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Innovation Ships Out

Innovation Ships Out

As US companies increasingly shift their R&D focus from new breakthroughs to product refreshes, they will be tempted to move that work offshore, where well-trained and well-educated engineers are available at a fraction of the cost of their US counterparts.

To survive, EMS companies have had to continually take on higher-order, more complex pieces of the electronics supply chain to keep their hollow-cheeked profit margins (overall industry average is 2 percent to 5 percent) from disappearing altogether. Design work typically has higher gross profit margins, between 8 percent and 11 percent, according to iSuppli's Pick. This has led to the growth of upstart companies such as Quanta that specialize in total design, manufacturing and shipping solutions for customers. Traditional EMS companies, accustomed to focusing exclusively on the manufacturing portion of the supply chain, are now expanding their design services to compete. "[EMS companies] want to get more of the value added at the research end," Tassey says. "Innovation is where you capture the big value, the new markets."

Quanta, unlike its larger EMS competitors, does not swallow customers' old factories and try to squeeze profits out of them. Quanta emphasizes design and logistics in Taiwan and assembles a network of manufacturers, mostly in China, to build its products. And Fang can use lightweight IT connections to hook his supply chain together and keep customers apprised of where their products are in the process. Fang has created an Internet portal for his network of 700 small suppliers. Each morning, suppliers download their purchase orders from Quanta's Web site and print out bar codes that they slap on the side of the box so that Quanta can quickly direct the materials where they need to go at its Taipei logistics centre.

IT Makes Outsourcing Easy

IT has accelerated the outsourcing trend in electronics because it allows OEMs to monitor the processes they give up, such as manufacturing and design. IT can't replace a good assembly line foreman or a chief engineer who watches over things, but in many cases, monitoring the process is enough. For example, OEMs don't need to test each PC made by an EMS before it gets shipped if they have set up a testing process at the factory that is monitored by IT. The OEM just has to verify, via an IT-based reporting system, that PCs that didn't pass the agreed-upon test were not shipped. Monitoring reduces the number of people from the OEM needed onsite at the EMS's factory and virtually eliminates the need for the OEM to physically take possession of the products.

For big US companies with diverse product lines such as HP, it's impossible to get everything they need from a single EMS company. Nor would these companies want to, for competitive, intellectual property and security reasons. But HP, for one, does try to limit the number of EMS companies it deals with, partly to shave costs, and also because the increased IT demands of monitoring the EMS's processes can be quite expensive for highly configurable products such as high-end servers. "If we want to create a build-to-order process for customers with an EMS, there is a lot more intimacy required in the information we exchange with the EMS," says Faber. More product options means more monitoring of the EMS company's processes. "The information pipe will be a lot bigger and must be much more responsive to changes than when we're dealing with a commodity product," he says.

If an EMS can take over the entire product process, from design to manufacturing to shipping to customers, and OEMs can verify through relatively inexpensive IT controls that the EMS is performing all these processes up to snuff, it becomes a much more enticing package for OEMs. Splitting up linked processes such as design, manufacturing and shipping is hard; it costs more and requires more oversight from the OEM. That's why design is becoming a deal maker (or breaker) for new outsourcing business. "All of the [EMS] companies realize they have to get involved in the design effort at the early stage because that's how the business is won today," says Needham's McManus.

With the relentless margin pressure that exists in the computer industry today, OEMs are quickly coming to the view that there is no point in devoting a great deal of R&D resources to mature product categories that change as rapidly as PCs, laptops and mobile phones. R&D engineers are the most expensive nonmanagement employees these companies have. "The OEMs are building entirely new product families every few years. So you either keep building R&D capacity to do that, or you outsource it," says Chris Smith, president and CEO of RiverOne, a maker of supply chain management software. "It's driven by the pace of change in the industry."

Indeed, Quanta is not designing anything all that original. The company is unlikely (at least for now) to invent the next revolutionary new product category. But it is perfectly capable of designing and manufacturing the next version of a PC, laptop or, in a move up the value chain, storage server on its own. "These companies started with circuit boards and worked their way up to design over the years. They've built up a lot of trust with the OEMs," says iSuppli's Pick. These companies aren't simply providing cheap labour, either. Pick says many have instituted quality programs such as Six Sigma that rival Western producers. Factory capacity utilization among EMS companies averages 85 percent to 90 percent in the Far East, versus 65 percent worldwide.

Innovation Not Far Behind

Quanta's Fang is careful to point out that his company has no intention of developing its own brands and selling against its customers. But other offshore EMS's have already broken that taboo. For example, BenQ, another Taiwanese EMS, sells its own brands of mobile phones and computer accessories in the Far East and the United States.

Quanta could be forced to do the same in the not-too-distant future. The incredible growth of electronics outsourcing has masked a fundamental weakness in the business model: Nobody has yet learned how to make much profit doing it. Even design margins have begun to erode recently, as EMS companies flock to the model and OEMs push for lower prices. To avoid a race to the bottom, the industry is going to have to find a way to earn better returns. "I don't think there's anything stopping the outsourcing push," says Needham's McManus. "The issue is: Can you be a successful corporation with returns on capital that are no better than 15 percent?"

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