Digital Audits as a Tactical and Strategic Management Resource

U.S. companies that outsource production to manufacturing hubs in countries such as China and India lower their costs, but the practice comes with substantial reputational risk. Manufacturers in these countries run the gamut in how lax or strict they are about enforcing labor and environmental regulations.

To offset this risk, enterprises have made sizable investments in factory audits, which can include asking suppliers to meet externally certified accreditations or hiring third-party auditing companies to make site visits. However, persistent scandals involving illegal or dangerous working conditions show that the standard factory audit is inadequate as a business risk mitigation strategy.

There’s a better way. A new type of audit system that digitizes the process is transforming on-site facility inspection programs. This advanced system increases the effectiveness of factory audits as a risk management tool, and provides new insights into the efficiency of remote manufacturing operations. By linking risk and product quality to inspection outcomes, digitized audits also can deliver cost savings and process improvements.

Problems in the Current Factory Audit System

Reports of poor or illegal practices by suppliers and subcontractors have become all too common. One of the highest-profile tragedies was the collapse of the Rana Plaza apparel factory in Bangladesh in 2013, which killed 1,134 people and injured another 2,500. Suicides in contract electronics manufacturing, forced labor across industries, and child labor in the toy supply chain continue to plague manufacturing operations in countries where costs are lower but regulatory oversight is less stringent.

Controversies like these — and countless others that go unreported — occur despite the existence of well-established factory audit systems and supplier management programs. Moreover, research being carried out by the MIT Responsible Supply Chain Lab indicates that less than 1% of consumer-facing companies share audit results publicly, making it is difficult to address the shortcomings of audit systems.

What we do know is that three key issues hamper modern audit practices: standardization, cost inflation, and fraud.

1. While standardization makes it easier to use the audit process, it also dilutes the value of the exercise. For example, companies might create a supplier code of conduct, which is then translated into a list of check boxes that guides third-party factory auditors. But standardized lists often fail to assess unique supplier issues and regional variations in production practices.
2. Cost inflation undermines the intrinsic financial value of audit systems. A factory audit can cost upwards of $600 to $800 per man-day, depending on location. The need for someone from the supplier to accompany inspectors must also be factored into the budget. As the number of audits has increased, the total cost across multiple vendors and locations in a supply chain has risen substantially.
3. Audits can fail to monitor the production processes they are supposed to evaluate. It is not uncommon for a supplier to conceal actual practices when a scheduled audit is occurring, or to create a “front” operation for the purposes of the visit. Sometimes companies discover that a supplier has surreptitiously subcontracted to another vendor that is guilty of various misdemeanors. Bribery is another issue that devalues the audit process.

In addition to these three problem areas, the technological advances that are transforming supply chains have, up until now, largely bypassed the audit process. Typically, audits are scheduled weeks in advance. The process is paper-based, and buyers receive the results via email or fax within a predetermined time.

Enter New Technology and Audit System Automation

A new generation of audit systems is emerging that automates the factory inspection process while tailoring it to specific inputs, and delivers analytical capabilities that are beyond the classic audit model.

For example, supply chain inspection company Inspectorio, headquartered in Minneapolis, Minnesota, and partially owned by Target Corp., has created an app that auditors can use to collect information, take pictures and video on their smartphones, and communicate in real time with buyer clients. Another audit company, London-based Sedex Information Exchange Ltd., has created a platform that allows suppliers to share their audits and performance ratings with other buyers, serving as a kind of Yelp for suppliers, with the audits as Yelp-like reviews.

These systems are beginning to address some of the core issues that hinder traditional audit models. Since data is collected and transmitted electronically in real time, companies can react faster to operational issues. Audits can be tailored to specific suppliers, allowing for the history of individual vendors. As unscheduled audits and the real-time transmission of data become routine, it will become easier to identify the sources of fraudulent practices. Further, over time Yelp-like platforms will reinforce the vetting of suppliers for buyers, making it more difficult for unscrupulous operators to hide their misdeeds.

Digitized audit systems complement advanced analytics that enable buyers to evaluate supplier performance in more depth, and support more effective decision-making. Buyers are better able to evaluate suppliers based on qualities that align with their strategic and operational goals. It becomes faster to weed out poor performers and to reward vendors that consistently meet their quality and corporate social responsibility (CSR) standards.

Importantly, this new breed of audit links client CSR goals with product quality and supply chain risk factors, tying CSR oversight to performance indicators that affect buyers’ bottom lines. This is a notable departure because the classic CSR audit is conducted independently of other functions such as quality control.

Inspectorio includes both CSR and product quality factors in its factory inspections via its digitized audit platform. This gives the auditor dual reasons for factory visits, which reduces the overall cost of inspections. Expanding the scope of audits in this way also raises the stakes for suppliers: Poor labor conditions might cause a buyer to drop a supplier, but inferior quality in addition to poor labor conditions almost certainly will.

More versatile audits also provide a major opportunity to analyze supplier quality in the context of labor conditions. For example, analytics can shed light on whether improving workers’ quality of life improves product quality. Similarly, technology-enabled audit models provide an opportunity to gain new insights into the link between working conditions and supply chain risk.

Other formats for more tailored auditing are emerging. Auditing company EcoVadis SAS, headquartered in Paris, links its pre-audit supplier survey to risk. EcoVadis does not conduct audits, but provides risk ratings based on suppliers’ audits, internal and external data, and other factors that identify when and how frequently a supplier should be audited. Industry associations are innovating in this space as well. For instance, the Electronic Industry Citizenship Coalition (EICC) has created the Validated Assessment Process to standardize on-site compliance verification. It’s attuned to industry-specific issues and can be further refined by aligning inspections with the risk profiles of individual suppliers.

Change, Which Is Inevitable, Will Raise the Bar

The transition to digitized audit platforms will not happen overnight. However, the pace of change will accelerate as the benefits become apparent and as buyers acknowledge that continuing to use traditional models could put them at a competitive disadvantage. As more data is shared, it will become easier to identify substandard actors. It will also become easier to find and address the root causes of quality problems in outsourced manufacturing operations.

Digitized inspections will reinforce the link between product quality and CSR standards. When product quality declines, companies risk losing market share, just as they do when CSR blunders damage their standing with buyers. For this reason, including social and environmental components in product quality audits makes sense.

Ultimately, factory audits will become a resource rather than an expensive burden. They will help companies manage supply chain risk and maintain quality standards and hence brand reputation. By providing insights into supplier practices and increasing supply chain transparency, technology-driven audits will support long-term supplier relationships.

More effective audits also will help companies to cope with the rise of regulations such as the California Transparency in Supply Chains Act and the UK Modern Slavery Act. Even if cost savings, efficiency gains, and improved risk management do not drive change, regulation eventually will.