Innovation Lessons From China

Foreign businesspeople complain that China doesn’t play fair. But anybody involved in international business should treat China not only as a place to sell but also as a place to learn.

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Despite China’s long and established demand for high-technology products, many leading global companies have become increasingly wary about operating in the Chinese market. They see unfair competitive practices, discriminatory regulation and intellectual property theft — all ostensibly condoned by the government — as part and parcel of the Chinese experience.1 Foreign businesspeople today routinely complain that in exchange for market access, they are required to transfer technology to favored Chinese competitors. And once such entities have the technology, they — in collusion with the government — will endeavor to seize market share not just in China but also in other markets.

We don’t deny that some of these claims are valid. After all, the Chinese government openly acknowledges its desire to establish companies that are market leaders and to do so, at least in part, through technology transfer. However, we see a different side of China, one that requires foreign companies to remain actively engaged.

Our research describes unique forms of China-based technology innovation, mastery of which is becoming increasingly indispensible for any company aiming to succeed in the global market. (See “About the Research.”) Anybody involved in international business needs to treat China not just as a place to sell, but also as a place to learn. In our view, companies need to lean in rather than pull back.

Innovation “China Style”

China today may not yet be the place to go for path-breaking R&D or radical new invention. But it’s becoming the best place to go if you want to learn how to make ideas commercially viable. Such knowledge — whether it involves product design for low-cost manufacturing, novel approaches to component sourcing or ways to accelerate speed to market — frequently lies at the heart of commercial innovation. We see innovation as linking invention — the origination of new ideas — with commercialization, the translation of new ideas into actual products or services that can command value.2 Each element requires creativity and distinct types of knowledge. That many inventors never realize returns from their creations, and that inventions are often licensed at low prices to companies that know how to bring them to market, suggests that the new idea itself can be a relatively small part of the equation. Indeed, you need to have the knowledge and ability to transform the new into the profitable. This is where the Chinese business ecosystem excels.

As we will describe below, such China-based knowledge can be grouped in four categories: capabilities for rapid tempo operations and speed to market; accommodation of unique customer preferences; world-leading capabilities for reducing waste and costs in the production process; and capabilities for new forms of networked production.

1. Capabilities for rapid tempo operations and speed to market

For several reasons — policy uncertainty, the vast number of competitors populating most sectors in China, legacies of traditional Chinese approaches to business, etc. — commercial success in China is often intimately linked with tempo. Innovation in this sense involves not the development of brand new technology, but rather the introduction of incrementally upgraded products with unprecedented rapidity. The new product may provide slightly new functionality, or it may simply offer an existing product at a slightly lower price point. Either way, its introduction permits the producer, at least for a brief period of time, to realize a slightly higher margin. The proprietary knowledge needed to deliver this product is understood to be fleeting; it will soon be learned or copied by competitors. The imperative, then, is to get the product to market as quickly as possible, capture increased margins during a narrow time frame, and then, as soon as the inevitable imitators jump in, scramble forward into a new round of incremental product innovation. In virtually all cases, winners in this system develop enhanced capabilities for speed in design, speed to market and speed in debugging.

2. Accommodation of unique customer preferences

The emphasis on speed can be seen in part as a response to a particular kind of customer routinely found in China. This customer, whether household or industrial, is at once impatient, frugal and sophisticated. For any given product, such customers demand new functionality, unprecedentedly low price and rapid delivery. Unwilling to wait for a fully mature product, they instead want it now (even if “now” means the product won’t perform perfectly), they want it cheap and they want immediate service when bugs arise. Meanwhile, they exhibit little brand loyalty, ready to jump at a moment’s notice to competing providers’ products when new functionality, better reliability or lower prices are offered. The pattern can be seen in products ranging from mobile phone handsets (where the purchaser is a household consumer and the product life cycle can be counted in months) all the way to wind turbines (where the purchaser is a commercial power generator and the product life cycle is counted in decades).

3. World-leading capabilities for “cost out”

In response to the pressures described above, Chinese producers have become masters of what we call cost out — identifying and removing all forms of waste that hurt the bottom line. At one level, cost out involves redesigning existing products to make them easier to manufacture or more compatible with cheaper componentry. Detractors often dismiss these efforts as mimicry, even piracy. But the truth is that redesign for cost competitiveness is knowledge-intensive, creative and critical for business success across a wide variety of global markets.3

Cost out often involves supply chain reorganization. Chinese businesses don’t just redesign products, they also source them differently, often relying on densely populated and intensively competitive supplier networks found within China. The goal throughout is to eliminate waste that elevates consumer prices and eats into corporate profits.

Foreign companies can learn from these approaches. To do so, though, they have to be willing to let go of existing (and from the Chinese consumer’s perspective, overengineered) offerings and reengineer their products to meet local customer needs. Moreover, they must be prepared to significantly rearrange their traditional business models, altering the way they source materials and components and how they handle make-versus-buy decisions. They must be willing to make these changes not just on their low-end offerings but even at the high end. By doing so, foreign companies can substantially improve their opportunities to succeed both in high-growth emerging markets and mature industrial settings.

4. Capabilities for new forms of networked production

Domestic companies in China, particularly those least tied to the state and least exposed to subsidization, tend to survive by carving out niche specializations in the production process and then partnering with other businesses that can perform the remaining functions needed to bring a product to market. These new entrants create opportunities for themselves by creatively reconfiguring the production process, often in unprecedented ways. The more experienced incumbents often have fully integrated operations, which were developed over many years of investment and learning. The best and most nimble Chinese entrants, however, quickly assess what they are able to do in-house — and then immediately go outside to fill gaps. As a result, a wide swath of Chinese industry has become extremely adept at operating in complex production networks, often involving very sophisticated technologies and intensely collaborative product development efforts.

What these networks offer global companies goes beyond just opportunities for outsourcing. Rather, the networks provide foreigners opportunities to learn from local partners who have proprietary knowledge about cost out, accelerated product development and new product definition. Some foreigners may be reluctant to expose themselves to such learning lest they give up proprietary know-how. Yet even the most wary foreign corporations — those least inclined to engage with Chinese production networks — must recognize that some of their global competitors will have no such reluctance. Thus, learning from China is not really an option — it’s an imperative.

Chinese Innovation in Action: Examples From the Field

Across widely divergent industries, Chinese competitors aren’t simply climbing learning curves defined by Western competitors years or even decades earlier. Instead, as we’ll see with the examples of wind turbine manufacturing and semiconductor design, the Chinese are creating their own paths and often in ways that can be extremely instructive to global companies.

Wind Turbine Manufacturing

Given widespread concerns about climate change and resource scarcity, numerous governments and companies have become interested in renewable energy technology. Until the mid-2000s, the center of activity for both the supply and demand of wind turbines was Europe and North America. But China has recently become the world’s largest market for wind power technology, accounting for 35% to 45% of annual installed capacity globally. Moreover, Chinese manufacturers such as Goldwind, Sinovel, Guodian United Power, Ming Yang, Dongfang Electric and Shanghai Electric have become major players in the global equipment industry. Goldwind, for example, is now a leading supplier of wind turbines.

What explains this dramatic shift? Although the role of Chinese government policy provides part of the answer, there are other important factors at work, including decisions by Chinese companies to develop products for the low end of the market, to form partnerships with other companies rather than developing a full range of capabilities on their own, to localize their supply chains and to treat time to market and cost out as essential.

Create products for the low end.

When Chinese demand for wind turbines began to boom, the most lucrative markets in North America and Europe were still red hot. As a manager for one multinational supplier recalled, “Our sales guys didn’t even have to leave their desks to sell all the products our production facilities could produce and still achieve a decent margin.”4 Major players such as Vestas and Gamesa, which had built large production facilities in China, were tentative in their responses to local demand from Chinese customers and Chinese indigenous competition. Chinese customers seemed to want low-end, low-quality and low-margin products, and local suppliers were eager to comply to get a foot in the door of a growing market, in a market segment that Western suppliers weren’t pursuing.

Chinese producers developed wind turbines that were 30% cheaper but only 10% less reliable. Not only were the products attractive to buyers in China, but they also met the demand criteria for customers in other emerging markets.

Early on, Chinese companies leveraged their engineering expertise to redefine the entry-level product — the mid-size, onshore turbine — for customers looking for something simpler and less expensive than what multinational players were offering.5 Indeed, by using lower-end components, Chinese producers developed turbines that were 30% cheaper but only about 10% less reliable. Not only were these products attractive to buyers in China, but they also met the demand criteria for customers in other emerging markets.

Team up with partners.

Chinese suppliers have generally approached the market differently from global incumbents. Rather than taking many years to develop in-house capabilities, they elect to work with outside partners to piece together production capabilities. Beijing-based Goldwind, for example, acquired turbine designs by partnering with, and later acquiring, Vensys, a wind turbine company based in Neunkirchen, Germany. This approach allowed Goldwind and other companies to gain a meaningful foothold in the market quickly.

Ironically, working closely with partners, which had at one point been dismissed by the established turbine manufacturers as amateurish, has become a relatively standard strategy for leading companies hoping to remain on the cutting edge of product innovation. For example, Samsung, which produces some of the largest offshore turbine models, works closely with SSP Technology A/S, a company based in Strensup, Denmark, on blade design and development.

Localize the supply chain.

Chinese turbine producers have differentiated themselves in other ways as well. They have been aggressive about localizing supply chains to China as a way to reduce cost. While competitors at multinational companies have attempted to play catch-up in this area, typically their efforts have been slower and more incremental. By the time foreign players understood what their Chinese competitors were doing and how they could respond, they had already lost substantial market share.

Emphasize speed to market and cost out.

Chinese turbine makers have embraced speed to market and cost reduction as managerial imperatives that take precedence over everything, including quality. Thus, some companies have intentionally released products before they were fully developed and tested, on the understanding that few customers were willing to pay for perfection and glitches could generally be addressed on the back end. Such companies have relentlessly pursued high-volume production, often capturing substantial market share in the world’s fastest-growing markets.

It’s difficult to see how established turbine producers might have been able to maintain their market share in China. Given the fact that the Chinese government had officially deemed the wind industry to be of strategic national concern (unlike solar, which, for the most part, was ignored), it is conceivable that there were no circumstances under which European and North American companies could have preserved dominant market positions. Looking forward, it’s equally difficult to anticipate the extent to which Chinese newcomers such as Goldwind will be able to realize success in markets where customers demand state-of-the-art technology products.

Yet, in many industries, it seems that market leadership is becoming increasingly contingent on the ability to absorb and master the type of innovation-related capabilities found in the Chinese business ecosystem. This is certainly true in emerging markets and lower-end products, where cost competitiveness is critical. But even in markets for high-end products, companies that turn a blind eye toward excessive costs or avoidable product development delays do so at their peril. If Chinese upstarts don’t identify ways to beat them, their global counterparts surely will.

Semiconductor Design

Similarly disruptive forces are at work in the Chinese semiconductor industry, which is loading increasing amounts of functionality onto mobile handsets and other devices. The number and range of devices available for plug-and-play operation, especially “no brand” smartphones, is proliferating on a monthly basis. But many of the suppliers of these “no brand” devices (the Chinese call them “Shanzhai”) have few or no engineering capabilities of their own. Rather, they are working closely with IC (integrated circuit) design houses, which themselves depend on third-party semiconductor foundries to fabricate the chips.

Emblematic of the phenomenon is a 12-year-old Silicon Valley company that has become one of the largest chipset providers to Chinese smartphone manufacturers. The company — we can’t use its name — is also developing a customer base among multinationals. When the company was founded, its peers were focused on chipset designs for the nascent 3G market. But the 3G market was slow to materialize, thus wiping out many design houses unprepared to wait so long without cash flow. What’s more, global phone manufacturers and large U.S. and European mobile carriers weren’t inclined to place big orders with an unknown design house, preferring to buy from more established suppliers.

So this company targeted a different kind of customer in a different kind of market: the Shanzhai handset manufacturers serving the burgeoning Chinese customer base at the market’s low end. These players were limited in what they could do technically; basically, they used 2G technology and only produced phone cases and the software for the “welcome” screen. Any further functionality had to come from outside vendors, which is where the Silicon Valley chipset designer came in, with full solutions on a chip. Although the solutions lagged well behind the technological frontier, there were tens of millions of customers seeking low-end tech-related innovation.

Shanzhai phone producers sought to make money by operating on narrow margins and winning quick sales by introducing cheap phones with basic functionality. Their aim wasn’t to produce something high quality or long lasting — the expectation was that end users would upgrade every few months. The idea was to produce cheap, attractive phones with features users liked or at least felt constituted something “new” (for example, analog TV or dual SIM card capability). It was up to chipset providers to suggest such functionality and make it possible.

Handset manufacturers needed new functionality quickly, given the short life cycles of their products. They expected low-cost upgrades from chipset providers every few months. And they expected rapid debugging. To meet such demands, the Silicon Valley startup moved its headquarters to Shanghai, believing it had to be located closer to its customer base. And it collapsed its product development cycles into a new kind of “China time.” Among other things, it learned to compress debugging processes that took normal chipset providers three months to complete into a mere three days.

Operating on a new kind of ‘China time,’ the Silicon Valley startup collapsed its product development cycles. It learned to compress debugging processes that took other companies three months into a mere three days.

With so many phone models and levels of functionality being released into the market — often with minimal lead time — the traditional relationship between technology providers and manufacturers had to be reconfigured. In addition to being able to design chips quickly, design houses, for example, had to be close to their customers to stay abreast of evolving functionality requirements, which in turn were being driven by rapidly evolving end-user tastes.

As the Silicon Valley design house found success in China, its overall competitiveness and standing in the global marketplace soared. Having proven itself with “no brand” customers, it was able to attract orders from major Chinese branded handset manufacturers such as Huawei and ZTE. Currently, at least one major mobile carrier in Europe is pushing a major handset maker to use the design house’s chipset for one of its European product offerings, indicating that it may be on the cusp of becoming a recognized global technology supplier. Whether the design house can solidify that position is impossible to say, given the intensity of the competition and the accompanying managerial challenges. But whichever companies prevail in this market will surely draw on the lessons and capabilities companies are learning in China.

Translating Ideas Into Commercial Products

Many people in China fear that their society’s focus on manufacturing has come at the expense of innovation. Conversely, many in the West fear that allowing manufacturing to migrate offshore over the past two decades has impeded their innovative capacity. We think both views miss the mark, particularly insofar as both treat innovation primarily as new-to-the-world invention. Clearly, invention is an important aspect of both commercial competitiveness and human progress. But even the most groundbreaking ideas are devoid of commercial value unless they can be delivered as products in a manner, at a price point and within a period of time that suits the preferences of an existing customer base. Whether we’re talking about specialized industrial equipment or mass-manufactured consumer products, knowing how to translate an idea into a viable product is in many ways at the heart of innovation, the fulcrum upon which value creation rests.

China today has become the leading global center for precisely this kind of knowledge. By operating in China, overseas businesses expose their intellectual property to risk. But deciding to stay away entails the even greater risk of missing opportunities to acquire knowledge that is critical for competitiveness across a wide range of global markets.

Once in China, senior managers must confront strategic questions on three distinct levels. First, they need to assess the extent to which they are in China to serve the Chinese market and how well they understand its competitive dynamics and its particular types of customer preferences. Does their overall business model or the product line that previously brought them success in other markets apply to China? If not, does the in-country management team have the capabilities needed to succeed there, and will headquarters provide the experimental space to develop those capabilities? How ready is the company to learn — and change its practices — to meet the demands of this market?

Second, managers must assess how prepared they are to leverage their knowledge from China to build competitiveness in other emerging markets. Can mid-range products developed for China be marketed in other developing or middle-income nations? Can supply chains or R&D operations localized for China be redirected to serve global production efforts, including efforts based in other emerging markets?

Third, managers must ask how prepared they are to apply the capabilities developed in China to become more competitive at home. Is the company ready to use this knowledge in the most advanced markets? Do employees involved with the R&D and product development functions back home believe they can learn from how things work in China? Do executives and strategists at corporate headquarters think competitors intend to leverage knowledge from China to build competitiveness in advanced industrial markets? And do those executives and strategists think that resourceful companies from China are making plans to attack those very same advanced markets?

We think there’s a real problem when technology-focused companies in the West shy away from China, whether out of fear or indifference. The contemporary Chinese innovation ecosystem is a force to be reckoned with. The real issue today for overseas companies is not what they have to give up to enter China but what kind of know-how they can acquire from being there. The decision to operate in China cannot be undertaken lightly. However, it often must be undertaken to ensure sustained competitiveness both at home and abroad.

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References

1. GE CEO Jeffrey Immelt’s comments in 2010 typified this view. See G. Dinmore and G. Dyer, “GE Chief Accuses China of ‘Hostility,’ ” Financial Times, July 2, 2010, sec. 1, p. 1.

2. For comparable views of innovation, see R. Henderson and K. Clark, “Architectural Innovation: The Reconfiguration of Existing Product Technologies and the Failure of Established Firms,” Administrative Science Quarterly 35, no. 1 (March 1990): 9-30; and W. Aulet, “Disciplined Entrepreneurship” (New York: Wiley, 2013).

3. Comparable phenomena have been observed in earlier cases of East Asian development. For example, in the case of South Korea, see A. Amsden, “Asia’s Next Giant: South Korea and Late Industrialization” (Oxford, U.K.: Oxford University Press, 1989); and L. Kim, “Imitation to Innovation: The Dynamics of Korea’s Technological Learning” (Boston, Massachusetts: Harvard University Press, 1997).

4. Interview, Beijing, June 2013.

5. Scholars have observed comparable patterns in the Chinese automobile and construction equipment sectors. See L. Brandt and E. Thun, “The Fight for the Middle: Upgrading, Competition, and Industrial Development in China,” World Development 38, no. 11 (November 2010): 1555-1574.

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Comments (2)
Ken Zimmerman
Bud Taylor asserts that "...innovating management is the key to commercializing ideas."  A problem, among many with this view and the views on Chinese industrialization and innovation presented by the MIT SMR is that both omit, skip over, deny some of the fundamental factors upon which Chinese "innovation" and "industrialization" are based.  These are slave labor, slave wages, totalitarian government, and brutal (very brutal) repression of basic democracy and open and universal decision making and economic life.  Such tendencies also existed and to some extent still exist in US Industrialization and capitalist economics.  Remember until WWII it was common for the US Army and local national guard to be used to break union strikes with guns and bayonets. In fact many historians would argue only the pressing needs of the War ended this practice.  So China is simply a bit more extreme case of what's happened already in the history of the US.  Some would say it's a usual part of industrialization and capitalist economics.  I won't comment on this contention.  But it would be naive and simplistic for anyone, including MIT SMR to argue that its not part of the shifts in Chinese economic life and so called "industrial innovation."  Thus it would dangerous and foolish to hold up China's actions as a model for the US or other western economies.  We in the west have a lot to learn.  But not from the current regime in China.
Bud Taylor
This is a terrific article.  It puts a positive light on what used to be known as "second-in" innovation (I spent over two years in South Korea observing this).  It explains that innovating management is the key to commercializing ideas.