IDC talks about flaws in EMS value propositions

The contract electronics manufacturing services (EMS) industry is crowded. Even as companies merge or are acquired, and some simply fade away, too much industry capacity remains while EMS companies are competing using the wrong message. However, companies can survive, and even do better. How is this so?

There’s a disconnect between the way EMS companies market their services (and the manner in which OEM buyers perceive the value of EMS services) but, this is only part of the problem. OEMs must also trust their EMS partners. In taking a closer look at EMS-OEM relations, it seems OEMs don’t trust EMS providers. At least not 100%.

VentureOutsource.com talks shop with Michael J. Palma, senior research analyst Electronics Manufacturing Services and Consumer Device Semiconductors for leading industry research and consulting firm IDC.

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Michael’s responsibilities at IDC include managing IDC’s OEM Manufacturing Value Chain program where he closely evaluates strategic supply chain relationships between EMS / ODM providers and their OEM customers, and organization types, across the electronics supply chain…developing supply chain maps and insights.

Michael also manages IDC’s Electronics Manufacturing Services (EMS) Forecaster product where his industry forecasting skills and analytical talent can be counted on to keep industry thought leaders up to date with innovative insight and analysis.

We asked Michael some tough questions. After reading his responses, we think you’ll agree he offers fresh, and direct but honest and encouraging insight for re-thinking the structure of EMS-OEM relations and the nature of the industry.

Transcripts from that discussion follow …

VentureOutsource.com: Throughout most EMS-OEM engagements, OEM buyers (e.g., purchasing agents of EMS services and, electronics components) face OEM company mandates to get the lowest price they can find. This price-sensitive OEM decision process is often counter-productive to getting the best suited EMS provider for the OEM. Meanwhile, EMS providers support this OEM low-price / -cost mindset by branding and marketing their low-cost service destinations as being the answer to everything. What are you thoughts about OEMs shifting away from a low-cost mentality and, instead, demanding actual value created by the EMS provider that truly helps improve the OEM’s business? What are some ways you feel OEMs can determine whether or not their current EMS provider IS creating value in the outsourcing relationship? What are some things EMS providers can do to explore ways they can improve the effectiveness of their marketing campaigns so such campaigns communicate real value to the OEM?

Palma: This is critical if current EMS firms expect to thrive five years from now because it has been my opinion for some time the value proposition for EMS firms has been a broken.
 

 
For most EMS firms, despite all the other language they use, the key message they communicate to customers, and what OEMs value the greatest in their relationship with EMS firms, is “we can reduce your costs.”

EMS firms have bought into the OEMs’ tactical focus on the lowest possible cost for discrete components and services. But, this perspective is, in the end, harmful for all parties involved.

Michael J. Palma Senior Research Analyst Electronics Manufacturing Services (EMS) & Consumer Device Semiconductor IDC

OEMs following the lowest cost strategy are missing all of the indirect and hidden costs to manage their outsourced processes and they ignore the total cost to produce and deliver a product to their customers. In the end, this near-sighted focus, which simplifies evaluating the purchasing function, can result in higher costs and other poor decisions that negatively impact their products and customers.

For EMS firms, the focus on cost reduction is, in reality, a race to bankruptcy or an invitation to be displaced by a competitor with a lower cost basis.

Even worse for EMS firms, this focus on commodity pricing often means EMS firms cannot price their services appropriately.

Almost all leading EMS firms cannot achieve the cost of capital needed to invest in and support their operations.

The true nature of outsourcing is the transference of risk in the execution of a process from the client to their outsourcer. For the outsourcer, the proper pricing of EMS services (this assumption of risk) should carry a premium for the assumption of these risks, in addition to ongoing costs driving operations; so that total composition allows significant margins, when the outsourcer executes properly, that the outsourcer can recoup costs, fund continuing investments, and reap an appropriate profit, after repaying the capital outlay to build the service delivery infrastructure.

However, another problem in the current market environment is that OEMs rarely transfer the full risk for operating their purchasing; logistics, design, manufacturing, and support processes to EMS partners.

This hedging shows either their reluctance to trust their partners or their short sightedness regarding how to engage with outsourcers and to manage their operations.

The result is the market is still too heavily engaged in contract manufacturing and not business process outsourcing.

OEMs’ focus should be on how to best design, build, and deliver products. And be smart enough to tap into EMS firms’ greatest asset, knowledge and experience in the execution of these functions. For at this stage, much of the knowledge resides in the EMS community as OEMs shed these skills and knowledge base long ago in the IT market.

My recommendation is that EMS firms should focus on their ability to improve their customer’s business – essentially, focus on how they create value for the OEM.

Doing so can both provide a way to better price their services but also be a key disruption to EMS competitors who remained focus on low cost.

But this means changing their perspective from a supplier to an outsourcer.

Now, this may not be possible for EMS companies deep in survival mode. But any EMS firm that thinks it has a chance to emerge from this recession needs to consider this transformation in their value proposition.

For on the other side of this recession, if an organization cannot radically change the nature of their relationship with their clients and realign its compensation, they will eventually find it impossible to secure future investment and face bankruptcy or displacement, as mentioned above.

As for OEMs determining if their EMS partner is creating actual value, OEMs must look to peer benchmarks and their own previous performance.

Most importantly, OEMs can look to their success with their end-market customers and their total cost to deliver product to these customers. OEMs can also look at how their organization and processes have evolved and the role their EMS partner has played in this evolution.

OEMs should ask themselves: Has the EMS partner led initiatives to change how I do businesses or have they merely executed on the initiatives I laid out in the beginning of the contract?

Other areas to look at are time-to-market, product quality and return levels. Customer loyalty and satisfaction along with the cost to service customers are some further metrics to examine to see if the OEM’s business has improved.

Finally, OEMs must evaluate whether or not they have really relinquished the management and control of these design and operational functions.

How do the parties involved achieve a metamorphous relationship between OEMs and EMS firms? This is achieved in words and through actions.

EMS firms need to engage directly with the strategic leadership of their OEM clients to communicate their potential and then lead the effort to improve the OEM’s operations and also to show what has been accomplished.

As for actions, EMS firms need to take the lead in transforming the processes, operations, and the mindset of OEMs. It also requires taking a proactive stance, searching out for areas to transform and improve their client’s business.

Proof is also critical for the EMS firm. Demonstrating what you have achieved as the EMS provider partner, even if initially hidden from the OEM because of their ‘blind spots’, is crucial.

For with time, and experience, in the best circumstances, the OEM will learn it can entrust its EMS partner with its core functions and the necessity of being a valuable customer to such a forward thinking EMS firm.

VentureOutsource.com: Outsourcing is really about transferring or sharing risk. Part of this risk can be broken down into the OEM having some ongoing operational (and related) administrative expenses while the EMS provider takes on a higher degree of fixed costs (capex). What are your thoughts on ways OEMs can approach outsourcing economically? What are some ways you feel EMS providers can gain greater control over their business?
 

 
Palma: I think the way for an EMS firm to gain control over their business and achieve a reasonable return on their investments and risks is to show their true value to OEMs, earn the respect of their clients, and recognize their own value. The route they must follow probably includes the following elements:

• EMS firms must be proactive. They need to raise and address challenges OEMs are facing. Seek out OEM weaknesses and find ways to address these, beyond just attempting to lower costs. First and foremost, what is the total cost to deliver a product and, how can you help address this total cost of delivery? Then, how do you help your OEM improve customer satisfaction? Next, how do you help the OEM differentiate itself from the rest of the competition? Other issues will surface, but in the end it falls to how to improve the value of the OEM.

• EMS firms have to transform their mindset from supplier to outsourcer — from contract manufacturing to business process outsourcing. This means taking ownership of processes, not just executing on existing processes. This also means EMS providers have to transform an OEM’s operations, not just provide lower costs.

• EMS firms need to change the conversation / dialogue and hammer in key points of their value proposition. For me, this includes the basis of the relationship between OEMs and their outsourcing partners: shifting risk to the EMS firm. Make sure the OEM knows that you’re not there to make their widget, but rather that you can help bring their ideas to market. This involves a new language. A communication focused on value, shared reward, and vision.

• EMS firms need to raise the level (and number of) conversations they have with OEMs. EMS firms need to be in constant communication with OEM lead decision makers, not just purchasing agents, product teams, and operations staff. The more EMS firms speak with and gain the respect (and trust) of OEM CEOs and the CFOs, EMS firms will find their conversation topics will shift from manufacturing and process to strategic value.

• EMS firms must clearly demonstrate their value. Document and provide proof on how you have helped the OEM transform their business. Take a look at IT outsourcing… One of the greatest success factors is the ability to quantify how the client’s business has changed since outsourcing. Investing in this measurement upfront, and then tracking the transformation over time is critical. With proof, the OEM can realize just what the EMS firm’s value is.

If an EMS firm can really deliver on these points, then it’s up to the OEM to reward their partner.

Otherwise, the EMS firm should dump the OEM and focus on clients who are willing to reward these efforts and the shortsighted OEMs will wind up with partners who cannot deliver, and they will suffer.

Achieving these objectives will differentiate an EMS provider from the next lowest EMS bidder.

VentureOutsource.com: What do you see as necessary components that should be included when defining the ideal OEM-EMS relationship? As OEMs go through the phases of evaluating and selecting EMS partners, what are some questions OEMs should be asking EMS providers before signing the contract and becoming committed to an engagement?

Palma: The first test would be asking how an OEM’s potential EMS partner addresses the question of how he can add value to the OEM’s business? Look for examples of what the EMS provider has done with other firms. But more importantly, how have the EMS providers being considered engaged with you in the contracting processes? Are they focusing on your future roadmaps; are they engaging in discussions of how to transform your operations and, are they challenging your assumptions about outsourcing?

OEMs can also ask if the EMS partner is willing to take ownership of all the related processes or, does the EMS provider expect the OEM’s team to remain largely involved? But this question can also be turned around. Are you (the OEM) willing to relinquish control of the process?

One way to accomplish this would be to step back from these decisions and then evaluate the OEM based on benchmarks from your previous operations and against other related engagements for the EMS firm.

Perhaps the most critical question for OEMs is: how willing are you as the OEM to explore alternative rewards for the EMS partner?
 

 
Is the OEM willing to depart from fixed pricing or cost-plus methodologies?

Can the EMS partner prove how they have improved your business or, show how their operations have enabled the OEM to outperform its peers?

Can the OEM shift its focus from lowest cost of individual commodities to the total cost to produce and deliver a product to end-customers?

In the end, is the OEM willing to share the rewards equitably with a partner who assumed the risks of building and operating a highly flexible manufacturing capacity and service delivery operation?

VentureOutsource.com: Following the large acquisition of Solectron by Flextronics, which did change the EMS landscape to a degree, and other industry mergers and acquisitions that have taken place since then, how much more consolidation do you expect (or is needed) in the EMS industry? Which EMS providers do you see (as a house of cards?) possibly collapsing or, perhaps continuing to shrink in size whereas to lose any chance of having a competitive advantage? Do you see any hope for companies in this type of situation remaining autonomous – independent of private equity taking hold, or mergers or acquisitions being part of the solution?

Palma: I think it is less about what the industry needs at this point and more about who will continue to be viable competitors.

In the notebook space, we would expect one to two of the tier one ODMs to be forced out of this sector. Hon Hai and Flextronics have entered this market and likely have the resources and the potential client relationships to build substantial notebook businesses.

The weakness of the PC market in the current environment, the growth of the netbook business, and the continuing falling margins for notebook manufacturing will likely force out the weaker manufacturers in this segment.

In the broader EMS industry, firms with poor value propositions presented to clients are at the greatest risk of collapsing. One EMS firm comes to mind. Sanmina-SCI.

Sanmina has pulled back from the PC business and is trying to transition to a lower volume, higher mix manufacturing, yet it does not seem to have transitioned its organization and business model to address these opportunities. In the current slowdown, Sanmina seems to have chosen to reduce spending, and investments, as part of its survival strategy.

Yet, I think the way to come through this recession and to remain viable once the market bottoms, is to invest and show clients what you can offer OEMs.

What new services can you provide?

How can you transform your client’s operations?

How can you help your OEM achieve outstanding customer satisfaction?

In other words, you cannot retreat from the risks, but find a way to beat them back.

VentureOutsource.com: Trust is a required component in successful outsourcing relationships. OEMs are sometimes reluctant to disclose their true product roadmaps with EMS providers for fear of losing a competitive edge in the market. (i.e., fear EMS providers might share OEM’s roadmap information with possible competing OEM customers also serviced by the same EMS provider) The outcome of this is many EMS providers are left second-guessing how best to service some OEM programs. What thoughts can you share with our readers on this spy vs. spy scenario?

Palma: The simple answer is OEMs need to trust their EMS providers.

Without this, EMS firms are not encouraged to invest in the future. Worse, without being entrusted with this knowledge, the EMS partner is prevented from bringing its knowledge and experience to bear on the OEM’s problems and opportunities.

It’s like a lawyer with a client who will not share their side of a dispute or, a doctor with a patient who will not say where they hurt.

In the end, this is the risk the OEM must take, because nothing will change without this trust.
 

VentureOutsource.com: Three electronics industry product segments expected to achieve the greatest CAGR for EMS/ODM companies through 2012 are medical devices (18% CAGR), industrial electronics (12%), and automotive electronics (12%). In looking at the top 10 EMS / ODM companies today, which two (2) of these companies do you feel are best suited for servicing the medical devices segment? Which two companies do you feel are best suited for servicing the industrial electronics segment? What about the automotive segment?

Palma: In all three of these three emerging segments, two firms currently lead the pack in terms of revenues; Flextronics and Jabil.

Both of these firms have significant businesses in all three of these segments. Jabil has long been the leading firm in the emerging areas, but in the past year, Flextronics has overtaken Jabil, following its acquisition of Solectron, which pursued these emerging opportunities with some success.

The key in this sector has to do with the level of investment the EMS provider makes to serve what are often smaller volume projects and, build expertise in the various product areas. Lower volumes in these emerging spaces explains the lack of ODMs among the leading firms.

Jabil has been the traditional leader in the automotive sector, focusing on various vehicle control systems and wiring systems, but Flextronics has been expanding in this sector, especially in various infotainment systems, as these products have gained popularity in the past two years.

Flextronics’ experience working with OEMs in the automotive sector has proved critical in certifying their operations with the OEMs and their investments should pay off once the automotive market begins to recover, as the electronics content of cars grows rapidly. Lite-on has also emerged as an EMS provider with a large business in the automotive space, especially with its growing LED operations.

In the medical electronics sector, Jabil has been the leader but Flextronics has been investing in its medical practice. Flextronics gained a significant presence in the medical space through its acquisition of Solectron and then followed this up with the purchase of Avail, an EMS firm specializing in disposable products.

Both EMS companies have invested in the appropriate certifications and have long established teams that have been working to win business with medical device makers. Sanmina is another company that has won a significant number of medical projects, and if it can weather its current challenges, it should be able to win new business. Sanmina has project wins across the range of product categories in the medical space and this area has been one of the stronger areas for the company.

In the industrial electronics area, Flextronics has built up a large business, especially with its plastic injection molding business plus, its acquisition of Solectron significantly added to its industrial operation business, surpassing Jabil’s industrial business.

Success in the industrial sector for both Flextronics and Jabil is due to accomplishments across a range of areas within the sector; from point-of-sale (POS) and kiosk systems to aerospace and defense systems; industrial automation products, semiconductor capital equipment, and a host of other products.

Other leading EMS firms in this space tend to be active in just one or maybe two corners of the industrial sector or, they simply haven’t been able to scale up their operations in this space.

 
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