An output contract is an agreement where a manufacturer sells its entire output of a specific good to a single buyer. Benefits include reduced costs and exclusive rights, but changes in the market or unexpected events can cause problems. A requirements contract is an alternative. The Uniform Commercial Code prescribes “good faith” to protect both parties.
An output contract, also known as an entire output contract, is an agreement in which a manufacturer or producer of goods agrees to sell its entire output of a specific good to a single buyer. In turn, the buyer undertakes to purchase all the goods that the seller is able to produce, regardless of the buyer’s actual needs.
Output contracts have several advantages for the firms that enter into them. Salespeople in an output contract can focus on producing a quality product and not have to worry about sales or distribution to multiple outlets. Benefits for buyers include exclusive rights to what is hoped to be a quality product, and like the seller, the buyer doesn’t have to manage relationships with multiple suppliers. Also, since the buyer has agreed to buy the seller’s entire output, the buyer can usually negotiate a good price due to the seller’s reduced costs.
On the other hand, output contracts can also be problematic: if there are changes in the market for a particular item, sellers who are stuck in output contracts may lose the opportunity to sell at higher prices. Also, if a buyer unexpectedly goes out of business, the seller will have to scramble to find a new buyer. Buyers are also at risk. If demand for a product or its market value drops unexpectedly, the buyer could be stuck with a product they can’t sell or have to sell at a loss.
An alternative to an output contract is a requirements contract. In a contract with requirements, the buyer agrees to buy from the seller only the quantity of product that he actually needs. In return, the buyer agrees that the seller will be his sole supplier of that particular product. In this situation, as long as the seller is able to meet the buyer’s purchase requirements, the seller is free to sell to other buyers.
A potential problem with both types of contracts is that they can technically allow one party to ignore its obligations to the other. A vendor in an output contract might stop or slow down production, claiming that he produced all that he could. In a qualifying contract, a buyer might refuse to buy something from a seller, because he no longer “demands” the product.
The Uniform Commercial Code prescribes “good faith” as a way to protect the interests of both parties: if the seller’s output of a good exceeds what is normal for that product, a buyer is not necessarily obligated to buy it all. . Good faith also extends to the seller: while a seller in an output contract cannot refuse to produce a good because the good is not profitable enough, if a seller goes bankrupt, he may be free to cease production.
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