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Electronics Production | September 07, 2011

Risk Factor #1: Prices are down but costs are up

In any commercial enterprise the difference between selling price and the total cost of what is sold needs to be a positive number in order for that enterprise to be profitable.
Simply put this means you need to sell your products or services for more than you spend producing and providing them. This is a fundamental tenet of business that everyone reading this article probably understands intuitively.

But what is the risk if the number is negative?

It depends.

If you are the seller and you continue to lose money you will go out of business. If you are the buyer you will have to find a new supplier. In either case a disruptive event occurs that impacts both parties.

Then why would either party tolerate such a circumstance?

Good question but one that is very hard to answer as the fundamentals of business, while simple, are not always in perfect balance with the realities of human nature. And as we rely on people to make business decisions there is inevitably a tension between these two forces.

Think of it as the motion of a see-saw, a game of balance where the person on one side must sacrifice his or her advantage to continue the process. Historically, rationality has trumped self-interest as everyone wanted to keep the game going. But recently in the arena of global outsourcing, something seems to have gone wrong.

During last quarter’s Outsourcing Navigator Council webinar we reported to our membership that the Composite Business Risk (CBR) index, a measure of risk in the global electronics manufacturing industry, has increased over 45 percent in the last four years and that…

“It is now believed that the CBR has been indicating a consistently increasing level of risk in the Global Electronics Industry since its inception early in CY2007. CBA believes this trend to be derivative of a decade long shift in the approach of (primarily) North American and European OEMs to supply-chain management that while economically expedient have proven incongruent with global economic and geo-political realities.”

In other words, the level of risk is currently so high it is no longer just selected outsourcing projects that are at peril but perhaps the entire outsourcing industry. Lower prices at any cost have now become the new normal. Endless, sequential cost-downs for electronic manufacturing services are virtually every OEM’s strategy for preserving next quarter’s margin if not actual profits.

Throughout the supply chain, each link has been stretched to the breaking point. Suppliers of everything from raw-materials to components to major sub-assemblies are pushing-back on both the EMS and ODM community with the result being that entire end-market sectors are being abandoned or sold off by the OEMs as they can no longer squeeze out a profit by squeezing their suppliers.

The “outsourcing dividend” has long been spent. And those next even lower-cost geographies, far out over the horizon, are more pipe-dream than viable alternatives, as they lack the infrastructure, resources, capabilities and political stability to replace the current solutions.

Can the situation really be this bad?

Yes, actually it is. The underlying costs in most of the current so called low-cost regions are going up and in some including China by as much as 1½ percent per month. The reasons are many; inflation, monetary exchange, adoption of new environmental, regulatory and labor policies. Nor is this just a manufacturing-value-add issue as these escalating costs impact the entire supply-chain which has concentrated in these very same regions.

So what is an OEM to do?

It depends on what market the OEM serves, their business model and their scale.

Scenario I

If the OEM is in a highly regulated industry such as Military, Medical (non-consumer), Aerospace or something similar that supports reasonably stable and sustainable margins then they need to take a hard look at their current outsourcing solution and determine:

- Is the solution providing both the level of support and service they require?
- Are they (at a minimum) reasonably satisfied with the value they’re receiving?

If the answer to both of the above questions is YES, then stay the course but build into your business planning the reality that prices go down only when costs go down.

If the answer to either question is NO then start shopping, but this time think LOCAL (the closer the better!) Contrary to what many so called experts tout, CBA’s data clearly indicate that closer is not only less risky but also in the majority of cases highly competitive on a True Cost of Outsourcing basis.

Scenario II

If the OEM is in a commercial mid-scale market such as Industrial, Automotive or Instrumentation and serves a niche that is innovation versus price based then they too need to take a hard look at their current outsourcing solution and determine:

- Is the solution a good technological match against both today’s and tomorrow’s roadmap?
- Has a solution analysis been performed to determine which party (i.e. the OEM or the EMS) should be performing which functions to maximize value and minimize overall cost ?

If the answer to both of the above questions is YES then stay the course but build into your business planning adequate resources to support and grow the relationship over time.

If the answer to either question is NO then repair the disconnect or start shopping! If you are outsourcing USD 25-100M/year then think REGIONAL (i.e. build in the region for the region to minimize time zone separation, which is a high impact variables for risk).

Scenario III

If the OEM is in the Computing, Communication or Consumer space or any of the other previously mentioned market segments and outsource over $100M/year they need to ask themselves:

- Are our products sold based on price?

If the answer is YES, either start innovating or stop outsourcing (if the answer is NO, re-read Scenarios I & II). The truth is, by definition your company is a commodity provider and a commodity provider’s only possible advantage is to MANUFACTURE their own products more cheaply and at a higher quality than their competitors.

Sorry, if that doesn’t happen to be your company’s “core-competency.” Maybe the management team should have taken their MBA in Operations Management versus Marketing. Outsourcing is not a strategy, it is a tool. And like dynamite it can be a powerful tool when properly applied to an appropriate task but misapply it and it will kill you.

In the beginning of this article we explained that based on our research we believe this trend of escalating risk and potentially failure of significant parts of the outsourcing industry is…

“derivative of a decade long shift in the approach of (primarily) North American and European OEMs to supply-chain management that while economically expedient have proven incongruent with global economic and geo-political realities.”

The bottom-line is crystal clear, the music is going to stop, and if you work for one of the OEMs we are talking about in the above quotation we suggest you find a chair! We just hope it isn’t a deck-chair on the Titanic.
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Source: http://charliebarnhart.com

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