Want to hear an industry growth story?

How about 25% annual compound growth in an industry with estimated global sales revenue of $US89 billion in 1998?

The figures - from Silicon Valley-based Technology Forecasters refer to the contracting out of manufacturing in high tech electronics.

Technology Forecasters estimates that 19% of total electronics manufacturing will be outsourced this year, up from 14.2% in 1997, and that future increases will be even higher. Growth in outsourcing is already more than three times faster than growth in total electronics manufacturing.

Actually, the story is not really about growth as such. It's more about the rate of change in the way high tech industries do business.

Technology Forecasters' director of high tech consulting, Dr Charlie Mullen, says most of the demand for contract manufacturing services comes from original equipment manufacturers (OEMs) in North America and Europe. Most of the suppliers - the factories themselves - are in North America and Asia. "There's a lot of activity in South East Asia, principally China, Hong Kong, Taiwan and Malaysia and Singapore," he says.

What is contracted out ranges from individual components to "full turnkey" - completely manufacturing a product on behalf of a client plus associated services extending even to supply chain and procurement management.

It is a model of doing business that is used widely in industries such as clothing and footwear manufacturing - famously by Nike, for example - where the production process is labour intensive and easily transplanted to low wage countries. But the communications revolution has meant it is also an increasingly attractive model for industries producing products with high knowledge content, using the most sophisticated of production techniques and where wages constitute a relatively low proportion of production costs.

As Technology Forecasters' research data show, contracting out of manufacturing is sweeping through the computer and telecommunications industries. Computer giant Hewlett Packard, for example, contracts out $US6 billion worth of manufacturing work, covering more than 20,000 separate products.

According to Mullen, industries producing elaborately transformed manufactures, such as automotives and medical equipment, are increasingly using contractors. Communications technology has allowed these giants to separate manufacturing by making it possible for them to be in constant and detailed dialogue with their suppliers.

Not too long ago, the only way that they could be certain that crucial quality, continuity of supply and purchasing functions were on track was to control the functions directly. See accompanying article: The Frictionless Economy.

Freed of the need to run factories themselves, companies are looking afresh at what their core competitive assets are. "A lot of the OEMs now want to concentrate more on their core competencies of marketing and design and developing new products", Mullen says. "So they are not really interested in trying to compete on a manufacturing level."

The advantages to the OEMs of taking such a route are significant. The most immediate is the release of the enormous capital invested in factories, plant and equipment. There is also the on-going saving in time and energy by not having to manage those facilities and the personnel needed to staff them.

But it also gives the OEM tremendous flexibility to respond to market or technology changes. Mullen says companies that have outsourced their manufacturing no longer have to worry about keeping their production lines running at high levels of capacity in order to generate sufficient return on their assets.

This also means they are free to more easily switch product lines.

A measure of the appeal of these factors is the number of companies divesting themselves of their manufacturing assets. Mullen says that mergers and acquisitions of contract manufacturers globally have risen from 30 to 44 in the three years to 1998. Of those in 1998, 23 were acquisitions of manufacturing facilities OEMs were divesting. "The trend is turning increasingly into purchasing OEM facilities," says Mullen.

Manufacturing Market Insider, a US newsletter focusing on the contracting out of electronics manufacturing, counted 26 contract manufacturing operations that were acquired in 1998 and estimates there will be another 32 in 1999. It sees this as evidence that the industry is consolidating.

But what's in it for the companies buying the plants? Mullen says they have a very different cost structure to the OEM because they can use the facilities to contract for multiple clients. A factory that might have been running only eight hours a day can run non-stop if the contract manufacturer is good enough at delivery and marketing to build an independent client base.

They can also more tightly control their inventory levels, because they can turn over stock more quickly.

Nevertheless, the margins on many electronic components reflect commodity market prices. They are well below 10% and volatile, as the experience of many computer chip fabrication plants in Asia demonstrated in the past 18 months. Also, the manufacturer carries the risk of technological obsolescence or market downturn that the OEM once bore alone.

Mullen says contract manufacturers have sought to protect themselves from these vagaries by expanding into providing ancillary services. They moved from taking over procurement and inventory management, to full turnkey services and logistics and supply chain management. Now, many are also moving into product design so they can become involved earlier in the product development cycle and at the same time make themselves a more valued partner. "So it's been a gradual progression, trying to add services which the customer might feel are useful," he says.

Mullen says the closer the contract manufacturer gets to the design point and the earlier it gets brought into a project, the more likely it is to be chosen as a long-term partner.

According to Manufacturing Market Insider, the next stage in outsourcing is likely to be finished product testing. It says this is a highly customised area that requires a strong working knowledge of the product's design, and is an area that will "separate the men from the boys" in outsource manufacturing.

Mullen says the immense power of some component suppliers, such as Intel and Cisco Systems, shows how the influence of component manufacturers can grow as they collect knowledge and intellectual force in their field. Eventually, they can become the drivers for technological development that their customers rely on for continued breakthroughs, rather than the potential victims of changes in their clients' businesses.

"For example: an Intel, which is the master of microprocessor. They have a lot of energy and resources that are looking at microprocessors and alternatives in that area. So naturally, you would tend to expect that with any great development in the microprocessor, there's a good likelihood that Intel's going to be the one making the advances, because they're concentrated there," he says.

"The same thing with a company like Cisco Systems. They're the leading supplier in their industry, so they have the intellectual might in that industry."

But even without the resources to sustain such huge R&D efforts, contract manufacturers can earn loyalty from their clients just by continually proving their mastery of what they do, Mullen says.

"As society's changing to more of a knowledge-based or information-based economy, you also have to consider that manufacturing is information-based", he says. "And so the contract manufacturers are concentrating their efforts at becoming the best at manufacturing."

If the manufacturers can demonstrate that they can make products of high quality and meet the timing and delivery needs of their clients over time, the chances are good that the OEMs will turn to them when something new needs to be made.

"The ability to manufacture itself is an intellectual property", Mullen continues. "If they've trusted you to build their current products and you've done a good job for them and proved your cost models are working properly, there's a good chance they're going to come to you with their new products."

Further Reading: 

Manufacturing Market Insider January 1999

Electronic Buyers' News January 4 1999

Business Review Weekly February 15 1999