Am I being screwed?

Source: Exec Digital UK

Date :03/06/2008 15:42:46

If you use offshore contract manufacturing, will you compromise your IP? Might hidden costs and quality issues cut your savings on labour? Is there simply too much risk?

Written by John O'Hanlon

Until the UK and China re-established diplomatic relations in 1972, followed by the United States in 1979, the place to look for local knowledge about China would have been at the US Embassy in Warsaw, Poland. This was the only place to which all three countries had accredited missions and was, for many years, the only place where the Chinese and American governments held meetings. Now trading relations are positively thriving but a scintilla of suspicion remains. We are only slowly recovering from the fear that China might replace the Soviet Union as a monolithic and hostile power and, even today, the size of its population, not to mention its consumption of resources, makes western governments wary.

China cannot be ignored, and in a decade it’s grown into something of a world outsourcing theme park, but it’s not as low cost as it used to be and, increasingly, there are concerns not only about the robustness of its manufacturing processes but also the ethical standards operated in the supply chain. The tribulations of Mattel last year, when it had to recall 250,000 Chinese-made toy cars in the United States because of unacceptable levels of lead-based paint, concentrated the minds of purchasing managers the world over. That was an extreme example of bad practice and poor control – it was hardly deliberate – but it focused attention on the vulnerability of complex supply chains to abuse, including price fixing.

The cost of fraud

In its April 2008 report on supply chain issues, global risk consulting company Kroll warns that, while the benefits of outsourcing, in terms of greater flexibility and efficiency in sales and production, have been great, the costs, in terms of fraud, theft and other losses, are also sizeable. Realising this, companies outsourcing to any low-cost economy should take note of the advice given by Bill Mitchell, the CEO of the US$16 billion Arrow Electronics, who says that it’s no more than common sense to physically check the operations of partners critical to your business. Here is his ten point checklist:

1. Source from reputable, well-established companies with tight internal controls

2. Conduct comprehensive background checks, including checking trade references and past business history, of supply chain partners before conducting business with them

3. Implement site inspections of supply chain partners and find out what systems have been put in place to track quality

4. Conduct ongoing performance reviews of supply chain partners and engage in ongoing communications with them to benchmark against preset goals and define improvement plans

5. Only source from companies that are willing to provide a guarantee for products in writing

6. Be cautious of buying from companies that do not have franchised relationships with distribution partners to avoid a greater potential risk of counterfeit product

7. Beware of unusually low pricing. While pricing is certainly important, it should not be the only determining factor in business relationships

8. Look for International Organization for Standardisation (ISO) or other equivalent, globally recognised certifications in a supply chain partner’s operations

9. Establish relationships with third-party organisations

10. Translate quality into measurable and clearly defined targets with supply chain partners and ensure these metrics are communicated regularly with employees

“I have one golden rule,” says Robert Freid, President of Seattle-based Contract Manufacturing Consultants. “I do not recommend a contract manufacturer to my client if they manufacture a similar branded product for themselves.” The key word here is ‘branded’, as opposed to pure contract manufacturers who produce exclusively for third party clients. Kent Kedl, whose book The China Ready Company is a valuable companion to companies considering doing business with, or sourcing from, the Far East, adds: “US manufacturers do not have as much experience of working cross-culturally as do Europeans, and it can be challenging if China is your first international experience. It is a tough place to learn to ride a bicycle!”

A political trade

The argument goes like this: 90 percent of what we will buy or use in 10 years’ time hasn’t been invented yet. Our job is to get smarter at developing new products and figuring out new ways to manufacture them. In the west we should invest in our laboratories and design workshops, train our graduates to work in them, but leave the messy business of series production to the people who are happy to do it for us. There’s a political trade-off to this too, as prosperity shifts the focus of whole populations from the pursuit of freedom to the pursuit of happiness: The more advanced India, Korea and China become, theoretically the more peaceful and democratic the world becomes - and the more hospitable to international trade.

A recent China Manufacturing Competitiveness survey by Booz Allen Hamilton and the American Chamber of Commerce (AmCham) Shanghai, has suggested, however, that China’s outsourcing attractiveness may be diminishing. Over half the foreign-owned or funded manufacturers surveyed considered the country to be losing out to other low-cost nations where competitive edge is concerned. Almost one in five had definite plans to relocate China operations elsewhere.

Endemic risk

All this puts pressure on Chinese factories to cut costs yet further; without adequate controls, shortcuts are inevitable. According to the Kroll report, modern complexities make companies vulnerable to frauds committed many links back in the chain, and beyond the scope of most internal controls. In 2006, two Chinese firms added toxic melanin to their pet food material. After purchase and sale by legitimate brokers and manufacturers, the feed poisoned animals across North America, forcing the recall of hundreds of pet food brands.

Stefano Demichelis, a Senior Director in Kroll’s London office, notes: “You’re facing fraud from the very beginning, on every single factor: raw materials, production, and delivery.” Supply chain fraud is too broad to estimate meaningfully. Two pieces of data, however, show that it is a huge issue. A survey for Kroll in 2007 found that 42 percent of firms worldwide had suffered from at least one of supplier fraud or the theft of physical assets – just two of the myriad ways to abuse supply chains – and nine percent had suffered both. Too many companies have not realised that the ongoing revolution in the structure and management of supply chains has increased their fraud risk.

For many, outsourcing has failed to live up to their expectations. Perhaps they went in with the wrong expectations; perhaps they were unprepared, or had not fully explored the alternatives. Others swear they are still in business solely because they went overseas: they are the ones who covered all their bases and, above all, insured against being ripped off by keeping tight control of all stages in the supply chain, including raw materials.

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