What is contracting?
Contracting involves entering into an agreement with a company that provides your firm with a service. In the case of the market-entry options we have been discussing, this service would involve the contract to manufacture and/or market your goods in an overseas target market.
A management contract is an agreement whereby a company (the management company) manages some or all of the operations of another company in return for management fees and, sometimes, a share of the profits. Many hotel groups have management contracts with hotels in other countries and earn fees for consulting and for providing management services. With management contracts, there is minimal risk associated with market entry, no expropriation risk, and no need for capital investment. These contracts capitalise on management skills and provide a guaranteed minimum income.
Contract manufacture involves a formal, long-term contract between parties in two different countries for the manufacture or assembly of a product. The company that places the contract retains full control over distribution and marketing.
There are a number of advantages to contract manufacturing:
- As there is no need to invest in manufacturing plant, the company placing the contract does not need vast capital resources, nor does it have to be concerned about the possible political instability of a market
- There is no risk of the company experiencing financial loss because of adverse movements in foreign exchange rates
- The company placing the contract can avoid labour and other problems that could result from a lack of familiarity with the country concerned; at the same time, it enjoys the advantage of being able to advertise its product as locally made
- Cost advantages could include savings in transport costs and lower production costs
- If a market proves to be too small or too risky, it is easier and less costly to terminate a manufacturing contract than shut down a wholly-owned off-shore production unit
Contract manufacturing, however, also has its drawbacks. It is often difficult to find a foreign producer with the ability to manufacture the product to the required standards and in satisfactory quantities; even when a suitable manufacturer is identified, the company placing the contract runs the risk of training a future competitor!
You may want to consider the following factors when deciding on whether to go the contracting route.