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Manufacturing Cost Tug-of-War - Part 1
By Mark L. Casey | February 14, 2008
The tug-of-war between original equipment manufacturers (OEMs) and their contract manufacturers (CMs) with regard to price always intrigues me.
It reminds me of the dance most of us have gone through when buying a new car. As consumers we understand that the car dealer needs to make a profit, we just want to make sure that their profit is as small as possible. In fact, we probably would prefer that the dealer did not make any profit off of us. We suspect they have other ways of making money anyway, even if they lose some on us. Besides, if they go out of business for selling cars at a loss, we will have little trouble finding another dealer to sell us a car the next time we need to buy one. We are a bit jaded about car dealers. At least I tend to be.
The case with contract manufacturers is different, though. If I need a CM to build my new solar powered toothbrushes, I am most likely going to sign a multi-year contract with them to be my supplier. We are going to be partners for a number of years. I need them to be financially strong enough to continue paying their people, paying their component suppliers, paying their electricity bill, etc. They are no good to me if they go out of business. Remember, my CM is my outsourced factory. We share a mutually dependent relationship.
So, how does an OEM determine how much they should pay for the manufacturing of their product? This is actually fairly complex. The typical process for determining manufacturing costs begins back at the product conception phase.
1. Marketing. Larger companies will use their marketing function to determine all aspects of a product’s market need, acceptance, and pricing. Regarding pricing, the question revolves around what the market will bear. Product pricing can be a deep, deep subject. Marketing also defines the specification for the product’s function, look, size, colors, versions, options, etc. Throughout the life cycle marketing will continue to have input on the process.
2. Finance. Marketing’s product pricing projection will then be analyzed by the company’s finance function to determine what the margin needs to be when the company sells to their distribution channels. Let’s say that finance has determined that our solar powered toothbrush must sell to wholesalers for $2.30 so the wholesalers can add their markup and sell it to retailers for $4.00. Retailers will then sell it for the suggested retail price, let’s say $7.99 (hey, that’s cheap for a solar powered toothbrush!), or some discount to that price. [I have very little background with the markups added to products by wholesalers and retailers, so take these examples with a grain of salt or three]. By knowing that we need to sell our product to our distributors for $2.30, finance can now determine what we want to pay our CM for the production of the product. We are assuming here that the decision has already been made to outsource the manufacturing. If the OEM has decided to build it in-house, the issue of the true manufacturing costs is a different can of worms. In-house manufacturing presents the challenge of correctly accounting for all of the costs of manufacturing, including costs that are non-obvious or hidden.
3. Engineering. Once finance determines that we will be selling our product to the wholesalers for $2.30, it is engineering’s job to design the product so that it meets both marketing’s specifications and finance’s cost constraints. This is what gave birth to Dilbert. So, we are going to say that engineering is trying to design a product that will cost $1.15 to manufacture. Engineering groups have access to some costing data on various components they will design into the product. They also often work with their purchasing groups early in the process to identify costs. In addition, vendors and reps for various components or services often help in this process as well. At the end of the process engineering hopes to have achieved its objectives and designed a product that meets the specs and the manufacturing targets. If either of these is not feasible, again, think of our pal Dilbert.
4. Purchasing / Outsourcing. As stated in the engineering discussion, purchasing people typicaly work with engineering groups to help them with costing information while the product is in design. In parallel with the design effort, the outsourcing group will also be in discussions with potential CMs about manufacturing the product. This process may include surveys of the suppliers’ capabilities, factory visits, and sample benchmark quoting on an existing product to eliminate the pretenders and assemble the contenders. When engineering has created the final design package, purchasing/outsourcing will send out the bid packages (RFQs) to the selected contenders. When the manufacturing quotations come in, purchasing will clarify any questions about the quotes and then present them to the decision makers for the final decision. In larger firms the decision makers are often a team. In smaller firms it may be a “the buck stops here” approach with one individual.
Part 2 of this article will explore the nature of the quotes that come back from CMs and the tug-of-war that often occurs at that stage as OEMs try to make their final supplier selection.
Topics: China, Contract Manufacturing, Electronics Manufacturing, Entrepreneurs, Global Sourcing, Services |
One Response to “Manufacturing Cost Tug-of-War - Part 1”
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March 21st, 2008 at 10:34 am
In point #2 in the article, I believe that the assumption that retail would mark up the price from $4 to nearly $8 is a poor assumption. As I wrote in the brackets, retail markups is outside of my experience. However, I now remember that retail typically has smaller margins.
If you have some insight into how much markup retailers typically get, please add your comments here.