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This page has a series of white papers written by Robert Wayland and me. They address management issues. The thrust of the articles is to show how the tools of economic analysis can be better utilized by managers than they have in the past. Jim Mulcahy


The Supplier Equity Concept: Managing Supplier Relationships as Assets

Bob Wayland
Of-Counsel, HawkPartners

Jim Mulcahy
Principal, J.M. Mulcahy Consulting

October 2008

The authors wish to thank David E. Leffler for his insights and review of this paper. Paul Cole, now at LRN, contributed greatly to an earlier formulation published in Wayland and Cole, Customer Connections, New Strategies for Growth (HBS Press, 1997). Cliff Moore, now CEO of 3CSI, shared his thoughts on customer/supplier relationships in response to an early draft.
This paper is one of a series of executive development materials dealing with intangible asset management. We welcome readers’ comments and suggestions. Please contact Jim at seamusdonn@roadrunner.com or Bob at rew@rewayland.com
Copyright 2008, not to be quoted without permission of the authors.

Supplier Relationships are Assets

Relationships with valued suppliers are among a firm’s most important assets. Regrettably, many companies treat their vendors like the proverbial rented mule and then complain that they are unresponsive. Companies should manage their valuable supplier relationships as assets, and their supplier network as a portfolio. The asset management perspective we outline here is superior to typical transactional and supplier scorecard evaluation because it takes a longer view and reflects the shared value of maintaining and increasing supplier value. We also provide a quantitative measure of supplier equity or relationship value that can be used to guide supplier relationship management efforts. While there are many qualitative factors in dealing with suppliers, measuring explicitly their value provides a commercial framework that is more substantive than the typical happy talk admonitions to treat the mules kindly and to avoid kickbacks.

Suppliers are generally more likely to recognize the asset value of commercial relationships than are buyers and to allocate their efforts in accordance with customer value and potential. If buyers adopt a similar and symmetrical perspective the two parties are more likely to act in mutually beneficial ways to maximize the fruits of their relationship. This can set up a virtuous cycle of mutual interest in each other’s success.

Companies today rarely operate as self-contained units. In order to maintain or increase competitiveness, firms are increasingly outsourcing non-core process and functions. In many industries, competition increasingly takes place among networks of informally allied firms and suppliers. In these sectors, a supplier's value often extends beyond the immediate transaction and comprises intangible factors such as an understanding of the buyer’s technology, personal relationships across the firms, shared intellectual capital, etc. Replacing these factors usually involves substantial search and transactions costs as well as time spent by both parties climbing a new learning curve. As Eric von Hippel pointed out, innovations are often co-created: in many cases conceived first by customers and later adopted by producers. Conversely, suppliers are often able to see potential improvements in the buyer’s product or process and to suggest ways to make improvements. Suppliers of complex products and services must have incentives to collaborate and to invest in the research that supports innovation.

Supplier relationships vary on a spectrum from indifferent competitive transactions to highly collaborative partnerships. Despite periodic outbursts of buyer talk about supplier partnerships, most buying firms have a limited supplier management perspective and employ transaction-focused, price-driven processes that often diminish supplier relationship value. The feeling often is that supplier partnership and collaboration are all well and good in theory but are expensive luxuries in today’s markets and, besides, there are always new suppliers willing to take the places of those who fall or walk away. There’s some truth to this position but it is not a universal truth and knowing when it applies and when it doesn’t is critical. A case in point is the treatment of its suppliers over the past sixteen years by General Motors.

Transactional Versus Relationship Management

One of the worst examples of company-supplier policies is that of GM. In the early 1990s, the GM board cashiered the chairman and president, along with some other officers. The new management team, led by Jack Smith, brought in Jose Ignacio Lopez de Arriortua as purchasing czar. His first act was to, essentially, rip up the contracts that GM had with its suppliers, telling them that they would have to drastically cut their prices to keep GM’s business. (“The good news is we won the GM account, the bad news is we won the GM account.”) Rockwell International, a well-respected firm, with deep engineering talent decided to walk away from the business. Rockwell reasoned that there was nothing to prevent GM from doing this again and again.

GM rode a strong economy and low fuel prices into the 21th century, masking, as it turned out, how fast their financial position was deteriorating. GM responded to its situation by shrinking their supplier base from thousands to six primary (sometimes called “tier one”) suppliers with a commensurate decrease in secondary suppliers. Some primary suppliers were downgraded to secondary status. GM’s attitude seemed to be that the suppliers needed their business and would put up with almost any treatment. It didn’t work out that way. Many suppliers chose not to bid on contracts. Others stopped offering suggestions that would have reduced costs and increased flexibility in ordering and inventorying parts.

GM blames health care costs and government mandates for its problems rather than undertake the deep introspection necessary to identify how badly they ruptured their supplier relationships. Moses had the children of Israel wander the desert for forty years because he felt that it took that long to eliminate the slave mindset. It is not clear GM has forty years to convince people that being one of its suppliers is not a form of servitude.

Globalization Begets Specialization

Companies buy things from other companies because the seller produces the product or service more efficiently or, to be more pedantic, has a comparative advantage in its production. As far back as 1776 Adam Smith noted that the extent of specialization or division of labor was determined by the size of the market. As markets grow, the opportunities to specialize in particular functions increase and the value of vertical integration decreases. Despite popular misconceptions of unchecked global monopolists, today’s global marketplace has spawned an enormous number of new specialized firms competing for orders, contracts and relationships. In addition, technological innovation is continuously adding new types of suppliers to the mix. The contemporary automobile contains computer components unheard of a decade ago provided by vendors who had never before served the car industry. Achieving the potential gains from global sourcing and supplier specialization requires more rigorous supplier analysis. The additional search and transactions costs and new supplier related risks must be weighed against the gains. As with any sort of shopping, the optimal level of search depends upon the distribution of supplier prices, search costs, and the successive probabilities of finding a better deal. As the number of highly efficient specialized firms increases and with them the search and transactions costs of establishing, developing, and assessing relationships, a species of intermediate firms serving as network managers has arisen in several industries. For example, automobile and aircraft manufacturers increasingly procure modules or subsystems from a number of intermediate firms that manage their own, often complex, supporting networks. ArvinMeritor has, like other vehicle parts manufacturers, vigorously pursued horizontal acquisitions in an effort to position itself as a tier one supplier capable of delivering component assemblies and managing lower tiers of specialized vendors.

Companies face increasing challenges managing their supply chains and networks. Typical supplier management techniques often exacerbate the situation and, while providing short-term buyer gains, may lead to longer-term problems. Many suppliers are under severe competitive and cost pressures. In many cases, suppliers have little choice but to acquiesce to buyer pressure for concessions but this often buys only a little time. In other cases, sellers are trying to increase their market power and leverage through consolidation. Supplier consolidation may hurt buyers by reducing price competition and diminishing suppliers’ incentives or willingness to collaborate with buyers. In extreme cases where sellers enjoy more market power than their customers, as in the case of Intel, buyers must share the rent from their own innovation and therefore have less incentive to be creative. It is no accident that the most innovative computer maker, Apple, was until recently outside the Intel community. It will be interesting to see how its adoption of Intel inside will affect its evolution.

The auction or competitive bid process is an efficient and effective shopping technique when the product is relatively well defined and suppliers are reasonably comparable. In short, it works well when information and transactions costs are fairly low. These conditions are of course met in very competitive supply markets but are less likely to prevail in markets where the players are differentiated and have some degree of market power. Managing suppliers in those cases requires a measure of the supplier value as well as the cost of searching for and maintaining relationships.

Valuing Supplier Equity

Supplier equity is the value of a firm's relationship with a vendor (or group of vendors) within the context of its supplier portfolio. Supplier equity is the difference between the net present value created in conjunction with the supplier and the present value of the costs of doing business with that vendor over the life of the relationship. A more formal definition is shown in the headache inducing figure and formula below. To reduce the algebraic clutter, we have suppressed the probability and expected value notation.

This formula isn’t really so bad if you break it down into the various components. There are nine major factors that determine supplier equity:

• Quantity or volume of purchases over time. This is the number of widgets or hours of time you buy (or expect to buy) each period over the life of the relationship. It is denoted, reasonably enough, as Qt.
• Unit price advantage refers to the difference in delivered price per unit for this supplier compared to the next best comparable supplier and is represented by Pt. Note that it may be positive or negative – you may pay more per unit from this supplier than another particularly if lifetime ownership costs are lower.
• Unit operating costs are the annual expenditures on the product or service provided such as operating and maintenance expenses. This is denoted as O and will be lower for suppliers offering better products, support, and warranties.
• Risk management costs, R, are those undertaken by the buyer to protect against loss due to supplier related factors. Examples include insurance, hedges, and inventories. These costs may decline over time as the number of the firms’ interactions increase, but never go to zero. Obviously, the more complex, critical, and unique the product in question the greater Rt will be.
• Relationship, M, costs. Relationship management costs are those related to doing business with the supplier. They include contracting, billing, and other routine activities. Suppliers that make these activities easier and less costly by, for example, facilitating on-line ordering and tracking have more value. Further, longer-term interactions tend to make employees in both firms more comfortable dealing with each other and issues are less likely to become confrontational.
• Search and switching costs foregone refers to the savings associated with continuing with this supplier, shown as S. In some cases, suppliers are able to enforce switching costs by, for example, imposing a termination fee. As a savings, it is a negative number when calculating net relationship costs.
• The co-innovation factor, defined as the natural log (ln) of I where I, represents the potential for collaborative efforts in which the supplier and buyer may share in the value mutually created. The innovation factor is related to the degree of competition faced by the supplier. In a perfectly competitive market, I = 1 and since ln 1 = zero, there is no supplier equity. In some cases, a supplier may have extensive market power and, while capable of co-innovation, elect to capture all of the value. (See discussion on “Intel Inside” and recent arrangement with Apple.)
• The discount rate, d, is typically one divided by one plus the firm’s cost of capital or whatever it uses to discount future events. Many firms use a risk-adjusted rate for specific projects. If a risk management action has been taken on one or more of the supplier equity elements, the relationship risk factor should be reduced to reflect that action and avoid double counting the risk.
• Duration of the purchase stream is simply the time, expressed here in number of years, t, that the relationship is expected to persist. The t value runs from 1 to n, the final period.

All suppliers are not created equal; each must be managed in light of its potential value and the expected costs of maintaining the relationship. Supplier equity value will depend on a number of market-driven factors:

• Cost and margin of the product or service; low cost, low margin commodity goods do not support much supplier equity unless volumes are very high.
• Degree of competition in the market for the input good or service; if the supplier contests with numerous similar rivals, the advantage to the buyer of a relationship with any one supplier is limited since the market is driving efficiency gains and individual players may face higher survival risks. There is no supplier equity among perfectly competitive vendors since the price, transaction costs, and risk profiles are identical.
• Relative market power of the parties; a monopolist isn't likely to partner enthusiastically or exclusively (see Intel), and if you are a monopsonist, your gains from investing in relationships are probably (but not certainly) minor compared to the clout you already wield.
• Product characteristics. Long-lived and technically proprietary products such as MRI machines inherently involve long-term relationships with the supplier for support, maintenance and even financing. The balance of power in the relationship and the capture of rents depends upon the organization of the buyer community. For example, a single hospital may find it better to enlist in a pool of MRI users large enough to be able to diversify suppliers and exercise some leverage over them. Potential actions to increase supplier value include direct investment in suppliers, supporting new production capacity, providing technical assistance, arranging or promoting affiliations among members of the supply network and, in some areas, consolidations and buyer pools, etc.

Direct Investment in Supplier Equity

The decision to make or buy is not always clear-cut. Companies often take or retain financial stakes in suppliers thus taking literal supplier equity positions. Direct supplier investments should be undertaken based on the factors discussed above with the additional element of potential financial returns or losses associated with the stake. Two examples illustrate the range of direct equity investment and outcomes.

Big Pharma frequently take equity positions in smaller, more innovative drug research and development firms. The smaller firms specialize and focus on fewer drugs, exploiting their comparative advantage in specific areas. The larger firms are able to bring their wide-ranging expertise and resources to bear as necessary. Both benefit: the smaller firms get access to capital, marketing prowess, and general expertise, while Big Pharma gets access to new drugs to add to their portfolios and opportunities to expand their own research agendas, while preventing competitors from gaining access. If the new drugs are especially successful, the investing Pharma may also reap some financial returns on its stake in the company.

On the other side of the supplier ownership spectrum, GM and Ford retained residual stakes in their former captive parts manufacturing units: Delphi, at GM; and Visteon, at Ford. (Chrysler kept Mopar in-house.) In large part, it was necessary to do so in order to get funding for them as stand-alone companies. GM is on the hook for billions of dollars of liabilities at Delphi. Unfortunately, due to their reliance on their former owners for sales, the parts companies have been vulnerable to price-squeezing. This contributed to the bankruptcy of Delphi and an interesting standoff between the company and GM. GM was ultimately forced to supply more capital to its offspring.

Being Obsequious to Customers is Not a Strategy

Active collaboration between suppliers and customers will usually create more value than a “go it alone” approach, but it is important to avoid sycophants - suppliers that merely echo what they hear from the customer and are so intent on pleasing them that they try to serve up whatever the customer fantasizes about rather than offering well thought out and effective alternatives. A recent case involving a bank and one of its IT suppliers demonstrates the distinction between professional co-creation and knee-jerk responsiveness.

The tale begins when a senior bank executive mentioned to a supplier that he wanted to reduce the costs of servicing customers in branch offices. Specifically, the bank executive conjectured that automating and hence speeding up some teller transactions would free time for tellers to cross-sell other products to customers and reduce the costs of transactions. In response, the supplier put together a project team to capitalize on what it perceived as a hot sales opportunity. Ultimately the team, with no further customer input or guidance, devised a product that was little more than an answer in search of a question; it didn’t really speed up transactions, it was expensive when all of the costs associated with it were included, and there was a strong likelihood it would antagonize the bank’s customers. Some members of the team, who worked at a subsidiary, felt that the proposed product was so seriously flawed that it was beyond redemption. They raised their objections but were pooh-poohed by the aggressive managers from headquarters who maintained that it was supported by top management and charged ahead with the project. For example, when the skeptical team members asked how much value would be created for the bank, they were told that didn’t matter, the point was how much value would be created for the supplier.

Eventually enough uncertainty arose due to the questions raised by the members from the subsidiary that an outside consultant was hired to evaluate the product and evaluate its likely acceptance in the marketplace. The consultants produced a very thorough report that concluded that the product was not good; that banks wouldn’t buy it, and, most importantly, that the company’s reputation for thought leadership would be seriously harmed.

Within twenty-four hours of the consultant’s presentation, the project was scrapped completely. The most vocal member from the subsidiary, whose concerns had been dismissed throughout the project, sent an email pointing out that a lot of time and expense could have been avoided if there had been a truly open discussion of the pros and cons of this product. A day after the email was sent, the SVP responsible for the subsidiary told the head of it that the company would have saved a lot of time, money, and trouble if it had listened to the skeptics on the team.

The point is that in order for there to be fruitful and value-added interactions the supplier needs to offer real alternatives, not just mindlessly react to every thought or stream of consciousness that a customer shares. In many instances the customer knows that the current approach isn’t optimal and is groping for a viable alternative. Their ‘thinking out loud’ is just a way to get the conversation started, not a blueprint for production. Be careful of those who would be nothing more than bobbleheads nodding in agreement to everything said by a customer.

Supplier Equity Risk

Alas, all equity bears risks. Supplier relationship management addresses the potential risks and rewards of the relationship by identifying and exploring alternative investment and operating strategies. The supplier portfolio risk reflects the risk of individual suppliers, their weight in the portfolio, and their covariance with one another. It does little good to “diversify” among suppliers with identical risk profiles.

Supplier risk affects the expected value of the supplier relationship. For example, a supplier may have a high possibility of bankruptcy and hence a shorter expected relationship lifetime, which in turn may lead to additional search and transactions costs which further reduce supplier equity. The risk of short-term supply disruptions due to labor actions may be extremely expensive as many shippers discovered in 2002 when UPS teamsters struck and the remaining delivery service capacity was strained. These risks are exacerbated when the supplier provides a complete package of services such as UPS’s logistics and warehousing which are very difficult to re-source quickly.

Many buyers analyze the financial condition of major suppliers but rarely examine closely the underlying risk profile of the vendor. The types and levels of supplier risks vary by geography (transportation disruptions, political volatility, etc), propensity for employee work actions, intellectual capital protection, financial condition or ownership, and upstream supply and production disruptions, etc. It is important to determine the risk factors of major suppliers and their correlation with one another in order to determine the risk of the portfolio. In some cases, supplier risks may be highly correlated and stem from a common source, say, fuel or raw materials. In those cases it is often best to hedge or insure against the underlying risk factor or even consider redesigning the product or service to reduce or eliminate the need for the risky element. Supplier equity risks may be managed in a number of ways including:

• Contract terms providing economic incentives for performance. But enforcement can often be difficult, expensive, and sometimes futile. Like prenuptials, complex procurement contracts are no guarantee of relationship success.
• Suppliers' shares of total purchases can be adjusted to reflect expected performance risk. This is a traditional multi-sourcing approach and is still effective with standard or commodity goods easily substituted by other suppliers.
• Options on production capacity may be purchased to hedge against disruptions and to support the preservation of capacity in lower risk, higher cost producers.
• Direct investments in suppliers can provide privileged access to technology and priority claims on output. It is sometimes difficult to determine the appropriate candidates and to gain insight into marginal rates of return and risks.
• Suppliers may be offered alternative risk and reward sharing arrangements beyond typical performance contract terms.
• Downstream customer contracts may be written to insulate the buyer from penalties arising from non-performance or supplier failure.

• In some cases, insurance and financial instruments may be used to hedge or mitigate supplier risks. The recent meltdowns of sub-prime securities and their derivative risk hedging products, reiterates the lesson that the efficacy of risk shifting depends upon the ability of the issuing party to deliver under all market conditions.
• Developing systems that track key supplier risk may provide early warning of upstream problems.
• Inventories, one of the oldest supply disruption hedges, are still cost effective in many cases. In some industries using standardized components such as utility poles, companies can jointly hold inventories with the total shared inventory less than the aggregate of stand-alone inventories.
• Muddling through is a common default risk management technique and is often effective. Heroic examples such as Apollo 13 and Ernest Shackelton usually follow poor contingency planning but day-to-day glitches are frequently resolved through extemporaneous muddling. Muddling is best supported by organizations and cultures that provide flexibility and reward initiative.

The cost of bearing risk is the expected loss from an unplanned or unanticipated event. The cost of managing risk is the premium or additional cost necessary to achieve the desired or acceptable exposure level. In principle a firm should invest in risk management up to the point where, at the margin, the foregone expected loss equals the premium.

The cost of risk management may be very low relative to the consequences of the unprotected event. Many catastrophic losses result from relatively minor components such as the Challenger’s frozen o-rings. This is especially true of horseshoe nails: we all learned very young the dangers of chain reactions set off by trivial events as in “for want of a nail the kingdom was lost” and more recently the 2008 Belmont Stakes was lost, at least in part, when heavily favored Big Brown experienced a loose shoe. Condoms and vaccinations offer low cost protection from very high cost consequences.

If there is but one (and hence, undiversifiable) supplier of a critical component, say, electricity and the risks of outages and lost production are 10 days per year, then the expected cost of that unmanaged risk is 10 days of output disruption. If insurance or backup can be purchased for less than that, it is worthwhile to pay the premium. A more sophisticated analysis might look at the marginal costs of avoiding incremental days of outage; e.g. 1 day, 2 days, etc. and determining the “optimal” or least level of outage.

Supplier Equity Portfolio Management

Supplier equity is the fundamental unit of analysis and management but should be viewed and managed within the context of a supplier asset portfolio. Supplier portfolio management entails identifying, evaluating, contracting and administering the firm's stable of vendors. The optimal supplier equity portfolio represents the highest valued combinations of supplier relationships in terms of expected rewards and risks.

The notion of a supplier equity portfolio builds on the concepts of supplier equity, value chains and networks. Before we address portfolio management, it is useful to introduce some of the tools involved in assessing options. The data necessary to calculate supplier equity and risk values should emerge from an examination of the total costs and the interactions involved in creating value for customers and shareholders. Companies may, for example, find that direct cost savings from outsourcing are outweighed by increased information and transactions costs. Perhaps counter-intuitively, we have observed a number of companies whose internal information and transactions costs exceeded those with their external suppliers.

One of the first steps in moving to a supplier portfolio perspective is building on the value chain representation of value creation to develop an enterprise process map. The typical starting point, the value chain, is an important concept because it illustrates the order and dependence among inputs and, hence, the company’s dependence on the suppliers of those inputs. The value chain is closely related to the economic notion of "value added" and can be converted into a "value-added chain" by introducing the contribution of each link in the chain to total value created by the whole. This step is important in assessing supplier portfolio options because of the possibility of merging or decomposing some links within the chain.

The value or value-added chain should be examined within the context of the business' major value producing processes and activities that span the enterprise from customers to suppliers, internal or external. (See the simplified enterprise process map below). The firm should have a decent idea of the cost of its various processes and functions on a basis comparable to outside vendors. Internally generated products and services are part of a company’s supply portfolio. It is important for the firm have an idea of how sensitive their cost functions are to changing circumstances. For instance, is price or availability more critical?

The enterprise map may inspire examination of some otherwise neglected outsourcing or insourcing opportunities and mitigate some of the defensive applications of the "core competency" notion within companies.

An enterprise-wide view is especially useful to explore and appreciate the importance of external and internal transactions costs. Most firms have only a vague notion of internal transactions costs and this can lead to sourcing mistakes. Looking at all the connections in even a simplified enterprise map such as that below makes the importance of transactions costs evident. Enterprise Resource Planning (ERP) systems have been employed to reduce internal control costs and can be used to estimate internal and external sourcing costs but may also reduce flexibility to alter supply paths.

Developing a reasonably accurate picture of the supply network supporting your company is useful in extending the corporate perspective from a supply chain to a supplier equity portfolio perspective. The supply chain implies a linear combination that suppresses the underlying layers of suppliers and their interconnections. The notion of a supply network is important because it expresses the relationships among suppliers and buyers and expands the analysis beyond the first tier of relationships. In many cases, supply problems may arise outside the immediate supplier group and infect the system without a great deal of warning to the downstream parties. Many of the difficulties faced by both Airbus and Boeing in bringing their most recent aircraft to market originated with suppliers and disrupted the entire network.

An assessment of the network risks faced by downstream buyers is often surprising and sobering. The current credit crisis is a case in point. The cost and availability of funds to many firms and individuals have been negatively affected by actions elsewhere in the financial system. Interestingly, the credit crisis seems to have been caused by suppliers unwisely providing equity (asset values were below securitized debt levels, hence the loans had an “equity” component to them) to unqualified buyers and failing to recognize or manage the risk of default.

Once you’ve identified the members of your supplier network, determined their share of your value added, explored their inter-actions and risk exposure you can use that information to construct a supplier portfolio. The supplier equity portfolio concept builds on the network and enterprise process mapping tools and facilitates the application of financial asset management techniques to supplier management. Each supplier in the portfolio can be represented by its supplier equity value (as estimated above) and a risk measure based on its characteristics and historical performance (if appropriate).

A portfolio management perspective enables firms to categorize suppliers by potential risks and returns and concentrate efforts on high value initiatives. Candidates for the supplier portfolio should be evaluated on the same basis as existing suppliers and the portfolio value assessed with and without the candidate at various shares of supply in order to capture the correlations among candidates. As with financial securities, the weighted risk of a supplier portfolio comprising diversified suppliers is lower than the risk of any particular supplier. For example, the portfolio risk of a delivery or logistics supplier portfolio made up of Fedex, USPS, and UPS is less than any one or two of them alone.

How’s Your Supplier Equity Doing?

There are a number of questions you can ask of your supplier relationship management processes that may suggest areas for more comprehensive reviews. Some of these include:

• Are your bidding and selection processes defined almost entirely by the size of the procurement?

• Do you make periodic evaluations of the value and health of key supplier relationships? • Are your supplier relationships shaped and driven largely by the suppliers’ account management activities?
• Are supplier relationships actively managed by accountable managers?
• Do you have a good idea of how your suppliers rate you as a customer and what steps you could take to achieve mutually beneficial improvements?
• Are there tensions between your operating management and procurement organization over supplier assessments?

Looking at your supplier relationships through the lens of supplier equity can reveal opportunities to better compete in today’s markets.