Table of Contents
- 1 Meaning of Contract Manufacturing
- 2 The Process used in Contract Manufacturing
- 3 Example
- 4 Advantages of Contract Manufacturing
- 5 Disadvantages of Contract Manufacturing
- 6 Summary
Meaning of Contract Manufacturing
Contract manufacturing is a process in which a company outsources its production to a third party in return for a mutually decided fee or remuneration. Production outsourced might be just of a component of a bigger whole being manufactured by the source company, or the complete product itself. A company can subcontract its production to reduce costs and to reap the benefits of technologically advanced machinery and the workforce of the manufacturing company. Unlike in toll manufacturing, the manufacturer is responsible for procuring the raw materials or required components itself to make the product. Hence it is responsible for the entire production process from beginning to end.
Such manufacturing is widespread in both domestic markets as well as beyond the company’s own country. Industries commonly using contract manufacturing are defense, pharmaceuticals, computers and peripherals, automobiles, and mobile telephony. Because of the advent of online marketplaces such as Amazon and eBay, a seller can practically get anything and everything produced through a third-party manufacturer and sells it across the world. Contract manufacturing enables a company to sell a product under its brand name without itself being engaged with the production process. As a result, they need not invest in expensive factory setups, hire workforce, equipment, and even arrange for its packaging and distribution.
The Process used in Contract Manufacturing
The contracting company would generally take quotations from several manufacturers of the product or component it wants to be made. The manufacturing companies will provide quotations based on the cost of materials, production and labor cost, etc. plus their fee for producing the product. After that the manufacturer meeting the contractor’s conditions at the best price will get the contract.
The manufacturing company will produce as per the specifications provided by the contracting company. The specs are generally regarding the product quality to be delivered, deadlines and quantity, and other conditions such as testing, inspection, etc. It is the responsibility of the manufacturer to adhere to the specifications and complete the contract accordingly to earn its fee.
Contract manufacturing is a common practice in mobile telephony. XYZ Pvt.Ltd is a leading mobile phone manufacturing company. It decides to venture into high-end headphones and earphones and sell it under its existing brand name. The company can start a new factory for the same by making a capital investment on land and machinery. It will also have to hire a specialized workforce with appropriate experience for the same.
On the other hand, it has the option of contracting production to a third party already manufacturing audio equipment. It gives the complete specification of design and quality, which it requires to the manufacturer. After a few rounds of negotiations, they settle on a price per piece and delivery schedule.
XYZ Pvt.Ltd. Benefits from setting up a new line of business without any substantial investments. Also, it can sell the new product under its current brand name and benefit from its goodwill in the market. The manufacturing company also helps from the new order, increasing its revenue and profits.
Advantages of Contract Manufacturing
Contracting Company’s View Point
Use of Specialization
The contracting company can make use of the manufacturer’s specialized skill set- be it technically advanced machinery required for a specific process, or specialized labor. The manufacturer may have some patented process which the contracting company can make use of.
The contracting company can save a lot of money by subletting the production process to a third company because it need not invest in expensive land and machinery for production. Also, it can save a lot on wages and salaries of the workforce.
Increased Revenue and Profits
A contracting company can sell any quantity of a product by contracting it to several manufacturers as per the demand. As a result, it would lead to higher revenues and profits for the company.
Manufacturing Company’s View Point
Economies of Scale
Because buying of all inputs is solely in the hands of the manufacturer, it can buy them in high volume at the best possible prices.
Optimum Utilization of Resources
A manufacturer on a contract basis can increase or decrease production as per the demand situation and ensure its resources are optimally utilized. If demand decreases from one contracting company, it can look for extra work from other companies. This will result in full utilization of its production capacity and labor.
No Requirement of Heavy Marketing Costs
A company producing on the contract basis is not bothered by heavy branding, marketing, and advertising costs for selling its produce. This is so because the contracting company bears such costs.
Disadvantages of Contract Manufacturing
From Contracting Company’s View Point
Lack of Control
The manufacturer controls the entire production process from the beginning to the end. The contracting company does not have any say in buying raw materials to control the production process. As a result, it will have to depend upon the manufacturer’s decisions solely.
Divulgence of Private Information
The contracting company may have to disclose its patented process or secret recipe for a product to the producing company. The producer may disclose it to competition for a price. Also, it may start producing for competition at a later stage. Such a situation would, therefore, result in the disclosure of private information.
If a contracting company is dependent upon a single company for production, the producer may delay deliveries in times of busy production season and high demand for the product. Also, any quality issue of output will directly dent the brand name of the contracting company and not the producer. Hence this can lead to severe losses for the company.
From Manufacturing Company’s View Point
Risk of Production Loss
A manufacturing company producing on a contract basis always faces the risk of the stoppage of production. This can happen in case orders are stopped from a contracting company. This will result in a production crisis because finding new orders is time-consuming and difficult.
Losses during Inflationary Trends
The prices which the manufacturing company will receive for a product are fixed before-hand at the time of the contract. Because of it, the company can suffer substantial losses at times of consistent rising prices of inputs, interest rates, rentals, or labor charges. The increased costs will have to be borne by the manufacturer only as any changes in contract price will take some time.
Contract manufacturing is an excellent choice for developed nations like the US and UK. They can make use of the low cost of land, capital, and set up in developing countries like China, India, and Bangladesh. Also, inexpensive labor matched with appropriate skill-set is an additional benefit to go for contract manufacturing in these regions.
Companies from developed nations also need to factor in bureaucratic delays and ease of doing business index in the developing countries. A judicious and balanced approach can result in higher revenues and profits for both the contracting company as well as the manufacturer.1,2