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Bad fit customers: when should EMS providers say good-bye?

Every time the electronics manufacturing services (EMS) sector goes through an economic downturn, individual EMS provider business definitions of acceptable projects widen. But, as demand increases and EMS providers need to make choices on whether or not to add production capacity, the definition of good fit projects may narrow. Projects that are no longer in line with the ideal project definition may be encouraged to leave. This article will look at a methodology for defining fit and strategies for de-booking bad fit customers.

Defining Fit

Fit generally falls into one of three categories:

* acceptable margin

* acceptable product mix

* acceptable industry.

In every downturn, pricing gets very competitive. Original equipment manufacturers (OEMs) experiencing drops in demand from their customer base are looking for their EMS providers to share the pain. Also, EMS providers hungry to fill capacity may get into bidding wars that lower price below their preferred margin levels. As demand increases to the point where additional equipment is needed, EMS providers must make a choice on whether or not to continue to support projects beneath their preferred margins.

Another issue is product mix. During this last downturn both the computer and telecommunications industry experienced significant drops in demand. This drop motivated many tier-one EMS providers to migrate their focus from high-volume to higher mix, medium-volume projects.

However, higher mix, medium-volume projects can be harder to manage. There may be less component commonality and resistance to design changes for process optimization. Schedule change requests may be more frequent, and a greater variety in the configuration of individual products may exist. Line changes are more frequent, resulting in lower capacity utilization. The administrative communications requirements have traditionally made this type of business less attractive in lower cost offshore locations. As markets recover and demand starts to increase, customer short lead-time schedule changes may make this type of work even more unattractive to EMS providers optimized for high-volume manufacturing.

Industry outlook may be another issue. Business is a cycle. Booms can be followed by busts, but the reverse is also true. Instrumentation, medical, defense, avionics and automotive tend to be relatively stable markets in terms of demand. While small and mid-tier EMS providers find stable demand attractive, the success of tier one is measured by growth. The telecom, computer and higher end of the consumer electronics industries are poised to enter another growth phase as companies resume capital spending and new technology options in consumer electronics start to hit consumer price points.

Consequently, in determining which projects to keep or de-book, analyze the long-term potential for account fit with the current issues in the project.

Issues to consider include:

* Is a "share the pain" pricing agreement available that would renegotiate prices based on increases in demand or has the customer been given below margin pricing with no conditions?

* Is all business from this customer unattractive or is just a portion unattractive?

* Could unattractive business be deployed in a different facility more aligned with that business model?

* Is the customer willing to work with the EMS provider to achieve a mutually acceptable pricing strategy or will it ultimately move once price changes?

* Are the long-term growth projections for the industry or product acceptable or would this project become increasingly unattractive over time?

* Is the customer's financial stability and commitment to their business strong?

Considering OEM Hardship

Many EMS providers announce their intention to say good-bye through price increases or lack of flexibility. The customer then has to make the decision on when and how to leave.

However, this approach is bad for several reasons. First, it puts the customer in a win-lose negotiating position and includes a surprise factor. They rarely remember how much they saved with below margin pricing. They simply remember that an EMS provider who made a commitment is now changing that commitment with little or no warning. They are faced with the choice of higher unit costs or absorbing transition costs to another supplier on short notice. They may also incur opportunity cost in terms of lost sales, as this transition will be occurring as their demand is increasing. Failure to meet increased demand may translate to loss of market share.

The second issue is that, when bad fit accounts are being de-booked en masse, the market talks. Dissatisfied customers tend to be vocal, and competitors who have not been de-booking accounts will use this negative word-of-mouth in their favor in competing for attractive accounts.

Finally, outsourcing decision makers have very long memories, and a job change may put them in charge of outsourcing at attractive accounts. The manager who takes a credibility hit for choosing an EMS provider who de-books the account will probably never seriously consider that provider again.

Exploring Options

The best option is to avoid taking bad fit accounts in the first place, but after industry downturns few EMS providers can say they only booked good fit accounts.

The first step is to thoroughly analyze account potential and identify issues relative to bad fit. This analysis should be done by the project team. In performing the analysis, contractual commitments and negotiation strategy options should be carefully considered.

Some bad fit accounts are easy to identify and should be first in line if de-booking is necessary. Typically, these are accounts that are either not strong financially or who have a lack of commitment to a long-term outsourcing relationship. Accounts priced poorly who are unwilling to consider increases may also fit in this category. Chances are that no matter how you approach de-booking, these customers will not be happy.

For accounts that are below margin or out of scope for the preferred business model but otherwise attractive, exploring ways to reach a middle ground may be worthwhile. In some cases, a management discussion on changing business conditions may be sufficient to enable an increase in price. Another compromise could preserve pricing on existing projects but change it for new projects. Another option would be to vary pricing based on degree of schedule flexibility desired. A longer term option would be redesign to incorporate EMS provider--recommended cost reductions without a change in price.

Finally, consider strategic alliances in de-booking business. While competition is fierce within a given EMS industry tier, certain business models don't compete. In some cases, tier-one EMS providers outsource bad fit business to smaller competitors as part of their normal business practice.

Consider the option of developing a pool of smaller EMS providers who would be a good fit for de-booked business and offering support in transitioning the project to the provider of the OEM's choice. Part of the deal with the smaller EMS provider might include that they support part of the transition cost in exchange for the business. This option works well for accounts that have a segment of unattractive business that you would like to move and also for bad fit accounts that may become more attractive over time as higher volume projects become available.

Issues to consider in selecting alliance partners include:

* expertise with product/industry process and quality requirements

* attractiveness of location relative to customer needs

* ability to price competitively

* similarity of processes/equipment relative to minimizing non-recurring engineering (NRE) cost

* financial strength of the identified EMS provider

* willingness of the EMS provider to provide a high level of service during the transition

* degree to which you may compete for accounts long term.

Saying good-bye to a customer is never an easy process. Yet, the margins in EMS do not allow for retention of bad fit customers in a stable or growing market. The opportunity cost for failure to identify bad customers is often failure to meet the needs of good fit customers.

Developing a process for identifying bad fit customers and creating an acceptable migration process for them is key to both optimizing the EMS business model and maintaining credibility within the EMS marketplace. Simply pressuring the OEM to either comply with new pricing or leave may be the easiest route, but, long term, it creates negative impressions that may be exploited by the competition.

The key to remember in the de-booking process is that the nature of business model evolution in the EMS industry is such that all EMS providers eventually have bad fit accounts. This reason is why most manufacturing agreements have several clauses defining different termination options for both parties. Most OEMs will understand a well--explained business rationale relative to fit issues. In some cases, they may be willing to make concessions in price or schedule to make the project attractive, if the issues are clearly explained. In other cases, the discussion will need to relate to the best way to migrate the business elsewhere. The differentiation factor between providers is the professionalism that they exhibit in dealing with this potentially awkward issue.

OEM/EMS Breakup: A Real Life Example

While a final resolution has not been found at press time, a jury awarded $934 million dollars against Flextronics International, Inc. in September 2003. The award resulted from a contract dispute with Beckman Coulter, Inc. and is an example of an EMS/OEM relationship gone sour. According to published reports, the contract dispute between the two companies stems from a 1997 contract between Beckman Coulter and a production facility acquired by Flextronics in 2000. Compensatory damages awarded by the jury were only about $3 million of the total amount.

While enforcement of the verdict was subsequently stayed by the judge while the companies discuss a settlement, the issue to consider is that management time at both companies is now being focused on an event that was operationally dealt with and reflected in financial results years ago. While a settlement will eventually have some onetime recognition in both parties' financial results, it is unlikely to change either company's long-term business outlook or competitiveness--it is simply a distraction that now has to be dealt with.

Both companies saw stock price drops immediately after the verdict. The verdict was announced the day before Flextronics' management was set to ring the opening bell at NASDAQ and hold an analysts' meeting. What should have been a day of conversations with analysts about an improving EMS environment and more positive business outlook now had to include answers to analyst and media questions about the dispute.

The nature of the EMS-OEM relationship ensures that some breakups will be inevitable, and rarely will proposed dispute resolutions be equally attractive to both parties. But, this situation offers valuable perspective in the importance of not letting disputes turn into win-lose negotiations. While jury trials are unusual in EMS-OEM disputes, never underestimate the potential resolve of an angry customer. The average jury is never going to fully understand the complexity of this type of arrangement. Finding ways to contractually agree to reasonable arbitration methodologies at the beginning of new relationships and finding acceptable middle ground when disputes do arise are valuable practices.

At the end of the day, neither company in an EMS-OEM breakup wins. In the best case, they leave the table wiser about business relationship structure and the importance of long-term complementary business objectives in an outsourcing relationship.

Susan Mucha is president of Powell-Mucha Consulting, Inc., El Paso, TX; email:
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Title Annotation:Electronics Manufacturing Services
Author:Mucha, Susan
Publication:Circuits Assembly
Geographic Code:1USA
Date:Nov 1, 2003
Previous Article:Is it worth the move? Examine the cost-benefit tradeoffs of shifting manufacturing to new regions.
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