Five years ago, Bob Cotton, co-founder of Sonic Impact Technologies, a six-employee San Diego iPod accessories company, noticed that Chinese firms were setting up U.S. offices to promote original design manufacturing to big U.S. retailers and corporations. The Chinese, however, miscalculated the U.S. market, starting with the language. "They staffed [their U.S. offices] with people who spoke only Chinese," says Cotton, whose 2007 sales were about $22 million. "They poured a bunch of money into it, and they produced no results."
That could change. Increasingly, Chinese companies want to leave the low-cost manufacturing game in favor of value-added production that's globally competitive. The Chinese government is busy providing an emerging sector of privately operated Chinese companies with R&D grants, favorable bank credit and other incentives. Chinese universities, meanwhile, are educating designers who yearn to create their own intellectual property instead of regurgitating the specs foreign companies give them.
"The Chinese are well aware that manufacturing products for which someone else receives the licensing fees is a low-profit business," says Nandani Lynton, professor of global business at the Thunderbird School of Global Management, Beijing. "This is one reason China has declared its goal of being an innovative society by 2010—and why manufacturers are changing their strategies."
China's trek up the value chain is already being felt. Between 2004 and 2006, related-party imports—a measure of imports to U.S. companies from their subsidiaries—from China declined from 27.1 percent to 24.6 percent. The difference represents $7.2 billion worth of imports that used to change hands between U.S. companies and their subsidiaries. "That's a pretty significant breaking trend," says Frank Vargo, vice president of international economic affairs at The National Association of Manufacturers. "Chinese companies are selling their things to U.S. companies [without] being in the same corporate family."
The "China direct" trend could affect entrepreneurial U.S. companies that already have trouble securing shelf space. "You're dealing with one of these [Chinese] factories that has 6,000 people and is well-armed financially," says Evan Chuck, head of the international trade client service group for law firm Bryan Cave. "That's going to make it difficult for entrepreneurs to be competitive."
For Jeff O'Shea, founder of IntelliTouch, a 22-employee San Diego technology company with sales of $11 million annually, competition from Chinese product lines has meant leaving entire product categories. IntelliTouch has transitioned from selling telephones—a market where it watched margins erode against Chinese brands—to selling iPod accessories. "The [iPod] market is so segmented and so explosive, there's a lot of room," says O'Shea, 49. At the same time, "it's forced us to be a little more risky because we had to do a lot more development work."
Chinese companies do face big obstacles, ranging from offering customer support to creating international brands. Whether China can become a direct-selling threat at a time when Americans are wary of Chinese products is another question: A June 2007 Harris Interactive survey of 2,071 U.S. adults found that just 3 in 10 were confident that China's proposed safety improvements would actually make the goods produced there safer. The safety factor will "slow things down a bit for Chinese companies," Vargo says.
Still, given China's swift economic transformation, it's not impossible to think that Chinese companies might one day dominate. "Chinese brands [will] develop quickly," Chuck predicts. "You're going to see these guys being very aggressive."
—By Chris Penttila
Copyright 2008 Entrepreneur.com, Inc. All rights reserved.