Chapter 25 – Take Care with Contracts

When you issue your P/O to the factory, it is typically your last chance to negotiate prices and outline your specific requirements.

It should be obvious that all information in your P/O must be final. Amending it later demonstrates to the factory that your company was careless drawing up the P/O and it makes dealing with your company somewhat risky in their eyes. Spend plenty of time drafting the content of your P/O before asking the factory to sign it. You may want to provide a draft to them first and have it checked. This helps save time-consuming amendments later on.

Prompt Purchase Order Placement

In China as anywhere else, people are highly regarded when they take action. If you visit the same factory five times without placing an order, you will become a low priority to factory management. The consequence is intentionally higher price quotes to discourage you from wasting their time in the future.

Be Ready With Your Graphic Materials

With your Purchase Order, the factory will ask you to open your L/C and provide all graphic materials for your gift box, instruction manual, and export carton. If the graphics and artwork has not been finalized by your company, the factory will put a clause in their Proforma Invoice (P/I), their counterpart to your Purchase Order, which states that the final delivery date will only be confirmed after all necessary materials have been received.

Of course, an unspecified delivery date is not helpful to you because you want your goods on time, which means according to your schedule.

This will likely impact your delivery schedule. However, it is understandable. The factory cannot start production without receiving the necessary packing materials and that depends on the receipt of your graphic materials. Some importers have requested that finished products be stored temporarily. This is completely impractical because the finished goods must be packed immediately as they come off the conveyor belt. Additionally, there is a high risk the goods will become damaged if not immediately packaged and the factory does not want to be responsible.

Another reason not to begin production without packing materials is that it costs money, which the factory is not willing to pay. The goods must be stored and then retrieved from storage. They may need to be cleaned before packing can begin. All of the extra handling is just another opportunity to damage the goods or affect their performance. The best process is to package them as they come off the conveyor belt.

How the Factory Organizes the Production

I should also give you some more information about how factories plan their customers’ production. Factories have a limited number of production lines that are allocated to customer projects weeks ahead of time.

Besides production capacity, they need to procure the materials and components for the various customer orders. This procurement has widely changed in the last couple of years due to the shortage of raw materials. Nowadays, most factories have to pay for the raw material upfront or upon delivery to their warehouse. “Guanxi” is dominant here because without a good relationship with the raw material vendors, factories may end up receiving the ordered material much later than anticipated. Meaning they cannot complete customers’ orders on time. If they are lucky, and that indeed depends on “Guanxi”, they can pay for their raw materials and their components after 30 days. You can see how the factories’ cash flow depends on punctual payments and their relationship with their banks. This relationship is often more important to their survival than taking additional new orders.

You should also know it is the factory’s discretion who gets their goods first. It is primarily an economic decision and a matter of good relationships between the factory and their customers. Please bear in mind, if you squeeze your factory too much for lower prices, you will automatically be allocated a later production slot, and there is nothing  you can do about it.

Chinese companies do not appreciate when a sledgehammer approach is used to obtain better prices although they may not discuss it openly.

What Must Be Included In Your Purchase Order (P/O)  

Here is a summary of what I suggest you incorporate in P/Os regardless of the product type you are dealing with:

  • Clear and detailed product descriptions including requested color, measurements, sizes, etc.
  • Clear and detailed packaging information including barcodes and shipping marks
  • Order quantity
  • Delivery date
  • Port or airport of loading
  • Price
  • Payment terms
  • Spare parts or spare units if any
  • Agreed defective rate
  • Guarantee clause
  • Indemnification clause
  • Late delivery clause
  • Transshipment clause
  • Clause for compliance with requirements in your home country
  • Information whether goods must be inspected and by whom
  • A clear statement that the mass production must comply with the submitted and approved samples

However, do not overdo it. I have seen P/Os that could have been issued by lawyers and you can imagine that factories do not make the effort to employ lawyers just for the sake of checking P/Os. Remember, it is all about partnership and if you are still afraid the factory will cheat you, your factory evaluation was not thorough enough.

Here are additional comments about what must be included in your P/Os:

  1. Order quantity – Should match the container loading capacity or the total quantity of products in case you want to place different products from the same factory in one container.
  2. Packaging information – Very important because it is a cost for the factory and could be manipulated in their favor. For instance, there are several levels of corrugated cardboard quality. These are measured in grams per square meter. If you did not specify the weight you could end up with a 2-layer corrugated cardboard sheet that is so thin that you could easily punch a hole through it with your fist. This quality is unacceptable as a sales packaging because you cannot stack sufficient cartons on top of each other. The barcode information is also very important because the inspector has to verify it during the inspection. If a barcode scanner cannot read the barcode properly, the product cannot be registered during checkout by the hypermarket/supermarket cashier. Companies like Wal*Mart consider this a major defect and would not allow any shipment under such conditions.
  3. Spare parts or spare units – This depends on what kind of products you import. For technical products, you can negotiate 1 or 2% of free spare parts/spare units included in the buying price. The factory will of course calculate it. If these goods come without a guarantee or service agreement, you had better negotiate net prices.
  4. Defective rate – Putting a clause in your P/O will help to protect your compensation claim in the event there is an epidemic of defects or overall poor product performance. It splits responsibilities between the factory and your company. Nobody can demand that production be completely without faults and defects. Therefore, it is fair enough to allow the factory a certain percentage of defects as an upper ceiling limit. You have to negotiate this and usually the factory will have some historic figures in mind. Everything exceeding this percentage will be the factory’s responsibility. You may say, “I will employ a good inspection company, which will help to protect my interests”. That may be true but there is still a risk that something has been overlooked or a defect shows up later. You can imagine that this could become very expensive because there will be compensation claims from your customers or demands for price reductions.
  5. Guarantee clause – Most countries have laws protecting the end consumer’s rights and provide them with a guarantee period of anything between 1-2 years. In some cases, retailers have even extended this guarantee period by another year. Three years is a long time for some products with a limited life cycle. Because it is a legal requirement (except the additional year offered by retailers), you must comply and protect your interests by adding a clause in your P/O. This gives you the right to ask the factory for compensation. Most factories however will not accept these clauses and you may have to negotiate to find a way around it and still protect your company’s interest.
  6. Indemnification clauses – This is another important clause that helps you if you become entangled in copyright claims or patent infringement claims. Unfortunately, Chinese manufacturers have a different understanding of copyright and patent infringements from Western societies. They think, if they copy a successful product and apply some design modifications, it is their own design and they even go so far as to have it registered at the Beijing Patent Registry under their company name. If you ask them you will usually hear, “No problem – it is our design and we have already registered it”. This will be of no help if the original designer sues you in your home country. Without an indemnification clause you would be in deep trouble and pay everything yourself.
  7. Late delivery clause – This is relatively easy to understand. If your goods cannot be shipped on time due to the factory’s fault, they will probably arrive too late for your customer’s promotion and that can become expensive as well. You have to be careful here because sometimes it can be your own fault if you failed to give the factory needed information, documents, or approval to start or finish production on time. I cannot provide exact figures because they vary from product to product and company to company but you should at least request the factory use an express vessel at their own cost to make up the lost time. In a worst-case scenario, the factory should share or completely pay the compensation costs your customers negotiated with you. Some importers may even include a clause that asks the factory to ship goods by air but in all these years, I have seen very few cases where this has really happened and usually factories will not agree to such a clause.
  8. Clause for compliance with requirements in your home country – This is another important clause because if the government authorities in your home country perform random checks at retail outlets, you may be in for a surprise when they find that the goods you supplied do not comply with local directives or laws. You should not assume that all factories are fully aware of all requirements in your home country. The opposite is mostly true. You, as the importer, you are responsible to import only goods that comply with your countries laws and you must protect your company from damage for non-compliance by adding a clause in your P/O.
  9. Information whether goods must be inspected and by whom – This clause is easy. If you want the goods to be inspected, which I strongly recommend, then you have to inform the factory about the details. The inspection procedure was previously explained.
  10. Information that mass production must comply with the submitted and approved samples – As mentioned several times, you set the quality standard by approving the samples and must enforce it now by not allowing the factory to produce anything else. If you are lenient in this request, your efforts evaluating the samples and factory will have been a waste of time.

Your specific product requirements may deem other P/O clauses be included. For instance, the garment or textile industries differ from home appliances. In general, you are supposed to be the expert for your products and should have the knowledge to figure out any other needed clauses.

Please be aware that any P/O is only legally binding after an authorized factory representative signs it. Sometimes factories delay signing for quite some time. In that case, the best solution is calling the person in charge to ask what is going on. There could be a reason for the delay but the factory will try to change the delivery date. Therefore, act immediately rather than waiting in good faith.

Other than adding your specific terms, try to write P/Os that are easily understood and are no longer than 2-3 pages. Anything else becomes too complicated and requires too much effort on both sides to read and comprehend. You should be able to establish the P/O format one time and then copy – paste the contents for other products without starting from scratch.

Do not underestimate the importance of this section. If you make mistakes here, it usually will cost you money and respect. Therefore, it is advisable to discuss as much of your standard P/O content as possible with the factory management during your visit. Trying to enforce your requirements when later communicating from your home country will prove much more complicated.

You can also shorten the whole process by providing a copy or draft of your standard P/O to management during the meeting or have it sent in advance if you are certain that you are going to work with that factory.

One Word of Caution Regarding Contracts

Chinese and Westerners often approach a deal from opposite ends. To a Westerner, starting with a standard contract, altering it to fit the different circumstances, and signing the revised version, seems straightforward.

Commercial law is ingrained in our thinking. But traditionally, commercial law scarcely existed in China and certainly indicated bad faith. The early appearance of a draft legal contract was seen as inappropriate or, more likely irrelevant, because it carries no sense of commitment.

The business clauses might form a useful agenda, but obligations came from relationships, not pieces of paper. Today, returning home with a signed piece of paper is a symbol of progress, but nothing more. The Chinese may be signing a contract to please their guests. To them, a completed contract may merely be proof that both sides have grown close enough to develop a trusting relationship. Further concessions may then be requested – a difficult prospect for the Westerner who has shaved his margin down to the bone.

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