The Logistics of Manufacturing

8/3/2019 The Logistics of Manufacturing

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THE LOGISTICS O F C O N T R A C T M A N U F A C T U R I N G 13

T he key issues involved in contract manu-facturing are examined.

The Logisticsof ContractManufacturingby Joseph L. Cavinato

The Logistics of OutsourcingThe factory is losing its role as the heart of the firm. Someof the reasons for this trend are wage rate and work ruledifferences between union and non-union operations, lowerwage rates overseas, ease of international transportationmovements, and the need to reduce manpower andoverhead costs. These have led many firms to look to otheroptions to produce and acquire goods in their lines ofbusiness. These other options include contractmanufacturing with other firms, using third parties toprovide some or all of the materials, production anddistribution services, and in some cases entire outsourcingof the finished product. But, though production might becut back or no longer reside inside the ownership of thefirm, a crucial need still exists within it to orchestra te thelogistics of the new product flow with the contractedcompany's operations.A firm's shift from in-house to contract manufacturing,or oursourcing, has broad strategic, organisational, andoperational implications. Product flow must still becontrolled and co-ordinated. Logistics, which has longserved pre- and post-production roles within thefirm, sa logical focal point for this control and co-ordinationrole in a firm using outsourcing. If logistics does not takethe initiative in this area, then a major reason for itsexistence will stand to diminish within the firm of thefuture.

What is Outsourcing?Outsourcing is a general term for the hiring ofmanufacturing and other value-added form, time and placeutility services from another firm. It is the use ofproduction services of other firms rather than thosecurrently in-house or what could be utilised within thefirm. The decision typically involves moving currentproduction to outside the firm, or entails using outsidesources rather than embarking on new production withinthe firm.This article shows whyfirmsare shifting to this methodof supply management. It includes why outsourcing is,or should become, within the sphere of logisticsmanagement. Key issues that firms face or should beconcerned with when looking to outsourcing are covered,and some of the risks associated with it are presented.Finally, some insights are presented for the future.

R esearch M ethodolog yThe primary thrusts of this research were directed towardsthe managerial approaches and issues involved withoutsourcing. The research was based on visits andinterviews conducted with available logistics, production,and upper management personnel in 137 manufacturinglines of business in the United States and Canada in early1987. A total of 122 firms were included. Primary productareas of the operations rep resented in the interviews areshown in Table I. A sem i-structured interview processwas used with people in purchasing, transportation,warehousing, production, materials, distribution and otherareas. Firm sizes ranged from $5 million/year in sales withonefinalproduct to $12 billion/year with over 1,000 finishedproducts.A total of 54 of the 137 operations, or 39.4 per cent haveproduction and related activities performed outside thefirm. This activity is either (a) production and relatedservices that formerly took place within the operation,or (b) new or expanded operations that, in the past, wouldprobably have been conducted in-house, but instead wereshifted to a vendor. Nineteen of the firms were theoutsource of other firms, and eleven of these engage instill further outsourcing with their vendors.The findings and contribution of this research are primarilyqualitative. Quantitative information was difficult toascertain for this research for several reasons. First, inmany firms, the outsource decision was dispersed or itwas entirely analysed and decided by upper management.Second, in many firms, the outsourcing step wasundertaken in the past, prior to the tenure of those holdingcurrent positions. Thus, while the current issues,concerns and risks w ere known by the current managers,they often did not possess specific facts regarding the


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Industries Represented in Visits/Interviews

AppliancesAutomotive/TransportationBuilding MaterialsChemicalsComputersCommunications EquipmentConstruction EquipmentDrug and Toilet PreparationsElectrical MachineryElectronicsFoodFurnitureMachine Tools/MachineryMetalsMineralsOffice EquipmentPaperPetroleumPharmaceuticals/Health CarePlasticsRubber ProductsTextilesTotal Operations Visited =

583965289

1012

7846575

11946

137

original decision by the firm. Third, many people werenot allowed by theirfirms o share specific data, but werewilling to discuss general issues, concerns andperspectives relating to outsourcing. Fourth, some of thefindin gs reported here were derived from interviews withinthe firms that were the outsource for other firms, andthesefindingsrelate to the nature of these commercialrelationships.

Why Companies OutsourceThe people interviewed for this study indicated a widerange of reasons for their firms either using or consideringcontract manufacturing. This is also supported by a 1987Temple, Barker and Sloane study that was confined toforeign outsourcing. Table II shows the results of thatstudy of 50 US firms. Cost saving was the over-ridingreason for foreign sourcing, followed by availability andquality. Other reasons were cited by over a third of thefirms surveyed[l].

Table II. Motives for Outsourcing

Factor

CostAvailabilityQualityOther

RawMaterials(%)68281835

Components(%)6996

37

FinishedProducts(%)64191439

(Multiple reasons cause findings not to add up to 100%)

Cost Savings. Outsourcing can offer savings by way ofreduced costs of labour, raw material or overhead cost.Firms also seek this option to reduce manpower and fixedinvestment in plant and equipment. Some of the earliestoutsourcing endeavours in the Far East by US firms inthe 1970s were motivated by significant reductions in labourcosts even though high ocean transportation delivery costswere incurred. Some of the US carfirmsoutsource withnon-unionfirms n the Southeast and Midwest that providethe product at less overall cost. West Publishing of St Paul,Minnesota, outsources typesetting of textbooks in Koreadue to the lower wage rates. The cost savings can alsoextend to the reduction of corporate overhead.Outsourcing can lead to reduced plant and equipmentinvestment which can have the effect of reducing thecorporate breakeven point. The reduced numbers ofemployees within the firm also reduces the costs ofmanpower overheads in the form of benefits, pensions,and personnel systems.However, outsourcing does tend to increase the purchasedexpenses-to-total expense ratio of the firm. Thepurchasing department of a non-outsource firm acquiresrelatively low-value raw materials. Labour, energy andoverheads are added by the firm's production department.The outsourcing firm acquires semi-finished or finishedgoods that already have another firm's full materials,labour, energy, overheads and distribution expensesincluded within them.Enhanced Cash Flow. Outsourcing can provide animproved cash flow for a firm . Afirm hat outsources isable to acquire afinishedproduct, distribute and sell it,usually in a relatively short time. This differs from theacquisition of raw materials, the conversion to finishedgoods, and recovery of cash after collections of accountsreceivable at a later point in time.Outsourcing can greatly enhance cash velocity within thefirm by shunting the purchase and production operations.Some firms visited have used outsourcing to such a degree


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THE LOGISTICS OF CONTRACT MAN

that they have increased inventory velocity to the pointof infinite turnover. That is, the product is acquired(outsourced), brought into the firm,sold, distributed, andcash settlement takes place with the customer before thefirm must pay the vendor.Capacity Considerations. Some firms outsource due toconstraints in current manufacturing capabilities. Chrysleroutsourced a successful and expanding line of carproduction with American Motors because it lacked thecapacity. Somefirmsoutsource new products so that thereis little risk in new capacity investment in the event thatthey are not successful. Still, some appliance firmsdo theopposite. They often produce new products in-house, thenthey outsource them in the Far East where massproduction cost economies permit them to compete witha proven product.Market/Competitive Timing. It often takes a publisher twoyears to bring a textbook on to the market from themoment it is received from the author. Editors' timeconstraints, typesetting, printing and binding can representbottleneck processes within the firm. Some publishers,on the other hand, outsource these four activities and areable to bring texts online within six months. In a m arketwhere a spring introduction is necessary in order to beon the market for consideration for the following academicyear, timing is critical.NewTechnologies. Some computerfirmspurposely do notinvest in some production a reas because this can preventthem from switching to new technologies when the m arketdemands such changeovers. Instead, thesefirmsrely onthere being an availability of firms that can be contractedwith to provide the latest technology and perform the latestrequired tasks. The risks of obsolescence in technologicalinvestments are borne by the vendorfirms[2].Little or No Investment Cost. Frosty Acres is anorganisation that supplies a wide range of packaged foodsto the institutional and retail sectors. It utilises contractpackers, outside warehousing, and arm's length orderentry operations. Thisfirmhas very little invested in theinventory andfixedfacilities. Major manufacturing firmsoften cite the elimination of fixed plant and equipmentinvestment as a major advantage of outsourcing.Perform Difficult Operations. Some manufacturingoperations are technically difficult to perform, or firmswish to avoid regulatory requirements involved with them.Drackett Company and many other firms utilise theservices of third party aerosol packaging firm s in orderto avoid involvement in this difficult and potentiallyhazardous production process for these goods in theirproduct line.

Release Firm to Marketing Expertise. Many clothing, toyand fast food companies contract purchasing, materials,production and distribution services. Martin-BrowerCompany and Golden State Foods perform much ofMcDonalds' materials and distribution services in theUnited States and overseas, thus enabling that firm toconcentrate on marketing. Sani-Tech Inc, a fluid transmission system firm, uses contract manufacturing. Thisfirm's key m arket advantage is design and building entirefluid transmission systems for food and other sanitaryenvironment settings. In both instances, the products soldare commodity-like in nature and could be produced bymany firms, but the contractor firm's strength is indevelopment and marketing.Globalisation Opportunities. Firms that seek globalproduction and distribution may utilise contract productiondue to joint ownership and production requirements incertain countries, as well as to minimise risk. Productionunder these contractual relationships can be easier toterminate or alter than would be possible with outrightownership.The actual or perceived major advantage being soughtthrough contracting will generally define the nature of suchan arrangement. For example, the avoidance of a difficultpart of production may cause firms to outsource only thatparticular subactivity of production. On the other hand,avoidance of investment, overhead and labour, or the needto concentrate on marketing will lead firm s to contractmuch broader aspects of production.Why Outsourcing is a Logistics ConcernLogistics' current and future involvement in outsourcingis important for many reasons. In many firms it alreadyappears to play a major role in outsourcing. Further, asproduction is shifted to outside firms, the logisticsexpertise of flow timing, storage, transportation andinventory investment control is still needed by the firm.Lastly, logistics, as well as purchasing, has experience indealing with outside parties in the forms of vendors,carriers, warehousemen and third party firms.The Temple, Barker and Sloan study revealed (Table III)that the management responsibility for outsourcing isfound in purchasing, distribution, with third parties andother areas of the firm[1]. These data show that purchasingtrends tend to play a stronger role in the raw materialsand components areas whereby distribution dominated thefinished products end of the production spectrum. Theresearch for this article determined the same generaltendency in domestic (US) settings. At this point in timethere is a small but increasing trend in the firms studiedto combine purchasing with materials and logisticsactivities within thefirm.This will no doubt reinforce therole logistics will play in outsourcing in the future.


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Table III. Management of Outsourced Goods inDistribution (Foreign Outsourcing)

DepartmentResponsiblePurchasingDistributionThird PartyOther

RawMaterials(%)4 3401536

Components(%)50416

38

FinishedProducts(%)2853

342

Contract manufacturing can change the organisational formand basic managerial constructs of the firm. The first chartof Figure 1 shows the traditionalfirmwhereby all inboundflows feed production while distribution handles productflows from the production line to the customer. In thissetting, production is a central activity that can oftendominate the firm in its scheduling processes or is a majormanagement function stemming from the high number ofemployees and fixed investment it controls.Contract manufacturing sometimes removes traditionalproduction management from the central product flow ofthe firm. The second chart of Figure 1 shows somematerial flow moving direct from vendors to companydistribution facilities or customers. This starts to have amajor impact on the make-up of thefirm.In the traditionalfirm, for example, a plant or production group oftencontrols purchasing, inbound materials, scheduling, actualproduction, warehousing and outbound shipping. In acontract setting, these functions can be performed by anoutsidefirm,and the contracting firm's control issues moveto managing the relationship with the outside source. Inthe fi rm s studied, this involved the functions of logisticspurchasing, with a much wider range of responsibilitiesand activities than simple buying.The firmusing complete contract manufacturing is shownin the third chart of Figure 1. Some food, toy and computerfirms fall into this group today[3]. In-house manufacturingdoes not exist; instead, co-ordinatedflowsfrom sourceto distribution and sales points are the central logisticsactivity.The management of contract manufacturing is largely alogistical control and co-ordination activity. It involvesdecisions dealing with timing, locations, transportation,delivery and customer service, quality, lot sizes,inventories, o rder informationflowsand purchasing. It isa procurement decision that is much wider than traditionalbuying in that it is the management of entire commercialrelationships.

Key IssuesThe research brought to lightfivekey issues companiesface with outsourcing. These are:

What is to be outsourced? How extensive should the outsource be? Which function initiates and manages therelationship? How should an outsource vendor be evaluated andselected? What should be included in an outsource agreement?

They are presented as a managerial model of major issuesand elements in the process.


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What is to be Outsourted?The decision as to what to outsource is linked with thequestion as to why outsource. Firms often face theoutsource decision with the option to contract out a currentongoing product or a new one. Black and Deckertraditionally developed products in-house and producedthem initially. Once a product gained success and requiredmass production and cost reduction was crucial to itssuccess in the marketplace, thefirm ended to outsourcecomponents, production and packaging. On the otherhand, Lederle Laboratories often started new productswith outsourced manufacturing and brought them in-houseonce they became successful. This forced the firm toexperience two learning curves, one with the vendor, then

another on starting in-house production. However, the firmavoided having to invest in equipment, thus reducingproduct failure risk. In both instances, the firms generallyhad available a range of vendors for either setting.Technology is another initial outsource issue . Should thefirm contract out high-technology or low-technology items?Some machinery manufacturers outsource electroniccontrols rather than invest into this area. The fast-pacedchange in technology often makes some productionfacilities obsolete before afirm s able to depreciate theinvestment. On the other hand, some firms avoidoutsourcing key technological items where competitivecopying or counterfeiting is a danger.


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Length of the product life cycle is another concern in thechoice of what products to outsource. Fad products, withthe risk of short product life cycles, increase the risk ofidle plant and equipment upon the maturity or decline ofthe product. Selchow and Righter used Western Publishingas one of its producers of the game Trivial Pursuit. Theavailability of many contract manufacturers avoids this risk.How Extensive Should th e Outsource Be?This is a function of the relative buying power, cost ofcapital, operational costs and management strengths ofeach party. Key areas for consideration here relate towhether the hiring firm or the outsource firm shouldperform such tasks as acquiring the materials for the work,arranging inbound freight, distributing the product todistribution centres, or movement of finished goods tocustomers.Figure 2 shows eight outsourcing configurations found inthe research. These range from having an outside firmperform a very narrow process all the way to havinganother firm perform nearly all logistics, production andmarketing processes.The simplest form of outsourcing is outside packaging.Export operations have long required special crating andpackaging, and firms have provided this service within theirfacilities or upon the hiring firm's site . Contract packagingis common in the food industry.Partial outside production is found where an intermediatestep is required in production, and the service is oftenbest performed by other firms. The practice of tolling,which is common in the metal fabrication industry, is anexample. The hiring firm acquires th e product and movesit to the service firm which performs some modificationto it; examples are bending, forming, plating, inspectionand welding. It is then returned to the hiringfirmfor usein its production.A combination of partial production and purchasing isperformed by many electrical and machinery firms . Thefirm acquires som e metals for use in its consumerproducts. It has other firms fabricate and finish thesematerials and affix them to particular products. Thesegoods are then moved back in-house for final production,packaging and distribution. Corning Glass Works oftenuses outside firms for some production processes involvingmetalworking. Corning, having market buying powergreater than some of these small fabricating firms, willacquire the necessary metals through its own purchasingoperation. The raw materials are delivered to theoutsource firm .Complete production, or production with packaging,outsourcing is common in the food industry. This optionconsists of the buying firm performing purchasing, raw

materials inventory, packaging, distribution and marketing.The production of the item is performed by an outsidefirm. The buying firm performs the materialsmanagement, distribution and marketing functions. Thereare also many computer and electronic firms that hireproduction capacity from firms that provide the assemblywork.Materials and distribution services are often part ofoutsource arrangements where storage and/ortransportation can more economically be performed bythe outsource firm . Differences in wage rates or ease ofproduct flow control are often a reason why these pre-and post-production services are also a part of productionoutsourcing. This is what the McDonalds outsourceconsists of, as does the Pepsico Food Service operationfor Taco Bell.Licensing and joint venture arrangements often consistof another firm performing most or all of the flow andmarketing facets of outsourcing. Here the managementexpertise of the outsource firm is applied to the entirerange of business activities, and the sourcingfirmsharesthe profits through dividends or royalties. This is oftenpractised in overseas selling of consumer goods. Entiresourcing, manufacturing and selling is handled by localoutsource firms that are familiar with specific nationalmarkets.WhichDepartment Initiates and Manages theRelationship?This is generally a function of the complexity and durationof the relationship with a contract manufacturer. In anarrow setting , such as metal process tolling, purchasingis often the primary department having responsibility forthis arrangement. The Safeway supermarket chain utilisesa purchasing group to oversee its private branding productsourcing. At Chrysler, purchasing oversees the outsourcingprocess and arranges for product delivery to theproduction line.Where there is greater complexity to the arrangementand many logistics variables enter the relationship,materials and distribution personnel are often involved.These might require the co-ordination of schedules,deliveries to many distribution centres, linkingtransportation options and communicating forecasts. Thisis the case in some drug and consumer firms wherebysome contract manufacturing operations deliver productsdirectly to company distribution centres whereas theoutsourcing firms maintain strict customer servicestandards of delivery to customers.The Temple, Barker and Sloane study (Table III) supportsthe strong presence of purchasing and distribution inoutsourcing. However, in this research it appears that themore complex the arrangement and those outsourcing


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THE LOGISTICS OF CONTRACT MA NUFACTU RING 19

arrangements that involve marketing (joint ventures andlicensing) then the relationship tends to be managed fromupper management echelons.How Should an Outsource Vendor be Evaluatedand Selected?The selection criteria are similar to those applied in anylong-term purchasing setting. The shorter the time spanand the lower the value-added service involved, the moresimple quality and price can be the managerial guidelinesfor vendor selection. However, the longer the time spanand the greater the complexity of the relationship, themore other objective and subjective elements of concern,to a wider range of departments, enter the decisionprocess. These relate to such factors as reserveproduction capacity, technical capabilities, quality andbalance of management, confidentiality, responsivenessof management, perception of priorities by the vendortowards the firm's business and initiative in costcontainment in the long term.What Should be Included in the Agreem ent?Outsourcing situations examined for this study includedarrangements that were general understandings in the formof verbal agreements between the chief executive officersof each firm, while in others they were reduced tocontracts of considerable size. One such arrangement witha firm in Germany consisted of a two-page letter, whileanother was over 100 pages in the form of an open-endedlong-term purchasing contract. Key elements included inmany of these arrangements are as follows:

identification of the parties and the productsinvolved; price and/or cost formulas; which firm owns the goods; FOB shipping term s; payment terms; liability of the product once it is owned by the final

customer; party holding ultimate warranty with the finalcustomer; confidentiality and security against competitorsviewing the production; force majeure term (a suspension term in the eventeither party has a catastrophe; fire, strike, etc); termination.

The RisksContract manufacturing is not without risks. It is a decisionthat requires careful short- and long-term balance ofbenefits and drawbacks. Some industries have usedcontract manufacturing for many years, while others areat the initial stages of the learning curve in this new area.


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Outsourcing risks appear to be common by both theexperienced and the firms new to it. Major risk elemen tsin this decision are as follows.Confidentiality. This includes secrecy about the producttechnology, production volumes, and customers andterritories to which the product is shipped. Some firmsmaintain a policy of not outsourcing produ cts involving newideas or specific technologies; instead, they outsource low-tech mass-produced items for cost advantage.Potential Competition by the Vendor. This problem hasoccurred in computer and automotive aftermarketindustries. Contract manufacturing, in this sense, hastaught the outsource firm or trading company how toproduce a similar product.Loss of Research and Development Strength. Newtechnologies and applications as well as development ofcost reduction advantages often occur because theresearch, development and engineering are in closeproximity to the actual production. Many of thoseinterviewed for this study indicated that th ese advantageswere diminished when their firms outsourced keyproducts. Some firms minimise this risk by outsourcingonly mass-produce d item s once th e firm has refined theproduct or process, and felt outsourcing confidentialityrisks could be minimised.Conclusions and RecommendationsContract manufacturing will no doubt continue to grow inuse . A view expressed by many top managementpersonnel interviewed for this study indicated a reducedneed today for th e firm to actually own and directly controlproduction . M ark et flexibility, financial, timing and cos tsfactors are advantages offered by outsourcing.The drawbacks of outsourcing require careful analysis.This is particularly th e c ase with long distance overseaslinks and the potential for US dollar volatility. Butoutsourcing offers a short-term reduction in investmentand manpower. However, if the firm eliminates itsproduction capacity, it can repre sen t a loss of contingencyoptions in addition to risks of confidentiality, and researchand development capabilities.Outsourcing involves the management of a commercialrelationship. Unlike simple buying, an entire set ofattributes must be defined for and controlled through theother firm. All of that firm's purchasing, production,quality, packaging and other activities are being performedat>arm's length from the hiring firm. T he use and succ essof this form of relationship can have major strategic impactson the firm.

Control over product quality is often simpler throughcontract manufacturing. Instead of inspection and controlof many inbound goods and production processes,outsourcing allows the acceptance or rejection of onefinished good. Sampling and acceptance processes ofoutsou rced private branded goods at Safeway, for example,involves much less manpower and effort than th e co rporateinfrastructures of quality management required for in-house production. An important question that must beresolved in the relationship, however, is the dispositionand settlement of rejected or poor quality goods madespecifically for the firm. Some firms provide contractmanufacturers with engineering, production and qualityassistance on-site as part of the quality assurance pro cess.Outsourcing approaches presented here apply to privatetrucking and warehousing alternatives as well. Th e benefitsand drawbacks, analyses, and tools of application aresimilar to those used in production. T he firms' q uest forminimised fixed investment and manpower commitmentas well as procurement and marketing flexibility alsoincludes scrutiny in the logistics area.Contract manufacturing is an opportunity for currentlogistics managers. Where many of the internal productflows were managed by production wh en this activity wasperformed in-house, w ith outsourcing, product flow timing,transportation and storage controls replace what was ofteninternal m aterials handling within a factory. P urchasing isalso being integrated more with transportation and overalllogistics in many firms. The development and control ofthe relationship as well as the co-ordination of the physicalgoods flows involves the analysis, skills and controlmethods used by logistics today.Corporate logistics has long provided the expertise of co-ordinating and controlling the firm's products while theywere inside the firm and in the hands of external firms.There will always be a need to monitor the status of, andmaintain tight controls over, the firm's inventory, no m atterwhere it is located and in whose hands it rests.Outsourcing will no doubt co ntinue, and many o bserv ersfeel it may accelerate. Logistics personnel who have strongprocurement, inventory, information, transportation andanalytical skills, will be the logical managers of outsourcingarrangements.

References1. Anderson, D., International Logistics, Temple, Barker andSloane, Inc, Lexington, Mass, 1987, pp. 1-6.2 . "The Ins and Outs of Contract Manufacturing",Purchasing, 8 August 1985, pp. 74A16-74A19.3. "The Hollow Corporation", Business Week, 3 March1986, pp. 57-83.

Joseph L. Cavinato is Professor of Business Logistics at the Pennsylvania State University, USA.

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The Logistics of Manufacturing