Main Points

• In today’s supply constrained environment, the power has swung to suppliers who can often choose their customers based on the profitability and strength of the relationship.

• A "customer of choice" relationship enables the customer to become the preferred sales channel for the supplier, which provides greater stability in periods of market volatility.

• This article explores different approaches and models organizations can consider to ensure continued value from their trading relationships.

My discussions with supply chain executives are starting to have a familiar tone: everyone is feeling the impact of major shortages and increased risk in a variety of supplied inputs. These impacts are typically first encountered in the form of the announcement of a price increase by key suppliers, either when contracts are re-negotiated, or even in contract management stages years later. In the past, a supply management executive’s first reaction in the face of a price-increase would have been to vehemently object, followed by a series of angry meetings terminating with a voiding of the contract and a new request for project (RFP) issued for a new supply chain relationship.

In today’s supply constrained environment, however, this is often not an option. Further, suppliers are often at or near capacity, and now have the luxury of "picking" their customers based on the profitability and strength of the relationship. Supply constrained environments are particular to certain sectors, and are felt most when the party facing supply constraints sells into a market that does not feel supply constrained. In this situation, certain segments of a buyer’s market may be over-supplied and highly competitive, yet other sectors (such as copper, rubber, resins and engineering services) may be supply constrained due to unique circumstances associated with these particular market conditions. This situation can trigger both financial pain and also some irrational internal/external behavior on the part of both parties to the transaction.

This situation leads to our discussion of the concept of "customer of choice" (CoC). A CoC relationship is unique in that the customer seeks to become the preferred sales channel for the supplier, which transcends the normal booms and busts associated with market dynamics. Although this concept has been around for some time (first explored by Michael Leenders and David Blenkhorn in their book Reverse Marketing: The New Buyer-Supplier Relationship in 1988), most supply chain executives I speak with have yet to really embrace this approach to any degree (Honda and Toyota are the exception). The effect of the credit crunch in terms of procurement behavior is still playing out. Faced with the current capital liquidity panic on global markets, the roller-coaster of commodity pricing, and the need to maintain margins in the face of these events, my experience (as well as those of Mark David who helped me with this article) leads me to believe that customer-supply management behavior is becoming even more aggressive. The concept of CoC requires one to look beyond the short term and realize that in the longer term, capacity will be re-adjusted (perhaps within months), pricing will stabilize, markets will re-adjust, and that the only element that will remain consistent will be competition. A few select firms have grasped this concept — in one instance, I gazed with wonder on a "thousand-year plan" by a firm that laid out the expectations of how the firm would grow organically based on current views of future global economic development.

Wise executives recognize that the concept of CoC is important now, and not when it’s too late and the "emotional memory" of aggressive tactics has polluted relationships. Recent research by the Supply Chain Resource Cooperative (http://scrc.ncsu.edu) points to the fact that CoC relationships are a function of multiple different dimensions of the customer-supplier relationship, and can often change suddenly based on different events and business environments.

While there are multiple global examples of supply constraints that illustrate the types of shortages that exist in the industry, I will speak of several US-based constraints that I have witnessed in the last two to three years.

On the supply side of the craft labor situation, there are an increasing number of young people who prefer white collar work. In general, young adults in college are interested in white collar, high-tech and software industries.

… if the trends identified in Indicators 2004 continue undeterred, three things will happen. The number of jobs in the US economy that require science and engineering training will grow; the number of US citizens prepared for those jobs will, at best, be level; and the availability of people from other countries who have science and engineering training will decline, either because of limits to entry imposed by US national security restrictions or because of intense global competition for people with these skills.

Even if action is taken today to change these trends, the reversal is 10 to 20 years away.

Cost-plus contracts are only practical when both parties agree to be transparent and open about how costs will be measured, tracked, and updated. Components of the contract should be structured to drive agreed-on costs through standard labor rate models and competitive negotiation, utilizing internal "should-cost" models around equipment to reach a total cost of ownership approach. Commodity pricing should be linked to rational external market indices, with the caveat that both parties will work together through value-analysis, product re-design, and substitution efforts to minimize the use of high-priced commodities. This approach also involves segmenting the supply base and using preferred suppliers for the majority of business in price-sensitive segments. When structured in a fair and informed manner, ultimately, any cost increases borne by the customer will be true cost increases.

This is a very different approach for many companies, and is hard to digest for traditional negotiators. It requires that supply management work more closely with the current supplier, armed with updated and valid market intelligence data to establish an open dialogue regarding the challenges the supplier faces in the market. There is a lot of inherent, intangible knowledge that exists which will be difficult to replicate if an open lump sum bid (LSB) is utilized, and the transition period required to shift the business to a new source is not without risk. There is no question that an open RFQ bidding process will drive the costs quote down — but there are additional transition costs that may be incurred. In addition, the safety, risk and compliance issues are a major concern when shifting business to a new supplier, and these are difficult to quantify in the total cost equation, but surely represent a risk worthy of consideration.

Firms must identify current "hot spots" for labor, reach out to local communities and push the benefits of that type of education, and be willing to back it up with training to provide an important supply-side resource at a relatively low cost. Investment in training and engagement with the workforce is also desirable. Many firms are now also offering to fund young people’s education in community college to obtain their welders’ certificate if they sign up to take a position upon graduation.

Many organizations are moving to a time- and materials-based contract, requiring suppliers to produce to actual payments made. Best-in-class companies are relying on suppliers to produce actual labor, material, and overhead/margin rates as part of their time and materials contracts. It is not difficult to discover who is bluffing and who is not. An empirical observation noted in past studies is that supplier labor rates are generally in the same range, and that it is rare to find a supplier with a cost that is 10–15% above others. Customers signing such a contract should also be willing to bear the risk of material and labor rates increases, given that the option of not having any reliable source of supply is highly undesirable!

These approaches require a different type of contractual relationship — one where trust and collaboration is front and center. When both parties agree to jointly bear the risks and rewards of an increasingly volatile global economy, the impact of constrained supply markets, reverse auctions, commodity increases, labor shortages and, most importantly, capital shortages can be bypassed to the benefit of both parties. Perhaps it’s time you take a look at that hundred-year view (let alone the thousand-year one!)

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Professor Robert Handfield, PhD,
North Carolina State University,
Email: robert.handfield@ncsu.edu http://www.mgt.ncsu.edu/index-exp.php/real/solutions/robert-handfield-solutions/

The SCRC is the first major industry-university partnership to integrate student projects into the MBA classroom in an integrative fashion, and has had over 20 major Fortune 500 companies participating as industry partners since 1999. Prior to this role, Robert was an Associate Professor and Research Associate with the Global Procurement and Supply Chain Benchmarking Initiative at Michigan State University from 1992-1999.

Robert has consulted with over 25 Fortune 500 companies, is the Consulting Editor of the Journal of Operations Management, and the author of several books on supply chain management, the most recent being Supply Market Intelligence, Supply Chain Re-Design and Introduction to Supply Chain Management (Prentice Hall, 1999, and translated into Chinese, Japanese, and Korean).

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