The China Code

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The bottom line: Outsourcing just got a whole lot more complicated. Although some entrepreneurs may give up the notion of manufacturing overseas altogether, those for whom it may still make sense have to be vigilant--very vigilant. The new rules of outsourcing include finding reliable manufacturers or brokers, vetting factories in person, drawing up carefully worded contracts, and testing, testing, testing. Sandy Goodman, CEO of MI Industries, a 100-employee, $25 million premium pet food company in Lincoln, Neb., had already been using an independent domestic lab to test the rabbit he imported from China for protein and fat content, as well as bacteria and other pathogens. But when the news broke about melamine in pet food, Goodman asked the lab to test also for melamine and cyanuric acid, another suspected culprit in the pet deaths. "This has caused us, and everyone in the industry, to go all the way back to the source of where the products are coming from," says Goodman, who spends about $5,000 a year on the tests. "We want to know who is producing them and who is checking them along the way, as well as doing our own quality checks."

CHECK, TEST, REPEAT
So how do entrepreneurs ensure that what they're producing in China arrives back home with reliable and safe components? There is no easy answer, and no matter what you do, there are no guarantees. To make sure every component of your product meets federal and industry safety standards, you need to follow each back to its original source, and check that everyone in the supply chain is legitimate. That process can be complicated because many Chinese factories outsource parts of their production process to other Chinese manufacturers if they think they can find an advantage. Make sure your manufacturer is the one who's actually going to do the work. "People off-load work all the time," says Jack Daniels, president of BuyersBridge/Eastbridge Partners, a buyer's broker in Boston. "Behind the scenes, invisibly, they will have it manufactured elsewhere." That is particularly troublesome if your product needs an official certification, such as from Underwriters Laboratories, for electrical components, or from the Food & Drug Administration. The factory you contract with may have the ability to apply such certifications, but its subcontractors may not.

Your first step is to find a potential factory and gather all the information you can about it. Basic information, like location, contact numbers, and product specialties, is available on thousands of suppliers on such sites as alibaba.com, globalsources.com, or China.tdctrade.com. Factory representatives often have booths at large trade shows such as the International Consumer Electronics Show.

First-timers may also rely on a broker to set things up. Brokers have a network of professional contacts in China, linking U.S.-based entrepreneurs with factories overseas. Many advertise in trade magazines, or online, though the best route is often through a referral from someone in your industry. Brokers typically charge a commission between 10% and 50% of your total order. But beware: Some brokers' markups are not clear, so make sure costs are broken down and ask under what, if any, circumstances, they might tack on additional costs later. They also may work in tandem with a factory to increase their profits on your dime. And they may choose substandard factories. In 2005, Jen Bilik, owner and founder of KnockKnock, a 15-employee, $4 million stationery company in Venice, Calif., used a broker to find a factory to produce a new line of products. On a visit after the run had started, she found the factory permeated by a noxious chemical smell, with few safety measures in place for workers. "I was alarmed," says Bilik. "It was no factory I wanted to be associated with." She discontinued her relationship with that factory and broker after the first run. To find another factory, she conducted Internet searches and attended the China Import/Export Fair, held twice annually in Canton. Eventually she started working with seven different manufacturers.

Another type of outsourcing middleman, called a production consolidator or aggregator, will take possession of all or large parts of your order, overseeing or improving the production process. These include Ariba, China Manufacturing Network, and Buyers Bridge.

Once you locate potential suppliers, nail down how much experience they've had making products similar to the ones you want manufactured. "Inevitably Chinese manufacturers will say 'yes,' and then figure out how to make it later," says Nick Connor, co-founder of Pacific Pathway in Solano Beach, Calif. The three-employee, $10 million company uses five factories in southern China to make first aid products such as safety backpacks and flashlights. "A small business owner must physically confirm they [the facility] can do what they say they can," says Connor. It is a good idea to make frequent visits--unannounced if possible. Examine machines and company maintenance records, assess the skill of the workforce, and determine whether there are quality-control people in place. After Goodman, unable to buy enough rabbit in the U.S., decided to source it from China, he visited several factories, examining them for cleanliness and procedural efficiencies, before he signed on with one. It's also a good idea to require any manufacturer you work with to have an internal lab that can test any incoming components from other suppliers. If a manufacturer balks at showing you these things, move on.

Also be sure to ask who a manufacturer's customers are and talk to those customers about whether they are satisfied. If a potential partner says it works with big players such as Costco Wholesale or Wal-Mart Stores, and can substantiate the claim, you're probably on the right track. "Big companies have stringent standards, and if manufacturers do business for them, it is one message that they can meet standards," says Bilik--although, as the recent Mattel recall shows, such an imprimatur goes only so far. Also, Bilik says, those manufacturers may bump your order for the larger company's in a crunch. Among the other questions Bilik asked potential suppliers were whether they have internal safety standards in place, whether they had dealt with Americans before, whether they previously manufactured consumer products, how they scheduled jobs, and, of course, how they priced their services.

To maintain quality, you'll want to hire an independent, third-party tester to inspect your goods. Testing should be done at key points in your production cycle--during a test run, a first run, a middle run, and toward the end. Intertek, SGS, and Bureau Veritas are among the companies providing those services, with costs ranging from hundreds to thousands of dollars, depending on a product's complexity. "We recommend [testers] document their whole procedure as well as the steps they take along the way," says Joan Lawrence, vice-president of standards and regulatory affairs at the Toy Industry Assn. "That way [business owners] can go back and look at the documents and determine if materials or equipment have changed."

LOYAL PARTNERS
Coast products found another way to try to maintain control: It invested in the factories that produce its goods. David Brands, CEO of the 61-person, $50 million company in Portland, Ore., began outsourcing in 1985 but had concerns about quality. He negotiated with a factory near Shanghai to allow a quality-control company to study and improve the production process. "It was a defining moment in our relationship because they realized they had a very loyal partner in us, who wanted to help them improve their equipment and quality and production methods," says Brands. Then in 2000, when the company developed a line of LED products, Brands worked with a Chinese company to build a factory in Yong Jian. The facility, supervised by some of the managers from the Shanghai factory, is owned and operated by the Chinese company but is devoted largely to making Coast's products. All told, Brands says he has invested about $5 million in equipment and improving processes in the two factories.

INK'S IMPORT
No matter what factory you work with, or where, you'll need a carefully worded contract, and probably a lawyer. Entrepreneurs working with Chinese manufacturers typically have used standard purchase orders with boilerplate legal language in fine print on the back of the form. But those slapdash efforts can spawn a blame game when problems arise. Erika Schenk, co-leader of the commercial practice group of law firm Bryan Cave, advises entrepreneurs to describe everything in detail, including all product parameters and specifications. Note what products will be tested on the site, by whom, and, crucially, who is responsible if something does go wrong. Because judgments handed down by U.S. courts are rarely enforceable in China, opt for arbitration, which is more frequently respected. "You want a contract where you are indemnified against lawsuits and claims, and one that would protect you from consequential damages if your business reputation is hurt," says George von Mehren, chair of the international dispute resolution group at Cleveland law firm Squire, Sanders & Dempsey. The contract should also cover problems, even minor ones, that might arise during shipping. Include language that holds the manufacturer responsible for covering the costs of a product recall. Some entrepreneurs stipulate that they must receive pre-production samples before agreeing to a complete run. Others, like Bilik, spell out penalties for late or defective products. Liability insurance is also essential.

Although it is critical to do all you can to try to prevent a blowup, don't underestimate the importance of the human touch. "Invest time to get to know the partner, as this goes a long way to help alleviate the issues later," says Schenk. Keep in mind that you are working within a different culture, one in which business owners put a lot of weight on personal ties, often dining and socializing with potential customers. Some even hold signing ceremonies with their customers. When Goodman committed to work with his rabbit processing facility, he was invited to a large banquet with the factory owner, the town mayor, and other officials who made goodwill speeches and toasts. "We felt the sincerity through the body language and the tone," says Goodman, who does not speak Mandarin. "It was moving and kind of awe-inspiring."

Jeremy Quittner is a staff writer for BusinessWeek in New York.