Company Background
Sanlu Group Company Limited was a state-owned Chinese dairy products company based in Hebei. For once, its low-price infant formula gained massive popularity among the Chinese, especially in third- and fourth-tier cities. Therefore, it attained the highest sales volume in the local milk powder market for 13 consecutive years. In December 2005, Sanlu underwent a tremendous change. It started a joint venture with Fonterra, a well-known New Zealand dairy company, which owned 43% of Sanlu’s stake.
In 2008, the tainted milk crisis broke out in China. A lot of infant formulas were found contaminated with melamine which led to death and hospitalization of babies. Sanlu was pointed at as the major culprit of causing the incident as its milk powder contained most melamine content. Chinese parents lost confidence in the long-standing brand and turned to foreign dairies. At the same time, Sanlu needed to pay huge amount of compensation to the victims of the incident. The damage to Sanlu’s reputation and profitability was severe and irretrievable. As a result, it filed bankruptcy in December 2008 while several senior managers were sentenced to life imprisonment.
The arise of Sanlu milk crisis
Timeline of the Tainted Milk Crisis
Stakeholders that should be deemed responsible for the crisis
The Sanlu tainted milk crisis arose due to the negligence of various stakeholders involved in the Sanlu milk powder supply chain. They included dairy farmers, milk stations, Sanlu itself, Fonterra, retailers and consumers. Other stakeholders included government and the media. In the following, each stakeholder will be discussed in details:
Dairy farmers
Dairy farmers are partially responsible for the issue as they engaged in illegal activities. Due to keen market competition and a lack of bargaining power, dairy farmers added melamine into raw milk to maintain low cost and boost protein readings. In fact, their act revealed their selfishness and lack of business ethics as they only focus on their primary gains at the expense of consumer’s health.
Dairy farmers are partially responsible for the issue as they engaged in illegal activities. Due to keen market competition and a lack of bargaining power, dairy farmers added melamine into raw milk to maintain low cost and boost protein readings. In fact, their act revealed their selfishness and lack of business ethics as they only focus on their primary gains at the expense of consumer’s health.
Milk stations
Many milk stations did not have proper license and formal contracts with the dairy farmers, they simply collect milk from them and ignore the quality of the milk. They often exploit farmers and delay payment to them. All these indirectly contributed to the incident
Sanlu
Due to inflation and rising cost of dairy farming and production, Sanlu transferred the cost pressure to the upstream suppliers, i.e. dairy farmers and milk station. This prompted them to adulterate the milk to minimize costs. Moreover, Sanlu failed to exert control over the suppliers. It was reported that adding melamine was an open secret in the industry. However, Sanlu did not try to stop the adulteration but further cover the negative news and comments on the Internet and delay in alerting the public about it. Their negligence worsened the situation and caused more victims to suffer from the crisis. Therefore, Sanlu should take most responsibility for causing the milk crisis.
Fonterra
In this milk crisis, Fonterra helped to reveal the issue the public by reporting to the New Zealand government and Chinese central government. However, Fonterra still hold some responsibility for the issue. For instance, they should be skeptical to the unreasonably low production costs when they read financial reports of Sanlu.
Retailers
Retailers should shoulder responsibility for assuring the quality of product they sold. At the early stage of the incident, a citizen posted on the Internet that he found problem regarding the production date of milk powder. This showed that retailers did not check the product thoroughly before placing them onto the shelves. Also, they did not recall the defective products immediately.
Consumers
Consumers were the victim of the incident, but they also bear some responsibility. First, parents should be alert of the quality of product they bought. However, they only focused on the price of milk powder and ignored the quality. Moreover, since they had little knowledge about breastfeeding, they over-relied on milk powder.
Government
The government failed to impose regulations and food safety guidelines for the suppliers. It did not monitor dairy farmers and milk stations properly and effectively. Moreover, they exempted large companies from quality tests. All these created a loophole for dairy farmers to engage in illegal practices and misled the customers to believe that the milk powder is in good condition. To make things worse, the government is the party which capped the price for the milk products and placed huge cost pressure on suppliers, causing them to sacrifice quality for profits.
Media
The media is supposed to monitor and reveal unethical issues. But in this incident, the reporting mechanism apparently failed. For instance, a newspaper company reported that Sanlu was on the list of tainted milk powder producers. However, after their meeting with Sanlu’s executives, they held a meeting to apologize for the ‘false accusation’ on Sanlu. This continued to hide the news and caused more deaths and illness of babies.
Reasons for companies outsourcing part of their business
Focus on core business
Outsourcing enables dairy companies to focus on their core business, milk production. Facing the competition of foreign dairy companies (such as Fonterra, Nestle, Danone) in the mid-1990, dairy companies have to improve their product quality and diversify their products for different age groups to stay competitive in market. Outsourcing, thus, enables dairy companies to concentrate on research and development, quality improvement, manufacturing and marketing of dairy products.Insufficient milk supply from self-owned dairy farms
Insufficient milk supply from self-owned dairy farms is another reason for outsourcing. The dairy market in China has been growing under the government’s promotion of dairy consumption. The increasing income level of Chinese and their desire for western diets also contribute to greater demand for dairy products in China. Some large dairy companies like Yili and Mengniu own their individual farms, but the raw milk produced from those farms can only support 10% of total volume consumed. To meet the growing demand for dairy products in China, outsourcing is the only way for them to get enough amount of raw milk for further production of various dairy products.Cost Reduction
Dairy companies also use outsourcing to reduce cost. Due to keen competition, dairy companies want to stay competitive by keeping the product price low. Contract-based outsourcing enables dairy companies to save cost on capital expenditure, like infrastructure and technology for raw milk production. Besides, there are several major dairy products manufacturers in China, but the milk farmers are rather small and scattered. Furthermore, the perishability of raw milk also weaken the bargaining power of milk providers. Thus, the dairy companies take advantage of these factors to buy in bulk and bargain for lower procurement price.The pros and cons of outsourcing
Pros of Outsourcing
Lower Cost
By outsourcing raw milk production, companies can save costs on investing in capital for building self-owned milk farms and cattle rearing which are inefficient and insufficient to meet market demand. Contract-based procurement enables the diary companies to reduce the raw material cost to maintain profit margins and stay competitive in China’s dairy market.Risk Diversification
Outsourcing enables companies to diversify their financial and operational risk. The operation responsibilities are shifted to the operators and investment cost is cut. For example, the milk that is safe cannot be sold after the scandal. If Sanlu owns its own farms, the business risk will be greater as Sanlu has to bear cost of the farming business when it is not profitable.Increased Efficiency
The raw milk production scattered over China’s region. It is time-consuming for dairy companies to negotiate with all individual milk providers and collect the raw milk. The milk centres and agents with an extensive network are able to collect milk from scattered milk suppliers more efficiently. Thus, dairy companies can save time and cost and ensure the freshness of the milk for further production by outsourcing the raw ingredients production.Cons of Outsourcing
Loss of Control
Outsourcing partners have separate operations and goals for their business. As the objectives of the outsourcing companies may not align with the production company, they have low incentive in producing safe and qualified semi-product for further production, especially when they are rewarded with unfair pay for their work.
Hidden Cost
Although outsourcing is always suggested to be one of the methods to lower cost, there are actually hidden costs behind. Companies need to bear extra expenses on quality checking. There are also costs in setting up contracts, making negotiation and transporting the outsourced materials from one place to another for further production. The cost of handling a lapse in quality control is huge such as compensation for affected customers, recalling products, disposal of unsafe raw material and rebuilding brand image. For Sanlu scandal, Sanlu had to pay up to US$102.3 million as refunds for sales agents and US$132 million as compensation for affected customers. The compensation eventually caused it to file bankruptcy and halt operation.Increase Operation Complexity
Although outsourcing helps diversify company’s operational risks, it increases the complexity of supply chains. Raw milk needs to go through more production stages before they become finished products. Therefore, when a problem is identified, it is difficult to trace back to the source and its responsible party. This also slows down response rate to consumer complaints. Take Sanlu case as an example, the government took 3 months to finish all the investigation on identifying legal responsibility of the involved parties.
The role of ethics in supply-chain management?
Ethics serve as a guide for human to engage in moral practices despite the absence of clear law terms. It is especially important in the food manufacturing industry as it directly affect the health of consumers. Therefore, it guides the judgement of food manufacturers and reminds them to be self-disciplined. In the Sanlu case, ethics should be in place to bring the following effects.
1) Balance of interest
Each stakeholder in Sanlu’s supply chain should uphold food safety. An ethical producer must follow the food standard strictly to protect the consumers. In this case, although Sanlu knew well about the adulteration of melamine which was an open secret in the industry, it did not exercise control over the suppliers but even cover it up. As one of the largest dairy producers of China, Sanlu should engage in ethical practices and bear in mind that it has to balance food safety alongside profitability.2) Production guidelines in addition to the law
Ways to restore consumer confidence for Chinese milk product
After the exposure of Sanlu scandal, Chinese milk products were labelled as dangerous to health. Consumer confidence was severely shaken as reflected by the unprecedented high import volume of milk powder in China. To restore consumers’ confidence towards locally produced milk products, Sanlu and other dairies as well as the government must implement a series of immediate and long-term measures.
Immediate Measures
Sanlu and other dairy companies
As the culprit of the incident, Sanlu and other dairy companies should take responsibility for putting infants’ lives at risk. To stop the contaminated products from proliferating in the market, these companies should immediately launch a product recall and halt production in unqualified milk stations until all milk supplies are tested negative for melamine. Apart from that, the company should also hold a press conference to explain about the incident and issue formal apology to the public. A special enquiry hotline should be set up to keep means of communication open. Dairies should also give direct compensation to victims through refunds and full coverage of medical expenses.
Government
After the crisis, investigation into the issue should be immediately carried out. The government should summon experts in the food industry to set up a task force who serves as a third party to carry out reliable tests and find out the root cause. The Sanlu scandal revealed the lack of supervision in China regarding food safety. Therefore, the government should close the loophole by reviewing legal framework. For instance, melamine content restriction should be raised and harsher punishment for violating the law should be imposed in order to exert stronger deterrent effect among dairies. In addition, the government should make sure that laws are enforced and regulations are followed by carrying out spot checks.
Long-term Measures
It is a long way for dairy companies to regain local consumers’ confidence for their products. Therefore, a three-step approach is developed to solve the root problem of low quality in the long run.
1. Form strategic alliance with foreign milk processing centre
Ever since the outbreak of the Sanlu crisis, consumers shifted to purchasing foreign milk powder. This shows that consumers generally feel more confident about foreign food production standard and technology. To acquire their skills, dairy companies in China can form strategic alliance with milk processing centres in New Zealand or Australia so as to learn from the industrial best practices and improve the standard of milk processing.
2. Conduct regular internal audit and spot checks
Improvement in milk quality cannot be assured without thorough checking. Dairy companies should carry out both regular and spot checks during milk production to ensure food safety. If there is any substandard quality, the company should immediately take action to remove the batch of milk powder.