Contract Manufacturing is not one of the most popular terms. More likely than not, you are one of the people who don’t know exactly what it is or how it works. Don’t worry, because you’re not alone.

There are a lot of people who don’t know the first thing about it. Others are not even aware of what it is for. They may reach a point where they understand that it is a very important business concept, but when asked how businesses use contract manufacturing in reality, they’d be stumped for an answer.

How Businesses Utilize Contract Manufacturing

Let us try to address that lack of knowledge with this discussion on contract manufacturing, and how it is utilized by businesses.

CONTRACT MANUFACTURING DEFINED

You may have heard of another more popular term closely associated with, and often used interchangeably with “contract manufacturing”, which is “outsourcing”. As you probably know, outsourcing is the business practice of transferring portions of work to outside sources and suppliers, instead of completing the whole work within the company, resulting in lower costs and expenses. Now, are you getting a vague idea about contract manufacturing?

Contract manufacturing is a form of outsourcing where a manufacturer enters into an arrangement or formal agreement with another manufacturing firm for parts, products or components, which the former will then use in its own manufacturing process, to complete its own product. This is why the term “subcontracting” also applies in this case. Incidentally, the primary party involved in this business practice is known as the “contract manufacturer” or CM.

Usually, the CM is the manufacturer that creates, builds or makes the products for other companies or firms. In some cases, CM may also be used to refer to specialized firms that provide contract manufacturing services to more than one business organization. Either they come up with a product design or concept, or they use the ones created by Company A, and have Company B manufacture the product (or some of its parts or components), under the brand or label of Company A. In other words, the CM acts as the bridge that connects the two firms together.

A typical contract manufacturing setup goes like this: the company procures the products or services manufactured by a third-party CM, supplier or service provider, and subsequently incorporates the procured products or services into its own products and services. Then it uses its own marketing, sales and distribution, and customer service to bring the final product to the end-users or consumers.

We often hear about large labels and well-known brands having their goods or products produced or manufactured by another firm. The question that goes through their mind is something along the lines of “should we make it, or should we buy it instead?” If they decide to buy it, that’s a classic example of contract manufacturing.

The next issue would center on how contract manufacturing is utilized by businesses. You’ll get to understand that better once you learn about the various forms of contract manufacturing, and its advantages and benefits.

WHAT ARE THE FORMS OF CONTRACT MANUFACTURING?

There are several forms of contract manufacturing, and this is mainly attributed to the fact that the nature of businesses and their operations also vary. The most common forms are described below.

  • Production of complete goods entirely by one firm for another, under the brand or label of the latter. Also referred to as “private label manufacturing,” this was the example mentioned earlier. For example, Taiwanese company Foxconn Technology Group is the world’s largest contract manufacturing company when it comes to electronics, having manufactured products such as the iPhone for Apple, the Kindle Fire for Amazon, and the XBox One for Microsoft.
  • Production of parts or components by one firm, to be used by the CM in the completion of products. This is a practice common among tech and electronic companies. For example, large companies that manufacture computer hardware use contract manufacturing for the smaller computer parts and components that are, in turn, manufactured by other firms. One example we can cite is Deerfield Machine Parts, a CM based in Deerfield, New Jersey, specializing in the fabrication of plastic tubing, aluminum and rubber, to name a few. Manufacturers in the automotive and marine industries enter into contract manufacturing agreements with Deerfield, so the latter will make these components, which will be incorporated in the final products of its clients.
  • Hiring of service or labor force. It is also possible to subcontract for labor. If you do not have enough manpower in your own company to carry out the production process smoothly and quickly, then you can outsource labor. If you are familiar with how large companies in the United States set up factories in Asia for the manufacture of their products, and subcontracting the labor forces of Asian human resource companies, then that is an example of this form of contract manufacturing. (Of course, this has been met with largely negative reactions, particularly when the issue on “sweat shops” came about.) The issue on these sweat shops aside, one example we can cite is Flex, which provides design, manufacturing, distribution and aftermarket services to its clients. One of its most notable clients is Apple. One reason why full-scale manufacturers opt to deal with CMs is the fact that CMs are experts in their specific fields. This aspect on specialization requires them to continuously hone those specific skill sets to the point that even the manufacturers will not be able to match the quality of their work.
  • Usage of a manufacturing equipment or facility. The principle is basically the same. If you do not have the equipment or even facility to manufacture your product, you can transact with a CM for the use of his facility.

WHY DO BUSINESSES ADAPT CONTRACT MANUFACTURING?

Make or buy decisions can be quite tough to make. Often, feasibility studies are conducted to arrive at this decision, for management to see which option will benefit them more.

From the standalone definitions of outsourcing and contract manufacturing, one glaring benefit can be noticed, and that is the reduction of costs and expenditure on the part of the company. But is that the only reason why businesses choose to utilize contract manufacturing?

No, it’s not.

For many companies, especially those that are only starting their operations or are currently facing shortages in resources, contract manufacturing may be the answer to their problems. Essentially, contract manufacturing is used by manufacturing companies in supply chain management, marketing or brand-building, cost minimization, and product quality improvement.

Let us go over the reasons that make contract manufacturing a tempting prospect for businesses.

Reduction of costs.

As much as possible, businesses would like to lower costs and expenses, since this would mean higher efficiencies and also higher net income appearing on their financial statements.

This cost reduction is mostly attributed to two benefits arising from contract manufacturing.

  • Fewer resources utilized. If you have another firm manufacture the product, or some of its parts, instead of manufacturing them internally, it means that you won’t have to spend on operational and maintenance costs of manufacturing machines and equipment. In the first place, you won’t even have to purchase any of those expensive machines and equipment, since you won’t be using them anyway. This is in the same manner that you are spared from having to purchase, and maintain inventory on raw materials and supplies to be used in the manufacture of the parts, since those will be shouldered by the firm that you contracted.
  • Lower labor costs. Since you won’t be manufacturing the product or its components, you won’t be spending on the labor needed for it. Let us say, for example, that manufacturing a certain part will require a team composed of at least 3 people. If you outsource the production of that part, you don’t have to pay for the salaries and wages and other benefits for at least 3 people. The same principle applies when you think about the number of people that the company must keep in its employ. As the full-scale manufacturer that left most of the production functions to a CM, you can maintain a lean workforce.

There is another factor at play that will aid in the reduction of costs, and that has something to do with economies of scale. Since CMs have more than one or two clients they make the same product for, it is possible for them to come up with ways and means to perform mass production.

Mass production will enable them to sell the products at a lower selling price, which translates to lower costs for the full scale manufacturer or company using the CM.

Improved allocation of resources and greater focus on core areas.

Remember the resources and labor that you were able to save? You can then allocate those resources to other aspects of the operations of the business. You can afford to spend more on advertising, for example. Maybe you can upgrade your marketing plan for your product, since you were able to free some resources when you entered into a contract manufacturing agreement.

If we look at the labor portion, the 3 workers that were freed from manufacturing the part may be assigned to another phase of the production process, or given another task altogether. Again, that means that you can keep your production team lean, and you can better assign the resources where they are most needed.

Some companies may even consider marketing and selling as their core competencies. If your company uses this model, you’d take the opportunity to focus on these core competencies by entering into a contract manufacturing agreement. Instead of hiring manufacturing workers, you can instead strengthen your sales and marketing team.

Streamlined business relationships.

Depending on the nature of the business and the products being manufactured, the supply chain can be anywhere from simple to complicated. One of the factors that complicate this is the number of players or links in that chain.

It is possible for a company to have to deal or transact with multiple suppliers for all the raw materials used in the production process. That is not to mention the distributors, dealers, shipping and warehousing companies, and all the other agents that act as middlemen in one capacity or another.

You can keep things sparer and simpler if you use a CM. Instead of personally having to deal with all those suppliers and middlemen, you’re basically going to leave that in the hands of the CM.

Reduction of manufacturing time.

If you choose contract manufacturing for a certain part of your product, you will be considerably reducing the whole production period of the product. You already have another firm working on the manufacture of that part, so all you have to do is make sure that those parts are on hand when you need them to be placed in your own process of producing the final product.

Reduced manufacturing time also results to faster delivery of the final products or service to your customers. Speed to market will be increased. This is especially beneficial for companies that manufacture and sell products with very high demand.

Increased innovation and improved quality of the product.

When a manufacturer looks for a third party to produce a component or a whole product under its label or brand, it will definitely make sure that the latter provides quality output. Therefore, usually, the third party that it will outsource the job to specializes in the manufacture of that specific component.

In that regard, the CM is seen as a specialist or expert in the manufacture and delivery of the product or service. This ensures that the component to be used will be of top quality, and so will the final product. In view of this, companies that want to foster innovation are more likely to resort to outsourcing.

It is also generally assumed that CMs leverage the most advanced technology in their manufacturing processes, and this will make it even more possible for quality of the final product to be improved.

Improved name or brand recognition and reputation.

If you are able to keep up the production of high quality products, thanks to the contract manufacturing setup that you utilized, this will ensure that the market will have a favorable impression of your product and your brand.

WHAT ARE THE DOWNSIDES OF CONTRACT MANUFACTURING?

But contract manufacturing is not without its disadvantages, especially if it is abused, and they mostly affect not just the company but also its workers and the economy as a whole.

Limited to no control.

If you are the CM and you are contracted by another company to manufacture a specific part or product according to their design and specifications, they pretty much call all the shots. You may make some suggestions here and there but, at the end of the day, the decision won’t be yours.

On the other hand, if you are contracting a job to a CM, you will not be able to fully control the process and methods used to achieve the desired results. You only give them the specifications of the parts or products that you need, then it is mostly up to them to decide how they will go about the production.

High risk of hiring the right CM.

On the part of the company contracting a job with a CM, there is that risk that they might choose the wrong company to enter into a contract with, and the quality of the product may suffer. Of course, this adverse effect will also trickle to the reputation of the company.

Competition among companies over prioritization by CM.

It would be naive to expect to be the sole client of a CM. More often than not, one CM will have multiple clients, probably even making the same parts or products for them. One disadvantage if this is the case is the matter of prioritization. During peak seasons, when all the companies have huge orders, there is no assurance that you will be prioritized by the CM.

Potential job displacements for existing workers of the company.

If you can get cheaper labor overseas, then you’d probably think that there is no point in keeping the full labor force you have on the payroll. Chances are high that this will lead to massive lay-offs, leading to the displacement of the currently employed workers.

For instance, a US-based company will trim down its domestic workforce in favor of contract manufacturing overseas. The laid-off domestic workers will then find themselves out of work. That can easily end in problems when not handled properly.

Possible labor and human rights abuses.

This is often seen in cases where companies make use of foreign laborers in countries overseas. Often, labor is so cheap that it is even lower than the minimum wage. Or the foreign laborers may be made to work very long hours, and in less than friendly working conditions.

It doesn’t help that many of these countries do not have airtight regulations and protections in place for their workers. As a result, some companies take advantage of the slack, resulting to the abuse of labor and even human rights of the workers.

Unutilized resources.

Let’s assume that your company is based in the US, and you outsourced the manufacture of your products in Asia. The final goal is to import the finished goods and selling them under your brand.

This means that the resources that you used to procure from US suppliers and sources will no longer be needed. The company that has been supplying the raw materials before (when you were still manufacturing the product internally) will now find itself without a buyer.

Without proper planning, it is also a possibility that since you are using the resources of the CM, the resources that are already in your possession or inventory will be unutilized. As such, you’ll end up spending unnecessarily on warehousing and storage costs.

WHEN SHOULD YOU USE CONTRACT MANUFACTURING?

You will notice that, no matter how the advantages of contract manufacturing are lauded and proclaimed, not all businesses use it. You will also notice how, even the large companies like Apple, Google and Microsoft that can afford to manufacture on their own are still resorting to contract manufacturing.

This is because they have decided to utilize contract manufacturing after very careful deliberation. The million dollar question then becomes: when should you opt to use contract manufacturing?

Contract manufacturing is the best decision if or when:

  • Your business is just starting its operations and startup costs are high while your resources are low. If you have barely enough working capital and you find that you can decrease the production costs if you make use of a CM, then contract manufacturing is definitely the most sensible decision. Once the company has become more established, and cash flow is healthy, then you may start considering whether to end the contract manufacturing deal and manufacture the product on your own.
  • Your business is facing financial or working capital difficulties. If this is the case, you’d want to save as much as you can, and going for a contract manufacturing deal will help you save not only money but also time. This can be a permanent arrangement, or it may be temporary, at least until the company is back on its feet.
  • You want to improve your product quality as fast as possible. You do not want to waste time trying to perfect your “formula” or spending a lot of time and money on “practicing” with the manufacturing. Outsourcing it gives more and better guarantees that the product will be of better or even the best possible quality given the available production technology.
  • You want to establish your brand early on. For many brands, it’s a matter of trial and error. They may take many attempts at a product before it becomes a hit with the market. If you cannot afford to spend so much time and resources on that trial and error, you can skip past that and proceed immediately to coming up with a great product, with the help of a CM. In some cases, your company may even benefit from being associated with a trusted and reputed CM. Consumers are more likely to look with favor on your product and brand once they find out that you are in a contract manufacturing relationship with a CM that they also approve of or feel positively about.
  • Demand for the product is uneven. There are some products that are very high in demand during certain seasons. You may opt to use contract manufacturing during these busy seasons, and not have to worry about downtime on the other, slower seasons.

Again, one thing that you should keep in mind is that not all manufacturing businesses can make a success of being in a contract manufacturing relationship. That is why it is important to conduct deep and detailed study on whether your business needs to contract with a CM, or if doing so will benefit the company significantly.

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