Transfer Pricing: Transactions and Structures: business structures: manufacturing: overview
The most common terms used to denote manufacturing operations which assume varying degrees of risk are ‘licensed manufacturer’, ‘contract manufacturer’ and ‘toll manufacturer’. These are imprecise terms with no clear boundaries between them and other terms may be used. The labels are not determinative of the appropriate pricing but can provide useful shorthand. We discuss all three terms below with examples of each in diagram form. In all cases it is essential to establish exactly how the structure operates in practice.
This term is generally used to denote a manufacturing operation that assumes a significant amount of risk.
The licensed manufacturer will be making goods under a relatively long-term licence agreement. It will use manufacturing intangibles owned by the licensor, such as patents, industrial know-how, designs, etc. In return it will usually pay an annual royalty. It may own some of the manufacturing intangibles used in the production process. It will buy raw materials and semi-assembled goods on its own account and will hold stock of both raw materials and finished goods. It will be subject to the risks of selling the goods. It will need to invest in skilled labour and expensive plant and machinery.
A contract manufacturer is the first step away from a licensed manufacturer. It still owns plant & machinery and employs a skilled labour force, but instead of making goods, holding them as stock and selling them to distributors, the goods are made for the principal. This means the contract manufacturer has none of the risks associated with holding finished goods, or of selling those goods. Provided it meets a specified quality, and quantity, the principal will guarantee to buy all the goods manufactured. The contract manufacturer will however still buy the raw materials (and bear the associated stock risk) and will probably hold title to the goods until bought by the principal.
Contract manufacturing is a concept recognised in the commercial world in some industries, e.g. the pharmaceutical business and the clothing industry. However in most instances third party manufacturers are not contract manufacturers, although some contract manufacturing might be carried out, ancillary to the main licensed manufacturing. In other cases, there may be independent companies who carry out manufacturing under contract (e.g. an order to make 10,000 dresses - same design, material and style, but different sizes), but will be working for a number of different principals. Everything will not rest on one particular customer. This is not indicative of a low risk contract manufacturer.
Here the principal always retains title to the goods throughout the manufacturing process. The principal buys the raw materials or sub-assembled goods, although the physical flow of goods will be directly to the manufacturer himself. The principal bears all the inventory and selling risk. The toll manufacturer may have to buy small amounts of raw materials (for example, a contract exists to put zips in 10,000 dresses. The dresses are delivered to the toll manufacturer, but remain the property of the principal throughout. The zips are bought locally by the toll manufacturer).