The story is so well-known that some think it’s an urban or Internet myth. It isn’t. It’s all too true.
Several years ago, an Oregon woman bought an inexpensive Halloween decoration kit at a local Kmart. When she opened the box, a handwritten note fell out. It was written by an inmate in a Chinese prison begging someone, anyone, to let the world know that he and others like him were forced to make the Halloween graveyard kit under horrific conditions in Unit 8, Department 2, of the Masanuia Labor Camp in Shenyang, China.
The incident left Kmart’s owner, Sears Holdings Corporation, scrambling to answer media inquiries. Sears officials said the company found no evidence that its Asian supplier subcontracted to a Chinese prison, but that Sears no longer was sourcing from that supplier. The company stressed that its contracts demanded strict adherence to safety and human rights standards, and it issued a statement that its investigation uncovered no violations.
But the damage to Kmart’s reputation was done.
The Kmart story is dramatic, but it’s not unusual. When companies establish a supply chain in emerging Asian markets, they generally focus their attention on first-tier suppliers. But a bevy of risks lurks below that tier.
Unauthorized subcontracting is common in Asia, and can cause significant quality problems and bring unknown, potentially unscrupulous players into the mix. Asian supply chains are also fraught with conflicts of interest that can lead to rigged tendering processes and disputes that can bring a supply chain to a grinding, and often inexplicable, halt.
These dangers are particularly acute for companies that produce basic products like toys and apparel in which a large number of suppliers may do the work. Supply chain executives must understand where the risks lie and how to avoid them.
Problem #1: Conflicting Interests
Trouble can start even before a company selects its suppliers. A procurement team seeking a provider in the Asian market usually identifies three or four primary candidates, and requests a bid from each. At this stage, the team rarely probes the business interests of these competing suppliers. But often unbeknownst to the team, the owner of one of the candidate suppliers has a financial tie to one or all of the others.
Since the bidding companies, for all practical purposes, are jointly or cooperatively owned and managed, they can coordinate their proposals and agree to share in the spoils no matter which company wins.
Such rigged bidding processes can inflate buyer costs, diminish profit margins and thwart a company’s ability to control the quality of its products. If a company has issues with the work of a given supplier, the company may threaten to use another. But that new supplier may be owned by the old one, so the threat is hollow.
Members of the procurement team may have conflicts of interest. Regional procurement teams typically include a manager from the region because that person knows the local language, as well as the suppliers in the area. Some procurement managers take advantage of their position by taking inside information to a provider. This provider can establish a new entity designed and promoted to secure this particular contract, in which the procurement team member has an interest (sometimes through a friend or family member). The team member then steers work to that entity.
Undetected conflicts of interest can stop a supply chain in its tracks. A large U.S. consumer products company experienced the consequences of such conflicts when it tried to withhold payment from a supplier for a large volume of goods that failed to meet contractually agreed-to quality standards.
Executives with the company did not know that its supplier owned the trucking company that had the contract to deliver its goods to port. In retaliation for its client refusing to pay for the substandard goods, the supplier ordered its trucks to block the company’s local warehouses. The blockade prevented the consumer products company’s employees from entering and its products from being shipped. Business stopped. Held hostage, the company had to make a quick financial settlement to restore operations.
Problem #2: Unauthorized Subcontracting
Although most contracts with suppliers prohibit unauthorized subcontracting, the practice is common. Local suppliers can become overbooked, and unable to take on a new project or order. Because the competition is fierce, they may fear that, if they turn down work, a client may never return. To maintain the relationship, the local provider subcontracts the work without informing its client.
Undisclosed subcontracting makes it more difficult to detect theft and counterfeiting, especially in logistics. Because of Asia’s immense size and the extensive volume of goods manufactured there, logistics industries commonly are fragmented and poorly regulated. Under time and cost pressures, local manufacturers often subcontract to small, unregulated and unauthorized storage and transportation providers. In many instances, these transportation providers make products disappear in transit.
One high-end global apparel company was finding that a lot of product was vanishing before reaching port and replaced by counterfeits. The culprit was a small, unregistered trucking company to which the apparel company’s factory subcontracted without informing headquarters. The trucks were making frequent stops en route to port and, at each stop, a counterfeiting syndicate switched the goods.
When a provider subcontracts without disclosure, the client company loses its ability to assure proper working conditions. Products manufactured in Chinese prisons are among the most recent examples of what may happen when the supply chain is not visible. The Chinese government requires that prisons fund themselves. They often do so through manufacturing work, reaping profits by paying miniscule wages, while demanding excessive hours from a captive workforce. This practice is not secret; prisons actively market themselves to local manufacturers.
Five Steps for Controlling the Supply Chain
Companies need to know the business interests and practices of their providers in emerging Asian markets. The good news is that this information, in many cases, is readily available from public sources. Also, businesses can (and should) require that prospective suppliers provide information about their directors, shareholders and business activities as part of the vetting process. A thorough process of documenting suppliers should include these steps:
- Audit for current quality and social compliance. Begin by identifying any information gaps in current audit processes. Was ownership of the supplier verified? Is all business license and location information current? The audits should assess production capacity to gauge the likelihood of unauthorized subcontracting.
- Check all available public records. Tap into local regulatory, litigation and bankruptcy records, as well as sanction and compliance databases. Also, review reports from local environmental and worker safety organizations.
- Include online research. Have individuals who are thoroughly fluent in the local language scour trading websites, industry forums, job postings and social media for clues about undisclosed conflicts of interest.
- Conduct discreet visits. Unannounced visits can verify if the supplier exists in the shape, form and location it claims. Discreet visits can be used to fill in information gaps found during the verification process.
- Reward procurement for due diligence. Company leaders should reward the procurement organization for thoroughly understanding its suppliers and the supply chain, not just for finding the lowest price. Information that procurement acquires from due diligence inquiries should be compiled into an accessible database and regularly updated. Important information likely surfaces from such a system. For example, if the database includes the mobile numbers of procurement employees and suppliers, the company can see if there are any shared connections among them and be alerted to possible red flags. The ability to make these associations increases as more information is added to the system.
Companies are making great strides in managing the quality of their first-tier suppliers in Asia, and ensuring that they meet international environmental and safety standards. However, companies often pay less attention to the deeper levels of their supply chain, putting their profits and reputation at risk. Businesses can mitigate these risks with a disciplined process that delves into the business practices of their suppliers and the complex web of financial relationships common across much of Asia.
Greg Hallahan is the senior director of FTI Consulting, Forensic & Litigation Consulting.