The market for your product is larger than it has ever been. Your market encompasses the world. But, the promise of a worldwide market is always threatened by worldwide competition. While you are sleeping, there is a bright businessperson on the other side of the world-or maybe just next door-planning to capture your market share, or try to prevent you from even entering the market.
Lower costs can lead to lower prices; and with all other variables being equal, the lower price almost always wins. Companies need to examine their costs to identify savings that will allow them to lower their prices to protect or capture market share from your competition. The savings are there.
Companies must find the savings they need to compete and win in the market. Most often, a company’s cost of goods sold (COGS) expense is the largest expense item on the income statement. If you outsource your manufacturing, that puts the spotlight on your turnkey contract manufacturing partner.
Not too long ago, you wouldn’t think of letting your contract manufacturer purchase and provide raw materials to be assembled into your product. Back then, you would purchase, receive and stock raw materials and ship kits of those materials to your manufacturing partner for their value add-manufacturing. Somewhere along the line, however, contract manufacturers convinced you that they “buy better” than you. Once overhead expense and income taxes are deducted from their 17% gross profit, what remains for your contract manufacturer is a net profit of 1 to 5%. The question then is: Why does a contract manufacturer require you to buy their materials? And the answer is simple-to increase their revenue. With material content averaging 60% of unit cost1, your contract manufacturer will more than double their revenue by selling these materials to you.
As stated earlier, your contract manufacturer wants you to believe that he can “buy better” than you can. But can he? In reality, you are paying at least $1.00 for every $0.83 of material purchased by your contract manufacturer. If your annual contract manufacturing expense is $5 million, at a 60% material content, then $3 million is spent on materials. Your contract manufacturer keeps 17 cents from this $3 million, or $510,000.
On the flip side, if your company already has a purchasing and material management infrastructure, then you’ll reduce your COGS by 10.2% and can mark that $510,000 as savings. If you don’t have a purchasing and material management infrastructure, or if you have insufficient infrastructure to purchase materials, you will most likely have to give some of your savings back as you invest in infrastructure. But don’t worry, that cost won’t be anywhere near $510,000 to procure $2,490,000 of materials annually. Companies tend to give up even more when their contract manufacturer procures the materials.
Theresa Metty, Motorola’s senior vice president and chief procurement officer claims, “In the outsourced world, the normal procurement process is disrupted by a third party (contract manufacturer).” Metty adds, “…maintaining the supplier/OEM link is vital. If an OEM is distanced from a (material) supplier, the OEM might not get the benefit of a shared technology roadmap, early adoption of new technology or the ability to maintain a competitive price advantage.”2 All of these factors are vital to maintaining a competitive edge. Because nearly all material sellers are compensated for their efforts at the point of sale, when the point of sale is the contract manufacturer, there is little to no incentive for the material manufacturer and/or supplier to expend any effort supporting you, the OEM. Therefore, you lose critical visibility with the material suppliers. Furthermore, the intense pressure placed on your material suppliers by contract manufacturers looking to leverage their anemic net profit margins at the expense of your material pricing, causes even greater pain in the supply chain.
As a result of these concerns, Motorola has launched a process they call “price masking.” Under price masking, neither Motorola nor its materials suppliers share the company’s price information with contract manufacturers. Quentin Samelson, a Motorola executive who helped draft the program with Metty notes, “When we talk about this with suppliers, you can see them breathing a sigh of relief.”3 Price masking requires Motorola’s material suppliers to focus their attention and efforts on Motorola, and not the on contract manufacturer. Motorola understands that there is significant proprietary value in directly managing their material supply.
OEMs will need to force their contract manufacturers to make their profits on manufacturing, instead of on buying components. This will also push contract managers to compete in terms of their manufacturing efficiencies, and not on procurement margins.