Tracking Global Trends in the Evolution of Global Outsourcing

The two prongs of Charles Darwin's famous theory of evolution outlined in his book,  Origin of Species, are as follows: (1) variability which occurs in nature in response to environmental stimuli and (2) the fierce struggle for survival that occurs because of limited resources. Those two conditions lead to breakthroughs in innovation in the biological world when the process of 'natural selection' allows the variations that have most successfully adapted to changing conditions to survive and continue reproducing. This principle of biology has been applied to business to describe how quickly business models change and evolve in response to changing global conditions. Take for example, the evolution of the electronics contract manufacturing services industry. There are many business models currently in operation, which represent significant variations on the first arrangement. Companies can operate as Original Equipment Manufacturers (OEM); pure Contract Manufacturers (CM) or Original Design Manufacturers (ODM), but these categories increasingly are blurred, with many companies in both the ODM and CM categories co-designing or jointly designing products with their customers, and with numerous schemes for deciding ownership of the resulting intellectual property.

There are also companies in the ODM category that sell products under their own brand name, a practice referred to as OBM, or 'own brand manufacturing.' There are OEMs, particularly in China, that provide CM services to foreign OEMs when they have extra capacity. There are also many CMs, particularly in Tier II and III, that sell branded electronic products. Indeed, the industry is evolving so quickly that it is difficult to outline a consistent historical analysis because of convergence in the industry product sectors and in the characterization of the  companies themselves¹.   Technology Forecasters Inc. (TFI) analysts believe that conditions are ripe for the emergence of new species of electronic manufacturing companies. This rapid evolution of business models will accelerate, and as the industry moves forward will be an important focal point for innovation and competitive advantage for companies that manage these complex relationships profitably. The supply chains that survive will be the ones that have most successfully adapted to changing environmental conditions.

Five Year Forecast

TFI analysts are forecasting the combined EMS/ODM industry growth rate for 2005 to be 13%.  The ODM market is growing at a rate of 18% in 2005 and is forecast to experience moderate slowing over the next five years, with a compound 5-year annual growth rate (CAGR) of 16.3%. The ODM market growth rate is moderated not only by falling margins, which have led many ODM companies to focus on OBM, but also by the fact that ODMs remain largely excluded from many segments of the electronics industry. The ODM model is difficult or impossible to adapt to produce electronic products for industrial, medical, telecommunications infrastructure, or military applications. TFI believes that in the longer run (3 to 5 years) the growth of joint design manufacturing will open opportunities in other segments for ODMs.

Regional Growth Rates

Regional Distribution of Total Outsourcing for 2004

Over the next five years, regional distribution is forecast to shift only slightly; in the Americas, dropping from 21 to 19% by 2009; in Europe from 16 to15%; with Asia increasing from 63 to 66% of the total global combined contract manufacturing revenue.

Why OEMs Choose NOT to Outsource

In a recent TFI Report, our analysts asked a representative group of OEMs why they had chosen not to engage with contract manufacturers².  Here are some of their reasons:

• Total landed cost considerations
• Control of IP/Fear of products' IP being stolen
• View the strategic decision to keep manufacturing in-house to be a positive competitive differentiator
• Belief that among the company's core competencies is manufacturing
• Utilization of outsourcing only to manage internal capacity utilization rate.
• Have not yet had the model proved to them
• OEM has sufficient internal capacity
• Quality assurance
• Internal resistance from stakeholders
• Work only with ODMs
• View in-house manufacturing as more economical
• Desire to maintain control of production
• Union contracts restrict it
• Concern over material pricing
• Limited awareness of second and third tier outsource providers

TFI tracks a metric we call EMS 'penetration rates.' TFI defines penetration as the ratio of EMS (or ODM) revenue to overall OEM cost of goods sold (COGS). This approach allows us to use widely published measures to create a standard yardstick for the volume of outsourcing within broad industry segments. However, not all COGS is accessible to outsourcing partners. That means penetration rates resulting from this calculation are conservative. In addition, some industries, notably military/aerospace, depend on considerable OEM-to-OEM outsourcing, which is not captured in these figures. TFI sets penetration rates currently at approximately 19%; we forecast that they will climb to nearly 24% by 2009.

TFI does not forecast an equilibrium penetration rate - defined as the percentage of outsourcing that will represent the end-of-the-trend shift on manufacturing from in-house facilities to outsourcing partners. However we have asked this question at scores of OEMs in all different segments for nearly 18 years. Our conclusion is that the rate will differ substantially by industry. Some, such as networking equipment, will be entirely outsourced, with penetration rates above 90%. Others, such as consumer electronics, may be closer to 40 to 50%. In either case, if current trends continue, the shift toward outsourcing will not be exhausted until at least 2020³.

Market drivers for margin improvement

For both EMS and ODM companies, margins have fallen. Net margins dropped from 10% to just 4% for leading ODMs and as low as 1% for second-tier ODMs. Many large and mid-sized EMS companies have been operating at a loss. These financial conditions are unsustainable and are the evidence of the Darwinian 'struggle for survival' driving the acceleration in new 'species' of manufacturing relationships. The following table shows how each segment has responded⁴. 

Outsourcing Processes at Japanese OEMs

Outsourcing has evolved in different ways in different regions, based on different stimuli, and depending on such things as product lifecycle management strategy of the OEM customer.

For example, while Western companies favor outsourcing product manufacturing as early in the life-cycle as possible (including the engineering prototype stage), Japanese managers are more cautious. They tend to outsource processes, as opposed to functions.

Japanese OEMs typically develop, test and refine their manufacturing processes internally before they consider outsourcing. Then when satisfied with first pass yields, predictability, stability of the design, and overall product quality, the Japanese move the entire process - generally including the tooling, fixtures and test equipment - to China for volume production.

Western companies often look for the lowest-cost supplier for each new opportunity, while Japanese companies place a much greater emphasis on finding suppliers they can work with over the long-haul. Consequently, Japanese companies spend more time in the initial stages of the relationship. Contracting with Western companies is typically a more drawn out process, with agreements running 55-65 pages, covering every possible angle. Standard Japanese agreements tend to be no more than 10-12 pages, with responsibilities outlined in broad brush strokes. Japanese companies pay their manufacturing partners faster than do their Western counterparts, who often require Chinese suppliers to manufacture, ship, and consign goods to distribution centers outside of China, but withhold payment until the products are sold to the end consumer - a practice that puts a heavy burden on their manufacturers' cash-flow⁵. 

Outsourcing in China

 As the outsourcing business model takes root in China, different stimuli again cause considerable variation. In TFI's recently released report on the indigenous Chinese EMS/ODM industry, "China Electronics Manufacturing and Design Services: Company Profiles and Market Forces," TFI analysts describe the many electronics entities making up the electronics industry in China today. They include global OEM, CEM (contract electronics manufacturing), EMS, and ODM, Chinese electronics manufacturing and design (EMD) providers, Chinese OEMs, joint ventures (JVs), wholly owned foreign enterprises (WOFEs), Chinese stock-holding companies, state-owned enterprises (SOEs), and private companies.

Chinese EMD services are forecast to grow from an estimated US$38.3 billion in 2005 to a total of US$74.7 billion in 2010. By comparison, combined global EMS and ODM revenue is expected to grow from US$202.4 billion in 2005 to around US$370 billion in 2010. Total available market (TAM) for electronics hardware is projected to increase from US$1 trillion to around US$1.5 trillion over the same period⁶.

Chinese companies are moving up the value chain in product design, hiring hundreds of engineers, and their engineering teams offer customers an increasing array of technical options and product features. Perceived advantages of China EMS/ODM providers include price, ability to service smaller size contracts, and the local Chinese company's facility in dealing with Chinese customs. Disadvantages are acknowledged in ease of communication, quality control, and intellectual property (IP) protection. Some Chinese EMS/ODM companies attack the communications problem with US or European offices and/or sales persons and managers recently hired from Silicon Valley.

Chinese OEMs expand abroad

Beijing-based TFI Analyst Mark Natkin reported on the Chinese Electronics OEMs in a recent Thought Leaders Newsletter article⁷. Chinese electronics companies have been pushing to expand abroad for some time, but until recently the strategy was to export products designed and manufactured in China to price-sensitive, less developed markets like SE Asia, Russia and Africa. For example, telecommunications manufacturers like ZTE and Huawei first build critical mass at home by taking advantage of preferential government policies and easy access to local sales channels, and then leveraging these capabilities to win sales in markets their global competitors overlooked. In this way they have not only expanded revenues, but also gained valuable experience in the international marketplace.

While China's relatively late entry into the high technology arena placed it too far behind the curve to compete against Nokia, Lucent or Nortel in their home markets on existing technologies, the introduction of new Greenfield technologies, like third generation (3G0 mobile communications has allowed China to align its R&D spend on the starting line of a whole new race.

Chinese OEMs are also quick to learn that to compete effectively in first-tier markets, they must provide local service, build brand awareness in the target market, and support local sales and distribution networks. So China's leading electronics and home appliance manufacturers have begun setting up overseas R&D centers, factories, and establishing distribution alliances or joint ventures with well-respected overseas brands. TCL, for example, formed a joint venture with French electronics giant Thomson SA in late 2003, giving the company access to both the Thomson and RCA brands, well-established North American and European distribution networks, industry-leading intellectual property, and production facilities in Mexico, Poland and Thailand. As part of its 3G network
agreement with Telfort, Huawei is building an R&D center in the Netherlands, that will soon be augmented by a production facility in Hungary.

Chinese companies think globally, act locally

It may seem surprising that a country with a vast supply of engineers and factory workers willing to work for lower wages would establish overseas R&D and production facilities. However, the strategy solves some current challenges: first, Chinese companies have found that by using only domestic R&D resources, they have been unable to design products that satisfy international tastes. Haier, for example, found that when they tried to design products in China for the US market, there were often minor details that failed to meet American consumer needs. By 2002, three years after setting up a design center, marketing center, and factory in the US, the company's Haier-America branded mini-refrigerator had gained more than a 50% share of the US market. Haier also discovered that once US consumers began to perceive it as a local brand, it could cost-effectively add other product lines for US distribution at its South Carolina factory by keeping production volumes low and supplementing periods of higher demand with finished products or component shipped from its lower-cost China facilities - thus simultaneously expanding their business base and leveraging their localized assets.

This practice of localizing assets close to Western markets also helps the Chinese respond to mounting pressure from the US and other WTO-member countries on currency valuation and trade surplus issues; plus it provides a means of avoiding anti-dumping cases - a major issue with the US, which over the past two years has brought more anti-dumping cases against China than against any other country in the world.

In 2005, in response to some of these trends, an old concept began to gain credibility again within the global EMS industry and with ODM companies-locating production close to end markets, for flexibility and reduced transportation costs. This strategy has been one factor behind the resurgence of EMS/ODM investment in Mexico and Eastern Europe after the 'gold rush' of 2003-2004 into China. The result has been a new emphasis on globally integrated operations for Tier-1 EMS and ODM companies, and flexibility in the supply chain.

Evidence suggests that this type of globally integrated operation presents a significant competitive threat to China EMD operations and to Chinese electronics OEMs generally.

While expansion overseas may be a good strategy for Chinese OEMs, it is not without challenges. Financing these projects can be daunting. To some degree, generous state-backed loans may continue to help supplement overseas expansion, and the Chinese government is encouraging them through further reduction and simplification of regulations. Companies are tackling the challenges in a variety of ways - through wholly-owned or joint-venture R&D centers and factories overseas, but also relying on OEM or distribution agreement with companies like Alcatel and Marconi to bolster their images and accelerate penetration. Lenovo has chosen perhaps the quickest route - acquisition of IBM's computer division, an established foreign brand - an option that provides some immediate benefits, but also carries the challenge of reconciling disparate corporate cultures.

The future of the global electronics industry is sure to include challenges and opportunities, as developing regions in Southeast Asia, the Middle East and Africa eye the skilled jobs and higher labor rates of electronics manufacturing. New varieties of relationships between companies providing product design and manufacturing are likely to arise from the global electronics gene pool. The next decade will likely see countries such as Viet Nam, United Arab Emirates, and others enter the fray.

For more information on Technology Forecasters Inc., a US-based global market research and consultancy focused on the global outsourced electronics manufacturing and supply chain go to www.techforecasters.com. 

1. Technology Forecasters Inc's 2005 Five Year Forecast Report, pgs 11-15.
2. TFI Report, "Why OEMs Choose NOT to Outsource," by Eric Miscoll, November 2005.
3. TFI 2005 Five-Year Forecast Report, pg. 24
4. TFI 2005 Five-Year Forecast Report, pg. 19
5. TFI Thought Leader Newsletter, November 2005, "Japan's Approach to Outsourcing in China," by Jeff  Berger.
6. TFI Report: China Electronics Manufacturing and Design Services, Company Profiles and Market Forces, by Clive Jones, November 2005.
7. Thought Leaders Newsletter Number Eight, "Chinese Electronics Giants Push into First-Tier Markets" by  Mark Natkin, July 2005.