|Guide to Outsourcing|
Originally Published MDDI January 2005
Eight Simple Rules for Outsourcing to China
Companies looking to take advantage of China's increased capacity for outsourcing should also take heed of possible pitfalls in planning.
Ames Gross and Loren Heinold
|Step by step, manufacturers in China are becoming more sophisticated and better able to accommodate the needs of medical device makers.|
Outsourcing medical device manufacturing to China has become increasingly attractive in the last several years. China was once seen as an option for producing only relatively simple medical products. Yet, significant improvements in Chinese manufacturers' sophistication, technology, and—most importantly—product quality have made China much more popular for medical device OEMs. But popularity does not always guarantee an easy process. Finding the right factory can be challenging. There are eight steps that should be part of any medical device outsourcing project for China. These steps, as well as some cautionary advice, are outlined below.
Identify Product Manufacturers
The Internet is being used more readily by Chinese manufacturers as restrictions on import and export rights are relaxed. In the past, Chinese manufacturers used government-approved trading companies to export, so manufacturers often did not have their own Web sites. As restrictions have eased, Chinese companies have embraced the Internet as a tool, and there is now a wealth of information for OEMs looking to build relationships with contract manufacturers in China.
Unlike manufacturers in some Asian countries, those in China tend to be technologically savvy and have user-friendly Web sites. Thus, the first and easiest place to look for potential manufacturers is on the Internet. Chinese manufacturers are increasingly comfortable with international companies. They often use English as their secondary business language, and many manufacturers have fairly well-designed English-language Web sites.
Standard search engines are a good place for an OEM to start because they can provide an initial list of Chinese manufacturers. Many Web sites, especially business-to-business hosting sites, compile lists of Chinese manufacturers and provide information on companies' backgrounds, products, and contacts. These hosted sites can be useful, but they typically list only member companies, and many high-quality Chinese manufacturers may not be listed. Web searches can be used as a starting point; they rarely provide enough information to complete an investigation.
After identifying manufacturers through Internet searches, the next step is to examine those companies' Web sites for more information. Be wary, however, of a Chinese company's English-translation site. A simple glance at the company's corresponding Chinese Web site, even if it can't be read, often reveals obvious differences between the two. Chinese-language Web sites often contain more information—and sometimes significantly different information—than the English-language sites. Ideally, both versions of the company site should be examined by someone fluent in both languages to gain a comprehensive view of the manufacturer's capabilities.
Using the Internet to research potential manufacturers is a basic first step. But it is important to bear in mind that all information on the Web should be taken with a grain—or sometimes an entire shaker—of salt. Some of the most relevant questions are not addressed on home sites or business-to-business listings. OEMs need to take further steps to confirm information that may be misleading or misrepresented on a Web site.
Companies need to ensure that the factory they are considering for outsourcing can actually manufacture the products it claims it can. They also need to confirm essential company details. Some companies claim they've been in business for 15 years, when the anniversary is actually closer to 2 years. Others may claim that an informal contact in South Korea is actually a full-fledged joint venture, in order to appear more legitimate. A factually accurate Web site is the first clue that a company is honest and likely to fulfill its contracts. So by all means, conduct on-line research. But be aware that some of the information may be inaccurate or incomplete.
Initial Planning and Communication
After compiling a list of potential manufacturers, contact the companies. English-language instruction has become widespread in China, and many companies will have someone in their international sales office who can communicate in English. However, not all companies have staff who can speak fluent English, so it is ideal to have someone on your staff who can speak Chinese in an appropriate dialect.
E-mails and phone calls are necessary to establish trust and credibility, and their importance should not be overlooked. However, it can take as many as 10 e-mails and calls just to make contact, and it may take many more to establish trust.
The time difference is often an unaccounted-for hurdle. It is difficult to contact a Chinese business when its hours of operation fall between 9 p.m. and 5 a.m. EST. Be sure to factor in the time difference and allow both companies several months to build trust. It is unrealistic to expect finalized results after the initial calls and e-mails.
When contacting Chinese companies, one of the first and most obvious questions to ask is whether they can manufacture the product to your exact specifications. Some Chinese companies realize that their products will not meet U.S. standards, and they often say so directly to avoid wasting time. However, it is critical to understand that some may claim to be manufacturing the product while making plans to purchase it from someone else, mark up the value, and then sell it. It can be extremely difficult to determine a Chinese company's intentions from phone and e-mail communication, so a certain amount of skepticism is healthy. Although open distrust will not lead to a productive relationship, keep in mind that further investigation is necessary for every business to protect its reputation and the bottom line.
Once you have developed a relationship with the manufacturer selected, the next course of action is getting a price quote. The manufacturer needs detailed product specifications and quantities of each item to prepare an accurate price quote. Be aware that a common problem with price quotes is that they often compare apples with oranges; that is, they often provide prices for products other than the ones you need. If the product is standard, this may not be an issue. But if it has many possible variations, ask for an itemized price quote. Investing time early to ensure that the manufacturer understands what is expected helps companies avoid basing financial projections on erroneous information.
Chinese manufacturers are most familiar with metric units. They may be confused by specifications presented in inches, pounds, or yards. Attention to small but important details, such as units of measure, saves time and energy in getting an accurate price quote.
Ask the manufacturer the price quote's expiration date. After several years of deflation or very low inflation, China has recently seen rising inflation and rising oil prices. Because of this, Chinese manufacturers are often unwilling to guarantee price quotes for very long.
The price quote is not the only cost consideration needed to arrive at a fully priced estimate. While the manufacturer's unit price may seem very low at first, this cost can balloon once international freight forwarding, customs duties, and domestic shipping issues are factored in. Additional costs can also arise from unexpected sources, such as expenses related to travel, cultural differences, language barriers, and time differences. These costs are difficult to outline, but a general estimate should be calculated into the price.
Know the Difference: Factories versus Trading Companies
Relaxations on import and export regulations have led to an increase in direct exporting from Chinese manufacturers. Trading companies, however, are still common in China. Trading companies that act as go-betweens for manufacturers and buyers usually have experience with Chinese exporting. There are certain advantages to using trading companies rather than going directly to the factories.
Trading companies offer a wider range of products. If a company needs multiple product lines, it may not be possible to purchase them all from the same factory. And sourcing products from different factories requires much effort to locate and evaluate each factory and can create logistical difficulties. The use of a trading company may simplify this process.
Trading companies also have the capital to purchase in large volume. Through established relationships with the factories, trading companies can get more-competitive prices than foreign companies that go directly to factories for relatively small orders. Even after trading companies add a markup, the prices they offer may be lower than the prices offered by the factories themselves.
A major advantage of trading companies is their experience in dealing with foreign companies. Trading companies are generally easier to communicate with because they tend to hire more English speakers. Because they have better-trained staff in their international sales departments, trading companies can help avoid common pitfalls of doing business in China.
Still, trading companies are not for everyone. Finding the right outsourcer also depends on your long-term objectives. If you are interested in maximizing short-term profits and having a relatively easy introduction to working with Chinese businesses, trading companies may be the best solution. But if you prefer to establish long-term relationships with Chinese manufacturers, you may opt for factories that export directly. Building relationships with Chinese factories offers more opportunities to develop company brands. It also allows companies to be directly involved in the quality control process.
Companies with an in-house sourcing group may decide to work directly with a manufacturer. Quality control issues for a factory require frequent communication, and an in-house sourcing team can handle this responsibility. Without such a team or significant resources from an outside firm, however, it may be difficult to monitor issues as they arise. In this case, a trading company may be preferable.
Choosing between a trading company and a manufacturing company is a function of long-term objectives. The key is your company's ability to monitor quality.
Due Diligence before the Site Visit
Before investing a lot of resources to visit factories, it is important to conduct further investigations for the companies being considered for outsourcing. Most may not have any major problems. However, some have problems that may not surface through long-distance communication and initial background research.
For example, a company that speaks enthusiastically about future deals may do so because it is on the verge of bankruptcy and is desperate to attract business to avoid shutting down. Another may be running a glorified sweatshop—a fact that, for obvious reasons, is not advertised on the company's Web site. A company may claim to be a manufacturer with several hundred employees, but in reality consists of five people in one downtown office acting as intermediaries. Others may boast of reliability and quick delivery times, but have recently experienced multiple weeklong power outages due to electricity shortages. Such problems are difficult to discover without visiting China.
Hiring a local Chinese person to perform due diligence is a good way to get complete information. A number of firms in China perform inspections, and several U.S.-based companies with experience in China can provide assistance in conducting due diligence.
The Chinese Medical Device Information Network provides information on medical device companies' licenses and registration with the Chinese State Food and Drug Administration (SFDA). The network can be accessed at www.cmdi.gov.cn. Local SFDA branches also have Web sites that provide such information. Some provinces and large cities have their own medical device associations, chambers of commerce (or a Chinese equivalent), and other business groups. Most of these associations have Web sites in Chinese (though most do not have English versions) that provide information on medical device manufacturers. These sites can be used to do further background checks.
In addition to basic fact-checking, due diligence also includes several other important steps. Having pictures taken of the factory provides you with a visual record of its layout and capabilities. It is essential to confirm that the factory has the current requisite business licenses to operate and export directly. Labor conditions and operation quality should be evaluated through third-party inspections. Waiting until the factory visit to examine these issues may result in wasted time and money on unnecessary visits to inappropriate factories.
Visit the Factory
Once an appropriate background check has been conducted, an OEM can plan a factory visit and a management meeting. In China, face-to-face communication is irreplaceable and can develop trust that greatly improves the business relationship. Moreover, factory visits are necessary to understand the manufacturer's operations and to become comfortable working with the factory.
When visiting a factory, one of the most important things to evaluate is the quality of the company's key people. However, speaking fluent English does not necessarily define the best business partner. Intangibles such as trustworthiness and capabilities are perhaps more difficult to judge, but they are central to determining the success of the outsourcing project.
Factory ownership is another point to address during the first visit. Many Chinese medical device manufacturers were originally state-owned enterprises run by the government. While many of them have been privatized or turned into joint ventures with foreign companies, ownership details are often hazy. A private enterprise is not inherently riskier than a state-owned or joint venture, but a small private factory may have more difficulty acquiring capital to expand output or to purchase state-of-the-art manufacturing equipment to meet increased demand. If a single owner controls the company, it may be wise to ascertain the source of the seed capital.
Most Chinese medical device manufacturers display their licenses, registrations, and awards prominently in a manager's office. They are usually eager to show them to visitors. Make sure such documents are current and that they refer to that particular factory. If a factory refuses to show its licenses, it may not be registered or its license may be expired. A missing permit is an immediate red flag. Certifications, such as a CE mark and ISO, are typically displayed with licenses and registration. Ask to see these certifications. It is useful to determine whether FDA has inspected the company or whether the manufacturer has filed a 510(k) with FDA before.
Quality control is a crucial detail to discuss during the factory visit. If it is not adequately addressed at an early stage, it could severely complicate the project. The level of automation in place at the factory is one way to gauge quality. Because labor is inexpensive in China, many factories still do by hand some processes that have long been performed by machines in other countries. Use of manual labor does not necessarily mean that the quality will be lower, but quality control may be more difficult to guarantee.
It is also important to determine whether the factory operates in a cleanroom environment. Due diligence conducted before the visit may provide this information, but a factory visit can confirm the manufacturer's claims. Examine the factory's current quality control mechanisms and determine whether they are sufficient to meet U.S. requirements and company specifications.
Examine Regulatory Requirements
FDA has a series of regulations relating to foreign medical device manufacturers. Some regulations can cause problems that make it difficult to source from a particular factory, especially in China.
All medical device manufacturers that export to the United States must select a U.S. agent and notify FDA of the name, address, and phone number of that agent. Foreign manufacturers that supply devices are required to register their establishments on form FDA-2891. Most medical device manufacturers required to register with FDA must list the devices designed for commercial distribution.
For medical devices that require 510(k)s, it is critical to work with the Chinese manufacturer to ensure that forms are filed correctly.
Many medical devices require the manufacturer to be compliant with the U.S. quality system regulation (QSR). While many Chinese medical device manufacturers have CE marks, GMPs (China), or ISO certification, some of them may not be able to meet QSR requirements. FDA conducts inspections of overseas factories only sporadically—especially for medical devices that are considered low risk. But a Chinese manufacturer's noncompliance with QSR requirements may pose long-term problems. Considering a factory's ability to meet stringent regulatory requirements could be a deciding factor for choosing a manufacturer.
Negotiate the Contract
Contracts with Chinese manufacturers should be concise. The contracts should be similar to contracts with domestic companies, but a few points deserve further attention.
Increasing input prices in China could translate into higher prices on medical devices, so contracts should clearly specify the time frame for which current prices are guaranteed.
A clause for disputes should also be included. This clause should specify the choice of law, whether it is PRC contract law, the Uniform Commercial Code, or the UN convention on the international sale of goods, for example. It should also include a mechanism for dispute resolution. An international commercial arbitration clause may work best, although, in China, arbitration is seen as a poor substitute for mediation and litigation is seldom practiced.
Shipping terms should be explicit in the contract. International Commercial Terms, also called incoterms, are the most common international terms of trade. These terms designate who is responsible for clearing the goods for import and export. They also determine who takes control of the goods at a certain point in the shipping process. The most common shipping term used by Chinese medical device manufacturers is free on board (FOB), by which the manufacturer is responsible for the goods until they clear the rail of the ship in a designated port. The port to which the goods will be delivered should be specified, and it should be clear exactly where control passes from the manufacturer to the purchaser.
If the shipping terms negotiated in the contract are for FOB, the buyer is, in effect, paying for the goods at a port in China but will not inspect them until they reach the United States. If there are quality issues after the goods arrive, it may be possible to have a new order sent or to cancel the order, but this will lead to costly delays in delivery times. The best way to protect against such problems is to have a thorough quality assurance system in place in China.
Quality control companies in China can be hired to perform periodic factory and product inspections. Also, most manufacturers will allow a customer's quality control team to inspect its factories and products. Combining a third-party inspection and an in-house quality team is optimal, but it may require consideration of cost, logistics, and dependability. Using a Chinese quality control company may be less expensive; however, you should carefully evaluate the company before making a commitment. Sending your own in-house quality assurance team to China may be more expensive but, because it does not involve a third party, it requires less coordination and may be more dependable.
Another option is to choose samples from the production runs and send them to testing laboratories for additional quality control and validation. Informing the contract manufacturer that random samples will be tested at Chinese testing labs may lead to an overall improvement of the factory's quality control.
China represents a huge potential market for medical device OEMs—and that potential is increasing. As China becomes more integrated into the world economy, its medical device manufacturers are becoming increasingly sophisticated and better equipped to meet the needs of U.S. companies.
Until recently, Chinese medical device manufacturers have focused on only domestic markets or foreign markets with relatively low quality standards. As product quality has improved, however, Chinese manufacturers have turned their sights to the markets of developed countries. Many foreign firms have already begun outsourcing medical device manufacturing to China, and there is still much untapped potential. Taking advantage of this opportunity, however, requires a serious commitment and attention to detail.
By using the steps outlined in this article as a starting point, it is possible to avoid some of the pitfalls associated with outsourcing medical device manufacturing to China. China may seem exotic, or at the very least, extremely foreign to U.S. medical device OEMs. However, careful planning, thorough research, and patience can help overcome the challenges that China presents and reap the rewards it offers.
Ames Gross is president and Loren Heinold is an associate of Pacific Bridge Inc. in Washington, DC.
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