Leverage as a Supply Management Strategy: The Good, the Bad and the Ugly
By Paul Ericksen | Industry Week
Leverage in supply management is often portrayed as something akin to either a silver bullet or the Holy Grail, with establishing leverage in negotiations considered paramount to just about everything else. I disagree with this perspective and will spend the next few columns discussing why. In doing so I’ll use two analogies. In this column leverage in negotiations will be compared to athletic competitions. In the next one it will be tied to the issue of personal relationship management.
Sports tend to be the ultimate in “win-lose” activities. A couple of months ago I wrote a blog about “positional” negotiations in which each side considers the other to be an opponent. Such win-lose negotiations are “zero sum.” This means that when one side gets more, the other side—by definition—ends up with less. Leverage is the primary tool associated with zero sum negotiations. In sports, a competitive aspect and win-lose outcome is understood and expected. As the Hall-of-Fame coach of my favorite professional football team once said, “Winning isn’t everything—it’s the only thing.” But is a leverage-based win-lose negotiation strategy really the most effective way to work with suppliers?
I’ll switch sports now, as I continue on with this vein of thought. You probably don’t need to be a fan of college wrestling—my favorite sport—to know what a half-nelson is. It is a wrestling hold where from behind your opponent you slip your arm between his arm and body—just under the shoulder—and then bring your hand up around behind to grip the back of his neck. In this position your arm can be used as a lever to pry your opponent into positions he’d rather not be in. Wrestlers like to say that the ultimate goal of a wrestling match is to “impose your will” on an opponent, and holds like the half-nelson certainly are tools for attempting to do just that! I think you can see where I’m going with this.
Using leverage in negotiations is akin to applying a wrestling hold that allows you to “impose your will” on those you are negotiating with. You might ask, “Who cares, as long as the prices go down? After all, isn’t that what supply management is all about?” Actually, as I’ve written before, piece-price should usually not be seen as the whole story in a purchasing transaction. And leverage applied inappropriately can lead to unintended negative outcomes.
In my mind there are two “good” scenarios relative to the use of leverage in negotiations. The first is with “economies of scale.” When increases in volume facilitate lower supplier direct and/or overhead costs, the negotiation for lower prices is no longer a zero sum game since both sides can win, i.e., piece-prices can go down without the supplier having to sacrifice financially. A primary tenet of mine was always “when costs go down, prices go down,” and it seemed to play well with the suppliers I worked with. So if, by providing additional volume you provide a supplier the opportunity to reduce their costs and they are not forthcoming with reduced prices, it is justifiable for a customer to use leverage to obtain them. Of course, if the supplier offers them without leverage having to be applied, that’s even better!
A second “good” scenario is with commodity type products. Commodities are considered generic and readily available from a multitude of sources. The reality with commodities is that leverage is the standard basis for negotiating pricing and that because of this there will likely be winners and losers—at least to some extent—in every transaction. Customers usually have the leverage. If you are a commodity supplier and don’t like being leveraged, my advice to you is get out of the commodity business. Or at least demonstrate to your customers that what you offer is really “above and beyond” a simple commodity.
And remember, when there is a shortage in a commodity the leverage goes over to the supplier and, in my experience, they take full advantage of it—just as the customer does when they own the leverage. But in both cases, sellers and buyers expect and anticipate this type of negotiation strategy as well as the outcome. So here again, there is nothing wrong in using leverage with commodity negotiations.
The difference between the “good” and the “bad” in use of leverage often involves answering the question, “What is a commodity?” Customers like to characterize as commodities as many product types as they can since this both simplifies transactions and gives them the leverage. Based on what I’ve seen from some OEMs, it could probably be said that they regard all products as commodities. Suppliers, on the other hand, tend to want to limit the definition of commodity to exclude what they are selling! Again, you might ask, “If applying leverage is effective in lowering piece-price, why shouldn’t all products be treated as commodities?” There are at least a couple of reasons.
First, it should be understood how commodities and non-commodities contribute to a customer’s cost-of-goods sold. Commodities are products that require little organizational support. For instance, a minimal amount of engineering resources are needed in applying standard hardware to the design of a product. Because of this, the primary contributor off-the-shelf fasteners make to a product’s cost-of-goods-sold is through their piece-price. On the other hand, products that are not commodities require organizational support such that piece-price—in-and-of-itself—does not adequately represent their actual contribution to total cost. The cost of this organizational support is usually hidden in customer overheads. The problem with using leverage in buying non-commodity products is that it is not an effective strategy for recognizing and accounting for organizational overheads.
I’ll relate a common scenario to demonstrate what I mean. Many suppliers try to differentiate themselves from their competition through their expertise in applications engineering. They often make suggestions to product design that would normally be considered the responsibility of their customer’s group and, in doing so reduce their customer’s product costs, product development costs and need for engineering overhead. Most suppliers do not directly bill customers for this support, instead wrapping it into their piece-price. Similarly, most customers would not want or accept a separate invoice for this type of support. A year or two later someone—usually a cost accountant—not familiar with the supplier’s past contribution to product development finds that another supplier can manufacture the parts at a lower piece-price and comes to the conclusion that the current supplier is not competitive.
Does that mean the supplier that helped their customer develop their product design is more expensive? No. It’s just that the new source wouldn’t have to account for development resources and costs in their piece-prices. In my experience “apples-to-oranges” piece-price comparisons are seldom recognized in leveraged negotiations. Resourcing to the new supplier might be okay if a customer is never in the future going to need supplier design support but otherwise could be considered a bit short-sighted. But tell that to a cost accountant!
A corollary of the above example is that quite often those suppliers who can provide slightly better piece-prices are the ones that generate higher customer organizational costs. An example of this can be seen in logistics. Significant increases in logistics overheads have been realized by organizations as they expanded their overseas sourcing. And although I’ve seen “logistics costs” incorporated into total acquisition price comparisons, I’ve never seen the increased overhead costs included. Consequently, total acquisition price evaluations between foreign and domestic quotations tend to be “apples-to-oranges” comparisons.
A second corollary of that example is that those suppliers that can do the most to lower a customer’s costs-of-goods-sold don’t usually appreciate it when a customer starts applying a piece-price half-nelson. In fact, in my experience they tend to either walk away or stop providing the extra support. For example, companies who have dabbled in online auctions—the ultimate leveraging tool—for non-commodity parts often find that their best suppliers elect not to participate. This is not because they are not competitive. Rather, it is because online auctions measure competitiveness in only one way, i.e., piece price.
The bottom line on the “bad” in leverage is that it isn’t an effective negotiating strategy for non-commodity products since it doesn’t recognize costs other than piece-price. Consequently, using leverage with non-commodity products can result in a form of “fool’s gold” savings where your material variance may look better but overall costs increase.
Leverage can take another form in the percentage of overall business a single customer represents to a particular supplier. Most supplier firms recognize, at least intellectually, that for many reasons it is not a good practice to have too much of your overall business with a single customer, i.e., putting all of your eggs in one basket, so to speak. Why? Because when customers achieve this type of position with suppliers they can use the leverage this gives them to—as in wrestling—impose their will on their suppliers. I am aware of some OEM companies that actually use this as a business strategy, at least an informal one. Specifically, they lead on unsuspecting supplier firms through regular business practice to become more and more dependent on them, and then lower the boom.
I had a conversation last summer with a supplier that had fallen into such a leverage trap and related the following story. This supplier had heard stories through the grapevine about how it was dangerous to direct too much of your overall business to a particular OEM but couldn’t resist taking what looked like “good” orders from them. Over a period of three to four years, they continued to get “good” orders from this OEM until roughly 40% of their overall production was for them. Then one day the OEM came in and applied the half-nelson, basically tearing up all of the existing agreements and threatening to immediately cease all business with them unless immediate significant piece-price concessions were made. Talk about imposing your will! The impact this would have had on this supplier’s cash flow would have been devastating, essentially drying up their access to credit, thus putting them out of business. To make matters worse, the supplier was coerced into taking on more of this customer’s business, under the same sort of leverage threat!
I consider the above practice unethical but know it occurs. My advice to suppliers is that if you hear through the grapevine about such a customer—run, don’t walk away from them if they approach you.
The bottom line on leverage is that it is a tool that more often than not creates antagonistic relationships. This is okay when you’re in a wrestling match or, as in the case with commodities, you don’t rely on the supplier for anything other than the parts you buy and you have other comparable sources available. But when you have costs that go beyond piece-price, leverage is a strategy that often doesn’t produce the optimal result.