Getting Rid of Cost

By Robert McGeary
REM Enterprises, Inc.

Will Intel ever rise to its former levels of profitability? I think not. The microprocessor is becoming a commodity. Who is winning in the PC market – Dell - because of distribution, availability, cost, and service. Content is no longer a protected competitive advantage - others can make your product.

To make matters worse, high-tech industries are plagued with "feast to famine." High R&D and Marketing costs cause severe degradations in profitability during industry downturns, as we are all painfully aware. One way out of this dilemma is to restructure the company, concentrating on core competencies.

More and more, companies are outsourcing many of their corporate tasks, choosing to focus on what they do best. Lam Research has only one-third of its former manufacturing space, choosing to manufacture only 10% of their product. Chairman and CEO, Jim Bagley, says that they will be able to handle more than three times the business with Lam's current capacity.

There has been a burgeoning of contract fabs. "Outsourcing-companies", such as Advanced Energy and MKS Instruments, are taking on critical manufacturing tasks for capital equipment companies. Concerns about transferring intellectual property are taking a back seat. But will these behaviors cause high-tech companies to go the way of the steel mills that outsourced their commodity products to “foundries?”

Commoditization

What was the real reason for the demise of our steel industry. We see the same play being enacted in semiconductors – the obsolescence of capital equipment. It is paramount for a company to wring as much profit out of a capital purchase as possible. However, the company often uses its “depreciation” dollars to enrich the shareholders, when this money should be plunged back into the company to keep its equipment current. The steel industry chose to operate its old open-hearth furnaces when the Japanese were facilitating their plants with the latest electric furnaces. The rest is history, even though the United States was head-and-shoulders ahead of Japan in material resources.

In the semiconductor industry, we saw the Japanese, and then the Koreans, and then the Taiwanese, sequentially capture dominant share of the DRAM markets. As they brought brand new fabs on line, with the newest generation of processes, the markets were ready to absorb the newer, high-memory DRAMs. Jerry Sanders, AMD's founder and CEO, taught us that the time to add new plant and equipment was during a downturn. Customers would be hungry for the new technology when things got better. In fact, during the 1995 downturn, he said, “I’m glad I didn't have more business, ‘cause then I would have lost more money.” He was plunging those depreciation dollars into new plant.

So for manufacturing-intense industries, the lesson is clear: Maintain your manufacturing resources to the highest degree possible. But this brings us to the conundrum, “What happens when your product becomes a commodity?”

Given the preceding discussion, we would assume that as long as new processes and equipment are being introduced, commoditization has not set in. That is, the impetus to design new equipment and processes should be market-driven – a demand exists for them. So for user and supplier alike, a continually evolving process technology connotes non-commoditization. This brings us to “core competency.”

Core Competency

Because of the huge swings that high-tech industries experience, especially the semiconductor industry, there is a motivation to reduce the sensitivity to these swings by reducing head count. A company can reduce head count by outsourcing many of its value-added tasks. Figure 1 shows Michael Porter's diagram of the firm as a value chain.

Consider the core competency of a leading equipment supplier. The company has excellent relationships with the leading companies in the target market. This allows them to be working on the processes that are important and that will be important in the next generations of products. They presumably have excellent service in order to keep complex equipment and processes reliably performing; they are the experts. They probably have world-class engineers and scientists working in their R&D departments, developing new products and processes. All of these relationship are focused on the customer and is depicted by the following Porter diagram.

Figure 2 - Value Chain Relationships

In this diagram, there is not a solid relationship between manufacturing in the supplier and manufacturing in the customer. One must question the importance of this activity as a competitive advantage. Whether it is an advantage depends on the company’s strategy!

There are, in general, three generic strategies which are given by the matrix in Figure 3, a la Michael Porter. The three strategies are (1) Cost Leadership, (2) Differentiation, and (3) Focus. One must remain aware that to choose one strategy does not mean that a company can neglect the other attributes. For instance, if one chooses to pursue a Low-Cost strategy, there must not be a large gap between that company’s product performance (i.e., differentiation) and the market Differentiator’s performance. That gap represents cost savings, and hence, price. When it is too large, the customer will either not pay the price differential or will not sacrifice quality, depending whether its Differentiation or Cost Leadership, respectively.

Ignoring the Focus Strategy for now, we see that one way to differentiate is to outsource a good portion of the manufacturing. So if a company truly has a competitive advantage in its technology, outsourcing, while more expensive, allows the company to invest in its process and product development, its sales and marketing, its service, and any other areas that add value to the product. One of the obvious benefits of this practice is that the company can reduce its manufacturing capacity substantially during downturns without sacrificing the resources that are dedicated to its core competency. Conversely, the company can ramp up production quickly as long is there are contract manufacturers that can meet the new demand.

It is not in the best interest of the Cost Leader to outsource manufacturing services. They should be more interested in learning how to manufacture better, since manufacturing is their competitive advantage. In the April 14th issue of Forbes Magazine (“The Ooof Company”, page 72), Toyota shows an excellent example of how to wring the most out of the manufacturing activity. The company has “made more profits in a single year than any auto maker in the last decade--$12 billion.” In the next decade, Toyota plans to expand its worldwide share by almost half, to 15%. They have become a global manufacturing company, choosing where to produce and assemble parts based on the least expensive method per value added step. The company has set up operations outside of Japan in Thailand, Vietnam, and Indonesia. It kept relations with their keiretsu while other Japanese companies were abdicating theirs so “it could count on getting first crack at its best inventions” but it “leaned on suppliers’ engineers for suggestions on how to cut their own costs. It zeroed in on 174 key components, such as air bags, fuel pumps, and brake systems.” They will not outsource their manufacturing.

Focus Strategy

Focusing is very much an opportunistic strategy. It must be utilized in a protected niche where certain needs are being neglected. For instance, if a niche has special needs that do not coincide with the Differentiator’s product feature set, it allows a smaller company to dedicate itself to those needs. Conversely, if the niche has different production and delivery needs than the rest of the industry, a company can unseat the Cost Differentiator by satisfying those needs. We see, that in the case of a segmented niche, either type of focus strategy could work, choosing to outsource certain activities in its manufacturing process, concentrating its resources on those components that exploit the niche’s particular needs.

Caveats – For the Cautious

One of the objections raised with respect to outsourcing is the risk of divulging the company’s intellectual property. If your company ships a vacuum chamber and tooling to a contract manufacturer so that it can study and develop systems for it, how can you keep trade secrets from finding their way into another competitor’s system? Does not the contractor learn from your technology? And does not it behoove them to offer their expertise as an incentive for other companies to use their services? This is a real concern!

However, it is mostly a concern for Differentiators and Focus Differentiators. We have seen that Cost Leaders will not tend to use outsourcing for their manufacturing activities. Is there a way to mitigate the risks with respect to intellectual property for outsourcing manufacturing?

Mitigating Risk

Risk is a common bedfellow to every manager. In Decision Science, and particularly in Game Theory, every set of strategies has a probability of succeeding and an associated outcome. If the probability is low and the outcome is very negative, that strategy is considered to be "risky." Given that a rational decision model leads an executive to outsourcing as a strategy, the manager must go about mitigating the inherent risks. Here are some steps to take in the outsourcing decision.

Risk Mitigating Behaviors

Training: There is no substitute for a well trained engineering staff, impressing the value of intellectual property. Whatever other measures that a company takes, they can be invalidated by a cavalier relationship with outside parties.
Choice of Contractor: It may be possible to find a contractor that will form an exclusive relationship to the company. Such a contractor may work primarily in another industry and will not have formed relationships in yours.
Separating Manufacturing Activities: Taking after Michelin Tires, a company could break the manufacturing process into separate steps and dole them out to different contractors. Michelin manufactures in several different buildings and employees from one building are not allowed into the others.
Using Generic Components: By using off-the-shelf components, esoteric process secrets can be hidden from knowledgeable people building the machine or developing working systems.
Well Written Contracts and NDAs: Contracts that give contractors either a motive to keep secrets or a detriment for divulging them can be very effective. Such contracts are very hard to write and even harder to enforce.

Summary

Perhaps the move of semiconductor companies and capital equipment companies is the harbinger of an industry shake-out as proposed by Charles Dilisio of D-Side Advisors in his article on capital spending, CAPEX Survivors. Or perhaps it is really an industry coming to maturity and rationality. I recall a study that I did some years ago on the retained earnings of capital equipment companies. If you put the companies in a list and divided it in half, the companies above the line had positive retained earnings and those below were negative. The sum total was about zero. One wonders why this condition persists for over 40 years, cycling every 5 to 10 years between feast and famine.

I believe that a strategy that tries to minimize the impact of industry cycles on the lives and livelihoods of company-employees will be a constructive one in the long run. Whether these companies go the way of the steel companies is left up to more complex factors, especially in this age of globalization. I, for one, am watching the performance of those companies that jump into the breach with outsourcing services.

Contact:
Robert McGeary
REM Enterprises, Inc.
503-617-6326
503-201-2343
robmac@remnet.com

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