THE LOGISTICS OF CONTRACT MANUFACTURING
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he key issues involved in contract manufacturing are examined.
The Logistics of Contract Manufacturing
by Joseph L. Cavinato
What is Outsourcing? Outsourcing is a general term for the hiring of manufacturing and other value-added form, time and place utility services from another firm. It is the use of production services of other firms rather than those currently in-house or what could be utilised within the firm. The decision typically involves moving current production to outside the firm, or entails using outside sources rather than embarking on new production within the firm. This article shows whyfirmsare shifting to this method of supply management. It includes why outsourcing is, or should become, within the sphere of logistics management. Key issues that firms face or should be concerned with when looking to outsourcing are covered, and some of the risks associated with it are presented. Finally, some insights are presented for the future.
The Logistics of Outsourcing The factory is losing its role as the heart of the firm. Some of the reasons for this trend are wage rate and work rule differences between union and non-union operations, lower wage rates overseas, ease of international transportation movements, and the need to reduce manpower and overhead costs. These have led many firms to look to other options to produce and acquire goods in their lines of business. These other options include contract manufacturing with other firms, using third parties to provide some or all of the materials, production and distribution services, and in some cases entire outsourcing of the finished product. But, though production might be cut back or no longer reside inside the ownership of the firm, a crucial need still exists within it to orchestrate the logistics of the new product flow with the contracted company's operations. A firm's shift from in-house to contract manufacturing, or oursourcing, has broad strategic, organisational, and operational implications. Product flow must still be controlled and co-ordinated. Logistics, which has long served pre- and post-production roles within thefirm,is a logical focal point for this control and co-ordination role in a firm using outsourcing. If logistics does not take the initiative in this area, then a major reason for its existence will stand to diminish within the firm of the future.
Research Methodology The primary thrusts of this research were directed towards the managerial approaches and issues involved with outsourcing. The research was based on visits and interviews conducted with available logistics, production, and upper management personnel in 137 manufacturing lines of business in the United States and Canada in early 1987. A total of 122 firms were included. Primary product areas of the operations represented in the interviews are shown in Table I. A semi-structured interview process was used with people in purchasing, transportation, warehousing, production, materials, distribution and other areas. Firm sizes ranged from $5 million/year in sales with onefinalproduct to $12 billion/year with over 1,000 finished products. A total of 54 of the 137 operations, or 39.4 per cent have production and related activities performed outside the firm. This activity is either (a) production and related services that formerly took place within the operation, or (b) new or expanded operations that, in the past, would probably have been conducted in-house, but instead were shifted to a vendor. Nineteen of the firms were the outsource of other firms, and eleven of these engage in still further outsourcing with their vendors. The findings and contribution of this research are primarily qualitative. Quantitative information was difficult to ascertain for this research for several reasons. First, in many firms, the outsource decision was dispersed or it was entirely analysed and decided by upper management. Second, in many firms, the outsourcing step was undertaken in the past, prior to the tenure of those holding current positions. Thus, while the current issues, concerns and risks were known by the current managers, they often did not possess specific facts regarding the
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Industries Represented in Visits/Interviews Table
Appliances Automotive/Transportation Building Materials Chemicals Computers Communications Equipment Construction Equipment Drug and Toilet Preparations Electrical Machinery Electronics Food Furniture Machine Tools/Machinery Metals Minerals Office Equipment Paper Petroleum Pharmaceuticals/Health Care Plastics Rubber Products Textiles Total Operations Visited = 5 8 3 9 6 5 2 8 9 10 12 7 8 4 6 5 7 5 11 9 4 6 137
II.
Motives for Outsourcing
Raw Materials (%) Components (%) Finished Products (%) 64 19 14 39 to 100%)
Factor
69 Cost 68 Availability 9 28 Quality 18 6 Other 35 37 (Multiple reasons cause findings not to add up
Cost Savings. Outsourcing can offer savings by way of reduced costs of labour, raw material or overhead cost. Firms also seek this option to reduce manpower and fixed investment in plant and equipment. Some of the earliest outsourcing endeavours in the Far East by US firms in the 1970s were motivated by significant reductions in labour costs even though high ocean transportation delivery costs were incurred. Some of the US carfirmsoutsource with non-unionfirmsin the Southeast and Midwest that provide the product at less overall cost. West Publishing of St Paul, Minnesota, outsources typesetting of textbooks in Korea due to the lower wage rates. The cost savings can also extend to the reduction of corporate overhead. Outsourcing can lead to reduced plant and equipment investment which can have the effect of reducing the corporate breakeven point. The reduced numbers of employees within the firm also reduces the costs of manpower overheads in the form of benefits, pensions, and personnel systems. However, outsourcing does tend to increase the purchased expenses-to-total expense ratio of the firm. The purchasing department of a non-outsource firm acquires relatively low-value raw materials. Labour, energy and overheads are added by the firm's production department. The outsourcing firm acquires semi-finished or finished goods that already have another firm's full materials, labour, energy, overheads and distribution expenses included within them. Enhanced Cash Flow. Outsourcing can provide an improved cash flow for a firm. Afirmthat outsources is able to acquire afinishedproduct, distribute and sell it, usually in a relatively short time. This differs from the acquisition of raw materials, the conversion to finished goods, and recovery of cash after collections of accounts receivable at a later point in time. Outsourcing can greatly enhance cash velocity within the firm by shunting the purchase and production operations. Some firms visited have used outsourcing to such a degree
original decision by the firm. Third, many people were not allowed by theirfirmsto share specific data, but were willing to discuss general issues, concerns and perspectives relating to outsourcing. Fourth, some of the findings reported here were derived from interviews within the firms that were the outsource for other firms, and thesefindingsrelate to the nature of these commercial relationships.
Why Companies Outsource The people interviewed for this study indicated a wide range of reasons for their firms either using or considering contract manufacturing. This is also supported by a 1987 Temple, Barker and Sloane study that was confined to foreign outsourcing. Table II shows the results of that study of 50 US firms. Cost saving was the over-riding reason for foreign sourcing, followed by availability and quality. Other reasons were cited by over a third of the firms surveyed[l].
THE LOGISTICS OF CONTRACT MANU
that they have increased inventory velocity to the point of infinite turnover. That is, the product is acquired (outsourced), brought into thefirm,sold, distributed, and cash settlement takes place with the customer before the firm must pay the vendor. Capacity Considerations. Some firms outsource due to constraints in current manufacturing capabilities. Chrysler outsourced a successful and expanding line of car production with American Motors because it lacked the capacity. Somefirmsoutsource new products so that there is little risk in new capacity investment in the event that they are not successful. Still, some appliancefirmsdo the opposite. They often produce new products in-house, then they outsource them in the Far East where mass production cost economies permit them to compete with a proven product. Market/Competitive Timing. It often takes a publisher two years to bring a textbook on to the market from the moment it is received from the author. Editors' time constraints, typesetting, printing and binding can represent bottleneck processes within the firm. Some publishers, on the other hand, outsource these four activities and are able to bring texts online within six months. In a market where a spring introduction is necessary in order to be on the market for consideration for the following academic year, timing is critical. New Technologies. Some computerfirmspurposely do not invest in some production areas because this can prevent them from switching to new technologies when the market demands such changeovers. Instead, thesefirmsrely on there being an availability of firms that can be contracted with to provide the latest technology and perform the latest required tasks. The risks of obsolescence in technological investments are borne by the vendorfirms[2]. Little or No Investment Cost. Frosty Acres is an organisation that supplies a wide range of packaged foods to the institutional and retail sectors. It utilises contract packers, outside warehousing, and arm's length order entry operations. Thisfirmhas very little invested in the inventory andfixedfacilities. Major manufacturing firms often cite the elimination of fixed plant and equipment investment as a major advantage of outsourcing. Perform Difficult Operations. Some manufacturing operations are technically difficult to perform, or firms wish to avoid regulatory requirements involved with them. Drackett Company and many other firms utilise the services of third party aerosol packaging firms in order to avoid involvement in this difficult and potentially hazardous production process for these goods in their product line.
Release Firm to Marketing Expertise. Many clothing, toy and fast food companies contract purchasing, materials, production and distribution services. Martin-Brower Company and Golden State Foods perform much of McDonalds' materials and distribution services in the United States and overseas, thus enabling that firm to concentrate on marketing. Sani-Tech Inc, a fluid transmission system firm, uses contract manufacturing. This firm's key market advantage is design and building entire fluid transmission systems for food and other sanitary environment settings. In both instances, the products sold are commodity-like in nature and could be produced by many firms, but the contractor firm's strength is in development and marketing. Globalisation Opportunities. Firms that seek global production and distribution may utilise contract production due to joint ownership and production requirements in certain countries, as well as to minimise risk. Production under these contractual relationships can be easier to terminate or alter than would be possible with outright ownership. The actual or perceived major advantage being sought through contracting will generally define the nature of such an arrangement. For example, the avoidance of a difficult part of production may cause firms to outsource only that particular subactivity of production. On the other hand, avoidance of investment, overhead and labour, or the need to concentrate on marketing will lead firms to contract much broader aspects of production. Why Outsourcing is a Logistics Concern Logistics' current and future involvement in outsourcing is important for many reasons. In many firms it already appears to play a major role in outsourcing. Further, as production is shifted to outside firms, the logistics expertise of flow timing, storage, transportation and inventory investment control is still needed by the firm. Lastly, logistics, as well as purchasing, has experience in dealing with outside parties in the forms of vendors, carriers, warehousemen and third party firms. The Temple, Barker and Sloan study revealed (Table III) that the management responsibility for outsourcing is found in purchasing, distribution, with third parties and other areas of the firm[1]. These data show that purchasing trends tend to play a stronger role in the raw materials and components areas whereby distribution dominated the finished products end of the production spectrum. The research for this article determined the same general tendency in domestic (US) settings. At this point in time there is a small but increasing trend in the firms studied to combine purchasing with materials and logistics activities within thefirm.This will no doubt reinforce the role logistics will play in outsourcing in the future.
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Table
III.
Management of Outsourced Goods in Distribution (Foreign Outsourcing)
Raw Materials (%) 43 40 15 36 Components (%) 50 41 6 38 Finished Products (%) 28 53 3 42
Department Responsible Purchasing Distribution Third Party Other
Contract manufacturing can change the organisational form and basic managerial constructs of the firm. The first chart of Figure 1 shows the traditionalfirmwhereby all inbound flows feed production while distribution handles product flows from the production line to the customer. In this setting, production is a central activity that can often dominate the firm in its scheduling processes or is a major management function stemming from the high number of employees and fixed investment it controls. Contract manufacturing sometimes removes traditional production management from the central product flow of the firm. The second chart of Figure 1 shows some material flow moving direct from vendors to company distribution facilities or customers. This starts to have a major impact on the make-up of thefirm.In the traditional firm, for example, a plant or production group often controls purchasing, inbound materials, scheduling, actual production, warehousing and outbound shipping. In a contract setting, these functions can be performed by an outsidefirm,and the contracting firm's control issues move to managing the relationship with the outside source. In the firms studied, this involved the functions of logistics purchasing, with a much wider range of responsibilities and activities than simple buying. Thefirmusing complete contract manufacturing is shown in the third chart of Figure 1. Some food, toy and computer firms fall into this group today[3]. In-house manufacturing does not exist; instead, co-ordinatedflowsfrom source to distribution and sales points are the central logistics activity. The management of contract manufacturing is largely a logistical control and co-ordination activity. It involves decisions dealing with timing, locations, transportation, delivery and customer service, quality, lot sizes, inventories, order informationflowsand purchasing. It is a procurement decision that is much wider than traditional buying in that it is the management of entire commercial relationships. Key Issues The research brought to lightfivekey issues companies face with outsourcing. These are: What is to be outsourced? How extensive should the outsource be? Which function initiates and manages the relationship? How should an outsource vendor be evaluated and selected? What should be included in an outsource agreement? They are presented as a managerial model of major issues and elements in the process.
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What is to be Outsourted?
The decision as to what to outsource is linked with the question as to why outsource. Firms often face the outsource decision with the option to contract out a current ongoing product or a new one. Black and Decker traditionally developed products in-house and produced them initially. Once a product gained success and required mass production and cost reduction was crucial to its success in the marketplace, thefirmtended to outsource components, production and packaging. On the other hand, Lederle Laboratories often started new products with outsourced manufacturing and brought them in-house once they became successful. This forced the firm to experience two learning curves, one with the vendor, then
another on starting in-house production. However, the firm avoided having to invest in equipment, thus reducing product failure risk. In both instances, the firms generally had available a range of vendors for either setting. Technology is another initial outsource issue. Should the firm contract out high-technology or low-technology items? Some machinery manufacturers outsource electronic controls rather than invest into this area. The fast-paced change in technology often makes some production facilities obsolete before afirmis able to depreciate the investment. On the other hand, some firms avoid outsourcing key technological items where competitive copying or counterfeiting is a danger.
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Length of the product life cycle is another concern in the choice of what products to outsource. Fad products, with the risk of short product life cycles, increase the risk of idle plant and equipment upon the maturity or decline of the product. Selchow and Righter used Western Publishing as one of its producers of the game Trivial Pursuit. The availability of many contract manufacturers avoids this risk.
How Extensive Should the Outsource Be?
materials inventory, packaging, distribution and marketing. The production of the item is performed by an outside firm. The buying firm performs the materials management, distribution and marketing functions. There are also many computer and electronic firms that hire production capacity from firms that provide the assembly work. Materials and distribution services are often part of outsource arrangements where storage and/or transportation can more economically be performed by the outsource firm. Differences in wage rates or ease of product flow control are often a reason why these preand post-production services are also a part of production outsourcing. This is what the McDonalds outsource consists of, as does the Pepsico Food Service operation for Taco Bell. Licensing and joint venture arrangements often consist of another firm performing most or all of the flow and marketing facets of outsourcing. Here the management expertise of the outsource firm is applied to the entire range of business activities, and the sourcingfirmshares the profits through dividends or royalties. This is often practised in overseas selling of consumer goods. Entire sourcing, manufacturing and selling is handled by local outsource firms that are familiar with specific national markets.
Which Department Initiates and Manages the Relationship?
This is a function of the relative buying power, cost of capital, operational costs and management strengths of each party. Key areas for consideration here relate to whether the hiring firm or the outsource firm should perform such tasks as acquiring the materials for the work, arranging inbound freight, distributing the product to distribution centres, or movement of finished goods to customers. Figure 2 shows eight outsourcing configurations found in the research. These range from having an outside firm perform a very narrow process all the way to having another firm perform nearly all logistics, production and marketing processes. The simplest form of outsourcing is outside packaging. Export operations have long required special crating and packaging, and firms have provided this service within their facilities or upon the hiring firm's site. Contract packaging is common in the food industry. Partial outside production is found where an intermediate step is required in production, and the service is often best performed by other firms. The practice of tolling, which is common in the metal fabrication industry, is an example. The hiring firm acquires the product and moves it to the service firm which performs some modification to it; examples are bending, forming, plating, inspection and welding. It is then returned to the hiringfirmfor use in its production. A combination of partial production and purchasing is performed by many electrical and machinery firms. The firm acquires some metals for use in its consumer products. It has other firms fabricate and finish these materials and affix them to particular products. These goods are then moved back in-house for final production, packaging and distribution. Corning Glass Works often uses outside firms for some production processes involving metalworking. Corning, having market buying power greater than some of these small fabricating firms, will acquire the necessary metals through its own purchasing operation. The raw materials are delivered to the outsource firm. Complete production, or production with packaging, outsourcing is common in the food industry. This option consists of the buying firm performing purchasing, raw
This is generally a function of the complexity and duration of the relationship with a contract manufacturer. In a narrow setting, such as metal process tolling, purchasing is often the primary department having responsibility for this arrangement. The Safeway supermarket chain utilises a purchasing group to oversee its private branding product sourcing. At Chrysler, purchasing oversees the outsourcing process and arranges for product delivery to the production line. Where there is greater complexity to the arrangement and many logistics variables enter the relationship, materials and distribution personnel are often involved. These might require the co-ordination of schedules, deliveries to many distribution centres, linking transportation options and communicating forecasts. This is the case in some drug and consumer firms whereby some contract manufacturing operations deliver products directly to company distribution centres whereas the outsourcing firms maintain strict customer service standards of delivery to customers. The Temple, Barker and Sloane study (Table III) supports the strong presence of purchasing and distribution in outsourcing. However, in this research it appears that the more complex the arrangement and those outsourcing
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arrangements that involve marketing (joint ventures and licensing) then the relationship tends to be managed from upper management echelons.
How Should an Outsource Vendor be Evaluated and Selected?
The selection criteria are similar to those applied in any long-term purchasing setting. The shorter the time span and the lower the value-added service involved, the more simple quality and price can be the managerial guidelines for vendor selection. However, the longer the time span and the greater the complexity of the relationship, the more other objective and subjective elements of concern, to a wider range of departments, enter the decision process. These relate to such factors as reserve production capacity, technical capabilities, quality and balance of management, confidentiality, responsiveness of management, perception of priorities by the vendor towards the firm's business and initiative in cost containment in the long term.
What Should be Included in the Agreement?
Outsourcing situations examined for this study included arrangements that were general understandings in the form of verbal agreements between the chief executive officers of each firm, while in others they were reduced to contracts of considerable size. One such arrangement with a firm in Germany consisted of a two-page letter, while another was over 100 pages in the form of an open-ended long-term purchasing contract. Key elements included in many of these arrangements are as follows: identification of the parties and the products involved; price and/or cost formulas; which firm owns the goods; FOB shipping terms; payment terms; liability of the product once it is owned by the final customer; party holding ultimate warranty with the final customer; confidentiality and security against competitors viewing the production; force majeure term (a suspension term in the event either party has a catastrophe; fire, strike, etc); termination.
The Risks Contract manufacturing is not without risks. It is a decision that requires careful short- and long-term balance of benefits and drawbacks. Some industries have used contract manufacturing for many years, while others are at the initial stages of the learning curve in this new area.
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Outsourcing risks appear to be common by both the experienced and the firms new to it. Major risk elements in this decision are as follows. Confidentiality. This includes secrecy about the product technology, production volumes, and customers and territories to which the product is shipped. Some firms maintain a policy of not outsourcing products involving new ideas or specific technologies; instead, they outsource lowtech mass-produced items for cost advantage. Potential Competition by the Vendor. This problem has occurred in computer and automotive aftermarket industries. Contract manufacturing, in this sense, has taught the outsource firm or trading company how to produce a similar product. Loss of Research and Development Strength. New technologies and applications as well as development of cost reduction advantages often occur because the research, development and engineering are in close proximity to the actual production. Many of those interviewed for this study indicated that these advantages were diminished when their firms outsourced key products. Some firms minimise this risk by outsourcing only mass-produced items once the firm has refined the product or process, and felt outsourcing confidentiality risks could be minimised.
Control over product quality is often simpler through contract manufacturing. Instead of inspection and control of many inbound goods and production processes, outsourcing allows the acceptance or rejection of one finished good. Sampling and acceptance processes of outsourced private branded goods at Safeway, for example, involves much less manpower and effort than the corporate infrastructures of quality management required for inhouse production. An important question that must be resolved in the relationship, however, is the disposition and settlement of rejected or poor quality goods made specifically for the firm. Some firms provide contract manufacturers with engineering, production and quality assistance on-site as part of the quality assurance process. Outsourcing approaches presented here apply to private trucking and warehousing alternatives as well. The benefits and drawbacks, analyses, and tools of application are similar to those used in production. The firms' quest for minimised fixed investment and manpower commitment as well as procurement and marketing flexibility also includes scrutiny in the logistics area. Contract manufacturing is an opportunity for current logistics managers. Where many of the internal product flows were managed by production when this activity was performed in-house, with outsourcing, product flow timing, transportation and storage controls replace what was often internal materials handling within a factory. Purchasing is also being integrated more with transportation and overall logistics in many firms. The development and control of the relationship as well as the co-ordination of the physical goods flows involves the analysis, skills and control methods used by logistics today. Corporate logistics has long provided the expertise of coordinating and controlling the firm's products while they were inside the firm and in the hands of external firms. There will always be a need to monitor the status of, and maintain tight controls over, the firm's inventory, no matter where it is located and in whose hands it rests. Outsourcing will no doubt continue, and many observers feel it may accelerate. Logistics personnel who have strong procurement, inventory, information, transportation and analytical skills, will be the logical managers of outsourcing arrangements.
Conclusions and Recommendations
Contract manufacturing will no doubt continue to grow in use. A view expressed by many top management personnel interviewed for this study indicated a reduced need today for the firm to actually own and directly control production. Market flexibility, financial, timing and costs factors are advantages offered by outsourcing. The drawbacks of outsourcing require careful analysis. This is particularly the case with long distance overseas links and the potential for US dollar volatility. But outsourcing offers a short-term reduction in investment and manpower. However, if the firm eliminates its production capacity, it can represent a loss of contingency options in addition to risks of confidentiality, and research and development capabilities. Outsourcing involves the management of a commercial relationship. Unlike simple buying, an entire set of attributes must be defined for and controlled through the other firm. All of that firm's purchasing, production, quality, packaging and other activities are being performed at>arm's length from the hiring firm. The use and success of this form of relationship can have major strategic impacts on the firm.
References
1. Anderson, D., International Logistics, Temple, Barker and Sloane, Inc, Lexington, Mass, 1987, pp. 1-6. 2. "The Ins and Outs of Contract Manufacturing", Purchasing, 8 August 1985, pp. 74A16-74A19. 3. "The Hollow Corporation", Business Week, 3 March 1986, pp. 57-83.
Joseph L. Cavinato is Professor of Business Logistics at the Pennsylvania State University, USA.
