Factories of Hon Hai Precision (also known as Foxconn) and other major Taiwanese contract manufacturers are currently running at full capacity churning out the iPhone 8 and other new models launched by Apple.

Economists regularly disparage Taiwan’s continued heavy reliance on contract manufacturing – also known as Original Equipment Manufacturing (OEM) and Original Design Manufacturing (ODM) – and urge domestic industry to develop their own brands to command better margins and greater control over their business.

Few companies have succeeded in making the leap to their own brands, however. Despite the shortcomings, production on an outsourced basis for overseas customers continues to be a standard business model – and for many enterprises it remains a big business, though much of the actual production is often done offshore.

That is the case with much of the business undertaken as part of the Apple supply chain. Apple’s leading contractor, Hon Hai, the world’s leading EMS (electronic manufacturing service) provider, has received some 95 percent of the contract production orders for the iPhone 8 and is also responsible for part of the orders for the iPhone 7 and iPhone 7 Plus.

For the latter two models, the bulk of the business is shared by two other leading Taiwanese contract makers, Wistron and Pegatron. Wistron is also due to become the major maker for the lower-priced iPhone SE2, scheduled to be rolled out in the first quarter of 2018.

To handle the new business, Wistron is investing NT$18 billion (US$600 million) to expand its factory in Kunshan in China’s Jiangsu Province, where its workforce has increased by 20 percent over the past year to reach 10,000. According to industry sources, Apple is cultivating Wistron to become another major contract supplier for iPhone, lowering the reliance on Hon Hai and Pegatron in order to diversify risk. The move is said to recognize the considerable improvement in Wistron’s manufacturing technology after years in which it concentrated on contract production for the lower-tier iPhone 5C.

Similarly, Quanta Computer, the primary contract maker of the Apple Watch, stands to benefit from production of the recently launched Apple Watch Series 3. Global Apple Watch shipments are expected to climb by 70 percent this year to reach a total of 17.5-18 million. For the older Apple Watch models, Apple has spread the risk by allocating part of the production this year to another Taiwanese enterprise, Compal Electonics.

Inventec, the exclusive contract maker of AirPods, is considering expansion of its Shanghai and Nanjing production bases, in order to meet influx of orders for the new iPhone earphone, whose shipment is expected to hit 20 million units in 2018, double estimated 8.5-10 million this year.

Meanwhile, as the sole contract manufacturer for Apple’s A10/A11 CPU, Taiwan Semiconductor Manufacturing Corp. (TSMC), the world’s largest integrated-circuit foundry with a 50 percent market share, is expected to continue dominating the contract-production business for the next-generation A12, thanks to its lead in the development of 7-nanometer process technology over its archrival Samsung.

The importance for Taiwan enterprises of contract production for leading international brands has not been confined to the ICT (information-communication technology) sector.

Pou Chen, for instance, is the world’s largest footwear maker, turning out over 300 million pairs a year for such brands as Nike, Adidas, Reebok, Asics, Under Armour, New Balance, Puma, Converse, Salomon, and Timberland. In addition, many leading textile firms in Taiwan are contract makers for international brands. Eclat Textile, the most profitable listed textile company in Taiwan manufactures sportswear from its own flexible knitted fabric for such brands as Adidas, Nike, Puma, Lululemon, Reebok, DKNY, Calvin Klein, Under Armour, Champion, and Polo Ralph Lauren. Makalot Industrial, another textile manufacturer, produces fashion wear for such brands as Hanes, Macy’s, Cabela’s, GAP, JCPenney, and Under Armour.

To reassure customers that they are not competing with their clients, some Taiwanese ICT companies with their own brands have spun off dedicated companies to provide contract-production services. Examples are Wistron, which split off from Acer in 2001, and Pegatron, which emerged from ASUStek Computer in 2007.

Difficulties in branding

For local manufacturers, dedication to contract production spares them the need to compete with famous brands in the global marketplace. A number of leading Taiwanese companies have sought to promote their own international brands, but in most cases the effort has failed or been only moderately successful due to the high cost of maintaining a brand and the limited size of the domestic market as a base of support. Computer maker Acer and mobile-phone brand HTC, for example, both enjoyed encouraging early success but later struggled to remain competitive.

In the case of DRAM maker Powerchip, the company found itself with a staggering NT$100 billion (more than US$3 billion) in debt and only managed to turn itself around since abandoning its own brand in 2012 and converting to foundry operations.

“It takes a population of at least 50 million to enable indigenous brands to succeed in such industries as autos and mobile phones, but Taiwan has only 23 million people,” observes Tsai Hung-ching, founder of the Taiwan Institute of Directors.

On the other hand, contract makers inevitably face the pressure of low margins, especially after products have become mature. In 1992, Stan Shih, founder of the Acer Group, put forth his “Smiling Curve” theory analyzing the sources of greatest value for an industrial company. The curve shows that the most profits come from R&D on one side and brand marketing on the other, with much less revenue generated by the manufacturing process itself.

Reflecting the acute competition in the notebook PC assembly business, Quanta’s gross margin stood at only 4.5 percent in the first half of 2017. To enhance its margin, Quanta has been seeking to improve its product mix, and has become a major supplier of white-label cloud servers, mainly for datacenters for such customers as Facebook and Google. In addition, its Quanta Storage subsidiary has gone into robotics.

To sustain its satisfactory gross margin – 26.7 percent in the first half of 2017 – Eclat Textile has been developing sophisticated, high-end soft fabrics for sportswear, often in close collaboration with customers such as Nike.

At Pou Chen, the strategy has been to tap into China’s huge domestic retail market. Its Pou Sheng International subsidiary has become the second-largest footwear channel in China, with 8,200 outlets and the equivalent of US$2.4 billion in sales in 2016. It is the largest retailer of Nike and Adidas shoes in China.

Numerous Taiwanese enterprises have attempted to utilize the huge China market as a base to develop a world-class brand, but few have succeeded. One of the rare successes is Cheng Shin Rubber, now the world’s ninth-biggest tire maker, whose Maxxis brand is the world leader for bicycle and motorcycle tires.

Perhaps the leading example of a thriving Taiwan brand are the “Giant” bicycles produced by Taichung-based Giant Manufacturing, the world’s largest bicycle maker. The company originally made its mark as contract manufacturer. In the mid-1980s it was producing two-thirds of the bikes sold by Schwinn, but in 1987 launched its own brand, taking advantage of the new popularity of the mountain bike and the company’s development of new lightweight carbon-fiber materials. Giant now ranks among the top three bicycle brands in the United States and Europe, and is the leading import brand in Japan, Australia, Canada, and Holland.

Giant is one the past winners of the Mittelstand (meaning “Medium Enterprise”) Award–named after a similar initiative in Germany–run by the Ministry of Economic Affairs (MOEA) through its Industrial Development Bureau. Those enterprises, dubbed “hidden champions,” boast internationally competitive products or services in their specific fields, though most are not well-known to the general public.

An example is Hiwin Technologies, whose branded ball screws and linear guideways are supplied to leading international semiconductor equipment firms, such as ASML, Applied Materials, and Tokyo Electron Limited (TEL).

Johnson Health Tech, the world’s third-largest fitness-equipment maker, is another example, making products with patented technologies and selling under the three brand names of Matrix, Horizon, and Vision.

To facilitate their development, MOEA assists the Mittelstand companies with talent cultivation, technological development, IP acquisition, and brand promotion and marketing.

Despite the obstacles, some major Taiwanese contract manufacturers still harbor the dream of creating their own brands in order to have greater control over their fate. Industry observers that even Hon Hai appears to be in that category, citing its acquisition of Sharp, once a leading TV brand worldwide, and its bid for the semiconductor arm of Toshiba.

Overall, OEM/ODM’s contribution to the Taiwan economy has been a mixed blessing, says Wang Jiann-chyuan, vice president of the Chung-Hua Institution for Economic Research. It enabled domestic ICT companies to “accumulate abundant manufacturing experience and gave rise to a solid ICT sector spanning finished products, components and parts, and ICs, creating substantial added value and job openings.”

But the slim margins meant that when production costs later increased and more overseas competition emerged, Taiwanese firms had little choice but to transplant their factories offshore. The result, he says, has been the loss of job opportunities and stagnation in salary growth.

The News Lens has been authorized to repost this article. The piece was first published by Taiwan Business TOPICS .

(Taiwan Business TOPICS is published monthly by the American Chamber of Commerce in Taipei.)