Why ODM Evolution Puts HP and Dell at Risk

The mounting suicides at Foxconn have put that company squarely in the media spotlight, and not in a good way. Those deaths are human tragedies, and one can only hope that the factors that contributed to them will be identified and addressed so that similar incidents can be prevented.

As the vast size of Foxconn’s manufacturing plants and campuses attest, contract manufacturing has grown into an enormous business, one that continues to evolve far beyond its humble origins. In the past, contract manufacturers built or assembled finished products on a third-party basis for brand-name consumer-electronics companies. In recent years, however, their mandate has expanded.

At first, the business bifurcated between those delivering outsourced electronics manufacturing services (EMS) and those categorized as original design manufacturers (ODMs). As the names suggest, the former restricted itself to providing traditional contract manufacturing whereas the latter offered design and development as well as manufacturing services.

Until  recently, as Joseph Wei wrote last year, Foxconn, Flextronics, Jabil, Sanmina and Celestica were classified  as EMS vendors, while companies such as Compal, Quanta, Wistron, Pegatron (ASUSTek),  and Inventec were deemed ODM vendors. Increasingly, though, the distinction between the two classifications has blurred.

The aforementioned companies are extending and expanding their capabilities. Acer founder Stan Shih has noted that bare-bones EMS companies eventually will disappear or transition into what he called design manufacturing services (DMS). That’s a transformation Foxconn and others are undergoing, strengthening their R&D and design services to offer more value to consumer-brand clientele.  In adding design and development to their services portfolio, companies formerly in the EMS business mitigate distinctions between themselves and their ODM counterparts.

Although many of these firms originated in Taiwan, nearly all have Chinese operations, which are growing quickly. Like China itself, these companies are eager to ascend the value chain. Cut-price manufacturing of consumer electronics has been a good business for them, but the margins are wafer thin and the competition is fierce. (Then, of course, there are the dispiriting and sordid issues relating to sagging employee morale.) The more value a company can offer its consumer-brand clients, the more margin and profit it can make.

Now let’s turn this around, and look at it from the perspective of shareholders in the brand-name consumer-electronics companies availing themselves of the services of Foxconn, Wistron, and Quanta. For a Dell or an HP, the obvious appeal of doing business with a DMS vendor is that it reduces your development and engineering costs, especially as you outsource a greater proportion of design and development to a third party.

As that happens, however — at least in PCs, netbooks, tablets, and even smartphones — the value of the brand-name consumer-electronics firm increasingly inheres in the commercial appeal of the brand. But in little else. If HP or Dell ceases to design and develop many of its products, what is its value in the marketplace? Moreover, what is its competitive differentiation or barrier to competitive entry? Such companies, at least in these particular markets, are only as strong as their brands.

After all, a competitor can easily contract with ODMs or DMSs to have similar, if not identical, products brought to market. As the ODM assumes a greater share of value creation in its bid to attain better margins, it effectively gains more power in the broader ecosystem. Brand names will depend on it to provide designs and development as well as manufacturing. But that design and development is not exclusive; it can be provided to any company willing to do business with it.

This is one reason why Stan Shih said earlier this year that American PC vendors HP and Dell might eventually be rendered extinct within the next 20 years. (Conceivably, it could take less time than that.)

Said Shih:

“The trend for low-priced computers will last for the coming years. But U.S. computer makers just don’t know how to put such products on the market. U.S. computer brands may disappear over the next 20 years, just like what happened to U.S. television brands.”

There’s a real danger that, at least in the realm of PCs and related products, America’s top vendors have sacrificed long-term viability for a short-term reductions in operating expenditures. In transferring design and development overseas, increasingly to China, what defenses do they have against lower-priced offerings that essentially will be the same as their own products. Their only defense will be provided by their marketing departments, which will promote brand identity and equity. The care and feeding of those marketing departments, paradoxically, will result in higher corporate cost structures than those incurred by their Asian (increasingly Chinese) rivals.

It’s a daunting dilemma, one that Apple has been keen to avoid. While Apple uses contract manufacturers such as Foxconn, it has been careful not to outsource its storied design and development to companies overseas. Unlike its North American PC rivals, Apple sees design and development as integral to the value of its brand. For Apple, the brand isn’t just, well, the brand. Instead, the brand derives its power at least as much from design and development (R&D) as from advertising and marketing prowess, though Apple is undeniably skilled in those dark arts, too.

Apple knows that product differentiation, based on the technological innovation, still matters. HP and Dell might have to learn that lesson the hard way.