New Market Factors Driving an Outsourcing Staple–Contract Manufacturing

Though most of Europe and the United States use the Internet, over 85 percent of the world’s population can’t because underdeveloped countries haven’t built the infrastructure to support online services or the masses simply can’t afford computers. Advanced Micro Devices (AMD) decided to do something about that. In 2004 it launched it’s Personal Internet Communicator (PIC), a $250 scaled-down computer and online connectivity service that local ISPs and telecom companies brand, market, resell, and support in China, Russia, India, Mexico, and Brazil, providing online communications, education, and entertainment to disenfranchised millions.

The catch, explains John Principe, Director of Strategic Supply Chain Management, Personal Connectivity Solutions Group, is that AMD makes microprocessors not consumer electronics. So while AMD designed the PIC, it outsources manufacturing and distribution to Solectron, a contract manufacturer (CM) whose core competence is high-volume consumer electronics devices like cell phones.

The relationship lets AMD expand its product line, adds Principe, as well as “leverage Solectron’s extensive network of Tier Two suppliers” so Solectron can negotiate quantity discounts on components it also uses in other products. What’s more, he points out, Solectron has manufacturing plants worldwide to support AMD’s global rollout.

Outsourcing to CMs is actually less the exception than the rule for most original equipment manufacturers (OEMs). This age-old outsourcing practice helps OEMs manufacture products cheaper, faster and better. CMs can take over everything from packaging to manufacturing to actual design of products which lets OEMs focus on sales, marketing, and business development. As Table 1 shows, CMs comprise a huge industry that will reach $237.5 billion in revenues in 2008, and most OEMs in most market sectors use them.

Benefits of Contract Manufacturing

Contract manufacturing thrives when high volumes of goods have to be made according to tight deadlines using standardized processes so that the CM can leverage economies of scale to produce each unit at a lower price than the OEM could. The more standardized the processes, the faster goods can be manufactured and the greater number of qualified CMs can plug into the supply chain, which increases competition and drives down production prices for OEMs. Multiple CMs also allow OEMs more flexibility in, say, scheduling work done at the last minute.

OEMs also benefit from using CMs because they can divest themselves of fixed costs for plants, machinery, and employee benefits. As a result, says John Fontanella, Vice President, Supply Chain Services, Yankee Group, for OEMs “there’s huge balance sheet savings and the revenue per employee is higher [which means the OEM is] probably a more profitable company.”

New Challenges for OEMs

In addition to the basic CM value proposition, new market factors are driving OEMs to use CMs. For instance, says Fontanella, high tech product lifecycles have become so short that building plants and hiring specialized staff to support them is sometimes not feasible for OEMs. CMs, on the other hand, cope with short cycle times by acquiring companies that are specialists in the type of product to be manufactured and using offshore workers that can be hired and laid off as needed due to less stringent labor laws outside the US.

Also, to keep down costs, automotive OEMs outsource increasingly more car manufacturing tasks to Tier One suppliers so the OEM does less assembly on its main production lines, the part of the process that’s most expensive for the OEM. Aerospace companies even outsource to foreign CMs in exchange for the right to sell US planes in foreign markets with their own national airlines.

CMs Expanding Their Value Proposition

According to Dan Miklovic, Manufacturing Research Director, Gartner, most CMs fall into two general categories–electronic CMs (ECM) make electronics parts or products that the OEMS designed, and original design manufacturers (ODM) use the OEMs’ product specs to actually design and then manufacture the part or product. Then there are miscellaneous CMs that perform functions like packaging.

Because of their razor-thin margins, says Fontanella, CMs are continually trying to pitch OEMs on new value-added services they might provide like designing products, managing the logistics of product delivery, or the reverse logistics involved in product returns. This is understandable, but Miklovic cautions that US OEMs open themselves to eventual competition from CMs if they outsource too many value-added activities to them for near-term cost savings.

For instance, he says if OEMs outsource warranty and repair capabilities for electronics products, they need to give CMs final test and assembly information so they can do diagnostics. This cannibalizes their own expertise and gives up a service for which they could themselves charge healthy margins. He cites the example of Flextronics, a CM that amassed so much expertise in telecom equipment manufacturing diagnostics and repair in Scandanavia that it launched a telephone system installation and operation business there that competed with similar services from its OEMs. He emphasizes that in outsourcing too aggressively OEMs “risk losing intellectual property of the design of the product (though OEMS can protect this by patents and other protective measures), but also their expertise in operation and maintenance, and that’s something they can’t protect by law, only by contractual stipulations.”

Offshore, But Not A Threat

Most contract manufacturers are located offshore, primarily in Asia, so laymen often mistakenly attribute the loss of American jobs to contract manufacturing. Miklovic explains, however, that the recent surge of outsourcing IT work offshore is a new and different phenomenon from contract outsourcing. “Contract manufacturing has been going on for ages in all kinds of markets,” he asserts, “and is necessary to keep American businesses competitive in the global marketplace.”