Such products only account for a quarter of China's dairy consumption today, compared with nearly 60 per cent of Japan's, but this proportion is forecast to change rapidly as Chinese incomes rise.
Research by McKinsey on consumption patterns and consumer preferences in more than 150 Chinese cities and towns suggests that sales of milk beverages, cheese and desserts, and yoghurt will grow by 22, 38, and 31 per cent a year, respectively, over the next five years.
The added value products can yield margins two to three times greater than regular liquid milk but for domestic dairies to be successful in this segment, they need to do more to differentiate their products than simply offer new flavours or packaging variations, say report authors Richard Cheung and Andrew Grant.
"Milk beverages and yoghurt, for example, are innovation-driven products requiring strong R&D formulation and consumer segmentation skills, and many domestic dairy companies have little of either," they write in the latest issue of the McKinsey Quarterly.
"The top five Chinese dairy companies, for instance, spend less than 1 per cent of their revenues on R&D, compared with 3 to 4 per cent for their Western counterparts."
The report explains that top dairy companies elsewhere in Asia target particular consumer segments and usage occasions. For example, a Japanese dairy markets coffee-flavoured milk in a container that resembles a paper coffee cup, which is designed to attract white-collar workers taking a break from work.
"The domestic companies must build new capabilities in areas such as product development, branding, account management, and marketing," say the consultants.
These are all areas where foreign dairy leaders have expertise and those domestic firms that have ventures with international groups - such as Bright Dairy with Danone, and Mengniu with Arla - are already in a good position to tap this experience.
But many of the smaller firms without such advantages are likely to disappear in a wave of consolidation.
China's dairy industry may be set to double in size, to nearly US$20 billion, by the end of the decade, according to McKinsey, but despite this burgeoning demand, "we expect that by 2010 more than half of China's 1,600 domestic dairy manufacturers will fail to survive the transition".
The shift to modern retailing formats is also driving this trend, with international retailers like Carrefour and Wal-mart placing higher demands on suppliers than smaller outlets.
There will also be increasing competition from retailers' own-label dairy products.
By 2010, nearly two-thirds of China's dairy sales will come through modern formats, compared with 40 per cent in 1998, predicts McKinsey.
For those that do survive the consolidation, much of the growth will come from the 40 second-tier and 60 third-tier cities where consumers earn less than the top tier of Beijing, Shanghai and Guangzhou.
In 2004, China's three biggest cities accounted for 14 per cent of all dairy revenues, according to the report, but in 2010, their share will fall to 11 per cent. Over the next four years, 70 per cent of the growth in net revenues will come from the 100 cities in the second and third tiers.