At a breathtaking pace, China has firmly established its position as "the world's factory."¹ With its dominant low-cost competitive advantage, abundant labor resources, and ability to quickly expand production capacity, China is emerging as the most competitive manufacturing platform in the world, ambitiously aiming to saturate the global market with low-priced products. In such product categories as apparel, footwear, electric appliances, furniture, toys, computers, and computer accessories, Chinese products have consistently captured a dominant share in markets around the world. Such is their economic clout that Business Week claims that "the China price" are the three scariest words for U.S. manufacturers.²

The China price implies that U.S. companies that manufacture in the United States, for example, must cut their product prices by at least 30 percent or risk losing their customers to Chinese-made products. This holds true not only for low-technology products, such as footwear and apparel, but also for high-technology products like telecommunications equipment and computers. Yet in spite of the huge potential impact of this economic trend, it is surprising how little literature exists explaining the how and why of low-cost manufacturing in China.

Low labor cost has become the convenient rationale for justifying outsourcing to any "low-cost country," including China. But low labor costs by themselves do not necessarily translate to low manufacturing costs, and thus, low product prices. For instance, labor costs in Vietnam and Zimbabwe are less than those in China. Yet neither of these countries has been able to offer lower prices than China for the same products in the global market.

The location of the existing manufacturing capacities in China further refutes the conventional wisdom that low labor costs are the sole source of manufacturing advantage. Most of the country's production capacity for export goods is located in the four or five eastern provinces in the coastal regions where wages (as well as the cost of living and prices for production resources) are usually among the highest in the country. While the inland provinces have lower labor costs, they have yet to attract much of the production capacity—even though infrastructure linking these inland provinces to the coastal-shipping locations does exist.

Further evidence can be seen in the product categories where labor costs are only a small portion of the overall product cost. In the case of certain sophisticated electronics, for example, direct labor contributes less than 10 percent of total costs.³ Yet Chinese-made products in this category hold a sizable competitive advantage over products made in most other countries.

In summary, then, although the cost of labor does play an important role in creating a cost advantage for low-cost countries, it is only one of a number of factors. These other factors include lower capital-investment costs, lower domestic-sourcing costs, greater economies of scale, and government incentives.⁴

In this article, we will present a systematic supply chain perspective on low-cost manufacturing in China. We argue that the Chinese cost advantage goes well beyond labor costs. Specifically, it is reflected in the value chain—particularly, in low-cost raw materials and sourcing inputs, in efficient logistics processes, and in a highly competitive marketplace. In other words, China's low costs are reflected in the entire supply chain from component sourcing to manufacturing, logistics, warehousing, storage, and finally, commercial transaction.

At this point, it's necessary to define explicitly the supply chain under consideration. For the purposes of this article, we will focus only on products that are made in China for consumption in other countries. The supply chain for such "Made in China" products consists of three main phases: the sourcing and manufacturing phase in China; the shipment of finished goods from China to the importing countries via air, ocean, or land transportation; and the distribution and retailing phase in the importing countries. The current supply chain setup for exported products would not be considered particularly advantageous for products to be made and consumed in China, a country that is slightly smaller than the United States in geographical area. The reason: Most of the country's production capacity for export is situated along the eastern coast. Thus, the transportation costs of moving products made on the east coast inland to other parts of China would be considerable.

The organization used in the sourcing and manufacturing phase of this supply network is called a supply cluster. Michael Porter describes a cluster as a geographically proximate group of interconnected companies and associated institutions in a particular field, including end-product manufacturers, component suppliers, and supporting firms.⁵ As a whole, an industrial cluster is essentially a collection of many interrelated supply chains (or supply networks). These supply chains contain many levels of independent suppliers and manufacturers with different suppliers possibly serving the same manufacturer, and different manufactures ordering from the same supplier. These many-to-one, one-to-many, or many-to-many relationships are also possible between the manufacturers and customers.

The large number of supply clusters formed in China in recent years has contributed significantly to the nation's manufacturing competitiveness. Foreign visitors to China are often surprised to find hundreds (or even thousands) of factories producing the same type of merchandise in a single township along the east coast. This production structure, which is built on the supply cluster concept, has become the means by which almost everything is made in China—and there is little indication that this will change anytime soon.

There are mainly two types of supply clusters in China. The first is the hub-and-spoke, where a giant manufacturer (mostly large state-owned enterprises or their joint ventures) is surrounded by a large number of suppliers and supporting firms in the local region. Generally, the hub company is highly regulated and limited to certain capital-intensive industries such as telecommunication, energy, utility, steel, and chemicals. The contributions of the state-owned enterprises (SOEs) to the overall economy have decreased significantly over the years. They have been overtaken by the non-SOE (or private) sectors, which operate within the next type of clusters.

The second type of cluster, which is the focus of this article, is formed by a large number of small- and medium-sized enterprises. These non-SOEs do not receive support such as loans and real estate from the government and have been left on their own for economic survival. These clusters of privately-owned companies have thrived and now form the backbone of the Chinese market economy. They have become the driving force of the national economy. These privately-owned firms today produce well over half of the national gross domestic product and contribute an overwhelming share of Chinese exports.⁶ In addition, these private companies advance the productivity and profitability of the whole economy and generate most of the new jobs in China.

In recent years, these types of clusters have proliferated across the country. There are now well more than 1,000 supply clusters for export products, covering almost every major product category. The majority of the supply clusters are located in China's most developed regions, which include the eastern provinces of Guangdong, Fujian, Zhejiang, and Jiangsu, and large metropolitan areas such as Shanghai, Beijing, and Tianjin. Nearly every city or township in these eastern provinces has one or more specialized production clusters. For instance, the Nanhai district of the city of Foshan in Guangdong province comprises about 18 towns. Each of these towns engages in one of several specialized manufacturing areas such as ferrous metal processing, construction ceramics, textile, electric appliances, household hardware, underwear, toys, and so on. As an example, the township of Dali in the Nanhai district, accounts for 40 percent of the national output of aluminum products in volume.

Another example of the size and capabilities of these supply clusters can be seen in Zhejiang province, where the hundreds of industrial clusters generate annual sales volumes ranging from 1 billion to more than 20 billion yuan (approximately $2.5 billion). Most of the firms in these clusters are privately owned and operated, and they contributed half of the overall manufacturing volume for the province in 2003. Again, each cluster specializes in its own area or product category. For example, about 5,000 enterprises in the Zhili township of Zhejiang province produce garments exclusively for children. Similarly, in the Datang township, thousands of sock manufacturers produce six billion pairs of socks annually. (Exhibit 1 shows the different textile products produced in some of the city- and township-level clusters in the Zhejiang province.)

These levels of manufacturing scale apply to nearly every cluster in their respective product categories. Moreover, the export level of the private sector has been gaining further momentum following the relaxation of foreign-trade license controls in 2003. To cite just one example, exports by the private sector in Zhejiang province in 2004 was up by 88.2 percent over 2003.⁷

It is important to note that supply clusters in different regions have different characteristics. For example, the production clusters in the Jiangsu province are mainly owned by foreign firms from Taiwan. (By one estimate, foreign companies have opened about 60,000 factories in China between 2000 and 2003.⁸) In the neighboring Zhejiang province, the hundreds of production clusters have been formed by domestic private companies. These regional differences are certainly important considerations for any company planning to outsource to China.

Supply clusters in China utilize a number of different marketing channels. For example, firms formed with foreign investments generally use direct marketing to large customers in foreign countries. On the other side of the continuum, many of the small- and medium-sized enterprise production clusters usually serve large and small buyers through brick-and-mortar marketplaces. One of the largest such marketplaces is the China Commodity City market in the city of Yiwu in Zhejiang province. This 15 million square-foot wholesale mall contains 40,000 stores. The marketplace's sales volume reached 26.6 billion yuan in 2004; of that amount, 60 percent represented exports to more than 208 countries and regions in the world. Dozens of specialized manufacturing clusters are situated in towns and cities within a 50-mile radius of China Commodity City and produce the huge volumes of ornaments, umbrellas, holiday gifts, toys, glasses, socks, and other commodity items sold at the marketplace. (For more on the marketplace, visit www.cccgroup.com.cn.) Having the centralized marketplace close to the supply clusters simplifies the process of conducting business and reduces the transaction costs for small buyers due to the economy of scale and risk-pooling effect.⁹

Two of the main difficulties of managing a supply chain are determining systemwide costs and dealing with demand uncertainty. A supply cluster addresses both of these challenges through its inherent advantages in efficiency, effectiveness, and flexibility. Clusters facilitate the efficient sourcing of inputs; the sharing of information, process improvements, and technological know-how; and the coordination among related companies.¹⁰ A supply cluster can help companies be more responsive and more effectively manage their supply chain. We will elaborate on the impact of a supply cluster on the four supply chain performance drivers outlined by Sunil Chopra and Peter Meindl in their book Supply Chain Management: Strategy, Planning and Operation. These drivers are facilities, transportation, inventory, and information.

Facilities are the places in a supply chain where product is produced and stored. Decisions regarding location, capacity, and flexibility of facilities have a significant impact on the supply chain's performance. The close geographical location of similar manufacturers within a cluster enables flexibility and capacity pooling to better handle uncertain demand. For example, companies can outsource orders or parts of orders that they may not be able to handle themselves to other firms with similar production capabilities within the same geographical area. Such an arrangement creates a perception to a purchaser that its entire order is being fulfilled by the same producer. The manufacturer, for its part, does not suffer any potential losses (for example, lost sales or customer goodwill) from not being able to satisfy the entire order due to capacity restrictions.

The close proximity of similar facilities also allows these companies to share the investment costs of building facilities and other required infrastructure (for example, steam and the sewage treatment plants required for the dying and printing industry). Building a few larger-sized facilities may be less expensive than constructing many smaller-sized facilities due to the scale economies.

Capacity aggregation also helps individual firms contend with supply disruptions since resources can be shared among firms located across the street (often literally). Further, on the supply side of the equation, a supply cluster allows each member to benefit when procuring raw materials, components, final goods, labor, equipment, and other supporting services from their suppliers. The cluster effectively affords them greater buying scale without requiring the firms to sacrifice their independence and flexibility.

This leads to improved performance on the second of the four supply chain drivers: transportation. By purchasing large volumes of inbound goods and consolidated shipments of finished goods, supply clusters can lead to substantial savings on both inbound and outbound transportation costs. When shipments cannot be aggregated, manufacturers are forced to turn to more expensive options like less-than-truckload (LTL). Consider the fact that enormous quantities of products are exported from China and that an estimated 60 percent of Chinese exports are made from imported materials, according to The Wall Street Journal. Bulk and aggregated full truckload or containerload shipping obviously becomes a competitive necessity. The cost savings from these transport options can then trickle down to the individual firms in the cluster and ultimately to the end customer.

Within the supply cluster itself, shipping costs between suppliers and manufacturers are greatly reduced because of the close proximity of these firms. Consider the example of the Flextronics production campus in the Pearl River Delta town of Doumen, Guangdong province.¹¹ Situated within 149 acres are 13 factories employing 18,000 workers producing cell phones, X-box game consoles, PCs, and other hardware. Within a two-hour driving distance of these factories are thousands of suppliers that provide almost every service and production support required by Flextronics. This logistical setup alone results in component costs that are less than 20 percent of similar products produced in the United States.

As there are minimal shipping requirements within the supply cluster, fewer shipping facilities are needed. Moreover, the short travel distances allow for increased responsiveness and efficiencies compared to longer, more traditional supply chains, where compromises have to be made between delivery speed and costs.

How supply clusters manage transportation also affects the management of inventories (another of the four supply chain drivers). The geographic closeness of the facilities and activities within a supply cluster facilitates the flow of inventories (raw, work-in-process, or finished-good inventories) in a somewhat just-in-time manner. With frequent small shipments occurring between facilities, in-transit inventories—which tie up working capital—are minimized. In reality, this is the current management practice in China. Many firms use a continuous replenishment ordering policy although they may not be able to identify the process as such.

Information, the fourth supply chain driver, plays a vital role and deeply affects every part of the supply cluster. Information transmission and sharing is recognized as one of the major advantages of industrial clusters. Because many enterprises in a supply cluster are small- or medium-sized, they do not necessarily have the means to build an effective information technology (IT) infrastructure. Although the Internet is being used increasingly at the initial stages of business transactions, much demand information is still being transferred through face-to-face interactions. The geographic proximity of firms in supply clusters provides favorable conditions for this kind of information transfer, which results in creating personal relationships (guan xi in Chinese) and strengthening community ties. And this, in turn, fosters trust among the members of the cluster, and facilitates the flow and accumulation of extensive market, technical, and competitive information leading to further value creation for the producers and customers.

Overall, supply clusters provide manufacturers with a superb capability to respond to unpredictable market demands and capitalize on them through fast delivery, by utilizing its advantages in the four supply chain performance drivers.

The advantages of supply clusters go well beyond the four supply chain drivers. When it comes to marketing, for instance, an old Chinese proverb comes to mind: "A chopstick can easily be snapped, but a dozen are hard to break." Marketing the cluster as a whole creates a reputation for the region within a particular industry. For example, in the last decade, the city of Suzhou in the Jiangsu province has developed several computer hardware supply clusters to become one of the most competitive IT-component manufacturing bases in the world. Cluster members benefit from joint marketing campaigns such as company referrals and trade fairs. The grouping of similar producers also makes buying from a cluster more attractive for purchasers as they are in contact with and exposed to many vendors in a single trip. Geographically dispersed companies are less likely to recognize and capture such benefits.

Although clusters can foster cooperation in efforts like marketing, they also fuel competition in other dimensions. This competition is driven by the desire to "look good" in the community and to win customers' orders. So, whenever there is a leader in process reengineering or product design innovation, for example, other enterprises in the cluster will try emulate the leader by developing similar technologies or adopting similar personnel hiring strategies. This continuous striving for improvement has the positive effect of attracting equipment suppliers, collaborative research labs, and other service companies to the cluster.

Efficiency and effectiveness in the supply clusters should only increase as Chinese manufacturers begin to acquire new production equipment and improve their practices and processes. These efforts are occurring at a rate faster than many Western managers anticipated. Many small- and medium-scale producers, who had been using relatively outdated manufacturing technologies, have purchased new manufacturing equipment to improve productivity and product quality. This has been particularly good news for Japanese and European equipment manufacturers.

The supply clusters in China have created low barriers of entry. Add to this an entrepreneurial culture and the ease of obtaining loans from private sources, and the result is that total production capacity greatly exceeds product demand. This, in turn, creates even stronger competition, improved business environments, and lower product prices. However, many firms may not be able to sustain their business in such an environment, especially with most of the supply clusters focusing on producing low-margin commodity products. Many of these factories and firms have merely imitated what their peers have been doing, which often results in suboptimal production processes. This reality, coupled with the over-abundance of capacity, could well result in a reduction in the number of supply clusters in the near future.

Two other prominent developments that may affect the continued success of supply clusters in particular and manufacturing in China overall are currency exchange rates and protectionism. Prior to July 2005, the Chinese currency was set to 8.27 yuan per dollar. Many in the United States thought that the yuan was undervalued and contributing to the increasing U.S. trade deficit. Although China ended its firm peg to the dollar in July 2005—an action that resulted in the appreciation of the yuan by 2 percent—it appears that Chinese currency is still under pressure, both financially and politically. Thus, any company considering medium- and/or long-term outsourcing to China needs to take this into consideration.

Although trade barriers in the global market are diminishing, the world market certainly can't be considered a giant free-trade zone. Restrictive protectionist policies are cards that can still be put into play. For example, the Chinese textile industry in 2005 suffered greatly from restrictive import quotas imposed by the European Union and the United States. The prudent strategy is to develop your own long-term action plan to deal with any potential protectionism issues that may affect your industry or company.

We have discussed how the current form of export manufacturing in China via supply clusters has contributed significantly to China's low-cost competitive advantage. Using the framework of the four supply chain drivers of facilities, transportation, inventory, and information, we explored the advantages created by a supply cluster toward improving the overall supply chain process. In this case, that process begins with production of a product in China, its transportation to the importing country, and finally its purchase by the end consumer.

Conducting business in China is complex, especially considering the pace of growth and change within that nation. Recognizing the supply cluster's role within the supply chain is a first step in simplifying that complexity. When developing a global supply chain strategy that includes China, companies in the West need to appreciate the supply cluster concept and how it can work to their advantage. As the success of the supply clusters should make clear, a successful global supply chain strategy certainly encompasses a lot more than simply low labor cost.

When companies more clearly understand the manufacturing and supply chain environment, China will become a less complex and risky business domain. We hope that this article has led to a clearer understanding while at the same time providing an impetus for further research into this fresh and fertile area.