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Good Fences Make Good Neighbors -- Like fences, good contracts make for good relationships between OEMs and their EMS providers.

In his poem, Mending Wall, Robert Frost wrote, "Good fences make good neighbors." A fence is a boundary. A fence may be impenetrable, or it may allow limited passage. Some fences restrict the view, while other fences provide transparency. All fences have gates that allow authorized passage. Fences, in the form of written contracts, are needed between original equipment manufacturers (OEMs) and their electronics manufacturing services (EMS) providers. A contract is simply a boundary, mutually established between two parties.

At the 2001 APEX show in San Diego, I served on a panel whose topic was, "Challenges to Small and Mid-sized EMS Providers." Nearly 75 participants were in the audience. One participant asked, "Do you see a need for a written contract with your OEM customers?" The question returned to the floor was, "How many of you don't have written agreements with your customers?" The large majority of raised hands indicated that most of the participants were without written agreements between their firms and their customers. I was so shocked that I nearly fell out of my chair. Although my industry has grown to be known as "electronics manufacturing services," it started as contract manufacturing.

Here's a real-world example of the need for a written agreement between OEMs and their EMS partners. Before founding my company, I was employed by an EMS provider that engaged with a small start-up company that only had one product. After one year, we had assembled about 10,000 of the product, and the company had, in turn, installed it in thousands of locations throughout the Americas. However, the product started to fail in the field, and our customer's entire business was on the line.

The customer announced that we had placed a part by a manufacturer that was not approved, and that part was causing the failures. The customer initiated a multi-million dollar arbitration. As general manager of my employer's division, I believe that I was last witness deposed. In my deposition, I pointed out the covenant in our contract that allowed my company to place any one of several components from the customer's approved vendor list (AVL), including the manufacturer's component in question. I also produced our customer's AVL, which was signed by them. Our customer dismissed the arbitration within 24 hours after my deposition.

After thorough diagnostics, we learned later that the failures were caused by a customer firmware error. But who knows how this case would have been settled without a written agreement? Conversely, if your EMS partner places an apparently functional substitute component and 10,000 of your products fail in the field, what happens? The mutual liability protections of a written contract are indispensable to the complex business in which we are.

A contract provides benefits and protections to the parties who sign it. Before opening my company's doors for business, attorneys were hired to produce a contract. They first presented a 21-page document, plus exhibits, all of which were so confusing that I could not understand it without the attorneys' interpretation.

I highlighted the benefits and protections that I felt were critical and returned the document to the attorneys. My instructions were to write a new document in plain English so that businesspeople could interpret it without needing lawyers and to keep it under five pages in length. I received exactly what I ordered, and the only provision for any addition is related to Specifications.

The major components of a functional contract for an EMS provider are: header, work, payment, price, taxes, components, warranty, returns, license, purchase order commitments, schedule changes, cancellation, minimum order quantities, shipping, term and termination, liability limitation, relationship of the parties, dispute resolution, miscellaneous and execution.

Header

The Header stipulates the date of the agreement and identifies the parties: the OEM and the EMS provider.

Work

The Work simply specifies the task, such as procuring the materials and assembling the products. The OEM is responsible for providing detailed written instructions such as bill of materials (BOM), approved vendor list (AVL), schematics, assembly drawings, revision number, test specifications and anticipated yield; all known as the Specifications.

The EMS provider is responsible for accepting the Specifications and performing the Work to a mutually agreed standard, such as IPC-A-610 Rev. C Class x, Bellcore/Telcordia, OEM-specific standards, or a combination of standards. If the EMS provider is designing the product, then detailed design criteria should be part of the Specifications. Typically, the Specifications are an attached exhibit to the contract.

Payment

The Payment describes when and how. Payment terms and currency specifications are required.

Price

The Price might be product-specific or as simple as, "to be agreed by EMS provider and OEM from time to time."

Taxes

This section specifies who pays the taxes, if any, related to the Work.

Components

This section defines what components means to your company and who will provide them.

Warranty

The OEM and EMS provider agree to the definition of a "defect," how long the products will be free from defects, and any commonsense exclusions to the warranty such as products that are altered, subjected to misuse, negligence or abnormal stress.

Should your EMS provider warrant functionality? I believe that the designer of the product should be responsible for functionality. If the contract's definition of Work has your EMS partner writing the Specifications, your EMS provider should be responsible for functionality. If the OEM authored the Specifications, then the EMS provider's liability should be strictly limited to the agreed assembly standards.

Who warrants components? Many would say that the party who purchases the components should warrant them. I disagree. An integrated circuit may include millions of transistors. The specifications and assembly of many of these devices are far more complex than the products in which they are used. From the EMS provider's perspective, considering very slim profit margins, providing a full warranty on materials is nearly impossible. If the EMS provider purchases the materials, a reasonable compromise is for the EMS provider to pass-through to the OEM any warranty that is offered by the materials manufacturer or supplier.

My company's material vendors are very eager to please us and our OEM customers who specify their components, so such pass-through arrangements work very well with all of our suppliers. In cases where the OEM purchases materials, the OEM should warrant them. The party responsible for the product design should warrant merchantability, fitness for a particular use and non-infringement. The other party should disclaim these specific warranties.

Returns

The OEM and EMS provider agree as to how defective product will be returned, and how long this right will exist. The EMS provider should state the remedies available to the OEM for defective products, such as prompt repair or replacement, or refund/credit of the purchase price.

License

The OEM grants the EMS provider license to perform the Work and stipulates that the EMS provider's performance of the Work will not infringe on the proprietary rights of any third party. Both parties specify that they have the right and power to enter into the contract, and they indemnify each other from liabilities that may result from any breach of the contract by the other.

Purchase order commitments

How often will the OEM issue purchase orders and what period of time will those orders cover? Considering component delivery lead-times and production planning requirements, I believe the OEM should issue purchase orders monthly, and those purchase orders should cover at least 120 days.

Schedule changes

This section sets boundaries for how the OEM may change quantities and delivery dates specified by the purchase orders. Although the contracts I've seen vary widely in terms and conditions for schedule changes, the basic protections for both parties include the flexibility for the OEM to reschedule deliveries up to 30 days. Any schedule change pushing delivery in excess of 30 days may be considered a cancellation unless both parties agree to the change in advance, in writing.

Cancellation

No one likes to send or receive an order cancellation, but it happens. Both OEM and EMS provider must establish a procedure to handle cancellations. The contract should offer the OEM the right to cancel without any cost or penalty whatsoever in situations where no real cost occurs to the EMS provider. Real cost is defined as any out-of-pocket expenses to the EMS provider. For instance, any materials that were purchased by the EMS provider that may be returned to the supplier at no cost to the EMS provider, or used in the assembly of other products for the EMS provider's customer, are not considered out-of-pocket expenses.

However, an argument exists that the costs to purchase, receive (including inbound freight charges), store, manage [via materials/enterprise resource planning (M/ERP)], cancel suppliers' orders and return materials (handling, packaging, outbound freight) for canceled products are out-of-pocket expenses and should be recoverable. If you go this route, anything over 4 percent of the material cost may be considered excessive.

Materials purchased by the EMS provider for a canceled OEM order that are not cancelable or returnable to the supplier are definitely an out-of-pocket expense to the EMS provider. The contract should specify that the OEM purchases these materials at the EMS provider's cost, plus a reasonable allowance to cover the EMS provider's expense of purchasing, receiving, storage, management, packaging and shipping the material to the OEM. However, the loss of the profit dollars on the canceled order is not considered an out-of-pocket expense.

Minimum order quantities

We always alert our customers to the fact that we often purchase more material than is needed for their orders. Two reasons exist for purchasing material in excess of the OEM's purchase order quantity. First, most EMS providers employ a high level of automation in the assembly of electronic products. Therefore, EMS providers purchase materials in specialized packaging to accommodate automation, such as tape and reel, trays and tubes. With tape and reeled components, the EMS provider may have to purchase a reel of 5,000 components to satisfy an order requiring only 100 placements.

Second, component manufacturers often set "minimum buy quantities" that may require the EMS provider to purchase 250 components, when only 100 placements were made to satisfy the order. Protections to both OEM and EMS provider commensurate with Cancellation terms may be stipulated here.

Shipping

This section specifies the "free on board" (F.O.B.) point for products and who pays for freight expense. While your attorney can explain all of the legal ramifications of F.O.B., your purpose for specifying F.O.B. is to determine the point at which the ownership of the product changes hands. "F.O.B. origin" means that title to the product transfers to the OEM when the EMS provider tenders the products to a freight carrier. If any damage occurs in transit, the damage and claim with the freight carrier are the OEM's responsibility.

Conversely, "F.O.B. destination" means that title to the product transfers to the OEM when the EMS provider's freight carrier delivers the products to the OEM's dock. If any damage occurs in transit, the damage and claim with the freight carrier are the EMS provider's responsibility. Because F.O.B. specification does not determine the party responsible for paying the freight charges, such specification must be made separately.

Term and termination

This section stipulates the life of the agreement. You may leave the Term open-ended with a statement such as, "This Agreement shall begin upon the date hereof and shall end upon notice from the customer that all Work hereunder has been completed." Or you may specify any Term you choose; for example, six months or 1 year. You may also make the Term "evergreen" by stating that it continues indefinitely until such time as either party issues a written request to terminate the agreement.

Liability limitation

This paragraph is for your lawyer to construct. In my opinion, the liability limitation should protect both OEM and EMS provider from claims from the other party for conditions such as incidental or consequential damages, lost profits, and procurement costs of substitute goods or services.

Relationship of the parties

At a bare minimum, the EMS provider will state that it is an independent contractor of the OEM and not the OEM's agent or employee.

Dispute resolution

Because litigation is very expensive, I recommend that OEM and EMS provider agree to no more than 30 days of mediation, followed by binding arbitration if the disputes cannot be settled in mediation. A few national and international mediation/arbitration firms provide homogenous services in a variety of locales. I suggest that you consult your attorney for recommendations and that you specify the mediator/arbitrator in the contract. Of course, you can relegate dispute resolution to the courts...

Miscellaneous

These topics are for your attorneys to complete. They are standard contract law and include topics such as governing law, force majeure (acts of God or acts of nature), assignability, amendment and waiver, notice, waiver of terms and conditions, entire agreement and severability.

Execution

This section contains the signatures and identities of both parties.

Qualcon's Contract

How effective is Qualcon's Manufacturing Management Agreement? It contains everything we need, and Intel and Motorola both executed it verbatim. Since our founding, not a single dispute has gone to mediation, arbitration or court.

You might be tempted to ask for a copy of our agreement, but please don't. We consider it to be proprietary because it offers a distinct competitive advantage.

Once you've created your own contract, stay open to changes. Creating a document compatible with all engagements is virtually impossible. We frequently make minor amendments to our agreement to accommodate our customers. If your contract is written in easily understandable language, minor changes will not be difficult. While changes to business terms are the normal requests, be sure to have your attorney review any requested changes to legal stipulations before you agree to them.

Do you need a contract for a manufacturing engagement that is limited to consigned materials? Granted, materials liability is one of the most treacherous issues an EMS provider will face because upwards of 75 percent of the expense of assembly are materials. But do not be deterred from insisting on a written agreement in a consigned-material engagement. An incredible amount of liability still exists for both parties.

In most of our consigned-material engagements, we have executed our standard agreement. Our agreement is written so that it is compatible with the provision of consigned materials as well as for turnkey engagements. Such contractual flexibility is required in instances where we purchase some materials and our customer provides other materials via consignment.

And, OEMs, please be reasonable with your contracts. My company once received a 14,291-word agreement from a Fortune 500 customer with whom we were doing business on a consigned-materials basis. This behemoth document was intended to be a one-size-fits-all agreement for vendors. It was clearly written for component manufacturers engaged with this firm. Some of the proposed agreement's fatal flaws were:

- The customer insisted that we warrant functionality of the assembled product, which they designed.

- The customer demanded that we warrant all components purchased by us to meet their expectations of functionality in the circuit.

- The customer would not accept any responsibility for excess materials during the engagement and at its conclusion.

The document was so complex that the customer's staff attorney could not explain some pieces of it. We prudently declined to sign the document, and we no longer do business with this firm. My company's record for consecutive manufacturing defect-free assemblies stands at 36,312 units, produced for this customer. Because of an unreasonable contract, they lost an excellent EMS partner and we lost an otherwise excellent customer.

EMS providers, do not be deterred by an OEM that insists on your execution of their contract. We executed a 52-page, 14,078-word agreement with one of our largest customers. Through the experience of producing your own contract, you will decide what is and is not important to you. Use this knowledge in interpreting the business requirements of contracts presented by your customers. By all means, once you and your customer have agreed to the business terms, have your attorney review it and offer legal interpretation and advice.

Conclusion

If your manufacturing partnership does not include a written agreement, I urge to you to engage a lawyer to create a document that works for you and your partner. Establishing the rules is much easier prior to a dispute. The advice offered herein is no substitute for competent legal counsel.

My father once said that a contract is only as good as the parties executing it. Nonetheless, I must reiterate, "Good fences make good neighbors."

Bob Bilbrough is the founder and CEO of Qualcon, Flowery Branch, GA; e-mail: bbilbrough@qualcon1.com.

http://www.circuitsassembly.com

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Title Annotation:original equipment manufacturers and electronics manufacturing services
Author:Bilbrough, Bob
Publication:Circuits Assembly
Geographic Code:1USA
Date:Nov 1, 2001
Words:2803
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