Avoiding the Pitfalls of Sourcing in China

by Michael Bloom

Chairman, Offshore Solutions, Inc.

Considering sourcing in China? China offers raw materials, inexpensive labor and engineering skills. Then why do so many projects fail in China? Learn how to recognize the pitfalls of sourcing and then overcome them, how to organize a project, choose a manufacturer, and deliver high quality product to your loading dock on schedule.

For U.S. manufacturers to remain competitive they must combine the best of American technology and advanced products with components built at lower offshore labor rates. “Purchasing Agents” are now becoming “Offshore Sourcing Specialists”. These buyers are looking for manufacturing capabilities that offer low production costs with as few drawbacks as possible.

Mainland China offers one of the best environments for offshore sourcing. In this paper we will explore the advantages and potential pitfalls involved in manufacturing in China and provide practical advice on how to proceed with a first sourcing project. The information provided is the result of more than 10 years of experience assisting companies with this process.

Why China?

Obviously there are many countries that are candidates for overseas sourcing. China, however, combines advantages that are unique to the world’s most populous nation. These include:
• One of the world’s lowest labor rates ($100 – $300 per month)
• Abundant indigenous raw materials
• A well developed industrial base
• Aerospace and defense industries that are technology drivers for the industrial sector
• A mature communications and transportation infrastructure
• A stable economy

Labor rate. The wage rate paid by Chinese companies ranges from $100 per month to $300 per month for labor ranging from blue collar assembly to white collar engineering. This is the labor rate that is calculated into the cost of the product. Foreign owned Joint Ventures (JVs) pay the best salaries and positions with JVs are highly coveted.

Abundant Indigenous raw materials. Most raw materials you will need are available in China as native products. For example, natural rubber, steel and aluminum are all native. However, due to the growth in the Chinese economy, even native materials are often insufficient to meet the demand, so China has become one of the world’s major importers of scrap iron, aluminum, copper, and steel.

Well developed industrial base. Since China was isolated from trade with the west from 1949 until the beginning of President Nixon’s ping pong diplomacy in the 1970s, China developed a highly self-sufficient industry. Aided by the Russians during the 1950s and 1960s, many large industrial facilities were built. From the perspective of a western observer there seems to be an amazing variety of factories that make the same kinds of industrial goods found in the U.S.

Aerospace and defense industries. Spurred by a need to develop militarily, China built many factories that are “mil-spec”. Certain regions of China, such as inland Szechuan and cities such as coastal Dalian are particularly noted for these plants. As the military standoff with the Soviet Union faded, China converted many of these factories to civilian production. Mature communications and transportation infrastructure. Ten years ago, telecommunications with China was fraught with problems. Phone lines were scarce, connections noisy, and costs almost prohibitively high. Now fax and voice communications between the US and China are cheap and reliable. Connections via Internet are becoming more common, dropping costs substantially. Lack of roads was a problem but now many superhighways are in place or under construction between metropolitan hubs. Ocean shipping from coastal cities is fast and reliable with typical transit times of 21 days to US west coast ports .

Stable economy. The Chinese economy is surprisingly stable. For example, although China has experienced periods of high inflation due to double-digit growth in its economy, export prices have remained surprisingly stable. By international agreement, the ratio of Chinese Renmenbi (RMB) to the U.S. dollar is held fairly constant. Quotations to US companies are almost always in US Dollars.

What Products Are Available From China?

This is a very difficult question to answer. Unlike the U.S., there are no comprehensive directories, like the Thomas Register. There are efforts underway to supply this kind of information through internet sites organized in China. In the US, factories are organized horizontally; that is, a manufacturer of watt-hour meters will buy the cast parts from one factory, the plastic parts from a second, and the glass parts from a third. In China, the watt-hour meter factory is likely to set up a casting workshop, a plastic injection molding workshop, and a glass workshop, as well as a tooling workshop to build the molds and jigs that are required. From a US perspective this factory is not only a good candidate for watt-hour meters, but also for the production of cast, plastic, and glass parts, or for the production of production tooling!

It is probably easier to define the range of available products by identifying those products that are not good candidates for Chinese production. Products with high labor content are better candidates than those with low. For example, machined castings are more likely to demonstrate greater cost savings then extrusions whose production is highly automated. The other limiting factor is technology. Generally speaking, in any given technology, China is one or two generations behind, so looking for a leading edge sub-micron integrated circuit is not likely to be successful. As a general rule, you won’t know if a product is available in China until you try to source it. And even then, you may be left wondering.

How Will Chinese Sourcing Affect Costs?

It is not unusual to see savings of 20-50% on production costs and more than 50% on tooling costs. The extent of savings is further complicated by the process at which the final price is arrived at. In the US there is generally limited negotiation in the area of price. In China the process of arriving at the final price is a ritual. The first price offered often bears no relation to the cost of production. It may just be an arbitrary price arrived at through guessing what the “traffic will bear”. Often, the Chinese see U.S. companies as having very deep pockets. Do not expect the first price offered to be the final price and do not lose patience. After you receive the first offer, be prepared to respond with an explanation of why that is not acceptable! A reasonable negotiation might include a discussion of domestic pricing and the need to see a cost savings of X percent in order to consider using a Chinese source.

Even more than in the US, you can expect to see a wide variation in prices between factories as they respond to identical Requests for Quotation. This variation could be due to the nature of the factory:
• rural vs village vs large city
• government owned vs Joint Venture vs entrepreneurial Chinese owned
• manual controlled equipment vs semi-automated vs CNC
• growth minded vs short term profit minded management

Also, the actions of an Import/Export company involved in the transaction will affect the price. None but the largest industrial concerns are authorized to do direct export and exchange currencies. In most cases, a government-authorized Import/Export company handles this. Some I/E companies take little or no profit from a transaction, being satisfied with profits from the currency exchange and receiving government encouragement to maximize the flow of dollars. Some extract a high profit. The bottom line, however, is that with patience, the world’s lowest costs can be achieved through this negotiating process.

Taking the Direct Approach

Some US companies have achieved remarkable success by working directly with Chinese factories. Unfortunately, this has been the exception rather than the rule. There are a number of reasons for this. First, trying to locate the right factory is exceedingly difficult. There are too many and they are scattered too widely geographically. To achieve the best price, it is important to select several factories so they can compete with one another. This means you really need to select several good candidates.

Assuming you have managed to select the best factory and negotiate an acceptable price, how will you supervise the quality of the production? Experience demonstrates that it is crucial to either have your own representative on site, or at least set up a monitoring program. It is not that the factory is dishonest, but its standards are likely to be different from yours. We’ll say more about quality later. If you do have a quality problem, and defective goods ultimately arrive at your shipping docks, you will find it expensive, if not impossible, to get a refund or correction. Unless you are willing to set up your own purchasing and quality control organization in China the direct approach is not advised.

Using Third Parties to Aid in Purchasing

Third parties can be very helpful in advancing sourcing projects while providing protection and value added services. The ideal third party would have the following attributes:
• Offices in the US and China
• Native Chinese engineers and negotiators in China
• A U.S. based engineering staff to support the technical communications with you
• A program in place to assure quality
• US and Chinese based logistic support for shipping, customs clearance, and warehousing
• Legal recourse and product liability insurance in the US

Offices in the US and China. A company based solely in the US is unlikely to produce the same results during the negotiating process as a company with on-site negotiators. One of the arguments for going “Direct” is the expectation that a direct negotiation will produce lower prices than using a third party since the third party will take some profit. However, this is not typically true. A good on-site negotiator, armed with knowledge of the culture, long-term experience with the factory, and a portfolio of projects completed and under way is almost guaranteed to get a better price. Sourcing cannot be done well at a distance . it requires face-to-face meetings.

Native Chinese engineers and negotiators in China. Communications takes place on many levels: verbal and non-verbal. US based negotiators, even in face-to-face meetings with Chinese counterparts, are at a disadvantage. The best results are achieved when Chinese negotiators, working for you, understand your goals, are given the broad parameters, and are set free to accomplish the goals according to Chinese precepts.

U.S. based engineering staff. As in most of life’s complex activities, given the opportunity for something to go wrong, it will, and at the most inopportune time. It is exceedingly frustrating to work directly with China via phone, fax, or email, and not have someone to talk with during your working hours, or to have to communicate with someone who speaks English haltingly. A U.S. based third party provider avoids this problem.

Quality assurance program in place. Even more than in the US, assuring quality from China requires constant vigilance. The quality program should demonstrate to your satisfaction (see below) before engaging the services of a third party. U.S. and Chinese based logistics. There is a lot of detail work connected with the importation of products from China. Errors in documentation can cause significant delays and can be rather expensive. The third party provider should be well versed in these issues and should not merely tell you to “call your customs broker”. Some third party providers can handle the transaction from shipping, through customs clearance, to surface shipping to your receiving docks. Some can even provide warehousing and provide JIT and Kanban delivery to your production line from their warehouse.

Legal recourse and product liability insurance in the US. In the US, we have a legal system that protects both sides in a contract dispute. Under pressure from the World Trade Organization, a group in which China seeks membership, China’s legal system is improving rapidly. However, litigating in China is still a quagmire. However, if you work with a third party who takes legal title from the Chinese manufacturer and then re-sells to you, you then have legal recourse in the US in any dispute that may arise. Also, considering the litigious climate in the U.S. purchasers are often concerned about product liability insurance. Such insurance is not offered by Chinese factories, but may be offered by third party providers.

These are, in our opinion, the ideal attributes of a third party provider. Such providers are not easy to find. In many instances, the third party is nothing more than a broker. If you use the above criteria, you should be able to adequately screen the companies offering such services.

Having selected the factory (either directly or through a third party) and having negotiated a price next comes a discussion of terms.

Payment and Shipping Terms

If you purchase directly, you are likely to be asked to pay using a Letter of Credit. While a substantial discussion of L/Cs is beyond the scope of this paper, suffice it to say that L/Cs are payment documents prepared by your bank that provide payment protection to both parties. In most instances, funds are transferred when goods are loaded on a vessel and the factory presents shipping documents to its bank. The downside is that money can be tied up for long periods of time and the process is complex and time consuming.

If third party providers are used, better terms can sometimes be negotiated. This is due to the nature of the relationship between the third party and the Chinese factory or Import/Export company. The Chinese side “trusts” the third party to stand behind the purchase and make payments. The terms may include some prepayment before shipping and payment of the balance when the goods are received and inspected, thus protecting the Chinese side financially and the US side quality-wise while depending upon trust on both sides. Beware of paying 100% of tooling costs up front; payment should be no more than 50% with placement of the order, with the balance due upon approval of tooled samples. A third party provider may provide conventional payment terms such as Net 30 while providing recourse for product-based disputes.

Shipping Terms

One way or another the customer pays for shipping, insurance, customs brokerage, duty, and surface shipping, plus miscellaneous charges such as port fees. The only question is who advances the funds and at what stage. Of course the simplest way is to insist that good be priced delivered to your loading docks (“FOB Shipping Dock”). However, other shipping terms, beyond the scope of this discussion, may be acceptable and provide cost savings.

Duty Payments

China now has permanent Most Favored Nation (MFN) status. This means that China has the same normal status as all other countries, except for pariah countries such as Libya, Syria, etc. As a rule, the duty will amount to between 3 percent and 7 percent depending upon the Customs Classification of the product. The US Department of Commerce publishes these Unified Tariffs. Payment of duty can be deferred by storing the imported goods under bond in a Foreign Trade Zone. Further, certain FTZ’s are granted authority to import goods with duty based upon the manufactured cost, rather than the invoice cost, thereby saving considerable duty.

Quality . Quality . Quality

If quality control is not properly addressed, the sourcing project is almost guaranteed to fail. At the early stages of negotiations you should make it clear to the factory what the quality issues are. Besides the usual issues of dimensional tolerances, you should discuss surface finishes, weight tolerances, standards (such as UL/CSA approval), metallurgical considerations etc. These should be clearly stated in writing. Increasing numbers of Chinese factories are achieving ISO9000 certification. However even factories that are not ISO qualified are often willing to learn and implement Statistical Process Control (SPC) methods if taught. It is suggested that SPC documentation be submitted with each shipment and that an AQL level be specified.

A third party provider can help greatly in assuring the integrity of the quality control process by performing on site quality audits. An in-depth audit can verify that quality control processes are in place and that they are being adhered to. The third party can provide a layer of surveillance over and beyond what the factory can provide. Some providers use test labs in the U.S. to verify that customer specifications have been met. Third party providers can also perform random samplings on production lots prior to shipment to guarantee that defective products are not shipped. A word about on-site monitoring. Chinese cultural norms make it very uncomfortable for a Chinese engineer or manager to verbalize negative feelings or admit problems. Production issues and delays occur that are not admitted by the factory. This is another argument for on-site monitoring by a third party.

Developing the Relationship

Doing business in China is all about relationships. This cannot be overstressed. There may come a time when you or someone on your staff will want to visit the factory. If you are working with a third party provider it should be clear that at some time you will want to have this direct contact. The third party may be reticent out of fear that the customer may try to circumvent him and cut him out of present or future transactions. This is a legitimate concern. If you use a third party you should be absolutely clear that even if you are given access to the factory that you will only communicate with the factory to the extent permitted by the third party. It is customary to sign Non-Circumvention and Non-Disclosure agreements in these circumstances.

Intellectual Property Rights

China has been, until recently, notorious for violations of intellectual property rights, especially in the area of recorded music and software. From personal experience, we can say that we have observed the disappearance, in China, of bootlegged tapes, compact disks, and software; first from major cities and then from smaller ones. In order to enter the World Trade Organization, China has had to promise to protect intellectual property rights and to obey patent conventions. On a practical level, Chinese factories do not usually copy industrial components and subsystems and then try to market them. They do not take these kinds of entrepreneurial risks.

Getting Started

Like anything else in life, the first step is the hardest. First, choose just one or two components for sourcing. These parts should be carefully selected according to the following criteria:
1. Pick a part where a price reduction will have a major impact. This way, success with this part will be a demonstrable coup for your purchasing group.
2. Pick a part that is mature and has been in production for some time; do not choose a new part.
3. Pick a part that is now being successfully produced by a domestic supplier. If your Chinese sourcing project is successful you can ramp up the Chinese supplier, ramp down the current supplier, and maintain smooth production.

Submit the drawings, estimated annual usage and quality concerns to the factory or to the third party provider. Submit multiple examples of samples, if possible, so that each of the Chinese factories under consideration can work with a sample. If you have promotional literature that tells about your company and its market, send that along too. Chinese factories love to hear that its project is an essential part of a major American enterprise and this may get your company more attention.

It’s All Worth It

Offshore Sourcing is no longer a choice, it’s a necessity. Although it has its risks, there are methods for beginning the process that minimize the risks, and offer a good chance for success. Earlier we suggested a simple safe way to begin the process with a single project or two. As you see the fruits of your labors entering your manufacturing stream as low-cost high-quality components, you will quickly climb the learning curve that makes the next project far simpler. Soon, you’ll become expert at recognizing opportunities for offshore sourcing. Now is the time to start developing that first project and the key relationships for the future.