Oil and tax spikes hit bottom lines

Commodity, oil and land prices

Perfect Pushup founder Alden Mills manufactures his Tiburon, Calif., company's fitness equipment in two Guangdong province factories. Since moving his manufacturing overseas in 2004, Mills has seen a 20% to 30% cost jump. Perfect Pushup specializes in ergonomically correct workout-equipment handles made of metal and rubber; the rise in oil and steel prices has taken a direct toll on the company's bottom line.

"We go through exhaustive design analysis and limit the need for costly materials, while also maintaining functionality," Mills says. "Everyone has to get creative to keep costs in line."

While steel and iron prices have surged more than 30% since 2007, oil and natural gas prices have nearly doubled, and are hurting small businesses that now pay more for both the raw manufacturing materials of their products and to transport the finished goods back to the U.S.

"We're being hit hard, seeing price rise every few months," says Richco's Hornbein. "To offset the price of the rubber and plastics we use, we have to make our manufacturing processes very lean and ship our inventory on an LCL [less-than-container load] basis to save on shipping and handling costs. Also, we have to investigate whether it's cheaper to import the materials on a duty-free basis instead of sourcing them locally."

Mills takes a different approach to curbing costs. "I've come to expect steel prices to change every 90 days," he says. "So I look to buy in bulk for six months out."

The price of land on China's east coast is also on the rise. Rents are increasing in Shanghai, Beijing, Guangzhou and Shenzhen.

"There's less land available now on the coast," says CLSA strategist Rothman. "Beijing has set up an infrastructure with roads and transportation inland to encourage heavy industry to develop there. Inland regions have cheaper land and power - but keep in mind that the labor force is moving against that trend, migrating to the east coast."

While rising costs for raw materials and land prices impact all business, the companies hit the hardest are those that conduct their transactions in U.S. dollars, thanks to the Chinese currency's rapid appreciation against the dollar.

Cutting tax rebates

Since 1985, tax rebates given to exporters have allowed Chinese products to be fiercely competitive on the international market. But over the past few years, and particularly in the past 12 months, Beijing has been axing rebates for thousands of goods across a wide variety of industries in an attempt to reduce China's trade surplus.

China levies a 17% value-added tax (VAT), a tax on the added value of goods and services that is incurred in any exchange. The country traditionally grated exporters a full rebate on the tax. But to curb its trade surplus, China has begun reducing the VAT refunds on most items from 17% to 5%. For some goods, especially those whose manufacture is highly polluting, the refund has been eliminated entirely. Batteries, for example, first had their refund slashed to 5%, and then, just weeks ago, were eliminated completely from the rebate list because they contain cadmium - a toxic chemical that harms the environment and workers' health.

Analysts expect China to continue using VAT adjustments as a tool for trade rebalancing - which means exporters in most industries shouldn't expect a return to the full-refund days any time soon.

"[China] is in image-building mode," says Ron Haddock, Shanghai-based vice president of consulting firm Booz Allen Hamilton. "These efforts promote high-quality goods."

Such moves are ultimately good for the global economy and for Chinese workers, but they're still painful for businesses accustomed to the old rules. "We feel the Chinese government's rebate slashes every time our goods leave the country," says Jason Carr. "It really impacts international distribution."

Now what?

The trends that are shaping China's evolution won't revert, but will progress slow after the Olympics are over? And for business owners seeking lower-cost locales, where is next? Will India and Vietnam become the new manufacturing epicenters? On Thursday, Fortune Small Business will check in with part 2 of China's changing business conditions.  

1 2