How much longer will contract manufacturers like Foxconn remain in the shadow of the West's tech giants?

Are the likes of Apple, Dell and HP in danger of suffering the same fate as bicycle maker Schwinn, whose business was irreparably damaged when its contract manufacturer in Taiwan decided to beat the US firm at its own game?

When Steve Jobs unveiled the first Apple Macintosh in 1983, he boasted that it was a computer "made in America", produced at an Apple-owned factory in Fremont, California.

Fifteen years later, when the first Apple iMacs started rolling off production lines following the return of Jobs as CEO, it was also at an all-American, Apple-owned plant, this time in Elk Grove in Sacramento - just 50 miles away.

But while he was away, his attitude to manufacturing had changed: just one year later, iMac production was transferred to the Far East.

Over the next decade, manufacture of every other Apple product followed the iMac to Asia, not simply to Apple-owned plants, but to contract manufacturers that would do the job on Apple's behalf.

Changing attitudes

The contrast in attitude was stark. In the 1980s, Jobs had studied "Kaizen", the Japanese industrial practice of continuous improvement in manufacturing, in a bid to make Apple's factories as efficient as possible.

In the 1990s, though, his mentor was former Intel CEO Andy Grove, whose attitude to manufacturing was very different, according to Victor Newman, professor of knowledge and innovation management at the business school at the University of Greenwich.

Under Grove, Intel used suppliers to do much of its manufacturing because Grove reasoned that manufacturing wasn't necessarily what made Intel great, says Newman. "Grove advised Jobs to replicate the Intel strategy," he says.

When Jobs returned to Apple, costs were slashed from $8.1bn in 1997 to $5.7bn in 1999, primarily through outsourcing, better inventory management, cutting the number of distributors and re-directing sales online. These initiatives were largely masterminded by Tim Cook, Jobs' successor as Apple CEO.

Today, Apple's Elk Grove facility is a distribution and contact centre, while the factories it once owned and ran in Ireland and Singapore are long gone. Instead, it relies on Taiwan-based Foxconn, the world's biggest contract manufacturer, to assemble its products.

In that regard, Apple is little different from many other big-name companies that put their logos on the front of products built by third-party manufacturing specialists.

Quanta, another Taiwanese outsourced manufacturer, produces about one-third of the world's laptop computers, while, Compal is the world's second-largest laptop maker - not HP, Dell or any of the other technology companies that rely on other companies to build their products.

So how do Apple, HP, Dell and others outsource their manufacturing, without losing either their own position in the market or their intellectual property?

Aggressive defence

The answer, says Nichola Jenkins, an associate in the commercial and intellectual property unit at law firm Cobbetts, is a combination of aggressive defence of intellectual property of all types with tight control of the supply chain.

"The first thing is to consider what is protectable and what isn't in terms of patents and designs," she says. "Then, protect yourself with new patent applications that cover the territories that you are looking to manufacture in, so that the company within that territory cannot produce something similar in the future."

Furthermore, if a company has a reputation for promiscuously filing patents and aggressively protecting them, that, in itself, also helps ward off the risk of copying, she adds.

How much longer will contract manufacturers like Foxconn remain in the shadow of the West's tech giants?

Are the likes of Apple, Dell and HP in danger of suffering the same fate as bicycle maker Schwinn, whose business was irreparably damaged when its contract manufacturer in Taiwan decided to beat the US firm at its own game?

But the real source of Apple's success - and a key factor in how it defends its intellectual property - is its tight control of the supply chain right from the supply of components to final delivery. Apple, for example, does not just provide the specifications, but also purchases differentiating components - especially new or unique technology - and tracks their use, too, so that stock is neither wasted, nor siphoned off at any point in the supply chain.

And the scale that Apple can bring to bear means that it can buy up stocks of that technology early on when production volumes are low, effectively monopolising its supply and thereby preventing rivals from copying it. For example, when Apple sought to put a special scratch-resistant screen on early iPhones, the supplier, Dow Corning, was only producing it in low volumes from one factory.

And in the late-1990s, Apple bulk-purchased air freight space early to enable it to get iMacs from the Far East to people's Christmas stockings quickly - denying rivals the opportunity to do likewise because it had gambled on the new machines' popularity, and bought all the spare air freight capacity at this important time.

"And at the end of a contract or production run, they make sure that they get back all of the stock that hasn't been sold to prevent it from going where it shouldn't," says Jenkins.

Companies that do outsourcing well also ensure that they have strong inspection and audit rights written into their contracts so that they can drop in to a factory at any time and make sure that procedures are being maintained.

Furthermore, contracts routinely have non-compete clauses built into them to prevent an outsourced manufacturer from marketing a similar product both during the contract, and for a period of time after its termination, adds Jenkins.

On your bike

US bicycle maker Schwinn is a classic example of a company that failed to take such precautions when it rushed into an outsourced manufacturing relationship with Taiwan's Giant in the early 1980s.

Initially, the deal worked well. Schwinn was able to return to the robust profitability that had long eluded it, while Giant was able to ramp up production on the production line that Schwinn engineers had helped to set up.

But when Schwinn sought a second manufacturer on mainland China, Giant's management felt betrayed and the company started competing directly against Schwinn in its core US market, using all the manufacturing know-how that Schwinn engineers had passed on.

In early 1992, Schwinn fell into Chapter 11 bankruptcy protection and today is little more than a brand in a Canadian conglomerate's portfolio. Giant, meanwhile, is now one of the world's biggest bike makers.

In Schwinn's case, while it had some intellectual property protection wrapped up in the design of its bikes, its major source of competitive advantage was its manufacturing know-how - which it shared all too freely with Giant.

While strict control of the supply chain can prevent components and supplies from falling into the "grey" market, blueprints and designs may still be at risk of corporate espionage.

How much longer will contract manufacturers like Foxconn remain in the shadow of the West's tech giants?

Are the likes of Apple, Dell and HP in danger of suffering the same fate as bicycle maker Schwinn, whose business was irreparably damaged when its contract manufacturer in Taiwan decided to beat the US firm at its own game?

Part of the due diligence process, therefore, ought to involve an audit of the manufacturer, says Jenkins, all the way down to the level of vetting they do on their staff as part of the recruitment process. "Obviously, specs and blueprints are held on computer systems, which can be quite vulnerable to attack. So if a company has an IT security certification, that's quite a big comfort," says Jenkins.

Major companies involved in high-tech manufacturing have, for years, audited key suppliers for computer security. Airbus, for example, when it was developing its A380 "super jumbo" put together a security team that would fly around the world to physically check out suppliers - whether they were based in Mumbai, Shanghai, Paris or Seattle.

And Airbus is not alone - although most companies prefer to keep their security audit practices private.

Even then, though, there is little a company can do if a partner is determined to rip-off its intellectual property. American Superconductor Corp (AMSC) found this out when, it claimed, its key customer in China reverse engineered the company's controller technology and started producing it at a subsidiary company.

While a former member of AMSC's staff was subsequently jailed for stealing the controller code, implicating the supplier company, a copyright infringement case is currently wending its way through Beijing's commercial courts.

Not so unique?

But how much intellectual property do the big-name computer brands actually have?

In his last financial conference call in December last year, Jobs asserted that the company's value was in its know-how - its intellectual property.

"We create our own A4 chip, our own software, our own battery chemistry, our own enclosure, our own everything," he said, later adding: "We engineer so much of it ourselves. The A4 chip inside it is an Apple creation. We develop a lot of our own components."

Ironically perhaps, the key components of the Apple A4 chip suggest that Apple's intellectual property may not be as "all-Apple" as Jobs implied: the A4 is based on an ARM Cortex-A8 CPU core, which is combined with Imagination Technologies' PowerVR SGX 535 graphics processor, and the chip is built by Samsung using its 45-nanometer silicon chip fabrication process.

Other key components of Apple's success have come from products and technologies that the company has uncovered and been imaginative enough to put to good use in mass-market products of unique design - staying one step ahead of the companies that seek to copy it.

The success of Apple's control over its whole supply chain is reflected by the delayed launch of the new iPad in China, held up by a trademark dispute. Despite the clamour for the new product, no units found their way from the factory into the grey market, and unauthorised imports were kept to a minimum.

But what would happen if the contract manufacturers should turn?

Already, Foxconn has started producing its own range of fanless PCs, dubbed Nano PCs, and has long produced its own-brand range of PC cases and motherboards. It also holds a growing stockpile of patents, numbering in excess of 25,000.

Furthermore, while Foxconn's profit margins are slim - just 2.5 per cent in its last financial year - Apple's are in excess of 30 per cent. In fact, Foxconn's margins have declined over the past decade, the more work that it has done for Apple.

Other contract manufacturers struggle with similarly razor-thin margins. Indeed, one of the first casualties of Nokia's sudden decline was the demise of Elcoteq, one of its contract manufacturers, when Nokia turned to cheaper manufacturers.

Who would therefore blame them if they were to reason that as they do the bulk of the hard work, and shoulder the risk of changing consumer demand, they ought to enjoy a greater share of the profits, too - and act accordingly?