So many companies now produce goods in China that simply relying on its low-cost labor to churn them out inexpensively confers precious little competitive edge. Overcapacity in many industries—from automobiles to household appliances—is already leading to price wars, squeezed margins, and, in some cases, heavy losses. Even Chinese exporters are feeling the pinch as global players move in and enjoy cost advantages similar to those of local producers.

As pressure on margins in the domestic market increases, more Chinese companies with a strong home base are successfully entering international markets with products that leverage China's low costs—for example, Lenovo, which last year purchased IBM's PC business; Galanz, the world's largest microwave manufacturer; and the telecom-equipment maker Huawei Technologies. Their success has intensified global competition and squeezed margins further.

Companies operating in China must find advantages that go beyond cheap labor, not least because there are already signs of incipient wage inflation that could eventually drive up labor costs, at least in heavily industrialized coastal regions. To generate profits from increasingly big investments, these companies will have to improve the utilization of factories, manufacture a broader and more customized range of products, and enhance product quality. The best way to achieve these goals would be to apply the same lean techniques that leading manufacturers around the world have implemented successfully. And this message is just as relevant for locally owned companies as for many multinationals, which struggle to transfer their production systems from other countries to China's chaotic, fast-changing environment—a struggle that is especially hard if those systems had preexisting quality and efficiency problems.

There is much room for improvement. Waste is endemic in Chinese factories—those owned by multinationals and by locals alike. Machines often sit idle, inventory piles up, bottlenecks choke production. Parts deliveries from suppliers arrive late. Defect rates for components run high. So long as the advantages of low-cost labor were substantial and competition was limited, companies tolerated such inefficiency. Now that margins are shrinking, they have little choice but to find ways of raising their productivity and of improving the quality of their goods.

Lean techniques aim to identify and eliminate the root causes of waste. But implementing these techniques in China presents challenges that can easily trip up even companies that are well versed in the discipline. Chinese managers, often recently promoted from the shop floor, lack not only crucial skills in problem solving, coaching, and performance management but also the industry-specific expertise needed to diagnose complex technical problems accurately and to develop effective solutions rapidly. Relentless growth in many industries means that since factories constantly scramble to fill orders and expand capacity, they have little time to refine their production processes. Furthermore, high employee turn-over undercuts the continuity that is central to the use of lean techniques.

Bottlenecks and stockpiles

Most leading global manufacturers from Asia, Europe, and North America not only operate factories in China but are also rapidly expanding production there. Demand for some Chinese-made products is growing by 20 to 50 percent annually—a pace that requires the building of up to three new plants each year. Factories typically ramp up in a few weeks or months in China rather than the many months or years needed elsewhere. Investment budgets are huge, and companies feel tremendous pressure to build whatever capacity they can.

In a few industries the rush to build new factories has gone overboard, creating overcapacity that is pushing down prices and squeezing profits. The price of white goods, for instance, has declined by 5 to 10 percent a year for more than a decade, and this slide is accelerating as global players ramp up their Chinese operations. Surging automobile assembly capacity has helped to push down average sale prices by half since the mid-1990s, though demand rose by more than 300 percent during that period. The profit margins of carmakers declined to 4 percent, from about 9 percent, from 2003 to 2005, according to government statistics. In the personal-computer industry, fierce competition spurred consolidation, which has reduced the number of players by 90 percent since the mid-1990s. Even in the steel sector, which benefits from China's boom in investment and construction, weaker companies are suffering: more than 50 mills, accounting for 10 percent of domestic capacity, shut down in 2005 because of low prices for steel reinforcing bars and other commodity products.

In China's fast-moving environment, companies tend to grow by adding machines and labor rather than by eliminating waste through common lean-manufacturing techniques such as poka yoke, a Japanese term that means designing fool-proof production steps to reduce the number of defects. Such techniques are now, however, being introduced in Toyota Motor's Chinese factories and in those of a few other large suppliers, such as Delphi and Lear. But the great majority of Chinese companies haven't begun to use the lean-manufacturing approach.

Chinese factories, for example, usually repair or scrap faulty products as they come off the assembly line rather than produce them properly in the first place. Quality control at each stage of production relies mainly on the experience of individual workers, not on rigorous and widely used statistical tools (such as Six Sigma), which are poorly understood and incorrectly applied in China, so that defect rates are high. At one telecom-equipment maker, for example, only 68 percent of all printed-circuit boards passed inspection recently, well below the target of 80 to 90 percent—and 90 percent is the norm in world-class plants. The typical Chinese worker's lack of technical know-how represents a significant challenge.

What's more, Chinese factories often make products in big batches, thereby creating large inventories of partly finished goods that are prone to damage, since they lie around for lengthy periods. The result is higher costs and late deliveries. Poor coordination between different steps in the production process often creates bottlenecks: at one manufacturer, workers spend 40 percent of their time waiting because of upstream delays.

Unfortunately, cultural norms often stand in the way of efforts to address these wasteful practices. Many Chinese managers celebrate success atthe first sign of any minor improvement. They just aren't accustomed to the kind of rigorous, long-term effort needed to make lean-manufacturing initiatives pay off. In addition, the hierarchical nature of Chinese organizations hinders the cooperation and joint decision making—across departmental boundaries, as well as up and down the chain of command—needed to solve the thorniest problems.

If the median factory in a McKinsey survey were to match the top performers, profits would rise by about $25 million a year

For companies that tackle waste successfully, the payoff can be significant. Inefficient work routines and poor equipment maintenance, for example, made one steelmaker's mill run at only 60 percent of capacity. If that level rose to the industry benchmark—about 90 percent—the company's profits would increase by upward of $100 million a year. Moreover, a recent McKinsey survey of 30 electronics factories found that wasteful practices and high defect rates reduced profits by 20 to 40 percent as compared with returns at world-class plants. If the survey's median factory (in terms of output) matched the top performers, profits would rise by about $25 million a year.

Many benefits, such as reducing inventories and raising quality, require limited investment and have a short payback period, so the incentive to achieve them by using lean techniques is strong. But to improve the likelihood of success, Chinese companies must ensure that some key elements are in place. Managers and factory workers alike need a new intellectual tool set to solve complex problems and make smart changes in the way they work. Companies need better systems to set performance goals and measure the workers' ability to meet them. Finally, in a country where swift change is the norm, companies must focus the minds of their employees on the importance of constant long-term improvement.

Closing the gap

In applying lean techniques, factories in China use the same basic approach that factories elsewhere use. First, they typically establish specific goals based on what their customers want, determine the ideal production process for achieving those goals, and select and train managers who can implement the required changes on the factory floor. Then they run a pilot program demonstrating the effectiveness of lean operations and roll out the program across the entire factory, business unit, or company. A few of the most successful organizations even link their lean initiatives to their overall performance-management systems.

Building know-how

For this approach to succeed in China, companies must surmount many hurdles. The kind of focus on fine-tuning production systems that works well in places such as Stuttgart and Detroit tends to fall flat in Shenzen and Shanghai, where steps in the production process are ill defined and the skills needed to understand and improve them are rare.

One way of filling the knowledge gap quickly is to tap outside experts. In China, this approach requires creativity because experienced production engineers are scarce. Companies can recruit retired engineers—a potential source of valuable technical know-how—from Japan and Taiwan through local trade associations or other industry and personal networks. Richard Ru-Gin Chang, the founder of the Shanghai-based chip maker Semiconductor Manufacturing International Corporation (SMIC), recruited engineers largely through personal contacts at his former employers.

Companies can also use headhunters and advertisements to tap the increasingly large pool of technical specialists from places such as Taiwan, Singapore, and South Korea who are willing to work in China. At Asia Pulp & Paper, an Indonesian conglomerate that is the largest paper manufacturer in China, for example, most of the mill managers are Taiwanese expatriates. In addition, suppliers of factory equipment are sometimes willing to work closely with a manufacturer if the collaboration will help them develop new processes or products. The supplier's technicians often work the bugs out of machinery and production processes inside a manufacturer's own plant, for example, thereby providing valuable on-the-job training for its personnel. European equipment makers such as Danieli & C. Officine Meccaniche and SMS Demag, for instance, are transferring steelmaking expertise to their clients' workers by designing their latest equipment in concert with Chinese steel companies.

Yet raising the technical and problem-solving skills of frontline factory workers still presents a special challenge because their knowledge base is often close to zero and turnover is so high. Training curriculums must be much simpler than they usually are in the factories of, say, Italy or Japan, and sessions must convene more frequently. Likewise, Chinese workers tend to learn faster from hands-on shop floor exercises than from the theoretical classroom sessions typical elsewhere. The challenge calls for experienced instructors who can roll up their sleeves and overcome the cultural customs that often impede training.

One common challenge is getting several departments to solve problems together. Because of the rigid hierarchies of Chinese organizations, the general manager or some other senior official usually makes decisions that cut across a number of functions. But this approach is impractical in everyday circumstances on the factory floor. Take, as an example, a common situation: mechanical engineers, electrical-maintenance personnel, and machine operators must together learn to disassemble a piece of factory equipment in order to identify a problem's root cause. Savvy instructors can break down the barriers among the three groups by playing on the Chinese people's deep-seated sense of hierarchy and inherent sense of honor—often referred to as "face." If the instructors, whose position commands respect, begin to tear down the machine, the workers watching will soon join in to save face themselves and show their respect, even if this kind of participation conflicts with the departmental hierarchy.

Although the skill level of Chinese workers is generally low, their hunger to learn is typically high, for they know that developing skills is the route to better jobs. And in a country where more than 40 percent of all manufacturing jobs are newly created or destroyed each year—compared with less than 20 percent in North America—workers have strong incentives to learn quickly.

Creating a performance culture

Chinese executives and supervisors lack experience in managing performance. They tend to focus mainly on fighting fires and have little time to use systematic management tools. The failure to bear down on performance is also partly cultural. The clear hierarchy in Chinese factories means that workers are reluctant to challenge managers, who tend to feel that it is beneath their dignity to get involved with nitty-gritty problems on the shop floor. And in general, the Chinese would rather avoid talking frankly with their peers about their personal performance. Together, these attitudes present a considerable problem, since to implement lean techniques effectively workers and managers must collaborate to identify problems and apply disciplined remedies.

To change the behavior of such employees, companies must have a strong leader who drives change by setting clear targets and holding subordinates personally accountable. The leader is usually a CEO acting as a symbolic focal point of the improvement effort but can also be a department head backed up by upper management. The leader must implement a performance evaluation system that reinforces the aims of lean manufacturing. In factories in Japan or the United States, managers typically pick performance indicators (such as defect rates) and routinely determine whether individual workers meet their goals. In China, however, workers are liable to accept such a system more readily if it analyzes the performance of groups rather than individuals. An effective model would thus be to tie a worker's pay to a team's performance, with perhaps 20 percent of total compensation rising or falling with the team's progress (or failure) in meeting set goals. A few companies already take an even more aggressive approach: the steelmaker Baosteel, for instance, ties 40 percent of an average worker's—and 70 percent of a manager's—pay to performance.

Unfortunately, this approach can go awry if, as happens all too often in China, companies choose inappropriate performance goals. At the Chinese factory of one multinational cable manufacturer, nearly half the bonus pay of production workers was tied to the number of pieces they produced. The result was overproduction and wasteful stockpiles of finished inventory ranging from 20 to 70 days, depending on the product. Managers took the bold move of linking pay to a balanced set of incentives—with metrics such as quality and cleanliness as well as daily production targets—even though they initially thought that it would depress production. In fact, the company has almost doubled its capacity, dramatically reduced its stock of finished goods, and made its employees more satisfied with their work.

Making sustainable gains

One of the most difficult hurdles companies in China face in successfully introducing lean techniques is sustaining the long-term effort needed to break factory bottlenecks. The current tendency is to work furiously on many projects and hope that improvement will somehow result. In a society where leaders have exercised political power through the mass mobilization of the Cultural Revolution and the Great Leap Forward, getting large numbers of people to look as though they are actively following a consistent path often seems more important than genuine, measurable improvement. Chinese factories are still festooned with posters announcing the current Communist Party slogans. Superficial campaigns to improve quality or boost production take the place of an exacting focus on well-defined problems.

For lean programs to work in China, managers must find ways to adapt them to this tradition of mass mobilization. The success of pilot projects in tackling waste or improving quality must be widely trumpeted as a way of triggering momentum toward change. More than in Western plants, companies must train the workers who participate in these pilots to serve as a cadre of specialists spearheading the rollout of change throughout the plant or the company. A pilot can demonstrate the benefits of lean manufacturing in a tangible way that is much more likely to convince skeptical factory workers than a more theoretical approach.

Simple improvements requiring few new skills send workers the powerful message that it is easy to learn smarter ways of performing even basic tasks. In the rolling mill of one steel plant, for example, the time needed to change the rolls that flatten metal into sheets fell by 50 percent (to ten minutes). This pilot project succeeded thanks to the introduction of simple changes, such as replacing faulty components quickly and rescheduling the overhaul of other equipment to avoid interference with roll changes.

In addition to using pilots, companies must organize their communications and training exercises on a much larger scale than would be needed in Japan or the West. In one organization of about 4,000 employees, nearly half of the workforce received instruction in the basics of lean manufacturing over a three-month period just to lay the foundation for the practical work ahead. This kind of mass communication about the intent of a program is critical in setting high expectations for its success and motivating change. Making lean techniques the focus of everything from media reports to education also dovetails nicely with the propensity of Chinese factories to celebrate activity. For senior managers, who are often concerned about the way lean manufacturing will affect their power, taking benchmarking trips to best-practice companies can help to remove misconceptions.

Another complication in applying lean principles is the relentless, rapid pace of change in most Chinese factories as they add new capacity and their product designs evolve. To cope, companies must give lean initiatives shorter time horizons than they have elsewhere and implement them more swiftly. Western companies tend to plan their programs and to identify pilot projects by asking themselves where they want to be in seven to ten years' time; in China, these plans must be updated every two or three years. The compressed time frame means that companies have just 12 to 18 months to move from the pilot phase to the rollout of changes through the whole organization.

Such a demanding pace is possible in China because factory workers are less bound by traditional ways of working and more adaptable to change than their counterparts in Europe, Japan, or North America. Nevertheless, China can adopt lean techniques rapidly enough only if strong leaders set the direction, give workers the know-how they need, and establish effective incentives.

Twenty years ago, China had only a modest manufacturing sector. The tremendous progress made since then is a testament to the dynamism of the country's economy and the hard work of its citizens. The sheer speed of change is clear evidence that when managers recognize the importance of improving quality and reducing waste in their factories, they will be quick to shift their attitudes and achieve dramatic results.