China Checkup

Companies move beyond penning codes of conduct to auditing supply chain practices

By James Hyatt

There was a time, long past, that companies with heavy exposure to manufacturers in China, were content to draft supplier codes of conduct and human rights policies. But, today, global corporations are stepping up and getting very involved in monitoring and clamping down on rogue supply chain practices in Asia and beyond.

Integral to many companies’ operations, supply chains in China are front page news, thanks to grim revelations about threats to U.S. public health and safety.

• Baxter International recalled heparin blood-thinner products following adverse patient reactions and deaths, and the U.S. Food and Drug Administration (FDA) identified a contaminant in the Baxter product. The active ingredient in heparin, derived from pig intestines, is produced by a supplier in China. The FDA initially hadn’t inspected the Chinese facility because of a confusion over the supplier’s name. More than 700 firms in China make drug products imported into the United States, but the FDA regularly inspects only a handful.
• Two Chinese nationals, their businesses, and two U.S. importers were indicted earlier this year for their roles in a scheme to import products used in pet foods that were found to be contaminated and sickening, cats and dogs; more than 1,000 pet food products were recalled.
• Mattel last year recalled more than 1.5 million toys made in China due to lead in paint. The toy maker also recalled millions of toys containing small magnets that could come loose and be ingested by children. Mattel said charges and costs related to recalls totaled $40 million in its 2007 third quarter.

The World Economic Forum in January warned of growing supply-chain problems in its Global Risks 2008 report, noting that “the extent and complexity of current global supply chains mean that the problem of supply-chain management is not limited to a single enterprise or industry; even a relatively small supply chain disruption caused by a global risk event may ultimately have consequences across the global economic system.” At the same time, “vulnerabilities to the supply chain are generally poorly understood and managed,” it said.

Scott Gottlieb, a resident fellow at the American Enterprise Institute, put it less diplomatically last year in testimony to the U.S.-China Economic and Security Review Commission: “The lack of reliable information about problems in China prevents our own regulatory agencies, principally the FDA, from being able to target its inspections of Chinese imports and take the necessary steps to implement a risk-based approach to regulation. We don't know who the past violators are. We don't know who the good actors are and we don't know who the local criminals are.”

And he told a Senate committee, “China's integration into the world economy means that problems with its raw ingredients to food and medicines are made more widely manifest and innovations in distribution and supply chains means imported products are more widely distributed shortly after crossing our border, amplifying risks; whether it is at least 51 Panamanians who have died since October after using cough syrup tainted with a chemical cousin of antifreeze, consumers put at risk recently from using tainted toothpaste, or the by-products of a slipshod manufacturing process that made their way into pet food bound for the U.S. and killed some American cats and sickened many animals. In all these cases, the potentially deadly ingredient originated in China ... Our current regulatory system was designed to deal with a mostly domestic food and drug industry, not a globalized system such as the one we have today.”

The heightened attention paid to supply-chain questions is only part of the broader corporate social responsibility landscape. “I’m still surprised at how many companies don’t even know where to start” in addressing supply-chain issues as part of their CSR policies, says Sandra Taylor, President and CEO of Sustainable Business International and formerly a Senior Vice President of Corporate Social Responsibility at Starbucks. “They still gravitate toward philanthropy as what CSR is all about,” then address green issues, “but the core of the matter is the supply chain...I don’t think companies are tackling that as much.”

Many firms, she says, “haven’t started to attack their own CSR issues, let alone look at where products are made for them,” with the related questions about labor conditions, water usage, and other social and environmental issues. In China, she says, many problems “have to do with worker conditions. Are people being paid decent wages? Is there employee abuse? Are they locked inside the factories with no access to latrines?” To address such issues, she says, companies “have to start out saying, here are our guidelines” and require “suppliers to sign on. If they refuse, the vast majority of responsible companies won’t do business with them. Then you conduct audits, hire external organizations experienced in China, to help companies assess how they ought to approach supply-chain issues.”

CSR considerations and supply-chain problems have led to a huge growth industry in firms hired to keep track of plants in China.

“We understand that the number of auditors and inspectors paid by multinationals to visit Chinese factories may equal or surpass the number of Chinese inspectors visiting factories,” says Randy Kritkausky, president of Ecologia, a nonprofit group based in Vermont that promotes sustainable development projects.

In a report last September, he wrote, “in many ways, these foreign inspectors have more powerful compliance sanctions, both negative and positive. Local inspectors are often caught in a conflict of interest over issues of negotiating fines and pollution permits, upon which their agencies depend for income, while having to answer to local officials for the economic impacts of their regulatory decisions.

By contrast, foreign inspectors can and do deliver ultimatums about compliance with labor, environmental, and product safety codes, many of which are more strict than Chinese national standards.”

Not surprisingly, Congress is awash in proposals to address supply-chain issues, often in ways that stiffen federal regulation and impose more burdens on companies. The House and Senate have passed separate bills beefing up the staff and budget of the Consumer Product Safety Commission, sharply boosting the maximum penalty for violations (to $10 million or $20 million, depending on the version). The Senate version gives state attorneys general authority to enforce CPSC violations, and gives federal employees additional whistle-blower protection, provisions the White House opposes. (The Heritage Foundation labels the Senate bill a windfall for trial lawyers.)

Sen. Richard Durbin (D-Ill.) and others propose creation of a new Food Safety Administration that would assume functions now conducted by the Agriculture Department and the FDA, and would consolidate monitoring and inspection functions now performed in a dozen or so agencies. And the Bush administration acknowledges the need for changes. “We simply cannot inspect our way to safety,” Health and Human Services Secretary Michael Leavitt has said several times. “No system of safety can succeed without collaboration from ... everyone that’s involved in the supply chain,” he told a panel on import safety last fall.

And members of Congress and consumer groups are pressing for progress in requiring country-of-origin labeling on imported food products. Congress has adopted such a proposal, but it hasn’t been fully implemented, in part due to resistance from food companies fearing a consumer backlash.

Getting control of supply chain safety and CSR issues is clearly a struggle, as illustrated by Nike’s most recent report on doing business in China. The footwear and athletic gear-maker uses about 180 contract manufacturers in China, employing more than 210,000 workers, and producing 35 percent of Nike footwear in fiscal 2007. (Nike sales to Chinese customers are approaching $1 billion a year.)

To get a measure of potential problems, Nike has stepped up its auditing of “focus” plants where most of its manufacturing takes place, including 57 in China. In addition, this year, all of the 36 contract factories in China that are producing Olympic-related Nike products are receiving focused compliance coverage. In its focus audit, Nike assigns letter grades in two broad categories—MAV (management audit verification) and ESH (environment, health and safety). Of 22 MAV examinations last year, five were graded A; three, D. In 21 ESH examinations, “the leading issues were poor management of chemicals, personal protective equipment, hazardous waste and occupational health,” Nike says.

In addition, in fiscal 2007 Nike began requiring potential new factories to undergo a pre-sourcing audit “that helps us to prevent poorly rated factories from manufacturing our products.” It says the most common reasons for failing the approval process are excessive overtime, failure to pay legal wages, falsification of information about workplace conditions and the environment, and health and safety issues. Excessive overtime, Nike says, “is one of the most commonly cited labor-standards problems in China,” and one of the “most difficult for buyers to influence through compliance programs.”

Mattel, more forthcoming than most companies about publicly identifying challenging situations, for several years has asked the International Center for Corporate Accountability (ICCA), New York, to determine whether vendor plants meet its global manufacturing principles. ICCA’s most recent audit of seven manufacturing facilities showed that “treatment of workers, training and protection from harassment are good,” said S. Prakash Sethi, ICCA president. But he added “there are a number of significant areas that demand improvement, including working hours and prompt payment of wages; maintenance; and environmental, health and safety requirements.”

Mattel said it has already begun working with the vendors to correct deficiencies. "While these facilities didn't show the improvement we would like to have seen, we will diligently work with our vendors to ensure that they make the appropriate improvements in order to comply with our GMP standards," said Geoff Massingberd, Mattel’s new Senior Vice President of Corporate Responsibility. “We have made it clear that compliance is not an option, but rather a requirement for continued business from Mattel.”

In the wake of last year’s recalls, Mattel announced a three-part check system requiring that only paint from certified suppliers be used and that every batch of paint at every vendor be tested; it has tightened controls at vendor production facilities and increased unannounced random inspections; and is testing every production run of finished toys to ensure compliance. It also created a new Corporate Responsibility organization and a new function of Product Integrity Policy & Audit to monitor Mattel’s and vendors’ compliance with its product standards.

Management consultants and suppliers see a business opportunity in the current supply-chain crisis. Supply-chain pressures are “growing incredibly fast right now,” says Philippe Tesler, co-founder and head of business development at Enablon, a maker of software to keep track of governance, risk and compliance issues. “There’s a realization that no matter how you control your own processes, if you don’t control the processes of your suppliers this can ruin everything you’ve done, especially in the corporate responsibility world.”

While an Enablon system can cost $50,000 to $500,000, depending on a customer’s size, “it doesn’t cost them anything. It saves them money,” he says, by identifying and eliminating exposures. One client’s system “paid for itself in one month” by helping identify plants experiencing a pattern of industrial accidents. Such tools, he says, help firms “eliminate suppliers they should not be working with. Some issues are non-negotiable—‘either fix it or we’re not going to work with you anymore.’”

Also joining the bandwagon, IBM in March opened its first “supply chain innovation center,” located in Beijing, to provide supply-chain research, consulting services and software products “to create new solutions for companies around the world.” The last year or so has demonstrated that even companies noted for being socially responsible businesses “are not in control of their supply chains,” says Dara O'Rourke, associate professor of environmental and labor policy at the University of California at Berkeley. “Even companies that are in the forefront can be surprised in a very expensive and damaging way—Mattel being the most obvious.”

Often, he says, companies involved in such scandals “are trying to spin these issues rather than address problems. Firms still think they can gloss over them or blame someone else. The first strategy... has been to blame China, a factory manager or worker, when at the end of the day the problem comes back to the design division, the sourcing division and, really, the buyers, who are creating pressures which I think are often at the root of these problems.

So what's likely to happen now? Companies, O’Rourke says, should be asking “what was it in our system that led to this pattern of noncompliance.”

O’Rourke says he's observed in his research over the last decade that “a lot of firms are demanding that suppliers meet codes of conduct" on issues such as pay or overtime, “but the sourcing guys come through the next day and say we need it 10 percent faster and we’re going to pay you 10 percent less,” prompting suppliers to modify their conduct to keep the contract. And while sincere companies adopt codes of conduct and maintain checklists, “in China and other places there are ways to train factory workers to pass the audit but not comply—to produce three sets of books for the tax collector, the U.S. Auditor and the internal auditor.”

And for companies, he suggests, the challenge is to design systems “to continuously find problems in the supply chain and continuously try to solve them. It really changes the dynamic from a code and conduct and pricing model to a continuous improvement model. Not many firms have gotten to that point.”