Contract Manufacturing

This article explores the world of contract manufacturing — how it began, where it is going, the challenges, the rewards and the players. The reader will gain a good grounding in what contract manufacturing is, as well as a firm grasp of the risks, rewards and controversies.

Keywords Brand Ownership; Contract Manufacturing; Flextronics; Globalization; Intellectual Property; Offshore manufacturing; Outsourcing; Product Life Cycle

Manufacturing > Contract Manufacturing

Overview

Contract manufacturing is the process of hiring a manufacturing firm to produce one or more components, assemblies or completed products. The hiring company is usually an Original Equipment Manufacturer (OEM), which uses the products produced by the Contract Manufacturer (CM) as subassemblies for its own products, or to sell as is (perhaps with its own packaging) to its customers. OEMs usually provide the CM with completed designs and oftentimes a prototype, though CMs are increasingly providing even these services to the OEM.

An OEM's selection of a CM is generally based on cost, expertise, quality and other factors related to the specific part or product to be produced. An OEM may negotiate a contract with a single manufacturer with which it has an existing relationship, or may put out a request for proposal (RFP) to multiple CMs, depending on the need, the size and complexity of the project, and whether or not the OEM has a good relationship with a CM that has the capabilities needed. A typical OEM, depending on the size and breadth of its offerings, may use many different CMs for various purposes and products.

Reasons for Contract Manufacturing

Expertise

One of the key reasons for outsourcing manufacturing is to obtain specific expertise. With the increasing complexity of equipment, some CMs are specializing in very narrow skill sets and capabilities. Rather than investing in expensive equipment and hiring the skill sets needed, it often makes sense for an OEM to outsource to the expert, gaining better quality, faster turnaround and very often a lower cost than manufacturing in-house. A good example is convertible automobile roof systems. Virtually all automakers contract out this manufacturing, which is dominated by German firms (Armitage, 2007).

Lower Cost

Another reason for contracting manufacturing services is to achieve a lower production cost. This may be done by leveraging off-shore manufacturers whose labor, land and materials costs are very often much lower than in the U.S. CMs also may get much better pricing from component suppliers, wherever they are based, since those suppliers typically buy the required materials in very large volumes. Overhill Farms, in Vernon, California, is a manufacturer of food products for brand owners, and purchases close to a million pounds of poultry per week (Schultz, 2007). That is buying power.

Speed to Market

Cost and specialization aside, speed to market is often the biggest driver. The ability to get an idea to market fast is often a critical success factor for profitability. CMs can ramp up much more quickly than the OEM, especially those that have widely diverse capabilities and have many factories that can handle spikes in design. Flextronics, for example, has manufacturing facilities in over 30 countries serving the automotive, computing, medical, mobile and many other industries ("About us," 2006). The ability to tap into this vast resource ensures OEMs a much quicker turnaround on products than would otherwise be feasible.

Innovation Possibilities

Outsourcing also allows OEMs to focus on innovation, rather than production. This enables a company to expend its internal talent on identifying emerging market needs, developing new products to fill those needs, promoting the new products aggressively and creatively, and moving them rapidly from design into production and out to the market. On the extreme end of contract manufacturing are companies like UK-based Innocent, a smoothie company with 71% of the UK smoothie market. Innocent outsources all of its manufacturing and focuses its own resources on sales and marketing, a strategy that has brought it enormous success. Penn refers to "OEMs" like Innocent as "Brand Owners" (Penn, 2007).

Another, high profile, example of speeding market innovations to market through contract manufacturing is Microsoft's launch in 2001 of the now ubiquitous Xbox. Microsoft, of course, is a software company. No factories, but lots of money. Contract manufacturing monolith Flextronics is the actual maker of the Xbox, and rapidly churns out the game boxes from a state-of-the-art manufacturing facility in the heart of poverty-ridden Guadalajara, Mexico, allowing Microsoft to compete effectively with manufacturing giant Sony and its Playstation (O'Brien, 2001).

While racing to market with lots of dollars to beat the competition works for companies like Microsoft, with lots of market data to support a rosy outlook for sales, other innovative products may have a more uncertain market. Manufacturing outsourcing, in these cases, can be a much less risky alternative to in-house production. If the product flops in the marketplace, or doesn't perform at a profitable level, the OEM's losses are minimized since it has not made investments in new factories, equipment, hiring and training.

Lastly, contract manufacturing has enabled much smaller companies to bring new products to market. Without the need to invest in equipment and workers, new companies with minimal funding can now enter the manufacturing game, even producing to demand in many cases.

History

The electronics industry was the first to engage in contract manufacturing with the outsourcing of circuit board assembly in the 1980s. IBM was the first to outsource an entire product when it contracted with SCI to build its personal computers.

Pharmaceuticals and medical devices were next to experience a boom in contract manufacturing. While lack of capacity had historically pushed outsourcing of specific product lines in the past, pressure to speed products to market has driven more outsourcing in these industries in recent years. Outsourcing has not only saved these companies money, but has also enabled them to focus more on R&D and brand building.

During the 1990s, outsourcing became a mainstream business topic, covered in business school curriculums and debated in business publications, including the pivotal paper "Make versus Buy: Strategic Outsourcing" by James Brian Quinn and Frederick G. Hilmer (Baatz, 1999). While outsourcing had been around long before this period, these discussions drove it from a contingency practice to a strategic model, prompting businesses to focus on their core competencies and to consider outsourcing everything else.

Also key to the growth of CM was the emerging Internet and Internet-related technologies that enabled real-time communication, collaboration and data sharing. The ability to resolve issues quickly and communicate instantly regarding product and process design was critical to success. By 1999, according to a Purchasing Magazine survey, "54% of computer, peripheral, communication, automotive, medical and industrial control equipment OEMs outsource(d) some or part of the manufacture of their equipment" (Baatz, 1999).

Military and aerospace prime contractors are some of the latest companies to delve into contract manufacturing beyond simple circuit boards. While there are more restrictions and encumbrances on these companies due to national security and accountability, they are increasingly finding CM is a cost-effective way of doing business for specialized parts and assemblies.

With these and many other industries following in the footsteps of the electronics market, the contract manufacturing market is poised for continued strong growth for the foreseeable future. However, competition is intense, particularly in the electronics field, and despite strong growth, the industry has experienced overcapacity in the last few years (Get Big, 2007). This has resulted in some significant consolidation, including the recent acquisition of Solectron (once the largest electronics manufacturer in the U.S.) by Singapore-based Flextronics.

Where are the CMs?

A popular misconception is to equate contract manufacturing, or outsourcing, with offshore manufacturing. In fact, there are many strong CMs here in the U.S., though the overall market in the U.S. is declining as offshore CMs increasingly dominate the market. Even so, it is important to recognize that contract manufacturing does not necessarily mean a company is contracting work to foreign entities.

Further, there are newer, niche manufacturing companies in the U.S. that are filling specific needs in the market through innovation and specialization. According to a study by the Kauffman Foundation, between 2000 and 2005 there was a 67 percent increase in manufacturing startups in the U.S. Strikingly, the study showed that 70 percent of all U.S. manufacturers have fewer than 20 employees. The result is an overall increase in U.S. manufacturing sales, which rose by 20 percent between 2002 and 2006, according to census data (Hise, 2007).

That said, offshore contract manufacturing continues with robust growth. To illustrate, consider the changes in the industry over the last several years. In 2000, California-based Solectron was the number one electronics manufacturing contractor worldwide, having just overtaken Alabama-based SCI Systems, which then dropped to number two. Toronto-based Celestica was in the number three spot, while Singapore-based Flextronics and Florida-based Jabil took the fourth and fifth spots, respectively (Levine, 2000).

Jump forward to 2007. Flextronics acquired the formerly number one Solectron and boasted over $18 billion in revenue in 2007 (http://finance.google.com/finance?q=flextronics&hl=en). SCI Systems merged with California-based Sanmina Corporation in 2001 (Sanmina, 2001) and had revenues of $10 billion in 2006 (http://finance.google.com/finance?q=SANM). Celestica weighed in with $8 billion in 2006 http://finance.google.com/finance?q=TSE:CLS), representing only a very slight growth over 2005. Jabil held on with over $12 billion in revenue in 2007, up from over $10 billion in 2006. However, it expanded its Asian presence with the acquisition of Taiwan-based Green Point Enterprises and the construction of a new facility in Vietnam (http://www.jabil.com/news/news%5freleases/2007/index.html).

Overall, China is the king of CM, with 52.4% of all CM revenue (Deffree, 2007). India, as well, is a hub for Contract Research and Manufacturing Services (CRAMS) for the pharmaceutical and biotech industry, accounting for approximately 10% of the global market share in this industry. And Vietnam is emerging as an important center.

One thing is clear — the contract manufacturing is booming and, as a result, is experiencing consolidation and volatile change on a literally global scale.

Challenges

Such a market is never without significant challenges. OEMs, Brand Owners and CMs alike have very real and diverse concerns. A 2007 Contract Manufacturing and Packaging (CM&P) study of 224 CMs and 150 brand owners showed that the key concerns of Brand Owners revolve around product quality, consistency and brand protection, while CMs' concerns are focused on customer loyalty and high energy prices (Penn, 2007). Add to this the complexity of time and cultural differences, and it's easy to see how complex the contract manufacturing arena can be.

Quality Control

One of the most obvious challenges in contract manufacturing is ensuring that the quality and consistency of the product is maintained. The OEM loses a great deal of control once manufacturing is moved to another entity, particularly to far-flung places. With this more limited oversight, and often beyond the reach of U.S. product safety laws, any number of practices can negatively influence product quality.

Probably the largest impediments to quality are poor communications between the OEM and CM and insufficient collaboration in the design process. When product design and development take place apart from the manufacturing plant where the products will be produced, misunderstandings and lack of involvement in the design process can lead to faulty manufacturing processes and products that do not fully meet the design requirements. This can result in costly adjustments after production has begun. A study released at the end of August 2007 found that 76% of the 550 toy recalls that have occurred since 1988 were due to design-related problems, with only about 10% directly attributed to manufacturing defects (Palmeri, 2007).

More insidious than simple miscommunication issues, however, are purposeful practices by CMs and/or their suppliers to keep costs down, a primary attraction for hiring firms. A number of counterfeit activities have surfaced in overseas markets. These include passing off recycled parts as new, declaring components to be compliant with regulations when they are not, and producing parts with lower cost techniques that make for a less robust product. Another practice is remarking a less expensive component to look like a more expensive version. Even worse, outright fakes have emerged that look, and even perform, exactly like their brand name counterparts, complete with trademarks and logos, but without the guarantees of the real thing ("High cost of counterfeiting," 2007).

But beyond the danger of customers dissatisfied with a faulty or substandard product is the much greater risk of safety. A rash of recalls in 2007 due to use of lead paint in toys, poisonous pet food and tainted toothpaste have made consumers in the U.S. and other countries skittish about buying products manufactured in China. A 2007 survey found that 69% of surveyed marketing and business professionals worldwide said that "made in China" hurts brands (Roberts, 2007). Jonathan Chajet, Asia-Pacific Strategy Director at consultancy Interbrand Corp., which carried out the survey for BusinessWeek, predicted that it would take five years for this brand damage to dissipate (Roberts, 2007). This, of course, presumes that the problem is fixed.

The impact on China's economy could be significant, and the government is taking it seriously. An investigation of its manufacturing companies following the string of tainted products resulted in 774 arrests and a reworking of their food and drug regulations (Barboza, 2007).

The cost of recalls to the hiring firms is also enormous. Mattel's toy recalls in 2007 racked up costs of $29 million. Mattel is also expected to lose sales in the 2007 holiday season and beyond due to the high visibility of these recalls in mainstream media. Mattel's customers, its retailers, will also take a big hit in costs associated with pulling a recalled product from shelves and replacing it with another product (Hirsch, 2007). An indication of the seriousness of the issue is the toy industry's strong support of tightened safety regulations to drive more rigorous testing of products (Palmeri, 2007).

More important than catching issues before products hit the market, of course, is to ensure they don't happen at all. One way hiring firms are countering these issues is by involving the contract manufacturer earlier in the product life cycle. By being involved in the product and process design, the contract manufacturer has a better understanding of the product, can provide valuable input to ensure efficient and quality-focused manufacturing, and set standards for testing and acceptance of the products.

IP Theft

As the CMs get more involved in the design and development processes and increase their own capabilities as a result, many are moving beyond simple collaboration to provide full design services to their OEM customers. By leveraging investments in equipment, technology and space, they can avoid the largest cost associated with design and prototyping. Furthermore, these manufacturers have the commitment to see design through and move towards manufacturing as quickly as possible, while also ensuring that the design will be manufacturing "friendly."

However, such deep involvement in design, along with the increasing practice by OEMs of contracting out entire products, creates a whole new set of problems in contract manufacturing. International laws do not provide the protections that the US market affords and hiring firms have much less control over where the contract manufacturer sources its own parts and assemblies (with whom it shares information) and what it does with the knowledge and capabilities it develops through contract manufacturing.

Such an environment creates the opportunity for Intellectual Property (IP) theft, patent infringement and copycat practices. These activities can seriously erode the revenue companies need to cover the costs of product innovation and development. This is particularly true in certain industries, like pharmaceuticals, where it typically takes years to develop and test new products.

There is often a fine line between IP Theft and innovation through the application of knowledge gained, and it can be tremendously costly and frustrating for OEMs to seek redress in international courts, where laws are less rigid than in the U.S.

OEMs can mitigate these threats to some degree by clearly and specifically identifying ownership rights in the contract. This includes identifying ownership of product designs, process designs, and manufacturing; right to sell and to whom, etc.

Many OEMs are finding that truly innovative products are often best kept in-house to reduce the risk of copying. Sony Ericsson and Cisco, as examples, both keep their current, cutting edge product manufacturing in-house.

CM Branding

IP thefts aside, CMs have legitimately developed a wealth of knowledge and capabilities through contract manufacturing. Many are now leveraging these to demand co-branding with their OEMs. A good example is Taiwan-based High Tech Computer (HTC), which made handsets for Sprint Nextel, AT&T, T-Mobile and other companies. HTC pressured its OEMs to allow it to put its logo on the back of the handsets, and spent money to polish its logo. In 2008, it launched advertising campaigns to promote its own products, one of which (the Touch phone) it claimed came out before Apple's iPhone (Einhorn, 2007).

Conclusion

Clearly, contract manufacturing can be fraught with risk, cost and complexity. As such, there are circumstances where contract manufacturing may not make sense. If the component or product needs to be tightly integrated with components and products of the hiring firm, or if the component or product is a core competency, it may not make sense to outsource, unless (like Innocent) the purpose is to focus the organization on innovation, marketing and sales. In this case, communication and collaboration will become critical success factors, perhaps more so than in any other mode of contract manufacturing.

Given the growth of contract manufacturing worldwide, and its spread across multiple industries, it is clear that it is here to stay. While a myriad of issues still need to be worked out, this is not unusual in a still young industry. Earlier adopters have blazed a trail and unearthed the complexities and risks, suffering the typical and sometimes significant costs of the fall-out, but also reaping the biggest rewards. As the model matures, best practices and regulations will continue to emerge and the industry will no doubt stabilize, while continuing to enjoy strong global growth.

Terms & Concepts

Brand: A name, image, logo or combination thereof that identifies a product or product line as distinct from other products by the same or different companies. Brands are usually trademarked to protect them from competitors.

Brand Owner: A company that has developed or purchased a brand, usually owning a trademark for such.

Component Suppliers: Companies that supply raw materials or parts to manufacturers for use in the manufacturer's products.

Contract Manufacturing: The process of hiring a manufacturing firm to produce one or more components, assemblies or completed products.

Core Competency: The skills and capabilities that enable a company to perform its core mission.

Intellectual Property: Intangible assets, including creative ideas and specialized knowledge that has commercial value; some of which can be protected by patents, trademarks and copyrights.

Manufacturing Outsourcing: The practice of hiring another company to manufacture parts or products that would otherwise be done by the hiring firm.

Offshore Manufacturing: The practice of moving manufacturing to overseas locations, usually for the purpose of lowering costs through cheaper labor, land and materials.

Original Equipment Manufacturer: Originally, the term applied to a manufacturer that produced a component that another manufacturer used within its own products. However, today it more often refers to a company that sources a product or component from another company and packages and sells it under its own brand, either modified or as is.

Outsourcing: The practice of contracting with another firm to complete work that would normally be completed by the hiring firm. This work can be anything from human resource management to manufacturing.

Prime Contractor: A company with overall responsibility for completing work contracted for by another firm. The Prime Contractor may use many subcontractors to complete the work required by the contract.

Process Design: The development of procedures, flow and quality practices needed to produce a product.

Request for Proposal (RFP): A formalized document created by hiring firms that details work to be completed and the terms under which it should be completed. Firms respond to RFPs with proposals on how they would accomplish the work specified, and at what price.

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Roberts, D. (2007). China's brands: Damaged goods. Business Week, 4051, 47. Retrieved December 9, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=26607209&site=ehost-live

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Suggested Reading

Arrunada, B. (2006). When your contract manufacturer becomes your competitor. Harvard Business Review, 84(9), 135-144. Retrieved December 14, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=21882984&site=ehost-live

Einhorn, B. (2007). What's in a name? Fatter profits. Business Week, 4058, 82-86. Retrieved December 26, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=27363591&site=ehost-live

O'Brien, J.M. (2001). The making of the Xbox. Wired, 9 (11). Retrieved January 3, 2008, from http://www.wired.com/wired/archive/9.11/flex.html%5Fhl%5F