11 May 2022 Transparency in the Supply Chain: Open Book Vs. Multiple Books
By Jeffery Cartwright, Managing Partner of Shoreview Advisors | 12 min read
In working with both Chinese and Mexican manufacturing companies over many years, we have identified key differences in the way that the countries operate. These include what they consider to be proprietary company information, how they account for costs, and how they view their U.S. counterparts. Let us set the stage, with the information that is needed, regardless of where a product is manufactured.
Background
Basic Product Information for Manufacturing
To successfully manufacture any product requires a certain amount of information. There needs to be a detailed bill of material, which lists each of the components or parts required to assemble the product. The specific source of each of these parts is also required, so that the buyers and planners can ensure that parts are available when assembly is scheduled.
Additionally, both 3D drawings and 2D drawings are needed. These drawings, in conjunction with specifications, ensure that the parts are produced accurately and within tolerance. All factories, no matter where they are located, require this basic information. Further, to accurately develop the cost of the product, specific costs are required for every part. Without those specific costs (prices for purchased parts), the company will not be able to place purchase orders with the suppliers of these parts.
Ownership of Product Information When Manufacturing
When a company manufactures in its own facility, clearly the company owns and controls all the above documentation required to manufacture a product.
When a company outsources manufacturing by purchasing products from a third-party manufacturer, then the manufacturing company owns and controls the above documentation. Information is then only released when required by regulatory agencies, or for servicing the product in some way.
When a company is outsourcing the manufacturing of a product that it has designed, it should own all the above documentation. However, things can become muddled over time. Periodically changes are made to a product which should be reflected in both the bill of materials, and in updated drawings. Sometimes these changes are directed by the company and sometimes made independently by the factory.
The changes we note above simplify the manufacturing process, reduce product costs, and/or improve product quality. Sometimes they are required as the source of parts and components may have quality or cost issues, and a change in the source becomes necessary. The engineering change process (ECN) is in place in most manufacturing companies and is the updating process for these changes. Note that nearly all of these updates have very valid reasons for being made.
Factory Ownership Types in China
Before delving in further to the specific Chinese transparency issues, we need to distinguish between the ownership of various factories in China. First, a wholly owned factory (that is a factory owned by the U.S. company) will not have transparency issues. Factories owned by Japanese and South Korean companies will be very forthcoming in the above information, and also won’t have these issues. Factories owned by Taiwanese or Hong Kong companies will be somewhat transparent. Factories owned by mainland Chinese will obscure and obfuscate, and the information provided by them will not be completely reliable. Also, note that there are exceptions, but that this is broadly true. Additionally, these factories owned by the Chinese now believe that they own the intellectual property, the design, the drawings, and many times the tooling that was paid for by the U.S. company.
Transparency Issues in China
We have recently asked many clients to provide a detailed, fully costed bill of material for the product that they have had manufactured in China that they now want to evaluate for manufacturing in Mexico. Unfortunately, most companies cannot provide this information to us, not because they have not asked, but because the Chinese company has not provided it. If they do have this information, they quickly back away from the accuracy of the information. The overarching question is: why is this generally true?
First, many Chinese manufacturing companies have much greater aspirations than producing just your product. They are interested in manufacturing on behalf of many other clients, and potentially interested in selling a version of your product to the Chinese market. A fair number of them aspire to develop their own brand, and therefore compete in the largest markets in the world: the U.S. and EU. Therefore, the theft of intellectual property is common, and the information that they are protecting is considered a trade secret. Many Chinese factories consider the current customer as part of the path to the future, and as such, a long-term competitor.
Second, there are multiple sets of accounting/financial books within some Chinese firms. Recent articles concerning the lack of transparency in China are frequent, and range from the origins of COVID-19, to the potential collapse of Evergrande, to overstating Chinese government statistics on the economy, to the U.S. Security and Exchange Commission challenging the listings of Chinese companies on U.S. stock exchanges.
In other words, the use of multiple sets of books is pervasive throughout China. There is one set of books for the Chinese government and regulators, another for the efficient operation of the company, and perhaps a third set to be disclosed to the customer. The information gap between reality and what is disclosed may hide cost savings that are now recorded as profits to the factory, and not shared with the customer. The failure to share the identity of supplying factories may be to prevent the customer from relocating elsewhere and thus protecting the current factory.
Experience with Receiving Accurate Costs from China
Over the years, U.S. executives, including the founder of Shoreview Advisors, have outsourced the manufacturing of many products to China. This has resulted in lower costs and has improved profitability. Since the products originated in the U.S., updates on product costs, due to changing prices charged by the supplying factories, were routinely asked for by the U.S. executives. The factory would be asked to provide an updated, fully costed bill of material. Some factories would readily provide that information, but most would not and many consider that information to be proprietary to them, and if over time the information was released, it would not necessarily be accurate, particularly as it pertains to either the sources of supply, or to the actual costs.
Full Transparency in Mexico
The Mexican manufacturing ecosystem is tied closely to the production of intermediate goods and aligned with the U.S. automobile industry. As such, many manufacturers are not vertically integrated. Their suppliers are sometimes pre-determined by the U.S. importer. Many of them strictly quote from drawings, not samples.
We typically describe Mexico as a manufacturing-oriented export economy. These factories are part of the North American ecosystem for the manufacturing of automobiles, aerospace equipment, and medical devices. As such, these factories are accustomed to sharing every detail of the manufacturing process. Note that these industries are heavily regulated with high product liability potential in the U.S. and deviations are not acceptable. When design changes are needed, most Mexican companies will not implement the change without authorization via the engineering change process (ECN). In contrast, if a Chinese company originated the change, and it benefitted the Chinese company, the change would be fully implemented and often never communicated with the customer.
Beyond that, open-book accounting is nearly a standard throughout Mexico. The U.S. customer might not like the specific elements of cost, but they will be fully shared. If backup information is requested, the factory will typically produce the last purchase order or the production records, to substantiate the cost information. Further, if cost improvements are made, it is typical that these are shared with the customer.
The Key Difference
The key difference between factories in China and Mexico is the view of the customer. Some Chinese factory owners consider that they are today, or will be in the future, competing against their customer. In Mexico, the factory owner generally considers the customer a long-term partner, and has no intention of ever selling to the customer’s competitor, or selling directly into the U.S. market. For the Mexican owner, benefitting the customer, is in the long-term best interest of both his company and the customer.
Conclusion
All of these issues are front and center when Shoreview’s team is reviewing potential sourcing relationships for clients. Failing to consider even one of these components to the sourcing equation can have drastic future consequences. Whether or not you choose to re-shore to Mexico, another country, or even remain in China, these are all issues that should be addressed with your current and future sourcing companies.
If you are interested in making the move from China to Mexico, contact us today to learn more about our expertise, and how we can help you make the decision that is best for your bottom line.
