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Little Trouble in Big China After decades of making its clothes exclusively in the U.S., R&H Designs made the painful decision to shift its manufacturing to Asia. That's when the problems began.
By Carlye Adler/Hong Kong

(FORTUNE Small Business) – Russ Berens had been designing and manufacturing clothes in Southern California his entire adult life, and after decades in the business he felt proud of what he had built. By 2002, R&H Designs, the women's casual-apparel company named for Russ and Hillary (now his ex-wife), was taking in about $20 million in revenue a year and employed more than 200 people in Chatsworth, Calif., near his hometown of Los Angeles. Berens also liked that every garment was made in the U.S. and came with a tiny American flag sewn next to the label.

But over the past few years the company--once profitable enough to fund four college tuitions and a house on a golf course near Malibu--had begun to unravel. Berens, like many other employers in California, found it easy to blame the state's much publicized mismanagement for his business woes. He was paying employees the state-mandated minimum wage of $6.75 an hour--31% higher than the federal requirement. His workers' compensation premiums had jumped fivefold in five years, and more increases loomed. Combine that with California's exasperating health-care laws (stress can be considered a work-related injury), and Berens saw no relief in sight. "It's getting out of control," he remembers thinking.

Truth is, prospects elsewhere in the country weren't much brighter for apparel firms. Some of Berens's competitors had already moved offshore to benefit from favorable trade regulations and low-cost labor--particularly in China. Manufacturers in the People's Republic were able to make pieces at prices he couldn't come close to matching; in some cases the garments were selling for $20 less than it cost R&H to produce them. The company reluctantly laid off 35 employees in 2003 but was still hemorrhaging money. Berens had to make a choice: Go out of business or go offshore.

The problems plaguing R&H Designs are ugly but hardly unique. California has lost a sixth of its factory jobs since July 2000, according to the National Association of Manufacturers. More than 2.8 million jobs in the U.S. have vanished in the past 3 1/2 years, including 270,000 in the textile and apparel business alone--about a quarter of the industry. Increasingly those jobs are moving to Asia. "Most large manufacturers opened facilities in China years ago," says Robert B. Cassidy, the former assistant U.S. Trade Representative for China and now director of international trade and services at Collier Shannon Scott, a Washington, D.C., law firm. "Now small companies are starting to make the move." A country once known for making plastic toys or cheap knockoffs, China is currently the world's largest producer of televisions and makes half the cameras and photocopiers on the planet. China's booming economy attracted more foreign investment than the U.S. for the first time in 2002, and grew 8.5% last year alone, largely because of exports.

The management at R&H Designs knew the arguments for setting up offshore, but making the choice to do so was still excruciating. "Everything is very personal to me," says Berens. Some employees had been with him for 18 years. But ultimately, he says, the company's survival was more important. "I have the responsibility to make sure that we stay in business and grow," Berens says. "China is the only way we see to pull that off."

That grueling decision would begin a yearlong roller-coaster ride to the other side of the world. "It may scream logic to take production to China," says Tim Runyan, 56, the managing director in charge of the company's move to Hong Kong. "But that's easier said than done." Operating in China may seem cheap, but it isn't easy, with intellectual-property rights protection to consider (you really don't have any), a host of hidden costs, and in some instances, corruption. There's also a serious case of culture clash: Negotiating takes place under a different set of rules, and lunch meetings often come with a side order of chicken feet.

The irony in all this is that Berens has never been to China--and he doesn't have much interest in going. He was born in Los Angeles, and at 65, he still seems the ultimate Californian. (He says "dude" a lot and voted for the Terminator for governor.)

The clothes made by R&H Designs aren't trendy. Sold under the label "Russ Berens--Malibu," they're made of linen, soft cotton, or rayon in the loose-fitting style that appeals to middle-aged women in the Sunbelt. They are consumers Berens believes most designers ignore, and focusing on them works for him: His brand is in about 700 boutiques in the U.S. and Canada, and the company also does private-label work for major department stores (which Berens declined to name).

When most businesses want to move overseas, they hire a trading company, an outside consultant that specializes in such transitions. But Berens thought doing so would mean sacrificing quality. "A trading company is an easier route, but they don't give a darn--they just want the commission," he says.

Instead, he wanted someone with a vested interest in the company who could go to China and set up the outpost the way he would. Enter Tim Runyan, a logistics specialist whose former company did supply-chain management for Federated Department Stores and who had 15 years' experience in Asia. The two had an instant, almost uncanny connection: Like Berens, Runyan was a serial entrepreneur (he'd started a meat-processing firm, a wine-importing business, and a coffeemaker company). Both men were pilots, both lived on golf courses, and both had dogs named Foster, named after the Australian beer. Runyan was given an equity stake in the overseas operation, and the two men called the new venture Russ Berens Hong Kong. Technically it's a registered Chinese company and a separate entity from the California manufacturer.

The first task was finding a factory. Most of the manufacturing in China is clustered in two areas, the east-central region near Shanghai and the southern section in Guangdong province. R&H focused its search in Guangdong, partly because Runyan, who would be spending time there, preferred the south's subtropical climate. Since he didn't want his negotiations to be subject to committee approval, Runyan looked for a private factory, instead of one of the many still owned by the government. The research wasn't clear-cut--the language barrier, the newness of private enterprise in China, and the lack of any public disclosure made it difficult to trade references or measure businesses the way companies can in the U.S."It's trial and error," says Runyan.

After months of investigating, R&H narrowed its list to two Chinese factories. As a final test, each was asked to copy five Russ Berens-Malibu garments, without any specifications, patterns, or instructions. To everyone's surprise, all the versions produced in China came back nearly perfect. "There was more detail, and the clothes were of equal craftsmanship to the ones made in California," Runyan says. He packed his bags for Hong Kong, where he would stay for the next three months--precisely as long as he could without being kicked out by Chinese immigration authorities. In the next 90 days Runyan would have to pick a factory, negotiate a deal, produce garments, and ensure that they'd be on U.S. store racks by Christmas.

Hong Kong may be on the other side of the world, but in many ways it doesn't feel like it. Because of its British heritage, much of the city is Westernized, with a largely English-speaking population, gleaming skyscrapers, and even Starbucks. Conversely, mainland China, a 90-minute train ride from Hong Kong, can feel completely foreign, with bad roads and restaurants best described as "unique" (snake is a delicacy--"It tastes like tire," says Runyan). Still, most factory owners in Guangdong speak English, and they treat potential business partners with the same respect that an American would offer the president of a friendly foreign nation. Many people still get around on bicycles, but Runyan would get picked up in luxury cars for his factory tours and was taken to elaborate tea ceremonies and lunches (more chicken feet, snake skewers, and duck tongue). After seeing the facilities under ideal conditions, he would be dropped off by the owners at his hotel.

Familiar with the drill, Runyan continued his research, following the pleasantries, by sending a Chinese associate back to observe the factory after business hours. Because it would be suspicious for a gweilo--the Cantonese word locals use for foreigners, literally "foreign devil"--to be out on his own, Runyan would usually stay behind (although on one occasion he went along and observed a factory from the window of a hired car). Sneaking back helped Runyan, as he puts it, "tell if somebody is bullshitting." He could confirm the number of employees by watching how many came out at the end of a shift, or measure productivity by counting the number of containers that emerged.

The factory R&H selected didn't do computerized sewing, unlike the other one under consideration, but its equipment was newer than the machines R&H used in Los Angeles, and it was able to do better detail work, such as pleats, ruffles, and cuffs. For proprietary reasons R&H would not let FSB visit the factory. It also asked us not to disclose its name or exact location. R&H did tell us that the plant has 400 employees, who work ten hours a day, six days a week (though in that region of China, such hours are the exception--many factory employees in Guangdong work 7:30 A.M. to midnight). The workers make about $100 a month, Runyan says, but because R&H is only one of the factory's clients, it is responsible for only a portion of that amount. By comparison, the average R&H employee in California makes $1,240 a month.

Wages and restaurant menus aren't the only differences in southern China. Dealmaking has its own rules as well. "You cannot bring an American practice here," Runyan says. "Americans have a tough time because they love to be direct. The Chinese are not direct." Instead, during tense business disputes, the most effective strategy can be silence. At one critical juncture in Runyan's negotiations, a factory owner wordlessly tapped his pen for ten minutes and later simply walked out of the room. Runyan adapted his strategies accordingly--instead of raising his voice, he would decline a lunch invitation or leave a competitor's business card out in plain view. They were subtle signals, he says, but meant to show that he had other options. In the end, he was able to exact a better price from the factory and better terms (including a 30-day lead time instead of 45 days).

But just as R&H was on its way to getting quality fabric and making better clothes more cheaply, everything suddenly went wrong. The factory in Los Angeles was still operating on a reduced scale, and some raw fabric had to be shipped from the factory in China. However, there was a problem with the "quota visa." Everything imported to the U.S. requires a visa documenting exactly what it is and where it's coming from. The Guangdong plant sent a visa for 19,500 yards of fabric but actually shipped 20,000 yards.

That sounds like a small mistake, but it meant the material was held up in U.S. Customs for five days. "That's five days closer to 'We can't deliver!' " exclaimed Runyan, who had timed everything to the arrival of those goods (and who was now back in the States). Further aggravating matters, a subsequent shipment had a similar mistake and was also delayed for five days--putting the California factory two weeks behind schedule. When the quotas were finally cleared up and the workers in California opened the plastic bags of fabric, they found 5% less than they had ordered. Worse, some of the fabric had flawed edges and was unusable.

Because R&H had inserted clauses covering such problems in the initial agreement, Runyan says that he and the factory reached a "satisfactory settlement." (There are judicial remedies for issues like those, but Runyan says that if you draw up the paperwork the right way, you can avoid the prospect of legal fights.) Despite that somewhat neat resolution, R&H knew it couldn't risk any further hiccups. It decided to keep a small contract with the first factory but send most of its business to the runner-up plant in China. It is much larger and manufactures clothing under its own label--something Runyan hopes won't come back to haunt him in the form of Russ Berens knockoffs. To cover his bets, he also struck a deal with a third factory, also in Guangdong. "Just in case," he says. "That's something you learn over here."

So far, things have gone well with factory No. 2. The five styles R&H started producing in China were on store racks in the U.S. by mid-November, just in time for the holidays. According to Runyan, seasonal sales were up, and he says the cost savings should help the company almost immediately.

How significant are those savings? Let's say a dress costs about $18 to make in the U.S. In China that same dress would cost just $10, including the freight and customs charges to ship it here. The difference becomes more pronounced if the dress has any kind of detail work, such as embroidery or beading. In the U.S. the extra labor involved will push the cost up to $25, while in China it adds only incrementally, to around $12. Some of R&H's garments now face a tariff when they enter the country, which cuts into the savings, but when China fully enters the World Trade Organization in 2005, most quota tariffs on textiles and apparel will end.

Cost savings in China not only allow R&H to produce more intricate designs but also lower its prices (an effect that will be seen sometime this year). The company has already increased orders for its foreign factory and expanded the line of products manufactured there to 20 styles as of this month (up from five when the project began). And it hopes to have more than half its garments produced in China by the end of 2004. Berens still doesn't plan to close the factory in California--instead he'll scale it back dramatically and use it to fix problems, such as a hem that may be sewn wrong in China. That requires far fewer workers, and the layoffs will continue. Both Berens and Runyan have been criticized for exporting American jobs--a golfing buddy of Runyan's recently spent 17 holes calling him names--but both say the move was necessary to save the company.

Even a year after his decision, Berens remains sensitive to the issue of lost jobs. Several months into the reporting of this story, he stopped talking to FSB, saying he was concerned about revealing too much to competitors. He added that he didn't want to unduly worry his vendors and customers. He declined to be photographed and refused to let us visit his California factory. "I'm not going to sit here and say how great going to China is," he told us. "But we'll do what we have to so that we'll survive."