Great Wall No Longer

After a recent series of product recalls and warnings about certain goods manufactured in China, a growing number of Canadian companies that are planning to invest or expand their businesses in China are working to recognize and assess their potential risks there. By developing a business strategy, they can take advantage of the vast opportunities presented by what has become the world’s largest economy.

A recent Mercer survey found more than 90% of multinational companies said China is important to their global strategies, with 52% calling it critical. Multinational corporations directly invested more than US$60 billion in China last year, and in 2008 investment shows no signs of slowing down. For the first nine months of 2007, exports from China were up 27%, to about US$880 billion. Canada imported Cdn$35 billion worth of goods and exported Cdn$8 billion to China.

Companies today are doing considerably more homework than firms that entered China 10 to 15 years ago. Those that stayed are seeing the benefits today after they learned, as a line from the book Mr. China, A Memoir1 states, to “extract value from difficult situations.”

The following are some recent questions received by Marsh’s supply chain risk practice:

• Why did the recall of millions of toys made in China happen in the first place?

• Have the recent recalls of products made in China dampened business interest?

• Are the risks of doing business in China greater today than they were a year ago?

• What is the quality of construction like?

• How does a firm identify and select the right partner?

• How can we protect our intellectual property?

Profitable business opportunities are available in China if risks are properly assessed; if the company’s leadership is able to keep abreast of the country’s evolving regulatory environment; and if the firm has experienced risk managers to help properly plan the new venture.

China continues to take actions to move toward a more open and liberal economy. It made this commitment in 2001 when it joined the World Trade Organization (WTO). At the five-year review in 2006, a number of organizations assessed its progress. Eighty-five per cent of respondents said they have seen “great” or “considerable” improvement in China’s business environment since it joined the WTO.

CHINA: IMPROVING STANDARDS

As its manufacturing sector continues to expand and evolve, China is being closely scrutinized by manufacturers and consumers in Europe and North America.

News media are looking closely at product safety, working conditions, and potential labour issues in countries where goods are manufactured. At the same time, businesses investing in China need to be aware of potential natural hazards, such as the country’s earthquake and flood zones, as well as potential transportation, infrastructure, and workforce issues, including turnover and lack of skilled technical labour in certain emerging regions.

China’s government has tightened up enforcement of quality, safety and environmental regulations. Nonetheless, companies operating in China or purchasing finished goods or components from suppliers

there must ensure that potential risks are adequately identified, assessed and mitigated.

For many Canadian companies, China presents two major opportunities:

• achieving a lower manufacturing cost; and

• selling into a new and rapidly growing marketplace.

Both come with significant pitfalls that should be avoided. That’s why companies must balance risk against benefit.

SOURCING FROM CHINA

Sourcing from China or other emerging markets has become a core strategy for many companies pressured to lower product costs. Companies routinely estimate they will save between 30% and 40% by sourcing components or products from China. However, the savings are more typically 12-14% because of the impact of unanticipated supply chain costs and volatility. One company, for example, saw its inventory carrying days jump from nine to 44 days, its finished goods carrying costs increase 184% and its freight costs become much greater than expected because of frequent expediting requirements and unexpected fees.

Some companies have found they will actually lose money if they source too much from a single country: longer lead times mean they can’t respond rapidly enough to meet volatile customer demand. For instance, a consumer goods company was convinced it should source 80% of its goods from suppliers in China. But a full cost-and-risk analysis showed it would make the most profit by sourcing only 18% from these suppliers.

Still, a growing number of companies find it worthwhile to do extensive business in China, as long as risks and volatility are well-managed. A consumer products distribution and logistics company reports achieving the same lead times, better quality and lower cost from its Chinese suppliers

than it achieves domestically. The high performance level came from applying rigorous analysis and mitigation of variability and other risks in its China supply chain and quality processes.

SELLING INTO CHINA’S MARKETPLACE

China’s domestic market is becoming increasingly enticing. Its rapidly growing middle-income population is expected to surpass 300 million people in a few years. A recent survey by the European Union Chamber of Commerce in China found the primary reason for European firms doing business in China was to produce goods for the Chinese market. Similarly, a

U. S.-China Business Council survey found that 57% of respondents cited having a presence in the country’s massive domestic market as a main reason for being in China.

When selling into the Chinese market, companies’ concerns ranged from infrastructure issues — arranging a reliable network of intra-China transportation and distribution partners — to intellectual property concerns. It’s also important to find the right construction partner. For instance, one company had a new distribution centre built in China, only to find out the building’s designers didn’t include loading docks.

Given the potential for increasing dependency on their operations in China, forward-thinking companies have spent time identifying and anticipating potential problems or risks. Problems arise when companies haven’t sufficiently evaluated their risks. A recent Marsh survey of European clients with operations in China found only 21% said they had a full business continuity management plan in place, 56% said their plans needed development and 8% said their plans were non-existent.

With this in mind, what framework should you use to assess potential supply chain issues? What should be part of your

business planning process once you have determined that China is a place you want to grow? How will you identify the potential impact of an impediment to your manufacturing or product supply chain?

BUSINESS PLANNING

A systematic approach should include the following basic steps:

1. Identify critical dependencies.

• Evaluate and map out the risks associated with your product supply chain.

• Identify and prioritize key suppliers and logistics nodes.

• Don’t forget to look for hidden interdependencies, such as too many of your suppliers relying on the same raw material or component supplier.

2. Diagnose key suppliers’ risk exposures and their resilience to supply chain disruptions.

• Identify and prioritize suppliers’ main risk issues.

• Design a risk management program.

3. Conduct an in-depth analysis of critical supplier and logistical risks, and prepare management and mitigation procedures.

• Implement risk management/transfer programs.

• Update sourcing and procurement policies.

• Provide project management support. 4.Monitor and control process.

• Implement reporting and measurement pro
cesses and standards.

• Continually test and update the program. These steps will help you conduct a

critical assessment of existing and potential suppliers and help evaluate the risks. Next, you need to consider the issues associated with bringing your products to market. The world of logistics in China is somewhat different than in North America, where the cost of moving the product is usually less than 5% of the product’s retail value, compared to 10% or more in China.

Location, local government regulations and inter-provincial licences can be significant logistical challenges. The Chinese government has taken many positive steps to improve transportation bottlenecks. It has established a national superhighway system, added 17,000 kilometres of track to the railway network, plans to build 44 new airports between 2006 and 2011 and invested US$80 billion for new ports by 2010. A recent regulatory decision allows foreign logistics firms to establish wholly-owned subsidiaries in China. This will help move China’s logistics industry from a manufacturer-owned, local and fragmented array of companies to a more national, streamlined and specialized approach with international expertise.

BRAND AND REPUTATION RISK

Last year, the headlines were filled with product-recall announcements, putting into question long-recognized household names. But all of it was due to manufacturing quality. To put this into perspective, let’s take toys as a category that has received quite a bit of press. Approximately 60% of toys sold worldwide are made in China. In 2006, that amounted to more than US$22 billion in the United States alone. A 2007 study conducted by Bapuji and Beamish looked at which portions of the supply chain were most in need of improvement: manufacturing or design. This study highlighted one recall that blamed problems on design rather than on manufacturing. The study found about 0.25% of U. S. toy recalls related to imported toys manufactured inside China; design-related recalls made up about 0.5% of U. S. toy recalls in 2006. In comparison, imported toys manufactured outside China accounted for about 0.4% of U. S. toy recalls, whereas design-related recalls of non-China-manufactured toys amounted to 0.7%. The authors point out an increasing trend in recalls. This would indicate a broader risk profile should be conducted, without limiting the study to manufacturing issues alone.

Chinese President Hu Jintao has vowed to make the quality and safety of Chinese products a top priority. The government has responded with a more robust enforcement of standards. For example:

• 2,150 small chemical companies on the shores of Lake Taihu will be closed by the end of 2008 due to a recent water-pollution scare. Lake Taihu is the third-largest freshwater lake in China; it is the source of

drinking water for about 30 million people.

• In January 2008, China introduced a new labour contract law to deal with a rising number of labour disputes. It will address severance pay, non-compete clauses, probationary periods, part-time employees, mass layoffs, collective bargaining, creating company policies and the role of labour unions.

• Last year, China revoked the licences of 564 food companies as part of a special campaign to ensure product quality and food safety and strengthen food safety supervision.

However, responsibility for quality assurance ultimately rests with the manufacturer. That’s why we’re starting to see companies in all parts of the world penalize suppliers that don’t adhere to proper product safety protocols by not accepting products.

A key challenge for product and component manufacturers in China is to ensure the quality of the product risk management capabilities meets not only the regulations in their local jurisdiction, but the stringent safety standards of the countries where they want to distribute products. This has led to the introduction of new risk management tools and insurance products. One of these products is an integrated product liability package that provides a broad-based, one-stop solution for original brand manufacturers; it includes a risk management analysis/ review, product safety, design audit and product liability insurance. The questions listed above — i. e. those related to expanding your business to China — should provide food for thought. However, it’s more important for a company to understand how to plan for and resolve potential product safety crises arising from their Chinese operations before there is any impact on their brand or reputation.

Among the steps companies can take to reduce the likelihood and severity of

major product or safety events are:

• establish a management system for product safety and product liability;

• analyze product risk exposures and design and implement product-recall plans;

• investigate the availability and pricing of products liability insurance;

• develop the capability to track and trace products from manufacture all the way through to the final delivery to the end consumer;

• enhance contractual protections with suppliers, vendors, and customers;

• audit supply chain production quality; and

• understand how to comply with the variety of local, national, and international regulations, treaties and laws.

Once you have done your homework, your business can select the right partner, put the right risk management procedures in place and continually monitor and update them. You will then be in a position to have the right insurance program built around your specific needs.

1 Mr. China, A Memoir by Tim Clissold, Harper Collins Publishers 2 Research Report, Toy Import and Recall Levels: Is there a Connection, by Hari Bapuji, Asper School of Business; Paul Beamish, Richard Ivey School of Business; Andre Laplume, Asper School of Business 3 National opinion poll conducted by the Asia Pacific Foundation of Canada and the Globe and Mail.