Four (4) types of common contract electronics manufacturing agreements
Most contract electronics manufacturing agreements fall into these four different pricing models.
The electronics contract manufacturing service contract is an important component of outsourcing when original equipment manufacturing (OEM) executives are tasked with outsourcing their design or manufacturing. (See, also: Fixed v. variable asset models)
The hardware manufacturing contract service level agreement is the most important document in the relationship between the electronics manufacturing services (EMS) provider and the OEM. Not just an agreement between two parties, the service agreement provides the critical outline of the exchange between the vendor and customer. Sprinkled in are rules of engagement that detail the who, what, where, when and how much.
Formal contracts enable EMS providers to reassign the risk to the customer (OEM). Without a contract, the customer typically is not held liable for its forecast, so all purchasing and other spending made by the EMS provider is at its own risk and comes with limited rewards. The OEM, on the other hand, is interested in mitigating its supply chain exposure and risk.
Well-managed EMS providers put significant internal forethought and discipline into determining the actual and anticipated costs of doing business with a potential OEM client well in advance of signing a contract service agreement.
Additionally, providers will also solicit input from various internal cross-functional groups such as process and test engineering, production, program management and finance. Individuals from these departments often have first-hand knowledge from working with similar technologies or products. This type of planning and input should be used to determine costs and help an EMS better manage its profits and margins.
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Contrary to what some device manufacturer executives believe, many OEM organizations do not invest enough time or resources when formulating and negotiating their contract service agreements. One likely reason is that they do not understand how a sophisticated EMS business model is run.
Regardless of the technology or marketplace, full-service global contract manufacturing organizations are still sometimes referred to as ‘board stuffers.’ This mindset needs to change.
When OEMs rush to an outsourcing endpoint against a tightly managed timeline or, more importantly, when they do not have enough internal outsourcing depth and scope, it will best serve them to carefully develop the contract agreement. Every supply chain director knows this, however, too few have the background or the time to execute successfully. Often, an outsourcing contract is typically only as good as the intentions of the parties who formulate it.
The success of the relationship is directly proportional to the amount of time invested and knowledge applied before negotiations begin. The initial stages of contract negotiations and the language of the service agreement are critical to the success of both parties.
Areas in which OEMs fail to emphasize enough during the contract development process include a common understanding of the language relating to the terms and conditions as well as cost reductions and how they will be passed on to the OEM.
Once a contract is signed, it should serve only as a periodic reference. If it is frequently being reviewed to contest terms, the relationship is likely on a slippery slope, and lawyers may soon be involved. This is because one or both parties failed to perform due diligence beforehand.
Offshoring and outsourcing contract manufacturing agreement types
Pricing is a constant battle between vendor and customer. Whether discussing printed circuit board (PCB) assembly or systems integration, the critical element of success in any partnership is providing the EMS vendor a reasonable profit. Without it, the contract manufacturer lacks motivation and may make compromises in other critical metrics such as quality, product lead time and staffing, which can adversely affect the EMS’ performance and, ultimately, that of the OEM.
Following the planning phase of a contract, an OEM will typically receive a first draft. OEMs should keep in mind that even when outsource contracts cost a fraction of what it costs to keep the manufacturing in-house, EMS providers still make a profit-in many instances, more profit than the OEM is lead to believe. This leaves room for greater savings and cost reductions if the OEM is patient, perceptive and persistent during contract development and negotiations.
Roughly 70-80% of all contract manufacturing agreements fall under four different pricing models:
- Fixed materials pricing
- Component cost pricing
- Cost plus pricing (fixed price)
- Return on invested capital pricing (ROIC)
Each model is based on the EMS provider’s understanding of its cost structure and determining the true cost to support the OEM’s program. At this point, the negotiations or pricing structures are simply exercises in determining which costs are revealed and the contract manufacturer’s key financial measurement (profit margin or ROIC).