Online Extra: "Design Is a Commodity"

Why is Flextronics CEO Michael Marks so convinced his radical vision is true? All the intellectual property now is going onto silicon

Michael E. Marks, CEO of Flextronics, has a radical view of the future of America's electronics industry. Just as manufacturing and logistical operations began shifting en masse in the early '90s to companies like Flextronics (FLEX ), which sent most of the work to its factories in countries like China and Mexico, Marks predicts an equally dramatic shift will occur in engineering and design. As a result, many of today's giant electronics and telecom hardware companies will massively downsize their in-house R&D operations.

Many view this scenario as extreme. But Marks has a special insight into the world of electronics. Flextronics is the world's largest manufacturing services provider, with more than 90,000 employees worldwide building $14.5 billion worth of printers, cell phones, computers, networking gear, game players, and other devices. Among its clients: Hewlett-Packard (HPQ ), Motorola (MOT ), Xerox (XRX ), Microsoft (MSFT ), Nortel (NT ), and other big brand-name companies, often referred to as original-equipment manufacturers (OEMs). Even though Flextronics itself stumbled a bit after the 2001 tech bust, Marks has correctly foreseen the outsize growth in contract manufacturing, which continues to gain steam.

For the past three years, Marks has been betting heavily that his new prediction about outsourced design is correct as well. Flextronics has spent more than $800 million on acquisitions in the past three years to assemble a 7,000-engineer product-design force spanning India, China, Southeast Asia, Ukraine, Europe, and Latin America. Marks recently explained his vision to BusinessWeek Senior Writer Pete Engardio. Edited excerpts of their conversation follow:

Q: What will be the impact of the trend toward outsourced design in the electronics industry?


Design no longer is a competitive advantage. Design is a commodity. Yet design in big companies is just as inefficient as manufacturing and supply-chain management used to be. So brand companies might as well buy the designs for their products off the shelf.

A big electronics company may have 10,000 designers, but maybe only 50 are doing real architecture for new products. Some of them will go down to 300 engineers. It's going to get ugly. The electronics manufacturing services [EMS] and the Taiwanese ODMs [original design manufacturers, meaning they design as well as assemble what they produce on a contract basis] will completely restructure design in the electronics world just as we did in manufacturing. We'll have huge design centers in China, India, and Ukraine.

You can save 15% to 20% by moving manufacturing to a low-cost country. But with design, the drop can be much more dramatic.

Q: Can you offer an example of what is happening with specific products?


Take a cell-phone project. Inside a typical OEM, it costs $10 million to develop a low-end phone. We could do it for them for $3 million. It may cost them $30 million to $50 million for a high-end phone. It costs us $10 million.

My contention is that 10 years from now, a Motorola will keep key people, and the rest of the work will be done in a factory. If you're making a [Motorola] Razr phone, which has special technology and materials, you need more people. What we can't do is develop new technology.

Q: Right now, companies are mainly outsourcing design of their low-end products. Why is this such a big deal?


What happens is that the low-end creeps up. Right now, many wireless telecom companies regard a cellular base station as a high-end product. It can take at least $200 million to develop. But the price of cellular base stations has been dropping fast. They cost $40,000 now, and will go down to $5,000 in a few years.

We're already designing software systems for base stations in India. We're getting to where the basic platform of a base station will be available off the shelf.

Q: What's driving this commoditization?


All the intellectual property now is going onto silicon. You can make a cell phone on a chip. You can make a router on a chip. Pretty soon you'll have cellular base stations on a chip. Every product is on a trajectory of becoming silicon surrounded by plastic.

One way to convince yourself is to look at where people in Silicon Valley are putting their money. If you look at the venture money, it is going heavily into chip companies.

Q: What's Flextronics' strategy with design?


We're developing a capability to design and make products cheaper than anyone on the planet. What we're doing is similar to the Taiwanese ODMs. But we can do the whole product, from soup to nuts. Many people don't understand that the Taiwanese ODMs are not very good manufacturers. They often outsource to us.

Also, datacom and telecom equipment is very software-intensive. Software is a major weakness of Taiwanese and Chinese companies, who basically are hardware guys. Therefore, many of our acquisitions have been in software.

Q: You've made a lot of design acquisitions, including Frog Design. How do the pieces fit together?


We've made five acquisitions in India and now have more than 4,000 design people there. We will do more. The five companies are doing hardware or software for the data communication or telecom industries.

In Ukraine, we have a design group that will work with India in network services and product design. We probably have 1,500 people there now. We have a major printer and imaging design group with centers in Singapore and San Diego. We bought two cell-phone design groups and have a minority investment in a company doing systems on a chip. We had a small industrial design operation in San Jose, but now we're integrating that with Frog.

Q: You recently told financial analysts Flextronics' profit margins on design are lower than expected. Might something be wrong with your new model?


There's nothing wrong with the model. In fact, it has worked fabulously because before we started doing original design, we were losing business. We just aren't making the money on it that we hoped we would.

We figured we could charge an 8% profit margin on cell phones that we designed, for example, rather than the 3% we charge just for manufacturing a phone. Instead, companies want to still pay 3% plus whatever our design costs are. However, we are making 20% profits in India, where we do more software design.

Q: So ultimately, who comes out ahead in this new design model?


The big winners are the Dells (DELL ), Wal-Marts (WMT ), and Best Buys (BBY ), who now are using ODMs and coming out with their own brands. What's happening in retail will bring wrenching changes to the world of electronics.

Before it's here, it's on the Bloomberg Terminal.