Defense and aerospace outsourcing trends: joint design manufacturers (JDMs) are the newest wave as EMS firms engage at schematic capture.

The defense and aerospace sector has always been in a follower-leader relationship to the commercial sector. Long ago the commercial sector realized the question is not, Should things be done differently? but What should be done differently?

Prime contractors in the defense and aerospace industry are at least behaving tactically--seeking to reduce costs, improve efficiency and increase competitiveness. They must do this just to maintain the status quo. Some are behaving strategically--using their own versions of the core process management roadmap to focus their strengths and re-engineer their core processes to add value for their customers and distinguish themselves as No. 1 or 2. Primes are becoming integrators of systems-of-systems and are shedding vertical capabilities. They are achieving vertical depth by teaming with other primes and with second and third tier contractors.

These contractors are wrestling with what to do, what to do differently and what not to do at all. They are beginning to focus on design and integration of systems and subsystems, emulating the behavior of the primes. They are looking at alternative strategies for producing CCAs and black boxes. They are struggling with whether to outsource and with the value proposition. With regard to production of CCAs and boxes, their options are

* Do nothing (continue stovepipes and silos).

* Further consolidation (corporate centers of excellence).

* Selectively partner (EMS).

All three approaches are present in today's defense and aerospace marketplace, but EMS is growing (Table 1). What stands out in Table 1 is that the worldwide defense and commercial aviation EMS production is about 3 to 3.5% of the total EMS production and has a compound annual growth rate of 7.2% compared to the total EMS CAGR of 10.8%. However, the telling figures are that commercial aviation EMS has rebounded (up from -2.1% CAGR a year ago) and is now projecting growth (5.6% CAGR) for the first time since 9/11. Defense EMS continues to experience healthy growth with a CAGR of 8.8% (from 7.2% a year ago).

The advantages of outsourcing production of electronic assemblies are becoming more obvious to prime, second and third tier defense and aerospace contractors. The following are two actual case examples of significant direct savings accrued by two companies that elected to outsource CCAs on two separate DoD programs:

Case 1. Annual outsourcing of $15 million in CCAs for major DoD aviation program.

* Reduced recurring cost 10%.

* Reduced inventory 15%.

* Increased customer's internal productivity 35%.

* Eliminated 10 customer CCA rework positions.

Case 2. Annual outsourcing of $10 million in CCAs for major DoD shipboard program.

* Reduced recurring cost 5% below Corporate COE.

* Reduced rejects at next assembly level by 71%.

* Reduced field return rate 62%.

* Reduced out-of-warranty repair time to 15 days from 30.

This is typical of what happens when manufacturing is turned over to manufacturing experts.

In addition to these direct savings to marginal cost and improvements in performance, additional indirect savings are available in capital investment, bricks and mortar and infrastructure. These indirect savings are more difficult to measure and often are not openly discussed because they are normally associated with line shutdowns, facility closings and reductions in force when companies decide to discontinue CCA or black box manufacturing. However, these hidden indirect savings can exceed the direct savings and because of their impact on ROI are more likely to be understood and appreciated by a company's chief financial officer than by the head of operations or procurement.

EMS providers, like all companies, must understand their customers' value proposition.

* What important attributes customers are seeking?

* What are the benefits associated with these attributes?

* What value do customers assign to these attributes and benefits?

In 2003 and again in 2004, customers were asked to complete scorecards ranking seven attributes and their associated benefits and values. The scoring ranged from five to 30 indicating the degree of importance.

The seven attributes of contract manufacturing selected to measure the customers' value proposition are listed below. The associated benefit and value are bulleted beneath each attribute. The average scores over 2003 and 2004 showing the degree of importance ascribed by customers for each combination of attribute, benefit and value are listed beside each attribute.

1. Class 3 workmanship (28)

* High reliability

* Operation in harsh environments

2. Conformal coating (19)

* Protection

* Operation in harsh environments

3. Price (24)

* Reduce cost

* Increase competitiveness

4. Firm fixed prices (26)

* Prevent overruns

* Increase profits

5. Flexible/ready labor and equipment (24)

* Reduce costs

* Increase return on equity

6. Offload non-core operations (19)

* Decrease capital expenditures

* Free-up investment dollars

7. DfM/DfT engineering services (24)

* Reduce costs

* Increase competitiveness

Once the customers' value proposition has been determined, EMS providers must measure customer satisfaction relative to the value proposition. To do this, customers were asked to complete a second scorecard indicating 1) the relative importance of each attribute and benefit in making source selection decisions, 2) how well the competition provides each attribute and benefit, and 3) how well their own company provides each attribute and benefit. Again, a scale of five to 30 was used.

The average scores and summary raw scores are summarized in Table 2. Using the summary raw score for the importance of the seven attributes and their associated benefits to the source selection decision as the benchmark, it was determined that the competition was satisfying customers at a rate of about 68% and that their own companies were satisfying customers at a rate of about 85%. This information is nice to know, but not really useful, as the expectation is that one's own customers would be more satisfied with one's own company than with the competition.

Perhaps the most useful information derived from the data was identifying those attributes and benefits most likely to be discriminators in the source selection process.

Class 3 workmanship and process control in accordance with ANSI/J-STD-001 and IPC-A-610 were identified as "must have" capabilities to be in the defense and aerospace EMS business and are already being provided by all players in the sector. Conformal coating was identified as important, but again, everyone in the sector provides it. The same is true of providing a flexible and ready labor force and equipment, and allowing customers to offload non-core operations. They are important, but they are standard in the EMS industry.

When customers solicit defense and aerospace EMS companies, most often they have already determined who they consider to be competitive for the services they seek. Occasionally, customers will solicit a large and a small commercial EMS supplier just to get a feel for what a pure commercial price would be and may use this for negotiating leverage. But most commercial suppliers do not have the infrastructure to meet the "must have" Class 3 workmanship and conformal coating requirements, nor are their factories configured to handle high mix and low volumes.

The attributes and benefits that emerged as most likely to be competitive discriminators are

* DfM/DfT engineering services.

* Price.

* Firm fixed prices.

More often than not, price means lowest price, but not always. At the least, price means being competitive. The competitive range can vary by customer, but it is rarely greater than 5%. This means an EMS provider can win with a 5% higher price if there is some other discriminator that permits the customer to make a "best value" source selection decision.

Firm fixed prices mean two things to customers. In one case it means getting a firm fixed price from an EMS provider rather than getting an estimate from, but paying actual costs to, its own factory or corporate COE. Because internal factories and corporate COEs usually transfer actual costs to the programs they serve, the program can experience cost creep. Thus, keeping work inside can actually mean operating under "cost plus" conditions. In the second case, it means that even in a firm fixed-price competitive EMS environment, the cost of doing business varies from EMS provider to provider. Therefore customers will apply factors to EMS competitors' prices to compensate for the ease (or difficulty) of doing business with any particular provider. The lesson for EMS providers: be easy to do business with. For customers: look for cultural compatibility.

Three Outsourcing Models

There are three outsourcing models for performing the classical functions of circuit card assembly, box build and testing. The first, best-known and most widely used model in defense and aerospace is traditional build-to-print. In this model, a contract manufacturer uses its in-place staff, equipment and processes to produce customers' products to the existing drawings and bills of material.

Less frequently used is the Inside-Out model. This involves the transfer of equipment, processes, technology and people in accordance with a phased/sequenced transition plan from the customer's facility to the contract manufacturer's facility. Reasons for using this model may be driven by economics or technology or both. Assets may either be given to, or purchased by, the contract manufacturer.

The third model, Divestiture/Acquisition, is common in commercial EMS but much less so in defense and aerospace. The contract manufacturer purchases and operates the customer's facility, continuing to build this customer's products, but free to build other customers' products there too.

The defense and aerospace industry is moving toward design collaboration between customers and EMS providers. All stakeholders seem to recognize that the earlier the manufacturer becomes involved in the design process, the better the product. Most EMS companies now offer their customers DfM/DfT engineering services. DfM/DfT tools vary from supplier to supplier and analyses may be performed manually, or using software tools and modeling, or using both. These analyses normally occur after PCB layout and parts placement, and may be performed on legacy as well as new products.

[FIGURE 1 OMITTED]

It is hard to imagine that defense and aerospace EMS providers will ever provide ODM services to their customers, as is becoming frequent in the commercial sector. An emerging trend in defense and aerospace is to go beyond EMS services and toward what in the commercial sector is known as a JDM--joint design manufacturer. A JDM helps design products for its customers. And this may well become the breakthrough competitive discriminator among today's defense and aerospace EMS providers.

Since December 2003, customers have been interested in handing design tasks to the contract manufacturer. Infrequently, customers have shown interest in handling the design task by providing basic requirements definition and having the JDM/EMS company complete a turnkey design and production operation. To do this, a JDM/EMS company would need to have expert systems engineers in the applicable field or technology such as radio frequency, infrared, electro-optics, signal processing, communications security and others. No JDM/EMS company could possibly maintain a staff to span the systems engineering design expertise necessary to address the range of defense and aerospace electronics product requirements. However, small pockets of specific systems engineering design expertise already exist at some defense and aerospace JDM/EMS companies and others may develop over time as traditional EMS companies evolve to become JDMs.

More frequently, customers are interested in handing off the design task at schematic capture, after completing the electrical design. At this point the JDM completes the design, performs design verification, assembles and tests prototypes, assembles and tests qualification units, assembles and tests proof of manufacturing units, and finally produces the production units. Different from the turnkey design scenario which starts with basic requirements, this limited design scenario is one that is more probable to be widely used because the engineering talent required to complete a design beginning at schematic capture is more common, regardless of the systems engineering technology involved.

Also, in 2004 customers assigned greater importance to engineering services than in 2003. The average score jumped from 23 in 2003 to 28 in 2004--clearly a sign of the growing importance of design services.

* Despite industry consolidation, prime, second and third tier defense and aerospace contractors still have too much infrastructure, driving costs higher and hurting competitiveness.

* Corporations must develop and implement post-consolidation strategies to achieve more competitive cost structures that eliminate redundancies, improve efficiencies and enable them to leverage their core competencies to improve value to their customers.

* Outsourcing is a viable post-consolidation strategy that can have dramatic transforming effects on a business.

* Contract manufacturing is an increasingly attractive option for defense business CCA and box build as evidenced by 8.8% CAGR through 2008.

* Commercial aviation contract manufacturing is rebounding as evidenced by 5.6% CAGR through 2008.

* All contract manufacturing stakeholders must understand the value proposition because it is key to achieving competitiveness and customer satisfaction.

* In addition to traditional build-to-print, other EMS models are available.

* JDMs will emerge as the suppliers of choice over classical EMS providers.

TABLE 1: EMS market, 2002 to 2005 (3) (in US$billions).

Sector                  2003    2004    2005    2006    2007   2008

EMS Production (CAGR   $101.4  $113.6  $125.8  $139.3  $153.8  $169.1
10.8%)

Defense and Comm.
Aviation
 EMS (CAGR 7.2%)       $3.57   $3.82   $4.10   $4.39   $4.71   $5.06

 Defense (CAGR 8.8%)   $1.77   $1.92   $2.09   $2.27   $2.47   $2.69

 Commercial Aviation   $1.80   $1.90   $2.01   $2.12   $2.24   $2.37
 (CAGR 5.6%)

TABLE 2: Measuring customer satisfaction.

Attribute      Important to Source  Provided by the  Provided by
               Selection Decision     Competition    Own Company

Class 3                28                 19             24
workmanship

Conformal              17                 14             18
coating

Price                  22                 14             19

Firm fixed             22                 10             15
price

Flexible               19                 16             19
lab/equipment

Offload                18                 15             17
non-core

DfM/DfT eng.           26                 16             17
services

Summary raw           152                104            129
scores

Percent                100                68             85

Ed.: This article is adapted from a paper presented at SMTA International in September 2004 and is used with permission.

References

1. P. Drucker, Management Challenges for the 21st Century, 2001.

2. W. Anderson, J. McGuinness, J. Spicer, "And the survey says ... The effectiveness of DOD outsourcing and privatization efforts," Acquisition Review Quarterly, Spring 2002.

3. Electronic Trend Publications Inc., The Worldwide Electronics Manufacturing Services Market, 1st Edition, 2004.

Jeff Kaylor is principal applications specialist at Sypris Electronics (sypris.com); [e-mail].