Increasingly, original equipment manufacturers (OEMs) are becoming virtual manufacturers. They outsource product, sub-assembly, and component manufacturing and assembly to tier 1 suppliers. On the surface, the transfer of manufacturing assets to the tier 1 suppliers leverages their core competency—manufacturing—thus enabling the OEMs to focus their efforts on brand management, customer management, and product innovation.

Below the surface, the financially driven trend to outsourcing can adversely affect the supply chain. Typically, outsourcing doesn't streamline or speed or simplify the supply chain; rather, it makes it more complex. Interfaces between OEM and tier 1 supplier increase. Information becomes more diffuse. Plants and facilities have new owners, but little else has changed.

By examining the effect of outsourcing relationships on the supply chain and consciously striving to improve collaboration, OEMs can reduce the operations impact of outsourcing and, in fact, create efficiencies and reduce time to market. This article tells how.

As depicted in Exhibit 1, outsourcing relationships can follow three basic operating models, based on the degree of integration between the OEM and the tier 1 supplier:

• Supply chain integration: The focus is on the coordination of internal activities and the relationship is one-way from the OEM to the tier 1 supplier.
• Supply chain collaboration: The OEM and the tier 1 supplier work together to optimize their supply chain by sharing information, making joint decisions, and using common tools and processes.
• Supply chain synchronization: Multiple players on the same supply chain optimize the entire supply chain through sharing information, making joint decisions, and using common tools and processes.

In the future, we expect an emerging model that extends synchronization. In this new model, which we call the network effect, multiple tier 1 suppliers and OEMs as well as other supply chain partners use common processes and tools to create an optimization effect for the entire industry. Supply chain partners vary significantly in their adoption of these models. Most fit into the first two categories, although a number are now reaching out to explore synchronization and the networked model.

In the integrated model, the ownership of the assets is transferred from the OEM to the tier 1 supplier. Little else changes hands, and the OEM's focus continues to be internal. In reality, the same old problems exist; however, the ownership has changed and the processes and systems have been dismantled. (See Exhibit 2.)

In this model, communication between partners and across business processes is essentially one-way: Data, such as forecast information and product content changes, flow from the OEM to the tier 1 supplier with little or no advanced information about future needs. Therefore, the tier 1 supplier is always reacting, never planning. Because information flows only one way, the tier 1 supplier does not give the OEM any information on material or capacity availability—or even confirm that it has the most recent release of product information.

For fundamental processes such as planning and forecasting and new product introduction, this change of ownership could actually amplify problems that existed previously. For example, frequent, short-notice changes in forecasts and demand have always affected delivery and inventory performance. Typically, a supplier will assess the accuracy of the forecasted information and add a fudge factor to the customer's forecast in order to increase the chances of meeting the production deadline. So when the process is transferred from the OEM to the tier 1 supplier, the forecast and demand fluctuations can be exaggerated, thus increasing the levels of inventory planned or held by the tier 1 supplier.

Outsourcing adds new complexity to the process of assuring that information is correct and consistent in the ERP/MRP system. The transfer of product information, such as bills of material and drawings, across the new boundary requires a whole new process to convert the data into a format that the tier 1 supplier can use and to validate part numbers and approved vendor lists. In an environment of shrinking product and component lifecycles, supply changes are common. All these changes must be converted and validated—a process that is often manual and therefore time consuming and susceptible to error. The result: lengthy time-to-market and excess and obsolete inventory.

In the integrated supply chain, both the OEM and the tier 1 supplier add additional resources and layers of management at the point of interface. They spend time and effort and money to manage these new challenges. Potentially, these costs outweigh the financial benefits of the outsourcing. OEMs that have recently outsourced their manufacturing capacity to tier 1 suppliers have already realized the financial benefits associated with reduced assets. By establishing a transactional relationship, these OEMs take on a significant competitive risk.

OEMs that operate more collaboratively and avoid transactional relationships improve their competitive position. Most outsourced manufacturing relationships today are more transactional than collaborative. As OEMs implement more collaborative processes, they will tap significant value across the supply chain.

The first step toward collaboration is to enable two-way communication. For example, let's say an OEM places an order with the tier 1 supplier for a quantity of a particular printed circuit assembly. The tier 1 supplier should be able to communicate back to the OEM the supplier's capacity and the availability of material, so the OEM knows whether or not the supplier can meet the order requirements. Also, when an OEM changes an existing product or sub-assembly, the tier 1 supplier should be able to report back that it has implemented the change and can produce the revised product.

The second step toward realizing all the benefits of collaboration is to use two-way communication to support joint decision-making. For example, when the tier 1 supplier communicates that it is unable to fulfill an order, the partners work together to determine when the order can realistically be fulfilled—to their mutual benefit—by considering other priorities, available material, etc. Or when an OEM changes a product component, the partners work together to determine when the change should be phased in, taking into account demand for the product and inventory goals. Exhibit 3 identifies six critical collaborative processes.

It can be difficult to establish collaborative processes because the supply chain is so dynamic. Demand is extremely difficult to forecast. Product and component lifecycles are shortening. Product changes come fast and furiously from both demand and supply side. Manual processes cannot keep pace. To achieve collaborative status in this environment, supply chain partners need new technology in the form of supply chain software solutions.

While many collaborative capabilities identified in Exhibit 3 are available, not all exist today for fully built-out, tried, tested, and standard products. The rapid advance in Internet-enabled capabilities, however, means that full collaborative capabilities are not far away.

As the need for collaboration becomes more important, OEMs and tier 1 suppliers implement the limited capabilities currently available. Those that wait for fully built-out solutions will be at a serious competitive disadvantage to those that are already piloting capabilities and working with software companies to drive the development process. Early adopters of new supply chain software will reap the following benefits:

• Reduced time-to-market and volume.
• Improved delivery performance.
• Increased supply chain efficiency.
• Reduced inventory excesses and obsolescence.
• Increased flexibility and customer service.

Supply chain synchronization is an extension of supply chain collaboration where the collaboration extends up and down the supply chain to multiple customers and suppliers. With this model, an OEM would communicate product availability and supply plans or product content changes, for example, up its supply chain to distributors and the rest of the channel. At the same time the OEM would communicate its demand requirements, based on an upstream forecast or product changes, down to its tier 1 suppliers and so on through the supply chain. In this fashion, each member of the supply chain has visibility to the same accurate and up-to-date data, enabling joint decisions that can optimize the performance of the entire supply chain. Of course, for supply chain synchronization to be successful, the supply chain as a whole must work toward common goals or suffer suboptimum performance of the supply chain.

So far, we have discussed relationships up and down the supply chain, from OEMs upstream through their channels and downstream through their supply base. But OEMs typically use the services of many tier 1 suppliers. And tier 1 suppliers in the electronics industry, for example, have their own tier 1 suppliers. Exhibit 4 summarizes the complexity of the supply chain.

While this complexity causes problems, it also creates opportunities. As individual partners (OEMs and their tier 1 suppliers) develop interface solutions, there is a great opportunity to replicate those capabilities across all other relationships. We call the opportunity for synchronization across multiple supply chains the network effect.

The network effect builds upon the benefits of synchronization through the use of standard tool sets that can drive process consistency among all supply chain partners. When every partner uses the same software across multiple relationships, with standard information formats and processes, most inefficiencies can be eliminated. Supply chain planning software by i2 Technologies and product content collaboration software by Agile Software (see accompanying sidebar) are two examples of such software. And even when different partners use different software, common standards for data and information structures and exchanges (for example, RosettaNet in the electronics industry) can drive efficiencies.

Naturally, the degree to which companies choose to standardize or differentiate their processes is a strategic decision. While consistent tools and processes across the supply chain can create value, some companies may have a strong desire to differentiate themselves to drive value over and above brand management, customer management, and product innovation.

As the network effect extends across an industry, significant value can be extracted from the supply chain because tier 1 and other suppliers will not have to operate multiple systems, solutions, and processes to support their different OEM customers. Most implementations today, however, are beginning with only a few supply chain partners. But as others see the benefits, this structure will be more widely adopted. We believe that collaboration will be a significant factor in differentiating competitive advantages over the next few years, as industries continue to focus on speed-to-value and the collaborative capabilities of supply chain software continue to develop.