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Research indicates the real economic threat China poses

By Shula Neuman

What company wouldn’t want to attribute its profits to the quality product it produces? The answer might be: the company that competes on price. According to research from Washington University in St. Louis and Southern Methodist University, producers of lower quality products actually have better prospects for gaining market share and improving their bottom line.

It’s a lesson that should put American companies on guard against their supposedly low-quality competitors in China, said Panos Kouvelis, the Emerson Distinguished Professor of Operations and Manufacturing Management at the Olin School of Business at Washington University. China is not just an outsourcing location for Western manufacturing companies, but also the base of the most potent manufacturing competitors American firms will face within the next two decades. Car makers might be the first industry in for a surprise as Chinese manufacturers start competing in U.S. and European markets with low-cost product lines.

“Over time, China has gained market share at the expense of manufacturing centers around the world and in the U.S.,” Kouvelis said. “While at one time, China’s products were considered inferior products, Chinese manufacturers have moved up the quality-spectrum, taking global market share along the way. By learning to compete in the extremely cost-sensitive Chinese environment, they have reached a level of superiority in designing and producing goods that sell at a low price”

Chinese manufacturers will follow a path similar to the entry strategies of Japanese firms in the 70s and early 80s. They will surprise their competitors at the low end by offering products that are relatively high in quality yet low in price, Kouvelis explained. Eventually, this will force the established companies into successive retreats towards the higher margin “luxury” niche segments.

“Allowing the Chinese manufacturers to gain the upper hand in pushing quality up while keeping prices low is a dangerous tactic for Western firms to face since higher volume, low-end firms often end up enjoying the lion’s share of market profits,” Kouvelis said.

According to his research, low-quality firms in general are better positioned to make disproportionate gains in many product markets than producers of high-quality goods.

The standard assumption has been that the cost curve is linear and that the only way for lower quality producers to become more like their high-quality competitors is by increasing quality and incurring the same costs.

“They have new and efficient factories, an abundance of cheap labor and a willingness to use cutting-edge, lean management approaches in their facilities,” Kouvelis said. “This drives costs down substantially while offering reasonable quality.”

The result is what Kouvelis refers to as a “convex cost curve,” which rises slowly across the quality spectrum and then rises sharply in cost once quality reaches the very high end. The more opportunities for a low cost firm to narrow the quality gap and strengthen its value-cost proposition, the more a high quality firm faces a competitive disadvantage.

“The high quality firm stakes its profitability in maintaining separation in quality levels compared to low cost firms,” Kouvelis said, “However, in an environment where firms have the resources, the know-how and the willingness to produce higher and higher quality goods with low variable costs, the truly high quality firms get backed into a quality corner, and might not have control over the price of their products if their costumers are getting sensitive to the high quality premiums they are asked to pay.”

The high end firm may be able to hold onto its niche for a time and continue to be profitable, but as the lower quality competitor gets better and narrows the gap in quality, the only feasible avenue for the high quality firm is to engage into price competition.

The current dynamics favor Chinese manufacturers and their low-end entry market strategies, the researcher said, but that does not mean there is no hope for U.S. firms.

For high-end western firms the only way to react is to constantly innovate and find creative ways to increase the quality of their offerings in ways that their competitors can not replicate (breakthrough designs, very responsive and mass customizing variety strategies, etc.) Kouvelis pointed to Harley Davidson motorcycles as an example of a company that recreated its quality level to the firm’s advantage. As lower cost, Japanese motorcycles landed in America in the 80s , Harley faced extinction until they began distinguishing their product as a custom-made, high end motorcycle. The company also branded their bikes in a way that created mystique around the product and the buying experience.

“By creating those differences, Harley Davidson thus paved the way for a highly differentiated sustainable competitive advantage. Harley changed the definition of quality, and created the needed quality separation,” Kouvelis said. Definitely a strategy to keep in mind as firms are engaging in competition with Chinese manufacturers in the coming years.

Kouvelis co-authored the paper, “Quality based competition, profitability and variable costs,” with Chester Chambers and John Semple, professors at the SMU Cox School of Business.

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