Manufacturing

Article Dean Dorton

The Manufacturing industry faces challenges and risks that are unique from any other industry. Since manufacturing is a vital spoke in the global economy and an essential component of many other industries, risks to manufacturers tend to have a much larger ripple effect. If risks go unaddressed they can lead to operational and financial losses throughout our economy, not to mention damage to the reputation of the company. It’s important for manufacturers to be aware of the basic and evolving risks they may face and take appropriate steps to mitigate them.

Some key risks include:

  • Supply chain constraints
  • Attracting and retaining quality workforce
  • Cyber security threats
  • Inflation


Our team of Manufacturing Experts have put together a risks overview so you can explore the risks to the manufacturing industry in detail and search for opportunities for growth as we cruise through 2023.

Risk Description
Supply Chain Constraints
Parts/materials difficult to find/long lead times.
  • Acquire logistics companies or develop in-house logistics operations. Greater supply chain visibility and higher quality as well as reducing shipping costs and time due to more streamlined logistics networks
  • Consider new suppliers and sourcing options
  • Relationship management
Attracting & Retaining Quality Workforce
Labor challenges experienced through a shrinking pool of applicants, aging workforce and shortage of highly skilled workers.
  • More favorable working conditions including pay increases and flexible work arrangements
  • Diversity, Equity & Inclusion (DEI) approach to attract more women and racially and ethnically diverse groups
  • Manufacturing companies today have a hard time finding employees who will show up and be on time for work and stick with their jobs
  • Considerable void when it comes to skills and experience – Manufacturers need to work with schools and universities in their communities to ensure that manufacturing focused subjects are being well promoted and taught
Cyber Security
Rise in cyber security incidents across manufacturing companies.
  • Potential effects of a network infiltration include shut down of operations, theft of sensitive customer information, or theft of sensitive banking information
  • Education of employees of potential phishing schemes is paramount to a successful cyber security campaign
Technology
Technology continues to evolve with endless possibilities.
  • Take ERP to the Cloud
  • Data analysis predictive maintenance and use of data analysis to identify anomalies in equipment performance
  • Data decision making around sourcing, production, fulfillment, cost reduction.
  • Controls around Artificial Intelligence
  • Autonomous vehicles in warehouses to move materials and product
  • Robots will change the economics of manufacturing with less time focused on low cost labor positions
Environmental, Social, Governance (ESG)
A sustainability mind-set becomes more of a focal point.
  • Complete visibility throughout supply chain for own compliance and that of their suppliers
  • Manage waste
  • Increase supplier diversity
  • Smart buildings
  • Electrifying fleets
Product as a Service (PaaS)
Diversifying revenue sources has become more important in establishing an indefinite future.
  • Manufactures lease equipment to customers and offer a list of subscription based value-added services
  • Collect equipment usage data from customers
Inflation
Manufactures have to integrate higher priced materials into budget and determine how much to increase prices to customers to absorb these cost increases.
  • Producer price inflation for goods other than food and energy slowed to an annualized 4.2% in the three months ending in December 2022 from 11.5% in the three months ending in April 2022. (Reuters)
  • Manufacturing payrolls increased at an annualized rate of 1.6% in the three months ending in December, down from annualized growth of 5.5% in the three months ending in April. (Reuters)
Possible Recession
Managing through a potential slowdown in the economy will be a focal point of 2023.
  • Sixty-two percent of manufacturers expect the U.S. economy to enter a recession in 2023, according to a survey conducted by the National Association of Manufacturers

Manufacturing Services

Article Dean Dorton

By: Maddie Schueler, JD, LLM | mschueler@deandorton.com

Like most states, Kentucky imposes a sales tax on the retail sale of tangible personal property, digital property, and some services. Kentucky also imposes a complementary use tax on the storage, use, or other consumption of taxable property in the state if no sales tax was paid to Kentucky when the property was purchased.

To achieve various policy objectives, the General Assembly has enacted multiple sales and use tax exemptions. The goal of many of these exemptions is to encourage the development and continuation of industries important to the Commonwealth. This article explores basics about how sales and use taxes apply to two major industries in the state—manufacturing and equine.

The Manufacturing Industry

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Manufacturers’ products sold to end users normally are subject to sales tax in the state where the product is shipped or delivered. The sales tax on a transaction generally is collected by the seller from the purchaser. Specific exemptions may cause the sale to be nontaxable. Because manufacturers typically sell to distributors or retailers who acquire property for resale, manufacturers’ sales often are nontaxable.

When manufacturers buy property for use in their manufacturing process in Kentucky, favorable sales tax treatment is tied to two major exemptions: (1) the exemption for materials, supplies, and industrial tools and (2) the exemption for machinery for new and expanded industry.

Materials that become part of a manufactured product, as well as supplies and industrial tools that are “used up” during the manufacturing process, are exempt from tax because tax ultimately will be collected when the final product is sold to the end user. All materials that enter into and become an ingredient or component part of the manufactured product are exempt from tax. Supplies and industrial tools must be “directly used in manufacturing” and have a useful life of less than one year to qualify for exemption. Notably, the exemption does not apply to repair, replacement, or spare parts.

The exemption for machinery for new and expanded industry permits manufacturers to purchase certain machinery without paying sales or use tax. For an item to qualify for exemption, it generally must meet four requirements:

Be machinery;

Be used directly in the manufacturing process;

Be incorporated for the first time into plant facilities established in Kentucky; and

Not replace other machinery.

A caveat applies to the fourth requirement: new machinery that replaces other machinery qualifies for exemption if it performs a different function, manufactures a different product, or has a greater productive capacity than the machinery being replaced.

The Equine Industry

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Breeding a horse involves producing a product, not unlike manufacturing. The mare may be thought of as “production equipment,” with the stallion’s contribution to the process being “raw material.” So, in what ways is breeding horses subjected to or not subjected to sales tax in a similar manner to manufacturing?

Sales in Kentucky of horses less than two years old at the time of sale are exempt from tax if the purchaser is a nonresident of Kentucky. A nonresident includes both an individual who is not a resident of Kentucky and a business that is not commercially domiciled in the Commonwealth. Sales of horses which are bought for resale also are nontaxable.

Horses, or interests or shares in horses, bought for breeding purposes only are exempt from sales or use tax in Kentucky. However, fees paid to breed to a stallion in Kentucky are subject to sales tax.

Kentucky sales tax law includes numerous general agricultural exemptions, but many do not apply to the equine industry. For example, Kentucky exempts from tax feed, farm machinery, and on-farm facilities. However, all of these exemptions apply in the context of raising “livestock,” which under Kentucky law excludes horses.

In Summary

In summary, both similarities and differences exist in how Kentucky applies its sale and use tax law to manufacturers, in general, and to horse breeders, who also produce items of tangible personal property.

Article Dean Dorton

With the 2018 changes to Kentucky’s tax code, there are a few particularly noteworthy for manufacturers: (1) for income tax: conformity with the federal tax changes, and adoption of single sales factor apportionment for multi-state corporations; (2) for sales tax: the taxation of some repair and installation labor, and a narrowing of the exemption for energy in excess of three percent of cost of production; and (3) for property tax: the phase-in of a credit for taxes paid on inventories, and the exemption of custom software.

Income Tax

Kentucky conforms to a majority of the changes to the federal tax code set forth in the Tax Cuts and Jobs Act. This means that the domestic production activities deduction is no longer available. The primary exception to Kentucky’s conformity is the decoupling from the federal depreciation and expensing provisions. Additionally, Kentucky’s income tax rate was changed to a flat 5% rate, and the state adopted single sales factor apportionment.

Single sales factor apportionment applies to multi-state corporations doing business in Kentucky. Previously, multi-state corporations apportioned income to Kentucky using a three-factor (sales, property, and payroll) apportionment formula. Effective for the 2018 tax year, only the sales factor will be used for apportionment purposes. The three-factor formula was retained for providers of communications and multichannel video programming services (cable and satellite TV) and certain financial organizations.

Sales and Use Tax

Kentucky joined 21 states and the District of Columbia in taxing installation and repair labor. This change was made by adding installation and repair labor to the definition of “gross receipts”, which is the tax base for sales and use tax. Specifically, gross receipts includes: “the amount charged for labor or services rendered in installing or applying the tangible personal property, digital property, or service sold.” Three general rules can be drawn from the statutory change.

  1. There is no sales tax on installation or repair labor, unless there is a transfer of tangible property or digital property.
  2. If a manufacturer is involved, there is no sales tax on installation or repair labor if the machinery or equipment is (a) directly used in manufacturing, (b) the labor is separately stated on the invoice, and (c) the customer provides the installer/repairer with a resale certificate.
  3. There is no sales tax on installation or repair labor if the customer is exempt from tax under Section 501(c)(3) of the Internal Revenue Code and the exempt entity gives the installer/repairer an exemption certificate.

The exemption for machinery and equipment directly used in manufacturing described in Rule 2 is critical to manufacturers. Machinery or equipment that is “directly used” in manufacturing is located at and between (i) the place where the raw materials start into a “continuous, unbroken, integrated process”, and (ii) the place at which the finished product is packaged and ready for sale. The manufacturer should provide the installer/repairer with a resale certificate. In the absence of a resale certificate, the installer/repairer should collect and remit sales tax at the 6% rate.

Historically, Kentucky has permitted manufacturers to exempt from sales tax energy purchases in excess of three percent (3%) of their cost of production. Some entities bifurcated the purchase of their raw materials from their other cost of production to maximize the energy exemption. The change to Kentucky’s statute forecloses this planning opportunity by requiring raw materials to be included in the calculation of cost of production, regardless of what entity purchases the raw materials.

Property Tax

The General Assembly also adopted an inventory tax credit to be phased-in over the next four years. The credit is a non-refundable income tax or limited liability entity tax credit allowed for ad valorem taxes timely paid on business inventory. The phase-in is as follows: 2018 – 25% of tax paid; 2019 – 50% of tax paid; 2020 – 75% of tax paid; and 2021 and forward – 100% of tax paid. Additionally, the legislature enacted an exemption from property tax for custom software.

Article Dean Dorton

Here are the key risks and opportunities for 2019:

Attracting and Retaining a Quality Workforce

Productivity challenges exist when a manufacturer can’t retain a consistent workforce. Manufacturing companies today have a hard time finding employees who will show up and be on time for work and stick with their jobs. When it’s hard to find reliable personnel, employers have to spend excess time hiring and training new employees, then rehiring and training new employees. While manufacturing firms are doing what they can to inspire a new generation of manufacturing employees and experts, there is still a considerable void when it comes to skills and experience. Manufacturers need to work with schools and universities in their communities to ensure that manufacturing focused subjects are being well promoted and taught. In addition, manufacturers need to bridge the gap by encouraging their older employees to gradually slow down to retirement, passing on valuable skills to younger employees during a transition phase.  Manufactures need to prepare for a wave of retirements in the next 10 years.

Cybersecurity

Manufacturers need to be proactive in cybersecurity by implementing effective controls to prevent and detect cyber-crime. Education of employees of potential phishing schemes is paramount to a successful cybersecurity campaign. Potential effects of a network infiltration include shut down of operations, theft of sensitive customer information, or theft of sensitive banking information.

Big Data Management and IT Infrastructure

Manufacturing involves a great deal of data and reliance on IT systems. Many companies are unsure of how to access and use that data to leverage positioning within a competitive market. In order for manufacturers to leverage their data properly, they must study data management opportunities and challenges, identify data management abilities, and prioritize data analysis plans. Additionally, manufacturers need to do an IT assessment to determine if investments need to be made to advance the company through more effective systems that facilitate data analysis. Additionally, controls need to be established around the use of artificial intelligence.

Product Development and Innovation

All manufacturers are cost conscious but should not miss out on well supported R&D opportunities. The global marketplace puts an emphasis on product development and innovation. Focus is needed to manage the innovation process and allow for a good flow of new product ideas and innovations to enhance future success.

Regulation Compliance and Traceability

The manufacturing sector faces increasing regulation and compliance measures. Inconsistent regulations from state to state and country to country present competitive challenges. Manufacturers must have complete visibility throughout their supply chain for their own compliance and that of their suppliers. Compliance can include everything from product safety to IT security to fair competition.  Revenue and lease accounting standards are changing and impacting manufactures’ financial statements in 2018-2020 as well.  Identifying a complete population of all leases under the new standard presents significant challenges to all businesses.

Safety, Including Overtime Management

Safety is a major concern for manufacturers as their employees routinely work around heavy equipment. Poor equipment maintenance can cause health and safety issues, as well as cause unplanned or excessive downtime. Manufacturers need to perform preventive maintenance on recommended schedules to keep operating costs low and throughput high while helping to ensure worker safety. Additionally, the monitoring of overtime hours to help protect the safety of employees represents an important oversight role and a vital way to control costs.

Embracing the Tax Cuts and Jobs Act

American manufactures should benefit from lower income tax rates which afford manufactures the opportunity to invest back into their businesses.  Owners may also look at stock buyback opportunities.  The new tax act allows for 100% bonus depreciation for five years which encourages capital investment.  Manufactures may be able to improve employee benefit packages as well to help retain key employees.  Lastly, manufactures should look to move business back to the U.S. from foreign locations to take advantage of the better tax landscape.

Robotics and Automation

(International Federation of Robotics; Robotic Industries Association)
Advancements in technology have afforded manufactures new tools that will alleviate some of the labor challenges.  Manufactures have begun to use autonomous vehicles in warehouses to move materials and product.  The nation is facing a shortage of truck drivers so the opportunity to use autonomous trucks could be accelerated as well.  Robot orders indicate high interest in the automobile industry, electrical/electronics industry and metals industry.  Experts proclaim that robots will change the economics of manufacturing with less time focused on low cost labor positions.  Robots are becoming lighter and less expansive which increases the potential applications.  Robots also offer the opportunity to be repurposed for multiple tasks.  The average global robot density is about 74 industrial robots installed per 10,000 employees in the manufacturing industry in 2016.  The most automated countries in the world are Republic of Korea, Singapore, Germany and Japan.  Smarter robots with a “brain” in the cloud as a basis will benefit from big data and collective learning.  Robots improve the quality of work by taking on dangerous, tedious and dirty jobs that are not possible or safe for humans to perform.  By 2020 it is estimated that approximately 3 million robots will be operational on a global basis.  In 2010 only 1 million robots were operational.  Global sales of industrial robots reached a record 387,000 units in 2017 (31% increase).  China saw the largest increase at 58% while USA increased 6%.

Culture

The culture at the company may not embrace change which puts the manufacturer at a competitive disadvantage.  Additionally, the tone at the top needs to be positive and sensitive to conducting ethical business.

Tariffs

Significant tariffs have emerged during 2018 which impact imported materials including aluminum and steel.  Companies will need to work closely with its vendors to understand any expected cost increases and the possibility of having to look for alternative vendors due to pricing pressure or the viability of the existing vendor.  The expected cost increase will need to be negated by a focus on after sales service, improved focus on maintenance to keep equipment operating efficiently and enhanced service part management that integrates ERP systems with vendors.

Sources: International Federation of Robotics, Robotic Industries Association, National Association of Manufacturers Outlook Survey

Article Dean Dorton

Here are the key risks and opportunities for 2018:

Attracting and Retaining a Quality Workforce

Productivity challenges exist when a manufacturer can’t retain a consistent workforce. Manufacturing companies today have a hard time finding employees who will be on time for work and stick with their jobs. When it’s hard to find reliable personnel, employers have to spend more time hiring and training new employees, then rehiring and training new employees. While manufacturing firms are doing what they can to inspire a new generation of manufacturing employees and experts, there is still a considerable void when it comes to skills and experience.

Work with schools and universities in your community to ensure that schools are teaching and promoting manufacturing-focused subjects. In addition, you can bridge the generation gap by encouraging your older employees to gradually slow down to retirement, passing on valuable skills to younger employees during a transition phase. You should prepare for a wave of retirements in the next 10 years.

Cybersecurity

Manufacturers should be proactive in cybersecurity by implementing effective controls to prevent and detect cyber-crime. A successful cybersecurity campaign includes educating employees of potential phishing schemes. Potential effects of a network infiltration include shut down of operations, theft of sensitive customer information, or theft of sensitive banking information.

Big Data Management and IT Infrastructure

Manufacturing involves a great deal of data and reliance on IT systems. Many companies are unsure of how to access and use that data to leverage positioning within a competitive market. In order for manufacturers to leverage their data properly, they must study data management opportunities and challenges, identify data management abilities, and prioritize data analysis plans. Additionally, manufacturers may consider completing an IT assessment to determine if investments need to be made to advance the company through more effective systems that facilitate data analysis.

Product Development and Innovation

The global marketplace puts an emphasis on product development and innovation, so make sure you don’t miss out on well supported R&D opportunities. Focus is needed to manage the innovation process and allow for a good flow of new product ideas and innovations to enhance future success.

Regulation Compliance and Traceability

The manufacturing sector faces increasing regulation and compliance measures. Inconsistent regulations from state to state and country to country present competitive challenges. You must have complete visibility throughout your supply chain for your own compliance and that of your suppliers. Compliance can include everything from product safety to IT security to fair competition. Revenue and lease accounting standards are changing and impacting manufactures’ financial statements in 2018-2020 as well. Identifying a complete population of all leases under the new standard presents significant challenges to all businesses.

Safety, Including Overtime Management

Safety is a major concern for manufacturers, as their employees routinely work around heavy equipment. Poor equipment maintenance can cause health and safety issues, as well as unplanned or excessive downtime. You should perform preventive maintenance on recommended schedules to keep operating costs low and throughput high, while helping to ensure worker safety. Additionally, monitoring overtime hours to help protect the safety of employees represents an important oversight role and a vital way to control costs.

Embracing the Tax Cuts and Jobs Act

Manufactures in the U.S. start 2018 with lower income tax rates, which affords you with the opportunity to invest back into your business. Owners may also look at stock buyback opportunities. The new tax act allows for 100% bonus depreciation for five years, which encourages capital investment. You may be able to improve employee benefit packages as well, which can help retain key employees. Lastly, you should look to move business back to the U.S. from foreign locations to take advantage of the better tax landscape.

Robotics and Automation

Advancements in technology have afforded manufactures new tools that will alleviate some of the labor challenges. Manufactures have begun to use autonomous vehicles in warehouses to move materials and product. The nation is facing a shortage of truck drivers so the opportunity to use autonomous trucks could be accelerated as well. Robot orders indicate high interest in the automobile, electrical/electronics, and metals industries. Experts proclaim that robots will change the economics of manufacturing with less time focused on low-cost labor positions. Robots are becoming lighter and less expansive, and they offer the opportunity to be repurposed for multiple tasks.

The average global robot density was about 74 industrial robots installed per 10,000 employees in the manufacturing industry in 2016. The most automated countries are Republic of Korea, Singapore, Germany, and Japan. Smarter robots with a “brain” in the cloud as a basis will benefit from big data and collective learning. Robots improve the quality of work by taking on dangerous, tedious, and dirty jobs that are not possible or safe for humans to perform.

Global robot installations in 2018-2020 are estimated to increase by at least 15% on average per year (a total of 1.3 million new robots installed). During 2018 alone, the industry expects 400,000 new robots to be installed around the globe, with 38,000 new robots installed in the United States. It is estimated that approximately 3 million robots will be operational on a global basis by 2020, as compared to only 1 million operational robots in 2010.

Sources: International Federation of Robotics, Robotic Industries Association, National Association of Manufacturers Outlook Survey

Article Dean Dorton

Fraud is estimated to be a $3.5 trillion annual business with the typical company losing 5% of its revenue each year. Managing the risk of fraud is challenging for any organization, but especially for a company in the manufacturing industry.

When ranking the number of frauds committed over the past 10 years, the manufacturing industry has been within the top five each year.

There are several reasons for this:

  • Decentralized operations make it difficult to ensure policies and procedures are being followed properly at all locations
  • Limited security and/or the size of certain products or supplies make it easy for employees or others to misappropriate assets
  • The use of low wage factory workers, especially in foreign locations, allows for employees to rationalize fraud
  • The increasing use of new technology allows hackers and outside fraudsters new opportunities to commit fraud
  • The complexity of accounting for inventory allows accounting personnel to cover up frauds
  • The tough economy continues to add pressure for management to meet or exceed budget

The continued increase in fraudulent activities is one of the reasons the Committee of Sponsoring Organizations of the Treadway Commission (COSO) has published a Fraud Risk Management Guide. Over the past 30 years, COSO has developed an internal control framework that is widely accepted and used and has provided thought leadership in the areas of enterprise risk management, internal control and fraud deterrence.

The Fraud Risk Management Guide’s executive summary emphasizes that deterring fraud is achieved when an organization has a strong fraud risk management program, which includes:

  • Establishing visible and rigorous fraud governance policies
  • Creating a transparent and sound anti-fraud culture
  • Performing a thorough fraud risk assessment periodically
  • Designing, implementing, and maintaining preventive and detective fraud control processes and procedures
  • Taking swift action in response to allegations of fraud, including, where appropriate, actions against those involved in wrongdoing

The guide includes examples of key program components and resources that organizations can use to effectively and efficiently develop a fraud risk management program. The guide also contains references to other sources of guidance for tailoring a fraud risk management program to a specific industry. It is designed for use by any organization, no matter the size or industry, and is highly recommended for companies in the manufacturing industry.

Our Recommendations
At Dean Dorton, we have assisted organizations in implementing various components of this fraud risk management program and have seen firsthand how it can reduce fraud. We recommend that your company starts by evaluating your existing business environment and gaining an understanding of the policies, controls, and processes you currently have in place. Secondly, you should gain an understanding of the objectives and mindset of your board of directors (or other governing body). This will give you a good idea of where you are today, what gaps you might have, and where you want to be. The COSO guide can then be leveraged to help you develop a strong fraud risk management program.

Questions?
Contact Jim Tencza at jtencza@deandorton.com.