Verifying and Monitoring Your Chinese Suppliers

The below post is by Renaud Anjoran, CEO of Sofeast, a leading Asia-focused quality assurance, product engineering, and supply chain management solutions company. Our law firm’s international manufacturing lawyers have worked with Renaud on countless Asian sourcing and manufacturing transactions over the last fifteen or so years. 

Most China commentators have been focusing on the geopolitical risks stemming from the US-China trade and tech war, China’s numerous territorial claims, Hong Kong, and so forth. At my level, though, when I hear “China” and “risk”, I think of the day-to-day issues foreign businesses face just to receive good products. Lack of transparency in China’s supply chain leads to lower visibility, less control, and higher risk.

Many of the difficulties I will be describing in this post can be found in other countries. The difference with China is that foreign product buyers see the technical advances made by companies like Alibaba, Tencent, Baidu, and others, and they expect China manufacturing and business practices will be similar to those of other developed economies. Most end up disappointed.

Here are some of the recurring challenges today’s product buyers face and some of the best practices they should be employing to mitigate or avoid them:

1. Supplier screening & qualification

First, the good news. There are plenty of excellent and reliable suppliers in China. They are a minority, but many buyers find a great match for their needs.

A foreign buyer who verifies everything he/she is told can uncover many pitfalls and avoid bad suppliers. For example, they can have a relatively precise idea of the type of company (trading vs. manufacturer) they are talking to.

One common frustration is the strong desire of the exporting manufacturer (who must order components and materials from its suppliers) to be in full control of its supply chain. If the importer does nothing to counter this, the suppliers of critical components and/or surface treatment will be unknown.

This has not improved over the years, as the typical Chinese factory owner believes that keeping its suppliers secrets is critical to keeping its customers. They also know that this secrecy better enables them to accelerate price increases over time since the buyer does not have any data to prove the price increases are unfounded.

Once China’s corporate social credit system is in place (maybe by the end of this year), more information on Chinese supplier companies should be available to product buyers. The overall score of each company is expected to be available publicly and this should help slow down the manufacturers that continuously play the price increase game

2. New product development (manufacturing side)

A new product often involves the development of new parts, and buyers need to know whether the key processes to fabricate these parts are stable (i.e. predictable) and mature (i.e. low scrap rate & low rework rate, also known as high yield).

The yield is, however, directly related to the factory’s cost, and this is very sensitive information. If half the parts end up needing to be reworked or scrapped, the manufacturer will certainly insist on passing these extra costs on to their product buyers. This should be evaluated and discussed before mass production. And the process should be tested, improved, and tested again, until there is reasonable assurance the yield will be over, say, 92%.  The buyer should be invited to monitor how the pilot run is made for each custom component.

All too often this process engineering work is not done and those types of issues are revealed only after big money has been transferred (and the importer is tied to a deadline). In other words, when the offer of “just what we promised, but at a higher price” cannot be refused.

That’s how thousands of manufacturing projects died. The price of a key component doubles and suddenly the whole product can no longer be made and sold profitably. After investors spent hundreds of thousands of dollars on new product development.

In China, the price of serious development and manufacturing mistakes is usually paid by the buyer. I know that sounds illogical and should not happen, but this is the reality.

3. New product development (design side)

Many companies get a Chinese manufacturer to contribute to the design of their new product and to create prototypes. And, often, to manage the fabrication of tooling for mass production.

Steve Dickinson summarized the situation very well in How Not to Lose Your IP When Developing a Product with Your China Factory. If a product buyer fails to take the right precautions, the manufacturer will end up owning the intellectual property rights and will not share the original drawings, schematics, sources, and other key information.

Can a buyer do design reviews, to pick up on potential sources of future issues? They can’t. They have to trust the supplier blindly.

How can the buyer debug a PCBA problem, for instance, if they don’t have the design files? They can’t. They have to rely on the supplier (who may also be relying on another party). It might be slow and expensive.

As I wrote above, the typical Chinese factory owner believes that if his customers have this information, they will go elsewhere. That’s certainly true if those customers are not treated well, but no customer wants to start training a new manufacturer. A supplier that has struggled through rounds of prototyping has a much deeper understanding of the product and is better prepared to make it.

4. Confidentiality of information

It has become commonplace in China to open several companies (e.g. one for manufacturing activity and two others performing trading activity). These sort of multi-company manufacturing enterprises are typically set up for three purposes. First, smaller businesses pay a lower tax rate (this policy was meant to be temporary, but many people expect it will continue). Second, if one company gets into some kind of trouble, the rest of the “group” is not directly at risk. Third, a partner can be brought in without giving away shares in the whole business — in practice, this means the shareholders of those different businesses can be different.

How can you make sure the different people who have access to your product and business information are working in “sister companies” rather than in entirely different businesses? This takes research and sometimes it will never be clear.

Many Chinese suppliers treat their customers’ IP in an offhand manner. They send too much information to potential component suppliers (who typically haven’t signed an NNN Agreement that will protect IP) for quotations. They don’t have training programs for their R&D team to respect confidentiality. They show samples in their showroom, their Alibaba account, and so on. All this tends to drive foreign buyers crazy, for good reason. And it is not always easy to monitor and control.

5. Purchasing materials & components

This is another “black box” that prevents buyers from verifying they got what they paid for.

Let’s say you specify that the assembler of your electronic widget must use a Samsung battery and you agree to pay a premium for this. Maybe your supplier can easily find counterfeit batteries with similar specifications (but lower consistency and reliability) and “the same” Samsung branding. If so, the assembler may be tempted to multiply his profit margin.

However, as the buyer, you have performed reliability testing with the original batteries. Now you are buying untested products that might cause fires. This type of situation quickly turns into a nightmare.

Can you check if your supplier purchased the batteries from the right source? Their volumes are probably too low to buy directly from Samsung. They likely need to buy from a distributor and that means you need to check to make sure that distributor is an authorized Samsung battery reseller. You would then have to trust that distributor’s supply chain security.

Performing independent lab tests on every batch is possible, but expensive. And some manufacturers play games in a way that makes it nearly impossible to catch them – for example, they use genuine components on 80% of the products and counterfeit components on the remainder.

6. Manufacturing

Some suppliers are quite successful in getting new customers. However, they bite off more they can chew. They don’t have the capacity to make all the orders in-house, especially during peak season. No worries! Subcontracting production is very common. Yes, even if you visited their factory and approved it.

Your Chinese factory will virtually never tell you they are farming your job off to another workshop — or to many other workshops. In one case, I remember a huge batch of garments was supposed to be made in one factory. That factory did make some of the garments, but someone there admitted to us that ten subcontractors were also making portions of that batch. You can send your inspection team to the approved factory to monitor the status of production, and they may detect a case of unauthorized subcontracting, but you will probably not be invited to visit the subcontractors and see your products. Remember, the typical supplier here wants to be in control of every detail of your supply chain.

A good manufacturing contract can help. See China Manufacturing and the Bike Lock Theory on Subcontractors. Regular production monitoring helps also. And, of course, the buyer needs to confirm that the factory capacity is adequate and it also must leave sufficient time for pre-production approvals and manufacturing. In my experience, the buyer’s side is responsible for undisclosed subcontracting about half the time for never collecting data firsthand or double-checking production plans in detail.

7. Your factory sells your product

All of you have heard the horror stories about a Chinese manufacturer selling a customer’s product to other customers, often by using that customer’s own molds. There are legal (manufacturing agreements) and non-legal (e.g. pulling the tools out of the factory between production runs) ways to address this risk, but these tools must be employed before the problem arises, not after.

Some factories will not only sell a customer’s product from under them, but they will have a friend or relative register that customer’s brand name as a trademark in China, so they can legally manufacture and export that customer’s products with their customer’s brand name. Again, there is little a foreign buyer can do to stop this after the fact. Preventive actions (e.g. registering your trademark in China before others do) are the best approach.

As I said, there are superb factories in China, but they are a minority. Most importers who source products in China have had to put up with some (or all) of the difficulties I listed above. The new generation of factory owners is more open and more progressive than the older generation, but many of the same practices remain. The question I often ask myself is whether we still be complaining of the same issues in ten years.