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Supply Chain Due Diligence Check List

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					DUE DILIGENCE:
How Operational Are the Operations?
                                                                 by Ellen B. Richstone
Last October, I described the         diligence themes apply to            ments if changes are needed
due diligence necessary to prop-      service firms too. I’ve broken     • payment terms, particularly
erly assess a company’s sales         the operational areas into seven     compared to the company’s
and marketing activities. But in      categories and added a question      cash inflow from customers
many economic sectors, it is          template that will help you        • lead times until purchase
often more important to thor-         further:                             orders become firm.
oughly evaluate what happens
earlier in the value chain – in       Vendors                            My firm has seen companies dis-
operations such as production,                                           cover that some vendors – even
quality, and purchasing.              A good due-diligence initiative    good ones – lack the capability
                                      covers the inflow of component     to meet a strong production
As with the due diligence             parts and materials, the suppli-   ramp-up. International sourcing
required with sales and market-       ers that make them, and the        both helps and adds complexity.
ing, more often than not the          channels that deliver them to      We have seen companies
right questions are either not        the loading dock. Once you list    outsource to Asia to cut manu-
asked or not asked correctly.         out the vendors, make careful      facturing costs only to find that
Questions must be posed in the        note of these factors:             they spend the money in work-
right way and subtleties and                                             ing capital because of the long-
ambiguities in the answers given      • the quality process for ensur-   lead transportation costs – on
must be followed up with fur-           ing that                         top of the carrying costs of the
ther questions. The operational         all supplied parts meet the      inventory.
side of the business is often           company’s standards
assumed to be “workable” – in         • how easily the vendors can       Inventory
integration as well as in due dili-     flex with the company’s vary-
gence. The too-frequent result:         ing volume needs – and at the    Conventional due diligence will
issues are not discovered and           right price and in the right     look at total inventory turns, but
integration decisions are not           timeframes                       it’s important to include: inven-
implemented.                          • what alternative suppliers can   tory turns by major products
                                        provide critical parts           and/or product lines; turns by
Although many of my examples          • what long-term agreements        major raw material and sub-
assume a target company in the          are backed by a thorough         assemblies; inventory records
manufacturing sector – technol-         evaluation of whether the ven-   accuracy at the individual SKU
ogy or non-tech – the basic             dor can achieve its commit-      level, particularly if using ran-
dom access warehousing sys-          • Capacity and process flow            Business Processes
tems; actual condition of the          throughout the entire
inventory and its storage envi-        company;                             This is an area where inconsis-
ronment; and newer product           • Locations of manufacturing           tencies, redundancies, or gaps
lines – especially those expected      engineers and other produc-          across organizations end up
to be the highest revenue pro-         tion specialists (how easy           frustrating and potentially alien-
ducers in the future.                  would it be to move them?)           ating all stakeholders. Proper
                                     • Locally accessible and clear         due diligence here will allow the
Inventory is an area where both        documentation supporting the         acquirer to better access the
the operational due-diligence          manufacturing of the product         time commitments and actions
team and their counterparts on         (example: if the product is          needed once the deal is done,
the finance side must be               made in Eastern Europe, is all       and thus to make realistic com-
involved. Each will evaluate           documentation in place and           mitments to its stakeholders.
from its own perspective, look-        how easily could it be under-
ing for answers to issues such as      stood elsewhere if the compa-        Examination should include:
calculations of excess and obso-       ny transferred production?)          customer complaint handling
lete inventory (it can be helpful    • Planned product changes and          and related chargebacks: war-
to get input from the R&D and          their impact on manufacturing        ranty terms and customer serv-
quality due-diligence teams here       requirements                         ice standards; access methods
too) as well as write-offs by        • Operational or financial rea-        and coverage, product/ service
product category over the last         sons for facilities to be close to   quality acceptance standards
two years.                             customers – as in aerospace          and purchase order terms and
                                     • Whether the facilities are in        conditions, as well as order entry
It is crucial to evaluate new or        special trade zones and what        methods. It is vital to have clear
planned products versus those           would be the operational and        performance metrics across all
now generating the bulk of the          financial consequences of           functions, entities, and locations,
revenue if you are to get a com-        moving them.                        with consistent and comparable
plete picture for the future. One                                           algorithms and good data
of my colleagues discovered          The issue of clear documenta-          integrity.
inventory issues that he felt        tion has been a real problem in
would at least have been high-       many deals. Even in the best of        We’ve seen big difficulties sur-
lighted if, during due diligence,    companies, there are often             face in comparisons of total life-
the acquirer had spent time          elements of the manufacturing          cycle costs and on-time delivery
assessing the “actual condition”     process that are “understood”          statistics. In several companies,
of the inventory and also look-      more than they are documented.         we found that 90% of the prod-
ing at how it was stored over        When one adds different                uct sold came from 5% to 10%
time.                                languages and cultures to this         of the product offerings. Unless
                                     equation, the issue gets extreme-      one is looking at new products
Facilities                           ly complicated. We know of             being introduced, this is often a
                                     cases where plants were going          great opportunity to reduce
Ideally, the acquirer should be      to be consolidated quickly, but        costs. Often, the response from
able to reach a quick decision       when the documentation was             the customer relationship man-
about whether the target com-        fully evaluated, the acquirer          ager was that “the customer
pany’s facilities are needed. But    ended up having to rewrite it,         requires the special design”.
implementation usually gets          delaying the transfer of produc-       When the customer was
mired in the reality of the          tion, and keeping the target           approached directly, it turned
details. To minimize the issues      company’s engineers on staff for       out that the additional offering
that are discovered after facility   a long time to ensure good             was not critical to their decision
closure decisions, acquirers         product quality.                       to buy.
should scrutinize:
Manufacturing                         Quality                               Relationship with Sales

It’s fundamental to ask about         Among the key queries here are        You should have the potential
the standard lead times quoted        these: What are the current           acquisition describe their
to customers for each product         quality standards? If flawed          mechanism for forecasting sales
line and to learn what dictates       product does leave the factory,       and developing the master
manufacturing lead times. Do          how much work has to be done          production schedules. It’s then
the new products mean big             in the field to bring it up to        interesting to follow the actual
changes to manufacturing              acceptable levels? The questions      process through the forecast, the
processes or expenditures? If so,     on quality must be asked in           booking, the connections to
what does that mean to the            every part of the company – not       purchasing and production, right
acquirer? How different are the       just manufacturing. Has the           through to shipment. The exercise
processes and procedures used         company met the ISO require-          often exposes vulnerable issues
to manufacturing the different        ments? If not, why not? What          or processes that will need
products – and how different are      would it take to meet them?           shoring up after acquisition.
they from those used by the
acquirer? There are important         We’ve seen companies being            Conclusion
ramifications for training and        bought for their new technology
quality standards.                    and new products. The acquisi-        Don’t underestimate the levels
                                      tion candidate had been ship-         of questioning necessary to
Effective due diligence will          ping the new product, although        develop a clear picture of the
closely evaluate the proportion-      not necessarily always in large       target company’s current and
al relationships between total        quantities. More than once, it        future health. And be alert to
production costs and the costs of     turned out that the product           the dangers of “wanting to do
material, direct labor, indirect      needed plenty of “on site sup-        the deal too much.” That’s when
labor, and manufacturing over-        port” once it arrived at the cus-     it can be useful to have third-
head. Other essential pieces of       tomer—well beyond what would          party professionals lend an
information are component uti-        be considered acceptable in any       objective hand. Sometimes it’s
lization percentages and the          normal situation. In some cases,      the question you didn’t ask that
extent of component standardi-        it turned out to be a manufac-        is the most critical one.
zation across product lines. A        turing quality issue that was fair-
thorough assessment will also         ly easily remedied; in others, the
determine which products are          result was that the new products       Ellen B. Richstone is president and CEO
standard and which are built to       had to be redesigned. In all           of the Entrepreneurial Resources Group, a
order. We’ve seen many situa-         cases, the costs to remedy were        professional services firm comprised of
                                                                             CEOs, COOs, and CFOs that uses proven
tions – especially in acquisitions    well beyond what the acquiring         models to improve operational perform-
of technology companies –             company had expected. The              ance and productivity, supporting interna-
where product believed to be          fall-out wasn’t only financial;        tional and growth requirements, M&A
                                                                             business due diligence and integration
standard actually had a               it also disappointed customers         needs. ERG has locations in Boston,
customized element to it. It          who expected immediate resolu-         Charlotte, Chapel Hill, New York City,
meant the synergies expected          tion from the new owner.               South Florida, London, and Paris.
                                                                             Richstone can be reached at ellen.rich-
from the acquisition were either                                             stone@erg-usa.com, 617-973-5130, or via
never realized or realized much       Please take a moment and view          ERG’s Web site: www.ergglobal.com.
later – after significant effort to        the “Due Diligence”
rationalize product lines.              Checklist on the next page.
DUE DILIGENCE CHECKLIST
    Data requirement                                                                                             Status
    • List and describe principal suppliers/vendors/subcontractors, with estimated annual purchase values

    • List and describe any sole sources among proprietary suppliers/vendors, with estimated annual
      purchase values

    • List and describe any critical parts suppliers/vendors

    • List and describe any special or unique supplier/vendor contracts (i.e., credit terms, rebates etc.)

    • List and describe any long-term supplier/vendor/subcontractor contracts

    • Summarize any cost reduction programs in process or planned for implementation

    • Get schedules for manufacturing overhead for the past two years and for the most recent interim
      period, including associated overhead rate calculations.

    • Summarize the proportional relationships between total production costs and costs of material, direct
      labor, indirect labor, and manufacturing overhead.

    • Summarize current production capacity by product family

    • Summarize inventory turnover by appropriate sub-groupings

    • Inventory cost accounting, standard cost, and product cost systems used in manufacturing
      operations, including:

             • Timing of updates
             • Rate methodologies
             • Variance accounts (calculations/amortization/activity)

    • List all significant operational functions that are computerized

    • Get sample copies of documented policies and procedures, including assembly procedures, work
      instructions, and test periods

    • Provide list of production tooling that is customer funded and owned. Are there future plans for
      customer-funded tooling?

    • Ask whether customers specify components and how easily sources are changed

    • Define your manufacturing engineering technical capability, including people and equipment

    • Describe product service and warranty policies. Provide warranty, returns, and allowance history and
      current status.

    • Check status of quality program (out-of-box failures, field failures, on-time delivery.) Ask how product
      quality and reliability are tracked by customers and by their customers. Supply reliability information
      on all major product lines.

    • Define your manufacturing approach, including people, equipment, and procedures

    • Specify the level of manufacturing technology you possess vis-à-vis your competitors and
‘     state-of-the-art processes

    • Find out what manufacturing and management techniques are used

    • Provide a matrix of manufactured products by plant and by user and customer locations

    • Describe the demand forecasting and coordination between sales and manufacturing in developing
      build schedules

				
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