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 / Third Quarter 2001 / Issue 24(originally published by Booz & Company)


Why Cisco Fell: Outsourcing and Its Perils

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. 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. The Solectron Corporation itself is a lesson in CEM expansion. (See Exhibit 2.) In 1997, it extended its presence with just one new acquisition. In 1998, it picked up another five; in 1999, 10; and, in 2000, it surpassed the total number of acquisitions in the previous three years with 27.

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. The following year, SCI Systems Inc. entered into outsourcing arrangements with the NEC Computer, Marconi, and Dell Computer corporations. 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. 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. 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. By filling the lines, they spread their overhead thinner. And they weren’t exposed to gaps caused by the ebb and flow of a collection of hit-driven businesses. By aggregating component volume from multiple customers, CEMs could buy parts in bulk and at lower costs.

Improve Scalability. 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. Because they had plenty of materials on hand, they would also be able to react better to changes in macro demand.

Reduce Inventory. Contract manufacturers could pool the inventories of multiple customers on similar items — components and boxes, to name two — and reduce overall inventory levels and costs while maintaining effective coverage against changes in demand.

Create Distribution Benefits. When CEMs possessed the right geographic footprint, shipping the finished good directly to end-users was a viable option.

Sharpen Focus. Outsourcing the essentially commoditized manufacturing functions would allow OEMs to concentrate on their core capabilities — innovation and owning the customer. The CEMs’ greater experience in manufacturing would yield quicker ramp-up of new products, smoother production processes, and speedier solutions to unexpected problems.

CEMs enthusiastically tooled up to accommodate outsourcing. They grew in scale — Solectron alone acquired 53 facilities and production contracts over three years — and increased their scope of work. To become one-stop shops, CEMs moved from simple board-stuffing to complete assembly of sophisticated components, as well as such higher-value activities as testing and aftermarket support. By providing more services, they set out to become a more integral part of the manufacturing process while creating stickier customer relationships. Indeed, for the next several years, the fates of Nortel and Solectron are inextricably bound together by a supply contract that all but mandates a seamless partnership.

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. Analysts predicted that CEMs would capture more than 40 percent of this outsourcing market (primarily computing and communications hardware products) by 2004.

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  1. Scott Buckhout, Edward Frey, and Joseph Nemec Jr., “Making ERP Succeed: Turning Fear into Promise,” s+b, Second Quarter 1999; Click here.
  2. Lawrence M. Fisher, “From Vertical to Virtual: How Nortel’s Supplier Alliances Extend the Enterprise,” s+b, First Quarter 2001; Click here.
  3. Keith Oliver, Anne Chung, and Nick Samanich, “Beyond Utopia: The Realist’s Guide to Internet-Enabled Supply Chain Management,” s+b, Second Quarter 2001; Click here.
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