Contract manufacturing is a process for production of goods by a third-party vendor for a person or a company that is not willing to or is unable to produce its goods within its own facility. Contract manufacturing involves outsourcing a part of or an entire manufacturing process to the point where, in multiple instances, even the employees of the company who is selling the product in its own name, have not physically touched the product they’re marketing and/or selling.
Although multiple companies believe in manufacturing their products in their own facility however, various companies still consider contract manufacturing an essential part of their businesses such as conventional brand owners who prefer to focus on their product research, development and design, while leaving the process of manufacturing for contract manufacturers.
Further, getting products manufactured from a third party contract manufacturer is excellent for startups and small businesses who have relatively less buying power for raw material while expecting high-quality results for their customers. Contract manufacturing is a wonderful solution for situations when the demand of the products exceeds the supply exhausting the manufacturing capacity of a particular brand/company.
What is a contract manufacturing Agreement?
In order for an organization to enter into a contract manufacturing arrangement with a third-party, the said organization will be required to enter into an exhaustive agreement with the contract manufacturer which will cover the complete legal and commercial relationship between the organization and the said manufacturer who is producing the goods. To keep the contract watertight, several elements need to be expressly mentioned which provides a clear clarity with respect to the subject matter.
Primarily, responsibility of each party needs to be precisely determined for the purpose of manufacturing the goods such as who will be providing the design, to what extent the manufacturer will be using its own equipment etc. Such factors depend upon both on the organization’s need and manufacturer’s capability.
The parties are further required to nut out all issues from the arrangement in order to avoid a scope creep. ‘Scope creep’ refers to modifications, continuous or uncontrolled growth in the scope of a project at any point after the said project begins. This may occur when the scope of a particular project is not accurately defined or documented amongst the parties and is considered harmful for the project and the parties. Following are the issues which are required to be eliminated before entering into an arrangement:
(a) The responsibility for providing design and other essential elements for production are required to be particularly determined amongst the parties;
(b) The quantity of products to be manufactured and supplied needs to be accurately mentioned in the contract manufacturing agreement and the associated purchase orders executed from time to time;
(c) The timeline within which the manufacturer is required to deliver the products to the organization and the place of delivery. Further, consequences for late delivery are also required to be properly defined;
(d) The contract manufacturing agreement and the purchase orders executed between the parties should also outline the requirements and specifications of the organization including but not limited to quality, standards, detailing, packaging, mode of delivery/ supply chain structures, damage control mechanism, insurance responsibilities etc.;
(e) The agreement should also include a clear dispute mechanism which shall be invoked by either of the party in case any dispute arises. The said dispute mechanism shall possess the following parameters:
- Clear mechanism of responsibility for handling a disagreement which may range from settling the dispute amicably by the points of contact of each party, the elevation of dispute to the senior executives of the parties and the appointment of an arbitrator in case the dispute is not settled amicably;
- Other aspects pertaining to the arbitration proceedings such as venue, language and laws of the said arbitration proceedings; and
- The ongoing responsibility of each party during the subsistence of a dispute.
Before executing a contract manufacturing agreement with a manufacturer, the organization is required to execute a Non-Disclosure Agreement (NDA) with the manufacturer which shall keep the organization’s confidential and proprietary information confidential that the organization may have shared with the manufacturer either prior to or during the subsistence of the contract manufacturing agreement. Generally, it is advised that the NDA is signed at the stage when the parties are at an initial stage of discussions and negotiations since the organization may share such confidential information with the manufacturer in order to determine whether the manufacturer will be able to undertake the manufacturing process in accordance with the organization’s expectations.
What are the pros and cons of onboarding a contract manufacturer?
(a) Advantages for adopting contract manufacturing:
- At the outset, contract manufacturing provides small and medium sized businesses an instant cost benefit and subsequent profits which enables the organizations to enable smooth functioning without putting in a substantial amount of capital in the business;
- This model enables the businesses to effectively expand their manufacturing workforce, their production capacity without taking a complete risk and responsibility of manufacturing in their own facility. By virtue of adopting a contract manufacturing model, the potential of growing the business can be huge, while the risks associated with taking on greater production capacity are substantially minimised;
- By outsourcing the manufacturing process, businesses are able to utilise their own workforce and in-house production capacity for the purpose of research and development and in some cases, manufacturing fresh innovative products.
(b) Disadvantages of adopting contract manufacturing:
- Although for small and medium size businesses the advantages would carry more quantum than the disadvantages, however, businesses who adopt contract manufacturing as their production model are likely to face certain quality control issues since the production process is not under their direct control and the contract manufacturer may not adhere to the quality standards as required by an organization.
- Contract manufacturers may, in some cases, prioritise production of certain goods of other organizations if they carry more value in terms of business relations with the said manufacturer. This may cause delay in delivery of the products which may lead to delay in supplying the products to the end customers.
- In addition to the above, in the event an organization engages a contract manufacturer, it is evident that such manufacturer will be privy to certain confidential and proprietary information of the said organization. There is a potential threat that such business information is leaked by the manufacturer or its workmen/employees which may consequently cause goodwill and monetary losses to an organization.
In light of the foregoing, it can be inferred that any business looking to associate itself with a contract manufacturer is required to consider all potential risks and benefits and determine whether it is suitable for them to enter into a legally binding partnership with a contract manufacturer. It is also advisable that any organization who intends to engage a contract manufacturer should consult a legal practitioner before onboarding any third-party vendor/manufacturer. A legal practitioner may help the organization in undertaking a complete due diligence of the contract manufacturer in order to verify that such manufacturer has the requisite licenses/ approvals/ permissions to undertake the manufacturing of the said products.
Further, a legal practitioner will help an organization in drafting and effectively negotiating all documentation necessarily required for creating a legal binding partnership between an organization and a contract manufacturer. This will certainly mitigate the risks (as mentioned above) which an organization may attract during the subsistence of the arrangement and will ensure a smooth business relationship amongst the parties.