How to Get The Best Deal in Contract Manufacturing

Oct. 30, 2007
Apply strategic outsourcing

The contract manufacturing industry is selling itself short by not leveraging the benefits strategic sourcing has to offer, such as obtaining top-quality resources, turning fixed costs into variable costs and increasing controls over unit pricing. Currently, the contract manufacturing industry remains largely focused on cost-plus or rate-of-return models -- resulting in negligible strategic benefit. By employing strategic outsourcing principles, the contract manufacturing industry's customers and vendors will be able to realize true business improvements that bolster both the success of their business and the industry as a whole.

Frequently in the contract manufacturing industry, third-party transactions turn into nothing more than out-tasking, where a third party performs the activities that the customer would have provided for itself, under the similar basic conditions. Many times, the customer believes they are entering a strategic outsourcing transaction, but the result is anything but.

As an example, say your company has decided to outsource its internal manufacturing to a third-party provider with the goal of obtaining strategic outsourcing benefits. Whether you've engaged Flextronics, Jabil Circuit, Foxconn, Plexus, or one of the other many providers, your vendor has committed to being a "strategic partner" that will enable your company to transform its business through benefits such as its global footprint, sophisticated systems, cutting edge manufacturing processes, world-class facilities and state-of-the-art training.

However, during the course of negotiations, it becomes apparent that a strategic outsourcing opportunity -- in the truest sense -- was never in the offing. Rather, it has become a cost-plus arrangement, whereby the vendor takes little to no risk and your company has few, if any, opportunities to obtain a strategic, competitive benefit. Strategic outsourcing was not designed to achieve this result, and customers should demand more.

Applying Strategic Outsourcing Correctly

When well executed, strategic outsourcing involves the outsourcing vendor utilizing its scale, purchasing power and lower wage locations to reduce its own costs as well as the vendor capitalizing on its ability to perform functions in a more efficient and effective manner by deploying technology, methodology, and leverage across multiple customers. A true strategic outsourcing model provides customers value-driven results that they would likely never be able to produce on their own. For example, vendors are able to deploy technology, resources and infrastructure across several customers, shifting resource allocation and corresponding costs to more closely align with each customer's demand -- an inherent impossibility when a customer provides itself the services.

In strategic outsourcing, the vendor is providing two critical elements: 1) a customer-driven defined result (rather than a mere activity) and 2) certainty of costs and terms during the contracted period. When the outsourcing vendor can achieve these results more effectively, it reaps the rewards of its innovation, efficiency, and expertise. Yes, there is some risk, but that is the nature of business --and the vendor is able to quantify, manage and price in those risks. Other industries have been doing this effectively for years, and in the process have been able to escape the commoditization of certain offerings, increase revenues and even expand margins.

Current Contract Manufacturing Pitfalls

In today's contract manufacturing transactions, because both parties typically cling to cost-plus or rate-of-return models, both party takes on much risk, and, in turn, neither party obtains much strategic benefit. We frequently see the following dynamics when entering a client engagement:

  • The contract manufacturing vendor focuses on protecting its downside by reserving the right to increase customer prices, e.g., component materials, labor costs, and overhead costs, during the term of the agreement.
  • The contract manufacturing vendor provides some form of a cost-plus pricing structure to the customer, where the vendor has no incentive to reduce costs or increase efficiency, innovation, or effectiveness in addressing the customer's needs.
  • The customer gains comfort from the belief that it will not overpay as it relies on the notion that all contract manufacturing vendors will be subject to similar cost structures.
  • The customer is willing to accept the inherent potential price increases because it retains the perceived flexibility to move its manufacturing to an alternative provider.
  • Both parties are heading down a path where the contract manufacturer will provide out-tasking services to the customer, with the threat of moving business as the only viable lever the customer maintains to control costs and obtain high-quality service.

These scenarios do not deliver real strategic value to either the customer or the vendor. The vendor only has a secured customer until that customer decides to do business elsewhere, and the customer ends up with a vendor that is more focused on marking up costs than innovating or gaining efficiency.

Strategic Outsourcing: Dramatic Benefits for Customers & Vendors

When strategic outsourcing is applied to contract manufacturing, the customer can obtain certainty of pricing (barring select unforeseen events that can be separately addressed) along with a vendor committed to improving and innovating to produce the required result more efficiently and effectively. The vendor secures a multi-year, strategic, committed customer, with the ability to participate in the customer's success and growth, along with valuable improvements in its processes and procedures that it can utilize to improve margin and industry competitiveness.

Ultimately, the vendor can leverage the improvements to competitively differentiate itself in the marketplace by sourcing components more cost effectively, running its operations more leanly, and vertically integrating its supply chain; thereby using these efficiencies to improve the traditionally thin margins that have long plagued the industry. They also can secure a more certain run-rate, global footprint leverage and better customer relationships that lead to greater innovation.

The contract manufacturing industry needs to break free of its current risk-adverse approach and begin competing on value rather than price. While strategic outsourcing is not right for all situations, we've seen companies realize dramatically improved results when vendors are willing to move to a true outsourcing model.

The strategic outsourcing benefits that are consistently achieved in other industries can and should be realized in the contract manufacturing industry. Your company should demand this level of strategic opportunity from your contract manufacturing vendors as both you and your vendors are otherwise leaving the best possible deal on the table.

David Rutchik is a partner at Pace Harmon, specializing in IT and Network Outsourcing, Business Process Outsourcing (including contracts manufacturing), strategic sourcing and other complex transactions. Betty Zimmerman is an associate at Pace Harmon, having supported numerous contracts manufacturing initiatives in industries including Health Care and Technology. Pace Harmon is an outsourcing advisory, strategic sourcing and technology consulting firm, providing support from strategy through implementation for complex transactions.

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