“I wrote this article Q3 2020. For years, Venture Outsource has been educating and training manufacturing professionals on costing and pricing of contract electronics manufacturing services vs ‘should cost’. This article touches on this but what’s really interesting is how much the macro environment has progressed since writing the article fall 2020.” – Mark Zetter
An edited version of this article was first published on supplychainbrain.com January 31, 2021. The original, unedited version is below.
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United States Fed implements monetary policy primarily two ways:
Federal funds rate and, open market operations.
This article focuses on the federal funds rate. By lowering federal funds rate targets banks pay less to borrow from the Fed, therefore banks have more money to lend. This makes capital more affordable, encouraging companies and investors to borrow.
If a manufacturer’s ROIC for borrowed capital returns a higher rate, this presents manufacturers and supply chain vendors higher liquidity, manufacturers will borrow more from banks and this is just like adding money to the money supply.
The challenge for manufacturers, which will only become worse as inevitable inflation takes hold, is balancing the cost of money (loans and sales acquisition) against the depreciating purchasing power of money.
Manufacturers sales revenue is computed using the present value of paper money. And while sales revenue may increase, the real income (the purchasing power of the sum received by companies) is declining from increasing quantitative easing (QE) by the Fed, the European Central Bank, and most other central banks, worldwide.
Below, the amount of U.S. currency in circulation as reported by the Federal Reserve Bank of St. Louis, one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System.
Similar to updating evaluations for market-to-market scenarios, in this instance the true value of company earnings can be hidden behind artificial numbers. On a side note, some readers might recall September 2019, in the overnight bank lending market when banks stopped lending to each other. It’s because bank balance sheets are being tabulated with figures that are not real and cannot be properly valued.
Meanwhile, US currency debasement (less purchasing power) is emphasized below.
In manufacturing supply chains, the moment a transaction occurs a financial obligation is created and the accounting ledger (tax liability) is fixed in figures. Then, in the period of time from when the liability is determined, to the point in time when the liability is actually paid, manufacturers and vendors/supplier experience further decreasing leverage with purchasing power of their cash and reserves.
Accelerating the decrease of manufacturer purchasing power will continue into the foreseeable future so long as the Fed continues to continue with QE policies.
No manufacturer or supply chain vendor or supplier can offset the inevitable inflation and declining purchasing power based on the debasement of US currency. Even foreign operators rely on the value, or exchange rate, of the US dollar because of its current status, worldwide.
In Western economies the European Union is nearing wits end with the EU’s bond market owned 66% by the State. This means the European Central Bank’s balance sheet now equals 66% of the Eurozone gross domestic product (GDP).
Add to this European pensions are on life support as politicians are coming up with ever-more creative ways to assess more taxes while justifying ways to raise existing taxes.
With the US dollar still being a global safe haven (for the time being) Europe’s bond market is struggling to survive, and Japan’s in far worse shape. There is good reason why two of the most heavily traded currency pairs are EURUSD and USDJPY.
The Japanese Central Bank’s balance sheet equals a staggering 136% of Japan’s GDP. In the US, the Fed is currently at 37%, which will rise as more credit continues to be created relative to a lower US GDP ratio from less being manufactured/produced in the US.
The above aligns with what we are seeing, with more and more European OEM companies seeking to reduce costs in their manufacturing supply chains and seeking cost cutting with their engagements with their EMS manufacturing partners.
Worldwide, bubbles created with credit expansion by central banks are becoming re-inflated and getting larger, and larger.
In the US, in just 2020 alone, Fed balance sheet debt has added $4 trillion and the Federal Reserve magically produced another $3 trillion with a strong likelihood to produce trillions of dollars more – deploying Modern Monetary Theory – the belief governments can print as much money as they want without consequence by creating credit out of thin air.
Combine this with stagnating wages further exacerbates angst among buyers and consumers in the US, and elsewhere, required to start paying more attention where and how (much) they spend.
One thing is certain, the Federal Reserve note (US dollar), the British Pound, the Euro, the Japanese Yen, the Aussie dollar…all fiat currencies are going to continue to lose purchasing power.
The other problem is it will become increasingly more difficult for central banks to manage interest rates while they continue to issue credit with increasing paper money ‘circulation’.
While the fiat debasement continues the hunt for taxes also grows to offset government balance sheets. In one creative solution, a recent Deutsche Bank report (PDF) by strategist Luke Templeman is floating the idea of a 5% work from home (WFH) tax and calculates such a tax could raise £7 billion in the UK, €20 billion in Germany and $49 billion per year in the US.
All of this is creating a perfect storm taking more spend power away from consumers and the manufacturing supply chain and placing more awareness on corporate spend.
Central banks fiscal stimulus and rising supply chain (and consumer) costs
As inflation eventually takes hold every manufacturer, vendor, supplier and buyer (customers and purchasing department) will face higher costs with further declining purchasing power. Rising interest rates will further advance the decline in purchasing power.
As prices rise this will place greater impact on the manufacturing export trade, which will also force even greater focus on manufacturing compliance policies and procedures, especially in areas of managing manufacturing commodities and inventories.
Manufacturer finances will come under further scrutiny. With debasing of fiat currencies happening everywhere, how will manufacturers calculate depreciation in order to determine real income vs apparent income? Manufacturing is already one of the most common sectors having to re-assess their manufacturing inventory values. OEM manufacturers with networked contract EMS manufacturing supply chains face even more pronounced challenges regarding manufacturing financial restatements.
Sourcing and procurement cost management of raw materials and components for electronics and electro-mechanical products will face ever more scrutiny by manufacturing finance executives, helping them meet or, more often preventing manufacturers, from making their manufacturing quarterly financial numbers.
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In frequent conversations, manufacturers are already asking questions and paying more attention to gaining greater control over their material planning and manufacturing supply chain execution.
There is a more concerted and disciplined effort surfacing by manufacturers on every aspect of the supply chain, especially inventory and related product changes as manufacturers weigh costs tied to introducing new product (NPI) vs revising existing products with product change notices (PCN).
Having PCN management capabilities to continuously update (and prioritize) changes to your electronics and electro-mechanical products, flag potential risks and disruptions to your manufacturing programs and, offer manufacturers deeper (and earlier) inventory insights to help manufacturers capture more revenue recognition, stop expensive production shutdowns and, avoid costly inventory and materials write-downs with a robust PCN platform.
Better PCN procedures will also help manufacturers to better identify and clarify in country-of-origin (COO) and UNSPS codes (and manage related disputes as governments seek more ways to assess and capture more manufacturer export trade taxes while fighting to manage growing pension liabilities) will help position smart manufacturers with better HTS codes accuracy across their supply chain while offering better capabilities to avoid customs delays and costly penalties.
OEM manufacturers sourcing services from EMS providers will be rewarded by investing time better understanding internal EMS factory costs vs RFQs and quote pricing presented to OEM prospect and customers. On average, MCOGs is typically 75% of ASP. Leveraging intelligence about EMS manufacturer internal operations and hidden costs can help OEMs achieve more favorable total landed costs as you reduce material spend, lower EMS profit mark-ups and, optimize your cash conversion.
Applying years of experience with EMS manufacturing balance sheets, P&L and cash flow statements, we analyzed 3,000+ EMS manufacturing sales quotes for OEM programs ranging from NPI to large-scale manufacturing and this includes highly complex systems builds across multiple factories and geographies, to help OEM customers make more informed EMS sourcing decisions.
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Using comprehensive manufacturing cost models, OEMs can account for currency foreign exchange rates, direct labor liabilities and loaded indirect labor costs, F,G&A and S,G&A plus, influence on thousands of other calculations impacting OEM global manufacturing supply chains operating in one, to 150+ geographies, while cutting costs five percent to as much as 15%+ per OEM-EMS program.
Material spend cash conversion
The value of a business is the present value of cash a business generates over its lifetime. In contract manufacturing, the value of the OEM customer relationship is equal to the revenue EMS manufacturers earn from the OEM customer over the life of the relationship.
But manufacturing supply chains are dynamic and fickle. This creates constant challenges for every commodity buyer and planner and supply chain manager.
Covid-19 has added to complexity to manufacturer cash flows and headaches. Feedback from manufacturing executives I talked with impacted by Covide-19 expressed rolling back two to three years, any progress they previously achieved toward Industry 4.0, because the risks they took to move forward with their programs didn’t pay off.
For some manufacturers, the fallout has left them focusing on $50 million in payroll costs that was previously ear-marked on SaaS project plans. Projects are being re-examined, re-prioritized, pushed out and even cancelled.
For all manufacturers, covid-19 is causing a hard reboot of how manufacturing supply chains are being managed. The reality for nearly every manufacturer I’ve talked with includes establishing new baseline expenses to be determined amidst tighter cash control.
Unfortunately, executives are confirming to me the virus has left manufacturing customers in every market sector, for both vendors (and customers of many lesser competing vendors), scratching their heads while customer exposure and losses are still being sorted out.
Let’s all agree, with changes to monetary policy by central banks and a pandemic among us, we are in a new era of supply chain management and we need new tools to truly solve Industry 4.0 challenges ahead.
To emphasize the strategic nature and importance of cash flow and how the pandemic has complicated things further, hedge fund titan Bill Ackman, founder and CEO of Pershing Square Capital Management, who famously turned $27 million into $2.6 billion buying insurance on various bond indexes, betting on the impact of the corona virus, is turning heads again. At the time of writing this article, Ackman is betting on the credit market – believing there is a good chance many companies will default on their corporate debts.
This, as the number of ‘zombie companies’ grows. For those unfamiliar, a zombie company is one that needs bailouts in order to operate or, is indebted so much it is only able to repay the interest on its debts but not repay the principal. Essentially, zombies don’t have enough revenue to cover their debt.
Meanwhile, manufacturers keeping their pencils sharp, practicing sound business practices and, having access to the right information and tools may be able to improve their odds of weathering the current economic climate, and coming financial challenges impacting manufacturers in the years ahead.
Mark Zetter is founder of Venture Outsource, LLC. Learn more.
You can read the edited version of this article here.
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