Contract manufacturing is now common in many industries. While this has been common in the electronics industry for a few decades now, we also see many instances of contract manufacturing in other industries, such as pharmaceutical and chemical. In order to pool demand, contract manufacturers try to serve multiple clients from the same factory. In that way, they can try to limit fluctuations in demand for the scarce capacity in the plant.

For the OEM clients of a contract manufacturer this implies that they need to provide advance demand information to the contract manufacturers. This information can be in the form of a formal order long in advance, in the form of a formal reservation, or in the form of a forecast. In our experience, often the exact character of this information may be an ambiguous combination of any of the above. In a recent article that I worked on with my former student (now professor) Youssef Boulaksil and my TU Eindhoven colleague Tarkan Tan, we try to understand how a manufacturer should act if it has contracted (part of) its manufacturing with a contract partner.

Despite the model being stylized, the results are insightful for (OEM) manufacturers and contract manufacturers alike:

In most cases, ordering each period a fixed order quantity with the contract manufacturer is best, and random demand fluctuations should be dealt with by safety stock at the OEM. This is driven by the fact that it is difficult for the contract manufacturer to respond at very short notice, since it has multiple clients to serve and typically operates at high utilization.
In case the dynamics in demand can be forecasted well, so are not subject to much uncertainty, it pays off to conduct the coordination with the contract manufacturer in more detail: make more specific reservations of the contract manufacturer’s capacity to enable the contract manufacturer to prepare. Relating this to (1): this only makes sense if there is little uncertainty in the demand and the demand pattern can be forecasted well.
The contract manufacturer needs to formalize the ordering process with its client by clearly separating between order reservations and actual orders, where a reservation is just focused on the total quantity (capacity) needed. The manufacturer does not instate a small change or cancellation fee in case the reservation is changed or cancelled, since otherwise their customers will not plan their safety stocks properly.
The two parties should agree and built a mechanism in the contract to ensure that reservations are not inflated by the manufacturer who clearly has an incentive to do so to secure future production capacity. This can be achieved by charging the manufacturer for unutilized capacity reservations, even if marginally.
Obviously, the latter is also dependent upon the “power balance” in the negotiations between the two parties, but we actually show that even for the customer it may be better, since in that case a proper tradeoff is being made between the small supplier charge and an appropriate safety stock level.

How are you managing this type of a relationship, and how is the order flow organized? Please leave your comments on the LinkedIn blog version of this post.

If you would like more information, or investigate how this stylized model can be engineered into a decision support tool for your company, feel free to contact us. We might be able to link you to an interested Master student.