From Imitation to Innovation

From Imitation to Innovation: Zongshen Industrial Group

Zuo Zongshen only had to step outside his office and go down one flight of stairs to reach a
balcony that overlooked the final assembly line for Zongshen Motorcycles. Starting with
neighboring countries in Southeast Asia like Vietnam and Indonesia, sales have increasingly
gone to European and American countries. Today its products are sold in 88 countries and
regions.

In the past 18 years, Zongshen had grown from a small assembler of motorcycle engines into
one of the top global manufacturers of motorcycles and small gasoline engines. Zongshen’s
revenue and profit growth for the last decade are shown in Exhibit 1. It had the distinction of
being China’s most profitable motorcycle manufacturer. the factory was at the bottom of a
mountain, and spreading uphill was the rest of the Zongshen Industrial Zone, a three-tiered
industrial park with sprawling factories that produced engines, frames, castings, plastic parts
and all of the necessary components to produce motorcycles, portable generators and
outdoor power equipment like lawn mowers and tillers. There was also a large canteen that
provided all employees with subsidized meals, employee housing, a recreation area, and a
model product showroom.

Zuo often walked the line, talking to employees and supervisors, and he liked being close to
where the final product was assembled. But today, between meetings with two of his
managers who were off to Brazil to work with an affiliate there, he was more reflective.
While the founding of Zongshen had been a consequence of a change in government
regulations which had created enormous opportunities for him and his company, the
Chinese government also was prone to change regulations at will to serve policy objectives.
Cities across China increasingly taxed or restricted the use of motorcycles in central urban
areas, relegating their use to the countryside or suburbs, or heavily restricting usage to main
arteries only during certain hours.

The increasing restrictions, along with a simultaneous change in tax laws and emission
requirements in 2005, put Zongshen’s sales into a free fall. Only in the last few years had the
company completely regained market and moved forward into a leadership position. But the
ban also spawned a new industry, electric motorbikes. it was estimated that well over 1000
firms, the largest of which had less than 5% market share1, many of them former gasoline
motorcycle assemblers, had moved into the market. Almost 20 million electric motorbikes,
scooters, and variants were produced in China each year. While many of these firms were
likely to be consolidated over time, the ‘e-bikes’ represented a threat to Zongshen’s core
business. Zongshen had launched its own e-bike unit, with a factory in a separate industrial
park about a half hour drive away. But Zuo was not satisfied with the e-bikes’ performance
or the durability of the battery system. More importantly, he was worried about where to
1
http://www.zongshenpem.com/company/growth-strategy.html accessed March 24, 2010

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source the technology for new innovations in this emerging business, as it was far from the
company’s core experience base.

Another urgent question for Zuo was talent. He felt his organization was resistant to change,
and he knew that it needed new and different skills to successfully tackle the e-bike market,
as well as to globalize the existing parts of the company and turn it into a world leader. He
found more often than not that he personally was the driver of change in the company.
While he enjoyed a strong hands-on approach, he worried about the impact this had on the
development of his management team. This was not an uncommon phenomenon among
Chinese companies with strong founders of his generation, many of whom were approaching
retirement. Would Zuo find the people he needed on the manufacturing floor before him, or
in the labs and the factories sprawling around him? How could he build Zongshen into a
company that would thrive as the world changed around it?

Founding of Zongshen: Imitation Phase

Chongqing, China is in central southwestern China. It is a very hilly city, so a visitor does not
see any bicycles, only motor scooters, motorcycles and many cars and larger motorized
vehicles. The area has a heritage in heavy manufacturing, as it was one of the centers of the
Chinese defense industry, especially vehicles. In the 1980s, when the Cold War slowed and
the central government wanted to in turn slow down spending on defense, it asked some of
the state-owned enterprises (SOEs) to begin the manufacture of civilian products. Many of
those firms moved into the production of motorcycles, producing copies of Japanese
models. They also imported technology and equipment from Japan.

The situation was quite unique. The coastal provinces of Guangdong and Zhejiang did not
have any defense industries, so only Chongqing had the large number of SOEs oriented
around vehicles to support a cluster, and as a consequence the center of the Chinese
motorcycle industry developed there.

The initial phase of duplicative imitation characterized by counterfeits and knock-offs was a
common strategy in the early industrialization of developing economies. It doesn’t require
specialized investments in R&D early on when firms cannot afford them, so it is a good way
to get started. In this regard, experience in the Chongqing cluster mirrored Japan, Korea and
Taiwan decades earlier.

The transformation of the Chinese economy began with Deng Xiaoping’s opening policy that
started in 1979. Prior to then there were no private enterprises as it was not possible for
anyone other than an SOE to obtain a business license. This changed completely in 1979, and
Zuo took the initiative to open a motorcycle repair business in 1982. The government
permitted people to go into business for themselves, but they could not set up companies.

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By 1992, the regulations changed again in several important ways. Individuals were
permitted to set up private companies, and the exclusive right of SOEs to produce
motorcycles was terminated. Zuo quickly set up a company to assemble motorcycle engines
from purchased parts. It was capitalized at CNY (Yuan) 500.000 –half was his own family
investment, and half was borrowed. Initially he only did assembly and produced a few simple
parts, as he did not have the capital to do much more.

Numerous SOEs in the 1980s had begun manufacturing individual parts of motorcycle
engines. The parts were copies of those taken from disassembled Japanese engines. The
government had organized the SOE parts manufacturers as specialists that would typically
each produce just a single part. One SOE might produce crankcases; another would produce
cylinder heads, and so on. The heritage of central planning drove a rationale that
specialization would facilitate efficient high volume production. There were hundreds of
these suppliers and assemblers had to figure out how to select the right ones. Each part
complied with one of several ‘standards’ that represented parts from different brands.
‘Honda parts’ were different from ‘Yamaha parts’ or ‘Suzuki parts’. Hundreds of assemblers
also cropped up, as the demand at the time for small gasoline engines in the relatively
underdeveloped economy was voracious. Assemblers that were best able to capture market
opportunities were those who were the quickest. Zuo observed:

I repaired motorcycles for 10 years, so I knew the quality of parts and which factories made
these good parts and what were the good brands. I accumulated lots of experience. So it is
not like I was starting from scratch. Instead, I had 10 years of experience and knew how to
select the best parts and where I could get them.

After three years assembling engines, Zuo became increasingly dissatisfied with the
approach. It was often difficult for him to get parts, because SOE motorcycle manufacturers
didn’t always allow the parts suppliers to supply private companies. Because the SOE
manufacturers had larger scale, the suppliers had to be responsive to them. This made Zuo
dependent on his network, using ‘guanxi’2 or ‘red envelopes’3 as a way to get parts. He also
came to realize that these assembled engines fell short on many aspects of quality and
performance. Manufacturing tolerances were highly variable, and engine performance and
reliability suffered as a consequence. His years of experience repairing engines gave him a
good perspective on what was important. He started focusing on core components like the
crankcase and cylinder heads, gradually pulling in the production of more components as his
capabilities improved. Zuo saw three key drivers for the integration of parts manufacturing:

At that time there were many privately owned motorcycle manufacturers in Chongqing, and
there was no differentiation among them. Everyone was using the same standards, the same

2
‚Guanxi‘ is a Chinese term that refers to a personal network of influence
3
A ‚hong bao‘, literally translated as ‚red envelope‘, is used at family gatherings or social occasions to present
cash as a gift.

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suppliers, so the products looked the same, and all they would compete on was price. So I
wanted to solve the problem of differentiation. Secondly, I wanted to guarantee the supply.
When the market was good and demand was high, there was no guarantee for the supply of
parts, so I wanted to get a stable supply of key components. And thirdly, I wanted to improve
the products, because the Japanese products were not perfect! It was still possible to
upgrade them, and it was also good to start innovation.

The Chongqing cluster also provided a unique way to finance work-in-progress (WIP)
inventory. In the early stages, small firms did not have much capital. They would purchase
parts from suppliers, but not pay for them until they had assembled the parts into
motorcycles and sold them. This early implementation of negative working capital persists
today, and has greatly facilitated the expansion of the industry.

Zongshen’s relatively early adoption of computer aided design (CAD) tools like AutoCAD and
computer aided manufacturing (CAM) tools at around the same time greatly facilitated the
process of bringing production in house. Once designs were entered as a digital model,
refinements were much easier to introduce, and parts could be quickly produced using
computer numerical control (CNC) tools. In the 1990s, some of the more advanced software
tools only ran on advanced engineering workstations, but the rapidly increasing power of
personal computers that ran Microsoft Windows brought these tools within reach by the
end of the decade. This was particularly helpful as the level of engineering integration rose,
and as the company’s engineering staff capabilities grew to encompass things like structural
analysis and functional verification.

When Zongshen sourced parts, it sought multiple suppliers for each to ensure competitive
pricing. As it brought more and more production in house, it used new avenues to improve
its own capabilities. It made extensive use of manufacturing consultants from Japan,
especially former (retired) Honda employees. This was particularly helpful in upgrading its
manufacturing system, and in its implementation of a lean production system. It was also
able to harness software providers to train in the use of more advanced tools like
Pro/Engineer. Finally, visits to competitors and prospective partners like Harley-Davidson in
the United States provided a constant stream of new ideas, as well as continually challenging
the company’s thinking. Zuo’s years of background in motorcycle repair also gave him a
rather unique perspective on engine design. This was ‘reverse engineering’ at its best.

Forming the Zongshen Industrial Group

I came to Zongshen in 1997. By then, the company just had two subsidiaries, one that made
engines, and one that assembled the whole motorcycle…At that time, the Chinese
government regulated the motorcycle industry, so only state-owned enterprises could make
motorcycles and have their own brand. So Zongshen could only rent the brand from
others…In 1998, the government instituted a special policy to support the development of the

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Three Gorges Area which included Chongqing. Private enterprises in the region were allowed
to have their own brand. That is when we started the Zongshen brand.
Li Yao, VP Zongshen Industrial Group

In 2000, Zongshen started to think about how to set up a company group structure. There
were only two subsidiaries working in parallel at the time, and Li Yao was in charge of
administration and planning on the motorcycle assembly line. Zuo asked him to start
working on setting up the group structure up. It was at this point that they decided which
responsibilities belonged to headquarters, and which should be carried out by the
subsidiaries. Headquarters would cover strategy, project research, new investment projects,
product development, marketing and finance. They also concluded that as the company
grew, they needed to tap into capital markets.

Becoming a world class competitor would require a lot of capital, and if Zongshen could float
its stock, it would have a source of equity capital that could prove critical. Being a publicly
listed company also accorded a strong message of prestige and credibility, and would make
available a currency for the acquisition of foreign technologies and companies. The
traditional route was through an initial public offering (IPO), but for Zuo that was a lengthy
and fairly complicated process that had no guarantee of success, and in 2002 there were few
Chinese companies that were executing this strategy successfully.

Public listings were also not without their shortcomings. Investor interests were often more
short-term than those of management, and might be focused on earnings or equity
valuation. Zuo resolved to keep the group parent company private, and start out by listing a
subsidiary.

A relatively new technique that Zuo found appealing was known as ‘reverse merger’ or
‘backdoor merger’. In this scheme, Zongshen would acquire a shell company that had an
existing listing, but had minimal assets or liabilities, often being a failed company. Li Yao
explained:

In 2003 we found a Chengdu company called Lian Yi that was failing and about to be
delisted. We divested the assets of the original company, and inserted our own assets from
the engine company. Today the company has a market value of CNY 10 billion…The Chendu
Company used to be a steel producer, today it has turned into the Chongqing Zongshen
Power Machinery Co. Ltd. and it is the largest engine producer in the Chinese motorcycle
industry.

Reverse mergers were attractive in these circumstances because they could be

accomplished with lower costs and more certainty, and they were not dependent on
investor interest. In Li’s view the listing accomplished several things:

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Mr. Zuo thought that the development of privately owned enterprises went through different
stages. When they get to certain stages of fast development, they encounter bottlenecks. So
when the company gets listed, it will be forced to have good decision making and
management mechanisms. Secondly, there are many private enterprises in China, millions of
them. But up until the end of 2009, there were only a little over 1600 listed companies
(including state-owned and foreign invested companies). So people think if the company is
listed, it’s a good company. And thirdly, it is for raising capital.

The Zongshen Industrial Group added its third business, another listed company in Canada.
Zuo had been thinking about going into green energy business, and he had the occasion to
meet with Swiss scientists in Vancouver, Canada. These scientists had established a
company, PEM Technologies, to make proton exchange membranes (PEM), a key element in
the manufacture of hydrogen fuel cells. Canada was a hub for hydrogen energy and fuel cell
companies, with significant clusters in Ontario province and the Vancouver area. Again,
Zongshen did a complicated financial transaction, buying PEM through Norstar Ventures, a
“capital asset pool” company with a Toronto Stock Exchange listing. It then “amalgamated”
with this entity to form Zongshen PEM Power Systems (ZPP), which then established a
wholly owned Chinese subsidiary. But with fuel cells commercialization far off in the
distance, it ultimately suspended the fuel cell business (in March 2009)4. In 2006 it set up
another subsidiary, Jiangsu Zongshen PEM Electric Vehicle Co. Ltd in Wuxi, Jiangsu Province.
Together the two subsidiaries had an annual capacity of 350,000 units of e-bikes. Positioned
as premium e-bike manufacturer, its sales volume quickly went up from 50,000 units in 2007
to over 220,000 units in 2008. However, 2009 witnessed a sharp decline in sales due to
falling demand in international markets and fierce price competition in China. For the first
nine months of 2009, they recorded revenue of Cdn$ 18.9 million and a net loss of Cdn$
1,246,893 on sales of 52,244 units. Despite the 2009 performance, the company remained
confident. When ZPP announced its intention to acquire the two-wheeled gas motorcycle
business from Zongshen Industrial Group on Oct. 23, 2009, Zuo commented:

We believe that the China market for gas and electricity motorcycles is a tremendous growth
opportunity. In the next few years, we expect the trend to be towards higher quality and
better performance as Chinese consumers’ needs and expectations evolve and (they) demand
superior products with a willingness to pay a premium. In addition, we expect the Chinese
government to pass and enforce stricter safety and emission regulations, which should
eliminate a large number of manufacturers who will be unable to comply with these
respective regulations. These market conditions will require motorcycle companies to invest
in new technology and manufacturing facilities. We believe this will lead to a consolidation in
the industry, in which only the larger players will survive and prosper. The consolidation of
the gas and electric motorcycle businesses of ZPP and ZIG is a first step in scaling up and
realizing operational synergies.

4
The company came to the view that so much work was still ahead on this commercialization that it did not
have sufficient resources to do it without significant government assistance.

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ZPP raised CNY 300 million in capital to commercialize two- and three-wheel electric vehicles
in 2007. The investment strategy shifted from a related diversification in thermal power
systems (i.e. internal combustion) to being driven by a product development strategy
centered on green energy and electric power. They were looking for advanced technology
globally. Li Yao elaborated:

When we get information about potential partners, we pay them a visit to see if the target
company fits the development strategy of Zongshen. Mainly we focus on whether the target
has complementary strengths. You know, Chinese companies don’t have advanced
technology, so we would want our partners to have that. If the target looks like a possible
cooperation partner, we will talk about the structure of the cooperation (or JV)…then we hire
professional firms like law and financial firms to do due diligence. Once we pass that stage,
we negotiate an agreement and send out the management team to share the Zongshen
culture…This is the same approach taken in America.

Zongshen employed a network of technical advisors to advise them on acquisition of

technologies. For example, if they were looking at lithium batteries, they would hire a
consultant from the International Lithium Battery Association. They also felt electrical
control systems was an important area that they needed to develop capabilities in.

Working with Partners

Honda entered China in the 1980s and soon captured one-fifth of the motorcycle market. But
cheaper Chinese imitations appeared and Honda’s market share quickly halved. The company
found that staying in China required that it enter into partnerships with some of the very
companies copying its bikes. Now, with over 100 motorcycle makers in China, the country is
the largest such manufacturer in the world, producing 25 million motorcycles a year (half of
all new vehicles sold worldwide). Still the copying persists. The Japanese government
estimates that of the 11 million motorcycles made in China in 2002, 9 million were imitations
of Japanese products.
Ted Fishman5

China represented a huge market opportunity for Japanese motorcycle makers. Motorcycles
were a key way for people to transport goods and get around in the vast country. Two of
Zongshen’s Chongqing competitors, Jialing and Jianshe had technical collaborations with
Japanese manufacturers. Jialing began working with Honda in 1981 when they signed a
technical collaboration agreement. Honda provided technology and engineering know-how
for specific Honda models. Yamaha produced bikes in China in a partnership with Jianshe
Industries. Grand River, based in Jiangmen, Guangdong Province, had collaboration with

5
Ted Fishman, “Manufaketure“, The New York Times, January 9, 2005

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Suzuki, establishing a joint R&D center. In each case, the Japanese companies supplied
lower-end technology that they were comfortable with releasing into the China market.
Over time all three Japanese firms developed large production networks with these
partners. But the rampant copying of Japanese designs posed a particular challenge.
Yamaha’s chief representative in Beijing pointed out that five out of six bikes with the
Yamaha brand in China were actually fakes at the beginning of the decade. As the blatant
copying started to decrease, the competition from local makers became equally brutal.
Moriyuki Matsushima, an analyst at Nikko Citi Securities in Tokio, argued6, “The number one
problem for Japanese motorcycle makers in China is that there are too many local makers
who churn out cheap bikes, setting quality aside, and they sell well.”

Piaggio of Italy also entered the China market relatively early (in 1993) through a moped
joint-venture in Foshan, Guangdong Province. Piaggio Lyman Foshan Motorcycle Co. Ltd. was
a 75/25 partnership with China’s Foshan Motorcycle Factory, a Guangdong Province SOE.
When the Italian company first came to China, it was successful in mopeds, and its pricing
was a little high. While initial sales in coastal urban areas like Shanghai were promising, the
driving restrictions that forced makers to focus on rural markets were devastating. Coupled
with a failure to adapt product to local needs, the JV ultimately lost about US$ 60 million. In
2001, recognizing that it needed a better understanding of rural markets, it began looking
for a new local partner. Zongshen started to negotiate with Piaggio then and finally reached
an agreement in 2004, receiving a 45% equity ownership for a nominal fee of US$ 160 from
the existing JV. In the restructured JV, Piaggio held 45% and the Foshan city government held
the remaining 10%. The company initially targeted producing 100,000 scooters a year.

As part of the new joint-venture agreement, Piaggio also agreed to outsource a significant
amount of parts manufacturing to Zongshen. The companies set up engine manufacturing in
the Zongshen Industrial Park in Chongqing with an annual output of 500,000 engines. By
2005, Piaggio was purchasing 35% of its accessories and components in China, with sourcing
expected to pass 50% by yearend 2006.

Zongshen took charge of the JV’s production management and sales in the China domestic
market while Piaggio was responsible for technology, the international export market, and
the introduction of popular motorcycle styles and technology. The JV’s main production and
inspection instruments were imported from Italy and its production management and
quality control systems followed Piaggio’s globally applied European standards. A team of
engineers from Piaggio worked in the JV and they were responsible for core motorcycle
technology transfer and quality supervision. Zongshen could select any Piaggio motorcycles
and related technology for introduction into China based on its assessment of local market
needs. The JV manufactured Piaggio branded products only. It had an annual capacity of
300,000 units in 2009 with half exported to overseas markets.

6
Briam Bremmer with Hiroko Tashiro, ”Japanese Motorcycle Makers Hit the Wall in China”, Business Week
Online, July 18, 2006

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Mr. Zuo appointed Zhou Jianchuan to lead the joint venture. As a staff member in the sales
department, he wrote the first export order for Zongshen motorcycle engines in 1998. He
was then assigned as assistant to chairman Zuo responsible for international affairs, and set
out to look for other global partners, initiating talks with U.S. engine manufacturer Briggs
and Stratton. While those talks ultimately didn’t pan out, Zhou also held discussions with
Harley Davidson and Kohler, before finally concluding an agreement to supply MTD, a
Cleveland, Ohio supplier of outdoor power equipment like lawn mowers and snow blowers
to retailers like Home Depot and Wal-Mart in the U.S.

The Pressure to Differentiate: Moving to Innovation

From 1999 to 2005 consumers bought motorcycles for the first time, so they cared more
about price than added value. When consumers cared more about price, the cheaper
motorcycles that had lower quality had an advantage and quickly rose in the market. But
when these consumers wanted to buy their second motorcycle, they knew that motorcycles
made in Chongqing were of poor quality, though cheap, and troublesome to ride, therefore,
they didn’t want to buy them again. The year 2005 was also a turning point for domestic
brands and JV brands, that is, the sales volume of domestic brands, the low-price, low-quality
ones all dropped while the sales volume of JV brands, the high-price, high-quality ones, all
rose. Why was that? Because consumers were fooled once, from the bottom of their hearts
they were willing to buy better motorcycles that were of higher price and higher quality.

- Chen Bo, Deputy General Manager for Domestic Sales & Director of Corporate Planning

In 2005 the Chinese motorcycle industry still had too many manufacturers, with too much
combined manufacturing capacity chasing after the same customers with relatively
undifferentiated products. Profits could be as low as CNY 50 – 100 per unit on selling prices
of CNY 4000 – 8000. Much of this problem had been masked by the rapid growth of the
market, but stiffening regulations caused a real crisis at Zongshen.

In his search for ideas, Zuo had studied Kim and Mauborgne’s book, Blue Ocean Strategy,
which argues that firms should go after uncontested “blue ocean” markets and chase after
new demand rather than trying to chase existing demand in hypercompetitive “red ocean”
markets.7 As 2005 unfolded, Zuo took charge of sales himself. He knew that all the
motorcycle models in the market were imitations of Japanese models like Honda or Suzuki.
He resolved that Zongshen would not launch any more imitations of Japanese brands.
Instead, he launched the “Cyclone” project to develop products using proprietary
technology, seeking to increase sales with differentiated products. Zuo explained:

_________________________
7
W. Chan Kim and Renée Mauborgne, Blue Ocean Strategy (Boston: Harvard Business School Publishing, 2005).

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We started Cyclone in 2005. By that time we had been manufacturing motorcycles for over
10 years and there was no differentiation (in the market). Models of Japanese motorcycles
like Honda or Suzuki dominated the market. It was a sad reality for the Chinese motorcycle
industry. Was there nobody in the industry that could innovate?

The Cyclone program aimed at developing innovative new products of which we owned the
intellectual property rights and intangible assets. The Cyclone program came from market
segmentation. Japanese manufacturers didn’t study the Chinese market, they simply
transferred the production of products they sold in Japan in the 1970s to China, and so they
didn’t develop a lot of products for the China market. We thought this was our opportunity.

Zuo ordered the original production facility in Erlang to be converted into an R&D center,
and he contracted with Nova Design, a Taiwan-based industrial design firm to assist with
new product designs. The new focus on design meant better ergonomics, more stylish metal
work with better paint and metal finishing, more rigorous testing and generally greater
attention to details. Zongshen’s present day product development process is shown in
Exhibit 2. After spending CNY 300 million on R&D and new test equipment, the company
managed to launch its first Cyclone products in 2007 and 2008. Key models did not sell very
well though, and many in the company thought this was mainly because of the global
financial crisis. Bo recalled:

Everyone was saying the financial crisis was coming and rural consumers started to hold off
on their purchases though they had the money. People all became conservative with their
spending, so the sales of the whole motorcycle industry started to drop.

More troublesome, the company had concentrated so much of its resources on the Cyclone
project that investment in traditional products had suffered. This only aggravated the
weakened competitiveness of those bread-and-butter products. Bo explained:

We called homogeneous products, the me-too products “Red Ocean” products. These
products faced fierce competition in the market. We called our Cyclone products “Blue
Ocean” products, but these products were not successful. There was a gap between “Red
Ocean” and “Blue Ocean” products. I will use an analogy to describe this: if you have a son
who merely passes the exam with a score of 60 every time and all of a sudden he gets a high
score of 90, your immediate reaction is to doubt whether he got the high score due to his
own efforts. You would think your son must have cheated and copied someone else’s answer.
You will only praise him after making sure that he didn’t copy others. Teachers and
classmates would react in the same way.

It is the same with Zongshen products. Zongshen used to make me-too products only. But all
of a sudden you launch such good products. Consumers and retailers will all doubt that
Zongshen could make such good products. So when retailers have doubts, they are unwilling

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to sell your products. When consumers have doubts, they won’t buy your products. So finally
“Blue Ocean” products failed because there was such a price gap when you went from selling
“Red Ocean” products at CNY 5000 to selling “Blue Ocean” products at CNY 7000. Besides,
the Cyclone product line was too narrow. So we said we would launch “Purple Ocean”
products to fill the price gap between “Red Ocean” and “Blue Ocean” products because you
get the purple color when you mix red and blue together. So in reality how did this work? We
upgraded the quality of “Red Ocean” products and lowered the quality of Cyclone products to
get “Purple Ocean” products that were more likely to be accepted by consumers. We
increased the price of our “Red Ocean” products and made them “Purple Ocean” products
and said we would lower the price of Cyclone products, but in fact we didn’t.

The “Purple Ocean” products coincided with a sharp rebound in profitability, though that
might also be attributable to a sharp improvement in market conditions and other changes
instituted by Zuo.

One key change was implementing a new performance evaluation and incentive scheme that
linked all employees’ base salary to the breakeven point of the company, and performance
incentive pay to the net profit of the company. Performance pay was distributed to ordinary
employees, middle-level executives and senior executives on a monthly, semiannual and
annual basis respectively. The company also provided key senior executives with stock
options that were linked to key business indicators for the next five years. The new scheme
proved effective for the Chongqing Zongshen Vehicle Industrial Manufacture Co., Ltd. in
2009 and was adopted by all the subsidiaries of the Zongshen Industrial Group in 2010.

Mastering the “E-Bike” Market

It should have similar performance indicators as the gasoline ones. But there is still gap in the
battery and control technology. We are integrating global technical resources to fix these
problems. The company in San Francisco is one of the key resources I want to integrate. And I
am also interested in a battery manufacturer in Boston. I am also interested in some
technology in Texas and Canada. The e-bike should be economical and also have a long
range. If you run out of battery after riding it for a short while, where can you go to recharge
the battery? And also the speed of the e-bike. At least these should match the standards of
gasoline driven motorcycles.
- Zuo Zongshen

The enormous demand for economical transportation coupled with the increasing limits
place on gasoline-powered motorbikes in urban areas of China led to explosive growth
among electric bike manufacturers. By 2006 one source estimated that there were over
1000 manufacturers of electric bikes and scooters, producing over 20 million units in that
year. Sinocast Transportation Watch reported:

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China reportedly has some 500 million bikes. If only 10% of them are replaced by electric
cycles, it will give birth to a huge market worthy of CNY 100 billion, calculated on the
mainstream price of CNY 2,000 per unit… (the) China market is currently flooded with 1,000-
plus manufacturers of electric bikes and the access threshold is relatively low, leading to a
disordered market (which is) short of uniform standards, poor after-sales services and
varying product quality… It means a good opportunity for big-ticket payers like Zongshen,
Lifan and Jialing to make inroads into the fledging market.

Unlike the gasoline powered motorcycle industry centered in Chongqing, many of the larger
players in e-bikes grew up in the Jiangsu-Zhejiang province coastal region, or around the
eastern city of Tianjin. Jiangsu Xinri was one of the pioneers, along with Tianjin Fujita Group.

Most e-bikes used traditional lead acid batteries. While inexpensive and a very mature
technology, lead acid batteries were heavy, and had a limited lifetime of deep discharge
cycles, leading to serious disposal problems. Zongshen PEM took a somewhat different
approach, using either lead-acid or lithium ion (Li-ion) batteries. The latter gave the e-bike a
longer range and stronger climbing capability. While some skills learned from gasoline-
powered motor bike production were directly transferrable, there was much that was new.
Base level skills were not too hard to develop, as evidenced by the 1000 plus entrants into
the market. But Zongshen was determined not to compete in the high-volume, low-end
market, so the big question was differentiation. In fact, the e-bike market might be even
more challenging in this regard as it didn’t have the entry barriers that traditional
manufacturers Zongshen, Loncin or Lifan had established, mostly having to do with
manufacturing scale of small gasoline engines.

Zuo recognized that key differentiators for e-bikes would fall into several categories: the
energy storage system, whether it was battery, fuel cell, or something else, power control
systems, and integrated design. The big question was: did his organization have the requisite
skills?

Zuo’s Challenge

It is still the case that greatest challenge is talent. China lacks the professional talent that has
the expertise, the people who have the deep understanding of technology and products.
While China is the world’s factory, engineers who really understand manufacturing – there
are really very few of them. People here are all just imitators. It’s very hard to get talent… I’m
trying to get people from Japan or other countries, but I realize that it’s very difficult to
develop my own team, and also to attract talent to work here. Are people willing to come,
and for those who are willing to come, do they even have the capability, even if Zongshen can
pay a high salary?
- Zuo Zongshen

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From Imitation to Innovation

When Zuo first set up the company, Zongshen tapped into the local cluster, especially the
SOEs, for experienced technical talent in developing and manufacturing gasoline
motorcycles. This was a common practice among private motorcycle manufacturers in
Chongqing. The two leaders of Zongshen’s R&D Department were both from SOEs. Faster
professional growth and more competitive compensation were the main attractions for
these individuals. Compared with other functions within Zongshen and the R&D staff of
other companies in the industry, Zongshen’s R&D staff had relatively higher compensation.
The company also equipped them with the best R&D facilities and equipment it could buy.

Zuo got personally involved in critical stages of important R&D projects, checking the
components and test driving new products. If R&D staff made a special request, such as
asking for a raise or naming a design studio in their name, Zuo would quickly satisfy their
requests, as long as their performance was on track.

As Zongshen grew, it increasingly hired new graduates from universities. It also continued to
hired experienced professionals in R&D, manufacturing, finance and marketing from other
companies, mainly in the machinery manufacturing industry and also from government
organizations. It also hired some retired Japanese experts to learn their work methods and
application of tools to help improve product quality and upgrade its technology. However, it
was hard to find talent with a “big picture” view and comprehensive set of skills to lead
projects, and there was also a serious lack of global talent to support Zongshen’s overseas
expansion. Since talent in some technical areas was hard to find, Zongshen jointly developed
a new Masters in Combustion Engines and Mechanical Engineering with Tianjin University,
and sent six members of its R&D staff to learn manufacturing engineering in Italy. Learning
from joint venture partners and benchmarking visits to other companies were also vehicles
for staff development.

In an emerging market like China where there was an abundant supply of semi-skilled labor
but a very limited higher-end talent supply, attracting the right people was hard, but
retaining them could be harder. It needed to attract and retain more talent. Zuo recognized
early the importance of accumulated experience for a manufacturing business and he made
great efforts to create a favorable environment to motivate and retain key personnel. One
tool was a “Master-Apprentice Agreement” with about 40 key personnel in technical and
managerial positions. Zuo emphasized values and professional expertise when selecting
these apprentices. As long as they didn’t make serious mistakes, the company would
guarantee their employment until retirement and give them preferential consideration in
development and promotion. Zuo would personally mentor them and provide guidance for
issues they had in their work and personal lives. During the Spring Festival every year, Zuo
would also present them with a hong bao, books and other gifts. If they broke the
agreement they would need to pay a penalty of CNY 50,000. However, the penalties were
not the “ties that bind,” those were really personal ties between Zuo and his apprentices. In
traditional Chinese culture “a teacher for a day is a father for a lifetime.” For these 40 key

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From Imitation to Innovation

people in technical and managerial positions, the HR Department also made a career
development plan for them.

Rapid growth of the company meant constant demand for more managerial staff, so in many
cases experienced technical staff would be promoted to managerial positions which would
take those people off the technical track. In China managerial positions were generally
better paid and viewed as having a higher status, as Mr. Zhou Shuxiang, Vice General
Manager of Zongshen’s R&D Function, pointed out:

The “system” is one important reason why China lags behind developed countries like Japan
and Germany in technology in industries like automobile and motorcycle. And this system is
influenced by people’s values. For example, in Japan, an engineer can make as much money
as the General Manager, so some people can set their life goal to be a senior technical
engineer. But in China this seldom happens, because if a Chinese person wants high income,
he should take management positions. Therefore, technical staff will try to move into
management roles after they accumulate some experience in their specialized fields; they will
gradually give up technology studies and turn to developing new talent who will also try to
move into management positions after they gain experience. This cycle makes it hard to
accumulate technology capabilities. The Chinese people value hierarchy and thinks they can
only embody a higher personal value by taking management positions. If you are an ordinary
engineer, no matter how many years you work, your salary will never be as high as that of
the General Manager. This is prevalent in all companies in China, not just in the private
companies. So you can only maximize your value when you become a manager. This is the
mindset of many Chinese.

As Zongshen grew, the competency threshold levels went up as well. This motivated the
development of systems to manage the attraction and selection of talent, training and
development, performance evaluation and incentive and succession planning.

While talent had always been a challenge for Zongshen, the issue had never been so critical
as today, when the company wanted to transform from gasoline driven motorcycles to e-
bikes. The company could hire talent from other companies in the industry for gasoline
driven motorcycles. But to achieve differentiation and be a premium e-bike manufacturer,
Zongshen need to acquire or develop capabilities in energy storage systems, power control
systems, and integrated design. And China didn’t have the talent as Zuo realized:

I was recently in San Francisco, and I ran into a team of young people who were studying
electrical power trains, and they all wanted to protect the environment, and they all loved
motorcycles. Some of them were even professional motorcycle racers. And many of them had
Ph.D.s in electrical engineering, chemistry. They were graduates of Yale, M.I.T. and Stanford.
They were also very young, just a little over 30 years old, and they were entrepreneurial and
wanted to create a new industry. This type of talent, you cannot find in China. So when I went

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From Imitation to Innovation

there, we had a good talk, and they wanted to cooperate. The automobile industry in China
has to rely on foreigners too!

The startup that Zuo was talking to had the goal of changing the paradigm for electric bikes
using smarter technology and a more powerful electric drive train that would surpass what
was achievable with internal combustion engines. They sought to build a new generation of
“super bikes” while minimizing impact on the environment. Talented people like these were
not only sought by companies in the motorcycle industry, but also the automobile industry
in the U.S., China and elsewhere. So how could Zongshen attract this kind of talent? Even if
such people were willing to join Zongshen, would they fit into Zongshen’s culture? How
could Zongshen manage them effectively to build up a technology base to secure its future?
At the same time, how could Zongshen develop its own internal talent to sustain growth of
the company?

Perhaps the best route was for Zuo to invest in this startup via a pre-Series A round. This way
the company could learn about the technology and become a manufacturing partner. Was
this the route for Zongshen to eventually become self-sufficient in technology?

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Exhibit 1 – Zongshen Industrial Group Revenue and Net Profit 2000-2009

CNY
000s 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Revenue 2,622,200 2,650,030 3,133,060 4,553,190 4,572,780 6,614,090 8,768,200 10,972,870 11,103,940 10,917,180
Net
125,650 83,030 63,350 99,290 156,670 203,230 376,450 421,600 378,050 693,530
Profit

Source: Company Data

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From Imitation to Innovation

Exhibit 2 – Zongshen Product Development Process

Product Planning – 30-40 Work Days

Conceptual Design & Analysis – 40-50 Work Days

Styling and Industrial Design – 70-85 Work Days

Detail Design – 60-70 Work Days

OTS Prototype – 160-180 Work Days

Small Batch Trial Production – 80-90 Work Days

Volume Trial Production – 30-40 Work Days

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