How to Manage the Hazards of Supplier Subcontracting in Asia

by Greg Hallahan, FTI Consulting, Forensic & Litigation Consulting.
Tuesday, 1 December 2015 12:23 GMT

A worker looks at baskets of steaming zongzi or Chinese rice dumplings inside a factory in Zhejiang province May 23, 2014. REUTERS/William Hong

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* Any views expressed in this opinion piece are those of the author and not of Thomson Reuters Foundation.

Products manufactured in Chinese prisons are among the most recent examples of what may happen absent supply chain visibility

Last year, Aston Martin (the British company that makes James Bond’s car) had to recall every automobile it had made in China since 2007 when it discovered that a subcontractor was using counterfeit plastic in its cars’ accelerator pedals.

Can’t have 007’s pedal falling off when he’s chasing a bad guy.

That’s not a particularly good joke, and it certainly wasn’t funny to Aston Martin, nor to the many companies that manufacture all or parts of their products in Asia.

Actually, most large companies do a good job of vetting their primary suppliers. Problems tend to arise when those primary suppliers hire subcontractors. Unauthorized subcontracting is common in Asia and can cause significant quality problems and bring unknown, potentially unscrupulous players into the mix. Companies must understand where the risks lie and how to avoid them.

The Risks of Unauthorized Subcontracting

Although most contracts with suppliers prohibit unauthorized subcontracting, local suppliers can become overbooked and unable to take on a new project or order. Because competition for Western contracts is fierce, suppliers fear that if they turn down work, their client may never return.

To maintain the relationship, the local provider will subcontract the work without informing its client.

Under time and cost pressures, local manufacturers often will subcontract to small, unregulated and unauthorized storage and transportation providers. In many instances, these transportation providers may make products disappear in transit, or substitute them with poor quality counterfeits.

Furthermore, if 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 absent supply chain visibility. 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.

Trouble can start even before a company selects its suppliers. Often, unbeknownst to the procurement team, the owner of one of the candidate suppliers may have a financial tie to one or all of the others. This allows the suppliers to coordinate their bids while agreeing to share in the spoils no matter which company wins the contract. Such rigged processes can inflate buyer costs, diminish profit margins, and thwart a company’s ability to control the quality of its products.

Mitigating the Risks

Companies need to know the business interests and practices of their providers in emerging Asian markets. A thorough process of documenting suppliers begins by identifying any information gaps in companies’ current audit processes. The audits should assess production capacity to understand whether the supplier can do the job and thereby gauge the likelihood of unauthorized subcontracting.

Businesses should tap into local public records, including regulatory, litigation and bankruptcy records, as well as sanction and compliance databases and reports from local environmental and worker safety organizations. Trading websites, industry forums, job postings, and social media also offer clues about potential undisclosed conflicts of interest. And unannounced visits can verify if the supplier exists in the shape, form and location it claims.

Company leaders also should reward the procurement organization for thoroughly understanding its suppliers and the supply chain, not just for finding the lowest price. Creating an accessible, regularly-updated database containing information from due diligence activities can uncover important information and alert companies to possible red flags.

Businesses have made 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, placing their profits and reputations 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 that are common across much of Asia.