The Definitive Guide to Contract Manufacturing

Overview of Contract Manufacturing

Contract manufacturing, otherwise known as outsourcing, has become an ever-more increasing trend worldwide as companies look to become more competitive in a new global economy. According to a recent survey by Micro Sourcing, 57% of companies in the United States increased their use of outsourcing, while 34% significantly restructured outsourcing agreements and only 9% terminated their outsourcing agreements setting the stage for continued growth in outsourcing.

The business model of a contract manufacturer is simply to perform a service for an external customer. The hiring firm will issue a request for quote and the contract manufacture will provide a quote based on estimated material, labor, tooling, overhead, and profit. There are many reasons for this arrangement with the primary one being cost. However, aside from cost, other reasons include access to new technology, expertise, quality, faster lead times, capacity, flexibility and better return on assets.

Contract manufacturing is used by many industries including the aerospace, defense, semi-conductor, medical, electronics, clothing, consumer products, and automotive industries. Within each sector and within each individual company there are a many facets to consider in a multi-variate analysis when making the decision to outsource. Strengths and weakness of the firm must be identified as well as opportunities and risks. Outsourcing and contract manufacturing decisions will affect companies for many years down the line and are not decisions that should be taken lightly, but ones that should carefully examine the advantages and disadvantages.

Types of Contract Manufacturing

Many industries utilize contract manufacturing, but rather than simply lumping all outsourced manufacturing service under a single contract manufacturing bucket, it is important to understand that different types of contract manufacturing exist, and each have their own challenges and opportunities. Contract Manufacturing is used for a variety of products including electronics, drugs, clothing, medical devices, finished goods fabrication, and parts fabrication. Manufacturing electronics is vastly different than manufacturing garments of clothing and therefore comes with different benefits and risks. Likewise, finished goods manufacturing is very different than parts fabrication. For instance, if a product requires a lot of proprietary intellectual property, then it may pose too great of a risk to outsource all the manufacturing to an external supplier. It may be better to only outsource the components to the external vendor and complete final assembly in-house.

Companies like Nike, for instance, contract all their manufacturing to external vendors because manufacturing shoes does not require a lot of proprietary technology. The value of Nike is in its marketing and branding, not its manufacturing. In contrast, companies like Boeing, the aircraft manufacturer, build complex products with a lot of proprietary information and manufacturing airplanes is a core competency that gives them a competitive advantage. Rather than outsourcing their final assembly, they utilize an extensive network of parts suppliers to design and fabricate simple components that they use to assemble an airplane. The two are radically different products with radically different relationships with their contract manufacturers.

Reasons for Using Contract Manufacturing

There are more reasons than lowering cost that companies decide to utilize contract manufacturers. As seen below, 59% of respondents listed cost cutting as a reason for outsourcing, but there are many other factors to consider that can also influence outsourcing decisions.

Focusing on core competencies, quality, and capacity are a few of the runners up to cost that companies cite as reasons for outsourcing. Utilizing outsourcing to focus on core competencies is a self-perpetuating cycle because as firms continue to become more specialized at a process or technology, the differences between firms will increase. As the firms differentiate, so do their comparative advantages. When the comparative advantages are greater then there is even more of an incentive to outsource as each firm will have its own specialty that it can provide to the market with greater efficiency and higher quality.

For instance, as firms develop their intellectual capital in a segment of the market, companies will be incentivized to contract with these firms to gain access to their technology and intellectual capital. New technologies such as additive manufacturing, otherwise known as 3D printing, may be an area that can offer a tremendous amount of value but is not a technology that many firms have a lot of experience or expertise in. Rather than investing heavily in developing this expertise in-house, firms can simply gain access to on-demand contract 3D printing through 3D printing services. At an improved level of speed and cost, contract 3D printing services can provide high-quality 3D printed part designs and products to customers.

Capacity can also become much more flexible as contract manufacturers provide companies the flexibility to quickly scale up or down with product demand. Manufacturing in-house requires companies to build and staff their own facility which requires investment in equipment, training, and management. Although, an in-house method can provide greater control, it decreases flexibility that companies have as it is much easier to hire and fire a contract manufacturer than it is to sell a building and liquidate its equipment. With contract manufacturing, fixed costs transition to variable costs and companies only pay for exactly what they need with less risk of running out of capacity or having excess capacity.

Areas to Evaluate Before Outsourcing

Defining Core vs Non-Core Operations

One of the first steps in making an outsourcing decision is to identify the core-competencies of the firm and what gives it a durable competitive advantage in the market. Likewise, the firm should also seek to understand which areas are non-essential and not their core competency. Non-core competencies are a prime target for contract manufacturing as companies can often achieve significant value through improved quality and expertise, in addition to lower cost.

Product Opportunities

Firms need to develop the very best products to compete in the market. To do this they leverage their internal intellectual capital, but also utilize their supply chains for additional value. Higher quality and expertise in a commodity can improve a company’s products as they have access to the very best technology and industry know-how. Contract manufacturing allows companies to leverage their internal core competencies with the expertise within their supply chain to create truly amazing products.

Identifying the Risks

Although there are many reasons to outsource, there are also many reasons to not outsource including loss of control, sub-par quality, late deliveries, and the potential loss of IP. One of the major risks in utilizing overseas contract manufacturers is the fact that laws protecting intellectual property differ from country to country and as a result a firm’s product could be reverse engineered, stolen, and reproduced. China is prime example whereby the IP of many products, most famously Apple’s iPhone have run into issues with counterfeits being distributed because of an IP leak.

While many times, outsourcing can lead to improved quality, in some instances, when due-diligence is not done properly, contract manufacturing can lead to a reduction in quality. This can be a result of a lack of communication about the product requirements or simply because of a poor manufacturer. In addition to quality issues, late deliveries can also plague companies that utilize contract manufacturers. The reasons can range from a lack of ability to successfully build a product to the contract manufacturer deprioritizing a customer’s order. If a customer makes up a small percentage of a contract manufacturers workflow then there is a possibility of the jobs being relegated to later in the queue to make room for more profitable work.

Evaluating Capacity Constraints

Companies should evaluate their manufacturing capacity and their anticipated demand when deciding whether to outsource. If there will be a sustained increase in demand, it may make sense for the company to build its own capacity. However, if the company is in a market environment in which demand is largely unknown or is anticipated to be cyclical or volatile then contract manufacturers are in a position to provide a great deal of value. The companies will then be able to use the contract manufacturer to quickly scale in response to demand and not run into a situation where they are left with a large amount of unused capacity or where they are over capacity and cannot deliver on commitments to their customers.

Effect on Financials

Maintaining property, plant and equipment assets on the books creates a situation where companies are scored on their ability to create revenue from those assets. Contract manufacturing allows companies to reduce their assets and capital investments but continue to build their products and create revenue. This has a positive impact on firms’ financial indicators including their return on assets, return on investments, and inventory turnover. By carrying less product inventory and less equipment, firms can run leaner operations that allow more speed and flexibility. Contract manufacturing can be a great way to turn fixed costs into variable cost and improve financials to attract more favorable financing from capital markets for future investments.

Contract manufacturing can also give companies access to new markets. When a company manufacturers their products in a different state or country then there is more awareness of the brand and its products in that region. This can be used to drive sales in growing markets. This has been true for companies such as Apple, who have used their contract manufacturing geographical location to drive sales in the Chinese markets. Likewise, although Tesla is still manufacturing their cars in a Tesla owned facility, increasing Chinese sales has been a driving factor in their decision to build an automobile manufacturing plant in China.

Getting Started With Contract Manufacturing

Interested in learning more about new technologies in contract manufacturing? Check out our article on contract 3D printing to learn more about 3D printing’s capabilities as a manufacturing technology and how it can provide innovative solutions to your product needs.

Ready to get started manufacturing your product? Contact ZABFAB to get started manufacturing your 3D printed products!

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