Are you the type of person who wants to know what is inside the computer? There was an old advertisement which says intel inside, but besides knowing that piece of information, how is the computer put together? If you are the least bit interested there is a wonderful book to read about the insides of the computer. The book is called Hardware Hacker by Andrew Huang, published no starch press, San Francisco, 2017. If you are similar to me, then the answer to the questions was not really, but there are lessons to be learned about the process of how the computer is made.

At the moment, there is a cry by politicians to bring back manufacturing to the US and most of us understand the sentiment but there is reality. The reality of manufacturing including components for computers is the ecosystem which has grown up. The ecosystem in China is highly developed, if you were to bring manufacturing to the US, which scale would you be talking about?

The book starts with Mr. Huang arriving in China in 2007 and going to the SEG Electronics Market in Shenzhen. Mr, Huang was the lead hardware engineer for Chumby, and found every part plus more of what he needed at volumes that made sense from a start up company. At SEG he was available to buy books and components for very inexpensive prices, he essentially saved the cost of the flight to China from the US buying in China as opposed to the US.

Mr. Huang describes in his book the ecosystem from the electronic parts, to the molding, to the factories, to quality control processes. In pages 190 -200 he puts in an interview of lessons learned, which most are not taught in school.

dealing with merchant buyers – brick and mortar retailers hire teams of buyers assigned to monetize shelf space. They think about products in terms of revenue per shelf space. How many times will the product turnover? if it does well, they reorder, if it does not, there are other alternatives.

margin – everyone in the supply chain has a hand out: the distributor, the merchant and the factory. The shelf cost of a product is about 3 times your BOM cost. This means adding a $0.50 part turns into a $1.50 retail price impact.

This is aggravated by the fact that prices are quantized into magic numbers (like $19.99, $49.99 and $99.99) that you have to hit. If a product retails for above $99.99, it is psychologically binned with the $149 or $199 products. When your product price reaches the magic numbers, to add a $0.50 part, either it comes from your margin or risk pushing your product into a higher price tier.

cash flow – retailers are notoriously bad at pay on time. You may negotiate 60-day terms, but that often turns out to be 90 and 120 days. If the product does not sell, you will be strung out even more. This can partially offset by factor insurance.

reverse logistics and returns – many retailers offer no questions asked return guarantees. Who pays? the retailer passes the buck to the entrepreneur. What to do with the returns – some are damaged and need fixed, some did not meet the customer expectation

VC funding – software funding is innately scalable. Hardware funding is much more difficult. In hardware, the first question is the distribution channel and how hard is getting your product to the end user. You might be very surprised how often people called support who forgot to plug the product in.

Mr. Huang recommends a maker try to first fund research and development out of pocket. Every time you turnover your inventory you can buy more and this will be good discipline to learn. If you are growing your capital base by 20% with every inventory turn, it only takes 4 times to double your money. The magic of compound percentages – $100 turns into $120 which turns into $144 which turns into $172 and the fourth turn is $207.

If you are selling a consumer electronic – up to 90% of your business can happen in the 4th quarter. If you miss Christmas, you miss the year for there will little revenues for the next 3 quarters. For hardware companies it is ship or die.

aim high with pricing – hardware startups typically want to set the price low to drive buzz and improve initial sales. The margins can be good but what happens when sales drop? If you sell higher, the margins are great but sales are average, however the retailer loves to use sales to make units move and they can reduce a $99 unit to $69 and still make a 29% margin.

Apple in 2017 was spending $ one billion a year on tooling. An injection molding tool may cost $40,000 and take 2 to 3 months to make; Apple is known to build 5 or 6 molding tools and then only use one while they were testing the other possiblities. Apple spending $200,000 in tooling to save 2 month’s time to market is a very small investment for them. For a startup that would be suicide. If you compare yourself to Apple’s design either have the money in the bank or try a different strategy.

Linking to dividend paying stocks, often times there are sound reasons why companies make profits to pay dividends. Some of that is the ecosystem which they are part of and use. For a competitor, building a better mousetrap is not the most important aspect, the most important aspect is does it sell at margins and volumes that produce profits. It is important to understand why the companies you invest in make money and the competitors are not as good, understanding will allow you to have tools to evaluate how the company is doing. There are generally good reasons why the ecosystem works the way it does, does your company investments work within it or trying to disrupt it?

There are more questions than answers, till the next time – to raising questions.