Contract manufacturing guide
Contract manufacturing guide
Table of contents
This guide provides a brief introduction to some of the most important topics when considering outsourcing or planning to outsource part of your production to a contract manufacturer. It stands to reason, that the nature of many of the concrete considerations relevant to outsourcing (part of) your production to a contract manufacturer depends on your company and your product. However, we have tried to offer a brief guide to the use of contract manufacturers, that – although by no means an exhaustive inventory of all aspects of this broad topic – can hopefully serve as a good starting point for both startups and more established companies.
In contract manufacturing, one company (the hiring company) outsources part or all of its manufacturing operations to another company – the contract manufacturer (CM). The services provided by a CM can be limited to the actual production processes, but may include engineering, logistics and technical advice related to the design of the product being manufactured. Some CMs function as development and manufacturing houses integrating product development and manufacturing – these are sometimes referred to as Original Design Manufacturers (ODM). Contract manufacturers may also be referred to as original equipment manufacturers (OEM).
Potential benefits of using a contract manufacturer (CM)
Improving time to market
By leveraging the CMs existing production capacity and expertise you avoid spending time building production capacity in-house – ie. establishing facilities, buying equipment, finding and hiring staff with the required technical skills, developing a supply chain for your product capable of delivering raw materials and components that live up to your requirements, acquiring the certifications needed to manufacture your product for the markets you want to target, building an organiaztion and fusing all of these elements into a viable production setup.
Additionally, the CMs experience and technical expertise can be a valuable asset during product development allowing you to increase the value of your product, speed up your product development process, optimize your product for manufacturing and ensure a smoother transition from development to production. Some CMs will provide actual product development services in addition to technical consulting and manufacturing.
Ideally, the CM will be able to manufacture your product more cost-efficiently than you – in some instances this will be the primary reason why you are looking to outsource production in the first place. The lower cost may be due to lower labor costs (e.g. if the CM is in another country where wages are lower), more production experience, better facilities, overhead costs spread over larger production volumes and so on.
However, whereas the unit cost may be lower, there could be other additional costs related to shipping and freight charges, clearing customs, duties, taxes, quality control, defective products and so on. Thus, when assessing potential cost savings, it is important to factor in all costs related to using a CM.
Total Landed Cost (TLC)
The sum of all costs associated with making and delivering products to the point where they produce revenue.
Scalability and flexibility
For many companies, an important reason for using a CM is the ability to manufacture according to market demand while avoiding the cost of maintaining production capacity when it is not needed. However, there may be a correlation between the business you provide for the CM and the priority your product is given in relation to the CMs other customers. The volume, fluctuations and growth of the business you (expect to) provide the CM with is an important aspect of the partnership and should be discussed before entering into an agreement.
Additionally, different CMs will vary not only in their willingness, but also in their capacity to scale production according to your needs. Aspects of their business that influence this capacity include their financial strength, their human resources, their own suppy chain, their strategic priorities and the culture and capabilities of both management and owners. As in other cases, correctly evaluating these aspects of the CMs business and their impact on its ability to scale with your needs, will require a certain measure of due diligence.
Streamlining your organization
Working with a proficient and reliable CM can allow your organization to focus on other aspects of your business by relegating some of the tasks related to managing your production and parts suppliers to the CM which in many cases will have the setup and experience needed to manage these aspects of your value and supply chain more efficiently.
Of course, the initial stages of establishing cooperation with a CM are likely to require both time and attention; and generally speaking, both establishing, maintaining and developing the value of the partnership require care and attention – and sometimes more than planned or even hoped for.
Potential benefits: Chapter summary
- Improve time to market by leveraging CM’s existing production capacity, technical expertise and development capabilities.
- Lower your cost of sales and overhead costs by taking advantage of economies of scale, the efficiency and experience of the CM and lower labor costs depending on the CMs location.
- Improve your ability to scale production capacity faster according to market demand and the development of your business.
- Focus on core business by relegating part of your production and supply chain management to CM.
Potential drawbacks of using a contract manufacturer (CM)
Control, visibility, flexibility
Using a contract manufacturer to some extent also means removing yourself from the action. As noted above there are a lot of advantages to this, but there are instances where this is not necessarily beneficial. Of course, by working closely with the CM throughout the process, you should have a strong sense of “how things are going” and at many critical junctures you can and should be involved – but to some extent you will have to substitute trust for control. All other things being equal, as the complexity of the manufacturing outsourced increases, so does the value of (well-founded) trust. It is, however, a good idea to put some mechanisms in place to help you monitor the process, f.ex. by agreeing upon reporting requirements with the CM.
Language and culture
If you are using a CM in another country, it is vital to ensure that both you and the CM understand what is being communicated. Both language barriers and cultural differences can be the source of misunderstandings. Note that in a CM in another country, the person who is charged with communicating with clients in English might not be the one who is responsible for your product – in fact they might not have the technical expertise required to fully appreciate its finer details.
Intellectual property (IP) risks
Roughly speaking, the risks of unwillingly sharing your IP with an unscrupulous contract manufacturer, can be mitigated on three levels: On the relational, the legal and the operational level.
The relational level requires you to ascertain that you can trust the CM. This can be done through visiting their company – perhaps several times – seeing their facilities, workflows, getting to know the company culture and the people who will ultimately be safeguarding your intellectual property. Such trust should also be built on research of the CMs history, financial situation and customer references. Note that language barriers and cultural differences can make it very difficult to gauge the credibility of a CM.
The legal approach to risk mitigation can seem straightforward but it is important to understand that the legal system and the enforcement of your rights that it provides can vary greatly from country to country. Relying solely or primarily on legal protection of your IP requires robust legal expertise, experience and sound understanding of the local regulatory and legal environment.
Protecting your IP on an operational level can be done by distributing the knowledge of your IP to several suppliers or CMs. For example, by sourcing various components at different suppliers and only outsourcing final product assembly to a CM that is easier to perform due diligence on and ultimately to hold legally accountable.
Lack of quality control
Contract manufacturers may be unable to guarantee the same level of quality control that an in-house manufacturer can. This can lead to higher costs due to rework, scrap, and product recalls.
Most contract manufacturers will have some form of quality control system in place, but it may not be as robust as your own in-house system. Additionally, the contract manufacturer may not be as familiar with your product, which can lead to errors or mistakes, especially where product requirements are hard to quantify. For this reason, it is important to ensure that the contract manufacturer has the necessary quality control systems in place and that these are regularly monitored and updated. An ISO9001-certification, although not a guarantee of the CM’s competence and reliability in and of itself, can be an indication that some thought effort has been put into quality control considerations.
The contracting company can help ensure that the right mechanisms are put in place by having a detailed quality control plan that outlines exactly what is expected from the contract manufacturer in terms of quality control. This plan should include specific processes and procedures for monitoring and inspecting the materials and components used, as well as the end product. Additionally, the plan should include regular audits of the contract manufacturer to ensure that the quality control systems are being followed. Some contract manufacturers may have quality management capabilities that are on par or even better than those of even well-established contracting companies. It is important to research the contract manufacturer thoroughly to ensure that they have the necessary experience and capabilities to meet your quality requirements.
Longer lead times
Lead times can be a major issue with contract manufacturers. Depending on the complexity of your product and the capabilities and capacity of the contract manufacturer, lead times can some times be longer than what could be achieved with an in-house production setup.
When using a contract manufacturer in another country, lead times may be longer due to international shipping, customs clearance, and language barriers. Additionally, the quality control process may be more difficult to manage due to the distance. Longer lead times due to distance can to some extent be mitigated by a well-planned production schedule and stocking agreement, although such measures, of course, will not necessarily enable a timely response to sudden changes in demand.
Supply chain risks
Contract manufacturers often rely on third-party suppliers for components and materials. This can lead to delays or supply chain disruption if one of the CM’s suppliers is unable to meet demand.
Contract manufacturers may have limited resources and may not have the same level of expertise in supply chain management as the contracting company. Additionally, the contract manufacturer may not have the same level of access to the suppliers and materials as the contracting company does. Therefore, it is important to do thorough research and due diligence when selecting a contract manufacturer in order to ensure that their supplier base and supply chain capabilities live up to your requirements.
Contract manufacturers may increase prices without warning for a number of reasons, including increases in raw material or labor costs, or simply to increase their own profit margins. This can lead to unexpected costs and budget overruns, leaving companies with no choice but to pay the higher prices or find a new manufacturer.
In addition to cost increases, contract manufacturers may also be subject to hidden costs. This can include things like additional fees for storage, shipping, or other services, or even higher prices for rush orders or custom orders. These costs can add up quickly and can be difficult to anticipate or budget for. Furthermore, contract manufacturers may also require minimum order quantities, which can lead to additional costs if a company is unable to make use of all the products ordered. It goes without saying that prudent mechanisms governing potential price changes should be considered, negotiated and if possible form be included in your (contractual) agreement with the CM.
Contract manufacturers often require a long-term commitment in order to ensure a steady stream of business and to recoup their setup costs. This commitment is often in the form of a minimum order quantity, expected annual sales volume or a set period of time. This can be a problem if your needs change or if the contract manufacturer is not able to meet your expectations.
When entering into a contract with a CM, it is important to clearly define the terms of the contract, including any minimum order quantities, estimated annual usage (EAU) and the length of the commitment. It is also important to negotiate for more flexible terms that may allow for changes in order size or termination of the contract if necessary. Ensuring your ownership of tooling and a way to enforce it is an important part of safeguarding your ability to change suppliers.
Potential drawbacks: Chapter summary
- Control, visibility, and flexibility: Reduced control over production process, limited visibility into process and outcomes, reduced flexibility in changing production processes
- Language and culture: Potential language and cultural barriers that can lead to misunderstandings
- Intellectual property (IP) risks: Risk of IP being unwillingly shared with an unscrupulous contract manufacturer
- Lack of quality control: Contract manufacturer may not be able to guarantee same level of quality control as an in-house manufacturer
- Longer lead times: Lead times can be significantly longer than those for an in-house manufacturer
- Supply chain risks: Risk of supply chain disruption if a (sub-)supplier is unable to meet demand
- Cost increases: Unexpected costs and budget overruns due to cost increases and hidden costs
- Long-term commitment: Contract manufacturers often require a long-term commitment that can limit ability to switch suppliers
Clarifying your requirements
Product development requirements
When considering outsourcing (part of) your product development process to the contract
manufacturer it is a good idea to define what features, functionalities and other product properties are required and what criteria should be met in order for the product to be considered viable (the latter could include unit and/or tooling costs for the finished product). If part of the development process includes incorporating user feedback into the design, a minimum viable product (MVP) criteria should be defined and plans put in place for handling MVP production, how to incorporate user feedback into subsequent development iterations and how to coordinate cooperation between staff at your company and the CM. Clear expectations and robust planning can go a long way towards making your partnership successful, especially if you have limited experience with development outsourcing in general or this particular CM.
Unit and tooling costs
Whether you communicate a target cost to the CM candidates before receiving their quotation or not, it goes without saying that defining this for yourself, or at least having a clear understanding of both cost of sales drivers and business aspects influenced by it, is critical. The unit price quoted to you by a potential contract manufacturer can include elements such as the cost of materials, parts and components, labor, overhead, quality control and costs related to duty clearance, logistics and freight. The components factored into the price quoted to you will not always be shared with you unless you ask for it – and even then, the price structure you are presented with might not always be entirely accurate. Importantly, of course, from the perspective of your business, your target cost will be influenced or determined by the price you will be able to charge for your product and your required profit margin, but understanding the components of the production and delivery cost of your product will help you when negotiating with the CM. Tooling costs can vary from country to country and supplier to supplier. For expensive tooling it will be relevant to have an agreeement on how many product unit should be manufactured, before new tooling is needed.
The required production and delivery lead times for a potential contract manufacturer will vary depending on the specific product. Factors such as complexity, order volumes, components, production processes, supply chain management and of course the requirements from a market and sales perspective will all play a role in determining the appropriate lead times.
What kind of contract manufacturer do you need and does the CM fit the bill? What services and what production capacity do you need from the CM short, medium and long-term? Is the CM capable of delivering on these needs, at what pace and at what price? If they lack some of the capabilities needed, are you a sufficiently attractive customer for them to be willing to develop them as you grow your business? What does their current customer and product portfolio and track record bespeak of their suitability as a partner? These are some of the strategic questions that you should ask yourself and use to gauge the suitability of the CM in question. Generally speaking, it is a good idea to look at your business development and sales strategy at clarify what and how various characteristics and properties that a CM might possess will influence your strategy positively or negatively. This can then serve as a list of characteristics that you can use to systematically score the attractiveness of the CM candidates in terms of how they fit with your strategic priorities.
What do you expect from communication in terms of response time, transparency and efficacy? Some requirements can be quantified and included in contractual agreements. Other requirements, say, a consistently proactive and positive response to your queries, are harder to define, measure and enforce, but if you know what you are after, it will be easier for you to ask the right questions and it will help you gauge the ability (and willingness) of the CM to meet those requirements. As mentioned above, extra attention should be paid to this topic when dealing with a CM in another country or another culture.
To some extent, this aspect of your requirements overlaps with that of strategic suitability discussed above. When determining the type of relationship you want to establish with the CM, you should consider what is required in order to make your manufacturing (and/or development) of your product a success. For example, if you are looking for a manufacturer of an already designed product that is perhaps an off-the-shelf product with a few modifications that can easily be made, establishing the highest level of trust and coordination should necessarily be your highest priority. However, if the product is complex, requires significant engineering or development work or you know that this is just the first of many prodcts in your company’s journey and development, then the quality of your relationship with the CM should be considered critical to your success. This might also require you to be more transparent in your dealings with the CM (e.g. by sharing more information relevant to both your interest and theirs). In cases where the project is short–term, low–risk or non-critical (e.g. delivery of a simple product part that can easily and readily be purchased from other manufacturers) the quality of the relationship is less likely to impact the success of your product, but you should still ensure that the contract manufacturer understands the company’s intellectual property rights and is willing to protect them.
Be sure that you understand what certifications will be needed from your CM as well as your product in order to comply with regulatory requirements in the markets where you want to sell your product. Even where no regulatory requirements exist at present, these may develop in time, and sometimes there will be industry standards that, although not enforced by law, are so widely accepted that compliance with them are critical to success in the market. Be sure to have an understanding of these issues and the requirements in terms of needed certifications that they yield. These can include certifications specific to your product, the circumstances under which it is manufactured, the capabilities or behavior of the manufacturer, various broader product categories etc. required by regulatory bodies or other various types of institutions or organizations representing industries or markets in a given country or region.
Clarifying your requirements: Chapter summary
- Lead times
- Technical expertise
- Company size fit
- Product portfolio
- Scale-up potential
- Supply chain
Finding a contract manufacturer (CM)
Talk with people with manufacturing experience
Connecting with people who have experience in manufacturing can provide insight into the challenges and opportunities of the process. Gather advice and tips from experienced people, such as suppliers and industry professionals, to learn more about potential partners and the industry in general. There are a variety of sources available to help you find qualified partners, including professional organizations and industry networks, social media platforms, professional networking sites, trade shows and conferences, industry publications, online forums and discussion boards, local business associations, industry experts and consultants, word of mouth, and networking with peers in the industry.
Create a list of 5-10 potential partners
Research potential partners and create a list of 5-10 candidates that offer the services and capabilities that are needed for the project. Consider factors that are fairly easy to gauge such as cost, location, product and customer portfolio, key personnel CV, industry reputation and customer testimonials if they are available.
Narrow it down to about 3 partners
Narrowing down the list of potential partners involves researching and evaluating their services, capabilities, and cost. Online directories, such as those provided by the Association of Equipment Manufacturers, can provide a wealth of information about potential partners and their capabilities.
Additionally, you can consult with relevant people and associations to get referrals and recommendations. Reviews on third-party websites can also provide insight into the quality of service provided by a potential partner. Taking initial contact is important to understand the company, its employees, and its capabilities. This can include making phone calls and sending emails to potential partners to introduce the project and ask any questions that may arise. After evaluating the list of potential partners based on the criteria mentioned above, the list should be narrowed down to about 3 finalists.
Create a design packageCreate a design package: Compile all the necessary documents, such as product specs, drawings, and any other relevant information, into a design package. This should include documents that are necessary for the partner to understand the project and provide a quote, such as product specs, materials, and drawings. It should also include a non-disclosure agreement (NDA) to ensure the protection of any confidential information.
Visiting a potential contract manufacturer is an important step in a project, as it give you an opportunity to validate and qualify the information and assumptions you have formed the basis for you evaluation of your evaluation of the CM so far. It is also a crucial first step in understanding operations, environment and processes, forming relationships with the staff, and gain greater clarity on any outstanding questions. Additionally, it is a great opportunity to understand the factory culture, assess the level of quality control, and understand the production processes that will be used to manufacture your product.
Analyzing responses from potential partners involves taking the time to review their responses to your proposal and design package. This includes looking at the quality of the responses and the level of detail they have provided. It is also important to assess the level of enthusiasm they have for the project and the commitment they are willing to make to ensure the success of the project.
Additionally, it is important to review the terms of the agreement, such as timelines, costs, and quality standards. Finally, it is important to compare the responses to your proposal from multiple potential partners to make sure you are selecting the best partner for your project.
Negotiating with potential partners involves discussing the terms of the agreement and ensuring that both parties are in agreement about the scope of the project, timeline, costs, and quality standards. It is important to be open to compromise and to make sure that the agreement is mutually beneficial for both parties.
Additionally, it is important to be aware of the local laws, cultural norms, and expectations in the country you are working with, and to adjust your approach accordingly. Additionally, it is important to ensure that you understand the implications of what is being said and done, including any legal implications of the agreement, as well as any cultural nuances that need to be taken into account. Finally, it is important to make sure that all the details of the agreement are clearly outlined in writing, so there is a minimum of confusion or misunderstandings down the line.
Get customer references
Getting customer references from potential partners involves speaking with previous customers of the partner to get a first-hand account of their experience with them. This can provide valuable insight into the quality of their work and the level of service they provide. It is important to ask questions about the partner’s timeline, communication style, overall professionalism, and any other factors that may be important to the success of the project.
Additionally, it is important to look for any red flags that may indicate that the partner is not the best fit for your project. Finally, it is important to make sure that the references are from customers who have worked with the partner on similar projects.
Select a partner
Selecting a partner involves weighing all of the information gathered from the previous steps. This includes comparing the responses to your proposal from multiple potential partners, assessing the quality of their work, speaking with customer references, analyzing the terms of the agreement and ensuring that a potential partnership will live up to your requirements.
- Talk with people with manufacturing experience
- Create a list of 5-10 potential partners
- Narrow it down to about 3 partners
- Create a design package
- Analyze responses
- Get customer references
- Select a partner