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The Outlook on Outsourcing

Survey Finds Disparities in How Contract Manufacturers And OEMs View the State of their Partnerships

By: John Lamb

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Medical device manufacturers and diagnostic companies continue to significantly increase their use of contract manufacturers to outsource the production of disposable, electronic and system products. Growth rates among disposable contract manufacturers, for example, have typically been greater than 18%.

As the volume and complexity of these companies’ outsourcing activities increase, developing and maintaining successful relationships with contract manufacturing partners have become increasingly important. Medical device and diagnostics companies are leveraging their relationships with contract manufacturers to not only reduce costs but also gain access to new technologies and reduce time-to-market while focusing more on their own core operations.

John Lamb
PRTM
We define contract manufacturing as the hiring of an external company to manufacture products or sub-assemblies, where some value-added assembly occurs. Your company controls the design and bill of materials, and the product is manufactured to your specification, bears your company’s brand name and is sold through your sales channels.

In this article we provide an overview of the strategic issues for medical device manufacturers (OEMs) to consider when working with contract manufacturers. We also discuss key factors in building successful relationships with contract manufacturers and the challenges in maintaining those relationships. And we go on to look at some OEMs’ future plans on how much additional outsourcing they intend to pursue and in which areas.

The insights discussed here are based on two surveys that PRTM conducted. The first survey was conducted in 2003 with more than 40 of the world’s top medical device companies. The second was done in 2004 with the Massachusetts Medical Device Industry Council (MassMEDIC). For this survey, we collected data from 19 MassMEDIC OEM members and eight national contract manufacturers. The issues addressed here are also based on PRTM’s project work with a number of leading medical device and diagnostics companies.

Strategy Drivers

The decision to outsource part of a company’s manufacturing operations needs to be aligned not only with its operations strategy but also with its overall business strategy. In particular, the executives evaluating this decision need to understand the company’s current and future core capabilities. Executives will need to decide which parts of the technology are core for the future and should remain in-house and which elements are better left to others, namely contract manufacturers who have a strategic commitment to those specific activities. Companies with a strategic commitment to specific activities will likely have a greater revenue base for maintaining the skills that support these activities in line with emerging standards of excellence.

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Typically, most leading companies do not outsource core capabilities; however, there may be many other development, supply chain and support operations currently performed in-house that could be more effectively done outside. For example, many pharmaceutical companies continue to manufacture the active pharmaceutical ingredient (API) in their drugs but outsource final formulation and packaging to contract manufacturers. These operations are not viewed as adding high value and are not deemed to be core capabilities.

The executive developing his or her company’s outsourcing strategy should have a good reason for not outsourcing non-core activities. This kind of focus is a prerequisite for maintaining leadership in a company’s core activities.

The essence of a good strategy is to achieve a good fit for both the original equipment manufacturer (OEM) and its partners. It is important for senior executives to build an understanding of this for key relationships so true partnerships of synergy can be developed, leading to increasing value over time.

The surveys aimed to identify key success factors and major challenges in outsourcing relationships, compare the perceptions of OEMs and contract manufacturers and analyze future outsourcing plans. PRTM spoke with the “owners” of the outsourcing relationship within the procurement, manufacturing and external operations units of our survey companies. In the first survey, which polled primarily larger OEMs, 65% of companies had more than $250 million in revenues; in the second survey of smaller OEMs, 79% had revenues that were less than $250 million. The use of these two surveys, in effect, allowed us to compare larger and smaller OEMs.

Outsourcing to a contract manufacturer has become one component of most OEMs’ operations strategies, but for most companies it is not the only strategy. Of the respondents whose organizations outsource manufacturing, well over 75% of larger OEMs outsource 25% or less of their total cost of goods sold (COGS). However, in the more recent (2004) survey, we found one-third of smaller medical technology OEMs outsourced more than 50% of their COGS, and another half of them outsourced between 10% and 50% (Fig. 1). More than half outsourced in two leading categories: 63% outsourced disposables, and 56% outsourced electromechanical equipment.

Cost remains the primary driver for smaller OEMs’ use of contract manufacturers (Fig. 2). This is usually relevant for total cost reduction—not just labor but also overhead. For at least half the companies, the decision to use a contract manufacturer is also based on strategic issues such as gaining access to new technologies and improving speed to market, followed closely by increasing the focus on core competencies. For the larger OEMs, cost actually drops below these strategic issues in importance.

The services most often outsourced are goods and sub-assembly manufacturing, procurement services, quality control and product or process design changes—all used by at least 50% of OEMs (Fig. 3). Procurement management and product or process design change are the two service categories showing the most growth during the past five years.

The primary reasons for not outsourcing were a fear of loss of IP and concerns that the volumes weren’t sufficient or stable enough to be of interest (both 43%). The other reasons often quoted (both 29%) were fear of losing proprietary process know-how and concerns that the product was too complex.

Nearly 80% of the large OEM respondents using contract manufacturers said their outsourcing relationships met or exceeded their expectations. Our survey (Fig. 4) and project experience have shown that a number of key factors contribute to successful partnerships. These are:


• A “partnership mentality”
• Good communications
• Trust
• Experience

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However, smaller OEMs reported more gaps. A quarter did not see their contract manufacturers meeting expectations, and only 8% thought they exceeded expectations (Fig. 5). Contract manufacturers had a considerably more positive view of their relationships in general, with a full 56% believing they exceeded expectations. This may reflect the greater maturity of the relationships contract manufacturers have with larger OEMs, including better-developed relationship management skills.

Securing the last key success factors—trust and experience—is obviously something that takes time. However, these can be promoted by keeping a stable management team in place on both sides and by documenting processes in a Joint Service Agreement (JSA) (Fig. 6). We found those relationships guided by some form of JSA in addition to specific product or service contracts were more successful, and within that group, those with more extensive JSAs were even more successful. This suggests that the process of addressing contingencies up front, rather than on the fly, builds an environment of greater trust and understanding, which serves both partners well.

OEMs, even those who are satisfied with their partners, cited a number of challenges when working with contract manufacturers (Fig. 7). The biggest was maintaining product quality. OEMs clearly cannot expect to simply ignore product quality issues once they have transferred production to a contract manufacturer. They need to be prepared to commit time and resources to this area for the life of the relationship.

The more recent survey, conducted with contract manufacturers and smaller OEMs in parallel, showed that at least 67% of contract manufacturers thought they were meeting OEM needs on quality, but only 25% of OEMs thought their quality needs were being met—a significant disparity. Clearly, there is a need to build a sufficiently robust level of understanding and communication to ensure these two perceptions are better aligned.

The next two greatest challenges cited by OEMs were maintaining target costs and responsiveness to changes. Interestingly, these top three challenges—maintaining adequate product quality, cost and production volumes—are the same challenges that most companies face in their internal manufacturing operations. So, outsourcing production to a contract manufacturer does not eliminate those problems. However, it does change how much time senior management will need to spend managing them and possibly the performance achieved in these areas. A contract manufacturer may be able to provide more focused resources than the OEM in many of these situations.

The high degree of trust required in a successful relationship is a crucial reason why the partner selection and start-up process is so critical and needs to be managed carefully and thoroughly. Having the right team with the right experiences in this process can ultimately mean the difference between a good and bad choice for a partner. If serious problems arise but the commitment still makes strategic sense on both sides, a joint ‘root cause’ analysis, coupled with a ‘reboot’ (starting over), can make a lot of sense.

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In our study, we found a number of conditions that successful OEMs specified in their JSAs with contract manufacturers, including cost reduction targets, performance measures and quality requirements (Fig. 8). However, most important of all were relationship support considerations such as agreement on issue-resolution mechanisms, defining roles and responsibilities on both sides and agreeing on and documenting both parties’ expectations. Clearly specifying all these helped companies form better partnerships, launch them on mutually beneficial tracks, and avoid miscommunication and misunderstandings. Based on survey results as well as our industry experience, five key points have been identified as drivers for a successful outsourcing relationship (Fig. 9).

OEMs plan to increase outsourcing volumes and complexity—the smaller companies more than the larger ones. More than half of these smaller device manufacturers are looking to increase the complexity, product range and product volume outsourced (Fig. 10). They are less interested in increasing the number of outsourcing partners, however–only 25% plan to do that. That’s also the case for large OEMs, 75% of whom stated that if they increase outsourcing, it would be through volume growth of products already outsourced or products with manufacturing processes similar to those outsourced, and less than 50% plan to outsource more scope or complexity.

Once again this suggests that getting in early and investing in building a solid relationship is the best way for contract manufacturers to grow. While maintaining a low-cost stance, contract manufacturers are increasingly talking about the cost of the relationship and not just product cost. They are therefore putting much more of an emphasis on access to technologies and speed to market as differentiators (Fig. 11).
Our survey of contract manufacturer use by OEMs highlighted a number of key messages:



• Use of contract manufacturers is becoming more of a key component in many OEMs’ operations strategies.
• The decision to outsource production to a contract manufacturer is primarily a strategic decision, not a cost decision. Further, while cost may play a key role in that strategy, it is not just a low-cost play.
• There are numerous key factors in successful outsourcing, including having a partnership mentality, good communications, a high degree of trust and experience (or some proxy to accelerate experience such as a JSA).
• Even in successful contract manufacturing partnerships, there are challenges, the biggest of which is maintaining product quality.
• Growth of outsourcing will continue, and OEMs prefer to grow with existing partners.
• OEMs continue to be interested, albeit not overwhelmingly, in outsourcing non-core activities such as manufacturing engineering and post-production sterilization and distribution management.

Developing and maintaining a successful contract manufacturing partnership requires a significant amount of work and commitment on the part of an OEM as well as the contract manufacturer, but judging by the attitudes of the survey respondents and the continued growth in this field, it would seem that the benefits are worth the costs and risks involved. OEMs that plan to use this strategy need to be prepared to work hard to manage the relationship not only during the partner selection process but also after the partnership has kicked off to make sure that it is successful.

About The Author

John Lamb is a director in the life sciences practice at global management consulting firm PRTM. His focus is in global technology and strategy development and implementation, combined with all aspects of product development and portfolio management excellence in the healthcare arena. Lamb’s healthcare experience is concentrated in clinical diagnostics, imaging, peripheral and implantable devices, laboratory and research products, and emerging drug delivery technologies. He holds an MBA from Harvard Business School, and a BSc (first class) in engineering production from the University of Birmingham in England. He can be reached at [email protected].

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