Contract manufacturing is fundamentally a purchase of a product. For any product purchase, the key terms are price, quantity and delivery date. In drafting contract manufacturing agreements for China, we find that many buyers treat these key term as secondary issues. As buyers focus on exciting issues like product design and “getting to market”, buyers frequently fall into a trap. They assume that price, quantity and delivery terms will never be an issue. When the issues arise, as they always do, the buyer is in a situation where it has no room to negotiate. The factory is now in control. Then the price trap is sprung.
Here is typical example of how the price trap plays out. U.S. start up works with a Chinese factory for design and manufacture of a new consumer product. The parties agree on a price for an initial order. The start-up does not know whether or not the product will be successful. For that reason, the start-up is not able to submit a long term order for the product. The contract manufacturing agreement applies only if a future order is placed. The key is that start-up is not obligated to make any future order.
After receipt of the first run of product, the start-up works on marketing. The product is successful and the start-up returns to the factory just before the holiday season. The start-up places an order for a large quantity at the earlier price. Then the trap is sprung. The most common explanations from the factory are:
a. We set the initial price before we did a full production run. Now that we have done a full run, we find that we must increase the price by 30% in order to be profitable.
b. We have taken a number of orders from other customers recently and we simply do not have the capacity to make your product. Come back to us in February and we can discuss.
c. Recent increases in costs mean that we have to increase the price to cover those costs. Normally, no explanation is given for what costs have increased and how those costs impact price.
The trap has been sprung. The start up needs the product. The marketing budget has been spent. Binding agreements with powerful big box retailers have been signed. The e-commerce platform is filled with orders. The start up now has no basis for negotiation with the factory. The power is all in the hand of the factory, and the factory can dictate the terms. This news is a terrible blow to any start up, with the bad news coming right at the time that success is at hand.
What went wrong? What can be done?
Ultimately, what went wrong is that the start up believed in two myths about China manufacturing. The first myth is that the “China price” will always be available. The product will always be offered at the lowest possible price, so there is no reason to lock down price for the long term. The second myth is that Chinese factories have infinite capacity. The view is that factories are hungry for orders and that any factory will accept any order to produce any amount of product at any time.
Neither of these myths reflects current reality in China. The China price went away a decade ago. Chinese factories area under constant price pressure. They are faced with rising costs in every area of their manufacturing process. They are also faced with unpredictable cost increases: sudden change in material price, currency fluctuation, increases in VAT and foreign tariffs. Factories are also faced with many new risks: pandemic, labor shortage, customs blocks, trade war.
In order to survive, factories must raise prices. This also means that factories that survive must also run lean. Running lean means capacity is limited: there is no longer the flexibility to accept any order for product. A factory must confirm that it has capacity before accepting orders. Capacity can change dramatically over time. A factory that will be happy to accept an order today by be completely booked up a month later.
Believing in the two myths, the start-up has ignored the nature of its agreement with the factory. The complex contract manufacturing agreement that covers intellectual property and inspection procedure and the rest will apply only if the buyer and seller ever happen to agree on a purchase of product. But a binding agreement purchase requires the basic terms: price, quantity and delivery date. Without agreement on the basic terms, there is no contract of purchase. So when the buyer shows up “some day” day with an offer, the factory is free to accept or reject. If the factory rejects, buyer is forced to negotiate the basic terms in accord with current conditions.
The start-up has intentionally contracted so that it has absolute freedom. It has no obligation to purchase even one item. What the start-up has missed is that this freedom goes both ways. If the start-up is free not to buy, the factory is free not to sell. So the freedom sought by the start-up ends up as a trap. This trap is then expertly used by the factory. Now that the start-up is trapped, the factory will then work to extract the most favorable price, quantity and delivery date terms possible. It is a sad fate, but it is a fate that was actively pursued by the start-up. The source of this trap goes back to the mistaken belief in the two myths: the China price is always available and the China factory will always accept a purchase order.
Start-ups usually come to me for contract drafting after they have already spent months negotiating price and terms for purchase of their new and innovative product from a Chinese factory. It is tough for them when I explain that all their work on price has little meaning since nothing in the contract obligates either party to enter into a binding purchase and sale commitment.
What can be done?
After the start-up gets the point that price is critical, the obvious question is: What can be done to escape from the trap?
In this situation, I outline three options:
Option One: “What, Me Worry?” Take your chances by assuming that the factory will agree to the basic terms that have been discussed during the negotiation phase. Many buyers follow this option. Some buyers understand and accept that they will be forced to negotiate price terms for every purchase. Price and availability fluctuation is part of their business. This is the standard in commodity purchase trades like seafood and timber. Most start-ups, however, are not prepared for price fluctuation. They have set the market based on a specific price point. They have committed to their buyers that they are ready to deliver. A change of basic terms in the middle of their product roll- out is not an option for them.
Option Two: Take a Stand. If a buyer wants a firm commitment from a seller, the normal way to achieve this is to enter into a formal, binding commitment to purchase a specific amount of product over a specific time period at a specific price. Before the rise of start-ups and just in time delivery, this is the way things were done and this is the type of contract that Chinese factories prefer. Provided that the buyer is willing to make a firm commitment for purchase, Chinese factories are quite flexible on the other terms. They will not require a letter of credit to back up the obligation. They will agree to a flexible delivery schedule that is not fixed in advance. They will accept price terms that are often ruinously low and they will live with that price for the entire term of the purchase commitment. What the factory wants is a firm commitment that allows them to plan for the Chinese production cycle: from one lunar new year to the next.
Option Three: Make a Plan. Once they understand the risk, most start-ups are not comfortable with What, Me Worry? But most are also unwilling or unable to Take a Stand. But they still want a solution. For these start-ups, the remaining option is to face the issue and develop a plan where they work with the factory on a flexible program that does not bind either side but that prevents surprises and misunderstandings. This plan will have the following elements:
1. Price Lock: The parties agree on a price and a period for which the price is locked. This agreement can then be made more complex by providing for the conditions that allow for an change in price over time.
2. Quantity and Delivery Date: The buyer submits a quarterly estimate of the amount of product that will be purchased and the required delivery date. The factory has the option to accept or reject.
3. Purchase Order: For any purchase order that is at the locked price and that conforms to an accepted Quarterly Estimate, the factory is required to accept.
This option does not provide the certainty of Option Two. But it eliminates the reduces the uncertainty of Option One. While the start-up cannot be certain that the factory will agree to sell, the start-up gains two benefits. First, through the Quarterly Estimate, the start-up will have advance notice if the factory is unable or unwilling to sell. Second, through the price lock, the start-up avoids the need to negotiate price for every order.
Option Two has two key weaknesses. First, the system is complex. Manufacturing contracts in China work best when the terms are simple and where judgment is not required. Option Three violates that principle. Second, the factory is still ultimately in control. If the factory wants out of the agreement, the factory will simply reject the Quarterly Estimate. Most commonly, if the factory wants to escape the price lock, the factory will simply reject the Quarterly Estimate, forcing a price negotiation. In spite of these weaknesses, however, we find that many start-ups follow Option Three and we have devised several standard programs that implement that option.