Contracts for Product Purchases from China

Product manufacturing in China’s coastal regions has become increasingly challenging for manufacturers and buyers alike. Wages and rent have risen dramatically over the past five years while at the same time the economies of major buyers have suffered severe setbacks. This has put tremendous pressure on the small and medium businesses that make up the Chinese manufacturers in the export-oriented belt extending from Jiangsu down to Zhuhai.

There have been many predictions that this process would fundamentally change the structure of manufacturing in China. Since as far back as 2008, many have predicted basic manufacturing would move from coastal China to inland China or to other countries in SE Asia. Even the Chinese government has predicted a shift in the coastal region away from basic manufacturing to high-tech, high value added, high investment manufacturing consolidated in the hands of a few highly capitalized players.

However, this has not happened. Basic level export oriented contract manufacturing in China remains concentrated along the coastal belt. Many businesses that experimented with inland China and SE Asia are now returning to the coast. There are two primary reasons for this.

First, the Chinese coast has an in-place manufacturing support base that simply cannot be duplicated anywhere else in China, Asia or probably the world. Ports, rail and road networks are first rate. Electricity is generally available and black outs are rare. Ancillary support is available everywhere. If you are making clothing and you need a new type of button, you can find a supply and have it delivered within 24 hours. If a manufacturing line goes down the repairman arrives in 4 hours with the replacement part in hand.

Second, China has developed the ability to implement complex production plans in ways that cannot be matched elsewhere. Foreign buyers have grown accustomed to showing up at a Chinese facility with a mere product sketch which then becomes a marketable product, rolling off the production line in quantity within 9 months. Chinese manufacturers have become masters at managing production of new products on a massive scale that simply cannot be duplicated.

As a result, even though China manufacturing prices are rising, foreign product buyers are still actively purchasing product in China’s coastal regions. This applies both to purchases of basic non-brand products and to purchases of highly customized OEM products. The buyers simply have nowhere else to go. Thus, to the surprise of many, China’s coast remains the manufacturer to the world and recent trade statistics bear this out. In the face of enormous headwinds, Chinese exports have increased substantially in 2013: 25% in January, 21.8% in February and 11.7% in March.

Though exports continue at a high rate, we do see a major new trend in purchases by foreign buyers from the manufacturing sector. In the past, foreign buyers were often content to purchase product from their Chinese manufacturers without using a written contract and with no long-term commitment on the part of the buyer or the manufacturer. We know many foreign companies that have purchased product from the same manufacturer for more than ten years on a per purchase order basis.

This approach is changing and more foreign buyers are entering into long-term purchase contracts with their suppliers (typically called OEM Agreements, Manufacturing Agreements, Product Supply Agreements, or Product Sourcing Agreements). There are several reasons for this trend. Probably the most important reason is the drive for standardization on the part of buyers. Chinese product is just one part of a worldwide supply chain. Major retailers have diverse sources of product. All product has to meet a basic standard to fit smoothly into the chain. Product delivered late or not to specifications fouls up the chain. Product subject to an intellectual property infringement challenge or that contains pirated, non-standard parts or a non-standard component that raises safety issues disrupts the supply chain.

In the early days of buying product from China, the price was so cheap non-compliance issues and their resulting costs were simply absorbed by the foreign buyers at each stage of the purchase chain. In the current environment of tight supply chain management, disruption is quite costly and cannot be tolerated by retailers already financially stressed by the current economic environment. As a result, retailers are imposing strict standards on their direct suppliers. The strictness of the controls and the magnitude of potential losses mean foreign buyers can no longer absorb the costs of non-conformance by the Chinese manufacturers.

Foreign buyers now have no choice but to impose the same standards on their Chinese suppliers. Thus foreign buyers must enter into written contracts for product purchases from their Chinese suppliers that mirror their own obligations to their major retailer customers. These contracts must be supplemented with detailed supplier manuals and codes of conduct to regulate the day-to-day business operations of the Chinese manufacturers.

None of this is unusual in North America and Europe, but the approach is new to most Chinese export oriented manufacturers. The purpose of these agreements is quite simple. The purpose is to impose liability for non-performance directly on the Chinese manufacturer. That is, the foreign buyer is saying: “I no longer will simply absorb the costs caused by your lack of compliance with the conditions of sale. If you (Chinese manufacturer) do not perform, I will suffer a loss and I am going to pass that loss on to you.”

Chinese manufacturers understand the purpose of these new contracts is to impose liability they previously were able to shrug off. As a result, many Chinese manufacturers resist entering into this kind of agreement. They have had a free ride for many years and they want that ride to continue.

Foreign product buyers are more often insisting on contracts with their Chinese suppliers that impose liability on the Chinese side. This trend is just part of the process of maturation of the Chinese manufacturing system and smart foreign companies are getting accountability from their Chinese product suppliers or moving on to another factory. Chinese manufacturers that get the message and enter into and comply with detailed purchasing and manufacturing agreements will survive and those that don’t won’t. I have discussed these things with many Chinese factory owners and none have disagreed.

Note however that this applies in the same way to foreign buyers. Foreign buyers that continue to absorb the cost of Chinese manufacturer non-compliance will be swept away. The rising cost of Chinese product coupled with the vigilant approach of major retailers means absorbing these costs is no longer economically feasible. Buyers that continue to operate on a per purchase order basis (without protections) will be looking at an enforced career change in their future.The coffee shop in my neighborhood in Qingdao is advertising for a new barista. Send me your name and I will make an introduction for you.