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OEMs must not only evaluate price when considering outsourcing, but the comprehension, accuracy and trust of the potential partner, as well.
By Brian Tracey
SMT assembly services necessitate such a significant investment in capital equipment and personnel that original equipment manufacturers (OEM) can find it difficult to stay at the forefront of technology. One popular solution is to outsource all non-core-competency tasks to contract manufacturers (CM).Today's full-service CMs provide everything from new product introduction programs and design for test (DFT)/design for manufacture (DFM), to hub-centered warranty service and depot repair (see sidebar). This wide array of services can make it difficult to compare the prices of competing CMs or to evaluate the cost of internal vs. outsourced services.
In addition to comparing prices, the ideals and goals of the CM must be considered if the long-term partnership is to be successful. Consequently, OEMs must look beyond the quoted price to assess the true value of the partnership. One way to do this is to evaluate the CM's level of comprehension, accuracy and trust (CAT level).
Comprehend Fully Burdened Manufacturing CostsThe goal of outsourcing is to accelerate the flow of product from the raw material stage to the final user while ensuring optimum financial performance for the OEM. Outsourcing must also strengthen the value chain between the supplier, the OEM, and the end-user or final customer. While there are many benefits to outsourcing, a lower cost of manufacturing is usually the first to be considered, and is the most obvious element in the quote.
One erroneous assumption in the SMT industry and, in particular, the high-mix arena, is that CMs should be able to sell their capabilities at a lower cost than the OEM's direct cost. This is usually not the case, as CMs must charge for non-recurring engineering (NRE) expenses. These expenses cover the cost of a variety of materials and services, from fixtures and stenciling to DFM/DFT assistance, and can sometimes run in excess of $100,000. While OEMs also incur NREs, some accounting systems may charge these expenses to engineering or test, resulting in an artificially low manufacturing cost.
When NREs are called out in the CM's quote, negotiating how these costs will be billed can reduce the impact of these costs. For some OEMs, it is financially beneficial to include NREs in the cost of the device, or amortize the costs over the life span of the product, while other OEMs may be able to realize a better tax benefit when NREs are billed as a separate line item.
Consider Startup CostsAnother often overlooked manufacturing cost is the fine-tuning of new manufacturing processes. Every manufacturer in startup production, no matter whether it is an OEM or CM, will experience cost inefficiencies and downtime when perfecting a process for maximum efficiency. This is especially true in SMT, where a minor design change can cause unforeseen and expensive problems when the device or product goes into production. Fortunately, a CM's experienced staff and validated processes can help mitigate these cost inefficiencies, as well as reduce time-to-market for new products.
The cost of direct labor (including payroll burden), the material content of the assembly and all non-direct costs associated with manufacturing must also be considered. Non-direct costs include plant and equipment utilization, the cost of inventory at the component level, inventory turns, and support functions such as supervision, engineering, purchasing and material handling (Table 1).
While plant and equipment considerations are straightforward, identifying overhead absorption and ascertaining the incurring levels of incremental cost necessary to support future manufacturing is more difficult. This is especially true in the SMT industry, where technology advances rapidly and new equipment is expensive.
Include Cost of InventoryCarrying costs of inventory are usually estimated at 1.5 to 2.5 percent of the average inventory dollar level per month. That works out to approximately 18 to 30 percent annualized, or $1.8 to $3 million per $10 million of inventory, including the cost of capital, vendor management, purchasing, receiving, inspection, storage, and issuing and returning material to and from the manufacturing floor.
Even companies that can finance inventories through internal cash flow have an "opportunity cost." For example, cash invested in a somewhat nonliquid asset may provide a better return on investment if allocated elsewhere (e.g., research and development or sales and marketing). Here again, outsourcing provides a financial advantage. By having the entire materials function focused on procuring, receiving and inspecting subassemblies, rather than on thousands of items at the raw material level, personnel capacity can be decreased, reducing the need for additional staff as the company grows.
Comprehend Manufacturing ComplexityWith an understanding of the true costs of manufacturing, OEMs are better prepared to judge whether the CM comprehends the complexity of an OEM's industry and the partnership. For example, is the CM asking the right questions? A CM that exclusively focuses on high-mix manufacturing must ask specific and numerous questions about labor (are there special assembly instructions?), materials (are raw board certificates of compliance required? Can alternate manufacturers or custom components be used?), test, inspection and quality requirements (are IPC-610A-Rev. B/Class II Workmanship standards acceptable? Is Good Manufacturing Practices (GMP) or ISO 9000 certification an issue?), and any special packaging requirements.
Analyze Quote's AccuracyAfter ensuring that the CM comprehends the OEM's manufacturing challenges, the next step is to analyze the accuracy of the quote. To do this, it is necessary to understand how CMs charge for their services. Activity-based costing (ABC), time-based costing (TBC) and contributive margin analysis are all commonly used models. Ultimately, the cost that the OEM should be most concerned with is the fully burdened cost of manufacturing. In the long run, understanding and comparing the gaps between the OEM's and CM's fully burdened manufacturing costs will provide the most accurate analysis.
In addition to discussing costing models, it is important to evaluate any immediate capacity restraints the CM may have, as well as its overall growth plan to accommodate additional capacity. The wise OEM will ask the CM what percentage of total capacity the newly outsourced product will require, as well as the percentage of capacity that is available for an increase in production.
Determine Level of TrustLooking past the quote to uncover "hidden" agendas is probably the most difficult task in the entire CAT process, as it requires trust from both parties before discussions of long-term strategy can take place. Trust is essential for the OEM and CM to share confidential product design and development data; it is also necessary for the OEM to conduct an efficient facility audit to ensure that the CM's systems and processes are consistent and compliant with GMP and other specific requirements. Competent CM providers understand the necessity for facility audits and do their best to cooperate, demonstrating their trust in the OEM.
As CMs must select their OEM customers carefully, OEMs must evaluate potential outsourcing partners just as carefully. An understanding of fully burdened manufacturing costs will help the OEM compare prices. However, price is only one element in the quote it is infinitely more important to choose a CM that is in synch with the OEM's product, marketing and financial strategies.
Comprehension, accuracy and trust are key elements to evaluate in an outsourcing quote. When the CAT level is high, the OEM can be confident that the CM will strengthen the value chain and improve profitability through a long-term, mutually beneficial relationship.
BRIAN TRACEY is vice president of strategic value chain management for EFTC Corp., 9351 Grant Street, Denver, CO 80229; (303) 451-8200; Fax: (303) 280-8358.