Management Accounting

Chinese Checking

What companies really think about the wave of defective products from China.
Russ BanhamSeptember 1, 2007

Is it really worth it? From tainted pet food, seafood, and toothpaste to unraveling tires, exploding cell-phone batteries, and lead-painted children’s toys, defective products from China are giving U.S. companies second thoughts about the benefits of China’s low-cost manufacturing.

In August, Mattel announced that its Fisher-Price division was recalling nearly 1 million toys — 83 products — that were finished with lead paint. All were made in China. Prior to that announcement, 24 types of toys had been recalled in the United States in 2007, and all were manufactured in China. In June alone, 68,000 folding chairs, 2,300 toy barbecue grills, 1.2 million space heaters, 5,300 earrings, 19,000 children’s necklaces, and 1.5 million Thomas the Tank Engine toys were recalled. All of them were stamped “Made in China.” A staggering 60 percent of all product recalls have been traced back to the country, according to the U.S. Consumer Product Safety Commission (CPSC).

Yet by and large, companies and the consultancies they hire to evaluate sourcing opportunities in China continue to say that the risk of recalls is worth taking. “If you manage and maintain quality in your sourcing operation and invest in it, the benefits are too large to ignore,” says Bill Ferko, vice president and CFO of Genlyte Group (2006 revenues: $1.5 billion), a Louisville-based manufacturer of lighting fixtures that sources components, subassemblies, and finished products from more than 20 factories in China.

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Learning from the experience of U.S. apparel makers, which achieved huge cost savings by manufacturing in China in the 1980s only to incur public wrath when inhumane working conditions in the country were revealed, many manufacturers like Genlyte have developed strict quality protocols in their China sourcing. The process begins with systematic evaluations of potential suppliers, which are provided written expectations of product quality and safety specifications. Quality-assurance inspections by in-house or retained engineers follow, ending with a final check of the product at the importer’s loading dock. In between is a legion of other tactics to combat potential problems such as intellectual-property theft and poor labor conditions.

But quality programs are not infallible. Mattel, for example, not only had quality controls but had also worked for 15 years with the Chinese plant that made the lead-painted toys. “They understand our regulations, they understand our program, and something went wrong,” CEO Robert A. Eckert told The New York Times in August.

Systemic Problems

There is no mystery why U.S. businesses flock to China: the country’s giant workforce churns out nearly a trillion dollars in goods and services at a labor cost that would be illegal here. Typically, a U.S. or Western European factory worker costs an employer $15 to $30 an hour; a Chinese factory worker, by contrast, earns less than $1 an hour, according to Boston Consulting Group (BCG).

Even if wages in China were to increase at a 15 percent annual rate over the next five years and rates in the United States were to increase at a 3 to 4 percent clip, average hourly wages would be a scant $2 in China and $18 to $36 in the United States. While currency exchange rates play a role in this calculation, BCG says even a fourfold strengthening of the yuan against the dollar would still make wages in China half what they are here. Small wonder that China currently provides 40 percent of U.S. consumer imports, nearly $250 billion worth of goods annually.

“China is generally competing on price, not on quality or safety or the integrity of the supply chain,” says Pietra Rivoli, a professor at the McDonough School of Business at Georgetown University and author of the book The Travels of a T-Shirt in a Global Economy. Expecting the government of China to solve manufacturing quality issues for importers is quixotic, she says. “There are few, if any, safety nets.”

For example, China has no equivalent to the CPSC. While the government has promised stricter enforcement of regulations, stepped-up inspections, and more-punitive actions against makers of substandard goods, it also has intimated that the recent debacle surrounding product quality was exaggerated by the foreign media. “The country’s usual response to a scandal is to find a scapegoat,” Rivoli says, pointing to the recent execution of the head of China’s food and drug administration, Zheng Xiaoyu, convicted of accepting bribes linked to substandard drugs.

“Officials don’t want to admit the fallibility of the system, because that hurts their power,” adds Rivoli. “They’d rather find fallibility in an individual.” Nevertheless, she says, the recent recalls “are not isolated problems of product quality. They’re systemic.”

A recent nationwide survey of food, drugs, and consumer products by China’s General Administration of Quality Supervision, Inspection, and Quarantine backs her up, finding that 20 percent were substandard or tainted. For example, more than 23,000 cases of low-quality or fake food were uncovered, requiring the closure of 180 food factories. The results were often shocking: bread with 50 percent paper-pulp content, pigs fattened on force-fed wastewater, lard made from sewage.

The disgusting revelations have taken the gleam off China’s low-cost labor for some. “Companies must move away from an all-China, all-the-time sourcing policy,” insists Paula Rosenblum, managing partner of Retail Systems Research. “Continual and increasing dependence on China as the sole source for manufacturing is a mistake waiting to happen.”

Do They Really Get It?

But despite the wave of product recalls in recent months, many sourcing specialists maintain that most manufacturers in China are sophisticated enterprises, with years of experience serving Western needs. “Since China joined the World Trade Organization in 2001, they really do get it — ‘it’ being the need for product quality and safety,” says Alan Schoem, senior vice president in the global product risk practice at insurance broker Marsh, and formerly the head of the compliance office at the CPSC.

Others concur. “Thousands of American companies import millions of different products every year from China that are of the highest quality and safety,” says Gene Rider, vice president of global retail services for Intertek Plc, which assists companies by monitoring foreign-supplier quality and safety. Asked to explain the high rate of product recalls, Rider notes that not all the recalls were for manufacturing defects. “On average, two-thirds of the recalls were the result of design defects,” he says, “and you can’t blame China for that.”

Rather than trim their sourcing from China, many companies expect to increase it. “Forty to 50 percent of our sourcing on behalf of our customers is from China, compared with 30 percent five years ago,” says John Caltabiano, vice president of sourcing at Solectron Corp., an electronics manufacturing services provider. “We expect this to grow.”

But Caltabiano acknowledges the concern over product quality. “The recent quality lapses of products made in China are alarming and should be of great concern,” he says. “However, the electronics industry is well established in China, and the components being manufactured in China are not life-threatening issues.”

Genlyte has no plans to reduce its dependence on the 20-plus factories in China it sources from. “We’ve been manufacturing in China for 20 years, and many of our suppliers have been with us over that duration,” says Ferko. “To ensure quality, we have a small staff of indigenous contract employees in China that works exclusively for us. We’ve trained them to identify quality issues and to maintain our standards, working closely with suppliers to ensure they understand our definition of quality and confirm that the products meet our specifications.”

Ferko says the defect rate for Genlyte products made in China is less than 0.02 percent, consistent with the defect rate for its U.S.-manufactured products. “We go through an exhaustive prescreening of all our contract manufacturers, most of them located in South China’s Guangdong region,” he says. “We check their reputation, ask for references, and see if they’ve done similar work to what we want them to do.” Ferko says Genlyte weeds out manufacturers that it believes will not maintain consistent quality standards or always look out for Genlyte’s best interests. “We haven’t had any significant problems over the years,” he says.

The same can be said for Arrow Electronics Inc., a Melville, New York–based global distributor of electronic components and computer products, with $13.6 billion in 2006 revenues. Arrow has sourced products and components like semiconductor chips from China for the past 15 years. “We purchase only from known suppliers and then do standard things like get trade references and cross-check them,” says CFO Paul Reilly. “We also check their banking relationships, and talk with trade associations and government bureaus. We see if they have global certifications like ISO 9000, and we’re big believers in physical onsite inspections and regular testing.”

Arrow has developed a broad list of performance metrics in its contractual agreements with Chinese suppliers. “The recent scandals made us stop and think about the challenges of ensuring quality products not just from China, but from everywhere else in the world,” Reilly says. “While we expect to increase our vigilance, we have not had quality issues emerge from the suppliers we deal with.”

Before making its sourcing decisions in China, Solectron looks at four supplier capabilities: manufacturing and quality systems, ownership structure, financial backing, and localization. Doing the evaluations are local quality engineers, commodity managers, and financial analysts. “They’re our employees, and they’re located in Shanghai, Beijing, Shenzhen, Hong Kong, and elsewhere in the country,” Caltabiano says. “The commodity manager looks at the supplier’s ability to meet our cost requirements; the quality engineer evaluates technical expertise and then tests and audits this; and the financial analyst examines financial backing, credit, and ownership structure.”

Surprise, Surprise

A key practice in evaluating supplier quality is unannounced inspections, either by an in-house staff like those employed by Arrow, Genlyte, and Solectron, or by an independent testing agency like Intertek, OnSpex, or Bureau Veritas. Such agencies audit suppliers’ quality systems against world-class manufacturing practices and ISO standards. “We’ve got 19,000 people on the ground in more than 100 countries involved with thousands of vendors every day,” says Rider from Intertek. “All of them are local, but they’re our employees, many of them trained in the West. We don’t use expats, because they don’t understand the culture or the working environment. In China, [our employees are] all Chinese.”

Intertek evaluates and measures critical control points in a supplier’s manufacturing process, and certifies that the factory is doing these evaluations and measurements itself. The agency also samples products, literally taking them apart for so-called destructive testing. “If you do a sufficient number of tests that are representative of the population of products produced, following established statistical protocols like ‘one-hundred-parts-per-million,’ you get a pretty firm grasp of quality,” Rider adds.

Ann Chen, a partner in the Hong Kong office of consultancy Bain & Co., who heads up the firm’s consumer-products practice in China, agrees that a combination of explicit rules of engagement, codified processes, surprise spot checks, and investments in internal or outsourced inspection programs can pare supply risks to a minimum. “It all starts with a very high hurdle in terms of qualifying suppliers,” Chen says.

She advises companies to consider a “probational” period before engaging a supplier and interrupting it with a random inspection by a third-party testing organization. “Have a list of things to test for that are very explicit, and a clear policy of [contract cancellation] based on violations,” she says. “You need to set an example that there’s zero tolerance for people who don’t follow your policies. If they pass, then constantly go back to square one in terms of requalifying them.”

Adherence to stringent supply-chain risk management is the antidote to product defects, the experts contend. “There are some great companies with unbelievable capabilities in China, but they vary by region and experience,” says Caltabiano. “If they’re brand new, they’re likely to not know what they’re doing. But the companies with a solid track record, and strong management involvement and commitment to provide oversight and manufacturing controls, are well worth the investment.”

Russ Banham is a contributing editor of CFO.

Sharing the Load

A database helps companies monitor Chinese factories.

Companies in the retail industry have found that sharing information on their Chinese suppliers helps reduce the risk of product defects.

In 2005, several U.S. and Canadian retailers and retail organizations — including Reebok International, Federated Merchandising Group, Hudson’s Bay, and the National Retail Federation — formed the nonprofit Fair Factories Clearinghouse to collect and trade information on their respective factory audits and compliance monitoring data in China. This information has been assembled into a database that is available to the industry over the Internet to assist company-sourcing decisions. More than 11,000 factory records have been assembled and presented to date.

The initial database was established by Reebok as a way to ensure that the factories it worked with were meeting the company’s standards. “We’ve been at this a long time and had used the tool internally as part of our human-rights initiative,” says Peter Burrows, head of Region Americas and Global IT at Adidas Group, which acquired Reebok for $3.8 billion in 2005. Previously, Burrows was chief information officer of Reebok.

“Other industries might consider a similar approach,” Burrows adds. “If you care about product quality and your brand, you have to treat these factories as if they belong to you.” — R.B.

A Recent Roll Call
U.S. recalls of Chinese-manufactured products, July 18–August 3, 2007
Importer Product Number
Reason for Recall
Raleigh America Bicycles 1,200 Forks can break
Mattel (Fisher-Price division) Toys 967,000 Lead paint
Springs Window Fashions Window blinds 140,000 Strangulation hazard
Orvis Toys 1,520 Choking hazard
Estes-Cox Remote-control airplanes 21,000 Explosion risk
Black & Decker Trimmer edgers 202,000 Hazard from projectiles
Yotrio International Lounge chairs 15,000 Collapsing hazard
CVS/pharmacy Sippy cups 84,000 Choking hazard
Hasbro (Easy-Bake division) Toy ovens 1 million Entrapment and burn hazards
Atico International USA Coffeemakers 392,000 Fire hazard
*Figures are approximate.
Source: U.S. Consumer Product Safety Commission