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Supplier Risk: Outsourcing To China Can Get Costly

Richard Meyer | July 31, 2007

Cheap is very often expensive. That’s the lesson being learned again by companies outsourcing production to China.

With the recent spate of food contamination and other product scares—from melamine in pet food to lead-painted Thomas the Tank Engine toys to toxic cough syrup—many companies in the United States are being advised to do what they should have done when they first moved production offshore: better assess their risks.

Specifically, companies need to do a better job identifying their supplier risks. That means asking some tough questions about exactly what they are buying and establishing the proper structures—both financial and physical—to protect against problems that can arise when outsourcing manufacturing to a developing country on the other side of the planet.

According to risk consultants, many larger and more experienced multinationals have fairly good systems in place already; they have simply been encouraged to recheck and enhance their management of supplier risk. But many other companies are far from prepared. In those cases, the companies were often drawn to China (or to other low-cost countries) by inexpensive manufacturing or development costs. Downside risks, however, sometimes were not taken into account; companies that signed contracts with Chinese manufacturers and shuttered domestic factories are now going back to reassess whether the move makes long-term strategic sense. Many of them may find that the move that once looked so financially attractive may ultimately be a very expensive proposition.

“People get too focused on price,” says Carl Lidstrom of the consulting firm RMR Risk Management Resources. “It may be one-fifth or one-tenth of the price, but that’s not the whole story. And you may not know the whole story for a long time.”

Lidstrom, whose firm provides risk consulting services on a variety of issues including outsourcing, notes that many companies have neglected long-term risk assessment—including brand risk and business-discontinuity risk—to save on the “unit cost” of manufacturing. “It seems to me that American industry is too focused on unit cost,” he says. “People get obsessed with unit costs and forget everything else.”

Lidstrom offers an example: A company sources a component from overseas and sells that component to another company. The unit cost may be low, Lidstrom concedes, but what if a bad batch comes in that is rejected by the customer? Suddenly, the company is faced with expensive damage-control issues with a party on the other side of the world. It might have to halt production overseas, appease the local customer, sort through the original shipment, air-freight replacement products, manually trace the source of the problem, renegotiate with (or replace entirely) the supplier, and do so while simultaneously working to restore its reputation, serve other customers, and grow the business. Language barriers and quality-assurance issues alone could give you a headache, and Lidstrom notes that one incident could wipe out the entire amount saved by buying cheap.

Companies that manufacture in-house, or those buying from a domestic supplier, are in a far better position. They have much more control over the process, and typically have more direct and rapid recourse if something goes wrong. In addition, if the company has cultivated a long-term relationship with the supplier, it likely has a good understanding of the strengths and weaknesses of that supplier, not to mention service-level agreements that are sometimes alien to outsourced manufacturing arrangements. As a result, risk can be significantly lowered. Jumping borders and buying from a party not well-known greatly increases the danger—risk adjusted returns on those relationships may very well be negative.

“You don’t have control over a Chinese company,” says Lidstrom.

Minimizing Supplier Risks

Far worse than the occasional substandard shipment is the possibility of buying and then selling something that is simply dangerous. If a company is dealing with food or critical components in a vehicle or a structure, the product purchased, if faulty, could harm or kill someone. If the American company’s name is on the product, that company may be sued or have to pay for a recall. Again, the company could end up paying out far more than it saved by going offshore; indeed, the company could be driven out of business.

That’s exactly what happened to Foreign Tire Sales, a New Jersey importer of tires from a Hangzhou, China-based supplier. After a fatal accident involving one of the tires sold by Foreign Tire Sales, the National Highway Transportation Safety Administration ordered a recall that will cost an estimated $60 million to $80 million. The regulator says that the gum strip, a layer in the tire that is supposed to prevent steel belts inside the tire from separating from the rubber or damaging it, was either insufficient or simply not present. Foreign Tire Sales says it doesn’t have the money for the recall and is going to declare bankruptcy.

According to Lidstrom, this type of case can get particularly expensive. The corporation may not protect the managers or major shareholders; lawsuits can seek damages from employees and bankruptcy may not provide sufficient protection. This is exacerbated by the fact that it is often difficult to take legal actions against Chinese companies; if the foreign entity has a presence and assets in the United States, a judgment may be collected, but awards against Chinese companies cannot usually be collected.



Lam

“Companies underestimate the risk and overestimate the benefit of outsourcing,” says James Lam, a former chief risk officer at Fidelity Investments who now runs an independent risk consultancy.

American companies can seek to hedge against some of these risks. Product liability insurance, for example, is helpful in protecting against costs associated with suits arising from faulty or substandard products. Recall insurance is also a possibility, though Lidstrom contends that this is an extremely expensive type of coverage. Companies can ask their Chinese suppliers to buy this insurance themselves; while many Chinese companies will refuse, some may agree if they are trying to build their business in U.S. markets. In addition, some experts note that a Chinese company’s refusal to purchase this type of insurance could be a hint that quality and reliability are issues.

Industry experts say that while insurance is good, it can not mitigate all supplier and subcontractor risk. Reputational risk, for example, cannot be transferred away. Even if a lawsuit is paid by an insurer or a recall covered by a policy, the damage caused to a company’s name is a separate matter. The cost of recovering trust is borne by the company. Insurance is also quite an expensive way to hedge against risk, says Lidstrom. While he does advise his clients to buy insurance and believes that it is a key component to any risk solution, he says that a company should always find ways to replace insurance with lower cost alternatives.

The Suppliers Of The Suppliers


“There’s a desire to get more transparency when you are moving offshore. Companies want to assess risk further upsteam, and not just start at the borders and ports.”


— J.R. Regan,

Managing Director,

BearingPoint



Extensive due diligence on the supplier is one way to lower risk. A company should consider visiting the supplier’s factory, investigating the firm’s management, and even reviewing the suppliers to the supplier. In some cases, the employment or transfer of a full-time employee from the home office to China may be justified; frequent unscheduled visits, at the very least, are a good idea.

A critical component of the risk-management strategy should also include a “Plan B.” If the product from one sub-contractor stops or is not up to standard, alternative sources should already be known and engaged. Moving some production back in-house may also be called for.

Experts say this diversification is very important. “If your supplier is not performing, you need an exit strategy,” says Lam. “You need a ‘Plan B,’ and you also need a ‘Plan A.’”

What is required, consultants say, is a holistic approach, where all parts of a company cooperate to counter a wide range of potential problems. This is where Enterprise Risk Management comes in. Companies can’t simply transfer your risk to an insurance company; it’s too expensive and leaves gaps in protection. Executives also can’t manage all outsourcing risks simply by looking over a subcontractor’s shoulder—you will never have enough control to be totally effective in someone else’s factory. Instead, companies need to institute a comprehensive program that works across divisions and expertise to address known and unknown dangers. All parts of a business need to work together, from finance to information technology to manufacturing.

Hard To Justify

Some experts, like J.R. Regan, managing director of consulting firm BearingPoint’s risk, compliance, and security practice, are less concerned than others about the recent product scares from China.



Regan

Regan thinks that what’s happening now is just part of a market-development process, and that beneficial changes will be instituted by the Chinese side as well as by companies buying from China. Significantly, he notes no great up-tick in client requests directly related to recent overseas product problems.

He does, however, see an increasing interest on the part of multinationals to get a better handle on their supply chain, and this growing interest does not seem to be directly related to the recent news from China. Rather, he believes that companies are working to gain a clearer and more comprehensive view of the whole supply-chain risk-management process.

“There’s a desire to get more transparency when you are moving offshore,” Regan says. “Companies want to assess risk further upsteam, and not just start at the borders and ports.”

The increased scrutiny of suppliers, and the more detailed analysis of the costs and benefits of buying from overseas, may lead some companies to interesting and counter-intuitive conclusions.

For example, some advisors argue that the entire outsourcing proposition may be flawed because it hasn’t accounted for the hidden expenses of doing business offshore. When the cost of insurance is added to the cost of keeping close tabs on your low-bid supplier—who subsequently has a strong incentive to cut corners—and when that number is added to the cost of establishing redundant supply chains and other unanticipated costs (like management distraction and opportunity costs), then the decision to buy from China may begin to look expensive indeed.

One might just want to stay home.

“The whole outsourcing equation is hard to justify for smaller companies,” says Lam.