TROUBLE IN THE WORKSHOP
Product recalls of made-in-China goods are not the only problems rattling global supply chains. A strengthening renminbi and Chinese policy changes could be equally disruptive.
By Russ Banham and Cesar Bacani

Is it really worth it? From tainted pet food, seafood, and toothpaste to unraveling tires, exploding cell-phone batteries, and lead-painted children’s toys, defective products from China are giving companies and consumers around the world second thoughts about the benefits of China’s low-cost manufacturing.

In May, two brands of Chinese-made toothpaste were pulled from shelves in Panama because they contained small amounts of diethylene glycol. The chemical was blamed for around 50 deaths in the country last year; the cough syrup that caused the deaths used diethylene from China as a suspension agent instead of the usual—and more expensive—glycerine. In July, the Philippine Bureau of Food and Drugs ordered the withdrawal of four Chinese-made biscuit and candy brands, including White Rabbit Creamy Candy, a staple of many an Asian childhood. The agency said the products contained formaldehyde, a disinfectant and preservative classified as a probable carcinogen if ingested.

In August, U.S. toy giant Mattel announced that its Fisher-Price division was recalling nearly 1 million toys—83 products—that were finished with lead paint, which has been shown to delay development in children under the age of six. All were made in China. In June alone, 68,000 folding chairs, 2,300 toy barbecue grills, 1.2 million space heaters, 5,300 earrings, 19,000 children’s necklaces, and 1.5 million Thomas the Tank Engine toys were recalled. All of them were stamped “Made in China.” A staggering 60 percent of all product recalls have been traced back to the country, according to the U.S. Consumer Product Safety Commission (CPSC).

Yet by and large, companies and the consultancies they hire to evaluate sourcing opportunities in China continue to say that the risk of recalls is worth taking. “If you manage and maintain quality in your sourcing operation and invest in it, the benefits are too large to ignore,” argues Bill Ferko, vice president and CFO of Genlyte Group (2006 revenues: US$1.5 billion), a U.S.-based manufacturer of lighting fixtures that sources components, sub-assemblies, and finished products from more than 20 factories in China. Indeed, in the latest Duke University/CFO Business Outlook Survey, fully 92 percent of CFOs in the United States said the recent problems with exports from China are not causing them to reevaluate their company’s supply chain risk.

But they may eventually have to do just that. China’s toy, garments, food and other low-value exporters are under extreme pressure. A strengthening renminbi is cutting margins, even as incessant demands for lower prices and stretched out payment terms from overseas buyers take their toll. And the Chinese government is no longer supportive; it is trimming rebates on value-added taxes paid on low-value goods (see “VAT, Me Worry?,” next page). “I’ve been through three cycles like this since 1984,” says Steven Dickinson, a lawyer with U.S. law firm Harris & Moure who has been working with Chinese enterprises for decades. “Each time, the price pressures got so intense that certain people just couldn’t make it anymore, and so they did a final, desperate, terrible thing to make enough money to pay their last payroll, and then they just went out of business.”

Systemic problems

There is no mystery why businesses flock to China: the country’s giant workforce churns out nearly a trillion dollars in goods and services at a labor cost that would be illegal in the United States or Europe. Typically, an American factory worker costs an employer US$15 to US$30 an hour; a Chinese factory worker, by contrast, earns less than US$1 an hour, according to Boston Consulting Group (BCG).

Even if wages in China were to increase at a 15 percent annual rate over the next five years and rates in the United States were to increase at a 3 percent to 4 percent clip, average hourly wages would be a scant US$2 in China and US$18 to US$36 in America. While currency exchange rates play a role in this calculation, BCG says even a four-fold strengthening of the yuan against the dollar would still make wages in China half what they are in the United States. Small wonder that China currently provides 40 percent of U.S. consumer imports, nearly US$250 billion worth of goods annually.

The product recalls have caused some to call for drastic measures. “China is generally competing on price, not on quality or safety or the integrity of the supply chain,” claims Pietra Rivoli, a professor at the McDonough School of Business at Georgetown University and author of the book The Travels of a T-Shirt in a Global Economy. Expecting the government of China to solve manufacturing quality issues for importers is quixotic, she says. “There are few, if any, safety nets.”

For example, China has no equivalent to the CPSC. While the government has promised stricter enforcement of regulations, stepped-up inspections, and more punitive actions against makers of sub-standard goods, it also has intimated that the recent debacle surrounding product quality was exaggerated by the foreign media. “The country’s usual response to a scandal is to find a scapegoat,” Rivoli says, pointing to the recent execution of the head of China’s food and drug administration, Zheng Xiaoyu, convicted of accepting bribes linked to sub-standard drugs.

“Officials don’t want to admit the fallibility of the system, because that hurts their power,” adds Rivoli. “They’d rather find fallibility in an individual.” Nevertheless, she says, the recent recalls “are not isolated problems of product quality. They’re systemic.”

A recent nationwide survey of food, drugs, and consumer products by China’s General Administration of Quality Supervision, Inspection, and Quarantine backs her up, finding that 20 percent were substandard or tainted. For example, more than 23,000 cases of low quality or fake food were uncovered, requiring the closure of 180 food factories. The results were often shocking: bread with 50 percent paper-pulp content, pigs fattened on force-fed wastewater, lard made from sewage.

The revelations have taken the gleam off China’s low-cost labor for some. “Companies must move away from an all-China, all-the-time sourcing policy,” insists Paula Rosenblum, managing partner of Retail Systems Research in the United States. “Continual and increasing dependence on China as the sole source for manufacturing is a mistake waiting to happen.”

View from the ground

On the factory floors, though, many sourcing specialists tell a different story. Despite the wave of product recalls in recent months, they maintain that most manufacturers in China are sophisticated enterprises, with years of experience serving Western needs. “Since China joined the World Trade Organization in 2001, they really do get it—‘it’ being the need for product quality and safety,” says Alan Schoem, senior vice president in the global product risk practice at insurance broker Marsh, and formerly the head of the compliance office at the CPSC.

Others concur. “Thousands of American companies import millions of different products every year from China that are of the highest quality and safety,” says Gene Rider, vice president of global retail services for Intertek, which assists companies by monitoring foreign-supplier quality and safety. Asked to explain the high rate of product recalls, Rider notes that not all the recalls were for manufacturing defects. “On average, two-thirds of the recalls were the result of design defects,” he says, “and you can’t blame China for that.”

A new study buttresses this claim. Hari Bapuji of the Asper School of Business at the University of Manitoba and Paul Beamish of the Richard Ivey School of Business at the University of Western Ontario examined product recalls in the United States since 1974, which involved over 680 toy products. They concluded that 76.4 percent of all the recalls were due to design flaws such as sharp edges that pose laceration hazards and small detachable parts that may cause choking if swallowed. Only 23.6 percent of the recalls were attributed to manufacturing problems such as poorly fitted parts that break, batteries that overheat, and the use of unacceptable chemicals like lead paint.

Rather than trim their sourcing from China, many companies expect to increase it. “Forty to 50 percent of our sourcing on behalf of our customers is from China, compared with 30 percent five years ago,” says John Caltabiano, vice president of sourcing at Solectron, an electronics manufacturing services provider. “We expect this to grow.”

But Caltabiano acknowledges the concern over product quality. “The recent quality lapses of products made in China are alarming and should be of great concern,” he says. “However, the electronics industry is well established in China, and the components being manufactured in China are not life-threatening issues.”

Genlyte has no plans to reduce its dependence on the 20-plus factories in China it sources from. “We’ve been manufacturing in China for 20 years, and many of our suppliers have been with us over that duration,” says Ferko. “To ensure quality, we have a small staff of indigenous contract employees in China that works exclusively for us. We’ve trained them to identify quality issues and to maintain our standards, working closely with suppliers to ensure they understand our definition of quality and confirm that the products meet our specifications.”

Ferko says the defect rate for Genlyte products made in China is less than 0.02 percent, consistent with the defect rate for its U.S.-manufactured products. “We go through an exhaustive pre-screening of all our contract manufacturers, most of them located in South China’s Guangdong region,” he says. “We check their reputation, ask for references, and see if they’ve done similar work to what we want them to do.” Ferko says Genlyte weeds out manufacturers that it believes will not maintain consistent quality standards or always look out for Genlyte’s best interests. “We haven’t had any significant problems over the years,” he says.

The same can be said for Arrow Electronics, a New York-based global distributor of electronic components and computer products, with US$13.6 billion in 2006 revenues. Arrow has sourced products and components like semiconductor chips from China for the past 15 years. “We purchase only from known suppliers and then do standard things like get trade references and cross-check them,” says CFO Paul Reilly. “We also check their banking relationships, and talk with trade associations and government bureaus. We see if they have global certifications like ISO 9000, and we’re big believers in physical on-site inspections and regular testing.”

Arrow has developed a broad list of performance metrics in its contractual agreements with Chinese suppliers. “The recent scandals made us stop and think about the challenges of ensuring quality products not just from China, but from everywhere else in the world,” Reilly says. “While we expect to increase our vigilance, we have not had quality issues emerge from the suppliers we deal with.”

Before making its sourcing decisions in China, Solectron looks at four supplier capabilities: manufacturing and quality systems, ownership structure, financial backing, and localization. Doing the evaluations are local quality engineers, commodity managers, and financial analysts. “They’re our employees, and they’re located in Shanghai, Beijing, Shenzhen, Hong Kong, and elsewhere in the country,” Caltabiano says. “The commodity manager looks at the supplier’s ability to meet our cost requirements; the quality engineer evaluates technical expertise and then tests and audits this; and the financial analyst examines financial backing, credit, and ownership structure.”

Surprise, surprise

A key practice in evaluating supplier quality is unannounced inspections by an in-house staff like those employed by Arrow, Genlyte, and Solectron, by an independent testing agency like Intertek, OnSpex, or Bureau Veritas, or by supply-chain specialists such as Li & Fung, Noble Group, and Global Sources. “We’ve got 19,000 people on the ground in more than 100 countries involved with thousands of vendors every day,” says Rider from Intertek. “All of them are local, but they’re our employees, many of them trained in the West. We don’t use expats, because they don’t understand the culture or the working environment. In China, [our employees are] all Chinese.”

Intertek evaluates and measures critical control points in a supplier’s manufacturing process, and certifies that the factory is doing these evaluations and measurements itself. The agency also samples products, literally taking them apart for so-called destructive testing. “If you do a sufficient number of tests that are representative of the population of products produced, following established statistical protocols like ‘one-hundred-parts-per-million,’ you get a pretty firm grasp of quality,” Rider adds.

Ann Chen, a partner in the Hong Kong office of consultancy Bain & Co., who heads up the firm’s consumer-products practice in China, agrees that a combination of explicit rules of engagement, codified processes, surprise spot checks, and investments in internal or outsourced inspection programs can pare supply risks to a minimum. “It all starts with a very high hurdle in terms of qualifying suppliers,” Chen says.

She advises companies to consider a “probational” period before engaging a supplier and interrupting it with a random inspection by a third-party testing organization. “Have a list of things to test for that are very explicit, and a clear policy of [contract cancellation] based on violations,” she says. “You need to set an example that there’s zero tolerance for people who don’t follow your policies. If they pass, then constantly go back to square one in terms of requalifying them.”

Adherence to stringent supply-chain risk management is the antidote to product defects, the experts contend. “There are some great companies with unbelievable capabilities in China, but they vary by region and experience,” says Caltabiano. “If they’re brand new, they’re likely to not know what they’re doing. But the companies with a solid track record, and strong management involvement and commitment to provide oversight and manufacturing controls, are well worth the investment.”

Beyond the a-ha

Still, quality programs are not infallible. Mattel, after all, not only had quality controls, but had also worked for 15 years with the Chinese plant that made the lead-painted toys. “They understand our regulations, they understand our program, and something went wrong,” CEO Robert Eckert told the New York Times in August.

In testimony before a U.S. Senate sub-committee the following month, he blamed subcontractors in China for the recent problems. From now on, Eckert promised senators, Mattel will ensure that all paint used by its manufacturers is purchased from a certified supplier and retested before use, that subcontractors and vendors store Mattel products separately from other goods, and that finished products are subjected to further retesting.

Later, Eckert told the Chinese that most of the recalls were due to design flaws that were Mattel’s fault. Manufacturing mistakes were only a minor part of the problem, the company admitted, in an apology of sorts that highlighted China’s importance to Mattel as both a production center and a market for its toys.

Kent Keidl, general manager in Shanghai of Technomic Asia, a strategic consultancy firm, argues that those at the apex of supply chains need to do more. “Many companies got so excited about low costs, but I think prices all across the chain have been unnaturally low,” he says. “They need to take more responsibility for the health and wealth of their suppliers.” Chinese companies tend to absorb the added costs instead of passing them on to the rest of the chain. “You’ll never have a Chinese company tell you ‘no’,” adds Keidl. “They’re used to living with thin margins and will find a way to make money.”

“The Mattels and Wal-Marts are putting price pressure on their Chinese suppliers,” says Dickinson, the lawyer. “It’s not so much that you’re complacent because you’ve worked with your suppliers for 15 years. You know what you’re doing to these people and you should expect these things to happen, and they’re starting to happen because the price pressures are so intense and they can’t survive anymore.” The multinationals, he says, must realize that “this relentless drive to push price down to the point where your suppliers are going out of business on a regular basis is not a long-term sustainable business model.”

Might multinationals begin withdrawing from China? “I don’t think we’re going to see a massive shift,” says Keidl. “Right now, the companies are so deeply involved in China that to move it over to Vietnam, say, at a moment’s notice is going to be impossible.” Eventually, though, he believes that companies will begin looking at other countries as alternative major sources, not just as back-up satellites as part of a China-plus sourcing strategy. “And that’s healthy,” says Keidl.

The fact is that China is emerging as a market in its own right. Wal-Mart itself now has 78 Supercenters, three Sam’s Clubs, two Neighborhood Markets, and 101 Trust-Mart centers (operated by a 35 percent-owned subsidiary) in 34 cities across China. Some of Keidl’s clients had originally come to China only to source low-cost goods. “They have now realized that there’s a vast market here,” he says. “Where before, coming to China was just a cost-savings strategy, it is now also a revenue growth strategy; they’re growing the bottom line and the top line at the same time. This is how China should have been looked at from the very beginning.”

All the more reason for the Mattels of the world to come to grips with their made-in-China product quality problems as soon as possible.

Russ Banham is a contributing editor of CFO in the United states. Cesar Bacani is a contributing editor of CFO Asia