The Central and Eastern European Opportunity Creat ing G loba l Advantage in Ser v ing Weste rn Europe

January 2005

BCG FOCUS

Companies that sell products or services intoWestern European markets may be basingtheir strategic sourcing decisions on some

significantly mistaken assumptions. In seeking thecompetitive advantage to be gained by sourcing andmanufacturing in rapidly developing economies(RDEs), they may be tempted to follow the rush toAsia, and particularly to China, without exploringopportunities closer to the markets they want toserve. But recent research by The BostonConsulting Group confirms that, contrary to popu-lar belief, Central and Eastern Europe (CEE) offersfeatures that make the region highly competitivewith China. Notably:

• For a number of industries serving WesternEurope, CEE’s costs are competitive with China’s

• CEE markets will continue to achieve attractivegrowth and consumer-spending levels for at leastthe next several years

• CEE countries offer exceptional capabilities andproductivity

• In important respects, several CEE countries offermore favorable business environments thanChina’s

It follows that companies aiming to sell productsand services into Western Europe should take aclose look at the opportunities for sourcing andmanufacturing in CEE countries—and should care-fully weigh those opportunities against the possiblebenefits and certain risks of going farther afield.

The Big Picture

Europe is facing a fundamental reshaping of itseconomic landscape as more and more WesternEuropean companies—like companies in otherhighly developed regions—move their sourcingand production to RDEs. This migration will con-tinue to accelerate, fueled by the five fundamentalcurrents of activity shaping globalization: therapid growth of RDE markets, the continuing costand capital advantages of RDEs, the developmentof talent and capabilities in RDEs, the migration ofcustomers to RDEs, and the emergence of RDE-

alone. Our research reveals thatfor many product categories soldinto Western Europe, totallanded costs are essentiallyequivalent whether the productis manufactured in China or inCEE. In some cases, in fact, CEEcountries have an actual costadvantage over China. In manyother instances, the cost differ-ential is small or negligible.

So if the costs to serve WesternEuropean markets from CEE orChina are essentially equivalent,on what basis should companiesmake their outsourcing deci-sions? The answer is that theyneed to look at these decisionsfor each product line, takinginto consideration a number ofstrategic factors, including localmarket potential, opportunities

2 BCG FOCUS

based global competitors. (For adetailed discussion, see the BCGFocus report Navigating the FiveCurrents of Globalization: HowLeading Companies Are CapturingGlobal Advantage, January 2005.)The question for many compa-nies is not whether to go butwhere. And for a lot of compa-nies that are selling into WesternEuropean markets, the leadingoptions tend to come down to Central and Eastern Europeor China.

How should companies makethat strategic choice? Tradi-tionally, companies have basedoutsourcing decisions on simplecost comparisons. Today, how-ever, for many industries, thedecision between CEE andChina cannot be based on cost

for capitalizing on local talent,and the general business envi-ronment in each country—espe-cially various kinds of businessrisk. We discuss these factors,along with our analysis of rela-tive costs, below.

A Closer Look at Centraland Eastern Europe

For purposes of this discussion,we define CEE as Belarus,Bulgaria, the Czech Republic,Estonia, Hungary, Latvia,Lithuania, Poland, Slovakia,Slovenia, Romania, Russia,Turkey, and Ukraine. (SeeExhibit 1.) Note that we haveincluded Turkey as part of theconsideration set for this regionbecause it is of interest to manyglobalizing companies.

HungarySlovenia Romania

Bulgaria

Poland

Belarus

UkraineCzechRepublic

Slovakia

Lithuania

Latvia

EstoniaRussia

Turkey

E X H I B I T 1

THE CEE REGION COMPRISES 14 COUNTRIES

suggests that misperceptionsabout the region, combined withthe tremendous attention re-cently afforded China, have ledsome companies to ignore CEEand take much of their sourcingand manufacturing to Asia. Anobjective analysis of the CEEregion, particularly as comparedwith China, suggests that thosecompanies are overlookinghighly attractive sourcing andmanufacturing opportunities—as well as very attractive mar-kets—practically next door. Let’sexamine the basic componentsof competitive advantage andcontrast CEE’s merits with thoseof China.

Competitive Costs

By moving their operations toRDEs, companies can signifi-

3The Central and Eastern European Opportunity

Our analysis demonstrates thatCEE can be a highly competitivelocation for sourcing and pro-duction, in terms not only oftotal landed costs but also ofstrong local markets, top-notchcapabilities, and a highly favor-able business climate. On a num-ber of measures—the availabilityof skilled labor and qualifiedengineers, the competence ofsenior management, and variouskinds of political and opera-tional risk—CEE countries com-pare very favorably with Chinaand other Asian RDEs.

Many companies, of course, arealready operating in CEE. Sur-prisingly, however, CEE’s shareof production for Western Eu-ropean markets is lower than itshould be, given the region’s rel-ative advantages. BCG’s research

cantly reduce not only laborcosts but also material costs,component costs (in partbecause of the lower-cost laborin purchased components), andcapital costs. The overall savingsthus achieved generally amountto 10 to 20 percent but can be ashigh as 40 percent; for industrialproducts, they typically amountto almost 30 percent. (SeeExhibit 2.)

Naturally, potential savings varywidely by industry, product line,and location, driven primarily bydifferences in labor content andcargo value per volume, whichdetermines transportation cost asa percentage of product value.(See Exhibit 3, page 4.) What isstriking is the number of indus-tries that have an opportunity tosave 15 percent or more. As these

E X H I B I T 2

RDEs CAN DELIVER SIGNIFICANT COST SAVINGSModeled Economics for a Typical Industrial Product Sourced from an RDE

SOURCE: BCG case experience.

Index

0

20

40

60

80

100

120

WesternEuropean

manufacturingcost

Labor DutiesSpecialincentives

Logistics costs (trans-

portation, additional

inventory, and expediting)

Other management

costs

Landed cost from an RDE

Depreciation Materials,components, and tooling

Scale RDEmanu-

facturing cost

100

50

Cost savings

70

Additional costs

105

5

20–25

5–1010–15

0–5 0–5

and Spain actually increased afterthey joined the EU.)

But blue-collar labor costs onaverage three times more in CEEthan in China. On the surface,that differential might appear tomake a decisive difference inoverall cost. In fact, however, itoften works out to be nearly neg-ligible. For instance, for a prod-uct whose labor content (directplus overhead) amounts to 30percent of its cost, the differ-ence in total labor cost betweenmanufacturing in China and inCEE amounts to less than 3 per-cent of total cost—and that’s

4 BCG FOCUS

WesternEuropean RDE penetration(RDE imports as a percentage of Western European consumption)

Games and toys

TV sets

Batteries

Tires

Motor vehicles

Steel products

Dairy

–200

10

20

30

40

50

–10 0 10 20 30 40

Beverages

Handbags

Sporting goods

Photo camerasLarge appliances

Insulated cables

Computers

Furniture

Migrating heavily to RDEs

Starting to migrate to RDEs

Average potential RDE cost savings1

(percentage points)

Likely to stay indeveloped economies

More relocationsexpected

E X H I B I T 3

POTENTIAL RDE COST SAVINGS VARY BY INDUSTRY AND CORRELATE WITH THE DEGREE OF MIGRATION TO RDEs

SOURCES: Eurostat; BCG analysis.

NOTE: Penetration is based on data from CEE and Asian countries, including China, the Czech Republic, Hungary, India, Indonesia, Malaysia, the Philippines, Poland,

Russia, Slovakia, and Thailand. Industry groups are based on selected NACE 3 and NACE 4 categories. (NACE is the statistical classification of economic activities in the

European Community.)

1The weighted average cost savings for serving Western European markets is based on labor cost and content, cargo value, and logistics costs.

industries continue moving toRDEs, an enormous amount ofproduction will migrate. If RDEpenetration reaches the relativelymodest overall level of 15 to 20percent observed in several indi-vidual industries (versus about 5 percent overall penetrationtoday), some €600 billion to €800 billion of annual produc-tion would migrate to RDEs overthe next five to ten years.

Where should all this productiongo in order for companies toachieve these savings? Clearly,some RDEs have lower labor coststhan others. But it is important to

consider how large a factor laboris in each product. For example,labor in CEE countries typicallycosts 4 to 10 times less than inWestern Europe—and can cost asmuch as 50 times less. (SeeExhibit 4, page 5.) This gap isexpected to remain largely intactfor the foreseeable future.Specifically, we do not anticipatesignificant changes to be trig-gered by the May 2004 accessionof ten countries to the EuropeanUnion, including eight fromCEE, or by the eventual accessionof other CEE countries. (In a his-torical precedent, the relativewage gaps for Greece, Portugal,

before taking into accountChina’s transportation penalty.When you factor in transporta-tion costs to Western Europe,along with the costs of labor,materials, and inventory, China’scost advantage declines to atmost 2 percent; and, in manyindustries, the CEE region actu-ally has an advantage in totallanded cost. Exhibit 5 (page 6)shows how total landed costs toWestern Europe differ betweenCEE and China for 20 generalproduct categories. As stated

above, it is important to under-stand—for each product line—how different RDE locationsaffect cost, quality, lead-time,and other factors.

As might be expected, China pro-vides the largest share of importsinto Western Europe in the in-dustries where it is advantaged(though, as just noted, that advan-tage is quite small); in these indus-tries, China’s share of importsamounts to almost 70 percent.However, where CEE has a cost

advantage vis-à-vis China, CEE hasonly a 57 percent share of importsinto Western Europe. Clearly, in by-passing CEE, companies are over-looking a cost-saving opportunity.

Moreover, in the newly emergingCEE economies such as Belarus,Romania, and Ukraine, laborrates are even lower than in themore developed CEE economies.Sourcing from these countries toserve Western Europe can bemuch more economical thansourcing from China and other

5The Central and Eastern European Opportunity

ChinaIndiaMalaysiaTaiwan

UkraineBelarusBulgariaRussiaRomaniaTurkey

LatviaLithuaniaSlovakiaEstoniaPolandHungaryCzech RepublicSlovenia

SpainItalyFranceUnited KingdomGermany

Indonesia

OriginalEU

CEEcountriesin EU

Asia

OtherCEEcountries

0 10 20 30 40

CAGR (%)

22233

57766777

58878

5

75

810

9

10058585440

201212

99888

86552

197431

2

10058585641

2316151111111110

98773

218542

3

Index3 2003 2009

2

6

3223

45555

55

57889

35

3

6

5

9

100

24

81856682

2820302218

2015

3725

788

3112

51

18

13

7

Hourly compensation for production workers1

(2003 versus 2009)

2003–2009CAGR (%) Index3

2003 20092003–2009

($)0 10 20 30 40 50 60

($thousands)

100

30

85856687

3124362722

2418

44349

1211

3314

54

23

16

11

Annual gross salary for engineers2

(2003 versus 2009)

2003 labor cost 2009 increment

E X H I B I T 4

THE CEE COST ADVANTAGE OVER WESTERN EUROPE IS BASED ON SIGNIFICANT DIFFERENCES IN LABOR COSTS

SOURCES: BCG analysis; press research; UBS.

1Compensation includes benefits.

2Salaries are for employees of industrial companies in the electrical engineering sector (in capitals and other major cities).

3The index was calculated as a percentage of the value for Germany.

6 BCG FOCUS

Asian countries. As companiesrecognize this opportunity,investment in the region is accel-erating. Romania, for example,achieved 38 percent growth inforeign direct-investment inflowsin 2003, amassing a total of $1.5 billion; it expects to haveattracted $2 billion in 2004.

Differences in labor costsbetween high-cost and low-costcountries, while large, will notremain constant, given thedynamism of the latter. In gen-eral, however, the optimal mix ofadvantages for each product lineis unlikely to shift abruptly; thefundamental sources of advan-tage are likely to stay relativelyfixed for at least several years.Nonetheless, companies that aredesigning global sourcing strate-gies would be prudent not tofocus exclusively on one regionbut to manage their sourcing inclassical portfolio terms, puttingsome in China and some in CEE.The question we are addressinghere is which region to use toserve Western Europe.

Naturally, costs vary to somedegree by region, by country,and even by area within a coun-try. One factor affecting localcosts is the established industriallandscape in the region. Forexample, the Czech Republicand Slovakia have emerged ascenters of production for theassembly of automobiles, Polandfor white goods, and Turkey forauto parts and some assembly.Taking advantage of such preex-isting “clusters” enables compa-nies to save time and cost inramping up their productionfacilities.

Furniture

Tires

Steel products

Automobile storage batteries

Motor vehicles

Lamps

Large appliances

TV and DVD combos

Games and toys

Microwaves

HDTVs

Handbags

Insulated cables

Sporting goods

Flat-panel TVs

Batteries

Bulbs

Handsets

Photo cameras

Desktop computersand laptops

–2 0 2 4 6 8 10 12

Cost savings: CEE versus China1

(percentage points)

E X H I B I T 5

ACROSS A 20- INDUSTRY SAMPLE, CEE AND CHINA ARE SIMILAR IN TOTAL LANDED COSTS INTO WESTERN EUROPEThe Exception: CEE Savings Are Much Larger for Bulky and Heavy Products

SOURCE: BCG analysis.

NOTE: Cost savings are based on cargo value, labor cost, and content as well as logistics costs. In this

exhibit, CEE consists of the Czech Republic, Hungary, Poland, Russia, Slovakia, and Turkey.

1Positive “cost savings” implies that total landed cost from CEE into Western Europe is lower than total

landed cost from China into Western Europe.

such households is expected toexceed 31 million in the nextfour years. These consumers rep-resent a market that is onlybeginning to be tapped.

Naturally, CEE is far from mono-lithic, as it consists of 14 nationalmarkets, each with its own lan-guage or languages and culture.Such variety no longer poses thesignificant challenges that itonce did: many companies havelearned to target regional sub-segments. For example, PepsiCohas different water brands in dif-ferent countries: Toma in theCzech Republic and Slovakia,Kristályvíz in Hungary, and

in Poland. Theproduct’s taste is also different:

7The Central and Eastern European Opportunity

If CEE competes effectively oncost, it can also hold its own interms of growing market oppor-tunities.

Growing MarketOpportunities

Taken together, the countries ofCEE represent an attractive andgrowing market opportunity.While the region is muchsmaller than China, with 380million people versus 1.3 billion,it generates nearly the sameGDP—and nearly four times asmuch GDP per capita. (SeeExhibit 6.) In CEE today, morethan 25 million households haveannual disposable income ofover $7,500, and the number of

some variants of Toma water areflavored to better satisfy thepreferences of Czech consumers.Nestlé, similarly, has differentwater brands: andMazowszanka in Poland, andAquarel and Kekkuti in Hungary.Some companies have addressedthe diversity within CEE bychoosing to focus on its fivelargest markets—Russia, Turkey,Poland, the Czech Republic, and Hungary—which togetherrepresent almost $1 trillion of GDP.

Excellent Talent Pools

In addition to low costs andhealthy markets, CEE provides apool of skilled laborers and qual-ified engineers who are generallymore educated than those inother RDEs. In some CEE coun-tries, levels of skill and trainingare competitive with those indeveloped countries. Through-out the region, both the availabil-ity and the quality of the skilledwork force are currently veryhigh. (See Exhibit 7, page 8.) InTurkey, for example, there aremore than 48 million people ofworking age—of whom only some22 million are in the labor force.In 2003 more than 600,000 peo-ple in Turkey aged 25 to 34 hadtertiary education in science orengineering, representing a sig-nificant pool of highly educatedworkers.

Nonetheless, there is a persistentmisperception that worker pro-ductivity in the region is low rela-tive to Western Europe. This issimply not the case. Our clientcompanies in CEE, as well asother companies that are doing

Country

CEE countriesin EU

Other CEEcountries

Asia

Other

PolandCzech RepublicHungarySlovakiaSloveniaLithuaniaLatviaEstonia

RussiaTurkeyRomaniaUkraineBulgariaBelarus

TOTAL CEE

ChinaIndiaTaiwanIndonesiaMalaysia

MexicoBrazil

209 85 83 33 27 18 10 8

4.1 4.2 3.9 4.5 3.0 4.7 4.7 4.6

5.4 8.3 8.3 6.0 14.1 4.9 4.2 6.0

434 238 57 49 20 18

4.6 4.5 4.7 5.9 4.2 4.7

3.1 3.4 2.6 1.0 2.5 1.8

1,410 592 286 208 103

8.0 7.1 4.7 4.5 5.0

1.1 0.6 12.5 0.9 4.3

626 495

2.6 3.6

6.0 2.8

GDP 2003 ($billions)

Real GDP CAGR (%)2004–2008

GDP per capita ($thousands)

473

1,289

4.1

4.5

6.4

4.0

816 4.7 2.7

E X H I B I T 6

CEE COUNTRIES REPRESENT $1.3 TRILLION IN GDP, WHICH IS EXPECTED TO GROW AT 4.5 PERCENT PER YEAR THROUGH 2008

SOURCES: Economist Intelligence Unit; World Bank; Euromonitor; BCG analysis.

business there, consistently con-firm that at the same level of cap-ital and technological invest-ment, workers in the region areat least as productive as theircounterparts in Western Europe.In fact, global manufacturerscommonly tell us that their plantsin the CEE region are among themost productive in their world-wide manufacturing networks. Inassessing productivity in anyRDE, it is important to distin-guish between the productivity ofthe labor force per se and theeffects of the labor/capital trade-offs companies make to furtherreap the benefits of low-cost labor.

Workers in CEE are also moreakin to those in most multina-tional companies in terms of lan-guage, education, training, andculture than are workers inChina. The percentage of thepopulation that speaks Englishcontinues to increase and isparticularly high among thelabor pool of people under age40. In the Czech Republic, forexample, almost 15 percent ofpeople aged 24 to 30 actively useEnglish or claim knowledge of English equal to their knowl-edge of their mother tongue.German and French are alsowidely spoken.

It should be noted that one areain which the CEE region has notyet caught up with the highlydeveloped economies is the capa-bilities of local middle- and sen-ior-level management. Many ofthese managers have had diffi-culty letting go of the antiquatedmanagement processes prevalentduring the Communist era andembracing a more business-ori-ented mindset. This orientationis already changing, and thechange process will accelerate asthe younger generation of work-ers moves into the ranks of man-agement.

A Favorable BusinessEnvironment

The major countries in the CEEregion, such as Poland and theCzech Republic, compare favor-ably with China and other AsianRDEs in terms of various kinds ofrisk, creating a relatively safeenvironment for investing. (SeeExhibit 8.) Political, legal, andregulatory risks are currently sig-nificantly lower in these coun-tries than in China, particularlyin those that are, or soon will be,members of the EU. So is intel-lectual property risk—an area inwhich China is known to harbor ahost of issues. The vulnerabilityof multinational companies tointellectual property risk is illus-trated by recent disputes overintellectual property betweenCisco Systems and HuaweiTechnologies; between Mag-nequench and major Westernretailers and electronics compa-nies; between global drug compa-nies and the Chinese govern-ment; and between Lucent andtwo of its employees—as well as

8 BCG FOCUS

Overallweighted rankCountry

Skilledlabor

Qualifiedengineers

Competent seniormanagers

Ranking of labor availability

India 1 2 1 2

Ireland 2 3 4 3

United States 3 1 7 1

Turkey 4 6 6 4

Hungary 5 7 3 5

Czech Republic 6 4 2 11

Slovakia 7 8 5 9

Taiwan 8 5 10 6

Poland 9 10 9 10

Russia 10 9 8 14

Italy 11 13 11 8

United Kingdom 12 12 13 7

Slovenia 13 11 12 13

China 14 14 15 15

Estonia 15 15 14 12

E X H I B I T 7

CEE RANKS HIGH ON SEVERAL DIMENSIONS OF LABOR AVAILABILITY

SOURCES: IMD; BCG analysis.

by the furor over WAPI standards.(For further discussion, see theBCG report Facing the ChinaChallenge: Using an IntellectualProperty Strategy to Capture GlobalAdvantage, September 2004.)

Of course, intellectual propertyrisk, like other elements of the business environment, variesgreatly among CEE countries.Russia, for all its resources andlarge end-market potential, iscomparable to China in terms of risk. In contrast, the new EUmember states represent a more

secure business environment,with regulations governing intel-lectual property rights beingharmonized with EU standards.

Also affecting the general busi-ness environment is basic infra-structure. While the quality ofthe transportation and telecom-munications infrastructurevaries across the region, CEE canoften offer much more conven-ient, faster, and cheaper commu-nication links with WesternEurope than can China. Turkey,for example, ranks twelfth in the

world in the total number ofkilometers of highways and hasexcellent expressway linkages tothe EU, as well as more than 100ports and eight international air-ports. The new EU memberstates will benefit not only fromshorter transit times within theEU but also from significantinvestments in highway networksand other transportation infra-structure.

And then there are other, lesstangible but very important fac-tors, such as the ease of manag-

9The Central and Eastern European Opportunity

Potentialrisks Poland SlovakiaHungary Russia UkraineGermany France

Established EU CEE countries in EU Other CEE countries Asia

Methodology India ChinaBulgaria Romania TurkeyCzech

Republic

Politicalstability

Legal andregulatorystability

Financialstability

Currency

Corruption

Intellectualpropertyrights(IPR)

Overallenvironment

EIU legal andregulatory risk(0–100; 100 = high)

Expected cumulative change in FX rate,3

2003–2008 (%)

Transparencyinternational index(0–10; 10 = low)

EIU IPRprotection index (0–5; 5 = high)

Fitch countrysovereign rating(D–AAA; AAA = high)Inflation, 2003 (%)

EIU politicalstability risk1

(0–100; 100 = high) 3520 2515 55 8010 NA2 654535 45 55

BBB+0.8

A–0.1

BBB+8.6

A–4.7

BB+13.6

B+5.2

AAA1.0

AAA2.2

BB+5.4

A–1.2

BBB–2.3

BB15.3

B+25.3

3825 3825 70 7313 NA2 60 7340 58 45

+6.7+13.2 +10.3+5.8 –12.9 –0.7+2.5 +2.5 +3.3 –3.64.5 –11.5 –38.8

3.63.9 3.74.8 2.7 2.37.7 6.9 2.8 3.43.9 2.8 3.1

44 34 2 25 3 23 3 3

Favorable AdverseImpact on business risk

5

E X H I B I T 8

SEVERAL CEE COUNTRIES RATE WELL AS SAFE BUSINESS ENVIRONMENTS

SOURCES: Organization for Economic Cooperation and Development (OECD); Economist Intelligence Unit; Amnesty International; Fitch Ratings; BCG analysis.

1EIU = Economist Intelligence Unit.

2NA = not available.

3FX = foreign exchange.

ing plants that are in the sametime zone as headquarters; thecost and the ease of travel backand forth between sites; and theefficacy of management acrosssimilar cultures. Such factors areharder to quantify than laborcosts and market growth rates,but they can have disproportion-ate impact on RDE operations,sometimes determining the dif-ference between success and fail-ure. One Western Europeanautomotive supplier talks aboutthe ability to visit plants (and cus-tomers) throughout the region ina single week: “There’s just nosubstitute for walking the produc-

tion lines, talking to the workers,randomly grabbing a few parts intheir various stages of productionand assembly. I’m in the region atleast once a month and oftenmore than that, because youlearn so much more in person,on the ground.”

* * *

Companies should take a portfo-lio approach to each sourcingdecision, analyzing a variety oflocations for each product lineand carefully weighing all thefactors that make up each loca-tion’s unique business opportu-nities and challenges. For most

global companies, China isimportant as a market, a low-costsourcing and manufacturingbase, and a source of talent, andtherefore should be taken intoaccount. However, companiesdesigning RDE sourcing strate-gies specifically to serve WesternEurope owe it to themselves togive Central and Eastern Europeserious consideration as well.For many, CEE’s significantadvantages—in terms of rela-tively affluent and growing mar-kets, excellent talent pools, andgenerally favorable, less riskybusiness environments—willdecisively outweigh China’s.

10 BCG FOCUS

11The Central and Eastern European Opportunity

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About the Author

Kevin Waddell is a vice president and director in the Warsawoffice of The Boston Consulting Group. You may contact him by e-mail at waddell.kevin@bcg.com.

Acknowledgments

The author wishes to acknowledge the valuable contributions of his colleagues Barry Adler, Thomas Bradtke, GrzegorzCimochowski, Elyse Friedman, , KathleenLancaster, Robert Maciejko, Harold L. Sirkin, MatthiasTomenendal, Dave Young, and .

For Further Contact

This report was sponsored by two of The Boston Consulting Group’sworldwide practices: Industrial Goods and Operations. BCG’sIndustrial Goods practice advises leading industrial companies onmany topics, including the strategic and operational implications ofglobalization. The firm’s Operations practice focuses on strengthen-ing companies’ operational abilities globally to enhance their per-formance, develop new strategies, and create competitive advan-tage. For inquiries about this report, about globalization, or aboutthe Industrial Goods or Operations practice, please contact theauthor or any of the following people:

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