Saturday, September 17, 2011

Supplier Power and Firm Competitiveness: Perfect Freedom versus Partnered Synergy

The bargaining power of suppliers is an important competitive force outtlined by Michael Porter in his theory of five competitive forces (Competitive Strategy, 1980). As with buyer power, supplier power arises from the singular value chain, of which the firm is a part of. It is however, interesting that the purchasing strategy of a firm to deal with supplier power has received only a perfunctory treatment rom Porter, relative to the other competitive forces or strategies. Part of the reason relates to the extensive treatment provided to some of the key purchasing and supply issues through the analytical framework on the strategic decision of vertical integration elsewhere in the book. As a result, the issues relating to supplier power are only partially addressed and that too, through the lens of buttressing the competitive position of a firm. Part of the reason also is his belief that many aspects of purchasing strategy go well beyond the scope of his book. That, unlike at least a portion of buyer groups which are individual consumers, the whole genre of suppliers are themselves firms having similar value chain of buyer-supplier has been ignored by Porter. Competitive strategy must provide a more detailed analysis of supplier issues than Porter has provided, even including
his analysis of vertical integration, and even considering that supply chain management is a different domain by itself.

According to Porter, there are four key issues in purchasing strategy from a structural standpoint. These are: stability and competitiveness of the supplier pool, optimal degree of vertical integration, allocation of purchases among qualified suppliers and creation of maximum leverage with chosen suppliers. Porter rightly hypothesizes that a firm should procure from vendors who will maintain or improve their competitive position in their own industry. He recommends the application of structural and competitor analysis which is found
throughout his work on Competitive Strategy to identify how a firm’s suppliers will fare along these dimensions. Amongst all purchasing related decisions, Porter considers the issue of vertical integration as the key strategic decision. This, however, is considered contingent on identification of items for make or buy. Porter considers that allocation of purchases by a firm among its suppliers is a key element of how bargaining power of suppliers is dealt with. He lists he conditions which create powerful suppliers such as supplierconcentration, non-dependence on customer, switching costs for customer, unique or differentiated product, and threat of forward ntegration. He advocates creation of maximum leverage through diffused purchases, avoidance of switching costs, qualification of allternate sources, promotion of standardization and use of tapered integration. He differentiates the lowering of long-run purchasing costs through such holistic purchasing strategies from the short-run increase in costs which some of the strategies may entail. He concludes, as any wise purchasing manager would, that the firm should purchase from low-cost suppliers unless there are offsetting benefits in terms of long-run bargaining power. While not contradicting theiewpoints of Porter, this blog post brings up several other interesting perspectives.

Division of labor

The development of supplier-firm differentiation, supplier-firm connectivity, behavioral aspects of supplier-firm relationship and upplier clusters are some of the fascinating aspects of structural evolution of an industry. It is a lacuna that Porter has not focused more on these aspects. Core competency in developing a component or even a whole group of components has rarely translated itself into a core competency in developing the end-product. The essence of the historical evolution of the supplier industry as an autonomous but dependent adjacent industry to the end-product industry or the original equipment manufacturer (OEM) industry is rooted in ownership and techno-economic considerations. By theory and practice, OEM requires huge investments and mega entrepreneurship, which makes OEM the preserve of the few. Component or system supplies, on the other hand, require low and mid scale investments and provide for dffusion of entrepreneurship. Government policies also encourage the reation of larger employment opportunities through small and medium scale enterprises. Separation of component and OEM industries helps OEMs access more cost-competitive components due to the lower direct costs and lower overheads of smaller enterprises. Once a component manufacturer gets established, it would prefer to diversify into the business of another component rather than forward integrate into OEM. At best, it may consider limited forward integration into systems manufacture.

The automobile industry, the world over, has been an excellent example of component and end-product manufacture dichotomy as well as symbiosis. Over the period, however, there has been a greater appreciation of integrating vendors from the very early stage of new product commercialization and ensuring seamless development of new components and end-products. In addition, the need for the OEMs to have a greater say in the development of new component systems has been felt in recent times. India offers an outstanding example of a component manufacturing group called TVS, which despite the established base to
manufacture every conceivable automotive component has restrained itself from entering into automobile manufacture. There are probably two interesting perspectives to this trend. The first one is that once omponent makers get established as the preferred vendors, they secure greater monopoly than OEMs. For example, while the automobile manufacturing arena has several companies churning out various types of automobiles, component makers are in duopoly or low oligopoly.

By remaining small and focused on research and manufacturing, with very little of marketing investments, suppliers tend to build core competencies. From Intel chips and Samsung OLED screens to Bosch spark plugs and ZF gear boxes, theomponent supplier industry structure is unmistakably concentrated. The second perspective is that being independent, yet not being visibly branded, gives suppliers complete freedom to exploit the total arket. As opposed to an industry comprising, say, thirty OEMS selling thirty million original equipment in the aggregate at an average one million end-products per manufacturer, the duopolistic component supplier industry lets the constituents enjoy an equal share each of fifteen million components, probably with greater profitability. The division of labor works advantageously to both the constituents, the end-product manufacturers and component vendors.

Integration of technology

Much as division of labor works to the advantage of suppliers and the firm, integration of technology should also work to their advantage. There are significant opportunities as well as limits to integration of echnologies. In many cases, component makers can admirably respond to firm requirements with proactive user signaling. In the automobile industry, self-cooled radiators, asbestos-free gaskets, parabolic springs, low friction oils, tight tolerance pistons, connecting rods, camshafts, and crankshafts are all examples of component makers rising to the technological challenges with component level leadership. On the other hand, there are a few areas which cannot be done without active and continuous collaboration. Vehicle control computers and
software, external trim and external lighting, for example, need complete technological integration. Concurrent engineering could be a great way to ensure collaborative development. Yet, both OEMs and
suppliers need to know the economics-deterrent integration level in each case. The OEMs must focus on the interface and optimization of equipment and component design while the component makers must focus
on similar interfacing and optimization with their materials suppliers.

Not surprisingly, the technological value chain of a component maker is more elaborate than the OEM value chain. Even evolved OEMs and component makers often tend to lose out on such a strategic view of technology. If it were not so, tablets would have got more powerful and appropriate chips from Intel, and more appropriate operating systems from Symbion, Android and Microsoft right at the time of first generation launches. Technological ntegration for optimum impact tends to be a fine balance between ensuring faster go-to market and greater proprietary confidentiality. While Porter speaks of the bargaining power of suppliers it would ppear that OEMs have a significant leeway in deciding on the direction and pace of component level technologies. OEMs can retain their proactive advantage by seeking design copyrights wherever feasible or staking claim to joint intellectual property. Suppliers can secure their bargaining power in this space even while planning a relatively more open approach by securing broad patent estates on their technologies. A good model would be for OEMs and component suppliers to dedicate a certain percentage of their developmentbudgets to integration of component level and OEM level research. Such a model could lead to a better cross-fertilization of ideas.

Collaboration of minds

As between a firm and its customers, the relationship between the firm and its suppliers needs to be more collaborative than competitive. In fact, suppliers need to have the same customer-centricity towards the
OEMs as the OEMs need to have with their customers. There are two ways in which such collaboration can be successfully nurtured. The first is through setting up of supplier-firm level steering committees to discuss field performance, customer feedback, cost competitiveness, technology vision, new product timelines, capacity plans, investment needs and so on. Such forums provide both the firm and the supplier a platform to dovetail their strategies better. If a firm is able to position itself as the complete provider of information on components, the firm would have better bargaining power over the suppliers. The other approach is for both the firm and the supplier to, individually and collectively, reach out to the customer in the marketplace directly. Direct interfacing with customers provides significant additional focus on the individual components and a more perceptive feedback. Larger and enlightened suppliers, in fact, prefer to secure irect feedback from the marketplace. In addition, the movement of fter-sales spare parts and service metrics provide valuable feedback to suppliers. Clearly, the direct feedback mechanisms can, and should, only be supplemental to the firm and customer level knowledge sharing mechanisms.

Supplier power gets enhanced when the suppliers are able to access the customers of the OEMs directly, and understand the levels of satisfaction and areas for improvement. Regardless of the methodologies adopted, it is established that collaborative planning between the firm and its suppliers brings manifold benefits such as prompt redress of performance issues, production and inventory smoothing, agility to meet market volatility,preparedness for model changes and technology upgrades, and in the overall better value chain performance and greater competitiveness. As opposed to Porter’s model of short run firm level performance maximization, a collaborative mindset between the firm and its suppliers enables long run performance maximization for both the firm and the supplier. While this is easier said than done, progressive OEMs and their vendors have traditionally sought to strengthen this approach through mechanisms such as steering committes, and annual vendor meetings. Collaborative working, however, requires greater institutionalization through processes uch as collaborative forecasting and planning, collaborative capacity planning and so on.

Dual sourcing and flexi-designing

The key challenge in the firm-supplier relationship is a fine balance between proprietory technology (as a market dominating factor) and freedom to operate (as a risk mitigating factor). Clearly, if the supplier has a unique and differentiated position, the firm would benefit from having an exclusive access to the supplier technology. At the same time, such exclusive dependence could lead to high supplier power in terms of high price or controlled delivery while the firm could face  risks associated with dependence on a sole supplier, including likely disruption in the case of force majeure conditions affecting the supplier. To be fair, the supplier is also subject to similar risks when the firm happens to be the sole buyer. While a strategic partnership between the firm and its vendor for strategic technologies and supplies is advisable to maximize the market opportunity in case of new proprietary developments, dual sourcing would always be an appropriate paradigm for a mutually beneficial and protective firm-supplier relationship.

Such an evolution of dual sourcing relationship would depend on flexi-designing being an integral component of product development philosophy of both the firm and the supplier. There are many industries which have not yet committed to the route of standardization of internal parts. Standardization does not imply dilution of
differentiation advantage. A supplier of headlamps may design his lamps to conform dimensionally to a standardized form factor, more particularly the fixing system, but could still achieve high ifferentiation in terms of lighting intensity, lighting angle, adjustments to ambient light, lamp life, cost level and so on. Industry level standards organizations can make a great deal of contribution to this effort. Certain industries such as electrical, electronics, nuclear and pharmaceutical industries are required to seek pre-registration of the products and the principal vendor supplied materials with industry level or governmental level regulatory agencies. Firms in such industries need to take more proactive steps to qualify alternate suppliers as part of the early product development and manufacturing processes. Flexi-designing and development help the firms to integrate alternate suppliers with low lead times for switching of components and supply sources in the event of exigencies.

Supplier power as partnership synergy

The goals of the end-product manufacturers or the OEMs and their suppliers are, in matter of fact, aligned. Power dynamics between the firm and its suppliers need to be harnessed in a more positive manner than articulated in the Porter model by focusing on leveraging of mutual capabilities for market competitiveness. Technological strengths of suppliers and market understanding of the OEMs must be utilized to result in better performance of the total value chain. In the contemporary model of competitive strategy, the firm should respect the technological specialization of its suppliers while the suppliers should respect the pressures on the OEMs for higher performance at lower costs. Collaboratively aligned and working together, the firm and its suppliers would achieve a more competitive presence in the marketplace for mutual benefit.

Posted by Dr CB Rao on September 17, 2011.

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