Factory within factory You can explore

www.deloitte.com/in

2

Factory within factory You can explore | 3

Concept:The need for manufactures to develop and refine the supply chain has arisen from the multiple challenges they face. With increasing competition and changing customer demands, manufacturers must innovate to ensure that they stay ahead.

Key questions that manufacturers need to evaluate: • Howtokeepcostslow,particularlywhenonlarge

partstheycompetewithsomewhatundifferentiatedproducts?

• Howtoberesponsivetocustomerdemandpatterns?

Thesetwoconcernsrequirethemtokeeptheirsupplychainsabsolutelyefficientandhighlyresponsive.Inthepast,thishasbeendoneinvariousways,outlinedbelow:• companieshavedevelopedstrategicrelationshipswith

their suppliers,

• frequentmaterialarrivalswasimplementedsothatobsolescenceandleadtimerelateddelayswerecountered

• theconceptofjust-in-timesupplieswasimplemented• supplierclustershavebeenformedtoensureefficiency

intransportation,componentkitting,aggregation,etc.

Allofthismustbeunderstoodinthelargercontextofthefactthatmanufacturersarereluctanttoownprocessesthat are not core to their product technology.

Before going into the greater detail of the emerging supplychainmodelsthatarebeingimplemented,itwouldbeusefultohaveanunderstandingofthemoretraditional procurement system for a manufacturer. The followingdiagramdepictsthetraditionalprocurementpattern of the supplier located in a different city, state or even country.

Figure 1 : Diagrammatic explanation : Traditional procurement pattern

Country A /State A

Country B /State B

Factory within factory You can explore

4

The traditional procurement pattern has certain inherentdisadvantages-keyamongthesearethecostsassociatedwiththetransportandstorageofthegoods.Thetraditionalpatternincreasestheworkingcapital requirements for product manufacturing. Further, incertaincases,thenatureoftheinputsrequiredbythe principal manufacturer may not permit such a procurement pattern. There is clearly a need to explore procurementpatternswhichhelpreductionofthesecostsand at the same time ensures no disruption in production on account of material supplies.

Toovercometheflawsoftheconventionalprocurementmodel,manufacturershavemovedtojust-in-time(JIT)suppliesfromtheirstrategicvendors.Thatsaid,manufacturersrealizeJITisanotionandinreality,JIT

resultsinsomeoneinthesupplychainholdingstockpossiblyatahighercostofcapital.Therefore,whilethereismovementtowardsJIT,thestocklevelsareconfiguredgiventherisksrelatingtotransportdisruptions,costofholdingstockandtheoperatingcycleoftheinputsupplier.

GiventheinadequacyoftheJITmodelinreallife,thepossibilityofyetanotherconstructmustbeexplored,wherethesupplierandconsumerofcomponents,additivesandintermediatescanbetteraligntheirsupplychains,therebygivingtheendcustomerbettercostandservice level advantages.

Oneofthemoreeffectivebutseldomusedmodelsfor procurement of inputs is the concept of ‘Factory

Reduced Travel Time/ Time lag

Factory A

Factory B

Figure 2 : Diagrammatic explanation : Procurement pattern in respect of Just in Time

The concept of the FWF model involves setting up a factory within the premises of the principal manufacturer

Factory within factory You can explore | 5

withinFactory’(FWF).Theremaybeinputsthatcanbemanufacturedatascaledeterminedbytheimmediatecustomerwithoutanylossofcostadvantage,wherethereistechnicalfeasibilitytoalignsuchproductiontothelinerequirement of the principal manufacturer. While it is true that the FWF model requires consideration of various tax, regulatoryandcommercialaspects,thebenefitsortheneedclearlyoutweighthesedifficulties.

TheconceptofFWPhasbeenrepresenteddiagrammaticallybelow.

Inthediagram,FactoryAisregisteredwiththeCentralExcise Authorities. The concept of the FWF model involves settingupafactory(FactoryB)withinthepremisesoftheprincipal manufacturer.

ThedifferentiatingfactorbetweenFWFmodelandtheexistingJITmodelisdepictedinthediagram.

Asaconstruct,theFWFmodelseemstohavebeenadoptedbymultiplesectors.Thereareexamplesof

chemicalmanufacturersinIndia,aglobalautoOriginalEquipmentManufacturer(‘OEM’)inaSouthAmericancountry and a leading consumer electronics company inIndia,tonameafew.Formanyyearsnow,theautoOEMshavesoughttocreatetheirdedicatedsupplierparksveryclosetotheassemblyplant,whichisclosetotheclassicFWFmodel.Therefore,itisnotjustaconceptualconstructbutsomethingmanufacturersundercertainconditions can consider.

Whilethein-sourcingandco-sourcingmodelsarequite popular in the information technology domain, themanufacturingworldisyettofullyexplorethis.Admittedly, there are greater challenges, as the eco-systemrequiredfortwomanufacturersisverydifferent – from the operational aspects to the structural rigidity this model imposes, the taxation complexities, the relativescalesandsoon.Giventheadvantagesitbringstothetableitisanoptionthatmanufacturersshouldevaluate.

Figure 3 : Diagrammatic explanation : Procurement pattern in FWF model

Production departm

ent/ plant

Finished goods

warehouse

Factory B(Production plant/

warehouse/office)

Administrati

ve

Block

Raw material

Quality and R&D

department

Factory A

6

Prerequisites/ conditionsThe rationale of opting for the FWF model lies more on the requirements of the principal manufacturer whosescaleofoperationsaremuchbiggerthanthesubordinatemanufacturer.Certainindustriesincludingprocessed chemicals, metal, etc. require specific inputs on acontinuousbasis.Thenatureoftheseinputsandtheirnexuswiththefinalproductclearlyjustifiestheneedofhavingthefacilitylocatedwithinthepremisesorinveryexceptionalcases,attheshortestpossibledistance.

Tounderstandthisbetter,letusconsiderahypotheticalexampleofXYZLimitedwhichisapapermanufacturingcompany.ItmayenterintoanarrangementwithasupplierPQRLimitedwhohasexpertiseforproductionofone of the significant inputs required to produce paper. Under a FWF model, PQR Limited may set up a factory withinthefactoryofXYZLimitedtoproducetheinputstobesuppliedtoXYZLimitedformanufacturingpaper.

Similarly,manufacturingsteelrequiresacontinuoussupplyofoxygenintotheblastfurnace.Thesupplyoftheoxygenonacontinuousbasisisthereforeapre-requisiteforsuchaplant.TheFWFmodelwouldverywellworkinthisscenario. For example, LMN Limited has expertise and technologytoproduceoxygenwhichisrequiredduringproductionofsteel.Insuchacase,LMNLimitedmaysetupanoxygenplantwithinthesteelplantofEFGLimitedto supply oxygen for steel manufacturing process.

Therearealsoexcellentexamplesofsuchfactoryset-upsinEurope,wheremultiplesuppliersco-existandmaximizeefficiencies.Thereisaparticularcar-manufacturer,whereall the suppliers come together to ensure that the final product,acar,isturnedaroundinthemosttime-efficient,cost effective and environmentally friendly manner. Whilethecar-makerhasoverallresponsibilityandisalso the module system integrator, process manager and manufacturer, each system partner also shares a considerableamountofresponsibility.

A continuous supply of certain specified inputs for a technologyintensiveprocessmakesaverygoodcaseforadoptingtheFWFmodel.Inadditiontothis,anotherfactorcouldbethewayinwhichcertaininputsneedtobetransported.Toillustrate,incaseofgases,theyneedtobesuppliedattheplantoftheprincipalmanufacturerthroughapipeline.Ifthissupplywasfromasubordinatemanufacturerlocatedatafar-awaydistancetotheplant

oftheprincipalmanufacturer,therewouldbesignificantcostescalations.Besidescost,thereisapossibilityoferosion/evaporation of the inputs or change in the chemical composition of the inputs. These reasons, especiallythecosts,makeitinfeasibleforactualuse.

Someofthekeyquestionswhichmayrequireconsideration at the time of deciding on the FWF model:• Isthemanufacturingactivityahighlyprocessdriven

one, say entailing a continuous process?• Whethertimeisofessenceinprocurementofinputs

so as to have an impact on their quality?• Whatistheforminwhichsupplyisprocured–solid,

liquid,semi-liquid,gas?• Cantheinputsbestoredorconsideringtheirnature,it

needstobeusedimmediately?• Isthemarketforinputseasilyaccessibleandarethere

anysupplybottlenecks?• Isthereavarietyofinputsinvolvedinmanufacturing

process?• Istheprincipalmanufacturerinapositiontoofferthe

subordinatemanufacturercertainadvantagesthatareotherwisenotavailabletothelatter–likebetter

AdvantagesWhile specific advantages may differ from industry to industry and from transaction totransaction,therearecertainclearadvantagesinusinganFWFmodelwhichareapplicabletoall.

SomeofthebroadlevelbenefitsthatmayarisefromFWFmodeloutlinedbelow

Dedicated suppliesTheburdenonprocurementteamislikelytosignificantlyreduceconsideringthattheremaybereducedornooutsidesupplies.Supplybottlenecksareexpectedtobezeroed.

Quasi Just-In-Time benefitsFWFmodelcanprovideJITbenefitswithanaddedadvantageofnorequirementfor inventory storage.

Benefits available under Indirect tax regime and opportunity for saving Itispossibletoexplorebenefitsavailabletojobworker,productionwithinthesamepremises,transferofcreditswhichwouldotherwisebecostsetc.

Economies of scale and opportunity to save owing to bulk/ continuous purchasing ThededicatedsupplyislikelytogenerateeconomiesofscalefortheSupplierandopportunity to negotiate for the principal manufacturer.

Factory within factory You can explore | 7

infrastructureatalowercost,accesstocommonfacilitiesthatforasubordinatemanufacturercanbeunaffordable,etc.

Methodology/Factors to be consideredWhile there is no specific methodology for such an arrangementbetweenthesubordinatemanufacturerandtheprincipalmanufacturer,themodelwoulddependupon the intentions of the parties to the arrangement. For instance,ajobworkermodel,acontractmanufacturingmodel,aswellasaserviceprovidermodelcouldbepossiblyusedinthepresentcase.

Certaincriteriawhichwouldbehelpfulindeterminingthebestnatureofarrangementwiththeprincipalmanufacturerhavebeenoutlinedbelow:

• Thetenureofthearrangement:Ifacomparativelyshort-durationarrangementoftwo-threeyearsisproposedthenthefeasibilityneedstobere-examinedbecauseofthehighfixedcostsassociatedwithsettinguptheFWF.Incasesoflong-termarrangementsofabovetenyears,thepossibilityofacontractmanufacturing or a service provider arrangement maybeworthexploring.Insuchcases,theprincipalmanufacturermaypreferablynotwanttotakeontheonusofvariousindirecttaxliabilitiesassociatedwiththemanufacturingprocessofthesubordinatemanufacturer.

• TheinvestmentrequiredinsettinguptheFWF:InvestmentrequiredalongwiththeexpectedInternalRateofReturnofthesubordinatemanufacturerwouldneedtobeconsideredinordertoarriveattheappropriate arrangement.

• Theindirecttaxesoftheprincipalmanufacturer:Indirecttaxesplayaveryimportantroleindeterminingthe appropriate arrangement. Depending on the rateofdutypayableonthegoodsoftheprincipalmanufacturer, the contract manufacturing option maybeexplored.Therearescenarioswherethefinalmanufacturermakesanexemptedproductoraproductwhichhasalowerrateofexciseduty.Insuchacase,thejobworkermodelortheserviceprovidermodel may lead to higher/inverted duty structure for the principal manufacturer.

• Capacityutilization:Incaseswherethecustomerrequirementsvis-à-visthemanufacturingcapacityof

thesubordinatemanufacturerisless,hewouldprefertofollowacontractmanufacturingoption.Thiswouldenablehimtofreelysellthebalancemanufacturedmaterials to another customer. Requirements of the principal manufacturer, hence, impacts the nature of arrangement

• Therelationshipbetweentheparties: The provisions underCentralExcisehaveaconceptwherebytheassessablevalueundercentralexcisedoestakeintoaccount the fact that the entities are related and thatthepricehasbeenaffectedonaccountofsuchrelationship.Insuchascenario,aserviceprovidermodelmaybepreferred,whereinservicetaxprovisionswoulddeterminethevalueofservices,consideringthestringency of service tax legislation.

• Overcominglogisticsissues:As explained earlier, in certain industries for example, the chemical industry orcementindustry,timeisofcriticalessence.Inputshavetoreachwithinacertaintime-frametoensurethat quality standards are met. A lag in supply chain cansignificantlydisrupttheprocessflow/demandobligationsandhenceFWFset-upcaneliminatethelogistics hurdles to a huge extent.

• Incometaxandtransferpricingissues:There are

caseswheretheoverseasparententityowningthetechnology may receive certain royalty directly from the

While there is no specific methodology for an arrangement of FWF model, it would depend upon the intentions of the parties to the arrangement.

Being transaction specific, indirect taxes play a very important role in determining the appropriate arrangement.

8

principalmanufacturer.Ifthisisthecase,thetransferpricingissuesmayneedtobeconsideredincasethe principal manufacturer and the overseas parent qualifyasassociatedenterprises.Thedisallowanceorotherwiseofcertainexpenditurebasedonthefactthattheincomeisincurredbytheprincipalmanufacturerandpartofitisbornebythesubordinatemanufacturerbasedoncertainparametersdoestendtobecomeanimportantdeterminantonthemodeltobeadopted.

Likely Challenges TheFWFmodel,likeinallcaseshascertainadvantagesanddisadvantages,andisthereforelikelytohaveitsownchallenges.

Someofthechallengesthathavebeenobservedinrespectofentitiesoptingforthismodelincludethefollowing:

Tax issues: The FWF model may give rise to some of the unsettledissuesowingtotheinfancyofthismodelintheentiremanufacturingindustryperse,bundledwiththeregulartaxissues.Someofthetaxissuescanbeasunder:• Registrationsundertaxlaws:Ithasbeen

observedinmanycasesthatthefactoriesoftheprincipalmanufacturersarebuiltonlandbelongingtoagovernment/quasigovernmentbodiesathighlysubsidizedcosts.Inalotofthesecases,theagreementswiththeseGovernmentbodiesclearlyput a restriction on the principal manufacturer for sub-leasingittoanyotherentityorformanufacturinganyothergoods.Thus,obtainingthepermissionforsettingupafactorybelongingtoapersonotherthantheprincipalmanufacturermayposeaproblem.

• CENVATcredits:Oneoftherequirementsfortakingcredits under central excise is receipt of goods into the premises/factoryofthemanufacturer.Sincethefactoryofthesubordinatemanufactureriswithinthepremisesoftheprincipalmanufacturer,thereisapossibilitythatthe excise authorities may challenge receipt of certain goodsinthefactoryofthesubordinatemanufacturerfor the purpose of credit availment.

• Timeforpaymentofduties: As a corollary to the inputcredits,excisedutyispayableonclearanceofthegoodsfromthefactory.IncaseoftheFWFmodel,whilethegoodsphysicallyremainwithinthesamepremises,principallythegoodscanbesaidtohavebeenremovedfromthefactoryandtherebytherequirement of payment of excise duty.

• Valuationaspects:Sincethefactoryofthesubordinatemanufactureriswithinthepremisesoftheprincipalmanufacturer,certainutilitiessuchaselectricity,water,etc.maybeprovidedfreeofcostorataconcessionalrateastheprincipalmanufacturermayhimselfbegetting some concessions from the Government owingtowhichthereisapossibilitythattheindirecttaxauthoritieswouldtendtoaddanotionalvalueoftheseamenitiestothetransactionvaluechargedbythesubordinatemanufacturertotheprincipalmanufacturer.Taxationaspectsofanyindirectconsiderationflowingfromtheprincipalmanufacturertothesubordinatemanufacturerneedtobeexaminedindependently.

Go–Nogo:InmostofthecaseswheretheFWFmodelisrequired,theprincipalmanufacturerislocatedafewkilometersawayfromthecity.Theplacesaregenerallyremoteanditislesslikelythatonehasthemanufacturersofidenticalgoodsinthenearbyvicinity.Thisbeingthe case, the annual requirements of the principal manufacturer play a significant role in deciding to opt for themodelorotherwise.Thesubordinatemanufacturerneeds to ensure that either its capacity is utilized or it has otheravenueswherebythegoodsmanufacturedbyhimwouldbesold.

Protecting the Intellectual Property: Sincetheentirefactoryiswithinthepremisesoftheprincipalmanufacturer,theriskofthemanufacturingmethodologybeingunderstoodandimplementedbytheprincipalmanufacturercannotberuledout.Thecontroloftheprincipalmanufacturercanbeminimizedbyimposingappropriate access controls including restricted inspectionchecks.Sincethesubordinatemanufacturer

Factory within factory You can explore | 9

setsuptheentirefactorywithinthepremisesoftheprincipal manufacturer, it is very important to ensure thattheownershipoftheplantalwaysremainswiththesubordinatemanufacturer.Thearrangementshouldtypically ensure that the principal manufacturer does nothavetohaveownershipintheequipmentofthesubordinatemanufacturer.

Itisequallyimportantfortheprincipalmanufacturertorealizethatthesubordinatemanufactureralsohasaccessto a lot of information of the principal manufacturer, some ofwhichmaysurelybeconfidential.Hence,protectingtheIP,notonlyforthesubordinatemanufacturerbutalsofor the principal manufacturer is a critical factor and a challengeatbothends.

Labour issues: Thesubordinatemanufacturer’sfactorywithinthepremisesoftheprincipalmanufacturerwouldalwaysbesmallerinscaleandcertainlyemploymuch lesser personnel as compared to the principal manufacturer.Thelabourunioncouldimposechallengesinasmuchaswhethertheunionwouldpersepermitemployeesofthesubordinatemanufacturerwithinthe premises of the principal manufacturer. There is alikelihoodofdisputesonaccountofthepossiblediscretions in the compensation levels of personnel of theprincipalmanufacturervis-à-visthesubordinatemanufacturer.Thisismoresoifthesubordinatemanufacturerisamulti-nationalcompanyandtheprincipalmanufacturerisanIndianentity.Theculturaldifferencescanalsorepurcateontheirown.Likewise,the principal manufacturer may equally face these issues assumingthatthebenefitsenjoyedbythepersonnelofthesubordinatemanufacturerarebetterthanthoseoftheprincipal manufacturer.

Deposits: Consideringthecommitmentsinvolvedinsuchkindorarrangementsfromboththeprincipalmanufacturerandthesubordinatemanufacturer,adeposit/bankguaranteecouldoftenbecomeakeyissue.The principal manufacturer may require such a deposit fromthesubordinatemanufacturerconsideringthefactthatthesubordinatemanufacturerwouldbelocatedinthe premises of the principal manufacturer for a fairly long periodoftime.Similarly,thesubordinatemanufacturermaydesireafixeddeposit/bankguaranteefromtheprincipalmanufacturertakingintoaccountthathewouldbeentirelysettingupaplantonthebasisofthecommitment of the principal manufacturer.

Thefortunesofthesubordinateoperationareentirelydeterminedbythatoftheprincipalmanufacturer.Thereisalso a certain rigidity that sets into the operating model of theformer.Thisisbecausethesubordinatemanufacturerhasasinglecustomerandwillthereforehavetolineuphisactivitiesonthebasisoftheactivitiesoftheprincipalmanufacturer.

Therearesituationswhereinthelong-run,theeconomicsmaynotprovefruitfulforbothparties,giventherigidityofthearrangement.Theforce-fittingofthesupplierin a particular size to suit the needs of the principal manufacturer may also impact the economics.

ConclusionWhileitisworthadoptingtheFWFmodelincertaincases,themodeldoesnotappeartohavebeenusedtothemaximumpossiblepotential.Moreover,thebenefitsofsuchanarrangementhavenotbeenadequatelyleveragedandcouldbringoutlotsofcompetitiveadvantages.

Thedecisionofwhethertoadoptthesameorotherwisedependsonvariousfactorswhichmaybeevaluatedfromexperts.Someofthefactorsthatneedtobeevaluatedareoutlinedbelow:• whetheritisworthwhiletoadopttheFWFmodelin

the given set of circumstances• determiningthemostfeasiblestructureconsideringthe

various aspects as regards the principal manufacturer andthesubordinatemanufacturer

• adviceandassistanceontheoptimumpricingstructureconsidering the various tax implications

• adviceonobtainingclearancesfromthetaxauthoritiesintheformofobtainingregistrationsasmayberequired

• on-goingadviceandassistanceonvariouscompliancesthatmayberequiredfromataxperspective.

10

Contacts

Kumar KandaswamiSeniorDirector&IndiaManufacturingLeaderEmail:kkumar@deloitte.comPhone:+91(0)4466885401

MS ManiEmail:msmani@deloitte.comPhone:+91(0)2266198552

Vijay IyerEmail:viyer@deloitte.comPhone:+91(0)2266220504

Rajan KamatEmail:rkamat@deloitte.comPhone:+91(0)2266679311

Factory within factory You can explore | 11

DeloittereferstooneormoreofDeloitteToucheTohmatsuLimited,aUKprivatecompanylimitedbyguarantee,anditsnetworkofmemberfirms,eachofwhichisalegallyseparateandindependententity.Pleaseseewww.deloitte.com/aboutforadetaileddescriptionofthelegalstructureofDeloitteToucheTohmatsuLimitedanditsmemberfirms.

The information contained in this material is meant for internal purposes and use only among personnel ofDeloitteToucheTohmatsuLimited,itsmemberfirms,andtheirrelatedentities(collectively,the“DeloitteNetwork”).Therecipientisstrictlyprohibitedfromfurthercirculationofthismaterial.NoneoftheDeloitteNetworkshallberesponsibleforanylosswhatsoeversustainedbyanypersonwhoreliesonthis material.

©2012DeloitteToucheTohmatsuIndiaPrivateLimited.MemberofDeloitteToucheTohmatsuLimited