On the level

Rebecca Ellinor Tyler is former editor of Supply Management
8 December 2009

27 November 2008

What did a major organisation learn by moving into low-cost countries? Rebecca Ellinor speaks to Marc Magistrali, sourcing VP of Kone

Three years ago KONE's sourcing operation was highly decentralised, comprising around 55 country organisations, seven research and development centres and eight manufacturing operations worldwide.

When Marc Magistrali joined the elevator and escalator manufacturer in 2005 as senior vice-president of global sourcing, he transformed the procurement and supplier quality operations into a unified global operating structure. At that time, less than 20 per cent of direct materials the company used in the manufacturing process came from low-cost countries. But the need to boost earnings meant this approach has changed.

Magistrali established local sourcing and supplier quality teams and local supplier networks to support the firm's manufacturing operations in countries such as Mexico, the Czech Republic, China and India. This increased the direct material sourced from emerging markets to more than 50 per cent of the company's total spend today and brought substantial cost savings. Although China is the most significant of KONE's emerging markets, Magistrali says many of the experiences the company has had there are equally applicable to other countries. Here, he shares his findings.

The company took a two-pronged approach with its move to emerging-markets sourcing. A portion of the growth was the direct result of long-term relationships with strategic suppliers (particularly for mission-critical components and systems). Many of these previously based only in 'high-cost' areas moved with KONE to China and other low-cost locations. In most cases the company's suppliers willingly joined its push into these new areas attracted by commercial growth opportunities. In some cases, however, volume commitments or joint investments were necessary enticements.

Another substantial part of the growth required KONE to perform due diligence on many potential local suppliers. This focused initially on components or systems with low complexity and high labour costs. They applied criteria including financial stability, reputation of the owners and management, and debt ratios in an effort to audit the supplier's ability to stay in business and enhance the potential for future growth.

But this was not without its problems. Magistrali says among the challenges encountered were "difficulties obtaining complete financial records, and dissimilar accounting principles undermining the financial statements' transparency, not to mention the reluctance of many suppliers to fully 'open their books'." To overcome the uncertainty and risk of sourcing from financially unreliable suppliers, KONE established longer-term contracts with qualified suppliers in order to build a dependable supply base.

Organisational structure can also be an impediment to progress in emerging markets such as China. Magistrali says KONE, like an increasing number of companies, "has a highly matrixed, horizontally structured organisation", with each person often working for multiple supervisors. In China, as in India, speed is often the critical business driver, so clear decision-making and direct reporting lines take on a heightened level of importance. As a result, clear identification of superiors in a hierarchical, vertical structure, is generally the preferred model because it leaves no room for ambiguity.

As in any other part of the world, the people a company hires, empowers and develops determines its success. This is no different in China, although Magistrali says the challenges of identifying these people have not always proved as simple as it sounds. "The talent pool has improved significantly during the past several years as a consequence of Western business management practices gaining wider exposure, but the challenges of hiring and retaining true business leaders with the right competence and English language capabilities are still significant," he says.

Having experienced churn rates of more than 25 per cent before 2005, KONE established an employee retention programme that has since reduced the staff turnover to less than 10 per cent in 2006 and 2007.

He says while money remains a motivator for the Chinese (as elsewhere), KONE has found it is not the only means to attract and retain the right talent. The establishment of internal and external training programmes (including English language classes), career development paths and foreign travel opportunities (including temporary foreign assignments) has gone a long way to ensuring talent stays. "Additionally, our company growth, well-known brand, competent managers and sensitivity towards the usage of appropriate titles are also important elements."

Bridging the gap between culture and business conduct with Asian suppliers can also present challenges. This has been a particular problem when using foreigners or expats with limited understanding of cultural norms and without the right connections to effectively manage relationships.

"To overcome this hurdle we have installed sourcing managers hired locally with long-standing connections and contacts in the region," says Magistrali. "They manage relationships with government entities and act as key contact points for designated suppliers."

He says this is the key to success given contracts rarely have the same level of significance and legal stature as they do elsewhere in the world.

"It is important to understand the intricate personal connections and social relations network in China referred to as guanxi, the concept of social capital," he says.

"Since China's business environment is largely relationship-driven, understanding guanxi and developing long-term business relationships is a crucial factor of doing business there.

"Foreign companies attain continuous supplier commitment to intellectual property rights by building favourable guanxi, which typically involves frequent banquets and low-value gift exchanges, but most importantly transforming the transactional supplier relationships into long-term relationships in which the suppliers are much less likely to violate intellectual property rights and misuse proprietary technology."

While quality is the single biggest concern in China, there is no question that suppliers in emerging markets are capable of delivering to the same quality standards as US and European suppliers for both low and high-tech applications.

"Today this is increasingly the case, with Chinese suppliers winning global performance distinction awards from leading organisations," says Magistrali (pictured).

The fact remains, however, that to get Chinese suppliers to reach internationally recognised performance and quality standards requires a lot of time and effort. And this should be taken into account when examining the business case.

Magistrali says investment in a range of areas has been significant in the success of KONE's emerging markets programme, as has board-level support. It invested in: supplier quality, engineering and sourcing personnel, a robust supplier qualification, management and development system and in-house reliability and testing capabilities. But without top management support, starting from the CEO, he says it is "extremely difficult to engage all the required internal business partners needed to support such an arduous effort".

Magistrali explains that a learning point for KONE is the number of suppliers overseen by individual supplier quality engineers or managers should be significantly lower than in high-cost countries. It takes more time and effort to manage Chinese suppliers and to ensure that no deviation to set quality requirements is allowed to occur.

"To ensure consistency of quality, the concept of 'resident engineers' at supplier sites takes on a new meaning in most emerging markets, especially China, where until the right relationship has been established what one says and what one does is often not the same thing."

Ensuring and monitoring a quality manager's presence at supplier sites is also vital to proper supplier management and development in China. The rule of thumb requires the company's supplier quality managers to be at supplier sites at least 70 per cent of the time.

Tight alignment and collaboration (including through joint audits) is key to delivering supplier quality. Continuous coaching and monitoring is also paramount to ensure quality systems are understood and adhered to in a methodical way and no shortcuts are taken.
"Although the sourcing return on investment has been very attractive in the past few years, there is a clear diminishing materials savings trend on the horizon," says Magistrali. Labour rates in China, as well as other emerging markets, have continued to increase by approximately 10 per cent a year, and shifts in exchange rates and the current, unfavourable raw material trends, have all had an impact on overall cost.

To overcome these risks ¬ and because KONE believes China will continue to be an attractive market for growth in the foreseeable future ¬ the company is planning productivity improvements, supplier development initiatives and will focus on continued recruitment and development of quality staff. As an additional back-up, it will continue its development of other emerging markets.

Sourcing from particular emerging markets will not end solely because of rising costs, since this is a natural evolution for developing countries. But internal and external (supplier) productivity improvements need to be a key ingredient to offsetting these increases and maintaining sustainable cost advantages.

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