Shanzhai!
“Shanzhai” is a Chinese term referring to companies that operate outside traditional rules or practices. Professors Mitchell Tseng (HKUST) and Hau Lee (Stanford) help us understand the particularities of “Shanzhai” mobile phone companies
From 1998 to 2006, the number of mobile phone users in China grew twentyfold from 20 million to over 400 million. Those 450 million users represented a penetration rate of 35%, still far below the 2007 OECD average of 96%, indicating further growth potential. With the growing number of Chinese users came growing Chinese production.
In 2007, China produced about 550 million phones or half of world production. The so-called Shanzhai manufacturers produced about 110 million phones or 20% of Chinese production, 10% of world production.
Shanzhai
The case (see reference below) takes a look at the novel, and not always legal, ways of these Shanzhai companies. They are small companies (typically 5-10 employees) with little capital (often less than $10,000) that go after underserved markets (rural areas, smaller cities) with low prices and fast response. The term Shanzhai dates back to 14th century Chinese literature where it designated a bandit’s mountain stronghold which escaped government control.
Viewed from a laudatory standpoint, Shanzhai companies are nimble firms that attend to ignored customers, dare to break rules and come up with innovative products or business models. Viewed from a more critical standpoint, they forsake quality control and often bypass regulations (hence the ‘bandit’ appellation) designed to ensure product safety or protect intellectual property.
Shanzhai phones cover the range from counterfeits of branded products to original designs with features catering to local preferences in functionality or appearance. Among the former type of products, think of Nckia and Sumsung phones. In the latter category, one can point to phones introduced during the Beijing Olympics, in the form of the Aquatics Center or the National Stadium.
The Shanzhai mobile phone industry is concentrated in Shenzhen (a special economic zone located across from Hong Kong). Shanzhai companies make up part of the 30,000 companies that constitute the Shenzhen mobile phone supply chain. Research and design companies, component manufacturers and assemblers feed off of each other in what one may well call a gigantic technotope. The world’s largest electronics manufacturing services (EMS) company, Foxconn, has its largest production facility in the zone, employing 270,000 workers; BYD, the world’s largest handset battery manufacturer is also headquartered in Shenzhen.
The role of MediaTek
One factor facilitating the development of the Shanzhai sector was the entry of the chip designer MediaTek. This Taiwanese firm started offering chipsets for mobile phones in 2003. MediaTek’s strategy was to offer good functionality, low prices and local technical support superior to that of competitors like Qualcomm or Texas Instruments.
In 2005 it took customer-friendliness one step further by offering a turnkey chipset solution which allowed the Shanzhai companies to create new products relatively easily and in as little or one or two months. With MediaTek taking on the chip design burden, the Shanzhai firms could focus more of their attention on sourcing components such as screen, camera, keyboard and the exterior housing. Nearly half of all the handsets (mainstream and Shanzhai) sold in China in 2006 featured MediaTek chips.
Shanzhai process
Shanzhai companies work downstream with phone wholesalers and upstream with component suppliers and phone assemblers. The process begins with prototype designs, based on the firm’s in-house intuitions and on input from wholesalers or other market participants. The companies then take these prototypes to wholesalers, for bids (quantity and price). It is these wholesalers who sell the phones to retailers (shops in rural areas and smaller, more remote cities) on a cash, not consignment, basis. In this way, the Shanzhai companies carry no inventory risk: they offload this risk onto the wholesalers and small retailers.
With wholesaler orders in hand, the company outsources the production, typically in lot sizes of 3,000 to 5,000. The assembly shops are small with a minimal amount of surface mount device (SMD) equipment; therein, teams of a few dozen workers can assemble more than 1,000 phones a day. Quality control of incoming components as well as outgoing products is typically minimal. All this keeps assembly costs to just 3% of the total handset cost (RMB 270 or $40).
Competition is fierce among the Shanzhai companies and profits at just RMB 10-20 ($1.50-$3.00) do not allow all to survive. Many of those who have survived began serving other price-sensitive emerging markets (Asia-Pacific, India, Russia, Middle East and Africa). Indeed by 2009, it was estimated that two thirds (100 million of 140 million units) of Shanzhai phone production was exported, with 60% of those exports going to the Asia-Pacific region.
The regulatory framework
The Chinese regulatory framework, which the Shanzhai companies were skirting, featured two main elements. The first was a production license. Set up in 1999, these licenses were awarded to 17 domestic and 13 global manufacturers. A simplification of the procedure in 2004 led to a doubling of licensed producers to 80. In 2007, the production license requirement was abolished, allowing Shanzhai manufacturers to become legal producers.
There remained the obstacle of the network access license (NAL). This license was required for all new handsets and certified that the products met telecommunication standards. But it cost up to RMB 300,000 ($44,000) and required up to six months of administrative effort so that many Shanzhai manufacturers bypassed the NAL route to keep introductions fast and prices low…
Challenges for the Shanzhai sector
Two particularities of Shanzhai phones have raised customer and government wariness. One is low quality and attendant physical safety issues. Exploding batteries can cause injury or even death. The possibility of high radiation levels led the Chinese Ministry of Industry and Information Technology to issue a warning against Shanzhai phones in March 2009. Quite apart from the physical risks, the lack of after-sales support has contributed to making faulty mobile phones the number one customer complaint in China.
Shanzhai manufacturers have also bypassed the mainstream obligation of equipping phones with a unique International Mobile Equipment Identity (IMIE) number. This number prevents stolen phones from accessing the network and also allows security services to track mobile phones. Shanzhai firms tend to shun IMEI because the testing costs $20,000-$50,000 and takes six months. While China has tolerated the sale of IMEI-less phones, India and Taiwan banned the use of such phones in 2009, with the Taiwanese instituting a fine of $9,000 per violation.
The case concludes by bringing up the question of how Shanzhai companies can respond to the various challenges. One way is to join the ranks of mainstream Chinese manufacturers. Indeed, the case presents Tianyu (see box), a former Shanzhai company that has become the leading domestic manufacturer. Another path is for Shanzhai firms to set up legal operations overseas. Some 20 Shanzhai companies are investing RMB 10 million ($1.5 million) in India to produce properly IMEI-equipped phones. Shanzhai companies can also start to negotiate licensing rights with major brands – the examples of Pierre Cardin and Jeep linkages with Shanzhai companies close up the case.
Reference:
GS-75
“Shanzhai (‘Bandit’) Mobile Phone Companies: The Guerilla Warfare of Product Development and Supply Chain Management”
Professor Mitchell Tseng and Power Siu (Hong Kong University of Science and Technology); Professor Hau Lee and David Hoyt (Stanford Graduate School of Business)
Published May 2010
