Real problems caused by virtual supply chains

Outsourcing and the virtual supply chain were buzzwords of the 1990s but losses have begun to mount as the electronics sector pays the price of ‘flexibility’.

Companies for which manufacturing was no longer a high-value activity -particularly in the high-tech and electronics sectors – moved to contract out manufacture, believing this would allow them to ‘scale’ production more effectively in response to demand.

In fact, says a new report by management consultant Booz-Allen and Hamilton, outsourcing has caused more headaches than solutions. Unexpected problems have hit earnings and profits.

For companies such as Cisco, Sony, Palm, Compaq, Apple and Philips, outsourcing has contributed to financial and performance difficulties. They have found their new ‘virtual supply chains’ incapable of increasing output when demand surged and impossible to shut off when demand slumped.

Cisco Systems, the data network hardware supplier, is the best example. Early last year shortages of memory and optical components began to constrict production so it could not meet demand.

A year later, hit by the telecoms downturn, it found itself unable to turn off its supply chain, culminating in a $2.25bn write-down of surplus products. In spring this year it announced its first quarterly loss.

Cisco is not alone. A shortage of PlayStation 2 chips meant Sony could supply only half the consoles it wanted for its US launch. Inability of suppliers to Philips to produce enough flash memory chips disrupted production of millions of phones in 2000. Palm’s revenues could have been 10-40% higher if it had been able to get all the LCDs it needed. Compaq, too, faced supply shortages, and was unable to fulfil orders for over 600,000 Pocket PCs.

Outsourcing was embraced enthusiastically, especially by electronics firms, because manufacturing was no longer where they added value. They wanted to focus on design and distribution. Profitability lay in getting products to market quickly, and they wanted to get their manufacturing assets off their balance sheets.

Meanwhile, contract manufacturers were keen to take on the work, seeing this as a route to greater market share, better economies of scale and less exposure to market variability.

The contract manufacturers did indeed experience dramatic growth. Between 1996 and 2000, their capital expenditure grew 11-fold, and revenues increased by a factor of almost four. One, Selectron, acquired 53 production sites and contracts over three years.

So what went wrong? Difficulty on the part of the manufacturers in forecasting demand is at the heart of the problem.

‘Moving to an outsourced model fundamentally changes your business,’ says the report, ‘and the old rules don’t necessarily apply.’ As a result, many of the new relationships were poorly structured.

The outsourcing manufacturers did not realise the importance of informal contacts and the sharing of information within their old integrated organisations, and how this contributed to solving problems when demand fluctuated.

‘There are things you could do when you had in-house manufacturing, like schedule a third shift,’ says Booz Allen principal Bill Lakenan. ‘The marketing guy could call the production co-ordinator and you could make modifications to the forecast.’ This was no longer possible in the new supply chain.

Meanwhile, there was a conflict between the aims of the outsourcers and their contractors. The electronics giants have comfortable profit margins and make most of their money on new products that grab market share ahead of competitors. And the contractors, with profit margins of 3-5%, depend on a stable workflow for profitability. Sudden demands for flexibility are the antithesis of that.

For the future, Booz Allen concludes that this does not negate the benefits of outsourcing – but firms must realise they have built an extra layer into their supply chain and they must make their contracts more flexible.

They should manage capacity as a portfolio, maintaining baseload capacity as well as planning for surges. ‘Outsourcing is here to stay, but for it to work, partners must re-evaluate their relationship and realign their processes.’