The Real Pirates to Worry About: Chinese Manufacturing Partners After Your IP Booty

CIO — Somali pirates who brazenly attacked container ships in the Indian Ocean have garnered a lot of recent attention. But for companies that source products from Chinese manufacturing partners, there are even greater and longer-term business risks due to pirating attacks on companies' intellectual property and supply chains.

China is, by far, the riskiest geography to operate in, as identified by respondents to AMR Research's most recent quarterly supply-chain survey (subscription required), taking the top spot in 10 out of the top 15 supply-chain risk categories.

While China continues to draw the world's business because of its cheap labor and lower material costs, that convenience comes with a price, writes AMR analyst Noha Tohamy. "China is still plagued by product quality failures and safety issues," she writes. (For more, see "Big Supply Chain Troubles in China.")

When asked to identify the risks associated with doing business in each country, intellectual property (IP) infringement in China was tabbed by 49 percent of respondents (the next closest country cited for that category was the United States, by 9 percent).

Other risk categories where China took the top spot include: supplier product quality failures (48 percent); regulatory compliance (36 percent); supply chain security breaches (32 percent); supply failure (29 percent); and IT risks (28 percent).

But it is the area of deteriorating IP protection that should most trouble companies doing business in China. As Tohamy's AMR colleague Kevin O'Marah points out in a January 2009 report, "A Whole New Mind, A Whole New Supply Chain," IP is a key to future supply chain excellence, yet it is severely undermanaged by most companies right now.

O'Marah argues that companies need to rethink the supply chain and focus less on the physical goods themselves and more on where IP-based services and networking opportunities can provide greater efficiencies and more control.

The shining example of this, O'Marah says, is Apple: From its physical stores (which carry very little inventory) to its iTunes digital stores and e-commerce outlets, "these guys have got a lot more than just plastic, metal and glass," he says in an interview. "They've got a ton of brilliant IP that we're all as consumers willing to pay for." (To read about Apple's and Nintendo's supply chain missteps, see "Apple's Networking and Supply Chain Mistakes Take a Bite Out of Its Shine" and "Nintendo Wii Shortage Turning Into a Glut for the Holidays?")

Supply chain managers, he contends in the report, need to think "of their jobs not just in terms of materials management. Intellectual property is generally worth much more than a pound of plastic or a yard of fabric, and yet, its marginal cost of production and distribution is essentially zero."

The risks are too great to not explore new supply chain thinking, O'Marah cautions. "Stone-age supply chain management could easily sink a company by losing control of brand to pirates and counterfeiters through contract manufacturing plants in China and elsewhere," he writes. "For apparel companies this is a persistent problem, and increasingly something affecting consumer electronics and even aircraft parts."

All of the uncertainty and increased levels of risk—especially with China's IP protection failures—has opened the door to new competition for China, Tohamy writes. Respondents in the supply-chain risk survey noted a significant uptick in their strategies to increase sourcing in India (compared with the previous quarter's survey).

"Companies cited the lure of India's up-and-coming, middle-class consumer base and its increasing cost competitiveness with China for materials and labor," Tohamy writes, "as major reasons for expanding their sourcing and manufacturing."