Does contract kill?

When branded goods makers also become contract manufacturers, what lies in store?

Take a close look at the label the next time you buy Tetrapak fruit juices such as Coca-Cola India's Maaza or Ladakh Foods' Leh Berry. The manufacturer is Godrej Industries.

Both brands are manufactured at Godrej's plant near Bhopal. What's unusual about this arrangement is that Godrej also has its own fruit drink, Jumpin', which competes in the same Tetrapak fruit drink category as Maaza and Leh Berry.

Like Godrej, companies in businesses from foods to consumer durables and automobiles have increasingly been exploring the option of contract manufacturing (see box).

Of course, contract manufacturing, or outsourced manufacturing, is not new to India. But until recently, it was driven largely by statutory limitations, rather than competitive requirements. For instance, Hindustan Lever Limited's toothpastes and hair oils were manufactured by third-party manufacturers, as were Britannia's biscuits and breads, since these products were reserved for the small-scale industry.

But in the present context, it's the big Indian companies that are actively scouting for manufacturing contracts, principally to augment idle capacity and occasionally gain new expertise and abilities. In the process, the emerging relationships are often more complex and the experiences range from the rewarding to the salutary.

Consider consumer durables manufacturer Voltas. In 1998, the company sold its 1,00,000-refrigerator capacity plant in Nandalur, near Tirupati, to global home appliances major Electrolux. Electrolux also acquired Voltas' two refrigerator brands, Allwyn and Voltas. But the sell-off still left Voltas with 2,00,000-refrigerator capacity at its Hyderabad facility, which Electrolux had declined to buy. In the absence of a marketing set-up, the management decided to manufacture for other brands.

The timing was providential "" Korean consumer durable brands like LG and Samsung were just taking off in the Indian market, and LG Electronics was yet to set up its own factory in the country. Voltas had found a customer.

The association proved more than a mere capacity-utilisation exercise. When the relationship ended five years later, Voltas had acquired a degree of expertise in best-practice manufacturing, product technology and design, which would not otherwise have been so readily accessible.

One direct benefit for Voltas was a 22 per cent reduction in manufacturing costs. The other, according to S M Tripathi, executive director, Voltas, was that the company was also able to expand its product basket to cooling appliances "" deep freezers for ice creams, coolers for chocolates and so on "" which allowed it to tap newer markets.

Between 1998 and 2002 (when LG set up its own factory), Voltas expanded capacity to 5,00,000 units, of which the Korean major's offtake peaked at 3,50,000, or 70 per cent of capacity. (Voltas's air conditioning business accounted for the remaining 30 per cent.)

Naturally then, LG's exit threw Voltas in a crisis. But with upgraded manufacturing skills and a wider basket of products as a result of the LG connection, the company was able to attract other buyers "" another Korean chaebol, Samsung, for instance, accounted for 2,00,000 units and Chinese company Haier recently started buying small quantities.

Voltas was also able to service the deep freezer needs of ice-cream manufacturers like Hindustan Lever, Amul, Mother Dairy, Dinshaw and Arun. The company claims to have sold about 25,000 freezers in the past year. This accounts for a capacity of roughly 1,00,000 since the effort taken to manufacture one deep freezer is equal to four refrigerators.

But by this time, Voltas had understood well the risks involved in being a pure contract manufacturer. As Tripathi puts it, "It is not advisable for anybody to become only OEMs (original equipment manufacturers)." Agrees Mohan P Pusalkar, executive director and president, foods division, Godrej Industries, "It's a bit like tightrope walking."

Nine months ago, Voltas started marketing a range of direct-cool refrigerators under its new brand, Coldcel. The company hopes to sell 3,00,000 Coldcel refrigerators by next year.

But even while Tripathi and Pusalkar talk of the risks in contract manufacturing, others insist it is a great strategy. Says Venugopal N Dhoot, managing director, Videocon International, "Being a low-cost manufacturing base, India has a great opportunity in contract manufacturing."

Videocon International started supplying glass shells (the sheet of glass on picture tubes) to competitors in 1998. At present, it is the only supplier of glass shells for the entire television industry in India "" others like Samtel make entire picture tubes.

Glass shells make up 30 per cent of Videocon International's turnover, up from 25 per cent three years ago. "To set up such a company will take another five years for others. Until then we have no competition," says Dhoot.

Of course, the gains are obvious. As the Voltas experience shows, contract manufacturing offers companies assured demand and spares them marketing spends, following up with dealers for payments and getting into the retail- and distribution-driven business.

"Companies earn 20 to 30 per cent extra by selling their own brand, but it's also a huge headache," points out one consultant. (In the case of durables like refrigerators, the gross margin in contract manufacturing is just 3 or 4 per cent. This is true even for global contract manufacturing majors like Singapore's Flextronics, whose gross margin in 2003 was 3.5 per cent. For a branded player gross margin will be in the range of 7 per cent.)

Still, sceptics question the opportunities for contract manufacturers who also own strong brands. "Having both is not sustainable in the long term. This is an interim arrangement and they will have to graduate to one end," says Prasanna Pahade, a management consultant at Tata Strategic Management Group. There are several reasons for this viewpoint.

'IP' service
Contract manufacturing is essentially relationship management. As the case of Voltas highlights, the sudden severance of relationships can throw companies off-gear. This means that the contract manufacturer has to bring something extra to the table.

For this, Indian contract manufacturers could draw on the examples of global electronics contract manufacturing giants like the Singapore-based $ 14.5-billion Flextronics and the US-based $ 12.27-billion Solectron. For these companies, operations span across 20-odd countries and they cater to industries ranging from communication and durables to automobiles.

In this case, it is the contract manufacturer that offers clients cutting-edge inputs in product development or design, using intellectual property to tie in the relationship.

For instance, both Flextronics and Solectron offer inputs to clients from conceptualisation to the production stage. These companies also offer customers value-added services apart from manufacturing solutions.

Flextronics offers its customers a supply chain solution called SimFlex, which simulates real-world supply chain issues; this helps customers understand issues they are likely to face when they put their products in the market.

Godrej is also using its R&D expertise to ensure that clients don't leave easily. The company claims to have provided its expertise in partly developing the seabuckthorn berry drink, Leh Berry, for Ladakh Foods.

Though the drink was developed by the Defence Research and Development Organisation (DRDO), Godrej helped adapt it to suit the packaging requirements "" beverages need to undergo specific processes to be packed in Tetrapaks.

But that is a small operation and an exception. Most Indian manufacturers are still picking the low hanging fruit, which means getting a client to use up additional capacity. Even Godrej entered the contract manufacturing business for the same reason as Voltas.

When soft-drink makers upped the noise levels in the mid-1990s, demand for Godrej's fruit drinks took a hit. The company's capacity utilisation fell to 40 per cent, where optimum capacity utilisation for fruit drinks is 80 to 90 per cent.

"We could not match the onslaught of the carbonated drinks," accepts Pusalkar. So when Maaza, which was sold in bottles till the late-1990s, launched a Tetrapak version, Godrej latched on to the manufacturing opportunity.

However, the big hurdle for companies like Godrej and Voltas is they have only one major client. For obvious reasons, no major competitor would care to source products from the same organisation at the same time. Executives at Godrej admit that it would be virtually impossible to convince PepsiCo to use the Bhopal facility to produce Tropicana fruit juices.

"Empirically, the rule for contract manufacturers is to have eight or nine large clients who use 10 to 15 per cent of capacity each," says Pahade.

But that rule looks good only on paper, because in most cases in the same industry, many companies have excess capacity. In refrigerators, capacity utilisation at the best of times has been just 60 per cent given that sales dropped in 2002 and then grew at just 5.4 per cent last year.

Of course, there is a flip side to the single client route. Godrej's association with Coca-Cola has helped it gain other projects as well: Godrej now also makes the premixes for Coca-Cola's Georgia coffee and tea, apart from its recently-launched iced tea. As Pusalkar points out, "Relying on one client helps understand the entire manufacturing process and standardising it."

The unbeatable nature of low costs
Customers will stick with contract manufacturers only if they deliver an unbeatable low-cost advantage. In fact, that's the source of China's current global economic power. "In China, lots of companies just manufacture and do not have any marketing set-up," says Tripathi.

Companies like Galanz make more than 40 per cent of the global requirement of microwave ovens, churning out more than 13 million pieces, while others like Little Swan churn out 10 million washing machines every year.

But the scale that gives Chinese companies an advantage cannot even be compared with the Indian context. The total market for washing machines in India, at roughly 1.1 million units, is just 10 per cent of what Little Swan alone makes.

If scale does not give customers a reason to patronise contract manufacturers, nor does the tax structure. Tripathi says that the 4 per cent central sales tax on finished goods of refrigerators means that brand marketers end up with no major cost benefits for manufacturing outsourcing.

Consider: LG paid Rs 250 as tax on a single refrigerator that it buys from Voltas. If LG bought 3,00,000 units a year, it would be shelling out Rs 7.5 crore as tax. In comparison, as Tripathi points out, the cost to set up a 5,00,000-refrigerator unit is Rs 50 crore.

One argument for contract manufacturing is the fixed costs that get attached to setting up their own plant (depreciation, employee wages and so on) whether companies produce full capacity or not, dissuades companies from setting up their own production base.

But for companies like LG and Samsung, which have built up an impressive customer base and consistent demand in Indian markets, this can hardly be a concern.

The price of growth
Another big risk for contract manufacturers that make their own brands is in production planning, particularly in the peak season. Typically, every manufacturer has a base load on production which is maintained throughout the year and a peak load that is utilised during the peak season. Take the case of fruit drinks, where demand goes up in summers.

In the case of Godrej, Maaza takes up 10 to 20 per cent of production throughout the year. But in peak season Maaza consumes 25 to 30 per cent of plant capacity.

"Mostly companies outsource their peak load. But in the peak season when even the company's own brand has excess demand, there is a conflict. This results in jacking up your own capacity to accommodate peak loads of the competitor," says Pahade.

Godrej Industries claims that even though its Jumpin' and Coke's Maaza are made at the same Bhopal plant, it has not faced this problem, at least, until now. This is because Maaza is packed in machines for slimline packs (rectangular Tetrapak) while Jumpin', which also used to be made on the same line, has shifted to baseline packs (square Tetrapak).

Another reason is that Godrej Industries "" which claims to have the country's largest Tetrapak facility in Bhopal "" has capacity to spare. But Godrej could be in for trouble, if Jumpin' continues to grow at its current pace. Over the last three years, Jumpin's volumes have grown by a healthy 30 to 40 per cent. And companies never outsource to a company that is as big as their own brand.

Indeed, Indian companies could learn from the case of global computer giant, Acer. In the late 1990s, the Taiwanese major was making personal computers (PCs) for practically every major from IBM to Hewlett-Packard and Dell. But the problem was it also competed with these players in many markets.

As other low-cost contract manufacturers sprang up, none of the big PC makers wanted to give business to Acer. After taking a beating in the stock markets and a huge slowdown in sales in 1999, the company created a separate company for its contract manufacturing activities, thus ending the own-brand versus contract-brand conflict. A lesson for Indian companies perhaps?

EYEING THE CONTRACT

Contract manufacturers are no longer the behind-the-veil enterprises operating from the hinterland. In some cases, if large companies with impressive set-ups are putting their excess capacity to good use, in other cases plants are being built to serve clients.

Take the case of erstwhile Indian market leader for automobiles, Hindustan Motors. Currently, the company supplies of engines and gearboxes from its Pithampur plant to Ford India's 1.3 and 1.6 petrol Ikon models.

Hindustan Motors invested more than Rs 25 crore in the plant for this purpose. The company also makes engines for General Motors' Tavera. For Hindustan Motors, whose sales of the Ambassador had taken a thrashing ever since Maruti Suzuki entered India in the 1980s, contract manufacturing seems to be the ideal refuge.

In December 2003, pharmaceutical major Nicholas Piramal, signed a deal with the US-based Advanced Medical Optics (AMO), a global leader in eyecare products, to manufacture select formulations for an initial period of five years, beginning from the fourth quarter of 2004-05.

The deal is expected to give Nicholas Piramal assured annual revenues of $ 20 million (Rs 85 crore). Two more such deals are expected to happen by September 2004. For the company, custom manufacturing (making patented drugs for the innovator pharma companies) was the avenue to give it a global presence, when other Indian competitors like Ranbaxy and Dr Reddy's are taking the generic drug route to a global presence.

But for most Indian manufacturers, contract manufacturing is an option for optimum utilisation of capacity. For fast moving consumer goods company Balsara, the maker of Promise toothpaste, it was clients like Colgate and Smith-KlineBeecham.

For Mirc Electronics (Onida televisions), it was a three-month affair with Philips for making television sets during the cricket World Cup in 2002 that made it consider contract manufacturing.

What are the risks for the company that lets out its product specifications to a contract manufacturer? The most obvious danger is copies of the product.

Contract manufacturers say that companies outsource only the basic models. So there is no major incentive to copy. "We take up the bigger risk of a client walking away," counters one manufacturer.

Then, contract manufacturing requires orchestra-level coordination "" plans could change at the last minute. "The contract manufacturer needs to be flexible," says a client. And finally, quality is the hygiene factor that will keep you in business.