Electronics manufacturing services (EMS) providers must have thick skins. They invest in manufacturing process improvements for the benefits of customers; take flak from governments, labor and human rights organizations as well as consumers − again for the OEM customers; get rewarded with low margins, and often are swiftly dumped by customers at the first signs of slowing sales.
That’s the nature of the lopsided relationship OEMs have with EMS providers. However, not even this unequal dynamics fully explains why the industry talks little about how or whether contractors get compensated for the expenses they incur improving manufacturing operations so that OEMs can bring products to market faster, cheaper and cost-efficiently annually.
OEMs use contract manufacturers because they need partners who can help them reduce production costs, smooth the inherent turbulence of unstable demand-supply cycles, and optimize supply chain efficiencies. EMS providers market themselves as capable of helping OEMs achieve these goals, and naturally, must constantly prove they are better at manufacturing than their customers. To achieve this feat, however, EMS providers constantly engage in process improvement involving a lot of money spent on manufacturing research and development (R&D). Do OEMs reimburse this expense or do they see this simply as a basic value that EMS providers must demonstrate to bid on manufacturing contracts?
Ken Bradley, CEO of Lytica Inc., a supply chain consulting, data mining and solutions company, has been observing this trend for quite a while, noting in an interview that many OEMs are typically unwilling to spend extra money on manufacturing R&D on top of design and other product development expenses. Bradley should know. As chief procurement officer at Nortel Networks years ago, Bradley prodded his employer then to outsource production because he realized manufacturing R&D being done by contractors gave them an edge over internal manufacturing operations.
This doesn’t mean OEMs are gladly paying for these additional expenses incurred by EMS providers, though. The low two percent to five percent gross profit margin at EMS providers confirms customers haven’t been eagerly rewarding them for the manufacturing R&D costs.
“OEMs invest in product technology and not in manufacturing technology, which is considered a strength for EMS companies,” Bradley said. “The fact that OEMs are able to get products to market in three months rather than one year or longer because EMS providers spend money on process improvement is lost on the entire industry.”
Here’s one example. Foxconn Technology Group, the world’s No. 1 EMS provider, is diversifying its customer base to reduce its dependence on Apple Inc., according to a recent Wall Street Journal report. In taking this necessary step, Foxconn exposes a major fault line in the relationship between OEMs and contract manufacturers: disconnect between value provided and compensation.
On the face of it, the relationship between Taiwan-based Foxconn, also known as Hon Hai Precision Industry Co., and Apple, the world’s biggest consumer electronics company by market value, has been beneficial to both companies. Foxconn leveraged the partnership to eclipse its EMS rivals while Apple scooped up huge profits on equally enormous sales. Foxconn’s recent sales performance hasn’t been nearly as good as Apple’s, however, and its market valuation is far lower than that of the consumer electronics customer.
Helping OEMs deliver products efficiently to consumers can only happen when Foxconn excels at manufacturing and invests in the latest production equipment, so the company recently began installing robots at some plants to further cut costs. That hasn’t helped Foxconn much; sales fell in the last few quarters once Apple began moving some manufacturing to a rival EMS provider.
Where is the EMS R&D?
Years ago when OEMs were vertically integrated and controlled all stages of the design and production process, they eagerly sought and paid for manufacturing improvements. Today, that task and any costs associated with it have shifted solely to contract manufacturers. Many contractors seem to have found a way to either reduce or completely hide this cost on their income statement, though. I checked data on the publicly-traded EMS providers, and in most cases the R&D expenses were negligible or even non-existent.
In fiscal 2012 ended August 31, for example, Jabil Circuit Inc. spent $26 million or approximately 0.2 percent of its $17.2 billion revenue on R&D while Benchmark Electronics Inc., Flextronics International Ltd. and Plexus Corp. had zero R&D expenses for the last several fiscal years. In the case of Sanmina Corp., its R&D expense for the fiscal year ended Sept. 29, 2012 was approximately 0.4 percent of its sales.
It is possible R&D expenses are being folded into the cost of goods sold by EMS providers. Flextronics’ income statement, for instance, shows the company has not spent a dime on R&D in the last five years. This seems implausible considering Flextronics is in the vanguard of companies seeking to improve manufacturing. Here’s what CEO Michael McNamara said on this during the company’s most recent conference call with analysts:
“Throughout this year, we are focused on transformational outsourcing solutions for our customers and it’s been paying off. We believe we are uniquely positioned to provide our customers with solutions that improve their cost structures, increase their supply chain velocity and reduce supply chain risk through the breadth and depth of our global service offering.”
Why Flextronics is pushing for these process improvements is clear but are customers paying for it? If they are not directly, this would explain why the contract manufacturing market is in such a messy state and why companies in the sector are forever reorganizing operations even as customers get rewarded with sky high valuations.
Flextronics was surprised recently when BlackBerry, formerly Research in Motion Inc., abruptly ended its years-long relationship with the contractor, which at one time depended on RIM for more than 10 percent of its fiscal sales. As BlackBerry’s contributions to Flextronics fizzled to zero at the beginning of this year, the EMS provider faced the unpleasant fact that all the R&D costs and other expenses it incurred supporting BlackBerry would have to be written off or, at best, recouped from programs with other customers.
“We’ve been operating in a challenging transitional phase,” McNamara said during the latest conference call. “We were experiencing significant revenue deterioration and the associated worsening impacts on our margin, while simultaneously being required to invest differently in our business to support the healthy, new customers and program wins, which are more complicated and diverse than typical.”
McNamara wasn’t expecting OEMs to suddenly start covering more of his company’s costs, leaving Flextronics and rivals with the only viable option: invest anew in productivity improvements to attract new customers.