What Are Contract Manufacturing and Toll Manufacturing?
Contract manufacturing and toll manufacturing are ways of doing business for many companies, large and small. What are they exactly and how do they differ?
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What is Contract Manufacturing?
Contract manufacturing is the process of outsourcing production to a subcontractor. It is often used in order to reduce expenses for manufacturing equipment and production worker salaries, to respond to spikes in demand, or enter into new markets.
There are many paths to manufacturing success. Some companies start from scratch and produce their products in-house from day one.
Others produce some aspects of their goods while buying partially processed materials or sub-assemblies from others.
And there are some who manufacture their entire product lines using another company’s facilities either as a transition to in-house production or as an element of their core business model.
In the case of the latter, those who manufacture their products through other entities are doing so using contract manufacturing.
In contract manufacturing, a company will initiate a contract between themselves and a manufacturer to produce a certain number of products for the parent company for a period.
Also called private manufacturing or white label manufacturing, you can see this type of arrangement in many industries.
One example is in food production where name-brand food labels produce their own product line while using the same equipment and often the same raw materials to leverage excess capacity to produce private-label foodstuffs for local grocery chains, which often sell the in-store and name-brand on shelves side by side.
Why Companies Use Contract Manufacturing
There are many reasons companies use contract manufacturing.
As manufacturing is usually a capital-intensive endeavor, contract manufacturing allows companies to focus on product design, marketing, sales, and development while rendering the manufacturing costs to a less variable, semi-fixed cost that is easier to manage.
Without the financial requirements of capital equipment purchases, companies can focus on core competencies and grow their product lines.
Contract Manufacturing may also be used as a partial or total bridge to transition to in-house manufacturing.
Again depending on the cost of capital, a company with an innovative product and an expanding market may choose to produce some of its products or subassemblies at a contract manufacturer to shore up production until capital equipment can be purchased and commissioned in-house.
This allows for incremental expansion without a high level of debt as the parent company can afford a “pay-as-you-go” concept to bringing production in-house.
Finally, contract manufacturing can be useful for companies experiencing highly cyclical, seasonal production where the additional investment in equipment is not desirable but extra production in support of existing product lines is needed for the season.
This gives the parent company the flexibility to scale back to its in-house production mode once the season has passed and it allows them to control cost, raw materials inventory, and other related operations and holding costs on a less variable basis.
Contract Manufacturing Risks
Contract manufacturing does, however, carry risks.
Some of the risks to be aware of when manufacturing through an outsourced, third-party manufacturer include:
- Geographic Considerations – Some third-party manufacturers may be limited by their country’s laws from shipping to certain destinations, leaving the parent company without a channel for their goods.
- Limited Logistics – Many contract manufacturers are bulk manufacturers and do not perform well or at all in fulfillment. In this case, the parent company may realize cost savings on the production of goods but will have to manage the shipping, logistics, and distribution costs separately.
- Quality Control – Regardless of whether the goods produced by the contract supplier are process-manufactured goods or discrete-manufactured goods, the parent company will have less ability to manage, control, and ensure quality from the third-party manufacturer compared to in-house controls.
- Intellectual Property – For highly patented or extremely technical goods, the use of a third-party manufacturer can lead to the leak of proprietary information being given to competitors who will produce a similar product at lower costs.
What is Toll Manufacturing?
While quite similar to contract manufacturing, toll manufacturing is different in a specific way.
In contract manufacturing, the third-party manufacturer is responsible for the entire production cycle of finished goods.
This includes the procurement of raw materials and all production phases from beginning to end.
In toll manufacturing, the parent company provides the materials and design while the third-party company processes raw materials or semi-finished goods.
In toll manufacturing, the parent company has greater control over the third-party producer because it is supplying and managing raw materials flow. Some notable examples of toll manufacturing include:
- Apple/Foxconn – While everyone knows who Apple is, many may not recognize Foxconn. Foxconn is the manufacturer to whom Apple sends its materials such as electronic components, housings, charges, glass for screens, and LEDs for the production of its computers and phones.
- Microsoft/Flextronics – Like Apple, Microsoft partners with Flextronics to produce its finished products, the components of which are supplied by Microsoft.
- Boutique and Small Footprint Wineries – Toll manufacturing isn’t just used by highly scaled companies such as Apple and Microsoft. Many small and boutique wineries across the world use mobile manufacturing bottling lines to bottle and label their wine at the end of its aging. This allows the winery, not unlike Apple, to maintain control of its product and quality without having to invest in expensive manufacturing operations that may only be used part of the time.
Toll Manufacturing allows companies a higher degree of control than contract manufacturing and mitigates the quality control risks mentioned in contract manufacturing.
It also allows them to manage logistics and fulfillment better and allows them more control over proprietary aspects of their business.
Contract Manufacturing with ERP/MRP
Contract and toll manufacturing may be conducted by third-party manufacturers.
But these production modes still lend themselves to the benefits of a robust manufacturing ERP system.
This is true whether the user of the software is the parent company or the third-party manufacturer.
In both cases, the utility of an MRP system comes down to its bill of materials (BOM) implementation.
With the BOM tied to routings, inventory use, and output of finished goods, a parent company can monitor and maintain visibility over some or all the goods it manufacturers through third parties.
This allows a quicker response when and if issues arise.
For third-party manufacturers, the use of flexible, agile manufacturing software means that they can take on finished goods manufacturing from a variety of parent companies and manage the flow through production with accurate BOMs, fully costed material, controllable labor centers, and flexible production lines.
These software platforms offer third-party manufacturers capabilities such as multi-level BOMs, EDI transmissions, production tracking, shop floor mobility, engineering change order management, revision and versioning controls, expiry and lot control, and many other features.
Although contract manufacturing and toll manufacturing are very similar modes of production, they are not interchangeable terms.
In contract manufacturing, a business uses another company’s production facilities from procurement to the emission of the finished goods.
In toll manufacturing, the parent company supplies the manufacturer with raw materials and design, retaining a degree of control over the production process.
In both cases, and for both parties, using an MRP software would make the partnership more transparent while improving many manufacturing processes.
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