‘Innovation’ will be key for China’s economic strategy for several decades. Therefore clarity on this issue is vital. However some discussion of innovation in China fails to understand the core of this issue, imagining that its key is matters such as ‘greater creativity in schools’. In particular such discussion does not distinguish between two fundamentally different types of innovation. The first is ‘cost innovation’ – the use of technology, managerial strength, etc. to reduce costs. The second is ‘product innovation’ – the introduction of entirely new products such as the iPhone, iPad, iWatch etc. This article analyses why ‘cost innovation’, not ‘product innovation,’ will be the key for China for the next several decades. Two extremely successful smartphone companies, the US’s Apple and China’s Xiaomi, will be used to illustrate the general principles.
To understand different innovation strategies in fundamental economic terms, it should be noted that as productivity increases there are two ways to translate this into competitive advantage:
• The same product can be produced at a cheaper price.
• The price can be kept the same and a superior product produced.
Apple is currently the world’s clearest example of the second strategy. Apple’s general policy does not reduce prices on new products - when it has done so, as with the cheaper iPhone 5c, they have generally been a failure. Apple’s strategy is to continuously produce greatly improved, best of all entirely new, products – the iPod, iPhone, iPad etc. This strategy of ‘maintain the price, raise the quality’, is therefore accurately termed ‘product innovation.’
Xiaomi is an outstanding example of the other strategy, ‘cost innovation’. Xiaomi is the world’s most valuable start-up with a value of over $40 billion. Xiaomi does engage in some product innovation - Xiaomi’s use of social media, its timing of product releases etc is superior to Apple. But the fundamental competitive advantage of Xiaomi is price and value. Xiaomi produces a product which in quality is comparable to the iPhone but for less than half the price. The outstanding value proposition of Xiaomi is of quality which is 90% or more of the iPhone for less than 50% of the price.
Success in this strategy does rely from an engineering standpoint on the quality of the product. If the quality of Xiaomi’s phones was only 50% of Apple’s then, even selling at 50% of the price, it would have no competitive advantage. It is only because a Xiaomi phone does deliver more than 90% of the functionality of an iPhone for less than 50% of the price that Xiaomi has a competitive edge. But this does not alter the fact that the fundamental advantage of Xiaomi over Apple is cost not a better product. Xiaomi exemplifies innovation in keeping costs down, ‘cost innovation’, not innovation in producing a superior product – ‘product innovation’.
This difference determines the strategy of the two companies - including marketing. Xiaomi’s style of launching products is similar to Apple – even to the type of clothes of Xiaomi’s CEO Lei Jun resembling those of Steve Jobs. This led to foolish Western criticism of Xiaomi, but in reality it illustrates Xiaomi’s strong strategic sense.
If a company’s strategy is product innovation emphasis must be on how different its product is to any previous one. The classic visual expression of this was the advert announcing Apple’s Macintosh computer at the 1984 Super Bowl - the most famous single advertisement ever. This showed a woman in brightly colored clothes smashing the grey images of a uniform totally regimented society – a visual interpretation of the message ‘the Macintosh is like no other computer before, it is vastly more individual and creative.’
But if the strategy is cost innovation then, in competition in relatively advanced technological products such as smartphones, marketing strategy must be on how similar the cheaper product is to the more expensive one - ideally there should appear to be no difference except price.
The reason for this is that the immediate suspicion of any customer who sees a product only 50% of the price of another is that this is because it is only 50% of the quality! Therefore everything must be done to convince the customer that the quality of the cheaper product is the same as the more expensive one.
Far from Xiaomi to be criticized for the similarity of its product launches to Apple it illustrates the company’s strategic strength – everything about a Xiaomi phone is as good as an IPhone but the price is 50% cheaper.
This explains the branding rationale for Xiaomi’s ‘high quality parties’ for key customers, skillful use of social media etc. It is to maintain the product’s image of high quality - ‘as good as Apple’. Xiaomi’s fatal weakness in marketing would be any suspicion lower price was due to lower quality.
But if Xiaomi’s marketers job is to maintain the high quality image, its engineers job is to keep the price down while maintaining the quality. Xiaomi’s huge success rests on two different strengths: the excellence of its branding in projecting an image of product quality, the excellence of its engineers in ensuring that the product really is of high quality. But the overall strategy remains ‘cost innovation’ – Xiaomi is not fundamentally attempting to produce a better product than the iPhone, it is attempting to produce a product as good as the iPhone at a much cheaper price.
The reason only ‘cost innovation’ can be the foundation of such a successful strategy as Xiaomi’s is because China is no longer a low wage economy. The Economist calculates China’s average factory worker earns $27.50 per day, compared with $8.60 in Indonesia and $6.70 in Vietnam – China’s manufacturing wages are three times as high as Indonesia’s and four times as high as Vietnam’s. China therefore cannot compete on price through low wages, instead it must rely on keeping price down through innovations in technology, management, logistics etc.
This contrast between Xiaomi and Apple exemplifies the necessary strategic direction for innovation in China economy as a whole over the coming period. This is because which innovation strategy is more effective cannot be separated from the overall level of a country’s economic development.
China’s per capita GDP in 2014 in IMF Parity Purchasing Powers (PPPs) was 24% of that of the US. This means, in approximate terms, that the productivity of China’s overall economy was slightly under one quarter of that of the US. Even with the most correct policies in China, and despite the recent overall slowing of the US, it will evidently take China several decades to close that gap. Therefore for several decades China, on average, will be behind the ‘technological frontier’ set by the most productive and advanced economies.
As China will be behind the technological frontier in the majority of economic sectors, it is utopian and unnecessary to believe it will be able to carry out Apple’s strategy of maintaining the same price, or raising it, but producing a superior product. By definition this generally means expanding the technological frontier – which China will not be able to achieve. Instead China’s strategy must necessarily be cost innovation - to produce the same, or more precisely a qualitatively comparable, product but at a lower price.
Xiaomi is therefore so successful because it has a very skillfully executed strategy in line with China’s economic fundamentals. The alternative strategy, ‘product innovation’, the attempt to compete by producing a phone which is qualitatively better than the iPhone could not succeed in China.
To avoid misunderstanding it should immediately be clarified that this is an average. It does not mean China cannot introduce any new products, and China’s companies have become extremely skilled at incremental improvement even of leading products. It merely entails that product innovation cannot be the dominant form for China’s successful competition.
To illustrate this historically China's per capita GDP in 2013 was 21% of that of the US - the ‘technology frontier’ economy. This is equivalent, relative to the US, of the position of Japan in 1951 or South Korea in 1982. At those times, Japan and South Korea, as with China today, were no longer dominated by agricultural populations but had evolved into upper middle-income economies. In the next decade after these dates, Japan and South Korea led the world in steelmaking, shipbuilding, construction equipment and similar mid-technology industries - exactly industries where China is becoming dominant today. But Japan and South Korea at that time were not equaling the US in ‘product innovation’, due to the huge gap in per capita GDP, and it is similarly utopian to believe China can.
The outstanding successes among China’s companies – to take only a few examples Huawei, Wanxiang, CIMC, Xiaomi – are by those which have mastered cost innovation. This is because they have combined innovatory skill with China’s macro-economic fundamentals.
China’s rising wages mean innovation is the key to its economic development. But China’s macro-economic fundamentals determine that it will be ‘cost innovation’ not ‘product innovation’ which will be decisive for China’s companies for several decades.
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This article originally appeared at China.org.cn.