Optimizing Supply Chains to Improve Financial Performance 1371

GUIDE TO OUTSOURCING

William L. Burton said, “If you do not like the past, change it.” If we take anything from history, it is that we can learn from mistakes or figure out how to make things better. Nearly 30 years ago, the contract manufacturing industry began to help OEMs in the telecommunications, computing, consumer, and automotive industries redefine business models to enhance their financial performance. As in the medical industry, the manufacturing needs of these industries cover a wide range of production volumes and product complexities.

Most contract manufacturers have now adapted to the most challenging low-volume, high-mix production situations, making them capable of addressing medical device manufacturing needs. The best contract manufacturers have also adapted rigorous quality standards, which has enabled them to meet traceability requirements dictated by the medical device regulatory environment.

By outsourcing part of their supply chain, electronics OEMs have become more cost-effective and more competitive. Today, the medical device industry is experiencing many of the same trends that affected other industries decades earlier. Medical OEMs are seeing that they too can improve financial performance and competitive positioning through an optimized supply chain.

What are today's trends, and how are they shaping the business landscape for medical device firms? Four major trends are taking place:

• Significant cost pressures are coming from group purchasing organizations and government payees, including new reimbursement programs such as the pay-per-use model.

• A convergence of the three elements of an end-solution medical device supply chain—the pharmacological, the disposable, and the hardware (often referred to as the box)—into a single end-to-end supply chain requires medical device companies to rationalize what is core intellectual property (e.g., the pharmacological or disposable elements) and what is noncore (e.g., the hardware), as well as what is the core process for each element (typically product development and marketing, not manufacturing).

• Home-use diagnostic and monitoring devices—consumed in the millions compared with the hundreds that are used in labs and hospitals—are necessitating a shift in design and manufacturing to an almost consumer electronics modality.

• Manufacturers need to increase the number and rate at which new products are added to the product portfolio. This requires significant increases in R&D spending from the current industry average of roughly 6–7% to approximately 12%, according to several recent analyses, including JP Morgan's “Medical Equipment & Solutions,” Global Equity Research.

These trends are driving medical device companies to look for outsourcing partners that can safely assimilate large portions of their supply chain. Critical to selecting a partner are such long-term relationship factors as regulatory expertise, new product introduction, global footprint, and the ability to optimize the supply chain for the OEM's competitive advantage.

Financial and Operational Analysis

Because of the complexity of the products and the stringent safety requirements imposed on medical devices, most medical device OEMs operate with gross margins in the 50% range or higher, according to research by Reuters and independent industry analyst firms. Yet unless they are part of a large conglomerate, they typically receive only a marginal market cap.

The reason for this discrepancy is that Wall Street increasingly is rewarding high-asset-velocity companies such as Cisco, Wal-Mart, and Dell. Asset velocity is the speed with which companies make a product, turn over inventory, or deliver the product to customers. Asset velocity tends to increase as fixed costs in the supply chain are transformed into variable costs. Transforming fixed costs into variable costs is a major financial benefit from supply-chain outsourcing.

Three cost levers come into play when an OEM is considering outsourcing to a contract manufacturer.

Cost Lever #1: Cost of Goods Sold (COGS) that Affects Profit and Loss. The majority of the average cost of a medical device (commonly understood within the device industry as roughly 65–70% of the total) is for materials. One way to categorize a medical device bill of materials (BOM) is to break it into red, yellow, and green items. Red items are those that cannot easily be outsourced because they are either custom-made or sole sourced. It is typically very hard to move red BOM items to yellow or green because of the unique nature of red parts. Green items are those that can be easily sourced elsewhere. Yellow items are those for which the contract manufacturer can suggest substitutes but would require OEM sign-off for various reasons.

Medical device OEMs should look for two forms of cost savings from their contract manufacturers. The first cost savings is found in cost reductions based on a partner's buying power—the contract manufacturer buys in much larger quantities and so typically enjoys cost advantages on most common components. The second form of cost reduction is dependent upon the contract manufacturer's supply-base locations. It is generally believed that 75% or more of all medical devices are made in high-cost areas, including North America, Europe, and Japan. The opportunity to move a device's supply base to a low-cost country offers significant long-term COGS advantages that can be projected over the long term.

Cost Lever #2: Assets Affecting the Balance Sheet. One way to transform fixed costs into variable costs is to rationalize assets either by repurposing them to higher value work such as new product development, by assimilating acquisitions, or by eliminating costs altogether through asset divestitures. Some contract manufacturers will work with OEMs to take over property, plant, and equipment (PP&E) and either incorporate these assets into their own asset base or dispose of them over time.

Usually the medical device OEM enjoys a one-time balance sheet improvement when inventories are transferred or machinery and facilities are disposed of. Many OEMs find that the cash released from an asset rationalization and invested in another program (usually a new product to be released or an acquisition) significantly enhances long-term growth of the company.

Cost Lever #3: One-Offs. One-off savings don't fall into any particular category that can be manipulated to improve financial performance. Examples include restructuring monies and performing engineering work that takes costs out of a product or repurposes an old product for a new use or market. These financial benefits may be on or off the balance sheet and may affect profit and loss, too. Usually an ongoing stream of benefits will accrue when the relationship between an OEM and a contract manufacturer deepens as collaboration occurs with product management, R&D, and finance. Of course, commensurate with these financial benefits should be operational benefits to the medical device OEM. There are three areas in which operational benefits accrue to medical device OEMs from outsourcing the supply chain.

Managing the Supply Base. Most top-tier contract manufacturers manage and control material spending much more tightly than OEMs. Commodity managers use sophisticated tools to mitigate risk in the supply base and to negotiate long-term cost reduction plans from suppliers. Effectively managing complex supply-base issues is a significant benefit to an OEM that uses scarce resources for new products that generate the majority of the company's revenue. Consider challenges such as the switch from lead components to lead-free components or the need to make end-of-product-life purchases. Other challenges could include providing the engineering talent to redesign printed circuit boards from through-hole to surface mount and then having them validated. A contract manufacturer can often manage these issues much more effectively than an OEM.

Operational Excellence. A contract manufacturer's operational excellence benefits the medical device OEM because ultraefficient facilities use the latest manufacturing techniques as well as processing methodologies such as lean manufacturing and six sigma. Although typically not a core competency of an OEM, efficient operations should be a core competency of a contract manufacturer. Contract firms make their money by focusing on executing manufacturing processes at a lower cost (combination of speed, leverage, and process focus) than an OEM, whose primary focus is on product development and product portfolio management. In other words, for OEMs, money is made on the value of a product, not on process excellence.

Postmanufacturing Services and Support. A combination of the first two benefits can be provided by a contract manufacturer that can manage a supply base of repair parts and inventory and perform remanufacturing and refurbishment activities. Access to this capability is essential to device OEMs that want to improve yields and product performance and differentiate themselves in the competitive world market.

Fundamentals of Outsourcing an OEM's Supply Chain

Medical device supply chains are more complex than those of many industries. The traditional model of contract manufacturing was focused on the product build portion of the process. It consisted of a contractual supplier-vendor relationship in which the OEM provided the BOM and the approved vendor list (AVL) and asked for bids to build the component or subassembly for less than the OEM could. Recently, the calculus changed because OEMs began asking contract manufacturers to use their AVL to determine whether they could procure the materials for a lower cost.

When it comes to outsourcing engineering, there are new offerings on both sides of the product build process. For example, design for manufacturability is on the front end of the build process and the redesign and repurposing of older products—often referred to as product life-cycle stewardship—is at the back end. To date, outsourcing these tasks is unusual in the medical device industry. As part of the highly vertical business model, device OEMs have provided their own product-sustaining engineering. When they do outsource engineering, it is usually as part of a new product design, and traditionally it's been to very small boutique-like engineering firms.

As product-driven companies, medical device OEMs generate most of their revenues from creating new and better products that solve healthcare problems. Therefore, the core competency of an OEM should be the design and introduction of new products that enter the market expeditiously and preferably at a lower cost point. It should not be in designing and managing an optimized supply chain.

Dividing the R&D process into its constituent subcomponents of concept, prototype, and new product introduction makes it easier to see that OEMs tend to spend most of their R&D dollars on development rather than on research. And they spend an inordinate amount of time getting products launched. It is commonly understood that, on average, it takes 36–42 months to bring a new product to market. Clearly, this is an area where outsourcing yields considerable financial benefits. Companies are asking for help with prototyping and new product introduction engineering work, thus freeing up scarce engineering resources for work on the concept or breakthrough part of R&D.

The last part in a supply chain is fulfillment. Fulfillment includes the delivery of the product to the end-customer. Brazil, Russia, India, and China represent major growth markets, and locations such as Africa characterize emerging markets with large potential for repurposed products. Meanwhile, the manufacturing of medical devices more frequently is taking place in low-cost countries. The need to understand and manage international logistics traffic is an essential element to having the lowest total landed cost. A contract manufacturer should provide complete logistics support for an OEM and calculate the lowest total landed cost using its global footprint of supply bases and facilities.

The Risks: Assessing Readiness for an Outsourced Business Model

Although the hypothesis is that outsourcing improves overall company performance both financially and through market leadership, there are risks inherent to rationalizing a change to the supply chain that would require a fundamental change in a company's business model.

It is possible to create a relatively straightforward assessment of a medical device company's outsourcing readiness quotient by defining it as a leader, a laggard, or a follower.

Leaders. Leaders are OEMs with executive teams that have thought through their business model in light of trends affecting their business. They have made a deliberate decision to structure their company around core competencies and work with a contract manufacturer.

Laggards. Conversely, laggards are those companies that believe they are impervious to industry trends and, therefore, do not need to take any action to modify their company's business model.

Followers. Lastly, followers know they must respond to industry trends but do not have a plan to make the transformation, and worse, usually wait for some significant negative event to push them to begin the outsourcing process.

Although an OEM can engage with a contract manufacturer at any point along the leaders-to-followers continuum, leaders tend to realize the greatest level of benefit through an outsourced partnership. They have the ability to engage early and with specific business metrics in place.

Here's an example of how to assess the readiness quotient based on real examples from OEMs. Company A designs, builds, markets, and supports highly complex diagnostic equipment. It is financially solid and a market leader in several of the segments in which it competes. The management team grasps the market trends that could negatively affect its business and engages in a deliberate process of evaluating contract manufacturers, their capabilities, and company management styles (versus their own), and performs both financial and operational due diligence. The goal is to assess the current state of their business and determine where they want it to be in five years to remain a viable player in their markets.

Working with this company, a contract manufacturer endeavors to create a detailed product and financial road map that delineates product transfers, PP&E rationalization, and restructuring. In collaboration with product management and the executive staff, the contract manufacturer works on initiatives for new markets and product portfolio extensions that fill the financial and market leadership gaps. Together, the OEM and contract manufacturer build into the road map a detailed risk analysis. It includes the accompanying gates to limit the company's exposure and to help meet or exceed Wall Street expectations. The entire transformation is treated as a special project reporting to the executive committee with CEO oversight. Because of the level of planning and collaboration with the contract manufacturer, the entire road map is accelerated, increasing the financial benefits, usually over an 18-month period.

By contrast, many companies believe they can fix financial problems by building or acquiring facilities in a low-cost country such as China. Doing so usually only exacerbates their problems by increasing fixed costs while the company runs parallel operations in the low-cost country and in its own plants. Spending time building or acquiring facilities in low-cost countries also consumes precious management time and resources that may be better spent on strategic activities like introducing new products, evaluating new market opportunities, and working with the financial markets.

Engaging with a contract manufacturer under these circumstances is a recipe for failure. The expectations for the partnership are immense and the time to deliver is unreasonable. Another variant on this model is to outsource only a portion of the supply chain—e.g., older products, difficult subassemblies, or poorly performing plants. However, this does not create a mutually beneficial relationship between the OEM and the contract manufacturer.

Conclusion

This article has covered a lot of ground discussing the benefits of outsourcing parts of the supply chain to contract manufacturers.

In the end, supply-chain outsourcing is all about being more competitive in a highly complex global market. Focusing on core capabilities is the key. As OEMs direct their attention to increasing their market share through product innovation, branding, and building customer loyalty, outsourcing partners can design and manage an optimized supply chain to help improve an OEM's performance. Waiting until a competitor takes market share or a company misses financial expectations is the wrong time to begin. Smart firms looking to increase competitiveness will begin the outsourcing process before they have to, rather than waiting until the need is acute.

Dave Busch is vice president, medical, for Solectron (Milpitas, CA), and can be contacted at [email protected].

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