What is contract manufacturing?
The economics of manufacturing in the 21st century meant many factories relocated to developing countries where labour is plentiful and costs lower. To further reduce costs and focus on ‘core business’, many manufacturers (principals) outsourced production to Contract Manufacturing Organisations (CMOs). This involves standard outsourcing activities as well as winding down a principal’s factories in favour of focusing on higher value add activities such as R&D, product management, sales and marketing. Examples of industries using CMOs include pharmaceutical and electronics companies.
Whilst use of CMOs might make commercial sense, it also introduces unique risks such as ‘shadow manufacturing’ which must be managed to maintain brand, product and supply chain integrity.
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‘Show factories’ versus ‘shadow factories’ – what’s the difference?
Most CMOs are completely above-board and legitimate, offering excellent service and conforming to a host of certification standards and regulatory obligations. However, ‘show factories’ and ‘shadow factories’ are an exception. Show and shadow factories can be defined as follows (adapted from APEC, 2017):
- Show factories – typically ‘impressive’ facilities which claim to manufacture a given product or component; however, this is intended to mislead (defraud) the principal seeking to contract with the show factory CMO
- Shadow factories – manufacturing facilities which operate in the shadows, either owned by a show factory or a ‘sub-contractor’ to a show factory
Theoretically, there is nothing to say a CMO cannot become a show factory at some point during the supplier lifecycle. Examples of triggers for this transition might include management or ownership changes, local crime or corruption in the area where the factory is based, or financial distress. This highlights the importance of performing regular, ongoing supplier integrity and supplier assurance throughout the supplier lifecycle.
Shadow factories introduce a host of risks for principals
The nature of shadow factories mean they expose the principal to a wide variety of risks, some of which can materialise or persist many years after the shadow factory has been shut down or eliminated from the supply chain, such as regulatory action or litigation arising from involvement with modern slavery. Examples of these risks include:
- Product Diversion – conforming product can be diverted, such as through overproduction using molds or trade marked materials supplied by the Principal to the show factory
- Product Integrity – shadow factories can introduce problems with product conformance and product safety, which mean the product obtained by an end user does not meet expectations and can give rise to financial, brand, ESG and safety ramifications
- IP and Trade Secrets theft – shadow factories might be provided with commercially valuable IP, such as trade secrets, manufacturing molds, recipes and authentic packaging. When uncontrolled, these could be used for counterfeiting, product diversion, and establishing competing businesses
- Brand Integrity & reputation risk – companies which find shadow factories in their supply chain can be left with adverse brand and reputation damage, as well as be required to pay damages to workers who may be victims of wage theft, modern slavery, or workplace accidents
- Modern Slavery – workers in shadow factories are often also vulnerable members of society. There is a high chance workers could be victims of modern slavery, such as bonded labour, debt bondage, or child labour
- Occupational Health & Safety (OHS) – shadow factories often have poor safety conditions, which can give rise to deaths or dreadful workplace accidents. Shadow factory owners may bribe public officials, such as workplace inspectors, to look the other way, further impacting the welfare of factory workers
- Environmental protection – as with OHS, a track record of environmental damage is common with shadow factories, particularly those which use hazardous chemicals or substances. The need for environmental remediation to remove legacy toxins or pollution is common when shadow factories are closed
- Business Continuity – shadow factories run as lean as possible, and are unlikely to be able to effectively mitigate unplanned interruptions. Further, show factories might not be able to scale up quickly enough in the event something happens to the shadow factory, leaving the principal with a false sense of security and no protection against business interruptions
By their nature, shadow factories are much cheaper as they typically lack the quality management, regulatory compliance, occupational health and safety, and environmental protections found in legitimate factories. Additionally, workers in shadow factories may be victims of modern slavery, which introduces legal, ethical and integrity issues for the contracting principal, not to mention ESG risk for the principal’s lenders or investors.
Indicators of show and shadow factories
When thinking about how we can detect show and shadow factory activity it is important to remember that manufacturing is a process comprising inputs (raw materials, components) which feed production, resulting in a standardised output. Conforming products are manufactured to a consistent standard, with inputs defined by the Bill of Materials (or BOM lists the precise inputs and quantities required to produce a conforming product).
The nature of manufacturing means it is possible to identify discrepancies between expected and actual inputs, production metrics, and outputs which could indicate a CMO is actually operating a ‘show’ factory and that work is being performed by elsewhere by a ‘shadow’ factory. According to APEC, indicators used to determine whether a CMO is operating a show or shadow factory include:
- Capacity versus output calculations in relation to a given factory’s estimated production capacity
- Recieving records which may indicate discrepancies in volumes, values, dates / times or other data points
- Materials reconciliation – reconciling usage versus output may identify unexplained anomalies or inconsistencies
- ‘Unavailability of packaging materials’ onsite for a given client – such as where the expected packaging materials are not physically located in the show factory (i.e.because they have been shipped to the shadow factory)
- Maintenance records – including records showing longer than expected gaps between servicing due to inactivity
- Production records – including staff rosters and payroll records
- Distribution records – including vehicle logs and delivery records
- Security access control records and vehicle access logs such as truck deliveries via a security gate)
- Equipment usage logs – including records showing below expected machinery usage counts
- Cleaning logs – potentially showing cleaning performed infrequently or less than planned in the show factory
- Accountability and traceability of rejected materials or defects arising during manufacture
- Utility usage versus manufacturing output – comparisison of electricity, gas, water usage and bills against plan
Identification of these red flags requires organisation. Prior to performing a site visit or desktop audit, auditors or investigators should have already built a spreadsheet model or similar assessment tool which outlines the expected case value for each of these indicators specific to the product, location of the factory, and other relevant contextual information. This allows auditors to focus on collecting the information necessary to provide an evidence-based assessment, as well as minimising distractions on what they need to collect or questions to ask during a site visit and enabling a laser focus on what they are seeing and hearing during the inspection.
Manufacturer Fraud Audit
To this day I can recall one of the earliest fraud audits performed in my career involving a manufacturing facility recieving government grants. I was green in those days and assigned to perform the audit alone. After spending a few hours examining the manufacturer’s books and records, something wasn’t adding up. I went into the CFO’s office asking him to explain some discrepancies, only to be asked which set of records I would like to see – the records he provided me, a set they maintained for tax purposes, or the real records!
Shocked, I left his office and called my boss, who informed the government. Suffice to say the CFO no longer worked there when I went back to continue my work the next day. However, the moral of the story for these types of audits is that you only have a limited time onsite in which to make sense of the data you are being given and take action. You need to be efficient, organised and prepared, otherwise you will miss your window of opportunity – by the time you get a chance to come back, all evidence of fraud or non-compliance will likely be destroyed.
As highlighted in this article, the involvement of shadow factories in your supply chain can introduce a host of risks, not to mention legal, ethical, safety, and brand concerns. The positive, however, is that it is possible to identify potential show and shadow factory involvement in your supply chain using data analytics. Analytics, supplemented with intelligence, can be used to target your audits or investigations towards high risk third parties, ensuring they know the right questions to ask and what to look out for during site inspections.
- APEC (2017). Show and Shadow Factories, Roadmap for Global Medical Product Integrity and Supply Chain Security, Manufacturing Practices Work Group, Life Sciences Innovation Forum – Regulatory Harmonization Steering Committee (LSIF-RHSC), https://www.apec.org/rhsc/rhsc-priority-work-areas/global-supply-chain-integrity
- Curwell, P. (2021). Magazine article – “Supply Chain Integrity: Detecting Product Diversion”
- Curwell, P. (2021). Modern Slavery, Human Trafficking & People Smuggling? (Part I)
- Curwell, P. (2021). How is confidential information compromised?
- Curwell, P. (2021). Unpacking AS6174 in relation to Supply Chain Integrity
- Curwell, P. (2022). Building your supplier integrity framework
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