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Article | December 2, 2011
Stretch your CapEx budget by managing risk
Through tight partnerships and careful planning, contract service partners can minimize risk and make the most of their budgets by considering the many options for financing capital equipment.
A business needs money in order to grow—that’s a given. But how companies get that money and how they allocate the capital expenditures can vary widely. There are no one-size-fits-all solutions in financial planning.
“Our company does have a systematic plan for capital expenditures in facility, equipment, and communications,” says Chris Nutley, president of MSW Packaging (www.mswpackaging.com), a contract packager in Lawrenceburg, IN. “As you can imagine, capital expenditures have taken a bit of a back seat during the struggling economy. As a result, communications expenses, such as computer hardware and software, have all experienced delayed replacement by 18 to 24 months.
“Facility CapEx has remained on schedule, however, partly because the real estate market has been so favorable to tenants. Many contract packagers have been able to improve their space, or reduce the cost of their current space, and utilize the savings for physical upgrades,” he explains.
“We systematically reinvest in the main staples of packaging equipment, such as shrink wrappers, printers, labelers, glue systems, taping systems, and more. These items are not product-specific. But routine purchases of such staples have suffered from the economic conditions by being delayed by 12 to 18 months in replacement,” Nutley admits.
Sometimes a shared approach between supplier and customer to equipment investment is an option, but MSW does not have packaging equipment on-site which is customer-owned. “MSW owns all of its equipment,” Nutley explains. “For projects that are package form-specific, MSW will typically share in the initial investment with one CPG company, and create a ‘buy-back’ scenario, in which MSW owns the equipment wholly after an agreeable volume level has been reached by the participating brand owner.
“If the required equipment is product-specific, custom-built, and fully relies on the success of that particular brand, most CPG companies understand that the contract packager cannot expose their business to a large portion of the capital expenditure,” Nutley says.
With any capital expenditure, Nutley advises that the company first do an honest and diligent assessment of how much risk the business can withstand. Next, the contract packager must predict whether the product/package will actually succeed in the market. “The contract packager must do this. Of course, the brand owner always thinks the product will be a success,” he ruefully admits.
MSW is gradually moving to a CapEx model that encourages mutual risk shared by the contract packager and its customers. One method would be to pay back the CPG over time and capacity utilization until the equipment is fully owned by MSW. But any such contractual arrangement has to be evaluated on a customer-by-customer basis, Nutley believes.
One way that MSW has been able to postpone many capital expenditures in machinery is by building a state-of-the-art in-house machine shop which can handle maintenance but also can retool existing machinery for new products or uses. Recycling, so to speak, and reusing has kept MSW nimble without extensive major investments, Nutley says.
Lance: supplier and consumer
Greg Flickinger, vice president, manufacturing and corporate engineering, Snyder’s-Lance (www.snyderslance.com) in Charlotte, NC, expresses a slightly differing view of CapEx. As a consumer packaged goods (CPG) company and also a contract manufacturer/packager, Snyder’s-Lance is uniquely positioned to both seek outsourcing when needed and also provide it to other—many quite large—CPGs.
“We do some selective outsourcing, but it is a very small component of our business,” Flickinger explains. “Typically, we will outsource products to companies that already have expertise or technology. Occasionally, we could do it for capacity purposes. This is a very small component of our business. Our business model covers three general business segments: Branded, Private Brands, and Contract. Private Brands and Contract makes up approximately 21% of sales. “We contract manufacture for a number of big companies. Depending on the product and capability, they will provide key equipment components to us,” he says.
In-plant upgrades for property, plant or equipment are well planned. “We have guidelines for in-house upgrades. The guidelines will vary depending on the type of project. The three types of projects would be business critical (maintain the business), cost savings (target 20+% IRR), or innovation/growth,” Flickinger explains.
Ownership of any required equipment varies upon circumstances. “When we outsource, we prefer that their company own the equipment,” Flickinger says. “When we serve as contract manufacturer, we generally expect the company we are making the product for to provide or own any unique equipment. We will consider purchasing equipment ourselves for the application, but that would require a longer term contractual agreement.”
Lisa Shambro, Executive Director, Foundation for Strategic Sourcing (F4SS, www.f4ss.org), explains eight different ways that a contract manufacturer/packager and a customer can finance a capital investment. Shambro is the author of Contract Packaging’s “Cost Cutter” column. “There is no right or wrong way to do this. It’s up to the parties in any arrangement to agree on an approach that works for both of them,” she says. The multiple financing options take into account that variables and uncertainties—such as the market success of a new product or the ability to obtain financing—are inevitable.
“A Capital Expenditure Matrix was developed by a team of F4SS members which provides a variety of alternatives to fund CapEx in the upstream CPG supply chain,” the team’s directive states. “Each option includes detail on equipment ownership, maintenance, capacity management, depreciation, installation costs, project completion, equipment removal, and penalties.” The matrix further outlines balance sheet implications for both the customers and suppliers.
The eight approaches identified by F4SS for financing capital investments are:
• Customer purchases the equipment which is installed at the supplier’s plant; customer owns the equipment outright.
• Supplier purchases the equipment on behalf of the customer and charges the customer on a pass-through billing; the equipment ownership transfers to the customer at the end of the contract (a capital embedded lease).
• Supplier purchases the equipment, similar to the above arrangement, but the customer has the “rights to purchase” the equipment at the end of the contract.
• Supplier purchases the equipment as an expansion of its manufacturing lines and customer is charged for its use; no transfer of equipment occurs.
• Supplier purchases equipment, as above, but a third party holds the lease and the customer is charged for its use; no transfer of equipment occurs and the third party owns the machinery.
• Customer purchases equipment as an expansion of the suppliers’ lines, and supplier is charged for its use. Ownership transfers to the supplier at the end of the contract.
• Supplier purchases equipment with a secured capacity payment by the customer; if the customer falls short of the secured minimum usage, the supplier can use the equipment for other customers. The secured capacity payment can be made up front or in installments.
• Supplier purchases equipment; the customer has a variable payment of “take or pay.”
Shambro says that most CPGs now shy away from embedded leases in any contracts with outsourced suppliers because such expenses must be disclosed in all financial reporting. This requirement is a result of the 2002 Sarbanes-Oxley (“SOX”) law, named for its sponsors, Sen. Paul Sarbanes (D-MD) and Rep. Michael Oxley (R-OH), The intent of the Sarbanes-Oxley Act is to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws. Spawned from the corporate scandals of the early 2000s, the Act specifies new financial reporting responsibilities, including adherence to new internal controls and procedures designed to ensure the validity of their financial records.
Contract suppliers and their customers have many completely legal approaches to financing the required capital expenditures needed to complete any project. The resulting agreements between the two parties are a reflection of the comfort level of both. To paraphrase Shabro’s statement, there is no one-size-fits-all.
Mary Ann Falkman is a veteran packaging industry journalist. Contact her at 630/653-5950 or [email protected].
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