What is Contract Manufacturing?
Contract manufacturing enables companies to offload part of their operations to an external vendor that can provide superior quality, cost, capacity, expertise, and/or lead time. This could include design, fabrication, or assembly. A customer will typically request an estimate and the contract manufacturer will provide a quote based on the estimated cost of material, labor hours, tooling, overhead and profit for the job. Most contract manufacturing jobs are build-to-print, meaning the manufacturer builds the product to the customer’s exact blueprints. However, another common setup for contract manufacturing is a design-build job whereby the contractor both designs and manufactures the product. With each structure, there are advantages and disadvantages of contract manufacturing that must be considered.
There are many reasons that firms chose to use contract manufacturing, but the primary reason is to reduce cost. Contract manufacturing allows companies to utilize firms with lower overhead costs and/or greater economies of scale for the operation that they are contracting for. However, aside from cost, other reasons for contract manufacturing include access to new technology, expertise, quality, faster lead times, capacity, flexibility and better return on assets. Like any business decision, there are both opportunities and risks associated. Likewise, there are advantages and disadvantages of contract manufacturing that must be weighed before making the make or buy decision.
Advantages of Contract Manufacturing
There are many advantages to contract manufacturing other than simply lowering costs. Contract manufacturing can give companies access to new skills, technology and expertise that they otherwise would not be able to utilize. For instance, 3D printing is a relatively new manufacturing technology that many companies still do not have a lot of expertise in. Rather than devoting resources to developing a 3D printing design and manufacturing capability in-house, many companies are utilizing contract 3D printing and partnering with a 3D printing service that offers expertise in that area. It gives companies access to a new manufacturing technology without requiring the capital investment in equipment, labor, training, and real estate.
Contract manufacturing can also lead to improved quality and productivity as contracting to a supplier with high expertise can lead to more advanced manufacturing practices and better economies of scale. If a firm outsources an operation that is not its core competency to a firm who specialize in that given area, then the quality and efficiency will likely be far superior. Products will have higher quality and shorter lead-times improving the product lifecycle and time to market.
The contract manufacturing decision can also be based around allowing a firm to concentrate on its core-competencies. Outsourcing non-essential processes allows companies to focus on the areas that differentiate them in the market and give them a durable competitive advantage. Nike and Apple are two companies that chose to outsource their manufacturing as it allows them to focus on their core-competencies: product design and marketing. They outsource to companies that can make shoes and phones more efficiently than they could in-house. However, the real differentiator for both Nike and Apple are their brands, for which flawless product design and marketing are paramount.
Contract manufacturing also gives companies more flexibility to adapt to changes in the marketplace. When a firm invests in in-house capabilities, they have real-estate, equipment, and personnel to manage, all of which cannot be instantly expanded or liquidated. Contract manufacturing allows companies to quickly adapt their products to changing consumer preferences.
Of course, the primary reason that any company chooses to outsource is to cut costs and improve financials. Removing property, plant, and equipment from the balance sheet increases the return on assets and dollars invested, which are both key financial indicators for businesses. Turning fixed costs into variable costs, allows companies to achieve greater inventory turnover and look like a more attractive investment for capital markets when firms decide to invest in future opportunities.
Contract manufacturing can also give companies access to new markets, especially when combined with offshoring. Building in different geographic regions exposes that area to a firm’s brand and product lines. Tesla, although still maintaining ownership over their Chinese facility, has utilized offshoring as a strategy to sell more of its cars in China.
Disadvantages of Contract Manufacturing
There are, of course disadvantages to contract manufacturing, the main disadvantage being loss of control. Although companies can use contract manufacturing to achieve higher quality, it can sometimes be the case, that quality standards are not adhered to and sub-par products are delivered. This can impact the brand and cause product shortages as companies spend time going back to correct the quality defects.
Delivery schedule, although stipulated in the contract, is also subject to risk as contract manufacturers can chose to prioritize other jobs with higher profitability over others. Likewise, some contract manufacturers may simply just not have the ability to make the products to the customer’s desired specifications.
A big problem with contract manufacturing, especially when combined with offshoring, is potential theft of intellectual property. Some countries do not provide adequate protections on intellectual property in their laws, which opens companies up to the risk of losing their proprietary information. This could lead to counterfeit products that siphon away sales from legitimate products.
The decision of whether to use a contract manufacturer is a nuanced decision with several factors to consider in addition to cost. Strategic importance and the firm’s own core competencies are key items to analyze when evaluating the advantages and disadvantages of contract manufacturing.
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