Is Leaving the China Supply Chain a Pipe Dream?

As the coronavirus, or COVID-19, affects more of the global economy, there has been an uptick in volume in the business media and analyst circle, clamoring for tech companies to leave or diversify away from China as its main supply chain. Apple has been a frequent target of this narrative.

Like most things in life, it’s easier said than done.

The Information recently published a detailed report of Apple’s previous attempts to move its supply chain away from China to India. The article presented a sobering look at just how hard it is to move to a different country. And not just any country -- India, the largest democracy in the world by population with the 2nd most STEM graduates produced annually.

So what makes this shift for Apple from China to India so difficult?

(I’ll cite from this Information article often in this post, because it is well-researched, high-quality tech journalism.)

You Have To Want It

One of the reasons why Apple’s foray into India’s supply chain maze has yet to succeed is because “suppliers aren’t willing to improve factories in India to meet Apple’s requirements...because of its small order sizes.” “Small” in this context is apparently “thousands per month.”

"[Indian] suppliers aren’t willing to improve factories in India to meet Apple’s requirements is because of its small order sizes." – The Information

This observation says to me that Indian manufacturers care more about short-term benefits than long-term learning and improvement of their skills, processes, and capacities. The opportunity to work with a company like Apple yields benefits far beyond immediate unit economics. The Indian manufacturers mentioned in The Information’s reporting clearly wasn’t interested.

The attitude in China has always been different. Shenzhen, the hardware manufacturing hub, routinely has factories that would take tiny orders from no-name companies from the U.S. and Europe to prototype, produce small batches or make to order. These orders most likely lose money or are done at cost. And that’s ok for these Chinese manufacturers, because they keep their workers busy, their processes sharp, and their product senses attuned to the latest designs and trends from more developed economies. (Some people will cast this behavior as a form of “piracy”; we can debate this point of view’s validity in a different post.)

Even though Shenzhen is now a dominant manufacturing center, its “do or die” attitude has not gone away. That raw, ultra-competitive drive will only get stronger when the COVID-19 crisis is over, because it will try to claw back from the coronavirus shadow. The rest of China will be too.

India, despite its vast potential, does not seem to want it nearly as much as China.

Cost vs. Quality Tradeoff

It has been objectively true for quite a few years now that China is not the cheapest place to make something.

When recently asked about possibly moving away from China’s supply chain in light of COVID-19, Tim Cook made clear that when Apple considers a supply chain location, it’s not only about lowering costs but also work quality, time to market, and the speed and depth of engineering. He also said that if Apple were to make changes to its supply chain operations, it’s “adjusting some knobs, not some sort of wholesale fundamental change.”

In short: Apple isn’t leaving China any time soon. And the reason is straightforward: the high quality manufacturing is too valuable to trade off for lower cost locations that produce less quality work.

As disclosed in its most recent earning report for Q1 2020, Apple products’ profit margin is at a healthy 34.2%. To maintain or expand on that margin, it has to be able to command its premium price and brand. And that means quality above all other considerations.

Now, if your business model isn’t predicated on making money from the hardware devices themselves, but on the software and services in your ecosystem, moving away from China might make sense. That’s why Xiaomi and Samsung both make smartphones and, more importantly, sell smartphones in India locally. They barely make a hair of profit from the devices, thus lowering the production cost by trading off quality while selling to a lower spending economy to grow a user base makes some business sense.

Xiaomi and Samsung aren’t alone. Except for Apple, pretty much all smartphone makers are deploying the cheap-device-plus-ecosystem business model in one fashion or another. Jury is out on whether moving supply chains to lower cost economies like India, Vietnam, and Thailand will help with this strategy. I have my doubts. Until a country has a large and quickly growing middle class, consumers of cheap smartphones won’t spend much on apps, ads, or services. (India’s middle class is only around 20% the size of China’s.)

Democracies Are Confusing

One under-analyzed, under-appreciated aspect of the global supply chain is that working with a low or mid-income country that happens to be a democracy is actually quite hard and confusing.

Before you take out your digital pitchfork, I’m not suggesting that doing business with non-democratic states are at all easy. But those challenges are well-documented and (hopefully) well-understood.

However, people tend to have a hand-wavy attitude towards democratic countries as a category, when the reality is far more complicated.

Democracies tend to be more stable and fair, because independent institutions and multi-party elections are supposed to moderate against extreme outcomes, but not always. The controversy, protests, and violence around India’s amended Citizenship Act is a telling example.

Democracies tend to be more liberal and open to the outside world, but not always. India has long standing tariffs on imported phone chargers, retail boxes, and PCB-As (printed circuit boards with chips already installed on them).

Democracies tend to be less corrupt and less bureaucratic, but not always. Apple’s own experience of owing taxes to various Indian government agencies is an example. Based on The Information’s report, “In 2019, Apple had $75 million in taxes under dispute with various Indian agencies, up from $7.7 million in 2016.” That’s a 10x jump in three years!

“Taxes” are often a source of personal or political slush fund for government officials in a country laden with corruption and without strong campaign finance regulations, which unfortunately is the case in India. On Transparency International’s Corruption Perceptions Index, India is ranked 80 out of 180 countries with a score of 40 out of 100. (Coincidentally, China has the exact same ranking and score.)

I highly doubt that between 2016 and 2019, Apple’s commercial activities increased 10x in India, or India’s overall taxation increased 10x for the purpose of bringing about 10x the improvement in public services or basic infrastructure. Apple’s choice to dispute these taxes (instead of just pay them) is perhaps most telling, because it is subjected to the Foreign Corrupt Practices Act as an American company.

Having worked in many facets of America’s democracy -- political campaigns, federal government -- perhaps I’m extra sensitive to the model’s strengths and foibles. As Churchill wisely said “...democracy is the worst form of Government except for all those other forms…”

I’m definitely not suggesting that China’s system is perfect. It’s not even close. This is a classic dilemma between the devil you know versus the devil you don’t.

Pipe Dream To Leave China?

No, as long as you know what you are giving up, and you are giving up a lot. Apple knows what it’s giving up by leaving China, and has decided not to. Samsung did leave, and has gone to India and Vietnam, but it was not done to diversify its supply chain, but because it could no longer compete in China’s domestic smartphone market.

Regardless of where China fits, and where the often-mentioned alternatives: India, Vietnam, Thailand, etc. fit in your supply chain operations, it’s unlikely that any company can completely replace China, though complementing it with more locations to add redundancy is always a good idea. Building up the level of capacity, competency, engineering skills, and operational processes that Chinese manufacturing currently has will take longer than the time it will take to deal with COVID-19.

Thus, rushing to leave the China supply chain because of COVID-19 is a fool’s errand.

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