The 4 Most Common Types of Manufacturing Agreements

We’ve come a long way since EMS providers were simply referred to as “board stuffers.”

Now, vendors are responsible for much more than printed circuit boards, often handling entire systems for OEMs. The industry’s shift to globalization brought with it major competition between EMS providers, forcing many to expand their services and capabilities to secure more jobs.

As a result, their role has grown over the years to what it is today: a key part in delivering high quality products on an aggressive schedule. The current hardware ecosystem is a complex one, where OEMs and EMS providers cannot exist without the other. And the thing that’s keeping these critical relationships together? A hardware manufacturing contract service level agreement.

The Importance of Contract Planning

That may sound like a hyperbole if you view a contract as just a piece of paper. What many OEM executives don’t realize is that the success of the vendor-customer relationship is directly proportional to the amount of time and resources invested during the contract planning phase.

A well-prepared hardware manufacturing contract should not only provide a sturdy framework which outlines all critical exchanges between parties, but also work with accurately-forecasted costs to maximize on savings while protecting profits.

The practice of choosing vendors on price alone results in short-term gains and encourages a lopsided vendor-client relationship which comes with its own risks. The key is to find a balance, where the OEM receives the right volume of high quality products at a lower cost, while the EMS provider makes a big enough profit so that their interest is in continually delivering without compromising on quality or product lead time.

Determine your actual and anticipated costs by gathering cross-departmental input during the contract planning phase (process, test engineering, finance, etc.). During the negotiation phase, remain patient and persistent to arrive at the right pricing model where both the OEM and EMS provider achieves what they are after: profit.

The 4 Types of Pricing Models

The majority of all contract manufacturing agreements encompass one or a mixture of 4 pricing models. Depending on what type of product the OEM offers, some models will be more suitable than others.

Below is an outline of how each pricing model is structured and what the key financial measurement is for the contract manufacturer.

1. Fixed Materials Pricing

Perhaps the simplest pricing model, fixed materials pricing locks in the material cost of goods sold (MCOGs) as a percentage of the OEM’s product program revenue.

It requires very little overhead to manage due to the fact that the EMS provider does not have to provide a new quote with each build program. This model is ideal for OEMs with similar types of product lines and manufacturing volumes.

2. Component Cost Pricing

In this model, the EMS provider determines the internal percentage costs across a number of categories such as materials, overhead and direct labour to calculate the profit it needs to cover costs. The provider can then work to improve margins internally to gain a bigger profit.

Though this model is commonly used today, OEM customers can find it to be frustrating as the true costs associated with the program can remain hidden.

Component cost pricing is suitable for OEMs with a mix of consumer products offering mid- to high-level technology.

3. Cost Plus Pricing

Often viewed as the fairest and most honest model, cost plus pricing involves the provider educating the OEM on all costs involved in running the proposed programs. Both partners agree on a fixed percentage of profit for the provider, and work together to identify new opportunities to reduce costs.

The open and transparent nature of this model cultivates a healthy vendor-customer relationship where both parties are collaborating for the same goal. Cost plus pricing can be applied to most product programs across various industries and technologies.

4. Return on Invested Capital (ROIC)

This model revolves around an ROIC formula as it relates to the EMS provider’s net profits. While more complex to calculate regularly, it is the most dynamic model out of the four and nicely sets up both partners to work together for mutual benefit.

Being able to change the individual component values creates a flexible system for both the provider and the customer without impacting the target ROIC, as long as the overall give and take of the equation is considered. For example, the OEM customer may request that the payments be pushed to a later date in exchange for a larger profit margin.

Remember, choosing the right pricing model for your contract manufacturing agreement is only part of the work. Your goal should be focused on setting up your vendor-client relationship for long-term, mutual gain.

Going into the negotiation phase with the sole goal of securing the lowest price per unit is no longer sustainable in today’s world.