WHILE OUTSOURCING OF NON-CORE BUSINESS functions has become almost an essential aspect of modern business processes, there are some basic themes underlying the practice that differ by industry i.e. the process and competencies required are different for say, software development outsourcing versus outsourced manufacturing. However, the underlying reasons are essentially the same—cost arbitrage and focus on core business processes.
However, after a decade of unbridled growth in outsourcing, there is reason to believe that there exist limits on the usefulness and applicability of the outsourcing process. Look at Electronics Manufacturing Services.

Good History
While the EMS industry itself is over 30 years old, it started coming of age in the 1990s when large electronics Original Equipment Manufacturers (OEMs) began outsourcing piece production of parts and then complete assembly and testing of high volume electronics products such as PCs, printers etc. There are two main reasons for this:

Product and manufacturing process maturity—Many of the products manufactured by OEMs are mature products produced with off-the-shelf components.

Manufacturing efficiencies—Given that the manufacturing process shared many of the same process steps, EMS providers are able to derive volume purchasing synergies and take advantage of low labor costs available in many offshore locations.

A number of other OEMs with maturing product lines—like Nortel and Lucent with their phone equipment business—also embraced contract manufacturing leading to the emergence of High-Volume, Low-Margin (HVLM) EMS players. These companies focus predominantly on consumer electronics products and while their overall margins are low, their Return on Invested Capital (ROIC) is respectable because of the low capital intensity of their business. In order to stay competitive, many of the HVLM players developed a significant manufacturing presence in Mexico and Southeast Asia and began to develop a “complete” service offering including manufacture of Printed Circuit Boards (PCBs), enclosure products and cable and wire harness assemblies.

The HVLM Business Model Stumbles
Over time, the EMS industry structure has evolved to be similar to the automobile and the apparel retailing industry such that there are a handful of large, dominant players and many smaller, niche-focused players that have developed a sustainable business model because of a particular attribute—geographic focus, specific capability such as optical module assembly or industry-specific knowledge and skills.

With the downturn in the U.S. economy—and the electronics sector in particular—the HVLM players were left holding large raw material and finished goods inventory and a manufacturing capacity that is geared to large production volume. However, that may not be their biggest problem. Many of the larger HVLM players have developed vertical service offerings such as PCBs that do not fit well with their business, and with the higher investment requirements for PCB fabrication, breaks down their historical ROIC equation. There is reason to believe that many larger HVLM players are struggling with their fabrication businesses and may divest them in the long run.

Other Business Models Emerge
Simultaneously, other business models have developed that have found resonance with different industry segments. One variant is the Low-Volume, High-Mix (LVHM) business model that focuses on more complex products (e.g. semiconductor capital equipment) that are either • produced in small batches, or • have a higher engineering/service content or • have a large form factor making closer proximity to the OEM essential. Examples of such companies include Suntron and Varian. The LVHM players have not made a big push towards low labor cost geographies because of the higher value-add within their business making cost pressures not as much of an issue. While the LVHM players have also been hurt because of the downturn, their focus on product development and higher complexity products as opposed to mass production products has somewhat sheltered their business.

A second variant has been Original Design Manufacturers (ODMs). ODMs gained prominence in the late 1990s as outsourced design and manufacturing houses that help OEMs design new products and then manufacture them as well. In other words, ODMs help an OEM design, manufacture and bring a new product to market. ODMs have, so far, been successful for price-sensitive products that are based on existing technology, like new notebook models for Dell. This is a much-misunderstood business model as ODMs do take some product risk as they control the design IP and may very well bear inventory and return risk as well. Well known ODMs include Compal, Quanta and Arima.

What does this all mean?
The EMS industry has undergone somewhat of a “coming of age” experience over the last few years. Since experiencing explosive growth over the last decade and riding the broader outsourcing wave, EMS players are now realizing their own limitations. Going forward, we believe a number of major themes will continue to play out. These are, by no means, the only changes the industry will undergo but some of the main structural changes.

Since many of the manufacturing assets acquired by EMS players were OEM facilities that were not necessarily optimized for the current environment, expect plant closings and rationalization to continue. Since the beginning of the downturn, EMS players have taken out over 30% of their manufacturing capacity as measured by square footage and over 40% of headcount. Interestingly, more than 90% of plant closings have taken place in the U.S. and Western Europe with a corresponding increase in manufacturing capacity in low-cost manufacturing geographies

OEMs will continue to embrace outsourcing. A number of industries have not yet fully explored the value of outsourcing –automobile components, medical devices etc. There still exists substantial manufacturing capacity within large OEMs. On the flip side, the competency requirements for these industries are also very different. Are the existing EMS players ready to provide outsourced manufacturing to these industries?

HVLM EMS players may reassess their ownership of fabrication plants (versus assembly plants). A number of the larger EMS players own PCB and enclosure fabrication facilities which they may look to divest. Other ancillary business units such as opto-electronic assembly or memory module assembly may also be on the cutting block. Additionally, independent pure-play fabrication businesses that had highly leveraged capital structures (APW, Viasystems, and Trend Technologies) are emerging from restructuring and may become formidable competitors. However, this debate will ultimately depend on how a particular OEM customer, say HP, views and wants to manage its supply chain

EMS players will try to develop “building block IP”, in other words, having a standard design for a sub-module that works in a system. This has a three pronged benefit: reduces design time and cost; builds in “hooks” with customers thereby making switching costs high; and provides the EMS providers an opportunity to add value right from the design and product development phase

Which Business Model Will Win?
EMS players have developed different business models driven by competitive pressures and demands from their core client base. To the extent, core clients continue with similar supply chain demands, EMS players will have to re-price their service offerings to take into account the dynamics of their respective situations, like price in inventory carrying costs, capacity utilization of owned fabrication plants and so on. In other words, OEMs will drive the redefined supply chain’s next avatar. To the extent customers/OEMs want to deal with only a handful of EMS providers, they may have to “pay for it.”

The Holy Grail for EMS still remains that both manufacturing and supply chain management, including product design and repair and refurbishment, can be successfully outsourced. While results to date have been mixed, this is the area that most large EMS players are focusing on such that they may be able to become entrenched “outsourcing partners” to their core OEM customers.

Can India Be the Next Manufacturing Destination?
So far, China has been the primary recipient of investment in new manufacturing facilities and because of a better infrastructure and less bureaucratic red tape has reaped large foreign direct investment in electronics manufacturing. India had an early head start in software and is now attracting new investment in design centers such as Intel’s new chip design center in Bangalore.

A number of recent VC investments point towards increased investment in India in hardware design and fabrication. Companies such as Celetron are making smart cards and magnetic components for power supplies in Class 100 clean rooms in India. Their growth trajectory over the next several years and incumbent changes in the global electronics supply chain may determine the direction Indian outsourced manufacturing may take. A number of U.S.-based EMS players are evaluating India to set up their design centers. They will be following the well-worn steps of the EDA and the software design and development industry.