Since the Chinese government announced in June that it would cease pegging its yuan to the U.S. dollar, the toy industry has been waiting with bated breath to see exactly how far the revaluation will go. The move initially triggered a relatively minor 2.1% bump, but any steeper increase will have a big impact on manufacturers operating in the region, and this beleaguered bunch is already dealing with rising oil prices and labor shortages.

‘We’re all just hoping things will stay stable, but it’s tough,’ says Techno Source CEO Eric Levin, fresh off of a plane from doing business in Hong Kong. ‘It’s all speculation at this point, of course, but people seem to be pretty convinced there’s going to be more change.’

At this point, the navel-gazers are all over the place. Some say the yuan will hold at 2%, others foresee it going up a percentage point per year, and the dourest of the bunch predict an increase of 10% in the next six months. For its part, the Chinese government has reportedly insisted that it will maintain the status quo for the time being.

But to toy manufacturers, any appreciation at all means the cost of doing business in the region will go up by the same amount. ‘If you roll in the labor inflation and power shortages, I think we’re all going to have to accept that China is going to cost us a bit more every year,’ says Nick Austin, CEO of U.K. toy distributor Vivid Imaginations. ‘We’ve been through a glory decade of incredible price stability there, but you could argue that this era may well have come to a close.’

While a 2% cost increase won’t likely show up in prices at the consumer level, it will stretch already tight margins even more. Because the announcement came in the middle of a toy production cycle, the factories have borne the brunt of the small exchange rate increase, since most toycos pay in Hong Kong or U.S. dollars. But the cost increase will eventually get passed on to the manufacturer, and usually, that’s where it stops.

‘If the supply chain is in sync, then when the cost of labor goes up 5%, it gets passed along and the consumer pays 5% more. But that is not what’s happening,’ says TIA president Tom Conley. ‘Rarely, if ever, do those increases get passed on to the retailer. For one thing, they are so powerful that they won’t accept it.’ He adds that increases in the highly volatile areas of labor supply, oil prices and transportation costs are already routinely passed on to manufacturers, even after a firm price has been quoted to retailers. ‘We have so many points of potentially high variability, that it becomes very costly and risky for our folks to do business.’

Levin and Austin are both convinced that at some point, retailers will be forced to recognize the market realities, and prices will have to go up. Levin points to recent price hikes in the cereal aisle as a good example. The big manufacturers managed to push them through after years of absorbing increased costs and trying to eke out a profit in the face of tighter margins, despite resistance from grocery chains. He adds that although toy prices have remained fairly static overall, they’ve gone up in certain categories of late (particularly plastics, thanks to increased oil prices).

But raising prices comes with its own risks, as even a small increase can mean a world of difference on a competitive toy shelf. ‘Every category is price-oriented, but lower-priced products are more sensitive,’ says Levin, adding that hitting the magic price-points of US$4.99, US$9.99 and US$19.99 makes enough of a sales difference that many companies are working short to hit them already. Studies have proven over and over again the difference in sales velocity at US$12.99 versus US$9.99, and in a retail environment that’s extremely crowded, toycos could lose an order of 200,000 units right off the bat.

While this volatility has led many non-toy manufacturers to ponder moving their off-shore operations to India or Malaysia, China is still the most advantageous region for toy production. Toycos have been operating in the country for years, siphoning talent and knowledge from nearby Hong Kong, which has built up the infrastructure and support system. However, inland regions and the area around Shanghai are beginning to look more attractive, says Austin, because labor costs there can be as much as 10% to 20% less than in the Southern provinces.

Finding adequate labor has been a difficult proposition in China since the SARS epidemic in 2002 immobilized its labor force. In fact, Conley says that the manufacturing industry in Guangdong province was short by as many as two million workers last year.

And since toy manufacturing is seasonal, factories that employ 5,000 to 10,000 during the off-season may need to expand by as many as 20,000 workers at times. ‘Companies were really worried about being able to meet their production deadlines, and we’ve heard that the situation isn’t getting any better,’ says Conley, who cautions that moving inland might be risky because the infrastructure there is still far behind Southern China.

Levin agrees that as you move away from Hong Kong, there are more factories hungry for business. While this is great for commodity items that don’t require a lot of expertise – for example, a plastic shovel and pail – you lose a lot of efficiencies that established factories already have in place. For electronic toys like the ones Techno Source makes, factories need a high degree of experience and equipment, as well as a lot of engineers on staff.