How to Best Understand Subcontracting and Contract Manufacturing

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Executive Summary

Subcontracting with a contract manufacturer is a specialized workflow within subcontracting.
We cover the relationship between OEM and contract manufacturer.

Introduction (Skip if You Watched the Video)

Contract manufacturing has grown tremendously in many areas, from electronics to food and pharmaceuticals. Subcontracting allows companies with no interest in participating in manufacturing or companies that manufacture to diversify what they offer without investing the time, money, and expertise to manufacture specific items. You will learn how contract manufacturing works within the context of subcontracting and what contract manufacturing has, in many cases, also morphed into running into sweatshops and allowing far greater tax evasion.

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What Is Contract Manufacturing?

Supply chain subcontracting is adopted from the general term of subcontracting.

This is where a subcontractor or subcontractee provides services to fulfill a contract.
The services are delivered to a contractor or general contractor.

Contract manufacturing is where the outsourced manufacturing entity manufactures the produced item’s predominant percentage. The answer to what contract manufacturing is is filled with complexities because contract manufacturing is, in some cases.

How the Term is Used Generally

Outside of supply chain management, subcontracting has a general definition. In supply chain management, it has a precise meaning.

For supply chain management, subcontracting is when a portion of the overall manufacturing process is assigned to an external company. This external company is called the subcontractor or subcontractee). How does this differ from simple procurement?

It differs in the following ways:

If a company purchases a component (called the contractor).
..and this component was manufactured by the supplier/subcontractor.
…then, didn’t the purchasing company “subcontract” to the supplier?

Subcontracting

Well, the actual definition of subcontracting is the following:

The purchasing company/contractor provides a component as an input raw material or semi-finished good to an external party.

This external party then performs a manufacturing process for the subcontractor. This is different than both contract manufacturing/outsourced manufacturing.

Contract Manufacturing Services

Contract manufacturing is when the contract manufacturer manufactures the entire finished good of the purchasing company.

Contract manufacturing can be seen as an extreme form of supplier collaboration or non-ownership-based vertical integration. That is, the customers are accessing the manufacturing facilities of the contract manufacturer without buying the company. The customer is referred to as the OEM or original equipment manufacturer.

Contract manufacturing is also called contract manufacturing services. For example, a division of GE advertises its contract manufacturing services. Luitpold Pharmaceuticals also announces contract manufacturing services rather than “contract manufacturing.”

The term contract manufacturing services are unusual because manufacturing is never described as a “service.” It is the opposite of service. On Luitpold’s website, under the contract manufacturing services page, it lists some of the following items:

Product Development
Analytical Development
Warehouse and Distribution
Labeling and Packaging Development

Interestingly, none of these things are manufacturing.

What this demonstrates is that contract manufacturing services are a euphemism for much more than just manufacturing.

Contract Pharma

Contract manufacturing is widespread in pharmaceuticals. Big pharmaceutical companies like Merck and Eli Lilly would prefer not to have to manufacture their pharmaceuticals. For a pittance, they can have their pharmaceuticals manufactured by someone else, thereby keeping most of the profits for themselves.

Contract Pharma is a big part of this corporate strategy of doing as little work as possible. This allows pharmaceutical companies to access cheap manufacturing capacity. Contract pharma has a great future ahead of it.

The Relationship Between OEM and Contract Manufacturer

Contract manufacturing is standard when the customer is in a different country from the contract manufacturer but is also common when the customer and contract manufacturer are in the same country.

The product is handed off to the companies in a normal customer-supplier relationship. But in contract manufacturing, the subcontractor, in effect, becomes a part of the company and, from concept to manufacturing. The process requires collaborative input from the customer and the supplier as if they were one company.

Contract manufacturing fundamentally changes the OEM into more of a general contractor. And with the work being performed by the subcontractors. Contract manufacturing is a detailed topic with its subject matter experts who are specialists in choosing the best contract manufacturer under all possible circumstances.

Selecting the Best Contract Manufacturing Companies

Many contract manufacturing companies have become so large that they dwarf the OEMs they do business with. Hence, the selection of contract manufacturing companies that are not too big for the OEM and giving the OEM priority is a frequent topic of discussion within the CM area. This goes beyond negotiating leverage, as contracting manufacturing companies may have certain volume requirements that the OEM must meet for the contract manufacturing companies to accept their business. What is interesting about the development of contract manufacturing companies (and a topic I don’t often hear discussed by economists or anyone else) is how contract manufacturing somewhat levels the playing field with OEMs.

While we discussed the “economies of scale” (or the efficiencies that come with size) of the OEM, it is now common to discuss the economies of scale of the contracting manufacturing companies. Contract manufacturing companies are aggregation entities, spreading many companies’ production over human resources, equipment, and plants.

Apple Manufacturing and Apple Outsourcing

Contract manufacturing has developed a bad reputation by companies like Apple that perform no manufacturing and no manufacturing jobs to Americans or Europeans but sell most of their product to the US and Europe. Apple manufacturing is, in reality, mostly a Foxconn factory. Foxconn Apple (Foxconn should always be called Foxconn Apple) has a Foxconn factory with 1/2, and a million employees paid extremely poorly. Estimates are around 50 cents per hour. A workday at the Foxconn Factory is often 16 hours per day, and the Foxconn Factory would meet all the normal technical definitions of a sweatshop. Sweatshops like Foxconn draw a stark contrast to the compensation given to Apple executives. And it is impossible to propose that Apple cannot afford to pay non-sweatshop wages with their enormous magins. The original idea was that very low-cost manufacturing would apply to low-margin products; not the highest-margin products would be made in a sweatshop where people have to sign no-suicide contracts. Generally, sweatshop labor has become accepted in developed countries, as long as those sweatshops are located in other countries.

Apple and Tax Evasion

Contract manufacturing has been fantastic for tax evasion. Apple outsourcing, which not only places 100% of the manufacturing jobs out of the country but through transfer pricing, Apple can keep untaxed profits overseas. Sales in Europe, the Middle East, Africa, and India are sent through an Apple corporation, Apple Ireland, a tax haven.

Apple Ireland is quite interesting. Apple Ireland is a paper company. Apple uses Apple Ireland to work its way out of taxes due to other countries. And the Irish government does not seem to care. The EU has reprimanded Ireland. The EU has ordered Ireland to collect billions of Euros from Apple Ireland. Apple Ireland seems to have decided how much tax it will pay. Apple Ireland is trading meager taxes in return for a plant in Ireland, where Apple employs around 6000 workers. However, even if Ireland receives $75,000 per worker, this only adds up to $450,000,000 in wages brought into Ireland. Meanwhile, Apple is worming its way out of tens of billions in the arrangement.

Contract manufacturing allows Apple to pay slave wages through Foxconn Apple and keep most of the profits overseas. Therefore, contract manufacturing is a perfect tool for tax evasion.

Responding to Apple’s Sweatshop

In many ways, it is unnecessary to continue supporting Foxconn and Apple’s Foxconn factory sweatshop. It is simply undeniable that Foxconn is a sweatshop. Strangely, a definable thing would be fine for Apple; such a well-regarded company would not pay some price in popularity for making almost all of its products in a sweatshop.

There are US suppliers of Apple computers called a Hackintosh. The Hackintosh is based upon standard PC components that break Apple’s restriction on what hardware their operating system runs on. Below is an example of a Hackintosh on eBay.

Hackintosh

The Hackintosh configurations are far more powerful for much less money than Apple offers. And these Hackintoshes are not made in a sweatshop, and the company that makes them most likely pays taxes. As pointed out by The Guardian.

“And it (Apple) pays a tax rate lower than 99.99% of the human beings reading this story right now — and they clearly work harder at the profit margin and squeezing their supply chain now than they do on their actual technology.”

For Apple, it’s all for themselves and nothing for anyone else. Therefore it’s difficult to see why anyone should respect its rules regarding which machines its software can run. And these restrictions have always had a limited legal basis. Understand this is not endorsing pirating the Apple software, but instead running the software on a non-Apple machine. Who is Apple to say what machine software should be run upon?

How to Understand Apple’s Contract Manufacturing of the iPhone

Contract manufacturing is when manufacturing is completely outsourced. Most business coverage of contract manufacturing tends to focus on just the benefits to the business. There certainly are benefits, and there are good contract manufacturing relationships. But there is also a very dark side to contract manufacturing that is epitomized by Apple outsourcing, leading to many negative externalities. This article will focus on these aspects of contract manufacturing and iPhone manufacturing or iPhone production.

Contract Manufacturing Agreement

The contract manufacturing agreement spells out how the two entities will interact. The contract manufacturing agreement includes things like when the goods will arrive, the lead times expected, the price, etc.. The price is often quite low in the contract manufacturing agreement when the contract manufacturer is in a foreign country. The contract manufacturing agreement never stipulates any rules around the treatment of employees within the subcontractor. This is very important because it removes any responsibility from the subcontractor. The subcontractor will want to deny any knowledge of labor treatment in overseas factories so that factories in countries with the lowest standards can be used and profits can be maximized.

It is common for a contract manufacturing agreement for overseas manufacturing to be very specific on quality because the profit margins are so low for the overseas manufacturer that they are highly motivated to perform a bait and switch.

iPhone Manufacturing or iPhone Production

iPhone manufacturing or iPhone production is performed at Foxconn, also known as Hon Hai Precision Ind Co LTD. Apple manufacturing is, in effect, no manufacturing at all. Apple manufacturing is just Hon Hai Precision Ind Co LTD. Hon Hai Precision Ind Co LTD runs the largest known sweatshop factories in the world. At least one Hon Hai Precision Ind Co LTD factory has over 600,000 employees in one giant sweatshop.

Most of these employees are drawn from rural areas, and the Chinese Government does nothing to help regulate the Hon Hai Precision Ind Co LTD employees’ treatment. Apple’s agrees with the Chinese.

Apple agrees with the Chinese Government and with Hon Hai Precision Ind Co LTD that those workers in these plants should not have any rights. It is precisely the reason why Apple outsources its manufacturing to China. It turns out that using a sweatshop and using contract manufacturers that have to follow no labor or environmental regulations is profit-maximizing. Apple could use contract manufacturers in any country yet choose the country with the lowest possible labor and environmental standards.

Apple computers have good margins, but iPhone manufacturing has enormous margins. And these margins are largely untaxed because of how Apple performs transfer pricing. This company has screwed down the labor price to make the iPhone, which may sell for $650 to $900, has been estimated to be between $12.50 and $30 per phone. If an average is taken, then manufacturing labor is 1/40th of the price of the overall phone.

Why is it strange for such a high-margin product like the iPhone to be manufactured in a country with no labor or environmental standards?

How to Outsource Manufacturing Intelligently

Manufacturing outsourcing has been a frequent area of focus for US manufacturers over the past several decades.

Analyses of outsourcing recommendations that have been provided by consulting companies given to their clients, which have to lead to outsourcing decisions, have proven to be incredibly simplistic. Many manufacturing outsourcing decisions have been based on nothing more than a comparison of part cost between the outsourced location and the internal plant.

Consulting companies ranging from Deloitte to McKinsey has provided this level of simplistic analysis. The consulting companies have been intent on getting their clients to outsource to essentially state that they have made a positive change to the customer. In fact, these types of consulting companies are for outsourcing 100% of the time, sometimes financially benefitting — at least on IT outsourcing as they all have “outsourcing solutions.”

What is often left out of outsourcing decisions is related costs such as inventory costs, transportation costs, service level implications, etc.. Furthermore, there have been constant quality issues with manufacturing outsourced. According to a survey by the American Society for Quality, the following statistics applied to their study on this topic.

55% of the companies were “substantially dissatisfied” with their outsource provider in innovation and making process improvements. Only 34% said outsourcing provided an excellent value.
Fewer than half of the companies, 41%, said outsourcing met their performance metrics.
While outsourcing can be a quick fix to lower costs, in the long run, it can backfire – sometimes badly.
Communication problems, poor customer service, slow delivery times, and quality control are just some pitfalls.

A perfect company that has botched outsourcing is Boeing. Their management of the outsourcing of subassemblies for their Dreamliner has cost the company mightily regarding its reputation and inability to get the product out the door.

The Blind Leading the Blind

Amazingly, many companies had another motivation to outsource – to impress Wall Street. Wall Street likes outsourcing stories and therefore perpetuates outsourcing. How Wall Street can drive bad decision making is covered in the topic of Warner Brothers’ outsourcing in the Brightwork Research & Analysis Press book Enterprise Software TCO: Calculating and Using Total Cost of Ownership for Decision Making.

Improving Outsourcing Logic and Standards

Outsourcing logic, as it currently stands, is incredibly simple-minded and should be improved. In the 2001 paper by Dr. Hart-Smith, he defines ten rules of manufacturing outsourcing. At the time, Dr. Hart-Smith was an employee of Boeing, and his paper shows a clear disagreement with Boeing’s continued emphasis on mindless outsourcing. The simple application of these rules would be more valuable than any major consulting company’s outsourcing analysis.

Top 10 Rules of Manufacturing Outsourcing from Dr. Hart-Smith

Look continuously at the entire activity. Do not minimize costs in isolation. Understand that one global cost minimization is worth far more than even 20 sub-optimum cost reductions.
Acknowledge that perfect efficiency cannot possibly be achieved and that it is counterproductive to try to do so.
Identify the minimum amount of production work that must be retained in-house to generate sufficient cash to develop future products. Do not let the tasks performed in-house fall below this level even if some tasks have a higher profit margin than others.
Retain sufficient in-house production manufacturing that it is possible for future engineers to acquire the skills needed to develop new products, without which all businesses will fail. Even the work that is out-sourced requires internal expertise to write the specifications.
Out-source only on the basis of better facilities; never on the basis of a temporarily lower labor rate. Out-sourcing as offsets for sales must be acknowledged as an increase in cost, on average, not a desirable cost saving.
Understand that out-sourcing work increases total span time and transportation costs. It out-sources all of the profits that are associated with that work. It also entails additional in house activities that would not have been needed if the work had been retained in-house.
Recognize the importance of precision in early tasks in reducing the larger subsequent tasks. Pay particular attention to self-assembling (jigless) structures as a proven method for eliminating expensive intermediate tooling that has no value once a program is over.
Acknowledge that cost-saving techniques that work in other high-volume industries are often quite inappropriate for low-volume industries like aerospace.
Find work to fill excess capacity; do not close it down or sell it off to boost RONA. Take on non-core activities, from time to time, if that is what is needed to reach a balance between head-count and budgets. Otherwise, irreplaceable critical skills will be lost and it will not be possible to deliver even core products.
Listen more to your own employees about how to save cost than to any outside business consultants who have never run a factory producing your kind of product. In any event, if the advice they offer changes every year, it cannot possibly be correct.

Improving Outsourcing Logic and Standards

As it currently stands, outsourcing logic is incredibly simple-minded and should be improved. It is necessary to determine how much of the manufacturing activities will be either given to contract manufacturing or subcontracting. Contract manufacturing is generally when the entire finished sound is outsourced, while outsourcing often means that a component or sub-assembly is outsourced. Contract Manufacturing is, of course, the total outsourcing of manufacturing. A crucial part of this is how the accounting and measurement are performed. In the 2001 paper by Dr. Hart-Smith, he defines ten rules of manufacturing outsourcing. The direct application of these rules would be more valuable than any major consulting company’s outsourcing analysis.

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Conclusion

The topic of subcontracting and contract manufacturing topics confuses many people, and it is, in fact, naturally confusing. Thus, often, the terms subcontracting and contracting manufacturing are misused.

Contract manufacturing can be a legitimate way of accessing external manufacturing capacity and specialization. However, in the case of offshore contract manufacturing, as with Apple Foxconn, it is a method of combining accessing sweatshop wages and labor conditions, low environmental regulations, and tax evasion. This use of contract manufacturing should not be endorsed, and companies that practice this way should be called out.

In a contract manufacturing business model, the hiring firm approaches the contract manufacturer with a design or formula. The contract manufacturer will quote the parts based on processes, labor, tooling, and material costs. Typically a hiring firm will request quotes from multiple CMs. After the bidding process is complete, the hiring firm will select a source, and then, for the agreed-upon price, the CM acts as the hiring firm’s factory, producing and shipping units of the design on behalf of the hiring firm. – Wikipedia

Outsourcing has its place, but the analysis must have the proper context. It must be performed by companies with the company’s interest at heart rather than consulting businesses that seek to make a big impression and make grandiose statements about manufacturing outsourcing that they lack the evidence to back up.

Contract manufacturing can be a legitimate way of accessing external manufacturing capacity and specialization. However, in the case of offshore contract manufacturing, as with Hon Hai Precision Ind Co LTD, it is a method of combining accessing sweatshop wages and sweatshop labor conditions, low environmental regulations, and tax evasion. This is how iPhone manufacturing or iPhone production is performed. This use of contract manufacturing should not be endorsed, and companies that practice this way should be called out.