The Business Context behind Outsourced Production
In recent years, OEMs have faced pressures from all directions to evolve innovative business models. Let us talk about some such challenges that relate to subcontracting:
[A] STRATEGIC PRESSURES ON OEMs
- Evolve from 'vertical integration' to 'strategic specialization': Most OEMs started with all activities done in-house. In the recent years, this model of "full vertical integration" has lost its relevance with the emergence of specialist companies catering to specific parts of the value chain. What makes sense today is a mix of in-house activities in which the OEM chooses to specialize and outsourced activities which are not the focus of the OEM.
- Adjust production levels to variable market demand: The older model padded the manufacturing processes with inventory and overheads to meet demand dips and upsides. In the new world, the challenge is to adjust production capacities dynamically without incurring extra costs.
- Reduce lead times for delivery to a global customer base: With the opening of markets in many emerging countries, the customer base has expanded multifold. The challenge lies in serving this customer base with competitive fulfillment lead times.
- Reduce needs for fixed and working capital: Every lever of cost reduction has come under examination recently. The challenge is to free up capital from non-strategic activities to focus on higher value add activities.
- Manage shortening product lifecycles and gain access to latest technologies faster: In some verticals (like electronics manufacturing), products and associated technologies become obsolete very quickly. The challenge for OEMs is to ensure immediate access to the latest manufacturing technologies without incurring huge costs.
- Reduce production cost and make it a variable component: Traditionally, production costs have had a variable (dependent on production volume) and a fixed (independent of production volume) component. With fixed costs coming under the scanner, the challenge is to convert the entire production cost as a variable component.
The pressures described above have elicited innovative responses from OEMs. Though the responses differ by industry, company size, and strategic priorities among other factors, the common theme seems to be an intense focus on the core.
[B] RESPONSE FROM LEADING OEMs
The response from leading OEMs can be summarized in one statement:
"Outsource non-core value chain activities to external partners to focus on core activities that build competitive advantages"
While this statement talks about a general direction for all non-core activities, the observations specific to manufacturing function are:
- Standardize production processes and components and modularize product designs: Standard processes (for example - the burn-in process in electronics manufacturing that tests components and finished products by turning them on for a while and observing failures) and components (for example, the standardization of memory chips or plastics) ensure common understanding with manufacturing partners. This helps in sourcing the right raw materials with options to aggregate purchases to get the maximum quantity discounts. Modular product designs - along with concepts like "Design for Manufacturability" (DFM) - ensure the design considers the details required for manufacturing and offers opportunities to produce multiple modules simultaneously (potentially at different locations in the world).
- Leverage product design, manufacturing, and supply chain execution capabilities of external partners: Today, contract manufacturers offer a variety of value added services along with the core service of outsourced assembly. Leading players have developed product design capabilities (For example, Original Design Manufacturers or ODMs in electronics manufacturing). They also offer advanced services like procurement, quality control / testing, forward and reverse logistics, and repairs, to name a few. In the electronics sector, production labor usually accounts for less than 10% of the product cost, while materials account for about 70-80%. Since contract manufacturers cater to multiple OEMs and have a larger aggregated quantity to procure, their increased bargaining power can help OEMs in shaving material costs.
- Focus on the core: Brand Management, Demand Generation, Product Lifecycle Management, Supply Chain Coordination, Sourcing, and Customer Service: OEMs now focus on the activities they consider core (defined as activities that provide a competitive advantage) in their value chain. Brand Management, Demand Generation, Product Lifecycle Management, Supply Chain Coordination, Sourcing, and Customer Service are typically seen as core activities, with external partners filling in the voids in the value chain. Everything that is seen as a 'commodity' is typically outsourced!
- Shift production closer to customer and supplier hubs: OEMs now have a globally spread customer base, while contract manufacturers now have production sites all across the globe. This is a win-win situation for both parties! Contract manufacturers reduce costs and increase flexibility by locating plants in low-cost regions like East and South East Asia, Eastern Europe, and South America. These regions now have the bulk of the world's production capacity. The spread of manufacturing capacity enables OEMs to cater to customers with production facilities located in the same region. This cuts down the lead time for customers and provides opportunities to localize products and processes as per customer expectations and regulatory requirements.
Key enablers provide a supporting infrastructure to make these best practices viable.
[C] KEY ENABLERS FOR CONTRACT MANUFACTURING MODELS
- Emergence of low-cost regions specialized in outsourced production (Enables rational and low-risk outsourcing decisions) In addition to this, as each contract manufacturer matures in handling increasing responsibilities, the OEMs have broader choices and lower overall risk.
- Reforms in international trade and regulatory barriers(Enables international outsourcing of production activities) With overall reduction in protectionist measures like tariffs and controls and with formation of special trade groups (like NAFTA and ASEAN), outsourcing relationships have become more viable and cost effective.
- Maturity in international telecom infrastructure (Enables real time collaboration between value chain partners) New technologies based on the Internet and social media enable real time enterprise collaboration through portals, web services, and standardized message exchanges. This increases the value chain visibility - which in turn alerts the OEMs of operational risks in advance.
- Establishment of standards in international transport (Enables free flow of goods with short lead times) The transport industry now offers many guaranteed service levels (like overnight shipment) at optimized costs. The emergence of specialized external providers in the transportation sector provides opportunities to access value-added services like transportation spend optimization, shipment consolidation, shipment tracking, border clearance, and denied party control to name a few.