Vertical Integration Might be Great at Making Ducks—But What if Your Product is a Swan?

by Mitch Nichols / May 18, 2023

“Vertical integration is the business arrangement in which a company controls different stages along the supply chain. Instead of relying on external suppliers, the company strives to bring processes in-house to have better control over the production process. Though vertical integration may result in increased upfront capital outlays, the goal of vertical integration is to streamline processes for more efficient and controlled operations in the long-term.”1 — but is vertical integration (VI) right for you?

Is Vertical Integration Right for You?

The dawn of contract manufacturing did not start in an offshore outsourcing push but can be traced back to 1961 with the National Aeronautics and Space Administration (NASA) and other government agencies looking for alternative manufacturing solutionsforsatellite and communications products. In the decades that followed, we have witnessed the outsourcing of complex industrials projects, semi-conductor systems, medical devices, and advanced computing and next-gen communications products. Once made in-house by original electronics manufacturers (OEMs), these projects have now largely migrated to electronic manufacturing services (EMS) organizations who are ideally staffed and located to support global demand. 

As OEMs began to increase the outsourcing of their products to various global contract manufacturers, the emergence and growth of the EMS industry was first concentrated in the United States. It has since moved offshore but has come full circle to see domestic sourcing once again gaining prominence.

According to the latest research, the EMS industry has blossomed into nearly $500 billion in 2021 and is likely to reach nearly $700 billion by 2028 with many analysts predicting a more than 6.5% CAGR through 2028. To understand this continued growth, we must first understand that the EMS industry was fed by acquisitions of manufacturing concerns from OEMs in the 1990s, followed by mergers of many EMS players in the 2000s. As a result, the worldwide manufacturing landscape has changed forever. In fact, the days of OEMs owning large vertically integrated manufacturing assets are fleeting and will probably never return due in great part to increasing capabilities and flexibility, as well as a reduction in capital expense. Oddly, the emergence of these EMS companies started dismantling the large vertically integrated manufacturing capabilities of OEMs. Ironically, some of these same EMS companies have now adopted the same vertically integrated solutions themselves, but one question remains—is this always the best strategy?

Changes in EMS—ODM & Vertical Integration

Even within the EMS world, the past 15 years have witnessed two significant changes. First, we witnessed the emergence of the original design manufacturer (ODM) as third parties participated more in the design and engineering of products on behalf of the OEMs. While there are a wide-range of ODM models, essentially the ODM provider offers a complete or near-complete design for various OEM customers to brand and market as their own devices. The expansion of this model gradually led to the merger of the ODM capability into the EMS players either through acquisitions or in-house development of the capability. Second, we witnessed a broadening of manufacturing capabilities within EMS companies through vertical integration (VI). Again,vertical integration originated as EMS companies either acquired existing technology manufacturers (such as sheet metal fabrication, plastic injection molding, and precision machining) or developed the in-house capability. Some have even taken it a step further and have added printed circuit board fabrication (PCB Fab), power supplies, or additive manufacturing. So, while OEMs were shedding these capital-intensive capabilities, some EMS players were investing significant dollars to add and expand their verticals. Let’s take a look at both the ODM model and vertical integration. 

The ODM Model

  1. The ODM factor immediately draws in the unwanted complication of Intellectual Property (IP) rights and the need to protect these rights. Benchmark’s strategic partners are typically oriented towards very specific technologies where their product is not commoditized. As such, the nuance of their design is what differentiates them in their respective markets. The fear of losing IP to competitors through ODM partnerships or the risk of your supplier eventually becoming a competitor is sufficient to justify staying clear of EMS partners who rely heavily on this capability for revenue. 

    The larger Tier-1 EMS players are heavily invested in customers with consumer products where small design developments can be a differentiation but the lifecycle of their product is so short that the need to maintain IP security is less critical. However, these same Tier-1 players have some customers who are not part of the consumer market yet the financial support of the ODM infrastructure within the Tier-1’s corporate structure is still burdened over the broader base of their corporate costs. 

    When evaluating how best to support our customers, Benchmark made the strategic decision to invest in design engineering resources dedicated specifically to processes such as Design for Manufacturability (DFM) and Design for Excellence (DFX). By moving in this direction, our customers enjoy a great many benefits, including:  

    1. Industry Experience and Expertise 
    2. Improved Product Realization Capabilities 
    3. Improved Manufacturing Efficiencies 

Vertical Integration in EMS

The vertical integration factor is a little less straightforward. Initially, the movement toward vertical integration of manufacturing capabilities was limited to the exceptionally large EMS companies and, at first, was usually the result of their acquiring an auxiliary manufacturing capability as part of the acquisition of circuit board assembly and surface mount technology (SMT) from an OEM. 

While the added capabilities did improve the marketing concept of “one-throat-to-choke” manufacturing, it also burdened the EMS company with large capital machinery assets that could not be easily relocated and manufacturing technology that required the addition of operational subject matter expertise. Over time, many of the larger EMS companies were better able to harness the technology by investing even further into the different technologies associated with manufacturing. This investment allowed them to offer the concept of a “one-stop shop” for the supply chain critical to building each customer’s product. The expansive EMS corporate campuses we see in the southern China today are the hyper-outgrowth of this vertical integration.

This manufacturing model works particularly well for high-volume consumer products where the repetitive manufacturing nature of the products—and the ability to dedicate capital machinery to single products —minimizes setup costs long term. Plus, the ability to stack margins on the multiple layers of the product bill-of-materials (BOM) enhances the overall profitability of the company and is less transparent to the end customer. Nonetheless, the recent global pandemic created challenges for OEMs and created the need to look beyond China for alternative supply chain solutions. 

Vertical Integration in Highly Complex EMS Outsourcing

Does the VI Model Work Well in Highly Complex System Manufacturing?

When we apply the same model to highly complex system manufacturing, the results become much more problematic. The profitability equation for any capital-intensive manufacturing machinery is utilization and setup minimization. As EMS companies brought in vertical integration, the need to optimize the utilization of their newly gained machinery often outweighed the need to support the required service level of the customer. Obviously, the practice of meeting each customer’s needs over profitability is doomed for long-term failure for a business. Adding to this are the often-heard frustrations within these vertically integrated EMS companies regarding misaligned priorities between manufacturing teams.  

Can a Direct Customer Provide the Best Margin?

The key objective for EMS providers specializing in vertical integration with designated VI task forces is to drive more insourcing rather than outsourcing—however, this is easier said than done. Most of the hard tool stamping capabilities are oftentimes handled in Asian countries, which doesn’t lend itself well to supporting system assembly needs in other key geographies such as Mexico, Eastern Europe, or the United States. In fact, some products are a better fit for “stage” rather than “progressive” stamping, making it problematic to justify a non-recurring engineering (NRE) investment. The same also holds true for injection molding where cavitation, cycle times, screw and barrel sizes, recovery time, and material processing have a direct impact on part cost. For these EMS providers, each vertical is often its own cost center, so the direct customer provides a better margin than supporting inter-company customers. 

Vertical Integration in High Mix/Medium Volume

When you apply the same model to the high-mix and medium-volume manufacturing environment, the results become less ideal. This is the environment that best aligns with Benchmark’s go-to-market-strategy and where we provide the best value. Benchmark has made a strategic investment in some capital-intensive manufacturing machinery, which has led to a specialized focus on precision machining to support the semiconductor capital equipment market. To offer the best vertical solutions to our partners, Benchmark’s Global Supply Chain and Commodity Management team has selected preferred suppliers that offer the right capabilities, technology, and processes that best align with the end market and product. Our supply chain management (SCM) team evaluates and expands our new supplier candidates on a monthly basis. Benchmark has also invested in aPriori, which allows us to verify and validate manufacturing processes and costs. So, whether it is plastic injection molding, hard or soft tool metal fabrication, high- or low-layer count PCB fab or other verticals, Benchmark offers the best supply chain options that fit rather than providing a “shoe-horned” in-house solution. OEMs have the added benefit of owning the tooling for the required verticals and this provides them the flexibility to best support their regional supply chain needs. 

Vertical Integration in Mid-tiered EMS

Curiously, vertical integration has seeped further and further into the EMS world, even to some smaller or mid-tiered EMS companies. While not having full visibility into their long-term strategy, it is difficult to judge if this model is right or wrong but clearly the Benchmark approach makes more sense to our customer base. Instead of trying to be the best in every vertical technology, it’s preferable to develop suppliers who are best-in-class for their respective technology.

Even within specific technology grouping, differentiations such as press tonnage, cosmetic or class of finish requirements, market-specific certifications, labor costs, proximity to assembly, and integration facilities are factors that differentiate one from another. At Benchmark, we seek manufacturing partners who offer the highest quality solutions to enhance our own industry leading, complex EMS, product realization, and manufacturing capabilities. We have true partnerships withour supply base so we act in concert to support Benchmark’s strategic customer partners. We have even replaced vertical integration with virtual integration, and it works when it truly matters. We aggressively measure and monitor these partnerships and leverage them between each other to make sure our final solution to our customers is a best-in-class solution. Ultimately, this “virtual” integration may be a better solution for the complex product companies we serve rather than the typical vertical integration solution others offer.

Benchmark is focused on providing the right end-to-end solution and our talented teams help our customers take steps toward developing the right supply chain architecture best suited for our customers. Whether it is as highly complex industrial product, lifesaving medical device, advanced computing and communications product, or a precision semiconductor system, Benchmark is the perfect partner to get you started. We are delighted to join our customers on this sustainable journey. Want to learn more? We’re just a click away!

Benchmark has the expertise to help our customers build sustainability into their products and solutions. From advanced process automation to design for manufacturing capabilities, power management, robotics and mechatronics, and connectivity we can support key technological upgrades to existing products as well as development of new ones. 

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about the author

Mitch Nichols

Mitch Nichols works as a Business Development Executive at Benchmark where he specializes in serving the needs of customers in the complex industrials market. He boasts 35+ years of leadership in the technology space and has held senior positions in contract manufacturing, plastic injection molding, thermoforming, sheet metal fabrication, cable assemblies, connectors, and capacitors. In Mitch's own words, “my approach tends to be analytical with the desire to thoroughly understand my customer’s product or concept and looking for creative ways to provide a proven solution.” Mitch enjoys spending time with his family, gardening, and planning vacations with his spouse.

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