Contract development and negotiations and pricing models

By Mark Zetter

Contract development and negotiations can sometimes be 'new territory' even for the veteran technology executive developing and negotiating engagements with contract manufacturers.

The information below will help executives understand the different outsourcing contract types while perhaps provide insight into how executives might make better business decisions when going through the phases of contract development and negotiations to better protect their profits.

It is helpful to realize about 80% of outsourcing contracts can be categorized into four distinct types of outsourcing contracts:

Fixed materials pricing model
Component cost pricing model
Cost plus pricing model
Return on invested capital pricing model

Fixed materials pricing models 'lock-in' the material cost of goods sold (MCOGs) as a percentage (%) of program revenues. This type of outsourcing contract is quite simple for both the OEM and the contract manufacturer to manage.

Fixed materials pricing models have minimal overhead costs for the contract manufacturer (no re-quoting multiple OEM programs and, no need for resources and infrastructure to do so) This pricing model fits OEM outsourcing programs with:

similar types of product lines
similar product testing requirements
similar manufacturing volumes

With a fixed materials pricing model, the contract manufacturer determines his business development and acquisition ‘cost’ required to win the OEM’s outsourcing program by using a sampling of the OEM's products; (PCB-by-PCB, assembly-by-assembly)

Component cost pricing models are ideal for OEM executives with a mix of ‘consumer-type’ products (mid-level and high-level technology products)
With this types of pricing model, the contract manufacturer determines the percentage (%) he needs in order to make a profit while keeping his ‘cost’ below the ‘price’ he charges the OEM.

Cost plus pricing models are sometimes called fixed profit pricing models. With a cost plus pricing model, the contract manufacturer basically 'opens his kimono' to reveal and openly discuss all costs involved for the contract manufacturer to manage the OEM’s outsourcing programs, profitably, while the contract manufacturer (and the OEM) both take into account the OEM’s requirement to also be successful.

he contract manufacturer and the OEM then openly agree on a fixed percentage of profit for the contract manufacturer.

Return on invested capital pricing models (ROIC) are similar in scope to an activity-based costing (ABC) pricing model. Any of the components in an ROIC equation can be changed during the contract negotiations process to suit the contract manufacturer’s business model objectives.

It is important OEMs need to realize that by gaining in one area, they may lose something in another area:

Looking at the equation (below) net profit is money left over after all costs are recovered.

Plant, property & equipment (when the OEM outsources, P,P&E is removed and the OEM's ROIC increases) .

The return on invested capital pricing model is best suited for OEMs moving from a fixed-asset business model to a total variable-asset business model.

To see how the above equation for an ROIC pricing model impacts the component variables, take for example, motivation for a contract manufacturer willing to accept less profit in order for him to 'win' an OEM outsourcing program.

In this type of situation, the contract manufacturer is reasonable to require the OEM to accelerate payment terms (OEM accounts payable and contract manufacturer accounts receivable) for the benefit of the contract manufacturer.

Contrary to this, if the OEM customer wants the contract manufacturer to concede to the OEM better payment terms, the OEM might knowingly allow the contract manufacturer to increase its profit margin.

An important aspect of the ROIC pricing model to be aware of is that in uncertain business segment environments, most OEMs will not want to help expedite a contract manufacturer's accounts receivable, therefore, it would be reasonable for a contract manufacturer to expect more profit in the business relationship.

During any contract development and negotiation process with a contract manufacturer, OEMs should keep in mind the contract manufacturer's primary objective is to help make his OEM customers successful but not at the risk of losing profits, where possible.

Helping OEMs be successful and helping OEMs reduce the cost of doing business is how and why good contract manufacturers stay in business.

VentureOutsource.com, August 2006