Vertical integration, not outsourcing

Nov. 17, 2005
Roland Bent was in the U.S. recently to announce expansion of manufacturing capacity and a new distribution center at the company's Middletown, Pa., facilities.

Roland Bent
Senior Vice President,
Marketing and Development
Phoenix Contact
GmbH & Co.
Blomberg, Germany

MD: You have strong feelings about companies that use offshoring as a strategy. Can you tell us about that?

Bent: If offshoring is your only strategy, you are going to lose. You'll lose technical competence and ultimately your ability to innovate. The same can be said of outsourcing. Companies that do this are playing a dangerous game. My company takes the exact opposite approach: vertical integration, something that is out of style right now. We think that if you want to offer a quality product, you have to be able to control the design, production, and the logistics. Vertical integration is the best way to do this and maintain competence in designing and producing products. With that philosophy you are always trying to better master your own processes. We feel that's the only way we can keep production facilities in Germany, which is known for high labor costs.

MD: To what extent are you vertically integrated?

Bent: I'll give you examples. We make our own screws! People are surprised when we tell them this, but it makes sense for us. Screws are a key component for our terminalblock products. By making them we can control quality and important factors such as corrosion resistance. We also make most of our own assembly machines. We have about 200 employees working on them. The reason is when we start a project for a new product, we can immediately put together a team that can discuss things in a design-to-cost context and know what they are talking about. We think you have to keep innovation and production physically close together. Companies that think they can innovate in one place and produce offshore are fooling themselves. It won't work in the long run. You have to put marketing, production, and innovation close together. With production located somewhere far away, you can't innovate.

MD: But you do, in fact, outsource some tasks, correct?

Bent: Yes, but we do it the right way. We'll outsource some of our molding tools, for example, but we will keep enough of this work in-house to maintain our competence. We use outsourcing as a way of benchmarking our internal processes. If the outsourced mold tooling has been coming back in four weeks and suddenly, it comes back in three we know something's up. We'll go back to our own operation and make sure our processes are state of the art, and that our turnaround times reflect what's happening on the outside. We also send out jobs to subsuppliers for items that have low volume. But when the volume is there, we bring it back in. And we do indeed have operations in countries where labor costs are low. But when we do that, it is not to get lower labor costs. We do it to open new markets. We still keep 80% of our value-add in Germany. That's the philosophy that led us to open facilities in China, Poland, and the U.S.

MD: But doesn't labor cost enter into the discussion? Wouldn't that lead you to manufacture product in countries where the labor costs are low?

Bent: When you outsource it should not be just to get lower labor costs. But cost does come up. In China, for example, tooling would cost us about one-third of what it normally does. We studied where the differences came from and reduced our own costs through process automation. And we will outsource operations that are labor intensive and which affect production in very small quantities, where it makes no sense to automate the process. While we have done this, we have seen other companies take the exact opposite approach. Now many of them just do prototyping in Germany. The future will show which is the right strategy.

On the other hand, we know of some companies that tried outsourcing that have begun to bring operations back inside. One reason is that the cost savings from outsourcing can be temporary. The labor rates in low-cost areas eventually rise and take away the advantage. For example, the labor rates in the developed regions of Romania went up 70% last year! And a good software architect in India now makes as much as one in the U.S. Labor rates for jobs like that have to equalize; otherwise, people just emigrate to where the money is.

That said, the reality is, that there's heavy competition from Eastern Europe and Asia, especially on the component side. We'd have problems if we didn't focus on competitive pricing. But there is no reason a highly automated process in Germany can't be competitive with a low-cost assembly operation in China. One reason is that customers want to optimize the cost of ownership, not just the purchase price. That includes service, logistics, and other factors that go into the complete cost.

MD: Phoenix is not a publicly held company. Does that have something to do with its philosophy about outsourcing?

Bent: We have an orientation that lets us do long-term stuff. Three of the six people on our board of executives, basically the company top management, are engineers. The main shareholder is also an engineer. He is in his seventies and he still knows what's going on. We reinvest profits in the company.

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