Advantages and Perils of Sole Sourcing
By Jeffrey Cartwright
Most Purchasing Managers Buy from Existing Vendors and Rarely Entertain Additional Sources
The purchases of raw materials and components is generally a repetitive activity that rarely looks for value. The process of purchasing is many times reduced to determining the quantity needed and simply placing orders with vendors with long histories of providing the materials. Rarely are the vendors reviewed as to whether they are the best and rarely is there a dedicated effort to look for alternative vendors that might provide better value.
Buyers almost always claim that they purchase materials or components based upon the best price and that the materials are suitable for the use in production. The latter part of this statement is always true, as the incompatibility of the materials would cause quality issues or high waste in production. The former is seldom true. Purchases are made by buyers based on a principle of “no disruptions”, not on pricing. If the buyer is late or if the material causes a disruption to the production line, the effects on the manufacturing process can result in shutdowns and subsequently missed customer shipments. The buyer will do everything possible to prevent these occurrences. Buyers may be disciplined for these events. Overpaying for a raw material or component occurs frequently but is generally unknown to the rest of the organization as buyers will not disclose that they have a supplier with a better price as it would lower their perceived performance in the company. Sole sourcing, done properly, is a great way of limiting buyer choice by partnering with a supplier that adds significant technical or other value to the organization.
Parameters for Strategic Partnering (Sole Sourcing)
Strategic partnering should be a goal when the source of materials or components can add a significant competitive advantage. Either the purchase quantities are so significant that they are a large part of the cost of goods sold or that the underlying materials can add value to the finished product in such a way that your competition is disadvantaged in delivery, quality, or the inherent performance of your product. Strategic partnering should not be considered if the materials or components are of a sporadic purchase or are readily available as an undifferentiated material (commodity). Partnering for a commodity should only be considered due to expeditious or best quantity of delivery, or consistency aspects of the commodity that then enable the manufacturing process to either reduce its cost structure or its time to respond to demand changes.
True strategic partnering requires a significant investment of time and energy in the processes of searching for the right partner, developing both a clear short-term and long-term understanding of each other’s needs and capabilities, and periodic review of the relationship. It goes well beyond the transactional aspect of the buying/selling purchase order and extends to the executive level in both companies. As such, neither business should have more than a few partners and they will normally be in different areas of the businesses.
Advantages of Strategic Partnering (Sole Sourcing)
Once a relationship is established there are clear advantages to the purchaser in strategic partnering. It eliminates the need for repetitive bidding. When it is a true partnership, both businesses will share strategic updates and tactical plans. If the supplier is bringing technical expertise or significant product advantages, then future changes will be communicated well in advance. As the capabilities and knowledge of the supplier increase, these are shared with the buyer. The seller is partnering with the buyer to lower the final cost of products to the next customer in the supply chain. Both companies benefit due to their combined ability to add tangible value to the buyer’s customers. Joint projects are common and, of course, strictest confidentiality is maintained by both parties. Co-branding may also be used to enhance the perceived value of both companies. There is clearly a sense of shared destiny rather than the drive for advantage in negotiations.
Sole Supplier Does Not Necessarily Mean Strategic Partner
Having a supplier that provides 100% of certain raw materials or components does not necessarily mean that the supplier is a strategic partner. It may well mean that the purchasing department has done not thoroughly searched the market and vetted alternative suppliers.
Let me provide an example. Shortly after arriving at an underperforming company, I spent a fair amount of time reviewing purchasing both the materials and the processes. By the way, since one of the largest areas within a business cost structure is materials, I never assume that purchasing is an area of strength for the company. One of the materials purchased was a variety of corrugated boxes used for shipping the product to customers. Generally, there are several potential suppliers available. They usually have some different capabilities and their individual cost structures will vary somewhat by equipment and distance. In discussing, with the purchasing manager, the category, one of the questions concerned periodic competitive bidding. He assured me that each year he solicited bids via a Request for Quotation (RFQ) process and that the materials involved were purchased from the low bidder in this process. I followed up with the question, “when was the last time that a different vendor had been awarded the bid”, he responded with “over 10 years”. So, for more than 10 years, the company was sole sourced with this corrugated manufacturer. This did not seem quite right. When asked to show me how the last RFQ process was conducted, he produced a well-done Excel spreadsheet of the items, specifications, annual quantities purchased and the results of the 10 bids solicited. In further discussion, he shared with me that the solicitation was done via faxing the spreadsheet of items, specifications, and annual volumes to the 10 bidders which included the incumbent. There were no meetings with them, no site visits by most of the bidders, and written responses from most. 4 of the potential bidders did not respond at all. 5 of the bidders were high. Of course, the incumbent bidder was the lowest and only marginally different in price from the previous year.
I did not view this as a bidding process, but rather as a minimal effort to be able to inform his executive that he had done a great job by conducting a competitive RFQ. Missing from this process were meetings with potential alternative vendors which would convince them that their efforts would be taken seriously and evaluated on the merits. By now, most were convinced that they would never be awarded the business as this manager was thoroughly committed to the incumbent. This was reinforced by his being a very difficult person for these, or most vendors in other materials, with whom to schedule an exploratory meeting.
From this low point, we engaged in a process of inviting potential vendors to meet with us and combined the visits with plant tours and a discussion of our strategy. We also visited several vendors and toured their manufacturing facilities. Once we had several potential vendors interested and that they felt it would be an open process, we began negotiations which generally consisted of an initial discussion round concerning both parties’ objectives, and an open dialogue on other issues. This was followed by an initial round of bids with feedback to each prospective bidder. After second round bids were submitted, we then entered in-depth discussions with 3 vendors (by now all of which had bids under our previous prices). We awarded the business to a new vendor even though the incumbent was very competitive with the lower prices. I wanted to send a message to these corrugated vendors, vendors of other materials, and our purchasing department that it was not business as usual. By the way the final prices were approximately 15% lower than from the previous RFQ process. Subsequently, the purchasing manager was terminated due to low performance.
In the world of Mergers & Acquisitions, the buyer side of a potential acquisition heavily discounts an over concentration of suppliers or customers. This implies a substantial risk should the relationship deteriorate. For materials that are generally available, this is probably a good practice. However, if the vendor is truly a strategic partner and the materials not as interchangeable, this is probably a poor practice.
Eventually One Party Achieves a Position of Strength that Can Be Detrimental to the Other Party
Reaching an agreement to become strategic partners is not the end of the process. The buyer and the salesman are incapable of becoming strategic partners as neither of them represent the commitment of their companies to do the things which these relationships require. They are characterized by continued dialogue, periodic benchmarking, and exploration over how both parties continue to add value to the relationship.
In the absence of the above, over a long period of time, one partner or the other becomes complacent in the relationship. This may result in the other party being able to entrench themselves further in the buyer’s mind and alternatives never explored. Advantage is sought by both companies to expand revenues, increase margins, reduce risks and other normal business objectives. When the selling party no longer feels that its business may be at eventual risk, then there is an opportunity for the vendor to incrementally expand margins by incrementally increasing prices.
Signs of this occurring include a failure on the buyer’s company to stay current with alternatives such as technology, an absence of periodic meetings with alternative vendors to explore what new developments are occurring within their industry, etc. Another potential sign is when benefits are bestowed by the seller to the buyer that build individual loyalty that supersedes the objectivity that both partners should have. This may be the case where “relationships” is overused rather than “partnerships”.
Breaking Out of Complacency and Shifting the Relationship Back Towards the Buyer (Customer)
When the customer side of the relationship feels that things are out of balance, there is a need to meet with the strategic supplier. One of the things that I have done when I begin in a new organization is meet with all suppliers and ask the question “why are we doing business together?” Most times, the answer is shallow such as the vendor being the low-cost supplier. Even more times, it is something like “we have been doing business for 20 plus years”. That is a historical fact, not a reason to conduct future business. There is nothing wrong with this response from most suppliers. It may, however, be an indication of complacent and under-performing purchasing department. If the vendor is a sole source, it is a terrible answer as it does not go to the value of the potential partnership. The follow up to such an answer should be to return to the home office and bring an executive who has can articulate what is unique about his or her firm and can clearly articulate the benefits to the buyer’s organization why such a partnership is in the buyer’s long term best interest.
Once a period of dependency by the buyer has begun and is relying on history and cannot articulate the reasons for the partnership, an objective look needs to be taken. There may be good reasons to continue and then again maybe the original reasons no longer exist. By the way, I am in favor of these relationships when they are clearly advantageous to both parties and they bring value beyond the transactional level of buying and selling of materials or components.
Thin Glass for Picture Frames
At the time there were 3 domestic producers of thin glass plus sources in China for the same material. A few months after arriving at a picture frame manufacturer and marketer that was clearly failing in a turnaround, the company received a “dear valued customer” fax announcing a 35% price increase. The company was sole sourced on glass. “A dear valued anything” letter received in any form is somewhat demeaning. If the customer is truly valued, then the communication of anything significant is in person. Certainly, a major price increase is significant event in an ongoing relationship.
Determined to not accept the price increase, we summoned their account manager and VP of Sales to meet with us and to explain the rationale. As a part of the meeting, we toured our manufacturing plant and they could see that our daily production rates were increasing for many of our production lines. In the conference room, they presented that their costs were increasing and that the price increase was a result of those changes. I countered with information from 2 of our sister companies that produced glass for housewares that the costs there were up in a very minor way. Since the manufacturing costs of glass has a very small labor component increases for those portions of cost were insignificant. Energy costs were significant; however, those plants were fueled with natural gas as are most glass plants around the US and those costs had declined in the last year. Soda ash and silica sand are also large components of glass manufacturing, but both are rather inexpensive commodities with very little cost changes over the last year. That leaves the major 2 elements of price being overhead and profit.
They were both somewhat taken back by our knowledge of the general industry. The VP of Sales, quickly shifted to it being a supply and demand issue with homebuilding and automobile manufacturing both being strong, capacity utilization was high throughout the float glass industry and the reason was that demand was high. I challenged them that they should decide what the reason is cost increases or supply and demand but that their answers were very disconcerting. We did agree to continue the discussion and arranged to visit their manufacturing plant in Corsicana, TX next. By the way, we already knew that it was demand related in that, although we purchased nothing from their competitors, we had received another “dear valued customer” fax from a different float glass company announcing a 35% price increase which seems somewhat like price collusion or just an uncanny coincidence.
In the meantime, we attempted to generate alternatives. We spoke with and ordered product from this competitor to test (?). We also ordered several containers of thin glass from China which was at a much lower price. However, the glass from China was paper interleaved. This paper needed to be removed by team members on the assembly lines and the additional labor made the total cost approximately the same as the US supplied glass.
When we visited the Corsicana plant, we were invited to meet with the President in Detroit. The Corsicana plant did not manufacture for our company. The product was produced in the Detroit area and sent to a different company which would cut the 4 ft by 8 ft sheets into the smaller sizes such as 5 in by 7 in or 8 in by 10 in which matched the size of the final picture frame. We ordered in these smaller sizes and the float glass manufacturer would manage the entire process including the outsourcing of the cut down process and the shipping to our 3 plants. The Detroit location was the best overall geographic location to service our plants and our direct competitors. During the Detroit trip, we visited the cut down plant and discovered that it was owned and operated by the President of the float glass manufacturer’s son and daughter. Both the visit to Corsicana and Detroit were cordial and each time we requested a withdrawal of the price increase and were rebuffed. An additional meeting at our headquarters plant was held. The usual factory tour was conducted with areas of the plant secured such that our supplier was not able to approach either the inventory locations or the production lines. Their material was being used on most production lines. Several others had the competitor’s glass and the Chinese glass on pallets as if it was being actively used. When questioned, we simply answered that they were forcing us to consider other options and that these were only trial shipments of glass. Knowing that the competitor’s price was the same as theirs and that Chinese glass had the added cost of labor to make it usable, they accepted the information.
The strategy to break this impasse included our building up of inventory over time at each of our 3 plants. The glass that we had received from both China and the competitor was not used. Once we had accumulated about 90 days of inventory in all locations, I directed a completion cessation of communications (within a week of their last visit). Our pattern had been to place a purchase order by plant on a weekly basis with delivery being about 2 weeks later. We stopped placing purchase orders. We did continue to pay invoices for product received per our normal business arrangements. At the end of the first week, we received phone calls and since none of our team members were permitted to answer, voicemails were left reminding us that we had not yet placed purchase orders. I reminded our team that the first team member who communicated in any way would be terminated immediately for insubordination. Communications by the supplier the second week were more frantic with faxes, emails, and phone calls received, but not answered. Knowing that the cut down plant’s significant cost was labor and that they were operating on a backlog of no more than 2 weeks of orders, I expected that they would be cutting back operations and not scheduling production shifts. As we were 80% of the cut down plant’s business, the effect would be quick and severe.
The third week included calls by the VP of Sales and eventually the President of the float glass company wondering if we had changed suppliers and wanting to meet with us immediately. These again were either via unanswered electronic communications of voicemails received. At the end of the 4th week, I called the President and informed him that I would be willing to meet in my location early the following week. I also told him that if the 35% price increase was still valid to not bother with the trip. I suggested that he leave his account manager home as he would be able to contribute nothing to the conversation. By now, I knew that the cut down plant was incurring major losses and its viability challenged by our not ordering.
During the meeting the following week, the price increase was rescinded. We also agreed to a pricing mechanism based upon the cost of manufacturing and agreed to a multi-year deal for these 3 plants. Since we were acquisition oriented that deal extended automatically by including them as the vendor at any acquired business if they were not already and to extend the same pricing to these new plants. They did gain significant share of the industry as we grew through acquisition by a factor of 3 in the next 2 years.
The lessons learned are several. Partnerships must be beneficial to both parties. In this case, one party clearly had a position of strength due to the oligopoly that existed and the ability to take advantage of the other when demand was strong and to earn extraordinary profits. Such behavior required the development of a credible alternative in the supplier’s mind. Here the potential alternative created a position of leverage to which the float glass manufacturer needed to change its policy to not incur an adverse impact at its captive cut down manufacturing company. Once the position of previous balance was re-established, a long-term agreement was reached that provided benefits to both parties. This never was and never would be a strategic partnership, but it did have long term benefits for both.
In the juvenile products industry there are several manufacturers of infant and juvenile car seats. There are significant product liability issues associated with injuries due to automobile accidents in which a child may be injured. The standards of performance are understandably very high, and the testing protocols include crash tests with instrumented dummies simulating accidents via sled testing. Over time, there were only 2 qualified vendors with outstanding records of reliability and quality performance. Of course, there are always Chinese manufacturers that would like to enter the market and would attest to their flawless execution. We, however, were not prepared to take such a risk with our customers that might result in high costs of potential product liability.
Fortune Magazine’s 75th Anniversary Edition published a feature story concerning the revitalization of a traditional manufacturing plant that was threatened by Chinese imports. The company spent nearly $25 million to reconfigure the plant, buy a number of state of the art injection molding machines, build a distribution center, and bring lean manufacturing with facets of Six Sigma to the manufacturing operation. The net result is that all products had lower costs than the cost of importing from China and that the workforce would continue and thrive for the foreseeable future. The added benefit is that quality standards were both high and the product performance well above government and industry standards. The risks of a Chinese manufacturer sometimes shipping inferior products without our knowledge was totally avoided.
Beyond the above initiatives, a part of achieving lower costs consisted of a complete review of all elements of the cost of product including raw materials and components. Car seat buckles was one of those areas to be reviewed. The incumbent supplier was outstanding, but our overall cost structure was not. The other US supplier was also a strong producer of great quality product. Aesthetically, their product was a different look and although we might have been able to buy buckles of equivalent performance, we would lose a point of differentiation with our customers.
We met with the other supplier and they were willing to design a different looking buckle; however, the cost would not be significantly lower, so we eventually passed on them as an alternative. Before challenging our long-standing partner, we reverse engineered the product and estimated the cost of producing the buckle ourselves. Our conclusion is that we could have made the buckles ourselves for 60% less that the price at which we were purchasing the buckles. We had significant manufacturing expertise, and this was achievable. We would have to qualify the manufacturing process and rigorously sled test the finished car seat to ensure high reliability. However, as the partner had done nothing wrong, we decided to present our results to them before embarking on in-sourcing project. Note that at 5 million buckles per year, a savings of more than $1 each was very significant for maintaining the production of the entire car seat within our US manufacturing plant.
After touring our suppliers Swedish manufacturing plant and offering improvement suggestions and by working together on resourcing materials which lowered their cost, we were able to arrive at a lower cost position while maintaining our volume with them. In this case, there was a true strategic partnership that employed both of our firms’ strengths to arrive at a lower cost solution securing for our company a continued US manufacturing base and for our partner a continuing strong US customer rather than a loss of business to a Chinese car seat manufacturer.
A lesson learned was that working together towards a common goal is a characteristic of a strategic partnership. Bringing our engineering and manufacturing expertise to bear and their willingness to adapt their supply chain and some processes resulted in a continued long-term relationship. The initial step of reverse engineering the buckles was a key part of having a common base of knowledge for both parties to be able to work together.
In this area the material is a two-part polyurethane foam consisting of buying a system solution with 3 major components. These are isocyanate, polyol, and a blowing agent. The first two components are commercially available chemicals. The blowing agent is highly technical and there are an extremely limited number of potential manufacturers. The actual process within the manufacturing plant was somewhat susceptible to quality issues due to poor equipment maintenance and limited technical understanding by production management. Defective product was not immediately detectible and therefor not promptly addressed as to finding and correcting the cause. Over time, the company became highly dependent on a field engineer from the supplier who would audit the process and equipment and make adjustment or recommend immediate repairs to the maintenance team. This had all the hallmarks of a true strategic partnership. Additionally, our supplier was the world’s largest chemical manufacturer, so we had the advantage of their scale and research & development expertise.
My early experience in manufacturing was process engineering related. Between that experience and my military background, I knew that understanding the technical aspects of the tasks which we were performing added greatly to the respect that the factory teammate or soldier would have for the leader. I was very uncomfortable with my company’s understanding and knowledge of the key process for manufacturing high performing coolers. We had pockets of knowledge, but I could find no one that truly understood the entire process. We also had periodic defective product because the foaming process did not occur as expected causing voids which would result in partial collapsing of the side walls of the finished product.
Even though this had been a long-term successful relationship, I was uncomfortable over several things that I had heard from their Sales team. First, the supplier offered to switch us to another formulation that would eliminate the environmental impact on the ozone layer and was willing to assist us with interest free loans to convert our equipment to radically different formulation. When asked why we would make such a change, it was stated that the current formula needed to be phased out to comply with the “Montreal Protocols” which were devised to address the depletion of the ozone layer. Second, the Sales team presented that the processes and formulations were patented. Formerly being a process engineer and having previously dealt with polyurethane adhesives, I had a need to delve deeper into both things.
The latter assertion of patents was both true and untrue. Since we purchased some of our finished products in China, we were able to determine that our manufacturer in China was sourcing essentially the same materials from a different, major international chemical company. Looking into this source further,it was discovered that the original process was developed by a third major chemical company many years earlier and they had subsequently sold the patents. In contacting them, the third company declined to re-enter the business. In any event, the patents had expired. However, the technology was difficult and their remained two in our field. The company manufacturing and distributing in China was headquartered in the Houston area. When contacted, they were willing to develop and manufacture for our company.
The first assertion of the phasing out of the material was true. With our company having a limited capital budget and with converting to explosion proof equipment being a significant capital outlay, further exploration of the required conversion date revealed that it was not mandated for another 10 years. That was beyond the typical hold period of a private equity company, so deferral might be desirable. Further discussion revealed that several years earlier there had been a capacity issue that resulted in a spike in prices. To avoid that occurring again, our supplier was moving customers to the new technology (which was required because of the ozone issue). Despite that desire, they were still producing the current formulation and would do so for several years.
Next came an announced price increase that would result in a $2 million plus cost increase. Given the incorrect information concerning patents, and the partial information concerning the ozone issue, I felt that we were being somewhat exploited. To break our reliance on the incumbent supplier, we hired a process engineer with 35 years of experience and began to strengthen our internal technical skills and understanding. We expanded our internal spending on repairs and were less reliant on the field engineer for auditing our equipment and processes.
With the Houston based international chemical company, we began a development process including testing within our plant of formulas that would achieve superior performance. We also asked that the price increase from our incumbent supplier be revoked. We received a firm no answer. It was now time to have a higher-level discussion with our supplier’s division president.
Following our normal business meeting where we did not discuss our alternatives but reviewed our company performance and other initiatives, we went on an extended tour of our manufacturing plant. Certain areas were excluded with barriers erected to obscure their competitor’s test equipment installed on several of our manufacturing lines. As this test equipment is large, it was difficult to hide it from the incumbent supplier and they clearly were able to observe the equipment from the well-known potential competitor. We did not point the equipment out and when questioned dismissed it as a minor test of a new process. Following a dinner, for which we hosted and paid, I asked the division president to have a private discussion. By now they had several hours to internally discuss our relationship and the potential threat to their business with us. I shared with him that we were moving forward one of two ways, with their competitor or with them at a price near their competitor’s proposed price. He asked for some time to respond to which we agreed. The conclusion was not only a revocation of the announced price increase, but an agreement for a price which lowered our cost by an additional $2 million to which we pledged to stop our alternative development effort.
There are several lessons learned here. First, that one should not become totally dependent upon any supplier for services like equipment condition and maintenance. The fact that the relationship was very lengthy allowed our company to become complacent. Second, that each company must look out for their best interest. They were certainly doing this while they were continuing to be a great supplier. However, they began to leverage our lack of knowledge and lack of perceived alternatives to their advantage. Not only that, the selective disclosure of information was not characteristic of a long-term strategic partnership. By upgrading our knowledge and skills, we were able to achieve a better result for our company while maintaining the long-term relationship and re-establishing what partnership means.
I absolutely believe in the benefits available to both parties in a true strategic partnership of which one of the principle characteristics is sole sourcing. This avoids the annual negotiating process and allows both parties to invest in the long-term. However, the reasons for current exclusivity may need to be re-examined. Are these original reasons still valid? If the reason is economic alone, it is not really a strategic partnership. Mutual investment, dialogue about future developments, and achieving and maintaining cost competitiveness and innovation of the final product are the hallmarks of this kind of partnership. The overall intent should reflect the “shared destiny” of the partnership.