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Chinese Manufacturing. Profit Margin, What Profit Margin?

By Dan Harris on Posted in China Business

A loyal reader just sent me an absolutely fascinating “case study” on a small Chinese manufacturing business. The case study is part of Emerald Emerging Market Case Studies, which dubs itself as providing a “library of teaching cases spotlighting the world’s emerging economies.” The case study on the Chinese business is called “The changing landscape for Chinese small business” and it highlights a company that started out making school uniforms for China’s domestic market, and then shifted to making bags/purses/backpacks for export.

I hate to say this because I am not even close to being an expert on Chinese manufacturing businesses, but in reading the case study, just about everything in it sounded “typical” to me. This bag company sounded like most of the Chinese manufacturers my firm’s non-Chinese clients have sought to buy, have bought, or have bought product from. In particular, the company’s lack of rigorous accounting and pricing and its unbelievably low profit margins, rang totally true to me.

In 2010, the company had sales of 5,417,003.64 Yuan and profits of 983 Yuan (approximately $150 US dollars!). Even in its very best year (2006), the company’s profits were only around USD$44,000. The case study attributed the low margins to one of the company owners oftentimes providing discounts without the knowledge or approval of the other owners.

We are always counselling our clients on how Chinese manufacturers tend to have incredibly thin margins. We do this for many reasons, including, just by way of example, the following:

  • If you buy product from a Chinese manufacturer for too low a cost, you are increasing the risk of that manufacturer cutting costs by doing something bad to your product without telling you. Believe it or not, you may be better positioned to know your Chinese manufacturers costs than it is. 
  • Because your Chinese manufacturer’s margins may be so low, if you do get bad product, do not expect to just pick up the phone, tell the manufacturer what happened and wait for a refund of the USD$500,000 you just paid it for the product. Your Chinese manufacturer probably does not have $500,000 so you are going to have to come up with some other solution. You also should be thinking about this issue before you place your orders.
  • With the margins being as thin as they are, think about what you ask for from your Chinese manufacturer. Should you require your Chinese manufacturer to provide product liability insurance or does doing so just invite the manufacturer to say it has done so but then never pay on the policy? Might it not be safer for you to buy the policy for yourself instead?  I am not saying one should always buy one’s own product liabilty insurance, I am just using this as one example.  

As bad as things already are for this Chinese bag company, the case study predicts things are only going to worsen due to the following:

 

  • The US Government is continuing to put pressure on the Chinese Government to strengthen the value of yuan and to do it fast;
  • The continuing rise in oil prices; and
  • The long-term decline of available migrant workers

If you buy product from China or are thinking of doing so, I urge you to read this case study (click through to the pdf). 

  • Twofish

    It’s rather misleading because managers pay themselves and stakeholders out of “direct labour”. There’s no incentive for a small Chinese business to have a “profit” since that just means that you get taxed on it, and so people will adjust the numbers to minimize “profit.”

  • PaulR

    Alfie and Ben have to raise prices – there is no other way. Continue to focus on quality, improving efficiency, and serving those customers who understand, and can pay for it. Its happening all over China, and there is no way around it. China as a whole is many years past the “name your price” sort of supplier it used to be.
    The good news for BoL is that the US customers will eventually be forced to accept it. They have little choice.
    There is NO way a Wal-mart bag will ever be made in the USA, by lazy USA workers. Moreover, most other “surplus labor” Asian countries, like India, have many other problems which do not give them an obvious advantage. Competition from “smaller countries” like Vietnam on labor costs may be competitive for a while, but again, its not an obvious, long-term advantage
    What China has brought together in the last 25 years, as a nation, in terms of stable Gov’t and economic policy, strong and hard-working labor force, excellent infrastructure – is a historical anomaly, and won’t be repeated in the same way by any other nation.
    Its not only BoL who needs to change, but consumers in the West will also need to adjust their ideas.

  • Eric

    While I agree with Dan’s overall points, it’s important to remember that this is a private, family-owned company, and that the accounting practices of such companies (even in the United States) are different from publicly traded companies. For example, this company’s overhead consistently runs around 100% of its raw materials and labor costs, which is a very high rate for a company that probably has little in the way of fixed asset depreciation, R&D, etc.. Instead, I suspect that like many family owned companies, they are using the company to pay for personal expenses or salaries specifically in order to reduce the company’s profitability and thus, income tax. (You can see that its tax liability decreases in lockstep with its profitability.) I’m not suggesting that this is necessarily a healthy company, or that it’s a goldmine. My only point here is that this company’s bottom line may not be a useful indicator of its real health.

  • http://www.barrigacia.cl Juan Xavier Barriga

    Hi Dan, this is your Chilean friend Xavier.
    Maybe the small Chinese manufacturers are getting the money out of the company trough a different way other than as benefits. This way they pay virtually no tax.
    Regards,
    Xavier

  • Twofish

    The other thing to notice is that the income statements and the balance sheets don’t match up. In a rigorous system of accounting any differences in the balance sheet has to be matched by an entry in the income statement. With the numbers that they given, it’s obvious that there are many cash flows that are not in the accounting statements, and it’s impossible to tell from the accounting statements, the actual health of the company.
    Not that there is anything wrong with this. This sort of “seat of the pants” accounting is common with small businesses both in China and the United States. The reason it works is that the managers and the owners are the same people, and so the people that matter know what’s going on even without accounting statements, and if the managers go into corporate funds and write themselves checks, it’s fine, since it’s their money.
    It’s a completely different story if the owners and the managers are different people.
    A few other things to point out:
    The company has huge amount of liquid assets, particularly stocks. It’s uncommon for companies in the US to have large amounts of liquid assets, and it’s almost unheard of for a US company to put their money in stock.
    What this means is that Chinese companies “die” in a different way than US companies. US companies usually die when they run out of cash. The cash to run the money comes from external sources so that the balance sheet is usually negative when the company runs out of cash, which means that you then have this process for figuring out who gets what (i.e. foreclosure or bankruptcy).
    In Chinese companies, it’s likely to die when the cash flow goes negative, and the owners figure it’s not worth throwing good money after bad. At this point the company may still have liquid assets and be cash positive, which means that the owner just locks the doors, turns out the lights, and liquidates. Since the company still has liquid assets when it dies, there isn’t a foreclosure or bankruptcy process.
    The company has probably gotten as big as it can get without massive management changes. Any bigger and you are going to have to completely redo the management structure, and it’s likely to be even less efficient. Also Chinese companies tend to be high-labor/low-capital. If the company wants to move to high-capital/low-labor, then there are a lot of account challenges. In a high-labor environment, you don’t have to do much accounting and there is low risk. If you are in a high-capital environment, then the accounting becomes much more complex and risk increases.
    One other thing is that the switch from foreign to domestic is hitting exporters hard. One thing that I found in talking to a factory owner that surprised me is how difficult it is to switch from foreign production to domestic production. You’d think that the hard part is just making the product, but getting the product from the factory to the customer turns out to be incredibly hard, and in switching supply chains, it is a massive undertaking.
    One thing about Chinese retail is that you really don’t have anything like Walmart that can just order a huge number of purses, and it turns out that it’s easier to move a purse from Dongguang to Peoria than it is to move it from Dongguang to Beijing. It’s not the lack of physical infrastructure, but human infrastructure. So the story of Chinese manufacturing is also the story of US supply chains.

  • Twofish

    PaulR: The good news for BoL is that the US customers will eventually be forced to accept it. They have little choice.
    Yes they do. If you raise prices, then consumers stop buying. If you don’t raise prices and the economy is bad, then consumers will stop buying anyway. A pretty large number of businesses are going to go out of business, but as businesses go under that leaving fewer people competing for what is left.
    PaulR: There is NO way a Wal-mart bag will ever be made in the USA, by lazy USA workers.
    And it’s less and less likely to be made by lazy Chinese workers. One thing that factory owners complain about is how the younger generation is just spoiled and has bad work habits. They are right. Twenty years ago, the person that you hired grew up in near starvation conditions, and was a hard worker who would work for peanuts because there were no other options. Today, you are hiring little emperors that will cry the second you ask them to spend one more minute in the factory rather than go to the mall.
    It’s ironic that one generation will work themselves to death so that their kids can be lazy, and then complain when their kids are in fact lazy.
    PaulR: What China has brought together in the last 25 years, as a nation, in terms of stable Gov’t and economic policy, strong and hard-working labor force, excellent infrastructure – is a historical anomaly, and won’t be repeated in the same way by any other nation.
    And there were also supply chains at the other end. Chinese manufacturing wouldn’t have gotten were it is without Walmart and advances in container shipping. We are in a global economy. The story of the Chinese economy isn’t just about China.
    And it’s not going to be repeated in China. Economies change, and one thing that I think that people in China all realize is that what worked in the last 25 years just will not work in the next 25, and so people are trying to migrate over to something that will.

  • James G

    Maybe the point is not that Chinese manufacturers aren’t making “any” money at all, but that if they have *official” books that state they are barely in the black, they can plead poverty that much easier when creditors come calling. Just my speculation, I’m not involved in manufacturing, but it seems like this would be a good course of action. Someone wants 500K (the figure Dan gave) and you have low profits, and correspondingly low cash, that lessens your chances of the courts coming after your deep pockets. Maybe put the money into “overhead” and “salaries” (lots of kinfolk on the payroll) and what can anyone say? After all, the factory owner is already demonstrably operating on a thin margin.
    Not sure if that is what Dan’s read-between-the-lines point is, or if I’m way off on my assessment here.
    Plus, aren’t there always at least two sets of books kept? One set certainly might paint a different picture.

  • James G

    @Twofish
    And it’s less and less likely to be made by lazy Chinese workers. One thing that factory owners complain about is how the younger generation is just spoiled and has bad work habits. They are right. Twenty years ago, the person that you hired grew up in near starvation conditions, and was a hard worker who would work for peanuts because there were no other options. Today, you are hiring little emperors that will cry the second you ask them to spend one more minute in the factory rather than go to the mall.
    It’s ironic that one generation will work themselves to death so that their kids can be lazy, and then complain when their kids are in fact lazy.
    ****************************
    That’s what lazy is, being asked that their time spent in factory exactly match their paystubs? If one must speak for an entire generation, I’d imagine that the older folks would be much, much more pleased with their kids having the choice to choose or decline work that is, at best, tedious, and at it’s worst… I find that encouraging, and signs of a familiar arc into the comfier working class strata.
    Doesn’t the Chinese govt itself want to move it’s workers up the value chain and get away from low end manufacturing?
    There will come a day when one generation doesn’t see the younger generation not involved in back-breaking, mostly dead-end work and lament the youth’s laziness out of some misguided sense of nostalgia. That’s pretty… striking, the idea that people who grew up in the most miserable conditions make the best workers because of their desperation and malleability.

  • matt

    I’ve spent plenty of time in Chinese factories (undoubtably like most CLB readers).”Lazy” is not a word that comes to mind when I think about people working in these factories. Poorly managed? Undertrained? Working with substandard equipment? Maybe, but not lazy.

  • http://www.summichina.ca Marius

    Again, I find myself fully on the side of two-fish. Here at Summit-ZJRC we would deem this company as one whose time has come and gone. We would not want our clients to get involved with it under any circumstance.
    China is much further on the curve towards full development and this company has stayed behind. The company is no more than an assembly line and has not other value. In particular in the more developed parts of China this kind of company can no longer compete and has to fail.
    It is no longer stereotypical and as a case-study it is irrelevant.

  • Bart

    I am not sure I agree with Marius. This type of company has not gone the way of the dodo yet. It will be a long time befoore that will be the case. The problem is that we should stop talking about China as one homogenous country. The east coastand Yangtze Delta can’t be equated with say Hunan. They don’t even speak to same language.

  • Twofish

    James G: Maybe the point is not that Chinese manufacturers aren’t making “any” money at all, but that if they have *official” books that state they are barely in the black, they can plead poverty that much easier when creditors come calling.
    This really doesn’t work well for most informal Chinese borrowing. Chinese borrowing tends to happen between people with personal relationships rather than getting money from impersonal institutions. If you borrow money from a bank, you aren’t going to feel guilty about not being able to repay, and if you move money between accounts to hide your real worth, that’s something that you won’t lose sleep over.
    This isn’t going to work if you borrow money from a very close personal relationship. If you borrow money from your brother-in-law, you are going to try to return it, and if your brother-in-law asks you how much money you really have, you are going to answer honestly.
    The thing about informal borrowing is that your friends and relatives can put you through hell that a bank or court can’t.
    James G: Plus, aren’t there always at least two sets of books kept? One set certainly might paint a different picture.
    What I’ve found with small businesses (both in the US and in China) is that you are lucky if the company keeps one set of books. Bookkeeping is a pain, and you’ll find that most small businesses have very chaotic financial records to the point that it’s often the case that the owners really don’t know if they are making money or not.
    Marius: Here at Summit-ZJRC we would deem this company as one whose time has come and gone. We would not want our clients to get involved with it under any circumstance.
    Didn’t say that at all. One thing about the books is that there is no way from the information given for an outsider to tell whether the company is long term viable or not. There are obviously unrecorded cash flows, and the type of those flows will tell you whether or not the business is long term viable.
    Also, these sort of businesses are a bad thing for an “outsider” to get involved in anyway.
    Marius: China is much further on the curve towards full development and this company has stayed behind. The company is no more than an assembly line and has not other value. In particular in the more developed parts of China this kind of company can no longer compete and has to fail.
    Strongly disagree with this. First setting up an assembly line is non-trivial. The other thing is a question of numbers. You might see lots of small manufacturing companies fail, but as they fail, the cost of workers will go down and the value of the orders will go up, so you’ll end up with a new equilibrium.

  • http://www.summitchina Marius

    Twofish: I did not mean to put words in your mouth – just commented that I agree with your general point of view and added my own – this company’s value chain in essence is only one link long: the assembly. They are not viable in the long run – simple as that – moreover, this is exactly the kind of company that will take “the midnight express”, if you get my drift!
    The Lenovo model also applies to SME – start as a source fo components etc. and then take ownership of your product, create a brand by either merger and acquisition or through r and d. I don’t see the case study co do that – they just don’t seem to have the wherewithall – hence my comment that in China this company as a model is irrelevant – and some will go sooner than others and some maybe able to hang in for a long time.

  • Justin

    Isn’t the case study itself poor if they didn’t consider (and address) the possibility that family-owned businesses like to keep their “book profit” low and get their compensation via other methods? This scenario seems entirely plausible, and it seems odd that the case study didn’t address that.

  • http://www.lccpartners.com.tw Marie

    It does sound pretty realistic – including the confusion in the accounting and the strong personal relations driving the company – family and supplier side.
    And when walmart demands defense for a lawsuit that results from a needle in a bag or a bad reaction to dyed leather there will be even more stress on the company because: the COI was fake, the cover was cheap as it only covers china, or …..
    Your comment on Products Liability Insurance more right on the money than many of the case study readers know. The balance between price and protection is a buyers decision and sometimes a blindspot

  • Brook Renwick

    Hello! This may be a silly question but I do not know much about communism or china. My question is: Where do profits go when a company is successful in China? What little I know may indicate to me that it goes to the government doesn’t it?? Isn’t that what communism is: An equalising measure so that all of the citizens benefit and no-one gets rich?!
    I hope someone can answer my question despite that it may be silly, sorry.