Due Diligence for Buying a Chinese Factory

Supplier ManagementMost Chinese factories are so poorly managed, there are real opportunities for savvy buyers who plan to restructure the company and boost profitability. At the same time, there are real dangers to avoid, and serious due diligence is necessary.

Looking at a factory from the perspective of a potential acquirer involves an analysis at many levels. I made the assumption that the due diligence process focuses on a Chinese-owned company.

1. Legal risks

The factory might not have the right scope of business, for example. Or they might be conducting a business that is illegal based on China’s law. Without a thorough review of their fundamentals by a local lawyer, you might buy a business that can crumble and disappear any day.

Sometimes it is more difficult to spot. The factory might be in an industry that has shady practices — for example, no VAT is paid in the construction industry and this practice, though illegal, is tolerated of local companies. It effectively prevents foreign companies to be part of that game. As soon as the local authorities realize the owner is non-Chinese, they will make it clear the business is operating illegally.

You can read about other examples in this article.

2. Compliance risks (in addition to strictly legal risks)

Do the factory’s operations have an environmental impact? What is the local government planning to do to this industry? For example, buying a ceramic factory in Foshan is probably a very bad idea — you will probably be forced to relocate to an inner province pretty soon.

Do production processes involve safety risks? In case an accident happens in the same industry, your factory might get closed for investigation. That’s what happened to 214 metal processing factories after the explosion in Kunshan this summer!

This type of risk is very industry-dependent and location-dependent, and is not always easy for industry outsiders to estimate.

3. Financial statements

Because of immature accounting systems and massive tax evasion, one can’t trust the level of profit declared to Chinese authorities. However, I would look at three indicators:

  • Profit: if it is positive, the business is probably making more profit than declared.
  • Assets: I would check whether their estimated value makes any sense.
  • Debt: if millions are owed to suppliers, it will be very difficult to push them to do a better job.

Note that getting a Chinese business’ financials has gotten much harder recently. In some cities, specialized firms can still get their hands on this information without the target company being aware of it.

4. Manufacturing practices

How far away are they from best practices in their industry? Can capacity be doubled or tripled by elevating a few bottlenecks and without any investment?

A big red flag is high levels of inventory. It is a sure sign of a mismanaged factory. So the good thing is, it signals a lot of room for improvement. But the bad thing is, it increases the price of the acquisition because the owner has a rough idea of how many RMB he spent on that stock.

It takes one of our consultants a few minutes to have an idea about a manufacturer’s efficiency and about its systems’ maturity. But, to an untrained eye, all factories look practically the same.

5. Ability to satisfy customers

How good and consistent is product quality? Are there frequent shipment delays? As a consequence, are customers ready to switch to a competitor who is a few pennies cheaper?

If calling a few customers and asking them questions, or reading through a salesperson’s emails, is impossible, there are other solutions to evaluate this point. A good look at their processes, their quality system, and if possible their records, will result in a reasonably accurate estimate.

6. Exposure to local competition

Since one can’t trust a Chinese company’s accounting books, a good approximation of its margin is its ability to avoid local competition. As Jack Perkowski wrote in Managing The Dragon:

The China market is actually two distinct markets. For virtually every product, there is a ‘foreign/local’ market, characterized by higher technology and higher price, and a second purely ‘local’ market, which is characterized by lower technology and lower price.

So you definitely want to avoid being in the “local market”. But the ability to launch new products also plays a role in maintaining healthy margins, especially in electronics, mechanical products, and similar industries.

7. HR practices

I wouldn’t waste any time looking at HR records or asking for formal one-on-one interviews with random workers. These methods have severe limitations, as I wrote before.

The best is to ask shopkeepers and passersby in the neighborhood if the factory has a good reputation and why — for example bad food or horrendous working conditions. A factory with a bad reputation will have trouble attracting good elements for years to come.

Another method is to look at the working conditions and potential hazards to operators. If even the basics (e.g. the workers don’t have protective equipment and aren’t aware of the dangers to their health) aren’t done right, it means management doesn’t care about safety. And it translates into higher staff turnover.

8. “Face to face” due diligence

I would look at the key people and try to answer a few questions:

  • Why does the boss want to sell out? Does he have another solid source of income (another business, some real estate investments…)? Or has he just lost a key account?
  • Are department heads competent? How long have they been in place? Is there a certain harmony among them, or is communication difficult?
  • How many members of the owner’s family have a position in the factory? The fewer the better.
  • Who are the main suppliers? Are they part of the owner’s very close circle?
  • If the factory sells a lot inside China: are there a few large accounts that do business “with the boss” rather than “with the company”?

9. What place for the owner in the future picture?

A Chinese “laoban” won’t act a professional general manager. In most cases, it is better for the boss to get out at the time of the sale. I would be extremely suspicious of a “laoban” who stays in a factory (whether he owns 0% or 50% of the business). I would suspect him of diverting money into his own pocket.

The touchy question is, who will act as legal representative? This position is often distinct from the owner or the general manager. The legal rep is the one who relates to government officials (in other words, who entertains them at night).

It is a key position, often held by a local employee who appears to be trustworthy. I won’t give general advice on this point… I’ll simply write that the acquirer should have a plan about how to deal with this issue.

10. Managing the switch from a Chinese-owned entity to a foreign-owned entity

What might employees do when they are told there is a change in ownership, and they are now part of a foreign enterprise? This is also a big question mark.

All of a sudden, all might ask for a raise, and might bring in the local labor bureau that might ask for retroactive payments of social security fees (as they did in last July with the Yuyuan shoe factory that employs 60,000 workers in Dongguan).

In theory, the proper way is to rent a building, start a new WFOE (foreign company), invest the capital required by the local AIC administration, hire staff, and so on. But this is not practical when acquiring a new factory. All I can advise is, talk to a lawyer and ask about the risks!

Would you look at other aspects of the business?

Amazon Does not Tolerate Low Quality Chinese Products

Many small businesses plan to buy products in China and sell them on Amazon as a Third Party Seller. It can form the basis of a strong, profitable business. But there is very little tolerance for quality issues.

We did a simple simulation of the impact of a serious quality problem (50% of defective products) on the importer’s profitability.

Example of profitability calculations

This simulation is based on the assumption that you get the goods in your warehouse and that you check 100% of them.

However, most Amazon Third Party Sellers I have met told me they deliver the products directly to Amazon’s fulfilment centers. In this case, they can expect to receive this type of message from Amazon:

Hello from Amazon.

We are writing to let you know we have removed your selling privileges and placed a temporary hold on any funds in your seller account.

We took this action because your order defect rate (ODR) does not meet Amazon’s performance target of less than 1%. The ODR metric is based on A-to-z Guarantee claims, negative feedback, and chargebacks.

How to avoid such a situation?

Work with the right supplier

Depending on the size of your orders, you need to work with a certain type of factory:

  • If you place small orders, you will probably have to work with a small workshop through a trading company that controls what happens. Make sure the trading company has processes and systems in place, and make sure they are specialized in your product category.
  • If you place orders above 20,000 USD per SKU for non-customized products, you can certainly buy from a larger manufacturer that can communicate directly with you. In this case, make sure to audit the factory and then to inspect the goods. Many agencies, including ours, can help you with that.
  • As a general rule of thumb, larger factories are more expensive, less flexible, and more reliable in terms of product quality.
  • In China there are very few “level 4″ factories.

4 Levels of Manufacturers

How to find out what type of factory you are in contact with? By auditing them. I strongly recommend to read How Factory Audits, Inspections, and Lab Tests Fit Together.

Videos about Factory Improvement in China

A couple of weeks ago, I sat down with David Collins (consulting director of China Manufacturing Consultants, a company I am involved in) and we shot a few videos on topics related to factory improvement in the Chinese context.

We have already uploaded some of them. They are very instructive, and about 2 minutes long. They are on Youtube and soon will also be on Youku.

Quality Improvement

Here are two concepts that 99.9% of Chinese factories don’t apply. Hence the heavy reliance on final inspections.

How to Mistake Proof Operations in China Factories

How good engineers can reduce opportunities for mistake, or make mistakes immediately obvious (before they become defects). It usually costs close to nothing.

How to Use Statistical Process Control (SPC) in a China Factory

Collecting data and running simple analyses can guide process improvement. These statistical techniques are much more simple than most people think.

General Improvement

3 Priorities for Chinese Factories: Quality, Maintenance, and Productivity 

What most manufacturers should focus on, and why.

Preventive and Predictive Maintenance for Chinese Factories

Basics about a solid maintenance policy.

How to Prevent Corruption of Purchasers in China

Tips to reduce opportunities to get kickbacks from suppliers.

How to Achieve Quick Changeovers in Chinese Factories

Did you see specialized mechanics changing tooling with cranes, and putting them in place with bolts? It is a sure sign of a factory that is very far behind best practices.

Beware of China Factories’ Pre-Christmas Rush

Supplier ManagementA few years ago we published Chinese New Year: how to manage the disruption?, since many quality problems show up in December and January. Basically, manufacturers rush to get the products on a boat before they close, and they don’t pay much attention to any type of detail.

As several clients reminded us recently, the pre-Christmas rush can be just as dangerous. Products typically need to be in stores by November, which means they need to be produced in a period spanning from June to September.

In industries such as toys, electronics, and many other consumer goods, factories have more orders than they can manage. So, what they do? They resort to a combination of the following four solutions:

  • They hire temporary workers and put high pressure on the workforce. Quality is often a secondary priority. Retailers have strict deadlines for getting Christmas products. Delays are always noticed and immediately punished, so shipping fast and getting to the next batch is the most important.
  • The usual sub-suppliers are overloaded and can’t deliver in time, so less reliable sub-suppliers are engaged and the components/materials are not all up to standard.
  • They promise short production cycles but end up shipping the goods later.
  • They subcontract some orders to small workshops with no quality control in place.

So, what should you do about it? Here are a few ideas.

  1. If you have a hard deadline, pushing a factory to rush production can create enormous quality issues that make the products unsellable. So, before pushing suppliers to hurry up, check the production status. Any inspection agency will be happy to do this for you. But the suppliers’ salespeople are busier and less responsive, so you can’t count on them.
  2. If your cash position allows you to order earlier and produce in March and April, consider this option seriously. You get better service, better quality, and probably lower pricing from your suppliers.
  3. Watch quality like a hawk. Don’t base your judgment on past factory performance — it is a special period where systems are overloaded and key people are maxed out.

 

Do you have other suggestions?

Chinese Supplier Verification Tips, Based on the Business License

Best Quality & Sourcing ArticlesHere are some interesting or useful articles that I found recently.

China Due Diligence. The Most Basic Things To Do.

Dan Harris explains what can be checked quickly and inexpensively before you make a deal with a Chinese company. A lot of information can be gathered simply by reading the business license.

Buying Product Packaging from China: A Complete Guide

Fredrik Grönkvist gives sound advice about packaging: when to source your own packaging supplier, what challenges arise for custom-designed packaging, what legal requirements might apply, etc.

Compliance in China. Challenges of Transparency, Interpretation & Enforcement.

Mike Bellamy wrote a great piece on what foreign companies established in China could get away with in the past… and what is no longer tolerated by local governments. In particular, increased attention to transfer pricing policies inside international groups, and a plan to increase labor costs, will impact many companies with an office/factory in China.

Case Study: a Cost Reduction Program in a Chinese Factory (video on Youtube)

David Collins gives us a first person account of a successful factory turnaround project in China. This program involved special training of workforce, in conjunction with the application of lean manufacturing techniques.

China seen pushing back plans to free yuan

It seems Beijing is afraid of “hot money” flows into China, pushing the RMB value up. They want to remain in control. For example, over the past 6 months, it seems Beijing decided to put a halt on the RMB’s appreciation against the USD.

USD-RMB-rate

Genius Sign In Shenzhen Tells Workers What Might Happen If They Die On Site

Many Chinese workers are not aware of the safety risks they are running in their job. A construction company in Shenzhen, tired of the high number of accidents, decided to resort to provocation…