UK: Innovation In Emerging Markets - 2007 Annual Survey, Part One

Foreword

Given the significant size and growing wealth of developing economies, it is hard to ignore the tremendous business potential these markets have to offer. While it’s not a new topic on the business agenda, emerging markets are fast becoming an integral part of nearly every CEO’s business strategy to drive sustainable profitable growth.

The perception of what precisely emerging markets represent has also changed. For a long time, manufacturers have viewed emerging markets as simply a means to lower global operating costs. While this remains true, the mindset is shifting dramatically. For manufacturers large and small, emerging markets are now gaining prominence in boardroom discussions as an avenue to grow the top line. What is also apparent is that manufacturers are seeing the increased capabilities in emerging markets to handle more sophisticated, high-value activities. This is rapidly changing the global competitive landscape.

Staying competitive and growing profitably in an environment in which business routinely transcends borders is the new challenge. Globalization has made leading and managing a complex, global business network harder. In this report by Deloitte’s Global Manufacturing Industry Group, we’ve observed that many companies are falling short of meeting their goals in emerging markets. And, as their global operations become increasingly complex, they face the daunting task of integrating and managing all areas of the business.

This report evaluates some of the strategic areas that companies need to address to succeed and realize the enormous market potential of the developing economies including China, India, Southeast Asia, Eastern Europe, and Latin America. It highlights some of the innovative strategies that successful companies are deploying to win the war for talent, manage risk and structure their operations to achieve their revenue and operating goals in emerging markets.

For global manufacturers to be successful, profitable growth in emerging markets is not an option, but simply a business requirement. We hope this report offers new perspectives and practical insights to help your business prosper and stay competitive in the new global business landscape.

Global manufacturers once regarded emerging markets primarily as low-cost locations for routine operations. Now, attracted by the enormous business opportunities, and often encouraged by government policies, manufacturers are locating higher-value activities such as complex production, research and development (R&D), and sales/marketing operations in these rapidly growing economies.

Yet, despite the enormous business opportunities in these markets, a surprising number of companies fall short of their goals. Indeed, Deloitte’s Global Manufacturing Industry Group, which is made up of Deloitte member firm manufacturing industry practices, found in its 2007 study of the challenges in emerging markets that less than half of the executives surveyed said their companies had been extremely or very successful in meeting either their operational goals or their revenue goals.

What is preventing so many companies from fulfilling their goals? Most likely, it is because business complexity continues to increase and because managing emerging market operations is a daunting task. To drive revenue growth, companies are developing innovative products that meet the needs of these new and growing markets. But as they locate more sophisticated activities in emerging markets, companies will need to rethink their business approach. They need to tailor their talent management strategy to each market, and go beyond relying only on compensation by placing more emphasis on training, non-monetary rewards and recognition, and career opportunities.

They must be more intelligent about how they effectively manage a highly complex set of risks. And they must install an organizational structure that lets autonomy thrive, while still leveraging strengths from headquarters. In fact, the 2007 study found that manufacturers that take these steps are more likely to be successful.

This report details the key findings of Deloitte’s Global Manufacturing Industry Group’s 2007 study of the challenges facing manufacturers in emerging markets. This is the second annual edition of this study; the 2006 report focused on how manufacturers can achieve commercial success by developing and producing products at costs that meet the unique needs of consumers and industrial buyers in emerging markets, which have much lower average GDP per capita than in developed markets. (For the 2006 study, please see Innovation in Emerging Markets: Strategies for Achieving Commercial Success.)

The 2007 study focused on the operational issues facing manufacturers as they locate and expand in five important markets: China, India, Southeast Asia, Latin America, and Eastern Europe.

The research for the study included a survey of 446 executives from manufacturing companies headquartered in 31 countries around the world and in-depth interviews with senior executives at eight major manufacturers. In addition, the study also drew from Deloitte member firm experience in working with manufacturers in emerging markets around the world.

The tremendous opportunities offered by emerging markets continue to be high on the agendas of manufacturers. In 2005, emerging markets accounted for more than half of world GDP measured at purchasing power parity (which takes into account differences in the relative prices of goods and services).¹ Their share of world exports is now 43 percent, up from 20 percent in 1970, and they consume more than half the world’s energy.²

They are also growing rapidly. While GDP in developed economies expanded by an average 2.3 percent annually over the last five years, annual growth in emerging markets has been almost 7 percent.³ The Economist predicted, "China, India and other developing countries are set to give the world economy its biggest boost in the whole of history. . ."⁴

As a result, companies are now operating complex global business networks in which they are designing, supplying, building, selling, and distributing everywhere around the world. Among the executives surveyed, 59 percent said their companies had operations in China, while more than one-third had operations in Eastern Europe, Southeast Asia, and Latin America (Exhibit 1).⁵ Not surprisingly, larger companies—those with $1 billion or more in annual revenues—were even more likely to be operating in these locations. More than three-quarters of these executives said their companies had operations in China, and roughly half or more reported having operations in each of the other markets.

Many executives also expect their companies to increase their investments in emerging markets in the coming years. Roughly two-thirds of executives expected their companies would establish or significantly expand their operations in China over the next five years, while roughly half said the same about India, Eastern Europe, Latin America, and Southeast Asia (Exhibit 2).

Among executives who thought it was at least somewhat likely that their companies would invest over the next five years, expanding sales/distribution operations was an important element of their strategies, with roughly three-quarters anticipating they would invest in these operations in each of the emerging markets (Exhibit 3). More than 80 percent of these executives expected their companies would invest in production operations in China, while roughly half anticipated an expansion of production activities in the other markets. Many of these executives who anticipated increased investment also said they expected their companies would expand their research and development activities. Forty-four percent thought it was likely their companies would expand R&D in China, while roughly half expected R&D investments in India and Eastern Europe.

At one time, manufacturing investment in emerging markets was largely about lowering costs through tapping less expensive labor, materials, and components. But today, companies are seeing these locations as new markets for their products and as sources of innovation. The top-rated reason for investments in emerging markets, even more than cost reduction, was to increase revenues and market sharerated as extremely or very important by 84 percent of executives (Exhibit 4). Reducing time-to-market, diversifying revenues sources, and accessing talent were other factors rated highly.

Seizing this wider range of business opportunities requires companies to rethink how they operate in emerging markets. In many cases, they will need to acquire an entirely new set of skills, processes, and organizational structures. Just as it is critical to produce products that meet the unique preferences of customers in each market, companies will need to adjust business processes, operational approaches, and governance models as well. As a Director of Global Process Optimization at a major US manufacturer explained, "You cannot simply take a North American version of a business practice, move it to China or India, and just flip the switch. It won’t work."

Although some approaches are proving to be more successful overall, each manufacturer should craft an operational approach tailored to its specific situation. How a company addresses issues such as talent management or risk management will depend critically on its industry, specific products, and the nature of the operation or process. Clearly, it also depends on the characteristics of the individual emerging market including the labor market, risk profile, nature of sales/distribution, government regulations and incentives, and culture, to name a few. These issues not only vary from country to country, they can also vary within a single market. For example, with foreign investment concentrated in a few locations, there is a wide variation in the labor markets in different locations across China and India.

This report details the study findings on how manufacturers are tackling the operational challenges in emerging markets in three critical areas:

• Talent management

• Risk management

• Operating models

To succeed in these intensely competitive markets, manufacturers will need to align their operations with the unique requirements of each location where they operate. Companies that gain a deep understanding of the local realities in each emerging market, and then strike the right balance between efficient global processes and responsive local operations, will be best positioned to prosper.

The 2007 study by Deloitte’s Global Manufacturing Industry Group examined how manufacturers are addressing three operational issues in emerging markets: talent management, risk management, operating models.

As companies locate more higher-value operations in emerging markets, they are now finding it more difficult to attract and retain the skilled employees they need. To compete effectively in this talent battle, manufacturers need to customize their human resources strategies to address local market customs and conditions. They also need to align these HR approaches with their specific business strategies and operating model. In addition to compensation, companies will need to offer employees a comprehensive value proposition that includes training, rewards and recognition, and career opportunities.

• Roughly one-quarter of the executives said their companies found it very difficult to attract qualified workers in China, India, Latin America, and Eastern Europe.
• Retention is an even greater challenge in China, India, and Southeast Asia, where roughly one-third of the executives said retaining qualified workers was very difficult.

• Sixty-three percent of executives said providing training was an important talent management strategy for their companies in emerging markets, the same percentage as cited compensation. In addition, 59 percent named career opportunities and 53 percent named rewards and recognition as important strategies
• Companies that rely on a broader range of human resources strategies were more likely to be successful.

Seventy-three percent of the executives at companies that use rewards and recognition as an important strategy said they were extremely or very successful in achieving their operational goals, compared to 51 percent of those that didn’t rely on this strategy. Executives at companies that rely on training were also more likely to report success.

While emerging markets are brimming with opportunities, they are also fraught with risk. In many locations, these can include weak intellectual property protections, uncertain political environments, corruption, and complex legal and regulatory regimes, to name a few. Success in emerging markets requires an intelligent approach to managing the risks necessary to drive future growth, while avoiding risks that have no upside potential.

• Only 56 percent of executives said their companies conduct a very rigorous risk assessment before entering an emerging market. Even among executives at companies with $1 billion or more in annual revenues, only 64 percent did so.

• For existing operations in emerging markets, only 45 percent of executives, and 49 percent of executives from larger companies, reported conducting very rigorous risk assessments on an ongoing basis.

• However, executives at companies that conduct a rigorous analysis of risk were more confident in their ability to manage the threats they face. For example, 86 percent of executives at companies that conduct very rigorous risk assessments of existing operations were very confident in their ability to manage risk, compared to 68 percent of those at companies where the risk assessment was less rigorous.

• When companies conduct risk assessments before investing in an emerging market, they often fail to analyze carefully the full range of risks they will face. For example, only 64 percent of executives said their companies conducted a very rigorous assessment of intellectual property risks, 57 percent for security risks, and 51 percent for geopolitical risks. For the risks of terrorism or natural disasters, only 30 percent reported examining these risks in a very rigorous manner.

• Only 47 percent of executives said the separate risk assessments conducted across their companies were integrated into a single, comprehensive view before investing in an emerging market.

• Yet, executives at companies that integrate their separate risk assessments were significantly more confident in their ability to manage the risks they face. Ninety-one percent of executives who reported their companies have a very integrated approach to assessing risk for their emerging market operations said they were very confident in their companies’ ability to manage risks effectively, compared to only 62 percent of the other executives surveyed.

• Executives at companies with $1 billion or more in annual revenues reported using a variety of strategies to manage their risks in emerging markets including keeping high-value activities in developed markets (53 percent), sourcing components from multiple emerging markets (53 percent), and distributing production across multiple emerging markets (51 percent).

Companies often enter into joint ventures or third-party arrangements, especially when first entering an emerging market. The executives surveyed, however, were far more likely to report their companies used newly-constructed, wholly-owned subsidiaries ("greenfield investment"), which provide greater control, more upside potential, and quicker decision-making.

• The most popular operating structure was greenfield investment, which was used by roughly 60 percent of the emerging markets operations that executives reported on.

• When executives were asked which operating structures they used for their production operations in emerging markets, acquisitions, joint ventures, and outsourcing were each cited by roughly one-third of executives. For sales/distribution operations, 30 percent reported using outsourcing, 24 percent cited acquisitions, and 20 percent cited joint ventures.

• Executives at companies that used greenfield investment were more likely to report success. Sixty-five percent of executives at companies that used this operating model for their sales/distribution operations in a market said they had been extremely or very successful in achieving their operational goals, compared to 46 percent of other executives.

• But while greenfield investments appear to be more successful on average, executives interviewed for the study reported using a variety of structures, depending on such considerations as the complexity of the operation, the size of the required investment, time to market, the potential market opportunity, and regulatory requirements. However, if an operation involves a core competency and uses proprietary processes or technologies, companies favor greenfield investment since it minimizes intellectual property (IP) and other risks.

Traditionally, the ability to tap a less expensive labor force has been a principal attraction of locating operations in emerging markets. Facing high wage and benefit costs in developed economies, manufacturing executives have been lured to these markets by visions of an inexhaustible supply of low-wage workers to hire for their factories.

But today that picture is changing fundamentally. As global manufacturers expand operations and place higher-value operations in emerging markets, they require employees with more sophisticated skills, and they are now competing with dynamic local companies for the most talented workers. As a result, labor costs for skilled workers in many emerging markets are rising quickly, and manufacturers are now finding it more difficult to attract and retain qualified workers.

To succeed in the fierce battle for talented employees in emerging markets, competitive compensation is important, but is only one of many tools that manufacturers need to use. Perhaps even more importantly, they need to ensure they develop the skills of their employees, place the right employees in the right positions, and connect their employees to each other and to the company as a whole. Deloitte member firms call this broader approach to talent management the Develop-Deploy-Connect model and found that it is used by successful companies across many industries.⁶ The 2007 Innovation in Emerging Markets study demonstrates that the insights captured in this model are just as relevant to talent management in emerging markets as they are in developed markets.

Global manufacturers are now looking to emerging markets for a broader range of highly-skilled employees. Many of these countries have made education a key part of their economic development strategies. Each year, roughly 1.2 million engineers and scientists graduate from universities in China and India, triple the number ten years ago, according to The Economist.⁷ Although all these graduates may not meet the requirements of global manufacturers in terms of technical standards, language ability, and familiarity with performance-oriented business operations, both countries have made technical education a priority. Eastern Europe and Russia also offer a labor force with excellent technical skills in science and engineering.

Many of the executives said their companies were encountering difficulties in attracting and retaining the qualified workers they need.

Roughly one-quarter of executives said hiring qualified workers in China, India, Latin America, and Eastern Europe was very difficult for their companies (Exhibit 5). An additional one-third of executives said hiring was somewhat difficult in each of these markets.

But attracting skilled workers is often not as great a challenge as retaining them. Roughly one-third of the executives reported that holding on to qualified employees was very difficult in China, India, and Southeast Asia—even more than reported problems in hiring. Indeed, roughly two-thirds of executives reported that retaining qualified employees was at least somewhat difficult in each of the five emerging markets examined.

In China, the booming economy has made it easy for talented, ambitious workers jump to a new job for small increases in pay or better perceived career opportunities. Several executives interviewed said turnover rates for their operations in China were significantly higher than in developed markets. The costs of replacing a high-performing manager have been estimated to range from three times to as much as 20 times the employee’s salary.⁸ In the American Chamber of Commerce’s annual member survey, human resources was the most important concern about doing business in China, ranked higher than such issues as government bureaucracy and corruption.⁹

Manufacturers face difficulties in attracting and retaining qualified workers in other markets as well. A 2006 survey by the Japan External Trade Organization of Japanese companies found an unmet need for qualified mid-level managers and engineers in India and Southeast Asia as well as in China.¹⁰ The survey found Thailand had the most severe shortage of engineers, due to the influx of R&D operations by major automobile manufacturers. A 2006 survey across 26 countries by Manpower Inc. found the largest shortages of professional workers in Mexico, where 41 percent of companies said they would have hired more professional staff over the preceding six months if they had been able to find qualified applicants.¹¹

Increased demand, both from global and local manufacturers, and growing labor shortages have led to rising labor rates in many countries. Wages of factory workers in some regions of China have been rising at double-digit rates, despite the migration of workers from the interior to the more developed coast.12 In the Czech Republic, wages were up 10 percent in the year ending in the second quarter of 2006, one of the highest rates in the EU.¹³

Executives expect this competition for labor will continue to drive up labor costs, especially in China. Forty-one percent of the executives expected labor costs in China to increase substantially over the next five years, while 26 percent had the same expectation for Eastern Europe and 24 percent did for India. Despite the competition they reported in attracting and retaining qualified workers, only 10 percent of executives surveyed expected they would face substantial labor cost increases over the next five years in Latin America and 9 percent did for Southeast Asia.

With manufacturers conducting more complex activities in emerging markets, the competition for higher skilled positions has intensified. Almost half the executives surveyed reported problems in hiring qualified managers and R&D personnel in China, while roughly 40 percent reported problems attracting sales/marketing staff, skilled production workers, and engineers (Exhibit 6). Roughly one-quarter to one-third of executives reported difficulties in attracting qualified workers for these positions in most of the other emerging markets studied. Finding qualified R&D professionals appears to be a particular problem in Latin America, where 40 percent of executives cited this as difficult.

While executives reported few problems with the technical and mathematical skills of the work force in emerging markets, they have encountered difficulties finding workers with a broader range of sophisticated job skills that are important for higher-level positions. For example, almost half the executives were not satisfied with the leadership skills overall among the Chinese labor force, while 42 percent had the same experience in Southeast Asia, and roughly one-third in the other markets (Exhibit 7). Roughly one-third of executives said they were less than satisfied with the problem-solving skills available in the work force in each of the five emerging markets, with the single exception of India.

Finding qualified English-speaking workers for senior managerial positions is another challenge. Many global companies use English as their common language, even if they are not headquartered in an English-speaking country. More than half of the executives were not satisfied with the English-language skills of the labor force in Latin America, and one-third or more of executives saw this as a problem in the other markets, except for India.

To compete effectively for skilled talent in this more difficult environment, manufacturers are finding they have to go beyond a narrow focus on compensation. Instead, they must offer a well-designed value proposition to employees that leverages a broad range of human resources strategies and tools. This integrated value proposition should include compensation, incentives, benefits, developmental opportunities, career paths, working conditions, company culture, and more.

And while global manufacturers may bring the advantages of consistent, company-wide policies in some cases, they also need to customize their talent management approach to the realities in individual emerging markets.

The experience of a major U.S manufacturer of construction and mining equipment provides an example. The company has traditionally hired workers within five years after graduation and planned to have them stay with the company for their entire careers. The company is growing so quickly in China, however, they decided their traditional approach would inhibit their growth. Instead, they decided to build management talent more quickly by also hiring older workers who already have 15 or more years of experience.

The fact that most production workers in Mexico rely on public transportation or bicycles had to be incorporated into their planning by Hill-Rom, a $1.2-billion subsidiary of Hillenbrand Industries that manufactures hospital beds and other healthcare products. In choosing a location, they found that a factory could only expect to draw workers from a distance of five or 10 miles. They also adjusted factory operations; while their shifts normally begin at 7AM, they have moved shifts earlier or later in Mexico to accommodate bus schedules.

Manufacturers often find they have to provide special benefits they wouldn’t provide in developed markets, such as medical benefits for parents of workers in India, or allowances in China for such items as transportation, clothing, and housing. AstenJohnson, a $260-million manufacturer of paper machine clothing, specialty fabrics, filaments and drainage equipment, has also found that the timing of compensation can be important. In its Chinese facility, the company provides three salary reviews each year rather than one, and also spreads out bonuses, to discourage talented employees from leaving.

These are just a few examples of the myriad ways in which companies find they need to adjust their human resource practices, both in design and presentation, to accommodate the needs of individual emerging markets. They also underscore the need for intimate knowledge of the local labor market and culture. Several of the executives interviewed stressed the importance of hiring a skilled local executive to manage personnel and talent issues.

It is not surprising that offering appropriate compensation is essential, but executives stressed the importance of other strategies as well. Sixty-three percent of the executives said training was an important HR strategy for their company in emerging markets, the same percentage as for compensation (Exhibit 8). In fact, 78 percent of executives said training was an important strategy for them in India, the highest-rated HR strategy for the country. Similarly, in China, more than two-thirds rated training as an important strategy, again more than for any other HR strategy. Roughly two-thirds or more of executives cited training as an important strategy for their companies in Southeast Asia, Latin America, and Eastern Europe as well.

In their efforts to attract and retain highly qualified employees, career opportunities and non-monetary rewards and recognition also figured prominently—59 percent of executives said providing career opportunities was an important strategy for their companies in emerging markets, while roughly half said the same about offering rewards and recognition. In Southeast Asia, providing rewards and recognition was the highest-rated HR strategy, cited as important by 72 percent of the executives.

Executives that reported these tools were important to their companies’ talent strategies were in fact more likely to also report they had been successful in achieving their operational goals. Not surprisingly, companies that used compensation as an important strategy to attract and retain qualified workers proved more successful. Sixty-six percent of executives who said that they relied on compensation in an emerging market rated their company as being extremely or very successful in achieving their operational goals in that market, compared 52 percent where compensation was not an important strategy (Exhibit 9).

But a broader set of strategies also provided real value, and perhaps served to differentiate companies that use them. For emerging market operations where training was an important strategy, 65 percent of executives of the executives said they had been extremely or very successful in achieving their operational goals, compared to 57 percent where training was not considered an especially important strategy.

There was an even bigger performance gap for rewards and recognition, a strategy that is often overlooked. Seventy-three percent of executives at companies where rewards and recognition is an important HR strategy in emerging markets said they had been extremely or very successful in achieving their operational goals, compared to 51 percent of executives at companies where this was not considered an important strategy. Companies have an opportunity to improve performance by going beyond compensation and benefits to carefully craft programs that leverage the power of non-monetary rewards and recognition to motivate employees.

The survey found only a modest difference between the operational success of companies that emphasized training and those that did not, and none for companies that emphasized career opportunities compared to those that did not. Yet, this may be due more to the skill at implementation than the potential of these strategies. A pay raise is easy to implement, and there is no difference between the same level of pay provided by different manufacturers. But training and career opportunities are another matter. Savvy employees know the career opportunities are brighter at a global manufacturing company with a well known brand name, or at a dynamic mid-size company. Similarly, training not only differs in its intrinsic quality, there may also be a perception that being trained at a strong global company is more valuable.

In fact, all the manufacturing executives interviewed in depth stressed the importance of training and providing career opportunities to their strategies to attract, and even more importantly, to retain qualified employees. In addition to ongoing training, Johnson & Johnson, the $53-billion healthcare products manufacturer, offers its employees opportunities to work at multiple operating units in the company to give them a breadth of experience. They also send talented employees to work for a period in its U.S. and European operations, which gives them a broader understanding of the company and a wider set of skills and professional experiences.

Siemens has a talent identification program that aims to identify top talent early in their careers with the company, continually develop their skills, and retain them by demonstrating they have a bright future with the company. For each employee in the program, a development plan and career path are developed, opportunities are provided to work in other parts of the company, and they are invited to top management meetings. The company also maintains a regional talent database, so that a top performer in one emerging market may be identified as the right person for an opening in another country in the region or at headquarters. Although this program is global, it has proven especially helpful in retaining talented employees in emerging markets.

Executives say that offering rewards and recognition has also proved effective. One element of AstenJohnson’s talent strategy at its production facility in the Suzhou Industrial Park in China is to reward employees by providing small promotions and new titles. It also works hard to create a strong team ethic, sending its entire work force of 75 employees on a leisure trip each year.

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