How to review your suppliers in China

In any global value chain, functioning supplier-buyer relationships are a key ingredient for successful and efficient conduct of business, as well as to ensure compliance with emerging global regulations on supply chains. From large multinational corporations (MNCs) to small and medium-sized enterprises (SMEs), managers must ensure that communication channels are functioning, and supply chain risks mitigated effectively. In the following article, Simon Laube and Ivy Gu of Dezan Shira provide an overview of areas that managers should consider when reviewing their suppliers or business partners in general.

Inroads for supplier review

Traditionally, larger buyers perform regular quality and financial audits of their suppliers. However, this is not possible for many SMEs that have suppliers in China. Lacking the political weight or financial resources of MNCs, many SMEs rely instead on suppliers’ self-assessments or even information discovered during visits on business trips. The latter approach has become increasingly challenging due to the restrictive travel policies adopted by countries during the COVID-19 pandemic.

This article provides suggestions for supplier reviews that can be performed by local teams in a cost-efficient manner, resulting in an improved understanding of a given supplier’s business, such as the business relationships, competitive pricing, potential exclusivity agreements and operational stability of a target.

The approach for a supplier review can be via either a ‘regular’ or ‘special’ route.

The regular route applies to business partners that have requirements for supplier reviews in their initial agreements. Usually this is the case if the end-customer has requirements that need to be implemented throughout the supply chain, or if a customer has large-volume contracts in place with a supplier. However, there are also low-volume cases with specific needs that require regular reviews in the absence of end-customer requirements.

Special supplier reviews can be initiated when there is a change in business or when irregularities occur, such as inaccurate delivery times or discrepancies between order and delivery. Quality claims, insufficient or uncertain capacity and stocktaking are also valid reasons for a special supplier review. While the pandemic disrupted global supply chains, it also opened up the opportunity to review suppliers.

In addition, special reviews are necessary for financial changes in a business relationship. A co-investment by the buyer or a change in the payment terms to aid a supplier’s working capital position requires financial and operational due diligence. If a customer has concerns about the solvency of a supplier, but does not have access to accurate financial data, hiring professionals on the ground to visit the recipient can help to maintain a basic level of trust. However, cooperation by the supplier to allow their books to be audited is necessary to gain certainty about the financial reality.

In cases when communication issues create uncertainty about future business outcomes, this can be dealt with by performing some simple fact checks and reviewing objective data.

What to review?

Supplier reviews can consist of multiple sections that can be roughly organised into operational, procedural and administrative reviews.

Operational review

An operational review requires a visit to all production facilities that play a role in the business.

Customers should pay attention to the accuracy of what a supplier claims, compared to what is actually found to be true. Examples are the exact size of the production facility, the production capabilities, the machinery and its operational status, material stock and material handling, inspection equipment, and the personnel at each production step.

Also, the shipping area, its accurate location and protection from weather, and the time products remain unfinished or pre-packed in the shipping area or between production steps, can hint at how quality-orientated a supplier is.

Official certificates and objective documents—like company hierarchies and process-flow charts, and work instructions at the specific locations—are usually part of such reviews.

A stocktaking, or inventory count, is part of more time-consuming operations that requires physical visits to a designated location. It can be performed independently or in conjunction with other reviews.

Procedural review

A procedural review requires a higher degree of supplier collaboration. Vertically-integrated industries, such as automotive, are more often subject to reviews of management procedures (for example, product development and risk mitigation). The customer can review whether the supplier has standard project management procedures implemented in practice with an internal reporting system defined for each milestone.

A mechanism to flag risks occurring in the development process that could lead to product failures or a simple breach of deadlines is also important. Sophisticated factories will have a Process Failure Mode and Effect Analysis (P-FMEA) system in place for production, while professional R&D departments will employ development FMEAs. Customers, however, should be cautious about the implementation of FMEAs and whether they are created and policed independently of customer requests.

In addition to these aspects, which are usually subject to full quality audits, there are other, simpler procedures. These can be investigated through business processes the supplier has with other stakeholders. One example is the material order process; how an order is placed, whether in bulk or according to demand, can reveal a supplier’s professionalism and financial prudence. The supplier should be able to show its order book and prove that its orders have been received on time. Such order-delivery accuracy will indicate if there are irregularities to be expected in your supply chain.

Another example is the availability of production manuals and instructions for workers, as well as official technical standards necessary to understand customer requirements. Furthermore, official certificates, such as insurance policies and management certifications, should be available when visiting a supplier without prior notice.

Administrative review

The third category is an administrative review, which can partially be conducted remotely.

Basic items a customer should review are the supplier’s business licence, its business scope and registered capital, as well as its legal history and changes to its business in the past. The official shareholder structure and potential non-public stakeholders can reveal how a supplier is integrated into an industry and where financial resources come from.

A second step requiring deeper investigation is the business relationships the supplier has with the customer’s competitors or major customers in other product categories. While this data is hardly easy to obtain, sophisticated suppliers will be open to disclose non-confidential relationships and provide customer references to verify their claims.

Of special interest are price benchmarks. This is not directly related to an administrative supplier review since pricing is confidential in most cases. Professional consultants, however, can help achieve clarity about market prices and the competitive position of a supplier.

Summary

In international business, face-to-face engagements are crucial to establish strong business relationships with functioning communication channels and swift risk mitigation. Traditionally, business trips have served to form such communication channels, while financial and quality audits have established facts. However, to overcome current issues with travel restrictions, supplier reviews may be outsourced and conducted on a sub-set of items tailored to individual needs, which may be distinct from full quality and financial audits.

Dezan Shira & Associates is a pan-Asia, multi-disciplinary professional services firm, providing legal, tax and operational advisory to international corporate investors. Operational throughout China, ASEAN and India, our mission is to guide foreign companies through Asia’s complex regulatory environment and assist them with all aspects of establishing, maintaining and growing their business operations in the region. With more than 28 years of on-the-ground experience and a large team of lawyers, tax experts and auditors, in addition to researchers and business analysts, we are your partner for growth in Asia. For further information, please visit www.dezshira.com