Archives: product sourcing

I’ve been deleting old emails today and in doing so I have deleted far too many that relate to China product quality problems.  Here’s the most recent such email, with all identifiers removed to protect the victim:

My company purchased hundreds of _____ from a company in China for about $65,000. Most of these _______ were defective when we received them. They [the Chinese manufacturer] told us that they would make up for this on our next order. We made another order and we got more defective _________.

We then upgraded the _________ to what was supposed to be a better quality ________. Again, we have received defective ________. We are
now getting many returns from our customers who bought these _______ and
this is costing us tens of thousands of dollars.

I would like to know if there is any way that we can get our money back for
all the bad ________. We have all invoices, communications, and videos and
pictures.

We also want to know if we can sue for attorney costs to resolve this matter
as well?

My response, which is pretty much pure template these days, was as follows:

I hate to have to tell you this, but you have probably set yourself up so that a good solution is very unlikely.
You say that you have all “invoices, communications, and videos and pictures,” but you fail to mention the most important thing of all, which is a signed AND sealed contract in Chinese that makes very clear exactly what the Chinese manufacturer was to provide you and the penalties it owes for having failed to do so.
Once you have the sort of problem that you had with a Chinese manufacturer, you run away.  Fast.  And you don’t go back for more and then back again.  Ever.
We typically charge a flat fee on these sorts of cases, along with a percentage of whatever we recover, with the fee and the percent based on how we access the case after reviewing all relevant documetns.
When we take on these cases, we review all the documents and try to get anything back for our clients by writing a letter in Chinese threatening to sue.  I don’t think that will work here and I would urge you not to retain us.
The other thing I would urge you to do is to not order anything from China again without a good contract in place. Good contracts usually work by driving away the bad Chinese companies and by forcing the good ones to toe the line.  China does not typically award attorneys’ fees unless that award is set forth in a signed contract. For more on what you can be doing to protect yourself by from China product problems, I urge you to read the following:

I am truly sorry this has happened to you and I am also sorry that I cannot be more positive about it, but the last thing I want to do is to add to your pain by taking more of your money on something that probably will not give you any value back.
Not surprisingly, I did not hear back.

Every December, we get an even greater than normal number of phone calls from companies that have received bad product or no product at all and the past two weeks have been no exception.  And as is almost always the case, I blame the “victim.”

I blame the victim because without exception, in every single case where we have gotten such a call, the non-Chinese buyer has done a lot of things wrong in its sourcing of product from China and now it is, to put it somewhat harshly, paying the price for that.

But what so often really drives me nuts about these people is that after I tell them exactly why my law firm has zero interest in their case, some of them say something like “I knew you can’t trust Chinese companies” or “I knew they had no law there” and then they usually say something like “I’m never going to do business there again. The risks are just too high.”

Wrong. Wrong. Wrong.

What I always want to tell them, but pretty much never do, is the following:

What are you talking about?  You did NOTHING to try to protect yourself.  You didn’t research the Chinese company before sending them money.  You didn’t use anyone to monitor quality control.  You didn’t use anyone to write you a contract that would actually work in a Chinese Court.  So really, what did you expect? I hate to tell you this, but we have hundreds of clients who buy from China all the time and they almost never experience anything close to what you are going through.

It reminds me of a relative I have (not on my side of the family, I might add), who during the tech boom would brag about how he had gotten so good at the market he would be earning 20% a year forever.  Yes, he actually said that.  But what is even more interesting is that after the market crashed and he lost a ton of money, he then started preaching how the market was rigged and he would never buy stocks again, not once even referencing his prior claims.  As my older brother the stockbroker is always saying, “genius is a rising market.”  But the corrollary to that for this relative is that a falling market is a rigged market to be avoided by everyone.

Wrong. Wrong. Wrong.

Just like there are ways to do well in the stock market (over time), there are ways to do well in the China product sourcing market.  The way to increase your odds of getting the product for which you paid is to do the following:

1. Make your product purchases from China under a well-drafted contract that is enforceable in China. Purchases under informal purchase orders simply do not work for China.  For more on China OEM Agreements, check out the following:

2. The contract with the Chinese manufacturer must provide for a mechanism where the foreign buyer can exercise constant control over the quality of the Chinese product. Liability for defect must be made clear and it must fall hard on the Chinese side. If possible, no defective product should ever be permitted to even leave the Chinese factory. If defective product is discovered outside of China, the Chinese side must be absolutely liable for dealing with the problem. The standard procedure (in China, anyway) for dealing with defects through a discount on future purchases must not be used.

3. The foreign buyer must actually follow through and constantly monitor the quality of the product. The best contract with the best procedure is no good if the foreign side does not follow through by rigorously implementing the procedures outlined in it. As I mentioned above, this is an expensive and tiresome process. Parties that do not follow through are almost guaranteed to experience problems in China. These problems are an irritant to the Chinese side but can be fatal to the foreign side. For this reason, the only side that has any incentive to follow through is the foreign side.

Is China product quality getting  better?  Yes and no. Chinese manufacturers are not doing a better job on their own at maintaining quality. In fact, if left on their own, much evidence suggests they are doing worse. But yes, the legal system and quality control systems have progressed to the point where aware and active foreign companies can force Chinese manufacturers to operate in a reasonably acceptable manner. “Forcing” means doing things right.

What do you think?

This is a guest post from Renaud Anjoran. Renaud runs a product quality inspection business in Shenzhen and he also writes the truly excellent and perennially helpful Quality Inspection Tips. My firm has worked with Renaud on a number of China product matters and we have consistently found him to be highly knowledgeable about China product sourcing. This post arose from a long email “conversation” between co-blogger Steve Dickinson and Renaud, which ended as so many of those do: with me suggesting that it be turned into a blog post.

So here’s the blog post, written by Renaud Anjoran.

 

Most transactions with Chinese suppliers are done through bank transfers. This payment method was described in a previous China Law Blog post, China Manufacturing Payment Terms. Limit Your Risks.

Many importers/foreign manufacturers are not familiar with Letters of Credit (LC) as an alternative to bank transfers. Letters of Credit were designed to protect both product buyers and product supplier in international trade. In practice, they are usually more favorable to the buyer.

How a letter of credit protects the buyer

An importer that pays by LC does not have to wire a deposit before production and it usually has the option to cancel the payment in the following cases:

  • If a supplier does not ship at the right time.  Typically if this happens, the LC simply expires, but the buyer still has the choice to pay if it wants the goods.
  • If a supplier does not honor the product specification or if there are too many defects. One of the conditions of the LC should be that the LC will not be paid on unless and until the product buyer has signed off on product quality or a specified third party QC agency has issued its certificate of inspection.
  • If the seller fails to provide any document listed as required in the LC or the documents do not fully conform to the LC’s requirements.

Why letters of credit can be cancelled by the buyer in most cases

Even something as small as a typo in the LC, or the fact that a quantity is written in dozens rather than in pieces in the invoice is usually enough to cause a discrepancy in the LC, which in turn allows the buyer to cancel payment.

In practice, a small minority of LCs are “clean,” i.e., without any discrepancy. In all other cases, the buyer has the option to refuse payment and cancel the transaction, even if the goods are already on a boat (in which case the buyer will not get the documents to get the products out of custom).

CLB Note:  We are aware of a Seattle buyer company that refused goods that had already arrived in Seattle because the street address (which was irrelevant) of one of the parties in the letter of credit was off by a single letter.

Tips for negotiating payment by letter of credit

For the reasons mentioned above, Chinese suppliers typically refuse to accept Letters of Credit. Here is how you can increase your chances of finding a Chinese company that accepts this payment method:

  • When sourcing your product, try to identify as many potential suppliers as possible. This will at least increase your chances of finding one that will accept an LC.
  • In your first conversation with your potential suppliers, mention that you always pay by LC on your first order. Try to get the supplier to accept this payment method in writing
  • Sell your project to your potential suppliers. Good manufacturers are inundated with customer inquiries, so you need to make yourself stand out. Explain why they should work with you. Call the Chinese company’s sales manager if necessary
  • Send your potential Chinese manufacturer a draft of the LC before opening it. You will usually need the commercial invoice, the packing list, the certificate of origin and/or GSM form A, the bill of lading, and an inspection certificate. Try to avoid putting “soft terms” into your Letter of Credit that will make it even more difficult for suppliers to collect payment.
  • If possible, use a major international bank. This will tend to reassure your suppliers.
  • Unfortunately, bank fees are much higher for an LC than they are for a bank wire, so an LC only makes sense for transactions of at least USD$30,000.
  • Chinese exporters are good at guessing whether a project is likely to become a source of long-term business. When they see what they think will be a a one-shot deal, they generally insist on getting a deposit and will not agree to an LC payment arrangement.

In summary, Letter of Credit are a payment tool that makes it unnecessary to transfer a 30% (or more) deposit to your Chinese manufacturer. They are usually more favorable to the buyer’s side, and for that reason, many Chinese companies refuse to accept them. But some Chinese product suppliers have been paid via Letters of Credit from some of their foreign customers for years, and sometimes Chinese manufacturers will accept your Letter of Credit if they really want your orders.

 

What do you think?

Interesting article on China product quality over at the Knowledge@Wharton site. The article is written by Paul Midler, founder and President of China Advantage, which provides China product outsourcing and supply chain management services. Paul is a Wharton MBA graduate, who has been living and working in China off and on for the last 15 years.

The article is entitled Quality Fade: China’s Great Business Challenge and its thesis is that the current emphasis placed on importers in preventing quality problems is misplaced. Chinese suppliers that want to play games with their product are well positioned to do so and it is very difficult for Western importers to prevent. Midler defines “quality fade” as “the deliberate and secretive habit of widening profit margins through a reduction in the quality of materials” and he sees this as pervasive in China, with no end in sight.

I agree and I disagree.

The article begins by remarking on how supply chain professionals not directly affected by the recent spate of China product recalls are remaining “unusually calm” based on their belief that as China “continues to develop, the quality of its products will naturally rise.” Midler sees this assertion as sounding logical, but “not necessarily true” and he uses China’s own history with silk in the late 19th century and early 20th century is proof of this.

Midler then notes how Chinese manufacturers continue to deliberately and secretly seek to widen their profit margins by reducing the quality of materials they put into their products:

Importers usually never notice what’s happening; downward changes are subtle but progressive. The initial production sample is fine, but with each successive production run, a bit more of the necessary inputs are missing.

What is maddening to importers is that quality fade often occurs in the last place an importer thinks to check. One American company had been importing a line of health and beauty care products for over a year when the cardboard boxes that held its product suddenly started collapsing under their own weight. There was no logical explanation for the collapse except quality fade, and the supplier in this case blamed sub-suppliers for replacing an acceptable cardboard box with ones that were inferior.

Midler correctly points out that the “only thing passed on to the customer” from these quality fades is “an increase in product risk.” “Suppliers push the limit by taking more and more out of the equation until they are caught, or until disaster strikes.”  Why don’t product buyers do anything about this?

Even when importers catch suppliers in a quality fade, they frequently don’t do much about it. Many quality problems are seen as too minor relative to the difficulties involved in rectifying them. Customers may not notice a product flaw, but they most certainly notice when a product is not delivered on time. The chance of a product failure is usually remote, but the penalty for late delivery is an almost certain loss of business.

Some importers bravely attempt to fight back against quality fade by insisting a supplier replace substandard goods at the factory’s expense. A savvy supplier — and most are extremely savvy — can respond to such demands by threatening to terminate the supplier relationship. Or the supplier can respond by raising prices. Importers might then say they will switch suppliers, but the factory owner knows this is an empty threat as finding and cultivating a new supplier can take a long time. And anyway, there is no guarantee that the next supplier won’t engage in the same willful behavior as the first.

Midler asserts that Chinese factory owners who practice quality fade have “virtually nothing to lose and only margin to gain.” “When the factory owner offers his most sincere apologies and promises that it won’t happen a second time, importers simply close their eyes and hope for the best:”

If Adam Smith were around today, he would have had to write a separate chapter on global outsourcing. Because it takes importers a long time to find suppliers and to get them up to speed, importers keep their suppliers a secret. The last thing that an importer wants to do is let his competitors know the source of any supply chain advantage he may have. Even when it is in their collective interest to share information, importers keep to themselves. As a result, factories pay little, if any, reputational cost for production shenanigans. The invisible hand doesn’t work well when the manufacturers themselves are unseen.

This lack of accountability also has legal implications. When a product is recalled in the U.S., the importer pays the cost of that recall. It remains next to impossible to take legal action in China, and only in the rarest case can an importer successfully sue the supplier responsible for a product failure. Since most suppliers are paid in full well before goods leave the factory, the importer doesn’t even enjoy the leverage that comes with owing payment to the supplier.

Midler then talks about how Chinese factories get around third party testing and asserts that “testing doesn’t work well when a supplier sets out to circumvent the system.” He cites for support a U.S. Consumer Product Safety Commission study finding that of “nearly 200 recalled electrical products from China, 25% had prior approval by an international third-party testing agency such as Underwriters Laboratories (UL), Intertek Testing Services (ETL) or the Canadian Standards Association (CSA).”

Midler sees there being a “feeling” in China that one must work fast before the government closes the windows of opportunity. “For factories, that means taking shortcuts on quality. Many factory owners can’t see beyond the next purchase order.”

One reason for the short-sightedness may have to do with China’s political environment. The one-party government does what it wants, when it wants. And while there may be some advantages to a government that can operate without restraint or controversy, such a system limits predictability and leaves the business sector keenly aware that it is subject to the evanescent whims of officials who may or may not know which policy is best.

The U.S. administration has recently been applying pressure on China to revalue its currency in order to close the growing trade gap between the two countries. To appease the U.S., China has responded by reducing the tax rebates it offers to manufacturers. For some suppliers, the tax rebates have constituted a major portion of their bottom line. Massive and sudden changes such as these only confirm the factory owner’s paranoid suspicions that the manufacturing opportunity could disappear at any moment. No one in China is sure how long anything will last — a situation that keeps many focused on the immediate present.

Chinese manufacturers often focus on extracting profit through short-term maneuvers that militate against long-term development. Despite all of this, Midler does not consider the situation hopeless:

Japan was known decades ago for making inferior products, but that changed. The key to turning the situation around is to incorporate a habit of quality into the culture. China, however, has not shown that it has any interest in doing so. Recent accusations of unreliability in Chinese products are now being met with tit-for-tat claims that U.S. products are faulty. This is an unfortunate strategy for China, and it means that we will continue to see quality problems. China will not be able to succeed so long as manufacturers are competing in a race to the bottom.

Midler has his facts right, but I disagree with his analysis. There is such a thing as quality fade in China and our China lawyers are constantly telling our clients to prepare for the fourth shipment. In our experience, quality fade tends to happen disproportionally on the fourth shipment, probably because it is at this point that the Western importer starts to feel comfortable enough with its Chinese manufacturer to place a large order and the Chinese manufacturer is by this point feeling comfortable enough to cut corners.

Despite my agreeing that quality fade is a reality in China, I think the product situation in China is slowly improving and will continue to do so.

Instead of analogizing China today to China in the 19th century, I would analogize China today to Russia right after the fall of Communism. I would do this because both China today and Russia back then looked at their governments as mercurial and unreliable. When laws and power bases change frequently, the smart manufacturer thinks short term not long term.

More than ten years ago, I wrote an article setting out four principles for doing business in emerging markets. Principle four directly addressed this short term thinking phenomenon:

PRINCIPLE FOUR: Exercise Extreme Patience.

This principle stems from the maxim that everything takes twice as long as you think it will. If it takes twice as long in the West, triple that in emerging market countries. You’ll go in both as a businessperson and a teacher—and in both roles, the learning curve of your partner will almost certainly take way more time to deal with than you think.

For example, many emerging market countries have a history where “bad business” meant “thinking long-term.” A year or two after the fall of Soviet communism, I was involved in a matter where an investor put $250,000 into a Russian joint venture. The business very quickly was making good money and all indicators pointed towards steadily increasing profitability. But, quite quickly, the Russian company stole the $250,000. Was it so irrational for him to think so short term in a country where the government and tax systems had such a history of unpredictability?

Remember: It takes patience to encourage change of mindset. Extreme patience.

I can remember going into a toy store in Russia fifteen years ago to buy a puzzle for my kid. The two girls behind the counter made no effort to help me in my selection and they both laughed at me when I had trouble figuring out the proper bill to give them to pay. That sort of thing is far more unlikely to happen in Russia today. Now I am not going to tell you that one small example like this should be extrapolated to Russia as a whole, but I doubt anyone out there will dispute that Russian business has become far more sophisticated and “Western-like” during the last 15 years, even as its government has been backsliding. I see no reason why China businesses will not similarly evolve.

Though China’s business and tax laws are changing so fast as to make long term decision making difficult, almost without exception, the trend in those laws is inexorably towards a fairer and better economic system for doing business in China. Importantly, the more sophisticated Chinese businesspeople realize this.

Quality fade is a major problem in China. However, the reason why this is happening is not so much so Chinese manufacturers can rake in big margins, it is so they can survive. Many Chinese manufacturers have no margin whatsoever. With currency revaluation, massive competition, tax reform and the end of VAT rebates, huge numbers of Chinese manufacturers are operating at a loss. They are doing the quality fade in a desperate attempt to stay alive for a few more months or years. China is in a desperate situation of pursuit of the absolutely lowest price. China’s manufacturers cannot continue this race to the bottom and continue to survive. At some point, they will need to shift to higher quality goods at a higher margin. This shift is already happening in the market as a whole and I have seen individual Chinese companies make this shift as well. Just this month, a client of mine was told by his Chinese supplier that the supplier could not continue to maintain expected quality without a price increase. My client wisely went along with this. I have seen companies fight a price increase when they had to have known there was no way quality could be maintained without it.

In my view, it all comes down to economics and, contrary to Midler’s assertion, Adam Smith will do just fine here. Economics is what is driving quality fade right now (just as it did when Japan and then Korea were known not for the quality of their goods, but for their low price), not some special characteristic of the Chinese people. Since it is driven by economics, it can be understood. The next topic is to consider whether China can break out of the cycle. Japan and Taiwan did it and I do not see why China cannot do the same.

Though I agree quality fade is both real and difficult to stop, this in no way absolves the Western company of the need to fight it. We have said this many times before and we will say it again. Those of our clients who do the right things from the get-go in China have, almost without exception, experienced very few problems. Unfortunately, there is very little written or said about the small and mid-sized companies that achieve long term success in their China manufacturing. This month, The Washington Post and the Christian Science Monitor interviewed me for stories on China product quality. In both interviews, I talked extensively about our clients who have achieved consistent success in China and how they have done so.

Both newspapers asked me to arrange interviews with those clients. I called probably around ten such clients and not a single one of them was willing to talk, not even anonymously. One client told me something along the following lines:

“Dan, I see no upside for us here, only downside. We do not want anything out there highlighting that we get our product from China, or even that others in our industry do so. The product we get from China is some of the best we have ever gotten anywhere, but the American people either do not want to or are just not ready to believe this. The other countries producing __________are years behind China.

Though it is difficult to secure high quality goods from China, countless companies are (quietly) succeeding in doing just that, so it is clearly possible. Possible, but not easy, and what this means is that the cost difference in sourcing from China must be great enough to make up for the time and money that will need to be incurred to maintain quality. Very briefly, companies getting product from China should, at minimum, be looking at the following:

1. Chinese Suppliers. Since Chinese suppliers run the gambit from superb to criminal, you must check out any potential supplier in advance. A basic credit check will reveal whether the Chinese company with whom you have contracted is in fact the factory owner, not just some broker posing as such. A thriving company is less likely to risk its reputation by cutting safety corners than a company on the verge of going under.

2. Quality Control. Since most Chinese product arrives already packaged for retail sale, a statistically valid inspection system within China is critical. The Chinese government has its own inspection system for food and drugs, but to reduce costs, many Chinese suppliers intentionally avoid this system. It is your job to make sure your Chinese supplier is licensed to manufacture the product you are buying, licensed to export it, and follows Chinese government inspection procedures. It is your job to have the right people testing that product, be it your own people or a reliable third party tester.

3. Contracts. A contract with a China supplier should detail safety and quality control requirements and inspection rights. If the contract states you are responsible for inspection, you must actually inspect. Your contract with your Chinese manufacturer can either shift liability towards you or away from you.

4. History. You know who your problem suppliers are and you need to replace them now before they cause even bigger problems. Ask a product liability defense lawyer whether having to deal with a bunch of e-mails from you to your supplier complaining of “continual quality shortfalls” is going to be good for your product injury lawsuit. Actually, don’t bother, you know the answer.

5. Insurance. Insurance is NOT a replacement for the above, but it is your backup. Insurance almost never covers more than your legal fees and out of pocket damages; it will not cover your time spent defending lawsuits nor will it cover your damaged reputation.

6. Marketing. Do not make claims about your product you cannot support. Many North American importers claim their Chinese manufactured product is manufactured to a standard that simply is not followed in China. Things like this just give the plaintiff’s lawyer more ammunition against you in any legal proceeding.

There is obviously a lot more to protecting your company from dangerous China product than just the above and many of those things will be industry and company specific. But, at minimum, every company getting product from China should be reviewing at least these aspects of its business.

Midler’s article has already drawn considerable internet interest and for those interested in reading more on it, we urge you to check out the following: