Sell the Plant? The Impact of Contract Manufacturing on Innovation, Capacity and Profitability

In the electronics industry and others, Original Equipment Manufacturers (OEMs) are selling their production facilities to contract manufacturers (CMs). The CMs achieve high capacity utilization through pooling (supplying many different OEMs). Meanwhile, the OEMs focus on innovation: research and development, product design, and marketing. We examine how this new industry structure affects investment in innovation and capacity, and thus profitability. In particular, innovation is noncontractible, so OEMs will invest less in innovation than is ideal for the industry as a whole. Hence, although contract manufacturing can increase profit through more efficient capacity utilization, it may instead reduce profit by weakening the incentives for innovation. We find that contract manufacturing improves profitability for the industry as a whole if and only if OEMs are in a strong bargaining position vis-a-vis the CM. Alternatively, OEMs may retain their production facilities and pool capacity with other OEMs through supply contracts or a joint venture. This may result in overinvestment in innovation and capacity. Nevertheless, weak OEMs would do better to outsource among themselves rather than to a CM.