What Is It? How Does It Work? Types (2024)

Introduction

This article takes an in depth look at Contract Manufacturing.

Read further to learn more about topics such as:

• What is Contract Manufacturing?
• Contract Manufacturing agreement and arrangements
• Advantages and disadvantages of Contract Manufacturing
• Non-disclosure agreement in Contract Manufacturing
• Choosing the right Contract Manufacturer
• Industries that utilize Contract Manufacturing
• And much more…

Chapter 1: What is Contract Manufacturing?

Contract manufacturing is a business model where a company hires a manufacturer to produce its products or components. It is an outsourcing method for producing products by taking advantage of the resources and expertise of an experienced manufacturer for the benefit of the contracting company.

When developing a product, companies assess the feasibility of producing the product by examining their resources, such as machinery, manpower, and raw materials, that are necessary and the availability of those resources. As a part of their manufacturing plan, they will interview and contact various contract manufacturing companies to determine which one will be the best fit for producing their product. Contract manufacturing producers offer companies an extra option when they are considering their manufacturing needs and have the available resources, equipment, and workers to meet the demands of a project.

Contract manufacturing is a strategy that saves a company‘s resources and improves its profits while gaining the benefits and expertise of a highly experienced and efficient manufacturer. It is a business practice that is known as outsource manufacturing or simply outsourcing.

When a company decides to hire a contract manufacturer, they interview various sources and present them with product designs or formulas. Once the contract manufacturer and the hiring company reach an agreement, the contract manufacturer does a trial production run for the hiring company‘s examination and approval. If the results from the trial run are successful and look promising, they proceed to mass production.

Materials, items, and products produced by the contract manufacturer are sold under the name of the hiring company or used for further processing and assembly. The hiring company is able to overcome the problems associated with introducing a product such as start up costs and limited resources.

Chapter 2: Contract Manufacturing Agreement and Arrangements

The essence of contract manufacturing is the agreement between the original equipment manufacturer (OEM) or product creator and the manufacturer. It specifies the terms under which the manufacturer will produce the product as well as the quantities, pricing, and method of delivery.

The key factor in the agreement between the OEM and the contract manufacturer is that the OEM retains creative control over the creative and intellectual properties (IP) of a product. Contract manufacturers must adhere to the terms of the agreement and are restricted to the OEM‘s specifications and design parameters.

Manufacturing Contract

The manufacturing contract lays out the details and requirements for the manufacturer, which include but are not limited to product specifications, quality requirements, manufacturing conditions, product volume to be supplied regularly, and delivery arrangement to be met by the contract manufacturer.

These terms establish the Service Level Agreement (SLA) between the hiring company and the contract manufacturer. The performance of the contract manufacturer is measured by the metrics stipulated in the SLA. In return, the OEM pays the contract manufacturer for fulfilling its obligations based on the manufacturing contract.

Below are the common arrangements of contract manufacturing. Each type has its advantages and disadvantages for both parties involved.

Component Manufacturing

In component manufacturing, the contract manufacturer produces most or all of the components of a product. The manufactured components are delivered to the hiring company for enhancement and assembling into more complex products and packaging.

Component manufacturing is ideal if a company needs help to produce the components of their products because they cannot afford to produce due to a lack of resources or expertise. Otherwise, a company may have the ability to produce those components but opt to delegate its production in order to give more attention to other manufacturing processes.

Private Label Manufacturing

In private label manufacturing, a company hires an Original Design Manufacturer (ODM). The ODM conceptualizes the design of the product and oversees every aspect of its production. The product is kept under the label or brand given by the hiring company, which is now referred to as the value-added reseller (VAR).

Private label manufacturing is ideal for the hiring company because it does not require capital and product research and development. The hiring company can sell products right away. However, the hiring company lacks influence in the design of the product and control of its manufacturing aspects. This agreement is beneficial to new contract manufacturers who seek to introduce their product to the market.

Labor Subcontracting

Labor subcontracting occurs when the contract manufacturer delegates some aspects of the manufacturing process to a subcontractor in producing one or more components of a product. Subcontractors offer a particular service in the area of their specialization that could not be supported by the staff of a contract manufacturer due to the lack of resources, expertise, or manpower. They usually make agreements with a contract manufacturer and not directly with the customer. Labor subcontracting is adapted to further increase production efficiency and cost savings.

Contract Manufacturing for the Use of Equipment and Facility

In this type of agreement, a company coordinates with a contract manufacturer to use the contractor‘s equipment and facilities to manufacture their products or components. The manpower will come from the hiring company. This option is suitable if a company has enough workers to support the production of a certain product or component but is not willing to invest in the required equipment or facilities.

Electronic Contract Manufacturing

Electronic contract manufacturing grew out of electronic companies' need to conserve their resources and limit their efforts, time, and money to produce their products. In the 1970s, companies began outsourcing their products, which allowed them to focus on research and development while having manufacturing and production performed by contract manufacturers.

With electronic products, the main focus of contract manufacturing is the assembly of components or parts for assemblies. Components are delivered to the contract manufacturer who has them assembled. The process helps electronic companies keep their costs down and provide high quality electronic products quickly and efficiently.

Unlike electronic companies, electronic contract manufacturers have larger facilities, more employees, and advanced machinery that can be quickly adjusted to meet the needs of technological advancements and changes. They purchase components and parts in high volume to lower production costs.

Short Term Contract Manufacturing

Short term contract manufacturing is a helpful tool when the demand for a product quickly increases beyond the capabilities of the manufacturer. Using short term contract manufacturing helps companies avoid the additional costs of labor and raw materials required to meet the rising demand.

The process of short term contract manufacturing is also beneficial when a company is producing prototypes and short run productions for testing and evaluation or for production when they are waiting for a manufacturer to complete a production run.

The contractual agreements for short term production are the same as longer agreements and include NDAs and SLAs.

Chapter 3: Advantages and Disadvantages of Contract Manufacturing

The following are the benefits gained by a company when it enters a contract manufacturing agreement. Some of the benefits from the contract manufacturer‘s point of view are stated as well.

Cost Benefits

By hiring a contract manufacturer, a company saves a significant amount of capital by avoiding investments in a production facility and its equipment, maintenance, and staff dedicated to a specific product or component. Extensive investments in research and development are not required in private labeling. They can also save on labor costs; these include staff hiring, training, and compensation. A company can strategically hire a contract manufacturer from a different country or region where labor costs, taxes, raw materials, and energy are cheap.

Benefits from Economies of Scale

As the contract manufacturer takes on more customers and produces more products, they will experience higher benefits of economies of scale. Economies of scale is a cost advantage achieved by a company when it increases its level of output. Both parties benefit from the economies of scale. For the contract manufacturer, the variable costs from acquiring the raw materials are reduced since more orders are purchased. The variable costs from set-ups may also be diminished and the fixed costs are reduced since they are spread over a larger quantity of products. Therefore, the contract manufacturer can offer its products at a lower price per unit to its customers.

More Focus

When a company enters a contract manufacturing agreement, it can give more attention to their core competencies and the other aspects of their business as well. Contract manufacturing eases the workload of the employees of a company; this enables them to work to their skills and talents. Therefore, the utilization of human capital is optimized. Companies whose core competencies are innovation, marketing, and customer care can delegate their production to a contract manufacturer.

Increased Quality and Efficiency

The hiring company can utilize and benefit from the skills and competencies of the contract manufacturer. Contract manufacturers can deliver high-quality products in large volumes as a result of their expertise, facilities, and established manufacturing processes and quality control procedures.

Enhanced Responsiveness to Variable Product Demand

The demand for a product may be seasonal or simply volatile. Contract manufacturing can help a company thrive through peaks of demand without having to worry about the idleness of the assets involved in production during low demands.

Lead Times

Since contract manufacturers have a global footprint, they have a more advanced supply change and delivery systems that are capable of meeting any production deadline. Regardless of the distance between facilities or where the OEM may be located, with a well developed delivery system, contract manufacturers are able to supply exceptional on time delivery.

One of the advantages of contract manufacturers is their access to multiple facilities, which makes it possible for them to easily relocate orders from one location to another without any decline in product quality.

Control and Flexibility

One of the stipulations of contract manufacturing agreements is full control by the OEM who outlines the requirements for the final product. This aspect of contract manufacturing is a key element in its growth. Customers have full control of designs, quality, quantities, and are capable of providing adjustments and changes. The products produced by contract manufacturing carry the name of the OEM and must meet their standards. Additionally, OEMs and their contract manufacturers work very closely together in a collaborative effort to produce the finest products.

Opportunity for Globalization

After studying and evaluating the political, economic, and social factors, the company can introduce its products and penetrate the market as a new entrant in the country where the facilities of the contract manufacturer are located. This is helpful when the company aims to expand its market globally.

The following are the risks and disadvantages of contract manufacturing from the perspective of the hiring company and contract manufacturer, and some of the actions to mitigate it:

Threat to Confidentiality of Proprietary Information

Some of the proprietary information (e.g., trade secrets, unique technologies) belonging to each party will be exposed once they enter a contract manufacturing agreement. It is critical to maintain the confidentiality of the information and ideas to the competitor. Such information can be used by the competitor to imitate, or even improve, the competitive advantage of a company. Hence, both parties must have a non-disclosure agreement (NDA) to avoid the leakage of sensitive and confidential information.

Outsourcing Costs

The hiring company should be ready for the expenses brought by outsourcing, such as shipping costs, labor costs, tariffs, taxes, contract fees, etc. These should be reviewed during the feasibility study.

Cultural Differences and Other Threats

The cultural differences between the hiring company and the contract manufacturer may create misunderstandings. A language barrier exists if both parties come from different countries or speak different dialects. Both parties may find it difficult or costly to comply with certain laws, policies, and regulations in order to make their business survive.

Chapter 4: Non-Disclosure Agreement (NDA) in Contract Manufacturing

Companies invest in research and development to provide better products and services to their customers and improve the standard process efficiency. Forming unique and valuable solutions which are difficult to understand and costly to imitate establishes a company's competitive advantage. A non-disclosure agreement (NDA) is a legally binding contract that protects confidential information such as trade secrets, strategies, product designs, and manufacturing processes from spilling into the hands of the competitor which may be used for their benefit.

A non-disclosure agreement is necessary in contract manufacturing. Oftentimes, both parties discuss their proprietary information with each other to a specific extent in order to carry out their obligations. Signing an NDA is a way so that both parties can share such information safely. An NDA may be required as early as the time when the hiring company sources a contract manufacturer to discuss its business plans.

There are two types of non-disclosure agreement:

Unilateral Non-Disclosure Agreement

A unilateral non-disclosure agreement is necessary when only one party is disclosing their confidential and proprietary information. Employees who have access to or learned the proprietary information during their stay in the company are required to sign this agreement, and may take effect a few years after their separation with the company.

Mutual Non-Disclosure Agreement

A mutual non-disclosure agreement is necessary when both parties share their confidential and proprietary information with each other.

The elements of an NDA are the following:

Names of the Parties to the Agreement

The disclosing and the receiving parties who agree to enter an NDA are identified.

Scope of Confidentiality Obligations

The disclosing party needs to precisely identify and inform the receiving party which information needs to be protected.

Exclusions from the Confidentiality Treatment

The disclosing party must identify which information is not part of the confidential data. This includes information that is already well-known to the public and the recipient.

Disclosure Consequences

The consequences and penalties that the receiving party must pay if it fails to maintain the secrecy of the information deemed to be confidential.

Terms of the Agreement

The period of time in which the NDA takes effect.

Chapter 5: Choosing the Right Contract Manufacturer

The main reason for choosing a contract manufacturer is to reduce costs, which is especially true for start up companies and small businesses who may have large orders without the resources to fill them. The choice of a contract manufacturer is the beginning of a lasting relationship that is built on trust and reliability. To make the proper selection, it is important to research and examine the qualifications and abilities of contract manufacturers to ensure they have the resources that match the needs of the hiring company.

There are several factors to be considered in the selection process each of which can determine if a certain contract manufacturer is the correct match.

ISO 9001 Certification

When searching for a potential contract manufacturer, it is always best to verify if they are ISO 9001-certified. ISO 9001 is the international standard that specifies the requirements for a quality management system (QMS). It can be used by any organization, regardless of its size or activity. Formation of highly efficient, organized, and repeatable processes, the satisfaction of various stakeholders, reduction of costs, and a drive for continuous improvement are some of the benefits of ISO 9001. Organizations seeking and adapting this certification are audited to monitor their compliance.

ISO 9001 is a valuable credential for every organization. By hiring an ISO 9001-certified contract manufacturer, the company guarantees they will be getting quality products and services, which meet customer and applicable statutory and regulatory requirements, promptly.

Facilities

The facilities of the contract manufacturer (e.g., production floor, warehouses) must be organized, clean, and properly maintained to uphold quality and avoid product mishandling and damage. The environment must be safe and stimulate worker productivity. To realize this, the 5S principle must be applied. Facilities must be visited and inspected by the contract manufacturer regularly.

Ability to Meet Production Demands and Quality Requirements

The contract manufacturer must be able to provide quality products expected by their customers at their agreed time of delivery. This means they should have the capacity to accommodate the peaks in demand from their customers. No matter how high the pressure is to deliver large volumes on time, product quality should not be sacrificed. Failing to meet the customer specifications may cause downtimes on the side of the hiring company, or worse, the defect could reach the end consumers.

Reputation in the Industry

The reputation of the contract manufacturer must be thoroughly researched by the hiring company. Their past performance in the market, customer reviews and feedback, and the perception of the people working in the industry should be considered. Their reputation can be an indicator of their future performance.

Technical Competence

The contract manufacturer must have strong human capital. Their people should possess relevant skills, talents, technical knowledge, experiences, and training to enable them to handle and develop manufacturing processes and quality control procedures necessary for producing the customer‘s product. Having a sound and robust process will increase the reliability of the product.

Aside from human capital, advanced equipment should be available to accommodate the production of complex products as well as to keep up with the latest technological trends. Having automated processes and properly designed tooling enables the manufacturer to increase their production efficiency and product quality as well. These aspects are important to keep up with the ever-evolving industry and technology and changes in the market conditions.

Location of the Contract Manufacturer

The hiring company must select a contract manufacturer from a country or region where minimal cultural differences exist between them. Politics, social conditions, and economic policies in the manufacturer‘s country should be studied extensively. The location should foster a prosperous business environment. The distance between the two is a concern since longer distance increases lead times. Delivery delays are inevitable if the facilities are too far apart.

Chapter 6: Industries that Utilize Contract Manufacturing

The following are the industries that utilize contract manufacturing:

Electronics Industry

The electronics industry is one of the leading industries utilizing contract manufacturing. Contract manufacturers are responsible for the manufacturing and assembly of advanced products (e.g., computers, smartphones, appliances), which are offered by the world‘s largest electronics companies. This is primarily because those industry giants want to focus on innovation and product development to offer better technological solutions as well as on marketing their products.

Metal Fabrication Industry

Some companies rely on contract manufacturers to perform metal fabrication services such as machining, casting, forging, grinding, drilling, spinning, bending, and broaching. The parts produced may be further subjected to other fabrication processes at the hiring company‘s site. This is a cost-effective action for those companies who lack expertise in a certain process and are not willing to invest in expensive machinery or tooling.

Plastics and Rubber Industry

Companies request contract manufacturers to mass-produce finished or semi-finished plastic and rubber components. There are several plastic and rubber processing methods, such as extrusion, molding (e.g., injection molding, blow molding, rotational molding), thermoforming, coating, rubber vulcanization, and much more. The contract manufacturer is responsible for tooling design and fabrication based on the company‘s products, as well as for prototyping and production trial runs. This makes switching from one contract manufacturer to another more difficult, as production qualification is tedious and expensive.

Chemical Industry

Contract manufacturers synthesize and produce large volumes of chemicals that are used as raw materials or utility chemicals in the production of more useful and complex products. Their products may also be used directly by the company for their operations.

Automotive and Aerospace Industries

Most automotive companies outsource the manufacturing of most of the automobile components, and even assembly, to contract manufacturers. Examples of automotive components produced by contract manufacturers are gearboxes, suspension components, front-end modules, seating, various automotive electronics, and auxiliary components such as car radios, dash cams, and security systems. These companies often outsource their production because automotive parts suppliers are focused on the quality and accuracy of individual components that are critical in the functionality and reliability of the whole automotive system. The same is true for the aerospace industries in which contract manufacturers deal with components for helicopters, airplanes, space vehicles, etc.

Pharmaceutical Industry

Pharmaceutical companies often receive pharmaceutical raw materials, ingredients, and packaging materials for the production of medicines and supplements from contract manufacturers. Private label manufacturing of medicines (e.g., sleep aid, allergy relief, medicine for cough and cold) through contract manufacturers is also prevalent. This practice prevents consumer disengagement towards generic medicines.

Other forms of outsourcing in the pharmaceutical industry are research and development outsourcing, clinical trial outsourcing, and sales and marketing outsourcing.

Medical Industry

Specialized contract manufacturers provide medical devices and supplies to hospitals and clinics. These contract manufacturers must produce quality products and strictly adhere to regulatory requirements as such products affect human health, safety, and well-being.

Food Industry

Companies dealing with food manufacturing or service rely on contract manufacturers for food ingredients, packaging materials, and other items. Contract manufacturers have advanced food manufacturing and packaging facilities to help food companies in their production and operations. Private labeling is also prevalent in the food industry.

Conclusion

• Contract manufacturing is a business model in which a company hires a contract manufacturer to provide products and services for them.
• In contract manufacturing, the company saves lots of resources by avoiding investments in facilities, equipment, and staff dedicated to a specific product or component. The company‘s resources and focus can be diverted into improving its core competencies and the main goal of their business.
• Other advantages of contract manufacturing are its cost benefits derived from the established economies of scale, increased quality and efficiency, opportunity for globalization, and enhanced responsiveness to variable product demand.
• When a company enters a contract manufacturing agreement, it loses control of some of the aspects of the business. The performance of the contract manufacturer can greatly affect the performance of the hiring company.
• Other disadvantages of contract manufacturing are the risks of imitation, longer lead times, outsourcing expenses, and threats from cultural differences, politics, economics, and other social factors.
• A non-disclosure agreement (NDA) is a legally binding contract that protects proprietary and confidential information from spilling into the hands of the competitor which may be used for their benefit.
• The types of contract manufacturing arrangements are component manufacturing, private label manufacturing, labor subcontracting, and contract manufacturing for the use of equipment and facilities.
• The factors to consider in selecting or renewing with a contract manufacturer are their ISO 9001 certification, facilities, ability to keep up with production demands and quality requirements, technical competence, reputation in the industry, and location.
• Every industry has a unique way of utilizing contract manufacturing for its benefit. Contract manufacturing is prevalent in many industries such as electronics, metal fabrication, plastics and rubber, chemical, automotive, aerospace, pharmaceutical, medical, and food.