Communication within Contract Manufacturing – The Secret to Reducing your Product Cost of Goods Sold

by | Jan 26, 2020

In early 2018, I had the pleasure of working in China to kickstart the production of 3 consumer electronic products. The more time I spent out there, the more I found it to be true what Scott Miller, CEO of Dragon Innovation, states: “Strong communication and teamwork skills are critical to success. Engineering is a team sport. It’s all about the people. 'Us' and 'Them' won’t work.” There are many strategies to reduce your product’s cost of goods sold, all of them require solid communication with your contract manufacturer (CM).

During production, bidirectional communication with your CM is critical. Most communication with CMs can be categorized into what Scott calls the "manufacturing management triangle": cost, schedule, and quality. In general, you get to pick two to focus on at any one time, but it is a game of balance and all three need to be taken into consideration. I'll be diving into the cost bucket in greater detail below.

Breaking down what goes into the retail cost of a product: there is the cost of goods sold (COGS), sell-in price (wholesale), and sell-through price (retail). Your company's profit margin is directly related to product COGS. There are 2 main elements of a product’s COGS. The part that is dictated by your product’s design (material and component selection, fabrication methods, quality requirements, packout efficiencies), and then the part that is controlled by the CM (BOM transparency, profit margin, labor rate, location, capabilities, supply chain).

On the design process side, there are some levers that can actively reduce costs. Take packout as an example: by adding batteries and extra components as accessories, you can effectively pull down the costs without modifying your design. Don’t spend too much on the packaging, especially if you are shipping direct. On the CM side, negotiation is critical to bring down the cost of your bill of materials (BOM). Labor costs and margins are good starting points, but to really cut costs you are going to want to break everything into the smallest possible pieces. As Scott says beautifully, “I don’t want to know that this product costs $500. I want to know exactly what every screw, spring, and piece of plastic costs, and then I can make sure that I get a fair price”.

By separating special components and getting the CM to apply different margins to components above different thresholds, you can save a lot of money. Make sure that the factory is super transparent and that costs are mathematically driven (no hidden formulas). One way to get them to comply is to give them the bill of materials in a fill-in-the-blank format. An area you can always expect to see fat is in the labor rate calculation. One high-level strategy you can use to get an accurate labor rate calculation is to count the number of workers (know that they make $X/hour), compare to the amount of product coming off the line, and then do the math to get a rough number. Make sure your number falls within the standard 15% markup on labor and that your CM isn’t double-dipping here.

Ideally, get multiple vendors to quote on the product, but know that it is twice the effort to do so and may not be worthwhile. Building a database of component prices from different factories can really help spot inaccuracies, but if you get out of sync it can become a nightmare.

Plastic costs can be calculated using the following formula:

Total Part Cost = (Material Cost + Overhead Cost) * (1 + Factory Markup)

Material Cost = Part weight * Resin Cost
Overhead Cost = Hourly Machine Cost * Cycle Time (sec) / (3,600 sec/hr)

EE costs can be calculated as shown here:
Cost = Component Cost * Usage (the number of components)

Typical CM Margins (profit, scrap, overhead) are around 6-8% for PCBs, 12% for toys, 15% for consumer products, and greater than 40% for medical products.

To finalize BOM cost estimates, make sure to include all of the following: plastics, purchased parts, electrical components, consigned components, deco (tampo, paint, etc.), labor (PRC $2-6 / hr), packaging (gift + master carton), CM profit, overhead, scrap, and finally overland transportation.

Wrapping up, I hope that you find these tips from Dragon Innovation for reducing COGS as useful as I have found them!
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