Some of China’s greatest successes have come in industries that require customer-focused innovation. As measured by share of global revenue, Chinese firms are growing rapidly across sectors such as household appliances, in which they now account for 39 percent of global revenue, Internet software (15 percent), and smartphones (10 percent).
In these sectors, most of the growth is driven by sales in local markets. Indeed, only in household appliances and consumer electronics do exports exceed 10 percent of sales. Largely based on the size of the Chinese consumer market, appliance makers such as Haier and Internet companies such as Baidu, Alibaba, and Tencent have become world leaders in their fields.
The success of Chinese companies in these industries illustrates some of the advantages that Chinese companies have in customer-focused innovation. Chief among these is the massive Chinese consumer market. China has become the world’s largest market for smartphones, personal computers, air conditioners, refrigerators, microwaves, and home laundry appliances.
Indeed, the Chinese market is so large that in many segments domestic leaders are, by definition, global market leaders. And niche markets in China, such as online gaming and beauty spas, are bigger than major industries such as autos in other economies.
The Chinese consumer market is not only large but also dynamic and fast-moving. Disposable income has risen by 10 percent per year in real terms over the past decade and, since 2000, more than 85 million households have joined the new mainstream consuming class (defined as households with disposable income of 106,000 to 229,000 RMB [$17,080 to $36,900]).
Some 106 million more households are expected to join the new mainstream consuming class by 2020. In this large and growing consumer market, innovations can be scaled up and commercialized rapidly. WeChat, a Chinese social media platform, garnered 100 million members in just 1.2 years—compared with 4.5 years for Facebook.
Chinese consumers also seem to be more willing than other consumers to participate in the innovation process by acting as perpetual beta testers. Consumer-facing companies routinely launch new models and continue to refine them based on market feedback. In 2014, for example, Xiaomi updated its smartphone operating system 52 times. Improving broadband and logistics networks also helps Internet content and retailing companies reach consumers efficiently.
Markets that rely on customer-focused innovation tend to have low barriers to entry, which is illustrated by the wave of Chinese entrepreneurs in Internet services, games, and e-commerce. In a 2013 job placement report, 12 percent of Peking University graduates said they had launched a company or were self-employed, compared to 4 percent in 2005. Venture investing has tripled, rising from $5.4 billion in 2010 to $16.9 billion in 2014.
Over the past three decades, Chinese companies have learned to adapt products from around the world to the needs of a rapidly urbanizing nation and have become very agile—moving goods into production quickly, then tweaking designs afterward to better address consumer needs. A new generation of entrepreneurs is solving consumer problems and developing new business models, often in uniquely Chinese ways. Makers of consumer goods are changing their approaches to address the rising expectations of China’s expanding middle class and moving beyond the “good enough” products of the past.
Here are three ways that Chinese companies are driving consumer-facing innovation:
1. Solving consumer problems.
One of the biggest challenges facing Chinese consumers is the country’s highly fragmented retail industry, which severely limits choice for consumers in all but the largest cities. Chinese entrepreneurs have built a world-leading e-commerce industry to address this problem. From its start in 1999, Alibaba has grown into the world’s largest online marketplace, based on the value of merchandise sold in its online stores ($394 billion in fiscal year 2014). Alibaba’s innovations include Alipay, a payments system, and Ali Finance, which provides financing for small-scale suppliers that are not served by the traditional banking system.
2. Rethinking business models.
Nowhere have Chinese entrepreneurs shown a greater flair for innovation than in Internet-based businesses. In many cases, they have done so by inventing business models. For example, in most parts of the world, online businesses generate 60 to 90 percent of their revenue from advertising.
However, in China, advertising is not as large a source of revenue—China’s advertising industry is only about one-quarter the size of the US industry—and Chinese companies have been forced to create new business models to monetize web traffic. Tencent generates 90 percent of its revenue from online games, sales of virtual items on social platforms, and e-commerce. Average revenue per user in 2014 was $16, $6 more than Facebook, according to 2014 annual reports.
YY.com, a video-based social communication platform, has built diverse revenue streams, including a virtual currency. In 2014, YY.com generated 57 percent of revenue from music and entertainment through sales of virtual goods such as virtual roses that viewers purchase to give to performers on the platform. Performers can redeem the virtual goods for cash and top performers can earn more than RMB 20,000 a month, seven times what the average factory worker earns.
3. From “good enough” to “cheaper and better.”
For years, customer-focused innovation in China meant creating “good enough” products, which cost about half of what multinationals charged and delivered about 80 percent of the quality. Good enough products still work for lower-income consumers, but in an increasingly affluent China, innovators must create “cheaper and better” products to win new mainstream customers.
Four-year-old Xiaomi, a Beijing-based smartphone maker, has become one of the world’s most successful startups with products such as the Mi4. Xiaomi phones typically cost half as much as top-of-the-line products from other global brands, yet offer comparable or better hardware features. Business model innovations such as online only sales and risk sharing with suppliers help Xiaomi offer its products at a low price. Xiaomi is now the largest smartphone player (by shipments) in China, with more than 12 percent market share in 2014, and is entering foreign markets.
I’m a Senior Partner in McKinsey’s Shanghai office and Director of the McKinsey Global Institute (MGI) in Asia. I also co-lead the Urban China Initiative (UCI), a thinktank devoted to transforming China’s urban future. Visit the UCI website here. Read my latest work as co-author of No Ordinary Disruption (PublicAffairs, May 2015), which examines how long-term shifts in the global economy challenge long-held assumptions.