Research: When Is It Smart to Outsource?

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 it 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 Stanford GSB, 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.

Consider the problem faced by biopharmaceutical companies: Manufacturing capacity is constrained, and the lead time to build new capacity is three to five years. Under those conditions, negotiating an effective contract is difficult. To solve this, Eli Lilly and other drug companies are entering supply contracts with Lonza, a leading biologics manufacturer. Contracts stipulate the start date (usually about three years hence), the volume of fermentation capacity to be purchased each week (though there is some flexibility), and a price per unit of volume.

Making this type of contract work is strikingly different than a typical manufacturing agreement; in fact, agreements between Lonza and its customers have at least some of the characteristics of a partnership.

The customer makes a transfer payment at the time of contracting, which Lonza uses to defray the cost of building capacity. Lonza evaluates the drug that the buyer has under development and assesses the likelihood that it will be successful in clinical trials. Lonza estimates the size of the market for the drug and the therapeutic dosage requirement (hence the volume of fermentation capacity that will be needed).

“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.