Factory started in January 1978. At that time there was a punk label in Manchester called Rabid Records, run by Tosh Ryan and Martin Hannett. It had several successful acts, including Slaughter & The Dogs (whose tour manager was Rob Gretton), John Cooper Clarke, and Jilted John. After his seminal TV series So It Goes, Tony Wilson was interested in the way Rabid Records ran, and was convinced that the real money and power were in album sales. With a lot of discussion, Tony Wilson, Rob Gretton and Alan Erasmus set up Factory Records, with Martin Hannett from Rabid. The Factory name was first used for a club in May of that year, which featured local bands including The Durutti Column (managed at the time by Erasmus and Wilson), Cabaret Voltaire from Sheffield, and Joy Division. Peter Saville designed advertising for the club, and in September Factory released an EP of music by acts who had played at the club (The Durutti Column, Joy Division, Cabaret Voltaire, and comedian John Dowie) called A Factory Sample.
In 1978, Wilson compered the new wave afternoon at Deeply Vale Festival. This was actually the fourth live appearance by the fledgling Durutti Column and that afternoon Wilson also introduced an appearance (very early in their career) by The Fall, featuring Mark E. Smith and Marc "Lard" Riley on bass guitar.
The Factory label set up an office in Erasmus' home on the first floor of 86 Palatine Road, and the Factory Sample EP was released in early 1979. Singles followed by A Certain Ratio (who would stay with the label) and Orchestral Manoeuvres in the Dark (who left for Virgin Records shortly afterwards). The first Factory LP, Joy Division's Unknown Pleasures, was released in June.
In January 1980, The Return of the Durutti Column was released, the first in a long series of releases by guitarist Vini Reilly. In May, Joy Division singer Ian Curtis committed suicide shortly before a planned tour of the USA. The following month saw Joy Division's single "Love Will Tear Us Apart" reach the UK top twenty, and their second album Closer was released the following month. In late 1980, the remaining members of Joy Division decided to continue as New Order. Factory branched out, with Factory Benelux being run as an independent label in conjunction with Les Disques du Crepuscule, and Factory US organising distribution for the UK label's releases in America.
In 1981, Factory and New Order opened a nightclub and preparations were made to convert a Victorian textile factory near the centre of Manchester, which had lately seen service as a motor boat showroom. Hannett left the label, as he had wanted to open a recording studio instead, and subsequently sued for unpaid royalties (the case was settled out of court in 1984). Saville also quit as a partner due to problems with payments, although he continued to work for Factory. Wilson, Erasmus and Gretton formed Factory Communications Ltd.