What it means
The meaning of OEM depends on the industry, but the core idea is a division of labour. One business designs and manufactures a component or product, and another business buys it to include in its own goods or to sell under its own name.
This lets the buyer focus on design, marketing and service, and avoid building every part in-house. In manufacturing, a supplier of seats to a car maker is an OEM supplier, and the car maker may also be called an OEM when speaking about the finished vehicle.
In computing, a company might build laptops to a retailer's specification and the retailer sells them under its own brand. The word is also used for genuine replacement parts, so an OEM part is one made by or for the original manufacturer.
For finance, the OEM model changes how a business earns money. OEM suppliers often sign long contracts with large customers and enjoy steady volumes, but they may have limited pricing power because buyers can push for lower prices.
Margins can therefore be thin, and a supplier that depends on one customer carries concentration risk. Buyers weigh costs and risks too.
Using OEM suppliers reduces capital spending and speeds time to market, yet it creates dependence on the supplier's quality and delivery. Contracts normally cover quality standards, intellectual property, minimum order quantities and what happens if the supplier fails.
A related term is ODM, original design manufacturer, where the supplier also designs the product and the buyer simply adds its brand. Understanding the difference helps when reading supplier agreements and when judging who owns the design and the know-how.
Good finance teams track the OEM's gross margin and the share of revenue coming from the biggest customers.
In practice
Real-world examples.
Example
A bicycle brand buys its frames from an OEM factory and adds its own logo, gears and marketing. The brand avoids owning a factory and can launch new models quickly. The factory earns a steady margin on large orders.
Example
A garage replaces a worn brake part in a car with an OEM part, meaning one made to the same specification as the original. The owner pays more than for a generic part but gets a guaranteed fit. The workshop explains the price difference on the invoice.
Example
A consumer electronics company outsources the manufacture of its headphones to an OEM supplier. The supplier produces 50,000 units a quarter under a two-year contract. The company records the purchases as cost of goods sold when the units are sold to customers.
Formula
Calculation
OEM gross margin = (revenue - cost of goods sold) / revenue
An OEM supplies 10,000 units of a component to a customer at $40 each, with a production cost of $34 per unit. Revenue = 10,000 x 40 = $400,000. Cost of goods sold = 10,000 x 34 = $340,000. Gross profit = 400,000 - 340,000 = $60,000, so gross margin = 60,000 / 400,000 = 15%.Case study
Seen in the real world.
Kestrel Components is a fictional OEM supplier used to illustrate the model. In this illustrative story, it sold 80% of its output to a single appliance maker, generating revenue of $9,000,000 a year with a gross margin of 14%. When the customer demanded a 5% price cut, Kestrel's gross profit would have dropped sharply.
The finance director calculated that a 5% cut on $7,200,000 of sales to that customer meant $360,000 less revenue and almost 29% less gross profit. The firm responded by seeking three new customers over the next year and by redesigning the part to cut material costs by 8%. By the end of the year the largest customer made up 55% of sales, which lowered the risk.
Kestrel also began reporting the share of sales from its three largest customers in every monthly board pack. Management set a rule that no single customer should exceed 50% of sales within two years, so that a pricing dispute with one buyer could never again threaten the whole business.
Watch out
Common mistakes.
- Assuming an OEM sells directly to consumers under its own name. Often its products reach buyers under another company's brand.
- Ignoring customer concentration. An OEM that depends on one or two buyers is exposed if they cut orders or switch suppliers.
- Thinking an OEM part is always better than an alternative. It guarantees a match to the original specification but is often more expensive.
Questions
People also ask.
What does OEM stand for?
It stands for original equipment manufacturer.
What is the difference between OEM and ODM?
An OEM builds to the customer's design, while an ODM designs and builds the product, and the customer only adds a brand.
Why do companies use OEM suppliers?
They save the cost of building factories, gain access to specialist skills and can bring products to market faster.
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