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The purchasing strategy and supplier dependency

In the book „The Everything Store: Jeff Bezos and the Age of Amazon” written by Brad Stone, Amazon’s employees compare trade on the company website to addiction to heroin. When product sales gains momentum sellers fall into euphoria, then into addiction but when Amazon starts to reduce margins comes self-destruction. According to Kerry Morris vendors know they „shouldn’t take heroin” but it’s too late for them and they can’t stop.

In the case of Amazon, or the retail industry in general, the supplier usually has the greatest risk of becoming dependent on the customer. In the defence, aviation, maritime, automotive or rail industries, the situation is not so straightforward and should be addressed in the purchasing strategy.

Heavy dependency can be dangerous for both the supplier and the client.

Based on Eveneum’s practice, the most frequent reasons for one source dependency are:

  • supplier indicated by the customer, so-called customer directed, customer nominated supplier. It is interesting that often such a supplier is not formally imposed by the customer but “highly recommended”
  • limited supply market, lack of sources in a certain region
  • specific product or material
  • monopoly due to IP or entry barriers like e.g. brand recognition and trust
  • the need for early involvement of the supplier in the design or preparation of the specification [upstream]
  • too high costs associated with the change and/or validation of the new supplier / solution
  • obsolete technology or material in combination with small volumes, and as a consequence lack of interest from other suppliers
  • purchasing strategy, e.g.  introduction of a distributor who takes over small suppliers. E.g. instead of buying fasteners from 20 manufacturers, there is  a supplier who is coordinating necessary activities on behalf of the customer
  • strategic decision about strengthening cooperation with the supplier. In Aviation establishing JVs with the key technology suppliers is quite common. An example that caused me a big headache in 2012 was the JV for fibres for ceramic metric composites created by GE, Snecma and Nippon Carbon, more information at: GE reports and yahoo finance. And I was managing composite materials category at Rolls-Royce that time…

Defining the purchasing strategy should take into account, among others, the value of spend with the supplier in relation to the value of his total turnover. We can calculate this “level of addiction” in the following way: the value of spend with the supplier €4 million, supplier’s turnover €10 million which gives us supplier’s dependency on the customer at the level of 40%. From the buyer’s perspective, it may seem a favourable situation – buyer has strong leverage, his decisions can have a significant impact on the supplier. Supplier needs to respect him. Unfortunately, this also has its downsides.

Possible consequences for the buyer who makes the supplier too dependent on him:

  • financial risk – limited ability to compensate for loss of income by the supplier in the event of seasonality or crisis in the industry. In 2009 crisis and problems of the OEM’s triggered chain-reaction in the whole automotive industry. Suppliers were losing liquidity, and the consequences were borne by the buyer – urgent resourcing, customer’s production line stoppage, need to finance operations of the supplier e.g. by buying for them materials necessary for the production. Article summarising the situation in the American automotive industry: www.businessinsider.com
  • continuous improvement – cooperation with one main customer limits the possibility of gaining experience by the supplier. For example, 20 / 30 years ago, many OEMs had Tier1 suppliers in their organisational structures. They were somehow ex officio involved in the production of new cars. Currently, most of the Tier1s are independent of OEMs. They need to compete and continuously improve their offer in terms of: Q, D, C, T, M, if they want to win a new project.

The level of „ buyer’s addiction” to the supplier can be calculated by dividing the spend with the supplier by the total spend within the category. For example, if the spend on plastic parts is $1000,000 and the spend from the supplier is $200,000 than the buyer’s dependency is at the level of 20%.

Possible consequences for the buyer who is too dependent on the supplier:

  • weak buyer’s negotiation position
  • possible lack of motivation for the supplier to improve his offer in Q, D, C, T, M
  • dependency on the supplier’s IP and know-how
  • reliance on the technology that is convenient for the supplier, but not necessarily for the client
  • BackDoor Selling and loss of control over internal partners by the buyer.

What is the right level of spend with a supplier? It is difficult to define one value that will be good for any industry, any type of product or service. When we work on category/commodity strategies with our clients, especially in automotive, aviation, rail and marine industries, we start with the 30/30 rule. It roughly says that:

  • no supplier should exceed 30% of the spend in a category
  • spend with the supplier should not exceed 30% of his sales

Of course, this is a very general rule and should be tailored to the industry, technology, supplier segmentation and the type of relationship we have in place or want to have in the future.

The key for the right decision is thorough analysis, reviewing the internal and external situation, and finally risk evaluation. A decision to increase level of dependency should include mitigation plan in case relationship deteriorates or risk materialises.

All of those element we are analysing with our clients helping them develop purchasing strategies and identify risk in their supply chains. Those processes can be supported by a user friendly IT systems like ESSA.