Reaching China’s Next 600 Cities

Consumer goods companies must adapt their sales, marketing, and distribution plans to reach rapidly expanding markets in smaller cities.by James A. C. SinclairDemand for consumer goods in hundreds of cities across China is increasing. While Chinese companies in smaller cities look to expand into larger cities, their international counterparts are trying to do just the opposite. The China market is no longer limited to Beijing and Shanghai, or even provincial cities such as Changsha, Hunan; or Harbin, Heilongjiang. International companies that do not ramp up their sales, marketing, and distribution efforts risk losing touch with consumers, losing market share to domestic and foreign competitors, and becoming marginal players.

Consumer goods companies should reevaluate what being a national player now means. Firms should examine their current approach to market research, assess which city segments have potential, check that they have a suitable product mix, determine whether to expand by region or by tier, and learn how to better work with traditional trade channels and large sales forces. To compete in an unfamiliar, diverse, and complex environment, companies must experiment, learn, and adapt over time.

Just as companies must understand the differences between Beijing and Shanghai to be successful in both cities, companies should understand that regional variations also matter for smaller cities. Tier 2 cities have become much less homogenous as they have developed, and smaller cities from different tiers in the same region will likely have much more in common than same-tier cities in different regions. (For a description of Chinese city tiers, see China’s Tier Variations.) Culture, dialect, cuisine, and climate all have implications for consumer goods companies because they influence consumers’ responsiveness to advertising, product preference and acceptance, price and quality sensitivity, and shopping behavior. For example, consumers in eastern China prefer entertaining and aspirational advertisements, whereas those in southern China prefer concise ads that explain product benefits. Not all regions have the same media and retail infrastructure, level and nature of competition, and exposure to a company’s brand. These are important factors to consider before entering a new regional market.

Competition from Chinese brands

China’s smaller cities are unfamiliar territory for many international consumer goods companies, which often face competition from Chinese counterparts that already know these markets well. Small cities have been serving as incubators for Chinese companies before they expand into larger markets. Such companies are skilled at identifying spaces in the market, experimenting, and learning and adapting as they go. Strong Chinese brands are emerging in packaged foods, quick-service restaurants, infant products, personal care products, and footwear and fashion retail.

For example, Xiang Piaopiao Food Co. Ltd. (XPP), a successful Chinese brand in the powder beverage sector, entered the market in 2005 with an innovative milk tea product. At the time, the China market had two established milk tea drinks: takeaway milk tea sold at roadside counters and three-in-one (tea, creamer, and sugar) instant milk tea packets sold in multi-packs for home and office consumption. XPP’s Chair and General Manager Jiang Jianqi saw an opportunity to capitalize on China’s established milk tea culture, combining the concepts of milk tea packets and three-in-one coffee cups to create milk tea cups. The milk tea cups would be more readily available, offered in single servings, convenient for impulse consumption, and sold at a lower price per unit. XPP was followed by one other successful early mover, Uloveit (ULI), a brand owned by Guangdong Strong Group Co., Ltd.

Though the existing market for milk tea packets had been in Tier 1 and Tier 2 markets, XPP saw potential for their product in roughly 600 smaller cities, which did not have the prohibitively high entry fees of bigger cities. To rapidly build its distribution and retail network, the company’s sales team trudged across fields with sample cases to find and persuade distributors and retailers to carry its milk tea cups. After the initial sales, the team transferred retailers to its distributors and nearby wholesale markets. Eventually, 400 distributors, each with a strong local presence, agreed to distribute the product. This gave XPP a flat distribution structure with nearly national coverage in breadth and depth. The company, however, continued to use its own sales force to conduct merchandising with retailers to ensure visibility, run promotions, and control retail prices.

Though milk tea packets had largely been sold through modern trade channels, such as hypermarkets, supermarkets, and convenience stores, few modern trade channels exist in smaller cities. To reach smaller markets, XPP prioritized traditional channels, including small independent supermarkets, mom-and-pop shops, and small retailers in schools and universities. Traditional trade channels eventually contributed 50-60 percent of the company’s sales.

XPP’s sales per city from provincial capitals (Tier 2) were by far the largest, but the aggregate sales from smaller cities and towns (Tier 3 to Tier 6) typically accounted for 75-80 percent of total sales in a province. XPP and its competitor ULI have both grown at a compound annual growth rate of more than 100 percent for the past three to five years and have been the major drivers behind the domestic milk tea industry’s growth. XPP has since moved down to Tier 5 and Tier 6 towns and up to Tier 1 cities, where it is competing head-to-head with international counterparts.

When it comes to expanding to smaller cities, international consumer goods companies have much to learn from companies such as XPP, including the importance of new product development. Successful expansion should not be about replicating models and capabilities, but rather developing insights that allow a company to play to its strengths. At minimum, foreign companies must keep an eye on the horizon to spot new companies emerging from smaller cities that could be competitive threats and acquisition targets.

Expansion of geographic coverage

Some international consumer goods firms, such as the Procter & Gamble Co. (P&G), entered smaller Chinese cities 10 years ago. P&G’s personal care products are now in 1,300 counties (Tier 5) across the country. Few other international players have entered China’s smaller cities, however, and foreign companies still face many challenges.

Foreign companies often ask which cities they should tackle first. The answer is often related to the product’s market potential and the company’s distribution capabilities. Most companies should use a larger city to launch into smaller cities nearby. For example, the provinces around Shanghai are relatively developed and likely have attractive markets. Clusters of small cities may share regional similarities, allowing for greater transferability of propositions and models, especially if out-of-town visits to bigger cities have already exposed consumers to the company’s brand. Proximity to a big city hub makes it easier and more feasible to expand the sales force, extend existing distributors or identify new ones, and handle warehousing and logistics.

KFC Corp. used the hub approach to expand in China from 1995 to 2000. KFC entered new provinces by selecting the provincial capital, usually the largest population center, as the hub. Because food service uses short shelf-life items, such as bread and vegetables, the supply chain had to be fully functional before operations began. Identifying suppliers and setting up logistics and a distribution center took significant time and effort, but once in place, the investment could be tapped for other cities and towns within a reasonable driving range. Though it took a relatively long time to establish the first restaurant in a province, the other restaurants could follow much more quickly. KFC reached 3,000 restaurants in China by June 2010, and it continues to add one new restaurant in China almost every day.

Evolution of retail channels

Expansion into new cities and towns is heavily dependent on available retail channels. Many global retailers in China—including Home Depot, Inc. and B&Q plc in home improvement, Isetan Mitsukoshi Holdings Ltd. and Parkson Retail Development Co. Ltd. in department stores, and Wal-Mart Stores, Inc. and Carrefour SA in hypermarkets and supermarkets—still account for only a small proportion of China’s total retail sales and an even smaller proportion of total retail outlets. Though modern trade channels will continue to expand rapidly, traditional channels will remain relevant for the next 5 to 10 years, especially in smaller cities. International consumer goods companies that seek to be national players must learn how to work with both types of trade channels.

Leading international hypermarkets and supermarkets are expanding their city coverage. Wal-Mart has 189 supercenters in 101 Chinese cities, covering all Tier 2 cities except those in remote western China, and in most cases has opened stores in surrounding Tier 3 cities. In Northeast, East, and South China in particular, Wal-Mart is building a higher density of stores, including in a handful of Tier 4 cities and Tier 5 towns. Carrefour, with 159 stores in 47 cities across China, and Tesco plc, with 78 stores in 35 cities largely concentrated in eastern China, are one step behind. The trend is clear: International retailers will expand rapidly far into the future. Tesco will likely open more floor space in China in the next five years than it has done in eight decades in the United Kingdom.

Chinese hypermarkets and supermarkets are also developing to rival their international peers. Lianhua Supermarket, owned by China’s largest retailer, Shanghai Bailian Group, already has more than 3,000 supermarkets and 5,000 retail outlets. During the first half of 2010, Lianhua opened 258 new outlets, focusing on the Yangzi River Delta.

In addition, convenience store chains will expand. Lawson, Inc., Japan’s second-largest convenience store chain, announced that it may spend up to $200 million annually on its China expansion in the next four years and will have as many as 10,000 stores in the country by 2020. Growth in the number of convenience stores will likely occur in eastern and southern China, where purchasing power is higher and the pace of life is faster. The number of Chinese regional convenience store chains will also rise, although in many cases their outlets will continue to resemble traditional mom-and-pop shops in the way they function.

Role of the sales force

A strong case can be made for a large sales force in China, especially in the fast-moving consumer goods (FMCG) sector. Because of the rapidly developing nature of the sector, distributors and retailers still lack the ability or resources to properly merchandise products. The problem exists in modern trade channels, but it is much worse in traditional trade. If merchandising is weak, products suffer from poor visibility, become neglected, and stop moving.

FMCG players in China have realized that merchandising is a key success factor for traditional channels. Some players that have tried to push merchandising to their distributors are now bringing it back in-house to allow stronger control. Companies should give sales personnel key performance indicators that incentivize them appropriately—combining total sales with sales per store or quality of display—and use supervisors to monitor performance against these indicators. The sales force should also generate and handle new orders and run in-store programs that increase influence at the point of purchase. In most cases, sales reps that work in traditional channels should be dedicated to traditional channels alone. This makes it more likely that sales reps will devote time and effort to develop the channel and consolidate and build on lessons learned along the way.

FMCG companies therefore must build and manage large sales forces. For example, Master Kong runs an organized and disciplined sales force of 7,000 employees. Owned by the Taiwan group Tingyi (Cayman Islands) Holding Corp., Master Kong earned ¥34 billion ($5.08 billion) in 2009 and is the market leader in instant noodles in China with a 55 percent market share. Master Kong has more than 1 million sales points across China, of which only about 60,000 are modern trade, the remainder being traditional trade.

Master Kong handles the vast majority of merchandising in-house. The company divides cities and towns into patches of roughly 300 stores each, with one sales rep responsible for each patch. Sales reps use an electric bike to cover about 30 stores on a daily fixed route, visiting most stores on a two-week rotation. During each visit they conduct inventory checks, merchandise the products, generate new orders, and gather competitor intelligence. In addition to the frequency and professionalism of the visits, the sales reps are also trained to build strong relationships with the store owners. Importantly, Master Kong is one of the few FMCG players that strictly implements a key performance indicator system that covers both sales and merchandising. Because of this sales system, most of Master Kong’s distribution partners are limited to warehousing, delivery, and payment collection.

One of the concerns companies have with running a large sales force is China’s relatively employee-friendly regulatory environment. Though Master Kong directly employs most of its sales reps, there are alternative employment models. For example, dispatching—employing and dispatching sales reps by a third-party human resources organization—is becoming more common. Another model involves sales reps that are employed by distributors but managed by the principal.

Look to the lower tiers

In the years to come, many relatively unknown Chinese consumer brands from smaller cities will achieve scale and compete with existing market leaders in various consumer product categories. Foreign consumer goods players may not even see them coming because existing retail audit data misses market activity that occurs beyond bigger cities and modern distribution channels.

Foreign companies that want to remain competitive should first ensure that the current approach to market research covers more than just bigger cities and modern distribution channels. Once nuances between city segments are properly understood, a go-to-market plan must be developed. For many companies, this will include contracting with distribution partners that are strong in traditional channels, and recruiting, training, and organizing a large sales force. Plans may have to vary across the country, and part of the challenge will be achieving a balance between a robust national model and customized local variations.

Though discussions now focus on reaching China’s next 600 cities, companies may soon focus on China’s thousands of towns. For some consumer goods companies that is already the case. The companies that get this right today will be the market leaders of tomorrow. Many Chinese companies have the ambition and are building the ability to replace international counterparts that fall behind.

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China’s Tier Variations

The hundreds of cities that are part of China’s consumer boom are far from homogenous. Companies must categorize these cities and determine which segments to tackle and in which order. Though many analysts use their own classification system, it is useful to understand China’s administrative tiers, which are loosely based on demographic and economic criteria and reflect a hierarchy of economic links. Tier classification can help companies under stand urbanization patterns, transportation links, distribution structures, flow of goods, and the mobility of the population. Though this classification system should not be used as a segmentation framework alone, it can serve as a basis for some more nuanced thinking.

Tier 1 cities are at the top of the administrative structure and usually include China’s municipalities: Beijing, Chongqing, Shanghai, and Tianjin. Guangzhou and Shenzhen, Guangdong, are sometimes included on this list—or substituted for Chongqing and Tianjin—because of their developed economies and sophisticated consumer markets. Provincial capitals largely make up Tier 2 cities. Provinces are further divided into prefecture-level cities (Tier 3), which are divided into county-level cities (Tier 4) and counties (Tier 5). At the bottom of the structure are townships (Tier 6) and villages (Tier 7). Though many analysts use gross domestic product and population size to classify large cities in China, some also use government tiers to classify smaller cities, towns, and villages.

Classifying China’s cities can be confusing. The term “city” in China refers to an administrative division, typically comprising an urban core and the surrounding rural area. The surrounding area often includes lower-tier cities, towns, and villages. For example, in Jiangsu province, Suzhou city (Tier 2) has jurisdiction over Kunshan, Taicang , and Zhangjiagang cities (Tier 4), among others. China thus has many cities within cities, which can complicate retail coverage and sales volume statistics and risk double counting and exaggeration.

—James A. C. Sinclair
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[author] James A. C. Sinclair ([email protected]) is partner and strategy practice director at InterChina Consulting. He is based in Shanghai. [/author]