January 19, 2004
Build or Buy - The Ongoing Manufacturing Dilemma
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by Jeff Rowe - Contributing Editor
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Build or Buy - The Ongoing Manufacturing Dilemma

It may not be as poetic as Hamlet's famous line, but "to build or to buy" is a question that becomes more crucial for manufacturing executives every day. Should your company keep control of its supply chain and manufacturing facilities when it needs to expand - and risk getting stuck with expensive capacity it can't use? Or should it outsource - and if so, to whom and for how much?

In an economy that mercilessly penalizes inefficiency, outsourcing production seems like the obvious choice. Indeed, it often is, which is why contract manufacturing of electronics and pharmaceuticals has long since passed the $100 billion a year mark. But solving the build vs. buy equation poses difficult strategic and tactical questions for outsourcing original equipment manufacturers (OEMs), say Erica L. Plambeck, assistant professor of operations, information, and technology at the Stanford Graduate School of Business, and Terry A. Taylor, assistant professor of decision, risk, and operations at Columbia University.

In a series of soon-to-be-published papers, the researchers demonstrate that:
  • Outsourcing to contract manufacturers may ultimately harm some OEMs (and market development) by reducing incentives to innovate.
  • Pooling manufacturing resources among OEMs is sometimes a better strategy than outsourcing to contract manufacturers (CMs).
  • Sophisticated new approaches to negotiating contracts between OEMs and contract manufacturers can significantly improve margins for both parties.
  • The classic manufacturing model is built on a vision of a vertically integrated firm; production is carried on in-house, along with activities that stimulate demand in the marketplace, including R&D, product design, and marketing. (Plambeck and Taylor call the sum of those three factors "innovation.")

    However, Plambeck notes, "Because each firm fills its demand from its own production capacity, inefficiency in the use of capacity can result. For example, the pharmaceutical industry is characterized by long development cycles (roughly 12 years) and intense time to market pressure. Consequently, a company that wants to manufacture its own product must make a large capital investment in a plant before the drug has completed regulatory reviews. If the drug fails, the plant may have little value."

    One response: Separate demand creation from production - the essence of the contract manufacturing model. The flaw in this response, Plambeck argues, exists when the contract manufacturer has much more bargaining power than the original equipment manufacturer. "If the bargaining strength of the OEM is sufficiently high, the level of innovation effort (and resulting market size) will increase due to outsourcing. On the other hand, if the OEM has little bargaining strength, then the OEM - anticipating that much of the value created by his investment innovation will be expropriated by the CM - will invest less in innovation," she wrote.

    In fact, this is occurring right now in the biologics industry, as firms delay or kill drug development projects because production capacity is scarce and they anticipate paying a very high price.

    There is another alternative to going it alone. An OEM can retain production capacity by pooling resources with other similar firms through supply contracts or a joint venture. Although it has received less attention in the business press, this type of outsourcing is widespread, Plambeck says. In electronics, the OEM outsourcing market in 2002 totaled some $115 billion, 53 percent larger than the contract manufacturer outsourcing market.

    For example, AMD and Fujitsu in early April set up a joint venture to produce flash memory. The new memory chip company, FASL LLC, is an expansion of their 10-year-old joint venture that will enable the two to better compete with Intel in the competitive flash-memory market.

    After analyzing the results of original equipment manufacturer outsourcing, the researchers conclude that OEMs will innovate more when their manufacturing capacity is pooled. Here's why:

    First, for any fixed level of capacity, an increase in market size for the products that are to be produced leads to a more efficient use of that capacity. Therefore, pooling reduces production expenses, which encourages the OEMs to invest more in innovation. Second, innovation increases not only the expected market size but also its variability because designers and marketers are likely to design more variations into the product.

    Variability, however, is seen as a negative by the isolated OEM because of the extra expense and hence greater risk. But when capacity is pooled, the additional resources that are available make variability less risky. So OEMs are even more willing to innovate. "By improving the efficiency with which capacity is used, pooling stimulates entry into a market that would otherwise be unserved," the researchers wrote.

    When all conditions are known, negotiating an outsourcing contract is relatively simple. If Dell, for example, knows it can easily sell 10,000 notebook computers in a certain configuration by a certain date, and an OEM such as Mitac already has the capacity to build those notebooks, there's no problem. But often an OEM, particularly in the pharmaceutical industry, doesn't know exactly when a product will be ready or how much it's likely to sell.

    "Thinking ahead, understanding that a contract will be renegotiated is key to a successful agreement," Plambeck said in an interview. "But if the parties fail to anticipate renegotiation, they will reduce the buyer's minimum order to avoid overproduction."

    If instead the initial agreement includes a higher minimum order quantity and the understanding that the quantity may have to be renegotiated later, both parties have more incentives to innovate, she said.

    Using data and mathematical models, Plambeck and Taylor find that renegotiation significantly improves total expected profit for the CM and buyers when contracts are designed correctly in anticipation of renegotiation.

    Outsourcing is a relatively new concept to the manufacturing world (at least to the extent that it is practiced today), but one that is becoming increasingly critical for many types of manufacturers as they struggle to thrive, or even survive. While outsourcing certainly can have benefits, it also is subject to just about as many pitfalls for the unwary. Of course the outsourcing trend that receives the most notoriety is that of offshore outsourcing (the politically correct term is "global outsourcing") - not just in manufacturing, but IT, technical support, etc., as well. Will this trend reverse itself? Highly unlikely. However, put in the proper context, global outsourcing can be more
    of an opportunity than a threat, although it may force many manufacturing workers to learn new skills and become more entrepreneurial. So, not necessarily a bad thing.

    Helping Students Learn About Manufacturing

    From its inception, the Society of Manufacturing Engineers (SME) has been committed to advancing the education of students as well as preparing students for future career choices. For more than ten years, SME has been an active participant and sponsor of student competitions, both regionally and nationally, during National Engineers Week (February 22- 28, 2004). The Future City Competition encourages students to expand their minds and SME sponsors the "Best Manufacturing Zone" award given to seventh and eighth grade student teams participating in regional and national competitions. Since 1992, National Engineering Week has recognized the globalization of professional engineering and honored
    and encouraged top students to explore the many avenues consistent with an engineering career.

    The "Future City" competition is designed to promote technological literacy and engineering careers for students. Students get a hands-on, real- world experience inspiring innovative problem-solving and teamwork that also triggers further interest in math, science and engineering, and the practical application of principles.

    The qualifications necessary to be considered for the "Best Manufacturing Zone" award state that each student team must create a detailed manufacturing plan of each futuristic city to a panel of engineer judges and defend the viability of the plan. The competition recognizes those futuristic cities that best demonstrate the strategic placement of industrial zones, environmental sensitive issues and address social issues. The quality of life during the planning stages is also a component the judges examine. The four regional winners will advance to the national competition in Washington, D.C. The regional winners will receive trophies and the national first-place runners up will receive
    $2,000 to be contributed to the advancement of the school's technology programs.

    At the core of everything SME does is the belief that continuous learning is the most effective way for individuals and organizations to accomplish these objectives and gain a sustainable competitive advantage. Since manufacturing creates wealth, by providing resources and opportunities for manufacturing professionals to develop and utilize new knowledge, improved skills, and manufacturing solutions, SME helps personal and professional growth that, in turn, contributes to the economic health of the companies, the industries and the nations it serves. Since it was formed in 1932, SME has worked to make engineers, companies, educators and others
    successful in their quest to advance the ever-evolving manufacturing industries.

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