Fair payment terms when paying suppliers in China
This article was created to help buyers manage financial risk when sending money to China via TT for PO’s greater than 10,000 USD but less than 1 million USD. Very large orders may involve letters of credit and very small orders may involve cash payment, credit cards and PayPal. Those payment methods are discussed in separate blog posts.
A while back, at a seminar I was hosting on doing business with China, a new-to-China buyer asked “what payment method do Chinese suppliers prefer?”
That’s easy, Chinese suppliers prefer 100% in advance via bank transfer (or better yet- cash) and they would be very happy if you don’t bother to use a contract or PO.
Believe it or not, some buyers are so eager to get the order going that they don’t think about how to protect their interests. Sure, 100% upfront will make the supplier very happy, but if something goes wrong, the buyer has no leverage.
So the more valuable question to ask is “what payment methods are fair to both the buyer and the seller?” Before we answer that question, let’s make sure we have some of the key terms down:
- PO = Purchase Order
- Net 30 = buyer pays 30 days after delivery
- 3rd Party QA = independent quality inspection/ quality assurance agents
- RMB = Currency used in China, also called “Yuan”
- TT = Tele Transfer AKA bank to bank payment.
Payment terms that protect the buyer and are fair to the seller
Is it possible to get Net terms?
In most cases, especially if it is an initial PO, China suppliers will rarely offer “net terms” . Keep in mind that for the Chinese factory, net 30 terms really mean 120 days of project finance- 30 days to buy the material, 30 days to process, 30 days to ship across the pacific and 30 more days to wait for payment. It certainly is possible to achieve net terms in China, but it will probably be easier for you to move to better terms with your supplier after both sides have established a working relationship and trust. Be prepared not to have terms during the initial phases of the relationship.
Don’t be surprised if a supplier asks for 100% payment in advance. Realize this is negotiable, just as you wouldn’t necessarily accept the first offer of price without a negotiation. I have found that “30-40-30 terms” are often an acceptable middle ground on payment terms, fair to both parties.
Linking payments to performance reduces risk for both sides
Under 30-40-30 terms, the initial 30% of PO value is placed as a deposit. This allows the supplier to buy materials and lock in the price (especially important if you have a long lead time or deal in materials which face great price fluctuations, or example metals.) The second payment, of 40%, occurs at shipping upon confirmation of quality. The final 30% is paid upon receipt and inspection at the final destination. Let’s look at this 30-40-30 from both the buyer’s and seller’s perspectives to find why it was an acceptable middle ground.
The seller is worried that the buyer will default on payment, so getting 70% (40+30) before the goods leave port limits their exposure. As the average factory in China makes between 10 and 30% mark up, the 70% covers at least the majority of his internal costs, so even if the buyer defaults it won’t put him out of business.
The buyer’s biggest concern is that the goods will have quality issues or not arrive at all. By holding out on the final 30% until delivery, the buyer has leverage if quality problems require re-work or replacement parts. It is also important to remember that the 40% is not paid until after the goods are inspected in China, so quality confirmation must be a key part of the payment process, and that brings us to the next point:
The importer’s financial exposure is directly linked to quality exposure at the factory!
Quality problems are the #1 source of payment friction between buyers and sellers.
New-to-China buyers may think they are protected by good payment terms, but if you want real protection, you need to see that quality risk and financial risk are one in the same.
Let us assume you were able to extract some great payment terms, for example Net 30. So you have plenty of time to inspect the product at your warehouse before making final payment. BUT, what happens if you find a problem? Who pays for rework, costs to ship back defects, and/or delays to the customer? What many new-to-china buyers don’t realize is that 3rd party QA firms are readily available and inexpensive (a few hundred USD per shipment) in China. Utilizing 3rd Party QA agents or even 3rd party 100% inspection to check the goods before the buyer pays the 40% (under a 30-40-30 system) is an excellent way to mitigate your financial and quality risk.
What currency should I pay my Chinese supplier?
You may have heard your supplier say “sorry, we can’t accept USD payment, we must have RMB.” This is especially true these days, as the RMB is no longer linked to the USD at a fixed rate. To accept USD, your supplier may ask you to send funds to a private account (often the GM) or to a 3rd party trading company.
My point is two-fold:
- Bring up currency early in the negotiation process rather than after the PO is placed.
- Due to currency regulations and business licensing, it may be true that the factory can’t accept USD. But if you must send money to a 3rd party, only do it if you get the vendor’s seal on an official document stating that payment to the 3rd party equates to making payment directly to the vendor and the vendor bears the risk if things go wrong for the 3rd party. Having said that, this should only be applied to small value orders. Anything over 10,000 USD should go to a formal business account.
Will the seller disappear with my deposit?
There is a concern that the supplier will “run away with your deposit” or not be in business long enough to ship your goods. Luckily there are tools to manage this risk.
- Ask for references. If they can’t give you a number of happy clients, then a red flag should be raised.
- Financial Due Diligence is affordable (a few hundred USD per audit) and readily available from providers like www.AsiaBridgeLaw.com and www.SourcingServiceCenter.com. Use it to learn the ownership and financial stability of your supplier.
- Most important is visiting the factory to ensure they are not a trading company. Trading companies can disappear into thin air more easily than a legitimate factory, which has physical assets, a real address and employees. See related article entitled “How to avoid middlemen in your supply chain and save on all fronts” for details on how to determine if your supplier is a trading company or not.