So many companies now produce goods in China that simply relying on its low-cost labor to churn them out inexpensively confers precious little competitive edge. Overcapacity in many industries—from automobiles to household appliances—is already leading to price wars, squeezed margins, and, in some cases, heavy losses. Even Chinese exporters are feeling the pinch as global players move in and enjoy cost advantages similar to those of local producers.

As pressure on margins in the domestic market increases, more Chinese companies with a strong home base are successfully entering international markets with products that leverage China's low costs—for example, Lenovo, which last year purchased IBM's PC business; Galanz, the world's largest microwave manufacturer; and the telecom-equipment maker Huawei Technologies. Their success has intensified global competition and squeezed margins further.

Companies operating in China must find advantages that go beyond cheap labor, not least because there are already signs of incipient wage inflation that could eventually drive up labor costs, at least in heavily industrialized coastal regions. To generate profits from increasingly big investments, these companies will have to improve the utilization of factories, manufacture a broader and more customized range of products, and enhance product quality. The best way to achieve...