Co-manufacturing arrangements

What is co-manufacturing?

A brand owner outsources production of some products to a co-manufacturer, also called a contract manufacturer or co-packer. The contract sets the recipe, packaging and quality standards, the prices, usually a conversion fee per unit plus materials, and often minimum volumes. Some arrangements share the co-manufacturer's general capacity with other customers; others dedicate a line, a room or a whole plant to one brand owner, sometimes with equipment the brand owner paid for. Each of these features affects the accounting. See FMCG accounting.

When does a co-manufacturing contract contain a lease?

Under IFRS 16, a contract contains a lease if it conveys the right to control the use of an identified asset for a period in exchange for consideration. For a co-manufacturing contract, three questions matter:

• Is there an identified asset? A specific line, explicitly named or implicitly the only one that can do the work, with no substantive right for the co-manufacturer to switch to another line. A share of a line's capacity is not an identified asset unless it is substantially all of it.
• Does the brand owner obtain substantially all the economic benefits? It does if it takes all, or nearly all, of the line's output.
• Does the brand owner direct how and for what purpose the line is used? It does if it decides what products are made, when and in what quantities, or if those decisions are fixed in advance and the brand owner designed the line.

If the co-manufacturer runs the line for several customers and decides its own schedule, there is no lease, just a supply contract. See identifying a lease.

Co-manufacturing: a dedicated line over five years

A beverage brand owner signs a 5-year contract with a co-packer. A specified filling line is used only for its products, and the brand owner sets the weekly production plan and the products to be filled. The co-packer operates and maintains the line. The brand owner pays a fixed capacity fee of US$ 500 thousand a year in arrears, plus a conversion fee per unit filled, plus materials at cost. Based on standalone prices, 60% of the fixed fee, 300 thousand a year, is for the use of the line and 200 thousand is for operating and maintenance services. The brand owner's incremental borrowing rate is 6%.

At the start, the brand owner recognises a lease liability and right-of-use asset of 1,263.7 thousand, the present value of 5 payments of 300 thousand. Depreciation of 252.7 thousand a year, the 200 thousand of services and the per-unit conversion fees are production costs, so they are included in the cost of inventory under IAS 2 and reach profit or loss through cost of sales. The per-unit fees are variable payments that do not depend on an index or rate, so they are not part of the lease liability. Interest is a finance cost, presented in the financing category once IFRS 18 applies. If the brand owner elected not to separate the service element, the whole 500 thousand fee would be treated as a lease payment and the liability would be 2,106.2 thousand.

Who owns the inventory at the co-manufacturer?

Ingredients and packaging that the brand owner buys and sends to the co-manufacturer usually remain its inventory, because it keeps control of them; the co-manufacturer provides a conversion service, and the finished goods belong to the brand owner as they are made. Some contracts instead have the brand owner sell its materials to the co-manufacturer and buy them back inside the finished products. If the brand owner is obliged or entitled to buy back the finished goods, IFRS 15 treats this as a repurchase agreement: the co-manufacturer does not obtain control of the materials, so the brand owner keeps them in inventory, recognises no revenue on the sale and treats any cash received as a financing liability. The brand owner's cost of inventory includes the materials, conversion fees, depreciation of any right-of-use asset or equipment used, and freight to its warehouses.

What about minimum volumes and shortfall fees?

Many contracts require the brand owner to buy a minimum volume or pay a shortfall fee. Where the contract contains a lease, the fixed payments are already in the lease liability. Where it does not, shortfall fees are expensed when the shortfall occurs. If the brand owner discontinues a product but remains committed to minimum volumes, the unavoidable costs of the non-lease parts of the contract may exceed the benefits, making the contract onerous and requiring a provision under IAS 37, while any right-of-use asset is tested for impairment under IAS 36. See onerous contracts.

Who accounts for equipment the brand owner pays for?

Brand owners often pay for specialised moulds, filling heads or packaging equipment installed at the co-manufacturer. If the brand owner controls the equipment, for example it holds title, can remove it and restricts its use to its own products, the equipment is its property, plant and equipment, and its depreciation is a production cost. If the co-manufacturer controls it and the brand owner's payment is in effect an advance on future fees, the payment is a prepayment, or part of the lease analysis if the equipment forms part of a dedicated line. See customer-owned tooling and supplier tooling.

How does the co-manufacturer recognise revenue?

Products made to the brand owner's recipe and in its branded packaging usually have no alternative use to the co-manufacturer. If the contract also gives the co-manufacturer an enforceable right to payment for work completed to date, including a reasonable margin, IFRS 15 requires revenue to be recognised over time as the products are made, rather than on delivery, so work in progress becomes a contract asset rather than inventory. If the arrangement contains a lease, the co-manufacturer is a lessor and splits the fees between lease income under IFRS 16 and service revenue under IFRS 15. See over time or at a point in time.

How does US GAAP differ?

ASC 842 identifies embedded leases using the same three questions. The main difference is the cost profile: if the lease is an operating lease, the brand owner recognises a single straight-line lease cost of 300 thousand a year rather than depreciation and interest, still included in inventory cost where it relates to production. The option not to separate service elements is also available. See ASC 842 leases.

This guide is general information. It is not tax or legal advice for your situation.