Is Your Pricing Model Right?
By Mark Zetter, Venture Outsource Group -- EDN, March 14, 2003
The contract manufacturing service agreement is the most important part of the relationship between the electronics manufacturing services (EMS) provider and the original equipment manufacturer (OEM).
It is not just an agreement between two parties. Outsourcing service agreements outline what one party will ‘give’ in exchange for some sort of remittance provided by the receiving party. The EMS provider is expected to provide goods or services to the OEM, in exchange for some sort of compensation provided in return by the OEM. Sprinkled in are rules of engagement that detail who; what, where, when, and how much.
EMS providers are motivated to pursue formal contracts with their customers because this re-assigns the risk to the customer (OEM) rather than the provider. Without a contract, typically the customer is not held liable for its forecast, so all purchasing or other spending that is done by the EMS provider is at the risk of the provider, with limited reward. This is the primary reason why the EMS provider pursues the contract more aggressively than most OEMs - because of the transfer of risk in the relationship that comes with the contract. Meanwhile, the OEM is interested in mitigating its supply chain exposure and risk.
Most providers are quick to establish and maintain contractual advantages
Well-managed EMS providers contribute significant internal forethought and discipline, focused on determining the actual and anticipated ‘costs’ of doing business with a potential OEM client program, well in advance of placing a contract service agreement in front that potential OEM customer for signature.
In addition to factoring the provider’s usual cost of doing business into a contract, providers will also solicit input from various internal cross-functional groups such as process and test engineering, production, program management, and finance; to mention a few. Individuals from these departments often have first-hand knowledge from either working with similar technologies or products within the provider or, from experiences with positions held previously with other contract manufacturing or OEM employers. This type of planning and input should not come as a surprise because once such costs are determined the provider is then able to manage its profit and margins more effectively.
Contrary to what some OEM executives believe, many OEM organizations that engage with an electronics contract manufacturer do not invest nearly a sufficient amount of time or resources when formulating and negotiating their contract service agreements.
One likely reason is that many OEMs do not understand how a sophisticated EMS business model is run.
Regardless of the OEM’s technology or marketplace, one can still hear many OEM board room conversations referring to full service global contract manufacturing organizations as ‘board stuffers’. This mindset needs to change.
When OEMs are being madly driven toward an outsourcing endpoint against a tightly-managed timeline or, more importantly, when they do not have enough internal outsourcing depth and scope, it will always serve the OEM best to take the time and carefully evaluate all phases associated with developing contract agreements.
Every supply chain director knows this. However, too few have the background or the time to invest in order to execute successfully. Some might say an outsourcing contract is typically only as good as the intentions of both parties who formulate it. This can be taken further by stating the success of the relationship (for both parties) is directly proportional to the amount of time invested and knowledge applied before actual negotiations begin. Initial stages of contract negotiations and the language of the service agreement are critical to the success of both parties. Some key areas where OEMs typically do not place enough attention during the contract development process include a common understanding between both parties on the language of the contractual terms and conditions as well as cost reductions and how they will be passed to the OEM.
Once a contract is signed, ideally it should be able to remain in a file cabinet with only periodic reference to it. If either party finds itself frequently pulling out the contract to review and contest terms and deliverables, it is likely the relationship is on a slippery slope and the lawyers will soon be involved. This is because one (or possibly both parties) did not perform due diligence beforehand.
Don’t get lost in the detail
Providers are here to provide services that fill a need in the marketplace. Regardless of any previous or existing relationships the OEM may have with the provider, the provider is in business to make money.
In most instances, unfortunately, OEMs feel they are getting a good deal as a contract reaches the point of a mutual understanding. Except for the medical sector, most OEMs tend to go for price only as the deciding factor when signing the dotted-line. This myopic view often ends in a very short-term relationship because in many instances, the EMS provider’s price may be below cost and is not sustainable. The reality is that the price per unit is important but it usually does not reflect the cost of a dynamic business model (opportunity costs) and as such poor decisions to engage are made daily which are in neither party’s interest.
At the end of the day, providers will continue to present contracts to OEMs enabling the provider to make a profit at the expense of the OEM. This is reasonable. The provider wants to charge as much as possible while also convincing the OEM to sign the contract. Conversely, the OEM wants to pay the provider as little without the provider walking out on the deal. In some way, both parties want something neither can have, simultaneously.
What happens in between determines how good the relationship will be.
