OEM Inventory Liability: How Low Can They Go?
Manoj Nanda and Gerhard Plenert -- Supply Chain Management Review, 7/11/2008 12:00:00 PM
Since 2001, most of the high-tech Original Equipment Manufacturers (OEMs) experienced large inventories at either end of their supply chain. Many of them felt the pinch when the market took a nose-dive and their trading partners offloaded millions of dollars of Finished Goods (FG) and Work-In-Process (WIP) inventory. Since than only a few OEMs, such as Cisco, have actually changed their business processes and developed a systematic approach to deal with these eventualities. In 2008 the US economy is again facing the challenge of another mild recession. The lack of preparedness to tackle inventory liabilities can be a significant challenge. What should an OEM do to avoid this liability?
Industry Background
High-tech industry has undergone dramatic changes in the last 15 years. A majority of the large OEMs such as Motorola, Cisco, HP, Apple, etc. have redesigned their supply chain. They have outsourced large portions of manufacturing to third-party vendors. This transition has resulted in increasingly bulging revenues for upcoming pure-play contract manufacturers such as Foxconn, Jabil Circuit, Flextronics etc. known as Electronics Manufacturing Suppliers (EMS). Each of these vendors has significant assets in low-cost locations across the world and often serves as manufacturing partners for multiple OEM customers. An EMS seldom provides any kind of differentiated service and hence rarely holds much pricing power. Historically this has been a very low-margin business where survival mostly depends on exploiting scale and scope efficiencies in sourcing and production. Large OEMs usually wield tremendous clout over their EMS vendors and can easily switch partners with relatively low transition cost. These OEMs predominantly focus on product design and own the customer relationship. They also operate as the "Channel Steward"[1] in the end-to-end supply chain for their high-tech products.
Supply Chain Design
During the very early stages of the product lifecycle, engineers from OEMs collaborate extensively with their counterparts from component suppliers such as TI, Maxim, Samsung etc. to design the product and determine the supply chain. EMS also gets involved in the process to ensure DFM (Design for Manufacturability) and to validate that what is designed in the board gets translated into a feasible product. Production design is monitored to determine acceptable cost, quality and lead-time and other commercial terms. During this design phase, vendors of custom components such as ASIC’s, baseband etc. are identified and the terms of the trade are negotiated and documented in a contract. EMS engineers involved in the development are expected to use the components from these approved vendors. Finished products may also contain several standard items such as cables, boxes, passives and lamps, which are used by multiple OEMs. Contract manufacturers usually source these products directly from suppliers and negotiate the terms of the trade by buying in bulk. OEMs usually have limited say in this transaction except for vendor approval.
In order to manage the demand uncertainties and achieve an acceptable lead time, inventories are built into the supply chain at several nodes as indicated in the above diagram. OEMs usually own the finished goods inventory (if any) located at the EMS facilities and also at their own Warehouses. These inventories are reported directly in their balance sheet and its trend is religiously monitored using common metrics such as "Inventory Turns" and "Days of Inventory Outstanding." However deep down the supply chain, both EMS and component suppliers carry tons of components and assembled circuit boards in finished products. Many of these inventories are custom-built items exclusively meant to be used for a specific product of an OEM.
OEM’s Ownership Challenge
Production planning ensures that just enough inventories are built so that they get consumed during the lifecycle of the product. However when the market turns sour and demand does not materialize as forecasted, these components remain unused. Therein lies the question of who will take the burden of this asset devaluation. Today most contractual agreements in the high-tech industry allow EMS or Component suppliers to off-load these inventories to their OEMs at some point. EMS have a limited responsibility of holding the inventory up to some period but OEMs have the ultimate ownership. Consequently the OEMs own the responsibility to write off these inventories and take the loss to their bottom line.
Similarly when the finished goods move from OEMs to the Distributors/Retailers, the inventory gets transferred off the books of the OEM, except where some sort of a VMI or SMI agreement exists between the trading partners. However if the forecasted demand does not materialize, Distributors/Retailers usually have the rights to return the products back to their OEM vendors for a full refund. Alternatively, they can sell these finished goods at large discounts. Existing price-protection agreements often allow them to pass this loss to their OEMs who take this hit into their bottom line.
In these scenarios, inventory in the balance sheet of an OEM may not tell you the entire story. This is particularly true when the firm is trying to hedge against the risk of a significant drop in demand. The ultimate inventory liabilities for an OEM can be very large and can severely reduce the earnings. During the dot-com bust in 2001, Cisco wrote off $2.25 billion in inventory, mostly custom components and WIP. This was bigger than their year ending inventory of $1.2 billion in the balance sheet. Now in 2008 another downturn is expected and the OEM should be prepared to minimize the damage of another large inventory write-off.
Managing the Extended Supply Chain:
As discussed, OEMs try to optimize their own end-to-end supply chain vertically through Component suppliers and EMS players at the supply end to Distributors and the retailers in the customers end. At the same time, contract manufacturers strive to optimize their own operation by standardizing processes across multiple manufacturing facilities and by negotiating better contracts with their vendors. Since OEMs have the greater bargaining power over their EMS vendors, they invariably succeed in optimizing the chain vertically through multiple partners thereby creating EMS silos.
These silos (as depicted in the diagram) create a compartmentalized manufacturing process where OEMs often influence the production scheduling, sourcing, inventory planning etc. for their EMS vendors. These are some of the very processes which EMS wants to standardize across multiple OEMs for their own efficiency. However OEMs usually succeed and EMS vendors end up developing dedicated processes that allocate separate resources for planning and information systems supporting each of their OEM customers. In the end, the EMS organization looks more like an aggregation of several disparate manufacturing lines supporting each individual OEM with very little value-creating synergy.
This is counterintuitive to the objective of the OEMs who wanted their manufacturing partners to increase efficiency and reduce cost. The EMS business model became popular in the 1990's based on this premise of scale-related efficiencies which is not available to a single OEM with its own captive unit. As illustrated in the diagram, by pursuing their own agenda too far OEM's are potentially creating a very dedicated manufacturing line which operates as an extension of their own operation.
Historically, most of the manufacturing facilities of the EMSs were in fact acquired from their present OEM customers when the later decided to outsource their operation. Hence there are several inherent dissimilarities that exist among the numerous facilities of each of these EMSs. Over the last few years, EMS management is desperately trying to integrate these units with standardized processes and a common set of technology platforms. However a persistent pressure from OEMs to standardize their processes vertically across multiple EMS partners is a big stumbling block in this effort. This is one more reason why most EMS firms operate with a razor thin gross margin and are highly vulnerable to any downturn in the market. And in the long run this is not helping the OEMs who strongly depend on these trading partners to perform consistently without any failure.
While negotiating terms, OEMs should understand where the synergies are coming from and subsequently design processes which should not be counter-productive to the EMS business model. Otherwise they would disrupt the very reason why they adopted an outsourced manufacturing model in the first place.
Lessons Learned from the Toyota Production System (TPS)
Toyota has received worldwide recognition for its production planning and scheduling methodologies. TPS is both a collection of tools and a philosophy of relationships. Fundamental to the TPS methodology is the development of relationships internal and external to the organization. This includes interfaces with both customers and vendors.
TPS relationships must be based on trust. This requires two steps:
1) The elimination of non-trust systems
2) The establishment of trust systems
This is often very difficult in a traditional environment that is heavily contract-based. However, in many cultures, the verbal contract is more binding than the written contract. Contract requirements cannot be used as an excuse for non-trust. Non-trust systems are a characteristic of poor relationships. By developing trust rather than controls, inspections, and validations, OEM-EMS-component supplier relationships will result in accelerated response times and reduced cycle times.
The non-trust systems need to be replaced by trust systems like open-access information tools. For example, free, unrestricted information access needs to be shared between all members of the supply chain. Information access should include inventory status information, demand information, and scheduling detailed information.
As long as relationships are non-trust, and therefore adversarial, a smooth integration of the supply chain cannot occur. TPS can teach all players about relationship optimization.
Inventory as a Liability
Over last several decades, outside the world of accounting, Inventory has gradually moved from being an asset to a liability. High-tech OEMs--and for that matter any firm--cannot pursue reducing inventory while ignoring tradeoff avoiding stock-outs, particularly when demand is uncertain. A typical relationship between Investment in working capital (a proxy for Inventory) and the Customer-Service level are described in the curve shown below. Depending on the level of customer service desired (whether 85 percent or 95 percent), firms can plan a certain level of investment in working capital (Point WCA or WCB). Where should we operate on this blue line? And this is a supply chain strategy issue which is strongly tied to the business strategy. Depending on the product and its positioning in the marketplace, the customers would expect a certain service which would require a corresponding of investment in working capital based on this trade-off curve.
What the OEM’s can do?
In order to optimize inventory throughout the entire supply chain OEMs need to take an extended enterprise approach and take proactive initiatives to deal with these off-balance sheet liabilities. This approach must span from the component suppliers and EMS providers on the supply side all the way to the distributors and retailers in the customer side. They need to follow the five-step process described below:
- Start with the Contract: During the design phase, contract terms are negotiated and documented between the OEM and its trading partners. OEMs must carefully evaluate the terms of the contact and use this as the starting point to estimate the scope of inventory liability. Going through these contracts, they should determine their overall liability in the supply chain. They need to view total liability and not just the liability generated by current inventory usages.
- Ensure Visibility: Since OEMs have the liability for the component and WIP stocked by their trading partners, they should have appropriate collaborating tools to view those numbers and monitor the trend. Similarly they should also invest in systems that allow them visibility into the finished goods inventory at Distributor and Retailer locations.
- Develop Metrics: Standard metrics such as "Inventory Turns" and "Days of Inventory Outstanding" (DIO) are often calculated using book-value inventory and therefore fail to account for the total liability of the OEMs. A similar set of metrics needs to be developed for the entire supply chain based on off balance sheet inventory liability. OEMs need to regularly monitor the performance of the entire supply chain. The measures and incentives of the inventory managers should be tied to these Extended Supply Chain-based metrics rather than to the book-value of the inventory which does not provide a holistic picture.
- Communicate forecast: An efficient inventory planning requires the communication of the demand forecast. Access must be provided to the tier-1 and tier-2 suppliers for viewing the actual demand as far as possible. This would ensure a higher percentage of perfect orders and less opportunity for a pronounced bullwhip effect. Using XML-based technologies in a standardized format such as RosettaNet, such information can efficiently be shared across different technology platforms in use by the trading partners.
- Develop processes to react to Change in Demand: Finally, in order to respond promptly to a change in demand, appropriate processes need to be developed and agreed upon beforehand by trading partners. Then, when the actual event occurs, everybody knows how to react. This planning process is a critical step in defining the inventory and production management needs during the period of uncertain demand.
As OEMs proceed in their endeavor to optimize their supply chain vertically through EMS, component suppliers and Distributors, they need to be careful about undermining the business model of contract manufacturers. EMS players produce in bulk for multiple OEM vendors. This reduces the cost of manufacturing and shares this benefit with OEMs. The process of optimizing the supply chain vertically may result in a sub-optimal operation for the EMS and this can hurt everybody in the network.
Conclusion
The fluctuating economy is forcing awareness in OEMs for a need to increase visibility into their Supply Chains. Supply Chain relationships need to be improved. Inventory overstock problems have hurt them in the past when the market took a nose dive. The lack of preparedness to tackle inventory liabilities needs to be addressed. By using the tools and suggestions mentioned in this article, OEMs, as well as the entire supply chain, can prepare themselves for serious economic fluctuations.
Manoj Nanda and Gerhard Plenert are senior principals at Infosys.
[1] A "channel steward" is a player in the supply chain who is best positioned to look out for the interests of all involved and devise a win-win strategy. Source: “The Strategic Way to Go to Market” by V. Kasturi Rangan Professor of Marketing at Harvard Business School. Link: http://hbswk.hbs.edu/item/5459.html
View All Resources
