This article explains in-depth, what is a manufacturing contract, benefits and drawbacks of using a manufacturing contract.
It also helps you analyze –
- whether a manufacturing agreement is right for you and
- helps you draft one yourself by showing you the main factors you need to take into consideration and the key components that must be present in a manufacturing contract.
So, let’s begin!
What Is a Manufacturing Contract?
Nowadays most start-ups as well as large scale businesses do not create their products in-house. While design and R&D are kept in-house, the production is outsourced to a third party.
A manufacturing contract is the agreement, which you need, in order to outsource your product manufacturing to a third party.
You, as the outsourcing business or a manufacturer may outright enter into a contract manufacturing transaction or may outsource the production of certain individual parts or the assembling of the product.
Since outsourcing companies, or contract manufacturers are in this manufacturing business, including services for design, production, assembly, and distribution, the consumer is usually provided by a template agreement by these businesses, which is their own manufacturing agreement.
The template that manufacturers provide contain their services based on their own designs, methods, and requirements via a standardized contractual format.
Unless the contract includes additional agreed-upon provisions, the contractor provides you with a standardized manufacturing agreement wherein the marketing and sale of your firm’s finished product is handled by your company and not the manufacturer’s.
However, it is always advisable that you ensure that the agreement is right for you and as such, you can negotiate so as to make the manufacturing contract more favourable for you or create a new manufacturing contract from scratch.
Related Read: Original Equipment Manufacturing Agreements Explained!
Is a Manufacturing Contract Right for You?
Contract manufacturing saves money since the manufacturer already understands how to produce the highest quality items, has the necessary equipment, and can produce additional components and products as well.
Outsourcing your production also helps you save money on energy, taxes, overhead, and materials. Manufacturing the goods in another location may also help get access to cheaper labour as well as manufacturing procedures, which are labour intensive.
Pros and Cons of Using a Manufacturing Contract
Like every other agreement, using a manufacturing contracts presents any business with its own set of pros and cons. So, let’s analyse them here.
Benefits of Using a Manufacturing Contract
A manufacturing agreement lets a business put a large part of its business process on autopilot. This allows them to focus on other areas of business such as marketing, consumer research, R&D, revenue model innovation, business model innovation etc.
#1. A Manufacturing Contract allows for Lower Fixed Costs
When a business is able to work with a manufacturer, it can significantly reduce its operating costs by outsourcing certain tasks, such as custom fabrication or special orders.
This can be both a positive and negative for the company, depending on its unique situation.
For example, if the company has large amounts of inventory, using a contract may allow it to reduce its fixed expenses by paying for raw materials only when needed instead of having them sitting around taking up space.
However, if the company has a lot of inventory that needs to be sold quickly, outsourcing can mean increased overhead costs due to the added labor required to fill orders as they come in. To avoid these issues, most manufacturers will have their contracts state when they will be paid and how frequently they will be paid until specified goals are met.
#2. A Manufacturing Agreement Helps Pave the Way for Higher Efficiency
Outsourcing also allows businesses to use automation more effectively since it doesn’t require as many people for each task. Automated processes are much more efficient than manual ones, so it’s important for businesses that produce goods or services on a large scale to automate as many processes as possible if they want their operations to run smoothly and efficiently
#3. You can Access Technical Expertise by using Manufacturing Contracts
The use of a manufacturing contract can be a good strategy for businesses who want to be more competitive in their industries. This is because it allows them to gain access to the different types of expertise that are available from their suppliers.
By using a manufacturing contract, companies can get involved with research and development, engineering and design. For example, if a company wants to start producing new products or services, they will need to make sure that they have all the information about how these new products or services should be made.
They will also need to know what materials are needed in order for them to produce these new products and services successfully. By using a manufacturing contract, therefore, companies will be able to access this type of expertise if they need it.
This means that they will not have to spend time sourcing out all these different types of expertise themselves. Instead, they can simply ask their suppliers for help with this process.
#4. Tap into Opportunities to Scale by Outsourcing Your Manufacturing
One of the biggest benefits of using a manufacturing contract and supply agreement is that you can scale your operations as your business grows. You’re not tied to one supplier or factory, but instead have access to multiple factories and suppliers. This means you can choose the best option for your business at any time.
If you have a large order from a customer, you can choose to take their orders from multiple factories, rather than just one. This means that even if there’s an issue with one factory, you still have the ability to continue production.
Drawbacks of Opting for Contract Manufacturing
While a contract manufacturing option allows a business with several leeways that it would not have otherwise, it also presents some issues that you should be aware of –
#1. Partner Reliability
Partner Reliability and difficulty to find a quality manufacturer is a key drawback of Using a Manufacturing Contract.
You’ll need to do some thorough research on manufacturers, and make sure they have the experience and technical know-how to deliver what you need, so that you can avoid problems down the line. Partner Reliability and difficulty to find a quality manufacturer is a key drawback of Using a Manufacturing Contract.
#2. Difficult to Change Requirements Mid-Contract
If you need to pivot your production to something else entirely based on sudden demand changes or consumer research, it can be extremely difficult to do so, as it might lead to violation of the contract.
This is why the contract needs to be very well thought out before it is drafted.
#3. Risks to Intellectual Property
Since you are outsourcing your production, you always face a threat of having your trade secrets disclosed or leaked or even worse, stolen.
That is why, you need to provide for compulsory safety measures to be followed by your contractors as well as ensure they sign NDAs as part of your manufacturing contract.
Factors to Consider Before Getting into a Manufacturing Contract with a Contractor
As in any contract, you need to be sure of the transaction before you enter into it. That’s because, a manufacturing contract causes you to part with some of your rights when you are doing business as well as makes you incur certain liabilities.
Here are what you need to consider –
#1. Reputation of the Contract Manufacturer is Sine-Qua-Non
Obviously, since your product is on the line, you need to ensure that the contract manufacturer can in fact deliver as per your requirements.
Check to see, previous client testimonials of the company that you wish to enter into a contract with as well as any online reviews if available. This is a necessary and a very important due diligence so you can even go the extra mile and contact the businesses who have previously taken the service of the contract manufacturers.
#2. Deliverables that the Contract Manufacturer agrees to, should be written down in the Memorandum of Understanding
Before you enter into any contract with another party, it is always advisable that you write down a list of your wants and the timelines that you expect it to follow.
The other party may also provide for the payment structure that they wish to receive as well as negotiate for a better deliverable timeline for themselves.
However it is important that you and your contractor decide upon a deliverable timeline that works for both of you.
#3. Quality of the Manufactured Products created by the Contract Manufacturer
Quality of a manufactured product is very difficult to account for in the contract. Therefore, make sure you check out a sample of the product that is to be manufactured. Thereafter, you can mention in the contract that the manufactured product has to be as per the sample.
Or, even better, try to ascertain a benchmark that the manufactured product has to adhere to and provide it as an essential stipulation in the contract.
#4. Quantity of Supply that the Manufacturer can agree upon and How Quickly Can They Scale
It is important to provide tangible scaling requirements in the contract. However, even more important is to ensure yourself that your contract can in fact, deliver the higher quantities in cases of higher demand.
In simpler words, you need to ascertain whether the manufacturer scale their manufacturing line, when called upon to do so and does the contractor agree for such a stipulation in the manufacturing contract in the first place.
How to Create a Manufacturing Contract – The Essential Components of a Manufacturing Contract
While each contract deserves special attention, there are a few high-risk concerns that emerge on a regular basis and should be addressed before the contract is signed and filed away. The idea is to ensure that your contracts are consistent with your expectations and that you are not caught off guard when things do not go as expected in your business deal.
And, that’s why here are the essentials that you need to get right, to ensure your manufacturing contract is legally binding and water-tight!
First, the Basic Contractual Requirements Must Be Present in the Manufacturing Agreement
Herein you need to ensure that the agreement contains the four pre-requisites that give it legal authority –
- Consideration for the contract, and
- Coercion and misrepresentation-free intent to create a legally binding agreement
Note these down in a draft document. These need to be inserted into the agreement at various relevant areas. Points 1, 2 and 4 need to be inserted in the recital itself, whereas point 3 can be inserted in various parts of the contract and depends upon the person who is creating the agreement.
Once these four elements are taken care of, you begin with drafting the agreement.
#0. Define Key Process Terms Right Off the Bat in the Agreement
You would be surprised to learn how easy it is for a contract to get challenged based on the interpretation of the words that are used in an agreement.
And, this is no different for manufacturing contracts.
Therefore, make sure your contract has a section on definitions of all the key terms that are used in the agreement. In this section, you need to very specifically define all the words that are used, in a detailed fashion.
Some of the terms that need to be defined may include –
- Manufacturing Process
- Intellectual Property
#1. Determine the Risk Areas in your Business
In any manufacturing contract, you need to be aware of the potential risks that your business may face, when you are entering into a manufacturing contract. Conduct a SWOT or PESTLE analysis if need be.
IP theft is seen by some startups as the most essential issue that must be detailed down in the contracts. So, for example, if you have are going to apply for a patent for the product that is about to be manufactured, you need to ensure that your trade secrets are kept air-tight and theft-proof.
This is how Coca-Cola keeps its recipe a secret despite of its product being manufactured around the world.
- Patent Application Essentials in the US
- Due Diligence Essentials before applying for a Patent in the US
- How to Write a Patent Specification as per Indian law
- How to Register a Patent in India – A Guide
Others consider warranty obligations or increases in raw material costs to be their most significant potential hazards. There has even been cases wherein the contract manufacturer becomes the competitor of the client!
Regardless of what it is, ensure you create a workaround in your contract so as to protect against the potential fallout.
#2. Nondisclosure Agreement
When dealing with your supplier for production of your goods, a nondisclosure agreement, or NDA, is essential.
This is especially common in the technology industry, which we, at WinSavvy serve. This is because, tech businesses are at the most risk of having their trade secrets stolen. Although IP laws offer protection to trade secrets, precaution is always better than cure.
Large tech companies like Samsung or Apple always include an NDA in any contract with a third-party manufacturer to guarantee that their latest products are not leaked to their competitors or consumers before launch.
#3. Specify Who Owns the Intellectual Property Developed in the Business Agreement
A well-defined contract will specify who owns the intellectual property (IP) rights that are incorporated into the product or used in its manufacturing.
Consider the following scenario: you’re creating a specialized gadget for a customer’s manufacturing process and you have left the designing process up to the manufacturer.
Now, if you do not want the manufacturer to claim the patent rights to the design and if the intellectual property is important to you (which it usually is), be sure your contract provides you with the necessary rights and safeguards. The contract should specify in clear terms that any design that the manufacturer comes up with, is your intellectual property and not the manufacturer’s.
#4. Termination Clauses and Arrangements for both parties to a Manufacturing Contract
The manufacturing contract must come to an end at some time, either after the contract has been performed or if the supplier is unable to follow the stipulations of the manufacturing contract.
To avoid a problematic conclusion to your business’s connection with its manufacturers, the contract should specify the conditions under which the contract can be cancelled, such as insolvency or a breach of the contract or inability of either party to perform the contract.
#5. Consider Cost Recovery for Engineering, Design, And Testing
Despite the best efforts of the parties, your initial product (or MVP / proof of concept) may not be successful or receive the expected response. Projects may have to be discontinued early or have their quantities considerably reduced.
But since there is a significant amount of time and money that has to be invested into the manufacturing programme to develop, design, and test (ED&T) the product, a supplier may expect to recoup that ED&T cost over time from the sales that the products may generate.
So, if you want to be able to amortize the costs via the sale price, ensure that you create a clause specifying this in your contract.
#6. Avoid Using Options in Long-Term Manufacturing and Supply Contracts
In a long-term agreement, you need to deal with various future uncertainties as you do not know several factors such as how much of the supply may be needed 3 years later.
This often tempts parties to use option contracts. However this allows the supplier an opportunity to not go ahead with a transaction in the future when you ask for supply in the future.
As such, your contract must deal with uncertainties in quantity requirements and set specifications for missing quantity clauses. Because each contract is unique, this is an area where you should get legal and financial advice.
Forecast the Future Sales and Demand Generation and Create Your Manufacturing Contract Accordingly.
Having to renegotiate and change your manufacturing contract repeatedly is a risky affair.
Although at times product engineering and delivery schedules need to be changed having regard to consumer demand and macro-economic variables, you should actually forecast for these before entering into the contract, as it is also a vital element for your business strategy.
Try using Porter’s Five Forces Model for your business forecast.
#7. Ensure Your Manufacturing Contract has Purchase Order Clauses
In a manufacturing contract, a purchase order clause is a clause that specifies the terms of payment.
The most common type of purchase order clause contains the following information:
- The date of delivery
- The name of the buyer
- The address of the buyer (if different from the shipping address)
- A description of the product or service being purchased
- The price/cost and payment terms (e.g., net 30 days, net 60 days, etc.)
#8. Incorporate Supply Chain Agreements in Your Manufacturing Contract
Supply Chain Agreements should be used in order for companies to have a clear understanding of their responsibilities with respect to their suppliers and customers. It also helps them determine what type of relationship they want with these parties. The importance of using supply chain agreements cannot be understated because they help make sure everything is done correctly when dealing with suppliers and customers alike.
Supply Chain Agreements are important because they help define who owns what when it comes to products moving through different areas within a company’s supply chain network. They also outline how each party will interact with each other and what responsibilities each party has as well as what obligations each party has toward each other at any given time during shipment or delivery of goods.
#9. Specify your Quality Standards, Servicing Requirements as well as Length of the Contract in Detail
Ensure you detail your quality standards and requirements. Also, it is advisable that you specify in the contract that quality of the manufactured products remain an essential component of the agreement.
This allows you to sue for breach of contract if the quality of the goods manufactured are not up to the mark.
If you need your product manufacturer to service the items they produce, it can lead to a rather lengthy deal which may extend to years on end.
Your contract should clearly describe each party’s rights and obligations as well as specific details that may be required in a service agreement.
The important areas that you should mention are:
- Product or service specification;
- Quantity or capacity;
- Specification of materials;
- Specification of equipment;
- Design specifications;
- Processes, procedures and methods;
- Testing requirements;
- Quality control procedures and controls;
- Inspection and acceptance criteria;
- Warranty provisions;
10. Licensing Clauses
If your company logo or trademark is to be used on the manufactured product, consider having a clause in the agreement which allows the manufacturer to use the trademarked design in the goods that they manufacture.
Wrapping up the Guide on Manufacturing Contract
Now that you know all about manufacturing contract, if you wish to go ahead, here are two exhibits on manufacturing contracts provided by the SEC. You can use them as templates for your own business purposes if your business is in the US –
If your business is in India, you can use this as a template –
If your business is in the UK, this agreement can serve as a template –
Well, that’s all for the guide on a manufacturing contract. If you have any questions, let me know. You can drop in a comment or send us an email as well and we’ll get back to you.