What Is Contract Manufacturing?

The Pros and Cons for Small Business

Workers using laptop in textile factory

Erik Isakson / Getty Images

Contract manufacturing occurs when a small business hires another company to produce its products. It enables small businesspeople to begin selling their products without obtaining the large amount of capital necessary to build and run a factory.

Learn more about contract manufacturing and its advantages and disadvantages for small businesses.

What Is Contract Manufacturing?

With the popularity of shows like Shark Tank and online marketplaces such as Amazon and eBay, an entrepreneur can dream up just about anything, have it manufactured relatively easily, and start selling it to the masses, thanks to contract manufacturers. These companies agree to make a certain number of a product according to the specifications given to them by the hiring company.

A contract manufacturer may be located in the U.S. or overseas. The hiring company should seek out a contract manufacturer that has expertise in the type of product the company wants to make. That expertise could take the form of more than just the manufacturing itself; the company may be able to offer help with chemical or engineering processes or packaging.

Here are some other things to look for in a contract manufacturer:

  • Highly reputable in the marketplace
  • Financially sound
  • A clean, well-managed facility
  • ISO-certified manufacturing quality standards
  • Dropshipping capabilities to send the product directly to customers if that's something the business needs
  • The ability to keep up with production demand for a product

Alternate names: Outsource manufacturing, outsourcing

How Does Contract Manufacturing Work?

The hiring company usually provides a design or formula to the contract manufacturer to replicate or improve upon. The hiring company typically focuses on the marketing and selling of the products.

For example, a small business might want to sell specialty cleaning products using a formula the owner developed. The small businessperson could hire a contract manufacturer to make and package the cleaners according to their specifications. The business would then be freed up to concentrate on finding customers for its products and handling sales from a central warehouse.

If the manufacturer is able to act as the drop shipper—keeping a supply of the products on hand at a warehouse and sending out orders at the business's direction—the business would basically be a marketer of the products it developed. Alternatively, the manufacturer may be able to ship products only within a specified geographic area.

Advantages of Contract Manufacturing

Businesses choose contract manufacturing for a few primary reasons, all of which make it easier and less expensive to bring new products to the market and distribute them broadly.

The biggest cost benefit of using contract manufacturing is from not having to build a production facility and staff it with workers and managers. Aside from that obvious benefit, companies may save money by hiring a manufacturer based in a low-wage country. The location of the manufacturing plant might also offer savings in energy, overhead, and raw material costs as well as tax savings.

Contract manufacturing frees up people at the hiring firm to stay focused on their core strengths of marketing and, possibly, sales. If the owner has a background in those areas, they may be able to hire fewer people to assist them.

The company may be able to easily introduce its products into the country in which they're made. It could also gain entry to the markets of neighboring countries.

Disadvantages of Contract Manufacturing

Perhaps the biggest disadvantage of contract manufacturing is a lack of direct control over the quality of the final product. The hiring company can't manage what goes on day to day, and it might not get exactly what it wants on a consistent basis.

A business that hires a contract manufacturer should keep in mind that it won't be the only customer and may not be as important to the manufacturer as other, larger clients.

The hiring company also runs the risk of having its ideas appropriated. Some unethical contract manufacturers have been known to give away product ideas from one client to another favored client or to produce its own similar product with only a slight tweak or two. Business owners should hire an attorney to get a strong legal contract that will protect against any such behavior.

When dealing with an overseas manufacturer, business owners should take care to identify which country's legal system the contract is governed by.

Cultural and language differences may also be a consideration if a business is working with a manufacturer in another country. In addition, potential political and economic risks should be weighed when choosing a manufacturer.

Key Takeaways

  • Contract manufacturing is the practice of hiring another company, perhaps outside the U.S., to produce a business's products.
  • It enables small businesspeople to sell their own products without building and running a factory.
  • The hiring company typically provides a design or formula for the contract manufacturer to replicate or improve upon.
  • The hiring company typically focuses on the marketing and selling of the products.