Taking the Wraps Off Cost Reduction
Cost reduction is at the heart of most outsourcing decisions. If it were not for the benefit of cost
reduction, outsourcing would surely not be the trend it is today. After 25 years of outsourcing, one
might think that product cost reduction has become a straightforward process for OEMs who put
manufacturing in the hands of electronic manufacturing services providers. Far from it. In fact, cost reduction introduces some
essential paradoxes:
- Product cost reduction is a given in outsourcing, but OEMs often do not take it for granted.
- In turnkey programs, it is not uncommon for the OEM, not the
electronic manufacturing services provider, to control the majority of cost savings.
- OEMs and their electronic manufacturing services
providers are encouraged to build trust in their relationships. Yet when it comes to cost reduction, skepticism can sometimes be a healthy attitude.
- OEMs have reasons not to demand guaranteed cost reductions.
- Despite years of experience in outsourcing, OEMs may differ in their approach to cost
reduction.
- Cost reductions achieved in the past do not mean that these savings will necessarily continue.
Unraveling these seeming contradictions will shed light on the complex nature of cost reduction today for
it is a topic that has largely remained in the shadows. Electronic manufacturing services
providers are leery of discussing it because
to do so might reveal information sensitive to customers. Or give one customer the feeling that its cost
savings don't measure up to what some other clients are achieving. OEMs, for their part, generally avoid
talking publicly about their outsourcing, much less the cost reduction aspects of it. Nevertheless, MMI
was able to find three OEMs willing to go on the record about cost reduction. What they said should
explain the paradoxes and give the electronic manufacturing services industry a good sample of the latest OEM thinking on cost
reduction.
Keeping tabs on cost reduction
OEMs expect cost reductions as a natural result of outsourcing. But there are OEMs who are not content to
sit idly by while their providers pass along cost savings. Take Teradyne. The maker of automatic test
equipment needs its own process to manage cost reduction for two reasons. One is a product life cycle
that can span seven years, with a seven-year after life. "We have a long product life so you must have
mechanisms in place to control the cost over a longer period of time," says Scott Cameron, who is
responsible for outsourcing at Teradyne. The other reason is that Teradyne's products follow Moore's Law,
which calls for continual increases in IC transistor density. That means Teradyne should pay less and
less for the same semiconductor functions. "If we don't have a process that ensures that stuff is
happening, we're going to lose," says Cameron.
In Teradyne's process for managing cost reduction, a team of commodity managers monitors the material
costs that drive the company's spend. They look at parts - both purchased internally by the company and
externally by electronic manufacturing services providers - accounting for about 90% of Teradyne's
spend. Quarterly, this team does a rolling four-quarter forecast of costs at the part number level, which include cost-down rates and how
those rates will be achieved. This data is then combined at the assembly level and further rolled up to
the product. Teradyne applies the same sort of forecasting to labor and test, which are broken down into
sub-elements. Each quarter, the company compares actual cost reductions at the part number, assembly and
test levels to what was projected. That way, Teradyne can address any costs that are out of line.
Also, by utilizing actual costs, the company can re-price quarterly the assemblies or products sourced
from its electronic manufacturing services providers. Teradyne won't do business with providers unless they share actual costs with the
company. With actual costs in hand, Teradyne can be sure that it is receiving the cost savings to which
it is entitled. Tera-dyne's cost reduction process was developed with this in mind.
"Electronic manufacturing services providers in general will let you know when they're paying too much and ask you to reimburse. And
they'll keep quiet when they're paying too little and keep the profit. That's one of the ways they make
money," says Cameron. He adds that if you don't have the right processes in place, "you're in jeopardy of
only hearing about the bad news and not the good news."
Although providers today may deny engaging in this practice, it is historically true that an unknown
number of electronic manufacturing services providers were able to capture extra cost savings through a well-known device called
purchase price variance, or PPV. MMI learned of this device over five years ago from a former quote
manager at an electronic manufacturing services company. PPV occurs when a component price drops below the value quoted to the OEM
customer. If the provider does not immediately transfer the new price to its customer, the provider
enjoys some additional profit until prices are adjusted, say at the end of a quarter.
"I've always talked bluntly with all the contract manufacturers I work with, and all of them have refuted
that," says Matt Douglas, a VP in filter operations at Andrew Corporation, which sells communications
equipment, services and systems. "They say, 'Oh no, we don't do that. We pass it straight through.' Do I
believe it 100 percent? No. I've always maintained a little bit of skepticism."
Like Teradyne, Andrew also uses its own people to manage cost reduction on the materials side. "The best
way in my view of assuring the product cost reductions that you're expecting is to have your internal
people at the OEM focus on the material, the BOM value. And we focus on making sure that we have the
absolute lowest possible BOM value," says Douglas.
Andrew retains responsibility for reducing the cost of high-dollar-value components, representing at
least 80% of the dollar value of the material in an Andrew product. Starting with the highest cost parts,
Andrew's people examine their options. Can they second source a part to introduce competition that will
lead to a lower cost? Or should they simply negotiate with the existing supplier to get the job done?
They also look at the possibility of consolidating component volume with other programs in order to get
better pricing based on a higher quantity.
"The dollar value of reduction from a contract manufacturer is generally less than what we go and get
ourselves by negotiation with raw materials suppliers," says Douglas. This statement makes sense since
typically more than 80% of the cost of Andrew's products lies in material, and Andrew is controlling the
pricing of at least 80% of the material's value.
Andrew still monitors prices of the remaining parts, for which contract manufactures handle supplier
negotiations as well as procurement. These parts might represent 80% of the items on a BOM, but only 20%
of its value. A software program used by Andrew compares prices of these parts quarter to quarter and
flags any significant increases.
Andrew's cost reduction process also accounts for PPV. If a provider finishes a quarter with material on
hand that was bought for Andrew at a price above the next quarter's rate, the company pays the provider
what is called a buy down. On the other hand, any material that the provider purchased at a level below
the quarter's starting price will result in a credit against the buy down.
Based on five years of experience working with contract manufacturers, Douglas says, "I've never really
put much stock in their ability to reduce our material cost." Still, he points out, "They do a very good
job of managing our manufacturing value add cost."
Andrew checks on that aspect of cost reduction as well. The company looks at three factors in the
manufacture of an outsourced product: manual assembly time, SMT assembly time and test time.
Douglas says his company expects time reductions on a quarterly basis as providers come up the learning curve.
Although the electronic manufacturing services business is now largely turnkey, Andrew and Teradyne show that there are OEMs using
internal staffs to manage cost reduction on the materials side by focusing on high-dollar-value parts.
Kodak is another OEM that has targeted component cost as an important source of cost reduction. The
company recently outsourced digital camera manufacturing to Flextronics (Aug., p. 3). "One of the key
things that I expect that we're going to be doing over the coming weeks and months is work with in this
case Flextronics specifically to identify opportunities to reduce component cost via either platforming
or other mechanisms," says Dennis Olbrich, worldwide operations director, Digital Capture and Devices at
Kodak. By platforming, he means replacing a component with a more commonly
used part that brings economies of scale and lower pricing. Olbrich expects that both Kodak and Flextronics will be involved in
this effort.
"Obviously, since we've been manufacturing these products, we have a very strong knowledge of the
component costs. And so we're starting from a little different point than most companies would be in this
relationship," says Olbrich.
AVL control for electronic manufacturing services providers: yes or no
If electronic manufacturing services providers are to play a greater role on the materials side of cost reduction, some say they must
be given more control over the AVL (approved vendor list). It is only then, the argument goes, that
providers have the necessary leverage to negotiate with suppliers. "Most of the
electronic manufacturing services providers do well
where they can move the spend without customer approval," says Teradyne's Cameron. According to Cameron,
suppliers are more likely to negotiate with providers that have the ability to move the business.
But giving AVL control to electronic manufacturing services
providers is far from a slam dunk. "It's probably the most hotly contested
topic in the outsourcing industry," says Andrew's Douglas.
"We have contemplated doing that. We have not done that," he adds. In Andrew's view, the people who
design the product have the best leverage with material suppliers. "So we have better leverage than the
contract manufacturer, even though they're a much larger company in some cases and they spend more money.
We have better leverage because the point where you get the best material pricing is when the raw
material supplier is being decided on whether they're going to be designed into the product or not,
qualified onto the product or not," says Douglas. Still, Andrew is discussing the possibility of turning
price negotiation over to an electronic manufacturing services provider once the design is complete and Andrew has specified the
suppliers.
If electronic manufacturing services providers have a negotiating advantage over OEMs, it lies with a provider's ability to aggregate
component purchases over multiple programs. But not everyone is willing to give the
electronic manufacturing services industry high
marks for combining component buys. "I find that most electronic manufacturing services
providers are still not good at aggregating and
using their spend," says Cameron. However, he does qualify this remark by adding that they do well with
commodity items such as low-dollar passive components. Cameron questions how providers that run disparate
ERP systems can know what they're buying across the organization.
Cameron offers a prescription whereby electronic manufacturing services
providers can improve cost reduction on the materials side. His
prescription contains three elements. One, providers should know what they're buying or about to buy
enterprise wide. Two, they must be able to aggregate it and influence the terms of sale with that spend.
Three, OEMs can help their providers in this regard by giving them more control over the AVL.
Still, Douglas is skeptical about an OEM turning over all control of material costs to an
electronic manufacturing services provider.
He does not see the motivations of the two sides aligned 100%. "The OEM wants lower material values, but
for the contract manufacturer, quite honestly, it's in their interests to have higher material values
because most product pricing is based on a material markup of some sort. So if there's a higher material
[value], typically the manufacturing cost is higher."
Open book vs. closed book
In order to give AVL control to an electronic manufacturing services
provider, the OEM must be able to see what the provider is paying
for the OEM's parts. In other words, the OEM must have full visibility of the provider's costs in what is
called an open-book relationship. When the two sides elect not to share such financial information, their
relationship becomes closed-book. These two types of relationships create another area of disagreement in
the outsourcing community.
Teradyne is a solid backer of open-book pricing. For Teradyne, openness is a key to understanding its
cost drivers. As mentioned earlier, a provider must openly share cost information with Teradyne as a
condition of doing business. 'The OEM will be much more successful in establishing this level of openness
[with a provider] early in the engagement... Otherwise, they're much less likely to do it," says Cameron.
A key ingredient in an open relationship is establishing a high level of trust and respect between the
two parties such as the relationship that Teradyne has with its electronic manufacturing services
provider.
Open-book arrangements come with an obligation for OEMs. "If you have open book, you very much have to
respect the confidentiality of that and not abuse the information in a way that puts the supplier in a
position where it's very hard for them to make money," he says.
According to Cameron, an open-book approach can minimize the friction that occurs between OEMs and their
providers during the cost reduction process. For example, an electronic manufacturing services
provider that takes business with a low
or negative margin will be hard pressed to deliver cost reductions in the future. But in the closed-book
scenario, the customer will still expect reductions. That is a recipe for frustration. With open book,
each side knows the other's financial position going in.
In addition, Kodak supports more transparency with suppliers as a general principle. The company believes
that the more visibility that it has working with a supplier, the more advantages that tend to result.
"So more visibility both ways tends to be the philosophy that we try to achieve," says Olbrich.
Andrew has engaged in both kinds of relationships, but prefers to agree on a pricing formula and then
stick with it, regardless of volume, through a closed-book approach. The company believes in sharing the
risk. "If volume is up, the contract manufacturer benefits from that. If volume is down, the contract
manufacturer is disadvantaged and may lose money in a quarter," says Douglas. Though the CM's fixed costs
would be underabsorbed in that case, the CM would be unable pass on additional charges that would
otherwise be recognized under open-book pricing. "So I'd say generally our approach is not to dig into
the contract manufacturer's cost situation because at the end of the day that's the whole reason for me
wanting to use them - to make my job easier. I don't want to go run the factory," he says.
Guarantees can be hard to come by
Perhaps the most direct approach to reducing the costs of outsourced products is to merely write cost
reduction guarantees into a contract. Easier said than done, as the saying goes. "More often than not,
that's a very difficult thing to ask unless you have a program that is highly attractive to a contract
manufacturer in terms of size or strategic importance," says Robert Freid, president of Contract
Manufacturing Consultants (Bellevue, WA). "I have seen it done, but it's not something in common
practice."
"I suspect there are a lot more targets going into contracts in the last two or three years, as companies
are striving to identify every possible advantage," he adds.
Adopting targets "tends to be the more typical way that it works - absolutely" says Kodak's Olbrich. "It
has to be a fairly stable environment and predictable before people are willing to give guarantees."
Cameron of Teradyne believes guarantees are problematic because if a provider cannot reach a guaranteed
reduction of say 10% without losing money, they likely won't live up to the guarantee. Yet if they do
better than 10%, "they're likely to deliver the 10% and keep the rest," he says.
Relying on cost reduction targets, Teradyne fixes rates on such things as material markup and labor and
then strives to lower the variable component of each cost. "So we might hold the labor rates firm, and
we'll ask the electronic manufacturing services provider to drive efficiencies in labor, take fewer hours as well as increase yields,"
says Cameron.
Andrew uses a mixed approach for cost reduction. The company specifies guaranteed reductions for a
portion of product cost and target reductions for another portion.
|
