Moving Your Supply Chain From China to Southeast Asia/South Asia: The Three Big Issues

As buyers work to diversify their supply chains out of China, many are finding the process extremely difficult. Most buyers are finding they have been spoiled by China. Foreign buyers have been working in China for over thirty years and during that thirty year period, these buyers have been training Chinese suppliers on the whole range of issues required for meeting the needs of foreign buyers and their customers. It has been a very difficult process. Though Chinese suppliers are far from perfect, the fact is that after this 30 year training program Chinese companies have reached a generally high level of performance.

In our own practice, we find many buyers expect their new suppliers from S.E. Asia and South Asia will operate at the same level achieved in China. Their supply chain system usually assumes this. They are then surprised to learn that the level of performance in these new territories is oftentimes just not at the same level as China. So buyers are faced with a new period of monitoring and training. Many smaller buyers are not prepared for the effort this requires. For this reason, buyers need to consider the key issues carefully before they move their manufacturing out of China.

Though right now finding the right manufacturer, shipping costs and delays, and COVID shutdowns and delays are obviously front and center for anyone manufacturing in SE and South Asia (or looking to do so), the below three issues are the ones that our international manufacturing lawyers see consistently arise for those moving to S.E./South Asia:

1. Quality Control

The first thing our clients usually notice is that the defect rate in S.E. Asia and South Asia is higher than in China. As buyers have moved into this region, local manufacturers have struggled to keep up with the increase in orders. This has resulted in a decline in quality. During the holiday season, as factories become even busier, the defect rate historically soars, and we’ve had clients tell us they’ve seen defect rates as high as 40% at this time of year.

Buyers must therefore plan on dealing with defects from the start. Inspection is key. Inspection after your product arrives in your overseas facility is not acceptable; inspection must be done on site before product is shipped. There is a larger issue hidden here. For many buyers, discovering that the defect rate is unacceptable at the end of the production cycle means the problem will be found too late. Buyers typically rely on a full delivery. A delivery in the holiday season with a defect rate of 40% or more can be a crippling blow for a buyer. For this reason most buyers find they are required to do ongoing, continuous inspection during the entire production process so as to be able to identify defects when they occur and not when they are all piled up in a warehouse ready for shipment.

Often the only realistic strategy is to hire an agent to visit the factory on a regular basis. For large orders, this may require a factory visit almost every day. The alternative to a resident agent is to engage an international inspection company to do regular on-site inspection. Either way, this level of inspection is costly and many smaller buyers determine they cannot afford the expense. This is generally a failed analysis; the cost of inspection is part of the cost of the product. If the cost is too high, the product is simply too expensive.

2. Delivery Delays

Factories in S.E./South Asia often accept any order without concern for scheduling production. This means that during “crunch” periods such as the U.S. holiday season, the factory will fall behind in production. Delivery is delayed and many deliveries are short. The factory will say: “we are only two months late, what is your problem?” But consider a delivery scheduled to arrive in October, just in time for the holiday season. If that delivery arrives in mid-December, it is just as if the delivery never arrived at all.

Due to the recent increase in orders throughout the S.E./South Asia region, the issue of late/short delivery for consumer products has become a significant issue and buyers must be realistic about the fact that just in time delivery may not be possible. This means your ordering system must take this into account and include a “cushion” for delivery dates. This requires ordering early and then dealing with the burden of warehousing for product that does arrive on time.

Buyers should assume the delivery date will be an issue. The issue must be discussed directly with the factory and a procedure must be devised to deal with it. This usually requires at least the following: First, the factory must be clear that when they contractually commit to a delivery date, that date is a hard date and not a wish or a goal. Factories will often respond by openly stating that any delivery date they agree to may be delayed by as much as six weeks before the delivery is considered to be “late.” Second, to make clear that the delivery date is a hard date, your manufacturing contract should  include an effective and enforceable contractual penalty for late delivery. This penalty must have a real impact, so it must be imposed by a reduction in the final purchase price payment. Third, given that late delivery is such a critical issue, some form of monitoring process must be imposed through factory inspection or some other process to confirm the progress of manufacture and the actual date of delivery. The buyer cannot afford to simply assume the shipment will be made on the required date.

We have found that many S.E./South Asia factories do not like to discuss the delivery date issue. They do not like being held to a hard date or to be penalized for late deliveries. This is because the know they will be late. When a factory strongly resists all discussion of this issue, the buyer should assume the probability of late delivery is high.

As with the issue of quality control, monitoring delivery dates and conducting periodic inspections is expensive. Buyers must take this expense into account in determining the real cost of the product they purchase.

3. Protection of Product Design

When your product purchase is an off the shelf product designed by the factory, there is no issue of protection of product design; the factory owns the design and it has the right to sell their product to any buyer without any restriction. The issue on design only arises when the off the shelf product has been customized for purchase by the buyer. This customization can take many forms. It can be as simple as application of a logo or use of custom colors. Customization may move on to changes in configuration of the product such as a change in control layout or cover design. Where this type of custom product is purchased, it is critical your require your factory not make the custom product for itself or for any other customer. Since there is no formal intellectual property protection in this case, this kind of protection must be done through a written contract.

At the other extreme is the custom manufacture of an item designed by the buyer and for which the design is owned by the buyer. Where the buyer owns the entire design, a contract is required that establishes the ownership of the design and that prevents the factory from making the design for itself or sale to any of its other customers. Such a contract is particularly important in situations where the factory is a direct competitor of the buyer. Buyers that do not enter into this type of contract before they reveal their design to the factory are simply giving their design away as a gift to the factory. See How to Give Away your IP in China Without Realizing it.

For factories in S.E./South Asia, we have found that the issue of protecting product design is different than the issues we see in China. In China, the Chinese factories will aggressively infringe on product design with the goal of selling directly into the foreign market — typically the United States or Europe. S.E/South Asian factories have not generally reached this level. Factories in this region are more like Chinese factories from the 1990s.

Once they have learned how to make a new type of product, they will add that product to their portfolio of items they seek to sell to foreign buyers. They feature the products in their showroom, in their brochures, on their website and in their tradeshow displays. Many factories do not see anything wrong with doing this. In their view, if the product is not protected by a patent or a trademark or a contract, why should they not go out and sell it? They did the hard work in learning how to make the product on a commercial basis and they should be allowed to leverage this expertise by selling the product to other customers.

The only way to prevent this kind of infringing sale to third parties is to enter into a contract that effectively addresses the issue. Conduct that is prohibited has to be described and penalties for any failure to comply must be specified. Factories will not want their own off the shelf technologies to be restricted. It is often a complex process to describe what exactly is protected and what is not. In the current conditions of South/S.E. Asia, failing to enter into an agreement on this issue is an invitation to disaster and our international manufacturing lawyers as well as our international IP lawyers have seen a massive increase in calls and emails from foreign companies seeking legal help to stop this after it has occurred.

It is simply not possible to successfully purchase product from S.E./South Asia by executing a simple purchase order and hoping for the best. The above issues must be assessed and a calculation of the real cost of the product must be made. An enforceable contract with the factory must be negotiated and executed. After the contract is signed and the order is made, continuous monitoring is required. All of this can be difficult to accept by buyers who are moving from China to another region.

Many of our clients are having great success in moving their manufacturing from China to SE Asia and we are big fans of many SE Asian countries for manufacturing. See e.g., Manufacturing Outside China: It’s Thailand’s Time. But too many product buyers just assume the conditions in S.E./South Asia will be basically the same as they are at the advanced contract manufacturing centers in China, but the notion that you can operate in Vietnam, Thailand, India, Pakistan, Bangladesh, Malaysia, Myanmar, or Cambodia just as you did for China will usually be wrong. On the other hand, experience gained in dealing with China during its rise as a supply center can be applied directly to avoid making mistakes in new regions. See also, How to Avoid Problems When Manufacturing Overseas.