Firms and Markets Mini-Case

Outsourcing at Ericsson
Revised: August 31, 2001

LM Ericsson, a leading marketer and distributor of telecommunications equipment,

surprised the business world in January 2001 by announcing that it would no longer
manufacture cell phones. Instead, Ericsson would outsource to Flextronics, a
leading designer, manufacturer, and supplier of equipment.

While other cell phone companies (including Nokia and Motorola) had already
outsourced portions of their manufacturing, Ericsson’s maneuver was the most
ambitious to date. “[We] will take responsibility for more than just manufacturing,” said
Michael Marks, Flextronics' chairman and chief executive. “We are being asked to
manage [Ericsson’s] operations, including new product introduction, supply-chain
management and logistics.”1

Ericsson

LM Ericsson Telephone Co. was formed in 1918, and by 2001 was involved in
international telecommunications, including systems and services for handling voice,
data, images and text. The company was organized into three business segments:
Network Operations and Service Providers, Consumer Products (including cell
phones), and Enterprise Solutions.2

Ericsson produces equipment for both wireline and wireless applications. In 2000,
Ericsson had a 10% market share in cell phones and sold 43.3 million cell phones
worldwide. However, market share had been declining, and in 2001 was expected to
fall to approximately 7%, with most of the loss going to the Finland-based industry
leader, Nokia.

Unlike some of its competitors, Ericsson traditionally focused on network

infrastructure devices, not consumer products. The Consumer Products division was
under significant profit pressure, losing money on an operating basis (excluding
restructuring charges).

In the fourth quarter of 2000, Consumer Products sales declined by 17% and losses
were substantial. There was speculation as to the future of the division; specifically,
whether the business would be sold or Ericsson would enter a joint venture, with, for
example, a Japanese electronics firm.
Flextronics

Flextronics International, Ltd. is a leading provider of electronics manufacturing

services to original equipment manufacturers (OEMs) in the communications,
networking, computer, medical and consumer markets. The company had design,
engineering, and manufacturing operations in 27 countries on four continents.3

Flextronics is one of the most successful Electronic Manufacturing Services (EMS)

firms – firms that make products on an OEM basis for other companies under
outsourcing contracts. Other leading EMS firms include Solectron, Celestica, and Jabil
Circuit. It grew very rapidly. Earnings per Share compounded at greater than 30% from
1998 to 2000, and the company employed over 70,000 people. Acquisitions played an
important part in growth. Sales were derived primarily from telecom (about 30% of
sales), computer (29%) and networking (24%). After Ericsson, Cisco was Flextronics’
second largest customer, accounting for 10% of sales. Its relationship with Ericsson
started in 1996, when it bought factories and signed an outsourcing contract.

Under the new agreement, Ericsson would account for about 20% of Flextronics’
sales. Cell phones were to rise to about 20% of Flextronics’ sales, up from 7% in
2000.

Mobile Handset Market

Following years of rapid growth, the mobile phone handset market was in a slowdown
by 2001, reflecting three market factors: product saturation, a longer replacement cycle,
and delayed introduction of products with next-generation technologies (such as 2.5 and
3G)
that had been expected to drive significant future growth for the industry. With
the industry maturating, price pressure was expected to intensify.

The Outsourcing Decision

Ericsson surprised some observers in late January 2001 when it announced its
alliance with Flextronics. Its stock fell 13%, due in part to the market’s
disappointment that a more radical solution had not been selected. However, the
transaction represented the
largest single acquisition of an OEM supply chain in the history of the EMS – based
on revenues. Prior to the Ericsson/Flextronics deal, only about 5% of global cell
phone production was outsourced.

Flextronics agreed to purchase (at book value) the equipment in several of Ericsson’s
existing facilities and assume responsibility for production of Ericsson’s handsets. 4,200
Ericsson employees were to be transferred to Flextronics and 6,800 made redundant.
Flextronics intended to shift production of the more competitive items to its own
facilities in China and Malaysia while putting more expensive products into the higher
cost Ericsson plants. Ericsson’s plants being transferred were in Sweden, the U.K.,
Brazil, Malaysia, and the U.S. (Virginia). Ericsson expected that all its production
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would be shifted to Flextronics by the end of 2001. The deal was for
manufacturing only; Ericsson would retain responsibility for product design,
marketing, and R&D.

Ericsson expected to save SKr15 billion (about $1.5 billion) annually beginning in
2002, while Flextronics anticipated a jump in revenues of $2 billion per year. Analyst
Keith Dunne at Robertson Stephens suggested that Flextronics might produce cell
phones in China and Malaysia and make infrastructure equipment in China, Poland,
Mexico and Sweden.

Ericsson management believed the agreement would allow the business to return to
profitability by the end of 2001. But not everyone agreed. A Merrill Lynch analyst
wrote, “We are giving no benefit of the doubt to this business due to its performance
over the last three years and we expect losses to continue in 2001 and 2002. As we
iterated, this is primarily due to Ericsson’s ability to read the market and design savvy
handsets that end users get excited about.” Similarly, UBS Warburg’s Jeffrey
Schlesinger wrote: “We remain skeptical of the company’s ability to turn the design side
of the business around on a sustained basis. First, Ericsson’s handset drama is as much
related to an inappropriate product mix and pure product design as it is to production
efficiency. Hence, lower production costs are unlikely to fully resolve Ericsson’s
handset woes. We continue to question the company’s understanding of consumer
markets, the pace of change in the mobile phone industry, and its ability to continuously
design products that can drive volume with good margin.”

Questions for Analysis

It’s December 2000. You are to make a presentation to the Ericsson Board of Directors
outlining the pros and cons of outsourcing to Flextronics and making a
recommendation on whether to do it.

Questions to think about:

(a) What are the pros and cons of outsourcing relative to keeping production in-house?

(b) What are the pros and cons of outsourcing relative to exiting the business altogether?

(c) Does Flextronics’ role pose a long-term risk to Ericsson?

(d) Although Ericsson’s arrangement with Flextronics is the most ambitious to date,
others in the industry are also turning to outsourcing. Why do you think they are doing
so now, rather than earlier in the “life cycle” of wireless phones?

ANSWER

Ericsson

By 2001, Ericsson was involved in international telecommunications, including services

and systems for handling data, voice, text and images. In 2000, Ericsson had a market
share of 10% in cell phones and sold 43.3 million cellphones worldwide. But the market
share was constantly declining and by 2001, it fell to 7%. It traditionally focused on
network infrastructure devices and not consumer products. In the fourth quarter of 2000,
the sale of Consumer products declined by 17% and caused a big loss for the company.

FLEXTRONICS

Flextronics is one of the most successful Electronic Manufacturing Services firm and
make products on an OEM basis for other companies under outsourcing.

Mobile Handset Market

By 2001, mobile handset market came to a slowdown due to major three factors: product
saturation, longer replacement cycle, and delayed introduction of products with
advanced technologies.

In such a scenario Ericsson’s decision of outsourcing was a wise decision taken by the
company.

a) Outsourcing – Outsourcing is any task, operation, job or process that could be

performed by employees within an organization but is instead contracted to a third
party for a significant period.

ADVANTAGES OF OUTSOURCING

1. Cost and Efficiency Savings: Companies which have got expertise in a particular
function are able to perform it at low cost and in less time. Ericsson will be able to save
cost and time and able to perform it more efficiently, if outsourced to Flextronics.

2. Reduced Overhead: Overhead costs of performing manufacturing would be reduced

for Ericsson.

3. Operational Control: Operations whose costs are running out of control can be
controlled by outsourcing. Departments that may have evolved over time into
uncontrolled and poorly managed areas are prime motivators for outsourcing. In
addition, an outsourcing company can bring better management skills to your company
than what would otherwise be available.
4. Staffing Flexibility: Outsourcing will allow operations that have seasonal or cyclical
demands to bring in additional resources when you need them and release them when
you’re done.

DISADVANTAGES

1. Hidden Costs: company will sign a contract with the outsourcing company that will
cover the details of the service that they will be providing. Anything not covered in the
contract will be the basis for you to pay additional charges. Additionally, you will
experience legal fees to retain a lawyer to review the contracts you will sign.

2. Loss of Managerial Control: Whether company signs a contract to have another

company perform the function of an entire department or single task, you are turning the
management and control of that function over to another company. True, you will have a
contract, but the managerial control will belong to another company.

3. Threat to Security and Confidentiality: The lifeblood of any business is the

information that keeps it running. If product design and technology that will be
transmitted to the outsourcing company, there is a risk that the confidentiality may be
compromised.

4. Quality Problems: The outsourcing company will be motivated by profit. Since the
contract will fix the price, the only way for them to increase profit will be to decrease
expenses. If they meet the conditions of the contract, you will pay. In addition, you will
lose the ability to rapidly respond to changes in the business environment.

b) Advantages of Outsourcing relative to exiting the business

Outsourcing can bring down the cost, operational expenses, and improve the efficiency
of the company. Thus, a company can improve its profits continuing in the same
business.

Exiting the Business

If a firm is chronically sick, even outsourcing the operations cannot bring in any profits
to the company. The decision to exit the business would then be a better option. Firm
can sell off its assets and utilize the surplus amount earned in growing other businesses.

c) Threat to Security and Confidentiality: The lifeblood of any business is the

information that keeps it running. If product design and technology that will be
transmitted to the outsourcing company, there is a risk that the confidentiality may be
compromised.

In a high technology market, product design and technology are very crucial. It Ericsson
outsources the operations to Flextronics; such information would be leaked and thus
would be hazardous to Ericsson in the longer run.

d) When the firms are new to the market, they are not very aware of the environment and
are little skeptical about the outsourcing as they are not ready to leak the important
information to the third party. Later in the maturity stage of Product Life Cycle, when
they start incurring losses due to soaring costs and reduction in revenue due to saturation
in the market and as they grow high in the learning curve, they start realizing the
importance of outsourcing and how it can bring down the cost of operations. Thus, other
firms are also turning to outsourcing.

In the maturity stage of the Product Life Cycle, there is decrease in revenue due to
market saturation and increase in costs if the firm doesn't have the expertise in the
required field. Other firms also realized the same in the maturity stage and thus they
started turning to Outsourcing.

Additional Information Sources

Ericsson's web site: http://www.ericsson.com/

Flextronics' web site: http://www.flextronics.com/

Notes

Charles Miller and Kenneth Goldman prepared this case under the supervision of David
Backus and Luis Cabral for the purpose of class discussion rather than to illustrate
either

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effective or ineffective handling of an administrative situation. © 2001 David

Backus and Luis Cabral.
1
Ojo, Bolaji, “Ericsson Transfers All Mobile Handset Production to Flextronics”,
http://www.ebnews.com/manufacturing/news/story/OEG20010126S0010
2 3
Marketguide.com, http://www.marketguide.com/mgi/busidesc.asp?nss=www&rt=busidesc&rn=30650
Wrolstad, Jay, “Ericsson Abandons Cell Phone Manufacturing”,
http://www.wirelessnewsfactor.com/perl/story/7019.html
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