MILT GREGORY
Original equipment manufacturers (OEMs) commonly use metrics to allocate assets and develop strategies for future performance. Department budgets are calculated, goals are set and success or failure is measured by a carefully predetermined set of metrics. Unfortunately, this same level of precision is often not applied to calculate the return on investment provided by outsourcing.
Some OEMs still take a tactical approach to maximizing profitability by cutting costs to the bone. The strategist, however, uses outsourcing to restructure the corporation around core competencies and outside relationships, thus focusing on long-term issues connected with an organization`s strategic direction.
Accurately evaluating the financial ramifications of outsourcing is important in the volatile semiconductor equipment market, where technology advances rapidly and faster time-to-market is the Holy Grail. For OEMs manufacturing very complex systems (defined as $3 million-plus, with 10-20,000 parts, a dozen integrated technologies and order-to-delivery timelines of under four weeks), evaluating outsourcing with accurate financial metrics is imperative.
Financial metrics enable OEMs to accurately quantify factors affecting capital investment decisions and inside-vs.-outside costs. Metrics also provide data that can be used to manage and control the level of economic and product volatility. This article describes how to employ standard metrics, such as return on assets (ROA), return on equity (ROE) and return on invested capital (ROIC) (Table 1), to effectively evaluate the outsourcing decision. Examples of leading semiconductor capital equipment suppliers using electronic manufacturing services (EMS) providers are included. Engineers and managers will also learn why attention to financial metrics, especially new metrics, such as EVA, can no longer be considered the exclusive concern of executive management.
Surviving the Volatile Semiconductor Market
The increase or decrease in production of capital equipment for the semiconductor industry is directly proportional to the health of the semiconductor market. Unfortunately, 1998 was one of the worst years in the industry`s history. However, industry analyst Dataquest projects stellar growth in the next few years, with chip makers` worldwide capital spending projected to climb 27.4 percent to $37.1 billion for 2000 and $59.4 billion in 2001.
One of the fastest growing segments of the semiconductor industry is the fabrication of interconnects – structures that “connect” the ever-increasing number of transistors within a semiconductor circuit. For the first time in history, the reality of Moore`s Law, which states that the number of transistors on an integrated circuit (IC) doubles every 18 months, is being challenged by the law of physics.
Semiconductor manufacturers are being asked to build devices that are more powerful by adding levels of metal without increasing circuit geometry or cost. To resolve the resistance and capacitance problems incurred with aluminum conductors and silicon dioxide dielectrics, a handful of chip makers, including IBM, Motorola, Texas Instruments, Novellus and Applied Materials, are racing to implement devices with copper interconnects. Copper reduces the number of interconnects by as much as 50 percent, potentially eliminating up to 200 process steps. That`s good news for a market hungry for faster, cheaper, and smaller devices and great news for capital equipment makers who are developing and manufacturing systems for new copper-based processes.
Although Applied Materials Inc. (Santa Clara, Calif.) is the largest supplier of wafer fabrication systems and services to the global semiconductor industry, Novellus Systems Inc. (San Jose, Calif.) (ranked a mere number eight in the list of the top 10 semiconductor equipment manufacturers by revenue), could be in the best position to cash in on the industry`s move to copper wiring.
Mark FitzGerald, a semiconductor capital equipment analyst with Merrill Lynch, believes that sales of copper tools will account for 30 to 35 percent of Novellus` total revenues in 2000, while competitor Applied Materials` copper tools sales will account for only 10 to 15 percent.
In addition to pioneering some of the technologies associated with this new process, Novellus uses an outsourcing strategy for the manufacture of major subassemblies, enabling the company to minimize its fixed costs and capital expenditures while also providing the flexibility to increase capital. According to a recent report by BT Alex Brown Research, this outsourcing strategy allows the company to focus on product differentiation through system design and quality control. By using third-party manufacturing specialists, a company can ensure that its subsystems incorporate advanced technologies in robotics, gas panels and microcomputers. The report concludes that, by working closely with its suppliers, Novellus is able to achieve mutual cost reduction through joint design efforts.
According to a recent report in Forbes, Novellus` strategic alliances to make next-generation chips were beneficial at a time when equipment stocks were weak and did not possess much buying power. Now, with a resurgence of equipment stocks, Novellus can outpace other companies that have been late to the table with copper processing tools, such as deposition, etch and CMP systems. This strategy has also given Novellus the currency to buy other companies that can further increase its technical dominance of dual damascene copper processing for IC interconnects.
This is not to imply that Applied Materials is in a slump. The company has expanded its line of products for the volume production of high-speed, copper-based chips and also reported that new orders for the second fiscal quarter of 1999 reached a record $1.39 billion, an increase of 35 percent from $1.03 billion for both the first fiscal quarter of 1999 and second fiscal quarter of 1998. Net sales of $1.12 billion were also up 51 percent from $742 million for the first quarter of 1999. In comparison, Novellus` annual report lists sales of $518.8 million for the entire 1998 fiscal year.
The lessons to be learned from this David vs. Goliath success story are the financial benefits derived from strategically allying with and outsourcing to manufacturing partners. Very complex system outsourcing requires a strategic relationship between the client and a complex system contract manufacturer (CSCM) that goes beyond purely tactical relationships in subcontracting for services with outside vendors. The available services make a profound difference in outsourcing complex systems. For example, technical CSCMs offer concurrent development capabilities, and an OEM/CSCM team approach to product and equipment design and development, manufacturing and test.
The added-value results stem from the very tight coupling of development with manufacturing, the technical skills required to assemble, integrate and debug technically difficult systems that encompass multiple technologies, and unusually tight performance windows. However, before a semiconductor equipment OEM can outsource effectively, it must decide whether it is outsourcing for tactical or strategic reasons.
Tactical vs. Strategic Outsourcing
An Outsourcing Institute study1 found that tactical and strategic outsourcing are driven by different factors. Typically, OEMs that outsource tactically are driven by the desire to reduce or control operating costs, reduce capital funds invested in non-core business functions and secure physical, technical or geographic manufacturing resources that would not otherwise be available. Tactical outsourcing can also give an OEM the opportunity to receive an infusion of cash (as an OEM`s assets transferred to the outsource vendor) and eliminate functions that are difficult to manage or control. Basically, tactical outsourcing increases profit margins without much effect on the asset structure (the denominator of the financial return on assets metric). The internal workings of the company are minimally affected and minimal partnership and communication with suppliers is required (Table 2).
Strategic outsourcing involves the wholesale restructuring of a corporation around core competencies and outside relationships. Moreover, it changes an OEM`s way of doing business and focuses on long-term issues, more to an organization`s strategic direction. Strategic outsourcing improves business focus toward core competencies and provides access to world-class capabilities. It can accelerate organizational change and enable the OEM to pursue new ideas. OEMs who outsource strategically share risks with the EMS supplier and free resources from non-core activities.
OEMs that outsource strategically most often seek to change their cost structure by moving fixed costs to variable costs to gain the greatest return on assets. However, this perceived need often obscures the potentially greater savings that could be gained using a variety of financial metrics to maximize strategic outsourcing.
Metrics: A Self-fulfilling Prophecy
John R. Hauser (Massachusetts Institute of Technology and the Sloan School of Management) recently presented the theory that every metric, whether it is used explicitly to influence behavior, to evaluate future strategies, or simply to take stock, will affect actions and decisions.2
If an OEM measures a, b and c, but not x, y and z, then managers begin to pay more attention to a, b and c. Activities that result in high performance, as measured by a, b and c metrics, are encouraged. Soon, the entire organization is focused on ways to improve a, b and c metrics and the OEM becomes what it measures.
For example, if R&D managers know that projects are chosen based on projected net present value (NPV), they will encourage engineers to work on programs and forecasts that make NPV look good – even if the NPV calculations are misleading. In another example, if the only metric used to measure success of the R&D department is an effectiveness index (the percent of profit obtained from new products divided by the percent of revenue spent on R&D), engineers will choose projects that are less risky, and consequently, short-term oriented.
Choosing the right metrics is critical to success. Metrics must be chosen so that actions and decisions that move the metrics in the desired direction move the firm`s desired outcomes in the same direction. By focusing metrics on the desired outcome rather than on the work processes, OEMs are free to identify new paradigms and discover new, more efficient, ways to accomplish goals.
Strategic outsourcing helps point OEMs toward the right metrics. Outsourcing benefits can include inventory reduction, increased turns and lowered equipment, facility and personnel costs, and increased productivity, ultimately resulting in higher ROA, ROE and ROIC. Additional benefits include faster time-to-market and time-to-volume, which means greater competitiveness, market share and profitability.
Using Operational and Financial Metrics
Financial metrics can be used to measure the economic consequences of past management decisions, including the effective use of resources, and to control and direct future performance, including profitability expectations and prudent financial choices. Financial metrics can also be used to educate and inform audiences with differing points of view, including investors, managers, lenders and creditors.
Metrics can be developed to measure a wide range of financial performance issues, including profitability, disposition of earnings, operational analysis, resource management, liquidity and financial leverage. However, for OEMs in the semiconductor industry, the financial ratios of primary interest are ROA, ROE, ROIC (also called ROTC or RONA) and earnings before interest and taxes (EBIT).
Outsourcing Increases ROA
ROA can be defined as the return before interest and taxes, the return after taxes but before interest, or the return after taxes and interest. ROA measures company performance based on the amount of assets needed to produce a given level of earnings and reflects how well a company allocates and manages resources. ROA is also the financial measure most closely linked with a company`s market value and, therefore, its per-share stock price.
ROA can be increased by increasing profit margin and increasing asset turnover ratio. Tactical outsourcing addresses profit margin by relentlessly pursuing lower materials costs, while strategic outsourcing addresses the asset turnover ratio by reducing the amount of assets required to run the business. Strategic outsourcing changes cost structures by moving fixed costs to variable costs, enabling OEMs to experience an even higher ROA.
ROA measures management`s ability and efficiency to use a firm`s assets to generate profits and reports total return accruing to all providers of capital, both debt and equity. When properly defined, ROA can be used as a comparative measure between firms with differing capital structures. The effects of outsourcing are dramatically demonstrated by changes in ROA because both the numerator and denominator are affected.
Improving ROE, ROIC, and Achieving Sustainable Growth
One of the most widely published corporate statistics, ROE is used by the media and financial rating agencies to rank companies and industry sectors. Consequently, ROE is closely watched by stock market analysts, management and boards of directors. Analysis of ROE components is often called “the Dupont model” because the E.I. Dupont De Nemours and Co. and its consolidated subsidiaries provide a set of measurement challenges common to many manufacturing companies.
ROE can be calculated using before tax earnings or net income. Although important to analysts, ROE focuses only on the ownership portion of capital structure and cannot be used to compare companies with widely differing capital structures. It also ignores the quality of capital structure.
Outsourcing provides many opportunities to positively affect ROE. Outsourcing increases EBIT and reduces interest expenses by reducing the need for debt. While the ROE ratio benefit is not as dramatic as ROA from reduction in asset usage, outsourcing operations increases EBIT by reducing operating expenses and the cost of goods sold (COGS). Outsourcing operations also reduces total assets, the amount of current assets (e.g., inventory) used and the need for fixed assets. For example, factory floor space requirements are lower, especially when tooling and fixturing are outsourced.
ROIC measures the returns to all providers of capital, debt and equity. Also referred to as return on net assets (RONA) and return on total capital (ROTC), ROIC is calculated using pretax, pre-interest profit. Debt included is non-trade debt, which circumvents the distortion of ROE. Unlike ROE, ROIC allows comparison of companies with widely varying capital structures. Outsourcing positively affects ROIC by increasing EBIT and reducing the need for assets, which indirectly reduces the need for debt.3
Achieving sustainable growth is another challenge for many OEMs, as owner equity limits the rate at which a company can increase its sales. As equity grows, liabilities can increase proportionately without altering capital structure. Growth in equity and liabilities determines the rate at which assets expand, while company growth determines the rate at which the owner`s equity expands.
Outsourcing can help balance growth rates. For example, if growth is too high, outsourcing enables OEMs to sell new equity, increase market leverage, eliminate sources of excess growth and increase prices. If growth is too low, outsourcing enables the OEM to return money to shareholders and acquire new sources of income.
The New Metric for Measuring Shareholder Value
As in any discipline, there are differences of opinion between academics and practitioners over financial performance measurements. Academics argue that ROE is flawed – that management`s goal should be to maximize stock price. Practitioners argue that the impact of business decisions on stock price is unclear because stock price relies on many factors not under management`s control. While some studies show a correlation between ROE and stock price, others show that share price is more closely correlated to ROIC. Fortunately, outsourcing can increase both ROE and ROIC.
This debate is not new. Twelve years ago, author and financial theorist Alfred Rappaport argued that management`s primary responsibility was to company shareholders. Rappaport eschews the most common measures of a company`s performance, such as ROI. Instead, OEMs should concentrate on developing a shareholder value approach that measures “value drivers,” such as sales-growth rates, operating profit margins and cost of capital. According to Rappaport, managing stock price should become a core competency.
However, it is important to remember that earnings growth does not always explain stock price performance. Economic value added (EVA), a new metric developed by G. Bennett Stewart, III, and his partners at consulting firm Stern Stewart & Co., examines other drivers of the majority of shareholder value creation. EVA has been gaining adherents in the institutional investment community.
Instead of focusing on EPS growth and other time-worn metrics of corporate performance, EVA starts with the intuitive notion that investors and management should look at cash-on-cash returns on capital that is invested in a business. EVA helps investors look past accounting distortions and identify those management and economic models that generate a truly positive economic return for shareholders.
EVA is a measure of operating profit adjusted for the cost of capital employed. It is officially defined as net operating profit after taxes subtracted with a capital charge.
EVA purports that shareholders must earn a return that compensates the risk taken. In other words, equity capital has to earn at least the same return as similarly risky investments at equity markets. If that is not the case, then there is no real profit made and the company operates at a loss from the viewpoint of shareholders. Stewart estimates that companies using EVA have posted annual returns of 22 percent vs. 13 percent for competitors.5
Compared to the more common financial metrics, EVA measures the difference of after-tax operating profit minus the cost of capital employed in generating the profit, while ROA measures company performance based on the amount of assets needed to produce a given level of earnings. ROA metrics are still valuable as basic measures of efficiency, reflecting how well a company allocates and manages resources. EVA, however, considers that equity has a cost while ROA (and other metrics) don`t. EVA captures the amount of value created by subtracting a capital charge from profits generated by a project or product. When consistently and rigorously applied, it ensures that a company acts in the best long-term interests of its shareholders.
With EVA, outsourcing becomes even more a business decision. Although not a panacea to accurately calculate financial payoffs for all programs, products or projects, it is one of the more effective tools available to measure the tactical, as well as strategic, importance of insourcing vs. outsourcing, especially where complex systems are concerned.
Integrating Financial and Non-financial Metrics
To make success measurable, Smith notes that, in addition to financial metrics, manufacturing challenges can be further measured by some combination of speed, on-spec quality and positive yield. Speed relates to the time it takes for a process to be complete, i.e., time-to-market (TTM). To develop a metric for TTM, the production process must be clearly defined, along with the starting and stopping points of that process. For example, if prototype design uses a significant amount of an OEM`s resources, then that process should be included in a TTM metric.
On-spec metrics derive from production and operational standards, legal and regulatory requirements, and customer and competitive demands. For this family of metrics, it is important to focus on specs that are known and defined, because those that are unknown (e.g., presumed customer expectations) cannot be intentionally achieved. Unknown aspects can be loosely grouped as positive yields.
Positive yields are the metric that answers the question, “What is this company trying to accomplish for its customers, shareholders and itself?” While many positive yields can be familiar objectives, such as revenues, profits and market share, others are not as commonly considered, such as the positive yield of a manufacturing partnership or a strengthening of core competencies.
Outsourcing to CSCMs satisfies all three non-financial metrics, in that it improves time-to-market and quality, provides sustaining engineering support, mitigates the impact of business/ economic cycles and moves risks to the contract manufacturer, thus enabling the OEM to concentrate on long-term goals with positive yields.
Concurrent Development Achieves ROA
Outsourcing allows OEMs to reduce investment in fixed assets, such as plants and people, and to “rent” qualified capacity from a CSCM. When confronted by an economic downturn, the OEM can rapidly shed that capacity. Outsourcing also allows OEMs to transfer large amounts of fixed costs to a third party and to buy them back as variable costs in the form of purchase orders. The OEM manufacturing organization`s direct access to an alternate source of development engineering talent also frees up development resources.
In the EMS industry, the use of CSCMs to build complex, multi-technology systems is an accelerating trend. Seagate, the world`s largest disk drive manufacturer, strategically outsources complex systems so that it can concentrate on high value-added disk drive design and marketing. This enables the company to track market changes faster while being less affected by periodic industry plunges. Compared to its competitors, Seagate has better profitability, productivity and ROE/ROA.
An OEM`s overall strategy determines the kind of outsourcing partners that match its products and its marketing approach. The best partners fill the holes in the OEM`s skill and competency sets to make a strong overall package.
For example, CSCMs are hybrid organizations possessing strong system manufacturing and development engineering skills. CSCM engineers provide concurrent development, cost reduction, and sustaining engineering as well as support for manufacturing. The difference in the use of CSCM engineering resources versus an OEM is that the OEM focuses on development engineering of the next product while CSCM engineers are focused only on production of the OEM`s system. For OEMs facing TTM pressures for complex semiconductor capital equipment, concurrent development helps achieve ROA and time-to-market and time-to-volume goals.
Analogous to concurrent engineering, concurrent development is broader in scope, as it reaches backward to the initial stage of product development and forward into production and test. Development engineering capability allows CSCMs to be involved with a product at any time during its development or manufacturing life cycle, whether during concept design, development, prototype, pre-production, transfer to production or full production. CSCMs have mastered the rapid product transitions from development into production and beyond.
As very complex systems are difficult to integrate and demand broad and high level expertise, true concurrent development must aggregate manufacturability and reliability/testability into all early and late stages. This comprises concurrent development including design for manufacturing, prototype development, support during transition to production (including CSCM staff education), production trouble-shooting, development of testing concepts, production cost reduction and sustaining engineering. The level and complexity of the development process is highlighted by its primary purpose of achieving faster TTM and higher ROA.
Conclusion
To be successful, semiconductor OEMs must learn how to mitigate the risk of roller-coaster silicon cycles. This can be done by strategically outsourcing to reduce cash invested in current assets, such as inventory and in fixed assets, by increasing EBIT with reduced manufacturing overhead and by using vertically integrated EMS providers capable of reducing material and labor costs, thus decreasing operating expenses through a reduction of ROA.
Outsourcing involves the extensive participation, understanding and interaction between the OEM and the CSCM, a deep strategic relationship that means concurrent development with all its engineering offload potential for the OEM`s development staff. Accordingly, OEMs once reluctant to outsource products because of product complexity now reap the benefits of third-party complex systems assembly. Strategic outsourcing using concurrent development in a true partnership is the best way to build complex systems.
Strategic relationships with a CSCM providing concurrent development with attention to financial metrics provide positive financial results for all semiconductor OEMs, but particularly for complex systems manufacturers serving the semiconductor industry. AP
References:
1. “Tactical and Strategic Reasons for Outsourcing,” The Outsourcing Institute, 1998, New York, NY.
2. John R. Hauser and Gerald M. Katz, “Metrics: You Are What You Measure!,” European Management Journal,1998 Applied Marketing Science.
3. Robert C. Higgins, Analysis for Financial Management, New York, Irwin/McGraw-Hill, 1998.
4. Alfred Rappaport, Creating Shareholder Value: A Guide for Managers and Investors, Free Press, 1997.
5. G. Bennet Stewart III, The Quest for Value: The EVA Management Guide, Harper Business, 1991.
MILT GREGORY, president and CEO, can be contacted at Gregory Associates, 575 Dado Street, San Jose, CA 95131; 408-432-8080; Fax: 408-432-8330; E-mail: [email protected].
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