Contract Manufacturing: Meaning, Advantages, and Disadvantages
What is Contract Manufacturing?
Contract manufacturing is a kind of international business in which a company gets into an agreement with one or more local manufacturers in foreign countries to produce particular components or commodities to its specifications. It is commonly known as outsourcing.
It can be divided into three categories:
- Production of specific components, such as automobile components or shoe uppers to be used later in the production of finished goods, such as automobiles and shoes.
- Assembly of components into final products, such as hard disc, motherboard, floppy disc drive, and modem chip are assembled into computers.
- Complete production of products, such as garments.
Foreign companies provide technological and managerial guidelines to the local manufacturers to produce and assemble the goods. The goods manufactured on contract manufacturing are either used as final products or sold as finished products by international firms under their brand names in various countries including home, host and other countries. Nike, Reebok, Levis, etc., use contract manufacturing to get their products.
Advantages of Contract Manufacturing
Contract manufacturing provides various benefits to both multinational companies and local manufacturers in foreign countries.
- Less Investment: With the help of Contract Manufacturing, international firms are able to produce their goods on a large scale without requiring investment in setting up production facilities.
- Less Risk: Because there is minimal investment required, it is less risky. Furthermore, local producers that have been assigned particular product design and quality standards comply with them. Also, there is no or little investment in other countries, and there is limited investment risk in foreign countries.
- Lower Costs: Contract Manufacturing helps international businesses in getting their product manufactured or assembled at lower costs, especially when the local producers are situated in countries which have lower material and labour costs.
- Better Utilisation of Resources: Local producers in foreign countries are benefitted from contract manufacturing. Manufacturing jobs obtained on a contract basis provide a ready market for their products and ensure greater utilisation of their production capacities if firms have any idle production capacities. For example, Godrej group- it manufactures soaps for many multinationals including Dettol Soap for Reckitt and Colman. In this way, it is making use of its excess soap manufacturing capacity.
- Opportunities for Local manufacturers: The local manufacturer also has the option to get engaged in international business and avail incentives if any available to export enterprises if the international firm wants the goods produced to be sent to its home country or to other foreign countries.
Disadvantages of Contract Manufacturing
The disadvantages of Contract Manufacturing are as follows:
- Issue in adhering to production design and quality standards: Local firms may fail to follow production design and quality standards, creating serious product quality issues for foreign enterprises.
- Loss of control: As goods are manufactured exactly according to the terms and standards of the contract, the local manufacturer in the foreign nation loses control over the manufacturing process.
- No Authority to sell products: The local enterprises engaged in contract manufacturing are not allowed to sell the contractual output as per their will. They must sell the goods to the multinational corporation at fixed rates. If the open market prices for such commodities are greater than the prices agreed upon in the contract, it results in lower profits.