Was cc’ed on an email the other day from one of our international manufacturing lawyers to a client for whom we were drafting a China manufacturing contract. The email was sent in the middle of the drafting process and it sought to dig deeper to determine what exactly to write on various points — in particular, product testing, product pricing and duration of terms. I am providing that email (stripped of all identifiers) because it nicely shows why international manufacturing contracts can be so complicated and why template manufacturing agreements do not work. See International Manufacturing Template Documents.
We are nearing the finish line with the English version of your China manufacturing contract, but first we need to clarify a few more matters with you. Once we get your answers to the questions below, we will provide you with a draft of the English language version and start drafting the Chinese language version as well. Though the Chinese language version will be the only official version, it is still critical that we get all of the provisions done exactly right in English first. Towards that end, please answer the following remaining questions, by email if at all possible:
1. Product Testing
Where and how will you test your product?
a. Will you do you own independent testing in China or will you wait until you receive the product in Sweden?
b. Will you require the Chinese factory to test and then provide you with test results?
c. If you will do your own independent testing inChina it is important that we set out that testing procedure in writing.
I will draft the manufacturing agreement in a way to provide you with maximum flexibility to do your inspection testing at any stage in the process.
2. Product Set Up Costs
Your Chinese supplier’s quote asks you to pay in advance for some of the set up costs. Though this is normal, the statement of set up costs is not clear and it is important that we clarify those costs and then get them in writing in the contract. In particular,
a. Tooling cost appears to include the case, which I understood you had decided to have made by another manufacturer. We should therefore be sure not to include this.
b. Testing equipment. The price is not high, but you should be clear about exactly what will be included here and where they will be located. It is probably not practical to provide what will happen to these items upon termination of the agreement, but we should discuss this. We need to get clear on these matters as you work to a final pricing quote.
3. Product Pricing
What you sent us indicates that your Chinese manufacturer will be permitted to change your product pricing based on changes in material costs. This essentially means you do not have a fixed price from them. You should try to confirm what it means to have a one-year, 500,000 units fixed price. Of course, it is not reasonable to make ________ [Chinese manufacturer] responsible for the price charged by your approved suppliers for the cables, packaging and any other items provided by these suppliers. In addition, _________ [Chinese manufacturer] likely will not be willing to be responsible for price changes due solely to changes in the price of key components.
The normal way pricing is done for this kind of item in China is as follows:
a. The product price is fixed for a set period, say one year. The Chinese manufacturer takes the price risk during this time, both for changes in component prices and for RMB/USD exchange rate risk.
b. It is easiest if the manufacturer builds in the cost of items from the approved suppliers and takes the risk of price changes. Often a manufacturer will calculate that amount at cost+ to cover the risk and to cover the costs of advance purchasing and warehousing.
If your manufacturer is not willing to do the above, the quoted product price from them is not really a fixed price and it can change over time. The risk in this situation depends on the integrity and reputation of the manufacturer. Some Chinese manufacturers will double or triple their prices after production has started and after you are trapped into using them as your manufacturer. On the other hand, reputable manufacturers typically will only raise their prices when there has actually been a material change in component prices.
This is all quite complex and a careful negotiation of terms can take weeks of negotiation and many pages of documentation. This does not make sense for your particular situation. You therefore have a several options :
a. Just accept their [Chinese manufacturer’s] quote, assuming that they will be reasonable and if they are not reasonable you can simply terminate the contract
b. Require that the price be broken out: Your Chinese manufacturer’s portion of the product will be for one year, but the prices for the components/parts from your approved suppliers will be added to the invoice at cost or cost+.
c. Same as b., but your Chinese manufacturer is permitted to increase the product price, but only after providing you documentation that justifies the price increase and only if its costs increase more than ten percent. You will have the right to terminate the agreement without liability of any kind.
Option c. is common in much of the world, but often rejected by Chinese manufacturers.
We will need to decide how to proceed regarding product pricing and then include our plan in the pricing exhibit to the Manufacturing Agreement.
4. Product Packaging Costs
I have not seen anything in writing relating to packaging. It should be made clear who has responsibility for packaging design, production, and payment. It should also be made clear how packaging costs will be included in the final cost of the product. We have had instances where companies (not previously our clients) who have come to us right after learning that their product cost did not include its packaging. It is important we get these costs clear and in writing.
5. Manufacturing Contract Duration
What will be the term of this agreement? Your purchases are fixed for 500,000 units for one year. We can leave it at that: a one year agreement, with the option to renew if both parties agree. Please advise if this approach is acceptable for you.
As we discussed, the really critical terms in an agreement like this are: price, payment, quantity, delivery, and quality assurance. In a project like this, where components are coming from many sources and where your Chinese factory will be loading software it did not develop, a lot can go wrong. You are engaging this manufacturer to manage this complex process. Focusing on management and fulfillment issues is the critical thing for you at the start up stage of your business.
For more on what it takes to draft an effective China/International Manufacturing Contract, check out the following: