Contract Manufacturing

Contract manufacturing is one company manufacturing products on behalf of another. For example, an Irish company, which once produced goods in Irish factories might engage a manufacturer in east Asia to produce the goods which bear its brand. 

It used to be the norm for a company to buy raw materials, manufacture the goods and sell the finished product for a profit equal to the difference between the sale price of the finished goods and cost of raw materials plus labour.

Nowadays, the company might buy the raw materials, but then pay another company to turn them into the final product. The factory might simply provide a service of turning raw materials into finished goods and be paid a fee for this service without ever owning the goods that pass through its doors.

This is the case for many contract manufacturers abroad who provide services to Irish-based companies. The raw materials used in this production process are owned by the company in Ireland, even while they are going through the factory abroad. Importantly, the know-how, or intellectual property required to make the goods is usually also owned by the Irish company. For example, the patent on pharmaceuticals can be a large part of the cost of the drug. The Irish company might own the patent, or might pay royalties to use the patent. Either way, this is a cost to the Irish company, even though it is being used in a physical production process overseas.

When the finished goods come out of the factory abroad, they too are owned by the Irish company not the contract manufacturer. It is only when the production cycle is completed and the goods are sold to a customer does the Irish company receive money for an export.

Contract manufacturing can be confusing because National Accounts looks at when goods change ownership, rather than when goods physically cross borders.

• When the Irish-based company buys the raw materials, that is an import into Ireland, even if the raw materials never come on shore here.
• If the company pays a royalty for the right to make the product, that is an import of royalties, even though the production will not be carried out here.
• The payment to the factory abroad that physically converts raw materials into finished products is an import of manufacturing services.
• If (as is usually the case) the finished goods are then sold to a customer outside Ireland, then there is an export of goods, even though the goods might never have physically touched our shores.
• The profit of the Irish company is then the sale value of the finished goods, less the cost of raw materials, less any royalties paid for IP, less the service fee of the contract manufacturer and less any other costs in the process.

Contract manufacturing, as you can see, adds a lot to imports and to exports. Goods which change ownership without crossing our borders are sometimes called 'goods for processing'. The effect of contract manufacturing can be seen in the difference between the Trade statistics (which exclude goods that don't cross our borders) and the Balance of Payments statistics (which include goods that are owned here but do not enter the country). However, most of the extra imports and exports counter-balance each other so the net effect is smaller.

Most Irish companies that engage contract manufacturers are Foreign-Owned, so their profit then crosses the border back to the owners in other countries. Hence a good deal of contract manufacturing has a positive impact on GDP, but much less impact on GNP and GNI.

To complicate the picture further, many companies that use contract manufacturers abroad also have factories in Ireland that also make physical goods. Furthermore, some companies in Ireland are contract manufacturers, and process goods in their factory here without owning those goods.

Read next: Intellectual Property

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