Originally posted on Ekos.
It is a common problem: a small brewery becomes popular and outgrows its current facility. Moving into a bigger space is a big decision – expensive, too. On the flip side, another common scenario is a brewery that has excess capacity. The company is burdened with too much overhead and may struggle to be profitable. Contract brewing and alternating proprietorship arrangements can be attractive options for producers on either side of the capacity challenge.
Contract brewing is the process of one brewer making the beer of another. The brewer sells the product to the client, and the client sells and markets the brand. An alternating proprietorship (alt prop) is an arrangement in which two different brewers use the same facility and equipment to make their own beer. The company that holds the property is called the host; the guest company is called the tenant. This post introduces contract brewing and alt props: the pros and cons, legal and accounting issues and logistics considerations.
LEGAL AND ACCOUNTING ISSUES
The laws around beverage alcohol are complex, and contract brewing/alternating proprietorships compound the complexity. Each state has its own licenses and rules for alcohol, and the same is true in this situation. Some states are friendlier than others. If a brand owner needs to contract with a manufacturer in a different state, check with legal counsel to ensure that each party has the correct business arrangement and licenses in place that comply with all regulations.
Some producers think that contract brewing may allow them to increase production beyond 60,000 barrels and still pay the lower federal excise tax rate of $3.50/BBL for small producers. Unfortunately, this is blocked by the TTB’s single taxpayer rule. Pronounced in 2018, the single taxpayer rule establishes that “two or more entities (whether or not under common control) that produce beer marketed under a similar brand, license, franchise or other arrangement shall be treated as a single taxpayer for purposes of the application of this subsection.” [TTB Industry Circular 2018-5] If a brewery is considering contract brewing as a tax management strategy, review these rules before taking action.
The complexity of contract brewing and alt-prop relationships also impacts accounting. Of chief concern is ensuring that there is visibility into the profitability of each line of production. In other words, if a brewery manufactures its own beer and also employs a contract brewer for some of its inventory, the accounting system should be set up to allow those two cost centers to be tracked separately. A brewer will have different expectations for the gross margin of beer made in-house versus the gross margin of beer made by a contract partner. The same goes for beer made in an alt-prop environment.
Detailed data tracking for contract brewing extends beyond financial reports. In the production facility, ingredients should be tracked in separate lots. It is important to segregate inputs for beer made for separate entities in order to achieve proper costing and for excise tax reporting. If one facility reports operations for two TTB license holders — as in an alt-prop relationship — it is incredibly important to have the correct record. Brew sheets and/or the production management software should be in a format that is familiar to both parties.
LOGISTICS TO CONSIDER
If you are on the tenant or client side of the relationship, consider how to manage inventory in multiple physical locations. Inventory may need to be drop shipped to a location that is different from the party placing the order. If a host is holding inventory the tenant has paid for, that inventory should be on the tenant’s books. Establish a process for monthly inventory counts and updating the value on the tenant’s books. Business partners should consider adopting standard operating procedures that address who is responsible for which parts of the process.
A contract relationship will only be successful if the finished product lives up to the desired specs. Every relationship should have an established process for test brewing, flavor match and quality assurance. Be sure to establish the process and expectations in the business partner agreement. For example, which party is responsible if a batch has to be dumped?
PROS AND CONS OF ALT-PROP RELATIONSHIPS
Some of the most obvious benefits of a contract brewing or alt-prop relationship are better utilization of space, an additional revenue center (for contractors and hosts) and (for clients and tenants) a way to enter the market as a startup brand without having to raise the capital needed to get a production facility built. Alternatively, these arrangements also have drawbacks. Loss of control of the process can be challenging for clients using a contractor. It also adds logistical and regulatory complexity, which may require additional personnel or input from legal counsel, which can be expensive.
Given the state of the industry, more breweries are considering either contract brewing or alt-prop arrangements. It can be a bridge into a new phase of the corporate life cycle. For growing companies it can be a way to ease into a larger level of production. And for those who need to fill out excess capacity, it can make an operation more efficient. With proper planning, these arrangements can be a win-win for both parties involved.