Outsourcing in the Manufacturing Sector

Outsourcing provides an opportunity to achieve operational efficiencies and cost savings and can be attractive to businesses in any sector.  At the same time, relying on a third party to deliver business-critical functions raises many practical and legal issues, and the contract governing any outsourcing arrangement should always be carefully reviewed.    

Many businesses outsource central services such as payroll or IT but in the manufacturing sector, it is common to outsource core elements of the manufacturing process itself.   

A business that wants to manufacture a product without incurring the capital costs associated with ownership of the required plant and machinery may outsource some or all of the manufacturing process to a third party. This is commonly referred to as 'contract manufacturing'.  

This article considers the general principles of 'contract manufacturing', what distinguishes 'toll manufacturing' from 'contract manufacturing', and some of the key legal considerations that should be taken into account by the parties involved in arrangements of this nature.

The functions of a manufacturing business can include the following:

• Designing products.
• Sourcing the required raw materials or components.
• Processing those materials to create finished products.
• Supplying the finished products for onward distribution.

A manufacturing business can outsource any of the elements of this process (and, indeed, even a business that is not primarily a manufacturer may want to contract with a third party to carry out manufacturing functions on its behalf).

Contract manufacturing commonly applies to arrangements where a business contracts with a third party to provide an end-to-end manufacturing service for a specified product or component. The business providing the contract manufacturing service will generally take responsibility for sourcing raw materials or components, processing them and delivering the finished product or component to their customer or directly into the customer's distribution network.

Many different models exist within the broad headings outlined above – terms such as 'private label manufacturing' and 'white label manufacturing', for example, are used to distinguish between the scenario where the manufacturing service provider delivers a product which is finished but unbranded (ready for their customer to apply their branding before onward sale), and the scene where they deliver a finished and fully customer-branded product.

As ever, though, usage of terms such as these can vary from industry to industry, and it is always important to ensure that the contract's provisions are tailored to reflect the specific arrangements intended between the parties.

Key issues to bear in mind from the outset when considering such arrangements include:

• What elements of the manufacturing process will be outsourced?
• What will the customer retain responsibility for? – this would include the sourcing of the raw materials in a toll manufacturing arrangement but could also involve the licensing of branding or designs, recipes etc., providing equipment (or bearing the costs of specific tooling required), coordinating the delivery of the finished products into the distribution network etc.)
• How long will the arrangements continue in effect before they expire or can be terminated for convenience, and will the customer undertake any minimum purchase commitments?
• What commercial terms in respect of pricing (and changes to the pricing model during the term) will apply?
• How will the customer's requirements be communicated, and does the provider of manufacturing services commit to fulfilling orders placed by the customer (perhaps following the customer's forecasts)?
• What measures will be implemented to ensure quality control for the finished product?
• What other service-level commitments will the provider of manufacturing services undertake?

As with any commercial contract, suitable provisions regarding caps and exclusions of liability can be used to allocate risk between the parties.

Because of the various models, there is no 'one size fits all' approach, and we always recommend taking legal advice to ensure that the agreement's provisions reflect the parties' intentions.