In a post entitled The 7 Major Risks You Run With Your China Manufacturers, China manufacturing expert Renaud Anjouran outlines the business risks foreign companies face when outsourcing their product manufacturing to Chinese factories. Renaud’s list nicely accords with what our China lawyers tell our clients for whom we draft Chinese contract manufacturing agreements. See China Manufacturing Agreements: Binding Contract or Contract Terms. When we first talk, our manufacturing clients usually want to focus on a) ownership of intellectual property, b) prevention of counterfeiting, c) ownership of molds and tooling and d) after sales warranty service. This is the kind of thing legal agreements are really good at resolving and it is easy to allow the discussion to center on these issues.
But in my 25+ years of working in China, it is rarely these issues that result in bankruptcy of foreign product purchasers. The matters that result in bankruptcy are usually on the list provided by Renaud. That is, the most serious issues are the core business issues tied to outsourced manufacturing: price, quantity, delivery date, quality and resolution of quality issues, subcontracting and shipping.
Renaud describes the basic issues, but, we should ask at the outset: what is the source of these issues and what can be done to address them. The source of the problems is the pervasive use of the purchase order approach to purchasing contract manufactured product from China. In China Manufacturing Agreements: Binding Contract or Contract Terms, I wrote how there are two basic ways to structure a China contract manufacturing agreement.
Option One is to enter into a binding contract with the China factory that directly confronts all of the basic manufacturing issues in a manner that is legally binding on both the parties. Under this option, the agreement on price binds both the Chinese factory and the foreign buyer. If material costs change, if labor costs change, if production costs change, the parties remain obligated to pay and sell the product at the agreed-upon price, no matter which party benefits or loses from the changes. Both parties are taking the price risk. If the agreement is long term and if the various input costs are likely to change over time, then the parties either take the risk or develop a detailed system for adjusting in response to the change. In most of the world, this is what is done. In China, however, the entire risk tends to be loaded on one side or the other. The same applies to the other key business terms in China manufacturing agreements, such as the terms for payment, quantity, delivery date and quality.
The issue for many foreign buyers is that under Option One, both parties are bound. Foreign buyers who do not want to be bound or who cannot be bound due to lack of resources will follow Option Two. Under Option Two, any form of contract manufacturing agreement is little more than terms and conditions. Such terms and conditions are binding on the parties only after a purchase order is presented by the foreign party and then accepted by the Chinese party. If the Chinese manufacturer does not accept your purchase order, there is no binding agreement you and your Chinese manufacturer. It is this lack of a binding agreement that is the primary cause of the seven manufacturing risks Renaud discusses in his post.
Consider for a second why that is the case from the perspective of the Chinese factory. Under the purchase order approach, the factory has no assurance that its foreign buyer will place even a single order. During a fiscal year, the Chinese factory has no assurance on price, quantity or delivery date. The Chinese factory is expected to develop the product, taking on the risk and expense of commercialization. The Chinese factory is then expected to turn over to its foreign buyer the plans, molds and tooling so the foreign buyer can move production to a lower cost factory down the road. In this type of situation, the factory really has nothing solid in the relationship with the foreign buyer. So the factory acts in the manner described by Renaud. This is perfectly natural and it is to be expected. That is, any foreign buyer that expects a Chinese factory to act differently under the purchase order approach option is living in a dream world.
So what is the solution? The obvious solution is to follow Option 1 by entering into a binding agreement with the Chinese factory that formally commits both parties to the basic business terms for a specific period of time. However, the lure of China for many foreign buyers is that Chinese factories are willing to do small runs on a purchase order basis. The purchase order system is oftentimes the reason why the foreign company is having its product developed and manufactured in China. To tell these buyers to follow Option 1 is unrealistic.
For this reason, our primary task as lawyers is to develop contract manufacturing agreements that recognize that the purchase order approach will be used and deal up front with the risks that come from that. The key here is that the foreign buyer understand the risks and work actively with the Chinese factory to deal with mitigating those risks in a way that is practical and fair.
How to Reduce Your China Manufacturing Risks
The source of the problems for Western companies that manufacture in China is the pervasive use of the purchase order approach to purchasing contract manufactured product from China. In China Manufacturing Agreements: Binding Contract or Contract Terms, I wrote how there are two basic ways to structure a China contract manufacturing agreement.
Option One is to enter into a legally binding contract (in Chinese!) that addresses all the basic manufacturing issues. The agreement on price binds both the Chinese factory and the foreign buyer, and even if costs change, the parties remain obligated to pay and sell the product at the agreed-upon price, no matter which party benefits or loses from the changes. This sort of contract is common in much of the world, but less so in China. China, however, the entire risk tends to be loaded on one side or the other. The same applies to the other key business terms in China manufacturing agreements, such as the terms for payment, quantity, delivery date and quality. Foreign buyers who do not want to be bound or who cannot be bound due to lack of resources will follow Option Two. Under Option Two, the contract terms and conditions are binding on the parties only after a purchase order is presented by the foreign party and then accepted by the Chinese party. It is this lack of a binding agreement that is the primary cause of the seven manufacturing risks Renaud discusses in his post.
The obvious path to contract certainty is to enter into an Option 1 manufacturing contract that formally commits both parties to the basic business terms for a specific period of time. However, the lure of China for many foreign buyers is that Chinese factories are willing to do small runs on a purchase order basis. The purchase order system is oftentimes THE reason why the foreign company is having its product developed and made in China. For this reason, our primary task as lawyers is to develop contract manufacturing agreements that deal up front with the risks that come from using the purchase order approach. Our job as China attorneys then is to make sure that our foreign buyer clients understand the risks and then to work on mitigating those risks in a practical way.
I explain below how our international manufacturing lawyers do that with each of the seven risks Renaud identified.
Risk 1: Lack of “Motivation.” The major risk we see stems from the foreign buyer loading the development costs onto the Chinese side with no incentive for the Chinese side to follow through on development. Renaud calls this risk “loss of motivation” and we see this all the time. The foreign side relies on the Chinese factory to do the product development, normally loading the cost on the Chinese factory. After two years, the development is not completed and the market has moved on, leaving the foreign side high and dry with no marketable product. The Chinese side assures the foreign buyer that they are “working on it,” but in fact the product development project is a low priority as compared to their ongoing manufacturing that pays their bills and so they are “working on it” only when times are slack. It is also common for Chinese factories to agree to take on a development project when they do not actually have the capability to do the work. In this situation, the delay results from the Chinese side being pushed up against the limits of what it can actually do.
The best way to address this lack of motivation risk basic method is to enter into a legally binding product development agreement with the Chinese factory that includes the following:
- Milestones: hard dates for development of prototypes or samples.
- Allocation of costs. If all costs are loaded on the Chinese side, the chance of success is dramatically reduced.
- A real incentive for the Chinese side to succeed. This incentive can be payments for the Chinese factory hitting its milestones or it can be a commitment to purchase reasonable (but predetermined) quantities of the developed product at a fair price.
Few foreign buyers follow this approach, with the predictable results described by Renaud.
Risk Two: Quality Failure at the Production Stage. The Chinese side agrees to manufacture the product at the “China Price.” Initial samples are acceptable in terms of quality, but once production starts, the quality is consistently bad. When pressed, the Chinese side says: “We gave you the China Price and you knew that at that price we would never be able to produce a quality product. It is your fault: you have to choose. If you want the China Price, you don’t get assurance of quality, quantity or delivery date. If you want all those items to be acceptable to you, we need a binding contract that covers all four issues in a manner that works for us too. But if you insist on the China Price and you do not provide us with a binding commitment for orders, you will have to accept what we provide.”
Price is not the only issue; there are four key factors involved in having your products made in China: price, quantity, delivery date and quality and if you fail to hold your Chinese factory legally accountable for all four of these things, you are likely to have problems. If your Chinese supplier takes all four factors seriously, its pricing must increase. Foreign buyers who are not willing to accept such an increase will continually face the Chinese factory failing to comply with the other factors. Quality will suffer, delivery will be short or late, or the factory will suddenly quit accepting orders right at the height of the delivery season.
Risk Three: Low Priority in Production Schedule. The Chinese side accepts your purchase order for a small run of product at a low “China” price. Then another buyer shows up and offers a slightly higher price for a larger quantity of product. The Chinese side then pushes your order down the line for priority and your delivery is delayed. In some cases, the delay extends to the point where delivery never takes place. The Chinese side is not concerned about failing to deliver on the purchase order, since the litigation risks are extremely low because you do not have a Chinese language contract that works. See China Contracts: Make Them Enforceable Or Don’t Bother.
This situation regularly occurs when the relationship is based on “one off” purchase orders. See How to Avoid Getting Bad Product from your Foreign Manufacturer. The way to deal with this issue is to have a contract manufacturing agreement that clearly incorporates your purchase orders into the legally binding contract and that provides specific monetary penalties if your factory accepts a purchase order and then either delays or fails to deliver. When pressed to enter into this sort of agreement, Chinese factories will treat accepted purchase orders seriously and their delay/default rate goes way down. In our experience, factories that intend to take a relaxed view towards their legal obligations under an accepted purchase order will simply refuse to execute a formal contract manufacturing agreement, which is exactly what you want. See China Contract Damages Done Right.
Risk Four: Sudden and Unpredictable Price Increases. Under the standard scenario, the Chinese side agrees to manufacture your product at a goal price, without ever having undertaken any serious examination of what it will actually take to manufacturer your product. The Chinese side then does the product development and the production implementation. The samples are acceptable and it is time to begin production. The foreign buyer then submits the first purchase order at the goal price. The Chinese side refuses to accept the PO and announces a substantial price increase. If the price increase is not accepted, the factory states that it will not accept any future purchase order.
There are two reasons China factories do this. The first and most common is that the factory never understood the price issue and never planned to meet the proposed price. The factory merely accepted the goal price to prevent you from going to another factory. The Chinese factory assumes you will be compelled to accept a purchase at the “real” price (whatever that price is) because you will be unwilling or unable to spend another 6-12 months (or whatever it will take) to start over with another factory.
The second common reason Chinese factories will take on a product development project with no intention of giving you the product you want at a price and delivery schedule that can make sense is that the factory is treating you as its outsourced R&D center. The idea comes from the foreign side, the implementation comes from the Chinese side. But the ultimate goal is for the Chinese side to make and sell the product on its own. The Chinese factory never planned to make the product for the foreigner. So they offer a very high price. If the foreigner accepts, they make the product for the foreigner at a price higher than they ever imagined. If the foreigner refuses the price, they move on to make and sell the product on their own. This sort of thing is incredibly common and hardly a week goes by without someone calling one of our China lawyers for our help to “require the Chinese factory to get its price in line with the market.” But unless you have a written contract that works for China and made pricing clear, there is nothing we can do to help at that point.
If the foreign buyer is purchasing an off the shelf product that is part of the Chinese factory’s standard inventory, the risk of any price issue is low. If you are engaging the Chinese factory to make minor customization of its standard product (maybe just adding your logo or changing the color), the risk is also low. But if the Chinese factory will be modifying/customizing its existing product, you should have a legally binding contract that the Chinese factory feels compelled to honor. The way to deal with this is under a product development agreement that includes the following three key components:
- A strict timeline for developing the working prototype.
- A provision that makes clear you own the prototype and all data, drawings and tooling required to manufacture based on the prototype.
- A provision that states that if the factory meets the target price, you will purchase exclusively from the factory, but if the factory cannot meet the target price, you are free to take the prototype and have it manufactured at any other factory.
Without an agreement like this, you should expect a price increase as an almost a certain result of the product development process.
Risk Five: Subcontracting. Subcontracting of production presents a number of risks often not clearly understood by foreign buyers. Renaud identifies the first and most common risk. The foreign buyer goes to substantial effort to verify that the Chinese factory it has chosen is capable of meeting its quality standards. If the factory then subcontracts the foreign buyer’s product manufacturing to another factory, all of the buyer’s verification work becomes meaningless. This then leads to other issues: How will inspections take place? How will quality control standards be enforced? How will worker safety or worker age rules be enforced? How will anti-bribery and related rules be enforced? Working to the next level, manufacturing by a third party where there is no contractual relationship means that confidential information agreements are automatically breached, and this is a primary way intellectual property gets lost in China. Finally, molds and tooling are often moved to the subcontractor, resulting in loss of control and the inability to retrieve these items when required.
There are three reasons Chinese factories typically subcontract. First, the “factory” is a front for a trading company that actually does no actual manufacturing on its own. This type of trading company will subcontract all of the manufacturing and will limit its involvement to supervising (usually very poorly) the manufacturing process. Second, the factory may be capable of doing the basic manufacturing process, but it requires subcontracting assistance on key elements of the production process. For example, it is normal for Chinese factories to subcontract mold making and electroplating of key components. Finally, the factory may decide that the foreign buyer’s purchases are too small to justify the effort of setting up production and it will subcontract to a factory with the time and the interest. Such a factory is almost guaranteed to be of lower quality, leading to the problems Renaud describes in his post.
Since subcontracting is always an issue when manufacturing in China, it is necessary to confront the issue directly in a formal agreement. The standard approach is to provide that subcontracting is prohibited without notice to and consent by the foreign buyer. The foreign buyer should condition its consent on inspecting the subcontractor and getting the subcontractor to execute a separate manufacturing contract with the same key terms as the foreign buyer has with its original manufacturer.
Though this approach is best, many Chinese factories insist on an absolute right to subcontract. In that situation, if the foreign buyer agrees, then the normal contract provision is to require (a) the Chinese factory at least identify its subcontractor(s) (b) the subcontractor grant the foreign buyer access to its premises for inspection and c) the Chinese factory agree to be directly liable for any violations committed by the subcontractor. Some Chinese factories will not agree to these conditions. When that happens, our China lawyers recommend the foreign buyer refuse to purchase its products from that factory.
Renaud identifies a more difficult problem: undisclosed subcontracting. This situation is unfortunately quite common. It arises most often during the busy season when a factory simply cannot keep up with the orders it has accepted. The best way to prevent this from taking place, the foreign buyer must regularly inspect the factory operations to ensure that the factory is really doing the work on the premises. Since the high season is the most likely time subcontracting will occur, this is the time when appropriate, unannounced inspections should occur. It is also crucial to enter into a formal agreement that prohibits undisclosed subcontracting as described above.
We typically put a provision in our OEM agreements (which we nearly always do in Chinese for better enforcement in China against the manufacturer) mandating that the Chinese manufacturer cannot subcontract out the manufacturing. We have been doing this for years and, as far as we know, no manufacturer has ever violated this provision. I know many of you are dubious of this record, but hear me out. Let’s say the Chinese manufacturer has 30 customers for whom it manufacturers product. Let’s say only four of those customers have a no subcontracting provision (my guess is this number is more like to be two, but for the sake of argument, let’s go with four here). The China OEM manufacturer gets really busy and has to subcontract out some of its manufacturing. It can subcontract out the product manufacturing of any of its 30 customers, so why wouldn’t it choose to subcontract out the product for the 26 customers who have no contract provision prohibiting subcontracting? I call this the bike lock theory of Chinese law because the no-subcontract provision operates like a good bike lock. The thief can still steal your bike, but why would he when there are so many easier targets out there?
In our experience, these no-subcontracting provisions work shockingly well.
Risk Six: Failure to Deal with Defective Product. The problem of defective products raises several issues. First, it is critical to identify a factory that will attain and maintain a reasonable defect rate. If the defect rate during production is over an “epidemic percentage” level, it is almost certain success will not be achieved. As Renaud illustrates in his post, the defects in Chinese factories are often at the cosmetic level. The base product is acceptable, but the finish is defective or scratched; fingerprints show up on glass in an enclosed case; greasy footprints are found on well sewn, elegant handbags.
There are two issues relating to dealing with such defects. The first is how to locate the defect. It is best to locate the defect during the production process. Second best is to locate the defect before shipping. Third best is to locate the defect after your receipt of the product. The worst case is to learn of the defect after delivery to the down stream customer.
As Renaud notes, once defects are found, the parties must have in place a formal plan that clearly deals with what will be done with the defective product. It is critical not to allow the defective product to enter into the retail market. Many Chinese factories will sell defective product “out the back door.” When this product gets into the market, the damage to your reputation can be substantial.
But what should be done with defective product? We usually provide that the defective product must be destroyed. However, this is not always the best alternative. In some cases, the defective product can be repaired or otherwise reworked. This is a common approach for complex and expensive cast metal parts for large equipment. In other cases, the defective product can be disassembled so that valuable components, such as precious metals, can be recovered.
Once you resolve how to handle defective products you receive from your China factory, your next issue is how to get reimbursed for the defects. The Chinese side will usually propose that the value of the defective product be applied as a credit against your future purchases. This is a bad system because the foreign buyer can only obtain credit if it makes another purchase. This forces the buyer into a relationship with a factory that makes defective product. Even worse, the amount paid to the factory is going down for each new purchase, which means the factory has even less incentive to do a good job.
The practical solution is for you to inspect your product before making any payments for its manufacture and reducing the invoice price to account for any short delivery resulting from removal of defective product from any given shipment. If the defect level reaches an epidemic failure rate (this rate must be determined on a product by product basis), your manufacturing contract should provide for you to be able to impose additional penalties.
Foreign buyers that delay dealing with quality issues until after they have made full payment for their product are virtually never able to successfully resolve their China product defect issues.
The above discussion shows that a detailed, formal system for dealing with quality control and handling of defects is required and the only way to do this is with a formal, written manufacturing agreement. The common one line statement that the Chinese factory will warrant the quality of its products will never work. Manufacturing in China will ALWAYS result in defects. A workable plan for dealing with those defects is therefore not optional. It is required.
Renaud’s post raises an even more important issue. In some cases, the defect level from the factory will be high and will remain high. In that situation, where a defect rate is over 20%, it is normally impossible to develop a workable solution with the factory. The solution here is to monitor the process from the very beginning. In China, factories do not do better work over time. Their performance almost always only gets worse over time. As soon as an excessive defect rate is identified, you should take immediate action. Usually that immediate action means cutting your losses and moving to a new factory. A good manufacturing agreement will make this transition as easy as possible.
Risk 7. Logistics Cost Increases Due to Factory Error. As Renaud notes, you need to beware of increased shipping costs due to your factory making an error in the size of container required to ship your product. This issue arises from a common mistake make by foreign buyers. Inexperienced foreign buyers often do not understand that in international transactions, “logistics” is an integral factor for success. Shipping costs, shipping timing, method of shipment (air/ground/ocean), port of delivery and a host of other factors can have substantially impact the marketability/pricing of your product.
This then leads to the standard mistake. The foreign buyer looks for the lowest China Price. So the China manufacturer provides a product price that does not include the shipping cost: free carrier or the (erroneous) FOB price. Under these terms, it is the foreign buyer’s responsibility to make arrangements for shipping. The illusory concept is that the foreign buyer will then negotiate the lowest shipping rate, making for an even higher profit.
In fact, however, foreign buyers are normally unable to effectively manage shipping in China. So even though they specify free carrier terms, they in fact end up needing to rely on their Chinese factory to make all the arrangements for shipping. But under this scenario, the foreign buyer has taken on all liability for mistakes and yet it has no effective control to prevent those mistakes. This then is a perfect setting for the kind of disaster that Renaud describes.
From a legal perspective, resolution of this problem is simple. The foreign buyer’s contract with its China factory should impose all of the responsibility and liability for shipping on the China factory. This is done with a manufacturing contract that provides for the product price to include shipping fees. The standard CIF (cost insurance freight) shipping term will achieve this goal. Use of CIF terms does not mean that your China factory will not make mistakes, but it does mean that your factory (not you) will be liable for those mistakes. Your China manufacturing agreement should also include a provision that requires your factory ship by air freight if delivery of your product will be delayed beyond a certain number of days. The only way to ensure that your China factory treats your key business issues as important is for your manufacturing agreement to impose an immediate penalty on your factory that does not require a cross border lawsuit to enforce.