Many companies in different industries don’t handle every aspect of the manufacturing process to produce goods.

Enter contract manufacturing, where a business hires a third-party manufacturer to create its products.

This frees up time for companies to focus on what they do best – designing, branding, or innovating – while specialized manufacturers cover the production.

So, what are the biggest advantages and drawbacks of contract manufacturing, and which industries can benefit the most from this business model?

Read on to discover how contract manufacturing works, the different types, and the key benefits and risks.

What is contract manufacturing?

In contract manufacturing (CM), the hiring company outsources some or all of its production to a third-party manufacturer.

“Contract manufacturing is outsourcing production to a third party,” Deepak Shukla, CEO of Pearl Lemon, says. “CM allows businesses to focus on their core strengths – be it design, branding, or R&D – while leveraging the expertise of specialized manufacturers.”

The products are still sold under the hiring company’s branding and label.

How does contract manufacturing work?

Think of contract manufacturing, sometimes called private label manufacturing, as working with subcontractors.

The company or general contractor has the concept or vision for the product and enlists another company to produce the product.

Contract manufacturing is common in industries involving supply chain management, such as:

• Industrial manufacturing
• Medical devices
• Consumer goods
• Automotive

CM is a rapidly growing industry. According to Fortune Business Insights¹, the global contract manufacturing organizations (CMO) market size was valued at $145.32 billion in 2023 and is projected to grow to 289.68 billion by 2032.

Contract manufacturing example

To understand how contract manufacturing works, here’s an example from a real-life company, Whitakers Chocolates.

“At Whitakers Chocolates, we work with clients to develop and manufacture bespoke chocolate products to their specifications, allowing them to bring high-quality chocolates to market without the need for an in-house production facility,” Marketing Director Gemma Whitaker shares. “This could range from creating white-label products to specific branded chocolates that align with the client’s vision and needs. “We have worked with various clients, from premium brands to smaller businesses, to produce custom chocolate products that align with their brand and customer expectations.”

What is a contract manufacturing agreement?

A contract manufacturing agreement is a legal document between you and the contract manufacturer that specifies the terms and conditions of the working relationship.

This manufacturing contract must include details such as:

• Services provided
• Product quantity
• Liability and ownership rights
• Production fees
• Schedules/deadlines

Let’s look at some of the benefits of contract manufacturing and why it has become such a widely adopted strategy.

You can find examples of contract manufacturing agreements online or use contract management software like PandaDoc to create, collaborate, manage, and eSign contracts.

PandaDoc also offers 1,000+ business document templates to help you save time creating important documents.

Advantages of contract manufacturing

Like any business strategy, contract manufacturing comes with advantages and disadvantages.

“The advantages are clear: reduced overhead, quicker time-to-market, and access to advanced production technologies without hefty investments,” Deepak says. “However, it comes with its own set of challenges, like potential quality control issues and dependency on your manufacturer’s reliability.”

Let’s explore the pros and cons to help you determine if contract manufacturing is the best fit for your business.

Cost reduction and time savings

Contract manufacturing helps organizations save money on overhead, and labor costs when products are partially or fully produced elsewhere.

You still have to supply the raw materials but you don’t need to build an expensive factory or buy machinery or equipment.

In fact, according to data from 2015², organizations can achieve an average 15% cost reduction through outsourcing.

Contract manufacturing is a cost-effective solution for smaller businesses or startups.

Smaller organizations can use CM to level the playing field and produce products without building a manufacturing facility.

Scalability

If you want to scale your company, increase output, or expand your product offering, contract manufacturing may be the way to go.

CM can help to increase production without the need to invest in additional equipment or machinery. Outsourcing can help you produce more products at a lower cost.

“Outsourcing production allows a company to reduce overhead costs associated with facilities, labor, and equipment,” David Romano, CEO of Prime Digital Solutions Inc., says. “Besides that, it also enables them to scale up or scale down the level of their production depending on demand, without bearing the financial load of large manufacturing facilities.”

Faster time to market

Since a company outsources production to an established manufacturer with the right equipment, employees, and know-how, they can reduce production time and bring products to market faster.

“By outsourcing production, companies can save on overhead costs associated with maintaining their own production facility,” Balázs Keszthelyi, Founder & CEO, TechnoLynx says. “Additionally, contract manufacturers often have established supply chains and access to advanced technologies, which can enhance product quality and reduce time to market.”

Product quality and expertise

Contract manufacturers generally work for different companies in a particular niche or industry, so they have the skill and expertise to create high-quality products.

This lets you focus on the vision while the contract manufacturers focus on the execution.

Disadvantages of contract manufacturing

So what are the downsides, and do they outweigh the benefits? Let’s explore.

Less quality control

Relinquishing part of your production process means sacrificing some amount of control. Someone else is making your product so you don’t have complete control over how it’s made.

This makes your contract manufacturing agreement even more important and you must include stipulations about quality standards.

Potential delays

While outsourcing initially saves you time, you could also experience production delays if your manufacturer experiences a shortage of materials, worker strikes, or other issues with employees.

Intellectual property risks

Sharing your prototype and plans can increase the risk of someone taking your ideas.

Again, this is something you must bake into your contract manufacturing agreement, which is why it’s important to work with reputable manufacturers.

Contract manufacturing benefits vs. risks

Benefits	Risks
Cost reduction (saves on overhead, labor, and production facilities)	Quality control issues (loss of control over production standards)
Scalability (increased production capacity without large investments)	Potential delays (dependence on third-party production schedules)
Faster time-to-market (leveraging third-party expertise and equipment)	Intellectual property risks (sharing sensitive product information)
Product quality (access to specialized manufacturing expertise)	Dependency on manufacturer’s reliability (risk ifthe manufacturer fails)

Types of contract manufacturing

Contract manufacturing doesn’t have to be an all-or-none arrangement. Different types of contract manufacturing can benefit different business sizes and models.

Private label manufacturing

In this arrangement, the company is outsourcing the entire production process to a third party.

The finished product is sold under your company’s name and label. You didn’t make it, but you’re able to sell it as your own product.

Individual component manufacturing

Component manufacturing means a contractor is responsible for producing one component of your product.

Take a car brand, for example.

They enlist another company to produce specific parts of the car, like the tires or batteries. The contract manufacturers create these components, and then the car company assembles them to produce the final product.

In individual component manufacturing, you could produce some parts of the product in-house or use multiple contractors to create different parts.

Component contract manufacturing is common in industries such as electronics, automotive, aerospace, consumer goods, and pharmaceuticals.

Labor or service contract manufacturing

In labor or service contract manufacturing, you’re outsourcing the labor or service to create your product.

Companies may choose this route if they don’t have enough employees, need highly skilled manufacturers, or don’t have the right equipment to manufacture their products in-house.

Some industries that use labor contract manufacturing include food production, consumer goods, and automotive.

Electronic contract manufacturing

Electronic contract manufacturing (ECM) is a type of CM that’s specific to the electronics industry. A company hires another company to produce electronic products or the parts for them.

While the concepts are the same, electronic contract manufacturers need specialized skills to create products like circuit boards, smartphones, computers, and more.

Medical contract manufacturing

Much like ECM, medical contract manufacturing is specific to the production of medical devices and equipment. A company outsources the manufacturing process to another company.

Medical contract manufacturers must have specialized knowledge, equipment, and certifications as medical products are subject to FDA regulations.

What is OEM vs. contract manufacturing?

OEM stands for original equipment manufacturing. In this arrangement, a company designs its own product but contracts another company with the required tooling and equipment to manufacture it.

Key differences between OEM and contract manufacturing:

• OEM: The company develops and designs the product but doesn’t make it
• Contract manufacturing: A third party is hired to make the product based on the design or instructions

A common example of OEM is computer software that’s sold to another manufacturer for its products.

Think of an operating system like Windows being pre-installed on a new computer. Microsoft sells the software to computer manufacturers like Dell and HP to install.

How risky is contract manufacturing?

As we discussed earlier, there are some risks associated with contract manufacturing. The biggest one is the risk of intellectual property theft.

To reduce the risk, find the right contract manufacturer that offers intellectual property (IP) protections. Always ask which types of IP protections a business offers and ensure you include language around IP in your written agreement.

With contract management software like PandaDoc, you can ensure accuracy by automating contract terms, adding dynamic rules to populate specific content based on industry or country, and securely collecting legally binding e-Signatures.

What is an example of a contract manufacturer?

Where can you find examples of contract manufacturing in the wild? One well-known company that uses contract manufacturing is Apple.

Apple works with Foxconn³ to produce products like iPhones, iPads, and the Apple Watch. Apple provides the product designs, and Foxconn creates the products to sell under the Apple label.

Contract manufacturing made easy with PandaDoc

Contract manufacturing offers a number of benefits to businesses of all sizes, including cost savings, scalability, and faster time to market.

But to ensure the relationship runs smoothly and avoid potential pitfalls, it all starts with a sound contract manufacturing agreement.

Discover how you can use PandaDoc to easily create fast, accurate contracts. Contact us to schedule your free, personalized demo.

Disclaimer

PandaDoc is not a law firm, or a substitute for an attorney or law firm. This page is not intended to and does not provide legal advice. Should you have legal questions on the validity of e-signatures or digital signatures and the enforceability thereof, please consult with an attorney or law firm. Use of PandaDoc services are governed by our Terms of Use and Privacy Policy.

Originally published August 20, 2024, updated November 12, 2024