Inadequate transparency & inflated profits – does your supply chain pass new levels of investor scrutiny?

  • Published: 26 September 2018

Waking up to your investors’ due diligence on supply chain might save your company’s valuation.

Retail is reaching yet another degree of competitiveness and it becomes necessary for consumer-facing brands to cut production costs without compromising their increasing accountability requirements. In order to pass audits, some factories maintain two (or more) sets of books and/or hide working hours and wage gaps – the difference between the legal wage a company should be paying and what they are paying. There are also factories who show correct records to buyers whom they trust while “comply or die” buyers get the fake records. Our data suggests transparency rates* are on the rise across all sectors yet few businesses are gearing up for increased investor scrutiny.

 

While excessive working hours and underpayment of wages are commonly known issues, their implications for retailer profits seem less well understood.

When manufacturing sites cut costs through unpaid overtime or lack of social insurance contributions, they improve their margins or pass on some of their savings to their buyers to remain competitive.

Lack of transparency on the aggregated value of these wage gaps can lead to inflated ratings of company profitability that are unsustainable. Consider how stakeholders are likely to interpret this scenario:

  • Investors would see wage gaps as profits that are volatile. Buy/hold/sell recommendations would be adjusted to reflect this outlook
  • Campaigners will see this as ‘corporate greed’, taking higher profits by underpaying workers

Based on ELEVATE’s experience working with private equity investors and pension funds, the current trend is that they are implementing more rigorous due diligence programs than in the past. Specifically, we have carried out impact modeling to understand whether social non-compliance not published in CSR reporting will impact profit volatility. We believe that company profits will come under increasing scrutiny, potentially leading to revised valuations. The following insight will explain the HOW and the WHAT of preparations you can make.

 

ELEVATE’s approach to supplier wage gap visibility through transparency review

In two different approaches for reviewing the transparency levels of existing social compliance audit programs, we discovered sobering results in terms of the level of wage gaps and aggregated impact on buyer profitability.

  • We matched supplier ratings and findings from a major database and data exchange association with our ELEVATE database. We found that 50% of the matched sites in the database and exchange did not find falsifications ELEVATE had previously identified.
  • ELEVATE was asked to compare all low-risk rated factories of a retailer’s own database with our own database of over 14,000 assessments annually. Our data found that about 80% of the matched factories the client thought to be low risk were found to have falsification violations.

Factories that were considered inconclusive or seen to have falsified records reported significantly lower working hours and days without rest than transparent factories. Reported weekly working hours were as much as 24% lower at factories that falsify records. Days without rest were as much as 65% lower at fraudulent factories. That means that supply chain transparency is not just key to improving conditions but critical and non-negotiable to mitigate risk, drive supplier ownership and improve working conditions at the factory level.


Brands and retailers will have a unique composition of suppliers based on product lines and size of factories. As depicted above, they will also have varying degrees of leverage, i.e. share of order volume or benefits per factory. This means that 100% of the wage gap is not likely to be passed on to the supplier but a share corresponding to their leverage.

Data showed that the average annual wage gap is the highest for factories with about 101-250 employees and is at approximately US$ 106,000. Assuming a share of benefits of 50%, half of this wage gap might be passed on to the brand/retailer.

Since about 22% or every 5th factory is of that size and we can add the assumed wage gaps of smaller and larger suppliers, we can estimate the value of wage gap savings for the entire supplier base of about 500 companies of varying size and leverage.

The potential benefit to a buyer’s total profit in our example could be as much as US$11 million.


To help your business stand up to investor scrutiny and prevent reputational damage through investigative consumer pressure groups, we recommend the following steps:


1. Vendors need to believe that buyers appreciate transparency over falsified records to meet audit requirements. Invest in your supplier relationships and build trust and promote transparency:

  • Develop a supply chain program that moves from compliance to performance, allowing more emphasis on business integration with quality and sourcing that drives higher supplier ownership and a shared responsibility for compliance
  • Implement and operate a sourcing program that provides full insights into social risks for designated factories
  • Update auditor procedures to ensure transparency is a priority
  • Recognize and reward good performance to help actively manage down the wage gap

 2. Once you are doing everything possible to increase transparency understand and manage your remaining risks:

  • What percentage of your strategic and core suppliers are transparent?
  • Have you got a due diligence process for your supply chain?
  • Start drafting responses to potential investigative questions

3. Understand the sustainability of your company’s profits:

  • What is the aggregate value of worker underpayment issues, e.g. wage gap, unauthorized subcontracting, lack of social insurance payments and how has that changed YoY?
  • Estimate the beneficial impact likely accrued by your company
  • Revisit your procurement strategy to explore contingencies to stabilise profits once underpayment issues are being addressed

What’s next?

Don’t be a beneficiary of the wage gap. Besides the reputational risk if found out, there is also the investment adjustment one must expect if some part of the earnings come from underpayment of wages. ELEVATE can help with supply chain performance, transparency reviews and brand protection through better supplier relationships.

For more detailed recommendations on supplier ownership to increase transparency see our insight on successful supplier ownership, and webinar.

To understand several of ELEVATE’s transparency reviews and our findings on working hours and wages, please refer to our previous webinar on: False Security and Risk to Market Value.

For further information on ELEVATE services to increase visibility into the supplier wage gap through a transparency review, please contact [email protected].


* ELEVATE definition of transparent for the purpose of an assessment, “Transparent: All records were provided and maintained for the required time period; there is consistency between various records (payroll, timecards, production, etc.); and there are no signs of non-transparency.” Note: This includes factories that were transparent but with unreliable records, i.e., legitimate record keeping errors.