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ENTERING GLOBAL MARKETS

The Growing Cost of Doing Business in China

Small businesses such as Olive Juice and Gonzo Games grapple with rising prices.
China, Expensive, rising prices, Gavin Potenza

Gavin Potenza

Currency Crunch A dollar doesn't go as far in China as it did five years ago.

Maryellen Kane and Robert van Gool don't seem to have much in common. Kane owns Olive Juice, an upscale children's clothing company based in Norristown, Pennsylvania. Van Gool runs Gonzo Games, the fledgling San Francisco video game company behind Potty Racers, a popular iPhone app that involves piloting a portable toilet.

But the two share a common problem: a roaring Chinese economy that has pushed up prices and created a tight labor market. In some areas, particularly the manufacturing port cities near Hong Kong, Chinese labor costs have risen as much as 30 percent in just the past few months, owing to increased competition for workers and higher costs of living.

The price of doing business in China could go even higher following the country's recent shift in currency policy: In June, the Chinese government officially removed the Chinese renminbi's peg to the U.S. dollar. Thus far, the renminbi has strengthened only a little, but the U.S. government is pressing for more movement. At the same time, companies importing goods from China face higher shipping costs based on a number of factors, including a shortage of shipping containers and new measures that increase shipping times.

For Kane, who uses Chinese labor to produce her line of children's clothes, these macroeconomic trends are causing real-world headaches. This summer, one of her best manufacturers was about two weeks late delivering items for her fall collection, because it was short on workers. "That's an eternity in the fashion world," says Kane, who worked in the industry in New York City before opening Olive Juice in 2003. The same thing happened with a different supplier; the order became available in portions, making multiple air shipments necessary. Kane was stuck paying an extra $6,000 in shipping charges. On top of that, her manufacturing costs have increased about 5 percent in the past two years. "The manufacturers just can't get enough workers," she says.

At Gonzo Games, van Gool has also run into problems with China's tight labor market. In 2009, as he was launching his company, van Gool was looking for programmers and struck a deal with a Chinese software firm. But the relationship fell apart after the Chinese contractor struggled to retain employees. "All of a sudden, my e-mails and calls were going unanswered," says van Gool. "I dug around and discovered that half the staff had quit to work on a bigger contract for a different company."

Currency Crunch
A dollar doesn't go as far in China as it did five years ago.

Van Gool eventually found a group in the Philippines that produces Web-based games. After he contacted the seven-person team, it agreed to work at the same price as the Chinese company and delivered a polished product before a contract was even in place. "That sealed the deal," he recalls. "I was done with China." Gonzo Games is now in the process of merging with the Filipino developer.

Many other companies that originally sought out China for its low prices are now scrambling to offset higher costs. Conrad Winkler, a partner at Booz & Company's Chicago office and a specialist in manufacturing strategy, says there are several mitigating factors that could help, starting with the fact that China is a massive country still brimming with cheap labor. Once China's inland areas develop more infrastructure, for instance, Western companies will have a cheaper alternative to the relatively higher-priced coastal regions.

That shift to the interior has begun. This summer, Foxconn Technology, the giant Taiwanese electronics company that makes Apple iPhones, announced it would build new facilities in China's interior. Savio Chan, president and CEO of US China Partners, a consulting firm that advises American and Chinese businesses, says he is seeing a similar movement among smaller companies. "They're doing small orders, testing the factories out first," Chan says. "For many, the plan is to slowly migrate production to these areas, not move it all at once."

Salary Hikes
Annual wages of Chinese manufacturing workers have jumped.

Winkler also points out that, despite the recent cost increases, China is still relatively cheap. "When you move a factory from the U.S. to China, you're talking about wages going down from $20 per hour to $1 or less," he says. "Now it's maybe $2." Until that reaches $3 or $4, he says, it's not worth moving elsewhere, especially for companies that have spent years and untold sums fine-tuning a network of Chinese suppliers.

That's why Kane and others say it would be even more painful to leave China than to swallow the higher costs. Tracking down a good supplier can involve a lot of trial and error, says Kane. "I tried to go to India three or four years ago and got burned," she says. But others have chosen to leave China, just as van Gool did. According to a survey by Booz & Company, many companies are looking to countries such as Vietnam, Thailand, and Indonesia as low-cost alternatives.

Winkler and Chan say an increasing number of American companies are now trying to sell Chinese-produced goods and services to China's increasingly affluent consumers. But breaking into the market can be challenging for small and midsize companies that lack global brand recognition. State-owned enterprises control most of China's retail space, e-commerce is barely a blip on the radar, and the Chinese have their own products to sell. Still, Western brands are becoming more sought after, says Chan.

Climbing Costs
From August 2009 to August 2010, producer prices in China climbed an average of 4 percent. Some industries were hit harder than others.

Even so, the economics don't always make sense. That was the case for Sleeptracker, an Atlanta-based company that contracts with Chinese manufacturers to make a device to help people get a better night's sleep. The business has been grappling with rising expenses -- its cost to ship products to the U.S. increased 35 percent in September alone. To help offset the increase, founder Lee Loree tried to sell his products in China, but the price, $179, was too high for most people. "We can't get the price point right," Loree says.

Even those most bullish on China's future agree that doing business there over the next five years will become increasingly expensive. For now, business owners such as Kane, Loree, and others have few good options other than to weather the rising costs in China as they explore alternative ways to keep their expenses in line. But Loree harbors no illusions about what he is up against. "It gets more and more difficult each year," he says.

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Last updated: Nov 1, 2010

RYAN UNDERWOOD

Ryan Underwood is a writer and editor living in Nashville, Tennessee.




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