I received several emails recently from readers asking how they can increase their control over a Chinese supplier.

They experience late shipments, unacceptable quality, and/or price increases mid-way through production. Sometimes they get no response to their emails. They have the feeling that the supplier does not care about them.

How can a supplier’s behavior be controlled more effectively?

Buyers should work on their suppliers incentives and follow production closely.

And how to do it? I have listed 4 solutions below (1 “carrot” and 3 “sticks”).

1. Be seen as a “good customer”

If you want to control your supplier’s behavior, do not be associated with small and unprofitable orders… Because they are seldom given attention and priority.

The objective is to ensure that your suppliers take care of your current production because they are happy about it and they hope to get future orders. There are two things you can do:

• Make your orders look more appealing: don’t drive their profit margin down to zero; be clear in your requirements and keep development work easy (for example by providing a sample to copy); avoid overly complex breakdown of colors or sizes; do not be unfriendly in their presence, etc.
• Find suppliers who will value your business: your orders might seem insignificant to a large factory, so try to find a smaller manufacturer. It is important that top management keeps an eye on your orders.

2. Know what is really going on

If you let your supplier ship the goods without somebody checking quality on your behalf, you are running huge risks.

When it comes to consumer goods for Western countries, it is safe to estimate that the average Chinese exporter ships products that are inadequate–for one reason or another–at least 20% of the time.

If you cannot control quality by yourself, get assistance from an inspection company. They propose tools for different situations. Here are two of them:

• You should try to detect quality problems before shipment, because a container cannot be returned to the factory. So most serious buyers conduct a final random inspection, to confirm that quality is acceptable.
• And if you suspect the supplier is not doing a good job, you should catch the issues early (and avoid poor re-work and late shipping) with an inspection during production.

If you don’t know where to start with QC inspections, you can read four simple steps for starting to do quality control.

3. Tie payments to results

As long as you owe money to a supplier, it is much easier to control his behavior (since he risks a cancelled order or a request for discount).

Then, how to ensure that (1) quality is satisfactory, and (2) timing is respected? The solution is to settle final payment only after an inspection is passed AND the goods are shipped out. This is totally standard, and you should not hesitate to require it.

Let’s take an example. You write “Penalties for late shipment: 5% per week after promised ETD” on your P/O, and you negotiate to wire 70% of payment after shipment. In this case, the supplier will think twice before delaying your order.

Unfortunately, there are cases where this will not help you control your supplier:

• You give orders in a continuous flow, and you depend on your supplier for a good part of your business. In this case, try to work with several suppliers to minimize risks.
• You purchase products with no customization, and the supplier can easily sell them to somebody else.

To know more about this topic, you should read Paying by bank wire (T/T) and Paying by letter of credit (L/C)

4. Sign a contract

If you cannot follow the above recommendations, you can try to do business on familiar grounds: with a legally-binding contract.
There are lots of misconceptions. No, a purchase order is not a contract. No, Chinese suppliers are not used to signing contracts, and sometimes they don’t even read them. But yes, a contract can be enforced (in China only, except if the supplier has assets in your country) if it is drafted by a lawyer specializing in Chinese law.

A contract can give you more control over a supplier’s behavior, in many ways. If you approve a factory, it can discourage sub-contracting. If you have valuable intellectual property, it can prevent copying (or re-use for other buyers). If you are not happy about your supplier’s behavior, a demand letter from your lawyer might frighten him into cooperating.

Contracts are mostly used for big orders, or for very sensitive projects. My clients (SMEs buying from China) do not use any contract. And, from what I observed, mega-retailers have contracts but seldom enforce them–they rely heavily on the hope for repeat orders, on quality inspections, and on the fear of penalties.

What not to do

Equally important is what I did not mention in the above list. Let’s take an example: developing a personal relationship with a factory boss. It might help. But importers often think that it is sufficient, and they are mistaken.
That’s why so many local trading companies cannot control the behavior of the manufacturers they work with–even when they pretend to own the factory. Sometimes they have all wrong:

• The factory sees them as a bad customer, since they have access to so many other local manufacturers and they push prices down.
• If they have a personal bond with the factory boss, they don’t dare to inspect quality (to avoid making him “lose face”), and they wouldn’t even think of a contract.
• Their payment depends on the importer’s payment, so this element of pressure is somewhat lost.

This is good news for savvy importers. If they use the right tools, they can be very effective without the need for any intermediary.

Photo credit Loren Javier

Very few importers make an effort to know the exact financial standing of their Chinese suppliers. China is viewed as a fundamentally opaque country, where “nobody knows who the real boss is anyway”. For example, meeting a representative of a given company, and then sending P/Os and payments in the name of a different company, is quite frequent.

I am not saying it is a mistake. It is perfectly fine for small purchases, especially if quality is confirmed before payment. But it is NOT advised when the purchaser is betting a lot (i.e. a lot of his money, or his own image with his customers) on a supplier’s reliability.

I just found a post entitled Let me tell you about China due diligence, written on the China Law Blog 2 years ago. It relates an example that perfectly drives the point home:

US company goes to China and meets with company there for manufacturing product.  The two parties sign an agreement and US company sends over a large sum of money to build the tooling.  Chinese company then says another large sum is needed to be ready to go as soon as the tooling is complete.  Months pass.  Nothing.  More months pass.  Nothing.  It has now been a year and still nothing.

US Company contacts my firm and wants to know about pursuing litigation against this Chinese manufacturer to recover the money paid.  We determine US company has a very strong case, but suggest we first investigate the Chinese company to determine whether it has sufficient assets to pursue.  We conduct a fast and cheap investigation and get a comprehensive report on the Chinese company.  From this report we learn the following:

1. Company is not a manufacturer. It is a trader, with a tiny, rented office.
2. Company does not even have an export license.  In other words, it gets its products from manufacturers and then has to bring on another company to ship them.  It is just a middle-person.
3. Its only asset is a small amount of inventory, which it may or may not own.

In this case, the importer has lost everything. Ordering a simple background check before wiring the cash would have been enough to surface these issues.

It would have been obvious that the owner of a small Chinese company (with no asset) that receives a large sum of money will seriously consider keeping the cash for himself. What is the risk if he does so and the buyer sues him? Fold his operations and start something else. It happens!

Yesterday, one of my clients called me to get my opinion on an issue they are facing. He imports garments into the EU, and the composition written on the labeling has to be true within 3 percentage points. For example, he is not in compliance if he writes 92% polyamide & 8% Elastane when it actually is 88% polyamide & 12% Elastane.

Up until now, he has told his Chinese suppliers to declare the composition of each fabric, without requiring chemical testing. However some of his own customers in the EU have run tests on what they purchase, and in some cases the declared composition was outside the 3% tolerance.

He knows he is running risks. If the customs test the composition on an incoming shipment, or directly in his warehouse, the products might be confiscated and many complications might arise.

On the other hand, the suppliers don’t run any risk. This importer never uses contracts (he issues many orders to maybe a dozen suppliers, and most of the time an order is below USD10,000). So the suppliers have no incentive to make any effort.

My client decided to push his suppliers to pay for lab tests. They refused it.

My client told his suppliers he would proceed to random lab tests, and apply penalties whenever the composition is found wrong. They protested loudly.

In conclusion, the only option to be 100% safe is for the purchaser to pay for the lab tests himself. This is hard to swallow for a European company: shouldn’t the supplier be responsible for what he sells?? Why don’t most Chinese companies hear this logic?

First, Chinese exporters usually purchase the components of the final product from their own suppliers. In 99% of cases, the choice of the sub-supplier is either based on price, or guided by a personal relationship. In any case, the reliability of the specs promised to the customer is not the priority.

Second, Chinese companies are big fans of the “it’s not my fault, it’s my supplier” excuse. They generally refuse to recognize any responsibility on their part. It is convenient to save face and to avoid penalties.

Third, this importer places small orders and systematically negotiates prices… He is notseen as a good customer, and it is obvious that most Chinese suppliers will consider him the same way. “Why give him a favor when we know he has no better alternative?”, they think.

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To learn more about compulsory laboratory tests: How to deal with laboratory tests?

In my last post I wrote about what I call “parallel supply chains” from China to Western countries: stock lots left in factories, and copies of brand name products.

My clients usually don’t buy stock lots, and they never buy any brandname knockoff. I am sure most importers see parallel circuits as a threat to their business.

What problems do parallels channels create for importers?

• If they order a shipment that is found not to comply with quality/safety requirements, the production will be rejected. What will the factory do with the resulting stock? They will look for another buyer, even if the design and the brand are proprietary. And that buyer will probably be from the same country as the original importer, for obvious reasons of taste and market standards. End consumers will purchase products that were judged unacceptable on their market.
• Copies create similar issues: the factory sells extra production to some type of rogue agent, who in turn will sell the goods on the same export market at much lower prices. Not only does this represent lost sales, it also hurts the brand image… Who thinks all these copies, made under no supervision, are produced in the same workshop, from the same materials, and at the same quality level as the originals?
• In both cases, nobody really knows where the products end up. There is no control on distribution. Some companies that source from China receive calls (for warranty, consumer complaints, reorders…) from countries where they didn’t know their goods were sold!

What can importers do?

Here is the advice I would give to a company facing these risks:

• First things first… If parallel supply chains are a real danger to your business, you have to wonder if there is a good alternative to placing production in China. If there is, go for it!
• There might be solutions in the importing country. If you are lucky enough to be in a highly regulated industry, you might be able to pressure the retailers. For example, an American pharmaceutical company was facing a growing parallel supply chain of its own products–purchased in other countries at a lower price and resold in the USA. What solution did they find? They sent a letter to all distributors, stating that no liability would be accepted by the pharma company in case of consumer complaints. It was immediately effective.
• You might be able to re-think product design in a way that reduces these risks. Maybe the product is highly technical and can only function with a certain part that is embedded when you do the final assembly? Maybe your products can be designed to be technically impossible to copy, like some LV handbags?
• You can set up local operations for sourcing components and taking care of final assembly. This will give you tremendous control over your supply chain… But it represents a large investment in money and time. Some Japanese companies are based in China and propose this as a  service. Passage Maker has started doing the same for Western buyers.
• The most economical solution for oversea buyers is to have a presence on the ground during production. Final inspections (just before shipment) are fine for confirming quality, but they do nothing to avoid parallel channels. As I keep writing, early inspections are strongly recommended. First, very serious issues (which can convince a buyer to cancel an order that is already produced) are less likely to happen. Second, a manufacturer will probably not launch extra production on the side if a representative of its customer is in its premises during production.
• I guess it is possible to require the physical destruction of the goods through a contract (in case the buyer knows about the situation). But I am wondering to what lengths one must go to ensure that a Chinese factory really does destroy a batch of products that has a market value somewhere. Maybe the best is to purchase these goods and pay a third party to destroy them…

I received a message from a potential client who is starting to import garments into the US. I broke it up in different parts, and I inserted my responses below. It might be helpful to other importers wondering how to comply with their country’s regulations.

I have run into manufacturers who ask me if I have a quality manual for testing and are negotiating who is responsible for the testing of the swimwear (manufacturer or my company).

There are 2 ways to deal with this:

-1- The safe way

You get the list of appropriate tests, you select a laboratory (you pay their fees and you receive all test results directly), and you ensure the samples sent to the lab come from production.

For extra safety, an engineer from an inspection firm can go and pick up a few products randomly during production, and at the same time perform a quality check on some samples. The advantage of doing this during production is that quality issues can be noticed and corrected early, without incurring significant shipment delays.

-2- The not-so-safe way

You trust the supplier, and they send you either a certificate that your products comply with all US regulations or some test results from a laboratory of their choosing. None of these documents is fool proof.

The problem with a certificate is that it does not protect you, so the supplier can sign whatever you want without incurring significant risks. There is virtually no way of sending a shipment back to China for refund, or to sue your supplier for compensation (except if you had them signed a contract drafted by a specialized lawyer and enforceable in China).

The problem with a lab test result from the supplier is that you don’t know if the products making up your shipment would give the same results, were they to be tested.

They are looking for guidance from me about test standards.  Do you know where I could find a “standard manual” and what manufacturers normally test for?

The best is to ask a large testing laboratory. They know what types of tests should be performed for about any category of product shipped between any two countries.

To be very clear… The results of these tests will show if the samples received by the lab comply with all the regulations of the importing country. These tests are highly advised. Not every importer bothers to do them, but they are taking risks.

In addition, is this testing to pass certain US custom restrictions?  Can you advise or give me some guidance?

You are importing garments, not very sensitive products. I don’t know of any custom restriction in the US, other than import duties or maybe import licenses (aka quotas). Your custom broker or your forwarder can give you more information about trade restriction issues.

What is clear, though, is that your country does not tolerate certain chemical substances and does not want any product that might harm consumers (for example, long strings that might strangle a kid). The testing lab will give us some indications as what is forbidden.

I had an interesting conversation with a Chinese friend who works for local district’s government (in Shenzhen city). He explained to me how “the Chinese legal system does too little for society”.

No recourse against factories closing suddenly

One of his examples was about factory owners who disappear with the cash, and leave millions of RMB of unpaid invoices and wages behind them. Some factory bosses are actually not the legal representative of their company—one of their employees is—so they run no risk when stopping all operations at once. They can do it when lots of cash is in their hands (pressing customers to pay early and doing the reverse to suppliers and staff).

Hundreds or thousands of employees suddenly have no dormitory, no food, and no salary.  It causes huge disruptions. Sometimes the local government actually has to give them some money (local officials need to ensure that demonstrators don’t get too loud). Many similar cases were reported in China, particularly last year.

The factory owners often start another business nearby, and nobody can do anything about it. There is no legal recourse. That’s what my friend was complaining about. And, of course, he was envying the legal systems of the US and Europe, where this type of things would never happen.

Is it better in more developed economies?

Actually I think it is even more widespread there! In France, I know that many small entrepreneurs organize their bankruptcy by first giving their assets to their spouse and then changing the marriage contract. Thousands of farmers have done it, to avoid years of unpaid taxes. In the US, according to the book Microtrends, close to 1% of the population of an American state (Massachusetts, if my memory is good) is legally bankrupt. As the author wrote, bankruptcy is “a way of life” there.

Does it also happen to large companies in the US and Europe? Probably not in the same proportions. Many of the Chinese factories that closed actually did not bother filing for bankruptcy: the owner disappeared and nobody could find him. That type of behavior might be particular to China (and other developing countries? I don’t know).

Takeaway for buyers of Chinese products

Don’t build your whole business on one supplier. Even if they make a margin on your orders, you cannot count on the boss to maintain a stable business. Want to know more? Read this post about the short-term view of Chinese suppliers.

If your interests depends in large part on one or two factories, get credit checks–you will see if they have are in good financial standing. If they have lots of debt and a small profit, you know that they might not be there for the long haul.

The China Law Blog just released an interesting post, introducing the “bike lock theory of Chinese law”. Dan Harris makes the point that lawyers can help prevent quality issues by crafting a good contract. And he takes an example: how a contract can ensure that production is not subcontracted to another workshop.
What is funny is that I touched on this point in a recent post entitled Chinese suppliers and subcontracting, with basically a very similar example.

I reproduced below the most interesting part of the post:

We often put a provision in our OEM agreements (which we nearly always do in Chinese for better enforcement in China against the manufacturer) mandating that the Chinese manufacturer cannot subcontract out the manufacturing. We have been doing this for years and, as far as we know, no manufacturer has ever violated this provision. I know many of you are dubious of this record, but hear me out. Let’s say the Chinese manufacturer has 30 customers for whom it manufacturers product. Let’s say only four of those customers have a no subcontracting provision (my guess is this number is more like to be two, but for the sake of argument, let’s go with four here). The China OEM manufacturer gets really busy and has to subcontract out some of its manufacturing. It can subcontract out the product manufacturing of any of its 30 customers, so why wouldn’t it choose to subcontract out the product for the 26 customers who have no contract provision prohibiting subcontracting? I call this the bike lock theory of Chinese law because the no-subcontract provision operates like a good bike lock. The thief can still steal your bike, but why would he when there are so many easier targets out there?

This is probably surprising for many importers, who have the feeling that China has no law. But I agree with this analysis. Good advice… As usual!

In a recent post, I was wondering whether many importers calculated the fully-burdened cost of imports. Today, I came upon an interesting article on Knowledge@Wharton (Can China Meet the Quality Challenge?) where Mr. Pinney, from BCG Shanghai office, explains the roots of this situation:

“They have a procurement mentality and focus purely on price negotiation, and it’s an arm’s-length transaction,” he says. Because their expectations are based on their experiences with home-country suppliers, they don’t always follow up with their Chinese vendors to monitor processes and quality testing.

But why didn’t importers adapt to this new system?

“Companies were in a rush, working with whichever suppliers were at hand or feeling their way in the dark, not knowing what they were getting into,” Pinney says. With little to lose, Chinese suppliers would readily agree to meet quality standards. “In the great rush to China over the last 10 years, players on both sides of the fence were incompetent.”

Both manufacturers and buyers might be incompetent, but who is at fault? The purchasers, of course. They went into a totally different system without virtually any type of quality assurance. Then they got locked in OEM relationships and were forced to compromise on quality. Thousands of importers are still operating under such circumstances, and they will until they are forced to deliver products of a higher standard.

Then the article touches on the solutions for reducing quality risks. For example, the central government has audited 3,000 exporting toy factories, 600 of whom lost their authorization to export. Unfortunately, China is a very decentralized country, and Beijing has a hard time enforcing regulations. It will not work very well. Too many local official have an interest in the status quo.

So, where will the solution come from? We need to enforce strict standards in importing countries, and the buyers, in turn, will put pressure on their suppliers.

A direct correlation seems to exist between Chinese suppliers’ adherence to quality specifications and the degree to which their industry is regulated in the West. For instance, pharmaceuticals and foods tend to be more advanced in quality control “largely because of the pressures and incentives at the client end,” Pinney says. Similarly, Pinney sees significant quality improvements in the automobile and white-goods industries. Where the consequences of failure are less dire, quality levels are generally lower. “Quality improvements are the least far along as you move down the food chain into low-end electronics and toys,” he notes. “The downside to quality mess-ups is relatively small in shoes and textiles.”

Basically, developed countries should demand higher standards–and punish harshly the domestic vendors who don’t respect them. Then importers will have to do what is necessary: monitor product quality very closely, switch to more reliable factories, etc.

Most companies buying in China don’t take the precaution to write a contract with their suppliers. Even when large sums are at stake. The common perception is that going to a Chinese court is a long and expensive process, for a highly unpredictable result.
But are Chinese courts’ judgments truly unpredictable? Or do they follow a logic on their own?

The China Law Blog just wrote a very interesting post entitled China Sex, Mistresses, And Improper Payments, And What They Mean For Your China Business Litigation. It points to a really weird Chinese court judgment … that is, weird by Western standards.

The facts: a mistress was condemned to reimburse the cash given to her by her (married) lover… because the court estimated the property of that cash had been “improperly acquired”. Why improperly? Because, according to Chinese law, “the owners of common property have the rights to and the responsibility for this property… while property is commonly held, one party may not make a decision for the property without authorization”. In other words, the husband was not allowed to give that cash to anybody, since it also belongs to his wife.

In a European or American court, the husband would be considered responsible for it (but not necessarily condemned). The mistress would not have to reimburse any of these gifts.

So, what motivated that court decision? According to Dan Harris, from the China Law Blog:

Chinese courts tend to give large account to what is “fair,” not just to what the law says. This means that if a Chinese company is late on a contract because its own supplier was late in delivering it a necessary component part, the Chinese court may very well excuse the delay. This means that if the price of a necessary component part jumps precipitously, a Chinese court might very well excuse the Chinese supplier for substituting in a cheaper part. Many times, Westerners ascribe Chinese court rulings to corruption, when they very well might have been due to equity.

I also read, in other articles, that a Chinese supplier, when accused of shipping substandard quality (whether a contract has been signed or not), can argue that the price was too low to respect his commitment. And this type of defense is actually effective in Chinese courts!

The takeaway, in my view, is this:

• Enforceable contracts are advised when large sums are at stake (even if you don’t go to court, it gives you leverage against your supplier in case things turn bad).
• To do this, you should definitely consult with a specialist of China law (who will know how Chinese courts get to their conclusions)… Not the usual lawyer that takes care of your business back home.
• Instead of giving a few large orders, try to reduce risks by giving smaller orders, to several suppliers if possible. And inspect product quality as early as possible, to detect issues and have time to react to them.
• Tie payments to quality confirmation… And, generally speaking, keep as much leverage as possible to keep your suppliers in line.

China Business Success Stories just posted an interesting article entitled What Do We Mean By ‘Trust’ In China? by Frank Gallo.
Nothing really new, actually, when you consider all the business books already written about China. But it is a good summary of several important differences between China and what we call “the West”. Two parts of this article got me thinking about the implications for importers.

About written contracts:

In the West, such a document is binding between people and organizations. A Westerner trusts that if such a document exists, then both parties will do all that they can to honour it. If one party cannot honour their part of the agreement, then some form of compensation must be paid to the other party to make up for not doing what was stated. In Chinese culture however, such an agreement is often just a memorandum explaining intentions and not a binding document at all. In China, if there is a problem with the agreement, both parties will often work things out informally until there is a new agreement.

That is very true. Exporters who understand what a contract means for their customers tend to say “we’ll do our best, don’t worry”. It actually means “we understand what you want, and we’ll work in that direction, but please don’t expect any guarantee”.
Another consequence: importers should define the specifications of their product very precisely, and then stick to it. The supplier might not respect everything, and might expect some “understanding” from the buyer. That’s why importers should do all they can to confirm that the product specs are achievable in bulk production. And they should confirm the supplier’s understanding that the specs are not negotiable down the road. It is their responsibility.

About telling the truth:

Often, employees in China will sacrifice truth in order to be courteous. Both cultures are truthful and both cultures are courteous. But Westerners are more direct and therefore more willing to get to the truth at the expense of courtesy. Chinese, on the other hand, are more likely to circumvent a direct response in order to allow everyone to save face.

This is so true… I saw importers urging their suppliers to let them know if the factory notices quality issues during production. It seems to make sense: in that case, the importer can estimate the gravity of the problem, and either accept it or suggest a way to re-work the goods this time and avoid it next time. However, suppliers usually don’t respect this guideline, and big issues get caught during a final inspection. Why? Sometimes their QC systems have just not stopped the problems. Sometimes the factory workers see them but would not speak up. And sometimes the salespeople actually know about it, but they don’t pass the info to the buyer.
This is the reason why inspections should often take place during production. Yes, the supplier is supposed to keep his quality under control. But no, most of the time he can’t be counted on to do the necessary. Chinese vendors tend to hope that a final inspection will not reveal the issues, or that the buyer will be in too much of a hurry to block the shipment at the last moment.

One word of caution, though. More and more exporters are used to dealing with foreigners, and they don’t fall into these traps. The sad thing is that factory employees are not in contact with foreigners, and there is very little progress–if any–in the way they do their work.