Contract Manufacturing: Perils And Profits

Dec. 21, 2004
Veteran companies struggle with crooked contractors, quality and labor problems, and outsourcing decisions.

Wall Street sure liked Sara Lee when the Chicago conglomerate announced it would shed manufacturing assets to focus on making megabrands. "This restructuring program is aimed at fundamentally reshaping Sara Lee Corp. for the future," promised John H. Bryan, chairman and CEO, in September 1997. Sara Lee would use the money from selling off factories to buy back stock and to beef up advertising and other marketing efforts. Delighted investors pushed the stock price of the $20 billion old-line food and apparel manufacturer up 50% to $62 a share. The company's decision attracted widespread notice, and Sara Lee became a clich associated with killing off manufacturing to focus on intellectual property. Two years later, its three-year "deverticalization" strategy nearing completion, Sara Lee looks slimmer, but analysts would like the company to lose more assets. It has by no means shed all of its factories. It still makes cheesecakes, Wonderbras, Hanes hosiery, and Jimmy Dean sausages, to name a few. Struggling with quality problems, the company has watched its stock price plummet to a low hovering around $23. The experience of Sara Lee offers lessons for other manufacturers thinking about selling off factories, and its struggles with outsourcing are not unique. First spawned by textile makers that needed to keep costs low, and honed by computer manufacturers that wanted to cut the time it took to bring products to market, outsourcing -- or farming out fabrication -- has gone mainstream. Now companies making everything from cars to tools to food products are asking themselves, do we need to make this ourselves? When the answer is no, original equipment manufacturers seek producers from San Jose to Taipei, and Budapest to the outskirts of Beijing. Today the manufacturer that doesn't outsource a part of production is rare. Even Intel Corp., which has thrived on its "copy exactly" production strategy, outsources some fabrication. "By no means do we restrict ourselves just to manufacturing internally. Where we do so is where we need the technology leadership and where we can manufacture in a very cost-effective way," explains Sunlin Chou, vice president and general manager of the Technology & Manufacturing Group. Intel outsources assembly of components, but makes its own microprocessor products. Automakers, too, are building less and less of each car they sell. Volkswagen do Brasil was considered revolutionary three years ago when it invited suppliers to establish themselves within its bus-and-truck plant south of Rio De Janeiro. Inside Volkswagen's walls, suppliers finish parts and assemble modules on production lines ("VW's revolutionary idea," IW, Mar. 17, 1997, Page 62). DaimlerChrysler AG has adopted a similar system, and in August Ford Motor Co. announced it would implement the approach at its new $1.3 billion auto factory in northeast Brazil. Analysts predict that if Ford's move to outsource critical parts of its final assembly works in Brazil, the company may try it in other parts of the world. Manufacturing is not the only function that companies are shedding to lower costs. Information technology and accounting services remain targets. Wall Street often applauds major outsourcing agreements, because, when successful, they reduce costs, improve time to market, and increase cash flow. However, many companies stumble in their rush to divest factories. "If you shed your assets, but still control their performance, you have the best of both worlds. That's what contract manufacturing does if companies handle it well, but not more than half do," warns Earle Steinberg, coleader of A.T. Kearney Inc.'s supply-chain manufacturing practice. Veterans of outsourcing provide examples of pitfalls awaiting novices. Nike Inc. founder Philip H. Knight turned to contractors in Asia in the mid-1960s to make U.S.-designed sneakers for his fledgling company. Thirty years later Nike became a corporate symbol associated with unfair labor practices in developing nations. Sara Lee promised too much and then struggled with quality problems, ironically, in a factory it never intended to sell. By 1999 Sara Lee had consolidated 26 European factories into less than a dozen. In the U.S. it had divested nine yarn and textile plants to National Textiles LLC, a newly formed company run by a former Sara Lee executive. It sold its Douwe Egberts Van Nelle Tobacco unit to Imperial Tobacco Group PLC. It also repurchased common stock valued at $1.5 billion. But a number of analysts wanted more bricks and mortar to be sold. "Not enough has been outsourced. That's their problem -- they should get rid of more," observes Sheena Shan, an analyst at Warburg Dillon Read, which rates Sara Lee a "hold." "We still haven't seen significant improvement in terms of the business performance," she complains. Worse, Sara Lee suffers from a public-health nightmare that emerged late last year. Since 1994 one of its largest factories, the Bil Mar Foods processing plant in Zeeland, Mich., which makes Ball Park franks and Sara Lee Deli Meat, has been the subject of five food recalls. In reports federal inspectors complained about poor sanitary conditions including spoiled meat left on equipment and cockroaches found near ovens. In 1997 the U.S. Dept. of Agriculture shut down the factory for a week because of contamination, but that didn't prevent a deadly listeriosis bacteria from finding its way onto franks produced in 1998. Last December Sara Lee announced a recall of nearly 15 million pounds of meat and temporarily closed the Bil Mar plant. The Centers for Disease Control & Prevention later linked the listeriosis contamination to 11 deaths and at least three miscarriages. By June parts of the factory were running again, an advertising campaign offered consumers free meat, and Sara Lee had hired a food-safety expert to improve its processing and testing procedures. Still, the recall left a number experts wondering how Sara Lee would manage quality among its suppliers when it had consistently failed to do so in a factory managed by its own employees. "Quality is a big problem that they're having. That's why outsourcing is such a small percentage of their business," concludes Shan. A spokesperson for Sara Lee points out that controls are in place to ensure quality among suppliers. "We have stringent quality-controls standards in facilities, and additional quality control is built into outside agreements with suppliers," says Jeffrey Smith, who directs media affairs for the company. Sara Lee is one of many corporations in a range of industries grappling with challenges presented by contract manufacturing. Nortel Networks Corp. thinks it has come up with a fail-safe approach. Once known as an old-line maker of telecommunications equipment, Nortel is essentially departing the business of manufacturing in a bid to become a designer and marketer of Internet and telecommunications solutions. Last January the Brampton, Ont.-based organization announced plans to close or sell off as many as 12 manufacturing operations in North America and Europe over three years. The corporation expects to save as much as $300 million annually after completing restructuring. "We decided we needed to be a much more agile company so we're taking fixed costs and making them more variable," explains Chris MacIsaac, vice president-Manufacturing 2000 and a 26-year Nortel veteran who is leading the restructuring. The company intends to change its culture from one that made equipment to one that passes information about equipment to suppliers and customers. Replacing its in-house production will be seven global "system houses," in effect, sophisticated switchboards linking customers, product designers, contract manufacturers, and other parts of the supply chain. By shedding most of its factories, Nortel is moving from a capital-based business to an information-based company. Core competencies -- the skills that differentiate the new Nortel from its competitors -- include testing and final assembly. It is putting prominence on intellectual capital -- brands, new-product development, channel strategies -- over bricks and mortar. Mission-critical employees Employees who thrive in the new Nortel will be those skilled in managing intellectual capital -- people who can delegate assignments to partners outside company walls, rather than those accustomed to sending it down to junior staff. "The mission-critical employees in a company like Nortel are its designers and salespeople," relates MacIsaac. Their goal is to create new products and put them in front of customers with lightning speed. Like many companies that choose to outsource, Nortel is holding onto a few critical technologies. It still will make its most sophisticated printed circuit boards. A similar shift is sweeping through the pharmaceutical and biotechnology industries. Start-ups and pharmaceutical giants alike are turning to contract drug-development firms to handle production for clinical trials and recently to make drugs for the commercial market. Regulatory changes, proven track records of contract manufacturers, and a spate of promising new drugs are forcing companies to seek help from outsiders. In 1997 the Food & Drug Administration (FDA) began granting drug approvals on the basis of product analysis rather than the manufacturing process, as it had in the past. Furthermore, scientists are coming up with promising potential cures to disease faster than companies can set up factories. Using a contract manufacturer can help a company to limit risks. Developing biopharmaceuticals is a lengthy and expensive process. Each drug goes through the FDA's three phases of trials, which can total five to 15 years and cost as much as $500 million. Building a factory alone can cost $50 million. In 1993 Synergen Inc. put up a large plant in Colorado to make a drug the company thought would treat septic shock. The drug failed in final clinical trials, Synergen's stock lost 68% of its value, and the factory was sold to Amgen Inc. "Ugly Americans," Taiwanese copycats Some companies back into contract manufacturing. That's what happened to $1.9 billion Pentair Inc. Its unusual system of farming out fabrication helped the St. Paul maker of pumps, industrial controls, and professional tools achieve market leadership in the tough air-nailers business in just four years. In 1994 it bought a patent for a pneumatic nailer -- a tool powered by air that ejects nails -- from a U.S. inventor, tweaked the design, and sent specifications to its office in Taiwan. Today Pentair is competing for the top market position. Pentair turned a problem into profits, but its experience shows just how difficult outsourcing can be. In the mid-1980s its Delta International Machinery Corp. unit couldn't make a product that wasn't copied. "If our product had a crack in the casing, theirs would have the same crack. We were suing 52 different Taiwanese manufacturers for trade violations," remembers Joseph R. Collins, vice chairman. As part of the lawsuits a handful of employees flew to Taichung, Taiwan, to meet the entrepreneurs allegedly copying their products. They returned advocating an "if you can't beat them, join them" strategy. The Americans realized the Taiwanese could make products more cheaply than they could be produced in the U.S. Quality levels weren't high enough, but that could be taught. So the group set up an engineering office in Taichung in 1984, leased a house they called the "Delta House," and went about lining up contractors and then teaching them consistency. "We made every mistake you could make. We were the ugly Americans treading on Taiwanese soil and thinking that everyone was what they seemed," recalls Collins, who flew to Taiwan every few months to work on alliances. A crucial lynchpin The group chose contractors who copied product designs, who sold them to as many as nine different competitors, and whose poor-quality products ended up on shelves at home centers. They established ties to entrepreneurs who couldn't meet delivery dates. They drank a good deal of Taiwan beer at business gatherings before realizing the custom of establishing a designated drinker. The one thing that Pentair did right was to hire away from a large local manufacturer an enterprising Taiwanese who understood the business of connections. Fifteen years later Collins swears that if it weren't for that lucky find, an individual who became the lynchpin in Pentair's Taiwan contract-manufacturing operation, the U.S. company would not have succeeded there. Acknowledging the man's strategic value and fearing acquisitive competitors, Pentair asked IndustryWeek not to mention him by name. Collins helped to win the Taiwanese man's loyalty, not with money, but through a personal favor. His daughter needed an organ transplant, and Collins assisted in arranging to have the surgery performed in the U.S. "We built a very personal relationship, very much built on trust," explains Collins. In return, the man established a tangled web of as many as 75 contractors and subcontractors throughout Taiwan and later in three cities in China. The relationship between Collins and his key Taiwanese manager may rest on trust, but the system Pentair and the man organized holds plenty of safeguards. Not every Pentair product is outsourced. The company chooses to manufacture the customized high-end items. In contrast, foreign contractors make inexpensive products that sell in large volumes. Pentair executives figure outsourcing a product should cost 15% to 20% less than making it in a corporate factory. Today, for example, foreign manufacturers make more than half of the products sold by its Delta unit. Pentair's system in Taiwan works like this: Each contractor makes a different piece of the finished product. Sometimes Pentair furnishes its suppliers with raw materials or equipment needed to make its specific piece of the whole. When finished, the supplier sends the piece back to Pentair's Taiwan office, which then sends it to the next link or to the final assembler. This way, none of the contractors knows about the others. So far, the system has prevented contractors from secretly collaborating to copy one of Pentair's products. "The key is to find the assembler," concludes Collins. "He's the one you're ultimately going to pay for production, and then you go with him and you qualify all his subsuppliers." Pentair employs 30 people in Taichung. Many of them test products and check quality. The company, which in Taiwan prefers informal arrangements to legal agreements, also controls the process in other ways. It carefully guards equipment designs and what it refers to as the "core of the product." The core, for example, may be the motor that runs the power tool. In its hot-selling pneumatic nailers the core is the seal that holds the tool to the air compressor. The St. Paul manufacturer agrees to buy 100% of its contractors' output and bans suppliers from accepting assignments from other companies. In return, it has invested in new equipment for suppliers' factories. It pays in advance and makes good on promises to buy everything ordered. If it suspects a contractor of dealing with the competition, it pulls its business and turns to others already lined up. Manufacturers need to worry about a good deal more than just crooked contractors. Some organizations move quickly to sign an outsourcing agreement without sufficiently investigating the supplier's track record. To achieve satisfactory quality in products, companies that outsource production must stay intimately involved with the manufacturing process. Some companies close factories, but hold onto product design. When that happens, the contract manufacturer usually takes over parts purchasing, and the original equipment manufacturer stops hearing from parts salespeople. As a result, its designers become out of date. They lose the ability to use the latest parts to create new products. Contract manufacturers themselves admit pitfalls exist. Outsourcing has changed a good deal in the two decades that Greg Willard, president of $33 million Quality Control Corp., Chicago, has worked in the business. Technology helps companies manage outsourcing, but used incorrectly, it can create difficulties. "Some manufacturers are almost like brokers with an exceptionally good database, which they use to pit one supplier against the next for the best price," says Willard. When one contractor takes on an assignment for less than it can be completed, the results can be dismal: poor quality, missed deadlines, even a bankrupt supplier. Intellectual-property protection remains a thorny issue. Most contract manufacturers share process improvements. That is, innovations in manufacturing developed for one customer will be passed on to the next. Covance Biotechnology Services, an arm of Covance Inc., retains rights to process technology, but if a new development emerges while employees are concentrating on one company's product, Covance grants that client a free worldwide license to the innovation. "It does become a gray area because it's not every day we come up with absolutely product-specific process improvements," admits Roger Alias, vice president of business development for Covance Biotechnology Services. Today's collaborators, tomorrow's competitors A greater concern is that one day a company's supplier may become its competitor. Although leading contract manufacturers insist they would never go into branded manufacturing, it has happened. For nine years, Giant Mfg. Co. in Taichung, Taiwan, learned everything it could about making bicycles while manufacturing them for such clients as Schwinn Cycling & Fitness Inc. and Specialized Bicycle Components Inc. Then it launched its own line of Giant-branded bicycles, which today stand next to Specialized and Schwinn brands on retail floors. Reliance on contract manufacturing also leaves the door open to powerful distributors that seek to sell branded goods. A contract manufacturer making new products for an array of competitors stores a powerful data bank of knowledge and skills, which usually is available to anyone who will pay for it. Solectron Corp., for example, has learned best manufacturing practices from its clients, which include IBM Corp., Hewlett-Packard Co., and Mitsubishi Electric Corp. Such information will prove critical to a collaboration it announced in April with Ingram Micro Inc. The distributor of microcomputer products will sell build-to-order branded and unbranded computer systems made by Solectron. Heavy use of suppliers in other industries has similarly lowered entry barriers to outsiders. The day may not be so far off when Wayne Huizenga, founder of AutoNation, who has acquired many auto dealerships, will start producing a private-label car to sell at his outlets. "He'll go to the companies supplying the large car manufacturers and ask them to build a car for him at half the price," suggests Ravi Anupindi, assistant professor of operations management at Northwestern University's Kellogg Graduate School of Management, Evanston, Ill. But with new money for marketing that used to go into operations, old-line producers turned lean and mean makers of megabrands may beat outsiders in the changed game.

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