Developing China Sales and Distribution Capabilities

The China market offers opportunities for companies that can navigate its evolving sales and distribution landscape.by Bradley A. FeulingBefore the launch of economic reforms in 1978, the PRC government controlled China’s nationwide distribution channels, including the system of managed distribution centers, wholesale operations, and retail outlets. The State Planning Commission issued production requirements and allocated inventory.

As reforms progressed, the government phased out central planning for many products. China’s 2001 World Trade Organization (WTO) entry brought more foreign competition, which led to the elimination of many local distribution points and the centralization of main provincial hubs. These changes allowed for greater privatization of distribution at a local level. In 2004, China issued rules that opened distribution to foreign investment and, among other things, allowed foreign distribution companies to apply for national wholesale licenses. Today, foreign enterprises may participate in joint-venture distribution operations for most wholesale operations.

Sales and distribution networks evolve

Bigger markets demand better distribution systems

With the increased privatization of distribution channels, sales in China have risen exponentially. Retail sales alone rose from ¥4.3 trillion ($520 billion) in 2001 to ¥12.5 trillion ($1.8 trillion) in 2009, growing about 12.5 percent each year. Last year, retail sales grew 16.9 percent over 2008 despite the global economic downturn, according to the PRC National Bureau of Statistics, and a PRC Ministry of Commerce (MOFCOM) official in November 2009 said that China’s retail sector is expected to grow 16 percent in 2010. An April 2010 Boston Consulting Group report noted that “the increase in middle- and affluent-class households will double consumer spending power in nearly a quarter of China’s cities and counties over the next decade.” The authors further estimated that consumer companies looking to reach 70 percent of this segment need to be in nearly 240 locations today—and in more than 400 by 2020.

Many companies are marketing their brands beyond the major cities to meet growing demand. More than 160 cities in China have populations of at least 1 million. Some companies, such as Adidas-Salomon AG and Nike, Inc., already have strategies to penetrate smaller cities. These developments and forecasts imply that companies in China will need to greatly expand and strengthen their distribution and logistics capabilities, whether on their own or through third-party providers. In addition, PRC government efforts to boost consumption will reinforce these trends.

Logistics and distribution take center stage

In recent years, the PRC government has invested a great deal in the country’s logistics infrastructure. China allocated nearly 40 percent of its massive 2008 economic stimulus (¥1.5 trillion [$219 billion]) to public infrastructure development. In 2009, China built or upgraded 156,000 rural stores and 1,100 distribution centers across the country, according to MOFCOM. China now has 420,000 rural stores that cover 75 percent of all townships and 50 percent of all administrative villages.

Over the last decade, China has invested in improving infrastructure in interior cities, with a focus on building larger interior cities into major logistics and distribution hubs. For example, Wuhan, Hubei, is becoming the multimodal logistics hub of central China. The city has one of China’s largest inland ports, handling up to 40 million tons of cargo annually, with shipping lanes that lead to 14 countries. National highways and railway lines link Wuhan to other major Chinese cities. In May 2010, the Wuhan government announced a ¥14.6 billion ($2.1 billion) investment in the Wuhan Tianhe International Airport, which will expand the airport’s cargo capacity to 400,000 tons per year. Many large multinational companies (MNCs), such as the Coca-Cola Co. and Kimberly-Clark Corp., have made the city a key strategic distribution hub. Other inland cities developing similar hubs include Chengdu, Sichuan; Chongqing; Xi’an, Shaanxi; and Zhengzhou, Henan.

Bottlenecks in logistics expansion

Logistics in China is a highly fragmented industry. Bottlenecks hamper efficient and low-cost product delivery. With more than 730,000 registered logistics operators, according to the Global Supply Chain Council, coordinating supply chain capacity and material handling often affect material flows.

One challenge with logistics optimization involves city restrictions on truck sizes during certain times of day. Shanghai, like many other major Chinese cities, limits the use of trucks during daylight hours to alleviate traffic congestion. This complicates distribution and batch shipment optimization. Distribution companies must resort to a fleet of smaller cars and vans or pay exorbitant taxes and fees to use trucks. In this fragmented industry, faced with high transportation costs and low sales margins, distribution companies survive by keeping their prices low.

Companies must also decide whether to outsource logistics or develop in-house logistics capabilities. In 2001, outsourcing logistics operations revenue was only $4.7 billion, less than 5 percent of China’s gross domestic product (GDP). In 2006, logistics outsourcing as a percentage of total logistics spending declined to 2 percent, compared with 10 percent in the United States and nearly 25 percent in Europe. In 2009, Deputy Dean Jiaqi Yang of Wuhan University of Technology’s School of Transportation estimated that China’s logistics outsourcing industry would grow 33 percent each year through 2010. According to the Global Supply Chain Council, third-party logistics is a more than ¥60 billion ($8.8 billion) market in China. As logistics outsourcing grows, competitive advantages for third-party logistics providers—namely in service and efficiency—will lead to greater integration for business operations.

Distribution networks with Chinese characteristics

The main distribution models used in China each have characteristics that affect reach and brand awareness.

• Recently privatized channels  Many of China’s domestic agents and distribution channels are offshoots of the state-owned system and were privatized over the last decade. Such distribution channels—made up of many smaller distribution networks—tend to be large, combine well-established infrastructure networks, and require companies to use strong guanxi at the county- and municipal-government levels (see Three Tips for Distribution in China). Companies that use privatized channels to distribute product in China may find it necessary to build strong relationships to make sure product moves as planned. Even when brand recognition and power is strong, bureaucratic processes may limit efficiency.
• Concentrated wholesale markets  In the late 1980s and 1990s, merchants began to congregate in various locations to sell branded and similar products. A decade or two later, some cities have become famous for certain products. Suzhou, Jiangsu, offers furniture wholesale markets; Yiwu, Zhejiang, is famous for small commodities. Such focused channels serve as distribution points for small- and medium-sized manufacturers, allowing them greater access to China’s urban consumers. According to a Li and Fung Group report, 4,567 wholesale markets boasted sales revenues that exceeded ¥100 million ($14.6 million) in 2008, up 10.8 percent year on year.
• Business-to-consumer services  Increasingly, manufacturers have been expanding their business-to-consumer capabilities. Customers that buy directly from manufacturers often get lower prices but receive service that tends to be below industry benchmarks, because customer service lies outside a manufacturer’s core competencies. Few manufacturers have successfully transitioned from original equipment manufacturer to original designer and original brand owner. Among those that have made the transition are Jiangsu Anyang Fashion Co., Ltd. and Shenzhen Kingsun Optoelectronics Co., Ltd. Anyang Fashion began as a US-invested firm that produced garments solely for export. Today, it is a Chinese-owned company with design capabilities and plans for brand and retail expansion. Shenzhen Kingsun Enterprises, the largest high-power light-emitting-diode (LED) lighting product supplier in China, now has a research and development team of more than 400 people.
• Decentralized distribution systems  With the liberalization of the commercial sector in 2004, a growing number of foreign agents and distributors have established themselves in China. Through complex subcontracting networks, foreign distributors can work directly with traditional retailers. But these networks tend to lack advanced practices in demand planning, inventory management, and logistics networking—which leads to higher operational costs. This is primarily because such networking involves Chinese partners who lack a sophisticated knowledge of international-standard operations and technology.
• Online distribution channels  The rapid expansion of the Internet in China, which now has more than 400 million users, has created online distribution channels. Alibaba.com Ltd. and its subsidiary Taobao.com reach a broad range of customers. In April 2010, Taobao reported over 190 million users. The combination of Alibaba and Taobao creates business-to-business and business-to-consumer opportunities. Foreign companies are also expanding into this market through such online distributors as JiGoCity.com. JiGoCity works with a large network of consumer service companies to offer collective buying directly to customers through their expanding network of online users.

Areas ripe for improvement

Downstream supply chain management

Companies should not assume that Chinese distribution partners have advanced knowledge of downstream supply chain management, including the ability to forecast accurately or to assess service levels. Operationally, this means that foreign-invested manufacturers and foreign companies that sell to China must invest more capital and time to transfer knowledge of material movement requirements, especially improvement strategies to reach key performance-indicator goals. If rapid expansion in China is the goal, the company should focus on improving flexibility in distribution scheduling, placing inventory closer to the customer, and buffering lead times. Ready-to-use contingency plans, including scenario-based strategic decisionmaking, should also be in place to respond to delays. As a whole, Chinese distribution companies lack the capabilities of world-class logistics and supply chain companies in more developed economies. In particular, they tend to be weak in inventory management, lead-time planning, distribution network optimization, and demand forecasting.

Inventory management

Inventory management and lead-time planning are becoming critical focal points for improvement as a more sophisticated customer base demands better service. In China, suppliers hold a large amount of inventory and restock only about three times a year on average, compared with suppliers in Europe, Japan, South Korea, and the United States, who tend to restock about 10 times a year. This means the lead time to delivery in China can be significantly longer than in countries with more developed distribution networks. Chinese suppliers face less flexibility when compared to more developed and advanced counterparts, where capital invested in on-hand inventory is lower. Faster inventory turnover increases liquidity, which can be invested in expansion and resource development. Foreign companies should invest their resources in helping downstream partners increase annual inventory turnover so that downstream partners maintain a healthier cash flow that allows them to invest in expansion.

Distribution structure

The distribution structure is another area that can be streamlined. Many of China’s distribution networks are highly decentralized, creating fractured and often redundant distribution systems. For example, as many as five tiers may exist at a given level of distribution in Shanghai’s complex beverage distribution network, resulting in lower profit margins at every level—producer, wholesaler, distributor, and retailer. To streamline this process, downstream distribution analysis should include a supply chain assessment of factors such as capacity, throughput, and operational metrics, as determined by the company’s key performance indicators. If bottlenecks disrupt distribution, suppliers can leverage their influence to identify more direct routes for end-product distribution.

The challenge of fractured and redundant distribution systems is compounded by highly localized and regional distribution networks. A wholesaler may have exclusive access to a district or city, but wholesale distribution remains fragmented nationally, and companies trying to distribute nationwide must use multiple channels and vendors. Network optimization suffers because distributors are reluctant to work with distributors in other geographic areas. To maintain low logistics costs on long-distance distribution, companies try to avoid hauling products one-way over long distances, which in turn often leads companies to establish storage facilities in multiple cities, increasing holding costs and the amount of capital tied to inventory. An alternative solution would be to invest directly by setting up in-house distribution capabilities rather than using local distributors, and companies such as Metro AG and Carrefour SA are investigating direct investment in cold chain logistics. Companies can also collaborate with other vendors in similar situations, such as through joint-procurement agreements.

Localized demand forecasting

Localized demand forecasting is also underdeveloped in China. Many distributors are, in fact, investment companies that purchase and resell products. Few Chinese distributors have sophisticated knowledge of demand forecast planning. They often exclude important variables such as seasonality, product cannibalization, and forecasting cycles; use weak assumptions to forecast sales; and rarely compare forecasts to actual sales to ensure accuracy. Use of more advanced modeling such as regressions, product correlation, and smoothing is limited. (“Smoothing” is the use of variables in demand forecasting to reduce fluctuations that disrupt otherwise normal behavior.) When working with local distribution partners, foreign companies should determine how sophisticated the forecasting tools used by their downstream networks are. To reduce risk, foreign companies should also factor in additional time and costs when planning to supply the China market.

Efficiency: Good for the environment and the bottom line

The potential market for distribution operations in China is large. Total transportation and logistics expenditures account for roughly 20 percent of GDP, compared to about 10 percent in the United States, according to the Council of Supply Chain Management Professionals. Analysts estimate logistics sector growth in China of between 15-20 percent per year. Consolidation in the highly fragmented market has yet to take place, but it will occur as service performance indicators— namely, on-time and in-full product delivery—improve. The PRC National Committee of Logistics Standardization has proposed regulations that aim to improve cold chain logistics, standardization, and information flow integration through technology. These and other new government regulations that affect logistics industry practices will play a role in standardizing the market nationally but may not be thoroughly implemented at the local level for some time.

With China’s target of reducing carbon intensity per unit of GDP by 40-45 percent of 2005 levels by 2020, the government will remain focused on improving efficiency in logistics and distribution. Efficient truck use and more sustainable supply chain operations are important to meeting this goal. For example, the PRC Ministry of Transport will consider global discussions about reducing unused transportation capacity, and such discussions are likely to affect domestic and foreign logistics use and packaging in China.

China’s Eleventh Five-Year Plan (2006-10) included an unprecedented focus on domestic logistics development. In Shaanxi, for example, Xi’an was selected as one of 17 national logistics centers, according to a Shaanxi provincial government website. In the four years since the plan was released, Xi’an has invested heavily in logistics parks, creating a new bonded logistics zone and a railway container terminal with a capacity of 23 million metric tons annually. Zhengzhou, Henan, was another city selected to become a logistics center. The city established an export-processing center and plans to invest ¥18.2 billion ($2.7 billion) in highway infrastructure in 2010.

MOFCOM is also focusing on rural distribution centers. The government’s focus on consolidating distribution and improving efficiency in inland China will strengthen the emphasis on improving China’s distribution network.

Continued growth and expansion of sales channels in China will spur advances in distribution in the coming years. Logistics networks will become more efficient, and logistics providers will gain knowledge of advanced capacity planning, inventory management, and demand forecasting. The development of China’s economy will lead to the evolution of its supply chain, which will become more similar to those in developed countries.

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Three Tips for Distribution in China

For companies targeting the China market, developing effective sales and distribution channels is critical. When developing sales and distribution channels, companies must consider

• Guanxi  Personal networks and relationships are an important component of a successful distribution strategy in China (see Marketing and Selling to Chinese Businesses). Chinese “networks” are often restricted and exclusive, especially at the local level, where these networks may consist of only a handful of decisionmakers. Thus, forging personal relationships with these individuals is particularly important for distribution channel development.
• Distribution partners  Companies must analyze potential distribution partners, paying attention to material movement within China, because poor inventory positioning and stock-outs can harm brand reputation.
• Efficiency  In many cases, responsibility for distribution operations is initially placed on the distributor without identifying clear procedures and targets. Companies that use material flow mapping, particularly in rural China, and that have fairly sophisticated logistics, in-transit inventory, and distribution capabilities are likely to be more efficient and better at delivering goods on time and with minimal loss or damage. Mapping helps identify each part of the supply chain and which stakeholder is accountable for what. By graphically mapping material flows, companies can more accurately assess the metrics that directly affect service levels and costs.

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[author] Bradley A. Feuling ([email protected]) is the CEO of Kong and Allan (Shanghai) Consulting and is based in Shanghai. Shaun Nath, associate consultant at Kong and Allan (Shanghai) Consulting, provided research assistance. Kong and Allan Consulting specializes in supply chain operations. [/author]