The Evolving Product Sourcing Value Chain in China – Part 2 | Article

The entire value chain for consumer products sourced or manufactured in Asia has become increasingly interconnected and mutually reliant—ownership of physical manufacturing assets and intellectual property rights has become more ambiguous and contentious. With ambiguity over ownership and rights to manufacturing assets, customers lose the key leverage of mobility. While brand companies were able to become more price competitive through lower production cost and reduced overheads within their own organizations by outsourcing their design engineering and manufacturing to Asia, their supply chains became longer and, while some new problems are obvious, others remain latent, only to emerge when the relationship breaks down.

Brand Companies

With greater reliance on suppliers in China to design their products and to finance their tooling and inventory, brand companies have found themselves more and more “married” to their suppliers. As a result, Brand companies find themselves directly and indirectly facing the same challenges as their suppliers: currency and commodity volatility, product quality and labor issues.

Brand companies are using the lowest-cost suppliers who themselves often employ unsophisticated purchasing, finance and management practices. As a result, the brand companies are receiving price increase requests from their suppliers on a monthly and sometimes weekly basis as their suppliers struggle to properly manage these issues. Suppliers that are facing these problems have been known to essentially suspend taking orders unless they get the price increases—bringing the supply chain to a grinding halt. Brand companies have an unenviable dilemma: either take the increases and the hit to their margins, or face the daunting prospects of trying to change suppliers during the product life cycle.

Poor product development processes in place between brand companies and their distant suppliers have given rise to three major problems: unclear responsibility for product quality, delayed product realization and ambiguous ownership of protectable intellectual property rights. Supplier financing of tools and lack of clear assignment and licensing of intellectual property can make it cost-prohibitive or impossible to change suppliers when things get tough in the relationship.

Because Chinese suppliers make up such a large portion of most brand companies’ cost of goods, brand companies are pressured to take into account additional concerns such as their suppliers’ environmental and social compliance (ethical) practices.

Finally, corruption continues to be a major issue in China, and brand companies need to be both proactive and vigilant in their management of this issue. Brand companies need to establish clear expectations for their staff and suppliers and adopt policies for doing business with suppliers that engage in corruption, including termination of the business relationship. Brand companies need to structure their affairs with their suppliers so that they can quickly move away from a supplier that engages in untoward business practices.

Manufacturers

As a result of their enhanced roles and capabilities, manufacturers find that they have new leverage in the relationship as well as a heightened awareness of the need to protect their interests and investments. Manufacturers also realize that Chinese non-legal dispute resolution solutions do not adequately meet their needs when dealing with overseas customers. As a result, Chinese suppliers are warming to the idea that manufacturing outsourcing services agreements are not just tools for their customers to control them, but with their new-found leverage, are a means to protect their own interests.

Many Chinese manufacturers today have further taken on advanced marketing services for their customers, including, in some circumstances, to “category management” ranges of products for their customer’s product portfolio. Some suppliers have even greater ambitions—to develop and sell their own brand of products both domestically and abroad.

As a result of increased reliance on manufacturers within the value chain and the investments made by brand companies to improve their manufacturers’ capabilities, brand companies have created a new set of their own competitors that, on their own or in collaboration with retailers, are increasingly well-positioned to chip away at the brand company’s market share and margins.

Retailers

Retailers (those remaining) have strengthened their positions greatly in past 20 years. Retailers now have two sets of suppliers to choose from: brand companies and Chinese manufacturers. A growing share of high-volume, low price-point products are being sourced directly from Chinese manufacturers, further putting pressure on product marketing companies.

Conclusion

Dramatic changes have taken place in the supply chain over the past 20 years, and manufacturing and product development services agreements used in today’s environment all too often do not adequately contemplate or address either the obvious or the latent issues present in this new highly-integrated, mutually-reliant value chain. Manufacturing agreements in use today are often based on the 1990s model of distinct responsibilities of the parties with a relatively simple range deliverables of Chinese manufacturers with a narrow focus on the product, rather than the basket of services now on offer (and often provided).

Supply chain contracts need to address the distinct, discrete services performed by the manufacturer, and adequately protect brand companies’ interests. In the absence of contractual coverage addressing these issues, the current trends tip balance of control in the supplier’s favor and raise an ever-increasing list of issues for brand companies to address without the proper tools.

Low-cost country manufacturing is here to stay. The myriad of issues and challenges that exist will increase, and all players in the supply chain will struggle to adequately control them.

Robust manufacturing and product development outsourcing services agreements should proactively address the new order problems that are emerging in the brand company Chinese manufacturer relationships. A thorough discussion and agreement addressing key issues and providing flexibility for growth and change can keep the relationship balanced and allow the brand company to maintain reasonable options.

Geof Master is a partner in Mayer Brown JSM’s Business & Technology Sourcing practice. He can be reached at [email protected]

Tom Keenan is a Registered Foreign Lawyer (Victoria, Australia) in Mayer Brown JSM’s Business & Technology Sourcing practice. He can be reached at [email protected]

 


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