Buyers beware: Your supplier may be your next competitor

February 11, 2009

When executed correctly, strategic sourcing yields many benefits for both buying companies and their suppliers. By aligning the interests of both parties and focusing on continuous improvement, companies can use strategic sourcing to decrease costs while improving supply management. But a dark side of strategic sourcing has emerged, according to Thomas Choi, professor of supply chain management at the W.P. Carey School of Business. "Some buying firms established long-term contracts with their suppliers, set up mutually dependent relationships, and then began to strangle suppliers with short-term, cost-driven decisions," he explains.

This relentless pursuit of cost-cutting can result in supply chain disintermediation (SCD), where suppliers sell their goods directly to buying companies' customers -- in effect, cutting the buying companies out of their own supply chain. "As a result," says Choi, "buying firms and their suppliers have now become competitors in the same market." The lucrative aerospace aftermarket is one place that has become ripe ground for SCD, shows Choi's recent research with a former doctoral student at W. P. Carey School, Christian Rossetti. This is largely because of the unique nature of aerospace products, and the dynamics between buyers, suppliers, and customers.

Recipe for disintermediation

Aerospace original equipment manufacturers (OEMs), such as engine manufacturers Rolls Royce, GE, Pratt-Whitney, have historically sold major components to airlines at or below cost, and relied on the aftersale market for maintenance and replacement parts to drive profits. "When an airline buys a plane from an OEM, they become beholden to them to maintain that plane -- this is a huge business," explains Choi. He likens the setup to Gillette's model for selling razors: "Gillette practically gives away the razors, but charges an arm and a leg for the blades," he notes. Therefore, when selling replacements such as engine or seat parts to the airlines, OEMs place a high markup on the components that they purchase from second- and third-tier suppliers.

While this structure works nicely for the OEMs, it has driven both their customers (the airlines) and their suppliers to look for alternative options. Many aerospace parts suppliers, already driven to the brink by the unilateral cost reductions buyers placed upon them, took a risk and began selling their products directly to airline operators in a so-called "gray market." Lobbying efforts to the Federal Aviation Administration resulted in a legal market for suppliers to sell parts directly to airlines (as long as suppliers produce the parts from their own blueprints and can pass safety tests), which has left many aerospace OEMs facing inefficient, disintermediated supply chains.

"By taking a simplistic approach to supplier management, OEMs inadvertently created a new competitor," says Choi. Now, he notes, aerospace OEMs must find ways to repair the damage by aligning their goals with those of their suppliers.

One mistake many buyers make is not approaching their supplier relationships from what researchers call an agency perspective. "Buyers must realize that suppliers have agency; that they can make choices to look after themselves," explains Choi. "Many buying companies think suppliers automatically do what they are told, but that is not always so." One OEM executive, when told his suppliers may be selling directly to his customers, replied, "They wouldn't dare." This assumption that suppliers only act in the interest of buyers and not themselves is shortsighted, states Choi.

Goals and game-changers

In addition to accepting that suppliers can, and will, make decisions and take actions to further their own agendas, buyers need to make sure their goals are in synch with their suppliers' goals. When buyers and suppliers achieve this goal congruence, the likelihood of SCD is much lower, shows Choi's research in collaboration with Rossetti. "Goal incongruence, on the other hand, leads a supplier to behave opportunistically," they note.

In addition, Choi believes that aerospace companies need to reconsider some of the basic tenets of their supply management approach. His research shows that certain practices common among OEMs are exacerbating the situation. "The year-over-year price reductions, constantly switching among suppliers, and high-pressure tactics may be the worst practices for OEMs wishing to protect their aftermarket," he says.

So how can buyers reduce the threat of goal incongruence and the disintermediation that often accompanies it? The first step is to develop a contract that lowers the risk of disintermediation. "In order to achieve a pro?table aftermarket, OEMs must create a buyer–supplier contract that contains the proper mix of incentives, disincentives, terms, and conditions to stop a supplier from engaging in SCD," Choi explains. "By combining a focus on the relationship with incentives that improve goal congruence, OEMs may be able to forestall the intrusion of suppliers into their aftermarket."

Obviously, the greatest consequence of SCD is a financial one -- for aerospace buying firms, lucrative profits from the aftersales market are at stake. But SCD also causes problems beyond the realm of finance. Once a supplier dons the mindset of being a competitor, it changes the game, says Choi.

He cites this example: one OEM wanted to switch to a new parts supplier, a process that would take about three months. The OEM's current supplier, instead of cooperating, reduced the level of finished goods inventory it would hold for the OEM to one month's supply, leaving the OEM without enough inventory during its transition to a new supplier. "There are a lot of implications from SCD that may not show up on accounting books, but really undermine what the OEM is trying to accomplish," Choi says.

And, while the aerospace industry's unique buying structure makes it particularly susceptible to SCD, implications exist for other industries as well. Overall, the message to buying companies is not to overlook the importance -- and the intricacies -- of the buyer-supplier dynamic when engaging in strategic sourcing.

"Everyone ought to know that strategic sourcing is more complex than it appears," Choi explains. While many executives think of a good buyer-supplier relationship as a "soft" goal with little economic implications, those relationships can actually make a difference to the bottom line. And ignoring the relationship-based approach in favor of a strictly cost-focused plan can have very negative results.

"Focusing only on simple metrics and unilateral actions can lead to unintended consequences, and buyers need to be ready for that," Choi warns.

Bottom Line:

  • In recessionary times, revenue/profits from repair and overhaul parts manufacturing can be a critical substitute for decreasing original equipment sales.  
  • Because they misapplied the tenets of strategic sourcing, many aerospace OEMs are now competing against their suppliers in the lucrative aftermarket segment of the industry.
  • To prevent SCD, buying companies need to promote goal congruence by taking supplier needs into account when making supply management decisions. Ensuring that buyer-supplier contracts provide incentives and conditions that are attractive to suppliers is key.

 

-- Original Illustration by Jessica Pullen