Outsourcing: Offshoring to China: What Should Your Model Be?

December 1, 2006
Jean-Francois Denault

BioPharm International, BioPharm International-12-01-2006, Volume 19, Issue 12

Offshoring to China has captured the imagination of Western managers seeking to reduce operating costs. What is the best approach?

By relocating operations overseas, life sciences companies expect to save costs, enjoy government incentives, benefit from modern industrial parks (as foreign governments make heavy investments in building incubators and industrial parks for the life sciences sector), and profit from a highly skilled labor force composed of returnees—people who have returned to their home countries after training in North America and Europe. With the wages of scientists 60 to 70% lower than those of their American and European counterparts,1 many Asian vendors offer cost savings as high as 60% in areas such as basic chemistry or clinical trials.

China, of course, is a key location for offshoring. With a GDP greater than $8.8 trillion, China is now the third largest economy of the world. At the same time, direct foreign investment in China has risen considerably in the last few years, to almost $70 billion in 2003, as Western and Asian companies have moved some of their traditional industrial activities there.2

Thus, many Western companies believe there are numerous long-term benefits to offshoring operations. But companies entering the Chinese market face a number of challenges. Besides the language and communication issues, there is an emphasis on short-term, profits and an inadequate enforcement of intellectual property (IP) regulation,3 and heavy state intervention for projects setting up in China. These concerns have led many companies to choose an offshoring strategy carefully before entering the Chinese market.4

Three major models have emerged for offshoring to China (Table 1). The first is the classical offshoring model, in which a company works with a local partner who acts as an intermediary. In the second model, two companies work together through a joint venture. The third model involves direct investment by the Western company, which acquires existing infrastructure or constructs new facilities. The three case studies that follow illustrate these three models.

MODEL 1: CLASSICAL OFFSHORING

O-Two Medical Technologies (www.otwo.com) produces devices for emergency respiratory care. Although the company is based in Toronto, Canada, its products are distributed worldwide, and the company has a long tradition of offshoring to Taiwan. Last year, it began sourcing product from China as well.

Quick Recap

O-Two has a classical offshoring process. O-Two supplies design specifications to its Chinese partner, who manufacturers the products and sends them back to North America. O-Two has not made any capital investments but, as occurs in all Chinese collaborations, there is a heavy investment in relationships.

Because the products offshored include proprietary devices, IP protection is key. "Copying is rampant in China, so you need to spend a lot of time selecting your partner," says Win Van Voorst, O-Two's chief operating officer. To reduce this concern, O-Two elected to work through a trusted Taiwanese partner who already handles O-Two's manufacturing in Taiwan. Van Voorst has found that in his experience, Taiwanese business executives are accustomed to both Western and Chinese cultures, which makes them ideal intermediaries. Thus, this collaboration not only helped alleviate IP worries, but helped sidestep communication and quality issues as well.

O-Two has not offshored all of its production line. Most of its durable goods, such as resuscitators and ventilators, are still manufactured in Canada. These products are complex, contain significant proprietary technology, and the cost advantage of manufacturing them in China is not high. The products that O-Two manufactures in China are primarily disposables, such as masks and tubing. "Mature commodities are ideal for offshoring," says Van Voorst. "The most important driver with these products is low cost, something China is very good at."

Table 1. Advantages and disadvantages of the three common business models for offshoring to China*

Although O-Two is using a classical offshoring model, it believes this approach is only a first step in its china strategy. In the future, the company may investigate more complex models.

MODEL 2: JOINT VENTURE

DGel Electrosystem Inc. (www.dgelelectrosystem.com) is an independent research and development company based in Montreal, Canada, that provides support to life sciences organizations. The company also produces its own line of diagnostic products. DGel's recent expansion into China has given the company access to additional production facilities that meet its own needs as well as those of its clients. Thus, DGel has become a North American R&D center partnering with an independent manufacturing facility in China.

A key factor in DGel's collaboration with its local partner, GSBS Shanghai, is cultivating a solid relationship. Like many companies that enter Asian markets, DGel found that its local partner's network facilitated the Western company's integration into the local environment. "Trusting the people you're offshoring to in China is key," says Pierre Sévigny, DGel's CEO and director of R&D and production. "We have a full-time associate in China [GSBS] that reports to us, and helps us in our communications with our local partner," he says. "GSBS is our eyes and voice in China."

In the beginning, DGel encountered some cultural difficulties in working with its Chinese partner. "Formality was an issue: our partners like producing, but did not like the accompanying paperwork," says Sévigny. In China, an important distinction must be made between external and internal formality. Although governmental bureaucracy is familiar to Chinese companies, the production of internal documents, follow-up reports, and regulatory approval documentation often does not receive the same level of attention. As a result, DGel had to take special care to explain the meaning and importance of some of the documents requested.

Novartis plans $100 million R&D center in China

Also, language was a constant barrier, especially in a partnership that relies on trust. But these are minor hurdles, Sévigny believes, compared to the benefits of having a partnership that significantly increases the company's capacity at a reasonable cost. "Good preparation is key," he says. "[The project] was slower to start up than we expected, but once we managed that, it became very efficient. The Chinese like doing things quickly."

So where does China shine? DGel has found that China offers great opportunities in the areas of costs and human resources. The Chinese workforce has many people skilled in accurate and quality product manufacturing who can handle difficult challenges. Sévigny says they tend to be fast learners of new technologies, and they adapt to new ways and understand the needs of their partners.

But shouldn't IP protection worry medical technology and biotechnology companies going over to China? Not necessarily, says Sévigny. In his experience, the products at the greatest risk of IP infringement in China are luxury items and simple technology-based items. That's not to say that medical technology companies are safe from IP risk, which is why a close local partner, with good connections to the government, is a must; a company must have a partner that can voice complaints effectively. DGel believes it has found such a partner in GSBS.

MODEL 3: CAPITAL INVESTMENT

Adaltis Inc. (www.adaltis.com) is an international in vitro diagnostic company. Headquartered in Montreal, Canada, Adaltis has offices in China, Hong Kong, Italy, Germany, and Mexico. The company develops, manufactures, and markets in vitro diagnostic systems and reagent products to detect viral infections, diagnose immune system diseases, and measure human hormone responses.

In 2003, Adaltis made the strategic decision to build a manufacturing facility in Shanghai. This facility manufactures reagents for its existing clients in Europe, South America, and India, while providing a platform to penetrate the high-growth Chinese diagnostic market.

What are the key drivers that led Adaltis to build a 100%-owned factory in China, rather than develop a partnership with a local company? Historical reasons factor in. One of its strategic shareholders, China International Trust and Investment Corporation Pacific, out of Hong Kong, is heavily involved in the Chinese market already, and was able to reduce the barriers to entry. Citic Pacific, which now owns approximately 13% of Adaltis's equity, became a key partner, providing Adaltis with timely assistance that facilitated Adaltis's quick entry into China.

Yet, Adaltis's management felt that the necessary local production expertise was not available. As a result, Adaltis decided early on to develop its own Chinese expertise and to build its own facility to go with it. Also, by building a team from the ground up, management believed the company would have a better chance of retaining that developed expertise over time, thus reducing copyright infringement risks.

The company also was unable to find a suitable facility, so it decided to build its own. Jacques Deforges, vice president of finance and chief financial officer for Adaltis, explains: "The high quality and modernity of the industrial park [where we built our site] made it a far more logical choice for us to build a new industrial unit than buying a 20-year-old building, recycling it to comply to European regulations, and putting new equipment in it."

Staffing a new production facility from scratch presented some significant obstacles, however. The initial project team included members in China, Canada, and Italy, so ensuring effective communication across different time zones was the first challenge.

Also, it was difficult to find local personnel with the required experience. The products manufactured by Adaltis in China are high-quality reagents based on a lot of know-how, and key employees at Adaltis's other plants have over 30 years experience in the in vitro diagnostic industry. The greatest challenge was transferring knowledge from existing production facilities in Italy and Canada to China.

Deforges continues, "We had to train local personnel to a level allowing this facility to become 'CE mark' certified and teach them our quality assurance and quality control standard. There is a limited amount of local knowledge related to European certifications in China presently."

The CE Mark is a mandatory marking which is required for products in various fields, including medical devices and in vitro diagnostics, sold in the European Economic Area. The mark certifies that the product conforms to the essential health and safety requirements set out in European Directives.

To address these challenges, Adaltis adopted a dual strategy of concentrating its efforts on transferring established products to China while preserving the development of new products in Europe. This strategy allows Adaltis to use its state-of-the-art manufacturing facility in Shanghai to produce diagnostic instruments and high-quality reagents at a low cost while attention in Europe is dedicated to research and development. Therefore, Adaltis has entered China with its stable product lines while preserving its knowledge in Europe. This strategy protects Adaltis from copyright infringement.

To provide an additional level of IP protection for the diagnostic instruments, Adaltis keeps a final step of the manufacturing process to itself, by installing and testing the software in the component. Without the software, the instruments produced in China are unusable.

As we can see, Adaltis has chosen to build its own facility in China to ensure compliance with European standards. In the process, it is developing local expertise, which it expects to conserve. It has moved its most stable product lines in China, and keeps the final step of production to itself to protect its intellectual property.

DISCUSSION OF CASE STUDIES

The growth of the Chinese market is leading to a more competitive environment in production processes. As the examples show, some of the first life sciences companies to produce products in China are involved in diagnostic equipment and reagents. Although there are particular factors that drove each company to certain strategies, there are common lessons that can be taken from these examples.

First, the human side of relationships is the key to a successful partnership in China. Logistical considerations and expertise might be important factors when choosing a partner, but never as important as the relationship, which includes the network of contacts the local partner will bring to the project. In all three of our case studies, the trust that was developed between partners was directly tied to the success of the Western companies' business in China.

Second, companies should evaluate carefully which product to offshore. As we discovered, most Western companies opt to offshore simple products, to take advantage of cost savings. For complex products or devices, a cautious approach is the norm; in all our case studies, companies kept some operations in their local facilities, and none talked of total production offshoring.

Finally, even though IP enforcement in China has improved, careful planning is still necessary to avoid losses related to infringement. Recent court cases have shown that there is a willingness to protect intellectual property in China far more aggressively than in the past, but this does not mean that companies can enter China without a careful IP protection strategy.

China's unprecedented growth has led many to take a closer look, and to take advantage to its success. With the proper model and a good local partner, the question asked shouldn't be "Should I go?" but rather, "When?"

Jean-Francois Denault is consultant at Impacts Solutions, Montreal, Canada 514.978.2676, jf.denault@impacts.ca

REFERENCES

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3. Dowd Greene C. India and China: Emerging generic strategies. GPHA API 2006 Meeting; 2006 Mar 21; New York, NY.

4. Goodall S, Janssens B, Wagner K, Wong J, Woods W, Yeh M. The promise of the East: India and China as R&D options, BIOEntrepreneur. Published online at www.nature.com/bioent. 2006 Jul; doi:10.1038/bioent910.

5. Boston Consulting Group. A game plan for China. Rising to the productivity challenge in biopharma R&D. 2005 Dec.