Observers of the Chinese home appliance market have not failed to notice a new phenomenon: manufacturers are scrambling to build their own distribution networks while distributors are partnering with manufacturers to procure private label appliances.

Ni Runfeng, former chief executive officer of colour TV producer Changhong, returned to the firm recently in an attempt to cure it of its "large company syndrome." The first important action he took after his return was to restructure the firm's distribution channel by abandoning its overreliance on distributors and building Changhong's own network in the air-conditioner market.

What does this vertical integration imply? Is it a move forward or backward given the increasing differentiation of industry roles? How can Chinese players restructure channels to deal with the challenges brought on by China's World Trade Organization (WTO) entry? How can they build up world class distribution networks now that international retailers are right on the doorstep of the Chinese market? Will Chinese retailers be marginalized, as were those of Brazil and Argentina? Georges Desvaux, partner in McKinsey & Company's Beijing office and leader of its Asia-Pacific Marketing practice, offered his answers to those question. Desvaux has been advising industry leaders on marketing and retail topics both in the global market and in China for many years.

I. Urgency of reform in Chinese retail and distribution channels

Q: What are the challenges facing retail and distribution in China?

Desvaux: The overall cost of distribution in China is very high compared to the international average. This is due to fragmentation (eg. 10,000 distributors in the household appliance sector), multiple layers of distributors and high cost. Many layers of wholesalers within the distribution channel result in high channel costs and high inventory levels. Although each distributor has very low gross margin by world standards, costs remain high since products often go through three or four layers. In some cases, the total inventory of some manufacturers has equalled their annual sales volume.

Another problem is very limited tracking of information. As a result, inventory piles up in the supply chain, causing a mismatch between demand and supply.Multi-layer channels also mean low profits for participants and, often, poor channel management, making it difficult to launch and provide products at the right time in the right place. Consumers therefore fail to find the right products they want, which creates missed sales opportunities for manufacturers. In addition, the large number and multiple layers of wholesalers accelerate price wars, thus eroding overall industry profitability.

Finally, logistics remains a challenge. Although infrastructure, roads for example, has improved, the skills of logistics players remain underdeveloped.

Q: How should Chinese distributors prepare to meet the potential challenges resulting from China's WTO entry and the inflow of foreign retailers?

Desvaux: Distribution and retail are two sectors that were the most protected in the past and that are the fastest to be deregulated after WTO entry. These sectors will be open to 100 per cent foreign ownership within three years of accession. We have heard that both Carrefour and Walmart might expand their presence in China to over 50 stores each by 2005. Overall, foreign hypermarkets may reach 170 stores in 2005 from 68 in 2000. For example, Zoellig in pharmaceuticals and Kingfisher and B&Q in construction materials have begun to build a presence in Shanghai's distribution market.

It is high time that China's distribution channel is reformed. Some domestic players such as Suning and GuoMei are already taking positive actions, but the challenges are high. Both retailers and wholesalers will need to change.

Suning is adopting a centralized purchasing strategy, a practice that prevails in foreign markets and that helps reduce costs drastically. GuoMei is rolling out large stores offering wide choice to consumers. Surveys have shown that consumers are increasingly willing to purchase in large retail stores.

Wholesalers will need to choose from three alternatives roles:(1) offering integrated logistics service only; (2) participating in sales by offering additional services while focusing on logistics (e.g., provide market information and installation and maintenance services to consumers); or (3) becoming retailers themselves.

Overall distribution channels in China will be centralized, and small and fragmented formats will disappear over time.

II. Little chance of success for "vertical integration"" of manufacturers and retailers

Q: Significant changes are taking place in China's distribution channels. Retailer Suning is venturing into manufacturing. Gree and Changhong are keen to establish their own distribution networks. Moreover, the pharmaceutical sector has witnessed cross equity swaps by manufacturers and distributors. What can we conclude from these trends?

Desvaux:This convergence trend appears logical. But from our experience the vertically integrated model is hard to manage. Retailers acquiring production assets have seldom succeeded in running them successfully. In the 1970s and 1980s, European retailers vertically integrated into manufacturing but most sold the assets afterwards because they found that the specialist manufacturers were more effective.

What has succeeded in Western markets is private label manufacturing. Retailers order from manufacturers products that they sell under their own brand. In France, 25 per cent of food is sold as private label products. The general practice is that, rather than manufacture themselves, retailers outsource production. This enables manufacturers to build scale in production and retailers to sell better segmented and more diversified products. In Europe and the United States, retailers often have a specialized department to manage manufacturers and order private label products. German retailer Aldi has entered into several 10-year agreements with manufacturers, for example in coffee, to produce Aldi brands for sale at low cost for Aldi. IKEA designs its own products but outsources production to manufacturers.

There are some success stories of manufacturers vertically integrating, but they tend to be limited to managing logistics from the factory to the stores or to the restaurants. Take Frito-Lay,the American potato chip producer, for example. The company has its own van network, which is very effective in bringing products to stores, and Frito-Lay salespeople often manage the store shelf themselves.

In the West, in the beer and soft drink industries, players such as Heineken or Danone can deliver products to outlets more effectively by establishing their own distribution channels.

In China, Gree has created value so far by owning its own distributors, as this enables it to control the sales channels and limit price wars. But, under this model, significant challenges arise in future channel management, especially since consumers prefer large stores with wide choice of brands. In most countries, manufacturers have now given up the idea of owning their distribution channels. Ten years ago, many manufacturers used to set up their own special retail outlets; nowadays, these special outlets have almost gone.

Ultimately, whether or not to consolidate manufacturing with distribution depends on consumer demand. The key issue is whether the customers want to compare and choose from multiple brands when they shop, or whether they are fiercely loyal to one brand. In this sense, channel decisions become complicated for manufacturers -- you have to consider not only product features but also consumers' purchasing behaviour, and ultimately balance the economic results.

Textiles is the only exception, as fashion involves personality and the store is usually a strong part of the brand image. This is why major branded chains such as Gap, Zara and Esprit have been successful. But this rule of specialty stores does not apply in the food industry or the consumer electronics industry, where consumers demand more choices.

III. Can China's distributors survive the post-WTO world?

Q: Since Brazil's and Argentina's distribution markets were opened up, foreign retailers have captured dominant market share, leaving local distributors struggling to survive. Currently, Walmart and Carrefour lead retail markets in Brazil and Argentina. In view of this, how should China's distribution industry prepare itself to meet the foreign challenge?

Desvaux: In order to compete with powerful foreign rivals and maintain long-term growth, Chinese firms must improve their competitiveness and become world-class players. Here are four ways they can do this:

1. Increase scale.

Enterprises like Walmart with large-scale centralized purchasing have far lower purchasing costs compared to small companies. This allows Walmart to attract more customers through lower prices and at the same time be more profitable. Most global retailers have realized the value of scale and are expanding fast. Gap, for example, is expanding globally by opening 55 additional outlets each year. Home Depot, a household goods retailer, is expanding at a similar rate -- 50 new stores every year. China's distribution players need to expand their scale too. The question for them is whether to do this through acquisitions and mergers, or through organic growth.

Taking supermarkets as an example,acquiring a competitor increases scale quickly by adding stores at one go while leveraging existing supplier relationships. However, there are many risks in acquisitions such as potentially unsatisfactory store locations, poor quality of sales people and the challenges of integrating cultures and processes. Organic growth takes longer but is considerably easier to manage.

2. Define operational model, service, price and positioning. That is to say, clarify the strategies and positioning of sales channels and retail outlets.

Experience shows that it is difficult for a company to manage a heterogeneous store portfolio. Successful retailers focus on a few store models that have very similar operating characteristics. For example, Walmart established its warehouse model a few years ago, marked by a very effective pricing strategy with low gross margin but high turnover,similar store size and number of products per store. Walmart is now able to compare the performance of stores in similar locations very effectively on a weekly basis, thus driving the managers to take concrete actions that enhance overall performance.

3. Define expansion strategy, including expansion speed and geographic focus, in particular.

Distributors should expand by creating strong and dense provincial networks around large cities, one after another, instead of covering all cities across China at once. The advantage is winning consumer recognition and enhancing logistics effectiveness. Relevant data show that the 10 biggest cities in China account for 20 per cent of overall national retail volume, and the first 24 cities account for 34 per cent. This allows retailers to create a strong position in certain areas that other retailers will have difficulty in entering and to create local scale in logistics and purchasing.

4. Improve operational and management capability.

To compete with world-class players, domestic retailers will need to put in place strong operational processes. For example, to improve purchasing skills, a rigorous purchase process should be established and relationship-based purchases should be eliminated. To enhance site selection and investment management skills, a market development department can be created to specifically focus on site expansion and selection.

It is equally indispensable to establish cost effective IT (information technology) as a supporting system. Walmart's success is also attributed to its advanced IT system and logistics network. Finally, talent and resources are equally important. The retail industry is labour intensive. It also requires perfect execution at the front line, which entails adequate training for staff. Given the fast growth of retailers, specialized training programmes must be set up.

IV. Conclusion

Judging from Brazil's and Argentina's experience, the retail landscape will be very challenging for Chinese players. However, they do not necessarily have to lose to foreign competitors. China's distribution players can win by quickly reaching world-class performance and skills. For this, they must launch programmes to match the world's best practices in terms of business models, scale, operational processes, logistics management and store location.