This article was originally published by Booz & Company. Asset- and people-intense parts of the business, notably manufacturing, were viewed as a distraction from the high-value parts — product innovation, marketing, and customer understanding. Nortel announced a layoff of 10,000 employees in February. Risk shifting may seem like a logical choice, but it is myopic for two reasons. The report card we’d give to the company and its contractors provides some perspective. P AGE: 7 / 21 IT O UTSOURCING: M AKING IT WORK W HAT HAS GONE WRONG I N OUTSOURCING Some early outsourcing arrangements were unsuccessful for a number of reasons, including: Failure to take a strategic ap proach Participants in this great experiment of outsourcing have been hit with lower total earnings and with lower margins. The solution was outsourcing — farm out all those prickly nightmares. The shortages limited its ability to satisfy customer demand as the market was peaking, ultimately limiting the company’s profitability. Those contracts are simply designed for different types of engagements. 1. The company was embarrassed to reveal the total person-hours across the organization required to create and manage these spreadsheets. 6. Three Major NHS Trusts Reverse Outsourcing Contracts - What Went Wrong? The combination of data analytics and artificial intelligence can give organizations a competitive advantage and mitigate risk along the value chain. 3. Before outsourcing changed the rules, OEMs could take advantage of such in-house production capabilities as capacity; the ability to make changes; and the ability to turn around prototypes. CEMs enthusiastically tooled up to accommodate outsourcing. Companies that master them will turn their big cost and speed advantages into dominance of their competition. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. The following year, SCI Systems Inc. entered into outsourcing arrangements with the NEC Computer, Marconi, and Dell Computer corporations. CEMs, on the other hand, need predictability — they want to make commitments in advance to reap benefits like big-lot purchases and decreased overtime. One company I visited had so many metrics that it needed a thick binder to keep track of everything on a monthly basis. No two outsourcers have identical problems. Service provider blacks out the client. Use a tiered management structure that ensures vertical alignment between the executives and the employees in the organizations that are tasked with getting the work done. Soon after the parts shortage started, most PC and electronics manufacturers missed their 2000 year-end quarterly earnings and revenues and revised their 2001 outlook, blaming the general downturn in the U.S. economy. By insisting on business as usual, CEMs also lost access to informal communication and problem-solving channels. A number of OEMs outsourced manufacturing without recognizing this and incorporating these changes into how they designed their new supply chain. High-tech has been rocked by a series of earnings announcements that have cut the Nasdaq index by as much as 68 percent from its March 2000 peak. Like Lucy and Ethel in the chocolate factory, the company was left with a glut of product and nowhere to put it. Navitaire provided internet booking, reservation, check-in and boarding … As the forecasts vaporized, the company was unable to rid itself of the excesses. The water-cooler comment from the marketing department that “the way these things are selling we may need to work that extra shift after all,” or the flexibility to grab the critical spare parts locked in the just-in-case closet, wasn’t available. In 2000, the five-year, $30 billion agreement between Motorola Inc. and the Flextronics Corporation made a four-year, $10 billion pact between Nortel and Selectron seem slight by comparison. Picking a supplier on value versus price will produce the best long-term results in a strategic relationship because it balances cost and quality considerations, thus ensuring ongoing value for money and promoting continuous improvement to further value for money. © 2020 Forbes Media LLC. The result: A one–two combination that sent them reeling. Reducing the time required for the alignment is the key to profitability. Indeed, the company locked in access to capacity when production lines weren’t running at full capacity, ensuring its ability to scale up better than its competitors. By consolidating production volumes from multiple customers, CEMs could fill their factories and minimize downtime with a portfolio of products across a portfolio of lines. Michael Winkler, executive vice president of Compaq’s Global Business Units, told Fortune last March “…If you take the units, accessories, and some of the services that go along with it, it’s a larger market in 2005 than the traditional PC market.”. While designing the new supply web, they need to keep this uncertainty in mind. But being prescriptive only works when you are buying commodity type goods and services in areas where what you are buying is a core competency. At pennies apiece and with tiny commodity margins, capacitors and resistors need to be sold in major quantities to support the kind of growth necessary to underwrite a fully responsive new factory. //--> Compaq, whose inventory-less strategy led it to outsource manufacturing of the handheld to the Taiwan-based High Tech Computer Corporation, was hit just as hard. Of course, it is tempting just to ask the service provider to do the reporting. • Coordinated Production Planning. Some OEMs were unable to construct an outsourced supply chain that allowed them to bail out when growth didn’t materialize. The business case for outsourcing abroad is simple: a lower cost of goods allows your company make higher profit margins while remaining competitive against other firms. A good example of shared risk/shared reward contract is the Department of Energy’s clean up and closure contract for the Rocky Flats nuclear site, which improved safety rates by more than 800% and resulted in lower insurance and security costs. Think of capacity as a portfolio, and manage it in such a way that you maintain capacity for the baseload as well as the surge when (optimistically speaking) your product takes off. I am a faculty member at the University of Tennessee. They didn’t translate the old practices that had made them successful into their new business relationships. As its customers stocked up to ensure their own ability to meet delivery commitments, Solectron incurred inventory-holding penalties and obsolescence costs associated with the inventory bubble. Too much of a good thing can be bad for you; this applies to bingeing on Halloween candy or to the exhaustive measurement of service providers. For those that can’t let go of their multitude of metrics, I suggest thinking of them in terms of “data.” Yes — you can still capture the data and, if needed, and generate ad-hoc reports or do data analytics. But when it comes to contractual service level metrics keep your dashboard limited to those that truly matter. The company announced a hot new product line: the Ipaq series of handheld devices, with full-color screens, multimedia capabilities, and unmatched portability. If there are unknown risks it must guess high. The Fall The overall message was clear: The OEM/CEM model didn’t scale. Perhaps no company underscored the limitless potential of the New Economy more than Cisco Systems Inc. Last year, Cisco was poised to become the world’s first trillion-dollar enterprise, wielding a market cap greater than that of General Electric Company in pursuit of annual revenue growth projected at 30 to 40 percent. Cisco overcommitted to inventory and capacity as the market was taking off and forecasts were rosy. We expected sales of about 7,000 per month but are a lot closer to 100,000.” A shortage of LCDs, and basic components like capacitors, resistors, and flash memory, had crippled the entire handheld devices market. Another apparent strength was its approach to manufacturing: It didn’t build most of what it sold. Anytime a company chooses to outsource there are risks. Early on, OEMs were wracked with day-to-day execution problems. Outsourcing: The Diagnosis and Prognosis Could there be anything worse than an outsourcing deal gone wrong? What comes next will depend on how well they face up to them. My work has been featured in hundreds of articles in publications like Forbes, Chief Executive Magazine, CIO Magazine, The Wall Street Journal, Journal of Commerce, World Trade Magazine and Outsource Magazine. OEMs need to pick and choose among these capabilities carefully in order to create an integrated supply web. We studied eight major CEMs — Solectron, Flextronics, SCI Systems, Jabil Circuit, Celestica, ACT Manufacturing, Plexus, and Sanmina — that together represent 92 percent of the Standard Industrial Classification market cap. Rather, consider using more collaborative bidding approaches with your suppliers to help you understand the best solution for your situation. By filling the lines, they spread their overhead thinner. And when the grease that smoothed the product flow was not available, the value chain ran rough. Painful lessons from IT outsourcing gone bad In tough times, companies look to shift tech work to outsiders, whether offshore or down the street. With that said, in this blog we will go over the high-level details of what to include in an outsourcing contract. The business insights you need to succeed. When times go bad, their different techniques for fixing problems are incompatible. Other papers confirm this because the focus is on the supplier’s expertise and thinking win-win. “First, the outsourcing contract does not stipulate exactly what the customer expects and what the outsourcer … Between 1998 and 2000, its revenues grew by a compound annual rate of 49 percent; gross profit rose 48 percent; net income increased 42 percent. I am an author, educator and architect of the Vested business model for highly collaborative relationships. Wall Street followed the deal-making with its own kind of gushing praise, rewarding the CEMs and OEMs with bigger market caps while touting their ability to: • Deliver Better Economics. It’s a free download and provides a simple yet effective way to make sure the measures you select for your outsourcing agreement align to your Desired Outcomes. What safeguards can you build into your contracts to reduce the risk of outsourcing and secure a favorable outcome? How well did outsourcing work in delivering the promised benefits in Cisco’s case? The theory was that manufacturing specialists — companies like Solectron, Sanmina, Celestica, Flextronics, and Jabil Circuit — could bring greater focus and expertise to projects, could develop procurement and risk efficiencies better than OEMs, and could lead in innovation if they were encouraged to do so. When you are contracting for outsourced services it is tempting to be as prescriptive as possible about what you are buying to avoid ambiguity and change orders. Also contributing to this article were Booz-Allen’s Keith Oliver, senior vice president (firstname.lastname@example.org), Rosemarie Rivera, senior associate (email@example.com), Nanette McFerran, associate (firstname.lastname@example.org), Koichi Hiura, associate (email@example.com), Jean-Philippe Kouakou-Zebouah, associate (firstname.lastname@example.org), and Angela Quintero, senior consultant (email@example.com). Recent trends in off-shoring have accentuated these difficulties. I have appeared on CNN, Bloomberg, NPR and Fox Business News. With so many companies outsourcing, it is no surprise that there are many arrangements that fail. The parties just haven’t done enough work and communication to stay on the same page with each other. The results of the Depart of Energy contract were impressive — with the supplier meeting all cleanup and closure targets 65 years ahead of schedule and $30 billion under budget. Entertainment and media companies are building business models that are resilient to the enduring changes in consumer behavior ushered in by COVID-19. It is also important that private providers are required to participate in an open transparent investigation with NHS commissioners when things have gone wrong, otherwise lessons will not be learned. Dramatic revenue shortfalls were compounded by the OEMs’ inability to step back from their commitments to inventory and capacity. Old Vertical Thinking. Although the process for creating and producing a single electronic product has become fairly routine, no OEM has mastered the coordination of a web that provides easy, cost-effective access to all those potential outcomes. Solectron doesn’t have a lot of margin to give away to its customers; even a bit of incremental cost significantly affects the bottom line. A high-tech supply chain that relies heavily on outsourcing can be successful, but not if partners approach it with the wrong assumptions. They had different appetites for surge capacity — OEMs were willing to pay for lower utilizations and just-in-case capacity, whereas CEMs were committed to consolidating the industry for better unit-cost production. Cisco’s focus largely blinded it to the possibility that demand might not continue to materialize. With access to “plug-and-play” assembly lines, the CEMs could establish standard practices that would enable them to turn on a dime to start or stop product manufacturing. As a result, there were tremendous pressures to get these less-profitable manufacturing assets off the balance sheet. Certainly, growth in the networking equipment sector slowed and contributed substantially to Cisco’s earnings shortfall. Gone are the days when owning and controlling every aspect of the business was desirable, or even possible. The OEM committed to a build schedule with a frozen production window. My research and work has led to five books, including Vested: How P&G, McDonald’s and Microsoft Are Redefining Winning in Business Relationships. OEMs were connected to the customer and would change the production mix to maximize production of the hits. So when we work together with our CEMs — and if we do our job right — the customers can’t tell the difference between my own plants and my CEMs’ in Taiwan and elsewhere.”. And if robots can learn to do this sort of talking, the applications could be far-reaching. Compaq itself missed fourth-quarter 2000 earnings and revenues after a record third quarter, and later in March cut 5,000 jobs. For companies as varied as Apple, Nortel Networks Inc., and the Nokia Corporation, manufacturing was no longer where they added value; instead, they got paid for understanding customer needs, design, and distribution. The CEM industry’s total market was estimated at $120 billion in 1999, or 15 percent of the $800 billion potential market for contract equipment manufacturing identified by the high-tech market research firms IDC and Forrester Research. Demand for the device outpaced supply 25 times, and Compaq executives were enthusiastic about its market potential. The sum of the pieces create a frightening whole: The aggregate market value loss of 12 major OEMs — Cisco, Dell, Compaq, Gateway, Apple, IBM, Lucent, Hewlett-Packard, Motorola, Ericsson, Nokia, and Nortel — over the period from March 2000 to March 2001 exceeded a staggering $1.28 trillion. Companies picked up the mantra of customer focus and concentrated on getting a wider array of products to the market. From 1996 to 2000, capital expenditures grew 11-fold, revenues increased almost 400 percent (see Exhibit 1), and market capitalization experienced an exhilarating compound annual growth rate of 87 percent. When outsourcing didn’t work, they exacerbated their problem by pulling the wrong levers trying to fix it. IT Outsourcing Deals Gone Bad By Steve Martin Print Before embarking upon an IT outsourcing transaction, CIOs should recognize an immutable principle - there is a high probability that their IT outsourcing contractual arrangements will not survive the initial term and extension periods. Formal contracts simply couldn’t capture that attitudinal energy — the kind of corporate-wide entrepreneurial spirit that had made so many OEMs successful. Salvaging an IT outsourcing deal gone bad. Asking the supplier to provide Gross Maximum Price for facilities management contract that includes snow removal will just mean the supplier had to guess high at the number of times it will likely snow. How to Develop a Successful Outsourcing Contract. Lessons from Cisco and Compaq The second – and most compelling reason — is that risk shifting does not necessarily mean the risk has gone away. In other cases, both parties in a contract will end up suffering as a result of being locked into it. This much we have learned: Although there are any number of options to build with (different plants, product flows, configurations), the OEMs can’t predict with any accuracy the specifications of what they will need. So although some common components like flash memory might be mined for other uses, most of the value in the core chip sets, assembly integration, and tests is lost. As a result, balance sheets became bloated. We are not lawyers. And customers complained as the marketing machines continued to help create unfulfilled demand. James Hills, president of marketing firm MarketingHelpNet, … Profitability forecasts at the unit level took a direct hit. The Compaq report card helps provide an overview. The resulting $2.25 billion overhang reflected the company’s outstanding contracts with CEMs as well as a measure of all the inventory it needed to write down. In deal after deal after deal, the partnership announcements were the stuff of headlines: In 1998, Silicon Graphics Inc. signed a five-year supply deal with Celestica Inc. “Improved scale and scalability,” they promised. But if you are procuring outsourced services it often backfires. After the 2000 second quarter, however, demand for handheld devices in general was outpacing supply, and most companies, including Compaq, Palm, IBM, and Ericsson, were losing customers and orders. When an organization is penny wise and pound foolish you often find the ‘A’ team from the service provider turns into the ‘C’ team as the service provider scrambles to make a profit. “The supply chain has been clogged with gobs of capacity and inventory,” they confess. In this case, avoid the Outsourcing Paradox. You want to ensure you are paying the supplier a fair profit so it can get the right level and skill of employees to do the job. There are some indications, however, that the OEM/CEM model it employed was a contributing factor as well. Only with adequate attention to both the why and the how will outsourcing deliver on its promise. Solectron held on to inventories more than two weeks longer in the second quarter of 2000 than in the fourth quarter of 1999 to cover its uncertainty about component availability. Spread their overhead thinner on how well they face up to expectations for many reasons — foreseeable. 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