China Manufacturing Agreements

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.

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 China manufacturing contract 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.

Photo of Dan Harris Dan Harris

Dan is a founder of Harris Bricken, an international law firm with lawyers in Los Angeles, Portland, San Francisco, Seattle, China and Spain.

He primarily represents companies doing business in emerging market countries, having spent years building and maintaining a global, professional network. 

Dan is a founder of Harris Bricken, an international law firm with lawyers in Los Angeles, Portland, San Francisco, Seattle, China and Spain.

He primarily represents companies doing business in emerging market countries, having spent years building and maintaining a global, professional network.  His work has been as varied as securing the release of two improperly held helicopters in Papua New Guinea, setting up a legal framework to move slag from Canada to Poland’s interior, overseeing hundreds of litigation and arbitration matters in Korea, helping someone avoid terrorism charges in Japan, and seizing fish product in China to collect on a debt.

He was named as one of only three Washington State Amazing Lawyers in International Law, is AV rated by Martindale-Hubbell Law Directory (its highest rating), is rated 10.0 by (also its highest rating), and is a recognized SuperLawyer.

Dan is a frequent writer and public speaker on doing business in Asia and constantly travels between the United States and Asia. He most commonly speaks on China law issues and is the lead writer of the award winning China Law Blog. Forbes Magazine, Fortune Magazine, the Wall Street Journal, Investors Business Daily, Business Week, The National Law Journal, The Washington Post, The ABA Journal, The Economist, Newsweek, NPR, The New York Times and Inside Counsel have all interviewed Dan regarding various aspects of his international law practice.

Dan is licensed in Washington, Illinois, and Alaska.

In tandem with the international law team at his firm, Dan focuses on setting up/registering companies overseas (via WFOEs, Rep Offices or Joint Ventures), drafting international contracts (NDAs, OEM Agreements, licensing, distribution, etc.), protecting IP (trademarks, trade secrets, copyrights and patents), and overseeing M&A transactions.