Bailment: The Fallacy
of Cost Reduction
Michael
Marcus, CPA
Stout Risius Ross, Inc.
The notion of cutting pennies
from unit prices or reducing manufacturing costs by tenths of
a percentage point represent to most people seemingly small
and uninviting prospects for improving a company’s bottom
line. However, in the mega-scale economies that exist in the
automotive industry, such opportunities are pursued most aggressively.
The sheer size of the industry financially justifies the pursuit
of such unitarily small improvements. However, while the drive
for productivity produces many innovative and initially unconventional,
but brilliantly successful solutions, there are times when apparently
feasible and novel ideas can spawn only unforeseen complications
and difficulty.
Recently, the automotive industry’s Original
Equipment Manufacturers (OEM’s), e.g. DCX, Ford, GM, Toyota,
Nissan, et al., have been considering a proposal to reduce material
costs by using bailment agreements within their supply chain.
A quick look at the industry shows that the complex, multi-level
task of manufacturing automotive components requires the input
of many suppliers and sub-suppliers prior to parts arriving
at the OEM’s assembly plant. This has resulted in a tier
structure of suppliers in the industry, whereby direct suppliers
to the OEM are classified as Tier 1’s. Companies supplying
the Tier 1’s are classified as Tier 2 suppliers (one step
removed from the OEM) and so on. Furthermore, over the past
few years the OEM’s, having concluded that the proliferation
of direct suppliers was unnecessary and a cost penalty, moved
to consolidate (reduce) their Tier 1 supply base. This reduction
of the supply base, together with placing more product development
at the suppliers, created Tier 1 suppliers of very large proportions,
e.g. Bosch, Delphi, Visteon, et al.
Normally, the Tier 1 suppliers are provided
a free rein to source sub-components to the Tier 2 supply base.
However, in certain instances, the OEM’s have required
(directed) the Tier 1 to use a specific Tier 2 on certain car
platforms or applications. This directed-source supply situation
has caught the attention of the OEMs as a potential area for
cost savings. The issue revolves around profit margins paid
to Tier 1’s on the components supplied by Tier 2’s
in a directed-source situation. There is a consensus at the
OEM’s that such margins are non-value added costs, because
the OEM is doing the work in directing the sourcing of the component.
The Tier 1’s disputed the OEM position and responded that
it was necessary to mark up even directed-source components
in order to cover costs and maintain profit margins.
One of the recent OEM responses to this “inequitable”
situation was to devise a manner to take the Tier 1 out-of-the-loop
by deploying a bailment agreement. The methodology entails the
OEM issuing a purchase order directly to the Tier 2 supplier
for components that are then delivered under bailment to the
Tier 1 supplier for conversion to a finished state or assembly
into a finished component for delivery to the OEM. In the above
methodology, the Tier 1 does not take ownership of the Tier
2’s product. Accordingly, the OEM’s have reasoned
that the “need” to mark-up the material cost is
avoided as such costs no longer pass through the financial statements
of the Tier 1. Seemingly a sound rationale, but even this argument
is problematic, as discussed later.
Bailment Demands a Different Perspective
The bailment process can be a viable alternative
to standard commercial transactional process provided that the
OEM, the Tier 1 and Tier 2 suppliers are well prepared for the
commercial and legal differences that accompany this method
of business.
Commercially, the OEM and the Tier 1 must be
able to track and identify bailed inventory. This concept is
not always appreciated or well-practiced by U.S. manufacturing
business. Most inventory control systems, including but not
limited to the computer driven software, are not set-up with
bailment in mind. In fact many companies have difficulty effectively
controlling their own inventory, let alone adding the complication
of bailed inventory. Typically, bailed inventory control systems
are off-line systems set–up to accommodate the infrequent
demand of bailment. As such, physical controls and procedures
are not integrated onto the MRP system and therefore not capable
of properly recording high volume transactions. Physically segregating
bailed inventory could be useful to identify bailed inventory,
however, the segregation control becomes irrelevant once the
bailed inventory is integrated into the assembly/manufacturing
operations at the Tier 1.
Additional commercial considerations for the
OEM come along with the bailment process. The OEM must record
bailed inventory on its books and ensure that the Tier 2 supplier
is paid on-time for the appropriate level of material delivered.
Freight and duty costs to deliver the material to the Tier 1
will also be incurred and will require verification. The OEM
must monitor the accuracy of the Tier 1’s inventory records
reconciling these to its own records. The OEM must also ensure
adequate insurance coverage. Finally, the effectiveness of the
above controls and procedures becomes further complicated, because
Tier 1s function in a remote environment, physically separated
from the OEM facility and its management oversight. The remote
situation presents significantly greater potential for critical
controls to be compromised, thereby resulting in inventory losses.
It is in the legal arena that the feasibility
of bailment finds the most significant challenges. Initially,
there must be a bailment agreement between the OEM and the Tier
1 supplier. Subsequently, appropriate UCC searches are required
followed by notification to creditors with security interest
or liens advising them of the bailment. This process continues
with the filing of a notice UCC financing statement that describes
the bailment agreement. Only when all of these steps are properly
executed should the OEM initiate the bailment process. On a
“go forward” basis, the OEM should also monitor
the Tier 1 to ensure that the bailed inventory is properly excluded
from the borrowing base certificates that are presented to the
lender. Additional consideration in the legal area needs to
be given to the form and content of the OEM’s purchase
orders and its warranty and product liability issues. This is
of special concern when the OEM is providing components to its
Tier 1 for conversion/assembly. The question of warranty and
product liability can become clouded in situations where there
are several suppliers for one component.
Also, it should be well noted that the above
requirements mandate additional system and manpower costs on
the part of the OEM and the Tier 1 supplier. In fact, deployment
of the bailment arrangement will result in increasing the number
of Tier 1’s to the OEM’s supply base. A process
that counters recent trends and will most certainly add cost
to the procurement process.
The Troubled Supplier Scenario
If a Tier 1, functioning under a bailed inventory
arrangement with the OEM, becomes financially distressed (“a
troubled supplier” situation), then a more complicated
workout scenario can result. Troubled supplier situations are
never easy on any of the participants. It is more a game of
minimizing losses than in gaining advantage or breaking even.
Troubled companies are subjected to demands from many stakeholders
including unsecured trade creditors, secured lenders and customers
(OEM’s). Each of these has their own agenda: the banks
are looking for collateral and for the customers to “share
the pain”, the customers want an uninterrupted supply
of components and, often-times, to exit the relationship, while
the unsecured are looking to someone to make them whole. The
common denominator is that each is fighting for a share of the
troubled company’s dwindling pie of economic value.
Into this controversy enters the situation
of bailed inventory. Even if the OEM has done the right things
and followed the proper steps, there is risk of loss to the
OEM. The bank often has secured status to all the Tier 1’s
assets which includes inventory. In the event that the bailed
inventory has been put into production and is now part of a
Tier 1 assembly, to whom does the value of the bailed inventory
accrue? Does it become part of the bank’s collateral?
If so, how does the OEM recover its outlay? (Of note is the
fact that there is case law currently under review that the
bank can assert a secured claim over bailed inventory.) Can
the OEM receive a recovery of the value of the bailed inventory?
If the bank has other claims against the OEM in the situation,
can it exert set-off? How is the value of the bailed inventory
determined? Can the OEM “remove” its components
from the Tier 1’s assembled product? What if removal is
physically not possible? What if the Tier 1’s plants have
multiple suppliers of the same components and the bailed inventory
has not been segregated? If it is a case of a fungible product,
then which accounting records control the division of product
value?
While there are many ways to resolve the above
questions, the important fact is that resolution will take additional
time, effort and negotiation among all the parties involved.
Such negotiations are almost never bilateral and usually require
three or more parties in interest to agree (e.g., banks, customer(s)
and unsecured creditors). This can be especially disconcerting
as time is often of the essence in ensuring the flow of product
to the customers.
The Fallacy of Cost Savings
As previously mentioned, the main driver behind
the bailment proposal is the desire to reduce costs. While the
complications of effectively deploying a bailment based inventory
system have been discussed above, the realization of cost savings
have not been fully considered. Most importantly, the Tier 1
markup cannot be completely eliminated, as certain costs of
maintaining the Tier 2 must continue and be covered by margin,
such as quality assurance, order processing, scheduling, systems
support, receiving and engineering. New systems will have to
be developed and additional manpower added by the Tier 1 to
manage the bailed inventory system.
The bailment process will almost certainly
result in additional inventory in the overall supply base system,
i.e., Tier 1 and OEM combined. Tier 1’s will have reduced
incentive to manage inventory levels because the inventory will
not be on their books, and the OEM will be hard pressed to reduce
inventory. The inventory will be offsite and not subject to
the daily controls and management attention that come when inventory
is physically present. The additional inventory levels will
generate increased expenses due to loss and damage, storage,
freight and handling, obsolescence and working capital related
interest expenses.
For the OEM, there are also other hidden costs
associated with bailment. Additional suppliers, additional part
numbers, and additional transactions all result in additional
overhead costs at the OEM level. The bailment further divides
the business relationship between commercial and operational
areas; it weakens the relationship among the Tier 1, the Tier
2 and the OEM. This is because commercial control remains with
the OEM and the Tier 1 is preempted from using financial leverage
with the Tier 2 to obtain compliance with quality and/or delivery
issues. At the same time, operational responsibility to deliver
quality components on time remains with the Tier 1. This presents
a long-term problem and a weaker bargaining position for the
Tier 1 that already face faces an OEM directed-supplier situation.
Summary
Overall, the bailment does not add real, tangible
value to the supply chain. When analyzed from the holistic viewpoint
of the entire supply chain, no real economic value is added.
The potential for profit improvement to the OEM is problematic
as there is no real cost reduction, only a shifting of costs
around the system. Additionally, there is risk that additional
costs will be incurred in the form of added inventory layers
(with all the appurtenant cost associated with increased inventory
levels), and added overheads to manage a new system. Furthermore,
the majority of these overhead costs will be added by the highest
cost element of the supply chain, OEM.
Bailment has historically been relegated to
special circumstances to temporarily address situations where
capacity is lacking or legal constraints are in play. It has
been utilized in a low volume transactional mode and has been
treated that way by the majority of manufacturers. To utilize
it on a wholesale basis would invite supply base problems. Furthermore,
the risks that accompany bailment in a troubled supplier situation
are so significant as to make the entire process problematic.
Michael Marcus'
experience covers both privately held and public traded companies,
including Tier I and Teir II automotive suppliers.
He was named Chief Financial Officer at Freudenberg-NOKK
for the NAFTA region. His experience also includes positions
as Senior Consultant at BBK, Ltd and Vice President of Finance
and Sdminstration at Robert Bosch Corporation. Mr. Marcus is
a CPA and earned an MBA from Michigan State University and a
BBa in Accounting from the University of Notre Dame.
