Brand-name personal-computer and telecommunications-equipment vendors should be thrilled by the recovering US economy. IT budgets are loosening, and many chief information officers and consumers are eager to replace aging equipment. But a stronger economy alone may not be enough to lift the fortunes of the companies that actually build the boxes—the electronics-manufacturing-services (EMS) contractors, which have fared less well than their customers have in recent years.

Although the names of these contractors are unfamiliar to most consumers and many businesses, they are increasingly responsible for the design, manufacture, testing, logistics, and even after-sales service of name-brand electronics products.¹ The original-equipment manufacturers (OEMs) have embraced outsourcing because it removes capital from their balance sheets and delivers personal computers, servers, and other technology products more quickly and cheaply than they could themselves. Since contract manufacturers can exploit economies of scope and scale, their customers can focus on differentiators such as R&D, marketing, sales, and time to market.²

While the EMS companies have passed along tremendous benefits to their customers, in the recent past they have had less success in capturing value for themselves. From 1999 to 2003, the operations of the six leading companies lost nearly $7 billion of economic value (Exhibit 1), and they had to take more than $12 billion in restructuring and onetime charges as demand plummeted and their operations were scaled back. Like nearly all capital-intensive technology companies, they underestimated the length and depth of the downturn and were slow to take capacity off line. Only two of the top six players—Hon Hai Precision Industry and Jabil Circuit—met their cost of capital over the five-year period. Of greater concern, though, is the possibility that the economic recovery may be leaving the EMS industry behind. Conditions are certainly better, but it still isn't earning its cost of capital for investors.

Why has an EMS recovery been slow to take shape? During the economic downturn, these contractors shared the pain of plummeting demand with their OEM clientele. Even as margins declined, they focused heavily on generating revenue to keep their manufacturing plants running. They competed ferociously for volume, trying to win business by making lower and lower bids and offering more and more attractive terms and conditions. In many cases, EMS players took on uncompensated risks—for instance, product liability. To avoid angering their customers, they no longer collected fees for services such as engineering-change orders in a disciplined way. And when they pursued hefty cost cuts by shifting their manufacturing plants to low-cost geographies, they largely passed on the savings to customers.

Thus even in the recovery, the profits of the EMS contractors still lag behind those of other technology companies. If this sounds like a free lunch for the OEMs, it is—up to a point. OEMs count on their contract suppliers to invest in technology, systems, manufacturing, and supply chain practices that drive costs down and help them remain competitive. But if the EMS industry fails to earn its cost of capital, its ability to make these investments will be compromised and OEMs will suffer. Since no one expects OEMs to offer suppliers more money, EMS companies must find their own route to profitability, beginning with three imperatives.

Match capacity to demand

The downturn in technology spending arrived just as the top six EMS companies had spent a total of $14 billion on new plants in countries such as China, the Czech Republic, the Philippines, Romania, and Thailand. The industry's high fixed costs make capacity utilization a top management priority; materials historically amount to 80 to 90 percent of revenues, and much of the remaining gross margin is invested in fixed plant, expert engineering and manufacturing resources, and corporate-support functions. Competition for volume thus became fierce, and EMS companies offered OEMs generous pricing and other terms to preserve market share and keep factories humming. The result was a price war and dwindling margins. Poor communication between sales forces (in many cases compensated by revenue rather than profits) and operational teams exacerbated the problem.

Even with incentives to customers, some EMS companies couldn't stem the tide. Average industry utilization fell from a high of 75 percent in the boom times of the late 1990s to about 44 percent in the trough of the downturn. Today it stands at about 50 percent. Despite these difficult conditions, few companies have taken factories completely out of service, because they want to fulfill their commitments to customers and ramp up quickly if demand suddenly rises. In aggregate, this behavior aggravates the supply-demand imbalance in the industry.

To get back on track, EMS companies have to change the way they think about capacity needs. Future requirements should start with realistic—not best-case—sales forecasts. Decision making must promote the goal of exceeding the cost of capital (Exhibit 2). While this approach may sound like mere common sense, few players appear to have based their capacity decisions on the maximization of potential returns; the priority has been to please customers and maximize revenues.

Address pricing problems

Customers also benefit from an outdated pricing model that limits the industry's profitability. Standard EMS contracts base payments to manufacturers on the cost of the materials required to make a given product, plus a certain percentage—traditionally from 15 to 20 percent—for the value the contractor adds. This pricing model was designed to pass savings on to OEMs while encouraging the contract manufacturers, some of which grew out of the companies that are now their customers, to become more efficient. But in some cases, it hasn't turned out to be the hoped-for win-win solution.

The model works when there is a particular correlation between the cost of the material inputs of a product and the cost of building, assembling, and testing it. But this correlation doesn't hold up for many product lines, particularly when the number of parts in a product is declining and materials are rapidly becoming cheaper. If, for example, the cost of an input drops overnight because of excess supply, this decline obviously doesn't make manufacturing any less expensive (Exhibit 3). And the cost of inputs declines frequently—and too quickly to be offset by greater efficiency in manufacturing and the supply chain. The unintended result is that the price model actually gives contract manufacturers an incentive not to reduce the cost of materials as quickly as possible.

When OEMs insist on specific suppliers and prices, thereby giving EMS players even fewer options for improving their margins, the situation gets worse. It is exacerbated further when OEMs fail to live up to their side of the bargain in volume-based contracts: at the trough of the recent downturn, they frequently demanded fixed prices based on volumes that never materialized, leaving EMS contractors to operate plants at lower volumes and higher costs. EMS companies also had difficulty persuading customers to accept practices, such as pricing models offering discounts only at higher volumes, that would have mitigated this problem.

Paradoxically, managers from both sides of the relationship believe that the model is unfair. OEMs believe that EMS companies profit excessively from an "adder" they charge as a percentage of the cost of materials in order to cover handling and management charges. But this adder is rarely a net benefit to EMS companies, since customers often have enough leverage to exclude expensive components. Each party blames the other for perpetuating the model, thinking that it is somehow in the other's interest. Both should consider a new model that works for everyone by removing the link between the cost of materials and the price of manufacturing and that passes along to the customer some anticipated savings from the EMS contractor's scale and newly learned efficiencies (Exhibit 4). EMS contractors should also move beyond cost-plus pricing, which often doesn't compensate them for the value they provide to customers—for example, when they offer environmentally friendly manufacturing and obsolescence-management services that regulators and OEMs increasingly require.³

Improve collections

EMS players have long struggled to document their services and to collect the fees they are owed, though not always successfully. Given the industry's razor-thin margins, this failure may seem surprising, especially when many of these fees are contractually guaranteed. But in an effort to hold on to customers, many EMS companies have let OEMs get away with late payments and demands for free changes in the specs of components. EMS contractors absorb such costs in hopes of hanging on to their revenues, and OEMs have encouraged them to do so by threatening to take business to competitors.

Now there are signs that EMS companies are beginning to stand up for themselves—for example, by demanding payment for everything, including changes in orders. And when one large personal-computer OEM recently tried to make contract manufacturers accept almost unlimited liability for the defects of products throughout their whole life, the EMS contractors bidding for the contract refused to accept the risk and the OEM backed down. At any rate, such risks should be taken into account in calculating profits and making bids.

EMS players, like their OEM customers, should be helped by the upturn in high-tech spending, but they might not be if they don't act quickly. Managing capacity better, improving the pricing model, and collecting reasonable fees for services delivered are steps that will help ensure that EMS companies also benefit from the recovery.