ABC of Contract Manufacturing + Markowitz Theory = Depth of Cost Iceberg
Organizations onset on this journey by gauging and developing a clear understanding of the capacity and capability requirements of manufacturing for their likely future portfolio, looking out a time window horizon into the future. This is what would eventually provide the enterprise an adequate time to think through and evaluate what to invest in developing internally and what to outsource. And when it comes to outsourcing contract manufacturing is the buzzword. As discussed earlier, Contract Manufacturing can be defined as the outsourcing of a requirement to manufacture a particular product or component to a third party. Contract manufacturing enables companies to reduce the level of investment in their own capabilities to manufacture, while retaining a product produced to a high quality, at a reasonable price, and delivered to a flexible schedule.
The most common reason why an organizations choses to outsource is the Cost Saving that would be realized at the end of the mission. There are three main drivers for this cost differential, which can be regarded as the underlying reasons for outsourcing. These are stated as follows:
- Access to capacity
- Access to technology
- Access to markets
Unlike any business opportunity there is a cost associated with outsourcing or contract manufacturing. There are two broad classifications of this cost.
- Direct Cost
- Indirect Cost
The direct costs of contract manufacturing are fairly comprehensible. These are:
- Conversion cost
- Cost of materials
- Cost of maintaining the contract relationship.
But the direct costs are only the tip of the iceberg. The depth of the iceberg can be gauged by the extent of the indirect cost which could be broadly classified into the following:
- Uncertainty Cost
- Risk
Uncertainty costs are those that are built into the supply chain like the one associated with maintaining appropriate inventory levels. There is an additional working capital tied up in the supply chain due to the fear of supply interruptions, and caused by lack of visibility and lack of systems integration. Then there are the risks which are inherent to the entire market or entire market segment. These are also known as the systemic risk. There is also an element of reputational cost associated with choosing an incorrect contract manufacturer that compromises on quality.
So what is the ABC of Contract Manufacturing? Access to capacity/technology/market provides the Benefits of Cost. If Markowitz Portfolio Theory is applied to the ABC of Contract Manufacturing, world class organizations can better gauge how enormous the Cost Iceberg really is?
