New Rules of Management May 13, 2009, 5:51PM EST

Battling China on Price

Businesses say Chinese-made items are pricier than Mexican if you consider costs associated with quality, logistics, and engineering changes

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Like many U.S. purchasing managers, Fred Heegan found himself under pressure over the "China price." Heegan is vice-president for global parts sourcing for the North American manufacturing operations of Takata, the Japanese maker of automobile air bag, seat belt, and steering-wheel assemblies. Over the past couple of years, U.S. customers often pressed him to cut costs by pointing to a lower-priced part from China.

But Heegan pushed back. He would patiently counter with PowerPoint presentations showing that many Chinese-made items aren't such bargains when one considers the costs associated with quality, logistics, and engineering changes. That's why he argued to have most parts made near Takata's factories in the U.S. and Mexico. "There are significant hidden costs to having supply lines that extend to China," he says.

Heegan now looks like a visionary. Rather than only considering factors like labor and shipping rates and raw material prices, companies are increasingly calculating the "total cost of ownership," tallying all of the direct and intangible costs and benefits linked to buying something in one place compared to another. Under this light, the China Price, which always seemed to be at least 40% below U.S. costs for everything from electronics products and bedroom furniture to high-end telecommunications gear, has not been as low as it seemed.

Dramatic Shift

Over the past three years, in fact, the once-formidable China Price edge has all but disappeared for a number of manufactured goods, according to a new study by Southfield (Mich.) consulting firm AlixPartners, To illustrate its point, Alix assessed the total cost of ownership of five categories of machined products, such as large, cast-aluminum engine parts requiring significant labor and small mass-produced plastic components requiring little labor.

Alix found there has been a dramatic cost shift since 2005. Then, the "total landed cost," meaning price after an item had arrived at a West Coast shipping port, was 22% cheaper on average for Chinese parts than those American-made in the sample AlixPartners studied. By yearend 2008, however, the average price gap with the U.S. had dropped to a mere 5.5%, which is often not large enough to be worth the hassle of sourcing something from halfway around the world.

The more surprising reversal is the comparison with Mexico. While China was around 5% cheaper on average than Mexico in 2005, China is now 20% more expensive. Compared with the U.S., the Mexico Price edge widened to 25% from 16%. "A couple of years ago, outsourcing to China was a no-brainer" says AlixPartners Managing Director Stephen Maurer. "Right now, Mexico looks super attractive."

To illustrate the change, Maurer cites a machined aluminum engine part, for which labor typically accounts for about 30% to 35% of the manufacturing cost. It would have cost $25 in 2005 to make that part in the U.S. The same part would have been made in China for $17. Today, he says, the U.S. price will have risen to $29. But the Chinese-made part will be $25. The Mexico Price? Around $20.

Currency Shifts

The biggest factors behind that sharp shift are currency and labor. The Mexican peso has lost nearly 20% against the U.S. since late 2005, while the Chinese yuan has appreciated by around 11%. On top of this, Chinese wages have steadily risen some 7% to 8% a year. Mexican wages also rose in peso terms, but measured in U.S. dollars Mexican labor rates plummeted.

Of course, some cost trends have shifted back in China's favor since the onset of the global recession. Ocean shipping rates skyrocketed early last year as oil prices soared to $140 a barrel, but they have since crashed. But because AlixPartners' calculations account for that because they are based on data at the end of 2008, by which time oil prices had already dropped.