Let’s start at the end. You’ve done your due diligence. Your new supplier has provided the first article samples of excellent quality. The pilot production run was good. The first two purchase orders (POs) were filled on time and with good quality. The newly sourced components assemble perfectly with the other components that make up the complete device. The transition from the previous supplier is complete. Cost savings are appreciable. The project has taken a minimum of your management time after the first factory visits. Customer response has been favorable and sales of the devices have started to gain traction. It’s time to ramp up.
The third PO, twice as large as the earlier ones, arrives a little later than the due date, but the parts assemble well; with a little overtime you’re able to get complete assemblies out on time. A fourth PO is in the works and is being expedited to bring you back on schedule. Three weeks later, however, reports start coming in from the field stating that there’s a problem with some of the new supplier’s components: “the plastic is cracking” or “the plating on the copper inserts is peeling” or “some stainless parts are rusting” or some other unexpected problem.
What Went Wrong?
Anecdotally, the most often heard question I hear from customers regarding their sources in China is the inexplicable breakdown of quality after excellent initial results. Why did things suddenly go wrong after nine months or a year of smoothly running production? We’ll come back to that question shortly.
But, first you have to recall the defective assemblies and conduct a failure analysis. Let’s say you discover the plastic raw material did not meet specifications, or the nickel plating wasn’t properly cured, or that the tools used to polish the stainless steel had been exposed to mild steel particles that became embedded in the stainless causing rust spots. These problems might have been caused by a sub-supplier (a new raw material vendor, perhaps), an outsourcing provider (maybe it was less for your supplier to job out the plating work), or an internal change (such as a new foreman in the stainless polishing area). Initially, your supplier claims the problem was caused during assembly of the parts, or by your method of sterilization, or by some other treatment of the components while they were in your possession. In any event, the supplier steadfastly maintains fault lies elsewhere.
One More Try
During negotiations over the defective parts, the vendor mentions that the price you were paying was too low. However, you gloss over this point at the time (assuming it is a negotiating ploy) and the vendor grudgingly offers to split the cost of making replacements. You need to send good parts back out in the field as soon as possible, so you agree to continue the relationship, even though you know the underlying problem was not of your making. It is going to take time to remedy the problem and gear back up. You notify your customers of a recall. As production resumes, you send an engineer to oversee the supplier’s operation.
The replacement parts are done on time and of good quality. While your customers were a bit disgruntled, you’ve managed to hold onto them by replacing all parts from the last lot. However, the recall has eaten up the cost savings you’d realized on earlier orders, but things are back to normal. You give the go-ahead on PO #4 while increasing your vigilance and oversight of the supplier.
The supplier now brings up again the assertion that the price you are paying per part is too low. You respond that you have a long-term contract. The vendor counters that some of your specifications changed during the development phase and were not taken into account in the pricing. You recall with a sinking feeling that there were some refinements made during development that the vendor happily incorporated—a sign you thought, of excellent cooperation, on the part of the supplier. Now the company is claiming these changes required additional equipment and personnel that increased their cost. Furthermore, you are informed, if you are unwilling to accept a price increase, you will have to find another supplier.
Unfortunately by this time you’ve dropped your U.S. supplier, which may or may not be happy to take you back. Plus, the components have gone through a couple of subsequent iterations and the U.S. supplier would need time to get back up to speed on these incremental, but crucial, changes. Your customers, though happy with your quick recall program, would have real misgivings if this were followed by a delay in delivery while you searched for another vendor and brought it up to speed. So you are forced to reopen negotiations with the Chinese supplier, whose new quotation is 75 percent higher than the current price. This hike will wipe out the cost savings you’ve been realizing (and counting on) from the initially negotiated low price. However, given your situation, it’s the only option. You negotiate the price down to a 55 percent increase, grit your teeth, and place another order.
So there you are after two years. You didn’t benefit from the lower piece cost on the first two orders because these savings were eaten up by the costs of the recall. The new price from the vendor isn’t much lower than what you were paying your U.S. supplier. Plus you feel the company was high-handed in negotiating the new, higher price. You don’t trust the vendor’s quality control (QC) and your management team is demoralized and second-guessing your decision to move sourcing offshore. Your customers have been burned and are more than likely looking for a secondary vendor for their assembly, even though they are still buying from you. You’re exhausted from simultaneously managing your company and getting the new supplier up and running over the last two years.
Things could have been a lot worse! The preceding example is a “morass” scenario: an enervating sequence of small things going wrong. They can be rectified, and you didn’t have a large monetary loss. But, they bleed management time, sap energy and afflict morale. Count yourself lucky that the situation didn’t expose your company to some greater liability. On the other hand, you have to worry whether your competition had a better China strategy and is now enjoying lower costs than yours and ramping up to larger-scale production overseas.
How can this morass be avoided? First, you need clear-eyed understanding that using an offshore supplier, means plugging into an entire foreign supply chain. Whom does the vendor buy raw materials from? Does the vendor outsource processes? Where does its tools, supplies and equipment come from? What are the internal manufacturing methods? Do they differ from those of your previous U.S. vendor? Does the vendor have stable management and a strong balance sheet? What’s the corporate structure? Did someone you trust make the recommendation? Unless you are willing to tackle these questions ahead of time and also on an ongoing basis, as the answers will change over time, you are exposing your firm to potential problems.
You are now responsible for this entire new supply chain—unless you want to simply leave it to the new vendor and take your chances, which an amazing number of small to medium-size companies do because of limited management resources. If you don’t have the resources to do comprehensive, ongoing due diligence, then you should not be moving production off shore, because without it, problems are certain to arise. When they do, you’ll have to commit management resources to fixing them while under pressure to retain your customers through the turbulence.
This brings us to the first hard question you should be asking yourself: What is it really going to cost to move sourcing offshore? Too many people take a quotation from a Chinese supplier, subtract it from their current cost, multiply it by the number of parts per year, break into a big grin, and launch headlong into the morass scenario outlined above. Instead, ask: Is the quotation from the Chinese company solid? Chinese firms do not have well-developed cost accounting systems yet, so per-piece cost calculations may be skewed. The actual cost might not become apparent until well into production. In the tradition of the old wild west adage of “shoot first and ask questions later”, many Chinese firms will quote low to preempt competition and get the business figuring they can sort out the real costs later. You know your business better than anyone else. Do a reality check. Ask yourself if the quotation makes sense based on known raw material costs, a labor rate of say $3.00 per hour and a reasonable machine rate. What about other processes such as plating or assembly, or outsourced components and accessories? What are the estimated savings vs. a Western supplier? If the foreign supplier’s quotation is way below this number, it probably isn’t real.
Then, what is it going to cost to enforce QC? For example, you’ll probably need to test each batch of material (which also lets the vendor know you’re checking up). What are the critical processes? Does the foreign vendor perform these differently (or use different equipment) than your U.S. vendor? What might be the impact on quality or delivery times? How are you going to verify production on an ongoing basis? The answer is someone from your firm or a third party needs to be on site with full access. What’s that going to cost? Plus, you’ll need a reserve for unexpected delays and problems, increased air freight shipments, and additional internal management time. So, calculate internally what a part made in China should reasonably be expected to cost, and add estimated overhead to enforce QC and a reserve for contingencies. On this basis what do your estimated cost savings look like?
Western firms looking for foreign sources are generally good about performing the due diligence specific to a potential vendor. They visit the firm; have samples made and verified; and ramp up slowly to production working out the bugs along the way. The weakness I’ve observed with these firms is that they quickly get lulled into complacency when things go well and become less vigilant in monitoring their foreign vendors. The thinking on the part of the Western firm goes something like this: my foreign vendor can make the part (is making the part) to the degree of quality specified; the price is established and set by a long-term contract; now I can start concentrating on some of the other areas of the business. In my experience, two to three years out is the time when major problems occur and they can accumulate before you notice.
When people talk about cultural differences, they often are thinking of music or food or the custom of using two hands to give someone in China your business card. However, there are cultural divergences in business, product design and manufacturing that can have a significant impact on vendor relationships and are less well understood. I will cite a couple of examples with the caveat that they are gross oversimplifications used here to illustrate a point.
Negotiations are never finished in China. In the United States, once specifications and QC levels, delivery schedules and price are agreed to, the QC level is inviolate. Manufacturing process improvements or productivity gains from investment in new tools and/or equipment, which reduce the U.S. vendor’s cost and increase profit, are done in the context of the established QC specifications. Chinese firms often see QC specifications as another variable to be negotiated: could the weight be a little less, the finish a bit duller, less-expensive raw materials substituted or a tolerance relaxed and still allow the part to be “acceptable”?
One way for a vendor to find out is to make a small incremental change, deliver the parts and see what happens. I can hear the reader saying to himself that he would simply reject the altered parts. But, you might be making this decision just as the goods arrive, and your customer is expecting delivery. If you have a substantial order for complete assemblies and one of the components you receive is a little bit off in weight, finish, material or tolerance, but still fits in the overall assembly and doesn’t seem to affect performance, you may accept this slightly inferior part on a one-time basis with the resolve that it will be rectified on all future parts. If you do, you will be setting a precedent. It gives the Chinese an insight into your business that can be interpreted as follows: the original QC standard was too demanding; the end user will actually accept a slightly lower level as proven by the fact that parts that diverged from the original standard were accepted. Alternatively, you reject the parts, shut down assembly and delay delivery to your customers to make the point that there can be no slippage in quality.
This is where another cultural difference comes in: the Chinese vendor probably thinks your product is overdesigned. This cultural bias is embedded in years of product evolution in economies that have had widely divergent resources. Compare a plastic Coca Cola bottle in the United States with a plastic water bottle in China. The Coke bottle has a certain heft, structure and stiffness. The Chinese bottle is wafer thin; as you drink from it, the emptying bottle collapses in your hand. It is as thin as possible while still being able to hold water. The substantial feel of the Coke bottle reinforces the company’s brand. The Chinese water bottle is strictly utilitarian holding water at the lowest possible unit cost. The Chinese view is: Why would you make a bottle any other way? The extra material and cost make no sense: the job is to just to hold a liquid.
Your foreign vendor may very well hold similar views about your product (i.e. that it is overdesigned and a little wasteful). By slightly reducing the quality standards of your product, the vendor is saying to you, “Look the product is still functional. Why waste money?” (Note: this article assumes that you are outsourcing products that will be sold in the United States and must meet U.S. “cultural” design standards. A Western company outsourcing in China to sell products into the Chinese domestic market must look at redesigning that product to China’s “cultural” standard, which is beyond the scope of this article.)
Robust design permeates U.S. culture. Minimalist design permeates China’s. Part of your challenge is maintaining the “cultural” integrity of a component that will be sold into the U.S. market in spite of a vendor who feels the design may not make logical sense. The real challenge is getting the vendor and the people on the manufacturing floor to appreciate the design and inculcating in them a desire to keep its integrity intact. This example provides a glimpse of the complexity of the management mission you are facing with off-shore manufacturing.
Enough of the theoretical. Here are some practical rules of thumb:
- Don’t drop your U.S. vendor too soon.
- Develop at least two foreign vendors; so you are not at the mercy of just one. Chinese firms are fiercely competitive. Nothing will control price like having a credible secondary source. This will take additional management resources, but it will be worth it.
- Think in terms of three to five years to realize cost savings, and understand that those savings are not just the difference between the cost per part in the United States and cost per part in China. Foreign outsourcing requires substantial overhead.
- Dedicate management resources to maintaining consistent quality.
- QC must be a zero-tolerance policy.
- Be aware that you are embracing an entire foreign supply chain, not just one or two new vendors.
- Take time to bring your own management team on board. What’s in it for them to have the increased workload of managing an offshore source?
- Be aware of the “culture” of your product, and don’t be offended or frustrated if your vendor does not see the wisdom of your design. Work to help them understand what you are trying to achieve overall, not just sticking to specifications.
- Add a reserve fund for increased air freight, occasional rework in the States, additional travel expenses, etc.
- Consider a third party intermediary. Seek one that has had some years of experience and get customer references.
Costs are lower in China. Great strides have been made in quality control. The domestic market is growing rapidly. (Eventually you’ll want to sell into those markets. It won’t always be a sourcing for the States strategy.) You can be sure your competition is trying to develop a China strategy. Part of your future success will hinge on how well you develop yours. The key isn’t simply finding a source in China; it’s sustaining and growing with that source.
Russell Johnson is the president of China Array Plastics. The firm provides applied engineering and manufacturing services for OEMs worldwide in niche markets including aerospace, medical, electronics, and semiconductors), which use high-performance thermoplastics (HPTP). With headquarters and engineering offices in Pittsfield, Massachusetts and a HPTP facility in Wuhan, China to support R&D with in-house tooling, molding and testing, China Array can take a HPTP project from conception to full-scale production. Johnson has served as an advisor to the Harvard Business School’s Asian Research Center. He can be reached at [email protected].