Int. J. Manufacturing Technology and Management, Vol. 19, Nos.

1/2, 2010

27

Evaluating the role and integration of contract

manufacturing strategy in supply chain management:
an empirical study
Liang-Chieh (Victor) Cheng
Department of Information and Logistics Technology,
College of Technology,
University of Houston,
Houston, 230E Technology Building, Texas 77204-6020, USA
Fax: 713 743 4032
E-mail: lcheng6@uh.edu
Abstract: Recently, the US manufacturers have been facing strong competition
domestically and globally for cost reduction and product customisation.
A key response to these competitive pressures is the outsourcing strategy.
While sporadic case studies have investigated outsourcings cost implication,
empirical analyses examining outsourcings financial and operational
performance are lacking. This paper investigates the impacts of outsourcing
in the US manufacturing sector and hypothesises that higher level of
outsourcing will lead to higher performance. Using the US Economic Census as
the data sources, the paper finds that outsourcing is positively associated with
ROA and ROI but is negatively associated with product specialisation.
Keywords: contract manufacturing; ROI; return on investment; ROA; return
on asset; product specialisation; capacity utilisation; outsourcing performance.
Reference to this paper should be made as follows: Cheng, L-C. (2010)
Evaluating the role and integration of contract manufacturing strategy
in supply chain management: an empirical study, Int. J. Manufacturing
Technology and Management, Vol. 19, Nos. 1/2, pp.2746.
Biographical notes: Liang-Chieh (Victor) Cheng is an Assistant Professor in
the College of Technology at the University of Houston, USA. He received his
PhD in Business Logistics and Supply Chain Management from the University
of Maryland in 2005. His primary current focus of research is outsourcing in
modular organisation, virtual supply chain integration, strategic supply chain
management, and inter-organisational information system. His research has
resulted in a published paper in a leading supply chain management journal,
Journal of Business Logistics, and four conference proceedings in Academy of
Management Annual Meetings, Decision Science Institute Annual Meetings,
Production and Operations Management Society Annul Conference, and
Industry Workshops.

Introduction

Since the mid 1980s, the trends and impacts of outsourcing strategies for international
manufacturing have strongly drawn the attention of academic and industry
experts (Cheng and Grimm, 2006; Schilling and Steensma, 2001; Sturgeon, 2002).
Copyright 2010 Inderscience Enterprises Ltd.

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L-C. Cheng

Original Equipment Manufacturers (OEMs) recently have been facing the need to
increase customisation and efficiency levels to remain domestically and globally
competitive (Plambeck and Taylor, 2005). The current globalisation environment has
extended OEMs supply lines and distribution channels. Decisions to invest additional
network assets or adopt external resources have now constituted a challenging, long term
task for the OEM to manage very complex supply chains (Cheng and Grimm, 2006;
Ro et al., 2004). One crucial response of OEMs to the competitive pressure is the contract
manufacturing strategy.
Contract Manufacturers (CMs) have played a salient role in helping OEMs for
production as well as upstream supply chain operations (Hilmola et al., 2005; Shy and
Stenbacka, 2003). As a result, jointly managing supply chains with CM partners has
become an essential criteria for OEMs to pursue strategic advantages (Lthje, 2002).
In industries with decreasing product life cycles, such as the electronics, computer, and
automobile industries, OEMs have substantially utilised contract manufacturing to
improve operational flexibility, sustain competitiveness, and even longer-term survivals
for the entire supply chain (Fixson et al., 2005; Ro et al., 2004). Scholars on strategic
supply management have consistently argued that outsourcing will sustain its pace
(Shy and Stenbacka, 2003; Sturgeon, 2002). A main driving force for this trend is the
swift advancements in information technology which makes it possible to integrate CMs
into the OEMs supply chain (Chopra and Meindl, 2007; Helo and Szekely, 2005).
Departing from the role of conventional manufacturer, OEMs tend to focus on core
competences, i.e., R&D and marketing, and outsource to CMs parts or all of the
manufacturing processes (Rajmanohar, 2007a) The scope of outsourcing may
also include design, purchasing, inbound/outbound logistics, or customer service
(Rajmanohar, 2007b). This shift in concentration is aimed at achieving higher efficiencies
for the total supply chain rather than in manufacturing alone. As manufacturers
increasingly outsource their non-core activities, CMs assume a greater role in the firms
supply chain. OEMs and CMs can share coordination tasks ranging from product
development, asset and investment allocations, and capacity planning, as well as
network-wide echelon inventory management, to ultimate physical distribution
(Cavinato, 1989; Chopra and Meindl, 2007). In the electronics manufacturing industry,
contract manufacturing has evolved into four refined strategies: pure contract
manufacturing, Contract Design and Manufacturing (CDM), Contract Design Service
(CDS), and Original Design and Manufacturing (ODM) (Hilmola et al., 2005; Holloway
and Hoyt, 2005; Lee and Hoyt, 2001). Firm-level examples of CMs successful
engagement in supply chains include Quantum-Dell in the computer industry,
Solectron-IBM and Flextronics-Motorola in electronics (Magretta, 1998; Sturgeon,
2002).
OEM-CM networks and outsourcing strategies can indeed exhibit higher level of
flexibility in using resources. Coordination between initially separate systems, however,
become critical for the OEMs ultimate performance (Kumar et al., 2004). Furthermore,
a larger scale supply chain also requires greater endeavour from the OEM to balance
and optimise expanding assets and technologies in the entire network (Fine, 2000;
Fine et al., 2005). In the resulting supply chain, it is challenging to identify performance
indicators for a flexible production system (Hilmola, 2001; Kumar et al., 2004;
Plambeck and Taylor, 2005).
Despite the abundant academic discussion and anecdotal evidence regarding contract
manufacturing, specific empirical metrics to investigate outsourcing practices in the

Evaluating the role and integration of contract manufacturing strategy

29

manufacturing industries are not fully developed in the literature. Existing empirical
outsourcing research mostly documents the cost reduction aspect on this organisational
strategy, and few works address which financial and operational performances should be
assessed beyond cost reduction by utilising contract manufacturing. Furthermore, current
empirical works investigating outsourcing at the industry level are merely on an ad hoc
basis (Daft and Lewin, 1993; Schilling and Steensma, 2001). As well, the research
settings are limited in scope and do not encompass the entire manufacturing sector,
thereby restricting the in-depth analysis of contract manufacturing decision-making
scenarios. Hence, there is a critical need for large-scale assessment with respect to the
dynamics between outsourcing and pertinent financial and operational performance
indicators over time.
The preceding observations motivate this research to conduct an industry-level
investigation as to the contract manufacturing impacts on the performance outcomes.
Specific research questions being examined are:

Beyond cost-effectiveness, what are the performance indicators that can validate
the use of contract manufacturing?

To what extent will the level of contract manufacturing at the industry level impact
these performance indicators?

To address these issues, this paper investigates the collective financial and operational
performance of the overall contract manufacturing practice by OEMs across the entire
US manufacturing sector. Critical indicators of outsourcing effectiveness examined
in this paper include: Return on Investment (ROI), Return on Asset (ROA), product
specialisation, and capacity utilisation.
Industrial economics researchers have conducted industry-level studies to analyse
critical manufacturing strategies (Balakrishnan and Wernerfelt, 1986; DAveni and
Ravenscraft, 1994; Levy, 1985; MacDonald, 1985; Porter, 1980; Ravenscraft, 1983;
Schilling and Steensma, 2001). In the spirit of this stream of literature, the present study
fills the gap in the contract manufacturing research with respect to the dynamics between
OEMs outsourcing strategies and the relevant performance implications. The large-scale,
empirical analysis contributes to the literature by determining the performance indicators
of contract manufacturing as a flexible supply chain design strategy through elaboration
of statistical analyses, supplemented by managerial implications.
The remaining sections are arranged as follows: Section 2 defines and explores
financial and operational outcomes of the outsourcing strategy. A set of hypotheses is
developed based on operations management literature. Section 3 details a method to
operationlise relevant variables and statistical procedures for hypotheses testing.
In Section 4, the results of statistical method are reported and discussed. The last section
of this paper concludes with discussion on managerial implications and future research
directions.

Theory, an assessment framework, and development of hypotheses

Compared to vertical integrated systems, outsourcing has the potential to achieve greater
joint asset and capital investment with supply chain partners, higher level of
customisation, and flexibility in utilisation of shared asset (Davis and Hong, 2007;

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L-C. Cheng

Helo and Hilmola, 2003; Sturgeon, 2002). Key indicators reflecting these outsourcing
implications are Return on Asset (ROA), Return on Investment (ROI), product
specialisation, and strategic capacity utilisation. A body of literature has shown that
outsourcing strategy entails substantial joint sharing of assets and inter-organisational
investment (Cavinato, 1989; Chopra and Meindl, 2007; Hilmola, 2001). Additionally,
outsourcing will affect the product design and use of production capacities (Cheng and
Grimm, 2006; Fine, 2000; Hayes, 2002; Hilmola, 2001; Randall and Ulrich, 2001).
In electronics and semiconductor industries, for instance, globally operated CMs have
taken the initiatives of deploying physical resources and product designs and oftentimes
served a number of competing OEMs using same facilities (Rajmanohar, 2007a).
While OEMs enjoy the strong scale economies resulting from aggregation among CMs,
CMs in the meantime increase their purchasing power against supply chain partners
(Delattre et al., 2007; Sturgeon, 2002). Therefore, examinations of the links between
the CMs and OEMs ROA, ROI, product specialisation, and capacity utilisation are
imperative. Confirming the links will establish comparative metrics to evaluate the
effectiveness of using CMs.
ROA and ROI are indicators of profitability performance and are usually stated as an
annual rate of return (Bettis, 1981; Frigo and Ciecka, 1995; Kousenidis et al., 1998).
The research defines ROA to be the ratio of total profit to total dollar value of assets in a
year. ROI is the ratio of profit gained on an investment to the dollar value of investment.
Thirdly, product specialisation is defined as the primary product dollar value as a
percentage of the total production output values (Brush and Karnani, 1996). Finally,
one of the most frequently used definitions of the capacity utilisation rate is the ratio of
actual production output to the potential output (Banker et al., 1996). Figure 1 illustrates
the relationships between contract manufacturing and the four examined indicators.
The figure suggests that for a manufacturing industry, the overall financial and operations
performance indicators are a function of the level of contract manufacturing.
Figure 1

Conceptual model of the performance indicators for contract manufacturing

2.1 Impacts of contract manufacturing on ROA and ROI

OEMs utilisation of contract manufacturing will extensively affect the allocation of
supply chain resources, and these allocation efforts will impact related ROA
and ROI. Regardless of choosing either vertical integration or contract manufacturing,
supply chain management requires constant, substantial commitments on assets
and capital investments to coordinate supply chain partners. Assets are long-term,
fixed costs typically include physical facilities to perform regular supply chain
processes, e.g., research labs, factories, fleets, or distribution centres (Bettis, 1981).
Capital investments are variable costs for resources beyond existing assets such as R&D
expenditures, information systems, production technologies, and logistics equipment

Evaluating the role and integration of contract manufacturing strategy

31

across supply chain stages (Banker et al., 1996; Chopra and Meindl, 2007). A vertically
integrated firm not only needs to account for all the current expenditures on its own but
also must adjust future procurement considering specific requirements.
In a vertical integration system, as OEMs strive to increase or sustain market share,
increasing the firms value system assets and capital pool appears to be inevitable.
This is especially true when OEMs attempt to maintain state-of-the-art operations by
continually upgrading internal manufacturing and information technologies and supply
chain solutions (Sturgeon, 2002). Given common budget constraints, this internal
expansion poses drastic pressures on OEMs to distribute financial resources and evaluate
performances. OEMs risk high sunk costs and switching costs, which prevent flexible
resource utilisation. Furthermore, the uncertainty inherent to competitive market
environments will worsen the potential for OEMs to swiftly achieve high level of returns
(Prahalad and Hamel, 1990).
In response to the relative rigidity in allocating resources, the use of CMs has
emerged to facilitate network effectiveness and enhance individual supply chain partner
efficiency. In an outsourcing setting, OEMs are operating on core competences along
with non-asset based supply chain strategies (Prahalad and Hamel, 1990). Aimed at
enhancing system level flexibility in deploying assets and capital investment, OEMs
can take advantage of CMs specialty in routine manufacturing operations to alternatively
direct assets and capital investment toward core value-added processes (Lthje, 2002;
Schilling and Steensma, 2001). Accordingly, direct efficiency can be leveraged on the
OEM side. Instead of investing new assets independently to respective internal facilities,
OEMs can remove redundant capacity and capabilities by strategically utilising CMs
competences. OEMs and CMs in the network thus can together minimise physical
investments and, in turn, pursue higher profitability (Gulati et al., 2000).
Additional efficiencies for the OEM-CM network can be gained from the CM
side as well. Large scale outsourcing by multiple OEMs enhances CMs abilities to gain
savings through deploying and structuring aggregated physical resources (Fixson et al.,
2005; Ro et al., 2004). According to the Square Root Law, consolidating manufacturing
capacities, assets, capitals, and inventories will manifest economies of scale,
i.e., reduction of unit costs as consolidation level increases (Chopra and Meindl, 2007;
Evers and Beier, 1998). As an example, frequent utilisation of physical resources, i.e.,
factories, marketing channels, and logistics facilities, can minimise waste and optimise
supply chain operations. Ultimately, the CMs strength in efficiencies will translate to the
OEMs advantage in terms of lower supply costs and reduced echelon inventories in a
supply chain (Kumar et al., 2004).
By re-configuring business processes, OEMs and CMs can also synergistically
benefit from the collaborative integration (Delattre et al., 2007; Lthje, 2002). Resources
originally exploited separately can be combined and exchanged in the OEM-CM network
to achieve greater collaborative gains (Gulati, 1998; Gulati et al., 2000). CMs and OEMs
can mutually reinforce their strengths and reduce unit costs to a greater extent.
Consequently, the investment return for the OEM-CM supply chain as a whole may grow
faster than the collection of originally separate supply chain entities.
The impacts of outsourcing on ROA and ROI will certainly vary widely across
different industries (Daft and Lewin, 1993; Schilling and Steensma, 2001). For instance,
industries relying less on capital but more on labour might exhibit less impact on
ROA from outsourcing. In contrast, capital-intensive industries, e.g., automobile and
semiconductor manufacturing with lower initial ROA and ROI, will likely benefit more

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L-C. Cheng

by integrated OEM-CM systems. However, rapid advancements in communication and

computer technology has substantiated the strategic integration between OEMs and CMs
(Fine, 2000; Helo and Szekely, 2005). Standardisation and technological developments
between OEMs and CMs make it relatively easy to distribute resources between OEMs
and CMs relationships (Fine, 2000; Schilling and Steensma, 2001). For instance, IBM,
Hewlett Packard, and Dell Computers have utilised the outsourcing strategy to leverage
CMs strength in R&D and production processes (Sturgeon, 2002). These examples
illustrate that outsourcing will potentially reduce the joint commitments of assets and
capital and at the same time enhance the return of combined resources.
Based on prior reasoning, the impacts of contract manufacturing on ROA and ROI of
OEMs in the entire manufacturing industry are proposed in the following two hypotheses:
Hypothesis 1: The higher the level of contract manufacturing, the higher ROA for the
OEMs in the focal industry.
Hypothesis 2: The higher the level of contract manufacturing, the higher ROI for the
OEMs in the focal industry.

2.2 Impacts of contract manufacturing on product specialisation

Current trends in customisation have formed a strong driving force for OEMs to augment
product scopes to serve an expanding marketplace (Ro et al., 2004; Sanchez and
Mahoney, 1996). Competition and growing markets also create heterogeneous demands
for finished products (Schilling and Steensma, 2001). The consequences are nontrivial
uncertainties manifested in forecasting, order quantities, material purchasing, and product
varieties. For OEMs, concentrating in limited product categories has become less
advantageous in competition.
Among the alternative supply chain structures, vertical integration leads to more
rigid supply chain arrangements which can allow fewer product categories because
of the pursuit for scale economies (Sturgeon, 2002). In contrast, a more encompassing
combination of assets, technologies, and workforce between OEMs and CMs can
incorporate broader product design development activities and expertise (Gulati et al.,
2000). In line with the aforementioned ROA and ROI discussion, a richer resource
pool in the OEM-CM network can lead to stronger joint innovation capabilities.
Not surprisingly, outsourcing has become an oft-considered strategy and CMs assume a
greater significance in OEMs product development (Fine et al., 2005; Fixson et al.,
2005; Ro et al., 2004).
OEMs utilise the capabilities embedded in contract manufacturing networks to
achieve product, process, and supply chain flexibility to hedge against uncertainty and
enlarge production volumes without incurring a substantial cost increase (Fine et al.,
2005; Gulati, 1998; Hilmola et al., 2005). Specifically, the advancement in
computer-enabled communication helps supply chain partners modularise production
processes and product designs (Helo and Szekely, 2005; Lthje, 2002). OEMs and CMs
can accordingly designate their respective supply chain activities based on the process
and product designs. This modularised, disintegrated supply chain configuration
translates to higher organisational flexibility to create more complete product categories
(Fixson et al., 2005). Since OEMs in this context are more capable of diversifying
product lines rather than offering narrower product scopes, outsourcing leads to greater
innovation and less production concentration.

Evaluating the role and integration of contract manufacturing strategy

33

The flexibility created through outsourcing will ultimately contribute to a higher level
of customisation capabilities (Fine, 2000). A number of manufacturing industries have
exhibited that leveraging outsourcing can help achieve high level of flexibility to serve
heterogeneous markets, e.g., Motorola in the electronics industry, Nike and Reebok in the
footwear industry, Dell in the computer industry, among others (Schilling and Steensma,
2001; Sturgeon, 2002). Since firms no longer concentrate on limited product categories,
OEMs can achieve higher diversification or product variety (Sanchez and Mahoney,
1996). The product specialisation hence decreases as higher outsourcing and pertinent
modularity is utilised. In sum, the relationship between contract manufacturing and
product specialisation for focal OEMs is hypothesised as follows:
Hypothesis 3: The higher the level of contract manufacturing, the lower product
specialisation for the OEMs in the focal industry.

2.3 Impacts of contract manufacturing on capacity utilisation

Contract manufacturing will not only re-shape the supply chain outlook but also impact
the utilisation of supply chain capacities. In the conventional vertically integrated system,
OEMs are more likely to set capacity utilisation high in order to attain production
economies of scale, a strategy largely associated with the push system (Coelli et al.,
2002; Helo and Hilmola, 2003). Using a push approach, manufacturers are more likely to
exploit manufacturing capacities for volume production aimed at lowering unit cost.
The finished good inventories are accumulated and in turn pushed to the marketplace
(Chopra and Meindl, 2007). Capacity utilisation, in this context, is set to be high.
Many capital-intensive industries, however, suffer from excess capacity on the pursuit of
scale economies (Porter, 1980).
Contrastingly, contract manufacturing strategies are often employed to institute a pull
system. Compared to the push approach, an OEMs pull system postpones assembly
processes until orders arrive. Assembly capacities are utilised for customised orders,
and production activities are pulled by actual, instead of predicted orders (Chopra and
Meindl, 2007; Hayes, 2002). Since the OEM capacities are used on an as-needed basis,
the pull strategy will lead to lower capacity utilisation for OEMs, relieving the pressure
of excess capacity. In the meantime, CMs increase capacity utilisation by consolidating
materials/module orders from downstream the supply chain (Davis and Hong, 2007;
Delattre et al., 2007). This arrangement between OEMs and CMs can help supply chain
partners serve heterogeneous markets more efficiently.
Finally, new technologies may facilitate the OEM-CM system to manage the
capacity utilisation tasks (Lthje, 2002; Sturgeon, 2002). As an example, the flexible
manufacturing system can assist manufacturers in sustaining efficiencies for multiple
production lines even with limited throughput (Sanchez and Mahoney, 1996). In line with
the prior ROA and ROI argument, capacities distributed between OEMs and CMs may be
utilised in a more effective, and perhaps, more efficient manner. Consequently, the
capacity utilisation for OEMs will likely be lower due to higher levels of contract
manufacturing.
The foregoing discussion regarding capacity utilisation is summarised as the
following hypothesis:
Hypothesis 4: The higher the level of contract manufacturing, the higher capacity
utilisation for the OEMs in the focal industry.

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L-C. Cheng

Figure 2 summarises the hypotheses development and illustrates the causal relationships
between contract manufacturing and the four indicators. The figure indicates that contract
manufacturing will generate positive impacts on financial performance in terms of ROA
and ROI. Contrastingly, a higher level of contract manufacturing on an industry basis will
lead to lower product specialisation and capacity utilisation.
Figure 2

Causal relationships between contract manufacturing and performance indicators

Data and methods

3.1 Sample
The research setting of this paper is the US manufacturing industries. The unit of
observation is a manufacturing industry per annum. The US Census Bureau has
developed the North American Industry Classification System (NAICS) to categorise
industries in the North America area (US Census Bureau, 2006). This paper applies the
most disaggregate industry category, i.e., the 6-digit NAICS system, to define a
manufacturing industry. The complete 6-digit NAICS system includes 473 manufacturing
industries.
The 1997 and 2002 Economic Censuses by the US Census Bureau are utilised for the
main data sources (US Census Bureau, 2004a, 2005). The initial panel data set comprises
946 industry-year observations. The final sample contains over 800 observations with
complete data items for hypothesis testing.

3.2 Operationalisations of variables

The dependent variables are ratios comparable across industries. Explanations of four
performance indicators are provided below:

3.2.1 Dependent variables

Return on Assets (ROA). ROA is operationalised as the ratio of operating margin
to the entire OEM asset dollar values for a manufacturing industry over a calendar year,
i.e., 1997 and 2002 (Bettis, 1981). The Census data items employed are

the price-cost margin (titled as value added in the Census Data)

total asset dollar values of 6-digit NAICS manufacturing industries in the years of
1997 and 2002, respectively.

Evaluating the role and integration of contract manufacturing strategy

35

Return on investment (ROI). ROI is derived by calculating the ratio of operating

margin to the dollar values of capitals for a manufacturing industry in a calendar year
(Banker et al., 1996; Frigo and Ciecka, 1995; Kousenidis et al., 1998). The Census data
items used are

the price-cost margin

total capital expenditures by 6-digit NAICS manufacturing industries in the years of

1997 and 2002, respectively.

Product specialisation. The degree of production specialisation is the percentage of

primary product dollar values over the total dollar values of entire production outputs
in 1997 and 2002, respectively (Brush and Karnani, 1996). The data sources are 1997 and
2002 Economic Census.
Capacity utilisation. The operationalisation of capacity utilisation is the percentage of the
actual output dollar values of manufacturers over the maximum output values that could
be produced per year, given the existing plant and equipment, with 100% indicative of
full capacity (Banker et al., 1996). The data sources are 1997 and 2002 Annual Surveys
of Plant Capacity for the US manufactures by the Census Bureau (US Census Bureau,
2001, 2004b).

3.2.2 Independent variable

Contract manufacturing. This paper utilises Schilling and Steensmas (2001)
operationalisation to measure the degree for the use of contract manufacturing.
Contract manufacturing is measured by calculating a manufacturing industrys
expenditure on contract work as a percentage of the total cost of materials. Measures are
collected from the 1997 and 2002 Economic Censuses.

3.2.3 Control variables

Given the different attributes of capital and labour requirements for different
manufacturing industries, the research controls capital and labour intensity in the
regression analyses. In addition, outsourcing and vertical integration are potential
alternatives to organise upstream supply chains. It is therefore necessary to control the
level of vertical integration in an industry. Accordingly, the degree of vertical integration
is held as a constant in regression runs.
Capital intensity. The degree of capital intensity is measured by dividing annual capital
expenditure by the total employee number in a manufacturing industry (Brush and
Karnani, 1996). The present study converts the capital expenditure measures into real
1997 terms (Dewan and Min, 1997). Measures are collected from the 1997 and 2002
Economic Censuses.
Labour intensity. The degree of labour intensity is measured by dividing total number
of employees by the dollar value of industry outputs each year (Schilling and Steensma,
2001). This study converts the industry outputs dollar value into real 1997 terms
(Dewan and Min, 1997). Measures are collected from the 1997 and 2002 Economic
Censuses.

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L-C. Cheng

Vertical integration. Based on industry dynamics literature, this study calculates the ratio
of operating margin (titled as value added in the Census data) over sales (the total dollar
value of shipments) as a proxy for vertical integration (Balakrishnan and Wernerfelt,
1986; Brush and Karnani, 1996; Jacobsen, 1988; Levy, 1985). These two measures are
obtained from the 1997 and 2002 Economic Censuses.

3.3 Statistical procedures for testing hypotheses

Specification of the regression model for testing the impacts of contract manufacturing on
four performance indicators is expressed as follows:
Industry Performance Indicator = 0 + 1 Contract Manufacturing
+ 2 Capital Intensity + 3 Labour Intensity
+ 4 Vertical Integration + error terms.
Based on the hypotheses, it is predicted that the coefficient of contract manufacturing
variable (1) will be positive and significant in the regression models for ROI and ROA,
whereas 1 will be negative and significant in the regression models for product
specialisation and capacity utilisation regressions, respectively.

Results

Table 1 reports the descriptive statistics and the correlation coefficients for all variables.
A number of variable pairs, e.g., capital intensity and labour intensity, have correlation
coefficients close to 0.50. High correlation might display multicollinearity which could
affect regression results (Greene, 2000). Hence, each independent variables Variance
Inflation Factor (VIF) is examined along with regression runs (Bae and Gargiulo, 2004;
Neter et al., 1990). All VIF scores are within the range 1.1561.575, substantially below
accepted VIF threshold in management literature (i.e., 10). The VIF test outcomes
suggest low multicollinearity effects on regression analyses.
Regression methods documented in the econometrics and industrial organisations
literature are utilised for hypothesis testing (Greene, 2000; Johnston and DiNardo, 1997).
STATA and SPSS are primary statistics software for regression runs.
Initial regression models apply Ordinary Least Squares (OLS) techniques to obtain
baseline results. Since the regressions are based on panel data, the Durbin-Watson (DW)
test is conducted to check the autocorrelation of error terms. The DW statistic values in
the regression models are all less than two, indicating positive autocorrelation between
1997 and 2002 error terms (Johnston and DiNardo, 1997). General Least Squares (GLS)
techniques are then performed to account for the autoregressive problems in the
regression error terms (Greene, 2000). Table 2 reports the OLS results and DW statistics
for all OLS models. Table 3 reports the GLS outcomes.
This study creates separate regressions for each performance indicator.
The significance of control variables is also examined for each regression. Regression
outcomes suggest that adding control variables will improve model fit, as manifested by
higher R2 values. As well, most F-statistics and 2-statistics for all R2 changes are
significant at the 0.10 level, implying the necessity to include control variables in the
regressions. The hypothesis testing results reported below are based on GLS outcomes.

Evaluating the role and integration of contract manufacturing strategy

Table 1

Descriptive statistics and correlation coefficients for variables

37

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Table 2

L-C. Cheng
Ordinary Least Square (OLS) regression results

Evaluating the role and integration of contract manufacturing strategy

Table 3

39

General Least Square (GLS) regression results

4.1 Hypothesis 1: Contract manufacturing vs. ROA

Hypothesis 1 suggests that high level of contract manufacturing should be positively
associated with high ROA. According to the full ROA regression outcomes in Table 3,
the coefficient for contract manufacturing is positive and significant (1 = 3.998,
p < 0.001), supporting Hypothesis 1.

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L-C. Cheng

4.2 Hypothesis 2: Contract manufacturing vs. ROI

Hypothesis 2 suggests that high level of contract manufacturing is associated with high
level of ROI. With reference to the full ROI regression in Table 3, the coefficient
for contract manufacturing is positive and significant (1 = 39.442, p < 0.001); hence,
Hypothesis 2 is supported.

4.3 Hypothesis 3: Contract manufacturing vs. product specialisation

In terms of product specialisation, Hypothesis 3 proposes that high level of contract
manufacturing is associated with low level of product specialisation. The coefficient for
contract manufacturing in the full product specialisation mode is negative and significant
(1 = 27.913, p < 0.001), showing support for Hypothesis 3.

4.4 Hypothesis 4: Contract manufacturing vs. capacity utilisation

The far right regression in Table 3 displays the regression coefficients regarding capacity
utilisation. The signs of contract manufacturing coefficients in the partial and full models
are both negative. Surprisingly, neither of the coefficients is significant (e.g., in the full
model, 1 = 0.024, p > 0.780), contrary to that predicted in Hypothesis 4. Hypotheses 4,
hence, is not supported.

4.5 Summary of hypothesis testing

Regression runs conclude that Hypotheses 13 are supported, whereas Hypothesis 4 is
not supported. The confirmed predictions regarding ROA and ROI (Hypotheses 1 and 2,
respectively) indicate that contract manufacturing improve profitability. The supported
Hypothesis 3 implies that contract manufacturing will increase product diversity.
However, CM-OEM supply chains are not necessarily benefited in terms of capacity
utilisation.

Discussion

5.1 Managerial implications

This study confirms that the preceding indicators, with the exception of capacity
utilisation, should be incorporated into the metrics for assessing outsourcing strategies.
The contract manufacturing strategy can significantly contribute to a higher degree of
ROI, ROA, and product diversification for OEMs. Given the significant impact of
contract manufacturing on these operational performances, OEMs will need to use these
indicators to evaluate the effectiveness of individual CMs and the OEM-CM network as a
whole.
The analyses on the US Census panel data offers support to the core competences
reasoning discussed in the second section. OEMs, by concentrating on core strength
and outsourcing non-core functions, can harvest a higher level of performance
in terms of ROA and ROI. Most certainly, it takes non-trivial investments and endeavour
on behalf of OEMs to institute supply chain integration with CMs. For instance,

Evaluating the role and integration of contract manufacturing strategy

41

inter-organisational IT systems, such as EDI (electronic data interchange), Auto-ID

systems (e.g., bar codes, Radio Frequency Identification (RFID)), Enterprise Resource
Planning (ERP), etc., typically require substantial time and financial commitments,
even before successful implementation. While outsourcing can lead to significant
investments in OEM-CM networks, statistical analyses in Section 3 indicate that OEMs
can be rewarded with higher operating margins, which can largely offset the additional
costs for asset and capital commitments. The sustainable high returns, perhaps, contribute
to the increasing adoption of outsourcing by the OEMs as suggested by the supply chain
research (Shy and Stenbacka, 2003; Sturgeon, 2002).
In the current globalisation contexts, commitments to reengineer a new format of
supply chain are very critical to OEM successes (Fine, 2000; Fine et al., 2005). The role
of CMs in expanding product offerings and increasing gains from existing assets and
investments cannot be underestimated. Furthermore, manufacturing industries can obtain
greater flexibilities by developing OEM-CM networks. On the product level, CMs help
OEMs achieve product-mix and design flexibility. In terms of process or operations
levels, outsourcing strategies helps OEMs achieve process flexibility by augmenting
resource bases in technology, production, and logistics systems. On the network level,
CMs can provide an OEM more alternatives to configure the supply chain, a strong
flexibility which cannot be easily achieved by vertically integrated manufacturers
(Fixson et al., 2005; Ro et al., 2004). Ultimately, contract manufacturing strategies may
result in higher ROI, ROA, and production variety and lead to sustainable competitive
advantages for the OEMs.

Conclusion

6.1 Summary
A great deal of attention is being focused on the role of the CMs in the supply chain
(Schilling and Steensma, 2001; Sturgeon, 2002). As the level of demand heterogeneity
grows, manufacturing systems specialising in a narrow product range may no longer gain
competitive advantages over more versatile systems with higher customisation levels
(Schilling and Steensma, 2001). Outsourcing literature has yet determined the impacts of
outsourcing or provided the basis for assessing this flexible manufacturing strategy.
This research proposes various performance indicators examining outsourcings
effectiveness: ROI, ROA, product specialisation, and capacity utilisation.
A set of hypotheses are developed to examine the links between contract
manufacturing and the foregoing four performance indicators. The empirical method
collects a large-scale archival data set and employs regression analyses to test the
hypotheses. Statistical outcomes suggest that higher level of contract manufacturing is
likely to lead to higher level of ROI and ROA, whereas higher degree of contract
manufacturing is associated with lower degree of product specialisation. Overall, this
study has displayed that outsourcing strategies are effective in achieving gains from
assets and investment. Outsourcing has also resulted in higher product diversification,
as displayed in the lower product specialisation coefficients of regression runs.

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L-C. Cheng

6.2 Contributions
This paper is the first empirical research that examines the impacts of contract
manufacturing on product development and critical manufacturing system outcomes.
Outsourcing literature has conceptually identified that using CMs can enhance supply
chain flexibility in uncertain environments. The statistics analyses of this paper offers
proof that utilising CMs can be valuable for OEMs in terms of enhancing ROI, ROA,
and product diversification. As such, the present empirical study fills the gap in
the outsourcing literature regarding to the role of contract manufacturing strategies.
The findings will offer crucial insights into the potential impacts of outsourcing in supply
chains.
Furthermore, the findings help determine which decision-making criteria influence
the use of CMs and robustness of the OEM-CM supply chains. OEMs can utilise the
affirmed performance indicators, i.e., ROA, ROI, and product specialisation, to refine the
performance metrics for their contract manufacturing operations as well as the likelihood
of extending outsourcing relationships. In addition, global CMs are expanding service
scopes through mergers and acquisitions. The discoveries of this study are valuable for
policy-makers to evaluate the trade-off between the outsourcing efficiencies and the
potential negative impacts of CMs monopolistic power exhibited in purchasing,
supply chain integration, etc. Finally, because of the potential benefits of contract
manufacturing, supply chain professionals can baseline the findings to carry out
outsourcing practices which may lead to innovative, flexible supply chain configurations.

6.3 Future research

Several limitations call for future research. The recent global, large CMs have
consolidated the manufacturing requirements of global clients, and the consolidation can
lead to lower echelon inventories. On the other hand, the distant communication between
OEM and CMs and intermittent coordination can lead to amplified bullwhip effects,
causing a severe drawback for global supply chain operations. Moreover, Prahalad and
Hamel (1990) and Plambeck and Taylor (2005) have also suggested that outsourcing core
competences will lead to OEMs disadvantages in competition. These negative impacts of
outsourcing have not been fully addressed in the empirical outsourcing literature.
Secondly, the contract manufacturing operationalisation is utilised to measure the
overall use of CMs by industry. While most manufacturing industries outsource solely
the manufacturing processes, CMs in a number of industries have developed product
design capabilities in addition to the pure contract manufacturing services. Specifically,
in the Electronics Manufacturing Service (EMS) industry, the outsourcing strategy can be
further grouped into four categories: pure contract manufacturing, Contract Design
and Manufacturing (CDM), Contract Design Service (CDS), and Original Design and
Manufacturing (ODM). The data for the present study does not provide the details of
these contract manufacturing strategies. Future studies may hence consider examining
their respective effects on performance through collecting data in greater detail.
In addition, while the independent variables exhibit statistical significances in all
regression runs, the R2 value for all of the models is not high, only approximately
1020%. Certainly, contract manufacturing does positively influence manufacturing
industry financial outcomes. On the other hand, the relatively low model fit also
indicates outsourcing impacts (together with other selected variables) may be limited.

Evaluating the role and integration of contract manufacturing strategy

43

Researchers have vividly suggested that in an outsourcing context, expanded

commitments in core competencies, e.g., R&D and marketing, by OEMs can improve
firms performances as well. Therefore, future studies should take into account the
preceding strategic variables and their interactions with contract manufacturing to
determine other aspects of profitability.
Ideally, researchers should take a longitudinal approach to examine the outsourcing
strategies for all US manufacturing industries in both domestic and international contexts.
Due to data availability, this paper is constrained to the domestic aspect of the
US manufacturing sector in the years 1997 and 2002. Future research will need
to utilise the upcoming Census data sets (e.g., Economic Census 2007) to analyse the
contract manufacturing development over a wider timespan.
Finally, firm-level study or industry specific research methods should be applied to
examine flexible systems. On the business-to-business setting, OEMs and CMs are
engaged in complex contracting processes. Aspects of supply contracts should be
investigated to provide roadmaps for effective outsourcing manufacturers with, for
example, high ROA and ROI. Beyond the performance indicators proposed by this paper,
future research should aim at developing additional metrics and measurements for
outsourcing strategies so that OEMs and CMs can more comprehensively determine the
pertinent impacts.

Acknowledgements
The author is very grateful to two anonymous reviewers for their helpful comments
to improve an earlier manuscript of this paper. The present research was kindly supported
by the University of Houston Small Grants Program, Grant No. I094254.

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