Sell the Plant? The Impact of Contract Manufacturing on Innovation, Capacity, and Profitability

Abstract

In the electronics industry and others, original equipment manufacturers (OEMs) are selling their production facilities to contract manufacturers (CMs). The CMs achieve high capacity utilization through pooling (supplying many different OEMs). Meanwhile, the OEMs focus on innovation: research and development, product design, and marketing. We examine how this change in industry structure affects investment in innovation and capacity, and thus profitability. In particular, innovation is noncontractible, so OEMs will invest less in innovation than is ideal for the industry as a whole. Hence, although contract manufacturing improves capacity utilization, it may reduce the profitability of the industry as a whole by weakening the incentives for innovation. Contract manufacturing is not the only means to achieve capacity pooling. Alternatively, the OEMs can pool capacity with one another through supply contracts or a joint venture. This may result in underinvestment or overinvestment in innovation and capacity, but always increases profitability. We find that the sale of production facilities to a CM improves profitability for the industry as a whole if and only if OEMs are subsequently in a strong bargaining position vis-à-vis the CM. If the OEMs are indeed very strong, the gain from pooling capacity via contract manufacturing is maximized in industries with moderate cost of capacity.