The concept behind contract assembly sounds great, but it’s not always the best solution.

Today, outsourcing is a fact of life for manufacturing engineers. Most printed circuit boards and other electronic devices are assembled by third-party companies. But, there are many hidden costs and pitfalls often overlooked in the quest to boost profitability and impress shareholders. Volatile economic conditions have forced manufacturers to reassess traditional business models and focus on the bottom line. Many executives view outsourcing as an opportunity to reduce costs, improve flexibility and streamline production processes.

Outsourcing tasks to an electronics manufacturing services (EMS) provider allows original equipment manufacturers (OEMs) to dramatically cut their fixed costs, while freeing up cash to invest in strategic initiatives, such as new product development or marketing. It also lets a company reduce labor costs by shrinking its direct work force.

"In most situations today, it doesn’t make sense not to outsource assembly," says Mark Zetter, president of Venture Outsource Group (San Jose, CA). "Most companies that outsource usually realize better financial ratios, improved cost of goods sold and faster time to market. You can derive an immediate cost savings of anywhere from 10 percent to 15 percent.

"In most cases, the benefits of outsourcing cannot be ignored," claims Zetter. In fact, if OEMs decide not to outsource, Zetter warns they risk the chance of being underpriced in the marketplace by a competitor that "is outsourcing its assembly and thereby lowering its overhead operating costs while increasing its flexibility."

Outsourcing Pitfalls

Despite numerous advantages, outsourcing is not always the best manufacturing strategy to pursue. For instance, some executives fail to realize that outsourcing assembly can be much more complicated and time-consuming than handling it in-house.

"Far too many companies think that by outsourcing manufacturing they move a problem off of their plate and into the hands of an expert," says Kevin Keegan, director of management consulting at PRTM (Waltham, MA). "This attitude is dangerous and leads to a much less productive and profitable relationship with the outsourcing partner.

"To avoid the pitfalls of the ‘handoff’ scenario, OEMs should plan their entire supply chain prior to making a change to any element of the supply chain, particularly one as critical as manufacturing," adds Keegan. "They should take a holistic approach to the change, dealing with elements of supply chain strategy, processes, information systems, management structure and performance monitoring."

What to make in-house and what to outsource typically depends on an OEM’s core competencies. A core competency is any activity or practice, such as product development, critical to a company’s long-term success and growth.

"Situations exist where companies may not be good candidates for embracing an outsource model," warns Zetter. Typically, core competencies are based on skills or knowledge sets rather than products or functions. They provide maximum return on investment and act as a barrier for other companies trying to enter the market.

Although every case is different, OEMs generally should not outsource assembly if:

  • Proprietary technology or proprietary manufacturing processes are involved. Anything that gives an OEM a unique advantage in the marketplace should not be outsourced. China and other Asian countries are a hotbed of outsourcing activity, but because intellectual property laws are not closely adhered to in that part of the world, OEMs run the risk of losing valuable processes.
  • High-margin products or services are involved. Never outsource the area producing the greatest profit.
  • Products require high levels of assembly or test specialization, such as environmentally sensitive procedures.
  • Products have low annual unit or dollar volume. To achieve econo-mies of scale, most contract manufacturers only want to assemble products with medium or high annual volume.
  • Security protocols exist.
  • Rampant engineering changes will occur during the first stages of production. Contract man-ufacturing is more suitable to high-volume products that require minimal engineering changes.

Hidden Costs

There are many hidden costs associated with outsourcing that OEMs should watch out for. "One common way for EMS providers to gain additional revenues is through various ways of billing OEMs for engineering change orders," cautions Zetter. "This is especially costly for start-ups or any new product introduction, where a tremendous amount of cost is incurred during iterations as a product evolves." Attention to detail in this area is important during the contract negotiations phase of an outsourcing agreement.

One way OEMs can help minimize this type of cost is by getting their outsourcing partners involved in the design and production stages as early as possible. "The good contract manufacturing organizations are highly-skilled and trained service providers," claims Zetter. "Through their experience working with other companies, they will know how to manage a product for optimal design and manufacturability.

"When an OEM learns how to leverage this expertise early on by engaging with providers as soon as possible, the OEM leverages the EMS providers’ historical knowledge gained from having worked with similar products or industries," adds Zetter. "The OEM also gains advantages in its materials pipeline due to the providers’ relations with distributors, not to mention its ability to reduce materials cost by sheer virtue of volume purchasing."

Zetter says product iterations are likely to have direct and indirect costs that are ultimately absorbed by the OEM as immeasurable lost opportunity costs. "The empirical knowledge providers possess can help identify and minimize such costs to the OEM," explains Zetter. "Any anticipated cost savings and reductions achieved by the provider can be spelled out ahead of time in the contract service agreement."

To generate better contracts, some EMS companies are pricing their services based on the length of the project and the overall volume involved. In some cases, contractors require their customers to have up to 12 months of cash reserves on hand before accepting product orders. Many EMS providers are also considering their customers’ overall financial position and the health of a product’s market before signing contracts.

Additional costs can arise from purchase orders, forecasts, excess inventory, rescheduling and cancellation charges, in addition to nonrecurring engineering, product replacement and implementation costs. "The contract service agreement is the most important item bridging the relationship between provider and OEM," says Zetter. "It outlines what the provider is required to do for the OEM, and at what ‘cost’ to the provider. It details what the OEM will receive from the provider, and at what ‘price.’

"The difference between cost and price is simple but extremely important," warns Zetter. "Providers want to charge the highest price to the OEM, to cover internal costs while making a profit, without the OEM walking away from the deal. Meanwhile, OEMs want to feel they are paying the lowest price to the provider, and getting flexible agreement terms, when signing on the dotted line." Zetter says OEMs must apply a substantial amount of attention upfront during the contract development phase and exercise considerable attention to detail during the negotiations phase.

According to Luke Kensen, director of business development at Express Manufacturing Inc. (Santa Ana, CA), "there shouldn’t be any hidden costs" in outsourcing. "As long as one company clearly defines all its needs, a contract manufacturer ought to cover all the specifics of its accommodations to avoid any surprises.

"From time to time, additional costs may arise due to unexpected engineering changes required as a result of product testing and evaluation," argues Kensen. "Upgrades and alterations derived from the evaluation would require re-engineering of a product, thereby resulting in additional contract manufacturing man hours. One method to avoid such possibilities is to budget re-engineering needs and to plan for various prototype phases."

Great Expectations

The process of transitioning production operations to a contract manufacturer can be very complicated. "Trying to complete the entire transition in one phase often leads to problems," warns PRTM’s Keegan. "Prior to completing a transition, the OEM and contract manufacturer should pilot the new processes and validate that the performance expected is achieved.

"Often, OEMs concentrate on production piloting and forget that many supply chain processes besides production have changed," adds Keegan. "Piloting and validation of all supply chain processes affected by the outsourcing initiative should be completed prior to the complete handoff of all manufacturing activity."

One of the most common problems when launching a project with a contract manufacturer is incomplete documentation. "The key to a problem-free launch is to ensure the details in your documentation," claims Kensen. He urges OEMs to consolidate and prepare all documentation with revision control.

For example, fabrication drawings should contain all the detail specifications, while the bill of materials should include all component specifications and procedures. Kensen also recommends developing a process flow chart for each product.

"Even though we are manufacturing specialists, the creators of a product usually have more history and experience," says Kensen. "All special techniques gained by trial and error should be passed on to ensure a smooth transition. And, the OEM’s quality team should monitor the contract manufacturer’s initial launch so additional feedback can be provided."

According to Keegan, three key areas are vital to building an effective relationship with contract manufacturers: supply chain planning, relationship management and transition management. In formulating a supply chain strategy for outsourcing, Keegan urges OEMs to ask the following questions up front:

  • What are we trying to accomplish over the next 5 years?
  • What are the incremental steps required to achieve that vision?
  • What partners will be required to achieve the vision?
  • What are the contingency plans if one of the partners does not perform?

"Answering these questions will help management build a sound business case, and action plan, leading to effective outsourced manufacturing," claims Keegan.

Once an OEM has established a strategy for outsourcing its manufacturing, and gone through a process to select contract manufacturers, Keegan says it is important to codify the expectations with contractors. "Far too often, companies jump into a relationship without clearly defining the mutual expectations and rules of engagement to control the operation," warns Keegan. "Many companies make the mistake of thinking a legal agreement alone defines the relationship. While a contract is necessary, we have found that it is not enough."

By establishing a joint service agreement (JSA), in conjunction with a contract that defines the processes, performance targets and expectations for both parties, many problems can be avoided. "It is also important for senior managers from both sides to be named as sponsors responsible for the success of the JSA," says Keegan. "The joint service agreement should be specific in terms of how the work will be done and evaluated.

"It should be supplemented by a management control system that requires a regular review of performance against the JSA expectations," adds Keegan. "This allows the two parties to factually review past performance and establish concrete expectations for future performance. This approach helps minimize the misunderstandings that often develop in outsourcing relationships."

Buyer Beware

"Assuming all factors influencing an OEM’s decision are equal, the most important element OEMs must consider when selecting an EMS provider is whether or not they believe the provider can execute on its business plan model," says Venture Outsource Group’s Zetter, "assuming the provider discloses the truth about its capabilities and business model.

"I’ve seen situations where providers have positioned themselves as being able to provide this or that," recalls Zetter, who formerly served as a senior executive at a leading contract manufacturer. "Ultimately, I knew they would have to source that function or service to a third-party-provider. No OEM wants to intentionally remove itself too far from its involvement when outsourcing its supply chain."

According to Zetter, not all contract manufacturers can do what they claim to be able to do. It’s important for OEMs to know the provider’s strengths, as well as to understand their weaknesses.

"The role and capabilities of the provider’s executive team must be understood," claims Zetter. "Make sure the executives are part of a team with a history of driving productivity and [adding value] in a fast-paced, quick-turn, full assembly model where product cycle times are measured in hours, not days."

Zetter says they should have experience managing multiple customer product programs and multiple product families, serving multiple product end markets and a wide variety of customer personalities. "It quickly becomes a game of not only having the right executive leadership team with a proven track record of working together, but it boils down to their ability to attract, hire and retain seasoned middle managers who can execute the vision," warns Zetter.

"In identifying good providers, throw into the mix the ongoing ability to scale processes up or down while effectively managing costs, executing against continuous process improvements, and driving the provider’s vision further into all levels." Zetter says a good outsourcing organization can anticipate issues, communicate needs, and respond internally and externally. "If an OEM has not chosen its provider carefully, it could end up with a recipe for disaster," he points out.

Today, many contract manufacturers are attempting to broaden their horizons by offering a complete turnkey solution to OEMs. In addition to traditional PCB assembly applications, they are now bundling together design, final assembly, shipping, repair and customer service in an attempt to become one-stop providers. "Contract manufacturers hope to build their business by growing complementary, higher-margin services," says Keegan.

While most OEMs understand the theoretical value of the one-stop shopping approach, Keegan believes they should be leery of putting all their eggs in one basket. "On average, OEMs try not to sole-source their manufacturing," explains Keegan. "Nor will they allow any one contract manufacturer to han-dle more than 50 percent of the growth in any particular product category."

Some OEMs claim that contract manufacturers have had trouble responding quickly and appropriately to the fluctuations in demand that often characterize the early phases of a new product’s life cycle. "By spreading their business around, ideally with two or three contract manufacturers, OEMs maintain the ‘competitive tension’ that helps keep prices in check," argues Keegan.

Engineers Play a Critical Role

Many manufacturing engineers believe outsourcing goes hand in hand with downsizing activity. However, that’s not necessarily true.

"Outsourcing production is not an end to an OEM’s internal engineering efforts," claims Zetter. "When an OEM program is transitioned into an EMS provider, it is in the best interest of the OEM to get its engineers involved as early as possible. The OEM’s engineers will often be the first to isolate any shortcomings in the provider’s suite of services, internal engineering capabilities, or staff assigned to transition the OEM’s program."

Express Manufacturing’s Kensen believes an OEM’s engineering department should be heavily involved in both the selection and transition process. "They’re usually the key individuals who evaluate the contract manufacturer’s ability to provide the technology needed to produce a product," explains Kensen. "This is extremely critical with today’s complex PCB applications, such as ball-grid array (BGA), micro BGA, flip chip, chip on board, multi-chip modules and memory stacks.

"Engineers need to evaluate whether the contract manufacturer has the correct equipment and can provide the controlled processes and consistent levels of quality needed to produce reliable products. They must identify the integrity of the defined process, flow and output, in addition to the contract manufacturer’s ability to support the overall testing requirements."

Engineers also play a major role after production is outsourced. "One of the major problems OEMs encounter when outsourcing is not taking into account their ability to manage the outsource relationship," notes Zetter. "Many OEMs think once they outsource, their hands are free and they can go on to doing their core activities. Product transition, engineering re-visions, root cause analysis, debug troubleshooting and...warranty repair issues surface regularly. These are all areas that can require some sort of OEM-engineering focus and management involvement.

"Although the move for an OEM to outsource may likely reduce its engineering staff long-term, its short-term needs remain necessary and are usually enough to keep many OEM engineering staffs busy," Zetter points out. "Naturally, with time, the need for a more reduced OEM staff could surface, depending on the OEM’s program complexity, maturity and volumes.

"In such situations where reduction in OEM engineering staff is inevitable, the best-run OEMs take note of the sensitivities involved. It is usually in everyone’s best interest to communicate the pending changes as soon as possible, based on the OEM’s internal knowledge on how such news will be perceived, and to include engineering in as much of the product transition and subsequent engineering needs where possible."

"Engineers are sometimes hired by the service provider absorbing the OEM’s program," concludes Zetter. "Members of the OEM engineering staff have a certain scope of understanding or depth of knowledge about nuances specific to the product. These individuals can bring priceless value to the communications activity between the OEM and the provider."