Week-7

Companies frequently mismanage their dealings with suppliers and miss

many opportunities to reduce costs. Perhaps it's time to reexamine purchasing,

reestablish some tension in buyer-supplier relationships,

and leverage the free market.

Aggressive Sourcing: A Free-Market Approach

Vikas Kapoor • Arnab Gupta

T he importance of a strong marketing fiinction is universally recognized, and every company invests enormous effort in "out-thinking" the

customer. But how much energy is the corporation, as customer, spending to out-think suppliers marketing to it? The answer in many cases is not much. Most com- panies have historically neglected the "reverse market- ing" function (or "purchasing"), and many Fortune 1,000 companies waste several hundred million dollars each year as a result.

In the 1980s, many mantifacturers instigated a pur- chasing overhaul. However, they focused on purchases that typically fall within the purview of purchasing de- partments, namely, "direct" purchases or "cost of goods sold." The vast array of expenditures dubbed "indirect" purchases went almost untouched. A model of pur- chasing excellence emerged that eschewed free-market competition in favor of supplier "partnerships." In some cases, companies extended the notion of parmer- ship to cover areas in which it had litde applicability. As a consequence, they sheltered many large supplier rela- tionships from rigorous competitive scrutiny and sel- dom realized the potential economic leverage from hard-nosed reverse-marketing.

During the past few years, some firms — particu- larly in the service sector — have acknowledged the chronic neglect of indirect purchasing and are redefin- ing canonical approaches to the subject. Companies such as American Express, Sears, and Chemical (now

Chase Manhattan) Bank have launched campaigns to tackle indirect purchases head on, using various free- market approaches. The results of these campaigns are impressive; they include a gready improved under- standing of and control over what is being purchased and a 10 percent to 15 percent reduction in the ex- penses reviewed without any changes in quality or functionality. The bottom-line impact of these dollar savings is obviously material. In a case in which indi- rect purchases represent roughly 33 percent of operat- ing expenses (not atypical for many companies) and net profit is roughly 10 percent of revenues, a 15 per- cent reduction in indirect purchases translates into a 50 percent improvement in profits.

We base this article on the phenomenal success of such campaigns. First, we review the scope of the ra- tionalization opportunity. Indirect purchases — for example, mainframes, advertising space, health care benefits, and legal services — represent a significant part of any company's cost structure. Yet, as they have seldom received adequate attention, they will probably survive the current wave of reengineering unscathed. Since companies generally regard them as "secondary" expenses, which shotild decrease in volume as "prima- ry" levers such as head count or activity level decline, they seldom address them directly.

Vikas Kapoor and Amab Gupta are partners in the New York City of-

fice of the Mitchell Madison Group, a management consulting firm.

SLOAN MANAGEMENT REVIEW/FALL 1997 KAPOOR & GUPTA 2 t

Second, we use case studies from our experience with indirect purchasing to challenge the prevailing partnership-oriented method. We argue that, for a sig- nificant portion of purchases, the notion of a supplier partnership is perhaps misplaced. In one basic respect, the supplier's objectives are always at odds with the client's: one's revenue is the other's cost. From the client's viewpoint, therefore, a degree of tension in the customer-supplier relationship is essential for reducing expenses, and competitive free-market approaches are extremely effective in creating this tension. If our view is correct, we hope to promote a properly capit'alist concept of supplier management in which free-market competition constitutes the norm and partnerships must justify themselves as exceptions.

We ask four simple questions: 1. What are indirect purchases? 2. Why are they poorly managed? 3. How should managers address indirect purchases? 4. How do supplier partnerships differ?

What Are Indirect Purchases?

U.S. corporations spend roughly $12 trillion each year. Nearly $2.3 trillion is for labor (permanent employees), $1.1 trillion for fmancial items (interest charges, credit losses, and so on), $5.4 trillion for direct purchases (to suppliers for items directly asso- ciated with end-products and services), and the re- maining $2.7 trillion for indirect purchases (items not directly associated with end-products) (see Figure 1).' In aggregate, therefore, indirect purchas- es represent nearly 25 percent of all expenses for U.S. companies.

The proportion of indirect purchases varies by in- dustry and company. In manufacturing companies, the number is generally arotind 25 percent, while, in the service sector, it is generally much higher. Whatever the ratio, companies spend an invariably large amount on indirect purchases — more than $20 billion for some Fortune 25 companies, and more than $ 1 billion for the smallest Fortune 500 company.

Although all these purchases share the characteris- tic of not being directly associated with end-products or services, the term "indirect purchases" is obviously broad, covering many distinct categories of items purchased for different purposes from different sup-

pliers. It is useful, therefore, to divide them into five major functional clusters (see Figure 2): • Advertising and marketing expenses amount to near- ly $300 billion in aggregate, or 10 percent to 15 per- cent of most companies' indirect purchases, and in- clude expenses for producing and placing ads on television or in printed media, expenses associated with direct marketing (printing, paper, letter shops, and so on), and a range of promotional and public relations expenses.

• Technobgy expenses amount to more than $500 bil- lion in aggregate, or roughly 20 percent of most com- panies' indirect purchases, and include all purchases associated with information technology — main- frame processors, data storage devices, networking equipment, PCs, telecommunications charges, pack- aged software, and contract programming services.

• Overhead expenses are those that people typically think of as indirect purchases. Nearly $700 billion in aggregate, or roughly 25 percent of indirect purchases for most companies, they include a wide variety of purchases required to support the company's infra- structure and day-to-day operations — facilities maintenance, security guards, office supplies, furni- ture, travel and entertainment, and insurance.

• Human resource expenses, over 25 percent of indi- rect purchases for most companies, add up to more than $700 billion in aggregate and include all ex- penses associated with providing health care and

Figure 1 Components of U.S. Corporate Expenses (In $ Billions)

Labor $2,270

Financial $1,091

"Indirect" Purchases

$2,700

100% = $11,436 Billion

"Direct" Purchases

$5,375

Source: Department of Commerce; Internal Revenue Service; industry associations; U.S. Statistical Abstract; Mitchell Madison Group analysis.

22 KAPOOR & GUPTA SLOAN MANAGEMENT REVIEW/FALL 1997

Figure 2 Functional Clusters of Indirect Purchases

Marketing & Advertising

Advertising Media Network TV CabieTV Print Radio Sponsorsiiips

Advertising Production TV Radio Print

Direct Mail Preproduction Paper Forms Printing Envelopes Printing Commercial Printing Lettershops Postage

Telemarketing

Indirect Purchases

Information Technology

Mainframes CPU DASD/Storage Printers Peripherals Maintenance

Distributed Computers PC Workstations Network Equipment Printers Peripherals Maintenance

Contract Programming Development Maintenance

Software Mainframe Applications

Overhead

Facilities Rent Cleaning Maintenance Security

Office Equipment & Supplies Furniture Fax Machines Copiers Forms/Paper Office Supplies

T&E Airlines Hotels

Insurance • •

Human Resources

Health Care Benefits HMOs PPOs Indemnity Dental/Vision Retirees Workers Comp

Non-Health Care Benefits Death Unemployment Education

Other Personnel Training Recruitment Relocation

Temporary Lahor Secretarial Operating

Professional Services Legal Consulting ^

Business Specific

Store Fixtures

Credit

MRO • • •

otiier benefits to employees such as HMOs, indemnity coverage plans, death and disability benefits, and re- cruitment and relocation expenses. • Business-specific expenses amount to roughly $500 bil- lion in a^regate, or 15 percent to 20 percent of most companies' indirect purchases. This category covers purchases that are generally unique to each indtistry — collection agencies for financial institutions, store fix- tures for retailers, and working gear for manufactttring companies.

Each of the 5 clusters contains roughly 25 to 30 dis- tinct major supplier industries, so there are roughly 125 to 150 distinct major indtistries supplying indirect ptir- chases to the corporate market. While there are some similarities and patterns, the buying challenges differ considerably across these industries. It is useful, there- fore, to think of the purchasing or reverse-marketing of indirect purchases as 125 to 150 distina buying prob- lems, each of which merits a slighdy different solution.

Why Are Indirect Purchases Poorly Managed?

Historically, few companies have paid particular at- tention to indirect purchases, so, in the main, they

have been badly managed. Companies have not rec- ognized the leverage from effectively purchasing these items, and their supporting role has kept them from senior management's scrutiny. In addition, three systemic problems in most companies prevent effective purchase of indirect items: (1) inadequate information, (2) insufficient resources, and (3) im- proper techniques.

Inadequate Information Surprisingly, few companies know exactly what they purchase. To be sure, companies can get "informa- tion extracts" from the accounts payable and general ledger systems (AP/GL), but any meaningful catego- rization into the roughly 125 to 130 categories we mentioned above is generally hard to come by. The category codes and coding process for most AP/GL systems were designed years or even decades ago and have grown organically to meet various information needs. Few relate to effective purchasing. The result is that most systems have anywhere from 5,000 to 50,000 codes and as many as 500 to 5,000 users or clerks interpreting the codes as they process invoices. With poorly designed information outputs and rela-

SLOAN MANAGEMENT REVIEW/FALL 1997 KAPOOR & GUPTA 23

tively undisciplined inputs, the resulting information base is extremely confusing. Indeed, when reviewing most companies' accounts payahle information, we are surprised that the lack of accurate information has not created serious audit problems.

If simple aggregate data about indirect purchases are hard to get, more sophisticated information about volumes, unit costs, pricing, or quality is even harder. The difFictJties go beyond the poor information in- frastructure and relate to the elusive nature of indirect purchases. Unlike tires — the prototypical direct pur- chase widi relatively well-defined, stable specificarions — many indirect purchases involve services (e.g., ad- vertising agency services) that are inherendy diffictilt to pin down in terms of unit cost or quality, or ex- tremely varied commodities (e.g., PC peripherals), the fragmented nature of which makes synthesized

Nearly 8 0 percent ofall indirect purchasesare approved and negotiated

without any formal purchasing process.

unit cost or quality information very elusive. And ex- ternal data about benchmarks and alternative suppli- ers arc ofben even more confUsing and elusive than internal information.

Insufficient Resources Nearly 80 percent of all indirect purchases are ap- proved and negotiated without any formal purchas- ing process. Some people conducting these negotia- tions lack necessary sourcing and negotiating skill, and even those with skill have other incentives — to ensure that marketing brochures are delivered on time, that the data center does not have an outage, or that the employee benefits survey shows positive results. Since suppliers oft:en help them meet these objectives, their loyalty to the suppliers is extraordi- narily high, oft:en higher than their loyalty to their own company. They are more likely to push to "get the deal signed quickly" than upset the status quo or

ensure that they have gotten the best deal in terms of quality, riming, and price.

Even when indirect items are purchased through a formal purchasing process, the resources are frequendy inadequate to the task. A Fortune 100 company with more than $2 billion in indirect purchases may have 40 to 50 purchasing staff people overseeing $400 mil- lion to $500 million in indirect purchases, largely in the overhead cltister (facilities maintenance, office sup- plies, furniture, and so on), and trying to indirecdy in- fluence or control the remaining expense base. Their challenge is daunting, because they have to outsmart as many as 2,000 to 2,500 sales and markering per- sonnel from 400 to 500 suppliers. This span of cover- age wotild challenge even a very capable, sophisticat- ed purchasing organizarion. Unfortunately, companies often assign the best people in purchasing depart- ments to oversee direct purchases, while ignoring indi- rect purchases.

Improper Techniques In a perfect market, information about alternatives would be readily and abundantly available, and sup- pliers would freely and constantly compete for any client's business. Since the markets for indirect pur- chases are far from perfect, gathering information and soliciting competitive activity require effort. Purchasers have to find alternative providers, issue requests for proposal, and so on.

Unfortunately, few companies undertake this ef- fort frequently or intensely. In our experience, fewer than one-quarter of all indirect purchases undergo serious scruriny each year, and nearly half escape ex- amination altogether for many years.̂ In most cases, companies renew or revise existing arrangements, generally with their current suppliers. This infre- quent or lackadaisical scrutiny is partly due to the re- source gap. In many cases, however, it is due to the prevailing view that partnerships with suppliers are preferable to a free-market or competitive approach.

Later, we shall return to the quesrion of whether the prevailing view is correct. Suppliers welcome the absence of frequent, intense scruriny. The most pow- erful weapon that buyers have in their dealings with suppliers is knowledge about, and a willingness to use, alternarives. In fact, suppliers commonly reduce prices preemptively to forestall a competitive review.

24 KAPOOR & GUPTA SLOAN MANAGEMENT REVIEW/FALL 1997

Despite the power of this weapon, most companies seem hesitant to use it regularly.

Each problem we've described severely under- mines a company's ability to tackle indirect purchas- es. Just as it is hard to do effective marketing with inadequate information, highly limited resources, and confused techniques, so it is with reverse-mar- keting.

How Should Managers Address Indirect Purchases?

Companies obviously have to recognize both the problem and the opportunity. The magnitude of both merits serious senior management attention; the companies that have successfully addressed indi- rect purchases have focused senior management on the issue. At American Express, for example, Kenneth Chenatilt, vice chairman (now president), initiated an indirect purchase expense-reduction program, and James Cracchiolo, a senior executive in the company and former CFO at Shearson, led an intensive two- year effort, one of the most important restructuring initiatives at the company. At Sears, CEO Arthur Martinez chaired its program, and Doug Shtiman, a senior executive in the Merchandise Group, led a pro- gram to cut purchased expenses by $1 billion. Edward Miller, president, and Joseph Sponholz, CFO, cham- pioned the effort at Chemical Bank. At Swiss Bank, CEO Marcel Ospel sponsored the effort, and a senior executive, Hanspeter Brliderli, led it.

Those companies that have not devoted senior- level attention to the problem have usually failed to make significant progress. The underlying problems with indirect purchases are too deep and the organi- zational impact of any solution too broad-ranging to address in a narrow or more clinical way.

The task of controlling relationships with 125 to 150 industries is daunting, and, without a sensible approach, managers assigned to it are unlikely to get very far. Too ofien, we have seen enormous enthusi- asm for simple ideas like "standardizing brochures," "eliminating unnecessary use of temps," "right-spec- ing of PC purchases," and so on fail within six months because of an inability to implement. What then should managers do? Relevant approaches dif- fer from one company to another, not least because

the supplier industries are quite different. Nevertheless, we have identified five common techniques that lead to successful programs.

1. Measure Pragmatically Meaningful information about what to purchase at what price and clarity about what metrics to use for measuring progress are essential. Unfortunately, as we indicated earlier, the existing infrastructure is of little use here, and, while transforming it is ultimate- ly necessary, such a mammoth undertaking is hardly an option in the short run.

Many companies reach for a silver bullet to re- solve this dilemma — for example, installing an all- encompassing purchasing system or integrated pur- chasing/accounts payable system. They hope that if they can process all purchases through such a system, intelligent information will emerge automatically. Unfortunately, these solutions take a long time to implement. Furthermore, unless managers have care- fully thought about the desired information outputs (metrics) up front and invest enormous effort in transforming the underlying information sources, the solutions are limited.'

Instead, managers should be extremely selective and focused when defining the information needed and very practical and wily in finding ways to obtain it. In metric definition, while there may be 125 to 150 industries all together, there are generally fewer than 25 supplier industries that dominate the pur- chases of any company, representing well over 50 percent of expenditures. It obviously makes sense to focus on these. Furthermore, while there is much in- formation about each industry, it is useful to start with a single synthesized metric that summarizes the economics of the company's purchases from that in- dustry. Ultimately, a manager might want the cost of printing by job, type of print, quality of paper, and so on. However, at the beginning, it helps to know the overall unit cost measured in cents per piece. Whatever a manager ultimately does, whether de- mand or supply related, success should be measured in a reduction in this metric.

In data collection, short-cuts can circumvent the need for systemwide efforts. Suppliers are generally able and willing to provide most of the information needed. If they can't, the pragmatic application of

SLOAN MANAGEMENT REVIEW/FALL 1997 KAPOOR & GUPTA 25

the 80/20 rule will often yield sufficient information for making reliable judgments. Purchases of indirect items tend to be concentrated: roughly 10 percent of

n most cases, companies should

increase significantly the level of resources allocated

to reverse-marketing.

invoices constitute 90 percent of expenses."* Even if scrutiny of each invoice becomes necessary, the effort required to create a useful information base is not necessarily gigantic.

2, Assign Resources Selectively Sales and marketing people representing suppliers frequendy outnumber their reverse-marketing coun- terparts by ten to one. In most cases, companies should increase significantly the level of resources al- located to reverse-marketing. In practice, however, most companies are reluctant to make such an in- vestment. Even if they are willing, finding and re- taining capable people is difficult.

The trick is, once again, to be extremely selective: identify the handful of supplier industries (twenty- five or fewer) that account for the majority of ex- penses and ensure that the right people cover them. This level of resource assignment is generally palat- able and manageable at most companies, and, while it does not solve the problem entirely, it secures most of the desired benefit. Should these professionals be part of the corporate center or the various business units? While organizational issues need to be re- solved on a case-by-case basis, given the scarcity of talent, centralization may be the right answer.

The job descriptions for these roles must clearly ar- ticulate the objective of reducing expenses. To enstire that people focus on the objective — and do not pas- sively administer existing supplier relationships — companies should link their compensation to achieve- ment of results. It is useful to think of these people as traders who receive a low "base" compensation but are rewarded if they outperform the market. If compa-

nies design these arrangements well, the resources applied to the reverse-marketing function can be fundamentally self-funding.

3. Demystify Business Requirements Whenever companies initiate significant reviews of purchases, concerns about quality reduction arise. Underlying this apprehension are two critical, highly questionable assumptions: first, that companies know business requirements or quality needs with precision and, second, that the only way companies can reduce purchased expense is by compromising service or quality requirements. These assumptions are seldom correct. There is generally great impreci- sion and confusion about quality needs, and in most cases, the "existing service level" is the only defini- tion of business requirements.

This imprecision obviously obfiiscates any evalua- tion of alternatives and trade-offs and works to the suppliers advantage, since it allows sales savvy to take precedence over economic reality. Indeed, it generally works to the incumbent suppliers' advantage, because they are meeting business needs and most buyers tend to be risk-averse when examining alternatives.

The language and metrics for establishing precise quality requirements, while crucial to dealing with suppliers and establishing control over indirect pur- chases, often do not exist. For example, after many years, buyers of ball bearings finally agreed to consid- er any ball bearing that did not have such-and-such radius (plus or minus some tolerance), such-and- such density, and so on, an "error." Once they agreed on these definitions, they could begin serious mea- surement and discussions of quality. But such robust frameworks for computer maintenance services, health care programs, and so on are far from defined.

Fortunately, this level of precision is unnecessary to achieving appreciable business impact. Simple, practical frameworks that improve upon the current disarray often suffice. In discussions about television advertising, for example, marketing executives often insist that the media they are using are uniquely ap- propriate, even vitally necessary, to their brand. If they are right, the premium they pay to advertise in these media is justified. But often they are mistaken. For instance, in one simple framework, program- ming was divided into three potential categories:

26 KAPOOR & GUPTA SLOAN MANAGEMENT REVIEW/FALL 1997

"brand enhancing" (e.g., the Academy Awards or the Super Bowl), "unacceptable" (e.g., excessively violent shows), and "acceptable." Managers and agencies classified 50 to 100 programs into these three cate- gories. With few exceptions (3 to 4 shows that were unanimously considered brand enhancing and 3 to 4 shows that were unanimously considered unac- ceptable), the results were quite inconsistent. Armed with this information, managers were able to change the mix of shows and achieve savings of 25 percent to 30 percent without reducing or compromising agreed-on measures of quality.

4. Clarify the Pricing Basis For a high proportion of indirect purchases, outputs are hard to define, so that pricing becomes an impre- cise, somewhat judgmental exercise. There is seldom any doubt, for instance, about the link between the price of a tire or microchip and its underlying out- put. But this link is much less clear with respect to, say, legal services or a software development project.

Indeed, indirect purchases like sofiivare develop- ment ofi:en get priced on a "job shop" basis, making it singularly difficult to relate price to output. Even if

"stablishing discipline " in pricing practices — is critical to any attempt

to control indirect purchases.

a sensible pricing basis can be agreed on up front, it is not unusual to find extras on any invoice that were neither anticipated nor negotiated. A survey of ser- vice-oriented jobs at one company, for example, showed that virtually every invoice included an aver- age of 30 percent to 40 percent in non-negotiated extras. Sofiware development projects are notorious for running up bills far in excess of what has been negotiated and agreed on.

This opacity and laxity in pricing practices work to the buyer's disadvantage. Without clarity about the specifications included in the price and how they contribute to cost, the buyer cannot compare alter- native suppliers' quotes before the fact and can't chal-

lenge prices charged afi:er the fact. In this "job shop" environment, the supplier has control over pricing, and the buyer is essentially helpless.

Establishing discipline in pricing practices is critical to any attempt to control indirect purchases. This daunting task involves creating and then enforcing a standardized pricing vocabulary across fairly large in- dustries that have an incentive to resist standardization. The trick, once again, is to be focused and practical.

For example, a substantial portion of any company's purchases is for temporary rental of people who are on someone else's payroll. Secretarial temps are the proto- typical example, but there are many others such as contract programmers, construction workers, lawyers, consultants, advertising agents, and so on. Most of this temporary labor is priced at the seller's discretion: temporary agencies typically associate a price with each individual, not with each skill or position. Standardizing skill or position definitions across agen- cies — let alone across other labor providers — wotild be a difficult if not impossible task. Fortunately, most companies' purchases of temporary labor are heavily concentrated in ten or fewer positions. Creating stan- dard position definitions — and agreeing on the cir- cumstances for overtime or other extra charges — is all that a company needs to capture 90 percent of the benefit.

5. Leverage the Free Market Most of the techniques we've discussed — measure- ment metrics, quality definitions, and pricing stan- dards — are the building blocks of a disciplined, ef- ficient market. The question now is: What are the right techniques for approaching suppliers and mar- kets once the building blocks are in place?

If a buyer's objective is to minimize cost (at any chosen level of quality or value), that objective is, to some degree, at odds with the interests of suppliers. As already noted, the buyer's cost is the supplier's revenue. The supplier is likely to resent and resist with as much sales and marketing savvy and muscle as possible. The buyer's challenge, therefore, is to counteract and outsmart this marketing force with reverse-marketing sophistication and power.

Knowledge of and a willingness to use free-market competition is the strongest weapon available to the buyer. Virtually every successful sourcing campaign

Si.OAN MANAGEMENT REVIEW/FALL 1997 KAI'OOR & GUPTA 27

we have observed has started when buyers explored prices with a wide variety of suppliers. The objective is not necessarily to change suppliers; it is simply to he well informed about the alternatives, conduct mean- ingful negotiations, and make sensible trade-oflFs. In well-managed situations, more than 75 percent of all competitive processes result in price reductions from existing suppliers. Buyers must he willing to take husi- ness away from those suppliers, however, if new sup- pliers are to take the process seriously.

Companies have to tailor the methods for accessing and leveraging the free market to their particular mar- ket. Most corporate purchasers use a "sealed hid" method; hidders suhmit confidential hids on the as- sumption that die low hid will win. In well-organized markets, with many hidders and homogeneous prod- ucts, this procedure is just fine. Some economic litera- ture argues that when these and other simplifying conditions hold, the outcome of different auction methods is likely to he identical.'

Unfortunately, the real world is seldom this simple, particularly when it comes to indirect purchases. Purchasers of indirect items are more akin to huyers in a Turkish bazaar than to clients at a Sothehy's auction, and their tactics and hehavior need to reflect this if they want to control their purchased expenses. Bidders are often unclear about the specifications on which they are bidding, and the huyer seldom has perfect in- formation about different suppliers' qualifications. Given these conditions, a hid is generally just the gamhit in an extended dialogue. A successful negotia- tion has to go through multiple iterations with several competitors until level ground is achieved with respect to specifications and the floor is found in terms of price.

As the markets for indirect purchases hecome more organized, standard auctioning and trading tech- niques may become increasingly prevalent. Someday, electronic auctions may he conducted for mainframes or advertising space. Until then, however, hargaining and negotiating skills will he crucial for getting the hest deal from suppliers.

Companies have to tailor the application of the five techniques to individual supplier industries and

huyers. In every situation in which they have heen applied, however, they have achieved significant re- sults.

How Do Supplier Partnerships Differ?

The approaches weVe descrihed are aggressive, root- ed in a competitive free-market worldview. That they work is hardly surprising; this is what the free- market capitalist economy is supposed to achieve.

However, the five techniques run counter to the prevailing purchasing model — the "partnership" ap- proach to supplier management. The notion of sup- plier partnerships gained popularity in the early 1980s, as one ingredient in the Japanese approach to "lean production." As Womack et al. put it, the key was to "ahandon power-hased hargaining and suhsti- tute an agreed-upon rational structure for joindy ana- lyzing costs, determining prices, and sharing profits."*̂ The idea gathered momentum and slowly hecame core to the estahlished method of effective purchasing in the United States.

The partnership approach is popular among pur- chasing managers, who frequendy talk ahout "shrink- ing the supplier hase and estahlishing partnerships with a few preferred suppliers," even when they are dealing with commodity items in extremely competi- tive industries. The puhlished literature on supplier management often endorses partnerships. Some duh them the new "Colden Rule" of husiness.' Others state, "In the hrave new world of procurement, cus- tomers are treating their suppliers almost like their own employees."^ There are similar statements in aca- demic articles.'

If the free-market approach we espouse is diametri- cally opposed to the prevailing partnership model, which is correct? To answer this question, we first de- fine what a partnership is and then examine the cir- cumstances under which it would he — or might he considered — appropriate.

What Is a Supplier Partnership? Most companies claim to have partnerships with at least some of their suppliers. Very few, however, are ahle to specify exacdy what these partnerships amount to. One large company, for example, purchased more than $200 million of goods and services annu-

28 KAPOOR & GUPTA SLOAN MANAGEMENT REVIEW/FALL 1997

ally fi-om one supplier for several years at a signifi- cant premium over the market. Most managers were reluctant to consider alternative suppliers hecause they felt they had a strategic partnership with the supplier. Yet none was ahle to say precisely what that partnership was. When one manager retrieved al-

"^artnership advocates might - ^ argue that companies never

really surrender the right to seek alternatives.

liance documents, written more than four years ear- lier, he found no specific commitments hy either party. The company had heen overpaying for ser- vices in the name of a partnership, the terms and commitments of which were entirely unclear and the henefits of which could not he identified, let alone quantified.

This situation is fairly common. Many partner- ship arrangements are simply loose agreements he- tween companies indicating that they intend to co- operate in some undefined way. As such, they have no real teeth, and their primary function is to act as hroad statements of corporate goodwill. We certain- ly do not ohject to these arrangements and agree that they are desirahle hecause they promote good feelings and encourage corporate commerce.

Our concern, rather, is with supplier partnership arrangements that do have teeth. While the specifics of such partnerships vary widely firom one situation to another, firom a huyers perspective, they always involve a significant concession, namely, forgoing the right to pursue alternatives for the duration of the arrangement. In this respect, a supplier partner- ship is no different firom a partnership in a social or personal setting — each involves a degree of exclu- sivity, a c o m m i t m e n t to work with a partner through good and had, rather than investigate alter- natives when things turn had or hetter alternatives hecome availahle.

How a company gives up its right to investigate alternatives varies. Most ofien, the company simply commits a suhstantial proportion of its purchases for a significant period of time to its supplier partner.

Alternatively, the company and supplier might share confidential information ahout each other's product plans and costs and agree that this shared cost infor- mation, rather than free competitive evaluation, will he the hasis on which to revise or renew terms.

Partnership advocates might argue that compa- nies never really surrender the right to seek alterna- tives. At one level, they are correct; the right is sel- dom, if ever, explicidy given up, and companies are always free to investigate alternatives and henchmark against competitors. However, this concession is im- plicit in most partnership arrangements. Frequent investigation of alternatives would not he in the spir- it of most partnerships; alternative suppliers would he reluctant to hid for husiness they knew they cotild not get, so reliahle information ahout alterna- tives would he hard to ohtain even if a company wanted it. Benchmarking and other circuitous meth- ods may occasionally provide information, hut mean- ingful market hids hecome largely unavailahle to clients locked into partnerships.

When Are Supplier Partnerships Appropriate? We have argued that the right to investigate and pursue alternative sources is the most powerful weapon that any huyer has. If this right is generally conceded in partnership arrangements, the question of when partnerships are appropriate is largely a question of when it is sensihle to surrender this weapon.

The answer depends on two factors: • Are alternative suppliers ahundantly availahle? With few viahle alternatives, the right to pursue them hecomes less powerful and valuahle. • Is it easy to change suppliers? If change requires ex- tensive disruption or cost, the threat of switching ohviously loses credihility and the right to pursue al- ternatives hecomes less potent.

Since these two questions can he answered inde- pendently, and each could have an affirmative or negative answer, from a huyers viewpoint, there are four supplier situations (see Figure 3). For a Type 1 situation in which there are many alternatives and change is relatively cost-free, the appropriate strategy is quite clear. Open pursuit of alternatives — hy fre- quent competitive hidding, if possihle — will almost certainly yield the hest results. Since frequent change

SLOAN MANAGEMENT REVIEW/FALL 1997 KAI'OOR & GUPTA 29

is feasible, it may even make sense to churn the sup- plier base if market prices warrant it.

Type 2 and 3 situations are slightly more compli- cated, but the right strategy is likely to be a modified version of the competitive approach in Type 1. If there are many alternatives but change is difficult or costly (Type 2) — as for providers of health care benefits to employees — it is important to continu- ously test the market and "back leverage" the results to secure concessions from existing suppliers. The existence of alternatives provides a credible threat to suppliers, even if the ability to switch is constrained.

In Type 3 situations, there are few alternatives, but the ability to switch without difficulty creates a constant threat that companies can use to negotiate targeted concessions from existing suppliers. In both Type 2 and Type 3 situations, having an abili- ty to pursue alternatives creates negotiating lever- age, and the sensible purchasing approach is to use this leverage to maximum advantage.

What is the appropriate approach for Type 4 situ- ations, in which there are few alternatives and change is difficult or costly? These are possible part- nership approaches, not so much because partner- ships are so successful in these circumstances, but, rather, because a company has no alternative but to work closely with an. existing supplier and hope that costs will be reduced and other goals met.

How frequent are Type 4 situations? In indirect purchasing, they seldom occur. Mainframe software, specialized information services, and a few others consistently fall into this category. As we discussed earlier, suppliers with a vested interest will always argue that the number of truly viable alternatives is low and the cost of change is prohibitive. If business requirements are systematically demystified, howev- er, the facts generally indicate otherwise.

Are Partnerships Misunderstood? One reason that partnership arrangements may have become popular in industrial environments is that Type 4 situations tend to occur more frequent- ly when companies deal with certain direct purchas- es. For many subcomponents, the amount of cus- tomized effort required is large, the range of qualified suppliers is small, and development or manufacturing of supplied parts often requires con-

Figure 3 Alternative Situations in Supplier Management

High

Cost is less than or equal

to 1 year's savings

Feasibility or Ease

of Change

Cost is greater than

1 year's savings

Low

Type 3

"Free-Market Competition — Target Negotiation" - Express Mail - Media

Type 4

"Partnership?" - Market Data - Mainframe Software

Typei

"Free-Market Competition — Continuous Churn" - Paper - Printing

Type 2

"Free-Market Competition — Back Leveraging" -HMOs - Advertising Agencies

Low Less than or equal to 2 Greater than 2 High

Number of Alternatives

siderable joint investment in engineering time and capital outlay.

Japanese lean producers seldom enter partnership arrangements by conceding the right to pursue alter- natives. Since they multisource most parts, they are al- ways benchmarking suppliers against their competi- tors on cost and quality. Toyota, for example, uses competitive bidding so infrequendy that people often think die Japanese approach to supplier management does not embrace free-market competition. This is not necessarily correct. The approach is, in many ways, intensely competitive, but the techniques for stimulating competition and sustaining competitive pressure are often informal and culture-specific.

The U.S. fascination with Japanese partnership- style supplier management may, then, have been based on misunderstanding Japanese practice. And what made the misunderstanding particularly insidi- ous is that, as Womack et al. point out, many U.S. companies gradually started to "single source," there- by removing any competitive leverage they might have had.'"

What we suggest — certainly for indirect purchas- es, but perhaps for direct purchases as well — is to re- verse the logic of the prevailing model. Rather than considering partnerships the norm, and competitive arrangements applicable only in special situations, companies should establish free-market competition as standard operating procedure in the management of supplier relations, with partnerships justified only

30 KAPOOR & GUPTA SLOAN MANAGEMENT REVIEW/FALL 1997

on an exception basis. It is only by relegating partner- ships to their appropriately narrow conftnes that com- panies can begin reestablishing the competitive ten- sion that is so essential to client-supplier relationships.

Conclusion

As companies begin to reduce the cost of indirect purchases, we hope that they will rethink how they manage supplier relationships. In the 1980s, compa- nies celebrated the many virtues of Japanese-style management. This celebration achieved much but led to many mistakes. The partnership approach to supplier management may have been a misunder- stood and somewhat misguided import from this period. As the star of Japanese production fades and the U.S. flirtation with Japanese techniques ends, it is time to discard relics such as the partnership ap- proach. The capitalist free-market approach to sup- plier management deserves to regain its proper place in U.S. companies. •

References: 1. We estimated all figures in the first section using a combination of Department of Commerce and Internal Revenue Service data, figures from a variety of industry associations, and proprietary Mitchell Madison Group databases.

2. This is based on Mitchell Madison Group s experience in sourcing indirect purchases for many large companies.

3. For example, many purchasing systems use the Dun & Bradstreet industry coding scheme for classifying purchases. This scheme is sin- gularly unsuited to indirect purchases; it has one code for mainframe equipment and fifty for different kinds of furniture, even though pur- chases of the former are an order of magnitude larger for most compa- nies. Even if a sensible classification scheme can be established and all the relevant users and payables clerks are trained how to use it, this would solve only the problem of classifying the dollar amount of pur- chases into meaningful categories. This leaves the problem of locating and integrating information on volumes, so that unit costs can be computed, and the company can know that $*• million was spent on printing and also that this represented a unit cost of y cents per page. Since existing sources (typically purchase orders and invoices) fre- quendy lack this information, solving this problem itself requires sig- nificant additional effort.

4. Based on Mitchell Madison Group databases.

5. P. Milgrom, "Auctions and Bidding: A Pnmer," Journal of Economic Perspectives, volume 3, Summer 1989, pp. 3-22. 6. J.P. Womack, D . T . Jones, and D . Roos, The Machine That Changed the l%r/<;/(New York: Rawson Associates, 1990), pp. 167- 168. 7. M. Magnet, "The Golden Rule of Business," Fortune, 21 February 1994, pp. 60-65. 8. F. Bleakley, "Strange Bedfellows: Some Gompanies Let Suppliers Work on Site and Even Place Orders," Wall Street Journal, 13 January 1995, p. A l . 9. See, for example, D . N . Burt and M.F. Doyle, The American Keiretsu (Homewood, Illinois: Business One Irwin, 1993); D.N. Burt and R.L. Pinkerton, A Purchasing Manager's Guide to Strategic Proactive Procurement^Hey^YorV., AMACOM, 1996); and D.W. Dobler and D.N. Burt, Purchasing and Supply Management (New York, McGraw-Hill, 1996). 10. Womack etal. (1990), pp. 158-161.

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