Contract manufacturing: A new era

Are you getting the most out of the partnership with your contract manufacturer and packager? Here are the benefits you can reap from an evolving business model.

For the last two decades, contract manufacturing and packaging for consumer packaged goods (CPG) has evolved at a steady and predicable rate. Products, practices and technologies changed but the basic value equation has remained relatively constant: Contract manufacturers offered capacity and CPG companies outsourced non-core, seasonal and sub-scale items. The stability of this equation benefited customers and contract manufacturers alike. Ongoing productivity gains enabled lower unit prices and increased quality for customers while largely protecting the margins of contract manufacturers.

Today, that equilibrium is being upended. Market forces are remaking the CPG sector and with it the role of contract manufacturing in CPG supply chains. This “new normal” is producing turbulence for an industry already in flux.

This new era, which we are calling “Co-Man 3.0” is no less than a sea change in industry structure and order. There was no press release, thunderbolt or starter pistol heralding its arrival. Rather, it has been a multi-year transition, well underway. The radical nature of the change is more obvious in retrospect. While we are still in the early years of this transition, the changes in the next five years will dwarf those of the past five.

Let’s look at the traditional Co-Man 2.0 model and see what is changing. Then we’ll examine how this impacts the contract manufacturing business model and the repercussions for providers and customers alike.

The current CPG contract manufacturing model—spoken in shorthand as “time, cost and quality”—has evolved with the market. It evolved during the mid 90’s as the role of contract manufacturing became more prominent for the first time. This shift involved moving from tactical capacity to a larger supply chain role. In supply chain jargon, it’s moving from just the Make portion of the SCOR (Supply Chain Operations Reference) model to the Plan, Buy, Make and Deliver equation.

The Co-Man 2.0 formula, itself disruptive at the time, was still easy to understand and measure. The expanded array of inputs—including variables such as cost, capacity, speed, scope, capabilities, logistics, variability, landed costs and geography—were straightforward. This expanding but consistent formula enabled customers to measure the relative value of outsourced production services and drive purchase decisions. It enabled contract manufacturing to grow into a major supply chain component, rather than a seasonal or marginal appendage. Today, the collective output of contract manufacturing represents a significant portion of the overall CPG production network.

Now that equilibrium is being disrupted. The reason? In a word, intensity. The enablers that produce marketplace change—technology, demographics, regulation, and economics—are shaping the CPG marketplace faster than ever before. The pressures on CPG brands to protect margin and find new value are immense. Even a partial list of escalating challenges includes private-label growth, new CPG competitors, activist investors, offshoring, supplier consolidation, omni-channel marketing, grocery consolidation, proliferation of stock-keeping units (SKUs), excessive regulation, globalization, wage pressures, sustainability, and consumer preference.

The quest for value against these headwinds has CPG companies looking for value in new places. One area is in the untapped value of tighter integration with trusted manufacturing partners. While it is overused in the extreme, the word “trust” here could not be more significant. Transactional providers or those lacking significant customer trust will not find these new avenues open to them. Conversely, partners that have earned trusted relationships in one domain have a huge advantage in helping their customers in other domains that may have been previously closed to them.

An example is new product innovation. Once considered a core competency and an exclusive bastion of elite CPG’s, it is now a highly collaborative inter-company endeavor. The world’s leading companies are looking for the world’s best ideas and are willing to go anywhere and everywhere to find them. One of the first places to begin is with partners with a proven competency in related domains.

New product innovation is just one area of intense innovation and collaboration. The competitive advantage created by those who embrace external innovation opened the door for other functional groups to mimic this model.

Supply chain vs value chain innovation

While today’s innovation includes the traditional supply chain functions such as materials sourcing, conversion, packaging and outbound logistics innovation, it entails much more. Value chain inputs—such as business process innovation, financial innovation, project management, engineering, equipment design/redesign, sustainability impacts and customers’ omni-channel requirements—all present emergent areas to innovate. The cumulative effects generate new value that flows to the customer.

The pressure to develop and deliver these services is morphing the role of contract manufacturers, forcing a more comprehensive set of solutions. It is also presenting a new challenge for customers. Seeing the value of these new services is much easier than accounting for them. Much of the value opportunity can be lost if the customer does not correspondingly either reduce internal cost structures or increase revenue opportunities.

This brave new world is jarring for customer and provider alike. No longer are “time, cost and quality” able to convey the complete value equation of this more complex solution. For example, the return on investment calculation of adding external engineering services to a project is contingent not just upon how the customer accounts for the project cost, but also if they are either truly reducing their overall costs or able to implement more projects. Was a person truly replaced—or added? Was an additional project commercialized or commercialized faster? In large organizations, these are never simple equations.

Is all this new value creation in pursuit of margin expansion? Not necessarily. The reality for the contract manufacturer is that they must add cost. These costs can only be recovered if customers recognize the added value and look beyond their product profit and loss (P&L) and into their total organizational cost structure. Those who can value this “Total Network” cost reduction will gain significant advantage.

Co-Man 3.0: World class in many ways

The adoption of new practices, such as lean manufacturing and continuous improvement, produces competitive advantage for early adopters. Firms that acquire these practices and execute them well gain a competitive advantage over others and are able to produce new customer value while protecting margins. However, lean and continuous improvement are no longer new. While some contract manufacturers still do not practice them, or do not practice them well, they are widely accepted as a competitive requirement. So what is the next set of skills that will become the new ante for contract manufacturers?

In the Co-Man 3.0 era we will see more and more of the extended value chain functions measured against still-evolving best practices. One challenge for providers and customers alike will be a need to move beyond the case. Long the holy grail of comparison, the simplistic “co-man case price” today doesn’t even come close to capturing the full value of one solution vs another.

The 2.0 era brought the procurement function into contract manufacturing. The metrics of procurement will struggle with other internal teams as customers find new measurements and equations for valuing various outsourcing options. The willingness and ability to make these assessments will produce competitive advantage for some CPG companies.

Let’s look at four factors—speed, space, staffing and sustainability—to see how they are changing in this new era:

1. Speed: Speed to market has never been more important. Missing a window can doom a launch, damage retailer relationships and impact brand value. Time-to-market often trumps most other considerations. Beyond simply commercialization speed, the contract manufacturer’s value proposition begins well upstream. Involvement in reducing formulation and package design lifecycles helps identify and shorten critical paths between concept and consumer, shortening concept to market timeframes and increasing customers’ competitive advantage.

2. Space: The spaces needed to innovate today go beyond production and warehouse areas. Development labs, test kitchens, prototype ovens, scaled production lines and small-scale test environments are just some of the new spaces emerging. Virtual spaces for greater customer collaboration are also expanding, as well as the practices for using these new tools. Having the right assets, people and PPE (a balance sheet metric for Property, Plant and Equipment) in the right place at the right time for maximum value / quality combination is more important than ever.

3. Staffing: The simple outsourcing math of swapping one production area and team for another at a lower cost has already been accounted for. The new value is in expanding the concept of staffing to include non-supply chain external value points. What value chain costs and functions outside the traditional supply chain structures can a customer move over to a contract manufacturing partner? This is a complex equation as the customer must either make internal rationalizations to realize these gains—calculating them into the total value of the relationship—or must be able to leverage contract manufacturer resources to manage additional projects, increasing top and bottom line opportunities.

4. Sustainability: This “S” is about much more than being green. It’s about relationship sustainability. The investment in a 3.0 relationship is high for both parties. The initial risks are higher and the ongoing intensity of the relationship requires organization-wide communication, understanding and buy-in. These relationships must produce value over the long term, and must endure on-going organizational changes, to be sustainable. We will look at this impact below.

Continued consolidation ahead

It does not take a crystal ball to predict consolidation. The CPG industry is one of ongoing consolidation at every level. The pressures of this new era however are forcing hard choices. Not every contract manufacturer or customer is willing or able to pursue this higher standard. At the same time, redundant and outmoded capacity is being idled. This will create a net reduction in the number of contract manufacturers and packagers serving the CPG industry.

The bigger consolidation driver, however, will be customer driven. Tighter integration with trusted partners lowers total network costs—but simultaneously increases engagement costs. This relationship intensity requires greater investment on both sides. Customers with a large cadre of contract manufacturers will find this unsustainable. The effects of this, which are already being felt, will be threefold. First, we will see continued and more rapid consolidation of the contract manufacturing sector. Second, small, still independent providers will find niches to survive. Third, suppliers will be stratified into tiers (a structure common in component industries such as automotive and electronics).

Plans for action

If you are contract manufacturer/packager, find more ways to add more value. Take off the blinders, engage with customers in deep listening and challenge your team to think beyond the case. If this were easy, it would already be the status quo. Customers have a major challenge determining what parts of their value chain can be moved outside, the value of doing so, the oversight costs of that move, the methodology for accounting for the move and the cultural adjustments of doing so. In the never ending struggle for value, Co-Man 3.0 represents a challenge and an opportunity for all involved.

Bob Scalia has spent most of the past two decades on the customer side of the contract manufacturing relationship including roles at General Mills, Nabisco, Kraft and the Hershey Co. Now on the vendor side as Hearthside’s svp of business strategy, he has a firsthand view of where the industry has been, its current state and where it is heading.