Should you charge penalties to suppliers when there is a quality issue?

And, if so, how to do it?

I discussed this topic with David Collins, one of my partners at China Manufacturing Consultants, and we agreed that the answer is variable.

1. One-shot deals

For a one-time project, there is a high probability that the supplier simply walks away from the deal if you charge high penalties.

I have even seen regular suppliers (including some who had agreed to getting paid 60 days after shipment) who felt they had the power to say no to penalties. The truth of the matter is, when a buyer relies on one manufacturer for regular shipments, that manufacturer knows he has power. Multiple-sourcing does not always make sense, so many importers are “hooked” by a single-source supplier.

2. What to do with regular suppliers?

When dealing with a regular supplier, the buyer’s focus should be on helping the factory solve its problems and implement corrective actions. As much as possible, both sides should work as partners.

For example, car plants often send quality engineers to a supplier’s factory that is experiencing difficulties, as a preventative effort to avoid shutting down the production line (it would be a disaster, since down time costs a car plant close to 40,000 USD a minute).

Naturally this is easier for large buyers. A small buyer will never have much weight, but still they can have an engineer go to the manufacturing plant and guide/oversee corrective actions. This is the right thing to do — the buyer takes his responsibility.

My point is, an antagonistic relationship never helps. A “penalty” or a “fine” sounds like the punishment of a child who doesn’t behave properly, and it does nothing to improve the relationship with a supplier.

3. In which cases do penalties make sense?

We can think of a few cases:

1. The supplier’s company is large enough to easily “stomach” the penalty. (Some factories had to close because of one quality issue that triggered a huge fine.)
2. Your company gets a penalty from one of your customers, and you charge it back to the supplier at the origin of that problem. Obviously it needs to be well documented.
3. You signed a contract beforehand that addresses this situation.

Still, we think penalties are seldom a good solution. Buyers should not wait until a supplier makes a mistake. They should “own their supply chain” by selecting suitable suppliers and training them, down to the second- and third-tier suppliers if possible (at least for critical components).

Do you agree?