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The World of Contract Manufacturers

Interview of Randall Sherman, a founding partner and president of New Venture Research.
Hosted by Doug Donahue, Vice President of Entrada Group

The Entrada Group is proud to bring you a series of informative interviews with leading authorities on some of the essential aspects of offshore operations. These free, educational programs, hosted by Doug Donahue, Vice President of the Entrada Group, cover current topics important to companies operating offshore or looking at moving operations.

DOUG
Welcome ladies and gentlemen to Entrada Group’s ongoing series of audiocasts related to manufacturing in low-cost countries. For those of you that this is your first audiocast, Entrada is a service provider dedicated to assisting manufacturers establish and manage manufacturing operations in Mexico and Central America.

Joining us today is Randall Sherman, a founding partner and president of New Venture Research. Randall’s practice specializes in contract manufacturing and outsourcing management consulting services. New Venture researches syndicated research work on the EMS industry through electronic trend publications is one of the most widely quoted in the industry.

Randall, we’ll start out today a little bit by defining what the EMS market is. It is so large and so vast, it’s often hard more me to get my hands around.

RANDALL
EMS stands for Electronic Manufacturing Services. It is a sub-segment of the overall electronics market. Now when I say ‘electronics market’ we’re talking about cell phones, computers and consumer electronics – things like that. Of which that today is about a trillion dollar market. It’s a market that has been growing very consistently for the last 20 years, almost six percent a year, on constant innovation. The real story here is not that so much. That is a story in itself. But the electronic manufacturing services sub-segment has evolved in the last 20 years and has exploded to literally about 20 billion up to almost 300 billion today. So, it’s almost a third of the total electronics market.

And why is that? Well, turns out that these electronic contract manufacturers are specialists in manufacturing. They do one thing very well and that is what’s called velocity manufacturing. So, whereas in the past we had large electronics companies like Motorola, IBM and Cisco, who manufactured their own products in house, they have recently begun to partner with these contract manufacturers who are much more efficient. They are able to utilize the manufacturing faculties on lets say 80-90 percent basis. That’s usually on the three shift, 23-hour-a-day basis. As a result, they are able to offer economies of scale that OEM never had in the past.

So, as a result, this new industry has grown up out of nowhere. They have become the subcontracting partner to the OEM. As a matter of pact, many of these large companies today such as Motorola, Alcatel and Cisco no longer have the ability to manufacture the products that they sell. They come through the contract manufacturer.

Doug
I’ve noticed that there’s a growing trend for some OEMs to take on contract manufacturing clients as well. That is becoming a gray area between a contract manufacturer and an OEM. I know that a lot of this happens with the Asian companies. Could you expand upon that a little bit?

RANDALL
That’s a good point. Technically speaking, a contact manufacturing is not in the business to compete with their customers. They technically have no product of their own. They are product neutral – product independent. They’ll make anything. And this is why they’ve been so successful – often they’ll have multiple customers that they’ll manufacture for. On the manufacturing floor they could have one line dedicated to one OEM customer, and another to another and this could change throughout the day. That’s the way the industry began.

Well, turns out a few years ago, OEMs primarily in Asia, although there are a few in the Western world, took interest and notice of this business. They said, “My goodness contract manufacturing looks very interesting because we have idle capacity. And we would like to get into that business.” The only difference is that they had their own product, their own brand of products. An example of this might be Acer who originally had their own laptop computers, but they began manufacturing for Dell and IBM and putting out private label brands for those companies. So, in a sense, this took on a new name. It’s called and ODM, or original design manufacturer.

And these types of manufacturers were actually cheaper than the contract manufacturers for one reason only. It was because they manufactured their own branded product and they had invested in R&D and the supply chain and they were basically able to bring out new product additions. Dell or someone like that could go to Acer and say, “We want this next edition to come out in six months and we want it to have these features.” And since Acer already had their own product development taking place inside, they would be able to come out with this brand very quickly, very efficiently, very inexpensively. And so they began taking away market share from the contract manufacturer.

But this brought its own set of problems. Now this ODM was not necessarily independent. There was a potential conflict of interest, where they made and sold their own product and yet on the other end, they manufactured the same kind of product for another OEM. There’s a couple of instances where this started to break up.

One example is a company called Legend, within China, that used to distribute laser printers for Hewlett-Packard. They had their own brand of printers within China and before long they began to reverse engineer the HP laser printer and it didn’t take too long before they came out with their own brand of laser printer which they began selling and distributing. So that necessarily broke up the partnership. This takes place quite a bit in China. Where the idea is just to get the business and notions like intellectual property are not fully respected. Things that are not tangible are difficult to understand as having monetary value.

Another amusing example. There’s a company called Wah Wei, out of China, that was manufacturing low-end routers for Cisco. Well, as before, they ended up designing their known low-end router. When Cisco got a hold of it, they were able to break into it and look at the source code. As it turns out, it had the same source code that the Cisco low-end router had - including all the bugs.

So, it just shows how conflicts of interests can exist in a relationship like this.
But the ODMs never the less are here to stay. They do have a role. They typically sit in what I call commodity types of products - cell phones, low-end routers, motherboards, notebooks and things like that. Today, they have captured that market. But the generic contract manufacturer is usually the preferable partner, because there is no conflict of interest and they tend to have more sustained relationships and better long-term prospects as well.

DOUG
I’m currently in Costa Rica for a month doing some research work, predominantly on the medical device industry. What I’ve noticed is how successful that small country has been in building a cluster around medical device products. Is this something that is very common?

RANDALL
Yes, there are a couple of trends. One is that you do have clusters of expertise. For example in the Scandinavian countries they have a lot of terrific experience in wireless technologies. This is the result of Nokia and Ericsson being dominant in those regions. But aside from the vertical. We find some vertical market expertise in things like medical, particularly in the United States and the U.K.

DOUG
Every country is different not only in geography, but economically, culturally and ethically. How do those differences affect manufacturing in various parts of the world, particularly between Mexico and China?

RANDALL
The trend that we normally see is a migration towards what we call low-cost countries, manufacturing companies. And this is where the cost per hour, the direct labor cost per hour to manufacture products is significantly different. Whereas in the developed countries, the U.S., Canada, Western Europe we’re finding an average hourly cost of eight to ten dollars and hour. That’s the direct wage rate for this sector. And in places like China it’s down to a dollar. So, we have an order of magnitude difference. Mexico, it runs about two dollars forty cents an hour. A little bit more than double, but what we’re finding is things like value-added-tax that the Chinese are imposing on products is taking away that competitive advantage. And remember with the logistics that you have involved with putting things on a container ship for six weeks, tying up the cost of capital in these products and the overhead you have in getting things transported and when there’s problems with manufacturing you have firefighting that has to take place. The appeal and the gloss of China is starting to go away. And places like Mexico and Puerto Rico have very low-cost manufacturing capabilities and this is where most of the work is going.

The kind of work that doesn’t go to those regions is low-to-medium volume and high-mix, high-complexity products things like MRI machines industrial process control aerospace and weapons, smart-systems and flight navigation, things like that. That’s going to stay domestic, that will not migrate off-shore.

Today, we’re seeing a lot of interest in Mexico particularly for medium-volume high-complexity products. They’re not going to get back the motherboard and the notebook market or the cell phone market. That’s gone. The entire supply chain tends to exist in China. And the lowest total costs for manufacturing these products is there.

But we have other types of products that fit the Mexico region very well. Appliances is a big one, we find industrial products, certain medical products, disposable types of things. The automotive industry is very strong in Mexico.

We find that Mexico in particular has a lot of the manufacturing practices that have come from North America. The so called Six-Sigma and total quality management have been instituted in Mexico. So, as a result, we see no difference in quality between North America and Mexico. We have good quality in China. They’re very smart people, very industrious, very ambitious and they learn very quickly. They are taking on these systems and are able to match the quality in many of the cases.

There’s a interesting book that has come out. I don’t recall the title. It has to do with making things in China and they speak about the quality fade that takes place. The Chinese typically will do anything that they can to actually get the business. In many cases this can be things like saying “We have the facilities. We have the capacities. We have the equipment.” And then you go over there and you realize they don’t have anything. They’re just kind of bootstrapping the operation until they get the contract and first payment. Once they get these things, often at cost, they start to change the quality of the product by using substitute products, by using different chemicals, different sanitary standards, packaging will cheapen, things like this. They tend to make up the margin in those ways. Without rigorous outside independent testing, which a lot of these OEMs have to do on a regular basis, the consumer can be the victim.

I think that being close to home in Mexico has a lot of advantages that Asia does not have. If it’s just money you’re looking for, you can get things made cheaper in Vietnam these days and possibly India. But are issues with infrastructure, overhead and cost that have to be factored into the equation - the total cost of the product to be made. A lot of OEMs have learned their lesson about going to China and these days they’re getting a lot more value out of going to Mexico.

DOUG
I know there are a number of contract manufacturers that were based out of Singapore making large investments in the Malaysia area. Is that continuing or has most of them migrated out of Malaysia?

RANDALL
Malaysia is still a very attractive place to manufacture. It’s very stable. It’s very low cost. Singapore, by comparison, is quite high and expensive. But remember that that was one of the first places that people like the hard-disk drive manufacturers showed up. Quite a bit of R&D still takes place in Singapore. It’s the ethnic Chinese people in Singapore. So they still have the same industry and good work ethic. But they have a bit of the Western morality that we like to see there which does not exist in the mainland of China.

DOUG
I’ve seen a number of your presentations in the past. You always end them with a quote from Darwin. “It is not the strongest species that survives, nor the most intelligent, but the ones most responsive to change.” Given today’s environment, the quote has never been more relevant. What do you see taking place, now and in the near future?

RANDALL
I think the trend is going to be more of the same. I love that quote by Darwin because it’s telling in the sense that the successful companies are not the ones that continue to use a formula that works initially and then not change that. Basically to stick to that formula. You have to be adaptive. I think the successful companies in the sector are constantly adapting, constantly looking for ways to cut costs, to be more competitive.

There are some natural advantages that exist in the market place. A lot of this has to do with economic differences. The cost of labor is a big swing factor you can’t get away with. For example, on the issue of intellectual property protection, you can pretty much count on your product getting copied if you take it particularly to Asia. Given the way things work over there. For the most part North American OEMs have resisted taking those high-intellectual property types of products. And if you think about a computer. The only intellectual property left in that today is in the Intel chip. Everything else is generic end commodity. So they can’t quite reverse engineer that, although they are coming up with their own solutions that mimic and can perform functionally on a dedicated basis like the microprocessor chip that Intel manufactures. Obviously in field like aerospace, where the intellectual property there has to do with weaponry, surveillance and critical things like that, that’s not going to go overseas. So, the suppliers that serve those vertical sectors succeed by developing their capability in that vertical sector, be it medical devices or military aerospace. They become very good at serving that customer. As a result they have a terrific market.

But certain sectors, it’s pretty much going to split up. We seem to have the ability to compete ourselves into non-existence at times. In other words we take so much cost out of products after a while that there’s really not much point in participating in those segments. This is what has happened in the consumer electronics segment. TVs is another example. Twenty or thirty years ago, Japan captured that market from North America and Europe. Then it was the Koreans who grabbed it. Then it was the Taiwanese. And now it’ the Chinese.

The analog cathode ray tubes in the old TVs are so cheap and dispensable now that you literally throw them away when they break. The flat panel displays that have come along are a whole new generation of device but the people who have captured that market have invested in the plants and facilities that make those large flat-panels.

So everyone’s got a little different niche. People like Nokia are very good at… In fact they don’t even use contract manufacturers much. They innovate so quickly, so rapidly, every few months with a new generation device that they can’t train contract manufacturers quickly enough to bring these products to market in time.

It’s all a matter of the stage of the product. That maturity that it is. Where it is in it’s life cycle. But one thing for sure, we know this industry is going to grow. It’s going to continue to grow. It’s not going to grow 10, 20, 30% a year like it did for the first 20. But its still growing at more than double the rate of the electronics market which is six percent. So it’s going to grow around 12% a year. Because of the economies of scale that these suppliers offer electronics companies.

DOUG
Will the amount of players continue to grow or do you see some significant consolidation in the business?

RANDALL
Yes, we’re seeing consolidation. There are clearly too many players and too much capacity. That’s tightening up and a lot of the big top tier companies couldn’t even make a profit. But that’s starting to change. We’re getting quite a bit on consolidation of the industry these days.

DOUG
Through the years, I’ve heard the Selectron and Flextronics guys wonder if they can continue to compete against some of these larger Chinese CMs. Has that trend started cost going out but people adapted and there’s much more competitiveness there?

RANDALL
Well, it has. What is making things more difficult is that some of these Chinese suppliers basically control the supply chain. So things like bare boards, connectors or things like that, basically they are lower in cost on all those things. But remember its only for those types of commodity products that demand that kind of cost reduction. All products require cost reduction. But where they get the edge is when it gets down to fractional pennies. We’ll see more of that.

DOUG
A lot of people who listen to this series are not necessarily in the contract manufacturing world, but, they’re looking for contract manufacturers to provide them product. As they go through their research on potential vendors how do they evaluate contract manufacturers?

RANDALL
It’s quite a mixed list of different capabilities. It really starts out with what your goals are with regard to volume, cost reduction, need to be local. If it’s a new product for example, or a prototype product, you’re going to need to be close by because changes happen. If it’s a volume situation, then you can move that stuff offshore. So basically it’s putting together a matrix of needs and capabilities. And then matching that up to the suppliers that are out there. Typically there is a vetting process you go through. You look at anywhere from a half a dozen and compare their capabilities, see what their strengths and weaknesses are.

Ultimately it’s a chemistry test, because when it comes down to it, you have to be able to trust your contract manufacturers. There’s a big issue on trust because they are making your product. And if they don’t deliver it on time and on spec with the right level of quality, you’ll fail. And your customers will leave you . So it really comes down to how well you work with these people. How much do you trust them. It’s all a bit of a chemistry match. It’s odd to say because the playing field is not quite level in that regard. But that’s the sort of thing we can help people with. It’s a process they all have to go through.

There’s an expression, “Once one cow crosses the river, they all cross.” If your competitor starts to manufacture products with your contract manufacturer, he’s going to have a lower cost. So, you’re going to have to look at that too as a way to maintain cost, quality, competition and distribution. When it comes to that, there are a lot of good people out there that can help. Certainly we’re in a position to assist people as well.

DOUG
We appreciate you taking the time to talk with us, Randall. I always like to ask at the end of these interviews: What haven’t I covered that is interesting out in the contract manufacturing world? Is there anything we didn’t touch on that you think is important to mention?

RANDALL
The only thing to note here is that the level of complexity, level of technology is such that machines have to manufacture these products, at least 70% off them. So, you’re probably familiar with the greenboard that is inside every electronics product. Those things are manufactured through what is called surface-mount technology. It’s basically a robot that’s placing millions of parts on that greenboard and soldering them at a very rapid rate. That’s just a given and there’s a leading edge to that. In other words, not everyone can afford to do that. It makes sense in many cases to engage a partner in your manufacturing processes. Unless you’re stable or it’s low-volume or so complex or a lot of hand work or what ever it is that makes it unique that you don’t need an outside partner. There are plenty of products that are like that. If you’re looking to innovate and lower cost and improve, contract manufacturing is a great solution.

DOUG
Okay Randall, I appreciate you taking the time today.

RANDALL
My pleasure.

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These programs are offered as a free service by the Entrada Group. If you have any questions on these or any other topics related to offshore operations, email Doug Donahue at ddonahue@entradagroup.com

The Entrada Group provides offshore manufacturing services for the ultimate in efficiency and effectiveness. Entrada supports companies in quickly launching and maintaining manufacturing operations in Mexico without establishing a legal presence. Through powerful economies of scale, Entrada’s on-site shared-services center offers clients exceptional production control with long and short-term cost reductions.

Learn more at www.EntradaGroup.com