The wrong message: EMS value proposition still rooted in cost reduction

Recently, I mentioned several critical issues facing the EMS sector as we sink deeper into a recession. This discussion with VentureOutsource.com culminated as the result of various other conversations I have been holding with IDC clients about the outlook for the contract electronics manufacturing services (EMS) industry, which we all know is not great, despite bright spots including increased outsourcing in the medical and industrial segments. For the most part, these conversations have focused on the recession and the coming pressure on EMS firms that is only going to increase in the following areas:

• greater inventory risks
• evaporating demand
• changing forecasts from OEMs
• increasing pressure on lead times
• the shift underway in manufacturing footprints, and
• the continual pressure on costs

Aware of VentureOutsource.com's online industry influence, I want to take the time and leverage this platform to further flush out ideas from these previous discussions in a series of articles for VentureOutsource.com readers, beginning with this piece. The result of all of these forces, as well as other issues, may be too much for the industry to bear, especially for some firms on the bubble. But, it's my thinking that none of these issues are the real problem facing EMS and ODM firms. That in fact, these problems are just symptoms of a more fundamental problem with the industry. The fundamental, real problem with the EMS industry is its inability to effectively communicate its value proposition. The pressure on EMS firms relates to the mistaken belief the core value proposition of outsourced manufacturing is cost reduction for OEMs. This mistaken belief is partly due to the ongoing sales messaging by EMS providers combined with the EMS partner evaluation and selection process by OEMs where OEM processes often take a short-sighted, commodity purchasing view, where individual buying managers and procurement units are evaluated based on cost reductions in their narrow purview. Few OEMs evaluate the total cost to design and deliver products to customers. This cost reduction ‘message' also is a result of the historical foundation of the EMS industry. Component suppliers initially won business on their ability to take on non-core manufacturing processes for OEMs. Now, OEMs have allowed EMS firms to take over all manufacturing operations. Finally, when OEMs in a product sector initially turn to outsourced manufacturing, there is usually some cost savings, but once the low-hanging fruit have been harvested (e.g., inefficient processes are re-engineered; logistics and purchasing processes are improved, and access to larger purchasing pools is obtained), cost savings become more difficult. Yet, future expectations by OEMs for further cost reductions remains. But, cost reduction has long been a fundamental misconception of the value of outsourcing. The true value, in my opinion, is the transference of risk. Let's take a moment to look at outsourcing and the state of the EMS industry. There are several dimensions across which we can define outsourcing relationships, all tied to the level of risk transferred from the OEM to the EMS provider:

• EMS management of complexity within and across outsourced business processes, on behalf of the OEM

• Management responsibility of the outsourced processes

• EMS performance's impact on the OEM's business

• Pricing relationship between EMS and OEM, whether transactional pricing or more advanced shared risk / reward

If we look at the range of relationships possible across these dimensions, we see four types or generations of outsourced manufacturing (Figure 1) which can be perceived as an Outsourcing Maturity Model. These outsourced manufacturing generations include:

• Contract Manufacturing - Non-core OEM activities are outsourced to EMS partners (component manufacturing or SMT, for example) or, to access extra capacity

• First Generation Manufacturing Outsourcing - OEM begins to release responsibility for the manufacture of components and / or complete systems to an EMS partner. System or sub-system manufacturing is still the core process being outsourced but other services may be provided. EMS partner is executing decisions made by the OEM.

• Second Generation Manufacturing Outsourcing - EMS firm provides more services, taking on greater responsibility for the performance of each outsourced process. EMS partners have greater responsibility for decision-making, not merely executing OEM decisions.

• Third Generation Manufacturing Outsourcing - The OEM completely transfers risk to the EMS partner. OEMs will still manage the relationship, but fundamental business / operational responsibilities for the performance of the outsourced processes lie with the EMS partner.

Fig. 1 Currently, I contend that most Tier 1 and Tier 2 EMS providers are operating in a hybrid of the first and second generations of manufacturing outsourcing. EMS providers are providing more services and taking on moderately high levels of risk and complexity management on behalf of their OEM clients. Yet, pricing relationships remain less mature and OEMs still retain a high level of decision-making. Meanwhile, the key benefits OEMs receive from partnering with EMS firms include:

• access to variable manufacturing capacity
• flexibility to scale production up or down
• increased time to market
• improved process efficiency
• process management
• complexity management

While this list is not exhaustive, cost reduction is not mentioned. This is because, for most product segments, the OEM will probably not necessarily save with outsourcing. OEMs can eliminate assets dedicated to manufacturing and related processes, improving their balance statements, while shifting some SG&A costs on the income statement into the cost of goods sold. Whereas, ongoing OEM-mandated cost reduction goals the EMS firms often need to achieve are mostly no different than what the OEM would be able to achieve if the OEM continued to in-source. Factoring in various ‘soft costs', OEMs may end up spending more money as they manage the OEM-EMS relationship and often duplicate some functions, especially related to purchasing. On the plus side, OEMs receive access to manufacturing capacity as needed. On the opposite side, EMS firms carry the cost of investing and maintaining sufficient manufacturing capacity to cover any upside demand from OEM clients along with purchasing and logistics networks. EMS firms also have to manage future risk in uncertain environments (without contracts specifying particular levels of demand) and oversee complex manufacturing processes. But, one has to ask, are EMS firms charging a sufficient premium? If the relationship were fair on both sides, we would expect the EMS provider to receive as much value as the OEM, illustrated by the equilibrium curve in Figure 2. This curve represents a fair pricing of the risk in the relationship between partners. The goal for EMS firms should be to price for the variable costs associated with the production on behalf of the OEM, then for the overhead costs of ramping up production for a new product and other services provided to the OEM. On top of this, a risk premium would be added for investing in the manufacturing capacity. Such pricing would fall on (or around) the equilibrium curve. Fig. 2 But today, most EMS firms are pricing below the fair price for their services. This is because of over capacity among EMS firms and intense competition in high-volume, low-mix product segments. The end effect is that cost reduction is still the primary benefit OEMs see from engaging with EMS firms. This mindset is becoming an ever greater threat to the long-term survival of the EMS industry. Without the ability to price appropriately, profitability for EMS providers is under attack and they are unable to achieve their cost of capital.  The EMS provider's ability to invest in new technologies, clients, and other initiatives will become threatened. Also, as long as the basis of the OEM-EMS provider relationships is cost reduction, EMS providers will be under intense pressure from other EMS firms with lower cost business models or, from other EMS firms willing to underbid just to win the contract. To turn this scenario around, EMS firms must shift their conversations with OEMs away from cost reduction. However, why would OEMs listen to such a message? Let's take a look at the current nature of the relationship between OEMs and EMS firms. First, the cost for switching EMS partners represents high costs for OEMs to move a product program. Costs are related to issues such as the OEM qualifying an alternative EMS provider's supply chain; certifying the EMS provider's production lines, establishing systems links, educating a new workforce, and establishing testing and quality protocols. Second, trust is a major concern for OEMs when selecting EMS partners. The OEM is placing critical IP in the hands of the EMS partner, along with fundamental business operations that will determine how well the EMS partner can serve the needs of distribution partners and customers. In fact, a lot of business in the EMS space is based on the personal relationships between EMS staff and key decision makers at OEMs. Yet, for OEM executives, picking the right EMS partner is critical to the future of their careers. Finally, over time, the knowledge and experience related to purchasing, logistics, and manufacturing migrate out of the OEMs to their EMS partners, eliminating the ability of the OEM to readily in-source production. If stickiness, trust, and experience are the fundamental hallmarks for the EMS-OEM relationship, and the core feature of outsourcing is the transference of risk, then we can start to see a much richer mix of elements EMS firms can draw from to help them craft new value propositions. This new value proposition is necessary if EMS firms are going to emerge from the current recession in a stronger position to stave off competition as well as prevent the commoditization of manufacturing outsourcing opportunities in emerging markets -- an opportunity starting to open up to EMS firms. If cost / cost reduction remains the focus of the OEM-EMS relationship, leading EMS firms are vulnerable to being squeezed between OEMs (with their focus on brand and end-customers) and semiconductor suppliers and technology providers (key developers of IP and reference designs). Each day, these types of companies are looking for new outlets / markets for their technology and are turning to new players to help bring their technologies to market. A new value proposition is also needed to help EMS firms achieve results to cover their cost of capital and to reward shareholders becoming increasingly dissatisfied with company stock performance. A new value proposition may also lead to more freedom for EMS firms to manage their capacity to achieve better performance for themselves and for clients, as they take on new responsibilities and risks. Finally, a new value proposition will also help to shift the mindset of OEMs to focus on the ‘net value' of their business instead of commodity purchasing. Share your comments below and stay tuned. I'll explain what I believe should be the new value proposition for EMS providers in my next article. VentureOutsource.com, March 2009