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As consolidation thrusts change upon the CM industry, mid-sized CMs are becoming almost nonexistent, resulting in an industry filled with large global players and small specialty shops.
By Mark Lyell
Consolidation is forcing the evolution of the contract manufacturing (CM) industry. This is no phenomenon, only an indication that the industry is on the road to maturity. At forecasted sales of $120 billion for 1999, the publicly traded CM companies now have demanding expectations from shareholders. Support industries have sprung up in recent years. An industry that once minimally shared a supply chain is beginning to dominate it, and almost every major investment firm now follows the market. As a result, the CM industry exemplifies corporate restructuring. What OEMs are trying to accomplish in the lean and mean philosophy of business (developed by Jack Welch of General Electric) has been a way of life for the CM industry for years.
What is the role of the CM firm? The contract manufacturer's expertise - gives OEMs a chance to focus greater energy on their own strengths," said analyst Daniel Bubbeo of Technology Forecasters, Alameda, Calif. His company predicts 25 to 30 percent growth over the next several years in the CM industry. What Bubbeo could say is that CMs are better, faster and cheaper than OEM-run manufacturing facilities, and the net result is higher profit margins for the OEM (which pleases another set of demanding shareholders). What was once a relationship of convenience or flexible capacity has now become a strategic partnership, two industries dependent upon each other, where the CM's success is measured by its return on assets (ROA) and the OEM on its profit margins (or in some cases, expected profit margins). Technology Forecasters also reported that nearly 65 percent of all CM growth is through acquisition of OEM manufacturing facilities, and with less than 20 percent market penetration, this trend will continue for years to come.Figure 1. CM sales chart.
Market SegmentationOne industry often provides insight into another. Because the retail industry is focused upon inventory turns, and in the CM industry value is based upon ROA, it is a good comparison. Two generations ago in the United States and today in many parts of the world the retail industry was segregated and specialized. Shopping was done at many smaller, specialty retailers. Because time is a premium for most people in the United States, warehouse-style stores have propelled to the forefront of the industry. They provide a one-stop shopping experience and, with high inventory turns, provide excellent pricing to the consumer. Many niche retailers still provide services that are more specialized (including E-tailers) and will always be around, but it is the middle-tier retailers that are being squeezed. This is the trend that the CM industry is following behemoths and boutiques squeezing the mid-tier supplier. Following this train of thought, could one rely solely on a warehouse-type outlet for all shopping needs? The answer is no. The CM landscape has changed significantly in the past few years and the result is that the mid-tier CM is gone (usually through acquisition). What remain are large global players and small niche players (Figure 1). Because the requirements of OEMs are as at least as diverse as the shopping requirements of an average person, newer strategies need to be deployed.
The Competitive World of an OEMThe only constant in the high-tech industry is change. OEMs need to reinvent themselves with almost the same frequency as new products are introduced. Better, faster and cheaper is what the marketplace wants and buys. This reality is documented by a recent joint study by the Japanese and World Technology Evaluation Centers that concluded that companies introducing products six months ahead of the competition can generate profit margins three times greater than the industry average, while the cost of being late to market can be as high as 35 percent. Another recent study of 189 electronics products by Pittiglio Rabin Todd and McGrath (PRTM) indicated peak production occurs at 28 percent of the way through the product life cycle, with 67 percent of ultimate product revenues occurring in the first half of the product's life. The common product life cycle is a bathtub-shaped curve (Figure 2) with four significant stages. At every stage, the premium is based on leading the curve (up or down). Mismanagement brings a host of woes that reduce margins and company valuations.
The challenge to add value in a compressed product life cycle has been met by varied responses from CMs, ranging from acquisition of OEM facilities to establishing global operations, establishing technological advantages, developing customer industry expertise, specializing in volume or complexity, vertical integration the list goes on and on. There is variety in the CM marketplace. So why, then, in a growing CM market, do the rich get richer?Figure 2. Common product life cycle.
For OEMs, having a minimal number of suppliers is easier than trying to manage a more tactical approach. This, in theory, focuses on core competencies. The reason the rich get richer in the CM industry is by default. OEMs have chosen to outsource everything, even overhead, to administer their outsourcing strategy. Adding overhead is always met with resistance; where management by objective is used, however, small niche suppliers are also used. At the strategic management level of several successful tier-one OEMs, they only recognize a few CM suppliers, but there may be 20, 30 or even 40 on the approved vendor list. It is reasonable to assume that formalizing this secondary supply base, eliminating redundant suppliers and creating strategic roles for suppliers would give the best economy of scale to the company. A tiered-supply base strategy creates a supply base of experts mixed with the generalists. This is not unlike using a warehouse-style retail outlet when appropriate and a smaller, more focused retailer when suitable. Examples of this secondary strategic supply chain could include specialists in RF technology or other specific industry expertise, regional support, advanced packaging, volume and/or complexity, design engineering, etc.
Much has been published on how to select a CM, but most strategies have been developed for tier-one, multi-billion-dollar OEMs. They generally funnel a matrix of variables, including revenue, global locations, services, etc., to narrow the field of suitable CMs. The net result is that tier-one customers have a choice of very few tier-one CMs (similar to the you will never get fired for buying IBM" philosophy). This strategy does not address smaller, more specialized suppliers that often provide a valuable contribution to the success of an OEM and could potentially be of benefit to small- and medium-sized OEMs, as well. In other words, the strategy does not address reality and is not scaleable. This is proven by the fact that many more CMs are being used to achieve the sales plans of tier-one OEMs. And at gross margins of 55 percent or greater, who can argue that they should not be used? Many other small suppliers are relied on for vital services required for successful product deployment (much like the shopping habits of an average person). If OEMs considered the need for diversity in their outsourcing strategies, it would result in several benefits¨
1. Recognize and create contingency plans for all product deployment issues.
2. Consolidate smaller supplier requirements for best leverage.
3. Help keep small, vital suppliers healthy.
4. Minimize side and lower rank-and-file dealing that can lead to messy legal entanglements.
Balanced Outsourcing ApproachAssuming an OEM's needs are at least as complex as the shopping requirements of the average person, how does the OEM create the greatest balance within its CM supply chain?
1. If it doesn't fit, don't force it. The predominant tier-one outsource strategy forces OEMs to settle" for what a tier-one CM offers. This strategy covers the broadest basic services, but continues to use the warehouse shopping analogy the lines are long and variety in specific categories is limited.
2. Stop ignoring the fact that small, specialized suppliers are being used. Whether the objective is first to market or high inventory turns, many small suppliers are being used. This tends to be through preference of engineers or managers responsible for an objective. Acknowledging the value of the supplier and formalizing a strategy pays the best dividends.
3. Understand the core competencies of your CMs. Many OEMs believe that if they give enough business to their CM, they can demand change and the development of new services. This is an unrealistic expectation. Developing new core competencies takes a significant amount of time. These services often fall outside of the CM's standard operation method and are probably managed by individuals. They often show up on the corrective action list for several consecutive quarters and are significantly impacted by employee turnover.
4. Keep small, valuable suppliers healthy. Regardless of the angle of specialization, consistent business helps keep a valuable supplier healthy. An example¨ A small manufacturing facility specializing in advanced packaging technology requires some volume to generate profits. Find a way to reward this type of supplier with low-risk or dual-sourced production business. Scraps from the table of the large CM will usually keep a smaller supplier healthy. Do not assume that sporadic high-priced business buys a level of service. Be realistic, as consistent business pays the bills and builds loyalty. It can be easy to lose track of your percentage of business to a supplier. Try to stay under 20 percent and above 10 percent.
Figure3. Product deployment between an OEM and CM.
The message is that conventional product deployment between an OEM and CM is not a short, straight-line process it is complex and requires formalized contingency plans (Figure 3).
Each OEM has specific needs and each CM has different core competencies. An OEM needs to use good judgment in creating a supply chain at each phase of the product life cycle and product deployment. If a specialist can improve any aspect of the two, an OEM must define a strategic role for that supplier, then commit to keeping the company healthy. The OEM must also make sure the overhead is in place to manage the entire supply chain effectively.
SummaryThe CM industry is moving toward maturity and already stands on its own in the financial community. The relationship between OEMs and CMs, once a relationship of convenience, has now become a relationship of necessity. OEMs that have chosen to outsource are dependent on CMs to achieve their financial goals and vice versa. The relationship is mutually beneficial and mutually dependent.
The CM industry is primarily dominated by large, global companies and small, specialized suppliers with few middle-tier suppliers left on the field. CMs need to either compete on a global scale or define their niche in the market. There is plenty of business for all. The right niche provides better margins and can attract stable customers. This environment offers an OEM an array of options to customize its supply chain based upon need. Many OEMs did not use this approach in the past because the predominate philosophy did not recognize how small niche suppliers contribute to the success of product deployment.
A balanced outsourcing strategy recognizes an OEM's total requirement and plans for contingencies. Each supplier has a clearly defined role in the supply chain and is recognized for that role. The benefit is suppliers working together to produce a more efficient product life cycle execution. This results in higher margins for the OEM.
MARK LYELL is vice president of business development at SMT Unlimited, 47650 Westinghouse Drive, Fremont, CA 94539; (510) 445-2410; Fax¨ (510) 659-9264; E-mail¨ MarkL@smtu.com; Web site¨ www.smtu.com.