Creating your distribution model for China
Foreign companies targeting the China market should develop an
effective distribution model. Personal networks and relationships are
an important component of a successful distribution strategy in China,
especially at the local level, where these networks may consist of only
a handful of decision makers.
Several distribution structures are available in China, including the
typical structures of distributorship, commission agency, franchise, trademark license and joint ventures. Apart from the usual business considerations such as whether the model can achieve better penetration into the market and serve the objectives of the brand owner, tax issues and actual logistic arrangements are also crucial in determining whether a certain structure is preferred. For example, it is common to use local agencies for importing cosmetic products due to certain testing procedures of the China Food and Drug Administration, and the distributors are supplied through such local agencies.
The most relevant taxes for foreign businesses and individuals are corporate income tax, value added tax and customs duties.
In general, the Contract Law of the PRC governs the relationship between a supplier and its distributor. There is no specific government agency regulating the distribution aspect, provided that in the context of franchising, the Ministry of Commerce is the regulatory authority that oversees compliance pursuant to the franchise laws and regulations such as the Regulations of Administration of Commercial Franchising. Recently, the government released a series of national standards for different sectors stipulating the necessary standards for management of different contractual relationships. However, the legal position of these national standards has not yet been defined.
In China, a supplier can terminate a distribution relationship without cause and is not required to provide a mandatory compensation or indemnity at the termination of the distribution contract.
Companies must analyze potential distribution partners, paying attention to material movement within China, because poor inventory positioning and stock-outs can harm brand reputation. Non-compete provisions are enforceable during the term of the distribution relationship.
In many cases, responsibility for distribution operations is initially placed on the distributor without identifying clear procedures and targets. Companies that use material flow mapping, particularly in rural China, and that have sophisticated logistics, in-transit inventory, and distribution capabilities are likely to be more efficient and better at delivering goods on time and with minimal loss or damage. Mapping helps identify each part of the supply chain and which stakeholder is accountable for what. By graphically mapping material flows, companies can more accurately assess the metrics that directly affect service levels and costs.
Distributors can also be required to follow the supplier’s pricing policy. But under the Anti-Monopoly Law, price fixing arrangements to monopolize the market are prohibited.
Many of China’s domestic agents and distribution channels are offshoots of the state-owned system and were privatized over the last decade. Such distribution channels—made up of many smaller distribution networks—tend to be large, combine well-established infrastructure networks, and require companies to develop strong relationships with county and municipal governments to make sure product moves as planned. It is common to agree on exclusive territories for a particular distributor.
Increasingly, manufacturers have been expanding their business-to-consumer capabilities. Customers that buy directly from manufacturers often get lower prices but receive service that tends to be below industry benchmarks, because customer service lies outside a manufacturer’s core competencies. Few manufacturers have successfully transitioned from original equipment manufacturer to original designer and original brand owner.
With the liberalization of the commercial sector in 2004, a growing number of foreign agents and distributors have established themselves in China. A foreign company may establish its own entity or may enter into a joint ownership arrangement with a local company or importer. Through complex subcontracting networks, foreign distributors can work directly with traditional retailers. But these networks tend to lack advanced practices in demand planning, inventory management, and logistics networking—which leads to higher operational costs. This is primarily because such networking involves Chinese partners who lack a sophisticated knowledge of international-standard operations and technology.
Unless it is required by law that a joint venture be established, from a corporate management perspective, a foreign invested commercial enterprise (FICE) is generally the preferred type of business vehicle for a foreign seller to import and distribute its own products. A FICE will be incorporated as a limited liability company in which the foreign supplier is the only shareholder.
In China, many distribution networks are decentralized, creating fractured and often redundant distribution systems. To streamline this process, downstream distribution analysis should include a supply chain assessment of factors such as capacity, throughput, and operational metrics, as determined by the company’s key performance indicators. If bottlenecks disrupt distribution, suppliers can leverage their influence to identify more direct routes for end-product distribution.
A wholesaler may have exclusive access to a district or city, but wholesale distribution remains fragmented nationally, and companies trying to distribute nationwide must use multiple channels and vendors. Network optimization suffers because some distributors are reluctant to work with distributors in other geographic areas. A possible solution would be to invest directly by setting up in-house distribution capabilities rather than using local distributors or collaborate with other vendors in similar situations, such as through joint-procurement agreements.
Many distributors in China are, in fact, investment companies that purchase and resell products. Few Chinese distributors have sophisticated knowledge of demand forecast planning. They often exclude important variables such as seasonality, product cannibalization, and forecasting cycles; use weak assumptions to forecast sales; and rarely compare forecasts to actual sales to ensure accuracy. When working with local distribution partners, foreign companies should determine how sophisticated the forecasting tools used by their downstream networks are. To reduce risk, foreign companies should also factor in additional time and costs when planning to supply the China market.
The rapid expansion of the Internet in China, which now has more than 400 million users, has created online distribution channels. Alibaba.com Ltd. and its subsidiary Taobao.com reach a broad range of customers. In April 2010, Taobao reported over 190 million users. Foreign companies are also expanding into this market through such online distributors as JiGoCity.com.
The restrictions as to the use of e-commerce intermediaries is a matter of negotiation between the parties but the engagement of e-commerce intermediaries is currently a growing phenomenon. The provisions on territorial limitation as to distribution activities with enhanced technological requirements are included in most of the distribution agreements. A supplier may require that its distribution partners, or e-commerce intermediaries, do not sell products outside the assigned territory.
To protect its intellectual property or brand from infringement by its distributors, foreign companies should register their trademarks and patents in China, under the corresponding categories. It is common to establish different kinds of agreements such as licensing and technology-transfer agreement with local parties.
In the coming years, the continued growth and expansion of sales channels in China will improve its distribution system. Logistics networks will become more efficient, and logistics providers will gain knowledge of advanced capacity planning, inventory management, and demand forecasting. The development of China’s economy will lead to the evolution of its supply chain.
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DISCLAIMER: All information in this article is verified to the best of our ability and is assumed to be correct at time of release; however, Woodburn Accountants & Advisors does not accept responsibility for any losses arising from reliance on the information provided within. The information provided is for general guidance and does not replace specialized advice.