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About Manufacturing in China

It is common for international corporations to enter China and set up a manufacturing or Assembly Operations. It is hard to resist the low cost of labor, especially if you have a labor intensive manufacturing or assembly process. China has actively opened it borders to foreign manufacturing investment since the mid 80's. Billions and billions of dollars are being invested in manufacturing start-up operations each year. The list of foreign firms is a Who's Who of International manufacturing.

Foreign investment are being encouraged for a number of reasons:

  • China is looking to improve it's infrastructure and it's industries, which has been stifled and decayed under state run organization.

  • Jobs for it's people. Low cost labor is bringing in manual, high labor intensive manufacturing and assembly operations.

  • Upscale of it's industrial capabilities. This is having mixed results as corporations are looking to China as a source of low cost, low skill (or unskilled) labor.

  • Long term, it is a source of major tax revenues. Short term this is producing mixed results as there are major tax concessions being offered, especially in Special Economic Zones(SEZ's) to entice new investment.

The big attraction to China is of course is the low cost labor. The second factor drawing major manufacturing investment is the potential access to the largest market in the world,where 1/3 of the people on earth live. Before you launch off prematurely with visions of 2X or 3X sales, see Marketing and Domestic Sales Rights.


Business Risk:

Once you get past the whys, the what's, the whens and the wheres and have completed early drafts of your feasibility study, the issue of risk will invariably come up. A frequently asked question is What is the risk that the communist country, The People's Republic of China will close its doors, confiscate foreign businesses, tax foreign enterprises out of the market or otherwise severely and negatively impact the new business?

The realities is that there is an highly inter-woven relationship between the PRC and foreign enterprise. It has grown to mammoth proportions and is deeply entangled in so many areas of the country. It affects everything from jobs to tax revenues. Although it is not unthinkable, to turn the tide now would have enormous social and economic impact upon the government and the people.

If the government were to act against one company of industry, it would cause foreign investors to react and restrict future investments. Many of the foreign companies are exporting their production, bringing much needed foreign exchange and millions of jobs, both of which would shrivel or dry up.

Where the game is really being played and where foreign companies need to be alert and sharp in their plans and investment is the domestic market. Currently, it is extremely difficult to gain access. So the risk is not one of going from a large market position.

Now that we have explored investment risk in the PRC from a negative perspective, let's look at why the risk will likely prove rewarding:

  • Low cost manufacturing, this should result in a competitive advantage if your competitors are manufacturing in a higher labor cost company.

  • Lower capital investment. For Capital adverse companies, low cost labor will likely translate to more labor trading off a lower capital investment in mechanization.

  • With low capital investment, your risk is lower....

  • Lower capital also translates to faster return on investment. You can invest in increments as your confidence grows.

  • Lower capital translates to easier exit should the unlikely need ever arise.

  • Security in numbers. With the number of firms already in China, and greater interdependency, there is less likelihood of adverse conditions. Can hundreds of international businesses from countries all over the world be wrong?


Technology Transfers:

In establishing your operations in China(or any country) you need to identify if the technology (knowledge, skills, products) if the home country government allows the technology to be exported to another country. In the U.S., there are a number of high technology products which are illegal to export. These primarily are around weapon and nuclear, and some computer technology. Most technology transfers for assembly and manufacturing operations in China are not a problem. Prior to the final stages of project approval, this should be reviewed with your Export-Import and Legal departments. You should also contact the U.S. government, especially in the case of high-tech or defense related technologies.

Second, you need to determine what technologies you intend to transfer to your subsidiary and how you will transfer it. This includes how the parent company is compensated for the transfer of knowledge as well as ownership and transfer rights. This equation touches upon tax, legal and repatriation of product issues. The home country tax jurisdiction will expect some reasonable tax revenues to be generated from the transfer. The reasoning here is that these technologies were developed over tie in the home country and the parent corporation benefitted from tax deductions and perhaps even tax incentives on the Research and Development costs and the technology is an asset of the company.

Technology transfer can be sold to the subsidiary, providing unlimited use and quantity of production. Or, it can be licensed with Royalty payments provided to the parent on either a monthly/yearly basis on per unit of production. If the technology is sold, then the subsidiary owns the rights to the technology, resulting in implications if it is a joint venture or if the unit is later sold. In addition, the terms of the contract should prohibit the subsidiary from re-selling or licensing the technology to a third party. This is a key reason why your legal department should review and approve the plans.

Our recommendation is to license the technology to the subsidiary and charge a per unit royalty. This has several advantages. First, the parent company retains ownership of the technology. Second, if the site is a start-up, royalty payments will help the fledgling company in it's early cash flow problems. The parent will be compensated with a steady flow of royalty income based upon the success of the subsidiary long term. This stretches out payments and with success of the subsidiary, results in greater lifetime revenues. It also is most likely the best alternative form a tax standpoint. The parent does not record a large revenue n the first year and the subsidiary does not incur and additional expense that it may not be able to use as early like of a company usually is at a loss on the earnings statement and the ax deduction is not needed.


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