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An old adage suggested, “You can have Quality, Low Cost or Quick Delivery, just not at the same time.” Lean and other continuous improvement practices have proven this to be generally inaccurate. Still, the challenge remains to achieve all three consistently while simultaneously dealing with increased regulatory and material costs, pass-through pricing pressure from hospitals and buying groups and global sourcing strategies. However, there are ways, even in challenging times, to reduce cost and lead times while maintaining or improving margins.
Identify and Address Cost Drivers
Whether you’re an OEM or a contract manufacturer, margin preservation is critical to your business success. To accomplish this, price reduction concessions must include equivalent cost reductions. Regulatory concerns and change control restrictions may make modifications to material—or in some cases even design for manufacturability—impractical, and so may not be a means to address this. Therefore, it is important to identify all cost drivers, not just the material-related ones. Two areas in which improvements can lead to non-material based savings are overhead leverage through improved capacity utilization and collaboration.
Leverage Overhead through Improved Capacity Utilization
One of the greatest challenges for a contract manufacturer is smoothing demand to avoid over commitment, or allowing equipment or staff to be idle through the typical demand curve, which can be a sawtooth cycle of demand that exceeds capacity, or not enough work. In addition to the impact that this has on overhead leverage and capacity utilization, it leads to erratic lead times and impacts margins with overtime and expediting. An important consideration to this end is to monitor and balance your equipment investment and staffing level to suit your business plan. Unfortunately, neither of these can be increased or decreased easily in the short term. The real challenge, then, is how to smooth demand and meet the delivery and cost requirements of the OEM while remaining competitive and profitable.
One solution that works to the benefit of both parties is to move from a purchase order-to-purchase order (PO-to-PO) strategy to a supply agreement that incorporates capacity management and projected demand in its terms. In its most basic form, the parties agree on a lower and upper capacity commitment. This commitment strategy gives the OEM the assurance of a consistent minimum or staged manufacturing schedule during periods of high demands, such as a new product release, with neither of the parties having to pay for overtime or expedited delivery. For the contract manufacturer, in addition to the smoothing of high demand, periods of low demand can be used to build semi-finished items or components for future assembly and complete some pre-agreed maximum quantity to be purchased by the OEM in the future.
Even though it includes cost to carry for the supplier, when managed well, this strategy is often a lower-cost solution then allowing equipment to sit idle and cost of expediting; it also offers significantly reduced lead time for the OEM on future orders. For this strategy to work, however, the OEM and the supplier must engage in meaningful cost-focused collaboration.
Collaboration
Not to be confused with open book negotiation, cost-focused collaboration requires only that the parties agree on what the cost drivers are for the products to be purchased, and which of these they can work together on to minimize or reduce. Savings from this collaboration, when accomplished, are shared between the parties and realized via reduced invoice pricing. This results in lower costs for the OEM while preserving margin for the supplier. Examples of collaboration that have resulted in savings are:
- Coordination of delivery to support staged releases rather than a single, very large delivery. This collaboration is most often associated with new product kit releases. For some companies, this could be a major paradigm shift from a “Won’t release unless I have 100% of total market requirements on hand” to a coordinated delivery for release strategy that matches the suppliers delivery commitment with the actual release timeline, which is often over a period of time, not all at once. For the supplier, delaying a portion of the total delivery for as little as four to six weeks can enhance their equipment and labor scheduling, reduce total cost and significantly reduce risk of missed or late deliveries. This savings must offset the potential increased cost to the OEM for inspection of multiple deliveries reduced by the savings from avoiding the internal expediting cost often experienced with these large volume orders and risk of missed deliveries.
- Providing projected demand to let the supplier plan and smooth its manufacturing schedule, which will improve capacity utilization and cost as well as stabilize and often reduce delivery lead time. This is most relevant for post-release instrument requirements, which some may say are not “forecastable. The alternative is reliance on PO-as-needed purchasing which, other than volume based tiered pricing, offers little opportunity to reduce price or lead time. In a number of cases, it has been found that by using historical information on similar instrument replacement requirements, you can project this demand and establish guidelines to minimize risk for both the supplier and the OEM.
- In addition to providing projected demand, you can develop a simple pull-based replenishment report that can be updated frequently and shared with the supplier. Real time usage information, combined with minimum inventory level guidelines and blanket orders, can reduce lead time and risk of stock outs and expediting. This can be completed without capital investment using your ERP system combined with commonly-used business software.
- Engaging suppliers early in the design phase for items that will be outsourced, when design for manufacturability can be incorporated into specifications and drawings. This has become more critical for achieving optimum invoice pricing as the “cost” of making post-release changes has risen. When implementing this strategy, parties must agree on what price would be without this effort without gaming the system, as well as agree on how to claim and get credit for the savings attained.
Supply Agreement Considerations
All of the above initiatives require that the OEM/Supplier relationship move from a purchasing-based to a relationship-based system of collaborative business interaction. The terms and basis of this relationship are best captured contractually with what is generally referred to as a master supply or service agreement. In addition to the terms and conditions to cover liability, intellectual property, indemnity and other legal concerns, you should include terms specific to the cooperative business relationship. These typically include:
- OEM obligation to provide forecasts on a regular basis. This should specifically state that the forecast is not a commitment to purchase, but may include a binding period equal to the typical delivery lead time in which the OEM can increase the forecast by a maximum percent equal to the supplier’s capacity flexibility as well as a lower percent reduction limit, so that the supplier can schedule more effectively.
- Statement of commitment to collaboration between the parties with specific timing, such as annually, and areas to be reviewed, such as cost reduction, lead time reduction and supply chain enhancements, all focused upon achieving year-over-year price reduction while maintaining or improving margins.
- If included, terms concerning supplier and OEM risk of forward building based on projected demand, e.g., prior to PO, which minimizes financial risk to both parties and substantially reduces lead time from PO issue to receipt.
- How to manage early engagement with supplier in design phase which does not violate the OEM’s purchasing policy and assures that pricing resulting from this engagement is competitive. This may include engagement selection based on prior competitive RFQ and performance and understanding that the final design may be used for competitive RFQ with a defined allowance to cover the participating supplier’s initial investment in that design.
- Unless there is an underlying business reason, there is no guarantee of a minimum annual purchase, but if based on process efficiency and price concession, a minimum order or batch quantities are acceptable.
In summary, OEMs and suppliers can reduce cost and lead times while preserving or improving margins by using numerous initiatives that do not require material or design changes. These require a cost-focused collaboration commitment to be incorporated into the terms of a master supply or service agreement.
In addition to author and speaker, David Finch is President and Founder of Insight Collaboration Partners, a consulting group that assists companies in M&A supply chain due diligence and post-acquisition integration, strategic partnering, improving collaboration & operational efficiency and lowering supply chain cost. Mr. Finch has more than 30 years of hands-on experience in global supply chain and manufacturing operations in the medical device and orthopedic industries with Becton Dickinson, Johnson & Johnson, Wright Medical and MicroPort Orthopedics.
