China: Manufacturing & Sourcing: in China for China

Last Updated: 10 June 2016
Article by Maarten Roos and Robin Tabbers

Many international companies are considering options to organize their sales into the Chinese market of China-sourced product, for example by establishing their own manufacturing or trading entity in China.

Companies have long sourced a broad range of products from China. In recent years, increasing wages in China have made Bangladesh, Vietnam, Mexico and even countries in Eastern Europe more attractive for sourcing low-cost goods, with the new phenomenon "re-shoring" gaining some popularity as well. Nonetheless, the availability of global supply chains combined with high skills, good logistics and the abundance of workers (even if no longer the cheapest) will ensure that China remains the primary destination for global sourcing managers for many years to come.

A new trend, however, is changing the way sourcing is being organized from a legal-structure perspective. China is becoming a major market for many of the goods that were once manufactured for export only. Western-branded products in particular are discovering a huge market in China, both for industrial and for consumer goods. Since most "international" products are actually made in Chinese factories, the question is often asked: what legal structures are available for an international company to source manufactured products in China, and then sell these in the Chinese market?

Manufacturing in China for China

Some international companies engage in manufacturing directly. If they already have a Chinese manufacturing entity, then they can use this entity to sell directly to Chinese customers – while also exporting goods to other countries.

Some international manufacturers that have not yet relocated manufacturing to China are now doing so. The growing Chinese market is driving decisions by international businesses to establish new manufacturing operations in China, so that they can ensure the quality- and price-advantages that are required to lead in a competitive market.

Larger companies may establish different manufacturing facilities for a better geographical reach, but from a legal perspective this is not strictly necessary: a manufacturing company in (say) Shenzhen is free to sell goods to customers all over China. Businesses that need sales staff or customer service representatives in other cities can establish branches or even hire them directly.

Sourcing in China for China

Other international companies rely on third-party factories or trading companies in China to manufacture their products. For international markets, they may choose to use an offshore trading company (e.g. in Hong Kong) to source goods from China and then sell them on to international affiliates or directly to customers all over the world.

For goods to be sold in China, on the other hand, these companies generally have the following options:

Option A: Export / Re-import

The offshore company can directly source product from China, and then re-sell these to Chinese customers or distributors. While simple and bypassing the need for a local Chinese entity, this structure is expensive: goods must first be exported and then re-imported, resulting in both logistics costs, additional VAT, and (in many cases) customs duties. These costs weigh heavily on margins that are generally very competitive in the Chinese market – especially in sectors where competing (local and international) goods are in abundance.

Option B: Domestic Trading Agent

A third-party Chinese trading company / agent may also be used to purchase from the Chinese factory, sell the goods to the Chinese customer, and after deducting costs and commissions remit the margin abroad. The commission will hurt margins, but this could still weigh positively against the cost of running an independent subsidiary. On the other hand, this structure brings a number of challenges that are difficult to overcome, such as:

  1. to find a very reliable domestic agent (since they will be holding your money),
  2. to ensure financing (the agent will not want to take financing risk),
  3. to smoothly coordinate suppliers and customers, and
  4. to find a (-cost-) efficient means for repatriation of the margin.

Option C: Domestic Distributor

Some companies rely on one or more distributors to purchase and then sell the goods to Chinese customers independently, for example subject to a licensing fee to the international brand owner. While convenient, this comes with several risks, including:

  1. your distributor will acquire intimate knowledge of your products and may compete or infringe on your IP,
  2. you would be completely dependent on your distributor which makes entering the market yourself or appointing another distributor in the future more challenging,
  3. your distributor may make promises to customer that cannot be fulfilled, hurting your reputation in the market, and
  4. your distributor may not tolerate your involvement with marketing activities in China, which again means dependence without the guarantee that this will also lead to a lot of business.

Option D: Wholly-owned Subsidiary

The most direct approach is to establish a wholly-owned trading subsidiary in China. Such an entity can purchase goods from Chinese suppliers and then sell to Chinese customers – leaving the margin as profit to be repatriated (via dividends or service fees). Establishing a wholly-owned subsidiary is no longer very complicated and maintenance can be easily outsourced to a dependable law firm or corporate service provider; the main issues are the time to establish and get the company operational (usually 3-6 months), and the cost of establishment and maintenance.

Comparing these main options, importing the goods from and then re-exporting the goods to China (Option A) is often only for a one-time deal. In contrast, using an agent (Option B) can be quick and is particularly common in situations where sales are uncertain or expected to be sporadic, or if volumes are too small to warrant the cost of setting up in China. Using a distributor (Option C) may be suitable for companies that are not (yet) interested in the Chinese market, or simply for not want to allocate the resources at this moment. For companies authorizing a distributor to take charge, the key is to retain sufficient legal leverage to take back control China becomes a key focus in the future.

Benefits to Establishing a Wholly-Owned Subsidiary

An increasing number of companies are deciding to directly establish a subsidiary, which in the long run will offer many international companies the most value, with the following considerations:

  • It is much easier than before to establish a wholly-owned subsidiary in China. Requirements on minimum capitalization have recently been abolished, while the few (licensing) restrictions left in place apply mainly to sensitive industries. Zones such as the Shanghai Pilot Free Trade Zone have adopted policies to become particular attractive to investors who prefer a lean organization. With costs and risks transparent, it has become easy for an international business to weight the benefits and drawbacks of a subsidiary as part of their China-strategy;
  • Despite recent concerns over growth, China is already the second largest economy in the world, and its domestic market is continuing to develop very quickly. But there is also a lot of competition. An important consequence is that investment – in a stable structure as well as in marketing – is becoming increasingly worthwhile and is likely the only way get sufficient traction with Chinese customers in the long run;
  • Through a Chinese subsidiary, the foreign investor can directly hire employees in China, for example to engage in local sales, marketing (incl. online) and customer service, quality control, logistics etc. In many industries it is crucial to have local Chinese-speaking staff on the ground; using agents and third parties to hire own staff is far from ideal and often comes at a cost;
  • A subsidiary in China is multi-purpose. It not only allows for the purchase and sale of goods, but also can engage in other activities. For example, goods can be warehoused before they are sold on, and goods purchased for export can be sold directly to international customers rather than via affiliates. Some companies may also be interested to import certain international products and spare parts for sale in China. These are all activities that a simple Chinese trading entity can engage in.

Conclusions

For companies from North America and Europe that operate internationally, it is no longer a question of whether to engage in China, but how. Some continue to rely on China mainly as a source of products, preferring to target other markets. Many others have turned to China as the next big market, and are looking for ways to reach Chinese customers.

Serving Chinese customers is never easy. Products may have to be adapted to Chinese tastes, and competition in the Chinese market can be grueling. On the other hand, the products of Western brands and Western quality can usually be sold at a premium, even if they are made in China. The Chinese domestic market is so big and continues to grow so fast that it is difficult for most companies to ignore its potential.

International companies that do wish to target the Chinese market need to consider the optimal structure. If the goods were produced in China to begin with, then the most popular long-term solution is to establish a wholly-owned subsidiary to trade between Chinese suppliers and customers.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Authors
Maarten Roos
Robin Tabbers
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