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Contract manufacturing and subcontracting practices: A propellant for tomorrow's world-class organizations

The dynamics in retail and consumer packed goods (CPG) industries has touched many aspects of the supply chain, and contract manufacturing is no exception to the rule. Industry players world over have leveraged this arena to its full potential, as each player focuses on its core competencies. 
Contract manufacturing can be defined as 'outsourcing of a requirement to manufacture a particular product or component to a third party.' It enables organizations to reduce the investments in their own manufacturing capabilities, helps them focus on their core competencies while retaining a high-quality product with a reasonable price, and delivered on a flexible schedule.

Introduction  

Contract manufacturing capabilities include activities that comprise blending, sifting, spraying, and turnkey processing. The success of this very vital supply chain link depends on the business know-how as well as the technology deployed to manufacture the best of breed solutions. Wherever contract manufacturing and packaging production lines are modular, the retail players can reap rich dividends by exploring the wealth of contract manufacturing. This modularity enables the manufactures meet a variety of specifications for contract manufacturing and packaging. Contract manufacturing goes hand in hand with packaging capabilities. Its abilities include activities that comprise vertical and horizontal forms, fill and seal, labeling, multiwall bagging, poly bagging, and labelling.

Information technology (IT) follows business; therefore the success of any contract manufacturing engagement also depends on the capability of both the primary retail / CPG player as well as on the contract manufacturer. The sophistication of the IT landscape at both ends will drive the richness of such engagements and the inculcation of industry best practices.

World-class organizations have the question of establishing the clarity of what capabilities and competencies are core today for an enterprise, and what should be in the future.

Organizations begin this journey by gauging and developing a clear understanding of the manufacturing capacity and capability requirements for their likely future portfolio, by looking at a time window. This would eventually provide the enterprise an adequate time to think through and evaluate what to invest in developing internally and what to outsource.

 

Reasons for outsourcing and associated costs

The most common reason for any organization to prefer outsourcing is the cost saving that would be realized at the end of the engagement. There are three main drivers - access to capacity, technology, and market - for this cost differential, which can be regarded as the underlying reasons for outsourcing.

Unlike any business opportunity, there is some cost associated with outsourcing or contract manufacturing. These are:

  • Direct cost
  • Indirect cost

The direct costs of contract manufacturing are fairly comprehensible. They are:

  1.    Conversion cost
  2.    Cost of materials
  3.    Value for maintaining the contract manufacturing relationship

However, 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 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 caused by lack of visibility and systems integration. Hence, there are the risks which are inherent to the entire market or market segment. They are also known as the systemic risk. Reputational cost associated with choosing an incorrect contract manufacturer that compromises on quality, also forms a critical element.

Lifeblood of a contract manufacturing engagement

Retail organizations aim to become world class organizations, evolving for better each day.  Utilizing specialized skills in the supplier manufacturing process can help achieve this vision.  Suppliers can provide value added services to lower packaging, manufacturing costs, and increase production quality. They also aim at using supplier capacity to increase the overall production capacity. They envision enhancing their stature to 'world class organization' by utilizing a successful contract manufacturing organization (CMO) relationship with its vendors.

A successful CMO engagement delivers several benefits. They are as follows:

  • Reduced investments in capital assets
  • Shift from fixed to variable cost model
  • Leveraging specialized knowledge and skills
  • Improved asset utilization
  • Retain and continued focus on core competencies
  • Spread risk and reduce costs
  • Faster time and access to market

CMO engagements are accompanied with many challenges. Some of them are as follows:

  • Critical dependence on supplier / vendor
  • Increased financial commitments -- expense and capital
  • Lack of shared vision and goals
  • Problems associated with supplier evaluation
  • Cultural difference between an organization and its CMO

The effectiveness of a CMO engagement could be determined by certain key performance indicators (KPIs) like:

  1.    Percentage of reduced manufacturing costs
  2.    Percentage of lowered packaging costs
  3.    Percentage of process and product quality improvement
  4.    An overall percentage increase in entire production capacity

For a successful CMO, it is pivotal to establish a centroid of triangle, which is balanced by:

  1.    Strategic fulcrum (long term vision)
  2.    Tactical fulcrum (short term mission)
  3.    Operational / executional fulcrum (implementation methodology)

Process standardization is indeed a best practice. Having a single point of contact at the retail organization will ensure a successful multi-vendor CMO engagement. Once the triangle's fulcrums are firmed up, an efficient CMO engagement will be established.

Alignment of system and business imperatives

Contract manufacturing is gaining importance in the retail industry rapidly as each industry player is focusing more on core competencies. As a result, there is increasing need for system capabilities to meet the business imperatives. An organization could base its business operations on a number of operating models for contract manufacturing but more often, hybrid models occur in which the inventory ownership lies with the parent organization, and it is recorded in the inventory book of records. With most of the industries moving towards contract manufacturing, enterprise resource planning (ERP) systems should have the capabilities that align with business.

Oracle's outside processing (OSP) aligns well with business needs. Subcontracting is another module that has been gaining popularity. Not unusual are scenarios where a brand owner or an original equipment manufacturer outsources its entire manufacturing operation or sometimes a portion of it to an external manufacturing service provider. Brand owners or OEMs will need to engage into a contractual agreement with the service provides who are also known as manufacturing partner.

From a system standpoint, following is the sequence of events involved in a typical subcontracting cycle:

  1.    Creation of a subcontracting order and its communication to the CMO
  2.    Automatic creation of the following:
a.       Discrete job for assembly production in CMO premises
b.      Purchase orders for procuring the component / ingredient items from the retailer
c.       Sales order for the component items
  1.    Shipment against the Sales Order for the component orders to the CMO
  2.    Automatic receipt of the component items in CMO
  3.    Assembly manufacture in CMO against the discrete job
  4.    Shipment of assembly to the retailer
  5.    Receiving the final assembly in the retailer premises
  6.    Automatic completion and closure of the discrete job

It is to be noted that modeling of business cycles requires setting up retailer and CMO as inventory organizations. The module supports two modes of component types:

Synchronized modes: In this case, the components are transferred to CMO against the specific subcontracting order.

Prepositioned modes: In this case, the components are transferred to CMO without referencing any subcontracting order in advance of assembly requirements.

In the nature of subcontracting, if the retailer charges the CMO upfront for the components supplied and pays for the services received separately, then chargeable subcontracting can be taken into consideration. If the retailer nets off the payables and receivables invoices in the case above, it is termed as buy/sell subcontracting.

Today, systems are available with strong features that can suit ever increasing business needs. In certain cases, we might have to customize the vanilla application, but as they say IT always follows business.

Conclusion

Organizations are now utilizing subcontracting and contract manufacturing to focus on their primary business. Once the systems are put in place to align business imperatives, there are rich dividends to reap.

Comments

Thanks for the in detailed blog pertain to Contract manufacturing and subcontracting practices and Oracle Support Blog.

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