Chinese high-tech and electronics companies are outgrowing the domestic market, improving their productivity, and forcefully defending the domestic consumer and corporate markets against foreign challengers. But our research also shows that most of these companies will have difficulty replicating these gains in other countries, where they must cater to very different customers; attract global talent; and confront higher development, sales and marketing, and labor costs.

In an ongoing project with Tsinghua University, in Beijing, we examined the productivity and financial performance of 43,000 state-owned, domestic private-sector, and foreign companies in China across ten technology sectors—aerospace, consumer electronics, enterprise computing, industrial electronics and automation, medical equipment, power equipment, semiconductors, services and software, telecom equipment, and transportation. Despite reports that Chinese manufacturing has lost some of its shine to rising labor costs, our analysis shows that its productivity in these technology sectors rose 11 percent a year from 2001 to 2006, outpacing labor cost increases of 10 percent a year. Productivity measured against unit labor costs remains competitively high compared with that of other low-cost countries, to say nothing of developed ones (Exhibit 1). As long as productivity grows more rapidly than labor costs, China should remain an attractive location for technology manufacturing.

Our research suggests that productivity gains, together with quality improvements and an emphasis on midrange product segments, will continue to propel the growth of Chinese technology companies, raising their share of the domestic market to around 75 percent by 2010, from 60 percent in 2002. A closer look at the numbers shows that in value-added per employee, private-sector Chinese technology companies are reaching and, at times, surpassing the productivity levels of their foreign-owned rivals in China (Exhibit 2). Among the largest private-sector Chinese companies—those with annual revenues of about 10 billion renminbi ($1.4 billion)—revenues per employee rose from 226,000 renminbi in 2001 to 417,000 renminbi in 2006, almost matching the 420,000 renminbi of their foreign counterparts. Productivity at state-owned Chinese companies also increased during this period but still trails significantly.

Some of the recent productivity improvements at Chinese technology companies result from increased scale. In 2006, 370 of them—three times as many as in 2001—had annual revenues of 1 billion renminbi or more. At the same time, our analysis shows that the largest companies, domestic and foreign, are easily the most productive. Productivity at companies with annual revenues of more than 10 billion renminbi, for example, is at least twice that of smaller companies. Those with annual revenues in excess of 1 billion renminbi also have an edge over small and midsize companies.

Scale has spurred productivity and helps Chinese companies to dominate the market in their homeland. However, to secure continued growth, companies must push into overseas markets, which require different skills and higher expenditures on marketing, research, and labor. Our research suggests that by the time a Chinese company’s sales exceed roughly 10 billion renminbi, exports become significantly more important—48 percent of sales, versus 21 percent for companies with sales from 1 billion to 10 billion renminbi—and costs increase drastically. For public- and private-sector companies combined, the largest companies get 39 percent of total sales from exports, compared with 20 percent for the next-largest companies.

Paradoxically, as Chinese technology companies grow in the domestic market, the ratio between R&D costs and revenue falls, since R&D expenses are spread across a rising revenue base. Once a company expands globally, the trend reverses abruptly: for example, as a percentage of revenues, the largest private-sector Chinese companies spend more than twice as much—3.6 percent—on R&D as do the next-largest ones (Exhibit 3). Globalizing Chinese companies also face cost increases for marketing (because they must build brand recognition and learn the ways of unfamiliar consumers) and for labor (as they begin hiring talent outside their own low-wage domestic market).

Weighed down by higher costs, Chinese technology companies with annual revenues of more than 10 billion renminbi average profit margins of 2.6 percent, compared with 4 percent at those with revenues from 1 billion to 10 billion renminbi. Margins are likely to be hardest hit during the initial phase of globalization, when companies make large investments to raise their game. But when Chinese companies start learning to serve global markets, margins improve as costs stabilize and as the volume of for-eign sales increases.

While technology businesses are in the vanguard of China’s foray into global markets, a company wishing to follow pioneers such as the computer maker Lenovo and the telecom giant Huawei must judge whether its operations and management capabilities are strong enough to absorb the shock of higher costs. A strong domestic position, capable talent management, and a detailed understanding of target markets are elements of a thoughtful globalization strategy. Our study also shows that companies must have the strength and patience to endure a short-term decline in margins.