Contract Manufacturing and Locking in Your Product Pricing

The key issues in nearly all the contract manufacturing agreements we draft (be they for China, Vietnam, Pakistan, Mexico, Thailand, Malaysia, Indonesia or wherever) are 1) price, 2) quantity and 3) delivery date. Yet many foreign buyers fail to address these critical issues as they are more focused on issues like intellectual property protection and control of molds. They assume the basic business issues will take care of themselves. This is a mistake.

Here is what often happens. The foreign buyer does not know whether a particular product will “take off” so it enters into a contract with its manufacturer that sets out the basic terms for purchase but does not mention any commitment on how much product it will purchase or when.

The buyer then makes small purchases of its product to determine whether there is a market for its product or not. The product then becomes a hit and the buyer returns to its manufacturer with a purchase order to buy substantial quantities of its product to be delivered just in time for the holiday season. The price and payment terms are the old terms set forth in the purchase order.  Based on that price, the buyer already has signed contracts with major retailers to provide its product in time for the holidays. The factory in will be excited to receive the big order? Right? No, wrong.

Here are some of the more common responses we have seen from factories that refuse to accept a purchase order:

  • We have to increase the price. Raw material costs have increased. Our production costs have increased. From those first small orders we discovered it is more difficult to make the product than we originally thought.
  • We don’t have the capacity to meet such a large order. Sorry.
  • To meet such a large order, we need to purchase materials, hire new employees, and expand our production line. To do all this, we will need you to pay a substantial deposit, much higher than the original deposit we required. We also need you to commit to a long term purchase agreement at terms favorable to us.

Since the factory is not required to accept the new PO, it (not you) is now in control. If the foreign buyer does not agree, the factory can simply walk away. The factory knows this.

This situation can be a real disaster for the foreign buyer. In fact, for every one company we’ve seen bankrupted by IP infringement we’ve seen three bankrupted by missing out on an entire holiday sales season because they could not obtain product at a price, quantity and delivery date needed to satisfy their market.

Some foreign buyers will enter into an agreement where their factory agrees to lock in the price for a specific period, believing this will protect them. But this does not work because the factory still has the right to reject purchase orders.

This is because as a legal matter, it is unreasonable to require a factory accept your purchase orders without exception. What if your purchase order contains provisions never to which your factory never agreed? There are an infinite number of possible conditions other than price. Quantity and delivery date are just the two most salient ones. Until you have an agreement with your factory on all relevant terms you have no “contract” requiring your factory fulfill your purchase order. If you submit your PO and your manufacturer accepts it, you have a contract: but only on the point of acceptance. Without your factory accepting your PO, you essentially have nothing.

Even on price, without an accepted purchase order or a binding commitment to purchase, no price lock from the factory is meaningful. The factory can always argue that a change in conditions requires an increased price. In many cases, this argument is legitimate. Since the argument may be legitimate, a court will not look deeper and the manufacturer will nearly always prevail.

Foreign buyers usually miss this fundamental issue: a PO is not a contract until it is accepted. Until the full set of terms has been agreed upon by the factory and the buyer, the factory will not be bound by a PO you submit to them. The factory is bound only by an accepted purchase order or a formal written contract that provides all the terms of the purchase transaction and for which the PO is just a formality. This is why our lawyers so vehemently discourage our clients from operating on strictly a purchase order basis.

Yet many foreign buyers are not in a position to make a hard commitment on product purchase quantities and many factories will not agree to lock in their pricing without this buyer commitment. What is to be done in that sort of situation? Very briefly, the below is what our international manufacturing lawyers have proposed and had work:

1. The factory agrees on a price lock period. This is rarely for more than a year.

2. The foreign buyer gives a one year quarterly estimate of its purchase amounts and delivery dates. The factory has a period of time in which to accept or reject this estimate. This right to accept is the critical issue. If the factory has a problem with the rolling estimate, the factory is required to respond. If there is no response, the estimate is accepted.

3. The foreign buyer submits its POs to the factory on a quarterly basis.

4. If the POs comply with the accepted rolling estimate and the price lock, the factory is required to accept.

5. We often provide that the foreign buyer has the right to increase its quarterly purchases by up to 100% or decrease those purchases by up to 50%. This adjustment sometimes still requires the final purchase amount be within the annual estimated amount, sometimes not.

6. We have never tried to run this kind of program beyond the price lock period. If a price adjustment mechanism is included, it could run for a longer period of course. However, the factory is not obligated to accept a PO unless and until a final agreement is reached, and that final agreement requires the factory accept the rolling estimate.

Some factories accept the above and some do not. For most factories, the big issue is the price lock. The factory states that the price it is offering is based on the quantity and delivery date and if those change, its prices will change.

The procedures for assuring your factory will accept your POs are complex, varied and variable. The key is that you as the buyer face the issue and decide how to proceed. If you do not do this, you likely will find yourself in a major jam right when your product is about to rocket to commercial success.