Innovation Ships Out

[David Farber <dave () farber net>]

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Subject: Fwd: Innovation Ships Out

 


From: <Wdimitr () aol com>
Date: Thu, 20 Jan 2005 16:33:24 EST
To: <Wdimitr () aol com>
Subject: Innovation Ships Out

http://www.cxo.com/go/index.html?ID=1615&PMID=2389567&s=1&f=1

Innovation Ships Out

U.S. computer makers such as Dell, Motorola and HP are outsourcing not just
the manufacture but the design of new products to offshore companies. Could
this be the end of America's innovative edge in electronics?

BY CHRISTOPHER KOCH

Buy a laptop anywhere in the world and there is a one-in-four chance that
T.J. Fang will process the order. You'll just never know it.

Fang's secret is cloaked in IT, in servers that consolidate purchase orders
from name-brand American companies such as Dell, Hewlett-Packard, Apple and
IBM. The order trail leads to Fang's ERP system at Quanta Computer in
Taipei. 
Fang, assistant vice president and head of IT operations at Quanta, feeds
those 
orders to his Taiwanese and Chinese suppliers and factories, and within five
days, Quanta "drop ships" to the customer a laptop that the buyer himself
configured on the brand-name website. No one at the company selling the
laptop ever 
lays a finger on it. Indeed, investment bank Morgan Stanley estimates that
the 
manufacturing for 89 percent of American brand-name laptops are outsourced
today. What's more, many of these famous computer brand names don't even
design 
their machines anymore. New models are chosen from a shelf of fully
functioning prototypes offered up by a handful of Taiwanese companies.
Quanta's ability 
to design and build new laptops from scratch has helped it gain a 25 percent
share of all laptops sold in the United States. "In the past 10 years,
[companies such as Quanta] have gone from undercover stealth to a massive
global 
business," says Adam Pick, senior analyst for iSuppli, a market intelligence
consultancy. 

Outsourcing has reached the highest level of the manufacturing supply chain:
R&D. By outsourcing R&D offshore, original equipment manufacturers (OEMs)
can 
freeze a portion of their R&D budgets while growing their product offerings.
Even R&D powerhouses such as IBM, HP and Motorola have frozen‹or even
reduced‹their R&D budgets since 2000. "[Outsourcing] is a tremendous
opportunity for 
cost savings on R&D," says Jack Faber, vice president of operations,
enterprise 
systems for HP. 

But there may be a downside to all this R&D reshuffling. Some economists say
the outsourcing of manufacturing‹and now design‹is the leading edge of a
longer-term trend toward reduced innovation and competitiveness among U.S.
companies. As OEMs turn over the development of new products to outsourcers,
it could 
have a withering effect on these companies' ability to create the next
breakthrough, especially as many freeze R&D spending. Spending on R&D by
U.S. 
companies declined more in 2002 (3.9 percent) than it has since the National
Science 
Foundation began tracking the number in 1953.

Though the technology slump that began in 2000 may play a big role in these
declining R&D numbers, there is a larger, more disturbing trend at work,
argues 
Gregory Tassey, senior economist at the National Institute of Standards and
Technology (NIST). For the past 12 years, the proportion of R&D money going
toward new innovation‹the "R" in R&D‹has also been going down, displaced by
incremental product development (next year's laptop, for example). Product
development‹the "D" in R&D‹swallows more resources than the "R" work, and it
does 
not create new opportunities for revenue; it merely extends current product
categories. 

Meanwhile, government spending on R&D has also been dropping over the same
period. R&D spending in the United States now lags behind many countries,
including Japan and Germany. The changing mix of R&D spending in the United
States 
could have a major impact on U.S. competitiveness over the long term, Tassey
says. Governments around the world are pumping money into private-sector R&D
to 
boost innovation. In contrast, U.S. government spending on R&D is almost all
focused on specific programs‹such as space, defense and health‹rather than
free-form research.

"We have the view in this country that private industry is capable of making
the necessary investments in R&D to keep the U.S. competitive," says Tassey.
"If that's the case, then every other country in the world is wrong."

The U.S. computer industry may be a bellwether for other industries that
have 
not yet begun to send product development work to outsourcers. As U.S.
companies increasingly shift their R&D focus from new breakthroughs to
product 
refreshes, they will be tempted to move that work offshore, where
well-trained and 
well-educated engineers are available at a fraction of the cost of their
U.S. 
counterparts. 

The trend is eerily similar to the offshore outsourcing of computer
programming. Unemployment rates among both R&D engineers and IT programmers
in the 
United States continue to trend downward, despite the recent economic
rebound. As 
more valuable components of the manufacturing value chain progressively move
offshore, will the ultimate value creators‹advanced research and
innovation‹eventually move offshore too? How long can U.S. companies
continue to innovate
when they no longer manufacture or update products? What will be left
behind? 
Marketing? 

For CIOs in electronics and other industries, the shift toward global
manufacturing and R&D means big changes in the supply chain. Companies that
outsource 
R&D or split it among different locations or suppliers will need IT linkages
to enable better collaboration among engineers. And as companies outsource
other pieces of the supply chain (customer service, shipping, and warranty
and 
repair, for example), CIOs will need to replace direct oversight of
processes 
with automated monitoring and reporting to ensure that suppliers are meeting
quality metrics and shipping on time.

Of course, if outsourcing is truly complete‹from design right on down to
shipping, service and repair‹there is a distinct possibility that companies
could 
drastically cut back on internal IT as well, severely reducing the CIO's
span 
of influence. Indeed, as OEMs turn more of their supply chain over to
offshore 
electronic manufacturing services (EMS) companies, they will rely more and
more upon the internal IT groups of these organizations to monitor their
supply 
chain for them. "OEM has become a misnomer unless you change the M to
marketing," says Kristian Talvitie, director of strategic marketing and
communications 
for Plexus, a global EMS company based in the United States.


Moving Up the Food Chain
In the past 15 years, EMS companies here and abroad have moved steadily up
the food chain in large part because the value of the work to which they
laid 
claim has been driven down by price pressure and global competition. Indeed,
the 
work that launched the EMS industry in the '80s, stuffing components such as
microprocessors onto computer circuit boards for big-name computer
manufacturers, has ceased to be profitable, industry insiders say. "Placing
components on 
boards is commoditized. You have to offer a whole variety of services to win
a new customer today," says John McManus, managing director and senior
analyst 
for Needham & Co., an investment banking and research company.

To survive, EMS companies have had to continually take on higher-order, more
complex pieces of the electronics supply chain to keep their hollow-cheeked
profit margins (overall industry average is 2 percent to 5 percent) from
disappearing altogether. Design work typically has higher gross profit
margins, 
between 8 percent and 11 percent, according to iSuppli's Pick. This has led
to the 
growth of upstart companies such as Quanta that specialize in total design,
manufacturing and shipping solutions for customers. Traditional EMS
companies, 
accustomed to focusing exclusively on the manufacturing portion of the
supply 
chain, are now expanding their design services to compete. "[EMS companies]
want to get more of the value added at the research end," Tassey says.
"Innovation is where you capture the big value, the new markets."

Quanta, unlike its larger EMS competitors, does not swallow customers' old
factories and try to squeeze profits out of them. Quanta emphasizes design
and 
logistics in Taiwan and assembles a network of manufacturers, mostly in
China, 
to build its products. And Fang can use lightweight IT connections to hook
his 
supply chain together and keep customers apprised of where their products
are 
in the process. Fang has created an Internet portal for his network of 700
small suppliers. Each morning, suppliers download their purchase orders from
Quanta's website and print out bar codes that they slap on the side of the
box so 
that Quanta can quickly direct the materials where they need to go at its
Taipei logistics center.


IT Makes Outsourcing Easy
IT has accelerated the outsourcing trend in electronics because it allows
OEMs to monitor the processes they give up, such as manufacturing and
design. IT 
can't replace a good assembly line foreman or a chief engineer who watches
over things, but in many cases, monitoring the process is enough. For
example, 
OEMs don't need to test each PC made by an EMS before it gets shipped if
they 
have set up a testing process at the factory that is monitored by IT. The
OEM 
just has to verify, via an IT-based reporting system, that PCs that didn't
pass 
the agreed-upon test were not shipped. Monitoring reduces the number of
people 
from the OEM needed onsite at the EMS's factory and virtually eliminates the
need for the OEM to physically take possession of the products.

For big U.S. companies with diverse product lines such as HP, it's
impossible 
to get everything they need from a single EMS company. Nor would these
companies want to, for competitive, intellectual property and security
reasons. But 
HP, for one, does try to limit the number of EMS companies it deals with,
partly to shave costs, and also because the increased IT demands of
monitoring the 
EMS's processes can be quite expensive for highly configurable products such
as high-end servers. "If we want to create a build-to-order process for
customers with an EMS, there is a lot more intimacy required in the
information we 
exchange with the EMS," says Faber. More product options means more
monitoring 
of the EMS company's processes. "The information pipe will be a lot bigger
and 
must be much more responsive to changes than when we're dealing with a
commodity product," he says.

If an EMS can take over the entire product process, from design to
manufacturing to shipping to customers, and OEMs can verify through
relatively 
inexpensive IT controls that the EMS is performing all these processes up to
snuff, it 
becomes a much more enticing package for OEMs. Splitting up linked processes
such as design, manufacturing and shipping is hard; it costs more and
requires 
more oversight from the OEM. That's why design is becoming a deal maker (or
breaker) for new outsourcing business. "All of the [EMS] companies realize
they 
have to get involved in the design effort at the early stage because that's
how the business is won today," says Needham's McManus.

With the relentless margin pressure that exists in the computer industry
today, OEMs are quickly coming to the view that there is no point in
devoting a 
great deal of R&D resources to mature product categories that change as
rapidly 
as PCs, laptops and cell phones. R&D engineers are the most expensive
nonmanagement employees these companies have. "The OEMs are building
entirely new 
product families every few years. So you either keep building R&D capacity
to do 
that, or you outsource it," says Chris Smith, president and CEO of RiverOne,
a 
maker of supply chain management software. "It's driven by the pace of
change 
in the industry." 

Indeed, Quanta is not designing anything all that original. The company is
unlikely (at least for now) to invent the next revolutionary new product
category. But it is perfectly capable of designing and manufacturing the
next version 
of a PC, laptop or, in a move up the value chain, storage server on its own.
"These companies started with circuit boards and worked their way up to
design 
over the years. They've built up a lot of trust with the OEMs," says
iSuppli's Pick. These companies aren't simply providing cheap labor, either.
Pick says 
many have instituted quality programs such as Six Sigma that rival Western
producers. Factory capacity utilization among EMS companies averages 85
percent 
to 90 percent in the Far East, versus 65 percent worldwide.


Innovation Not Far Behind
Quanta's Fang is careful to point out that his company has no intention of
developing its own brands and selling against its customers. But other
offshore 
EMS's have already broken that taboo. For example, BenQ, another Taiwanese
EMS, sells its own brands of cell phones and computer accessories in the Far
East 
and the United States.

Quanta could be forced to do the same in the not-too-distant future. The
incredible growth of electronics outsourcing has masked a fundamental
weakness in 
the business model: Nobody has yet learned how to make much profit doing it.
Even design margins have begun to erode recently, as EMS companies flock to
the 
model and OEMs push for lower prices. To avoid a race to the bottom, the
industry is going to have to find a way to earn better returns. "I don't
think 
there's anything stopping the outsourcing push," says Needham's McManus.
"The 
issue is: Can you be a successful corporation with returns on capital that
are no 
better than 15 percent?"

Indeed, during a recent conference call, Jure Sola, chief executive officer
of Sanmina-SCI, a large EMS company, told financial analysts, "There's no
way 
in the world this industry can exist on the margins that we are delivering
today." 

Innovation is the route out of low-margin manufacturing. IBM, Xerox, AT&T
and 
HP built their R&D capabilities with cash from unique products that
commanded 
high margins‹or, in the case of AT&T, from an outright monopoly. But those
companies have a harder time justifying investments in research today. "It's
difficult to make an ROI argument for creating fundamentally new scientific
knowledge," says Mark Bernstein, president and center director of PARC, the
former 
Xerox think tank that was spun out into an independent subsidiary in 2002.
"Faster product cycles and the increased focus on efficiency and
productivity 
have made it harder for companies to have a long-term vision."

The loss of manufacturing and design could make it difficult for the
traditional R&D powerhouses to innovate in the future. "Real breakthrough
product 
development usually requires manufacturing and research to be located
together," 
says NIST's Tassey. Supercomputers and high-tech weapons, for example,
required 
close collaboration between engineers and manufacturers.

But PARC's Bernstein says R&D must become more global by necessity. "The
breadth of research required to master a market these days is pretty
significant," 
he says. "You're going to see a lot more partnering" around the globe to do
research. Besides outsourcing manufacturing and design, many U.S. companies
have opened their own dedicated R&D facilities in low-cost countries such as
India and China. Innovation still occurs under the banner of a U.S.
corporation, 
but it happens elsewhere, employing lower-cost engineers. Though U.S.
corporations will continue to innovate under this model, the United States
and its pool 
of engineers will become lesser engines of that innovation.

To some observers, this may sound a death knell for the United States'
current lead in technology innovation, but HP's Faber isn't overly worried.
"I hate 
to sound like a Republican," he says, "but when I first came here 20 years
ago, we had our own factories for sheet metal and screws and everyone
thought we 
had to keep them. As we outsource, we just keep focusing on higher
value-added 
work." HP's newer 64-bit servers are examples of products that are largely
conceived and designed in the United States, he says.

It's clear, however, that this is a sensitive issue for the traditional R&D
powerhouses. All but one (HP) declined to comment on the growing trend in
outsourcing the "D" in R&D. At the same time, the EMS companies we spoke to
denied 
they have any plans to expand into the "R" part of R&D or offer their own
products for sale. Given their dependency on brand-name companies for
business, 
it's unlikely that we'll see a "Quanta Labs" anytime soon. But as the EMS
companies take on more and more design work and build up their engineering
groups, 
there is little doubt that they will eventually have the capability to come
up 
with their own ideas.

Quanta, for instance, has 1,500 design engineers today. The plan is to
expand 
that number to 7,000 in the next couple of years. Fang thinks other EMS
companies will follow suit. "The profits in manufacturing aren't large," he
says. 
"So moving into design is an obvious choice. It's a natural evolution." Even
if 
Quanta has no plans to sell its own products, surely one of those 7,000
engineers will have a good idea up his or her sleeve.

Executive Editor Christopher Koch can be reached at ckoch () cio com.



All content copyright CXO Media Inc., 1994-2001. All rights are reserved. No
material may be reproduced electronically or in print without written
permission from CXO Media, 492 Old Connecticut Path, Framingham, MA 01701.

CIO Magazine - January 15, 2005
© 2005 CXO Media Inc.





 
 

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> --- Begin Message ---
>
>
> From: Wdimitr () aol com
>
> Date: Thu, 20 Jan 2005 16:33:24 EST
>
> http://www.cxo.com/go/index.html?ID=1615&PMID=2389567&s=1&f=1
>
> Innovation Ships Out
>
> U.S. computer makers such as Dell, Motorola and HP are outsourcing not just 
> the manufacture but the design of new products to offshore companies. Could 
> this be the end of America's innovative edge in electronics?
>
> BY CHRISTOPHER KOCH
>
> Buy a laptop anywhere in the world and there is a one-in-four chance that 
> T.J. Fang will process the order. You'll just never know it. 
>
> Fang's secret is cloaked in IT, in servers that consolidate purchase orders 
> from name-brand American companies such as Dell, Hewlett-Packard, Apple and 
> IBM. The order trail leads to Fang's ERP system at Quanta Computer in Taipei. 
> Fang, assistant vice president and head of IT operations at Quanta, feeds those 
> orders to his Taiwanese and Chinese suppliers and factories, and within five 
> days, Quanta "drop ships" to the customer a laptop that the buyer himself 
> configured on the brand-name website. No one at the company selling the laptop ever 
> lays a finger on it. Indeed, investment bank Morgan Stanley estimates that the 
> manufacturing for 89 percent of American brand-name laptops are outsourced 
> today. What's more, many of these famous computer brand names don't even design 
> their machines anymore. New models are chosen from a shelf of fully 
> functioning prototypes offered up by a handful of Taiwanese companies. Quanta's ability 
> to design and build new laptops from scratch has helped it gain a 25 percent 
> share of all laptops sold in the United States. "In the past 10 years, 
> [companies such as Quanta] have gone from undercover stealth to a massive global 
> business," says Adam Pick, senior analyst for iSuppli, a market intelligence 
> consultancy. 
>
> Outsourcing has reached the highest level of the manufacturing supply chain: 
> R&D. By outsourcing R&D offshore, original equipment manufacturers (OEMs) can 
> freeze a portion of their R&D budgets while growing their product offerings. 
> Even R&D powerhouses such as IBM, HP and Motorola have frozen—or even 
> reduced—their R&D budgets since 2000. "[Outsourcing] is a tremendous opportunity for 
> cost savings on R&D," says Jack Faber, vice president of operations, enterprise 
> systems for HP. 
>
> But there may be a downside to all this R&D reshuffling. Some economists say 
> the outsourcing of manufacturing—and now design—is the leading edge of a 
> longer-term trend toward reduced innovation and competitiveness among U.S. 
> companies. As OEMs turn over the development of new products to outsourcers, it could 
> have a withering effect on these companies' ability to create the next 
> breakthrough, especially as many freeze R&D spending. Spending on R&D by U.S. 
> companies declined more in 2002 (3.9 percent) than it has since the National Science 
> Foundation began tracking the number in 1953. 
>
> Though the technology slump that began in 2000 may play a big role in these 
> declining R&D numbers, there is a larger, more disturbing trend at work, argues 
> Gregory Tassey, senior economist at the National Institute of Standards and 
> Technology (NIST). For the past 12 years, the proportion of R&D money going 
> toward new innovation—the "R" in R&D—has also been going down, displaced by 
> incremental product development (next year's laptop, for example). Product 
> development—the "D" in R&D—swallows more resources than the "R" work, and it does 
> not create new opportunities for revenue; it merely extends current product 
> categories. 
>
> Meanwhile, government spending on R&D has also been dropping over the same 
> period. R&D spending in the United States now lags behind many countries, 
> including Japan and Germany. The changing mix of R&D spending in the United States 
> could have a major impact on U.S. competitiveness over the long term, Tassey 
> says. Governments around the world are pumping money into private-sector R&D to 
> boost innovation. In contrast, U.S. government spending on R&D is almost all 
> focused on specific programs—such as space, defense and health—rather than 
> free-form research. 
>
> "We have the view in this country that private industry is capable of making 
> the necessary investments in R&D to keep the U.S. competitive," says Tassey. 
> "If that's the case, then every other country in the world is wrong." 
>
> The U.S. computer industry may be a bellwether for other industries that have 
> not yet begun to send product development work to outsourcers. As U.S. 
> companies increasingly shift their R&D focus from new breakthroughs to product 
> refreshes, they will be tempted to move that work offshore, where well-trained and 
> well-educated engineers are available at a fraction of the cost of their U.S. 
> counterparts. 
>
> The trend is eerily similar to the offshore outsourcing of computer 
> programming. Unemployment rates among both R&D engineers and IT programmers in the 
> United States continue to trend downward, despite the recent economic rebound. As 
> more valuable components of the manufacturing value chain progressively move 
> offshore, will the ultimate value creators—advanced research and 
> innovation—eventually move offshore too? How long can U.S. companies continue to innovate 
> when they no longer manufacture or update products? What will be left behind? 
> Marketing? 
>
> For CIOs in electronics and other industries, the shift toward global 
> manufacturing and R&D means big changes in the supply chain. Companies that outsource 
> R&D or split it among different locations or suppliers will need IT linkages 
> to enable better collaboration among engineers. And as companies outsource 
> other pieces of the supply chain (customer service, shipping, and warranty and 
> repair, for example), CIOs will need to replace direct oversight of processes 
> with automated monitoring and reporting to ensure that suppliers are meeting 
> quality metrics and shipping on time. 
>
> Of course, if outsourcing is truly complete—from design right on down to 
> shipping, service and repair—there is a distinct possibility that companies could 
> drastically cut back on internal IT as well, severely reducing the CIO's span 
> of influence. Indeed, as OEMs turn more of their supply chain over to offshore 
> electronic manufacturing services (EMS) companies, they will rely more and 
> more upon the internal IT groups of these organizations to monitor their supply 
> chain for them. "OEM has become a misnomer unless you change the M to 
> marketing," says Kristian Talvitie, director of strategic marketing and communications 
> for Plexus, a global EMS company based in the United States. 
>
>
> Moving Up the Food Chain 
> In the past 15 years, EMS companies here and abroad have moved steadily up 
> the food chain in large part because the value of the work to which they laid 
> claim has been driven down by price pressure and global competition. Indeed, the 
> work that launched the EMS industry in the '80s, stuffing components such as 
> microprocessors onto computer circuit boards for big-name computer 
> manufacturers, has ceased to be profitable, industry insiders say. "Placing components on 
> boards is commoditized. You have to offer a whole variety of services to win 
> a new customer today," says John McManus, managing director and senior analyst 
> for Needham & Co., an investment banking and research company. 
>
> To survive, EMS companies have had to continually take on higher-order, more 
> complex pieces of the electronics supply chain to keep their hollow-cheeked 
> profit margins (overall industry average is 2 percent to 5 percent) from 
> disappearing altogether. Design work typically has higher gross profit margins, 
> between 8 percent and 11 percent, according to iSuppli's Pick. This has led to the 
> growth of upstart companies such as Quanta that specialize in total design, 
> manufacturing and shipping solutions for customers. Traditional EMS companies, 
> accustomed to focusing exclusively on the manufacturing portion of the supply 
> chain, are now expanding their design services to compete. "[EMS companies] 
> want to get more of the value added at the research end," Tassey says. 
> "Innovation is where you capture the big value, the new markets." 
>
> Quanta, unlike its larger EMS competitors, does not swallow customers' old 
> factories and try to squeeze profits out of them. Quanta emphasizes design and 
> logistics in Taiwan and assembles a network of manufacturers, mostly in China, 
> to build its products. And Fang can use lightweight IT connections to hook his 
> supply chain together and keep customers apprised of where their products are 
> in the process. Fang has created an Internet portal for his network of 700 
> small suppliers. Each morning, suppliers download their purchase orders from 
> Quanta's website and print out bar codes that they slap on the side of the box so 
> that Quanta can quickly direct the materials where they need to go at its 
> Taipei logistics center. 
>
>
> IT Makes Outsourcing Easy 
> IT has accelerated the outsourcing trend in electronics because it allows 
> OEMs to monitor the processes they give up, such as manufacturing and design. IT 
> can't replace a good assembly line foreman or a chief engineer who watches 
> over things, but in many cases, monitoring the process is enough. For example, 
> OEMs don't need to test each PC made by an EMS before it gets shipped if they 
> have set up a testing process at the factory that is monitored by IT. The OEM 
> just has to verify, via an IT-based reporting system, that PCs that didn't pass 
> the agreed-upon test were not shipped. Monitoring reduces the number of people 
> from the OEM needed onsite at the EMS's factory and virtually eliminates the 
> need for the OEM to physically take possession of the products. 
>
> For big U.S. companies with diverse product lines such as HP, it's impossible 
> to get everything they need from a single EMS company. Nor would these 
> companies want to, for competitive, intellectual property and security reasons. But 
> HP, for one, does try to limit the number of EMS companies it deals with, 
> partly to shave costs, and also because the increased IT demands of monitoring the 
> EMS's processes can be quite expensive for highly configurable products such 
> as high-end servers. "If we want to create a build-to-order process for 
> customers with an EMS, there is a lot more intimacy required in the information we 
> exchange with the EMS," says Faber. More product options means more monitoring 
> of the EMS company's processes. "The information pipe will be a lot bigger and 
> must be much more responsive to changes than when we're dealing with a 
> commodity product," he says. 
>
> If an EMS can take over the entire product process, from design to 
> manufacturing to shipping to customers, and OEMs can verify through relatively 
> inexpensive IT controls that the EMS is performing all these processes up to snuff, it 
> becomes a much more enticing package for OEMs. Splitting up linked processes 
> such as design, manufacturing and shipping is hard; it costs more and requires 
> more oversight from the OEM. That's why design is becoming a deal maker (or 
> breaker) for new outsourcing business. "All of the [EMS] companies realize they 
> have to get involved in the design effort at the early stage because that's 
> how the business is won today," says Needham's McManus. 
>
> With the relentless margin pressure that exists in the computer industry 
> today, OEMs are quickly coming to the view that there is no point in devoting a 
> great deal of R&D resources to mature product categories that change as rapidly 
> as PCs, laptops and cell phones. R&D engineers are the most expensive 
> nonmanagement employees these companies have. "The OEMs are building entirely new 
> product families every few years. So you either keep building R&D capacity to do 
> that, or you outsource it," says Chris Smith, president and CEO of RiverOne, a 
> maker of supply chain management software. "It's driven by the pace of change 
> in the industry." 
>
> Indeed, Quanta is not designing anything all that original. The company is 
> unlikely (at least for now) to invent the next revolutionary new product 
> category. But it is perfectly capable of designing and manufacturing the next version 
> of a PC, laptop or, in a move up the value chain, storage server on its own. 
> "These companies started with circuit boards and worked their way up to design 
> over the years. They've built up a lot of trust with the OEMs," says 
> iSuppli's Pick. These companies aren't simply providing cheap labor, either. Pick says 
> many have instituted quality programs such as Six Sigma that rival Western 
> producers. Factory capacity utilization among EMS companies averages 85 percent 
> to 90 percent in the Far East, versus 65 percent worldwide. 
>
>
> Innovation Not Far Behind 
> Quanta's Fang is careful to point out that his company has no intention of 
> developing its own brands and selling against its customers. But other offshore 
> EMS's have already broken that taboo. For example, BenQ, another Taiwanese 
> EMS, sells its own brands of cell phones and computer accessories in the Far East 
> and the United States. 
>
> Quanta could be forced to do the same in the not-too-distant future. The 
> incredible growth of electronics outsourcing has masked a fundamental weakness in 
> the business model: Nobody has yet learned how to make much profit doing it. 
> Even design margins have begun to erode recently, as EMS companies flock to the 
> model and OEMs push for lower prices. To avoid a race to the bottom, the 
> industry is going to have to find a way to earn better returns. "I don't think 
> there's anything stopping the outsourcing push," says Needham's McManus. "The 
> issue is: Can you be a successful corporation with returns on capital that are no 
> better than 15 percent?" 
>
> Indeed, during a recent conference call, Jure Sola, chief executive officer 
> of Sanmina-SCI, a large EMS company, told financial analysts, "There's no way 
> in the world this industry can exist on the margins that we are delivering 
> today." 
>
> Innovation is the route out of low-margin manufacturing. IBM, Xerox, AT&T and 
> HP built their R&D capabilities with cash from unique products that commanded 
> high margins—or, in the case of AT&T, from an outright monopoly. But those 
> companies have a harder time justifying investments in research today. "It's 
> difficult to make an ROI argument for creating fundamentally new scientific 
> knowledge," says Mark Bernstein, president and center director of PARC, the former 
> Xerox think tank that was spun out into an independent subsidiary in 2002. 
> "Faster product cycles and the increased focus on efficiency and productivity 
> have made it harder for companies to have a long-term vision." 
>
> The loss of manufacturing and design could make it difficult for the 
> traditional R&D powerhouses to innovate in the future. "Real breakthrough product 
> development usually requires manufacturing and research to be located together," 
> says NIST's Tassey. Supercomputers and high-tech weapons, for example, required 
> close collaboration between engineers and manufacturers. 
>
> But PARC's Bernstein says R&D must become more global by necessity. "The 
> breadth of research required to master a market these days is pretty significant," 
> he says. "You're going to see a lot more partnering" around the globe to do 
> research. Besides outsourcing manufacturing and design, many U.S. companies 
> have opened their own dedicated R&D facilities in low-cost countries such as 
> India and China. Innovation still occurs under the banner of a U.S. corporation, 
> but it happens elsewhere, employing lower-cost engineers. Though U.S. 
> corporations will continue to innovate under this model, the United States and its pool 
> of engineers will become lesser engines of that innovation. 
>
> To some observers, this may sound a death knell for the United States' 
> current lead in technology innovation, but HP's Faber isn't overly worried. "I hate 
> to sound like a Republican," he says, "but when I first came here 20 years 
> ago, we had our own factories for sheet metal and screws and everyone thought we 
> had to keep them. As we outsource, we just keep focusing on higher value-added 
> work." HP's newer 64-bit servers are examples of products that are largely 
> conceived and designed in the United States, he says. 
>
> It's clear, however, that this is a sensitive issue for the traditional R&D 
> powerhouses. All but one (HP) declined to comment on the growing trend in 
> outsourcing the "D" in R&D. At the same time, the EMS companies we spoke to denied 
> they have any plans to expand into the "R" part of R&D or offer their own 
> products for sale. Given their dependency on brand-name companies for business, 
> it's unlikely that we'll see a "Quanta Labs" anytime soon. But as the EMS 
> companies take on more and more design work and build up their engineering groups, 
> there is little doubt that they will eventually have the capability to come up 
> with their own ideas. 
>
> Quanta, for instance, has 1,500 design engineers today. The plan is to expand 
> that number to 7,000 in the next couple of years. Fang thinks other EMS 
> companies will follow suit. "The profits in manufacturing aren't large," he says. 
> "So moving into design is an obvious choice. It's a natural evolution." Even if 
> Quanta has no plans to sell its own products, surely one of those 7,000 
> engineers will have a good idea up his or her sleeve.  
>
> Executive Editor Christopher Koch can be reached at ckoch () cio com. 
>
>
>
> All content copyright CXO Media Inc., 1994-2001. All rights are reserved. No 
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> permission from CXO Media, 492 Old Connecticut Path, Framingham, MA 01701.  
>
> CIO Magazine - January 15, 2005 
> © 2005 CXO Media Inc.
>
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