How to Keep Your Supply Chain from Killing You, Part 2

The one-handed economist grew up in the shoe business, where the family’s motto was: “You can sell two left shoes if they are cheap enough.” We had two factory outlet stores and five Little Red Shoe House stores in Connecticut. The company sold private-label shoes, or make-ups, and distressed footwear — closeouts and factory-damaged goods. My sister and I learned the business from factories scattered throughout New England and down into Pennsylvania.

As we worked wholesale trade shows and visited factories, Sears and its huge number of stores loomed large over the industry. Small manufacturers would hope for a test run from Sears. We often heard: “All I need is a case in each store,” and, of course, they offered Sears their best prices. Then Sears’ Anaconda Buying Strategy would take hold. If the product sold, the buy would go up and Sears would squeeze nickels and dimes from the manufacturer, all the time increasing its share of the manufacturer’s production. Next, we would hear: “I sell Sears tight, it carries my overhead, and I make my money on the others.” Our Little Red Shoe House was among “the others.” Finally, either the manufacturer collapsed, or the manufacturer — knowing only how Sears bought — would have lost track of the market and emerging trends. The Sears Anaconda would squeeze and squeeze and squeeze some more, until the company died.

Fast forward a few decades. On March 21 of this year, Sears Holdings issued its annual report and got some attention of its own.  After a head-scratching takeover by Kmart, years of store closings and downsizings, lack of investment, and the sale of its iconic Craftsman brand to Stanley Black & Decker, management let investors know that “substantial doubt exists related to the Company's ability to continue as a going concern."

So now Sears is on the way out, having missed the rise of Walmart and much, much more.  But the Anaconda lives on in the buying strategies of other dominant companies, which is why it’s so important to track the purchases of your customers, and to understand their purchasing strategies. As I see it, there are two polar-opposite supply chain models, with significant variation between the poles.

First is the auction model of the supply chain relationship.  In this model, the OEM specifies the part or subassembly required in great detail and then puts the part out to auction, awarding a supply contract to the lowest-cost bidder. In a sense, an auction supply chain relationship is “plug and play”— that is, any supplier that meets quality and delivery targets can bid, plugging its part into the supply chain if it wins the auction.

The model at the other pole is the business relationship model. Under the relationship model, a supplier is pre-qualified by having an existing relationship with the OEM. The supplier bids for the work, but the number of bidders is limited. Both OEM and supplier place economic value on the business relationship, often share a similar business culture, and usually exchange detailed information. The return that both parties receive from these relationships is risk mitigation.

What are the risks that are mitigated, and where are the cost savings for the OEM?  They show up throughout the lifecycle of the part or subassembly, as well as in the production process itself:

1. The first benefits are transaction cost savings. The OEM has a pre-qualified supplier with knowledge about quality requirements, delivery expectations, and the OEM’s production process. In the best-case scenario, the supplier anticipates the idiosyncrasies of working with the OEM, and each OEM delivery site.
2. In a relationship model, suppliers and the OEM frequently work in partnership to engineer parts and subassemblies. The cost savings from this relationship may involve lower supplier costs, but more typically accrue from improved lifecycle performance of the part or subassembly³, and can include:

• Improved performance of the subassembly,
• Introduction of new product features,
• Cost savings in engineering,
• Improvements in assembly processes, and
• Reductions in warranty costs.

The supplier benefits, too, in three ways:

1. The long-term working relationship reduces the risk involved in bidding, because the supplier trusts the accuracy of sales forecasts provided by the OEM.
2. The value placed on the business relationship ensures that the OEM will not “price them [the supplier] out of business.”
3. Finally, the supplier knows that investments made in engineering and product development will result in a more stable operating environment.

There is, however, symbiotic danger in the relationship model for both OEM and supplier. The first is that the relationship can slip into what economists term “efficiency pricing.” This occurs when the supplier is paid an amount slightly above market rates, to ensure that the supplier does not leave the OEM’s fold. It’s like paying an insurance premium to ensure the value of the relationship.

The danger for the OEM is that it can become overly dependent on the business of a single supplier, increasing its supply-chain risk by not being able to dual-source, or by ending up with a final product that is over-priced. The corresponding danger for the supplier is twofold: First, the supplier’s fortunes rise and fall with its dominant customer. Second, its customer can become a monopsonist (a single purchaser of a supplier component), with the power to determine the price of that component — and to start using the Anaconda strategy.

The survey responses and interviews in our research for Driving Ohio’s Prosperity found no evidence of efficiency pricing in the automotive parts industry at the dawn of the Great Recession. There was simply too much capacity before the recession hit, and the resulting competition generated margins that were tight up and down the value chain.

What, then, is the benefit of a business relationship for Tier 1, 2 or 3 suppliers? Interviewees indicated that they benefited from honesty built into the relationships, and that they were willing to accept lower margins for immediate work in return for a more successful long-term business horizon. They saw their relationship with the OEM as reducing their long-term business risk.

However, the relationship model is only sustainable if the OEM has a very good idea of what the market price of the component should be — or if there’s a credible threat from an alternative supplier.

One last point in favor of the relationship model: Several Tier 2 and 3 companies mentioned that “business ethics” were a major problem in the automotive supply chain. These complaints and comments were closely related to how satisfied suppliers were with their business relationships with OEMs.  An executive with a company that supplied Detroit-headquartered OEMs found the auction model particularly risky because of frequent — and possibly intentional— misrepresentations of the size of potential production runs. These flawed estimates caused the supplier to miscalculate its average fixed costs, endangering its financial health. As an example, he cited a quote for 100,000 parts — but with the parts to be released in increments as need arose. “In the end,” he said, “the requests only came in for 60,000. It destroy[ed] the original cost quote.”

The relationship supply chain management model removes this source of risk—as long as your OEM doesn’t shed its friendly skin and turn into an Anaconda.