An Example of a Co-manufacturing Contract Gone Awry

2/10/2019

This is another rip off that I’ve been seeing recently that just absolutely amazes me. In fact, I’ve negotiated three exits because of this exact same type of crappy contract. I call it the “set margin/transparent pricing scheme.”

Co-mans do this to little companies, newbies, ones who don’t know better. You’re doing a million dollars in sales, or even just a half million, maybe a quarter. What they say is this: “We’re going to give you fully transparent pricing.”

And you’re wowed, because you think, “Nobody else is giving me that.” You’re shocked, because you’re thinking, “How awesome! I’ll know my ingredient cost? My packaging cost? Oh, that’s more than anybody else is offering me.”

Then they’ll say, “I will let you know exactly what cost I buy stuff at. You can even audit it. My labor? I’m going to charge you exactly what my labor costs me, so if my full labor costs $13 an hour and there are six people, you’ll see that those six are being paid $13 an hour. You’ll have all that upfront. And all I’m asking is that I make a 30% margin.”

So you sit there, thinking, “Okay, so I’ve got 65 cents in raw materials and packaging, 5 cents in labor, and then I have 30 cents in conversion costs… Well, this is fantastic! Especially since as I grow my business, my material costs will go down.”

And you’re right to think that this will be the case, because as you’re ordering more stuff, and when you go from pallets to truckloads, your costs should go down. You’re also calculating that 30% margin, thinking, “Every dime my costs go down, I pay roughly 13 cents less, so this is awesome.”

But this is what happens: You’re paying the co-man a set percentage of the costs: 30%. So when the co-man buys your ingredients at the most expensive rate possible, he’s making the most money making your product. This kind of contract actually encourages the co-man to buy your ingredients at the most expensive prices, from the most expensive sources, because those high prices mean he will get more money.

And what happens when you become bigger? Now you’re ordering in truckloads. There’s this thing called inflation and product scarcity, because they’re buying everything. They’re not contracting for you; instead they’re buying everything on the spot market. So if you buy almonds, today it’s $3.85 and that’s in season. If you buy almonds out of season, it’s $5, because there are no almonds left. And they’re going to buy it when it’s out of season, because they get 30% on top of those expensive prices.

Don’t get me started on the labor. So you have those six people on the line and you are maxed out on capacity. A good co-man would look at the line and say “Here is my bottleneck” and invest the 50k to make the widgets faster. The margin co-man wont do that because he will make less money by making product faster and with fewer people.

When you’re a little guy, you don’t really notice this is happening to you until you come to size. And then when your ingredient costs go up a dollar, it’s now gone up $1.33. And you start saying, “Wait a minute… you’re making 34 cents more a unit, for doing the same amount of work, taking the same amount of line jobs, using the same amount of people, for doing the same amount of work. Only now I’m paying you more for it.”

But when you’re a little guy with no experience, they sell you on the concept of it. They say, “Oh, when you’re ordering truckloads, it’s going to be so much cheaper, and you’ll be paying me less. But I’ll be making it up because I’ll be making more units for you. Everybody wins.”

The end result? You are encouraging them to do a bad job. You’re encouraging them to have more people on the line than they need, to not invest in automation. You’re encouraging them to make it inefficiently. You’re encouraging them to buy poorly, because all that happens is they make more money.

Whenever I see one of those contracts, here is what I say to the co-man: “You know what? I’m going to fix my toll with you.”

They always acted shocked. “What do you mean?”

I tell them, “I want to fix the toll.”

Especially if I’ve got a client who’s just shy of ordering ingredients by the truckload, I tell the co-man, “I’m going to fix your tolling at 27 cents,” or whatever it is.

They always try to bluff me, saying, “But if costs go down, you’re going to lose out on this.”

I just look them in the eye and say, “You believe costs are going to go down, but I’m willing to bet costs are going to go up. If you believe costs are going to go down, you should be ripping my arm off for this contract.”

And then there’s the pause.

That’s when I tell them, “I do this for a living. I’m fat because I’m good at it. There are no meals missed in the Madden household. You can take this or not, I don’t care. I’ll find somebody else who’ll give me a fixed cost. But I want full transparency and a fixed cost.”

That’s the kind of contract you want. NOT a “fixed margin and transparent cost,” because that’s a shit deal if I ever saw one.

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