The practice is called value-chain climbing, and it's not especially rare. A number of big names in high-tech got their start making product for someone else, says Brian Wu, strategy professor at the University of Michigan. They include Japan's Sony, South Korea's Samsung and Taiwan's HTC Corp.

Wu recently teamed up with Zhixi Wan, assistant professor at the University of Oregon, on a research paper that examines the phenomenon of value-chain climbing. They offer some guidance to original equipment manufacturers (OEM) on how to deal with it.

“It presents a dilemma to western firms,” Wu admits. “Think of yourself as a master teaching an apprentice.” With the prospect, unfortunately, of the apprentice putting the master out of a job. 

For OEMs, it’s a risky trade-off – seeking cheap labor in exchange for the possibility of being undermined by one’s contractor. Of course, that doesn’t always happen. Plenty of contract manufacturers – Foxconn Technology Group, Jabil Circuit, Flextronics International and Celestica Inc., to name some major ones – are content with remaining in that role, and keeping the business of the world’s largest high-tech brands.

In the past, OEMs might have considered their greatest risk to be that of a supplier shipping copies of the exact product out the back door of the factory, and selling it on the gray market. That’s a patently illegal practice, of course, and is grounds for termination of a contract. Value-chain climbing, though, poses a more serious problem, in that it violates no aspect of a current agreement, but can entail the transfer of valuable intellectual property and loss of market share over the long run.

OEMs heighten the risk of value-chain climbing by squeezing suppliers, Wu says. The endless quest for procurement savings can shave already thin margins for the contract manufacturer, giving it an incentive to dump the OEM at the earliest opportunity, and launch its own brand.

There’s also the very real possibility that the contract manufacturer will lure away the OEM’s engineers, scientists and product designers. The loss of I.P., it turns out, can occur in multiple ways.

So the choices open to an OEM facing competition from a trusted supplier appear to be twofold: either dump the supplier, or pay it more to stick with the original deal. Wu says both options entail certain risks to the OEM’s profit sheet and market position.

There is a third way, he says. OEMs should consider embracing that “master-apprentice” relationship at the outset. Under such an arrangement, the supplier agrees to accept lower profit margins in the early stages of the relationship. In exchange, it’s allowed to learn the OEM’s design and marketing secrets.

Meanwhile, the OEM is designing the next generation of the product – work that isn’t being immediately shared with the supplier. Comes time to begin building the new model, the two parties can decide whether to continue their relationship.

Wu and Wan believe there’s a natural lifecycle to any manufacturing contract. “Our model shows that it’s not a question of whether to dump or accommodate [the supplier], but when,” Wu says. The key questions: “What are the market conditions, and what is the right time?”

The OEM would do well to assume that the supplier will eventually learn enough to launch its own brand – even if experience has shown that’s not always the case. “It’s OK as long as you are able to squeeze all of the profits out,” Wu says.

That prospect should be acknowledged from the start. For their part, suppliers must understand the benefit of sticking with the OEM for a sufficient period of time, Wu says.

Wu and Wan’s idea raises the question of whether the supplier would be satisfied with learning how to make a product that is fated to become obsolete. But Wu insists that the arrangement can be made attractive to the supplier by ensuring a greater share of the profits as the relationship matures. In addition, there might well be room for the older version of the. Apple’s introduction of a new model of its iPhone doesn’t immediately kill the market for previous versions.

What’s more, access to the OEM’s expertise can provide the supplier with intelligence that can be applied to future models as well. “It’s faster than developing a product from scratch,” says Wu.

In any case, the lines of responsibility aren’t always clear-cut. Samsung makes a number of successful products under its own name, but also is responsible for most of the processors that go into the iPhone. The relationship between OEM and supplier can be multifaceted.

Wu says the “apprentice” approach isn’t widely practiced at the moment. What’s more, the supplier might choose not to shoulder the burden of building its own brand, with all of the uncertainties that accompany that effort. Still, there’s an opportunity for the parties to a manufacturing contract to think creatively about the nature of their deal over the long term. Not every relationship has to end in tears.

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