Contract Manufacturing On the Rise
As numerous original equipment manufacturers (OEMs) continue to pursue aggressive weight loss programs, outsourcing is the closest thing to an industrial-strength dietary supplement. By shedding plants and equipment, manufacturers hope to make themselves more appealing to investors and Wall Street analysts.
As OEMs slim down, contract manufacturers have been bulking up. Indeed, these growing companies have become the new heavyweights of production in many industries.
Contract manufacturing traces its roots to the mid-1970s when several companies sprang up to handle the overflow of printed circuit board assembly. Today, the electronics manufacturing services (EMS) industry offers numerous services aside from building boards and boxes, such as product design, supply chain management, global distribution and logistics, and repair service.
From 1997 to 2001, increased use of contract manufacturing helped telecommunication equipment makers drive total supply chain costs from 11.6 percent of revenue down to 6.1 percent of revenue. In fact, contract manufacturers have made it possible for some companies to operate without owning any brick-and-mortar factories.
For instance, Cisco Systems Inc. (San Jose, CA) grew into a giant with no internal manufacturing of its own. Last year, another leading telecommunications equipment company, Alcatel SA (Paris), said it will shed most of its manufacturing plants, going from more than 100 to less than 12 by the end of this year. Of the factories it plans to keep, about half a dozen will be used for new product introductions, while others will produce sophisticated, high-tech products with proprietary equipment.
Until recently, contract manufacturing was a phenomenon primarily confined to electronics manufacturers in the United States and Europe. But, Japanese companies are now focusing less on traditional vertical integration and jumping on the contract manufacturing bandwagon. And, automakers are beginning to open their eyes to the possibility of outsourcing assembly.
Outsourcing to EMS providers has traditionally appealed to makers of computers, cell phones, telecommunications hardware and other electronic products. It also is quickly becoming a cost-effective option for manufacturers of fiber optic components and medical devices. Many companies outsource older, more stable products so they can focus operations on newer, more technically complex products with higher margins.
That trend bodes well for contract manufacturers. In fact, a recent survey conducted by Bear, Stearns & Co. (New York) discovered that 87 percent of OEMs plan on increasing their outsourcing in the coming year. "OEMs expect to increase their outsourcing to reduce costs and capital spending," says Thomas Hopkins, Bear Stearns man-aging director and electronics manufacturing services analyst, who coordinated the survey.
The strongest responses for increasing outsourcing came from manufacturers of semiconductor equipment, consumer products, auto parts and telecom equipment. International Data Corp. (IDC, Framingham, MA) predicts the worldwide market for contract manufacturing will grow from $103 billion in 2000 to $231 billion in 2005.
With $35.8 billion in sales in 2001, EMS providers represent approximately 30 percent of the total North American electronics assembly industry. By 2005, IPC (Northbrook, IL) estimates the industry will generate more than $60 billion in sales.
An Evolving IndustryPrice pressure and the need for global product expansion are driving the growth in contract manufacturing. "Branded vendors are looking at their core competencies and outsourcing the production of product that is not considered critical to the vendor’s corporate identity," says Kevin Kane, manager of IDC’s contract manufacturing services research program.
"The contract manufacturing industry has significantly evolved in the last decade. It has moved from being one-service shops to providing services for almost every aspect of the manufacturing supply chain," explains Kane. Today, the ultimate goal of a contract manufacturing vendor is to become a critical partner of a branded system vendor.
"Contract manufacturers have become integral partners in the product development cycle because they have added expertise in areas such as front-end design, full system assembly, repair and warranty service, and logistics," adds Kane. "Providing additional services helps to further integrate the contract manufacturing vendor into a branded vendor’s business."
"A contract manufacturer’s specialty used to be labor for component mounting," notes Luke Kensen, director of business development at Express Manufacturing Inc. (EMI, Santa Ana, CA). "Now, customers are outsourcing the entire process, from conceptual design to product fulfillment. Contract manufacturing is becoming a complete solution vs. just one aspect in a product’s evolution."
Today’s contract manufacturing industry has three tiers. According to Kane, Tier 1 players comprise a handful of companies that each boast global facilities and generate more than $1 billion in annual revenue.
Tier 2 contract manufacturers generate less than $1 billion in annual revenue. Many of these companies are niche players that focus on certain market segments, such as fiber optics component assembly.
Tier 3 contract manufacturers are small players that typically operate one plant and generate under $250 million in annual revenue. They tend to operate locally or regionally.
The industry is dominated by the Tier 1 companies, which include Solectron Corp. (Milpitas, CA), Flextronics International Ltd. (Singapore), Celestica Inc. (Toronto), Sanmina-SCI Corp. (San Jose, CA) and Jabil Circuit Inc. (St. Petersburg, FL). In fact, these five companies alone account for approximately 59 percent of total market share.
"We have seen considerable consolidation within the EMS industry in recent years, from the bottom to the top tier," says Kane. "I expect to see continued consolidation as vendors attempt to diversify their customer base and service offerings."
Despite the consolidation, Phil Fok, senior vice president of Solectron, claims the EMS industry is still just in its early stages. "There’s a lot of room to grow," he points out. "We only have 15 percent to 20 percent of the total market for electronic products. And, given a choice between spending $6 million on a production line vs. $6 million on product development, most companies would choose the latter approach to enhance long-term growth opportunities."
According to Kane, contract manufacturers are facing cost pressures from every angle today. "Customers have put pressure on the EMS vendors to cut as much cost as possible out of production," he explains. "At the same time, EMS vendors work with such slim margins that investors are constantly pushing to increase the margins any way possible. It’s a tough business."
Express Manufacturing’s Kensen says contract manufacturers must continue to perfect and streamline the services they offer. "Customers expect a certain percentage of continuing cost reduction," he explains. "Therefore, a contract manufacturer must constantly strive to identify new means of improving efficiency in all areas, including design, purchasing, engineering support, customer relations and transportation. We then pass those savings and benefits on to the customer."
However, Kensen says contract manufacturers are "facing rising costs all across the board, especially in the areas of labor, materials management, engineering and hardware. The biggest challenge faced by contract manufacturers today is the visibility of product requirements from our customers. Customer forecasting has always been uncertain, which complicates our business fulfillment at Arial."
Smaller contract manufacturers are feeling the most pressure. "There is less business to go around than there was 2 years ago," laments Noah Shah, president of Key Electronics Manufacturing Inc. (Vista, CA). "That means we have to work much harder to win new business, which right now seems to come mostly from people who are very unhappy with their current vendor.
"There is a great deal of fragmentation with the smaller competitors," adds Shah, "which offers a great deal of variety and ability to get good pricing to the OEMs, but also probably confuses them as to what to expect from one shop to another."
But, despite those challenges, the contract manufacturing industry has proven that it certainly is not a fad. Indeed, love it or hate it, outsourcing is here to stay.
Cost-Cutting and Other BenefitsContract manufacturing offers numerous benefits to OEMs, such as improved efficiency, cost reductions, enhanced quality, flexibility, advanced production technology, additional capacity, faster time to market and responsiveness. Manufacturers are willing to cede control over production in exchange for a chance to limit their financial risks and get time-sensitive products to market faster. As product lifecycles get shorter and shorter, building proprietary assembly lines becomes less practical.
"Cost is the biggest advantage from using contract manufacturers," says Reiko Tomasch, senior EMS analyst at Gartner Dataquest Inc. (Stamford, CT). "Because contract manufacturers have a lower cost structure than OEMs, they can usually reduce the cost of the product. If OEMs are divesting their manufacturing arm to these companies, they are going from fixed cost to variable cost. They only pay for what they can sell."
Tomasch claims that many top-tier contract manufacturers have manufacturing capabilities that surpass OEMs. "They often have more buying power than the OEMs and are thereby able to offer lower product cost," she points out.
"A contract manufacturer can aggregate demand from a multitude of OEMs and use that clout in the marketplace to get better prices and a more stable supply of parts than any OEM could muster on its own," explains Kevin Keegan, director of management consulting at PRTM (Waltham, MA). "With materials accounting for up to 80 percent of a product’s cost, small gains through materials management can have big bottom-line results."
"Cost is driving demand for contract manufacturing," adds Tomasch, "but there are other drivers, like time-to-market. As electronic product lifecycles shorten, time-to-market increasingly affects the bottom line."
Tomasch says OEMs want products out very quickly and look for quick turnaround Arial from contract manufacturers. "You want to leverage the EMS supply chain as well as their manufacturing expertise to mitigate any delays in product launch," she points out.
Tomasch claims many manufacturers want to focus on what they’re good at, such as product design, product development, sales and marketing. They simply don’t want to build products anymore. In fact, Tomasch says a successful company, such as Handspring Inc. (Mountain View, CA), couldn’t have grown as fast as it has if it had to build manufacturing facilities rather than relying on Flextronics and Solectron to assemble its line of handheld computers. It brought in contract manufacturers while designing its breakthrough Visor product, which hit the market only 15 months after the company was founded.
"We control cost pressures by establishing very close-knit relationships with our customers," says EMI’s Kensen. "By acting as an ‘in-house’ manufacturing arm, we truly understand their needs and can tailor manufacturing strategies and manage our suppliers in a cost-effective manner that meets the goals of our customers. We also do a very high volume of business with our suppliers, enabling us to stipulate cost reductions."
"The contract manufacturing market is very mature," adds Johanne Picard-Thompson, senior vice president of Celestica. "People are confident with our capabilities and technical leadership. The EMS model leverages the talents of both partners."
Indeed, many manufacturing executives are sold on the idea of contract manufacturing. They claim it allows their companies to respond flexibly to changes in market demand. It also helps them focus on core competencies, boost their revenues and protect themselves from volatile market gyrations.
"Leveraging the expertise of a strategic partner in the electronics manufacturing services industry enables Motorola to anticipate our customers’ evolving needs better and speed our products to market around the world," says Christopher Galvin, chairman and chief executive officer of Motorola Inc. (Schaumburg, IL), which has outsourcing contracts with Celestica and Flextronics. "Motorola must remain nimble in order to stay ahead of the marketplace and grow our position as a technology leader."
Despite those advantages, "a surprising number of electronic product companies still have not begun to outsource manufacturing," says Pamela Gordon, president of Technology Forecasters Inc. (Alameda, CA). "Manufacturing outsourcing is not the optimal solution for all electronic product companies, such as for companies whose high-volume, low-mix products are being manufactured by well-equipped, company-owned facilities in low-cost regions such as China.
"But, by outsourcing most or all of their products, most electronic product companies can achieve faster product introductions," adds Gordon. They also achieve "5 percent to 20 percent savings on material and labor costs, 10 percent reductions in overhead, and investor-attractive financial ratios."
There’s Also a DownsideManufacturing engineers need to be aware of several disadvantages associated with contract manufacturing. "You are losing control of manufacturing," warns Gartner Group’s Tomasch. "Rampant engineering changes during the first stages of manufacturing can be more difficult to implement. If you are a small company, you may not get the attention that you require from the EMS staff, as you would from your own manufacturing staff.
"Contract manufacturing is not a cure-all," Tomasch points out. "You cannot just let go and think that everything will be OK. OEMs need to set goals and monitor EMS progress."
Some manufacturers still view internal production as crucial to their survival. They question whether contract manufacturing is a hinderance or a competitive advantage. Without factories, they argue that you cannot differentiate your products and you lose competitive power in the long range.
"Moving from an internal manufacturing model to one that incorporates a large element of outsourced manufacturing is a long and complicated transition for any company," warns PRTM’s Keegan. "Managing relationships with contract manufacturers is not the same as managing a captive manufacturing environment, and, too often, OEMs underestimate the challenge.
"Companies must realize that outsourced manufacturing is still very much an arm’s length transaction," adds Keegan. "At the end of the day, the OEM and the contract manufacturer have divergent goals based on competing shareholder interests for profits and growth. That creates potential for conflict of interest, especially if the objectives of both parties—OEM and contractor—are not aligned."
When companies require assembly processes or equipment that are unique to their products, they may find it hard to work with contract manufacturers. "If you couldn’t transfer the physical production resources over the course of a single weekend, then it’s probably not a program that will interest most contract manufacturers," says Robert Freid, president of Contract Manufacturing Consultants Inc. (Bellevue, WA). "If you have high levels of assembly or test specialization, then you should plan to maintain that portion of the work internally."
Typically, products with low annual dollar or unit volume are difficult to outsource, in addition to products with variable demand and high complexity. Many contract manufacturers look for products with medium-to-high annual volume with common processes and good stability. If you vary along too many dimensions, Freid says, it will be very difficult to find a contract manufacturer that can consistently do a good job.
"Outsourcing a complex manufacturing function is far more complicated than handling it in-house," warns Keegan. "Most OEMs plan to keep their high-level engineering and design work as internal competencies, particularly as they apply to new products and higher-end products. In general, OEMs are more likely to use contract manufacturing services for optimization of commodity products or those nearing end-of-life status.
"Contract manufacturers are at their most efficient when running at high volumes, with minimal engineering changes," adds Keegan. "But, when demand for a newer product is ‘lumpy,’ or when bugs are still cropping up requiring more frequent engineering changes, contract manufacturers run into difficulty. For this reason, many OEMs are retaining new product production in-house, until both the design and the demand for a new product have stabilized."
What to Look ForManufacturing engineers charged with the task of outsourcing any assembly process must consider a number of important questions. For instance, how will the relationship with the contract manufacturer be managed? What types of incentives will be put in place to obtain the desired behavior and results? How will outsourcing affect future product changes and improvements? How will quality assurance and legal liability issues be addressed?
"Once you start transferring production lines to a contract manufacturer, there is often little or no time to respond to unforeseen issues, such as quality problems, supplier shortages or inflexible lead Arial around the world," notes PRTM’s Keegan. "It is therefore crucial to have identified and worked around the rocks before the water level plunges.
"Any contract manufacturer should provide an advantage that isn’t already part of the OEM’s infrastructure," adds Keegan. "It should be more than just an order taker and order filler. A contract manufacturer should be a process-oriented manufacturer that has a well-oiled new product ramp up process. It also should be capable of truly isolating all production costs."
Solectron’s Fok says it’s important for OEMs to understand their true internal costs before outsourcing. "A lot of simple things are taken for granted," he points out. "For instance, companies assume that their internal quality is better than what can be done outside."
According to Gartner’s Tomasch, most top-tier contract manufacturers share comparable technical capabilities and experience levels. She believes it’s more important to look for compatibility in corporate style and culture. In addition, Tomasch says it’s vital that you can communicate well with them. "Remember, you are probably in it for the long-haul," concludes Tomasch.