Chapter 9: PLAN SECTION 4: MANUFACTURING OR METHODOLOGY

CHAPTER 9

Plan Section 4: Manufacturing or Methodology

I HAVEN’T FAILED. I HAVE JUST FOUND 10,000 WAYS THAT DON’T WORK. – EDISON

MANUFACTURING INVOLVES A WIDE VARIETY OF ACTIVITIES dedicated to the commercial production of the company’s physical goods in quantities and at rates consistent with market demand for the products. Although research and development can be quite expensive, manufacturing also represents a significant cost to the company, and every effort should be made to reduce manufacturing costs so that the company can obtain a pricing advantage over competitors. Some of the activities during the manufacturing and production stage include: ■ The construction of manufacturing facilities and related equipment ■ The design and implementation of quality control procedures ■ The development of a distribution system (i.e., shipment and warehousing processes) ■ The creation of customer assistance schemes ■ Contracting for procurement of parts, raw materials and other production items A service provider will be faced with many of the same issues as a manufacturer. The primary distinction will be the focus on the methodology of services instead of the manufacture of products. A service provider may need training facilities, educational procedures, continuing support for improvement of services and quality control, a distribution system, customer assistance program and a means for procuring the materials necessary to support the provision of the services. Often, a service provider also sells goods in connection with the services, in which case, manufacturing issues also will come into play.

Business Plan Disclosure Issues

The business plan should describe how the company intends to manufacture its goods or establish its service methodology, and how it will distribute its products to customers or into appropriate distribution channels. The following issues should be addressed:

■ Will the company retain its manufacturing of goods or methodology of services internally or subcontract with others for all or part of the process? If the company will be subcontracting, does it plan to develop internal capacity in the future?

■ Does the company or its subcontractor have manufacturing or methodology advantages in relation to the company’s competitors? If so, how long can those advantages be exploited and how are they protected? ■ What is the company’s current manufacturing or methodology capacity? Is it sufficient to meet the requirements of the company in the future? If not, what plans does the company have for expanding such capacity and what costs and risks are associated with such plans? ■ What are the critical parts or components in the manufacturing or methodology?

How are these parts or components acquired or derived? Are any of them “singlesourced,” or does the company have several suppliers or resources? What lead times are required to obtain the parts or components or to train service providers?

How does this delay impact the ability of the company to meet increases in demand? ■ What are the standard costs for manufacturing products at various volumes or of establishing the methodology of services at various amounts?

Internal Manufacturing or Methodology

Many companies prefer to rely on their own internal facilities for production.

A company may establish its facilities in a single location or may set up facilities in multiple places to take advantage of reduced costs and to provide products in close proximity to the actual markets. For example, if the company develops a large market for its products in a foreign country, it may decide to manufacture or train local residents to provide services there to satisfy local demand as opposed to importing products or employees from remote locations.

A company’s internal manufacturing or methodology strategy must address the following key issues: ■ Can an internal process achieve costs that enhance the profitability of the product?

Management must consider on a per unit or sale basis the initial investment required to establish the facility, the overhead costs associated with operating and maintaining it and additional operational costs. In many cases, it may be cheaper to outsource.

ADVISORY: Both manufacturers and service providers should consider implementation of Activity Based Costing (ABC) techniques as early as possible in the processes. This form of cost accounting provides “true” per unit cost figures since it traces overhead usage to individual products rather than assigning overhead on a production volume basis.

■ Can the company develop proprietary processes? Processes that can be patented create significant competitive and cost advantages as well as revenue opportunities through licensing. In this regard, an added advantage in the service sector is the availability of business method patents in some countries. ■ Can automated equipment be used to reduce and/or control production costs (e.g., manufacturers use assembly line robotics, services use interface technology such as ATMs)? Can a methodology be largely learned by self-instruction? Companies may achieve significant cost economies by automating these processes, particularly if the automation process is also proprietary. ■ Can the company take advantage of low cost materials and/or labor? A primary

attraction of establishing a wholly-owned foreign production facility is the ability to access lower cost inputs to the production process, including raw materials (e.g., petroleum refineries) and workers (e.g., Bangalore’s computer programmers). The downside is that training costs may be significantly higher.

The business plan should contemplate the development and use of productivity programs focusing on ongoing strategies for reduction of manufacturing and methodology costs and increased productivity in future planning periods. In addition, if the company elects to adopt a global strategy for its manufacturing or methodology, systems must be established to monitor the quality of the goods produced or services provided throughout the organization. Otherwise, the apparent cost savings will be worthless if the products are sub par, have significant defects or require extensive post-sale support.

Third Party Production Arrangements

Some companies invest in their own facilities (sometimes to take advantage of lower costs of foreign labor and materials), but another common arrangement is to enter into various production and supply arrangements with third parties.

These arrangements are ongoing contracts pursuant to which a firm agrees to manufacture or otherwise procure specified goods or services for sale to the buyer to be resold by the buying firm in its own business operations.

The basic form of production and supply arrangement requires that the buyer deliver orders for the products over the term of the agreement. Those orders will be accepted and filled by the third party producer in much the same way as a longterm sales contract. The contractual terms of these arrangements can be quite complex, with variations triggered by the term of the agreement and the company’s volume and delivery requirements. For example, a production and supply agreement should always include the following items: ■ Description of the products ■ The manner in which the products are to be priced ■ The manner of delivery of products and any requirements with respect to shipping and insurance ■ The specific requirements of the buying firm with respect to performance and content of the products ■ The form and timing of payment and related credit arrangements ■ Any warranties and limitations that might be imposed on the respective liabilities of the parties to the agreement

TYPES OF PRODUCTION AGREEMENTS Several variations on the basic form of a production agreement are described here.

■ CUSTOMIZED

Production and supply agreements often cover products that are already in commercial production, although such arrangements may also be appropriate when the product has just been created and the developer is seeking assistance to produce in sufficient quantity to begin marketing activities. Such an agreement to

produce will focus on the specifications of the products and will generally provide for the seller to produce a prototype acceptable to both parties before large-scale production begins. The parties will typically limit the projected production levels for an initial period, pending feedback of market acceptance. A somewhat looser form of customized production arrangement is a long-term contract under which the seller is limited in its choice of vendors for supplies necessary for the production covered by the contract. Such an arrangement may not include unique specifications, but the purchaser is looking for mechanisms to assure the consistency of products purchased over the term of the contract.

■ REQUIREMENTS CONTRACT

A requirements contract is an agreement on the part of the seller to provide all products that the buyer may request during a specified period of time and at a predetermined price, whether fixed or periodically adjusted. The essence of a requirements contract is that the buyer agrees not to purchase similar products from any other party, although the seller may be free to sell the products to other customers. However, if the seller is unable to meet all of the buyer’s requirements, the buyer has the right to purchase elsewhere or terminate the contract. Pricing of products sold under a requirements contract will vary with the volume of purchases, and the buyer usually has a right of termination in the event of price increases by the seller.

■ OUTPUT AGREEMENT

An output agreement involves an undertaking by the producer to sell its entire production to the buyer in return for the buyer’s commitment to take all the output. Each party’s obligation under an output agreement will continue only for a specified period of time. In general, the law imposes a good faith obligation on the parties to such an agreement. This obliges the seller to sell what it produces in good faith and, thus, cannot tender a quantity either far greater, far less or unreasonably disproportionate to a stated estimate. If there is no stated estimate, the law generally fills in by assuming the parties would have intended the output to be in an amount that is “normal” or comparable to prior output (for example, based on output during the prior years of the agreement).

■ ORIGINAL EQUIPMENT MANUFACTURER AGREEMENT (GOODS ONLY)

Another common form of manufacturing relationship, and one that is especially popular in global markets, involves a seller and a buyer who is an original equipment manufacturer (OEM). An OEM relationship combines elements of manufacturing and distribution functions. The seller will agree to sell goods to the OEM which, in turn, will add some “value” to the goods, such as enhancements or new applications, and then sell the “value-added” products to its own customers. An OEM agreement usually involves detailed negotiations over the specific requirements of the OEM with regard to the products as well as the terms on which the products will be sold to the OEM. If properly structured, an

OEM relationship can provide a smaller firm with a significant customer for its products at a time when it may be struggling to develop its own distribution network and stable of customer accounts.

In OEM arrangements, the seller may agree to provide additional service and maintenance on the products delivered to the OEM, and the scope of these services

may be included in a separate form of service and maintenance agreement. An OEM relying on products that are to be furnished by the seller over an extended period of time may require that the seller deposit certain technical information and source codes in escrow. This will protect the OEM in the event that the seller should default under its obligations to continue to supply the specified products to the OEM. If there is a default, the OEM would have the right to access the escrowed materials and commence manufacturing the goods covered by the agreement without the need for further consent from the seller.

LICENSE TO PRODUCE AND DISTRIBUTE A developer or owner of a product line (goods or services) may grant a license to another party to produce and distribute them as finished products to customers.

In return, the licensor would receive a royalty based on some measure of the producer-distributor’s performance, such as the quantity sold or the net proceeds it receives from the sale of the products. This type of relationship, which will include contractual provisions typically found as part of a distributorship arrangement, may be attractive if the producerdistributor can produce at or below the costs that would be incurred by the licensor. Similar benefits would be derived if the products needed to be adapted to conform with specific local requirements of the country or region where they are sold by the producer. A license for the conduct of both activities can be costeffective, but the licensor may be rightly concerned about losing control of the licensed technology or methodology.

LICENSE AND PRODUCT PURCHASE AGREEMENT An interesting hybrid form of production arrangement is a license and product purchase agreement. This arrangement involves the grant of a license for the production and sale of goods or services developed by the licensor, coupled with an agreement for the sale of a specified number of the licensed products by the licensee back to the licensor at the best prices offered by the licensee to its OEMs and/or resellers. The licensor obtains revenues from the sale of the products by the licensee, and also obtains a guaranteed source of the licensed products that it can resell to its own customers. In turn, the licensee effectively receives a guaranteed purchase order to help defer some of the initial costs of “ramping up” for large-scale production of the licensed products.