Many foreign firms in China have become caught in the value trap which destroys shareholder value. Lowering operating costs and studying the Chinese consumer could secure long-term profits, say Hubert Hsu and Jim Hemerling.

China continues to represent an enormous opportunity for consumer goods companies. With an economy seven times larger than it was 20 years ago, the country is undergoing the greatest economic expansion ever witnessed – anytime, anywhere. It is already the largest market for washing machines and mobile phones, the second largest for beer, and the third largest for carbonated soft drinks.

That growth shows no sign of slowing as consumers’ disposable incomes keep rising. With the full package of World Trade Organisation benefits kicking in over the next few years, industries will continue to expand at a rate several times of that in more developed markets. And although highly regulated industries – such as telecommunications and financial services – must devote significant time and resources to cultivating and managing government relationships, consumer goods companies can spend more of their energy on business because they are among the least regulated in China.

No wonder multinational companies are encouraged by their initial forays into China. But their early success – often a result of skimming off the most affluent consumers in the biggest cities – can create a false sense of confidence in the sustainability of their business models. Because the fastest growth in China’s high-income households is expected to come from outside the largest urban areas, many companies are now trying to penetrate the mass market – and they are counting on those same business models to work for them there (see chart 1).

When they expand into new locations and categories, however, they typically run into a wall of new problems including: fragmented markets, consumers, and channels; low prices in areas beyond the large urban centres; different competitors in different regions, each employing completely different go-to-market approaches; immature distribution infrastructures and players; and extraordinary strains on organisational capabilities and infrastructure.

Most companies respond to these difficulties by allocating additional financial and human resources, only to become ensnared in the China value trap: the more they invest, the more they seem to lose as shareholder value drains away. Expatriate and local managers find themselves working harder and harder with no turnaround in sight.

Huge losses

Chart 1: High income household growth fastest outside cities

We estimate that more than 50% of today’s consumer-goods and retail multinationals are caught in the value trap. In the beer industry, for example, international brewers have experienced annual losses that run into tens of millions of dollars, on top of hundreds of millions in write-offs from failed investments. Moreover, the problems occur across many sectors, such as packaged food and beverages, personal care, household chemicals, consumer durables, and retail groceries.

A few leading companies, however, are emerging from this trap with remarkable speed, and they are developing large, profitable positions across a range of markets (see chart 2). Conventional wisdom asserts that the key to success in China is a combination of low costs and low prices. Of course, those advantages are crucial but a more dynamic and sophisticated model is needed in a market as complex and varied as China’s. The companies that accelerate quickly out of the trap all pay close and early attention to scale, costs, and prices, but they also focus on local market insights and think creatively about resource deployment.

Exit this way

We’ve identified the collective strategies required to break out of the value trap as the China success model (see chart 3). These strategies do not work independently. Rather, their power lies in their integrated nature and the ways in which they complement one another. The value trap, then, may be hard to avoid. But if a company prepares ahead of time or changes course once it is snared, it will find a way out.

Indeed, the approach a company employs will have a lasting impact on its business trajectory – in both the severity of the losses it experiences and the speed with which it escapes the trap. What follows is a closer look at the components of the China success model.

With a national savings rate of more than 30%, China is famous for the frugality of its citizens. To attract value-conscious shoppers, successful local companies focus on the high-volume, lower-price-point segments. Huiyuan in juices and Sanxiao in toothbrushes, for example, price their products more than 20% below those of the leading multinational brands and, as a result, dominate the mass market. To compete with these successful local players, many of which have also improved their product quality and positioning, global companies must proactively cut prices. Lower prices will help deepen penetration into the mass market, which in turn will provide scale benefits to support additional pricing and value-enhancement strategies.

Success story

Tingyi, a Taiwanese company, has captured the market for packaged noodles by being the value and price leader in the premium segment. Leveraging its scale, it has built its own sales and distribution (S&D) network, which includes more than 300 sales offices across China, serving nearly 34,000 retailers directly.

The remaining retail outlets are serviced through distributors, who provide logistics, and wholesalers, who sell to remote locations. That approach has allowed Tingyi to build strong relationships with its retailers and, as a result, dominate their shelves.

The brand frequently commands as much as half the total space allocated to the category. Having established its S&D system, Tingyi has now embarked on an aggressive programme of value improvement (larger package sizes), product extensions (an economy-priced noodle brand), and category expansions (ready-to-drink beverages and snacks).

When global companies focus on value pricing and scale, they frequently complain about low margins. Often, the problem is that they have not fully explored how truly low cost their operations could be. Most companies could significantly reduce their costs in at least three ways: by ensuring that economies of scale are fully exploited, by localising cost structures to benefit from China’s favourable factor costs, and by increasing their focus on the parts of the business that deliver real value to consumers and eliminating or reducing those that do not.

Contrary to what many multinational companies claim, our experience does not support the notion that local companies enjoy significant structural advantages. Some may discover small advantages by locating in lower-cost regions within China, but in relative terms, the savings are small.

Chart 2: China’s value trap – how firms can fall in and climb out again

Cost cutting

Most multinationals believe they cannot reduce costs by much more than 5%-10%. We believe the opportunity is often more than 20% and possibly as high as 40%. When lowering costs, however, such companies need to ensure that their Chinese operations continue to leverage useful experiences and processes from the worldwide system, while they also develop local management capabilities and a business model that is relevant to serving the Chinese market.

For example, when Colgate discovered Sanxiao’s 30% cost advantage in toothbrush production and realised it would take significant time and resources to narrow the gap, it acquired the company. Now it not only owns the Chinese toothbrush market with more than 50% volume share but it also uses the low-cost facility as an international sourcing centre.

Local knowledge

China poses an enormous challenge to multinational consumer-goods and retail companies when it comes to gaining insight into its local markets. The wide-ranging differences across the country – with its 600-plus cities, seven major dialects, and 80 or so spoken “tongues,” not to mention its huge disparities in education and income – are made even more daunting by the severe inaccuracy or lack of published data. Rather than rely solely on market research, successful companies get out and talk directly with channel partners, competitors, and consumers. They also tap into the direct experience of local managers, whose in-sights into the subtleties of local lifestyles and preferences help the companies tailor products to meet local demand.

Multinational companies often view Chinese consumers only in the context of their global brands. Although such brands provide many advantages, they also bring with them many constraints, especially when it comes to positioning, icons, and messages. Chinese consumers still admire western products, but they are more inclined to shop for brands they feel serve their specific needs. For example, Shiseido long ago discovered that many Chinese consumers believe that Asian skin is significantly different from the skin of non-Asians. Acting on that insight, the Japanese company established an early lead in the fast-growing cosmetics categories by noting in its advertising that its products are designed specifically for Asians.

The challenge of offering localised products is made harder by the fact that consumer preferences vary considerably within China. What sells in the chic environs of Shanghai might be rejected in rural communities. That is why Tingyi tailors its products to regional tastes, marketing sweeter flavours in Shanghai and saltier flavours in the northeast region. Supported by a highly sophisticated regional production capability, the company is then able to revise its formulation continually in order to meet changing tastes, which brings it even closer to consumers.

Chinese consumers also place a high value on superior service. That is an area in which multinationals can gain an advantage because local companies often find it difficult to deliver even the most basic service. KFC and McDonald’s, for example, leveraged their global capabilities to deliver a consistently high-quality service experience that stands in stark contrast to the indifferent service typical in competing local restaurants.

Leading Chinese companies are beginning to catch up, however, and some are offering very high standards of service. Haier, an appliance retailer, for example, differentiated itself from both local and global competitors by offering a national 24-hour hotline for its appliances. Furthermore, it extended the concept to its channel partners, proactively servicing retailers to support sales, promotion, and marketing. Those actions have contributed to making Haier number one in China’s appliance market.

Business battles

In a country as vast as China, resource deployment can be a complex issue. Like leaders in combat, business leaders must first decide which battles to fight, the optimal configuration of forces to use, and how best to deploy those forces to break through competitive positions.

In short, they must adapt their go-to-market models for each regional market. Then they need to organise to ensure that those resources are not overwhelmed by the ensuing complexity of battle. Clear lines of communication and supply, as well as effective processes and policies, are vital to making certain that the troops at the front are aligned and equipped.

Leaders must also decide whether to align their forces with others and how to orchestrate that deployment. Mergers, acquisitions, and alliances – together with effective integration plans – are often critical to building scale and capabilities. Although effective resource deployment can seem difficult, many companies in China are already making great progress.

Chart 3: The China success model

Out of the city

Large cities account for a relatively small, albeit very attractive, share of the market in most consumer categories today. What is more, future income growth will be highest outside those cities. Sooner or later, most multinational companies will decide to expand beyond their initial, fortified position to tap into the vast potential of the rest of the country (see chart 4). But once they encounter less sophisticated consumers, new competitors, immature distribution infrastructures, fragmented channels, and woefully inadequate data and information, just how many business models will they need?

Clearly, one model cannot work for every area. Companies will need to customise products, distribution, advertising, and promotions. But that does not mean that each city requires its own unique model.

We recently helped one of the largest packaged-goods companies in China reassess its business model across the more than 600 cities it served – nearly every urban centre in the country. First, we segmented the market into city clusters with similar characteristics, winding up with a much more manageable number. Then we devised a go-to-market model for each cluster, which included channel priorities, media and promotion strategies, salesforce deployment, as well as logistics models.

Along the way, we identified certain regions that were simply unprofitable to serve and devised exit strategies. The exercise had a significant impact on the top and bottom lines, and it allowed the client to focus scarce resources on its most important geographic markets and channels.

Brand umbrellas

Huiyuan, the leading local juice company, provides another good example. Unlike most packaged-goods companies, it eschews a diverse brand portfolio in favour of collecting most of its products under a single brand umbrella. That strategy simplifies marketing, advertising, and distribution; in addition, it enables the company to enjoy significant marketing scale advantages.

What is more, the approach allows Huiyuan to enter new categories – such as packaged juice drinks – that it can introduce under the established umbrella brand and distribution network. As a result, the company has been able to achieve a profitable growth trajectory while maintaining its leadership position.

Expansion will inevitably increase organisational complexity because the new cities that have a growing mass market will be smaller and channels and distributors more fragmented. Expanding an initial market to 10 or 20 cities typically results in an exponential increase in the number of staff, distributors, and customers. Left unmanaged, these factors result in overwhelming organisational complexity.

When expatriate and local managers underestimate that complexity – as happens all too frequently – they find themselves spending more and more time on the road working longer and longer hours to deal with mounting operational problems in one market after another. Companies can make this process considerably easier by codifying standard processes and procedures using good management-information systems. In nascent Chinese markets, simple approaches are frequently just as effective as the sophisticated ones that multinational companies adopt in more developed markets.

For instance, a well-managed S&D network is critical, but China’s market complexities cause many companies to struggle with even modest expansions. One of the few exceptions to this is PepsiCo’s beverage division. The division realised that its core global processes could be just as effective in China as they are elsewhere, but success would depend on careful implementation.

Therefore, PepsiCo has piloted selected processes in a few key regional markets in order to customise them for China. These sales tools are then codified in manuals and reinforced across all of the company’s teams. Global companies such as Pepsi-Co have found that a profitable pilot can be a persuasive tool for convincing Chinese managers to adopt a new system.

PepsiCo’s continued success is also based on constant process renewal. To encourage innovation, it gives its supervisors significant decision-making power. Twice a year, the company organises a national conference to bring its sales managers up to date on the latest S&D information and to share local best practices.

Managerial freedom, however, is tempered by a rigorous monitoring system that entails regular evaluations by internal teams as well as third parties on key performance indicators. With these strategies, PepsiCo has rapidly and economically built a deep and expansive S&D network and gained significant share compared with Coca-Cola.

Chart 4: Where is China’s buying power?

M&A advantages

Reluctant to relinquish any management control in this strategically important market, many companies opt for organic growth in China, despite its many – often unique – challenges. Yet the creative use of mergers and acquisitions can often be a more effective way to escape the value trap. Rather than buying a local brand simply for its products and volume, companies should consider the broader role that the acquired company could play. It could help establish a low-cost production base, for instance, or provide a mass-market S&D system for the accelerated expansion of a global product portfolio. In addition, it could offer the freedom to market a local brand – enhanced with global product technologies but free from global brand restrictions – to a huge market of price-sensitive Chinese consumers.

Nevertheless, mergers and acquisitions can involve risks that are unique to China. Due diligence for even a medium-sized acquisition could (and probably should) take months to complete. What is more, given the complex structure of government in provincial China, it is vital to use a facilitator with solid knowledge of the region.

Finally, in the post-merger integration phase, it is easy to overlook the inherent differences in the operating models of acquirer and target. Companies must guard against adding layers of expenses that transform otherwise successful low-cost businesses into general-and-administrative-loaded failures.

China’s potential

As some nimble multinationals are proving, it is possible to reduce the inevitable growing pains of expansion in China and quickly return to profitability. To realise its true potential in China, a company must start by assessing its position today in relation to where it wants to go and how soon it needs to get there. Answering the following questions will help guide that effort:

Where does the company stand today in relation to the value trap? Will its business in China be in a fundamentally more advantageous position within a year?

Have all the complexities that are inherent in the expansion plan been factored in? Have the challenges and investments required been underestimated?

Is there a sufficiently deep understanding of the Chinese consumer in order to position brands and customise products and services?

Can operating costs be lowered by 20%-40% in order to support a value-pricing strategy?

How will the company’s go-to-market model be adapted as it starts to expand beyond its initial efforts?

Are the right organisation, performance disciplines and processes in place to support the expanding business model?

How would a merger, acquisition, or alliance help the company climb out of the value trap more quickly? Has the organisation explored all the creative options? What are the challenges and risks inherent in the post-merger integration?

The China value trap is real. Many companies are caught in it today and have seen significant shareholder value destroyed. If a company has not fallen into the trap yet, chances are it will soon. And once caught, it may seem like quicksand, because the harder you try to escape, the deeper you will sink. It takes vision, creative strategy, courage and precise implementation to break out.

Hubert Hsu is a vice president and director in the Hong Kong office of The Boston Consulting Group, hsu.hubert@bcg.com. Jim Hemerling is a vice president and director in the firm’s Shanghai office, hemerling.jim@bcg.com