1. Contract Manufacturing’s Three Key Issues: Price, Quantity, and Delivery Date
The three key issues in nearly all contract manufacturing agreements — be they for China, Vietnam, Pakistan, Mexico, Thailand, Malaysia, Indonesia or wherever — are 1) price, 2) quantity and 3) delivery date. Yet many product buyers that have their products manufactured overseas focus so much on issues like intellectual property protection and control of molds, that they neglect these three key issues. 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 overseas manufacturer that sets out the basic terms for purchasing the product but fails to set forth any commitment on how much product it will purchase or when.
The buyer then makes small purchases of its product to determine whether the market for its product. The product then becomes a big hit and the buyer returns to its manufacturer with a purchase order to buy large 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 original purchase order (or two). Based on that price, the buyer already has signed contracts with major retailers to provide its product in time for the holiday, expecting its overseas factory will be excited to receive the big order.
This though is often not the case.
2. Is Your Overseas Manufacturer Legally Required to Accept Your Purchase Order?
Since the overseas factory is under no legal requirement to accept the new purchase order for the large order, it is now in control. Your foreign factory can simply refuse to sell you your products at anything but a newly inflated price and it knows this.
Here are some of the more common responses our international manufacturing lawyers see from factories that refuse to accept the new purchase order for the large order:
- We have to increase the price. Raw material costs have increased. Our production costs have increased. From those first small orders we have learned 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 need you to pay a substantial deposit, much higher than the original deposit we previously required, and we will need to increase our prices. We also need you to commit to a long term purchase agreement at terms favorable to us.
The above situations can be a real disaster for you as the product 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 they 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 legal right to reject purchase orders.
This is because as a legal matter, it is unreasonable to require a factory to accept your purchase orders without any exceptions. What if your purchase order contains provisions 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 your “contract” does not require your factory fulfill your purchase order. If your manufacturer accepts your purchase order, 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 may be legitimate and most courts will not look deeper and the manufacturer will nearly always prevail.
3. How to Lock in Product Prices with Overseas Manufacturers
Until the full set of terms has been agreed upon by the buyer and its factory, the factory will not be legally required to fulfill a purchase order and you have no lock on your product prices. Your 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 purchase order is just a formality. This is just one of the many reasons why our international manufacturing lawyers discourage our clients from buying their products strictly on a purchase order basis.
With all that has been happening with the global supply chain, our law firm has seen about a ten-fold increase in companies seeking legal assistance to “force” their supplier to provide them with desperately needed product. Unfortunately, in most instances, these companies coming to us do not have a legal leg to stand on.
So obviously a good manufacturing contract or supply agreement is necessary with your overseas factory to prevent the sort of problems set out above.
4. How to Lock in Product Prices with Overseas Manufacturers WITHOUT Making Massive Product Buying Commitments
Many foreign product buyers are either unable or simply do not want to make firm commitments on product purchase quantities, and few factories are willing to lock in product prices without this buyer commitment. In this sort of situation the below is what our international manufacturing lawyers have proposed and had work:
1. The overseas factory agrees on a price lock period, typically for a year or less.
2. The foreign buyer gives a one year quarterly estimate of its purchase amounts and delivery dates. The overseas factory has a period of time to accept or reject this estimate. 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 purchase orders to its foreign factory on a quarterly basis.
4. If the purchase orders comply with the accepted rolling estimate and the price lock, the overseas factory is required to accept.
5. We often provide that the foreign buyer has the right to increase its quarterly purchases by up to some specific percentage or decrease those purchases by up to some specific percentage. This adjustment sometimes requires the final purchase amount be within the product buyer’s annual estimated amount, usually depending on what we can get the overseas manufacturer to agree.
Most overseas factories accept terms like those set out above. Generally, we have found that Thai, Indian, Pakistani and Mexican factories re the most likely to accept these sort of terms, followed by Vietnamese and Taiwanese factories. Chinese factories — especially in the last couple of years — have become increasingly less likely to accept such terms. But even with them, our record is above 50 percent.
Bottom Line: The key is that you as the product buyer should be aware of the above issues and make conscious decisions in light of that awareness. If you do not do this, you likely will find yourself without access to your product just when it is about to rocket to commercial success.
