Market Watch

Rising Costs Impact Electronics Producers’ Profit Margins

June 27, 2005

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But boosting prices is no answer
China’s electronics manufacturers are being squeezed by rising costs for materials, energy, labor and other items on one side, while struggling with retail price erosion on the other side. This daunting pair of forces must be closely managed in the coming years if manufacturers are to continue succeeding. To survive in this increasingly hostile market environment, China’s electronics manufacturers must become leaner and meaner competitors, iSuppli Corp. believes.

China Takes the Lead in Electronics Production
China’s electronics products have gained substantial market share in regions throughout the world. For example, as a manufacturing or assembly location, China in 2004 accounted for 27 percent of all mobile-phones, 52 percent of mobile PCs, more than 80 percent of MP3 music players and 92 percent of DVD players, according to iSuppli.

Low-cost materials, relatively inexpensive labor, cheaper land and preferential investment policies among Chinese provinces helped attract overseas electronics makers to China in recent years. And as these overseas electronics manufacturers established large factories in China, this trend assisted the prospects of domestic makers.

A Change in Market Winds
However, starting in 2004, many of the forces underlying China’s success began changing dramatically.

First, labor shortages cropped up last year in the Yangtze River Delta and Pearl River Delta regions, the two main locations for electronics equipment manufacturing in China. Labor costs also are increasing in these areas.

Second, electric power shortages are impacting the production schedules of many manufacturers. In fact, many producers were forced to operate factories at night and during weekends in order to comply with requests to stagger the peak consumption of electric power in the summer of 2004. They will face the same difficulties this summer as well.

Meanwhile, the price of electric power is increasing.

Third, profit margins also are being impacted by the escalating prices of materials, such as petroleum and steel. China must import 50 percent of its iron ore and more than 30 percent of its petroleum, and the level of imports is likely to continue rising. In fact, as of May 2005, the overall price of imported iron ore has risen 71.5 percent compared to the beginning of 2004.

The wave of international petroleum price increases is severely impacting operating and material costs for many industries, including the electronics manufacturing business. For example, in the second quarter of 2005, the production costs of home appliances increased by 8 to 15 percent compared to the fourth quarter of 2004, iSuppli believes.

Fourth, the government now is embarking on a plan to limit real estate usage by the industrial sector in order to ensure that there is sufficient land for agriculture.

Rising Prices Impact the Bottom Line
The overall impact of the increasing prices of major materials on China’s electronics makers is easy to see.

For example, escalating prices contributed to a loss posted for last year by Guangdong Kelon Electrical Holdings Co. Ltd. of Shunde, Guangdong Province, a major maker of white goods. Guangdong Kelon’s losses amounted to US$7.7 million in 2004, according to the company’s most recent annual report.

Swelling prices for major materials, including plastics, steel and copper, contributed to the company’s losses. Notably, the production costs of DVD players increased 5 to 10 percent in the first quarter of 2005 compared to the fourth quarter of 2004, due to the rising prices of major materials.

In an example of the impact of rising costs, Siemens recently increased the retail prices of its refrigerators sold in China. Boosting the sales prices of products is a possible way to cope with rising costs, but this typically results in lower market share. Thus, the major makers are cautious about raising prices for their end products.

Dealing with Inflation
Manufacturers are studying how to cope with such issues over the long term. Most manufacturers are improving their internal management structures while striving to accelerate the development of new products. Furthermore, international makers are reconstructing their corporate structures in China and promoting internal reforms.

For example, Tokyo-based Olympus Optical is accelerating its development times and changing the development directions of its new models of digital cameras. Moreover, the Japanese camera company will reduce its workforce by 3,000 positions at its two factories in China.

"This restructuring is symptomatic of the two major problems afflicting the digital camera market today: product parity and extreme price erosion," said Christopher Crotty, senior analyst, consumer electronics for iSuppli.

Both Chinese and overseas makers are endeavoring to deal with the new realities of higher costs, and although they may use different means to cope with this trend, they all recognize that there’s no time to waste.

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