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by Stanley Chao

 

With the recent quality problems in China--contaminated pet food, toys tainted with lead, and poisoned toothpaste--the U.S. media have become quick to blame the Chinese as “cost-cutting, get-rich-quick cheaters.” At first glance, the accusations seem justified. The Chinese are killing pets and risking children’s health to make a few pennies more. But these knee-jerk reactions are too simplistic. Two parties make up a transaction, and we forget the responsibilities of the purchasers, the U.S. companies. They should look at themselves and make drastic changes to their outsourcing policies. These mishaps will serve notice to U.S. companies to revamp the selection, screening, and auditing processes of their Chinese suppliers.

Most companies, big and small, meet Chinese suppliers at trade shows or through the internet. The subsequent cursory “due diligence” process includes phone calls disguised as quality inspections; testing handpicked, pristine samples; and an on-site factory tour where more time is spent sightseeing than “factory-seeing.” Finally, a contract is drafted that is neither enforceable in China nor understandable to the Chinese partner. These practices, though well-suited for noncritical components and products, should not be implemented for electronics, medical disposables, toys, and foodstuffs.

Before seeking a Chinese supplier, companies should learn basic Chinese business principles. These are based on a combination of experience and knowledge of the Chinese culture and mentality. Though not comprehensive, these recommendations will allow any U.S. company to develop successful outsourcing relations with the Chinese.

Unenforceable contracts
Importers have virtually no legal recourse in China’s court system. With domestic crime growing at double digits and myriad social problems, China’s courts are not interested in white-collar crimes or recuperating foreigners’ lost profits. Furthermore, the judicial system is undergoing major changes as it evolves from communist law. Issues like patents, copyrights, and trademarks are just starting to get attention.

What does this mean for U.S. companies? Contracts are useless in China because they are not enforceable. Chinese companies know this. Contracts are important but must be written in such a way that U.S. companies can enforce them on their own, not rely on a formal judicial system. The contract should include only items that can be self-enforced or confirmed by third parties.

An orthopedic joint-replacement manufacturer instituted unique methods to control and monitor its component suppliers. The U.S. company had many fears about working with new Chinese suppliers: sourcing of alloys from approved vendors, 100-percent component testing, accuracy of the test equipment, and competency of the technicians.

To enforce quality standards, Chinese suppliers submitted raw-material invoices, purchase orders, and bank receipts to the U.S. company to confirm that they were purchasing from approved vendors. The company then purchased test equipment and set up a new test facility specifically for its Chinese supplies. The laboratory was owned by the U.S. company but used by the Chinese for the sole purpose of testing the company’s orthopedic components.

During the initial production phase, U.S. engineers stationed in China hired, trained, and managed experienced staff on behalf of the Chinese company, implementing the U.S. company’s own test procedures with translated manuals. It also hired an independent government medical laboratory for 100-percent verification along with its own incoming inspection at its headquarters. To further emphasize quality, the U.S. company awarded financial incentives to its suppliers for exceeding specific quality parameters.

A contract’s purpose is different to the Chinese than it is to Westerners. A signed agreement serves two primary functions for Chinese companies. First, the contract shows good faith and trust in wanting to do business with the partner company. It’s a symbolic gesture or an extension of the personal bonding. Along with the dinners, social drinking, and karaoke, the contract is an act of friendship.

A U.S. energy company signed an agreement with China’s third-largest solar module manufacturer. The supplier could not deliver its first order because it lacked the necessary equipment to perform the required quality tests. Also, the company could not produce certain module sizes and power capacities. The U.S. company was dumbfounded; why sign a contract when the manufacturer knew that it couldn’t meet product or test specifications?

The solar company responded, “The contract shows our friendship and loyalty to our customer. We have good intentions and planned to do the testing in the future. We never intentionally mislead our American friends. It’s the opposite--we want to be friends first, and business partners second.”

Second, Chinese see the contract as a commitment to the terms but only under current market conditions. As market situations change--for example, if there are raw-material shortages or if demand increases--the Chinese feel that they have the right to make changes. In their eyes, it’s not fair to be tied down when business is constantly changing. Likewise, they don’t feel offended if U.S. companies make changes. To the Chinese, the contract is a moving target that both sides monitor and negotiate as market forces change.

As an example, an enterprise software vendor signed a contract with a major Chinese distributor. The payment terms were clear, that product would be delivered only after funds were wired to the United States. After the contract was signed, however, the Chinese government temporarily halted foreign transactions to stabilize its currency. The distributor asked for payment terms, citing the recent government actions that were out of its control. The software vendor refused the request, and they are no longer working together.

The distributor commented, “I don’t know why Americans are so stubborn about their contracts. Conditions change every day, and we need to adapt to these changes. Relationships should mean more than signatures on a contract.”

In another case, a major U.S. industrial company outsourced cooling towers from China. The Chinese manufacturer stopped accepting new orders, citing increased costs. This wasn’t logical for the U.S. customer. The manufacturer signed a contract to deliver product at a specific price for a specific time and, according to the customer, the Chinese company should adhere to those terms. However, this all made sense for the Chinese. At the beginning of the relationship, steel prices were lower. Later, conditions changed as prices increased, so the Chinese voided the contract. When market conditions changed, they felt that they had the right to demand changes.

The Chinese have another difficulty in comprehending contracts, and this is due to historical reasons. A contract assumes that a third party will oversee the terms. In the United States, we trust this third party, the judicial system, to make a just and impartial decision.

Chinese companies do not trust their government or the judicial system. The reasons date back to China’s Cultural Revolution, when the government was corrupt. The communist government jailed professionals, lawyers, educators, and anyone else thought to be associated with subversive antigovernment activities. Children ratted on their parents, neighbors ratted on friends. Government institutions, banks, courts, and police were all corrupt. People hid their cash under beds for fear that banks would confiscate it. Politicians bribed the courts and police.

Given this scenario, it’s easy to see how the Chinese have a different view about contracts. But to do business with Westerners, Chinese companies must adopt the Western ways. As one toy factory owner said, “I don’t like contracts. I don’t trust our legal system and they don’t know my business, but I do it because foreigners always want it.”

U.S. companies will need to seek other means of protection. Many manufacturers in China are now joint operations between Western and Chinese companies. The automotive, industrial, and medical industries have hundreds of joint operations making components, finished material, and systems. These factories are managed by Westerners, who understand the western mentality and obey contracts. Other Chinese suppliers rely solely on overseas businesses and have geared their quality processes and management teams to meet the demanding needs of their Western customers. Often, these suppliers are government-owned and will not jeopardize their reputation by chasing short-term profits or providing poor quality products.

It’s customary for a Chinese company to squeeze every nickel out of its suppliers, which contributes to quality deterioration. Chinese factories make low bids knowing that they can find ways to recoup the profits. Though difficult, U.S. companies should estimate suppliers’ costs, thus knowing if prices are reasonable. Companies have even tied their suppliers’ profits to quality. Companies assigned different prices to shipments based on the incoming inspection data. Better quality goods render higher prices, with corresponding financial penalties for poor quality.

Successful outsourcing relationships in China have veered away from the traditional buyer-supplier roles. Quality is not just the factory’s responsibility, but a shared duty. Chinese suppliers are still not equipped with the technical know-how and, more important, the quality awareness to produce a consistently high-grade product. They need help. Instead of playing the blame game, U.S. companies should take part in the quality process. Participation can come through long-term training programs or the establishment of a local subsidiary to assist in quality and procurement, helping to create proper supply chain systems.

Assume the worst for best results
As cynical as this may sound, U.S. companies should assume the worst about suppliers and devise preventive measures against worst-case scenarios. What deliberate and secretive acts can ruin the quality of your imports--raw material changes, improper test procedures, reduced tolerances, falsified data?

The Chinese are not unscrupulous or evil, but government and economic forces have created a short-term, profit-at-all-costs mentality. China’s central government is erratic. Companies will enjoy tax breaks, relaxed labor laws, and low pollution standards one day, and then suddenly face currency devaluations, raw material tariffs, or product standards changes. The government acts at its own discretion, and companies must react in the short term to these changes. They need to make money now, knowing that policies may change suddenly.

The Chinese business mentality is still primitive. Most manufacturers know how to make things cheaper, not better. With multiple competitors, shortcuts are taken and quality is compromised. Cutting costs is a short-term strategy. Companies make money now, knowing that the competition will make it cheaper next week. As in Japan and Korea, China will eventually move up the food chain and make quality products, but this takes time, experience, and knowledge.

Knowing that the Chinese will take shortcuts brings up another question: Do the Chinese feel guilty about it? Similar to speeding past a red traffic light, the Chinese view their actions as an innocent crime. So what’s the big deal? Is a little lead paint really going to kill anybody?

Some Chinese don’t know that these shortcuts are illegal or harmful, so it would be unfair to categorize all companies as dishonest. Again, due to cultural and economic reasons, Chinese factories may not know the harmful effects of lead paint. The ages of factory owners or managers are typically in the mid-fifties to late sixties. Most grew up in a time of poverty and hunger, and didn’t even have toys as children. Now as adults they don’t understand the big deal about lead paint. As one manager commented, “Children should just be happy to have good, cheap toys. We had nothing growing up.”

U.S. companies not only need to instruct suppliers on their manufacturing processes, but also explain the reasons for following these procedures. In the past five years, U.S. companies asked suppliers to change from latex to latex-free components. When latex-free material was in short supply, the manufacturers temporarily switched back to latex, not realizing that people were allergic to the material. U.S. companies had never told suppliers the reasons for the change.

Once a company pinpoints potential areas of fraud, they can implement preemptive measures. Similar to contracts, these actions should be self-enforced, measurable, and, if possible, have financial penalties attached.

After several years of poor-quality products, a medical company demanded unannounced inspections, direct relationships with the manufacturer’s suppliers to monitor component quality, outgoing inspection done by its own local quality team, and financial penalties for nonconforming products. These procedures ended the guessing game, and gave no wiggle room to circumvent the system.

An automotive parts company, tired of receiving defective parts, established a subsidiary in Shanghai. With its own staff, the company performed incoming inspections at the supplier’s warehouses. The added costs in establishing a subsidiary were more than offset by the reductions in defective returns, late shipments to customers, and aggravating late-night calls to China.

Speak Chinese only
When choosing a vendor, U.S. companies often view English as one of the major criteria in the selection process. Quality becomes a secondary concern when they find English-speaking employees at a factory. U.S. companies are not worldly enough to adapt to local customs and languages. Rather, they expect foreigners to adjust to them. Foreigners, Chinese included, complain about the “Ugly American,” and the “English-only” attitude doesn’t help this sentiment.

An executive at a U.S. medical equipment company said in a recent trip, “We are the customer, and I expect Chinese vendors to speak English. English is the world’s business language.” This attitude has lead to some of the past misunderstandings resulting in quality-related recalls.

Language will not solve all problems, nor will it prevent a Chinese company from being dishonest. It can, however, provide insight into our Chinese counterparts. Many intangible qualities are revealed when speaking in one’s native language--educational background, social status, and family upbringing. It can also detect behavioral patterns--optimism, doubt, nervousness, or confidence. These clues are not easily observable when the Chinese are speaking a foreign language such as English.

U.S. businessmen complain about the difficulties of analyzing their Chinese counterparts’ personalities or behavioral patterns. This is due to the language barrier. Speaking in broken English will not reveal the true person because he or she cannot express complete and detailed thoughts. Only simple child-like comments can be communicated--not enough to “size up” the person. An ad hoc translator, typically one of the company’s managers, often lacks proficiency and complicates matters.

Conversations in Chinese with one factory owner revealed that he was from a desolate part of China and had no proper education or family upbringing. His demeanor was similar to that of a crook as he cursed and used slang in discussions. All Chinese-speaking members from the U.S. company later agreed to the personality assessment, which was confirmed when speaking to other employees. The non-Chinese-speaking members had no opinion as communication with the owner was limited. It was advised not to do business with him.

A factory tour revealed that the senior managers had a gambling problem and considerable debts to local gangsters. This red flag was only discovered through small talk with factory workers during meeting breaks. Personnel who spoke only English would have never obtained such valuable information.

The ability to speak Chinese has another advantage. Having Chinese-speaking members allows U.S. companies to control meetings. Typically, the side with better language abilities will dictate the agenda, negotiate better terms, and achieve more of their demands. However, companies make the mistake of using translators from local translation firms. They can be used for general business discussions but are not well-versed in specialized terminologies.

A professional translator was used in a plastic injection-molding project, but the native Chinese, having an English and tourism degree, was unable to understand tooling jargon such as “hot runner” or “stack molds.” In subsequent meetings, a Chinese mold engineer who had worked at a Western company translated the jargon.

Having staff that can read and write Chinese is even more valuable than verbal skills. Companies can clearly document their demands without having to use broken English. These documents then become part of the formal contract. U.S. companies will have documents in Chinese and in English. The Chinese contract should be referenced when problems or misunderstandings arise. This leaves no doubt as to the U.S. company’s intentions and procedures.

Reading Chinese is also invaluable in factory audits and inspections. Factory quality documents, test data sheets, inspection reports, and government-related specifications are always in Chinese. To appease Americans, the factories have poorly translated versions that typically leave U.S. auditors confused. Chinese documents, stamped with government-approval seals, are never corrupted because factories can lose their licenses if caught. Translated English documents are not officially recognized and can be doctored without any government penalties. Factories can say that their English documents were incorrect due to translation errors.

Conclusion
China is still the wild frontier, as were Japan and Korea, and it will take a few generations for Chinese manufacturers to think and act like their Western counterparts. Until we reach that point, U.S. companies need skill sets to handle Chinese outsourcing and quality issues. Though nothing will take the place of experience, the issues discussed in this article will help foreigners appreciate the differences in the Chinese and Western business philosophies. Instead of blaming the Chinese for recent quality issues, let’s acknowledge that U.S. companies also made mistakes and look to ourselves in solving the quality problems. Thinking like the Chinese will move us toward this mutually beneficial goal.

About the author
Stanley Chao is managing director at All In Consulting, a company providing outsourcing and product market-entry strategies for the Asia Pacific region since 1999 ( www.allinconsult.com ). All In Consulting specializes in medical, industrial, semiconductor, automotive, and high-tech industries. Its customers include Kingston Technology, Baxa Corp., Nanosolar, Emerson Electric, Intel, Hekuma, and National Technical Systems. Chao has a master’s degree in electrical engineering from the University of Pennsylvania, and an MBA from UCLA. He speaks fluent Japanese and Chinese and has lived in Asia for more than 15 years. Part two of this article will appear in the May issue.