Sourcing in China

by Michael Bloom
Chairman, Sinotech, Inc.

Like it or not, the world is a global marketplace. For U.S. manufacturers to remain competitive they must combine the best of American technology and advanced products with components built at lower offshore labor rates. "Purchasing Agents" are now becoming "Offshore Sourcing Specialists". Like Jason in search of the Holy Grail, these buyers are looking for manufacturing capabilities that offer low production costs with as few drawbacks as possible.

The consensus is that mainland China offers the best environment for offshore components sourcing. In this article we will explore the advantages and potential pitfalls involved in manufacturing in China and provide practical advice on how to proceed with a first sourcing project. The information provided is the result of 10 years of experience assisting companies with this process.

Why China

Obviously there are many countries that are candidates for overseas sourcing. China, however, combines advantages that are unique to the world's most populous nation. These include:

One of the world's lowest labor rates ($100 per month)
Abundant indigenous raw materials
A well developed industrial base
Aerospace and defense industries that are technology drivers for the industrial sector
A mature communications and transportation infrastructure
A stable economy

Labor rate. There are actually two different labor rates in China. The rate paid by indigenous Chinese companies ranges from $80 per month to $150 per month for labor ranging from blue collar assembly to white collar engineering. If you buy from an indigenous company this is the labor rate which is calculated into the cost of the product. If you attempt to hire Chinese labor directly, the labor rate will jump to about $400 per month with the worker receiving $80 - $150, while the rest reverts to the government. Foreign owned Joint Ventures (JVs) pay the best salaries and positions with JVs are highly coveted.

Abundant Indigenous raw materials. Most raw materials you will need are available in China as native products. For example, natural rubber, steel and aluminum are all native. However, due to the growth in the Chinese economy, even native materials are often insufficient to meet the demand, so China has become one of the world's major importers of scrap iron, aluminum, copper, and steel.

Well developed industrial base. Since China was isolated from trade with the west from 1949 until the beginning of President Nixon's ping pong diplomacy in the 1970s, China developed a highly self-sufficient industry. Aided by the Russians during the 1950s and 1960s, many large industrial facilities were built. From the perspective of a western observer there seems to be an amazing variety of factories that make the same kinds of industrial goods found in the U.S.

Aerospace and defense industries. Spurred by a need to develop militarily, China built many factories that are "mil-spec". Certain regions of China, such as inland Chengdu and coastal Dalian are particularly noted for these plants. As the military standoff with the Soviet Union faded, China converted many of these factories to civilian production.

Mature communications and transportation infrastructure. Ten years ago, telecommunications with China was fraught with problems. Phone lines were scarce, connections noisy, and costs almost prohibitively high. Now fax and voice communications between the US and China is cheap and reliable. Connections via Internet are becoming more common, dropping costs substantially. The transportation infrastructure is still somewhat of a problem. While ocean shipping from coastal cities is fast and reliable, there are vast inland areas which have very poor highways making rail transport a necessity.

Stable economy. Despite the political scrutiny that China is subject to, the Chinese economy looks surprisingly stable from the outside looking in. For example, although China has experienced periods of high inflation due to double-digit growth in its economy, export prices have remained surprisingly stable. By international agreement, the ratio of Chinese Renmenbi (RMB) to the U.S. dollar is held fairly constant. Quotations to US companies are almost always in US Dollars.

What Products Are Available From China?

This is a very difficult question to answer. Unlike the U.S., there are no comprehensive directories, like the Thomas Register, in China. A number of attempts, some quite serious, have been made to develop a comprehensive directory, but none have succeeded. Part of the problem lies in the way in which Chinese factories are organized. In the US, factories are organized horizontally; that is, a manufacturer of watt-hour meters will buy the cast parts from one factory, the plastic parts from a second, and the glass parts from a third. In China, the watt-hour meter factory is likely to set up a casting workshop, a plastic injection molding workshop, and a glass workshop, as well as a tooling workshop to build the molds and jigs that are required. From a US perspective, this factory then, is not only a good candidate for watt-hour meters, but also for the production of cast, plastic, and glass parts, or for the production of production tooling!

It is probably easier to define the range of products by identifying those products that are not good candidates for Chinese production. Products with high labor content are better candidates than those with low. For example, machined castings are more likely to demonstrate greater cost savings then stamped metal products whose production is highly automated. The other limiting factor is technology. Generally speaking, in any given technology, China is one or two generations behind, so looking for a leading edge sub-micron integrated circuit is not likely to be successful.

As a general rule, you won't know if a product is available in China until you try to source it. And even then, you may be left wondering.

How Will Chinese Sourcing Affect My Costs?

Another tough question. All we can say is that it is not unusual to see savings of 75% or more on both tooling and production in many product areas. The extent of savings is further complicated by the process at which the final price is arrived at. In the US there is generally limited negotiation in the area of price. In China the process of arriving at the final price is a ritual. The first price offered often bears no relation to reality. It may just be a fantasy price arrived at through guessing what the "traffic will bear". Often, the Chinese see U.S. companies as having very deep pockets. Do not expect the first price offered to be the final price and do not lose patience. After you receive the first offer, be prepared to respond with an explanation of why that is not acceptable! A reasonable argument might include a discussion of domestic pricing and the need to see a cost savings of X percent in order to consider using a Chinese source.

Even more than in the US, you can expect to se a wide variation in prices between factories as they respond to identical Requests for Quotation. This variation could be due to the nature of the factory:

rural vs village vs large city
government owned vs Joint Venture vs entrepreneurial Chinese owned
manual controlled equipment vs CNC
growth minded vs short term profit minded management

Also, the actions of an Import/Export company involved in the transaction will affect the price. None but the largest industrial concerns are authorized to do direct export and exchange currencies. In most cases, a government-authorized Import/Export company handles this. Some I/E companies take little or no profit from a transaction, being satisfied with profits from the currency exchange and receiving government encouragement to maximize the flow of dollars. Some extract a high profit.

The bottom line, however, is that with patience, we believe that the world's lowest costs can be achieved through this negotiating process.

Taking the Direct Approach

Some US companies have achieved remarkable success by working directly with Chinese factories. Unfortunately, this has been the exception rather than the rule. There are a number of reasons for this. First, trying to locate the right factory is exceedingly difficult. There are too many and they are scattered too widely geographically. To achieve the best price, it is important to select several factories that will be asked to compete with one another. This means you really need to select several good candidates.

Assuming you have managed to select the best factory and negotiate an acceptable price, how will you supervise the quality of the production? Experience demonstrates that it is crucial to either have your own representative on site at all times, or at least set up a monitoring program. It is not that the factory is dishonest, but their standards are likely to be different from yours. We'll say more about quality later. If you do have a quality problem, and defective goods ultimately arrive at your shipping docks, you will find it expensive, if not impossible, to get a refund or correction.

Unless you are willing to set up your own purchasing and quality control organization in China, we advise against the direct approach.

Using Third Parties to Aid in Purchasing

Third parties can be very helpful in advancing your sourcing projects while providing protection and value added services. The ideal third party would have the following attributes:

Offices in the US and China
Native Chinese engineers and negotiators in China
A U.S. based engineering staff to support the technical communications with you
A program in place to assure quality
US and Chinese based logistic support for shipping, customs clearance, and warehousing.
Legal recourse in the US

Office in the US and China. A company based solely in the US cannot possibly produce the same results during the negotiating process as a company with on-site negotiators. One of the arguments for going "Direct" is the expectation that a direct negotiation will produce lower prices than by using a third party since the third party will take some profit. However, this is not necessarily true. A good on-site negotiator, armed with knowledge of the culture, long-term experience with the factory, and a portfolio of projects completed and under way is almost guaranteed to get a better price. We believe that sourcing cannot be done well at a distance . it requires face-to-face meetings.

Native Chinese engineers and negotiators in China. Communications takes place on many levels: verbal and non-verbal. US based negotiators, even in face-to-face meetings with Chinese counterparts, are at a disadvantage. The best results are achieved when your own Chinese engineers and negotiators understand your goals, are given the broad parameters, and are set free to accomplish the goals according to Chinese precepts.

U.S. based engineering staff. As in most of life's complex activities, given the opportunity for something to go wrong , it will . and at the most inopportune time. It is exceedingly frustrating to work directly with China via phone and fax and not have someone to talk with during your working hours, or to have to communicate with someone who speaks English haltingly. A U.S. based support staff avoids this problem.

Quality assurance program in place. Even more than in the US, assuring quality from China requires constant vigilance. Unless the quality program can be demonstrated to your satisfaction (see below) do not engage the third party services.

US and Chinese based logistic. There is a lot of detail work connected with the importation of products from China. Errors in documentation can cause significant delays and can be rather expensive. The third party should be well versed in these issues and should not merely tell you to "call your customs broker". Some third parties can handle the transaction from shipping, through customs clearance, to surface shipping to your receiving docks. Some can even provide warehousing and provide JIT (just in time) delivery to your production line from their warehouse.

Legal recourse in the US. In the US, we have a legal system that protects both sides in a contract dispute. Under pressure from the World Trade Organization, a group in which China seeks membership, China's legal system is improving rapidly. However, litigating in China is still a quagmire. However, if you work with a third party who takes legal title from the Chinese manufacturer and then re-sells to you, you then have legal recourse in the US in any dispute that may arise.

These are, in our opinion, the ideal attributes of a third party provider. Such providers are not easy to find. In almost every instance, the third party is really nothing more than a broker. If you use the above criteria, you should be able to adequately screen the company offering services.

Now we assume that you have selected the factory (either direct or through a third party) and have negotiated a price. Next comes a discussion of terms.

Payment and Shipping Terms

Payment Terms. If you purchase directly, you will almost certainly be asked to pay using a Letter of Credit. While a substantial discussion of L/Cs is beyond the scope of this article, suffice it to say that L/Cs are payment documents you prepare with your bank that provide some protection to both parties. In most instances, funds are transferred when your goods are loaded on a vessel and the factory presents shipping documents to its bank. The downside is that your money can be tied up for long periods of time and the process is complex and time consuming.

If third parties are used, better terms can sometimes be negotiated. This is due to the nature of the relationship between the third party and the Chinese factory or Import/Export company. The Chinese side "trusts" the third party to stand behind the purchase and make payments. The terms may include some prepayment before shipping and payment of the balance when the goods are received and inspected, thus protecting the Chinese side financially and the US side quality-wise while depending upon trust on both sides. Beware of paying 100% of tooling costs up front; you should only need to pay say 50% up front, with the balance due upon your approval of tooled samples. With a particularly strong US company, the third party may provide Net 30 terms or better. This is actually an exciting new development which allows Chinese factories to look, financially, much the same as US suppliers.

Shipping Terms. One way or another, the ultimate buyer is going to pay for ocean shipping, ocean insurance, customs brokerage, duty, and surface shipping, to say nothing of the miscellaneous charges (such as port fees) that will creep in. The only question is who lays out the money and at what stage. Of course the simplest way is to insist that good be priced delivered to your unloading docks ("FOB Shipping Dock"). However, other shipping terms, beyond the scope of this discussion, may be acceptable and provide cost savings.

Duty Payments. China has Most Favored Nation (MFN) status. This merely means that China has the same normal status as all other countries, except for the pariah countries such as Libya, Syria, etc. As a rule, the duty will amount to between 3 percent and 7 percent depending upon the Customs Class of the product. The US Department of Commerce publishes these Unified Tariffs. Payment of duty can be deferred by storing the imported goods under bond in a Foreign Trade Zone. Further, certain FTZ's are granted authority to import goods with duty paid based upon the manufactured cost, rather than the invoice cost, thereby saving considerable duty.

Quality ... Quality ... Quality

If quality control is not properly addressed, the sourcing project is almost guaranteed to fail. At the early stages of negotiations, you should make it clear to the factory what the quality issues are. Besides the usual issues of dimensional tolerances, you should discuss surface finishes, weight tolerances, standards (such as UL/CSA approval), metallurgical considerations etc. These should be clearly stated in writing. There are almost no ISO9000 approved factories in China (other than a handful of US-Chinese and Japanese-Chinese Joint Ventures). However, we have found that factories are willing to learn and implement Statistical Process Control (SPC) methods if taught. We suggest you demand SPC documentation with each shipment and specify the AQL level required.

To assure honesty in this process, you may wish to have a third party perform an on-site inspection. Societie Generale Surveillance (SGS), a Swiss-based company with offices throughout the world, provides these services on a contract basis. We have found it sufficient to have the "ideal" third party, with offices in China, visit the factory just prior to shipping, to take an honest sample of n items from the final production. These samples are shipped to the US by air courier and sent to the customer or the customer's specified laboratory for analysis. The goods do not ship from China unless the analysis indicates that the customer's specifications have been met. If a Letter of Credit is used, the issuance of a Certificate of Inspection based on the lab analysis can even be made a condition of the L/C.

A word about on-site monitoring. There is a quirk of Chinese culture that makes it very uncomfortable for a Chinese to verbalize negative feelings or admit problems. This often causes problems as production problems and delays occur that are not admitted by the factory. This is another argument for on-site monitoring by a third party.

Developing the Relationship

Doing business in China is all about relationships. This cannot be overstressed. There should come a time when you or someone on your staff will want to visit the factory. If you are working with a third party in the US, it should be clear that at some time you will want to have this direct contact. The third party may be reticent out of fear that the customer may try to circumvent him and cut him out of present or future transactions. This is a legitimate concern. If you use a third party you should be absolutely clear that even if you are given access to the factory that you will only communicate with the factory to the extent permitted by the third party. The third party should expect that as trust in the relationship grows, it is natural for the factory and the customer to become closer.

Although not supported by all third party providers, it is often helpful to expose both the Chinese factory and the US customer to verbatim communications that are addressed to the third party (excluding, of course, proprietary information such as internal pricing). This sharing of communications promotes better understanding of the issues for both sides.

Current Hot Concerns

Intellectual Property Rights. China has been, until recently, notorious for violations of intellectual property rights, especially in the area of recorded music and software. From personal experience, we can say that we have observed the disappearance, in China, of bootlegged tapes, compact disks, and software; first from major cities and then from smaller ones. In order to enter the World Trade Organization, China has had to promise to protect intellectual property rights and to obey patent conventions. On a practical level, the Chinese do not usually copy industrial components and subsystems and then try to market them. They do not take these kinds of entrepreneurial risks.

Most favored Nation Status. There has been a great deal of saber rattling in the US over issues of perceived human rights violations, prison labor, weapons proliferation, threats to Taiwan, etc. For many years, the US Congress and the President have, at times, threatened to withhold MFN status to punish China by raising tariffs. President Clinton has announced the decoupling of the granting of MFN status from these issues. With the tremendous US investment (Motorola, Coca Cola, etc) in China, there appears to be little likelihood the US will withhold MFN status.

Getting Started

Like anything else in life, the first step is the hardest. First, choose just one or two components for sourcing. These parts should be carefully selected according to the following criteria:

Pick a part where a price reduction will have a major effect. This way, success with this part will be a demonstrable coup.
Pick a part which is a mature part that has been in production for some time, do not choose a new part.
Pick a part which is now being successfully produced by a supplier that is doing a good job. If your Chinese sourcing project is successful, you can ramp up the Chinese supplier, ramp down the current supplier, and maintain smooth production.

Submit the drawings, estimated annual usage and quality concerns to the factory or to the third party provider. Submit multiple examples of samples, if possible, so that each of the Chinese factories under consideration can work with a sample. Now comes the hard part, waiting for the quote. For simple components this could take a week or less. For complex parts and assemblies it could take months. If you have good promotional literature that tells about your company and its market, send that along too. Chinese factories love to hear that their project is an essential part of a major American enterprise and this may decrease the response time.

As with American companies, you can expect several iterations until the factory "gets it right". A time table might be developed at this point to help you track the project. Here is a typical time table:

Time to quote	1 month
Time to place order	1 month
Tooling	3 months
Analysis of tooled samples	1/2 month
Time for first production	1 month
Ocean transport	1 month
Customs and surface transport	1/2 month
	-------------
Total	8 months

It's All Worth It

Offshore Sourcing is no longer a choice, it's a necessity. Although it has its risks, there are methods for beginning the process that minimize the risks, and offer a good chance for success. Earlier we suggested a simple safe way to begin the process with a single project or two. As you see the fruits of your labors entering your manufacturing stream as low-cost high-quality components, you will quickly climb the learning curve that makes the next project far simpler. Soon, you'll become expert at recognizing opportunities for offshore sourcing. Now is the time to start developing that first project and the key relationships for the future.