Last fall’s melamine scandal illustrates the dangers of a less-than-rigorous approach to quality assurance.

Companies doing business in China have had difficulty maintaining quality throughout the supply chain, as illustrated by recent food and product safety scandals. For example, in last year’s melamine-tainted milk scandal, inherent problems in manufacturing processes and supply chains led to a breakdown of quality assurance. The scandal severely damaged China’s dairy industry; it took more than six months from the time the scandal broke for dairy-product sales to recover 70-75 percent of their pre-scandal value, according to one Beijing dairy analyst. To salvage consumer confidence, companies must place new importance on quality assurance. And to achieve good quality control, managers must build more accountable, transparent, and ethically managed supply chains.

The melamine scandal provides lessons on how companies can better control their supply chains. Melamine, a chemical used to produce plastics and fertilizer, can appear to heighten the protein levels of milk so that the milk is erroneously iden- tified as a higher grade and yields a higher price. PRC author- ities found that melamine was added to roughly 70 milk products from 20 companies in China last year; the chemical sickened nearly 300,000 infants and caused the death of at least six children, according to press reports. Leading dairy company Sanlu Group, a partially state-owned enterprise that is now defunct, sat at the heart of the scandal. Investigations determined that some Sanlu staff were aware that third parties had added melamine to milk used for its baby formula, but that Sanlu continued to produce and distribute the formula for months after the discovery. The scandal forced New Zealand dairy company Fonterra Cooperative Group Ltd., which at the time owned a 43 percent stake in Sanlu, into the international spotlight. Meanwhile, Beijing Sanyuan Foods Co. Ltd., another state-owned Chinese dairy company, man- aged to keep fairly free of the scandal, and its business is booming—2008 net profits rose 87 percent over 2007.

Transparency, accountability, and ethics

An analysis of the quality assurance management and financial performance of Sanlu and Sanyuan illustrates the importance of accountability and ethical management in the supply chain. The lack of accountable supply chain partners—specifically the lack of training and monitoring of business partners—allowed Sanlu’s suppliers to taint milk with melamine. Ultimately, weaknesses in Sanlu’s supply chain destroyed the company. Though other companies’ products tested positive for melamine, all of the publicly reported deaths (as of spring 2009) and most of the controversy in the milk scandal were linked to Sanlu.

By contrast, Sanyuan’s business model—with an integrated, company- owned and operated supply chain—has contributed to a boost in sales following September 2008 product tests that confirmed the quality of its products. According to a November Xinhua News Agency report, the company said that its sales had tripled in Beijing, “panic buying” was reported in other cities, and machines ran 18 to 20 hours a day. (At an auction in March 2009, Sanyuan bought Sanlu Group’s core assets for ¥616.5 million [$90.1 million]—less than half of its peak worth. Fonterra has written off its investment in Sanlu.)

Supply chain management pitfalls

Companies investing in China should be aware of several potential pitfalls when trying to build and manage supply chains ethically in China. Though the examples below are discussed in the context of the dairy industry and the melamine scandal, many industries in China face similar problems.

Weak regulations and enforcement

The PRC Administration of Quality, Supervision, Inspection, and Quarantine (AQSIQ)—China’s primary quality watchdog—launched a food and toy recall system in August 2007. Under the system, if a food manufacturer becomes aware of a defective or unsafe food product, it must halt production and sales, notify vendors and cus- tomers, and report problems to AQSIQ and other quality-control authorities. If the manufacturer does not voluntarily recall its product, the government will order a recall. Prior to the melamine scandal, China’s recall rules were not strictly followed or enforced, and the country had inconsistent standards for food additives. China’s new Food Safety Law, which the National People’s Congress Standing Committee passed on February 28 and takes effect June 1, will toughen China’s recall rules and food safety standards, improve monitoring and supervision, and increase fines and punishments.

Without strong local, provincial, and national product safety laws or consistent, transparent enforcement, Sanlu missed or even ignored melamine product safety issues. Sanlu received consumer complaints about its baby milk formula as early as December 2007, according to Xinhua News Agency reports. In her court testimony, former Sanlu Chair Tian Wenhua said that by May 2008 she knew the company was selling contaminated formula. Having learned of the melamine problem in August, Fonterra CEO Andrew Ferrier said in September that Fonterra would have preferred the public recall to have occurred earlier but had to follow the procedures of the local authority and that Sanlu followed local regulations.

Weak oversight of local dairy produc- tion due to corruption was another con- tributing factor to the melamine scandal. According to an October 2008 New York Times article, dairy experts say that local regulators are “known to take bribes or favor companies that are partly owned by a local government entity,” which could mean that the regulator and the regulated are the same entity. This conflict of interest and lack of accountability in the industrial inspection system allows quality assurance breaches to go undetected or unreported. Furthermore, before the scandal broke, AQSIQ had exempted certain dairy companies—including some state- owned enterprises—from quality assurance tests. AQSIQ revoked this exemption on September 17, 2008, about a week after the scandal became public.

Low-cost, low-value substitutes

The product safety scandal illustrated how operators, managers, and owners at some milk-collection stations tainted milk to mitigate rising costs. Government food price controls that took effect in 2007 and feed price hikes created pressure on farmers and the industry, prompting some actors in the dairy industry to add cheaper chemical substitutes, such as melamine, to milk. In trials related to Sanlu’s case, more than 31 individuals were accused of sell- ing, procuring, and using melamine to taint milk.

Unskilled labor force, low entry barriers

In China, almost anyone can become a dairy farmer or milk station collection agent without quality assurance training or a background check. As Xiang Zhikong, an agricultural economist at Renmin University in Beijing, explained in an October 2008 New York Times article “The problem was and still is that anyone can become a dairy supplier, and anyone can own or invest in third-party dairy stations.” Compounding the problem, farmers often raise cows without the knowledge or channels to protect the quality of their milk.

Scattered and unreliable tracking information

Milk collection stations do not necessarily regulate or organize the process of milk collection according to source. For example, farmers may bring their cows to the same milk collection station but be directed to a different pump each day. Therefore milk mixes in the same container with milk from other farmers. Limited collection documentation prevents the identification of a problem’s source and reduces the ability to hold perpetrators accountable for quality assurance breaches.

Tips for ethical supply chain management

To reduce risks stemming from miscommunication, cultural differences, and logistical challenges while improving accountability and quality assurance in the supply chain, companies investing in China should consider taking one or more of the following steps.

Focus on ethical supply chain management early

When considering a joint venture (JV), the potential foreign and domestic partners should emphasize the importance of establishing an ethical supply chain management process early in the contractual negotiation stage—when trust is being built between the two companies. Once the partners agree on a set of values, the values become the foundation on which the partnership builds its supply chain and quality assurance management systems. Foreign investors should also use their negotiating power to set high ethical standards for a subcontractor’s supply chain management in their business agreements and contracts—including by making subcontractors’ adherence to a contractual clause related to quality assurance and supply chain management mandatory. Companies may want to establish financial consequences for breaches of these contractual commitments.

Integrate ethical considerations into technical solutions

Companies may wish to discuss supply chain management best practices with consulting companies that focus on ethics and corporate social responsibility (CSR). Such consultancies can help foreign companies locate partners with strong corporate values and find districts and zones that maintain legal policies and training programs that uphold high standards in employee relations, supply chain management, and environmental sustainability. Consultation on ethical criteria facilitates the building of trust between JV partners and emphasizes the importance of ethical considerations in business decisions.

The global network Business for Social Responsibility, which has been operating for more than 15 years and has offices in Beijing and Guangzhou, Guangdong, helps its member companies develop more sustainable supply chains by moving beyond policing of the supply chain and looking at holistic solutions. Such solutions involve working with suppliers to improve labor and environmental conditions, among other things (see Moving Beyond Supplier Auditing).

Smaller and newer companies also offer innovative ethical consulting solutions. For example, Norark Management Consulting Co., based in Beijing, develops ethical criteria that companies and development zones can use to assess partners. This is a new area of consulting in China in which a small group of Chinese and expatriate pioneers have set out to assess the needs of potential Chinese JV partners and preliminarily address their main ethics-related questions.

The Center for International Business Ethics (CIBE), a Beijing-based nonprofit, suggests that companies use ethical principles—such as those in the United Nations Global Compact—and corporate social performance measures—such as those used by Beijing University or the investment research firm KLD Research and Analytics, Inc.—when establishing and conducting business.

Grow sustainably

With more than 45 years in the milk industry, Sanyuan was cautious about enlarging distribution beyond its base in northern China. This strategy allowed Sanyuan to focus less on market growth and more on the effective management of its infrastructure, with a huge payout in the long term. In contrast, Sanlu’s relatively quick expansion after its founding in 1995 led to a shortage of milk sources, the collection of milk without close supervision of quality, and ultimately the company’s demise. Sanyuan’s March 2009 takeover of Sanlu’s dairy farms and distribution infrastructure poses a challenge to its sustainable growth and has opened an online debate among consumers about the future of Sanyuan and the quality of the company’s products as operations expand.

Invest in greater integration and ownership of supply chain channels

Sanyuan’s integrated, company-owned supply chain focuses on quality assurance. A November 2008 Xinhua News Agency article explained that Sanyuan “escaped the scandal because of its nearly self-sufficient production chain. Its raw milk came largely, or 80 percent, from dairy farms that the company owned or had a stake in.” The company built secure milk sources by using dairy farms run with strict quality-control systems for animal feed procurement, veterinary care, milking, and delivery of raw milk to processing plants. With strong ownership in the supply chain, Sanyuan directly participated in the establishment of these quality-management systems.

Go beyond compliance training to develop a stronger ethical culture

Companies should consider training programs and quality assurance processes that link product safety, consumer safety, and profit in employees’ minds and thereby encourage employees to identify quality as a company hallmark. For example, Sanyuan’s workers test-drank every batch of milk before it left the factory, according to Xinhua’s interview with Sanyuan. Companies can also consider conducting training seminars in leadership and business ethics. The dairy company Inner Mongolia Yili Industrial Group Co., Ltd. delivered leadership and business ethics training seminars to help develop a deeper ethical sense among its employees. These efforts created a stronger ethical culture at Yili, which survived the product safety scandal, though it too had to recall melamine-tainted products.

Focus talent recruitment efforts on candidates who value business ethics

For entry-level positions, companies can attract talented individuals devoted to ethical supply chain management by participating in student organization and nonprofit initiatives. For example, companies can attend conferences on CSR or innovation that are run by business school students. Companies can also reach out to university students interested in business ethics through research competitions.

To recruit managerial-level candidates or executives, companies can tap local CSR and nongovernmental organization (NGO) networks to find skilled professionals who are spear-heading CSR projects. Contacting local NGOs to explore whether they have board members with related experience in the same industry or with the desired functional specialization is another option. Recruiters may attend community service events and communicate their hiring needs to attendees.

Once a company finds suitable senior-level candidates, it can use behavioral interviewing to assess how the candidates think and react to conflicting ethical issues. For example, companies can ask questions about moral and business dilemmas related to the candidates’ target responsibilities to better understand the candidates’ thinking. In addition to investigating a candidate’s technical skills and achievements, human resources personnel should ask the candidate deeper questions about his or her character, including about his or her ethical acumen and professional and personal integrity.

Share best practices with other companies

Companies can learn more about supply chain best practices by joining CSR-related groups. For example, the Beijing Ethics Network, a group of about 15 CSR practitioners from the business and nonprofit sectors, holds a monthly round-table to discuss CSR best practices. In a meeting that focused on labor rights and ethical supply chain management, human resources and compliance officers shared ethical supply chain management problems and best practices with colleagues from various industries. One discussion centered on how contracting companies in the technological and financial services sectors handle subcontractors that stand out as high ethical performers. Participants described their companies’ preferential policies in which subcontractors that excel receive more business from the contracting companies. Some managers explained that their companies took initial steps toward this type of reward policy, while others require that ethical performance clauses be added to every contract signed with a subcontractor.

China’s future: quality assurance as goal of supply chain

Ensuring quality throughout the supply chain will become more critical for businesses in China, as the food and product safety scandals of the last few years have strengthened regulatory enforcement there. In addition, higher expectations among consumers have increased corporate awareness of the importance of quality assurance. Quality assurance concerns will push corporations to address product safety more effectively with their JV partners, suppliers, and distributors. By harnessing internal and external resources and skills, these committed firms and their employees will collaborate with CSR-focused consulting firms, research organizations, NGOs, and social enterprises to respond to product safety challenges. Dynamic, innovative companies and individuals that collaboratively, strategically, and resourcefully apply ethical best practices to supply chain management are best poised to ensure product safety and achieve long-term business success in China.

[author] Teresa DeLaurentis is Research Department manager at the Center for International Business Ethics (CIBE) in Beijing. She would like to thank Marc Lloyd, Werner Wang, and Harry Chen of CIBE’s Research Department, who contributed to this article, and Dr. Stephan Rothlin, Dr. Liu Baocheng, and Professor Ma Shaojun for their editorial comments. [/author]

Posted by Teresa DeLaurentis