In most industry verticals and in mature economic regions of the world like North America and Europe, outsourced manufacturing has become a market reality. This development requires a thorough rethinking of all supply chain processes, not just manufacturing. Many companies have already begun this process. A recent AMR Research study of more than 700 managers revealed the emerging trends in manufacturing outsourcing and outlined the components of a successful outsourcing relationship.

As different industries describe "outsourced manufacturing" in different ways, it might be helpful to start by giving our definition. At its core, outsourced manufacturing is a relationship between a brand owner and a contract manufacturer.

The brand owner contracts for the manufacturing services. This is the company whose name is on the finished product—whether it does the final assembly or contracts out the entire manufacturing process. Brand owners typically develop and own the product concept, design, and marketing. The brand owner is focused on ensuring product quality and consistency.

The contract manufacturer provides manufacturing as a service for the brand owner. In addition, it may provide a wide variety of other services, including design, sourcing, and logistics.

Many brand owners—particularly in the United States—are turning to a hybrid strategy for contract manufacturing in which part of the manufacturing is retained in house and part is outsourced. The goal of this approach is to improve flexibility and agility. A major U.S. pharmaceutical company we studied, for example, outsources 25 percent of its mature products to free up capacity in its own factories for new product launches. As part of this strategy, higher-margin products that have greater demand volatility and require closer coordination are manufactured internally, while the more mature products with more constant demand are manufactured by third parties.

But no matter how much of its operations a company outsources, contract manufacturing relationships are deeper than traditional, arms-length supplier relationships. Accordingly, they need to be carefully designed, sourced, and monitored.

Our survey found that labor cost is the major driver for more than 65 percent of the companies outsourcing manufacturing today. In some industries such as apparel, high tech, automotive, and consumer durables, labor is almost always the key driver—at least initially.

As companies mature in their management of these complex networks, however, they find that successful outsourcing is not about chasing lower costs. Instead, it's about broader issues such as designing the network to protect and support the brand, selecting the right suppliers for a reliable supply stream, and then managing and developing those network relationships for high quality and reliability.

With any manufacturing outsourcing strategy, the brand owner must ensure protection of the brand. This begins with the design of the actual component or product. That design process needs to consider two important factors: protection of intellectual property and social responsibility. Both considerations must be part of the original design process and not an afterthought.

Intellectual-property protection: A critical factor to consider in the design of a contract-manufacturing network is the protection of intellectual property for formulas, design drawings, and specifications. These elements form the essence of the brand. Designing the network to protect intellectual property in international markets is paramount because each country has different legal standards regarding contracts and patent protection.

Many companies learn about the importance of intellectual-property protection too late, after they find that their brand has been copied in a faraway place like China and then distributed in global markets. Making matters worse, they typically have little recourse to redress the situation.

Smart companies take proactive steps to protect the brand. For example, a major footwear manufacturer sews the top of sneakers in factories in China to reap the benefits of lower costs, makes the bottoms in U.S. factories to protect the product's uniqueness, and then assembles the finished sneaker in a third factory close to markets to reduce the risk of duplication.

Social responsibility: Being socially responsible and ensuring compliance to standards by all network members has become a big factor in sourcing decisions and supply chain management. When brand owners outsource manufacturing, particularly to low-cost countries, they must protect themselves from being tarnished by claims of unfair labor practices or from allegations of inferior quality.

The following illustrations show what can happen even to companies that are aware of the importance of social responsibility. In July of 2005, Reebok faced a staged protest by the National Labor Committee outside the National Basketball Association store in midtown Manhattan. The labor group accused Reebok of paying workers 19 cents for each $75 jersey sewn. Reebok responded that its pay at the factory is "consistent with requirements under local law." Similarly, in its 2004 "Corporate Responsibility Report," Nike revealed that 27 percent of the 497 factories making its apparel scored a "C" or "D," denoting serious code-of-conduct violations. The reality is that even companies experienced in contract manufacturing like Nike and Reebok struggle to develop effective contracting, monitoring, and control systems for supplier development.

Sourcing technologies are continuing to mature with more advanced auction and automated requests for proposal/information/quotation ("RFx") capabilities. As a result, we see companies rushing to automate the selection of their contract manufacturer. In fact, they often treat outsourced manufacturing as a procurement exercise and use advanced sourcing techniques as a way of squeezing margin. The effective management of contract manufacturing, however, requires balance. Done right, contract manufacturing is not just the selection of a supplier; it is the selection of an ecosystem.

In this ecosystem, potential suppliers need to be qualified, systems need to be evaluated and synchronized, and materials and logistics networks must be assessed. Only then can the brand owner ensure reliable supply and minimize problems surrounding social responsibility or intellectual property. This evaluation process requires tighter global coordination of corporate supply chain teams, manufacturing operation groups, and procurement teams. Systems are needed to enable the brand manager to plan globally and act locally in a manner that best supports the brand.

The real key to successful outsourcing is the brand manager's skill in managing and developing the relationship with the contract manufacturer. Our study findings suggest that this skill will become even more important as the number of outsourcing relationships grows. More than half of the respondents to our survey forecast that the number of contract manufacturers they manage will increase over the next two years.

There are several companies that excel at managing contract manufacturing relationships. According to the contract manufacturers that participated in our study, Boeing, General Electric, Herman Miller, Hewlett Packard, and Honda have some of the most advanced processes and systems for managing this relationship. In follow-up interviews, we found that the leaders were redefining their operations to support the contract manufacturing relationship and were aggressively working on supplier development programs. The best-practice organizations manage the outsourcing relationship neither as a procurement task nor as a corporate supply chain initiative. Instead, it is an organizationwide way of doing business founded on relationship management and supplier development.

Other best practices included the use of technology to manage the demand signal and the sourcing of materials. Leaders also focus on maintaining product quality and using a collaborative approach to managing inventory through strategies and tactics like postponement, vendor-managed inventory (VMI) hubs, and multiple sources of supply.

The decision to outsource manufacturing has far-reaching implications for the business. It needs to start with the design of an ecosystem for reliable supply, selection of reliable suppliers, and investment in operational systems for contract manufacturing management. But perhaps the most important ingredient is the brand manager's skill in developing the relationship so that it adds real value across the supply chain.