When Your Contract Manufacturer Becomes Your Competitor

R0609J PC maker Lenovo started out as a distributor of equipment made by IBM and other companies; now it has formed a joint venture with IBM and will eventually affix its own logo to its computers.

IBM essentially created the personal computer industry. It won’t be long, however, before the company’s nameplate disappears from PCs and IBM leaves the business, except for the joint venture it recently formed with PC maker Lenovo. Founded in 1984 as a distributor in China of equipment made by IBM and other companies, Lenovo will eventually affix its own logo to the PCs. Certainly, Lenovo has come a long way. So has Sanmina-SCI, the actual manufacturer of some IBM PCs in the United States: It recently acquired some of the factories where the computers are made. Like Lenovo, Sanmina assembles products for a variety of well-known brand owners. The company has expanded its role, however, and now also designs and engineers custom electronic components. These two firms are representative of a host of formerly anonymous makers of brand-name products that are stepping up and pushing the brands themselves aside. Indeed, the complexities of IBM’s environment challenge the common view of contract manufacturing as no more or less than the anxious resort of large brand owners suffering from thinning profit margins.

Yes, outsourcing the entire manufacturing of a product allows original equipment manufacturers (OEMs) to reduce labor costs, free up capital, and improve worker productivity. OEMs can then concentrate on the things that most enhance a product’s value—R&D, design, and marketing, for instance. Facilitating these gains are the contract manufacturer’s (CM) special strengths, which may include location in a low-wage land, economies of scale, manufacturing prowess, and exposure to the engineering and development processes of products it handles for other OEMs. (Such exposure puts the CM in a position to propose improvements to different clients’ products.)

As IBM and other companies have learned, however, contract manufacturing is a two-edged sword. For one thing, a CM is privy to an OEM’s intellectual property (IP), which it can leak to other clients or arrogate. For another, an ambitious, upstart CM can claim for itself the very advantages it provides an OEM. Having manufactured an OEM’s product in its entirety, the CM may decide to build its own brand and forge its own relationships with retailers and distributors—including those of the OEM. When these things happen, the OEM may find itself facing not only more dangerous incumbents but also a competitor of a new kind: the once-underestimated CM. Adding insult to injury, if the OEM had not given its business to the traitorous contract manufacturer, the CM’s revenues and knowledge might have remained sufficiently meager to prevent it from entering its patron’s market.

Although launching a brand would not be a trivial undertaking for any contract manufacturer, a brand identity rooted in the CM’s production prowess would have immediate credibility. Moreover, a CM working for several OEMs has experience making a wider range of products than do most of its clients, permitting it to concentrate on producing the most profitable ones. And its cost structure does not necessarily bear the burden of investments in R&D.

In short, OEMs’ humble attempts to realize operational improvements and cost savings can plunge them into a strategically treacherous realm in which partners quickly outgrow one another, spy more attractive opportunities elsewhere, and, in the most flagrant cases, bite the hand that has been nourishing them. Put simply, OEMs that retain contract manufacturers may unleash forces they find hard to control. It would be no exaggeration to say that the players soon find themselves immersed in a melodrama replete with promiscuity (CMs pursuing liaisons with a variety of OEMs), infidelity (retailers and distributors shifting their business to an OEM’s CM), and betrayal (CMs transmitting an OEM’s intellectual property to the OEM’s rivals or keeping it for themselves).

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