Globalization and the Private Equity Community

danielle fugazy | Danielle.fugazy@sourcemedia.com | IP: 72.64.137.138

Globalization To Take Hold Of Middle Market
Globalization is a hot topic in the private equity community today, and rightfully so. With more and more companies outsourcing some part of their business to Asia and companies from abroad looking to sell their wares in America, it’s no wonder private equity shops are making efforts to become truly global. Of course, the big firms like Carlyle and TPG have had this capability for some time, but you know the trend is pervasive when almost every day you hear of another middle market investment bank or private equity shop aggressively looking for a presence overseas.

Case in point: Lincoln International, an investment bank that has spent a great deal of time making this happen. In fact, they changed their name from Lincoln Partners to Lincoln International after partnering with Germany’s Peters Associates and then a different one in Asia last year. Additionally, they are expected to open another office somewhere in the world this summer.

Goldsmith Agio Helms, another investment bank, boasts a London office and says it contacts international buyers in virtually all transactions. Additionally, international buyers participate in the sale process in 95% of the firm’s transactions.

“Investment banks and private equity firms that become truly global will have the advantage,” says one middle-market private equity pro. “No businesses are located in just one place these days. To be able to help companies navigate in Eastern Europe or Asia is a huge competitive advantage.”

Clearly, this isn’t lost on the Association for Corporate Growth, our publishing partner, which has launched several chapters outside the U.S. and is hosting its first-ever China conference in early June.

So where does this leave middle market players that aren’t globalizing? “In the dust,” jokes the private equity pro. While that might be a little harsh, will private equity firms that don’t globalize be able to compete in years to come? Or more importantly, are we going to start seeing a consolidation take place in the community? Many say ‘yes’, but with the caveat that firms should have a game plan and spend their money in specific overseas locations, as opposed to setting up offices all over the world.

Please send me your ideas, and I will share my guesses. And of course, your emails will be kept confidential unless you indicate otherwise.

Danielle Fugazy
Danielle.fugazy@sourcemedia.com

Baysource www.baysourceglobal.com continues to work with the private equity community in reaching out to identify portfolio companies, particularly those in niche manufacturing and distribution segments, who may not have the resources or infrastructure to embark on long range sourcing projects in China.  Several U.S. manufacturers have experienced dramatic reductions in cost of goods via strategic sourcing initiatives implemented by Baysource. 

China as a thriving market

As a provider of sourcing services to U.S. companies with manufacturing projects in China, we undoubtedly hear of the negative stereotypes about lost jobs domestically. However, those companies savvy enough to recognize there is a huge market in China for their products, realize just how global our economy is. Note the following from a McKinsey report:

Article at a glance:
The value of China’s emerging middle class

As global companies have entered China, many of them focused mainly on serving its urban-affluent consumers. However, if these companies continue to use this strategy they risk missing the real opportunity—the emerging middle class.
During the next 20 years we expect a huge middle class, with enormous spending power, to emerge in China’s cities, following two distinctive waves of growth.
As incomes increase, the spending patterns of this consumer group will evolve, fueling various levels of growth across consumption categories.
Although it will be difficult, companies should broaden their focus to include this swiftly evolving middle class. Since this segment is a hard one to serve, companies must think creatively to succeed.

*****
BaySource works with companies on manufacturing outsourcing projects for components of their finished goods, many of which could be headed right back to China markets. It is more the low value add/high labor projects that are ideal for tapping into China’s huge labor market. As well, we specialize in assisting U.S. companies with high value add projects that consist of high labor content in the final cost of goods.

The lopsided stereotype of Business in China

There has been an understandable bias against companies who outsource manufacturing in China. However, as the economy moves to a global marketplace, strategies need to consider emerging markets for goods and services in all parts of the world. Key points were made recently in a WSJ article by Jeremy Haft titled “The China Syndrome,” where he clearly points out that “China’s rise need not drive America’s fall.” The article looks at the overall U.S. economy, where he states that “efficiently produces a wide variety of goods and services.” He goes on to say that “In most industries, we’re decades ahead of China. And, huge swaths of our economy — like the services sector and high-tech manufacturing — don’t even exist in China yet.”

China Map

This should be enough to allay unfounded fears that exist about outsourcing in China. Companies like Baysource Global work on projects where there is a high degree of low value add/high labor requirement in the actual manufacturing of the product. It remains that the products’ engineering and innovation are the product of their U.S. intellectual property holders. The fact of the matter is that as the base of wealth grows, China consumers will want quality products and services. As Haft goes on to say, “China is increasingly buying American and growing five times faster than any other market for U.S. exports.”

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So before the uneducated make claims about a lopsided relationship between the two countries, they should consider this exciting age we are in. As Mr. Haft ends, “By tapping into its expansion and capitalizing on our strengths, America’s companies have a once-in-a-century windfall opportunity to build value, make money and create jobs here at home — not shutter the shop.”

David Alexander
BaySource Outsourcing Solutions

Instead of worrying about China, companies are better off embracing the opportunities.

Solutia looks to capitlize on growing China market
ST. LOUIS POST-DISPATCH
06/17/2008

Solutia Inc. Chief Executive Jeffry Quinn on Monday signed $182 million in contracts with companies from China, a country that looms large in his corporation’s future as well as in the minds of many American executives.

Quinn was in a line of local industry leaders who put pen to paper and sealed deals with Chinese customers during a trade delegation conference at the Ritz-Carlton hotel in Clayton.

Among these, Ferguson-based Emerson sold $70 million in telecommunications and power-related equipment. And locally based soybean trade groups, representing companies such as Bunge, Cargill and ADM, closed deals worth nearly $5 billion.

“Solutia obviously is very pleased to participate in this event and have a small role in demonstrating the vitality of the St. Louis region, as a source of economic development and as a trading partner with China,” Quinn said. The company, based in Town and Country, makes specialty chemicals and performance-enhancing window films.

As the U.S. economy lags, rapid growth and an expanding middle class make China an irresistible market for domestic companies.

Solutia, with annual sales of nearly $4 billion, said that 58 percent of its total revenue growth between 2006 and 2011 will come from China. That translates to total Chinese sales of $439 million in 2011, up from $166 million in 2006. These sales stem from lines of business that are becoming increasingly profitable as Solutia raises prices and improves logistics and manufacturing efficiency, Quinn said.

Solutia exports nylon resins and polymers to China from a plant in Pensacola, Fla., which played host to nearly 30 members of the trade delegation on Sunday. Solutia’s products fill the holds of cargo ships returning to China after bringing loads of low-cost manufactured consumer goods to American shores.

The Asia-Pacific region is key in Solutia’s strategy of transforming its under performing domestic nylon carpet-fiber business into a global supplier of resins and polymers for plastics.

Gone is the view of China as simply a place to outsource jobs and lower the cost of manufacturing. The booming nation is a market in its own right — in Solutia’s case, for goods manufactured in the United States.

“We look at China not as a place to outsource production and find cheap labor, but as a vibrant market that needs and desires the quality products that Solutia produces around the world,” Quinn said.

But that’s not to say the company lacks investment in China — that was a key point in Solutia executives’ closed-door remarks to that country’s trade officials, the CEO said.

In China, Solutia produces tinted window films and, through a joint venture, makes heat-transfer fluid. Solutia recently disclosed plans to build a rubber-chemical plant. And its automotive and architectural window films are sold through more than 5,000 retail locations.

Zhou Lin, general manager for Liaoning Yinzhu Chem-Tex Group Co., said his company buys a type of nylon pellet produced at Solutia’s plant in Pensacola and spins it into fibers. His company chose Solutia for the high quality of its products, but will deepen the relationship by seeking its advice on how to make technical advances.

Kingfa Science & Technology Co. also buys the nylon pellets for melting into plastic materials. It is mainland China’s largest domestic engineered plastics compounding company, and is growing at a rapid clip — which will mean more business for Solutia, said Li Nan-jing, Kingfa’s vice general manager.

The products of these companies — along with Hangzhou Youngchang Nylon Co., which also signed a contract with Solutia on Monday — are found in everything from industrial products to non-stick spatulas, and from electrical-outlet covers to under-the-hood car parts.

Solutia’s drive to do business in China doesn’t mean it is neglecting the American market, Quinn said. North America remains the company’s biggest market in many product lines. However, China’s economy is growing fast, as is demand.

“China is still a work in progress, and, like many of the developing economies around the world, there is certain room for improvement” in its openness to American goods, said Quinn. “But we have found the Chinese marketplace to be a very receptive market.”

10 Tips to Better China Sourcing

Best practices in low-cost country sourcing

By William Atkinson — Purchasing

Everyone in the supply chain seems to have a “China story” these days. Either they found dramatic savings and saved their company a boatload of cash, or they got burned by a fly-by-night supplier and vow never to source overseas again. But, as in most things, when it comes to sourcing in China, success is as much dependent on the preparation as the execution.

With that in mind, Purchasing recently tapped the expertise of several procurement executives with experience sourcing in China to develop a list of China sourcing tips.

One bit of good news is that, if you have experience with any type of sourcing overseas in general, it should give you a leg up when sourcing in China specifically, according to James Ullum, managing partner with Louisville, Ky.-based Source International, a global manufacturing outsourcing company. “I was at a conference recently on sourcing in Latin America, and it was striking to me just how much similarity there was to sourcing in China,” he says. “I think, in general, the tips for buying offshore are almost universal.”

1. Set a clear China strategy

Gordon Smouther, senior industry advisor with the Center for Supply Chain Management at Rutgers University in Newark, N.J. says most companies are sourcing in China and similar countries for two reasons. “One is the long-term goal of establishing a market presence in the country in order to serve the economy,” he states. “The other is a more short-term goal to take advantage of some of the low-cost capabilities and labor in the area.”

2. Consider going direct

In the past, a lot of companies that were sourcing in China were going through brokers, because they didn’t know the players in China, and they didn’t have the ability to manage quality, according to Bob Sullivan, a director with Southfield, Mich.-based AlixPartners, a consulting and financial advisory firm. “One of the big pushes these days is to go direct,” he states. One reason is that some brokers were charging a 10–12% fee, which dramatically reduced the savings potential of sourcing overseas. “We worked with one client to help them go direct and were able to take almost 30% out of the cost structure,” he states.

A second reason for going direct is control. “When you’re dealing with highly engineered products, you don’t know what the broker looks at in the factories,” he notes. “You need to have your own eyes on the process.”

3. Improve supplier evaluation

The most critical step is to select the right partner, according to Source International’s Ullum, who adds that buyers “need to check references, verify that the suppliers have adequate capital, quality systems, and capacity, and that they buy from reliable sources.” Then find out what the priorities are for the supplier’s factory. For example, some are focused more on quality, some on price, and some on fast production.

4. Build relationships

Ullum points out that building and maintaining a strong relationship with the supplier may be more important in China than anywhere else because business is based more on relationships there than it is in some other countries, especially the U.S.

Jan Palmen, new-product development commodity manager for Ingersoll-Rand Security & Safety in Colorado Springs, Colo., agrees. “While it is not unique to sourcing in China, you first have to establish relationships,” Palmen says. “For example, as a commodity manager, I can call almost any supplier in the U.S., introduce myself, and then ask if they would be willing to put together a quotation. This tends to be a straight business transaction.”

In China, he says, it is necessary to establish a relationship first, and this is usually done through an intermediary, such as a U.S. representative of the Chinese company.

5. Convey clear expectations

According to Palmen, buyers need to be very clear about what they want from Chinese suppliers due to things like language barriers and metric conversions. “It is particularly important to have robust and thorough documentation,” he emphasizes.

Ullum agrees. “Be sure to clearly define your expectations and specifications,” he states. Some companies in China, he says, don’t understand the requirements of the U.S. market, such as the importance of things like cosmetic appearance. “A lot of U.S. companies aren’t used to having to do this, because they have either made things in their own factories or have purchased them from other U.S. suppliers that understand the market better,” he says.

In addition, it is important to put requirements in writing. The more you assume, the more problems you will have. Conversely, the more reference points you can provide, the more likely the factory will deliver what you expect. Source International does this in three ways: a written bill of materials and quality specs, physical samples, and mechanical drawings.

“You also need to create and explain performance requirements,” continues Ullum. “This includes information on what the product is supposed to do and what the testing protocol is.” In sum, consider: What will your customer do with the product once they receive it? And does this product meet those requirements?

And an equally important step: Get the supplier’s agreement. “I have never seen anything more powerful than—as simple as it may seem—having a reliable person in the factory actually sign the specifications,” points out Ullum. This may require a bilingual document, because there may be some misinterpretations in an English document.

6. Address intellectual property issues

It is important to ensure protection of intellectual property when sourcing in China, especially in terms of design and tooling. While legal documentation and contracts can help, AlixParters’ Sullivan believes it is actually more important to have commercial leverage.

“Getting a contract enforced in China, even with good legal representation, is a challenge,” he cautions. Commercial leverage means having other business there, such that if the company compromises your intellectual property, they risk losing a lot of other business.

7. Create technology teams

When moving technologically driven business into China, it is very important to have teams focused on the process on both sides of the ocean, according to Sullivan. This requires a great deal of coordination. “You need your technical guys in the U.S. working with the technical guys at the factory,” he says. “They often don’t speak the same language. However, my experience with engineers is that, once you get them working together, even if they don’t speak the same language, they figure out how to work together on their own after a while.”

8. “Trust, but verify”

You may be surprised to know the words of Ronald Reagan apply to global sourcing, but they do. “You want a good partner and a trusting relationship, but you need to check on things,” Ullum explains. A complete quality monitoring program, either conducted by a third party or your own company’s personnel, is essential to ensuring that the product shipped meets all of the specifications and performance criteria that are agreed to. “Even one bad shipment can do serious damage to the procurement department’s credibility and wipe out projected savings quickly,” he cautions.

Sullivan agrees. “You need a local presence, where you can get to the factories on a regular basis,” he states. Relationships matter, but it’s more than just that. It gets back to control. You need to qualify the actual pieces of equipment and tools that your products are running on. “If you don’t have your own eyes on these, then you really don’t know what’s happening,” he notes. “A Chinese company can promise that your products will run on certain equipment, but you may find out that things have changed once you actually go there and look.”

9. Be open to R&D projects

According to Sam Datta, regional director, sourcing and procurement practice lead, southeast region, for Chicago-based Grant Thornton, a lot of companies want to involve suppliers more closely in R&D, but have been nervous about doing so with Chinese suppliers.

“It is possible to do this in China, but you have to be careful and work very closely with those suppliers,” he says. The biggest challenge is finding qualified suppliers to handle the needs of U.S.-based firms. “You need to look at their processes, technologies, innovation, and other capabilities,” he suggests.

Once you select suppliers, you have to treat them as though they are next door to you, and you have to have your own people over there to make sure they are doing what you need. Working closely also helps to resolve the potential problems related to intellectual property (patented information) and concerns that they will do reverse engineering, according to Datta.

10. There’s more to global sourcing than China

Finally, don’t just automatically assume that China is the best place to source everything. The global supply and business landscape is constantly changing and it is important to keep up with these changes as you are making current and future sourcing decisions.

Certainly, China is an excellent place to look first. “Even though there are other countries getting involved, China still has the overwhelming majority of low-cost country sourcing business,” says Sullivan.

Smouther suspects China could be getting to a tipping point, where labor costs are increasing, so the low-cost labor advantage is beginning to erode a bit. “Other countries, such as Vietnam, are gaining popularity for low-cost labor,” he notes.

Sullivan adds that the Chinese government is also revising the tax structure, reducing value-added tax rebates on a commodity-by-commodity basis. The strategy is designed to try to push very low value-added business out of China and focus on the higher value-added business. Sullivan also echoes one of Smouther’s comments. “There are a lot of other rising stars, particularly Vietnam, where labor rates are about half of what they are in coastal China,” he states.

In addition to Asian markets, Sullivan adds that now “we are finding that Mexico’s star is rising again, and some business that went to China is now coming back to Mexico.” In addition, new business that would have once automatically gone to China is now giving Mexico a hard look, not only because it is becoming more competitive, but because of logistics costs and the inventory impact.

 

 

 

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Five things you should understand before launching in China.

 

By David Alexander

 

 

You’ve just climbed in the taxi and are on the way back to your hotel after the closing dinner with the principals of your latest deal.  As the QB in the deal process you’ve spent months cultivating a relationship with the owners, convincing them that out of all the groups courting them, your firm was the best fit in terms of culture, business philosophy and opportunities for future growth.  With new resources in place, one of the first priorities identified is implementing a China strategy—something your firm could certainly make happen.  Right?

 

Firms with multiple funds under management constantly consider the idea of opening a sourcing office in China, leveraging volume across multiple companies to drive costs down and margins up.  No brainer, right?  Here are some considerations when determining if such an investment is worthwhile.

 

1.  Get to Break-Even

 

For any business of scale, it conservatively requires $1.5MM annually to operate a functioning “in-house” sourcing office in China today.  This takes into account travel, relocation costs, salaries for just one expatriate staff member and a Chinese support staff typically consisting of sourcing individuals, project engineers, Quality inspectors, supply chain coordinators and the necessary admin support.  This estimate does not even include the opportunity cost of valuable human resources and set-up dollars needed to get it up and running.  In five years this means a firm will invest $7.5MM in incremental fixed costs. 

 

Be sure to double the timeline and halve the payback.  Setting up is the easy part.  Becoming operationally efficient proves a little more elusive. Expect your operations leader to be hands-on, which could affect timelines on other domestic restructuring programs. On the ground support during the nascent phase is critical to long-term effectiveness of the Far East operation.  In reality, if your goal is to achieve 20% savings (net of working capital adjustments) on components you have to be able to push $8MM in projects through each year for years 2-5. Do you have the $40MM in transfer projects to China from US manufacturers needed to get to break-even?   If not, consider the variable cost option of a strategic sourcing partnership until such time that the in-house volume justifies the investment.

 

2.       Beware those who claim they are “China Experienced.”

 

After purchasing a valve and fitting company, you inherit “Bill” who is quick to inform you that he has traveled to China numerous times and has even learned a few words of the local tongue.  Single handedly, he’s “saved the company millions” overseeing outsourcing projects on behalf of the organization.  With more China experience than anyone in the firm, he has impressed a number of partners with his knowledge and has even volunteered to move to China to establish your operation.  Who better, right?

 

Bill might be proficient with his industry-specific knowledge of say, castings and forging suppliers, and may even have enough supply chain knowledge to be dangerous.  However, how his ability to transfer his knowledge and experience to other products and to the critical elements of managing the new sourcing office can test his learning curve (at best) and inhibit execution speed.  When you consider other daily administrative duties such as recruiting, personnel issues, financing and taxation details AND managing relationships with the Chinese and local governments, there’s hardly anytime left for sourcing!  He has also relied heavily in the past on his company’s Quality personnel as well as those extensive resources provided by the handful of suppliers he’d worked with in China.  Is Bill fully prepared and qualified to monitor these Quality details for your other operations?

 

Bill has never set up a business from scratch, let alone one in China, and probably lacks the broader business acumen to get the China sourcing company off the ground.  Does Bill understand the difference between a “Rep office” and a WOFE (Wholly Owned Foreign Enterprise) and the tax implications of each?

 

Running a China sourcing office is a broad-based leadership role and requires solid general management instincts and experience. If integrated into the business effectively, the China sourcing office will interface with all elements of your US operations.  Bill’s a great nuts & bolts guy but you need a heavy hitter.

 

 

3.       Location, Location, Location

 

Manufacturing expertise tends to cluster in China.  Should you really be in Zhejiang or is Guangdong Province better suited for your products?  You have heard that manufacturing is moving north and west in China.  Should you be going there?  What type of product categories do you anticipate supporting from your new office, now and five years from now?  What’s going on in the Mekong Delta?  This region in Southwest Vietnam where the Mekong River meets the sea via distributaries could likely be the preferred next low cost sourcing hub in Asia. Could Cambodia and Laos be additional low cost frontiers?  Many products are coming from India lately. Maybe you should have an office in Mumbai?  Did Bill sign that five-year lease yet?

 

 

4.       What does the Chinese government think about your business?

Regardless of the aforementioned, China remains the low cost factory of the world today and will continue as such for many years ahead.  Did you know however, that the Chinese government has a clever system to encourage and/or discourage different industries to manufacture in China? Big cost advantages through generous VAT rebates can still be enjoyed by companies in “encouraged” industries while VAT rebates for businesses now falling in “discouraged” categories were eliminated last year, with a generous one week notice from the central government in Beijing.

Delivering a speech to the 1st session of the 11th National People’s Congress (NPC) in March this year, Premier Wen Jiabao made known China’s determination to end its position as a global center of “smokestack industries” or those energy-intensive, polluting and resource-based ventures. As a result VAT rebates for 1,115 commodities in these sectors were ended.  Add in worldwide commodity price inflation, today’s soaring energy costs and a 15% appreciation of the Chinese RMB in the past 18 months and suddenly that 25% savings Bill got for your pipe fitting company may not be realistic across the board.

5.       Scale

 

Flash forward to year-five and let’s assume your office has developed a business rhythm.  You have a few successful projects under your belt and are finally realizing some savings on behalf of your portfolio companies, albeit not quite what you were promised.  The sourcing team is working with 20 or so decent manufacturers.  Independently though, each of your projects represent a small fraction of these factories’ overall volume since you are supporting only your U.S. businesses. You need to continuously look for opportunities to leverage scale. How can you do more business with fewer suppliers to ensure you have their ear on important schedule and quality issues?

 

 

The good news

 

PE firms with small and mid sized portfolio companies should do their homework before taking the plunge into China.  There are firms in place today who have absorbed startup costs, are highly capable and experienced in running a China office, and are staffed with experienced sourcing experts, engineers and Quality personnel.  These firms have a working knowledge of and ability to navigate China, the flexibility to respond and adapt to the changing landscape and command significant volume leverage with the factories with whom they work.  When choosing a solution, carefully consider the variable cost option and work with a team who has only your best interests at the forefront of their activities—whose success depends on your success.

 

David Alexander is President of BaySource Global®, www.baysourceglobal.com a U.S.& China based Project Management firm who oversees Strategic Sourcing Initiatives on behalf of clients worldwide.  BaySource is based in Tampa, FL and Mr. Alexander is a member of ACG.

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Making It in China

For U.S. companies working with Chinese partners, here’s a crucial bit of advice: Don’t let expectations get lost in translation
By ANDREW R. THOMAS, TIMOTHY J. WILKINSON and JON M. HAWES
May 12, 2008; Page R11

Any business relationship works best when both sides understand what the other expects. For U.S. companies working with Chinese business partners, that understanding can be particularly difficult.

The problem is that each side comes to the partnership with very different cultural and economic perspectives. Americans tend to view a business relationship as a win/win proposition — a contract between two corporate entities designed for their mutual benefit in long-term profitability and growth.

In China, personal relationships among business partners are far more important, and the benefits foreseen in entering a partnership often are broader and focused more on the near term — and not necessarily evenly balanced.

Any U.S. company that joins a Chinese partner without understanding these differences risks failure. The key to success is paying close attention to the relationship, both on a personal level and by implementing procedures to monitor the progress of the venture.

Several years ago, one of the authors of this article worked with a U.S. company in a nonexclusive partnership with a Chinese motorcycle manufacturer. That venture is a case study in the difficulties of a Chinese-American business relationship, and the importance of understanding and overcoming those difficulties.

Different Priorities

In the mid-1990s, a U.S. export-management firm established an alliance to purchase small motorcycles made in China, for sale to consumer markets in Latin America and Africa. The Chinese manufacturer agreed to produce motorcycles at its facility for export, while the U.S. company took charge of quality control, sales, distribution and after-sale service.

The basis of the relationship seemed clear enough, but from the beginning there were unstated differences in what the two sides hoped to accomplish.

The U.S. executives assumed that their Chinese partners shared their focus on ensuring long-term profitability by pleasing the venture’s distributors and customers with quality motorcycles. But from the Chinese perspective, the relationship with the U.S. firm provided multiple opportunities, some of which had nothing to do with the venture’s long-term profitability.

Think back to the mid-1990s. China was desperately short of foreign currency. So, first and foremost the Chinese saw the relationship as a source of regular inflows of U.S. dollars. In addition, the Chinese executives were more interested in the venture for what they could learn than for what they could earn — they saw the Americans primarily as teachers. The Chinese managers knew nothing about selling their motorcycles outside of China. Through their affiliation, the Americans provided the Chinese with market insights and knowledge the Chinese would never have been able to acquire on their own.

These differences in focus between the American and Chinese sides would emerge later, much to the detriment of the venture.

Since the mid-1980s, the Chinese manufacturer had been producing about 450,000 motorcycles per year, all for its domestic market, under a licensing agreement with a Japanese auto company. But the performance of the motorcycles was poor. To ensure higher quality for this new partnership’s motorcycles, the U.S. partner insisted on the use of Japanese imports for key engine components, in place of the inferior Chinese-made parts the manufacturer had been using. Both parties agreed that the U.S. partner would send an observer for the purpose of quality control, including confirmation that the Japanese components were being installed in the bikes.

The observer was a Chinese-American who had returned to China to explore newly available business opportunities. He was retained for one week each month by the U.S. company. Every time a monthly production run was scheduled, the observer would make sure that the Japanese engine parts were used on the motorcycles to be exported.

This system worked well for five years. Nearly 250,000 high-quality motorcycles were profitably produced and sold. Customers were pleased with the quality and service. But just as the Americans began to think of expanding the venture with the introduction of new product lines, a conflict arose between the two parties.

A Rift Opens

At the beginning of the sixth year, the observer representing the U.S. partner quit. The American executives chose not to replace him, assuming that after five years of high-quality production, the Chinese would continue using the Japanese parts for the export motorcycles. This decision was made without consulting the Chinese.

A few months later, the U.S. company began to receive complaints from customers about the quality of the motorcycles. The problem was the same everywhere: The engine would run well for the first 200 miles or so, then it would begin to smoke and eventually the engine would seize up, rendering the bike inoperable. It was quickly determined that the Chinese manufacturer had substituted poorly made Chinese parts for the specified higher-quality Japanese-made components.

From the American perspective, this is where the relationship went bad — when the Chinese began using inferior parts. From the Chinese perspective, however, the removal of the observer was where the problems started, because it signaled a major change in the relationship between the two companies. While the Americans had viewed this person simply as a quality-control monitor in an overseas factory, the Chinese looked upon him as the personal representative of the U.S. company within the Chinese operation. The disappearance of this person, with no explanation and no replacement, was seen as a breach in the relationship. No longer strictly bound by the terms of that relationship in their minds, the Chinese partners acted in their own self-interest, cutting costs to maximize their profits.

Frictions Worsen

Efforts to resolve the problem caused greater friction.

Confronted with several thousand motorcycles that would require replacement parts as well as major servicing in 15 countries, the U.S. partner calculated that $400,000 would be needed just to begin to deal with the problem. The Chinese manufacturer was consulted, and it was decided that customer credits should be issued to maintain the integrity of the brand. Because of stringent foreign-exchange controls in China, the U.S. partner issued the customer credits. Both parties then agreed that they would meet in Shanghai later that year to negotiate how to share these costs.

Prior to the meeting in Shanghai, the Chinese sent a fax demanding that the Americans provide comprehensive documentation for every customer complaint. The Americans objected, but the Chinese wouldn’t budge. This angered the Americans, who felt that both sides understood that the Chinese were to blame for the problem. In the end, the U.S. side compiled a report for each defective motorcycle, resulting in almost 50,000 pages of documentation.

The Americans were further distressed to learn that before any negotiations could occur, they would have to verbally present their findings on each motorcycle. The presentations were scheduled over a four-day period. On the second day, after presentations had been made for only about 200 of the motorcycles, the U.S. side decided that they had had all they could take. The two Americans stormed out of the room.

As the Americans were walking out of the building, one of the Chinese managers tracked them down. The Americans told him that if this continued, they would never buy another motorcycle from the Chinese. The ultimatum worked, at least in one sense — the Chinese executives agreed to at last begin discussing how to cover the $400,000 of customer credits.

After more than six hours of further talks, the Chinese executives offered to pay half of the $400,000. Incredulous, the Americans again staged an angry walkout. In a repeat of the day before, the English-speaking member of the Chinese team caught up with the Americans. He explained the Chinese position, saying that the Americans were one-half responsible for the defective motorcycles because they had allowed their Chinese partner to violate the arrangement by using Chinese parts.

Eventually the U.S. side agreed to split the costs evenly, but bad feelings remained on both sides. Again, the Americans had failed to appreciate the importance of personal relationships to the Chinese. Rudeness and anger are out of place in China and are considered embarrassing. By having a public tantrum, the Americans looked like barbarians in the eyes of the Chinese. In addition, the Chinese viewed the American demands as unreasonable because in their minds it was the Americans who devalued the relationship in the first place.

The problems between the U.S. and Chinese partners ultimately were resolved.

Mark Twain is quoted as having once said that “Nothing is as weak as a relationship that has not been tested under fire.” With a better understanding of Chinese thinking and with close monitoring, American companies in ventures with Chinese suppliers can keep those inevitable fires from spreading out of control.

–Dr. Thomas is an assistant professor of marketing and the associate director of the Taylor Institute for Direct Marketing at the University of Akron’s College of Business Administration, in Akron, Ohio. Dr. Wilkinson is an associate professor at the College of Business at Montana State University, Billings. Dr. Hawes is a distinguished professor of marketing and the director of the Fisher Institute for Professional Selling at the University of Akron’s College of Business Administration.

Outsourcing makes customers nervous. Here’s how you can help reassure them.

Outsourcing makes customers nervous. Here’s how you can help reassure them.

(FORUTNE Small Business) — Dear FSB: My two partners and I own and operate our own factories in China. With the anti-China trend these days, how do we find companies that are looking to go overseas but do not have a trusted partner? We hold ourselves to U.S. and European standards, but we’re still having to search for businesses to whom we can provide our contract manufacturing services.

– Carlos Valdes, World Manufacturing Group, Philadelphia, Pa.

Dear Carlos: When putting a Western face on an Eastern service, don’t discount good old-fashioned face-to-face conversation.

This can be done at tradeshows, during one-on-one sales calls, or with networking among industry trade groups. Being completely transparent about your business reassures potential clients, so show photographs and encourage visits to your plant even if a client relationship hasn’t been established yet. Be as detailed as you can with information about your years in service, references, number of employees, biographies of the management team, and products currently being rolled out of your plant.

Is sourcing in China worth it?
Most importantly, always be ready to discuss a worst-case scenario and a back-up plan, advises David Alexander, president of BaySource www.baysourceglobal.com , a Tampa, Fla., firm that assists U.S. companies in developing China outsourcing strategies.

Companies don’t budget for failure, and anything you can do to reassure them that you have contingencies covered will help reduce indecision and anxiety. Be honest and realistic about cost projections, production rates and potential issues that may arise. Even if there are negatives, offset them by listing all the world-class quality standards that your plant has met (such as ISO or UL) and offering quality and service guarantees. For example, you could promise that no portion of the manufacturing will be subcontracted, and that all client phone calls will be returned within 24 hours.

“It is paramount to recognize and be able to articulate that the product being provided is actually a service,” Alexander says. “A trusted set of hands mitigates the inherent risk associated with entrusting a project to an unfamiliar source in China.”

Would you trust a plant in China? How do you convince customers your overseas operations are high-quality? Join our discussion.

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BaySource Outsourcing Solutions

Offshoring Pleasures and Pitfalls

Does it or doesn’t it pay?

Robert B. Aronson, Senior Editor Manufacturing Engineering

The loss of many manufacturing jobs to overseas sources or “offshoring,” is a serious concern and the subject of a lot of debate. Statistics and reports are available supporting both the positive and negative aspects of this event. They range from concluding, “US manufacturing is about to die,” to “No problem, nothing to worry about.”

Much data on offshoring is subject to question because of the variety of ways many sources, including the Federal government, report data. For example one company may report product manufactured domestically and overseas together. Others report them separately. But unquestionably, US jobs are being lost. In addition to offshoring being added to our new buzzwords, so has the word “deployees.” It indicates those who have lost jobs or business because of offshoring.

The offshoring situation is not a case of deciding if you will or won’t be involved. The issue is how much it will influence your work and what you can do about it.

Offshoring may not last forever. Offshoring will be with us for the foreseeable future. But, there are indications it will not be as pervasive as it is today.

The middle class in advanced Asian countries, particularly China and India, is growing. Workers demand higher wages and more of the population is becoming a market for their own country’s products, thus reducing the drive to export.

There is also evidence that Asian countries are becoming more willing to carry out reforms, such as protecting intellectual property, and honoring patents. Such moves take away some of the negative factors of offshoring.

Stories of quality problems with overseas suppliers are common. But the recent problems with lead in paint and hazardous materials in imported grain and pet food have done a lot to shake confidence in Chinese products in general.

It also caused the Chinese government to change, or at least report they are changing, quality-control regulations. They have also executed a few officials reportedly to blame for the problems.

For those faced with an immediate decision as to whether or not to try offshoring, and if so, how deeply, here are some comments by those who have been involved with this situation.

One of the first suggestions given to manufacturers who want to avoid an offshore arrangement is to evaluate their own operations to determine what can be done to reduce production costs. And this means all costs. Many companies make decisions on a limited number of cost factors, chiefly machine operation and associated labor. More accurate evaluations look at costs from the time the raw material comes in until it’s shipped, plus any support or warranty action that might be required.

Among the more prominent techniques for cutting at-home manufacturing costs is the Design for Manufacture and Assembly (DFMA) software developed by Boothroyd and Dewhurst (Wakefield, RI). It is software that combines Design for Assembly (DFA) and Design for Manufacture (DFM) programs. DFA software reduces part complexity by consolidating parts into multifunctional designs. DFM helps identify parts that can be improved and indicates what the cost of the new part might be. The result is a design that can be optimized while the product is being developed. DFMA therefore provides a way to evaluate and understand the cost effects of design decisions. The result can be a lower-cost product.

Many companies neglect to take advantage of the latest technology, so production techniques and equipment becomes dated. Or, cost-saving opportunities are ignored in the rush to meet immediate needs. A minimal change in equipment or process often can significantly lower costs.

One option to the yes or no offshore question is a partial yes. Some companies, after a thorough evaluation of their production costs, decide to offshore only those parts where there are significant data supporting the change.

Companies such as BaySource (Tampa, FL) www.baysourceglobal.com specialize in this work, chiefly with small and midsize companies who want to get work done in China.

“We have saved a number of companies from going out of business by arranging for them to have only those parts they cannot make economically go overseas,” says company president David Alexander. It is chiefly those that require a lot of low-talent labor.

Setting up any offshoring is safer with competent help. Team 2000 (Austin, TX) is a training and consulting organization that specializes in dealing with India. Company President Rai Chowhary admits, “Offshoring decisions are a real minefield, particularly because there are no hard and fast rules. Every situation is very product and process specific.”

It is not just the small companies that have trouble. “Many US manufacturers have been swept into offshoring in the lemming-like rush to cut labor costs, andthe herd mentality that anything made offshore will be very beneficial,” says Chowhary. “Often, in a short time, they find there are problems they had not counted on.”

For example, there is the case of a large manufacturer who committed to a long-term agreement for a major number of parts with an offshore supplier, without thorough investigation. When the overseas-made parts started showing up, it was found they needed a lot of rework before they were in a usable condition. As a result, special repair shops had to be set up in the US to rework the parts. The parts kept coming because of commitments made earlier and so did the rework costs.

“This does not mean it can’t, or shouldn’t, be done,” says Chowhary, “But it has to be done carefully with the guidance of someone who knows the capabilities of the foreign suppliers as well as the real needs of the US manufacturer. I have advised many of my clients not to go overseas because their particular needs could not be met overseas at a cost advantage to them.”

False assumptions are a frequent cause of offshoring problems. A survey sponsored by technology providers E2open (Redwood City, CA) and Manugistics Group (Rockville, MD), found that many companies that had elected to offshore have unexpected logistics costs as well as erratic delivery times. The report concludes: “If you just do it based on pricing negotiations and have not thought through the logistics of delivery, assurance of supply, flexibility of supply, and quality, your total cost very quickly outweighs the price savings you made in the negotiations up front.” The report also notes that, too often, companies look at the current design of a product and naturally, but mistakenly, assume that its redesigned predecessor will cost the same amount to produce.

Properly managed, offshoring can be a profitable move. As Gisbert Ledvon of Charmilles (Lincolnshire, IL) notes, “To remain competitive you have to recognize you are operating in a global environment.” He suggests those considering such a move stay with parts that need a high degree of low-skilled labor such as simple drilling, punching, or bending processes.

“Another area where overseas help may be beneficial is start up cost,” Ledvon comments. “For example, if someone needs a complex die that requires a lot of hand polishing, that might best be done overseas.”

Ledvon also notes now this might be a good time to reverse offshoring to some degree. The US dollar might make US goods more attractive to overseas buyers.

Both good and bad results from offshoring are reported by Mike Rickabaugh, president of Livonia Tool and Laser (Livonia, MI). In one case his company, which specializes in laser cutting and steel stamping, benefited from low-quality Chinese work.

On a contract for metal stampings used for industrial shipping containers, a company had to quickly fill an order. It was placed with a Chinese manufacturer. The Chinese ignored the spec to make caster holes in the braces. Casters are critical to this type of container, so the container maker had to quickly farm out all the Chinese parts to have them reworked so he could meet a contract obligation. As a result, Rickabaugh gained a customer.

And it isn’t just toys that the Chinese have painted improperly. “We know of other contracts with the Chinese that were cancelled when the buyer, warned by the toy-painting scandal, found his Chinese-manufactured products tested high for lead content,” says Rickabaugh. “Several US manufacturers that discovered the same problem now specify American production only.

“You don’t always know why the Chinese beat you out on price,” Rickenbaugh explains. “It’s strange, but we have found that the more weight a product has the tougher it is to beat the Chinese price.” For example, his company makes two brackets used for container bracing. “One part’s weight was just one pound, and we beat the price on that easily. But the Chinese, making a second part weighing two pounds, using the same processes with comparable machines, were cheaper. Possibly it’s an issue with shipping costs or the raw material,” he observes.

Vicount Industries (Farmington Hills, MI), is a contract manufacturer with about 25 employees that has been in business for over 30 years. About 90% of their customers are in the auto market, and much of their work involves the manufacture of stamping dies.

The company uses advanced processes, such as laser scanning and 3-D modeling, to establish designs and evaluate manufacturing processes.

“About four years ago, we began looking at some help from overseas suppliers,” says company president Leonard Lavoy. “On our own we began a dialogue with some Indian companies. We now have a supplier producing low-tech parts for us. These parts require a significant amount of labor because of set up and handling. So far that has worked out well.”

Currently, Lavoy is working through a broker to evaluate some Chinese suppliers.

“Overall, our experience has been on the positive side. We did not lose any workers. In fact, offshoring allowed personnel and machine time to handle more detailed work.

“I would caution any shop considering using an overseas supplier to be sure of their capabilities before you jump in. I find the work quality from India and China below what I would expect from a US company. You have to be as certain as possible that they can do what you expect them to do,” he concludes.

It’s not practical to make all products or parts offshore. According to a recent Boothroyd and Dewhurst report, the “don’t try it” list includes products that:

  • Need some highly automated process,
  • Have a weight or size that incur high shipping or air-freight charges,
  • Require scheduling flexibility,
  • Require engineering and design changes to ensure quality, and
  • Have intellectual rights and/or patents that may be copied and marketed less expensively.

What the CFOs Think

A survey of CFOs and senior financial executives by Alix Partners LLP (Southfield, MI), a global restructuring, consulting, restructuring, and financial advisory services firm, gives both positive and negative views on offshoring. They looked at selling and general administrative trends at 35 blue-chip North American companies and divisions. Their survey found:

  • Outsourcing projects were already under way at 55% of the respondents.
  • Within the next two years 74% reported either continued or planned outsourcing.
  • The hoped-for cost savings of 15%, or expected operational improvement such as enhanced flexibility and access to best practices, was not enjoyed by 60%.
  • Expertise and stability of the overseas supplier was most important for 48% of those surveyed.
  • Reduced cost was the key factor for 31%.
  • Outsourcing projects were considered less than fully effective by 38% of midsize companies, and 15% reported being worse off.
  • Among companies taking six months or more to implement their outsourcing programs, 40% realized savings only after two years or more, while 20% realized no savings at all. But, all companies that carried out their implementations in six months or less realized their expected savings.

The survey also found that the top two reasons for not outsourcing SG&A functions are reluctance to count on overseas suppliers for highly critical parts or products and the perceived risk of losing confidential information.

Alix Partners analysts concluded that companies don’t look ‘inward’ enough, to adequately prepare for all that successful outsourcing demands inside their own companies. Internal resource issues placed well above poor vendor performance, when it came to major problems with outsourcing. “The overriding reason companies aren’t getting the returns they want,” said Neal Ganguli, co-leader of the survey and a director at AlixPartners, “is they don’t … adequately prepare themselves for all that successful outsourcing demands inside their own organizations.”

An executive summary of the survey is available at <!– var username = “nganguli”; var hostname = “alixpartners.com”; document.write(‘‘ + ‘nganguli@alixpartners.com’ + ‘‘); //–> nganguli@alixpartners.com.

Here’s What You Need to Know

Here, a sampling of the questions taken from an 80-question survey developed by Team 2000. It is suggested you know the answers before committing to any offshoring deal.

  • What is driving you to outsource: Because others are doing it? Cost, quality?
  • If you are outsourcing to save cost, how long is your planning horizon?
  • Do you have a cost-benefit analysis for the short and long term? What does this analysis include?
  • How will you deal with rejects and rework? Where will this work be carried out? At whose expense? Is that specified in your contract?
  • What about delays? What assurance do you have on delivery time?
  • What do you know about the suppliers and their capabilities? What is the source of your information?
  • How will your product be packaged to prevent damage or pilferage during shipping?
  • Is your staff conversant with the culture in which the supplier is located? Can they accurately pick up the true meaning of what is said? For example, what does the potential supplier mean by “soon,” “accuracy,” or “best possible?”
  • How much does the supplier know about the ultimate use or function of your product? And, how do you know that your supplier understands this?