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Rethinking profitable growth
           The productivity imperative for
           foreign multinationals in China
           September 2012




Page 0   Rethinking profitable growth
Our view

  In the business environment that is now emerging
  in China, companies have an increasingly urgent
  need to raise productivity if they are to maintain
  profitable growth.

                                        A detailed look at productivity

                                        ►   Rethinking profitable growth is part of a major
                                            program of research on productivity in China

                                        ►   Ernst & Young and the Economist Intelligence Unit
                                            (EIU) surveyed C-suite and senior managers from
                                            over 200 foreign multinational corporations in
                                            China between March and May 2012


Page 1            Rethinking profitable growth
Foreign multinationals remain profitable …

  For the last full financial year, what was your company’s approximate
  EBITDA margin?                                                                                                       •   97 percent of
                                                                                                                           foreign
                                                                                                                           multinationals
                  Overall 3%                             49%                                39%             9%             reported positive
                                                                                                                           profitability


                                  Company’s number of years in China                                                   •   Time in China was
                                                                                                                           a key determinant
 Less than 5 years                   13%                         50%                              31%        6%            of profitability



                                                                                                              5%
                                                                                                                       •   Services industries
             5-10 years            7%                         51%                             37%                          proved more
                                                                                                                           profitable,
                                                                                                                           suggesting that the
More than 10 years                                      48%                            41%                 11%             shift toward a more
                                                                                                                           services-driven
                                    By sector                                                                              growth model has
                                                                                                                           already started to
               Industrials 3%                                                                                              happen
                                                              53%                                 38%             7%


                  Services 4%                            41%                            41%                  14%


             Negative                  Less than 10 percent              10 to 20 percent         Over 20 percent

  Source: Ernst & Young; Economist Intelligence Unit.




Page 2                                                  Rethinking profitable growth
… but past performance is no guarantee of
  future success

    How does your company’s current EBITDA margin compare to two years ago?                                                  •   59 percent of
                                                                                                                                 respondents in
                                                                                                                                 the
                    Manufacturing                                       59%                            24%            18%        manufacturing
                                                                                                                                 sector reported
      Information technology                                          50%                        27%                 23%         decreasing
                                                                                                                                 margins
                                                                                                                                 compared to two
        Professional services                                     45%                            36%                  18%        years ago

                          Chemicals                              40%                       28%                 32%           •   IT, professional
                                                                                                                                 services, and
                                                                                                                                 chemicals have
                             Retailing                          33%            13%                      53%                      not done well,
                                                                                                                                 suggesting a
               Consumer goods                               30%                20%                       50%                     relative decline
                                                                                                                                 in overall
          Telecommunications                               27%                    33%                         40%                corporate
                                                                                                                                 demand and in
                                                                                                                                 industrial activity
                          Healthcare                      20%                    45%                           35%

                                                                                                                             •   Retailing is a
                                                                                                                                 strong
                                                                                                                                 performer,
                                Overall                         35%                    29%                     36%               followed closely
                                                                                                                                 by consumer
The margin has decreased                        The margin has stayed roughly the same            The margin has increased       goods
    Source: Ernst & Young; Economist Intelligence Unit.




  Page 3                                                    Rethinking profitable growth
What’s different now?
  •                          China’s export growth has slowed significantly since 2010
                                                                       Export growth by geography
                                                         Europe                                             North America
                              100%
      year-on-year growth




                                    80%
                                    60%
                                    40%
                                    20%
                                     0%
                                    -20%
                                    -40%
                                        2007   2008   2009     2010     2011    2012          2007   2008    2009      2010   2011   2012


                                                             Asia                                                   Other
                                    100%
              year-on-year growth




                                     80%
                                     60%
                                     40%
                                     20%
                                      0%
                                    -20%
                                    -40%
                                        2007   2008   2009     2010      2011    2012         2007   2008    2009      2010   2011   2012

 Source: General Administration of Customs, Ernst & Young analysis.



Page 4                                                                Rethinking profitable growth
What’s different now?

                                                                                                                •   Productivity growth has
                                      Accounting for China’s growth                                                 fallen
16%                                                                                                                 •   Earlier rounds of market
                                                                                                                        liberalization and
                                                                                                                        privatization have largely
14%
                                                                                                                        run their course
12%                                                                                                                 •   The mass reallocation of
                                                                                                                        labor from low productivity
                                                                                   6.9                                  agriculture to higher
10%
                                                                          6.8                                           productivity manufacturing
                                                                                                                        is coming to an end
 8%                                                              6.3               0.2
                                         5.6                                                             6.9        •   The size of China’s
                            4.7                       6.5                 0.2
              4.3                                                                          6.8                          workforce will begin a long-
 6%                                                                                               7.0
                                                                 0.2                                                    term decline from 2015
                            0.3          0.3
 4%
              0.5
                                                      0.3                                                0.2        •   Very rapid growth in capital
                                                                                   7.2     0.1                          stock without productivity
                                                                          5.8                     0.2
                                                                 4.8                                                    growth leads to a decine in
 2%           3.5           4.1          4.1                                                             3.5
                                                      3.3                                  2.7                          capital efficiency, and
                                                                                                  2.1                   eventually inhibits growth
 0%
             2001         2002          2003         2004        2005   2006      2007     2008   2009   2010

                      Total factor productivity                   Labor         Capital     GDP growth
Source: National Bureau of Statistics; Ernst & Young analysis.



Page 5                                                      Rethinking profitable growth
Productivity is firmly on the government
             agenda
                                                                             12th five-year plan targets
                   2010          2015

                                                                                         26,810                                 80.9
               10.3%
                                                                     10,109
                                  7.0%                                                                                                           68.0                                       2.20
                                                                                                                                                                            1.75



                    GDP growth                               Urban disposable income (CNY)                              Energy consumption per GDP                      R&D as percentage of GDP
                                                                                                                            (TCE/CNY millions)
                                   47.0%
                  43.0%                                                                     1,603                              8.33
                                                                                                                                                 6.91                                       8.0%
                                                                           870
                                                                                                                                                                            3.0%

       Service sector value-added                                Minimum wage standard (CNY)                         Carbon emissions (billion tonnes)                Strategic emerging industries as
      output as percentage of GDP                                                                                                                                           percentage of GDP
                                   Growth                                                      Labor                                             Resources                          Innovation
Government




              • Lower growth, but more efficient and                         • Raise urban disposable                                  • Increase carbon and energy         • Movement up the value
                sustainable                                                    income                                                    efficiency                           chain for the entire
                                                                                                                                                                              economy
              • Shift away from capital-intensive                            • Gradual increase in social                              • Reduce water and land use
                industrial production                                          welfare benefits and minimum                              per unit of GDP                    • Supported by an increase
                                                                               wage                                                                                           in R&D spending
              •
Companies




              • Move to targeted, efficient growth                           • Pressure to boost labor                                 • Pressure to boost resource         • Incentives for innovation
                                                                               productivity                                              efficiency
              Source: National Bureau of Statistics; Ministry of Human Resources and Social Security; Xinhua; Reuters; Ernst & Young analysis.


             Page 6                                                    Rethinking profitable growth
Companies overwhelmingly acknowledge the
importance of productivity

           Has the importance of improving productivity increased in the
           past two years?
                                                                                                 •   Nine out of ten respondents
                                                                                                     said that the importance of
           Yes                                                                           91%
                                                                                                     improving productivity has
                                                                                                     increased in the past two
             No                9%
                                                                                                     years



            How important is increasing productivity to your company’s
            performance in the next 1-3 years?
                                                                                                 •   84 percent said productivity
                                                                                                     is either “extremely” or “very”
                                                                                                     important to business
                Extremely important                                     26%
                                                                                                     performance in the next 1-3
                                                                                                     years
                          Very important                                                   58%

               Somewhat important                                 16%

                       A little important                 0.5%

                  Not at all important                    0%


    Source: Ernst & Young; Economist Intelligence Unit.



Page 7                                                    Rethinking profitable growth
A focus on profitable growth
 • Foreign multinationals are focused capturing growth segments in the China market with targeted products
   and services whilst reducing inputs for every dollar of revenue generated

         What areas could have the most impact on company profitability in the next 24 months?

           Introduction of new and better products/services                                                          47%

                                                       Increased productivity                                  35%

                                  Restructuring of current operations                                      33%

        Hiring of new talent/management of existing talent                                               29%

              Increased focus on research and development                                          24%

                         More sophisticated pricing management                                    23%

                        Better use of outsourcing/subcontracting                              21%

Geographic expansion into new/more profitable markets                                        18%

                          Exit from certain less attractive markets                         16%

                            Undertaking mergers and acquisitions                       8%
Respondents were asked to choose up to three.

 Source: Ernst & Young; Economist Intelligence Unit.


Page 8                                                  Rethinking profitable growth
Companies are already feeling the pressure
 What drivers are having the most impact on your company’s
 overall cost structure and profitability?

                             Labor costs                                                           50%       •   The current
                                                                                                                 environment is
    Exchange rate movements                                                       32%                            characterized by rising
                                                                                                                 cost pressure,
                    Commodity costs                                           27%                                intensifying
                                                                                                                 competition, and
                                                                                                                 continuing volatility in
      Competition from domestic                                               27%                                global markets
                     companies
                         Cost of capital                                 22%


         Competition from foreign                                        22%                                 •   Foreign multinationals’
                       companies                                                                                 concerns about labor
                                                                                                                 and commodity costs
                           Energy costs                                 22%
                                                                                                                 reflect what has been
                                                                                                                 happening in the
                    Regulatory costs                                    21%                                      market

                   Reduced demand                                     19%
                                                                                        Rising input costs
             Other, please specify                     2%

             Respondents were asked to choose up to three.
 Source: Ernst & Young; Economist Intelligence Unit.



Page 9                                                 Rethinking profitable growth
Companies are already feeling the pressure
                                         Weighted cost indices, China domestic
                                                   (Jan 2007=100%)
220%                                                                                                                                                    Cost increases
200%                                                                                                                                                      since 2007

180%

160%
                                                                                                                                                           100%
                                                                                                                                                             Labor
140%

120%
                                                                                                                                                            77%
100%                                                                                                                                                        Energy

80%

60%                                                                                                                                                         19%
                                                                                                                                                             Metals
40%

20%
                                                                                                                                                            60%
 0%                                                                                                                                                     Soft commodities
                   2007                         2008                         2009                         2010                         2011

                                        Labor              Soft commodities                      Metals              Energy
 Source: National Bureau of Statistics; National Development and Reform Commission; United States Department of Agriculture; United States Geological
 Survey; BP Statistical Review of World Energy; Ernst & Young analysis.



Page 10                                                  Rethinking profitable growth
We expect these cost increases to continue


                           ►    The roll out of mandatory employer social welfare contributions,
  1
      Labor                     accompanied by government targets to increase the minimum wage,
                                rising expectations from employees, and the increasing cost of living, will
                                undoubtedly put continuous upward pressure on labor costs




                           ►    The price of commodities, generally lower in China than globally, will also
                                continue to rise in the medium term as the Chinese government removes
  2   Commodities               administrative controls. Commodities prices are likely to remain volatile,
                                and will be subject to spikes and sharp corrections depending on global
                                conditions




                           ►    Volatility in global markets itself also imposes a significant cost upon
  3   Volatility                companies, who must hedge against uncertain movements in prices.
                                These costs especially impact on firms that source components and
                                raw materials internationally



Page 11             Rethinking profitable growth
Nowhere to pass on costs

      What percentage of rising costs do you expect your company to be able to
      pass on to your customers?
                                                                                                       •   85 percent of
            None or very little                                                                  43%       respondents expect
                                                                                                           they can pass on at
      Less than 33 percent                                                                      42%        most a third of rising
                                                                                                           costs to the final
 Between 33 to 66 percent                                            12%                                   customer. There was
                                                                                                           remarkably little
      More than 66 percent                           3%                                                    variation between
                                                                                                           industries in the extent
                                      All         1%                                                       to which they could
                                                                                                           pass on rising costs
      Source: Ernst & Young; Economist Intelligence Unit.


                            Input/output price growth ratio, manufacturing                             •   In manufacturing, for
                                                                                                           example, input prices
    115.00                                                                                                 have consistently risen
    110.00                                                                                                 faster than output
                                                                                                           prices. The gap
    105.00                                                                                                 between the two has
                                                                                                           increased from an
    100.00                                                                                                 average of 4.5 percent
                                                                                                           in 2009 to 10.0 percent
     95.00                                                                                                 in 2011
               2008                          2009                    2010                2011
    Source: National Bureau of Statistics, Ernst & Young analysis.



Page 12                                                   Rethinking profitable growth
Case Study: McDonald’s
Balancing rising costs and service standards


                                                                         McDonald’s also monitors the external
   The cost of food, utilities, and occupancy all                        environment to gauge customers’
   impact McDonald’s profit in China, but it is the                      expectations around level of service and at
   cost of labor which has emerged as the                                what price points. Year-on-year, the company
   leading consideration. McDonald’s staff have                          is only able to recover a fraction of rising
   seen their real wages rise steadily throughout                        input costs through pricing. Like many of its
   the past decade, culminating in a 15-17                               competitors in the fast food industry, it has
   percent increase in 2011.                                             had to keep its annual price adjustment to low
                                                                         single digits.




                            For McDonald’s, the balance between rising costs and
                            maintaining standards of customer service lies in
                            productivity improvements.



                                             “The main driver of success for us has always been our ability to run our
                                             restaurants efficiently – the number of customers served per hour of labor.”

                                                                                  -- Dan March, CEO of McDonald’s China


Page 13                             Rethinking profitable growth
Concern about operating model alignment

                                                                                                                                     •   64 percent of
    Please indicate your level of agreement with the following statements.                                                               respondents agreed
Please indicate your level of agreement with the following statements.                                                                   that their company’s
                                                                                                                                         operating model
      Our company’s current operating model impairs our competitiveness.                                                                 impaired their
                                                                                                                                         competitiveness
                           36%                                        28%                       21%             14%          3%
                                                                                                                                     •   Productivity should
                                                                                                                                         be understood in its
                                                                                                                                         widest sense –
                                                                                                                                         improving
      Our company’s operating model does not allow us to keep pace with rapid growth.                                                    processes and
                                                                                                                                         organization within
                 23%                                          37%                            21%              16%          4%            a business

                                                                                                                                     •   This requires a
                                                                                                                                         competitive
      We need to overhaul our organizational structure in China to tap new opportunities.                                                operating model
                                                                                                                                         suited to the fast
               19%                                           43%                                   29%                8%        2%       pace of the
                                                                                                                                         domestic
                                                                                                                                         environment in
                                                                                                                                         China
           Strongly agree                Agree             Neither agree or disagree        Disagree     Strongly disagree


     Source: Ernst & Young; Economist Intelligence Unit.




    Page 14                                                  Rethinking profitable growth
More productivity gains will come from
front office
                                                                                              •   operations (45 percent), and
 In your opinion, which functional areas in your company offer the                                marketing and sales (37
 most scope for productivity improvements over the next 24 months?                                percent) are the two
                                                                                                  functional areas that offered
                                                                                                  the most scope for
                                                                                                  productivity improvements
                    Operations                                                          45%
       Marketing and sales                                                        37%
                                                                                              •   These two areas are also
                                                                                                  traditionally the biggest in
                Research and                                                                      terms of cost, where
                development                                        23%                            productivity initiatives
                                                                                                  usually have the biggest
                        Finance                                  21%                              impact.
                                IT                          16%                               •   many foreign multinationals
                                                                                                  have already achieved
           Customer service                               14%                                     gains from back office
                                                                                                  initiatives, and it seems that
                               HR                6%                                               they are new moving the
                                                                                                  focus of performance
      Other, please specify              1%                                                       improvement programs to
                                                                                                  the front office
  Respondents were asked to choose up to two.


 Source: Ernst & Young; Economist Intelligence Unit.



Page 15                                                Rethinking profitable growth
Case Study: Li & Fung
Moving the productivity focus to front office


                                                             Introduced tablet computers
                                                             to the company’s sales force
    Shared service center model:
                                                             to increase their effectiveness
    centralizing finance, human
                                                             and efficiency.
    resources, and IT functions to
    reduce back office costs per unit
    of output.
                                                             Conduct more business
                                                                                               Move the productivity
                                                             online, both for its obvious      focus from back
                                                             cost advantages, and to           office to sales and
                                                             access the vast online            marketing.
    Many support services are                                population in China.
    concentrated in Nanjing, where
    labor costs are relatively cheaper
    than first tier cities like Beijing or
    Shanghai.
                                                             Experiment with selling
                                                             account services to its
                                                             existing customers.



                                                “For the next few years, technology is what we will focus on, because
                                                outsourcing and shared services has been a model which we’ve been using
                                                for many years. ”
                                                               -- Herman So, Executive Vice President of Finance at Li & Fung


Page 16                                Rethinking profitable growth
A failure to capitalize on information
technology
 Has your company adopted any of the following methods to increase
 productivity?
                                                                                       •   Given the potential, a
        Workforce mobility tools                                                 40%       surprisingly low number of
                                                                                           foreign multinationals
                                                                                           have adopted IT initiatives
                     CRM systems                                                 39%       to drive productivity. More
                                                                                           needs to be done to
                                                                                           capitalize on IT
     Cloud computing services                                                   37%        investments already
                                                                                           made in core business
                                                                                           systems such as
             Data center capacity                                          33%             enterprise resource
                                                                                           planning
Supply chain management systems                                           30%

  Enterprise resource planning tools                                      30%          •   Examples of Information
                                                                                           technology enabler:
                                                                                           Mobile internet and e-
          Staff collaboration tools                                 23%                    commerce, cloud
                                                                                           computing, and data
                                                                                           analytics
                     Data analytics                        15%
Source: Ernst & Young; Economist Intelligence Unit.


Page 17                                  Rethinking profitable growth
Case Study: Cisco
Time to capitalize on IT


                                           The company employs common
                                           productivity metrics globally, and
                                           tries to limit administrative
                                           complexity – for example by
                                           simplifying its legal entity structure.




   TelePresence is a collaboration
   platform developed by Cisco to
                                                                                        It sees great potential in cloud
   help geographically dispersed
                                                                                        computing to raise utilization
   organizations overcome physical
                                                                                        rates while slashing IT costs by
   barriers, and cut down on
                                                                                        20 percent or more.
   travelling costs.



                         Capitalize on IT to reduce costs and increase productivity.


                                          “Cisco is in the business of selling productivity tools, but we’re also a primary
                                          user of the same technology – often before it goes to market.”

                                                                           -- Michael Foy, Finance Director of Cisco China


Page 18                          Rethinking profitable growth
Barriers to improve productivity
 What barriers are most likely to hamper your organization’s efforts to improve
 productivity?

             Shortage of labor or management talent
                                                                                                             30%

                              Inappropriate business model                                                  29%

                                           Unclear accountability                                     25%
   Lack of communication between management
                                and workforce                                                         25%
        Overly centralized control by home country
                                      headquarters
                                                                                                    23%

                                          Excessive government                                20%
                                                      regulation
            Lack of access to up-to-date productivity                                   15%
                                         information

                        Incompatible information systems                               14%

                                                                Other            3%
                       Respondents were asked to choose up to three.

  Source: Ernst & Young; Economist Intelligence Unit.



Page 19                                                 Rethinking profitable growth
The top 5 productivity initiatives among top-
performing MNCs:
 Has your company adopted any of the following methods to increase productivity?



                                                                                                                     49%
          Business unit strategy reviews
                                                                                                  32%


  Improved people development and                                                                                    48%
                     management                                                                            39%


                                                                                                                   45%
                   Cost reduction programs
                                                                                                 29%


                                                                                                          38%
   Enterprise resource planning tools
                                                                                           24%


      Greater autonomy for regional or
                                                                                                   33%
            country management from
         global/regional headquarters                                                18%
Source: Ernst & Young; Economist Intelligence Unit.                                              High performers     Others


Page 20                                               Rethinking profitable growth
Case Study: Ford
Raising productivity on many fronts


          Within each business unit and
          region, Ford assesses
          performance against its peers
          around the world.



          The company continues to invest
          in training and development to
          accelerate labor productivity in its
                                                                          Raise productivity and aim
          relatively young workforce.                                     for global best practice.




          Globally consolidated functions
          work across geographies in a
          matrix structure.



                                        “You have to look at every cost element, to pay attention to every line on the
                                        income statement. You need to balance the global capacity to share assets,
                                        ideas, and technologies, with an in-depth knowledge of local business and
                                        employee practices. ”
                                                                      -- John Lawler, CFO of Ford Asia-Pacific & Africa


Page 21                        Rethinking profitable growth
Five lessons for foreign multinationals

                                         ►   Companies should adopt strategic, cross-functional approaches to raise
                                             productivity across the organization


 1        Productivity as a
          strategic imperative
                                         ►



                                         ►
                                             A strategy with focus and clarity is needed to avoid complexity and
                                             wasted effort
                                             Companies should prioritize operational improvement initiatives that drive
                                             productivity improvements and allocate resources accordingly


                                         ►   Local autonomy needs to be balanced with a strong risk and controls
                                             framework
          Operating model

  2
                                         ►   Companies should pursue opportunities for active mergers and
          alignment                          acquisition activities in China in order to increase local market presence
                                         ►   opportunity to collaborate should be better explored




                                         ►   Prioritizing locally initiated cost management programs enables
                                             management to deliver on bottom line commitments and retain more
          Proactive cost

  3       management
                                         ►
                                             control
                                             Processes ought to be streamlined and non-core functions outsourced,
                                             while making sure that core information and expertise is retained
                                         ►   Increase efficiency and flexibility of core business processes with
                                             sophisticated techniques such as identifying cost drivers and using
                                             analytics techniques to target cost areas

Page 22                          Rethinking profitable growth
Five lessons for foreign multinationals
(continued)
                                           ►   Management should do more to capitalize on information technology
                                               investments
          Driving business value

 4        from information
          technology
                                           ►



                                           ►
                                               Improve the level of compliance, ensuring workarounds are minimized
                                               and all users are using the IT system as they are supposed to
                                               leverage the data generated by the IT system through the use of
                                               business analytics and customer relationship management (CRM) tools
                                               to improve their operational efficiency, more closely target customers,
                                               and better predict outcomes and risks



                                           ►   Boost the productivity of their employees through innovative ways to


  5
          Enhancing people                     incentivize staff, and transforming process flows so as to reduce physical
          development                          and technical barriers between employees
                                           ►   Effective managers should possess balanced management skills and
                                               sales ability, as well as the ability to manage every aspect of the P&L.
                                           ►   The focus of training programs ought to put a greater emphasis on
                                               productivity topics such as reengineering business processes, reducing
                                               costs, and improving sales effectiveness




Page 23                            Rethinking profitable growth
Questions for management

 ►    How well are you doing against industry and internal peers?

 ►    Do you know how the major drivers of margin are trending in your industry

 ►    What actions are you taking to boost productivity?
      ►   Are there any short term cost reduction initiatives?

      ►   Have you started to think about the longer term operational improvements that can be made?

      ►   Does your company have the governance structures in place to enable productivity
          improvement?

      ►   Does your company have the capability for sustained productivity gains to match long-term
          cost increases?




Page 24                         Rethinking profitable growth
Appendix
Survey respondent demographics

    Global revenues                                               Headquarters by country



          17%
                $500 million or less

          10%                                                        41%       Europe
                $500 million to $1 billion


          24%
                $1 billion to $5 billion


          11%   $5 billion to $10 billion                             31%      North America




          37%   $10 billion or more
                                                                      27%      Asia-Pacific


                                                                      1%       Other

Page 26                            Rethinking profitable growth
Survey respondent demographics

    Industry                                                 Job title

                                                                  5%
                                                                         Board member
      13%      Chemicals

      11%                                                                CEO
               Manufacturing                                     29%     President
                                                                         Managing Director
      11%
               Information technology
                                                                  5%     CFO/Treasurer
      10%
               Consumer goods                                     4%     Other C-level executive

      10%      Healthcare, pharmaceuticals and
               biotechnology
          7%
               Professional services
                                                                 40%     Senior Vice President
          7%
               Retailing                                                 Vice President
          7%                                                             Director
               Telecommunications
          7%
               Construction and real estate
          6%   Energy and natural resources                       4%     Head of business unit
          4%
               Financial services                                        Head of department
          6%                                                     12%
               Other


Page 27                           Rethinking profitable growth
China still has a long way to go when it
     comes to productivity
                                                                         World technological frontier, 2010
                       90


                       80
                                                                                                   United States                                                  Japan


                       70


                       60
thousands USD/worker




                                                                        United Kingdom
  Labor productivity




                                                                                                                                      Inset
                                                                                              France        Germany           8
                       50
                                                                                                                  Australia
                                                                                                                              7
                                                                                                                                                        Peru        Colombia
                                                                                    Canada          Italy
                       40                                                                                                     6                    Egypt            Romani
                                                                                                                                                                      a
                                                                                                                                                                    Morocco
                                                                      South Korea                                             5
                                                                                                                                                                  Thailand
                       30                                                                                                              Philippines
                                                                            Spain                                             4
                                                                                                                                        Indonesi
                                                                                                                                                             China, 2010
                                     Poland             Argentina                                                             3            a
                                                                                                                                      India
                       20       Malaysia    Turkey
                                                                                                                              2
                                                  Mexico                                                                                           China, 2001
                                                  Venezuela, RB                                                               1
                       10                                                                                                                     Vietnam
                                         Brazil                                                                               0          Bangladesh
                                                       South Africa
                                     China                                                                                        0            5        10        15         20
                        0
                            0                           50                      100                              150                     200                        250
                                                                                       Capital intensity (K/L)
         Source: World Bank, Ernst & Young analysis.                                  thousands USD/worker



    Page 28                                                      Rethinking profitable growth
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Page 29                                                       Rethinking profitable growth

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Rethinking profitable growth - the productivity imperative for foreign multinationals in china

  • 1. Rethinking profitable growth The productivity imperative for foreign multinationals in China September 2012 Page 0 Rethinking profitable growth
  • 2. Our view In the business environment that is now emerging in China, companies have an increasingly urgent need to raise productivity if they are to maintain profitable growth. A detailed look at productivity ► Rethinking profitable growth is part of a major program of research on productivity in China ► Ernst & Young and the Economist Intelligence Unit (EIU) surveyed C-suite and senior managers from over 200 foreign multinational corporations in China between March and May 2012 Page 1 Rethinking profitable growth
  • 3. Foreign multinationals remain profitable … For the last full financial year, what was your company’s approximate EBITDA margin? • 97 percent of foreign multinationals Overall 3% 49% 39% 9% reported positive profitability Company’s number of years in China • Time in China was a key determinant Less than 5 years 13% 50% 31% 6% of profitability 5% • Services industries 5-10 years 7% 51% 37% proved more profitable, suggesting that the More than 10 years 48% 41% 11% shift toward a more services-driven By sector growth model has already started to Industrials 3% happen 53% 38% 7% Services 4% 41% 41% 14% Negative Less than 10 percent 10 to 20 percent Over 20 percent Source: Ernst & Young; Economist Intelligence Unit. Page 2 Rethinking profitable growth
  • 4. … but past performance is no guarantee of future success How does your company’s current EBITDA margin compare to two years ago? • 59 percent of respondents in the Manufacturing 59% 24% 18% manufacturing sector reported Information technology 50% 27% 23% decreasing margins compared to two Professional services 45% 36% 18% years ago Chemicals 40% 28% 32% • IT, professional services, and chemicals have Retailing 33% 13% 53% not done well, suggesting a Consumer goods 30% 20% 50% relative decline in overall Telecommunications 27% 33% 40% corporate demand and in industrial activity Healthcare 20% 45% 35% • Retailing is a strong performer, Overall 35% 29% 36% followed closely by consumer The margin has decreased The margin has stayed roughly the same The margin has increased goods Source: Ernst & Young; Economist Intelligence Unit. Page 3 Rethinking profitable growth
  • 5. What’s different now? • China’s export growth has slowed significantly since 2010 Export growth by geography Europe North America 100% year-on-year growth 80% 60% 40% 20% 0% -20% -40% 2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012 Asia Other 100% year-on-year growth 80% 60% 40% 20% 0% -20% -40% 2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012 Source: General Administration of Customs, Ernst & Young analysis. Page 4 Rethinking profitable growth
  • 6. What’s different now? • Productivity growth has Accounting for China’s growth fallen 16% • Earlier rounds of market liberalization and privatization have largely 14% run their course 12% • The mass reallocation of labor from low productivity 6.9 agriculture to higher 10% 6.8 productivity manufacturing is coming to an end 8% 6.3 0.2 5.6 6.9 • The size of China’s 4.7 6.5 0.2 4.3 6.8 workforce will begin a long- 6% 7.0 0.2 term decline from 2015 0.3 0.3 4% 0.5 0.3 0.2 • Very rapid growth in capital 7.2 0.1 stock without productivity 5.8 0.2 4.8 growth leads to a decine in 2% 3.5 4.1 4.1 3.5 3.3 2.7 capital efficiency, and 2.1 eventually inhibits growth 0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Total factor productivity Labor Capital GDP growth Source: National Bureau of Statistics; Ernst & Young analysis. Page 5 Rethinking profitable growth
  • 7. Productivity is firmly on the government agenda 12th five-year plan targets 2010 2015 26,810 80.9 10.3% 10,109 7.0% 68.0 2.20 1.75 GDP growth Urban disposable income (CNY) Energy consumption per GDP R&D as percentage of GDP (TCE/CNY millions) 47.0% 43.0% 1,603 8.33 6.91 8.0% 870 3.0% Service sector value-added Minimum wage standard (CNY) Carbon emissions (billion tonnes) Strategic emerging industries as output as percentage of GDP percentage of GDP Growth Labor Resources Innovation Government • Lower growth, but more efficient and • Raise urban disposable • Increase carbon and energy • Movement up the value sustainable income efficiency chain for the entire economy • Shift away from capital-intensive • Gradual increase in social • Reduce water and land use industrial production welfare benefits and minimum per unit of GDP • Supported by an increase wage in R&D spending • Companies • Move to targeted, efficient growth • Pressure to boost labor • Pressure to boost resource • Incentives for innovation productivity efficiency Source: National Bureau of Statistics; Ministry of Human Resources and Social Security; Xinhua; Reuters; Ernst & Young analysis. Page 6 Rethinking profitable growth
  • 8. Companies overwhelmingly acknowledge the importance of productivity Has the importance of improving productivity increased in the past two years? • Nine out of ten respondents said that the importance of Yes 91% improving productivity has increased in the past two No 9% years How important is increasing productivity to your company’s performance in the next 1-3 years? • 84 percent said productivity is either “extremely” or “very” important to business Extremely important 26% performance in the next 1-3 years Very important 58% Somewhat important 16% A little important 0.5% Not at all important 0% Source: Ernst & Young; Economist Intelligence Unit. Page 7 Rethinking profitable growth
  • 9. A focus on profitable growth • Foreign multinationals are focused capturing growth segments in the China market with targeted products and services whilst reducing inputs for every dollar of revenue generated What areas could have the most impact on company profitability in the next 24 months? Introduction of new and better products/services 47% Increased productivity 35% Restructuring of current operations 33% Hiring of new talent/management of existing talent 29% Increased focus on research and development 24% More sophisticated pricing management 23% Better use of outsourcing/subcontracting 21% Geographic expansion into new/more profitable markets 18% Exit from certain less attractive markets 16% Undertaking mergers and acquisitions 8% Respondents were asked to choose up to three. Source: Ernst & Young; Economist Intelligence Unit. Page 8 Rethinking profitable growth
  • 10. Companies are already feeling the pressure What drivers are having the most impact on your company’s overall cost structure and profitability? Labor costs 50% • The current environment is Exchange rate movements 32% characterized by rising cost pressure, Commodity costs 27% intensifying competition, and continuing volatility in Competition from domestic 27% global markets companies Cost of capital 22% Competition from foreign 22% • Foreign multinationals’ companies concerns about labor and commodity costs Energy costs 22% reflect what has been happening in the Regulatory costs 21% market Reduced demand 19% Rising input costs Other, please specify 2% Respondents were asked to choose up to three. Source: Ernst & Young; Economist Intelligence Unit. Page 9 Rethinking profitable growth
  • 11. Companies are already feeling the pressure Weighted cost indices, China domestic (Jan 2007=100%) 220% Cost increases 200% since 2007 180% 160% 100% Labor 140% 120% 77% 100% Energy 80% 60% 19% Metals 40% 20% 60% 0% Soft commodities 2007 2008 2009 2010 2011 Labor Soft commodities Metals Energy Source: National Bureau of Statistics; National Development and Reform Commission; United States Department of Agriculture; United States Geological Survey; BP Statistical Review of World Energy; Ernst & Young analysis. Page 10 Rethinking profitable growth
  • 12. We expect these cost increases to continue ► The roll out of mandatory employer social welfare contributions, 1 Labor accompanied by government targets to increase the minimum wage, rising expectations from employees, and the increasing cost of living, will undoubtedly put continuous upward pressure on labor costs ► The price of commodities, generally lower in China than globally, will also continue to rise in the medium term as the Chinese government removes 2 Commodities administrative controls. Commodities prices are likely to remain volatile, and will be subject to spikes and sharp corrections depending on global conditions ► Volatility in global markets itself also imposes a significant cost upon 3 Volatility companies, who must hedge against uncertain movements in prices. These costs especially impact on firms that source components and raw materials internationally Page 11 Rethinking profitable growth
  • 13. Nowhere to pass on costs What percentage of rising costs do you expect your company to be able to pass on to your customers? • 85 percent of None or very little 43% respondents expect they can pass on at Less than 33 percent 42% most a third of rising costs to the final Between 33 to 66 percent 12% customer. There was remarkably little More than 66 percent 3% variation between industries in the extent All 1% to which they could pass on rising costs Source: Ernst & Young; Economist Intelligence Unit. Input/output price growth ratio, manufacturing • In manufacturing, for example, input prices 115.00 have consistently risen 110.00 faster than output prices. The gap 105.00 between the two has increased from an 100.00 average of 4.5 percent in 2009 to 10.0 percent 95.00 in 2011 2008 2009 2010 2011 Source: National Bureau of Statistics, Ernst & Young analysis. Page 12 Rethinking profitable growth
  • 14. Case Study: McDonald’s Balancing rising costs and service standards McDonald’s also monitors the external The cost of food, utilities, and occupancy all environment to gauge customers’ impact McDonald’s profit in China, but it is the expectations around level of service and at cost of labor which has emerged as the what price points. Year-on-year, the company leading consideration. McDonald’s staff have is only able to recover a fraction of rising seen their real wages rise steadily throughout input costs through pricing. Like many of its the past decade, culminating in a 15-17 competitors in the fast food industry, it has percent increase in 2011. had to keep its annual price adjustment to low single digits. For McDonald’s, the balance between rising costs and maintaining standards of customer service lies in productivity improvements. “The main driver of success for us has always been our ability to run our restaurants efficiently – the number of customers served per hour of labor.” -- Dan March, CEO of McDonald’s China Page 13 Rethinking profitable growth
  • 15. Concern about operating model alignment • 64 percent of Please indicate your level of agreement with the following statements. respondents agreed Please indicate your level of agreement with the following statements. that their company’s operating model Our company’s current operating model impairs our competitiveness. impaired their competitiveness 36% 28% 21% 14% 3% • Productivity should be understood in its widest sense – improving Our company’s operating model does not allow us to keep pace with rapid growth. processes and organization within 23% 37% 21% 16% 4% a business • This requires a competitive We need to overhaul our organizational structure in China to tap new opportunities. operating model suited to the fast 19% 43% 29% 8% 2% pace of the domestic environment in China Strongly agree Agree Neither agree or disagree Disagree Strongly disagree Source: Ernst & Young; Economist Intelligence Unit. Page 14 Rethinking profitable growth
  • 16. More productivity gains will come from front office • operations (45 percent), and In your opinion, which functional areas in your company offer the marketing and sales (37 most scope for productivity improvements over the next 24 months? percent) are the two functional areas that offered the most scope for productivity improvements Operations 45% Marketing and sales 37% • These two areas are also traditionally the biggest in Research and terms of cost, where development 23% productivity initiatives usually have the biggest Finance 21% impact. IT 16% • many foreign multinationals have already achieved Customer service 14% gains from back office initiatives, and it seems that HR 6% they are new moving the focus of performance Other, please specify 1% improvement programs to the front office Respondents were asked to choose up to two. Source: Ernst & Young; Economist Intelligence Unit. Page 15 Rethinking profitable growth
  • 17. Case Study: Li & Fung Moving the productivity focus to front office Introduced tablet computers to the company’s sales force Shared service center model: to increase their effectiveness centralizing finance, human and efficiency. resources, and IT functions to reduce back office costs per unit of output. Conduct more business Move the productivity online, both for its obvious focus from back cost advantages, and to office to sales and access the vast online marketing. Many support services are population in China. concentrated in Nanjing, where labor costs are relatively cheaper than first tier cities like Beijing or Shanghai. Experiment with selling account services to its existing customers. “For the next few years, technology is what we will focus on, because outsourcing and shared services has been a model which we’ve been using for many years. ” -- Herman So, Executive Vice President of Finance at Li & Fung Page 16 Rethinking profitable growth
  • 18. A failure to capitalize on information technology Has your company adopted any of the following methods to increase productivity? • Given the potential, a Workforce mobility tools 40% surprisingly low number of foreign multinationals have adopted IT initiatives CRM systems 39% to drive productivity. More needs to be done to capitalize on IT Cloud computing services 37% investments already made in core business systems such as Data center capacity 33% enterprise resource planning Supply chain management systems 30% Enterprise resource planning tools 30% • Examples of Information technology enabler: Mobile internet and e- Staff collaboration tools 23% commerce, cloud computing, and data analytics Data analytics 15% Source: Ernst & Young; Economist Intelligence Unit. Page 17 Rethinking profitable growth
  • 19. Case Study: Cisco Time to capitalize on IT The company employs common productivity metrics globally, and tries to limit administrative complexity – for example by simplifying its legal entity structure. TelePresence is a collaboration platform developed by Cisco to It sees great potential in cloud help geographically dispersed computing to raise utilization organizations overcome physical rates while slashing IT costs by barriers, and cut down on 20 percent or more. travelling costs. Capitalize on IT to reduce costs and increase productivity. “Cisco is in the business of selling productivity tools, but we’re also a primary user of the same technology – often before it goes to market.” -- Michael Foy, Finance Director of Cisco China Page 18 Rethinking profitable growth
  • 20. Barriers to improve productivity What barriers are most likely to hamper your organization’s efforts to improve productivity? Shortage of labor or management talent 30% Inappropriate business model 29% Unclear accountability 25% Lack of communication between management and workforce 25% Overly centralized control by home country headquarters 23% Excessive government 20% regulation Lack of access to up-to-date productivity 15% information Incompatible information systems 14% Other 3% Respondents were asked to choose up to three. Source: Ernst & Young; Economist Intelligence Unit. Page 19 Rethinking profitable growth
  • 21. The top 5 productivity initiatives among top- performing MNCs: Has your company adopted any of the following methods to increase productivity? 49% Business unit strategy reviews 32% Improved people development and 48% management 39% 45% Cost reduction programs 29% 38% Enterprise resource planning tools 24% Greater autonomy for regional or 33% country management from global/regional headquarters 18% Source: Ernst & Young; Economist Intelligence Unit. High performers Others Page 20 Rethinking profitable growth
  • 22. Case Study: Ford Raising productivity on many fronts Within each business unit and region, Ford assesses performance against its peers around the world. The company continues to invest in training and development to accelerate labor productivity in its Raise productivity and aim relatively young workforce. for global best practice. Globally consolidated functions work across geographies in a matrix structure. “You have to look at every cost element, to pay attention to every line on the income statement. You need to balance the global capacity to share assets, ideas, and technologies, with an in-depth knowledge of local business and employee practices. ” -- John Lawler, CFO of Ford Asia-Pacific & Africa Page 21 Rethinking profitable growth
  • 23. Five lessons for foreign multinationals ► Companies should adopt strategic, cross-functional approaches to raise productivity across the organization 1 Productivity as a strategic imperative ► ► A strategy with focus and clarity is needed to avoid complexity and wasted effort Companies should prioritize operational improvement initiatives that drive productivity improvements and allocate resources accordingly ► Local autonomy needs to be balanced with a strong risk and controls framework Operating model 2 ► Companies should pursue opportunities for active mergers and alignment acquisition activities in China in order to increase local market presence ► opportunity to collaborate should be better explored ► Prioritizing locally initiated cost management programs enables management to deliver on bottom line commitments and retain more Proactive cost 3 management ► control Processes ought to be streamlined and non-core functions outsourced, while making sure that core information and expertise is retained ► Increase efficiency and flexibility of core business processes with sophisticated techniques such as identifying cost drivers and using analytics techniques to target cost areas Page 22 Rethinking profitable growth
  • 24. Five lessons for foreign multinationals (continued) ► Management should do more to capitalize on information technology investments Driving business value 4 from information technology ► ► Improve the level of compliance, ensuring workarounds are minimized and all users are using the IT system as they are supposed to leverage the data generated by the IT system through the use of business analytics and customer relationship management (CRM) tools to improve their operational efficiency, more closely target customers, and better predict outcomes and risks ► Boost the productivity of their employees through innovative ways to 5 Enhancing people incentivize staff, and transforming process flows so as to reduce physical development and technical barriers between employees ► Effective managers should possess balanced management skills and sales ability, as well as the ability to manage every aspect of the P&L. ► The focus of training programs ought to put a greater emphasis on productivity topics such as reengineering business processes, reducing costs, and improving sales effectiveness Page 23 Rethinking profitable growth
  • 25. Questions for management ► How well are you doing against industry and internal peers? ► Do you know how the major drivers of margin are trending in your industry ► What actions are you taking to boost productivity? ► Are there any short term cost reduction initiatives? ► Have you started to think about the longer term operational improvements that can be made? ► Does your company have the governance structures in place to enable productivity improvement? ► Does your company have the capability for sustained productivity gains to match long-term cost increases? Page 24 Rethinking profitable growth
  • 27. Survey respondent demographics Global revenues Headquarters by country 17% $500 million or less 10% 41% Europe $500 million to $1 billion 24% $1 billion to $5 billion 11% $5 billion to $10 billion 31% North America 37% $10 billion or more 27% Asia-Pacific 1% Other Page 26 Rethinking profitable growth
  • 28. Survey respondent demographics Industry Job title 5% Board member 13% Chemicals 11% CEO Manufacturing 29% President Managing Director 11% Information technology 5% CFO/Treasurer 10% Consumer goods 4% Other C-level executive 10% Healthcare, pharmaceuticals and biotechnology 7% Professional services 40% Senior Vice President 7% Retailing Vice President 7% Director Telecommunications 7% Construction and real estate 6% Energy and natural resources 4% Head of business unit 4% Financial services Head of department 6% 12% Other Page 27 Rethinking profitable growth
  • 29. China still has a long way to go when it comes to productivity World technological frontier, 2010 90 80 United States Japan 70 60 thousands USD/worker United Kingdom Labor productivity Inset France Germany 8 50 Australia 7 Peru Colombia Canada Italy 40 6 Egypt Romani a Morocco South Korea 5 Thailand 30 Philippines Spain 4 Indonesi China, 2010 Poland Argentina 3 a India 20 Malaysia Turkey 2 Mexico China, 2001 Venezuela, RB 1 10 Vietnam Brazil 0 Bangladesh South Africa China 0 5 10 15 20 0 0 50 100 150 200 250 Capital intensity (K/L) Source: World Bank, Ernst & Young analysis. thousands USD/worker Page 28 Rethinking profitable growth
  • 30. Ernst & Young Assurance | Tax | Transactions | Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 167,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit www.ey.com. © 2012 Ernst & Young (China) Advisory Limited All Rights Reserved. FEA no. 03002101 This presentation contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither Ernst & Young (China) Advisory Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. www.ey.com/china Page 29 Rethinking profitable growth