March 2000

Contract Manufacturing

The virtual corporation: Where is it?

By Anne Millen Porter

People getting paid big bucks to predict the future of American business love to talk in terms of virtual corporations. In the future, they say, manufacturers will focus on one, maybe two or three core competencies, all else will be outsourced. As popular wisdom has it, the ongoing vertical dis-integration of manufacturers will continue to the point where they no longer produce or assemble their own products. Instead, they’ll focus their resources on R+D, end product design or customization, sales and marketing, service, and management of the supply network. Manufacturing and assembly of products will be outsourced to contract manufacturers, or in other cases, pushed into distribution channels.

This vision of the future is certainly attractive. And there’s plenty of evidence to suggest that high-end manufacturing companies¾ in industry segments such as high-tech, pharmaceuticals, and automotive¾ are moving purposefully toward greater standard use of contract manufacturers. So far, however, you can count on your fingers the companies that appear willing or capable of pursuing this trend to its virtual extreme

Case in point: A recent Purchasing Magazine survey of 1,400 of the nation’s largest procurement organizations finds no widespreadmajor defined trend toward outsourcing of manufacturing activities. While many among the survey respondents say their companies have defined strategies for outsourcing manufacturing activities, the speed of the trend looks to remain very slow.

For example, the purchasing pro for a company making refrigeration compressors and condensing units says his firm will continue to produce 100% of its assembled finished products and will outsource only 15% of its major subassemblies over the next five years. The purchasing pro for an automotive supplier says his company will go from making 90% of subassemblies today to 75% in five years. The purchasing pro for a lighting products company says his firm today makes 95% of finished products and 100% of subassemblies and systems. In five year’s time, he says, the figures will be 90% for finished goods, 100% for subassemblies and systems.

Data from the Outsourcing Institute also fails to show a defined national trend toward outsourcing of manufacturing activities. A 1997 study (updated 1999 figures are due out next month) shows that manufacturing companies are, by far, the largest population of companies pursuing outsourcing strategies (accounting for 65% of the total outsourcing population). However, their efforts are apparently focused on outsourcing non-manufacturing activities such as information technology (30%), human resources (16%), marketing and sales (14%), finance (11%) and administration (9%). The "all other" category, into which it must be supposed that the manufacturing falls, makes up 22% of total outsourcing activity, according to the data.

Mum’s the word

It may be that the trend to outsource manufacturing is bigger than it appears. Companies with labor unions—and most U.S. manufacturers have them—are particularly cagey about verbalizing their strategies for outsourcing manufacturing. As the supply management exec for a heavy-duty truck manufacturer points out, "Many manufacturers have it written in their labor contracts that every outsourcing must be reviewed by the union." For this reason, he says, many companies can pursue outsourcing only for new programs or as a means for supplementing existing capacity or increasing throughput.

It certainly can be said that contract manufacturing is much bigger in some industry segments than in others. The trend to outsourced manufacturing is well defined in high tech (electronics, telecom, medical) and pharmaceuticals where¾

Manufacturing processes are easily standardized.

R+D and marketing costs can be very high.

Speed of innovation and time-to-market are critical.

The trend to outsourcing assembly and other manufacturing activities is also clearly discernable among automotive manufacturers where companies are developing their tier-one suppliers to deliver and sequence completed subsystem modules such as carpets, seats, exhaust systems, rear axles, bumpers, and dashboard and instrument panels. Perhaps the best example of this is Volkswagen’s experiments with "modular consortia" in South America whereby it jointly owns and operates major assembly plants concurrently with small numbers of tier one subsystem suppliers.

"Outside of high tech," says Glenn Ramsdell, partner with McKinsey & Company in San Francisco, "you’ll find few examples of companies that have experimented with contract manufacturing, let alone made a wholesale change in this direction." Electronics is the trendsetter, he says, because "there’s no other industry with faster requirements for time to market or more pressure to take investment dollars out of low return activities such as manufacturing. The objective in electronics is to get to market fast with the smallest possible investments in both the front and back ends of the company."

Among more traditional manufacturers, Ramsdell says, people continue to see contract manufacturing in its more traditional sense¾ as a form of marginal production capacity. "For companies that have made products for a long time, outsourcing just feels wrong in their bones. The activity seems too important to outsource." While noting that companies like Cisco Systems design and market "extraordinarily complex products with a high price to be paid for field failures," Ramsdell says, "the difference is they’ve never had their own manufacturing facilities. They started with a clean slate, identified manufacturing management as a core competency, then hired the best people for the job."

Gary Venner, director of consulting with Technology and Business Integrators in Woodcliff Lake, N.J. suggests that the virtual ideal is really coming from new companies. "The startups we’re seeing don’t want any fixed costs. They’re starting from scratch so they don’t need to overcome the emotions that go along with trying to outsource a piece of their business. Companies that have manufactured for a long time may pride themselves on making great products. It’s very difficult to give this up. Even when they realize their core competency may be in design or marketing and sales, it’s very difficult to get over the emotional hurdles."

Over time, as competition from these startups intensifies, information technology proliferates, and companies adopt modern models for financial decision making, it may become increasingly difficult for traditional manufacturers to ignore the types of return-on-investment and profitability calculations that seem to favor outsourcing some, if not all, manufacturing and assembly activities. Nonetheless, it’s likely the transition to outsourced manufacturing activities will continue to evolve extremely slowly, as the process embodies countless sources of friction each of which take time to work through.

According to experienced manufacturing outsourcers, some of the most prevalent sources of this friction include—

Traditional financial metrics

Difficulty in defining core competencies

Fear of losing intellectual capital, expertise

Difficulty finding qualified manufacturing services companies

Difficulty attracting good contract manufacturers for less desirable programs

Difficulty understanding and documenting capabilities of contract manufacturers

Difficulty earning most-favored-customer status

Necessity of managing risk exposure

Trouble with technology and/or knowledge transfer

Unforeseeable problems (such as parts shortages)

Traditions die hard

Pete Berkowitz, global outsourcing commodity manager for Honeywell’s Industrial Automation & Controls division in Phoenix, Ariz., has been working for two years on a single project to outsource the company’s printed wiring assembly (PWA) to a contract manufacturer in China. "This has been a very difficult process," Berkowitz says. "We experienced culture shock. People were scared when they first heard about it."

Beyond the hardship of displacing people, Berkowitz says there are other, more subtle, sources of resistance to outsourcing manufacturing. One source of friction lies in traditional accounting systems. "The fixed costs don’t go away so easily, so every piece we outsource drives up the burden rate on what remains." With traditional financial metrics in place, he says, the people responsible for manufacturing will quite naturally oppose new outsourcing programs. In the case of PWA, Berkowitz says the division’s vice president of operations had to become the prime mover behind the outsourcing initiative.

Simple difficulty in defining core competencies can also slow the outsourcing process, Berkowitz says. For a couple of years, he notes, manufacturing argued successfully that printed wiring assembly was a core competency for the division. "However, we constantly assess what we’re good at. We ask the question, ‘If we’re so good at making something, then why are we doing it only for us? Are there people in the marketplace that would pay us to make this product?’ If the answer is no, then we need to investigate outsourcing. With PWA, we got to a point where manufacturing could no longer sell the core competency idea. It was clear that we weren’t the best at surface-mount technology and the investment necessary to keep pace with the technology was a cash drain on our business."

In this context, Berkowitz says it became impossible to ignore the low burden rates available at the Chinese contract manufacturer. Another advantage: "We knew the contract manufacturer would give us access to the Asian components market where costs can be 3%-5% cheaper, sometimes for the same parts."

Losing your religion

The very rational fear that intellectual property will be eroded, lost, or exposed to competitors is another major outsourcing inhibitor in manufacturing.

As the supply management executive for a heavy-duty truck maker puts it: "When you outsource your manufacturing¾ when you decide something is not a core competency¾ you consciously create a dependency. Once you outsource, you no longer have those 20-year veterans who know everything there is to know about processing frame rails, for example. You give up your equipment. You give up your expertise. Over time, you may erode your ability to talk intelligently to the supply base. This isn’t a problem as long as you can be sure it’s not a core competency for your company and as long as you establish supply relationships that allow you to ensure your suppliers remain on the cutting edge."

Harry McGrath president of Pacific Partners in Clemmons, N.C. remarks that, "A manufacturer may have a competitor in Asia. If they do, the odds are this competitor would very much like to manufacturer their products for them. If the manufacturer allows this, they’ll be putting their intellectual property very much at risk."

Nonetheless, McGrath says, "There are plenty of excellent Asian suppliers who see their strength as manufacturing and engineering and their weakness as sales and marketing. They have no interest in competing with the manufacturer. They’re eager to be a supplier. They want to do as much manufacturing as the manufacturer will allow."

Of course there are risks, McGrath says. "As with all new suppliers, approach them with caution. Minimize the money you put at risk until they build a successful track record and earn your trust."

For Honeywell IAC, this has meant holding back a critical piece of the manufacturing process¾ functionality testing. "The contract manufacturer has our assembly but not our functionality equipment," Berkowitz says. "If we give them the functionality testing, that would raise the relationship to a new level of trust and complexity. At that point, we might need them to agree not to work for our competitors."

Who wants our business?

Simply finding interested contract manufacturers can be a problem for traditional manufacturers, says Robert Freid, president of Contract Manufacturing Consultants in Bellevue, Wash. (formerly, Freid was a new business development manager for Solectron, one of the nation’s leading electronics contract manufacturers).

"Outsourcing is not practical in many manufacturing situations,"Freid says. "Where companies require processes that are unique to their products, they’re going to have a hard time finding high-performing contract manufacturers willing to accept their programs."

A good rule of thumb, according to Freid: "If you couldn’t transfer the physical production resources over the course of a single weekend for an end-product build program, then it’s not a program that will interest most good contract manufacturers. This simple rule allows you to gauge the level of specialization in your processes. If you have high levels of assembly or test specialization, then you should plan to maintain that portion of the work internally because the established supply base won’t accept or adequately support it."

Also difficult to source are programs with low annual dollar or unit volume, high product mix, or variable demand. "Ideal manufacturer programs have medium-to-high average annual dollar spendfewer products, more common processes, with good stability," Freid says. "If you vary along too many dimensions¾ say, for example, you have 500 products each with an annual spend of $25-$50K per year¾ it will be very difficult to find a CM who can consistently do a good job. Remember, the CM will be experiencing all the pressing needs of its other customers as well."

To get around these difficulties, Bill Knab, purchasing manger, contract manufacturing, for BASF in Mount Olive, N.J., says he allocates jobs among a carefully established group of contract manufacturers. "We award our contract manufacturers a combination of big programs, medium-sized programs, and smaller programs. We give them a mix of good programs and some not so good programs. The promise of good programs ensures that they accept the less attractive ones."

The company can do this, Knab adds, "because we have the advantage of being large. Smaller companies may have less ability to alleviate the cherry picking syndrome. They might be able to find CMs who will take on less desirable programs, but they’re going to pay for it, and their quality may suffer."

The supply management exec for a major maker of heavy-duty trucks observes that, "It’s easy to find suppliers that are interested in taking over our subassemblies, but they aren’t necessarily qualified or capable of making the commercial commitments we would require. There are also plenty of qualified suppliers that aren’t interested in our end of the automotive business or in our relatively low annual volumes." A manufacturer can decide to outsource, he says, but it also needs to be part of the supplier’s strategy roadmap. "It’s a real challenge to find suppliers who are both capable of and willing to become part of our business and to give us the level of service and responsiveness we would require."

Due diligence

Researching contract manufacturers is also, by necessity, a time-consuming process as the costs of choosing poorly can be very high.

"Switching is very difficult," says Freid. "For turnkey programs where the contract manufacturer is purchasing raw materials to support your program, the contractor will have a major investment in parts inventory to support a program for which the manufacturer is ultimately responsible. There may be considerable investment in integrating systems and procedures with the contract manufacturer. There may be tooling or equipment that the manufacturer has purchased and installed at the CM’s site. All this would have to uprooted and transferred."

Contract manufacturers, Freid says, are well aware of this fact and may not be forthcoming with their doubts about their being best able to support the program. "They know it’s going to be very difficult for the manufacturer to switch, particularly if they’ve also contracted other services such as product engineering and physical distribution. If, a year down the road, the manufacturer decides they’ve made a mistake, it can be very costly and time consuming to transfer to a different CM."

Despite this, Freid says, "There’s an awful lot of trial and error going on out there. It’s not uncommon for companies to go through one, two, sometimes three contract manufacturers before they settle on one they can work with long term, one that’s doing an acceptable job."

To avoid such an outcome, he says, "Manufacturers need to clearly define their outsourcing objectives and contractor-selection criteria up front. Cost models can be used to estimate CM pricing locally and internationally and can help weigh the advantages and disadvantages of offshore sourcing. Identifying potential contractors should include surveying other manufacturers with similar needs for their recommendations (although they should not rely on these opinions alone). Manufacturers need to conduct focused on-site surveys to better understand CMs’ capabilities." Contract manufacturers, he notes, "have highly polished sales and marketing pitches. Manufacturers need to spend time looking past these pitches, to see CMs’ real capabilities. Doing this up front will make or break their success at outsourcing."

BASF’s Knab agrees. "It takes years to develop good contacts and to find out who’s good at what. It’s hard work traveling around, beating the bushes and analyzing the financials." The goal, Knab says, is to develop an established corps of contract manufacturers to which you can award most programs. "If you don’t spend time on the investigative work, it will come back to haunt you every time."

Who’s in control?

Control may be the most controversial aspect of manufacturing outsourcing. People with experience say it’s important for the manufacturer to maintain tight control—over performance parameters, troubleshooting, etc., especially during the transition to outsourcing. However, for smaller companies with less leverage, this may be much easier said than done. There is also disagreement over the extent to which manufacturers should dictate the ‘how’ as well as the ‘what’ in contract manufacturing programs.

"In my experience," says CMC’s Freid, "there are manufacturers who think they can turn over a program to a contract manufacturer while maintaining little control or monitoring over day-to-day operations. But, this is a mistake. Assuming they’ve chosen well¾ and that’s a big assumption¾ the manufacturer still needs to be aggressive, insisting on continuous improvement in cost, quality, delivery, cycle times and so forth. These things don’t happen automatically."

To ensure their accounts receive priority treatment, Freid says manufacturers need to focus first on being high-return customers. "IIf you need a sudden increase in production, you want to have sufficient leverage to gain priority treatment from the CM. The relative size and profitability of your account to the CM site can sometimes affect your ability to get the best possible attention."

During contract negotiations, Freid says, there’s a lot a company can do to set parameters for how they’ll be treated by the CM. "You specify the number of accounts that will be shared by your program manager. "You can set production schedule change flexibility and key performance expectations. You can set expectations for service and responsiveness in a wide range of on-going CM support activities.

Once contracts are written, Freid says regular oversight is still a must for ensuring good performance and continuous improvement from the CM. "Unfortunately," Freid says, "the contract manufacturing industry is not to the point where you can select, fire, and forget. As good as it is, the industry is not yet to the point where you can expect your requirements will be consistently met. This requires ongoing work. Not a large staff, but rather, a few key people on the manufacturer side."

Says Berkowitz of Honeywell IAC: "We’re in an early stage of evolution with our contract manufacturer. We started with very tight control. We will progress to less and less control. The supplier has delivery and cost reduction metrics that it needs to meet. We conduct quarterly performance reviews. Three times a week we hold two-hour teleconferences regarding production runs. And all the time we have e-mail flying back and forth."

Eventually, Berkowitz says, "We’ll give the supplier control of establishing components contracts. Over a number of years we’ll give them control over other processes. For example, we continue to perform final systems tests in-house, but once they can build capability to perform in-circuit testing, we may outsource that activity as well."

To make its outsourcing more successful, Patrick Walker, manger, Global Projects Supply Management for Honeywell, says the division also reversed a successful supply management idea. While the company routinely invites suppliers to become resident in its own facilities, it asked the Chinese supplier to accept a resident customer, a Berkowitz representative working on site with the CM in China, looking after price and timing issues. "The supplier has been very receptive to this," Walker says.

As a rule, however, it may be difficult to exercise this level of control over CMs, especially if they’re offshore and the manufacturer is a smaller company with less attractive programs and/or long-term growth prospects.

McGrath of Pacific Partners says, "I advise clients to review suppliers’ capabilities. Look at their equipment. Look to see if they have a systematic approach to quality and materials supply. Give them the critical parameters for a part and ask them to inspect to these parameters as the parts move through their process." McGrath says ISO 9000 certifications in Asia may not be "quite as rigid" as they are in the U.S. Nonetheless, he says, "I work with many companies employing very tight quality systems. As long as the manufacturer can communicate its requirements well, as long as the CM can understand what makes a good part, they will be capable of delivering good parts.

"Across international borders," McGrath says, "no contract is really enforceable so the manufacturer is going to have to assume some risk. They may have to put money up front and this cash will be at risk until they receive good parts from the contract manufacturer." Nonetheless, he says, "while there is some trust required, it’s still business. The supplier wants to keep the manufacturer as a customer. And manufacturers can be sure their competitors are actively working to reduce costs, so their biggest risk is that competitors beat them to the draw."

Controlling the ‘how’ as well as the ‘what’ in an outsourcing may leave the biggest savings opportunities on the table, says the supply management executive for a major heavy-duty truck manufacturer. "When manufacturers outsource existing products¾ things they designed¾ they give the supplier minimal latitude in terms of lowering overall cost. The true opportunities in outsourcing come when you have a new product platform. The manufacturer designs the end product, but leaves subassembly design, manufacturing, supply management, logistics, etc. to the supplier. This gives the supplier real opportunities to add value to the process."

Technology transfer

Even assuming that manufacturers make the best possible supplier selections for their outsourcing programs, experienced outsourcers say the transitions rarely occur quickly. Technology transfer, they say, may be the biggest time consumer of all.

As Honeywell’s Berkowitz puts it: "The transition can be difficult because there’s a certain amount of ‘tribal knowledge’¾ undocumented manufacturing know-how that has been developed over the years on the production floor. Documenting and transferring this knowledge is no simple task."

Freid of CMC agrees: "This is a real fly in the ointment for manufacturers with older technologies involving a great deal of handwork, complicated testing and so forth. It’s often something that gets overlooked and can turn a six-month transition into a yearlong transition."

Tribal knowledge, notes Freid, resides with people who’ve been doing undocumented work a job for a long time. "Naturally, they’re going to be unwilling to educate the contract manufacturer, especially if their jobs are being eliminated. For those working on the outsourcing team, there’s difficulty in understanding what has not been documented and getting that information documented so the CM can come up to speed as quickly as possible."

As the supply management exec for a heavy-duty truck maker puts it: "Maybe you’ve built a subassembly for 30 years. Inside your company, everyone knows how to do a process, but there’s a very good chance all this knowledge is not well documented or that process documentation is no longer accurate. This causes problems when you try to farm out the product. You also encounter resistance from the workforce saying, ‘Hey, this isn’t what we’re used to receiving.’ You have both tribal knowledge and resistance to the other tribe."

It’s important, he says, to work at replacing the personal relationships, the informal communications, that developed when the company was doing work internally. "When you make or assemble something inside, you have personal relationships among buyers, schedulers and production workers. Much of their communication is informal. When you outsource, it’s important to find ways to establish new personal relationships so these very important informal communications continue to occur."

Also difficult, he says, is the process of reconfiguring materials or enterprise resource planning systems to reflect that a subassembly is now being bought rather than made internally. "To order an assembly that previously was defined as a combination of many individual parts requires a great deal of reconfiguration in these information systems. You have to clarify all the components that go into the subassembly. You have to understand testing. You have to define where the subassembly starts and stops. You need to answer a hundred questions like, ‘Is such and such a bolt part of the subassembly or not?’"

External market conditions are yet another factor that can hamper even the most carefully coordinated outsourcing attempts. Says Honeywells’ Berkowitz: "We started in January 1999. We completed most of the trial runs and transferred 75% of production. Now shortages have developed in the markets for tantalum and ceramic caps. We’ve had to help our supplier obtain these components. This was unplanned." As CMC’s Freid puts it: "Even the largest CMs need to be better at anticipating extensions in materials leadtimes. Manufacturers will find they need to maintain good visibility with their key suppliers of components and they’ll need to make sure their demand forecasts are communicated to those suppliers.

More outsourcing ahead

While there are plenty of factors hindering the trend to outsourced manufacturing, there’s good reason to believe that, over time, U.S. manufacturers will begin to look less like manufacturers, and more like powerhouses in design, supply management, sales and marketing, and customer service.

Experienced outsourcers say proliferation of information technology, value-add management models, enterprise resource planning and activity-based accounting systems will continue to change the way companies define their core competencies. As Honeywell IAC’s Berkowitz puts it: "We now have ‘Six Sigma black belts.’ These are people whose sole purpose is to save the company money. It’s their job to map processes and to assemble cross-functional teams that will lead to lower costs. I think outsourcing is a solution that we’re going to be seeing more often."