Contracting it out

On the face of it, the huge spread of contract manufacturing is one of the best things to happen to India’s corporate sector in recent times. A cover story published in The Strategist section of this newspaper yesterday shows how contract manufacturing helps companies such as Hindustan Lever and LG to lower costs while, at the same time, helping utilise existing idle capacities.

In the case of Voltas, for example, the company had a 200,000-unit refrigerator capacity idle at Hyderabad after it sold off its main brands to Electrolux.

The contract to manufacture LG Electronics’ products helped it acquire state-of-the-art manufacturing techniques, product technology, and design capabilities.

Indeed, the LG connection helped Voltas reduce manufacturing costs by 22 per cent. Similarly, had it not been for the contract manufacturing deals with Ford and General Motors, Hindustan Motors would have had a bleak future.

However, for all the obvious synergies, there are huge risks as well. For the contract manufacturer, dependence on a single buyer could lead to a sudden loss of business—as it happened in the case of Voltas when LG decided to set up its own facilities.

Internationally, this happened to Acer when global clients like IBM and Dell stopped giving it business. On the other hand, the company getting the work contracted out faces the risk of losing its trade and technology secrets to the contract manufacturer.

While most top FMCG or pharma firms deny this happens to them, several experts agree that the process of getting soaps, shampoos and medicines contract-manufactured can be a double-edged sword.

Once contract manufacturing firms get familiar with the ingredients of FMCG or pharmaceutical products as well as their packaging techniques, it is not too difficult for them to branch out on their own or launch rival products.

They can also produce fakes and lookalikes, if they are not so ethically inclined. The magnitude of the potential problem is best judged by the fact that anywhere between 5 and 15 per cent of all FMCG products sold in the country may be fakes, as are between 20 and 30 per cent of all pharmaceutical products.

Given the huge loss in revenues due to the presence of these fakes, it could be argued that in the long run, the benefits from contract manufacturing could actually be a lot less than originally envisaged.

While this is clearly not something that applies to all industries equally, it is a lesson that needs to be kept in mind for industries that aren’t particularly technology-intensive in nature and don’t have much control over the point-of-sale either. For many companies, contract manufacturing would make sense only if the work outsourced is not central to its value chain.