Center for Management of Emerging Companies

Many Forms of Innovation - Lessons from China

By all accounts, China has made a significant investment in “independent innovation” and entrepreneurship as part of an announced effort to break out of its traditional profile as a country that thrives by undercutting competitors and copying their technologies in order to execute a strategy of mass production and routine assembly.  Capital has been allocated for research and development, science parks have been established around the country and major Chinese universities have followed the lead of their counterparts in the West by launching “innovation and entrepreneurship” programs.  However, The Economist, among others, have been critical about the actual returns on these investments, arguing that the most successful Chinese companies thrive on producing low-cost versions of Western products or adaptation of Western innovations to the Chinese market and that Chinese “venture capitalists” are hardly risk-takers when they choose to focus on established industries (e.g., agriculture and hotels) and support firms relying on copycat technologies.  Other apparent problems include excessive intervention by the government in the marketplace through its constantly changing pronouncements on standards and weak intellectual property rights even after cosmetic changes were made in the legal infrastructure in the form of new statutes and regulations.

It should be noted though that not everyone is writing off Chinese innovation.  Breznitz and Murphree have argued that while Chine may not yet be as successful as it wants to be with respect to innovation that takes the form of developing and commercializing “breakthrough products”, it nonetheless has become a formidable competitor with respect to several other types of innovation such as “process innovation”, which includes improvements in the manufacturing and distribution systems necessary for efficient production and delivery of products, and “product innovation”, which includes the steps needed to adapt existing products to the requirements of China’s own huge domestic markets.  Numerous examples exist for the proposition that, at least for now, Chinese firms are the global leaders in key processing tasks from mass production to logistics and have become invaluable partners for foreign companies looking to introduce their products and technology into a market that now boasts 1.3 billion consumers.  The preferences of Chinese university graduates also fit this strategy nicely as schools regularly pump out engineers who arrive at their employers with the tools necessary to further refine and improve production methods and quickly understand the technologies embedded in products first conceived overseas.  The long-term viability of this strategy depends on various factors including the possibility that other countries, such as India, will overtake China from a technical perspective and that foreign firms will grow weary of using Chinese companies as “intermediaries” to access the Chinese market.  Another risk for Chinese firms dependent on foreigners to create new products is that something may happen at the point of conceptions that slows or stops the process and thus leaves Chinese factories without orders to process and complete.

All of the above is informative for emerging company managers everywhere as they ponder their own innovation strategies.  The lesson from Breznitz and Murphree is that there may be more than one way to lead the innovation race and firms need to decide what is best for them and remain relentlessly focused on their strategies.  There book, “Run of the Red Queen: Government, Innovation, Globalization and Economic Growth in China”, is available now through Yale University Press.

Supplier Assessment Techniques

It is now commonplace for manufacturers relying on outside suppliers for parts and components to require all suppliers to regularly complete a comprehensive assessment questionnaire and go through other due diligence procedures.  This report discusses some of the techniques that manufacturers are using to review the quality controls and compliance procedures used by their key suppliers.

Vendor Selection Policies and Procedures

This week I'm presenting a comprehensive policy that sets for the steps that should be taken by companies and their personnel in selecting vendors and negotiating and consummating contracts for the purchase of goods and services from those vendors.  Care in this area is particularly important in trying economic times such as this.

Identifying and Evaluating Prospective Suppliers

Supply chain relationships are key elements of any company's business strategy.  This week I am featuring a report on how to identify and evaluate prospective suppliers.

Vendor/Supplier Due Diligence

The process of selecting a vendor, including conducting a comprehensive due diligence process, can be quite complex and time-consuming.  For significant projects and functional activities vendor selection may take anywhere from three to nine months and the costs associated with the process may be significant and should be included in the company’s analysis of the target return-on-investment for the project or activity.  Vendor/supplier due diligence is something that companies need to learn to do right.  For more about setting up procedures for vendor/supplier due diligence, read the attached report. 

Extending Compliance Programs to Suppliers II

I’ve been discussing the need for companies to extend their compliance program obligations to their suppliers. One basic step that should always be taken is to include standard language in every contract with an outside party that creates a contractual duty on that party to comply with all applicable laws and regulations and spells out specific areas of concern (e.g., the Foreign Corrupt Practices Act in the case of foreign parties dealing with local government officials).  Beyond that, however, companies are beginning to create their own standards for supplier activity and integrating those into how they create and manage their supplier relationships.  For example, a company may promulgate a social and environmental responsibility policy for its suppliers.  This policy becomes a public statement of the values and business practices that the company seeks in its supplier group and a de facto checklist for the due diligence that company personnel are expected to do before entering into a relationship with a new supplier.  The requirements and expectations in such a policy can then be made a part of the formal contractual arrangement between the parties through the use of a supplier social and environmental responsibility agreement.

Company policies regarding social and environmental responsibility are often derived from industry-wide efforts to develop, and build a consensus for, standards for socially responsible business practices that would apply to all participants in a supply chain regardless of their size or where they are located.  An example of such an approach is the Electronic Industry Code of Conduct released in October 2004 following collaboration by some of the major manufacturers in the electronics industry.  This Code of Conduct becomes the basis for company-specific policies that include standards for labor, health and safety, environmental matters, and business ethics.  In addition, companies electing to comply with the Code of Conduct would be expected to establish and maintain an acceptable system of internal controls and procedures to ensure that they carry out their business activities in a manner that meets or exceeds the specific standards in each area.

While imposing compliance standards on partners in the supply chain seems to make a lot of sense, and may have actually become a mandate to fulfill specific legal obligations, a word of caution is in order for those companies adopting such an approach.  One obvious potential problem, especially with suppliers in remote foreign countries, is making sure that adequate resources are invested in actual monitor of supplier activities and enforcement of the standards set forth in policies and supplier agreements.  One of the reasons for including third parties within a compliance umbrella is the ability to represent to regulators, customers and investors that the company is indeed a good “corporate citizen” and deals only in goods and services that have been produced in accordance with the highest legal and ethical standards.  If it turns out that their vendors fail to follow those standards the company runs the risk that its own reputation will be tarnished, particularly if it can argued that the company did not adequately monitor a vendor’s activities.  It is important therefore for companies to use their contractual audit rights and take other reasonable steps to monitor their suppliers including regular visits to supplier facilities to observe the effectiveness of the supplier’s efforts to adhere to labor and environmental standards.  In fact, failure to do so might even be perceived as a breach of an unexpected duty to a third party such as a customer injured by products provided by the supplier or even employees of the supplier.  Potential problems of this type should be managed by including language in policies or supplier agreements that expressly deny that anything therein is intended to create duties to and rights in favor of third parties.

The content in this post has been adapted from material that will appear in Business Transactions Solutions (Fall 2008) and is presented with permission of Thomson/West.  Copyright 2008 Thomson/West.  For more information or to order call 1-800-762-5272.

Extending Compliance Programs to Suppliers I

An issue that is coming up more frequently in the context of vendor relationships is whether or not the purchaser should insist that its vendors and other parties involved in the supply chain process should be subject to specified elements of the purchaser’s own global compliance rules and procedures.  It is clear that with increased use of rapid communications technologies and sophisticated logistics tools, companies are becoming more dependent on the skills and actions of outside firms and persons who are not their employees.  As such, it is understandable that companies may be concerned about whether their domestic and foreign partners are adhering to ethical principles and obeying applicable laws.  However, before extending the scope of their compliance programs to their suppliers companies must carefully evaluate the legal consequences associated with that decision, including the possibility that they will be held responsible for liabilities arising from supplier legal problems, and also consider possible adverse impacts to their image and reputation.

Potential legal liability for the conduct of others, including firms in the supply chain, may be based on a variety of common law theories, court decisions and statute-based rules:

• Companies are increasingly vulnerable to expansion of common law principles of “respondeat superior” that could lead to liability for actions of suppliers who are deemed to have become “agents” of their customers by virtue of the duties that they undertake and the benefits derived by their customers.
• Liability for illegal actions of third parties may occur under the Foreign Corrupt Practices Act of 1977, which makes it unlawful for a company to make a payment to a third party while knowing that all or a portion of the payment will go directly or indirectly to a foreign official for the purpose of influencing the official in his decision-making capacity.
• The Sentencing Guidelines for Organizations (the "Guidelines") have attempted to create real incentives for corporations to establish and maintain an "effective compliance and ethics program" as a way to identify and respond appropriately to misconduct and mitigate sanctions for such misconduct that might be imposed by governmental agencies.  In its definition of what constitutes an effective compliance program the Guidelines call for (i) communicating company compliance standards and procedures to agents and providing training therein to agents about their roles and responsibilities; (ii) establishment of a publicized system that allows agents of the company to report misconduct anonymously or under protection of confidentiality; and (iii) encouragement by larger companies to their smaller business partners that such partners implement their own effective compliance and ethics programs.
• The Sarbanes-Oxley Act of 2002 effectively requires audit committees of public companies to establish procedures for confidential, anonymous submission of concerns of accounting-related misconduct that are broad enough to be known, and accessible, by non-employees.
• The voluntary Guidelines for Multinational Enterprises promulgated by the Organization for Economic Cooperation and Development includes a strong recommendation that companies actively encourage their business partners, including suppliers and contractors, to establish and adhere to principles of corporate conduct that are consistent with the Guidelines.

In addition to these specific legal considerations companies are also becoming increasingly sensitive to how the business practices of their partners, particularly foreign vendors, may reflect on how they are perceived by regulators, customers and investors.  For example, US companies have come under strong criticism when it is disclosed that they have used overseas suppliers that have used child and/or forced labor in their manufacturing activities on behalf of their US customers.  In light of how the business conduct and practices of third parties can expose companies to legal liability and/or have an adverse impact on their image and reputation it comes as no surprise that they are considering and implementing various strategies for making sure that the rules and principles in their corporate compliance programs are applicable to their business partners (i.e., suppliers and contractors performing various activities such as customer service and maintenance).  I’ll describe some of those strategies in my next post.

The content in this post has been adapted from material that will appear in Business Transactions Solutions (Fall 2008) and is presented with permission of Thomson/West.  Copyright 2008 Thomson/West.  For more information or to order call 1-800-762-5272.

Vendor Selection & Procurement Policies

As a company grows it is important to develop and enforce formal rules and procedures for selection of vendors and negotiation and completion of procurement transactions.  In many cases the responsibility for procurement will be vested in a purchasing department that will assume the leadership role for purchasing goods and services on behalf of the company.  In order to achieve its goals and objectives the purchasing department should prepare and disseminate a policy that covers the following key areas:

• Purchasing authority, including the signatures and other approvals required for certain types of contracts and expenditure amounts;
• Evaluation and selection of vendors, including bidding procedures and prohibitions on conflicts-of-interest;
• Delivery and inspection procedures;
• Invoicing and payment procedures; and
• Contract review and approval procedures.

The general responsibilities of the purchasing department should be formalized and widely disseminated throughout the company.  These should include the following:

• Establishing and administering requirements with respect purchase orders, written agreements, bids and quotations and vendor qualifications;
• Pre-qualifying suppliers with joint input from the requisitioning department;
• Preparing requests for quotations;
• Receiving and evaluating quotations;
• Coordinating all search and due diligence activities with respect to prospective suppliers in conjunction with the requisitioning department, consultants and external expert, as required;
• Negotiating with suppliers;
• Awarding the business for supply of goods or services;
• Releasing award information;
• Monitoring all purchasing activities for compliance with purchasing policies and procedures;
• Establishing and maintaining standards of quality; and
• Establishing and enforcing insurance and bonding requirements for vendors.

Each requisitioning department (i.e., the department that is actually requesting the particular product or service) should be expect to contribute to the process through preparation of purchase requisitions with sufficient lead time to allow the purchasing department to complete bidding requirements and/or process orders, provide accurate specifications when requested, verifying that funds are available and securing the appropriate budget manager's signature, and verifying delivered orders for accuracy.  Additional rules may apply to the purchase of specific products and services such as computer equipment, construction services, consulting and professional services and maintenance agreements and it is important to have the departments with the most expertise involved in the procurement process (e.g., the legal department should not be ordering computer hardware or software without input from the information technology department).

As with any other policy, plans should be made for reviewing the effectiveness of the purchasing procedures on a regular basis and the review should be conducted against very specific performance metrics outlined in the policy itself such as the following:

• Incurring the lowest cost in the fulfillment of specified needs with appropriate levels of quality and service;
• Establishing and maintaining a fair and open process when calling for, receiving, and evaluating quotations and tenders;
• Developing and implementing a strategic procurement plan that ensures that goods and services will be acquired after consideration of needs, alternatives, timing, and availability of funds;
• Establishing processes to ensure that all necessary approval are obtained for procurement transactions and that documentation is retained for review and auditing;
• Identifying and satisfying all relevant legal and ethical obligations (including vetting of potential conflicts of interests) in the acquisition of goods and services by purchase or lease; and
• Establishing a core competency in purchasing techniques by recruiting and training skilled professionals on negotiating, contractual terms and conditions, cost reduction techniques, and cooperative buying processes.

The content in this post has been adapted from material that will appear in California Transactions Forms: Business Entities (Summer 2008) and is presented with permission of Thomson/West.  Copyright 2008 Thomson/West.  For more information or to order call 1-800-762-5272.