and ProceSSes Manufacturers must continuously innovate to grow and succeed. The NewsleTTer of the BDO MANufacturING & DistrIBuTIon PracTIce

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1 Summer The NewsleTTer of the BDO MANufacturING & DistrIBuTIon PracTIce Innovating New Products and ProceSSes Manufacturers must continuously innovate to grow and succeed. An improving economy should be good news for manufacturers. Yet many manufacturers scramble to respond to increased demand for innovative new products and miss product launch windows and the revenues and profits they could earn by getting new products to market in time. Why? Because many firms lack streamlined productdevelopment and marketing capabilities that will enhance their profit potential from new products. Innovation doesn t necessarily mean a succession of new product launches by your company. Growing through innovation also can mean well-timed product extensions or upgrades. Or it might mean packaging value-added services with existing products, which can make old seem new: e.g., additional roles in a B2B customer s operations, such as kitting your products with those of other suppliers, or information, such as product guides, usage tips or online communities that help consumers and business customers make better use of their purchases. Is your company ready to innovate? Make sure you are by implementing four innovation keys: 1. Understand what your customers want. 2. evaluate your current products against what customers want. 3. Improve the people and processes that innovate and get goods to market. 4. Continuously invest in innovation. BDO Manufacturing Output regularly examines how manufacturers are rethinking their operations, processes, supply chains, workforces, business systems, and products and markets to gain competitive advantage. Amid a changing yet uncertain economy, manufacturers must continue to evaluate how they can reinvent their organizations and leverage emerging opportunities for growth. This installment of BDO Manufacturing Output includes three articles that reveal ways that manufacturers wield innovation for competitive advantage: Innovating New Products and Processes New Products by the Numbers Leveraging Government Incentives

2 2 BDO Manufacturing Output Continued Innovating New Products and Processes u Innovation Key #1 Understand what your customers want. Is your company giving customers what they really want, when they really want it and how they really want it? The first step for improved innovation is to develop a clear picture of customer needs. Make sure that your team is using the right tools (business intelligence, customer surveys, analysis of online and social media feedback) with the right talent (sales force, customer support staff, distributor networks) to fully understand why customers like or dislike your products. u Innovation Key #2 Evaluate your current products against what customers want. A well-planned innovation program will rigorously evaluate how well your current products satisfy (or don t satisfy) both current and future demand. A portfolio approach works best: Ensure support and capacity for strong/ thriving products: Bestsellers, preferably early in their profit cycles, should be capturing substantial market share. Can production keep pace with demand? Understand why new products are missing sales and profit targets, and fix them: If products aren t selling, perform new-product triage. Why aren t products moving sales and marketing, production delays or problems, bad product design or a combination of all three? u Innovation Key #3 Improve the people and processes that innovate and get goods to market. Identify strengths and weaknesses along your innovation pipeline, finding and fixing gaps (where you are vs. where you need to be): R&D/product-development talent: Manage recruiting, onboarding and development practices to ensure your innovation processes are staffed with skilled senior leadership, designers, engineers, customer support staff, etc. Innovation processes: Innovation is a stream of varied functions. Establish transparency of functions ideation, forecasting, R&D, design and development, scheduling, procurement, prototyping, tooling, manufacturing, sales and marketing and efficient handoffs from function to function. Intellectual property (IP): Capitalize on the advantages that only your company can offer or, if IP is lacking, partner for or acquire IP, patents and technologies. Not every gap will be addressed internally. Supply-chain partners can help to close both product and process gaps by offering unique technical expertise or even outsourcing of entire product lines. Or you might acquire skills, processes, IP or an entire company. u Innovation Key #4 Continuously invest in innovation. Lastly, carefully consider how to fund innovation in your company and where to apply those investments. For example, will new products require new tooling or machinery? Depending on cash flow and sales potential, you might purchase new flexible equipment, leveraging it for various new products. Alternatively, you might lease only the equipment or tooling needed right now. Only careful, quantifiable evaluation of the options will deliver the correct decision. Government incentives and credits can help to minimize the funding burden (see Leveraging Government Incentives). Reinvigorate products that are losing their margins to competitors: Upgrades or iterations can often re-energize an aging product line, satisfying short-term customer needs. Similarly, a new marketing push can spur sales. Retire products at the end of their profit cycles: Eventually most goods lose their appeal. Establish a well-defined pricing strategy to lower inventories, in part to make room for new product introductions. But remember, you want to set a price that will clear inventory while delivering maximum profits.

3 BDO Manufacturing Output 3 New Products By the Numbers What will it really take to get your company s innovations to market? What you don t know might surprise you and waste your company s time, resources, and reputation. Yet with effective business intelligence and analysis, manufacturers can identify newproduct risks and rewards while products are still on the drawing board, and avoid innovation failures. Competition Matrix First, identify and quantify the external forces customer demand, compliance criteria and the competition that will determine the success of your product entering a market. u Quantify customer demand: what do customers really want, and when will they really want it? Quantify customers willingness to purchase potential products, as well as how quickly that demand will arise. Factor in existing customers willingness to migrate to newer versions of your products. what price will customers pay? Identify pricing thresholds at which customers gain or lose interest. This will typically vary depending on the demographic and geographic makeup of the customer market. how much product will customers want and for how long? Accurately size the profit window for the product (brief because of a one-time purchase, or lengthy due to iterative purchases and maintenance). u Quantify the effort and costs to achieve product compliance Most industries operate within stringent state/ province and country regulatory requirements, often governing all facets of product development, from energy consumption to incorporation of materials. Non-compliance is expensive: You could have an entire product line pulled from a market because of a single non-compliant part or material. In some industries, your customers also can impose voluntary guidelines that have the impact of regulatory clout. What level of compliance will your major customers demand? u Quantify the competition Identify established brands that have high visibility and customer loyalty. Pay attention, as well, to which companies back various brands (see Competition Matrix). Even a fantastic new product can fail in fighting an established brand with corporate muscle behind it. Conversely, emerging markets may offer a more level playing field, where even well-known companies must fight for brand recognition. Your company s innovation success depends on a profitable balance of external factors affecting demand and internal innovation capabilities, determined through a three-step process: 1. Quantify your pricing targets and sales volumes both at launch and during product maturation. 2. Account for all estimated costs to develop, source, make, ship and market compliant products. 3. run what-if? scenarios with both optimistic and pessimistic ranges and calculate ROI given the most likely risk scenarios. These steps will support a go/no-go decision that drives new product launch success or stops or alters product development before it s too late. It s important to remember that not all product development leads to a new product in fact, sometimes the best outcome of innovation accounting is to prevent an unsuccessful product from being launched.

4 4 BDO Manufacturing Output Leveraging Government Incentives R&D Credit Stages 1. Identify stages of development process. 2. Determine to what extent each stage qualifies. 3. Identify components on which qualified work was performed. Manufacturers from all industries have taken advantage of the U.S. R&D credit for decades, reporting billions of dollars annually in such credits. These are dollar-for-dollar offsets against regular tax liability for attempts to develop new or improved products, processes or software, as well as for what is commonly thought of as R&D. On Dec. 31, 2011, the credit lapsed for the 15th time, and currently awaits renewal in Congress. It s been renewed retroactively every time but once since it was enacted in 1981, and both political parties and President Obama have sponsored bills calling for the credit s extension and enhancement. Smart executives will be prepared to report federal R&D credits, as well as seek out and claim the sometimes more flexible and generous R&D incentives offered by most U.S. states and other countries. For example, if a business in California had qualified spending of $1 million in 2011, the net value of its 2011 federal and California R&D credits would be just under $150,000. To take advantage of R&D credits, manufacturers should look at their product-, process- and software-development processes to identify whether and to what extent each stage of those processes qualifies. R&D, as traditionally understood, is likely to qualify. Most R&D credits, though, relate to attempts to improve existing products, processes and software, through hard sciences but also through applied fields like engineering and software development. In addition to understanding how general development activities qualify, tax examiners will want to see how those qualified activities relate to specific projects or business components, i.e., generally, to the products, 4. Determine qualified spending on each component in terms of qualified stages. 5. Calculate credit. 6. Gather information and documentation related to components development. processes, software, technique, invention or formulae that are being developed or improved. Manufacturers, therefore, should prepare or gather existing documentation to show this nexus between qualified activities and costs, as well as to show that the general and specific activities of major initiatives qualify. Some companies have such documentation readily available: e.g., in time-tracking or project-accounting reports, design requirements and specifications documents, drawings and lines of software code, test plans and test results, etc. Many do not.

5 BDO Manufacturing Output 5 Continued Leveraging Government Incentives The documentation to be gathered or prepared should show how the activities meet the definition of qualified research, often outlined as a four-part test requiring the activity to be: Intended 1 to create a new business component or improve a component s functionality, performance, reliability or quality Through a process designed to evaluate one or more alternatives to achieve a result where That process fundamentally relies on the principles of engineering or the physical, biological, or computer sciences; and The capability or the method of achieving that result, or the appropriate design of that result, is uncertain at the activities beginning. Permitted purpose Process of experimentation Technological in nature Uncertainty Contact: Howard Sosoff Manufacturing & Distribution Practice Leader / hsosoff@bdo.com Matt Becker Tax Partner, Grand Rapids / mbecker@bdo.com Brian Eccleston Assurance Partner, New York / beccleston@bdo.com John Fenton Assurance Partner, Atlanta / jfenton@bdo.com Stephen Ferrara Assurance Partner, Chicago / sferrara@bdo.com Businesses with little or no such documentation should plan their next step with their tax advisor. In addition, because the credit calculation can be affected by variables not required by the form on which the credit is reported e.g., whether the business ownership makes it a member, for purposes of the idiosyncratic R&D credit rules, of a group of businesses under common control a tax advisor should be consulted to ensure the credit is calculated correctly and that all the appropriate elections are made. It is not uncommon for businesses to materially underor over-report their credits simply because they haven t factored in these variables; and because some elections must be made on a timely filed original tax return, they can t be corrected or dealt with later by amending the return. Finally, in addition to R&D credits, consider other tax and non-tax benefits related to your innovation investments, including: Tax benefits: R&D credits and deductions often available for the same dollars in multiple countries including investment credits; tax exemptions or holidays; accelerated depreciation; and training incentives. Non-tax benefits: cash subsidies and grants; government-sponsored centers/ programs; no- or low-interest loans; and reduced red tape. Issy Kotton Assurance Partner, Los Angeles / ikotton@bdo.com Fred Rozelle Assurance Partner, Detroit / frozelle@bdo.com Rick Schreiber Assurance Partner, Nashville / rschreiber@bdo.com John Tucci Assurance Partner, Woodbridge / jtucci@bdo.com 1 Note that the activity does not have to succeed in creating a new or improved component to qualify, as is required in many other countries. About BDO BDO is the brand name for BDO USA, LLP, a U.S. professional services firm providing assurance, tax, financial advisory and consulting services to a wide range of publicly traded and privately held companies. For more than 100 years, BDO has provided quality service through the active involvement of experienced and committed professionals. The firm serves clients through more than 40 offices and more than 400 independent alliance firm locations nationwide. As an independent Member Firm of BDO International Limited, BDO serves multinational clients through a global network of 1,118 offices in 135 countries. BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms. For more information, please visit: To ensure compliance with Treasury Department regulations, we wish to inform you that any tax advice that may be contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or applicable state or local tax or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. Material discussed is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual circumstances BDO USA, LLP. All rights reserved.