Under various economic policies, newly set up trading companies have sprouted up as a sales office to handle overseas clients in China. Some Chinese manufacturers intend to put their sales entities in between for some reasons. Also, dealing with sales or trading entities brings flexibilities and convenience in terms of manufacturing integration and communication. However, the hidden risks behind this, such as quality issues and intellectual property contamination, are the common topics that need special attention in Purchasing and Order Management, especially when dealing indirectly with a manufacturer via a trading entity as a sales office or independent intermediary to manufacturers.
For example, customers lose the power to negotiate with the manufacturers legally when any issues occur. You are not alone if you have ever experienced similar unpleasant situations. Some of our clients experienced a similar one, resulting in a financial loss of the deposit or a compromise of taking the goods which are not in compliance with the agreement.
They contacted us to help with the management of the production order at a manufacturer. Unfortunately, we found that the manufacturers were doing business via some related trading entities in between.
After that, we raised a question: how to make a manufacturer responsible for the order and production via a contract under its related trading entity?
The situation involving 3 parties will be introduced in the following:
1．The use-case scenario: improper purchasing management
One of our clients wanted to place an order to a factory located in Chinese mainland, which was sourced online in the first place. However, we concluded that the factory only issued a contract under its trading company (sales office) registered in Hong Kong, while the production would be produced by its mainland factory. In China, quality issues after the production can always be a considerable damage to the manufacturers. With this cooperation structure, the factory could avoid any responsibilities by dragging its trading entities (sales office) in between.
Furthermore, the One Country Two Systems policy made this case particular complex.
According to the laws, it’s legitimate for the factory not to deal with the clients directly as the contract was signed under its trading entities, weakening the client’s negotiation power. Besides, it becomes even more complex to manage contracts and procurement when it involves two different law systems. The contract was not protected by the law of the PRC (People’s Republic of China) but by the Hong Kong Special Administrative Region.
More importantly, there were no (strategic) actual terms agreed in the contract that would affect the factory’s legitimate legal and financial interests. That means the factory can take advantages of the entity and cooperation structure to avoid legal responsibilities. On top of that, its so-called sales office (trading entities) in Hong Kong has no tangible assets to cover the obligations (financial losses) it may occur.
All these could cause you troubles in many situations, such as critical quality issues, high defective rate, Intellectual Property infringement, lacking compliance, incorrect product specifications, production delay, price increases and so forth.
2．Problems encountered: quality issues
– Contract couldn’t signed with the direct party who produced the goods.
– No (strategic) actual terms and conditions agreed in the contract involving legal and financial interests to the Mainland manufacturer entity.
– The contract itself had no legal power to force the Mainland manufacturer to take any responsibilities, only if they want to.
– Client had no legal power to negotiate with the manufacturer would not be involved in the contract.
– The trading company or sales office in between couldn’t cover the risks for the manufacturer as it has no tangible assets.
3．Origin of the problems: lacking manufacturing management
Finding the source of the problem helps you understand the trigger behind this and avoid similar future issues.
（1）Manufacturers need to have financial interests – margins and benefits:
It’s understandable that manufacturers want to keep their margins and assets safe as much as possible even mistakes made by themselves.
Although some manufacturers are bigger with many assets, detailed terms and conditions can damage their entities. For example, margins become lower when the order values increase. The higher values of the order, the higher risks will hurt their entities. Some small problems could possibly damage all the profits, not to speak in a quality issue situation which could make them face financial losses or go bankrupt.
To keep the damage away from financial interests, if any disputes, having a trading company or sales office in between could help the manufacturers “escape” from the legal responsibilities. That’s one of the reasons they would get a sales entity involved.
（2）No strategic purchasing:
Unexpected quality issues or failures might occur if we ignore the importance of risk-based quality management. Quality risk management is a core element to successful purchasing, especially when it comes to orders involving two different parties protected by different laws.
4．A practical solution to a successful purchasing
In this case, our clients didn’t do a thorough factory investigation and neglected the country’s One Country Two Systems as well as its supply chain and manufacturing environment.
Solutions by IAAD China Working Method
To really solve the issues, there are three essential questions we should ask ourselves:
- What do we expect from the manufacturer in this cooperation?
- How can we make sure the manufacturers legally responsible for the products’ quality and specifications?
- How can we ensure manufacturing are under control and manufacturers will deliver the right products as agreed in the contract?
We can find the answers to these questions by implementing several practices according to the book IAAD China Working Method.
Solutions vary in different situations and issues. You may take this case as a reference to apply the key of the solution to the same or similar cases with customized strategy, when necessary, to prevent repeated issues.
(1) Interest – IAAD China Working Method
In this situation, the manufacturer and its legal and financial interests were not included in the contract. They have no legal responsibilities to take, even though there are any issues and disputes.
Therefore, creating legal and financial interests would generate interests for the factory to take good care of the productions, requirements, quality, specifications, and related responsibilities.
Additionally, the manufacturer will also be motivated by financial interests. When the manufacturer entity has legally agreed on the legal responsibilities, such as monetary compensation, its financial interests will become relevant.
The solution to this case would be:
- Create a legal interest for the factory by issuing an agreement having you, the sales entity/office, and the manufacturer included.
- Make the manufacturer officially sign the agreement with a signature and stamp, creating it commits to all terms and conditions legally written.
- Create legal and financial interests by demanding that the original manufacturer entity will be included in the agreement. Otherwise, you shouldn’t place the order.
- Also, you may increase the financial interest by scaling up your order value. The more value your order brings to the company, the more a Chinese company is willing to cooperate with your demands in this way.
(2) Agreement – IAAD China Working Method
Strategic contract management in procurement starts with a proper agreement that possibly applicable to similar scenarios.
In this scenario, the terms and conditions should focus on the manufacturer’s legal and financial interests apart from the regular details.
There’re a few more steps to follow for the suggested terms and conditions:
- Create an agreement that clarifies each party’s legal responsibilities in the contract, including terms, specifications, or any other conditions.
- Define the details of the manufacturer’s responsibilities, such as product specifications, quality standards, and the legal responsibilities to the manufacturer in case of any quality issues or production delay.
- Most importantly, the manufacturer should agree that you are allowed to execute quality inspections onsite. Besides, if any quality failures, you should think about – what you need the manufacturer to solve the problems? Re-make the products? Refund the payment? Or any other solutions?
It would help if you want to avoid further discussions and negotiations.
Whereas, the more you agree by a written agreement, the more the factory will consider its risks. On the other hand, the more the factory will consider its risks, the more it becomes clear to what responsibilities they can or want to commit, leaving no room for them to find excuses not to commit to the agreement.
(3) Assessment – IAAD China Working Method
Once the agreement has been signed, you can start to execute assessments to see if the manufacturer is proceeding with what they agreed. In production, these assessments are called quality inspections.
In this use case, the key to successful purchasing is to make the manufacturer carry out what they agreed as early as possible. That means timely inspections are critical to preventing financial damages.
A step-by-step assessment you can implement:
– Make quality assessments of the products produced by implementing quality inspections at the factory.
– Keep an eye on the factory by asking questions related to the specs, updates of the production status, sending you the PP and shipment samples to check.
Conclusions:
A few key takeaways for the solutions:
- Create legal and financial interests for the manufacturers in Mainland China.
- Create a proper agreement to clarify all interests and terms covering all legal responsibilities you expect the manufacturers to take.
- Execute assessments (quality inspections) to see if the manufacturer is proceeding with what they agreed.
To learn more about the supply chain environment in China, contact us or read the book IAAD China Working Method.