Manufacturing Heat-Not-Burn: The Nitty-Gritty Economics
Part-Two of our ‘Manufacturing Heat-Not-Burn’ Series
As we discussed in our last article, the fact that a large number of Heat-Not-Burn products come from Shenzhen, China is not a coincidence. China has, in an effort to secure its place as a global leader for business, industry, and trade, developed complex economic policies that entice investment in the Chinese market. In our last article, we explored the concept of Special Economic Zones, geographic areas which are permitted by the Chinese government to operate under less restrictive economic regulations. Ultimately, SEZs house mini free-market economies. But SEZs are just one aspect of an intricate economic system. Behind the scenes there are many more policies, regulations, and practices at play. In part-two of our two-part series, we will learn about production costs (including labor cost, raw material costs, and large-scale production), Minimum Order Quantities (MOQs), Original Equipment Manufacturers (OEMs), and Value-Added Resellers (VARs).
The Many Aspects of the Manufacturing Business
China has one of the most sophisticated economic systems in existence. It’s no wonder that industries like Heat-Not-Burn are able to easily grow and expand there. Nevertheless, there is alot to think about when manufacturing any kind of product, not just HnB.
Production Costs: Labor
When Special Economic Zones were first established, it was incredibly cheap to manufacture products in China. Since the economy wasn’t the strongest at that time, labor costs were much less than those in Western countries. These low prices drove down the overall cost of production.
Since that time, labor costs have risen, but as of 2019, China still ranks the no. 1 cheapest country to produce goods in. Labor costs remain lower than in most Western countries, nevertheless labor is not the only reason for inexpensive production. There are several other main reasons, such as infrastructure and lower raw material costs.
Production Cots: Raw Materials
When the Chinese government discovered that SEZs were successfully working to boost the economy, infrastructure became much more geared towards transportation of goods, often on a large-scale. Items are easily transported nationally and internationally by planes, trains, boats, and automobiles. This kind of accessibility makes it easy to do business in a global world. It also means there the costs of transporting goods is often less than in countries where there does not exist infrastructures designed solely for the purpose of aiding in the transportation of manufactured products and the raw materials needed to make them.
For raw materials, even though China is not rich in many natural resources, it is easy and cheap to bring the materials in. To drive the price down even more, raw materials are often sold in large quantities. Much like Costco’s business model; the more you buy, the more you save.
Production Costs: Large-Scale Production
If you ever visit the websites of Heat-Not-Burn manufacturers you’ll often notice that their devices are manufactured in large factories with many workers and alot of high-tech machinery/tools. This is common practice for manufacturers who want to reduce production costs. By investing in their products (for example, buying raw materials in bulk, purchasing machinery, hiring experts) the total cost of production goes up, but the average cost of production comes down. This is know as economies of scale.
For instance, if a company wanted to manufacture 100 devices and each device needed 1 foot of sheet metal, the company would need to buy 100 feet of sheet metal, which will cost them $500. This means that the production cost for each device will be $5. However, the company that the manufacturer buys their sheet metal from wants to maximize profits, so they attempt to make a deal with the device manufacturer; if the manufacturer buys 200 feet of sheet metal instead of 100 feet, the sheet metal seller will sell it for $750 total instead of $500 each ($1000 total). That is a $250 discount for the device manufacturer. If the manufacturer accepts the deal the average cost of each device will go down to $3.75 instead of $5. So while the total cost of production has gone up (from $500 to $750, the average cost of production has gone down). This means that if the manufacturer sells the devices for $10 they would make a profit of $6.25, instead of a $5 profit. So now their returns have also increased, which is beneficial to the company as they can now reinvest that profit.
This is also a common practice called large-scale production. Many manufacturers, especially in China and other like countries, use this to help increase their profits. Large-scale production is one the main reasons that HnB products that do not belong to big tobacco are so inexpensive. With many different price options, everyone is able to access HnB, rather than only the wealthy.
Minimum Order Quantities (MOQs)
Like how many manufacturers work on large-scale production models to cut costs, they also want to sell on the large-scale to ensure they don’t lose profits. To do so manufacturers often use what are called Minimum Order Qualities, or MOQs.
MOQs are exactly what they sound like. They are the minimum amount of devices a manufacturer will sell so that they do not lose money in the manufacturing process. So going back to the example in our last section. Our manufacturer has produced 200 devices. Each device cost them $3.75 to produce, sells at $10, and bring in $6.25 profit. What happens though if they only sell that original $100? The average cost of the devices went down and their average profits went up, but if they only sell 100 of the 200 devices, then they will only make $625 back. This doesn’t even cover the $750 production cost.
Instead, what many manufacturers will do is enact MOQs, so that buyers must purchase a certain percentage of the devices. For our example manufacturer, they may require that the buyer purchase 150 of the 200 devices. Even if the other 50 devices do not sell, the manufacturer will still make $937.5 from the sale of the devices. This covers the original production cost for all 200 devices and leaves the manufacturer with $187.5 in profit.
Now for the average consumer MOQs may not be something you ever encounter, nor that you should worry about, but this is important to know for investors, wholesalers, and other resellers.
Original Equiptment Manufacturers (OEMs) and Value-Added Resellers (VARs)
Often it is mistakenly believed that the reason why so many products come from China is because of the cheap price associated with the manufacturing process there. It is believed that businesses which did not originate in China and are not owned by Chinese citizens, build factories and other production plants in China, then ship the final product back to international retail outlets. As we’ve seen from the above content, this belief is in some part true, however it completely overlooks the fact that many businesses purchase Chinese designed, developed, and manufactured products and sell them as their own. Enter OEMs and VARs.
OEMs, or Original Equipment Manufacturers, are businesses which have developed original products and make those products available for sale. Sometimes these businesses operate under brand names, such as iBuddy or HiTaste, but they can also be, essentially, brand-less. By this, we mean that some OEMs create products that they do not market as their own design. Instead, they sign into contracts with VARs, or Value-Added Resllers, sell them the original products, and thus give the VAR the right to modify the product and sell it, or simply stamp the VAR’s logo on it and resell it.
Why would a company who has spent time and money designing and producing an original product want to let another company take credit for their work? Well, that too can have economic benefits. The contracts between OEMs and VARs offer a level of stability to the OEM that is not guaranteed otherwise. If an OEM can sell 10 000 units of a product to a VAR, then they’ve made their profit. Done and over! If the product turns out to be unpopular with consumers the financial loss falls solely on the VAR, who now owns the 10 000 units. Alternatively, if an OEM sells their own products without a VAR, those 10 000 units that didn’t sell? The profit loss for those units is entirely on the OEM. This could have a negative affect on future productions for the OEM. If the financial loss is serious enough, it could put the OEM out of business.
Up until now, we’ve focused mainly on branded HnB products here at Heat180, but we wanted to let you know about OEMs and VARs because it’s important to be aware that these are all things HnB manufactures have to take into consideration when starting a business, and even later on, in the business’ lifespan.
Another appealing aspects of manufacturing in places like Shenzhen and other like areas is the numerous different kinds of ideas, technology, and equipment available. China, specifically, is known for innovation. Remember, it was in China that the first commercially successful vape product was developed. Even when Chinese manufacturers and investors are not the original developers of a product, they can certainly improve upon it.
Successful products need the insight of experts and visionaries. successful products also need competition. One of the best things for the Heat-Not-Burn industry is that alot of these devices are coming out of the same general region. It forces manufacturers to constantly keep improving their product, by adding new features, and pushing the limits of what HnB devices are capable of.
What Does It Matter?
The Heat-Not-Burn industry as it currently stands is very much dependent on this type of manufacturing. Big tobacco may have created the first commercially successful HnB devices, but these smaller retailers that come out of Shenzhen and similar economic areas are also essential. They are the ones who driven development and innovation, who promote HnB equipment and make it available to the global masses.
In one of our earlier article series, we wrote about the knock off market and how we would recommend you approach it. To summarize, we feel that some knock off (and counterfeit) devices are sketchy, but for the most part, these devices, even though they’re not created by big tobacco companies, can offer really cool features and experiences that rival brand names like IQOS. Whether the devices be smaller brand names, like Lambda, JOUZ, or UWOO, or whether they be unbranded products, they should not be written off. Alot of time, effort, and passion goes into manufacturing Heat-Not-Burn products and that’s something we can get behind!