Contract manufacturing is the production of goods by a third party (the contract manufacturer) for a company that cannot produce its own goods in-house. Ultimately, contract manufacturing is a form of outsourcing that helps businesses manufacture their products and goods. Depending upon the strategies of the entity, it may outsource any of the following activities associated with the manufacturing process namely, design, assembly, production or distribution.
Did you know? Indian government has implemented a number of initiatives to promote the country as a manufacturing hub, including the "Make in India" campaign.
What is Contract Manufacturing?
In contract manufacturing, an entity agrees with a third party to perform some of its manufacturing-related activities for consideration. The contract contains all the terms of performance and responsibilities of both parties owing to the contract. The third party is required to execute the contract and provide the goods produced or services to the party entering the contract within the specified time frame.
Contract manufacturing has gained huge importance in today’s business world, where few companies can produce in-house goods with the burden of costs, time and resources required. Contact manufacturing helps get the work done through experts in that field, and the company can focus more on its core activities.
How does contract manufacturing work?
Upon entering into the contract, the hiring company provides a design or formula based on which the hired company has to complete the manufacturing process. This formula is a blueprint for the company's vision of its product. It stipulates the quality standards, the utility, the costs the company is willing to incur for the same, and the designs.
The contract manufacturing company has to study the specifications to develop a process that will not only adhere to the specifications but also generate a reasonable profit for the hired company from the contract. This can be done by minimizing costs, improving quality, reducing defects, and finding alternative means with desired results in terms of quality and costs. It completely depends on the hired company's strategy to perform the contract to optimize its business activity.
On the part of the hiring company, the costs involved in outsourcing the project or process are of utmost relevance because, ultimately, they will be considered in the valuation of the final product. An imbalance in the costs and benefits of outsourcing will trickle down to the product's pricing and defeat the purpose of contract manufacturing to the very core. To understand what risks and rewards are associated with contract manufacturing, it is vital to study the benefits and disadvantages of contract manufacturing.
Examples of Contract Manufacturing
Some contract manufacturing examples are as below.
- Pharmaceutical Industry: Drugs required to prepare medicines can be outsourced to other companies.
- Automobile Industry: Many automobile companies use parts produced by other companies and focus on assembling those parts to generate the final product.
- Food products: Important ingredients required in any food product can be outsourced.
- Petroleum products: Companies use the extraction of minerals from crude oil to generate other by-products.
- Computer manufacturing company: They use electronic components produced by other companies and assemble them into the end product.
Benefits of Contract Manufacturing
Contract manufacturing is like any other business decision a company takes. It requires strategic intent and vision to make the best decision in favour of the company. To understand the benefits of contract manufacturing, first, let us understand what can lead to the benefits of contract manufacturing.
Focus on core competencies
When a process is outsourced to a contract manufacturer, the company no longer has to invest in equipment and resources to cater to the needs of the process. It can simply reply to the contract manufacturer for that part and focus on its core competencies to get ahead in the market.
Contract manufacturers are usually experienced in their field and, after working for so long, can produce products with the utmost quality. But for this to come true, selecting a good contract manufacturer is important. The factors for selecting a contract manufacturer are discussed later in this article.
By subjecting contract manufacturing, costs can be reduced to a great extent because the company doesn’t need to invest in resources. Also, overheads are reduced, which leads to an increase in the company's Return on Investment (ROI). Reduced costs will also affect product pricing, thereby gaining an advantage in a competitive market.
Disadvantages of Contract Manufacturing
Risks associated with contract manufacturing begin right from when the company chooses the contract manufacturer. Hence, the company must make the right choice at every first step. Factors involved in choosing the right manufacturer are discussed further. First, let us discuss the risks involved in contract manufacturing to understand that step better.
Lack of control
One thing that is appreciable in in-house manufacturing is the control of the company on the manufacturing process. As and when the process continues, the company has hands-on information regarding the costs, inputs and outputs of the process and is at liberty to make any necessary changes to mitigate losses in the future.
However, once a company enters into a contract, it has no control over how the process is performed in contract manufacturing. Above that, it has to wait to hear from the contract manufacturing company about the costs and outputs from the process, which can be a time-consuming task. High dependency on the hired company to produce outputs is a risky factor to be considered before outsourcing.
Risks associated with Intellectual Property
In the initial stage, we discussed how a company must provide design and formula to the contract manufacturing company to execute the contract. Giving away a formula is not as easy as it seems. At the stage where the company decided to do contract manufacturing, it did high research on the product and process, which may have involved huge costs.
Depending on the market it works in, its product can be strategized as a differentiating or low-cost product. In both cases, the company has to do heavy research to develop a formula that will reap benefits for the company in the long run. This may involve patents and trademarks over the design. Giving away such patents to other companies can lead to their theft.
There are many unethical practices in the picture where the hired company sells the formula to a more profitable client leading to a contract breach. This will ultimately ruin your business strategy and lead to a heavy loss of money and reputation.
As discussed earlier, the contract manufacturer may choose means to reduce costs and increase profits. One way to achieve this objective is to compromise on the quality of the product and find alternative inputs at cheaper rates. An entity earns its brand through product and service quality, and any such step resorted to by the contract manufacturer may hamper the company's goodwill in the long run.
Employee turnover is high
Inhouse production requires tremendous resources. Outsourcing a particular activity can render such resources no more useful. The company may be required to lay off its employees associated with that activity. This will lead to huge employee turnover and dissatisfaction among workers and employees.
How to choose the right contract manufacturer?
A diligent screening is required to select the right contract manufacturer who can produce results worth the investment. Some key factors to be considered during such a screening process are below.
Look for a more experienced contract manufacturer and analyze the other clients they work for. This will give a fair idea of selecting the right one. A good market Reputation can help you take the first step toward selection.
The International Organization for Standardization (ISO) issues a certificate for the product considering multiple health, environmental, and economic concerns to permit quality standards of the product. While selecting a contract manufacturer, ensure that the goods produced by the company are ISO-certified. This will enhance the quality standards and increase reliance on such third-party contractors.
Quality must not be limited to the end product. Quality should be maintained in each process within the company of the contract manufacturer.
You may require hiring someone from a different country to execute the contract. The contract manufacturer must be conversant with your comfortable language and approachable for any information you require about the product. Communication must be excellent to ensure good relationships.
Adaptive to market changes
The contract manufacturer must be a proactive and dynamic business person. The company must keep its processes up to date with the technology, economic fluctuations, security controls, innovation, etc. Constant market research and knowledge about the current trends and customer requirements are essential to achieve this level.
A company must conduct good research on the costs involved in being outsourced to get a clear idea about cost-benefit analysis and quotation for the project. Reaching out to the best contract manufacturer available will take time to fulfil the company’s expectations. Still, consideration must be given when selecting a contract manufacturer to avoid the consequences.
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