How to Prevent Business Killed by Wrong Cost Assumptions?

The manufacturing cost is usually one of the first things to consider when making a new product.

Most of the fresh business owners would plan their spending budget based on quotes provided by suppliers. Looks like a feasible plan, especially when there aren’t professional resources to evaluate product details. The question is – can you afford the gap between the assumption and actual cost?

Another common practice is to calculate cost by comparing similar products, from potential competitors in the marketplace. This is an effective way to get rough estimates.

However, be aware, there is a huge variance in manufacturing complexity, processes, quality requirements, or quantity change. If your supplier tends to be a mismatch, the result can be quite different.

So, how can you prevent your business from being killed by wrong cost assumptions? Here are some head-ups that you should pay extra attention to.

1. Materials Cost

Getting quotes from unqualified component suppliers

  • In today’s world, asking for quotation is quite easy; search suppliers online, send request, collect feedback, done! Can the supplier be trusted? Will promises be kept after placing order? How to verify that? If you have these concerns in mind, take time to verify the supplier, before you move on to quotation analysis stage.

Electronics components prices change from time to time

  • You probably have noticed electronics components prices are changing constantly, depending on raw material stock, life cycle, technology breakthrough, or other situations. It’s suggested to leave a reasonable buffer. Meanwhile, keep an eye on the price trend.

Customized parts price varies due to design change

  • Customized parts cost more than standard parts as they are dedicated for your project. If ordered prior to design verification, it’s very likely that they will soon become valueless and scrapped. So be cautious at the design stage. You should better test everything before the design is locked. The more mature the product design is, the less risks you’ll face.

Same product, same price?

  • Certainly no. Cost is highly related to volume, so getting the same offer for 20 pieces and 20,000 pieces is impossible. This is because all cost factors are amortized in one order. That’s why it’s recommended to get quotation with different volume scenarios.

2. Labor, Overhead and Profit

Lack of cost breakdown and transparency

  • As emphasized many times, breakdown is critical for review and verification. You can also seek cost down opportunities with data provided.

Different regions, different labor cost

  • The minimum wages for manufacturing sites are different. Let’s take south China as an example. In 2017, the minimum wages in Shenzhen is 2,130 yuan, Dongguan 1,510 yuan and Guangzhou 1,895 yuan. But these numbers don’t mean manufacturing in Dongguan is definitely more cost effective than that in Shenzhen, and the difference will be taken into account to make a quote.

The difference between tier 1 and tier 3 manufacturers

  • The calculation is also in line with the size of the manufacturer. In short, tier 1 manufacturer is more likely to employ advanced machines, hire seasoned team, and develop integral process. At the end of the day, all these will be combined into expenditure and charge to customers. Normally the difference can be around 10-20% upon BOM cost.

Manufacturing process, testing methodology, cycle time matters

  • Similar products don’t mean product with similar functions, but similar ways of how they are produced. How does the supplier understand the whole process, allocate resources on work stations will be directly reflected in the final cost. Therefore, don’t be surprised with data delta. Understand production process, and make sure you and your suppliers are on the same page.

Different quality requirements, different prices

  • Product positioning is another fundamental element to cost. If you have a craftsman spirit, and are targeting high-end market, you are requesting higher quality assurance; that is, more skilled operators, more thorough tests as well as more strict inspection. As a result, the cost is up accordingly.

Typical LOP rate

  • Although LOP rate alters, you can still take the following typical practice as a reference:
  • PCBA: 6% – 8%
  • Toys: 12%
  • Consumer Electronics: 15% – 20%
  • Medical: 20% – 40%

3. Non-recurring engineering (NRE) Cost

Start tooling without DFM

  • Needless to say, DFM is a crucial step to anticipate tooling modification cost risk.

Don’t forget trial run cost

  • Always leave buffer for trial run investment, make budget on 2nd source materials qualification.

4. PPV

Lack of materials planning

  • Sit down with the supplier, look into whole project milestone to go through all materials lead-time, focus on long lead-time parts. You can purchase by yourself or work out a strategic plan with them or their distributors to reserve some buffer stock or capacity for you, at least prepare raw materials to shorten lead-time.

No PPV control documents and procedures

  • Before working with the Contract Manufacturer, it’s essential that both sides agree on a PPV claim principle in written form. Ideally, such claim should be one of the clauses in Manufacturing Service Agreement (MSA). In normal practice, PPV report is reviewed before it actually takes place, weekly review will help you identify PPV risks, analyze root causes and figure out what actions can be done in advance.
  • Read Purchase Price Variance (PPV) – 5 Pitfalls You Should Know to find useful practices to reduce PPV.

5. Excess & Obsolete (E&O) Cost

E&O cost arises in various situations. For instance:

  • Engineering changes
  • NPI build failure goods (Not because of workmanship)
  • Demand downside
  • Minimum Order Quantity (MOQ) or Minimum Packaging Quantity (MPQ) requirements
  • End of Life (EOL) materials/components

A proactive procurement and fulfillment strategy can significantly reduce material waste. When the strategy is formed, work together with your supplier for the most economic approach – transfer to other projects, return to distributor, resell, or others.

Now you have some idea of what kind of investment is necessary, you must still include all the other costs to run a project – for example:

  • Logistics
  • R&D
  • Employee payroll and benefits
  • Operations expense (office rental, administration, traveling)
  • Sales and marketing
  • Royalty fee
  • Licensing fee

Beginners are often encouraged to adapt a more conservative approach in terms of cash flow projection, as there are so many items to be covered (expected and/or unexpected). More importantly, a business can be killed easily because of time difference between paying for products and achieving revenues.

Typical Chinese contract manufacturer (CM) payment terms for new customer:

  • Product: 40-70% at material authorization (MA), balance payment on shipment.
  • Tooling: 50% at tool start, 50% at engineering pilot qualification.
  • NRE: 50% after signing contract, 50% before tooling.
  • Fixtures: upfront payment.
  • Retail: differ from net 30 to 120 days.

Manufacturing cost management is a never-ending exercise. Companies continue to find new ways to maximize value with less cost. Setting up proper estimates to reduce risks effectively takes a lot of thoughts and planning. Meanwhile, keep in mind that cost estimation is part of your production strategy that involves many considerations. Ultimately, it should fit your own business needs.

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