Yaqin Sun, PhD Candidate at Drexel University

Title: Can learning-by-doing hurt profit? The case of outsourcing and contract manufacturer encroachment

Abstract: Many original equipment manufacturers (OEMs) today reduce their manufacturing costs by outsourcing their manufacturing functions to contract manufacturers (CMs). Outsourcing, however, carries significant risks, such as reduction in manufacturing quality and CM encroachment in the OEM’s end market. To reduce these risks, OEMs face critical decisions about which CMs to use, and how much product to outsource. CMs also face subsequent decisions about whether to develop and sell a similar self-branded product. An important consideration in both OEM and CM decision-making is the so-called learning-by-doing effect. The learning-by-doing effect refers to the later decrease in unit production cost that arises from increasing production quantity. As the CM builds more product, it learns to make the product more efficiently, and thereby lower its future production costs. The CM’s learning rate is the magnitude of the CM’s subsequent decrease in unit production cost per unit increase in initial production quantity. In most circumstances, CM profits are enhanced by having a higher learning rate. Interestingly, however, when a CM decides to encroach in the second period, there exist particular market conditions wherein a higher learning rate hurts CM profits. We describe these conditions in detail below. Notably, whether the wholesale price is exogeneous or endogenous, and the specific magnitude of the wholesale price relative to market size and production costs, play important roles in the relation between learning rate and CM profits. Our findings suggest it is prudent for CMs to consider market conditions for their future selfbranded product prior to making investments to enhance their learning rate.