By George Yip and Bruce McKern
Chinese companies have moved from outright imitation to pure business innovation. This article discusses the three phases of the shift of China’s extraordinary economic growth in less than 40 years.
In less than 40 years, Chinese companies have moved from outright imitation to pure business innovation, in parallel with and contributing to China’s extraordinary economic growth. The three phases of this shift, though not strictly in chronological sequence, provide a narrative of relentless refinement of China’s innovative capacity.
We call the first phase “from copying to fit for purpose”. Adaptation to the Chinese market was evident even in China’s earliest attempts at competing with the world’s global manufacturers – simplification and cost reduction were present from the start. As Chinese companies refined the concept in a market that rapidly grew more discriminating, “fit for purpose” became a formidable competitive strategy. The second phase we call “from followers to world standard”. Chinese companies have shown little inhibition about reproducing what successful companies elsewhere do. Where they are unusual is in the speed with which they have developed the ability to apply research and development and deep customer understanding to redefine products and business models, and capture leadership in their chosen markets. The third phase has taken Chinese companies “from new resources to new knowledge”. The received wisdom is that Chinese corporate investment abroad is all about acquiring primary resources in emerging economies. We believe the reality is rather different; quietly, and often behind the scenes, Chinese companies are buying the market access, the brands, the technology, and the human expertise that will allow them to mount a formidable innovation challenge to the incumbent companies of the developed countries. We describe these three phases in more detail in the following subsections.
From Copying to “Fit For Purpose”
Companies have to learn to innovate. The multinational corporations of the developed countries have vast troves of technology and know-how, the fruits of investment and learning over scores of years. Most Chinese companies had to start from scratch after markets were permitted after 1979, with no experience of modern management or technology, so they began by copying and then by making small improvements to an existing product or process – often foreign. Companies called shanzhai, meaning “mountain stronghold (of bandits)”, copied brand-name products ranging from fashion accessories to telephones. The products were cheap and the quality was low, but customers didn’t much care so long as they were affordable.
But the Chinese market changes very fast. As customers became more discriminating, entrepreneurs learned to move from imitation to incremental innovation, improving their products and their processes. Incremental innovation is a big step beyond imitation – it marks the recognition that innovation is at the heart of longterm competition. Chinese companies based in the Pearl River Delta, in Beijing, and in Shanghai began by making components for global supply chains in the information, computing, and telecommunications industries. Because they were under intense pressure to meet the cost and performance requirements demanded by their multinational customers, their technical capabilities had to be close to the state of the art. As they grew, they used the skills acquired in the hard school of cost reduction to explore opportunities in adjacent markets and with other customers, adapting and improving their existing technological base through incremental innovation. The capabilities developed through incremental innovation made them essential players in supply chains for products sold in the developed countries. Early imitators of consumer products were often greatly aided by an open market for standardised components, such as Intel microprocessors and other components for personal computers, MediaTek wireless chipsets for mobile phones, and later Google’s Android mobile operating system. These technologies provided them with a base to develop products for the burgeoning domestic market.
The special demand characteristics of the Chinese marketplace meant that in this first phase of innovation Chinese companies became adept at producing products or services designed with just the product attributes Chinese customers were willing to pay for, and no more. This “good enough” strategy worked both in markets that serve lower-income consumers and in industrial markets, such as food processing, mobile phones, household appliances, and electrical machinery. Companies learned to eliminate unwanted features, to economise on materials (and sometimes on durability), to reduce waste, and to streamline processes. Their products and services are not inferior, but rather “fit for purpose”. They suit what customers need, whereas Western-designed alternatives may have costly features for which customers aren’t prepared to pay. “Fit for purpose” is a strategy that has moved these companies well beyond copying and low-cost production; it also focuses on identifying emerging needs and, as segments mature, responding with higher-quality products and services. Taobao, Baidu, Tencent, and many other companies began by copying products, services, or business models from abroad. Taobao, for example, was created by Alibaba in response to eBay’s entry into China. Its agility, its understanding of China’s market and institutions, and its willingness to forgo medium-term profitability enabled it to drive eBay out of China. Baidu copied Google’s search model, but moved more quickly to include paid search advertising. Tencent began with imitative online games and messaging services but then added its own successful WeChat live chat application, now being extended to other countries.
[ms-protect-content id=”3162″]Academic studies confirm that Chinese companies learned to upgrade their own capabilities by competing with foreign entrants into China. This adaptive copying strategy enabled Chinese companies to grow rapidly, to achieve economies of scale, to learn what customers want, and to move into other segments as customers’ needs changed. Some call this process “secondary innovation”. Initially based on foreign technology, it goes beyond imitation and adaptation to create something unique for China. Many multinational corporations operating in China have adopted a similar strategy in order to penetrate markets that are very different from their home markets. But they have had to overcome internal concerns about quality and brand reputation and, at the same time, to catch up with local competitors’ deep understanding of the specific characteristics of Chinese markets. Their Chinese competitors have no such inhibitions and have much deeper knowledge of their customers. We assert that this capability is also preparing Chinese firms to compete in foreign markets where they are already challenging Western multinationals.
From Followers to World Standard
The “fit for purpose” phase represents innovation driven by market necessity. But many Chinese companies have chosen a more ambitious route of innovation by choice: innovation that drives the market, rather than being driven by the market.
There are many examples of Chinese companies that began by supplying the fast-growing Chinese market with products that depended primarily on low-cost labour, but that now supply markets that depend primarily on innovation. These companies include Sany and Zoomlion (which make construction equipment), the online travel companies Ctrip and TongCheng (also known as 17u. com), TCL in consumer electronics and mobile phones, and Tencent in online games, instant messaging, and e-commerce. Some of these companies invested heavily in technical talent from the start; others have turned to innovation as a strategy for future competitiveness. Several are now active in global markets, competing against the very multinationals that served as their models. One of the most visible of these companies is the appliance manufacturer Haier. In 1984 Haier was a state-owned enterprise and was on the verge of bankruptcy. Today it is the largest producer of white goods in the world. Along the way Haier acquired refrigerator technology from German company Liebherr and Western management ideas wherever it could find them. By 2014 Haier’s annual revenue had reached $31 billion (here and elsewhere we give the US dollar equivalent of Chinese renminbi), and it had 10 percent of the global market. Haier moved from supplying underserved niche markets, such as those for bar refrigerators and wine coolers, to offering a full range of high-quality appliances.
Haier understood the need for innovation from the start. It spends 4 percent of annual revenue on R&D, and it has filed more than 4,000 domestic invention patents, including 541 in 2012 alone. But Haier understands that invention is not innovation. Its technical capability is accompanied by a deep understanding of its customers, an extensive distribution and service network, efficient logistics, and a willingness to serve segments that have been neglected. A legendary example of its readiness to innovate for the customer was its washing machine adapted for washing potatoes as well as clothes.
Like Haier, many Chinese companies developed strong innovation capabilities out of evolutionary necessity. Mindray (in medical devices), Neusoft (in software engineering, IT services, and medical information), Huawei (in telecommunications), Goodbaby (in strollers and juvenile products), and Yuwell (in self-monitoring medical devices) are all examples of companies that have created effective R&D departments and strong capabilities for innovation – incremental up to the present, but now ready to disrupt global markets.
A remarkable feature of the industrial landscape in China is the myriad of startups, seemingly in every field, many of which have developed world-class capacities to develop new products. One example is Han’s Laser Technology Industry Group Co., which overcame a multitude of hurdles as a tiny startup to capture the majority market share in China in the field of laser printing, marking, cutting, and welding. Its dominant position is due in large part to its stream of incrementally innovative and patented products.
Other companies have created novel business models. For example, Xiaomi developed an Android-based smartphone that succeeded not only because of its high quality, but also because the company has developed an ecosystem of applications and customer relationships that is unique to China. The Four Dimension Johnson Industries Group in Beijing, which makes specialised cash-in-transit vehicles, uses a “mass customisation” business model that exploits comparative advantage by combining body-panel manufacture in China with flat-pack shipments to Europe and final assembly close to European markets. That isn’t radical innovation, but it is an innovative business model based on relative capabilities.
Established global companies operating in China are often astonished at the speed with which local companies introduce new products to the market. They follow the precept of “fail fast and learn” (one of the principles of the design thinking of companies such as IDEO). The product may not be perfect, but it doesn’t have to be; on the basis of customers’ reactions, it can quickly be succeeded by an improved model, and then a more improved model. And because the market is so large, a market launch in one location may not affect a company’s overall reputation. Such an approach is very difficult to countenance for a large corporation with worldwide customers, but it is one that Chinese companies are entirely comfortable with.
From Seeking New Resources to Seeking New Knowledge
Since 2005, Chinese companies, and especially state-owned enterprises (SOEs), have been pushed to enter foreign markets by the government’s “go global” policy. As of the time of writing, the official plan is to balance the stock of inward foreign direct investment with the stock of outward foreign direct investment (OFDI) by 2015, and to encourage overseas expansion by private-sector companies. This includes the creation of R&D centres overseas. China’s government is fully committed to helping Chinese companies to become insiders in foreign markets. Although the FDI target for outward FDI stock was not reached in 2015 and will not be reached for many years, the outward flow of Chinese direct investment in 2014, at $103 billion, was not far below the inward flow of $120 billion. By May 2015, OFDI had reached 94 percent of inward FDI ($9.2 billion versus $9.8 billion in that month).
With foreign exchange reserves close to 4 trillion US dollars, China can buy the foreign industrial capacity it thinks it needs. Yet until recently, outward investment was overwhelmingly in the minerals and energy sectors of emerging economies where primary commodities are found. Although China’s OFDI stock more than doubled between 2008 and 2012, only a small portion went into developed markets. The Heritage Foundation estimates that 71 percent of outward investment between 2005 and 2012 was invested in energy and metals, and our own detailed analysis of announced investments shows that during 2012 and 2013 (the most recent two years on record as of this writing) 66 percent of investment was still concentrated in energy and metals. The limited diversification that has occurred has been in finance, real estate, transportation, and agriculture. Manufacturing remains a relatively small component.
So is China’s foreign investment still fully fixated on the world’s natural resources, at the expense of building up the kind of offshore manufacturing and services capacity that will give China an innovation platform abroad? We think not: behind the headlines, something very interesting is taking place.
The fact is that, in contrast to China’s engagement with the rest of the world, much of recent Chinese investment in Europe is in manufacturing and services, and is driven by companies looking for new markets outside China. Their successes in the home market have given them surplus funds (cash in our Four Cs framework), manufacturing skills, and experience with consumer marketing. While Western competitors have been suffering from lackluster home markets (and in some cases losing money by entering China only to leave when profits failed to match expectations), Chinese companies have taken a longer view and have bought European manufacturing assets – especially assets that provide immediate market access and a strong brand name.
Recent acquisitions support the view that a marked shift is under way. For example, Lenovo recently bought Motorola Mobility, Dongfeng Motors (number 31 among global automobile firms in R&D expenditures) bought a 14 percent stake in Peugeot-Citroën, and Volvo was bought from Ford by Zhejiang Geely, an auto company with enormous ambitions but lacking a strong brand and short on design expertise. In stark contrast to the previous focus on acquiring physical assets, in 2014 two thirds of China’s offshore investments were in services, about which Chinese firms still have much to learn.
Although Chinese companies have developed good manufacturing skills, they lack understanding of sophisticated markets – and they know this. They also know that they often lack the full range of scientific and engineering expertise needed for more demanding customers. This has led to a new phenomenon: the creation, through direct investment and acquisition, of Chinese corporate R&D centres in the United States and in Europe. A Chinese company creates such a center in order to embed itself in the innovation ecosystem of a developed country so as to acquire and develop technologies, brands, and marketing know-how.
Chinese companies, fully conscious of the need not only to tap into the local expertise but also to assimilate new knowledge into their global network, are internationalising their innovation activities. They are challenging established MNCs in China, which are now finding their strongest competitors are not their traditional MNC peers but local companies. They have established organisational processes for sharing newly developed knowledge among their R&D centres in China and other parts of the world. An example of that is Goodbaby, the world’s largest producer of strollers and baby carriages (although its products are not yet branded with its name outside China). Goodbaby has established design and technical centres in China, Europe, the United States, and Japan, where local knowledge and expertise enable its branches to satisfy the idiosyncrasies of each market while sharing this consumer and product knowledge among its centres. And in 2014 the company made its first foreign acquisitions: of CYBEX (a leading child safety brand established in Germany) and Evenflo (a US company). These acquisitions broaden its product line while providing brand reputation and complementary expertise in areas such as child safety seats, as well as distribution in Europe and the United States.
The proportion of private companies (rather than SOEs) investing abroad is also growing, having increased from 4 percent in 2010 to 9.5 percent in 2012. Private firms tend to be more aware than their state-owned counterparts of the need to develop their capabilities, and they are usually able to act faster. They know they need to acquire brands, technologies, and markets as platforms for innovation in developed countries. In many cases they have already learned how to innovate at home, and they are battle-hardened from furious competition in the Chinese market.
This isn’t the first time China has brought its resources and capabilities to developed Western markets. Chinese labour was important in building the California end of the Transcontinental Railroad in the nineteenth century. Ironically, it may be Chinese technical know-how that will build California’s high-speed railway (if it ever takes off) in the twenty-first.
This article is an excerpt from the book China’s Next Strategic Advantage: From Imitation to Innovation (MIT Press 2016) and is reprinted with permission.
[/ms-protect-content]
About the Authors
George S. Yip is Professor of Marketing and Strategy and Associate Dean for Executive Programmes at Imperial College Business School. His previous academic positions include Professor of Strategy and Co-Director of the Centre on China Innovation at China Europe International Business School (until end June 2016), Dean of Rotterdam School of Management, and Harvard, UCLA, Cambridge Judge and London Business School. He is the author of China’s Next Strategic Advantage: From Imitation to Innovation (2016), Strategic Transformation (2013), Managing Global Customers (2007), Asian Advantage: Key Strategies for Winning in the Asia-Pacific Region (1998), and Total Global Strategy (1992 and 2012).
Bruce McKern is a researcher, educator and corporate advisor on corporate innovation, strategy & international business. He is currently Visiting Professor of International Business in China Europe International Business School, Shanghai, Honorary Professor of International Business, University of Sydney Business School and Visiting Research Fellow at The Saïd Business School, University of Oxford. He is the author or editor of numerous academic papers and nine books, including: Transnational Corporations in the Exploitation of Natural Resources; Managing the Global Network Corporation; China’s Next Strategic Advantage: from Imitation to Innovation, (with George Yip). MIT Press, April 2016.
