The Situation
X Co was providing toll manufacturing services for a 4 million lbs a year customer. At 20 cents/lb, the contract was widely believed by X Co personnel to be generating $800,000 per annum contribution margin. They were pleased.
Change Request
The customer asked X Co to take over the purchase and supply of a key raw material worth over $2 per lb. Without much thought or hesitation, the commercial manager agreed. After all, the raw materials cost would just be a pass through cost. That’s OK, right?
Chemvalon Finding
Not so fast. X Co’s annual sales revenues now increase by $8 million per annum as the raw material costs are recharged to the customer, prompting a healthy increase in business insurances of $26,000 a year when the year- end declarations were made.
Oh yeah, and did we mention that the special customer had 60 day credit terms, but the raw material supplier was strict 45 days. In just 2 months, X Co had made an unplanned $300,000 investment in working capital – until the contract ends!
Now that $300,000 working capital is funded by a bank line of credit at 4% per annum interest. Oops – an extra $1000 a month extra bank interest. And it used up 10% of the $3 million facility.
And that yield-sharing agreement that kicked in an extra $16,000 a year when X Co production ran 0.4% in excess of the contract required 98% yield on raw materials – that’s right – that went away also.
Paying the supplier 12 x per year incurs $400 in wire fees.
Net cost to X Co $54,400. A 6.8% reduction in net margin contribution.
Additional Problems
X Co has now accepted the risk of losing the business and being left with unused raw materials.
Raw material price variations cause billing delays. Average DSO is now 64 days.
X Co might need to re-up its bank line of credit to support next year’s business growth.
X Co now needs to operate just-in time-raw materials management to control its exposure to working capital fluctuations.
Outcomes
As a result of Chemvalon’s analysis of the true costs of X Co supplying its manufacturer client, X Co was able to renegotiate its contract for more favorable terms.
