High-tech manufacturers add brains to brawn
The contract manufacturing business, once just a cheap source of labor for assembling electronic equipment, is undergoing a radical transformation.
- Shankland covered the tech industry for more than 25 years and was a science writer for five years before that. He has deep expertise in microprocessors, digital photography, computer hardware and software, internet standards, web technology, and more.
The industry got its start assembling basic computer components and other electronic equipment--typically at much lower expense than possible at the companies that brought the products to market. But as time has passed, contract manufacturers have become full-service companies, handling not only assembly, but also repair, shipping and component procurement. They're building complete, powerful systems, not just circuit boards for inexpensive PCs.
More significantly, though, contract manufacturers also have encroached on the job of design, the hallowed ground of companies that stake their reputations on the quality of their products. In other words, contract manufacturers are providing an ever-greater intellectual contribution to computers, cell phones, network routers and other products, carrying themselves to what Merrill Lynch estimates will be a $900 billion market in 2003.
For example, when Neenah, Wisc.-based Plexus bids for manufacturing jobs, the first thing it mentions is its design skills. "Their core business is research and development," said Robertson Stephens analyst Kevin Dunne, who follows the industry closely. "They get paid for that. It's a profit center."
That engineering ability won Plexus a job as the sole builder of a high-tech optical switch for Corvis, Dunne said.
Nortel Networks, a maker of telecommunications and networking hardware, has seen the light as well. Though the telecommunications sector was much slower to embrace contract manufacturing than were computing companies, it's catching on now and transferring some of its internal engineering staff to contract manufacturing partners.
Though shifting engineering personnel to a contract manufacturer means a competitor also will be able to benefit from those engineers' experience, it's a two-way street, Dunne said. When Nortel and its competitors beef up the engineering staff of a manufacturer such as SCI Systems in Huntsville, Ala., Nortel and its competitors benefit from the combined engineering expertise.
Dollars and sense
There are powerful economic motivations underlying the handing of increasing responsibility to contract manufacturers: lower cost and faster time to market.
When a new product is designed, the development often occurs in close consultation with the contract manufacturer, whose job it is to find ways to cut costs without cutting quality. For example, the careful direction of airflow throughout an enclosure can help a multi-CPU server run cooler, reducing its power consumption and the number of cooling fans required.
Or, a collection of electronic components often can be collected in a single custom chip the contract manufacturer will design.
"We redesign to take parts of a printed circuit board (PCB) and put them onto silicon, reducing part count and the size of the PCB," Tom Smach, vice president of finance at San Jose, Calif.-based contract manufacturing giant Flextronics International, said at a recent Robertson Stephens conference. "All that drives materials cost out of the product for the customer." Flextronics employs 600 design engineers, he said.
Contract manufacturers often can design several elements simultaneously and therefore faster than can brand-name companies--original equipment manufacturers, or OEMs--which do the work one step after another, said Koichi Nishimura, chief executive of Milpitas, Calif.-based Solectron, the largest contract manufacturer.
"More and more OEMs are almost forced to consider outsourcing to move more rapidly than they have in the past because they feel they need to keep up with their own competitors," Nishimura said.
To handle this collaboration between contract manufacturers and OEMs, manufacturers not only often place staff at their clients' facilities, but also build test-production lines nearby, where the manufacturing process can be tested and refined.
Contract manufacturers also can offer clients services that appeal to the ultimate customer. Privately held Synnex Information Technologies, for example, can install on each computer made for VA Linux Systems a custom selection of software from among hundreds of packages, a feature VA chief executive Larry Augustin said will help keep customers coming back.
Low cost still keyAll this design work doesn't mean contract manufacturers are abandoning their cheap labor roots, however. Contract manufacturers have increasingly large plants in Mexico, China, Taiwan, Malaysia, Hungary and other countries.
Labor costs at these sites are far cheaper than in the first-world countries where the goods end up. Chinese laborers are paid an average of 70 cents an hour, Malaysians $1.40, and Hungarians and Mexicans $1.80, according to statistics from Merrill Lynch. By comparison, contract manufacturing workers average $11 an hour in the United States, $18.05 in Japan and $28.80 in Germany.
Mexico has at least 15 major manufacturing plants, eight of them in Guadalajara, according to Merrill Lynch. Brasil has seven--Hungary, nine. And China, benefiting from the transition to a free-market economy, has 17 and counting.
These plants aren't necessarily sweatshops in dingy warehouses, however. Take, for example, a Flextronics plant that builds inkjet printers for Hewlett-Packard in Hungary. Within a collection of more than a dozen buildings, Flextronics handles many tasks such as molding plastic or building circuit boards, while on-site partners build foam and cardboard packaging and load finished products, Smach said. There's even an on-site customs clearance facility so the products can be shipped directly out of the country.
About 30 percent of Flextronics' business comes from industrial parks such as this, Smach said.
More responsibility
As companies place more trust in the expertise of contract manufacturers, the companies end up building increasingly complex and expensive devices. For example, Bill Albrecht, executive leader of Waukesha, Wisc.-based APW, said his company designs and builds enclosures for the computing and storage products of high-end companies such as Sun Microsystems and EMC.
Telecommunications companies also are loosening control. "In the past, IBM and HP were our most important customers," said Yancey Hai, vice president of engineering at Taipei, Taiwan-based Delta Electronics, which makes power supplies and other components. "Now the weight is shifting more to data communications and telecommunications companies such as Cisco. Our Cisco sales increased close to 500 percent compared to last year."
There's a drawback to handing over this much responsibility, though, said Jose Mejie, chief procurement officer of Lucent Technologies. A company has to pay extremely close attention to its contract manufacturing partner.
The oversight required is similar to the attention Lucent gives to a company it has invested in: monitoring financial results, acquisitions and other goings-on that affect Lucent, he said.
Bigger and bigger
Contract manufacturers aren't just getting smarter. They're also getting larger.
Another major change to the contract manufacturing business, also known as the electronics manufacturing service (EMS) industry, is the sheer size of some of its participants. Merrill Lynch analyst Jerry Labowitz uses the term "mega-EMS providers" to describe the five largest: Solectron; Flextronics; SCI Systems; Toronto, Ontario-based Celestica; and St. Petersburg, Fla.-based Jabil Circuit.
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One way the companies are getting bigger is through buying sprees. Dunne has spotted 120 acquisitions in the past year in the contract manufacturing market. "That's where we know the names, and I'm sure there are some we don't know," he said.
The contract manufacturing industry accounts for only about 15 percent of hardware being built today, Dunne said, but that should increase to 60 or 70 percent in coming years. "Every 10 percent is $100 billion" in sales, he said.
Limits to the trend today are the slower adoption of contract manufacturing in Europe and even more so in Asia, Dunne said. Japanese manufactures tend to keep everything within one company, while elsewhere in Asia, companies favor a method in which manufacturing is handled by the same businesses that design the products--companies called original design manufacturers, or ODMs.
ODMs are growing more important, said Stanly Huang, director of marketing and business management at Intel. ODMs such as Acer and Quanta are handling design and inventory management, getting software and hardware to work together as well as assembly. Quanta, Mitac and other Taiwanese manufacturers are also handling technical support and warranty services for major U.S. computer makers, Huang said.
Dunne is convinced the Japanese will come around to the U.S. way of doing things because contract manufacturing companies are good at managing the tangled Web of supplies needed to build equipment. "It's not because we have better companies; it's because we have better supply chains," Dunne said.
Buying brand-name production lines
A part of the acquisition trend is the takeover of manufacturing lines formerly run by brand-name companies. Among its eight acquisitions in the past three months, Solectron acquired lines from NCR, Ericsson and Nortel Networks, acquisitions that provide Solectron with personnel and production capacity, Nishimura said.
Flextronics, for example, just bought Chicago-based Chatham Technologies for $590 million, giving it expertise in designing and building cases. Flextronics also bought one of the larger contract manufacturing firms, Dii Group, for $2.4 billion in April.
All this buying doesn't go unnoticed by comparatively small companies such as APW Enclosure Systems, another casing maker. Every company has its price, APW chief executive Richard Sim said when asked whether he would consider selling his company to one of the larger contract manufacturers.
Flextronics' Smach said growing as fast as possible is a matter of survival. Since 1993, his company has moved from 22nd place to third based on revenue.
"Today it's a game of critical mass. You need to be big to compete for some of the big opportunities out there," Smach said. "It's a game of giants."
News.com's Michael Kanellos contributed to this report.