Header graphic for print
China Law Blog China Law for Business

The New Role Of Written Contracts For Product Purchases In China

Posted in Basics of China Business Law, China Business, Legal News

Product manufacturing in China’s coastal regions has become increasingly challenging for manufacturers and buyers alike. Costs such as wages and rent have risen dramatically over the past five years at the same time that the economies of major buyers have suffered severe setbacks. This has put tremendous pressure on the small and medium businesses that make up the 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, it has been confidently predicted that basic manufacturing would move from coastal China either 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 way 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. Moreover, the Chinese have become masters at managing production of such new products on a massive scale that simply cannot be duplicated.

As a result, even though prices are rising, foreign 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 reason is simple. The buyers simply have nowhere else to go. Thus, to the surprise of many, the China coast remains the manufacturer to the world. 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 oftentimes 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 over ten years on a per purchase order basis.

This approach is changing and more 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 that is delivered late or that does not meet specifications fouls up the chain. Product that is subject to an intellectual property infringement challenge or that contains pirated, non-standard parts or that contains 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 that these non-compliance issues and their resulting costs were simply absorbed by the foreign buyers at each stage of the purchase chain. However, in the current environment of tight supply chain management, the disruption is normally 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 that foreign buyers can no longer simply 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 that seek 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 very new to most Chinese export oriented manufacturers. The purpose of these agreements is quite simple. The purpose is not to make the situation better but rather 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 fully understand that the purpose of these new contracts is to impose liability on them that they have been able to shrug off in the past. 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 buyers are now more often insisting on contracts that impose liability on their Chinese manufacturers as I have described above. This trend is just part of the process of maturation of the Chinese manufacturing system and there is nothing anyone can do to stop the process. Smart foreign companies are getting accountability 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.  It is that simple. 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 that absorbing these costs is no longer economically feasible. Buyers who do not protect themselves and continue to operate on a per purchase order basis 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 more on the kind of written contract required to hold your China manufacturer responsible for things like bad product or late delivery, check out the following:

 

 

  • http://twitter.com/theeastasiaco East Asia Co.

    Steve:

    Interesting piece but I wonder. You make it sound like the Coastal Regions are enjoying a Renaissance which they certainly are not, at least not in the South. Factory closures in the Pearl River Delta region are still happening with regularity from what I read and hear (often directly from vendors) . The fact that so much business is still sent to these regions is, as you say, because of the “clusters” which locate industries next to their supply chains. This makes for quicker lead times, more reasonable MOQs and a host of other advantages. But I wonder if this may simply be a lag effect. In other words, as supply chain “clusters” get built up in the Central and Western Provinces I tend to think businesses will move there as labor tends to be on average 20-30% cheaper. The cheaper labor results in huge savings for vendors and their customers. In fact, many vendors in the South and Eastern China already outsource parts of their orders to factories in Central and Western China. I would add that Central China has extensive inland navigable waterways and the infrastructure in a place like Henan for example is very good. And this is why big companies like Foxconn, Coca-Cola, Unilever and GE have recently set up shop in Central China, and why Central China’s GDP in 2012 far outpaced that in the rest of the country. So I guess I am still bullish on Central China. Yes, it may take awhile but anyone who has lived in China and who has seen the astounding change that does take place there, knows it will happen.

    Regarding contracts, It is encouraging to hear you say that you think things are getting better in terms of vendors and their customers reaching a new level of understanding – in the face of the unforgiving standards of global retailers nowadays. At the same time, I cannot help but think that it is going to take a while for this attitude to trickle down to a lot of industries and vendors in China, and
    overseas buyers. Just yesterday I had an email from a customer who received a
    bad order from her vendor. She didn’t inspect the order before it left China. Vendor
    blamed the subcontractor. My customer is asking me if there is anything she can
    do. Same old song and dance. It will be very refreshing if you are right.

    Thanks for the piece. I enjoyed it

  • http://www.qualityinspection.org/ Renaud Anjoran

    Great article. Just yesterday, a Canadian client who buys large quantities from China was asking me for advice: “my customers are charging me back for quality issues; how can I protect myself from these chargebacks while getting my suppliers to improve their quality?”

    This trend has two implications, from my viewpoint:
    1. Many importers are wondering how to make sure the liability rests on their suppliers’ shoulders;
    2. More and more importers are looking for ways to help their key suppliers improve their operations.
    The difficulty, as you mentioned, is that Chinese manufacturers see this as a game played by buyers. The “I will give my business to another factory if you don’t improve” threat is usually not credible.