A new kind of professional purchaser bent on getting rock-bottom costs
threatens suppliers of basic materials. But these companies can save
themselves by taking up the purchasers?weapons
There is a killer on the loose near the start of the value chain. Suppliers of
basic materials1 have seen tough times as their own suppliers
consolidated and customers squeezed their margins. Now some of those
customers are using a kind of sophisticated professional purchaser,
known as a "sourcer," who threatens to rub out the meager margins that
remain. Armed with a detailed knowledge of the suppliers?economics,
the sourcer spurns the traditional approach of building close relationships
in favor of extracting the most value at the lowest possible cost. Some
suppliers may not survive the assault.
Indeed, this mismatch can destroy value quickly. One global producer of
specialty lubricants recently acquired several service businesses in an
effort to distinguish itself from competitors. The initial strategy was
sound. But then sourcers demanded that the supplier bundle its new
services with the lubricants at no extra charge. To preserve sales volumes,
the supplier acquiesced. In the end, what had started as a sensible effort to
combine a chemical business that had a 5 percent return on sales with
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service businesses that had a 一五 percent ROS gave the company an
overall ROS of less than 5 percent.
Some suppliers have suffered so much from the sourcers?attacks that
countering them, rather than passively watching margins erode further,
must now be a strategic priority. A first step is for suppliers to understand
how sourcers have shifted the odds against them. The second is to use
that understanding by fighting back through internal improvements and
by taking advantage of the mentality of the sourcers to create value for
both them and the suppliers. And suppliers must take a much tougher
negotiating stand 梚 f necessary, reducing their services to customers or
even abandoning customers, however long-standing, that have become
too expensive to serve.
SMART STUFF
Professional sourcers first appeared about ten years ago. Initially, they
targeted retailers and distributors; later they moved up the value chain to
include suppliers of basic materials. Instead of looking for suppliers that
offer the lowest unit price for products, sourcers concentrate on reducing
their companies?total cost of owning the products in question. The total
cost of ownership (TCO) includes all expenses incurred in getting and
using products 梟 ot only invoice prices, but also costs such as delivery,
storage, and the disposal of packaging materials and by-products.
Sourcers start by using their volume to squeeze as much value out of a
supplier as possible. This approach isn 抰 new, but they win additional
value by shifting costs and risks to suppliers. Sourcers don 抰 care about
the effect this line of attack might have on relationships: the goal is to
grab value.
Knowledge is the second important weapon of the sourcers, who
understand their own economics and the total cost of using products or
services and, no less important, the economics and offerings of their key
suppliers 梠 ften better than the suppliers do. Why? Because sourcers
systematically aggregate all of the available information from their own
organizations, other suppliers, trade magazines, other customers (legally,
through consortiums), industry experts, and the like. Meanwhile, the
information that suppliers have about themselves lies in various functions
and IT systems and usually hasn 抰 been pulled together. Sourcers
therefore have intimate knowledge of the economic impact of their
options (for example, the cost of switching suppliers), so they can
generally decide on their sourcing strategies and pinpoint acceptable
trade-offs before they even start discussions with suppliers.
Sourcers, for example, typically shift costs such as freight, storage, and
financing to sellers by having sales contracts specify delivered rather than
plant-departure prices, thereby excluding the cost and risk of getting
goods from the supplier 抯 to the user 抯 plant. Another tactic is to shift
risk to the supplier by using fixed-price contracts,2 which force it to
absorb unexpected price hikes for raw materials. Since the mid-1990s,
pulp and paper manufacturers, for example, have demanded fixed prices
for hydrogen peroxide on contracts with terms of up to a year. Because of
this price cap, many hydrogen peroxide makers posted returns well below
their cost of capital in 2001, when a sharp rise in natural-gas prices
pushed up their costs. In theory, suppliers benefit from fixed-price
contracts if raw-materials prices fall. In reality, when that happens,
suppliers bent on preserving relationships with their customers often let
sourcers, who watch upstream prices carefully for such opportunities, cut
prices by renegotiating contracts prematurely.
Costs in most basic-materials industries are rising because consolidation
among their own suppliers has pushed up the price of raw materials and
because a drive for high-tech, efficient production has forced them to
make large capital investments. Meanwhile, strong competition and the
commoditization of formerly differentiated products are holding down the
price of the basic materials these companies sell. The supplier 抯 sales
force is an easy target for professional sourcers, since in basic-materials
industries most incentive plans for sales reps are based on volume, which
predisposes them to accept the sourcers?demands. When margins are thin,
sales reps often try to build sales volumes by offering buyers the lowest
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list price and even giving away services, particularly to large customers.
Managers encourage this volume mentality by pressing for greater market
share at almost any cost. And these industries as a whole emphasize the
importance of retaining customers, thereby prompting sales reps to avoid
measures that could jeopardize relationships with them.
THE SOURCERS?APPRENTICE
Most companies in basic-materials industries already feel pressure from
sourcers. Many such companies have so far followed a strategy of
"stealth" defense; that is, they hope to stay off the sourcers?radar screens
by keeping a low profile. But sourcers are systematically moving up the
value chain and will eventually confront almost all companies.
When that happens, suppliers must be able to avoid surrendering value on
any terms the sourcers choose. The key to success is to understand the
sourcers?approach, which focuses on total value rather than lowest price,
and to prepare the organization for a new kind of selling. In this way, a
supplier can restore the balance of power with its buyers and give them
greater value while not threatening its own viability.
For most basic-materials suppliers, two measures should go a long way
toward rebalancing the scales: countering the knowledge of the sourcers
by understanding the economics of the companies they work for and
retraining the supplier 抯 entire organization to sell not just volume but
also more value (Exhibit 1). The amount of emphasis a supplier places on
each option should depend largely on how active sourcers are in its
industry. A company that has already been critically weakened by their
power probably also needs to reevaluate its core business 梩 hat is, the
way it makes (as opposed to sells) its products.
WISE UP
Since sourcers come to the negotiating table armed with a detailed
understanding of their own and the supplier 抯 economics, the supplier
must do the same. That is, it must understand how it makes (and loses)
money from its current customers, the key factors that
make them buy, and its competitors?blind spots.
As we have seen, the sales reps and even the managers of a supplier often
only vaguely understand its economics, because the relevant information
is dispersed across functions and IT systems. Thus, for example, sales
reps who must factor the cost of freight into an invoice price when their
own company pays for shipping may have only a rough idea of what the
real cost might be. A detailed analysis of individual transactions at one
European chemical company showed that, for some clients, freight
expenses borne by the supplier actually exceeded the invoice price when
expedited arrangements were factored in. Warehousing too, though not
always itemized on invoices, can sharply reduce a customer 抯 value to a
supplier.
Indeed, suppliers rarely calculate the pocket price3 for each order or
customer. But the pocket price is vital for making a key strategic decision:
whether the supplier should walk away from any customer 抯 business.
At a minimum, information about a customer 抯 historical price
performance should strengthen the supplier 抯 resolve during
negotiations by showing where losses usually occur. If a company 抯
customer base is very fragmented and scrutinizing individual accounts isn
抰 practical, analysis of groups based on considerations such as
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purchasing patterns, key buying factors, or size could inform these
decisions.
To raise prices or cut service levels for an underperforming customer to
the point where it might defect, a supplier 抯 sales force must embrace a
profound cultural change and develop the ability to assess risk. The
payoff is a better negotiating stance and thus improved margins.
Dropping a customer always poses dangers, but they can be mitigated by
a thorough knowledge of the business at risk. When one large North
American petrochemical supplier, for example, saw its market threatened
by an Asian competitor offering lower prices, the supplier, in a carefully
calculated move, let go three of its largest but most unprofitable
customers (whose sourcers tried to force it to offer full service free of
charge). The North American supplier understood what was
fundamentally important to its customers as well as the weaknesses of its
new competitor. Two of the three defecting customers came back to the
supplier after just two months of coping with the competitor 抯 poor
logistics and even poorer product quality. Indeed, they accepted higher
net prices and longer, guaranteed-volume deals.
A supplier can find out its customers?key buying factors and its
competitors?blind spots, initially by questioning its sales and marketing
employees and then by holding thorough discussions with its current and
prospective customers. The insights it gains will help the sales force and
managers weigh potential trade-offs in negotiations with particular buyers.
Say that one of them threatens to switch suppliers to get a lower price. If
the sales force knows from the customer analysis that another buying
factor 梖 or example, the level of service 梒 oncerns this customer less
than price, the supplier can offer to cut both its prices and its service
levels, thus keeping the customer and its previous margin. Such trade-offs
must of course be managed to assure that the company balances the risk
of losing volume and the ability to control fixed costs across the entire
customer portfolio.
An accurate knowledge of customers also gives a sales force the power to
deny historic discounts, rebates, or other services that have ceased to
make business sense. Such information, for example, inspired a large
European aluminum processor to stop playing lifeguard for a disloyal
clientele. Some of this company 抯 largest customers had begun to source
up to 20 percent of their business from new East European producers.
When the new suppliers missed a delivery date, the old one often rescued
these customers by expediting their emergency orders, but the incumbent
eventually decided to let them feel the full pain of the shift to
lower-quality suppliers. As a result, 90 percent of the customers stopped
using them and asked the incumbent for guaranteed-supply agreements at
higher prices.
SELL VALUE
A knowledge of customers includes an understanding of their
requirements as well as their economics. By looking at a product or
service from the viewpoint of the customer and understanding its total
cost of ownership and the way it creates value, a supplier can determine
how existing or new offerings could help the customer add still greater
value (Exhibit 2). Such "value selling" differs from the common
costs-plus approach, which bases prices on the sum of cost components; it
is instead based on creating, emphasizing, and capturing more of the
economic value from a product or service for all downstream players. A
supplier that takes this approach goes beyond its current catalog by
inventing combinations of products and services and by suggesting
outsourcing opportunities that meet each customer 抯 long-term needs
better than its competitors could.
Selling value is different from the traditional job of selling basic materials.
To make the transition and master the art of value selling, a company
must often change the skills and even the personnel of its sales force,
which will have to undertake additional knowledge-building activities
such as conducting interviews with customers, end users, and industry
experts; visiting customers?sites; and even placing orders with
competitors to experience their service and processes directly.
Suppliers that identify combinations of products and services capable of
reducing a customer 抯 total cost of ownership can bring a strong
package to the negotiating table. Typically, costs related to acquisition,
operations, and safety and assurance can be cut. One global packaging
supplier, for instance, saw that it could reduce the operating costs of its
customers in the consumer electronics industry by designing a more
durable box that would reduce their losses from broken televisions. By
quantifying the total value of that cost reduction, the supplier justified
incorporating some of the additional value into the price of the better
boxes. Although they then had higher prices and margins, the
customers?total cost of ownership fell because fewer breakages occurred.
The value may seem obvious, yet the sales pitch couldn 抰 be made until
the supplier estimated the cost of the broken television sets, offered
guarantees to its customers, and helped them to track the impact. In
certain instances, this type of bundling could even serve as the foundation
for new business units offering broad-based solutions (for example,
consulting services for packaging).4
Consider another example of the way suppliers can benefit from reducing
their customers?overall expenses. A global paint manufacturer recognized
that labor accounted for two-thirds of the costs of its professional
customers. Acquiring paint was particularly labor-intensive because
painters left their work sites to purchase supplies as needed. By delivering
paint directly to work sites and changing its formulation to provide for
one-coat application, the supplier made orders easier to fulfill and
lowered these customers?overall costs. Although the price of the paint
didn 抰 rise immediately, the improvements shifted discussions with
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customers away from price and toward the value offered by the supplier
and seemed likely to yield a margin improvement over time.
Selling value in this way answers the sourcers?main concerns. It
proclaims that the supplier has the interests of its customers in mind and
that both parties have a common understanding of what is on the table.
And such a compelling value proposition also makes alternative suppliers
less attractive to customers.
Risk is another common problem that suppliers can assume for sourcers if
the price is right. To start, a supplier must understand the historic and
potential risks in question 梥 uch as volatile raw-materials prices or a
shortage of supply 梐 nd the way they affect the customers?product costs.
Then the supplier must understand who is absorbing these risks now and
at what expense. With this knowledge in hand, the supplier can set a
range of prices it will charge for accepting different levels of risk. Above
all, it should make its minimum (or walk-away) prices clear to its sales
reps so that they don 抰 create new options on the spot during
negotiations.
One metal company that supplies the aerospace and automotive industries,
for example, developed a deep understanding of the costs and risks of its
customers?supply chains, from raw materials to inventory control. It also
calculated its own costs in the same areas. After analyzing the two
positions, it proposed to some customers that it assume, for a reasonable
price, the risks inherent in the entire supply chain. These moves actually
thinned the supplier 抯 margins at first but also locked in customers for
the duration of their product programs 梪 p to a decade in aerospace 梐
nd allowed the supplier to eventually increase its margins by improving
performance all along the value chain.
To meet the sourcers head-on, suppliers must be willing to make these
tough decisions. The trick to getting this approach to pay off is knowing
how much flexibility you have instead of making uninformed trade-offs,
under duress, that are almost guaranteed to be disadvantageous.
A COURSE OF ACTION
Many companies will find that defining the level of threat posed by
sourcers is the starting point for deciding on a course of action and its
tempo. In the worst case, the sourcers?tactics will affect most of a
company 抯 business, and executives may well feel that the whole
enterprise is under attack. In this event, the supplier should immediately
move to build a knowledge base that will allow it to go head-to-head with
sourcers as soon as possible. Thereafter, it will know enough to drop
customers that ask for too much and to take a firmer stand in negotiations.
Shifting to value selling will be a secondary priority. In the hardest cases,
where the margins of the core business have been cut to unsustainable
levels,5 management may have to consider more fundamental changes,
such as forming joint ventures 渨 ith service companies, buying
distributors to gain better access to customers, or selling portions of the
company.
A company less severely affected by sourcers can take a more balanced
approach, not only by developing an improved knowledge base but also
by making the move to value selling. In this case, a supplier has more
time to preempt some of the pressure sourcers could bring to bear in the
future 梐 strategy that would set the tone for discussions with them and
uncover new sales opportunities. Still, the company must be ready to
counter more aggressive demands from its customers by holding firm to
its pricing policy and resolving to walk away if the full cost of serving
them is unacceptably high.
Sourcers have only begun to pressure basic-materials suppliers and to
threaten their long-standing relationships with customers. To counter
these dangers, suppliers and others must consider the sourcer 抯 mind-set
by selling their products in a better-informed, more value-oriented way
Notes:
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John Abele is an associate principal in McKinsey 抯 Cleveland office,
where Eric Roegner is a principal; Brian Elliott is a consultant in the New
Jersey office; Ann O 扝 ara is a consultant in the Stamford office.
1Companies that produce refined raw materials such as chemicals, paper,
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and metals or components such as ball bearings and gaskets.
2In the past, indexed and volume-based contracts were more common. In
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volume-based contracts, prices 梑 ased on an industry average,
particularly for purchases that are large, infrequent, or both 梐 re
negotiated for each order. Indexed contracts base prices on a standard
index reflecting current supply and demand.
3The invoice price less discounts and rebates, freight charges paid by the
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supplier, advantageous payment terms, and all other costs to serve the
customer.
4See John E. Forsyth, Alok Gupta, Sudeep Haldar, and Michael V. Marn,
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"Shedding the commodity mind-set," The McKinsey Quarterly, 2000
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Number 4, pp. 78?5
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