Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

The Dark Side of Chinese Manufacturing

Outplaying your partner
Poorly Made in China by Paul Midler

Reviewed by Muhammad Cohen

When you buy for US$2 in New York an umbrella that's made in China, you have to wonder how they do it. After all, the umbrella components have to cost something, there's shipping, and there's profit for numerous middlemen and the retailer. Among the economic miracles unfolding in China over the past two decades, the most mysterious may be how a country that skipped the Industrial Revolution, substituting the Cultural Revolution, became the low-cost factory floor to the world.

Poorly Made in China: An Insider's Account of the Tactics Behind China's Production Game provides fascinating and disturbing answers. Chinese manufacturers cut corners wherever they can, from product quality to factory equipment and maintenance. They unilaterally change product and packaging specifications to trim costs. They raise prices after the deal is signed, leaving the importer to absorb the added cost. They reproduce their customers' products for sale at higher margins in other markets. With support from government, bankers, and networks of fellow manufacturers, they conduct manufacturing and customer relations as a game, treating the other party as a patsy not a partner, playing for the short term of making an extra penny at the risk of product quality but also taking a long-term, multidimensional outlook that outflanks the hapless customer.

Paul Midler, a self-styled version of Raymond Chandler's detective Philip Marlowe investigating on behalf of importers, shows readers the dark side of Chinese manufacturing. A Chinese-speaking American with more than a decade of experience in China and a Wharton MBA, Midler himself seems to have followed the relationship curve he describes for Chinese manufacturers and importers. It begins with infatuation and satisfaction beyond expectation, but turns into a source of constant frustration at a situation in which the Chinese manufacturer has the upper hand, taking advantage because the bond is now too difficult to sever.

Poorly Made in China provides ample evidence supporting the Hong Kong adage that once you sign a contract in China, that's when the real negotiations begin.

To Midler, lead paint in toys and melamine in baby milk formula are not surprises but predictable outcomes from a manufacturing culture that takes customers for granted and assumes no responsibility for its outputs.

'All we need is your sample'
Despite that approach, China for nearly a decade has been phenomenally attractive to importers, particularly Americans. Even though other countries can undersell it, China remains the top choice for contract manufacturing. China has better infrastructure and internal stability than low-cost producers such as Vietnam or India, so shipping channels are more reliable. It has a wide range of manufacturers, eager to make anything importers want, offering the equivalent of "no money down" deals, driven by the mantra, "All we need is your sample".

Intangibles also boost the Middle Kingdom's appeal to Westerners. China is exotic without being bizarre, romantically foreign yet as familiar as the local Chinatown. People may speak a different language and use that weird writing, but they wear familiar clothes, not robes or headdresses. Chinese don't pray five times a day, sacrifice animals, or insist visitors adopt odd gestures such as bowing. While this 4,000-year-old civilization insists on its cultural uniqueness, modern China has also made conscious efforts to accommodate Western business. For example, Midler cites the widespread use of English names, in sharp contrast to Japan or India, where cultural barriers for foreigners begin with local names.

As more United States companies turned to China for contract manufacturing and Chinese goods became ubiquitous in the US, it became trendy to use China for production (just as Western exporters have felt compelled to have a China strategy to penetrate its market). Doing business in China is the sign of a savvy 21st century company.

Midler frames his tale around US importer Johnson Carter, supplying large chain stores with house-brand shampoo and soaps, run by a sharp salesman called Bernie. Midler finds it odd to manufacture products that are mostly water in China and ship them halfway around the world, but that's not his business. The Chinese manufacturer is King Chemical, located outside Guangzhou, the trading center once known as Canton, owned by Sister and her husband A-Min. (Names in the book are altered, according to Midler, but the stories are genuine.)

Who's fooling who?
Bernie first called Midler to examine King Chemical's factory. Midler reported to Bernie his suspicion that the production line had been arranged for his benefit and that the factory wasn't actually making anything. Bernie said he suspected the same thing on his earlier visit. Rather than disqualifying King Chemicals, the charade made Bernie more anxious to do business with them. "They're desperate for my business," he observed. Bernie was a Syrian Jew, a group with a long, proud commercial history, and he thought he knew all the tricks of the trade. He was about to learn new tricks: even when making soap in China, one hand doesn't wash the other.

Chinese manufacturers are dismal at marketing their products but are masters at winning deals then playing their importer customers. King Chemical's initial ruse illustrates the lengths that Chinese factories go to capture business. Even Bernie found himself wondering how King Chemicals could make money selling him a bottle of shampoo for US$0.30, including the pump, label and contents.

One answer emerged when Midler accidentally heard about King's "other factory". That facility was making Bernie's products but for an Australia importer paying a higher price than Bernie. The practice was common; factories took on clients for little or no profit to learn product formulas and designs that they could recycle into "second markets" such as Africa at higher margins. This model helps explain why many products cost less in rich countries where people can afford to pay more, and why Africans find bargains shopping in New York and London.

Non-profit business
For Chinese manufacturers, a deal with an importer can be desirable even if it doesn't appear profitable. Reasons range from domestic counterfeiting opportunities to status to customer contacts (for disintermediation - cutting out the importer to deal direct with retailers) - to cash flow or capital (secured by an enlarged plant) for other investments. While most small importers are playing checkers, focusing on profit on each contract, Chinese manufacturers are playing chess - and playing to win - Midler says.

Midler recounts how manufacturers outplay importers across the board, sometimes to shave costs, sometimes to save trouble, sometimes for the fun of the game. One explanation of Mattel's lead paint debacle in 2007 was that the toy giant's supplier's supplier switched the paint as part of routine gamesmanship.

On Johnson Carter orders, without consulting Midler or Bernie, King Chemical switched to thinner bottles, flimsier packing cartons, different fragrances (because Sister said she didn't like one soap's smell), and new product formulas, one that caused itching and another that clotted at temperatures below 15 degrees Celsius (60 degrees Fahrenheit). Sister gave away the clotting problem by asking about the weather in the shipment's destination city, Chicago, but she wouldn't reveal the ingredients of the altered formula when Johnson Carter tried to find a way to fix it.

King Chemical also tried to ship improperly filled and mislabeled bottles. In each instance, the factory suggested the importer take the shipment and deal with the fallout from customers, King Chemical only offering assurances to do better next time.

Doesn't wash anymore
Midler points how these games can turn dangerous. At King Chemical, poor factory oversight and lax employee discipline put people with skin infections on the production line, risking product contamination. Factories slap on quality-control stickers but they're meaningless. Midler laughs at "No Animal Testing" labels on Johnson Carter products - because there's no testing at all. Laboratories can only check for a specific substance in each costly test, and there's no limit to the harmful substances that might have been introduced to a product, either accidentally or by changes to the product formula without the importer's knowledge, so most importers just cross their fingers. While working with Johnson Carter, Midler became so paranoid that he stopped using soap.

Manufacturers get away with these stunts, including arbitrary price increases, because once an importer starts a contract manufacturing relationship with a supplier, it's usually stuck. As with a marriage, it's often generally better to try to work things out than break up. The cost and effort of finding another manufacturer - and networking between manufacturers to discourage poaching clients - mean that importers have few options, unless they're ready to forego supply for several months. The longer the relationship, the more the factory takes the upper hand, according to Midler. Manufacturers expertly play importers' anxieties, and the customer often winds up begging the factory to deliver the product.

For the factory, an established relationship becomes a one-way street, not a partnership. According to Midler, the Chinese side simply looks for all the advantage it can, using every tool at its disposal. The author sees that as a cautionary tale beyond the world of manufacturers and importers to the heart of US diplomacy with China. The prospect of the US being drawn into that kind of a relationship with a nuclear armed, numerically superior China holding trillions in US Treasury securities is a lot scarier than questionable body scrub. Midler has written a fascinating, funny and important book.

Poorly Made in China: An Insider's Account of the Tactics Behind China's Production Game by Paul Midler. Hoboken, New Jersey, USA, John Wiley & Sons, April 2009. ISBN: 978-0-470-40558-1. Price: US$24.95, 242 pages.