Financial Variables in Manufacturing

by Michelle Bomberger | March 30, 2010

Dennis Hebert of CFO Selections shares insights on the finance side of your manufacturing relationship. 

———————————

Congratulations!  You have found a company that will manufacture your product.  The company will produce your product at the quality level you want, and at a price that gives you great margins.  You’re ready to sign the formal manufacturing agreement.

But wait!  Is it really such a great deal?  Are you stepping onto the path to success, or stepping into the abyss?  How do you know?  How do you decide?

You could decide with your “gut” feeling, but it’s not a recommended approach.  Even simple manufacturing arrangements can have complicated financial results for a business.  A much safer approach is to see how the manufacturing agreement will fit your business, in terms of your company’s financial plan. 

A financial plan, or budget, is simply a quantified model of a business.  At a minimum, it includes Profit and Loss Statements, Balance Sheets, and Cash Flow Statements for the business by month.  In most cases, annual statements are insufficient.  You need a monthly plan.    

Constructed correctly, a financial plan enables you to assess the impact of each of the terms, conditions, and ways your manufacturing relationship will operate.  It puts you in a position of power; being able to tell what works, what doesn’t work, what’s more important, and what’s less important.  With it, you can negotiate and evaluate trade-offs effectively.

Think of building your business like assembling a finely crafted Swiss watch.  You want all of the components to mesh perfectly and work in concert with one another.  Now, imagine sitting in front of a bin full of random parts and trying to assemble such a watch without instructions.  How would you select and evaluate each component?  Your chances of success would be slim.  However, if you have an engineering blueprint, your chances of success increase greatly.  The blueprint enables you to decide which components to select, and how they fit and function with one another.  A financial plan acts as the blueprint for your business.

Entrepreneurs in search of a manufacturer tend to focus on the “big three” attributes: cost, quality and service.  How much will the product cost me?  Can the manufacturer meet or exceed my quality expectations?  Will the company provide me with good service? These are important components, but there are many others that are often overlooked, and usually to the detriment of the entrepreneur. 

Examples of other critical variables include, terms of sale, order lead times, quantity and timing of shipments.  These need to be considered and their impacts on your company’s financial plan assessed.  Cash flow is typically the biggest surprise when variables than the “big three” are considered.

How important can these other variables be?  Very important!  For an example, consider your manufacturer’s terms of sale.  Does it require a substantial down payment at time of order, or are payment terms net 60 days?  The difference in these scenarios can make or break your business.  In the first case, you have cash requirements at the time you order your product – a large cash requirement up front.  With net 60 day terms, your cash needs don’t show up until 60 days after you have received your product.  In this second scenario, your cash requirements might even be less, if you are able to sell and collect from your customers within the 60 days.  Would you like to know the likely impact of both scenarios on your business?  Run it through your financial plan and compare cash requirements.

Because a financial plan is a mathematical model, it’s a wonderful tool.  It’s invaluable when evaluating alternatives.  You can experiment with various assumptions and assess their impact.  It eliminates surprises, and helps you determine your resource requirements over time.  An additional benefit is that investors and bankers look favorably upon entrepreneurs who have a comprehensive financial plan.  It provides instant credibility.

As you proceed with your process of selecting a manufacturer and finalizing a manufacturing relationship, make sure you have a financial plan that works.  Don’t go to the parts bin without a blueprint, or you may end with a watch with finely crafted gears that don’t mesh.