's structural capability allowing for gradualintegration into the global market.

Only a few years ago, there was a general concern that China's accession to the World TradeOrganisation would have a grave impact on the domestic automotive industry, but market developmentshave proved otherwise. Was it luck? Or are there risks that have yet to surface? To explore this issue,Deloitte China conducted a survey of senior executives in the Chinese automotive industry. We hope toprovide a better understanding of the current state of the development of the Chinese automotiveindustry, the export related challenges Chinese automotive companies face, and future trends for exportsof automotive products.

1. Preface

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2. Summary• The Chinese automotive market has grown rapidly. The passenger vehicle segment has been and will

continue to be a key driver. Competition is intensifying in a dispersed and fragmented market.Domestic brands are gaining an increasingly important market position.

• Sales of Chinese-made parts and components have been growing steadily year on year, and comprisean increasing share of the domestic automotive market. Foreign invested entities, includingSino-foreign joint ventures, as well as domestic producers continue to increase their presence in themarket. Increasing competition has resulted in lower profits.

• Exports of Chinese automotive products have continued their strong growth. The number of vehiclesexported exceeded the number of vehicles imported for the first time in 2005 and there was a breakthrough of exports of local brand vehicles.

• Export sales as a percentage of total sales has been growing at an increasing rate; about half of thesurvey respondents predicted that by 2010, export sales would account for 25-50% of their total sales.

• A majority of the automotive parts and components companies responded that North America andEurope are their priority target export markets; and 45% of the survey respondents predicted that by2010 exports to the American market would reach one-third of their total export volume.

• A majority of survey respondents believe the main factors in achieving success in exports are: quality,low cost, distribution channels and networks or relationships, brand, and meeting safety and emissionstandards. Vehicle manufacturers are more concerned about after-sales service and maintenancenetworks or relationships, whereas parts and components companies rank technological innovation asmore important.

• A majority of the survey respondents believe quality standards and certifications, cost competitiveness,after-sales service, international relationships and logistics present the greatest difficulties andchallenges for exporting their products. Because of market differences and trade barriers, qualitystandards and certifications have become the main factors influencing exports. Automotive companiesare giving more attention to international relationships and after-sales service as export volumeincreases. Due to upstream and downstream price pressures, and low technological content in most ofthe current products, a majority of the parts and components manufacturers are faced with thechallenge of reducing costs.

• To address the difficulties and challenges for exports, the survey respondents indicated differentstrategies in the near term versus the long term. In the near term timeframe of one to three years,establishing joint ventures with foreign companies to leverage their technology, brands, distributionchannels and service networks is the priority choice of the survey respondents. In the mid to long term,their selection of strategies become more diversified, but the main theme is to enhance competitivenessthrough building their own capabilities.

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1. China becomes the second largest automotive market in the worldThe rapidly growing Chinese automotive market is a critical part of the global automotive market.

In 2005, the sales and production of automobiles in China reached 5.75 million units and 5.85 millionunits, respectively, overtaking Japan to become the second largest automotive market in the world. Chinanow represents nearly 9% of the overall global automobile sales volume and 23% of the globalautomobile market growth.

The passenger vehicle segment,especially economy sedans, is the fastestgrowing segment in China. Between2000 and 2005, the compound annualgrowth rate of Chinese passengervehicle market sales was 37%. Thepassenger vehicle segment, comprisingan increasing share of total market, isnow the major driver of growth.

The Chinese automotive market isapproaching a stage of intensifiedcompetition. Multinational automotivecompanies, optimistic about China, arenow facing a market that is difficult tonavigate due to increasing competitionfrom international and domesticcompanies, unpredictable marketdemand, and lack of consumer brandloyalty.

The rapid growth of the market has provided development and growth opportunities for domesticbrands, resulting in a more fragmented market today compared to that of 2000. Japanese and Koreanbrands have gained share. Domestic brands have established key positions with combined market sharereaching 25% in 2005.

3. Industry background

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The growth of the automotive parts andcomponents segment in China is alsostrong. 2005 revenues reachedRMB216.8 billion, with a compoundannual growth rate of 15% between2000 and 2005.

The proportion of the parts andcomponents companies in theautomotive segment has also continuedto increase. By 2005, sales of automotiveparts and components have reachednearly 40% of the industry's total. Thereasons for this increase include: 1) thehistorical integrated automotivemanufacturing organisational structurehas changed and the proportion ofoutsourced subcomponents is graduallyincreasing; 2) customers are demandinga broader portfolio of products andexpecting more value to be added;

3) the global automotive parts and components companies have shifted its attention to China, with manyof them entering or expanding their investments in China.

The Chinese automotive parts and components segment is fragmented for historical reasons. There areover 5,000 companies, but only about 130 companies have annual sales of RMB100 million or more.Most lack economic substance and research and development capability.

With the gradual opening of the Chinese automotive market, Sino-foreign joint ventures and foreigninvested companies are taking up a greater share of the parts and components segment. While therewere about 28 foreign parts and components companies committed to investing in China in 2004, thenumber of foreign invested companies has reached 90 by 2005 with an agreed investment amount ofaround US$4 billion. With a large number ofinternational parts and componentscompanies gradually expanding theirinvestment in China, it is predicted that by2010 the Chinese automotive parts andcomponents segment will increase to aroundRMB800 billion.

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2. Exports exceed imports for the first timeIn 2005, Chinese automotive product exports maintained its growth to reach an overall value of US$19.7billion, representing a growth of 56% over the prior year. This growth resulted in exports exceedingimports for the first time.

Automotive parts, accessories and bodiesmake up a significant proportion of theautomotive product exports. The exportvalue of these products in 2005 reachedUS$8.5 billion, comprising 43% of totalautomotive product exports andrepresenting a growth of 51% over theprior year. Automotive parts andcomponents exports were mainly items withlow value-added, high level of labourcontent as well as raw materials andconsumables. The markets for Chineseautomotive parts and components exportsare comparatively more concentrated, andby order of value are the United States ofAmerica, Japan, Canada, Germany and Korea.Exports to the United States of America andJapan represent nearly 50% of total export.Exporting companies are primarily whollyforeign-owned enterprises and Sino-foreign jointventures, amounting to 56% of total exports.

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In 2005, total exported vehicles(including chassis) reached 170,000 unitsand for the first time, exports exceededimports. Export value reached US$1.6billion, a growth rate of 157% over theprior year. Exports are shipped to 179countries in the world – the destinationregions ranked by volume are: Asia,Africa, Europe, South America, Oceaniaand North America. Of the 170,000units exported, trucks made up nearly100,000 units, with 90% of them beinglight weight trucks less than five tons(including pickup trucks).

Exports of sedans in 2005 grew rapidly to reach 31,125 units, or a growth rate of 224% over 2004. Mostof such exports were of domestic brands. The export destinations have also started to shift from thedeveloping countries to the mainstream automotive markets of developed countries.

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To better understand the current state of the Chinese automotive exports and their future prospects, as well asthe action plans that companies may adopt, Deloitte China's Manufacturing Industry Group conducted asurvey in January 2006 of senior executives at vehicle and parts and components companies operating inChina. 50% of the survey respondents are state-owned or privately-owned enterprises, and the other 50% areSino-foreign joint ventures or wholly foreign-owned enterprises. 20% of the survey respondents are vehiclesmanufacturers and 80% of them are parts and components manufacturers.

1. Companies predicted that exports willgradually increase to 50% of overallsalesA majority of the survey respondents plan toincrease the proportion of exports in theirtotal sales. For 2006, 19% of therespondents expect exports to be 10% to25% of total sales and 6% of therespondents expect exports to be 25% to50% of total sales, representing one-fourthof the total survey respondents. Lookingforward to 2010, 22% of the respondentsexpect exports to be 10% to 25% of totalsales and 50% of them expect with exportsto be 25% to 50% of total sales,representing three-fourths of the total surveyrespondents. Based on the survey results,automotive products exports as a percentageof total sales are estimated to be on average14% in 2006, 16% in 2007, 20% in 2008,23% in 2009 and 28% in 2010, a cleartrend of rapid growth for exports.

4. Senior executive expectationsof export opportunities andrelated strategies

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2. Parts and components segmenttargets North American and Europeanexport marketsRespondents from the parts and componentsmanufacturing segment consider NorthAmerica and Europe as their primaryoverseas markets. 57% and 25% of themranked North America as their primary andsecondary overseas market, respectively,while 19% and 40% of them ranked Europeas their primary and secondary overseasmarket, respectively. And 45%, 19% and14% of them estimated the United States ofAmerica, Germany and Canada will make up33%, 14% and 26% of their export volume,respectively.


3. Quality is the number one successfactor for exportsBased on our survey, regardless of whethera company is currently exporting or not, allrespondents expressed their serious interestand expectation over the potential ofexporting their products. The main reasonscited by companies for not yet exportingtheir products are: 1) their products havenot yet been modified to meet theinternational market standards; and 2) theylack effective channels to connect with theinternational markets. When asked aboutthe five most important factors forsuccessful export activities, a majority of thesurvey respondents named quality, lowcost, sales channels and connections orrelationships, brand, and product meetingsafety and emission standards as their keyconsiderations. Vehicles manufacturers aremore concerned about after-sales serviceand maintenance networks or relationships;while parts and components manufacturersplace technological innovation as a moreimportant consideration. Sino-foreign jointventure vehicle manufacturers havedifferent views on whether to export fromtheir manufacturing operations in China.Certain foreign invested enterprises havealready begun to export or are consideringexporting their vehicles to overseas markets.Others have no current plans to do so;primarily due to their concern over sharingprofits with their joint venture partners aswell as their current production capacity notbeing sufficient to meet domestic demand.

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4. Quality standards and internationalrelationships are the most significantchallengesA majority of the surveyed automotivecompanies responded that qualitystandards and certifications, costcompetitiveness, after-sales service,international relationships, and logisticsand deliveries present the most significantchallenges to exporting automotiveproducts. Automotive companies thathave tried to export products to overseasmarkets realised that product quality is akey success factor in entering theinternational market. Currently, Chinesevehicle exports are mainly targeting themid to low-end market segments and aredeploying a low-price strategy. But it willbecome increasingly important to improvequality – striking a balance betweenacceptable quality and attractive sellingprice. With the growth in export volumeand expansion plans, automotivecompanies are paying more attention tointernational relationships and after-salesservice issues. Due to upstream anddownstream price pressures, and lowtechnological content in most of thecurrent products, a majority of the partsand components manufacturers are facedwith the on-going challenge of reducingcosts.

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5. From relying on joint venture partners to developing independent capabilitiesOur survey results indicate that to overcome the difficulties and challenges for exports, domesticcompanies plan to adopt different strategies at different stages of their export development. Formingjoint ventures with foreign companies in order to leverage their technology, brands, sales channels anddistribution network are priority actions for survey respondents in the first to third years of exportdevelopment. In the third to fifth years, or even beyond the fifth year of export development, thestrategic choices become more varied. A consistent theme, however, is on enhancing competitivenessthrough building their own capabilities such as increasing investment in serving overseas customers,establishing their own research and development capabilities, and employing overseas market experts.

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The fragmented parts and components segment in China is facing market-driven and government-encouraged consolidation pressure. Price pressure from both upstream and downstream players continues tosqueeze profits and margins of parts and components manufacturers. Continued entry and expansion ofinternational players has also increased competition in the market. Domestic parts and componentsmanufacturers that do not have a competitive advantage in technology, scale, and distribution channels willlikely be absorbed or eliminated. A few will become system integrators in select product niches. China’s partsand components segment will become part of the global supply chain, and exports of parts and componentsare expected to continue their rapid growth well into the future.

According to our survey results, parts and components manufacturers recognise that to reap the full potentialof the export opportunity, they have to continually improve product quality to meet international standards,and to maintain cost advantage. We believe that Chinese parts and components companies have theopportunity to play an increasingly important role in the global arena. In addition to quality and costs, theyshould also consider expansion to achieve scale and improve supply chain process to integrate effectively intothe global network. Multinational companies making global sourcing decision will not only compare pieceprice, but will also balance the total cost of doing business with suppliers, including efficiency in transactions.Companies should increase transparency of information both internally between departments, and externallywith vendors, partners, and even customers. An information technology system that is designed to supportbusiness operation needs can improve coordination through the entire supply chain.

A country with a highly competitive and efficient domestic market is more likely to grow into a strongexporting country. With the exception of United Kingdom and China, all of the top seven automotive marketshave their own globally competitive brands of scale and technological advantages.

After several decades of development, China’s commercial vehicle manufacturers have achieved a certaincompetitive position internationally in some low-end and niche product segments, such as light weight trucks,buses and coaches. The future for sedan exports will depend on development of a competitive domesticmarket, better understanding of export market needs, and adoption of appropriate market strategy.

According to our survey results, executives of automotive export companies place a high emphasis onestablishing joint-venture or cooperation with international partners, to leverage their sales, distribution andafter-sales service network and professional experience. We believe these are important steps for entrance intooverseas markets. In addition, because China exports have expanded from the more utility-driven light weighttrucks, buses and coaches to sedans, that their purchases are more influenced by personal choices, automotivecompanies should pay attention to creating a strong brand image. Through better understanding of marketrequirements, design and develop products catered to consumer needs, and overcome market perception of“low price, low quality” products. Internationally-recognised quality improvement methodologies, such as SixSigma, can help companies improve product quality, and even reduce costs, by critically examining qualitycontrol systems and processes.

The ‘Eleventh Five-Year Guidelines for Chinese Automotive Industry’ under discussion by governmentauthorities outline the following prospects for China’s automotive industry: a sustained average annual growthrate of 40% from 2006 to 2010; increased share of global automotive trade volume from less than 2% to10% within 10 to 15 years; emergence of 2 to 3 large automotive enterprises which will hold a 60% share ofthe domestic market and are globally competitive players. The recently announced “Notice on Speeding upthe Implementation of Restructuring of the Over Capacity Concerns in the Industry” (Guo Fa [2006] Number11) also shows the government’s intention to strengthen the industry through policies which promotestructural adjustment, consolidation, and optimisation.

China’s automotive industry still has room to grow before achieving true global competitive standing.Nonetheless, this goal is within reach if companies can adopt international concepts and implementmanagement processes to improve operating effectiveness and market competitiveness.

5. Creating competitiveadvantages in exports

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1. Trends in the parts & components segmentDomestic parts and components manufacturers face steep challenges in a competitive market. The factorscontributing to this include:

• The market is highly fragmented, and the majority of players are small in scale.

• Relatively weak product research and development capabilities in comparison with leading globalsuppliers.

• Most segments are dominated by multinationals and their joint-ventures. This is particularly the case fortechnologically intensive products.

• Most multinationals are expanding their market share in China.

• Unfavorable developments in both upstream and downstream industries have driven higher rawmaterial cost and lower component sales price. This has resulted in plunging profit margin for parts andcomponents manufacturers.

• Reduction in import customs duties for auto components and accessories.

The fragmented parts and components segment in China is facing market-driven consolidation pressure.Domestic parts and components manufacturers that do not have competitive edges in technology, scaleand distribution channels will likely be absorbed or eliminated.

Nonetheless, we believe parts and components manufacturers will play an increasingly important role inthe global market, and the segment is likely to continue their rapid growth well into the future. This trendis based on the following observations:

• Low labour cost advantage is sustainable in the medium to long term.

• Compared to other low cost countries, China’s manufacturing base is mature, there is high availability oftechnical personnel, and it has a more effective support infrastructure.

• Large size of domestic market and its continuing rapid growth.

• Manufacturers’ desire to expand.

• Government policy support for this trend.

In fact, there is already some evidence of this trend. Manufacturers of some product segments, in areassuch as wheel rims and brake pads, have attained international competitive positions, and have beensupplying the OEMs in Europe and America. In addition, many companies are exporting their products tothe relatively less demanding after-market. Furthermore, the fact that international automakers areactively expanding their components procurements in China is another indication of the above trend.

6. Trends in the domesticautomotive industry andmanagement implications

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2. Trends in the passenger vehicle segment2005 has been a milestone for the Chinese auto industry. This was the year where China became a netexporter of vehicles. Exports of passenger vehicles grew 224% over prior year, and most of which camefrom domestic brands. Although currently most of the exports are going to developing countries,we believe local brand vehicles will be destined for Europe and the US in the not too distant future.

However, the passenger vehicle market has lost its initial optimism from a few years back that fueled highgrowth. This shaped the segment in the following ways:

• Excess capacity resulting from rapid expansion has caused a steep drop in vehicle prices.

• The speed of cost reduction has not been able to keep pace with the drop in prices, thus hurtingindustry profitability.

• Reduction in import customs duties for vehicles.

This market environment puts local brands at a disadvantage, especially for those small local OEMs with alimited product range. However, with challenges come opportunities; manufacturers that have alreadycaptured a certain market share are likely to be able to grow in the domestic markets, and also expandtheir reach into overseas markets, if they can adopt and implement appropriate strategies.

3. Trends in the commercial vehicle segmentCompared to passenger vehicles, commercial vehicle production has a longer history in China. Moreovercommercial vehicles are usually produced in smaller quantities, and as technical specifications are also lessdemanding compared to passenger vehicles. Locally produced commercial vehicles, particularly the lightweight vehicles are perceived to have an edge in price-performance ratio. The introduction of advancedengine technologies to China in recent years has led to further extensions of this advantage. China'scommercial vehicle exports to developing countries generally face lower entry requirements, and areearning good returns. Furthermore, domestic demand is experiencing significant growth driven by thecountry's construction boom. However, commercial vehicle manufacturers are likely to face the fact thatproduction capacity will exceed demand in the future and therefore cannot afford to rely solely onprice-performance to compete.

4. Management implicationsWhat strategy should companies adopt in light of these opportunities and challenges in export? In thissection, we select three management issues, and explore implications in formulating and implementingmanagement strategies.

OEM cost leader strategyThe US market is the biggest and most competitive market in the world. From the perspective of a localbrand automaker, entry into the US market will undoubtedly raise a Chinese automotive manufacturer’sbrand and market image, and therefore, to a certain extent, help the company increase sales and retainmargins.

Japanese and Korean car makers have successfully entered the US market through a cost leader strategy.It is likely that Chinese brands will have to do the same. Furthermore, since Chinese manufacturers haveto overcome the weaknesses in brand perception compared to joint-venture brands in the domesticmarket, they have to pursue a cost leader strategy in both the domestic market and the US market.Achieving this, however, is easier said than done. Most manufacturers of local brands currently haveadvantage over joint-venture competitors in terms of cost structure; but as joint-ventures increaseproduction scale and improve their operations, this advantage will be eroded, and may even disappearover time.

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In order to maintain their cost advantages, local brands must continue to improve all aspects of theirsupply chain, from procurement to production to distribution. Companies need to consider the following:

i. Purchasing strategy as a means to gain access to strategic resourcesThe domestic parts and components segment is highly fragmented, which creates the impression thatlocal automotive manufacturers have much choice of supply. In reality, finding a cost-efficient, highquality components or sub-systems vendor who also have an acceptable research and developmentcapability and can provide stable supply is a difficult task. Having access to or ownership of such resourcefrom reliable low cost suppliers would create a competitive edge.

ii. Integration of supply chain information systemsEnhancing the visibility of information helps to promote and improve internal and external coordination.A well-implemented supply chain information system can provide the technical infrastructure to facilitatethis. Implementation of the supply chain information system should start with the basics. For instance, isthe cost accounting module in the Enterprise Resource Planning system (ERP) compliant with ActivityBased Costing (ABC) principles to truly reflect actual costs? Unless OEMs can ensure accuracy andeffectiveness in each core module, the implementation of supply chain information systems will realisefew benefits. An additional important consideration is not which brand of information system software touse, but how to design the system to meet business and operational requirements effectively and to usesystem implementation as an opportunity to optimise these processes. Furthermore, the implementationand development team should consider the interaction between the system, the employees,organisational structure, processes, and partners.

iii. Utilise limited research and development budget effectivelyDomestic brand manufacturers have very limited product research and development budget compared tothe international players, yet, they have to maintain a series of product lines in order to compete. Theright technology strategy is key - this is discussed later.

Enter the US market with good quality vehiclesThe experience of automakers from developing countries who tried to enter the US market suggests thatgood quality is an imperative for success. An appropriate strategy is launching and maintaining goodquality products to establish a good brand image. Low-price does not mean lowering quality standards.Although it may take 5 to 10 years to change the perception of consumers in developed countries thatcars manufactured in developing countries are of poor quality, the highly competitive environment oftoday’s vehicle markets leaves no alternative. In fact, China’s domestic market is already a globallycompetitive environment. Therefore, quality is not only required for overseas markets; it is fundamental tosuccess in the domestic market as well. Quality improvement should include the following considerations:

i. Formulate an appropriate auto technology strategyFor a carmaker, auto technology includes platform and system or module technology. Generally speaking,system or module technology can be acquired from vendors. Whilst some platform technology, such asbody design, can also be bought from research and development organisations, most need to be boughtfrom vehicle manufacturers or developed in-house through research and development. In the case of thelatter, local brand automakers will need to invest heavily in equipment, technical personnel, and will alsohave to accumulate expertise from experience. For this reason, to be able to emulate, learn, cultivate, andinnovate at low costs should be one of the core competitive competencies for these local brandautomakers. It should be emphasised here that emulation should not infringe on intellectual propertyrights.

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ii. Strict adherence to quality management processesQuality improvement requires full and detailed compliance with quality management processes.Companies should instill a quality culture in all employees – employees must realise that qualitydetermines the success or failure of the product, and therefore determines the competitive position of thecompany. Furthermore, companies should implement advanced quality improvement methodologies,such as Six Sigma, which can help companies improve product quality, whilst reducing costs.

iii. Strengthen vendor quality managementQuality management of vendors is an extension of the vehicle manufacturer’s in-house product qualitymanagement. Vehicle manufacturers should ensure that the components procured from subsidiaries andsuppliers can consistently meet their quality requirements.

Parts and components manufacturers may consider expansion strategies to achieve economiesof scaleParts and components manufacturers face a difficult competitive environment in today’s market. So whatshould local parts and components manufacturers do? We believe one approach is expansion to achievescale. Two possibilities include:

1. Attaining economies of scale through industry consolidationWith foreign-invested parts and components companies dominating the market, domestic companiestaking the path of organic growth may face some significant risks. Merger and acquisition offers aquicker way to reach the scale required to compete. It is important to make sure that the merger andacquisition deal is properly structured, and that there is a plan for post-merger integration.

2. Optimise resource allocation and enhance core competencies through overseas expansionOne of the biggest obstacle in overseas expansion for domestic parts and components manufacturers isthe lack of sales and distribution channels. Finding an overseas partner is one option, but since mostpartners usually work with a number of domestic suppliers, this weakens the bargaining power of theChinese manufacturer, and may result in lower profit margins, and no guarantee of long term orders. Fordomestic manufacturers who have already gained scale and market position, direct ownership of overseassales and distribution channels, possibly through acquisition, may be a better option. Generally,companies in the after-market are easier acquisition candidates than those in the OEM market.

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ContactsFor more information, please contact one of our specialists as below:BeijingRicky TungPartnerTel: +86 10 8520 7130Email: [email protected]

Hong Kong SARTerence CheungPartnerTel: +852 2852 6405Email: [email protected]

ShanghaiTed LeePartnerTel: +86 21 6141 2288Email: [email protected]

Steven AschkenasePartnerTel: +86 21 6141 2212Email: [email protected]

Edmond ChingPartnerTel: +86 21 6141 2718Email: [email protected]

Warren ClarkPartnerTel: +86 21 6141 1898Email: [email protected]

Stanley DaiPartnerTel: +86 21 6141 2222Email: [email protected]

ShenzhenEileen SunPartnerTel: +86 755 8246 3255 Ext 8117Email: [email protected]

Tony KwongPartnerTel: +852 2852 1003Email: [email protected]

John HungPartnerTel: +86 21 6141 1828Email: [email protected]

Rosa YangPartnerTel: +86 21 6141 1578Email: [email protected]

Desmond YeungPartnerTel: +86 21 6141 1088Email: [email protected]

Eric ZhangDirectorTel: +86 21 6141 2266Email: [email protected]

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GuangzhouTerence CheungPartnerTel: +852 2852 6405Email: [email protected]


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About this publication

This material has been prepared by professionals in the member firms of Deloitte Touche Tohmatsu. It is intended as ageneral guide only, and its application to specific situations will depend on the particular circumstances involved.Accordingly, we recommend that readers seek appropriate professional advice regarding any particular problems thatthey encounter. This information should not be relied upon as a substitute for such advice. While all reasonableattempts have been made to ensure that the information contained herein is accurate, Deloitte Touche Tohmatsuaccepts no responsibility for any errors or omissions it may contain, whether caused by negligence or otherwise, or forany losses, however caused, sustained by any person that relies upon it.

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