China is a land of opportunity for business, but it is also a land of counterfeiting and intellectual property theft

Few consumers get fooled by street markets selling luxury handbags at knock-down prices. But there are many cases where it is difficult for buyers to distinguish counterfeit goods from the real thing. As more manufacturing shifts to China, businesses in the west need to learn how to value their intellectual property and protect it from theft.

While the world waited for Apple’s new  iPhone  to hit the stores, made-in-China imitations were already on sale for a quarter of the price. Apple has been battling against the counterfeiters in China for three years with, so far, limited success.

China is not the only source of pirated goods but it is by far the worst offender, accounting for 85% of counterfeit goods seized in the European Union last year, according to the European Commission.

The problem is not confined to hot-selling electronic gadgets—almost every industry suffers from this plague. Counterfeiting costs Europe’s engineering industry €10 billion ($13.5 billion) a year, according to trade body Orgalime.

For some companies, their intellectual property is more valuable than the physical assets on their balance sheet. But many businesses undervalue their intellectual property and downplay the risk of counterfeiting—until it is too late.

Remade In China

“You must always assume your intellectual property is under threat,” says David Seall, a consultant to the U.K. manufacturing sector.

The popular image of counterfeiting is a back street garage in China with workers “reverse engineering” Western products. But more sophisticated counterfeiters go straight to the source and steal design files and software code from the manufacturer.Toys, luxury fashion goods, medicines, aircraft spare parts: There are a thousand stories of Western industries battling against made-in-China counterfeit goods.

This one features Bowers & Wilkins, a small U.K.-based manufacturer of loudspeakers whose products grace homes of audiophiles—as well as the famous Abbey Road studios.

British firms once dominated this industry but many of its famous brands such as Wharfedale, Mission and KEF are now owned by Chinese concerns. B&W had no intention of throwing in the towel. But it risked pricing itself out of its biggest market, the crowded entry-level segment where speakers cost from €300 a pair —the firm’s high-end products cost a hundred times as much.

The solution was to build a factory in China. This allowed B&W to reduce the labor costs in its new 600 Series line of loudspeakers by a startling 90%, according to Geoff Edwards, B&W’s head of operations.

“The labor savings paid for the improvements in technology,” he says.

B&W’s 600 Series has some unusual features including woven Kevlar speaker cones and diamond-cut brushed aluminum tweeter trims. Its bespoke components are difficult to counterfeit—or so B&W hopes.

“We are not too worried about reverse engineering,” says Mr. Edwards, who argues the real value of its intellectual property lies in how the speakers are manufactured, rather than in the components. Mr. Seall, a leading authority on manufacturing, says B&W is unusual as most manufacturers do not think of “process innovation” as intellectual property.

Counterfeiters will find it much harder to replicate a just-in-time manufacturing process, for example, than they will in mimicking the components used in the product, Mr. Seall argues.

B&W knew the IP in its manufacturing process was worth protecting, so it built its own facility in China—a mirror-image of its existing U.K. factory—rather than sub-contract to a Chinese partner. The latter would have meant sharing details of the manufacturing process, which Mr. Seall cautions against in China.

Experts say one of the big misconceptions surrounding economic espionage is that it only affects big-name brands that own a soft-drink formula, a new microprocessor design or confidential data on an electric car program—Renault suspended three employees earlier this year for allegedly divulging such data to Chinese spymasters. But it’s not just the big players that have a lot to lose from counterfeiting. Most businesses own intellectual property, although its value is often not fully appreciated. This makes it easier to steal, particularly if the intellectual property exists in digital form. Recent years have seen a spate of sophisticated attacks on the computer networks of Western businesses, many in strategic sectors such as defense or energy. Unlike the opportunist attacks that hackers mount to steal credit card data or customer records, these focused attacks aim to steal intellectual property—and many of them appear to originate from China.

Thomas Winfield, professor of international law at the George C. Marshall European Center for Security Studies, describes these attacks as “state-sponsored cyber-espionage”. Because of the time and resources required to mount these attacks, he believes it unlikely they are purely the work of commercial rivals.

Indeed, there is a long history of state involvement in industrial espionage: In the 1960s, Israeli spies allegedly stole three tonnes of paper specifications for France’s Mirage 5 fighter aircraft. If repeated today, the data could be stored on a couple of USB sticks.

Western manufacturers know they ignore China at their peril. Counterfeiting remains a problem but the risks can be overplayed. B&W, for example, says it has never had to take anyone to court in China for infringement. “From time to time we see people trying to copy our products but a cease-and-desist letter is usually sufficient to make them stop,” says Mr. Edwards.

As well as the risks, China is also a land of opportunities. Thanks to its presence in China, B&W has found a new market for its premium speakers with China’s growing number of affluent audiophiles.

The original article by Geoff Nairn, editor of EngagingChina, was published in the Wall Street Journal Europe on October 11 2011 and can be read here