Contract manufacturing explained: The pros & cons for firms

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Contract manufacturing is when a business outsources certain manufacturing requirements to another. It is often used by major companies requiring the mass production of goods that find it more financially viable to outsource the manufacturing. It can also be used when a small venture is looking to upscale, but does not yet have the ability to invest in equipment or labour at the necessary level. As such, it can be a helpful structure as businesses grow and expand. In this article, we explore how contract manufacturing works, what contract manufacturing agreements should cover, and the pros and cons of operating in such a way. We also consider how to manage such a business, and what to look out for when doing so. 

Who uses contract manufacturing?

Contract manufacturing is used across numerous industries, and across businesses of different sizes. The goal is the same however; to create products in bulk, and in the most efficient way.

Large companies such as Apple, Microsoft, Hewlett-Packard and Cisco have used contract manufacturers for many years. In electronics particularly, contract manufacturers have become an integral part of many business models and workflows. As a consequence, electronics contract manufacturers have become some of the largest businesses in the world.

On the other end of the spectrum, startups can also turn to contract manufacturers to create products in numbers they don’t have the capacity to support. Startups are often teams of only a few bringing an innovative product to market. Contracting out the manufacturing of the product enables the business to scale without the need for investment in a factory, or even the machines and labour required to produce the product.

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How does contract manufacturing work? 

Contract manufacturing is an important part of many modern and up-and-coming businesses. As a business model, contract manufacturing has been around for several decades, dating back to the 1960s and the founding of Space Craft, which built gear for NASA and other government agencies.

As that company developed, so too did the industry of contract manufacturing. Today, contract manufacturers are major players in the production of goods across numerous industries. Contract manufacturers such as FoxConn, which manufactures products for companies from Japan to America, have become some of the largest employers in the world. FoxConn has more than 1.2 million staff and revenues exceeding US$170 billion.

The relationship between the contract manufacturer and the product seller can be complex, however. It is important to ensure the scope of business and related responsibilities are well defined before entering into a legally binding agreement with a contract manufacturer.

One key aspect to consider, for example, is the design of the original product, and how that may be replicated when produced in bulk, or alternatively, altered to better fit a mass market model. Inherent in these discussions will be concerns around intellectual property of the original product, and how that will be protected if that product is changed throughout the manufacturing process.

manufacturing station

Preserving intellectual property rights is a key concern in contract manufacturing.

Once an appropriate design is confirmed and the contract manufacturer has a full brief of what is to be manufactured, it can be build it in its own factory, in the numbers required by the seller.

It should be noted, however, that a contract manufacturer’s role can go far beyond simply manufacturing on behalf of a seller. Due to the nature of the responsibilities, staff working within a contract manufacturer often have a huge amount of knowledge and technical know-how across a variety of manufacturing needs.

They are able to supply advice, guidance and best practice suggestions for the seller, who would normally be less experienced in manufacturing and its many nuances.

What is a contract manufacturing agreement?

A contract manufacturing agreement covers the legal relationship between the seller of the products, and the manufacturer making the goods. In order to create as waterproof a contract as possible, several elements need to be very clear.

Firstly, what aspects of the production are the responsibility of each party? This can vary hugely, and depends both on the seller’s need and manufacturer’s capability.

In order to avoid ‘scope creep’, the two parties need to nut out issues including:

  • Responsibility for design and other elements of production
  • The number of products expected to be delivered
  • Timeframes for delivery.

The contract should also outline clear expectations in terms of quality, and detail what supply chain structures are acceptable. It should also include guidance as to what happens if there is a disagreement or dispute. This would normally cover:

  • A clear line of responsibility in terms of handling a disagreement
  • The possibility of mediation to resolve it
  • The point at which the contract would be terminated.

A contract manufacturer would also be expected to sign up to a Non-Disclosure Agreement (NDA) with regards to all information that is shared by the seller, to ensure the competitiveness of the product is maintained and protected.

The contract manufacturing cost model explained

Contract manufacturers generally charge their clients based on a ‘cost-plus’ model. In its simplest terms, this means the contract manufacturer estimates how much it will cost, including labour and materials, to meet the requirement of the contracted work. It will then add its profit margin on top, to come up with a sum then presented to the client.

The client then needs to figure out if it makes sense to contract out the production of the goods, or if it should retain production of the product itself.

Generally, however, if mass production is needed, the capabilities of a contract manufacturer, along with its specialist workforce and ability to access materials in bulk, means it makes sense to contract out.

Pros and cons of using a contract manufacturer

As with any business relationship, there are pros and cons to partnering with a contract manufacturer.

Contract manufacturing pros

On the upside, contract manufacturing should provide immediate cost benefits and subsequent profit. The model allows businesses to effectively expand their manufacturing teams, capacity and knowledge, without taking on the full risk and responsibilities of doing so inhouse. As such, the potential can be huge, while the risks associated with taking on greater production capacity are minimised.

By outsourcing manufacturing, businesses are also able to utilise their own staff and production capacity in other ways, such as developing new products or innovations.

Contract manufacturing downsides

However, there can be downsides to partnering with a contract manufacturer. The delegation of production means there is the potential for quality control issues, and the contract manufacturer may prioritise certain goods to be produced over others. There may also be issues in terms of quality control and risks around the leakage of business information.

As such, any business which is looking to partner with a contract manufacturer should think carefully about the risks and benefits, and weigh this up before entering into a legally binding partnership.

Contract manufactured lighters

A benefit of contract manufacturing is the ability to get a new product to market, quickly and at scale.

How to start contract manufacturing

A contract manufacturing business starts, as with any new venture, with identifying a gap in the market and figuring a way to meet that need. The gap may be geographical, skills-based, cost-based, or simply identifying that market demand isn’t being satisfied.

Contract manufacturing also has, of course, its own special requirements for success. As the nature of the business is mass production, a factory, piece of land, or other site on which a production line can be developed will be important. This is where complications can come into play. Various rules and regulations around the use of land, density of building, safety requirements and the destruction of waste will need to be understood and costed into the business plan.

Beyond developing the practical aspects of the business, it will be necessary to have clients! Contract manufacturers are designed to support other businesses, so it will be essential to have clients already in mind or signed up as part of the business plan.

Many contract manufactures start out by making their own products, then fill gaps in their production schedule – thus reducing their costs – by manufacturing for other companies. A classic example of this arrangement is contract brewing.

Managing a contract manufacturing business – what you need to know

Managing a contract manufacturing business comes with significant responsibilities, given the reliance on client relationships, huge financial outlay for equipment and labour, and the need to meet complex environmental and land usage rules and regulations.

However, if done well contract manufacturers can become incredibly successful, as evidenced by huge global operators such as FoxConn, Flextronics, and Jabil. On a smaller scale, they can support burgeoning new businesses and become an important part of bringing new innovations to market.

Client relationships in contract manufacturing

A vital part of managing a contract manufacturing business well is ensuring the client relationships are well handled. As contract manufacturers really only exist due to the business clients they serve, it is imperative to ensure those relationships are protected and cared for at every step.

This means thinking about what can be offered that will improve the client’s output, at a competitive price and without lowering quality. It will mean ensuring pricing is fair and transparent, and delivery on time and as expected.

It will also mean ensuring a great customer service team, to keep the client informed and comfortable with the process.

Another vital aspect of building a successful contract manufacturing company is the ability to bring great skills and valuable information to the client relationship. This will bring a true ‘value add’ to the business relationship, and cement it for future partnerships.

What is toll manufacturing?

Contract manufacturing and toll manufacturing can often be confused, but they are very different business offerings.

Toll manufacturing is when a manufacturer with particular equipment processes materials into a form another company requires. In toll manufacturing, the materials are supplied by the client, and put through a production process by the toll manufacturer.

Toll manufacturing can often be used by, for example, major retail chains who may want to sell certain goods under a house brand. So they will provide the materials required to create those goods, but then receive them back for packaging and sale.

As such, the business relationship is quite different from that with contract manufacturers, who generally source the materials and goods required to manufacture the product being sold by the client.

Which industries use contract manufacturing?

The medical, energy, food and defence industries often use contract manufacturers to produce their products in bulk. Other industries producing goods with high design needs also often turn to contract manufacturers, given the special skill sets required.

The electronics industry is the most notable and major user of contract manufacturers. The rising demand for contract manufacturers in this industry has led the behemoths such FoxConn, which manufactures products for the likes of Apple, Google, Amazon, Huawei. Other huge players include Flextronics Corporation which manufactures for Microsoft, Ericsson, and Hewlett Packard.

At the other end of the spectrum, smaller contract manufacturers such as Argonaut, a startup which was founded in 2016, supports other emerging businesses in the medical field. 

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Greg Roughan - Unleashed Software
Greg Roughan

Article by Greg Roughan in collaboration with our team of inventory management and business specialists. Greg has been writing, publishing and working with content for more than 20 years. His writing motto is 'don't be boring'. His outdoors motto is ''I wish I hadn't brought my headtorch', said nobody, ever'. He lives in Auckland, New Zealand, with his family.

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