By Brad Steiner

The explosion in consumer demand will change how the world thinks about products

China’s rise as the factory of the world is on some ways a blessing and a curse. Through continued investment in infrastructure and manufacturing, China has built a competitive advantage in sectors from housewares to heavy equipment. Though wage levels continue to rise, eroding China’s once dominant cost advantage, labor productivity has been growing as well, as producers move up the value chain. The market is now able to offer a value proposition based on more than just low-cost labor.

But a second factor is at play which looks to change the way goods are produced and brought to market. The prospect of a consumption explosion from China’s rising middle class is causing a shift in strategy for domestic and global firms alike.

After 20 years of double-digit GDP growth, China’s middle-class is starting to emerge. This new generation is determined to live an affluent consumer lifestyle. Retail sales in China rose 17% in 2011, to US$2.86 trillion. This is a result of not just rising wage levels, but active policy support to incentivize consumers.

Industrial policy

Government leaders recognize the power of basic research and innovation, and are determined to place China in a leading role. These ambitions were laid out in the National Medium- and Long-Term Plan for the Development of Science and Technology (2006-2020), often abbreviated as the MLP. The document called for China to be a technology powerhouse by 2020, and a global leader by 2050.

A significant part of the policy focus has been on basic science research, and this has naturally led to support for intellectual property (IP) and patients. In 2008, China spent US$133 billion on science and technology, or 1.54% of national GDP.

Leaders certainly recognize the importance of domestic demand in supporting industrial development. In 2009, the government drafted a public catalogue of products approved for government procurement, focused on Chinese products. The list focused on high technology areas like telecommunications, and required products to have a commercial trademark initially registered in China. This effectively eliminated foreign-designed products, even if they were manufactured completely in China through a joint venture. In many ways, China is learning from the examples of the US and Japanese paths to industrial innovation.

Basic research

Multinationals are shifting research and development to China as well. US based firms like 3M, Caterpillar and General Electric have invested billions in expanding their overseas research activities, including a significant portion in China. Even with blockbuster products developed in the US, like the iPhone and microprocessors, production will still largely take place in China.

This shift to Asia is not just due to changes in consumer demand, but also in the supply of talent. Over half of the world’s engineering degrees are awarded in Asia each year, compared with 4% in the United States, according to a report from the National Science Board. Even in the US, over half of doctorial degrees in engineering are to foreign students predominantly from East and South Asia.

This combination of a skilled workforce with relatively low labor costs is appealing to global firms, especially as they increasingly look to the global marketplace to sell their products. Hiring researchers in a growing market like China can help firms better understand product needs in local markets. Research facilities in multiple time zones can also be useful for urgent projects which require round-the-clock attention.

OEM no longer

Continued investment in transportation combined with the prospect of a consumption explosion make producing in China the best option for many global firms. But these same factors are prompting local producers to develop and market their own brands. Chinese manufacturers who have been content to produce goods for global brands are seeing value in making their own offerings, particularly in the domestic market. But this is not without its challenges.

One obstacle is their traditional manufacturing clients, who might not welcome the competition. Unless there is sufficient market segmentation or regional division, their bread and butter partnerships may dry up.

William at Octopus Innovation cited an example of a Chinese client who wanted to diversify their offerings under their own brand. The company produced aluminum garden furniture for Wal-Mart, and so had cyclical demand. Octopus worked with the client to develop their own line of fitness equipment using the facilities they already had. The product was proposed to the leadership, who decided to drop the endeavor, rather than risk the 30-year relationship with Wal-Mart.

Perhaps a greater challenge is developing internal capacity for branding and product development. Just having the capacity to make a product doesn’t necessarily get it in to the hands of a customer.

This can be less of a problem for technology manufacturers, as those industries are largely driven by new functionality, or improvements in production. In the fashion and lifestyle sectors, however, marketing and image are key. It is here where new brands will have to overcome the stigma attached to the “made in China” label.

New image

China’s success with producing low-cost goods for the world has been central to rising GDP and living standards, but has also brought an association with sweatshop labor and low quality when marketing abroad. Even successful Chinese brands have focused on the value segment in other emerging markets.

This role of image is being felt in more sectors, from autos to smartphones. The success of luxury brands in China is a further indication of consumers increasingly sophisticated tastes. One strategy for brands has been to distance their identity from China. Sportswear company Li Ning focuses on a personality, while luxury brand Shanghai Tang draws on the image of a cosmopolitan city.

Global design and innovation consultancies like IDEO and Frog have been in China for several years, hoping to take advantage of this trend. On one hand, they are seeking to serve multinational clients who demand more global offerings. And on the other, they are increasingly targeting Chinese clients. These quickly growing firms are looking not just for strategies to go abroad, but also new ways to reach their customer base in China.

But these design houses face challenges of their own. Few Chinese managers understand the design process, and so are reluctant to invest in expensive conceptual work. A second is sourcing design talent in a country which is still developing design education. Doreen Lorenzo, president of Frog, sees a change happening in the design talent pool, “But its still going to take several years to get to the very senior level. We have a couple of Chinese creative directors. but at the executive senior director level, we're not quite there yet. but it will happen.”