Is the China Outsourcing Model in Trouble?

Monday, October 10, 2011 6:00

A number of articles lately have focused on the economic sustainability of the outsourcing model in China.  The articles in many ways are simply the same as others that have popped up in the past. With one exception.

In the past, when the question of China’s outsourcing model being asked, it was nearly always framed as China being too expensive for firms, which would force firms to look elsewhere (in Asia) for low labor costs.  At the time, early 2008,the economies of the world were still largely “stable” above water, and consumerism as we knew it then seemed to have no end.  So, there was no question that demand would increase.  It was a “China” problem.

Now the conditions are a bit more complex.  Like in 2008, China’s rising costs (materials, labor, land, etc) are still a concern, but the overseas consumer is not as hungry.  China’s consumers are now the hungry ones.

Which has forced a number of things to change, but none more important that then fact that in the last 5 years, investors are no longer (solely) export focused.  They are looking to sell into China, and as such, are investing in factories (vs. outsourced lines) around China that will produce products for China.  Another dynamic that has reduced the need for firms to outsource, or at the very minimum, changed the way in which firms are looking to outsource.

Over at the China Supply Chain Council, Max Henry and his team asked readers whether or not Li & Fung’s business model was in trouble.  A question that followed a recent press release where Li & Fung announced losses of 10 billion in the last year.  Losses that the Council attributes to two conditions:

One, their business has slowed because the majority of their clients are in the struggling European or US economy. And two, their sourcing base is largely in China, a country that continues to experience tremendous rising costs of business.

Conditions that have been discussed on a wider level in both the foreign and Chinese press, and ultimately lead to the Council asking its readers to respond to the following 5 questions:

– What are the biggest flaws in Li & Fung’s business model?
– What should Li & Fung be doing to add sustainability to their business?
– What kind of value-added services are sourcing clients demanding but Li & Fung not offering?
– Have all the acquisitions benefited or hurt Li & Fung’s long-term outlook?
– Will sourcing giants like Li & Fung eventually disappear in favour of smaller, more specialized firms?

Some very valid questions, and questions that lead me to take the questions a bit further and ask you (my readers) whether or not you feel China’s outsourcing industry is in trouble.

  1. What are the biggest pressures on China’s outsourcing model? Is it sustainable on any level?
  2. What is the value-add for outsourcing to China?  What are firms looking for when coming to China? Has this value reduced over the last 8-10 years?
  3. Have the investments (by foreign firms) in domestic manufacturing benefited or hurt outsourcing firms?
  4. Will sourcing giants like Li & Fung eventually disappear (from China) in favour of smaller, more specialized firms?
  5. What is the biggest threat to outsourcing firms?
  6. Is it realistic for large outsourcing firms like Li & Fung will begin to produce under their own label?

Thinking about my own experience with those in the middle of outsourcing, one of the things that I have always felt goes unmentioned in many articles is the fact that many of the agreements between buyer and outsourcing firm have a short life to them.  Either the buyer is a small buyer, who is not buying at scale, and is most likely in a low value add capacity themselves, or the firm sees the trading firm as a short term band aid that gets them through a short period which they find a long term relationship, or the buyer is only interested in the relationship for goods that require a lot of work with lower return.

All three having distinctly different impacts to the outsourcing firm’s top line, but at the same time indicate to me that this model only had a short life span.  Or at the very least, was one that would be very difficult to manage as large clients would eventually find other means to purchase goods (i.e. go direct), and thus leave the firms with a lrge portfolio of smaller buyers.

Not exactly my idea of a stable business model.  Not that it is going away anytime soon, but the costs have certainly gone up while the rewards have certainly gone down.

Which leads me to the next logical question (in my mind): Is it realistic for groups like Li & Fung to move up the chain and begin creating branded lines?  Some of them are already OEMs or managing entire categories for clients… what is stopping them from becoming the brand themselves?

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7 Responses to “Is the China Outsourcing Model in Trouble?”

  1. Renaud says:

    October 10th, 2011 at 7:36 am

    Interesting questions. I don’t know L&F enough, but here is how I see it:
    # I don’t see L&F launching its own brands in competition with its customers. 
    # Major retailers don’t want to get locked in a relationship with 1 intermediary. Example: Wal-Mart negotiated an option to purchase L&F’s division that was set up to serve W-M. It is a ruthless game when huge contracts are easily lost. 
    # The trend is currently to buy more direct, and it might get reversed in 2 years. I see it as fashion, rather than ROI-driven decisions.

  2. Rich says:

    October 10th, 2011 at 8:22 am

    Hi Renaud.

    Interestingly enough, I was with a L&F executive right after Wal-Mart asked them to build that business, and they were quite excited about it. There was no discussion of branding anything as L&F, but if WM did exercise that option, L&F would be left with a pretty big hole to fill..

    Why do you see the trend of going direct reversing, and in which areas?

    R

  3. Renaud says:

    October 10th, 2011 at 9:03 am

    Rich,
    I just mean that large retailers often need to please their shareholders/boards, and the pendulum swings back and forth between more or less direct sourcing. 
    I have the feeling L&F had a huge momentum 2-3 years ago, and now might be the time where costs are considered more important than risks or speed. 

  4. All Roads Lead to China » Is the China Outsourcing Model in Trouble? « Outsourcing Yes says:

    October 10th, 2011 at 8:54 pm

    […] the rest here: All Roads Lead to China » Is the China Outsourcing Model in Trouble? Comments […]

  5. Chris Devonshire-Ellis says:

    October 11th, 2011 at 6:43 am

    I can advice that our China & India offices are increasingly handling domestic Chinese companies who thtemselves want to outsource – and are doing so, especially to India. – Chris

  6. Outsourcing Headlines - ITO, BPO, HRO, Healthcare, more | 3FORWARD says:

    October 13th, 2011 at 4:08 am

    […] Is the China Outsourcing Model in Trouble? […]

  7. FrontierStrategyGroup says:

    October 31st, 2011 at 9:09 am

    Most Asian countries have maintained strong economic growth in recent months despite the turmoil in global markets; however, significant downside risks threaten the region’s continued performance. In China, a spate of defaults in the informal banking market is casting a shadow over the country’s prospects. This could pose difficulties for outsourcing in China.