Profitability of foreign investment in China

China Herald talked about the profitability of P&G and Unilever in China.

It linked us to a McKinsey interview with P&G's head in China, who dodged the question diplomatically (but answered qutie accurately)

• "Our profitability in China today is comparable to the company average. With developing markets—and China, in particular—becoming an increasingly important part of the company's total operations, our shareholders would not accept a dilution of its financial performance. It is a financial imperative to continue delivering superior returns to our shareholders.
  Some companies may take the attitude that China is a growth market where they need to build a position for tomorrow, thinking that eventually they could raise profitability to target levels. This is not what we are trying to accomplish in China. We have set adequate, definable profit objectives for ourselves and believe that from both a strategic and an organizational focus this is the best way to take on the cost challenge involved in serving the midtier consumer segment in China. Tough profit objectives force you to get your cost structure competitive."

Many multi-nationals are more profitable than they appear to be (and how they reported in their accounting books), mainly because the profit tax is higher in China, or that the China subsidiary is a Joint Venture where you have less % share of the profit, plus other reasons as explained below.

What explains (and how to create) the difference between 'real' profit and 'book' profit? Here are some examples:

• Transfer price:
• Pharmaceutical companies: cost of good is typically 5-10% of sales (or less), but when it is sold to the China JV (from Ireland or an intermediate in HK), the price is immensely inflated for 3 reasons: (1) profit tax in China (33%) is higher than in HK or Ireland (under 20%); (2) JV is not 100% owned and profit has to be shared with local silent partner; (3) China's price control in drugs, the higher the cost you can demonstrate, the higher the price you can charge; the higher the unit price, the more commission hospitals and physicians can earn
• Similar case for Coca-cola, the bottler JVs have to pay for an inflated price for the 'secret formula', and hence is less profitable
• Consumer goods that export (P&G and Unilever): the wholesale price for the exported goods is underpriced, because the HK subsidiary pays much less profit tax than the mainland factory.
• The reverse may be done in the initial years of tax exemption in the 1990s, or if the operation in China is really in a deep mess and does not have to pay for profit tax anyway, but such examples are rare.
• Equipment and machinery: inflate the price of the equipment. Inflating the size of the investment has good PR effect and will surely make local mayors happy (their promotion depends on such stats)
• Other costs (cross charging expenses, salaries, to the China subsidairy)

Now you understand why so many companies are still so eager to exapnd their investment in China, even though some may appear to be unprofitable, because they are actually quite profitable.

• Almost all pharmaceutical companies are profitable in China
• Most of those with sales over $20M are also profitable in China, mainly because of scale (fixed cost) factor; the scale required may be higher if there is major investment in the production lines (e.g. auto industry)

How can China cope with the leak in taxation? perhaps lower its tax (for some industries) to increase its competitiveness. I guess the whole discussion above also applies to many other countries as well.