2. Literature Review
2.3. Sourcing Industry In China
Over the years, China has established itself one of the greatest and most dynamics economies in the world, mainly because of its industrial capabilities and low costs
(Nassimbeni and Sartor, 2006), which are the results of investments made in the past, starting from the late 1970s, after the death of Mao Tse Tung, and turning it into a common
destination for outsourcing (Fredriksson and Jonsson, 2009)
According to Nassimbeni & Sartor (2006), “since 1979, the Chinese government has launched a series of reforms that have gradually paved the way for economic growth”, which included incentives for foreign investments, creation of logistic infra structures, and
investments in research and industrialization, meanwhile ignoring international complaints regarding the violation of property rights, in order not “hinder the first phase of
industrialization”, and linking the exchange rate of their currency (RMB) to the dollar so ensuring a monetary stability, making it advantageous for other countries to import from
10 China and obtaining favorable conditions for entrance into the WTO (World Trade
Organization) in 2001.
These investments have not stopped, as “over the last decade the Chinese government has continuously invested heavily in the construction of logistics and transportation
infrastructure” (Rahman and Wu, 2011)
China became one of the most attractive place for outsourcing because of many factors: the low cost of manpower (Nassimbeni and Sartor, 2006; Brown, 2005, Lau and Zhang, 2006; Rahman & Wu, 2011; Perkowski, 2011); high manufacturing infrastructure and competence (Zakkour, 2012; Brown, 2005; Lau and Zhang (2006) ; Handfield and
McCormack (2005) in Rahman & Wu, 2011); presence of its domestic market, that serve as incentive for foreign industries to outsource to China in order to serve the Chinese market (Nassimbeni and Sartor, 2006; Zakkour, 2012; Perkowski, 2011; Zheng, 2000) accessibility to other resources for productions, such as raw materials and commodities (Harris, 2012c;
Zheng, 2000); and increase in the flexibility, quality and quantity of its products output (Anjoran, 2011; Nassimbeni and Sartor, 2006; Zakkour, 2012). The presence of
governmental actions that support the manufacturing industry also is noted as an factor that stimulates outsourcing to China (Zheng, 2000; Nassimbeni and Sartor, 2006).
However, the Chinese economy also presents some weakness/liabilities for its sourcing industry as well: Rahman & Wu (2011) point out that the Chinese companies have difficulties in coping with fluctuating product demands, logistics competencies, and real-time distribution ability, as their concepts of supply chain management are “far behind those of their Western counterparts”, as well as problems related to its logistics infrastructure,
difference in culture, human capital (unskilled and very mobile) and policies and regulations.
According to Goh and Ling (2004) in Platts and Song (2010), China’s “ current logistics infrastructure, particularly those of transportation networks, telecommunications systems,
11 warehousing facilities and customs procedures are still relatively poor”. Another issue is the rising of prices and work wages in China, which erode its costs advantages and can cause some companies to outsourcing to other low cost countries, such as Vietnam and Malaysia (The Economist, 2011; Harris, 2012b).
Nevertheless, despite its shortcomings, China still presents itself as the best option for international sourcing, as its logistic infrastructure is still better than other low cost sourcing countries (Perkowski, 2011; Swizstick, 2008) – for example, one of the largest differences between the China and Vietanm is the level of port and logistics infrastructure – as well as Vietnam’s lack of access to resources and industrial technology, in comparison with China (The Economist, 2011; Perkowski, 2011).
In contrast, India is the leader of sourcing of services related to IT enabled Services (ITES) and Business Process Outsourcing (BPO). According to Oshri, Kotlarsky, Rottman and Willcocks (2009), India’s ‘’role as the primary sourcing destination for these services was cemented in the late 1990s as multi-national corporations struggled to deal with the looming Y2K conversion effort. India was well positioned due to its educated work force, foreign investment friendly government policies, stable political climate and English language proficiency. India has steadily grown in its delivery capacity, higher value capabilities and reputation throughout the last twenty years’’.
India’s information technology and outsourcing industries are expected to cross $100 billion in 2012, a 14.8 percent increase from 2011 and double the value from 2007, while its’s share of global outsourcing industry was 58 percent in the 2011 fiscal year (Thirani, 2012).
12 2.4. Risks
Merna and Al-Thani (2008) define risk as a measure the probability of an occurrence of an event with negative connotations. Rowe (1977) defines as the potential for unwanted negative consequences to an event or activity (Merna and Al-Thani, 2008).
The authors also present that the difference between a risk and an uncertainty is in the possibility of measurement: “A decision is said to be the subject to risk when there is a range of possible outcomes and when known probabilities can be attached to the outcome.
Uncertainty exists when there is more than one possible outcome to a course of action but the probability of each outcome is not known”. Moore (1983) maintains that there are two basic components of risk. The first is risk as a future outcome, which can take a number of forms, such as a supplier raising prices. The second component is the probability that a particular outcome may occur..
Khan and Burnes (2007) listed some authors that defined risk, stressing its negative risk:
Lowrance (1980) describes risk as a measure of the probability and severity of adverse effects.
Rowe (1980) defines risk as the potential for unwanted negative consequences to arise from an event or activity.
Simon et al. (1997) perceive risk in terms of the likelihood of an uncertain event
or set of circumstances occurring which would have an adverse effect on the achievement of a project’s objectives.
Because of its negative connotation, it is necessary to develop risk management tools to minimize its effects. There are many definitions and methods for risk management. For Dickson (1989) in Khan and Burnes (2007), it involves the identification, analysis and
13 response to risks which can threaten the assets or earning capacity of an enterprise. Cox and Townsend (1998), argue that “the actual process of risk management normally begins by assessing two factors: firstly, the likelihood of specific events occurring; and secondly, the consequences should the events actually occur”.
In the case of sourcing activities, the risk management process “may be summarily described as an exercise in value protection, the objective of which is to minimize the chance of delivery failures” (Kam et al, 2011).
2.5. Risks Of Sourcing
Some organizations do not achieve the expected benefits from global sourcing. For example, a survey made by Harland et al (2005) suggested that only five per cent of companies in their study achieved significant benefits from outsourcing.
The risks faced by international sourcing companies, or rather more specifically the negative outcomes derived from sourcing, are well researched and documented by past studies. The risk of international sourcing can increase due to extended material pipelines, longer lead times, reliance on new and unfamiliar sources of supply, total costs that may far exceed unit costs, and the management of cultural differences (Trent and Monczka, 2003).
Below is a condensed study of the most cited problems and challenges that arise from sourcing and particularly when western companies source from China:
Extras costs that arose during production: Costs arising from implementing
outsourcing operations - investment in additional infrastructures, delivery cost, etc.
The extra cost generated may outweigh the outsourcing gains (e.g. Harland et al, 2005; Kam et al, 2011; Tsai, Liao & Han, 2008)
14
Service provider’s lack of needed capabilities - Services provider’ capacity fails to meet buyer’s product or service requirements (e.g. Dayton, 2011b; Ruamsook, Russell, and Thomchick, 2009)
Fear of job Loss among staff - Staff dismissal or redeployment resulting from
outsourcing, which weakens staff morale, loyalty and trust in organization.
( Harland et al, 2005; Lau and Zhang, 2006;)
Use of confusing terms in contracts that lead to future problems and difficulties in
delivery and quality (for instance, when the requirements of products sourced are not made clear and cause misinterpretation). (Harris, 2012a; Yount, 2013)
Entering into a long-term contract with outsourcer could lessen an organization’s
flexibility because changes in business requirements or technology may render the contractual terms obsolete (e.g. Horn, Schiele and Werner, 2013; Kam et al, 2011;
Tsai, Liao & Han, 2008)
Information leakage - Leakage of confidential information due to openness and information exchange in outsourcing. (Christopher et al, 2011; Harris, 2011b;)
Loss of control - Transferring control of certain processes or resources to service
provider(s), which become hard and costly to reverse back when outsourcing ceases (Lau and Zhang, 2006; Tsai et al, 2008).
Changes in market conditions make sourcing not beneficial (Kam et al, 2011)
Social risks - Risk (e.g., communication failures) associated with social stability,
and social, cultural language, and customs differences between organization and vendor/supplier. (Buckley, 2010;Wang et al 2011;)
Chinese government laws and regulations that are hard to comply with (Hoenig, 2006; Wang et al 2011)
15
Quality fade: loss of product quality over time (Enderwick, 2009a; Enderwick, 2009b);
Fraud: the sourced supplier does not deliver or does not exist (Ajoran, 2012;
Hoenig, 2006)
Constant delays on the delivery time (Dodson, 2008; Ruamsook et al, 2009)
Some authors (Dayton. 2010; Harris, 2011a; Dodson, 2008) note that the specifically for China, sourcing companies will often encounter the risk of increased costs (due to hidden costs or opportunistic behavior by the Chinese), quality below expectations, contractual breaches, information and intellectual property theft, and physical risk due to poor working conditions. Rahman and Wu (2011) mention that “outsourcing to China faces further country specific constraints in terms of underdeveloped information technology, transportation, and telecommunication infrastructure, local protection regulations and lack of overall post outsourcing review “
2.6. Risk Management Of Sourcing Risk
Due to its negative impacts, companies should actively manage its operational risks.
There are many reasons to managing risk, such as: reduction of possible taxes, reduction of transaction costs, and improvement investment decisions (Rawls III and Smithson, 1990 in Lam, 2003).
There are many strategies, methods and practices to mitigate and manage the risks of sourcing, with many past researches detailing its various forms:
16
Internal enhancement prior to sourcing: Identifying core competencies before
sourcing (Kam et al, 2011); Focus on core competence, product differentiation, proactive supply management (Khan and Burnes, 2007); creating a risk
management culture within the company (Christopher et al, 2011).
Supplier selection and management: Adopting multiple criteria to select service
provider (Kam et al, 2011), creating systems to assess and monitor the supplier’s performance, using multiple suppliers ( Christopher et al, 2011; Khan and Burnes, 2007)
Selective sourcing: Selectively managing a network of sourcing partners by
allocating specifics tasks to the most appropriate supplier based on their skills, limiting contract duration and measurement (Kam et al, 2011), ensuring suppliers quality, auditing standards, and proper certification (Dayton, 2010; Khan and Burnes, 2007)
Contract management and Enterprise Risk Management: Managing contract to
improve flexibility and trust, monitoring and evaluating adherence to the
outsourcing contract (Kam et al, 2011). However, the Chinese people historically seldom use formal contracts to do business (Davidson and Ou, 2008) ;
Verifying the performance of the sourcing companies: through quality assessment
on the products and services provided (Davidson and Ou, 2008, Wang et al ,2011), as product quality has an effect on the transaction cost of sourcing (Fredriksson and Jonsson, 2009);
Relationship management: Building long-term relationship, minimizing contract
ambiguity, exclusive partnerships, establishing strategic alliances, risk sharing and knowledge transfer management – thus ensuring the collaboration between the parties(Christopher et al, 2011; Embleton and Wright, 1998; Khan and Burnes,
17 2007; Quer et al ,2010). In the Chinese case, the use and developing of the concept of Guanxi can also be included as relationship management (Kam et al, 2011;
Ponte, 2007).
IT infrastructure aid: Improving ICT infrastructure enables firms to obtain and
increase supply chain visibility and improved communication, such as knowing inventory level or product flows (Kam et al , 2011;Khan and Burnes ,2007)
It is more effective to use many approaches when dealing with sourcing risks to achieve better results, instead of using a single method (Kam et al, 2011).
Power, Bonifazi and Desouza (2004) suggest that companies follow a disciplined outsourcing lifecycle methodology, in order to reduce outsourcing risks. They should prepare and analyze if sourcing and outsourcing are realistic goals and prepare accordingly (by protecting its intellectual property and other assets, and developing contracts carefully, and analyzing beforehand all possible rewards and risks, and prepare for when the relationship between the entities are to end, in order to avoid surprises.
Regarding the risk management practices that should be conducted when sourcing specifically to China, many authors emphasize the following practices as vital for success (Anjoran, 2012; Dayton 2010; Harris, 2011a, 2012a;Wang et al, 2011): thorough contract management, establishing quality standards and providing Intellectual property protection, noting that contracts should be written in Chinese language in order to be enforceable in China; monitoring of service and product quality, usually using a third party for inspections;
and evaluating and certifying the potential suppliers, using various criteria beside price (e.g.
possession of international certificates, physical visits to avoid fraud).
The results of the research by Fredriksson and Jonsson (2009) show that some industries in China (in their case, the casting manufacturing sector) are not reliable and
18 inconsistent, thus need to be continually monitored to ensure the quality level of its
production..
The use of Guanxi is also noted by some authors as very important, when dealing with Chinese companies. The definitions of what is Guanxi differ slightly across the literature, but they all indicate that it is linked to relationship management: according to Quer et al (2010),
“tThe Chinese word guanxi primarily relates to personal relations and involves the exchange of social obligations or favors (renqing) and the giving of social status or face in the society (mianzi)” and “it is widely recognised that guanxi is a key practically significant business determinant influencing firm performance because the lifeblood of the Chinese economy and business conduct is guanxi network.
It is related to the interpersonal relationships, connections and contacts, in which these can be used to provide mutual interests and benefits, “a medium for relational ties that bring business partners together through regular and voluntary reciprocal exchange of both favors and obligations” (Kam et al, 2011.Te difference between Guanxi and the Western way of using its connections is that Western companies usually are guided by laws and regulations, with the use of binding contracts and are economically driven, whereas Guanxi are based on implicit and personal expectations, not limited to financial exchanges and based on social and moral laws and guidelines (Davidson & Ou, 2008).
However it is also perceived as a form of “culture of corruption” and detrimental to business, as some view it as a form to use connections to bypass laws, gain favors with Chinese government officials, and to hinder litigations from foreign companies (Brubaker, 2010). For Dayton (2011a), quality can be affected by Guanxi, as many factories will subcontract their own production to other companies, usually through the use of informal connections, thus getting better prices but with higher tolerance for quality deviation.
19 In sum, when sourcing from China, Guanxi must be also taken into account, as
another tool for mitigating and controlling sourcing risks in china. Even today, the use of guanxi, relationships to facilitate business is very common among the Chinese (Ponte, 2007).
Quer, et al (2010) propose that “there is a positive association between guanxi and
performance in China”, while Kam, et al (2011) argue that “failure to account for the role of Guanxi on the choice of outsourcing risk management strategies would constitute an
incomplete analysis”.
20 Chapter 3. Research Methodology
The aim of the research was twofold: 1.to gather which were the most frequent risks associated with sourcing in China and 2. To infer which risks had more impact to sourcing companies. An online survey was used to measure the frequency of risks, while in-depth interviews with professionals that source in China and the commentary received during the online survey were the methods used to analyze which were the most important risks of sourcing in China and the tools to manage and mitigate it.
3.1. Most frequent Risks: Online survey
The online survey method was chosen because the quality of the responses in online surveys can be the same as paper-based surveys (Gordon and McNew, 2008) and, with the advent of social networks, it is easier to reach many people from around the world than other methods, which in result made the scope of the research broader (Vasconcellos and Guedes, 2007; Wright, 2005). Other reasons include the availability of online lists of
companies/communities and forums of the sample population of the study (individual from companies that outsource manufacturing activities to China), low cost, easy tabulation and formatting of the questionnaire.
The questionnaire was composed based on the literature review presented in the last chapter and was written using the software Google Docs. A copy is available at the appendix of this research. The questionnaire was separated in two parts:
1- The first part is designed to measure what is the frequency of each risk presented (total of 13 sourcing risks of China, taken from the literature and often quoted as frequent when doing business in China), in accordance to the perception of the survey participants.
The use of five point Likert scale was chosen to measure the frequency, in which 1
21 represented “Never” (meaning the variable never occurred) and 5 represented “Very
frequently”.
2- The second part was designed to measure the profile of the professionals that outsource to Mainland China, including their industry/area of occupation, type of outsourcing (based on Nassimbeni & Sartor ,2006), location of their outsourced company in China, their company’s country of origin, company’s size (by number of employees) and an email for contact.
The criteria to classify the size of the companies were taken from SEBRAE –BR (Serviço Brasileiro de Apoio às Micro e Pequenas Empresas) (2013):
Table 3.1
Criteria for company size classification from SEBRAE Classification number of
employees
Using the results from the survey, the research presented the most frequent risks of sourcing in China, and made a few comparisons between the perception of companies of different industries, sizes, sourcing method and of Chinese partners of diverse locations.
The survey was mostly conducted in website “Linkedin”(www.linkedin.com), which is aimed at providing connections between professionals and it was believed to be best suited for this research, because would allow professionals in China to participate (Linkedin does not have its access blocked in China, whereas other social media such as Facebook are).
Other methods of online survey were also attempted (sending the questionnaire to prospected
22 participants, publishing it in forums and websites about the subject) but were not as
successful, as most of the replies were received from the online questionnaire was sent through the social network Linkedin, through international communities of professionals that were associated with and participated in communities about in doing business with Chinese companies.
A topic of discussion was created in these communities urging its participants to answer the questionnaire about the frequency of the risks of sourcing in China. The questionnaire was also presented in 2 business online forums.
Table 3.2
Communities and website in which the survey was published Linkedin Community
Analista de Comércio Exterior China Guanxi Network China Import & Export China Law Blog
China Sourcing Forum China Trade Group Comércio Exterior BR Global Sourcing
Import - Export / Global Trading Group Profissionais Brasileiros na China Sino-Brazilian Studies (SBS) Sourcing Forum
The China Sourcing Information Center Online forums
Global Risk Community Alibaba Buyer Forum
23 3.2. The most Important Risks Of Sourcing In China And The Management Tools To Mitigate it
The in-depth interview method for studying the most important risks was chosen because of the availability of the participants for interview and was a suitable approach to understand how the managers view and mitigate sourcing risk from China.
The in-depth in person interviews were conducted with 2 Brazilian managers that worked with sourcing in China, from different backgrounds and years of experience in China.
The reason for choosing Brazilian professionals was convenience and their willingness of the participants, as well as their experience in sourcing from China. The interviews were made in persona and conducted in Foshan, China, between 15/04/2013 until
The reason for choosing Brazilian professionals was convenience and their willingness of the participants, as well as their experience in sourcing from China. The interviews were made in persona and conducted in Foshan, China, between 15/04/2013 until