How to Avoid a Product-Recall Disaster
from January/February 2008
by William J. Holstein
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But Dorfman’s strategy may now be the blueprint for a lot of big American companies, in view of the wave of difficulties hitting supply chains throughout China. Herald Holdings, started with Chinese partners by Dorfman’s family after they fled to China from Russia’s Bolshevik Revolution, has been spared allegations that its factories engage in unsafe or unsound labor and environmental practices. And its commitment to quality has enabled it to sidestep the rash of product recalls that hit the toy industry (there’s debate over whether all of Mattel’s recalls of Barbie-doll accessories and other China-made products were due to its own faulty designs) as well as retailers like Wal-Mart, which had to pull pet treats from its shelves, and various other outlets that yanked a variety of products ranging from tires to toothpaste. Herald, which trades on the Hong Kong Stock Exchange, in effect runs its own supply chain, and that gives it hands-on control over the quality, safety, and social-compliance aspects of just about everything it sells. “Only manufacturers who understand these issues can expect to be long-term players in China,” says Dorfman, who still works with members of the Chang family, co-founders of the company all those years ago. The country itself, he adds, is very concerned that “Made in China” stand for quality goods produced for both domestic and foreign markets.
Manufacturing problems are almost certain to escalate with the passage of time. The reason: Western manufacturers and retailers, caught in bitter competitive battles with one another, are putting huge pressure on their Chinese suppliers to cut costs. That, in turn, creates huge incentives to cut corners in a country where hunger for profits tends to swamp all other considerations, including the environment, the lot of workers, and the quality of goods.
So getting Chinese supply chains right is a priority for companies that source there. Adopting noble-sounding resolutions, embracing codes of conduct, hiring compliance officers, and allowing third-party auditing and monitoring may all be positive steps, but alone they hardly suffice. Boards should understand that the value of their brands is at stake if “Made in China” becomes synonymous with flawed goods. Ultimately at stake is the future of the nearly three-decades-long love affair between Western business and China. “The Chinese know they have an issue,” says Daniel Vasella, 54, chairman and CEO of the Swiss drug giant Novartis AG. “They’ve earned such huge trade surpluses, and they don’t want to jeopardize that. They also have a big employment issue”—meaning the millions of workers who depend on manufacturing jobs.
The Chinese government has taken a series of steps to correct lapses in quality, most glaringly the execution of the official who once led China’s version of the Food and Drug Administration. Vice Premier Wu Yi, the so-called Iron Lady of the Chinese government, is leading a work group that’s attempting to respond to the problem, much as China eventually responded successfully to the outbreak of the SARS disease. Over the longer term, the government is attempting to shift the country’s manufacturing upmarket, away from the types of goods where cost is the primary differentiator. China is also enticing foreign companies to help develop technology and science.
But even in a best-case scenario, it will take the Chinese years to find a systematic fix for what has gone wrong. “Their growth is outstripping their ability to control quality,” says Novartis director William George, 65, the former CEO of Medtronic, who serves on the boards of Exxon Mobil and Goldman Sachs Group as well. “It’s a matter of huge concern. There’s going to be a rethinking [inside U.S. corporations].”
George, also a former member of the Target board, says that the big retailer has 4,000 employees in Hong Kong making purchasing decisions and attempting to safeguard the quality of the goods it buys from China. Robert Dorfman can’t come close to fulfilling all Target’s needs, so what should the retailer do now? “If the Chinese government isn’t going to back up their products, U.S. companies have to do their own quality control,” says George. The economics of sourcing in China will change profoundly if companies are forced to build their own factories. Some outfits, George predicts, “will have to change their sourcing and go somewhere else.” Among the likely destinations: India and Vietnam. But don’t expect either to be problem-free. India’s infrastructure is bad; Vietnam simply can’t handle the same volume of manufacturing as either China or India. The CEO of one major U.S. retailer says that if he’s forced to invest more in quality assurance in China it may even make sense to bring some manufacturing back to the U.S., particularly of items that are time-sensitive, such as fashionable clothing or seasonal goods. “The transportation costs of China are obvious, but what’s less obvious is that we may need to make a distinction between products you make through a longer supply chain versus the products you need on a shorter time frame,” he says. To put it another way, China’s quality problems may combine with deeper shifts in how CEOs are thinking about their supply chains to produce big changes in how and where their companies source.
There are essentially four models of manufacturing and sourcing in China:
- Wholly owned manufacturing. Intel Corp., for example, is investing $2.5 billion in a plant in Liaoning Province to make semiconductors that will be sold in China and abroad. It will have thorough control over the operation.
- Joint ventures with Chinese entities, mostly government-related. This has been the preferred route for hundreds of U.S. companies. They must have personnel on the ground, which provides some measure of assurance about quality and ethical-sourcing issues.
- Long-term contracts with Hong Kong- or Taiwan-based companies that take responsibility for manufacturing on the mainland exclusively for export.
- Pure sourcing, usually through agents or middlemen, often by means of an auction process where many buyers have no relationship with suppliers and no knowledge of where anything originated.
These last two strategies are where most of the trouble lies. Relying on third-party monitoring may be sufficient to identify labor or environmental problems, but it’s not enough to protect the quality of products. Monitors don’t have the expertise or resources to vouch for every aspect of quality. Pure sourcing, of course, means that the cheapest goods sell, not the best-made.
Manufacturers and buyers frequently have little alternative but to deepen their presence on the ground, as Dorfman has done. “Many of these smaller manufacturers have very little regard or understanding of compliance or code-of-conduct issues,” he says. Even when his company does farm out work, he adds, “we invest substantially in educating our subcontractors on compliance issues and spend a great deal of time and energy in monitoring everything from production-floor issues to the usage of raw materials.” All of which costs money.
One implication for U.S. companies is that they will have to abandon the common practice of sourcing from dozens or even hundreds of suppliers about whose own supply chains they have scant knowledge. Building and running your own factories isn’t the only option, however. U.S. companies could also just source from fewer suppliers and engage with them more deeply. If you account for only 1% to 2% of a Chinese factory’s output, you have little hope of swaying factory management. Account for 40% and you can make sure a supplier complies with your quality and ethical policies. In fact, “if you say ‘Jump,’ they say, ‘How high?’” says William Fung, 58, group managing director of Hong Kong’s Li & Fung Group, a $10 billion-a-year contract manufacturer based in Hong Kong whose clients include the likes of Nordstrom.
Li & Fung Group is the 800-pound gorilla in the world of contract manufacturing, with 25,000 people in 40 countries. It has a particularly strong presence in China and is a leader in managing supply chains in their totality rather than merely acquiring finished goods.
Fung says many U.S. board members don’t understand the reality of how Chinese factories operate. They are typically owned and managed by people who want to make a lot of money fast and therefore wish to run their factories at or close to capacity. Workers, who often migrate to coastal provinces such as Guangdong from low-paying agricultural jobs deep in the interior, also want to make money in a hurry so that they can go home. The system is thus geared toward long work hours, and the American ideal of a 40-hour workweek just isn’t relevant. “The workers sign up for two to three years and know they will live in a dorm,” Fung says. “If you tell them they should relax and live the good life, they say, ‘Are you kidding me?’”
Many factories display codes of conduct on their walls that have been imposed by managements and boards in the U.S. But there’s little chance of changing the way managers manage or workers work, says Fung, who earned an engineering degree from Princeton and then an M.B.A. from Harvard Business School.
That gap between good intentions and reality widens when a foreign company has divided its purchasing operations from its compliance or corporate social-responsibility folk. The purchasers apply relentless pressure to drive down costs, improve quality, introduce new features, and speed up cycle times. When compliance officers make their on-site appearance at a factory, they are often too late. “If buyers gear up manufacturing and then the compliance guys show up and say, ‘Not in compliance,’ that’s crazy,” says Fung. U.S. companies have to recognize that their buyers and operations people must cooperate closely with their own compliance people.
A better way for U.S. companies to impose codes of conduct, Fung says, would be for their managers to spend time at the factories and work with local counterparts to improve their operations step by step. Sears, for example, has a program focused on its employees’ eyesight. The company pushes to make certain work areas are properly lit, conducts vision tests, and helps workers who need them get eyeglasses.
This approach functions best when a company has Chinese-speaking executives on its own payroll, with experience in all aspects of manufacturing and workforce development.
Working with Chinese owners and managers to persuade them to raise standards is far more effective than plastering the walls with unrealistic codes of conduct. When Fung talks to factory managers and owners, he tries to appeal to them to improve product quality and social and environmental practices because it will help them make more money over the long term. “I tell factory owners that they are building barriers to entry against hundreds of other competitors,” he says. “I say, ‘If you want to distinguish yourself from the competition, you’ve got to look at this positively.’”
Companies that merely source in China, such as Wal-Mart, are the most vulnerable. The ticking time bomb for them all is that some of their products will be discovered to be unsafe. This is especially likely if the buyer exerts tough pricing demands on its suppliers, as Wal-Mart does.
Corruption is another reality of doing business around the world, and China is no exception. A frustrated buyer for one major retailer recently pulled out his PDA and displayed a photograph showing a pile of crisp Hong Kong dollars worth US$5,000. Then the buyer clicked a button and brought up another picture of a pile of currency, and another. “When our company’s monitors go to factories in China, the managers routinely offer them these piles of cash” to certify that the factories are in compliance with the company’s standards even when they’re not, he explains. “We’ve trained our people to take pictures of the bribes but then turn them down.”
Why go to that trouble?
The buyer doesn’t put all the blame for corruption on the Chinese or their culture—he saves some for U.S. boards and managements. “The standards they set are so aspirational,” he says. “So you force people to lie to you. You force them to bribe each other. There’s not a single factory in China that wants to operate only 49 hours a week. They want to double that.” When a monitor shows up in an attempt to enforce 49-hour weeks, the only alternative that factory managers perceive they have is to bribe the monitor.
Can companies expect China’s government to implement any kind of system that safeguards quality production and ethical working conditions? Western businesspeople in China are skeptical. In many crucial respects, Beijing has lost control of what happens at the local level. Provincial and municipal Communist Party officials, who are deeply involved in jobbing and subcontracting, would resist edicts from on high that might eat into their own profits. In other words, the burden of improving how goods are made and under what conditions will fall on foreign companies.
Mattel chairman and CEO Robert A. Eckert, 53, says his company will now test every single batch of paint from every single vendor for lead and other dangerous components, launch more surprise inspections of manufacturers at various stages of production, and conduct an increased number of tests of finished products. The company has also named Geoff Massingberd to head a new corporate-responsibility unit reporting directly to Eckert. Massingberd, most recently with Mattel’s international division, will be a senior vice president and sit on the company’s management committee. His mandate will include product integrity, global sustainability, environmental health, and safety.
Mattel’s real quandary, of course, is the same one facing other companies that get goods from China. Should it spend the money and engage more deeply and comprehensively with an entire supply chain in China, or make the tough decision that it’s time to diversify to another country? One thing is for sure: Assuming that Chinese supply chains will adhere to Western standards of their own volition is a recipe for disaster .
