Developing and Executing a Successful Subcontracting & Sourcing Model in Asia

The Golden Rules Of China/Vietnam 1. Everything is possible 2. Nothing is easy 3. Western business logic does not apply 4. It is a fun project if there is no deadline 5. You must persist - things will come your way eventually 6. Patience is the essence of success 7. There are no secrets in China 8. You Don t Know China means they disagree 9. New Regulation means they found a new way to not do something 10. Internal Regulation means they are mad at you 11. Basically, No Problem. Means BIG PROBLEM 12. When you are optimistic, see Rule #2 13. When you are discouraged, see Rule #1

What does East West do and why are we speaking? EWA is a manufacturing and operational consulting firm providing strategic, implementation and hands-on problem-solving services for clients in the US and Asia Pacific. EWA has a team of seasoned executives in the US and China with deep manufacturing and operational experience in Asia. EWA team drawn from small-mid sized companies and larger MNC, including Owens Corning and Michelin Group. EWA operates with US and Shanghai, China office which interface extensively with our clients. Shanghai office responsible for Supply Chain: Product Sourcing and Subcontracting, Identification and Qualification of Suppliers, Supplier Oversight, Shipping, etc.

China Observations Decision to go to China or Vietnam Electro Description Manufacturing Terminology and Formations Subcontractors Generalized Model Vetting Manufacturing Qualification Issues of IP, Quality and Oversight Questions

Observations Estimated China will produce a demand of over 9 million automobiles by 2010 and have the largest automotive market by 2020 thus, large opportunity for US die cast manufacturers servicing US automotive manufacturers. Chinese die casting companies are located in almost every major area of the country about 50% are State Owned and 50% are private. State Owned companies tend to be less automated and require more manual labor to meet manufacturing needs. Non-Chinese die cast equipment manufacturers are taking a big lead on building plants in China and selling locally. According to our Shanghai office, those already setting up plants include UBE of Japan, Buhler of Switzerland and FRECH of Germany. Challenges for Chinese manufacturers: Automation Energy cost increases (significant) Environmental concerns by Chinese government - not encouraging new casting business in major cities.

Decision to go to Asia? (1) Customer s Demands US company source from Asia Customers require U.S. manufacturer to source or subcontract product in Asia and import to the US in order to remain competitive. (2) Customer Support in China/Asia U.S. company has Asian customers who want their supplier nearby, i.e. Asian customers are US companies with operations in China. (3) Market Penetration U.S. company has determined an Asian country is a good market for their products thus, they decide to penetrate and gain market share.

Electro Company Background Privately held US metal fabricator with US customers and a few Asian customers (who are primarily US firms manufacturing in Asia). Primary market in the US. Manufacturers metal fabrication products with great reputation for quality and long history in the marketplace. Customers are demanding the company source and/or subcontract product from China and import into the US in order to stay competitive. Customers want to purchase lower-priced products from Asian suppliers. Asian suppliers moving up quality curve and producing competitively-priced products, and taking market share from Electro in China and US.

Electro Company Challenge: Develop Asian sourcing strategy to meet the demands of US customers and service US and Asian customers with competitively-priced products. Strategy must balance desire for lower cost Asian products with need for IP protection and maintenance of quality reputation US company has significant manufacturing know-how Electro has minimal experience identifying/qualifying Asian subcontractors, quality control and oversight in Asia, etc. Initial Questions: What type of manufacturing capability must the supplier have? How do I find the right partner? How to protect quality of the product when manufactured by a 3rd party? How to protect IP? Am I creating a competitor? How do I get started? Can supplier/subcontractor ship directly to my Asian customers?

Subcontracting Chinese manufacturer producing product based on company s technical specifications Product not available in the commodity market Subcontractor may be purchasing from company s AVL of raw material suppliers Subcontractor producing specific product for specific client using specific technical and manufacturing practices Subcontractor usually has exclusive relationship with US manufacturer not to produce product for any other customer Subcontractor producing when receive PO from US manufacturer Sourcing Commodity or off-the-shelf products Supplier identification and qualification less relevant Less concern of creating a competitor or IP loss

Representative Offices (RO) Opened in conjunction with Subcontracting model Can NOT perform financial transactions Quality oversight keep subcontractor honest Little growth for employees significant turnover for group designed to provide quality oversight Subcontractor responsible for branding product so company would have separate contract with subcontractor to protect branding (IP) Foreign Invested Commercial Enterprises (FICE): Opened in conjunction with Subcontracting model Invoicing and distribution allowed * can buy from Subcontractors in China and Asia * sell to Customers in RMB/USD * can distribute finished products in Asia Subcontractor responsible for branding product so company would have separate contract with subcontractor to protect branding (IP) Same capabilities as WOFE (without the manufacturing)

Outside of China Oversight Agency in China Role - Trading company or establish own FICE or Rep Office - Insure Quality of Sub - IP Oversight - Procure Raw Materials - Handle I / E -S&M Focus Generalized Model Generalized Questions Sub Contractor In China Role -Manufacture to US Company Specs -Deliver to Next Customer or Export to the US - What are the options for oversight - Domestic trading company, RO or FICE etc - What are the legal barriers / considerations to executing this model? - What are the REALISTIC considerations that must be addressed? * Ease of management / execution * Communication with Subcontractor from the US or China - What are the various options for flows and control of: - Raw Materials assuming some selected items must be imported - $ in terms of payments to profits, A/R & A/P - Taxes (including VAT) - What are the lessons learned from other experiences that may assist? USA Company - Maintains Specs -Owns IPR - Controls AVL -Procurement personnel - Maintains relationship with the customer Outside of China China

Subcontractor Vetting Purpose using a defined set of criteria, EWA analyzes potential subcontractors in order to determine those best suited to meet the needs of the client. As a result, the process weeds out subcontractors which do not meet the company s requirements, resulting in the identification of the best candidates. Examples of Vetting Criteria Used: Operations Capabilities Process and Engineering Specifications Raw Material Sourcing methods Quality raw material suppliers Facility Specifics Process control, Bonded W/H Logistics i.e. proximity to airports, suppliers & customers Freight forwarding capabilities Customs Compliance Procedures and compliance with Chinese tax regulation Utilities: availability and dependability of electricity, water & sewer Order Fulfillment Process Equipment Capabilities Supply Chain Quality Control Warehousing Capabilities Senior Management Team Scope of Chinese Business License Quotas on sales (Import/Export) Factory Architecture Environmental Assessments + Client s Technical Specs

Subcontractor Manufacturing Qualification Purpose perform Manufacturing Qualification on subcontractors approved during Vetting Process. Qualification ensures the remaining list of manufacturers can meet manufacturing requirements. * Chinese use of No Problem Steps: 1. Company provides product specifications to identified subcontractors. 2. Subcontracts the manufacture of products under the defined quality standards for a given price and within a specified timeframe. 3. Company grades products from different subcontractors using their defined testing methods. 4. Company should have prospective subcontractors build 3-4 different versions of the product before ramping up.

Questions: (1) Creating a Competitor? Example: Chinese Subcontractor producing 2X orders and selling additional products in the market. (2) IP Protection? Oversight..Oversight..Oversight Choosing right factories for leverage Ability to leave because have other suppliers Operational issue, NOT a legal issue Relationship with end-customer dominated by US company and not turned over to Chinese firm (3) Quality Protection inspections and oversight; raw material and finished goods (4) Pricing Transparency - want them to provide a costing breakdown raw materials, mfg costs, labor, management costs, transportation, etc.

Questions: (5) Characteristics of the right partner Technical capabilities How significant is your business to the supplier Provided products for other companies Willingness to go through Vetting and Qualification Process Level of communication

Questions???

On the Ground in China Seminar When and Where: August 6, 2008 8:30 a.m. to 1:00 p.m. The Club at Key Center 127 Public Square Cleveland, OH 44114 Topics: Manufacturing and Operational Excellence in China China Legal Topics Chinese Tax Laws Sponsored by: East West Associates, Inc. Grant Thornton, LLP Benesch Friedlander, LLP

The Great Wall, Near Beijing www.eastwestassoc.com