The following commentary is Bob Ferrari’s weekly guest posting on the Supply Chain Expert Community web site.

In June of 2011, I penned a Supply Chain Expert Community commentary, Hon Hai’s Annual Meeting Provides Signpoints for a Changed Contract Manufacturing and Value-Chain Model. That commentary reflected on how the largest contract manufacturer in the world was communicating new strategic direction and important strategic messages for high tech and other industry players to contemplate. Current CMS operating margins averaging 2-3 percent are not sustainable when other parts of the high tech and consumer electronics value-chain are generating far higher margins, including OEM’s such as Apple.

The above Community commentary was followed in March 2012, Will Apple’s Supply Chain Strategies Take a New Turn?  This commentary apparently was of interest to this Community since it has recorded over 800 views to-date. The name Apple obviously draws more reader attention. The takeaway from my March 2012 commentary was that strategy changes were forthcoming for Apple’s supply chain for a number of stated reasons, the most obvious being developments coming from Hon Hai/Foxconn.

Nine months later, as we wind down 2012, snippets of information continue to support the premise of a significantly changed contract manufacturing model.  The latest edition of The Economist magazine features an article on Foxconn, (paid subscription or free metered view) which I recommend for Community reading. The sub-title of this article summarizes the gist: Can Foxconn, the world’s largest contract manufacturer, keep growing and improve margins now that cheap and willing hands are scarce?  Foxconn, who employs upwards of 1.4 million workers across 28 campuses within China alone, cannot find adequate numbers of affordable workers to fill needed positions. A strategy to move facilities to inland areas to take advantage of other untapped sources of labor is yielding mixed results.  More importantly, there is a continued reality that in order to grow revenues and profitability, Foxconn must continue its strategy for both increased factory automation, but more importantly, of horizontal integration up and down the consumer electronics value-chain.

The Economist article astutely points out that increased expansion to inland facilities will ultimately add higher inventory and logistics costs, increased direct labor costs as well as declining government subsidies. Instead, Foxconn is moving down the value-chain by buying a previous equity stake in LCD supplier Sharp, which could possibly lead to a rumored line of Apple designed and brand high definition televisions. This CMS firm has also moved into other component areas including metal finishing, enclosures, batteries, lenses, speakers and other value-chain areas.  Upstream, there are efforts to leverage Foxconn’s logistics and fulfillment muscle to provide OEM’s and retailers guaranteed inventory management and replenishment services. While Hon-Hai/Foxconn chairmen Terry Gou continues to deny that the firm will ever offer its own branded products, the reality at some point would be that this CMS will de-facto, control a good majority of the manufacturing and logistics value-chain. With Apple representing what the Economist estimates as 40-50 percent of Foxconn revenues, Foxconn can ill afford to aggressively press for higher margins.  However, other OEM’s and product areas may well present more opportunities for applying full value-chain integration and margin expansion opportunities.

Thus we have another checkpoint regarding manufacturing and supply-chain strategy for the high tech industry. If firms feel that continuous product design and innovation, coupled with close proximity and communication with manufacturing is of strategic advantage, than they may want to re-think strategic direction.  If on the other hand, individual product design alone is perceived to be the sole strategic advantage, with the majority of the value-chain outsourced to an offshore, full-service CMS provider, than we might adopt the terminology as being “the Apple model”.

Candidly, this author believes that there are strong arguments for either model. However, how you decide to manage and oversee either model has vast consequences in terms of people and technology enabled capabilities.

One final obvious conclusion.  If industry analyst firm Gartner continues with its Top 25 Supply Chains ranking, it had better internalize the implications of a changed contract manufacturing value-chain model.  The weighting of higher Return on Assets (ROA) negates full capability, reach, and supply chain competency of the new contract manufacturing business model.  Is there no wonder why the world’s largest contract manufacturing firm never appears?

What’s your view?

Bob Ferrari

Today’s edition of the Financial Times reports that two of Germany’s largest ocean container shipping companies, Hapag-Lloyd and Hamburg Sud, are engaged in talks over a possible merger of the two lines.  Both companies issued statements indicating: “if, and under what conditions, a merger of both companies would be of interest.”  FT notes that if this merger comes to pass, it would represent the world’s fourth largest container shipping line with a capacity of more than one million TEU’s, a combined fleet of 250 vessels and over €11 billion in revenues. The deal, if consummated, would represent a stronger challenge to industry dominants Maersk Line and Mediterranean Shipping Company.  FT further notes that the last time consolidation occurred in the ocean container transport  sector was six years ago.

Supply Chain Matters has been continually reinforcing our belief that the ocean container industry is currently anchored in way too much capacity and arrogance toward shipper needs. Current business and rate setting decisions are geared more toward justifying a level of profitability in spite of customer needs for reliable and cost efficient rates.   As more and more overseas shippers elect modes for surface transportation, ocean container lines respond by slowing down steaming times to lower fuel consumption costs while imposing multiple interim container shipping rate increases, all with a global economic environment of declining shipping volumes.

There is also another linking part of this ongoing problem for the global ocean container industry. Business news channel CNBC featured a recent New York Times story, that certain German banks have a problem of titanic proportions.  According to Moody’s Investors Services, 10 of Germany’s largest banks hold an estimated $128 billion in outstanding credit and other risks related to the global shipping industry. That amounts to double the debt held from countries such as Greece, Ireland, Portugal, Spain and Italy.  It turns out that financing ship purchases is a popular German tax shelter and thus these banks helped to fuel the glut in purchases of more and larger container ships.  We would add that these efforts also provided a boom for Germany’s shipbuilding industry. One German banking executive is quoted as indicating that grave mistakes were made in the years prior to 2009. Certain German banks are now making provisions for potential losses on industry loans.  Meanwhile, some estimates indicate that some 300 container ships continue to lie idle around the world while other lines can literally acquire an older excess vessel for the mere cost of its scrap metal. Great bargains abound for any existing shipping line or governmental agency in the market for a container ship.

The good news from this latest development is that finally, the ocean container industry may be moving towards efforts of consolidation which in our view, is good for shippers and the industry as a whole.  The status quo is obviously not sustainable and neither is targeting shippers to compensate for both container and banking industry missteps.

Bob Ferrari