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Managing the Supply Base

within Business Networks

A Module Reader
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Edited by Glyn Watson and Chris Lonsdale


Managing the Supply Base within Business Markets

© University of Birmingham, 2016.

Previous Versions, 2003, 2014.

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Managing the Supply Base within Business Markets

Contents

Preface 3

PART I THEORY

1 Understanding the Limits to Management Action in 5


Supply Networks

2 Thinking Strategically about Supply Chain Relationship 11


Management: The Issue of Incentives

3 Common Obstacles to Obtaining Value for Money 22

4 What is Business Power? 37

5 Mapping the Attributes of Power: The DNA of Business 42


Life

6 Managerial Behaviour in Business Networks 50

PART II IMPLEMENTATION

7 Managing the Internal Client Relationship: An Analytical 61


Framework for Aligning Demand and Supply

8 The Role of Competence and Congruence In Supplier 81


Selection Decisions

9 Developing ‘Fit-for-Purpose’ Buyer-Supplier 91


Relationships: An Analytical Framework

10 Managing Negotiations in Business Markets 103

11 Contracts and Contract Management: Developing Self- 111


Enforcing Agreements

12 Blue Eyes and Brown Hair: Making Sense of Supply 121


Chain Individuality

13 Cases in Supply Base Management 129

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Managing the Supply Base within Business Markets

Preface

This collection of chapters, articles and papers has been compiled to serve as one of
the module texts for purchasing and supply management courses at the Birmingham
Business School.

The reason why it is necessary is that such modules are taught from a ‘behavioural’
perspective. This perspective bases its ideas and models on certain assumptions about
the way in which managers behave in business. We discuss what these assumptions
are and why they matter during the modules.

However, despite the fact that this perspective on management boasts a number of
Nobel prize-winners, a supply chain management textbook written from this
perspective has not yet been written. Thus, the production of this reader.

The reader is divided into two sections: theory and implementation. The theory
section starts with a chapter discussing the debate in this subject area (chapter 1).
Having established the perspective within the debate taught at Birmingham, the
remainder of the section looks at various theoretical elements of that perspective. This
is first in overview (chapters 2 and 3) and then in chapters dedicated to power and
aspects of business behaviour (chapters 4 to 6).

The second section looks at various aspects of implementation, starting with internal
organisational buying behaviour (chapter 7), and then moving out into supplier
management, with chapters on supplier selection, supplier relationship management,
negotiation and contracts/contract management (chapters 8-11). The final input
chapter considers attempts to manage the extended supply chain (chapter 12). To end
the collection, various aspects of the implementation section are then highlighted in a
series of cases (chapter 13).

One final comment. This course reader has been designed for use with the overall
reading list provided for your course. It is intended to provide you with a platform for
further reading, not to provide you with all of the reading that you will need during
the year. You should read other material featured on the reading list, not least so you
can take in the views of other academics beyond the two of us and our colleagues in
the Business School.

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Managing the Supply Base within Business Markets

PART I: THEORY

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Managing the Supply Base within Business Markets

Understanding the Limits to Management Action in


Supply Networks1

Introduction

Having for many years been something of a poor relation, the management of
business to business relationships is now recognised a key issue in the management
field. Out of all the contributions that have been made in this field of management,
three groups stand out as major schools of thought. These are the lean supply school,
the agile supply school and the IMP school, which has developed its interaction
approach.

The profile of these three schools brings to the forefront a key issue in this subject
area. That is, to what extent can managers plan the management of their supply
networks and control the outcomes. The lean and agile schools (which have much in
common, but deal with different supply chain demand conditions) are optimistic about
management’s capacity in this respect. The IMP school is much less optimistic, and is
rooted in the realist ideas of organisational theory.

In this paper, the authors will explain how their current research is aimed at assessing
the extent to which the concept of inter-organisational power can bridge the gap
between these schools and explain the vast discrepancy in their research findings. Our
belief is that inter-organisational power both facilitates and constrains attempts to plan
and control supply networks – whether or not that involves buyer-supplier
collaboration – a fact that goes a long way to explaining the discrepancies. It is also
our view that this belief can be used to provide managers with a set of tools and
techniques that can, on the one hand, warn them of the potential obstacles to
implementing lean or agile approaches and, on the other, move them beyond the
strategic conservatism of the IMP school.

The testing of our beliefs is being undertaking in collaboration with 8 sponsoring


organisations, brought together under an EPSRC-sponsored research project. These
organisations are: Rolls-Royce, Conoco, HSBC, Bernard Matthews, Interbrew,
Carillion, BUPA, and the UK’s National Health Service. This paper will explain our

1
This chapter was originally delivered by Andrew Cox, Glyn Watson and Chris Lonsdale as a paper to
the British Academy of Management Conference in London, September 2002.

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Managing the Supply Base within Business Markets

research agenda, locate it within the literature on inter-organisational relationships and


foreshadow the findings.

The Debate over the Management of Supply Networks

Over the past 25 years, a recognisable academic community has grown up that is
interested in the subject of purchasing and supply chain management. Whilst this
academic community enjoys a diverse range of contributions, three prominent schools
of thought stand out. These are the aforementioned lean, agile and interaction schools.
At present, there is something of a stand-off between the lean and agile schools on the
one hand and the interaction approach of the IMP school on the other. In particular,
the schools have vastly different views about the capacity of organisations to plan and
control their supply networks. An important reason for this may well be the different
subject and, often occupational, backgrounds of the academics in the different
schools. But whatever the reason, it has led to a situation where academics interested
in purchasing and supply chain management are offering clients and other interested
parties vastly differing advice on how to manage their supply networks.

The Lean and Agile Schools


The lean supply school has developed out of research undertaken in the 1980s into the
Japanese automotive industry. The academics in this school saw that Toyota, in
particular, had gained huge benefits out of planning and controlling their supply
network. A key part of this plan and control strategy was the development of close
relationships with suppliers. Toyota had created ordered tiers of suppliers, with each
tier working closely with the next, all in accordance with its plans and targets.

It was observed that this sharing of technical knowledge and demand information,
development of just-in-time systems and the like and establishment of joint problem-
solving forums had allowed Toyota to leap ahead of its Western competitors, whose
supply chains were still adversarial and chaotic. These observations of ‘best practice’
were published at the beginning of the 1990s and formed an impressive body of
literature. Major contributions came from Womack and Jones (1990 and 1996),
Lamming (1993), and Hines (1994). The arguments of these academics were
supported by the slightly earlier work of John Carlisle and Robert Parker (1989).
Carlisle and Parker had used the prisoner’s dilemma to show how an absence of trust
and, consequently, co-operation led to outcomes that were unnecessarily sub-optimal.

The agile supply school, whilst presented by some as a competitor, is really highly
complementary to the work of the lean school. Again, the focus is on the development
of trust between buyers and suppliers and on the need for them to work together in
close collaboration. A further similarity is the requirement for co-ordinated supply
network activity. Indeed, the main differences between the lean and agile
prescriptions concern the nature of their operational techniques, rather than general
business philosophy. The agile techniques are very different from the lean techniques
as they have been developed for very different types of marketplaces. Alan Harrison
and Remko van Hoek commented recently:

‘Supply chain performance improvement [or lean] initiatives strive to match supply to
demand, thereby driving down costs at the same time as improving customer

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Managing the Supply Base within Business Markets

satisfaction. This invariably requires that uncertainty within the supply network
should be reduced as far as possible so as to facilitate a more predictable upstream
demand. Sometimes however uncertainty cannot be removed from the supply network
because of the product and market characteristics … Hence, specific supply networks
are faced with a situation where they have to accept uncertainty, but where they still
need to develop a strategy that enables them to match supply and demand … The
capabilities needed to respond to such volatile conditions have been given a distinct
term – agility.’ (Harrison and van Hoek, 2002, p166).

Therefore, both the lean and agile approaches require buyers and suppliers to work
together closely, albeit towards different ends, on the basis of trust. The theories also
contain a considerable confidence in the capacity of management to plan and control
their supply networks over a significant period of time. It is assumed that, in their
different ways, managers can put together a stable and reliable network, which will
remain focused on the ultimate need to satisfy the end customer. This is not a
confidence that is shared by the IMP school of academics that have developed their
interaction approach.

The Interaction Approach of the IMP School


The business world is a very different place to the IMP school of academics. This
school argues that it is unrealistic to expect managers to plan and control their supply
networks over any given length of time. To justify this view, the IMP school has
mapped at length the internal and external restricting factors that managers will
inevitably face if they try to do so. The external restricting factors arise for four linked
reasons. First, firms in supply networks are highly interdependent. Second, firms in
supply networks have different interests (a view that contrasts with the lean view
which states that all players in the network have a common interest in delighting the
end-customer, an imperative given the nature of competition). Third, there are
different power relationships in supply networks, so managers will often not be able
to persuade a supplier or customer to re-order its priorities. Fourth, business markets
are always in a considerable state of flux

The conclusion the IMP school draws from these restrictions is stark: ‘The search for
a straightforward and effective strategy that can be sustained over the long-term is
doomed to failure. This is partially because the company will be subject to the
heterogeneous behaviour of different counterparts. It is also because of the changes
that will occur within each of its relationships.’ (Ford et al, 1998, pp75-6)

Consequently, the advice given under the interaction approach is cautious: ‘This does
not mean that attempts to direct the development of supplier relationships … should
not be considered. The importance of these relationships for a company’s
performance means that it must strive to control and direct their development. But, it
will need to do this in the realisation that change is likely to be slow, complex and the
result of interventions by both companies rather than as a straightforward result of a
single ‘master plan’ or a few major decisions.’ (Ford et al, 1998, pp120-1)

Ford, writing on behalf of the IMP school, continues: ‘Effective decision-making by


managers is likely to be based at least as much on analysis of experience of what has

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Managing the Supply Base within Business Markets

happened previously within their company’s relationships as it is on explicit planning


… The strategy process in business markets is not one that is wholly amenable to
explicit detailed planning.’ (Ford (ed), 1997, p559) As a result, managers should work
towards organisational flexibility rather than pursue grand plans.

The Management of Supply Networks and Inter-Organisational Power


Structures

The IMP group also provides its own view of the Japanese automotive industry’s
supply management practices – key to the development of the lean view. Ford et al
comment: ‘It seems that many of the Japanese sub-contractors have been more or less
forced into relationships involving extensive co-ordination by a customer because of
the considerable power of those customers. Although those suppliers that achieve a
first-tier position [within the Keiretsu] seem to have benefited from the process, those
on other tiers have very little discretion over their activities and are very vulnerable to
changes in customer requirements or attitudes.’ (Ford et al, 1998, p147). Ford et al
also make a further statement on the Japanese experience: ‘It is likely to be very
difficult for a small customer to involve large suppliers in these efforts except on the
most favourable terms.’ (Ford et al, 1998, p147) A similar position is taken by the
IMP group on retail supply chains.

We would agree with the IMP school that the lean school has underestimated the role
of inter-organisational power in facilitating lean supply in the Japanese automotive
industry. However, we believe that the IMP school itself has also failed to appreciate
the full significance of the concept of inter-organisation power for the management of
supply networks – albeit for totally different reasons. It is our view that the concept of
power can actually bring together the messages of the lean and agile schools on the
one hand and the IMP group on the other and go a long way towards explaining the
discrepancies in their research findings – both schools claim to have evidence
supporting their contradictory perspectives. Indeed, this contention can be explained
through the use of the IMP school’s own words.

In the above quotes from the IMP school about the lessons of the Japanese automotive
experience two points are made. First, the success of Toyota and other Japanese
assemblers in planning and controlling their supply networks can be explained by
pointing to their considerable power over their suppliers. Second, not all firms will be
able to emulate Toyota et al as they will not possess such power. We would argue that
these two points are not only a convincing evaluation of the Japanese automotive
experience, but are also the basis for a hypothesis concerning the management of
supply networks.

This hypothesis would run as follows: Inter-organisational power both facilitates and
constrains efforts to plan and control supply networks. Therefore, if a series of power
relationships similar to the Japanese example are stable (and we believe that
economics can be used to predict with reasonable accuracy whether this is the case)
then it will be possible to manage either the whole supply network or part of it – what
we call a sub-regime – to beneficial effect.

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Managing the Supply Base within Business Markets

We have argued elsewhere, as have others, that there are four generic buyer-supplier
power relationships. These are buyer dominance, interdependence, independence and
supplier dominance. (For example, Cox, Sanderson and Watson, 2000; Cox et al,
2002) Where the buyer has dominance over the supplier, it will be able to direct the
relationship as it sees fit, which on many occasions will involve close collaboration.
However, as in the Japanese automotive case, the buyer will expect to secure the
lion’s share of the gains, even when they are the result of collaboration. Situations of
buyer-supplier interdependence will also provide opportunities for similar co-
ordination activities, although the process will be more difficult. In other power
situations, the benefit of a focus on power will come from the recommendation of
more defensive strategies.

Space has not permitted a detailed summary of our ideas and past research findings.
However, on the basis of our past and current research, we believe that in many
supply networks the opportunity exists for managers to improve supply performance
by managing with an awareness of the impact of power – as a facilitator and a
constraint on planning and control activities. Therefore, our continuing research is
aimed at testing the following propositions:

 There is a link between supplier behaviour and inter-organisational power


structures;

 Certain inter-organisational power structures (namely Buyer-Supplier


Interdependence, but especially Buyer Dominance) provide opportunities for plans
to be initiated;

 In certain instances, these power structures are relatively stable and can, therefore,
provide opportunities for outcomes to be controlled over a reasonable length of
time.

Conclusion

The aim of our current research is to provide a body of evidence that can bring
together the very different perspectives of the three main schools of thought in the
area of purchasing and supply chain management and explain their differences. We
believe that the vastly different evidence they have uncovered, which has led them to
very different conclusions about how managers should approach the management of
supply networks, is explicable if it is interpreted using the concept of inter-
organisational power. Our hope is to enlist other academics in this agenda.

References

Carlisle, J. and Parker, R. (1989). Beyond Negotiation, Wiley, Chichester.


Cox, A., Sanderson, J. and Watson, G. (2000). Power Regimes, Earlgate Press,
Boston: UK.
Cox, A., Ireland, P., Lonsdale, C., Sanderson, J. and Watson, G. (2002) Supply
Chains, Markets and Power, Routledge, London.
Ford, D. (ed) (1997). Understanding Business Markets, 2nd Edition, Dryden, London.

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Managing the Supply Base within Business Markets

Ford, D. et al (1998). Managing Business Relationships, Macmillan, London.


Harrison, A. and van Hoek, R. (2002). Logistics Management and Strategy, Prentice
Hall, New York.
Hines, P. (1994). Creating World Class Suppliers, Pitman, London.
Lamming, R. (1993). Beyond Partnership, Prentice Hall, New York.
Womack, J. and Jones, D. (1990). The Machine that Changed the World, Rawson
Associates, New York.
Womack, J. and Jones, D. (1996). Lean Thinking, Simon and Schuster, New York.

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Managing the Supply Base within Business Markets

Thinking Strategically About Supply Chain


Relationship Management: The Issue of Incentives2

Introduction

The study of supply chain management is the study of incentives. Supply chain
managers and their vendors are competitors as well as collaborators. The mutual gains
from trade bring the parties together in the first place. Additional benefits accruing
from closer collaboration can keep them working together thereafter. However, the
value generated from the exchange process must be distributed and this is what makes
buyers and sellers competitors as well as collaborators. Consequently, the function of
the supply chain manager is to ensure that the interaction between the buying and the
selling organisation generates as much value-add as possible but that the value-add
passes to his or her organisation, rather than being retained within the organisation of
the vendor. In order to achieve this, the supply manager must be skilled at crafting
the incentive structures that will modify the behaviour of the vendor in ways that are
consistent with the interests of the buying organisation. It is for this reason that the
study of supply chain management is the study of incentives.

This chapter divides into three sections. Section one deals with the incentive issue
itself by establishing its central importance to supply managers. Section two deals
with outsourcing. Under certain circumstances it will be impossible for the supply
manager to incentivise its vendor. Having such activities outside the boundary of the
organisation therefore not only threatens to inflate the costs of the buyer but may also
undermine the firm’s revenue streams as well. Knowing where to draw the boundary
of the firm is integral to the development of supply chain competence. Once the
boundary has been drawn the supplier has to be effectively managed. Supplier
management is the subject of the third and final section. Here it is suggested that
effective supplier management have as much to do with the management of demand
as it does the management of supply. However, in relation to the management of
supply the firm must consider both questions of governance and contractual
management.

Incentivisation and the Process of Exchange

All exchange involves both elements of cooperation and competition. Assuming that
the concerned parties have voluntarily agreed to the deal, the very act of signing a
2
This chapter is a 2002 pre-publication chapter written by Glyn Watson, Andrew Cox, Chris Lonsdale
and Joe Sanderson.

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contract is a cooperative activity. The vendor (or seller) is getting something that
he/she wants – cash – while the buyer is getting something he/she wants – the
products and services supplied by the vendor. However, the cooperative aspects of an
exchange can (and frequently do) go beyond this. Buyers and sellers can actively
work together to streamline the contracting process and/or adapt/develop the vendor’s
products and services so that they more closely match the requirements of the buyer.
The creation of such value-adding relationships has today become a staple of supply
chain management.

Buyers and sellers are also in competition, however. While both sides gain from a
trade (else why trade in the first instance), it is not necessary for both sides to gain
equally for a trade to take place. For the buyer, the aim is to get value for money from
a deal. If he/she is a rational agent this means maximum value for money. Every
time he/she is able to negotiate the price down a notch, the value for money that is
obtained, increases. Of course, for the vendor, passing value to its customers means
smaller profits. Economists refer to the contested ground that exists between the two
parties to a trade as the surplus value. Surplus value is the difference between the
value that the customer places on the vendor’s products (i.e. the customer’s utility
function), and the supplier’s costs of production. That portion of the contested ground
that passes to the customer is said to be the consumer surplus while that which is
retained by the vendor, the producer surplus (see Figure 1).

Figure 1. Surplus Value and its Division

Even when buyers and sellers increase the cooperative element of an exchange by
actively working together to add-value to the relationship, the competitive element to
it remains i.e. cooperative relationships can be adversarial or non-adversarial. This is
because the fruits of the cooperation (either in the form of lower production costs for
the vendor or a higher valuation of the vendor’s products on the part of the customer)
have to be divided up. If for example, the effect of collaboration is to reduce the
supplier’s costs by £100 a unit there would be an issue about whether the vendor
should pass all of the savings onto the customer or whether it should retain some of
them in the form of higher profits. Alternatively, if the supplier invests £100 in
developing its products and as a result increased the value to the customer by £200,
should the vendor raise its prices by £100 to cover just the cost of the investment, or
by the full £200.

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Managing the Supply Base within Business Markets

What determines who wins out in this competitive process are the incentive structures
that underpin the exchange relationship. Take for example the vendor that finds itself
in a highly competitive market where its many customers are free to pick and choose
where they buy their goods and services. Such a context forces the vendor into a
Dutch auction in which it is forced to constantly drop its prices to buy its customer’s
business. In such a situation, the surplus value is bound to pass to the consumer.
Compare that to a situation in which a particular customer has invested heavily in the
vendor’s technologies, even building the value proposition that it offers its own
customers, around the technologies of a particular supplier. This happened in the case
of the PC market where PC manufacturers fell over themselves to advertise the fact
that their machines had an ‘Intel inside’. In the end, it became impossible for PC
manufacturers to compete unless they were able to make this boast. Unfortunately,
this had the effect of handing enormous leverage over to Intel and as a result the
surplus value passed from the consumer to the producer.

Consequently, much of supply management is reduced to game between poachers and


gamekeepers in which the vendor assumes the role of the poacher (trying to ‘steal’ its
customers’ scarce financial resources), while the procurement manager assumes the
role of the gamekeeper, in trying to stop them. What follows is a cat and mouse game
in which through a combination of guile and the development of distinctive
capabilities the vendor attempts to close markets; while the procurement manager
responds in kind with a range of counter strategies, designed to stop its vendors by
keeping its supply markets contested. To the victor go the spoils. Power (formally
defined as the ability of one party to adversely affect the interests of another), and the
pursuit of power are at the heart of the exchange process. (Lukes, 1974, Cox et al,
2000, Cox et al 2002).

To some it might appear that the competitive elements of an exchange have been
overstated. While it is true that some people in life are maximisers (i.e. they are
always looking for the highest possible return from a deal), critics would argue that
most people are in fact happy to just satisfice (i.e. obtain a settlement that provides
them with a deal that they can live with). If two people cooperate on a venture, then
generally speaking those people are happy to split the proceeds. This may or may not
be true; it is hard to say. What is true, however, is that such an approach is sub-
optimal and imprudent. That satisficing is sub-optimal should be self-evident. The
fact that it is also imprudent needs further elaboration.

The issue of prudence arises in a number of contexts. Firstly, it puts the profitability
and even the survival of a firm at risk. The reason that firms come into business in the
first instance is to make a return for shareholders. While it is true, as a number of
resource-based writers have observed, that markets are often heterogeneous (i.e. they
are capable of supporting laggards as well as world beaters), it is not true that markets
are infinitely forgiving of the weak (Peteraf, 1993). Firms that fall too far behind the
competitive frontier are on borrowed time. Firms that forget about the competitive
elements of an exchange, however, risk seeing their costs rise and falling behind the
competitive frontier.

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Managing the Supply Base within Business Markets

The second problem with cooperation and trust is that it demonstrates an unwarranted
confidence in the capacity/willingness of others to reciprocate. Many firms that
acquire leverage are happy to use it. Even those who do not possess a structural
advantage may be attempt to use guile instead, where they think it will pay-off for
them. Furthermore, denials that this is not true cannot be taken at face value
(Williamson, 1985). The thing about people is that very few of them are honest all of
the time. One only has to reflect on one’s own experience to see that this is true.

According to business economists, economic agents are not simply self-interested but
they pursue this self-interest with guile – not all of the time, but sufficiently often so
that opportunism is a fact of commercial life. What permits the existence of
opportunism is two things: one a lack of honesty (obviously); and two a lack of
transparency between buyers and sellers. Economists distinguish between public and
private information (Molhow, 1997). Information is regarded as public if it involves
something that is widely known. Information is regarded as private when access to it
is restricted. When ‘restriction’ means that one side in an exchange knows something
that the other side does not, then an information asymmetry is said to exist. It is
information asymmetry permits dishonesty to pay.

Business opportunism exists in a number of forms but for buyers the twin guises in
which it is most common are adverse selection and moral hazard. Adverse selection
is ex ante opportunism or misrepresentation that arises prior to the signing of a
contract. Shorthand definitions of the concept might revolve around buying a ‘lemon’
or being sold a ‘turkey’ (or ‘pup’). The scope for adverse selection varies but is more
common under some circumstances than others. Commentators often distinguish
between search, experience and credence goods. Search goods are products that allow
buyers to make systematic comparisons prior to a purchase. They are normally
tangible products like chairs, pens or iron ingots. Experience goods, by contrast, are
products that can only be evaluated subsequent to purchase. Typically, they include
services like cinemas or restaurants. However, the category can also include tangible
products like cars or records.

The final category of good is the credence good. Credence goods defy easy
evaluation, even after consumption. They include intangible services such as
advertising, consultancy or medical services. What makes evaluation so hard usually
comes down to a difficulty with attributing blame or success. For example, a piece of
professional advice might have been responsible for a commercial disaster. However,
the blame might lie with some other concomitant factor. The point is, where pre-
contractual evaluation of a product is difficult – either because evaluation is
inherently difficult or because the buyer lacks the resources or expertise to undertake
it – the buyer is open to the risk of adverse selection. Experience goods and credence
goods, by definition are difficult to evaluate prior to purchase.

If adverse selection involves being suckered before a contract is signed, moral hazard
involves being suckered once a party has signed on the dotted line. Some things that
are bought involve a simple one-off interaction. The product is purchased and it
either works or it doesn’t. Following this, buyer and seller go their separate ways.
Other exchanges, by contrast, require a prolonged association. Either the contract

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Managing the Supply Base within Business Markets

must be serviced on an ongoing basis (e.g. a facilities management contract) or the


buyer requires repeat purchases (e.g. a contract to supply car engines). Either way,
the vendor attempts to change the terms of the deal after the contract has been signed.
They might do this openly by seeking to exploit a loophole in the contract; or they
might do it covertly by simply not delivering on a promise.

Regardless of the form that opportunism takes, the potential for it means that firms
must always be aware of the competitive nature of any trade. Even if a customer is
honest and believe in giving the other guy a fair break, they cannot be sure that the
other side is operating according to the same code. Because a trade always involves
some private information we just don’t know what we don’t know and what we don’t
know might turn out to be quite important. One of the essential elements of
procurement and supply chain competence, therefore, centres on the capacity of
buyers to ensure that their vendors offer a good deal (or at least keep to the terms of
the deal that has been agreed).

Incentivisation and the Outsourcing Dilemma

Nowhere are the issues of competition between buyers and sellers more acute than in
respect to outsourcing. This is evidenced by the fact that so many outsourced
contracts go wrong. One survey found that in only five per cent of cases did
outsourcing prove to be an unqualified success (details of this survey are reported in
Lonsdale and Cox, 1998). More often than not respondents indicated that it was
something of a curate’s egg (that is, good in parts). Thirty-nine per cent of
respondents in the survey said that their outsourced contracts were simultaneously
moderately successful and moderately unsuccessful. Of course, this may have
something to do with the way in which the contracts were managed. (The issue of
contractual mismanagement will be discussed in the next section). Such, is the scale
of disappointment, however, that it suggests that something deeper than simply poor
contracting is at work.

On the face of it the decision to outsource should not be particularly problematic. It


should involve a simple cost comparison between the expenses associated with
undertaking the activity in-house as opposed to the expenses associated with
contracting it out. For example, the size of the firm’s requirement might be
insufficient to cover the fixed costs associated with production in an efficient fashion.
Under these conditions, sourcing externally, from a firm that can amortise its fixed
costs more efficiently, might make eminent sense. Alternatively, a particular activity
might be suffering from a lack of effective managerial oversight. Managerial time
within the firm is a scarce resource and most of it tends to be devoted to the firm’s
key activities. Residual activities tend to get overlooked and production suffers as a
result. It is this thinking that in effect underpins much of the core competence
writing. If your firm can’t do something well, find another firm that can.

Outsourcing tends to go wrong, however, because it exposes the firm to either a


strategic or a contractual risk. Strategic risk arises if the firm outsources its
competitive differentiator. Within strategy, there are three types of differentiation:
cost leadership, product differentiation and niche production (Porter, 1980). In each

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Managing the Supply Base within Business Markets

case the firm is attempting to achieve the same thing through differentiation i.e. break
the relationship between cost, price and profit in order that it might earn an economic
rent or sustained producer surplus. In a competitive marketplace, the consumer’s
ability to pick and choose between alternative vendors drives the firm’s prices down
towards the marginal cost of production. This is the last thing that a firm wants.

In the case of cost leadership the firm is attempting to earn a rent by developing a
uniquely efficient production processes that is difficult for its competitors to imitate
through the creation of ex post barriers to entry. So long as the firm is able to stave-
off competitive imitation it can afford to drop its prices below those of its competitors
and still make a higher return. In the case of product differentiation, by contrast, the
firm is attempting to develop a superior utility proposition for the customer. The idea
here is that when people comparison shop and realise that the firm’s products are
better than those of its competitors, they will be prepared to pay a premium for the
product that offers the higher utility. Again its ability to sustain its producer surplus
and turn it into a rent is contingent upon its capacity to hinder or retard competitive
imitation. Finally, niche production also seeks to target customer’s utility. This it
achieves, however, not by creating relatively superior products but by servicing
segments of a marketplace that nobody else is particularly interested in.

Because being able to competitively differentiate is so valuable to the firm (and


indeed it is what strategy is all about), firms must be able to protect those resources
and capabilities that generate the differentiation in the first place. However, if the
firm outsources such a resource or capability then the odds are that it will end up
paying the rent to its supplier that it should be earning for itself.

Outsourcing can also expose the firm to significant contractual risk (or moral hazard).
Again, this involves the surplus value passing to the vendor, rather than being retained
by the consumer. Sustaining the performance of a vendor depends upon a firm’s
ability to motivate them. Motivation might take the form of a carrot (bonuses for
good performance), or a stick (the cancellation of the contract if the performance is
poor). But in order for the incentive structure to work it must be credible. This means
being able to monitor the supplier to see if they are complying with the terms of the
deal; and having the ability to punish the supplier (by invoking penalties or by
threatening exit), if they are not. Imagine a myopic and doddery old teacher trying to
keep discipline in a playground if his head teacher has told him that even if he catches
one of the children misbehaving, he is not allowed to threaten them with punishment.
Under such circumstances the children in his charge would run wild. So it is with
suppliers.

The tasks that the firm has to perform, therefore, concern being able to spot those
transactions for which there is significant scope for opportunism and to be able to
craft safeguards against the risk. Where contractual safeguards cannot properly be
introduced, then the firm would probably be better to retain the competence within the
organisation, rather than to outsource it.

Moral hazard is always a problem with outsourced contracts because effective


monitoring is always an issue. However, sometimes the risks are particularly acute.

16
Managing the Supply Base within Business Markets

Contracting which takes place in a highly volatile or uncertain environment is difficult


because it raises the issue of renegotiation. Buyers attempt to draft contracts in as
complete a fashion as possible but when an environment is particularly volatile,
specifying the all the terms of an agreement in advance is likely to prove next to
impossible. This in itself need not present a difficulty unless the firm becomes
locked-in to its outsourced provider. If this happens the supplier may choose to
renegotiate on terms that benefit it, rather than its customer (Williamson, 1985).

Contractual lock-in occurs if the contract requires the buyer to make some form of
highly specialised investment in the relationship. The investment might take the form
of time. An organisation that has spent months negotiating and implementing an
outsourced relationship might be reluctant to write-off all of this hard work –
especially if re-sourcing means repeating the effort with no greater chance of success
next time around. Alternatively, firms might have made substantial and non-fungible
investments in specialised training or equipment (otherwise known as asset specific
investments (Williamson, 1985). Less creditably, though, firms are often reluctant to
call time on a poorly performing supplier if the managers who negotiated the contract
have a significant reputational investment in the deal. Calling a halt to the affair
means admitting that they got it wrong and nobody likes doing that. Whatever the
form of the lock-in, the effect is the same: the firm loses its capacity to impose costs
on the vendor and thus its ability to impose discipline.

Of course just because an outsourced contract presents the firm with a risk, it does not
follow that the risk cannot be managed and that outsourcing should not take place.
One strategy often pursued by firms involves unbundling a contract. This means
separating out those elements that pose a risk from those that do not. The highly risky
elements are retained in-house and only the less risky elements are outsourced. The
supplier may even be asked to post a bond or share the costs of the dedicated
investments, as a sign of its good faith (i.e. to show that its word of honour and
commitment to the relationship are credible).

Incentivisation and Supplier Management

Outsourcing requires the firm to understand what it is that allows it to leverage its
customers (in the case of strategic outsourcing); and what it is that allows its
‘potential’ suppliers to exploit it (in the case of both strategic and tactical
outsourcing). Effective relationship management is about reversing things by
understanding what it is that allows the firm to control and leverage its suppliers. The
question is to what end? This is where we are required to re-introduce the subject of
surplus value.

The first decision that the firm must ask itself is whether the relationship should
include a value-added element. Many commentators would argue yes, citing the
benefits that often flow from extending the co-operative elements of a trade. Lean
thinking, for example, highlights the 7 supply chain wastes that often plague buyer-
supplier relationships. These relate to overproduction (1); unnecessary inventory (2),
waiting (3), motion (4), transportation (5), defects (6); and inappropriate processing
(7) (for a discussion of these see Hines et al, 2000). Yet, just because extended co-

17
Managing the Supply Base within Business Markets

operation might potentially generate additional value it doesn’t mean that it will or
that the buyer will be the main beneficiary if it does. Four factors play a part in
determining the buyer’s calculation about whether cooperation is worthwhile: the
upfront investment, the potential pay-off, power and risk. Creating a value-adding
relationship requires an investment, even if only in terms of the time and managerial
effort that it involves. The first thing that the firm must ensure is that the expected
payback matches the upfront investment. No firm is going to spend a lot of time
developing its supplier of toilet rolls. The improvement for the buyer is likely to be
miniscule compared to the effort.

What complicates the calculation is that both the investment and return may be hard
to determine ex ante. Take defence contractors. Suppliers of defence equipment
work closely with their customers (governments) to ensure that the weapons that they
develop are the ones that the customer wants/needs. The industry, however, is
notorious for the delays in introducing new equipment and the cost overruns. In a
number of instances the additional cost that the customer ends up committing itself to
runs into the £billions. When the equipment finally arrives, it may be too late to be
useful. It may not even work properly. Consequently, there is the issue of which
party takes the risk and which party obtains the reward. This is a question of power.
A simple example will illustrate the nature of the calculation that the buyer faces.

Take two firms: a buyer (A) and its supplier (B). B proposes to A that an upfront
investment of £50 is capable of yielding cost savings of £200. In other words the
additional surplus value that has been created through the cooperation comes to £150.
If A exercises leverage over B it will probably think that cooperating is a good idea.
As it has the power it will probably insist that B takes all of the upfront risk, agreeing
to cover B’s costs only if the initiative pays-off. This is a no lose situation for A. If,
however, A and B are interdependent then the calculation becomes more complex. B
will probably insist that A shares both the investment and the reward. This means that
A must invest £25 (half the £50 cost) to get a payback of £100 (half the £200 cost
savings). This leaves it with a net gain of £75 (£100 savings – the £25 costs). Once
again cooperating makes sense – although the pay-off for the buyer is smaller than in
the first example.

What if the costs are fixed but the gains are far from certain, however. Say, for
example, there was only 25 per cent chance of a successful outcome. Under these
circumstances the firm would be investing £25 to get a 25% x £100 return. The cost-
benefit calculation here is finely balanced (£25 cost - £25 return = zero). Change the
parameters again (e.g. increase the upfront investment by £1) and the initiative may
cease to make commercial sense. This is why power is so important to all
relationships: it affects the pay-off structures of buyers and sellers and thus over-
determines the management of the relationship. It decides which side takes most of
the risks and which side extracts most of the rewards. Furthermore, the same
calculations pertains whether the firm is thinking in a dyadic or a wider supply chain
context.

The second set of operational issues confronting the firm relate, therefore, to how it
acquires or maintains a power advantage over suppliers. Buyers are aware that

18
Managing the Supply Base within Business Markets

vendors segment their customer base. One simple segmentation (which none-the-less
is still widely used), involves the vendor categorising customers on the basis of the
size of the customer’s business and the difficulties associated with servicing it. The
attempt here is to determine the overall profitability of a specific contract to the
vendor’s business. Obviously, what the buyer is looking for is large contracts that are
easy (i.e. cheap) to service. What they are not looking for is low value, costly and
therefore nuisance business. This is why the procurement functions within many
organisations have created commodity councils aimed at rationalising specific items
of spend so as to maximise their attractiveness/value/leverage over/to supply markets
in general and to specific vendors in particular. The hope here is that if the buyer can
select a supplier that is both competent and whose interests dovetail with the buyer’s
objectives (i.e. is also congruent). Then the buyer will get a better deal.

However, creating this congruence is easier said than done. Operationally, the key to
effective supply management is usually effective demand management but as often as
not a supply manager will experience considerable difficulty in getting the managers
in other functions to recognise this point. Functional autonomy and principal-agent
problems are facts of life. In theory organisations should be hierarchies or authority
structures with a strong focus on maximising shareholder value. If it has been
determined that rationalising and consolidating a particular item of spend would save
the organisation money, then the word should go down from the top that a
rationalisation needs to take place.

In practice though, each department tends to see the world from its own particular
point of view, and set its priorities and fight its corner accordingly. Thus the sales
department of an organisation is usually more focused on winning business than the
overall profitability of the business that it has won. Frequently they will attempt to
meet the customer’s specification even if this means significantly adapting the firm’s
existing supply offering at great cost. There was a reason why Henry Ford said that
his customers could have any colour of car that they wanted, as long as it was black.
Whereas sales departments are often trying to buy business regardless of cost,
engineering departments tend to strive for technical excellence and quality. The
knock-on effect of this is that there is a tendency amongst engineers to over-specify to
insure themselves against the potential for product failure. The fact that this over-
specification dramatically limits the organisation’s supply options and the price that it
must pay its suppliers rises accordingly is of little consequence to the engineer.

The problems that the supply manager faces are not just related to the misalignment of
organisational incentives and the fact that others within the organisation are reluctant
to see things from his/her view. They also concern the fact that when trying to affect
a change the supply manager often finds himself/herself at the bottom of the pecking
order. As long as the organisation is making money it may be reluctant to challenge
existing practice, preferring instead to muddle through and accept the organisational
slack.

The final set of operational issues facing supply managers concern the management of
the chosen vendor itself. Supply management involves two issues: relationship
management and contracting. Relationship management concerns how the buyer and

19
Managing the Supply Base within Business Markets

seller are going to interact on a day-to-day basis. Is the association between the two
essentially going to be an arms-length one of is something closer going to be called
for? If the firm has opted to pursue a value-adding relationship them presumably
close interaction is required. The contracting parties will need to trade information,
mutually adapt their processes etc., so the maximum value-adding potential is
achieved. At the same time relationship management will also involve managing the
tensions that exist between the two. Some forms of co-operation, for example, might
be deemed neutral in the sense that they add-value to the relationship without
disturbing the commercial balance within it.

Other forms of co-operation, however, are far from neutral. For example, if the buyer
calls for the supplier to open its books, then the buyer is acquiring a considerable
advantage over its supplier in that it now knows just how much money the supplier is
making from the deal. Bother buyers and sellers, therefore, tend to want to manage
the relationship so that while it adds-value it doesn’t tip the balance of power the
wrong way. The same goes for performance measurement. Performance
measurement may be a way of monitoring how quickly things are improving - or if
they are not improving where and why this is the case. However, performance
measurement is also a mechanism of control and both sides tend to be aware of this.

In contrast to relationship management that tends to contain a value-adding element as


well as a controlling element, contracts are primarily about control. They are about
specifying in a legally binding way, the manner in which buyers and suppliers are to
work together i.e. who is responsible for doing what. They are also about specifying
(again in a legally binding way), the outputs of the relationship: what the supplier is
expected to deliver, what the buyer is expected to pay, and which party own the rights
to any exploitable technologies or processes should they emerge from the association.
Contracts take three main forms: tight, flexible and relational (Williamson, 1985).
The shift from tight to relational contracting tends to occur as the uncertainty within
the relationship increases.

Where an element of a deal is simple to specify with a high degree of confidence, a


tight contract will tend to be used. Where, by contrast, a degree of uncertainty
surrounds a particular aspect of the deal, but that uncertainty falls within clearly
defined limits, the contracting parties may seek to draft a flexible element to the
contract. This allows the requirement/reward relationship to be adjusted in a
predictable way. Relational contracts tend to be used when the future trading
environment is unpredictable and cannot easily be contacted for. Under such
circumstances the point of a relational contract is to provide a structured framework
within which the terms of a deal can be renegotiated as the future becomes clear.
Although a contact may be mainly of one of the three types, it can contain elements of
each. Short-term, arms-length relationships tend to call for tight contracts but may
include a subsidiary element. Longer-term arms-length relationships tend to require
the flexible element to increase. Long-term co-operative relationships (whether they
are adversarial or non-adversarial) tend to call for all three.

Of course, while contract aim to serve as instruments of control, whether in fact they
succeed in this function depends on the ex post power balance. As we saw in our

20
Managing the Supply Base within Business Markets

discussions on outsourcing and contractual risk, if the buyer loses his/her power then
the contract may not be worth the paper that it is written on. As the political
philosopher Thomas Hobbes once put it, ‘contracts without the sword are but empty
breath’.

Conclusion

Exchange takes place in the first instance because it is mutually profitable. Closer
forms of cooperation occur because they can increase this level of profitability.
However mutually profitable exchange is not the same as equally profitable exchange.
Buyers and sellers are competitors as well as collaborators. Consequently it is
important for supply chain managers to understand the following things; first, they
must understand when it is not sensible to exchange (that is, when exchange imposes
unacceptable levels of strategic and contractual risk). Second, they must also
understand (when it is sensible to exchange), how to craft the incentive structures that
will maximise the return to their organisations. At root, therefore, the study and
practice of supply chain management is the study of managerial and contractual
incentives.

References

Cox, A., J. Sanderson and G. Watson (2000) Power Regimes, Boston, UK, Earlsgate
Press.
Cox, A., P. Ireland, C. Lonsdale, J. Sanderson and G.Watson (2002) Supply Chains,
Markets and Power, London and New York, Routledge
Hines, P., R. Lamming, D. Jones, P. Cousins and N. Rich (2000) Value Stream
Management, Harlow, Pearson.
Lonsdale, C. and A. Cox (1998) Outsourcing: A Business Guide to Risk Management
Tools and Techniques, Boston, UK, Earlsgate.
Lukes, S. (1974) Power: a Radical View, London, Macmillan.
Molhow, I (1997) The Economics of Information, Oxford, Blackwell.
Peteraf, M (1993) ‘The Cornerstones of Competitive Advantage: A resource-based
view’, Strategic Management Journal, 14: 179-91.
Porter, M (1980) Competitive Strategy, New York, Free Press.
Williamson, O. (1985) The Economic Institutions of Capitalism, New York, Free
Press.

21
Managing the Supply Base within Business Markets

Common Obstacles to Obtaining Value


For Money3

Introduction

Before prescribing any solution to a problem it is first necessary to offer a diagnosis


of it. If the aim of the buying organisation is to maximise the value for money it
obtains from its suppliers, it is first necessary to understand the factors that might
cause value to flow out of the buying organisation and onto the balance sheets of its
suppliers. In other words, it is necessary to understand what factors are at play in
affecting which party takes the majority of the surplus value? This chapter considers
three of the most common factors that affect the division of surplus value:

• the competitive structure of supply markets;


• the opportunistic nature of some supplier’s behaviour;
• sub-optimal buyer behaviour

The Competitive Structure of Supply Markets

Commercial markets vary enormously. They vary in terms of their size. They vary in
terms of their technological sophistication. And, of course, they vary in terms of their
profitability. Some markets, for example, exhibit high levels of investment and
technological sophistication, but yield only low levels of profitability. The automotive
and aerospace industries are both cases in point. Last year the mean industry return
on revenue for the two industries was 2 per cent and –0.3 per cent respectively.

However, they are not alone in earning modest or negative rates of return. Of the 36
industry sectors covered in Fortune magazine’s global survey, 21 of the sectors had
mean profits falling within a range between 0.7 and 5.2 per cent. In fact, only three
industries recorded double digit returns. One of these was the drinks industry, with the
profits of its top companies averaging out at 14.9 per cent. Above this in the table was
the financial services industry. However, topping the league was the pharmaceuticals
industry, with the average return for the 14 companies that made it onto the list,
coming out at 17 per cent.

3
This chapter has been compiled by combining a report written by Chris Lonsdale and Glyn Watson
for the NHS with a pre-publication article written by Chris Lonsdale. Both were written in 2002.

22
Managing the Supply Base within Business Markets

To put the pharmaceutical industry’s performance into some kind of perspective this
profitability figure was 17.3 per cent more than that of the aerospace industry, 16.4
per cent more than that of the airline industry, 15.6 per cent more than that of the food
retailing and 14.9 per cent more than that of the telecommunications industry. Only
one of the pharmaceutical companies in the list – the Roche Group – did not make a
profit last year and only one other failed to make a return of less than 10 per cent. It
should be fairly obvious, even from this very crude data, that healthcare markets are
particularly profitable ones for firms to be in.

When justifying the high profit levels, many have argued that pharmaceutical
companies have a large need for R&D investment. Indeed. But are automotive and
aerospace companies any different in this respect? Furthermore, a recent report
showed that whilst the top 10 pharmaceutical companies spent $19 billion on R&D in
2001, they spent $45 billion on marketing, advertising and administration.

So, how can we explain these differences in profitability? Part of the answer, at least,
lies in the competitive dynamics of the market in question. This, in turn, is
determined by its competitive structure. In some industries, the structure is very
fragmented and, as a result, the competition is cutthroat. Again, to use the case of the
automotive industry, there are over 50 different brands currently being sold in the EU
and, as a result, not only are margins very low but most of the profits are actually
made in the aftermarket. Conversely, in other markets there is only one supplier and
no competition. Microsoft’s stranglehold over PC operating systems is an example of
this. This stranglehold has for over two decades allowed Microsoft to massively
outperform most of the other companies in its broad sector.

In fact, analysts have identified a range of different competitive structures, each with
its own competitive dynamics. The main ones of note are: monopoly (a supply market
consisting of one firm), oligopoly (a supply market consisting of a few collusive
firms), monopolistic competition (a supply market where there are many competitors,
but where there are certain ‘monopoly brands’) and a perfectly competitive market
(consisting of a large number of firms).

We looked for these different competitive structures during research we undertook


within the NHS. The news was not good for the organisation. We found that many of
the supply markets that NHS organisations buy from were not especially competitive.
In many markets, for example, those delivering medical equipment, there was only a
choice of a few suppliers. In other markets, for example, the markets for certain
pharmaceutical products, the NHS had no choice at all. This was often, of course, due
to the use of patent protection. A healthcare company, having developed a new
product, will usually seek to patent it. For the lifetime of that patent the manufacturer
is a virtual monopolist.

Furthermore, even after a patent has expired, the manufacturer may seek to retain its
position by ‘reformulating’ its product. One recent report on the subject marketed to
the industry by Reuters was actually entitled, Achieving Market Dominance through
Reformulation. As we have mentioned, there is a competitive element in all business
relationships, however cordial they might seem.

23
Managing the Supply Base within Business Markets

However, research also showed that not all of the supply markets from which the
NHS acquires goods and services are quite as difficult. Examples of where
competition is plentiful includes clinical waste management, wound management
products, catering and general facilities management (a big area of spend for any
hospital trust) and non-specialist medical equipment (for example, patient warming
blankets and beds). In these markets, it is critical that the NHS makes full use of the
competition that exists and ensures that it receives the greater share of the surplus
value.

The Opportunistic Nature of Suppliers

However, the problems faced by buyers in getting value for money from suppliers do
not end with supply market structures. Buyers also have to consider the issue of
supplier behaviour. Ethical and commercial standards vary a great deal between
suppliers and some pursue profit not through strategies of innovation but rather
through strategies of misrepresentation. Economists have a word for it: opportunism
or ‘self-interest seeking with guile’.

All firms are expected to be self-interested. Indeed, as we have said, a firm’s senior
managers have a legal obligation to maximise shareholder value. However, in the
pursuit of its self-interest, an opportunistic supplier will not seek to bind itself with
any conventions of honesty - in other words, it will act with guile.

In its attempts to combat opportunism, the problem for buyers is usually an


informational one. What allows the opportunistic supplier to profit from its behaviour
is a lack of awareness on the part of buyers as to the game being played. And, because
the opportunistic supplier masks its strategy carefully, its duplicity will only become
apparent after the fact – if at all. A successful strategy of opportunistic behaviour will
be highly profitable, even more profitable, often, than strategies of simple monopoly
leverage.

Whilst there are many different ways that a supplier’s opportunism can manifest itself,
most practices fall within four main categories. We will review these categories.
However, before we do so we need to discuss further the concept of opportunism, and
its relationship to the further concept of bounded rationality.

Bounded Rationality, Opportunism and the Behavioural Context to Supplier


Management
If managers are considering entering into any contractual relationship, it is critical that
before they do they develop a view on what they believe is the ‘behavioural context’
within which they are operating. This is critical, as different views on the behavioural
context will indicate totally different courses of action. The two main aspects of the
behavioural context are cognitive ability and self-interest orientation. Orthodox, neo-
classical economic theory has, since the 1940s, been criticised for developing a
convenient model of economic man that has not and will not ever exist. The
fundamental principle of institutional economics, by contrast, is that man should be

24
Managing the Supply Base within Business Markets

studied ‘as he is’ (Coase, 1984, p231). What is meant by this statement can be
explained by dealing with the two behavioural aspects in turn.

Orthodox economics, when considering the cognitive abilities of economic actors, has
always proceeded on the basis of hyper-rationality. The assumption is made that
economic man is an all-seeing, all-knowing individual that operates on the basis of
perfect information and can, therefore, develop complete contracts. Many other
economists, including institutional economists, reject this view of cognition and work
instead on the assumption that man operates under a condition of bounded rationality.

This concept, most associated with Herbert Simon (1947), has been defined as ‘a
semistrong form of rationality in which economic actors are assumed to be intendedly
rational, but only limitedly so’ (Williamson, 1985, p45). McGuinness (1994, p67)
adds to this definition by commenting: ‘People are assumed to try to make rational
decisions, but their ability to do so is constrained by limits on their capacity to
receive, process, store and retrieve information … One implication is that people are
unable to take full account of, or possibly even imagine, all future situations that
might require changes in the terms of a transaction’.

The significance of bounded rationality is that it can lead to either (a) an information
asymmetry between the buyer and the supplier and/or (b) an inability on the part of
the buyer to sign a complete contract. These outcomes are not necessarily problematic
in of themselves, but become so when bounded rationality is combined with the
condition of opportunism, a condition that concerns the second behavioural aspect –
the self-interest orientation of managers.

There are three broad types of self-interest orientation. The first is obedience, where
man is held to possess no self-interest at all. This type is associated utopian
collectivism (Williamson, 1985). The second is simple self-interest seeking, the type
of self-interest orientation that informs neo-classical (or orthodox) economics.
Economic actors with this orientation are assumed to pursue their own self-interest,
but do so in a manner that is open and reliable.

Oliver Williamson (1985, p49), the leading exponent of transaction cost economics (a
strand of the institutional economic tradition), comments on the neo-classical
assumption: ‘Initial positions will be fully and candidly disclosed upon inquiry, state
of world declarations will be accurate and execution is oath- or rule-bound’. Under
conditions of simple self-interest seeking it is possible for managers to mitigate the
problems caused by bounded rationality – i.e. contractual incompleteness – by asking
the other party ‘to make self-enforcing promises to behave ‘responsibly’ in a joint
profit maximising way’ (Williamson, 1995, p29).

However, Williamson rejects this neo-classical assumption about self-interest


orientation and, instead, subscribes to a view that a more realistic assumption about
orientation is that economic actors have a tendency towards opportunism. Williamson
(1985, pp47-8) defines opportunism as ‘self-interest seeking with guile’ and

25
Managing the Supply Base within Business Markets

elaborates this by stating: ‘Opportunism refers to the incomplete or distorted


disclosure of information, especially to calculated efforts to mislead, distort, disguise,
obfuscate or otherwise confuse [as well as more blatant forms of lying, stealing and
cheating]. It is responsible for real or contrived conditions of information asymmetry
which vastly complicate the problems of economic organisation’.

In other words, an opportunistic supplier is a ‘wolf in sheep’s clothing’. The


behaviour of its managers might suggest that they are acting in good faith, but in
reality they are pursuing self-interest with guile, through one of the mechanisms
described in the above definition. Indeed, the key to opportunism is that the self-
interest is only recognisable after the event. For Williamson, why bounded rationality
becomes a problem when combined with opportunism is that what it means is that
suppliers are always seeking to take advantage of the gaps in the knowledge of the
buyer.

So there is some debate over the behavioural context to business management. The
view taken in this chapter is that the most credible depiction of business behaviour is
bounded rationality on the part of the buyer and opportunism on the part of the
supplier (there are other permutations, but they are not relevant to (most of) our
discussion in this chapter). It is in the context of these behavioural assumptions that
we now proceed to investigate the four different ways in which supplier opportunism
can manifest itself.

Pre-Contractual Strategic Misrepresentation


The first way in which one party to an exchange might act opportunistically vis-à-vis
the other is termed ‘strategic misrepresentation’. The issue here is the information
asymmetry between the two parties concerning the value that each party places on the
product in question. Milgrom and Roberts (1992) put forward the following scenario
to illuminate the problem:

Consider two people, a buyer and a seller. The seller owns a unit of a product in
which the buyer is interested. Each party to the exchange, of course, is privately
informed about the value that he or she places on having the product. However,
neither party knows for certain the value placed on the product by the other party. Let
us say that the permutations of this are the following:

Buyer:
 Actually values the product at $3.
 Doesn’t know what value the seller attaches to the product, but believes it is
between $0.5 and $2.

Supplier:
 Actually values the product at $0.5.
 Doesn’t know what value the buyer attaches to the product, but believes it is
between $1 and $3.

26
Managing the Supply Base within Business Markets

Because of the information asymmetries that exist in this scenario, it is possible that
problems will arise should the two parties try to misrepresent their valuations of the
product – they could do so in an attempt to get a better price. Remember, we have
described the self-interest orientation of suppliers as being characterised by a
tendency towards opportunism. In this case, it is also necessary to assume a similar
self-interest orientation on the part of the buyer. Let us play out the game of
misrepresentation:

 Even though the buyer actually values the product at $3, he or she may well wish
to convey the impression that it is really only worth $1 to him or her. In the
negotiation trade, this is something that is referred to as conditioning. This is
discussed further in the chapter on negotiation - chapter 8.

 However, the seller can play the same game. Whilst the seller in this case, in
reality, only values the product at $0.5, he or she might wish to convey the
impression that he or she values it at $2 in the hope that this will lead to the sale
being struck at a higher price than $0.5.

The outcome of this mutual conditioning could be that one or both parties secure a
deal that is an improvement on their actual valuation of the product in question.
However, in situations where the real valuations are different from the example given
here, there is the risk that the sale will fall through. The supplier may demand a price
that is higher than the valuation placed on the product by the buyer or the buyer may
demand a price that is lower than the valuation placed on the product by the supplier.
In either case, it will be an example of how information asymmetry can cause market
failure.

Pre-Contractual Adverse Selection


Another pre-contractual problem caused by supplier opportunism is adverse selection.
Adverse selection is the outcome of a scenario where a buyer does not have, prior to
purchase, the information to assess the quality of the product in question. A guide to
whether there is a risk of adverse selection comes from a categorisation developed
within the economics literature. Products in both consumer and business markets have
been placed by economists in one of three categories: search goods; experience goods;
and, credence goods.

Search goods are those goods that can be evaluated as to their value for money (that is
quality against price) prior to purchase. For example, in a consumer market you can
pick up a pair of trousers and pull at the seams to ascertain whether they have been
stitched properly and whether the material looks to be of a high quality. There are
similar examples in business markets. Engineering components, for example, can be
inspected prior to their purchase in order to ascertain their quality.

However, not all purchases allow such an evaluation. Some purchases are classified as
experience goods. With these goods an evaluation of the value for money achieved by
the buyer can only take place after it has been consumed or used or, in the case of a
service, delivered. The classic example in a consumer market is a haircut – many of us
can remember wearing a hat for weeks after a particularly disastrous visit to the

27
Managing the Supply Base within Business Markets

barber. In business markets, business services, like IT services, are often in the
experience good category.

A third category of purchases, however, cannot be evaluated as to their value for


money even after they have been consumed / used / delivered. These are termed
credence goods. The classic example of a credence good in a business market is
management consultancy. It is quite difficult to sue a management consultancy for
negligence (there is no shortage of those who would like to) because there are so
many intervening variables that can interfere with the causal link between the
consultants advice and the client firm’s performance. For example, the consultancy
might say, if things have gone wrong, that the competitive environment changed in
the period after it had given its advice, but that it could not have been expected to
foresee that. Alternatively, the consultant may argue that the advice it gave was good,
but that the clowns in your firm did not implement it properly.

So, in the case of many purchases, there is an information asymmetry between the
buyer and the seller, prior to the point of purchase, as to the voracity of the product in
question. A further classic example of adverse selection is the second hand car
market. Here the seller has greater knowledge of whether the car is a ‘diamond’ or a
‘dog’. The problem here is that market failure can result because the buyer, not being
able to tell the good from the bad, will be reluctant to pay a price consistent with the
going rate for a ‘good’ car. As a result, all of the sellers of ‘good’ cars leave the
market, leaving only ‘poor’ cars that nobody wants.

A final illustration of adverse selection concerns the mis-selling of endowment


mortgages that took place in the UK in the 1980s. Endowment mortgages are only
really suitable for people with secure incomes because the costs of exiting from
endowment policies early are very high. However, this was not known by all of those
who were looking for mortgages at that time. Furthermore, the sales representatives
received the highest commissions from their employers from selling endowment
rather than other types of mortgages.

As a result, the ignorance of many buyers, combined with the opportunism of the
sellers and the incentive structure created by the mortgage lenders led to the
widespread mis-selling of endowment mortgages, the consequences of which are still
being played out today.

Post-Contractual Moral Hazard


The next problem caused by supplier opportunism concerns supplier conduct after the
two parties have entered a relationship. It is, therefore, referred to as a ‘post-
contractual’ problem. However, like the pre-contractual problems discussed before, it
is again the consequence of the exploitation of an information asymmetry between the
two parties. Alchian and Woodward (1988, p68) describe the problem thus: ‘Moral
hazard arises in agreements in which at least one party relies on the behaviour of
another and [where obtaining] the information about that behaviour is costly …
Because it is costly for the principal to know exactly what the agent did or will do, the
agent has an opportunity to bias its actions more in his own interest [and] to some
degree inconsistent with the interests of the principal’.

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Managing the Supply Base within Business Markets

The problem of moral hazard can arise in relationships between a business owner and
the senior management that it employs to manage on its behalf, managers and
employees or lenders / investors and managers. However, in our context, the relevant
principal-agent relationship is between the buyer and the supplier. The opportunities
for moral hazard in buyer-supplier exchanges are myriad. For example, in large and
complex exchanges the opportunity arises out of that complexity. It is impossible for
the buyer to know exactly what is going on (what hours are being worked, what
materials are being used, etc) in all aspects of the exchange.

However, even in small, relatively simple exchanges moral hazard is possible. Here,
the reason is that buying firms rarely spend any time checking their smallest
purchases. The opportunity cost of using scarce management resources checking such
purchases is too high. Therefore, small suppliers to large customers can often add a
few extra percent here and there to their invoices and not be noticed.

A case of moral hazard recently hit the newspapers. It concerned the practices of the
US office of the law firm Clifford Chance. Reena SenGupta (2002, p19) looked into
the case: ‘The hourly rate – the method by which most [US] lawyers bill their clients
– has long been criticised. In the UK, companies – and many lawyers – argue that it is
a disincentive for lawyers to provide value for money, encouraging them to spend
longer than they need to on a given task.

In the US, the main complaint is that it facilitates the “padding” of bills – the charging
of hours not in fact worked. A recent New York Times article, for example, cited
several examples of hourly rate abuse, such as that of the Baltimore product liability
lawyer who in the 1980s billed 5,800 hours in one year and was to found to have
defrauded a client of $3.1 million’.

Sengupta (2002, p19) continued: ‘Clients in the US tend to assume there will be a
certain amount of padding and will make sure the rates are as low as possible’. This is
reminiscent of the instruction that Tom Cruise was given on his first day as a lawyer
in the film, The Firm. He was told: ‘If you are having a shower and you think about
the client, bill them. If you are eating your breakfast and you think about the client,
bill them. If you are driving in to work and think about the client, bill them’.

Moral hazard is by no means merely a phenomenon seen in the legal services


industry. It is seen everywhere. Two further examples we have come across illustrate
the point. The first example concerns management consultancy. A number of years
ago, a healthcare organisation, that we were working with at the time, hired a team of
management consultants to look at their purchasing process and policies. Having
completed their investigations, the consultancy team went away to write up their
findings. When it returned, the leader of the consultancy team claimed that the
production of the report had covered their employees’ time to the tune of 25 days and
handed the client an invoice consistent with that claim.

Unfortunately, when they presented the report – nicely designed and bound and 200
pages long (“feel the width”) – the consultancy team found that one of its members

29
Managing the Supply Base within Business Markets

had made a catastrophic error. To understand what that error was, we need to rewind a
couple of weeks. Having completed its investigation of the healthcare organisation,
what the consultancy team had actually done when its staff had returned to its office
was not produce a report from scratch, but rather bespoke an existing generic report
that was used for many low value clients (i.e. clients that do not provide much
business). The work needed to bespoke this existing report would actually have taken
one employee about two days – nothing like the 25 days worth of employee time that
was claimed.

This practice, whilst hardly ethical, would not have been a problem for the
consultancy if the member of the team responsible for producing the report had not
forgotten to change the footer on the powerpoint generated text. This footer had a
code on it that referred to the previous client that had been presented with a differently
worked version of this same generic blueprint. As you can imagine, the client was not
very happy on discovering what had happened.

A second example concerns a beverage manufacturer’s procurement of advertising


services. This firm employed an advertising agency to manage its advertising
requirements and the service the agency provided extended to it managing the process
of commissioning and managing sub-contractors. The arrangement was that the
agency simply billed the marketing team within the firm at the end of each month for
what had been purchased over that period.

When a new director of marketing joined the firm he decided that the marketing spend
should be investigated by the purchasing team. The purchasing team found a large
number of examples of the agency taking advantage of the information advantage the
nature of the role bestowed upon it. The most egregious concerned a poster design
that had received a mark-up of about 9,000% - the agency paid the sub-contractor, but
then added a much higher amount to the monthly invoice presented to the beverage
manufacturer’s marketing team.

The Post-Contractual Hold-up Problem


The final problem caused by supplier opportunism is known as the hold-up problem
and also occurs post-contractually. It is associated with the economic concept of asset
specificity and, as we shall discover, made worse by the existence of transactional
uncertainty.

Asset specificity refers to the extent to which the resources used in a business
exchange have a higher value to that particular exchange than they would if they were
subsequently re-deployed to any other exchange between the firm and a different
buyer or supplier. We can explain this further.

In order for business transactions to be conducted effectively there is often a need for
investments to be made. These could be investments in machinery, investments in
training or investments in plant. Some of these investments will be transferable to a
future transaction with another buyer or supplier, should a switch be desired.
However, some will not and are referred to in transaction cost economics (TCE) as
transaction-specific investments. Williamson categorises all business transactions into

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Managing the Supply Base within Business Markets

three broad types, depending on the level of transaction-specific investments


involved: high, medium and low asset specificity.

Uncertainty, in this context, is said to exist when ‘there are very many known
alternatives or there are known to be currently unimaginable possibilities’
(McGuinness, 1994, p70). Burnes comments that ‘uncertainty arises because of our
inability ever to understand and control events fully, especially the actions of others,
whether outside or inside an organisation’ (Burnes, 2000, p75). Uncertainty is likely
to be a considerable problem in complex contractual situations, especially when
supply involves a new innovation or constitutes a new venture.

Asset specificity and uncertainty provide the buyer with different contractual risks –
risks that are heightened by the existence of supplier opportunism. In the case of asset
specificity the risk arises from what Williamson refers to as the ‘fundamental
transformation’. He comments (from the point of view of the buyer): ‘Transaction
cost economics holds that a condition of large numbers bidding at the outset does not
necessarily imply that a large numbers bidding condition will prevail thereafter.
Whether ex post competition is fully efficacious or not depends on whether the good
or service in question is supported by durable investments in transaction-specific
human or physical assets’ (Williamson, 1985, p61).

The reason for this is that when significant transaction-specific investments are made
by the two parties to a transaction, the buyer (our focus here) can only re-access the
market if it is prepared to write off those investments. This provides a significant
barrier and often leads to the buyer persevering with the supplier even if the
relationship is not progressing well (clearly an opposite scenario is also possible).
Such a situation is commonly referred to as ‘lock-in’ or the ‘hold-up’ problem and can
clearly be observed as a serious hazard if set in the context of supplier opportunism.

The risks that arise out of asset specificity are added to if a transaction is also
characterised by uncertainty. The risks that arise out of uncertainty concern the need
for adaptation. If, during the contract, the circumstances surrounding the transaction
change to the extent that the product or service provided has to be significantly
adapted, then it will often require a change to the statement of work provided under
the contract. This gives rise, under conditions of supplier opportunism, to a danger of
the supplier seeing the change of circumstances as an opportunity to increase its
returns – an opportunity that would arise in the re-negotiations. This will clearly be a
greater problem for the buyer if it has allowed itself to become ‘locked-in’, as it will
possess no credible threat of returning to the market – a key negotiation chip.

Can Managers Address the Risk of Hold-up?


TCE attempts to address this question. It presents a managerial prescription that is
aimed at managing the risks arising out of the combination of bounded rationality,
opportunism, asset specificity and uncertainty. This prescription is the judicious use of
alternative governance structures. First, where a transaction is characterised by low
asset specificity, TCE states that it should be managed through basic market
governance (i.e. arm’s length contracting). This is because where there is low asset

31
Managing the Supply Base within Business Markets

specificity managers can manage the risk of opportunism by credibly threatening a


return to the market.

Second, where the transaction is of high asset specificity, TCE argues for the risk to
be managed through unified governance. The rationale is that as the risk of
opportunism is significant when a transaction is of high asset specificity (because re-
accessing the market has such a high cost attached), and because no supplier can offer
any economies of scale for a transaction of such a specialised nature, it will be most
efficient to manage this type of transaction in-house.

Finally, when the transaction is characterised by medium asset specificity, a third


arrangement is prescribed. With such transactions buyers are faced with a dilemma.
On the one hand, there are economies of scale to be had from procuring the goods or
services from the market – as they are only partially specialised. However, such a
level of asset speciality does still bring with it a risk of lock-in or hold-up. What is
suggested is that managers develop a balanced bilateral contract with a supplier.

A bilateral contract is a legal arrangement that contains clauses specifically designed


to apportion risk equally between the two parties to the exchange. The risks that it
seeks to manage are those arising out of asset specificity and uncertainty. The idea is
that such risks are managed by creating an interdependent, or balanced, relationship
through mutual lock-in. The mutual lock-in creates incentives for actions that make
the relationship work and disincentives for actions based upon opportunism. The idea
of bilateral contracts is that they are intended to allow the buyer to enjoy the co-
ordination benefits of in-house management, whilst sparing it the costs of ownership.

On some occasions, the sought-after mutual lock-in occurs naturally. It will just so
happen that the nature of the transaction requires both parties to make equal
transaction-specific investments in order for it to be undertaken efficiently. However,
on other occasions, the interests of efficiency will require one party to make greater
transaction-specific investments than the other. This leads to the party undertaking the
greater share of the investments becoming vulnerable vis-à-vis the other party.

As a result, TCE posits that the two parties should work together to contrive balance
in the relationship. This is through the making of ‘credible commitments’
(Williamson, 1985). There are a number of different ways in which the two parties
could make such commitments. A buyer could guarantee a supplier a certain amount
of work, so that the supplier can be confident that its investment will be covered. A
supplier, on the other hand, could agree to cost transparency and a limit on the profit
margin it earns from the contract. Alternatively, either party could post a financial
bond that provides a level of insurance to the other.

So, TCE offers three alternative governance structures. But how do managers know
which type of governance structure to adopt in the different circumstances they face,
and how to develop that structure effectively? To understand this we need to consider
the third element in TCE’s behavioural context. This concerns managerial vision.
TCE argues that whilst managers are constrained by bounded rationality, this does not
mean that they are myopic. Managers can look ahead and recognise general categories

32
Managing the Supply Base within Business Markets

of problems, even if bounded rationality means that they cannot accurately detail
those problems.

This ability is termed feasible or plausible foresight, which allows managers to


undertake farsighted contracting (Williamson, 1990). So, whilst managers cannot
develop complete contracts, they can use feasible foresight to develop broad
contractual safeguards. As we have seen, sometimes safeguarding the firm will mean
unified governance. On other occasions it will mean the development of a balanced
bilateral contract.

Problems with the Transaction Cost Economic Prescription for Hold-up


The TCE prescription for the risk of hold-up sounds very logical. However, there are
numerous problems with it. The most important of these for our purpose concerns the
development of balanced bilateral contracts. There are serious problems with the TCE
expectation that buying firms will be able to make such contracts balanced. First, the
power position at the initial bidding stage could be skewed towards one party.

Here power is defined as the ability of A to make B act in a manner that it would not
otherwise have done (Lukes, 1974) and understood in terms of dependence relations
(Emerson, 1962). If, at the initial bidding stage, the buyer is in a weak position (see
Cox et al, 2002 for details of the commercial factors between buyers and suppliers
that lead to dependence relations) then it may not be able to persuade the supplier to
commit to a balancing of the contract, in the manner outlined by Williamson.

Second, contrary to Williamson’s assumption (1995), the purchasing organisation will


often possess inferior resources to the sales team of the supplier. This could lead to
the purchasing organisation signing an inappropriate contract – through sheer pressure
of time as much as anything else. This is definitely relevant to the NHS, where
hospital trusts’ purchasing teams routinely face a large number of MNCs, selling
complex products or services, with only about five to ten people in their team. The
familiar refrain that the NHS contains too many managers is definitely misplaced
when it comes to its purchasing operations.

Third, Williamson’s concept of feasible foresight also does not take into account the
possibility that there might be different agendas within the customer organisation that
might lead to actions that are inimical to effective contracting. It is stretching
credulity to expect all members of an organisation to (a) possess the contracting
foresight that Williamson deems necessary to avoid post-contractual dependency and
(b) prioritise such issues above the other concerns they might hold.

This is especially because, as Dearborn and Simon (1958) discovered in their survey
of managerial attitudes, managers tend to see organisational issues through the prism
of their own functional sub-culture. In many functional sub-cultures issues of
contracting hardly figure at all. It is unlikely, therefore, that contractual foresight will
exist and be prioritised in all parts of an organisation. Yet as studies of organisational
decision-making have routinely shown, it is not necessarily those that are best

33
Managing the Supply Base within Business Markets

qualified to make (or influence) decisions that do so. Rather, decision-making is


heavily influenced by intra-organisational power (Hickson et al, 1971; Child, 1972).

All of these three issues have the potential to affect the ability of buyers to achieve
contractual balance. Yet even if contractual balance was achieved by a public body,
would the relationship with a private sector supplier actually be one of genuine overall
balance? Experience suggests not, because even where there is contractual balance the
buyer has always got more to lose than the supplier, particularly where the purchase is
of high importance to the organisational objectives of the buyer.

We can see this clearly in the public sector because public bodies have to fulfil
statutory duties one way or another. Therefore, when a relationship collapses, or
falters, it is not just the transaction-specific investments that the public body has made
that are the issue – that public body has to continue to be able to operate and it may, in
the short to medium-term, require the recalcitrant supplier to do so. A supplier, on the
other hand, may have to write off its investment in a relationship if it collapses, but
the consequences of this will often be far less significant than the interruption of
statutory duties, especially if the supplier has a large customer base.

The hold-up problem, therefore, is profound and one that is endemic to industrial
purchasing and supply management. It is responsible on a great many occasions for
buyers being forced to concede to the supplier the lion’s share of the surplus value.
Furthermore, as we have sought to demonstrate here, it is a problem that is more
difficult to address than the TCE school might have us believe.

Sub-Optimal Buyer Behaviour

Hand-in-hand with the behaviour of some suppliers goes the weakness of the
negotiation position that many buyers find, or put, themselves in. Take the NHS for
example, in its role as an industrial buyer. Think about the nature of the situation
when an agency of the NHS (for example, a hospital trust) enters into an exchange
with a large, multinational pharmaceuticals company.

Let us think about the pharmaceutical company first. The marketing operations of a
multinational pharmaceuticals company will invariably be very well resourced and
sophisticated. It will employ a large expert sales force, all of whose members will be
intimately acquainted with its client’s operations. And, of course, that force will have
as its sole priority the objective of winning the client’s business, keeping it and
making it profitable.

Contrast this with the staff of individual NHS buying units. While the salesman sells
and negotiates every day of his life, for most clinical members of such units this is
only an irregular and occasional activity. Their time and attention has to be split
between a dozen different and competing priorities so, notwithstanding the skills and
experience that those purchasing within the NHS have acquired over the years, the
contest is inevitably an uneven one.

34
Managing the Supply Base within Business Markets

However, organisations, like the NHS, do have a few potential advantages of their
own. One of the most important of these potential advantages relates to the way in
which organisations organise their spend. If organisations can present themselves to
the supply market as buyers with attractive contracts to offer then it will find it much
easier to control supplier behaviour and get good deals. The way in which
organisations can present themselves to the supply market this way is by
consolidating their spend – that is reducing the number of similar products they use
and reducing the number of suppliers from which they buy those products from.

Why does consolidating spend lead to better deals on many (although not all)
occasions? There are a number of reasons, but one important reason is that
consolidating spend with fewer suppliers will often transform the profile of a buyer’s
spend in the eyes of those suppliers. When purchasing, managers need to remember
that the supplier or suppliers they are dealing with will be profiling their organisation
as to its attractiveness. Some suppliers are in a position where they can segment their
customer base and decide (a) which customers to sell to and (b) what type of deals to
give to the different customer types in their segmentation.

When suppliers are able to do this, certain customers will be considered ‘core’. These
will be those that provide the supplier with high levels of revenue and are easy to
service. Such suppliers receive the best treatment. At the other end of the scale are
nuisance customers. These customers are deemed peripheral and receive very poor
treatment by suppliers.

The point being made here is that if a buying organisation unnecessarily fragments its
spend it can, all things being equal, put itself in the nuisance box and get a poorer than
necessary deal. It is critical, therefore, that purchasing managers assess very carefully
the portfolio of products they are currently purchasing to ascertain whether there are
opportunities for consolidation.

A further aspect of buyer behaviour that can provide obstacles to achieving value for
money is what is known in the trade as ‘maverick’ buying. This is where purchases
are made by individuals outside of the formal purchasing and contracting process.
Whilst sometimes individuals taking this route will get a good deal, overall maverick
buying can lead to serious problems. These problems can include the fragmentation of
spend across many suppliers (with the consequences discussed above), poor
contracting, ill-informed negotiation and damage to existing contracts set up by the
organisation as a whole. Both of these two issues of buyer behaviour – fragmentation
and maverick buying - are discussed in greater depth in chapter 7.

Conclusion

This chapter has briefly explored three common obstacles to buyers achieving value
for money in their dealings with their suppliers. The chapter has shown that the ability
to achieve value for money is not simply dependent on the structure of the supply
markets from which buyers are purchasing. The nature of supplier and buyer
behaviour in commercial exchanges also has a critical impact on the outcome.

35
Managing the Supply Base within Business Markets

There are many things for a purchasing manager to think about if he or she is to retain
a large share of the surplus value in his or her exchanges with suppliers. Purchasing
and supply management is a difficult and demanding job. This is increasingly being
recognised by organisations in the salaries being offered to senior purchasing
executives – at many stages in the managerial scale, purchasing managers now earn
more than managers working in HR or marketing.

References

Alchian, A. and S. Woodward. 1988. ‘The Firm is Dead; Long Live the Firm’,
Journal of Economic Literature, 26, 65-79.
Burnes, B. 2000. Managing Change, Harlow: Pearson.
Child, J. 1972. ‘Organisational Structure, Environment and Performance: The Role of
Strategic Choice’, Sociology, 6, 1, 2-22.
Coase, R. 1984. ‘The New Institutional Economics’, Journal of Institutional and
Theoretical Economics, 140, 229-231.
Cox, A., P. Ireland, C. Lonsdale, J. Sanderson and G. Watson. 2002. Supply Chains,
Markets and Power. London: Routledge.
Dearborn, D. and H. Simon. 1958. ‘Selective Perception: A Note on the Departmental
Identification of Executives’, Sociometry, 21, 140-144.
Emerson, R. 1962. ‘Power-Dependence Relations’, American Sociological Review,
27, 31-41.
Fortune. 2003. Fortune 500 Survey.
Hickson, D., C. Hinings, C. Lee, R. Schneck, and J. Pennings. 1971. ‘A Strategic
Contingencies Theory of Intraorganisational Power’, Administrative Science
Quarterly, 6, 216-229.
Lukes, S. 1974. Power: A Radical View. New York: Free Press.
McGuinness, T. 1994. ‘Markets and Managerial Hierarchies’ in Thompson, G., J.
Frances, R. Levacic and J. Mitchell (eds), Markets, Hierarchies and Networks.
London: Sage, 66-81.

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Managing the Supply Base within Business Markets

What is Business Power?4

Introduction

Power is a feature of everyday life. We use the term all of the time. It underpins many
of our most important social relations. Many people feel uncomfortable with this
assertion. After all, power has so many negative associations. It conjures up images of
rifle butts, of secret plotting. In the movies, good guys wear white hats and try to help
out the weak. The bad guys, on the other hand, dress in black and want to control
people or appropriate things. Clearly, power is about these things, but it is not only
about them. Its exercise is not always as obvious or its effects so sinister. Quite
frequently, it shows itself in the most mundane of ways.

For example, when a boy meets a girl and they fall in love it does not end the power
play between the sexes. Disputes will continue to arise over who should wash the car,
walk the dog or clean the dishes. Who wins these little battles is likely to depend on
the respective resources of the participants and the skill with which they deploy them.
If there is a rough balance of power in the relationship then the distribution of
responsibility will be determined by the old-fashioned principle of give-and-take. If
one particular party has the power, however, then they may well choose to shirk on
the housekeeping. Throughout the lifetime of the relationship, the balance of power is
likely to shift between the two parties. But if one party should ever fall out of love
then the other is likely to find him or herself at a grave disadvantage. Many marriages
are emotionally abusive, even if they are not physically so.

Power is also important in other areas. It is central to an understanding of politics, for


example. Differences of opinion over the way economies should be organised divided
the continent of Europe for fifty years. One side saw market economics, with its
emphasis on free will and individual freedom, as the best way of organising the
processes of production and social (re)distribution. The other side held that Western
freedoms were largely illusory and masked a class war that left the vast majority of
people greatly disadvantaged. At root, what divided the two protagonists was a
dispute over the structures of power in a capitalist society.

However, whilst power clearly plays a central part in helping to structure everyday
life, what exactly is it? More importantly, what does it mean in a business and supply
chain context?

4
This chapter originally appeared in Cox, A., Sanderson, J. and Watson, G. (2000) Power Regimes,
Earlsgate Press.

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Managing the Supply Base within Business Markets

Understanding Power

Power, Gallie argued in 1955, is an ‘essentially contested concept’. What he was


implying was that it is a concept, the meaning of which cannot be formally verified,
although it is amenable to rational debate. These difficulties can, of course, be
overcome by using a working definition, which applies solely in the context of a
specific study. The working definition of power that will be employed in this book is
the ability of one actor to affect the behaviour of another actor in a manner contrary
to the second actor’s interests. This was the definition developed by Steven Lukes in
his now classic study on the subject. It is not enough, however, to simply choose one
definition from amongst the many on offer, because each definition is based upon
certain key assumptions. We must therefore explore these assumptions.

The various perspectives on power, and the definitions derived from them, can be
crudely divided into what might be called an objective view and a subjective view.
Analysts adopting each of these views would probably agree that a power relation
involves a conflict of interest between two or more parties. Furthermore, they would
also probably agree that the resolution of this conflict is determined by the attributes
that each party has at its disposal and the skill with which these attributes are
deployed. Where an analyst taking an objective view of power parts company with
one adopting a subjective view is on the approach that each takes to the concept of
interests. This represents a crucial difference, because it directly delimits the range of
circumstances in which power relationships are held to exist.

For writers adopting a subjective view, an actor’s interests are held to be equivalent to
expressed preferences or desires. Within this conception, a power relationship exists if
actor A desires outcome x and actor B desires outcome y, and if A can achieve its
preferred outcome against the explicit and direct opposition of B. The study of power
within the subjective view thereafter entails an examination of those attributes that A
or B might consciously deploy to secure their expressed preferences. Writers adopting
an objective view claim, however, that this is not the only dimension to power, nor
indeed the most important dimension. They contend that there are other aspects to
power, that can only be highlighted once the definition of interests is expanded
beyond the articulation of preferences. We share this latter view.

A critical element of the objective view is that interests are not always correctly
perceived by those who attempt to articulate them. This is central to Lukes’ work and
that of his contemporary, Connolly. They have argued that interests may be distorted
in a number of ways. Ignorance and the existence of social norms both alter
preferences and obscure the recognition of needs. Beyond these structural distortions,
interests are subject to conscious manipulation so that conflicts that might be expected
to arise remain latent. The subjective approach is incapable of recognising this critical
exercise of power.

Take for example a typical pay negotiation. If in such a negotiation you were unaware
of the fact that all of your colleagues had been offered ten per cent and you thought
that the average award was five percent, this would affect your strategy. You might

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Managing the Supply Base within Business Markets

well respond positively to an offer of eight per cent, taking it as an indication of the
value placed on your efforts. If somebody were to tell you how much others were
receiving, however, then this would change everything.

Nonetheless, manipulation of interests through the careful management of information


is a fact of everyday life. Indeed, such manipulation to gain a power advantage is
particularly common in relations between buyers and suppliers. Economists did not,
however, explicitly incorporate this factor into their thinking until the early 1960s.
Since then economic models have recognised that if one of the participants in an
exchange is unable to effectively monitor the position or actions of the other, the
relatively informed party will probably take the opportunity to pursue their interests
with guile. Central to this process of distortion are attempts to manipulate the
expectations of the vulnerable party in ways that are least damaging to the
manipulator.

The objective view generates certain methodological difficulties of its own, however.
The analyst is presented with the problem of distinguishing an actor’s real interest
from one that is false, because the actor’s expressed preferences cannot be taken at
face value. It is easy for the researcher to spuriously ascribe particular interests to an
actor, because he does not understand that actor’s needs. Connolly asserted that one
way out of this dilemma is to undertake a counterfactual conditional judgement about
what an actor might reasonably be expected to want, were he or she aware of all of
the alternatives and the costs and benefits that might be expected to flow from them.
Under this conception, an option x can be held to be more in an actor’s real interest
than a second option y, if the actor, having experienced the results of both x and y,
decides to choose option x.

Judgements about what an actor might reasonably be expected to want in the


commercial context are of course complex. For the buyer, it is typical to talk in terms
of value for money. This involves a series of complex trade-offs. The buyer has to
make decisions about the appropriate mix of functionality and cost for the portfolio of
goods and services that must be acquired. In theory, the rational buyer is concerned
with obtaining the required level of functionality at the lowest possible cost, which
means at cost. In this way, the supplier’s gross profit margin is the key measure of the
buyer’s power. For the buyer, therefore, power is not about achieving the lowest
price, but about its capacity to drive the supplier’s returns on a transaction towards the
long-run marginal cost of production.

For the supplier, on the other hand, power is used to push the level of return above
long-run marginal cost, and, assuming there is repeat business, to hold it there. Given
this definition of the buyer’s objective interests, it is necessary for the buyer to know,
with certainty, the supplier’s costs of production. Conversely, if the supplier is to
pursue its own objective interests, it is imperative that it conceals this same cost
information. The extent to which there is an uneven distribution of cost information
related to any given level of functionality between buyer and supplier is critical,
therefore, to an understanding of both potential and actual power in exchange
relationships. This uneven distribution is normally referred to as ‘information
asymmetry’ in business-to-business relationships.

39
Managing the Supply Base within Business Markets

Another key feature of power is that it is relative. Power is not something like money
that can be accumulated and stockpiled. In other words, no one firm has power in all
contexts. Furthermore, a buyer-supplier exchange can never solely be about power,
because there is always some measure of mutual interest between two contracting
parties. The fact that firms are resource constrained means that they cannot do
everything for themselves. They must, therefore, look to others to provide them with
the goods and services that they are incapable of supplying for themselves. Thus, two
contracting parties are dependent upon one another to the extent that each is able to
offer the other something that it needs.

Recognising that a degree of mutual interest is a prerequisite of any buyer-supplier


exchange is not the same, however, as saying that there is an equivalence of interest.
Given that each firm is being offered something that it requires, and that each has to
give up something in return, it is in their interests to ensure that the terms on which
the exchange takes place offers them the maximum possible benefits. In order to
achieve this, it is imperative that each firm is able to influence, or even control, the
other’s behaviour. Their capacity to do so will depend principally on the perceived
ability of each contracting party to grant, hinder or deny the other’s gratification
relative to the other’s perceived ability to do the same to them.

This was the core insight first arrived at by Richard Emerson in 1962. It was later
applied to exchange networks by Emerson in conjunction with Cook, Gillmore and
Yamagishi, and by Pfeffer and Salancik (1978) in the context of inter-organisational
power relations. Both of these works demonstrate that this ability to grant, hinder or
deny another’s gratification is in turn reliant upon that party’s dependency. It has been
argued that such dependency is a function of two variables. These are the relative
utility and the relative scarcity of the resources brought by each of the parties to an
exchange relationship.

Figure 1. Alternative Buyer-Supplier Power Relations

As Figure 1 shows, a buyer would have power over a supplier if two conditions held
true. First, the buyer offers the supplier resources that are both relatively scarce and
regarded by the supplier as having a relatively high utility. Secondly, the supplier’s
resources are relatively plentiful and are of relatively low utility for the buyer. Of
course, if the exact opposite is true in terms of resource utility and scarcity, then
logically the supplier must have power over the buyer.

40
Managing the Supply Base within Business Markets

The two remaining quadrants in Figure 1 represent those circumstances in which there
is no power relation between the buyer and supplier. The buyer and supplier are said
to be interdependent if the relative utility and scarcity of the resources held by each
party are high. Finally, a situation of buyer-supplier independence is created where
the relative utility and scarcity of the resources held by each party are low. The key
question is how does one determine the relative magnitude of these variables in the
context of a particular buyer-supplier relationship?

It is the answer to this question that forms the backbone of the next chapter.
Specifically, we consider two issues. Firstly, we look at the contribution that scarcity,
utility and information make to our understanding of power in business. Secondly, we
begin to look at how an appreciation of these factors contributes in turn to a wider
appreciation of supply chains and supply chain types.

41
Managing the Supply Base within Business Markets

Mapping the Attributes of Power:


The DNA of Business Life5

Introduction

It is often said that there are parallels between biology and business. So, let us begin
this chapter by reminding ourselves about them. And, what better place to start than
with some of Hollywood’s most famous people.

It’s no accident that Cameron Diaz and Danny DeVito look as they do. An
individual’s physical appearance is determined by his, or her, genetic code. Cameron
Diaz’s code told her to grow tall and willowy, with beautiful eyes and a dazzling
smile. Danny DeVito’s code, on the other hand, dictated that he should be shorter,
stouter and a little light in the hair department.

David Cronenberg, the American director, once mischievously observed that he


would like to hold beauty contests based on people’s physical interiors rather than
their exteriors. Within such contests, the prizes would be awarded for one’s spleen or
liver rather than one’s face or figure. So far, however, he has had no takers. This is
perhaps not surprising, because our physical appearance plays a major part in shaping
the value that others place on us. We might wish that this was not the case, but there is
an abundance of evidence that tells us that it is.

Numerous psychological studies have shown that physical beauty is accompanied by a


halo effect. That is, if we are perceived to excel physically, people also expect us to
shine in other areas of our life. One such study of fifth grade pupils in Missouri
classrooms found that teachers expected attractive people to be smarter, more
outgoing and more popular with their peers than their less attractive counterparts.
More disturbing still is that attractive students tend to do better in tests – unless, of
course, their papers are marked blind.

Even more remarkable than the fact that beautiful people get a better deal out of life
than less attractive people is the realisation that the basis for their advantage is so
slim. Indeed, it rests on nothing more than a series of chemical interactions. Our DNA
consists of two interlocking strands, which in turn is made up of a series of chemical
compounds called nucleotides. These strands are arranged like a ladder that has been

5
This chapter originally appeared in Cox, A., Sanderson, J. and Watson, G. (2000) Power Regimes,
Earlsgate Press.

42
Managing the Supply Base within Business Markets

twisted to form the shape of a winding staircase often described as a double helix.
Each nucleotide is made up of three units, a sugar, a phosphate and a base. There are
four such bases – adenine (abbreviated to A), guanine (G), thymine (T), and cytosine
(C) – and they act as the rungs of the ladder.

Each rung of the ladder consists of two bases, but their significance is not confined to
the part that they play in joining the two strands together for it is these bases that
literally tell the body how to build itself. This they do by providing the instructions for
the production of proteins. A particular sequence of bases (the triplet GAC, for
example) will direct the body to create one type of protein (in this instance, the amino
acid leucine). A different sequence will lead to the production of a different type of
protein (CAG is the code for valine). Shift the sequence of the bases around a little
and an ugly duckling becomes a swan with all the aforementioned advantages.

Business is like biology in that some power structures benefit the firm more than
others. It is obviously more beneficial for a firm to be dominant in relation to its
customers and suppliers, than it is for it to be dependent. It is also normally more
advantageous for the firm to be dominant rather than interdependent with its suppliers.
This is because dominance offers the firm a flexibility in its dealings with customers
and suppliers that interdependence does not. Thereafter, it is up to the firm how it uses
this flexibility.

However, the similarity of business to biology does not end here. As with biology, the
emergence of a particular power structure in business is not a random event. Rather, it
is a direct function of the power base of the firm. Each side in a business related
exchange relationship possesses certain resources that can augment or diminish the
relative power of each player in the game. The balance of resources between the buyer
and supplier in the exchange relationship, as we saw from the previous chapter,
determines which of the four power categories will emerge to structure the process of
exchange. These resources that shape which power category is likely to emerge fall
into two main types (against the four of biology): utility and scarcity. Each of these
bases (or attributes) of power is discussed below.

Resource Utility

Resource utility is determined by two factors. The first factor is the operational
importance of a particular resource in a business, while the second is the commercial
importance of that resource to a firm’s overall revenue generating activities. These
factors must be addressed differently, however, depending on whether we are
considering the buyer’s or the supplier’s perspective.

From a buyer’s perspective, operational importance relates to the degree to which a


particular resource (good or service) is indispensable to the provision of the firm’s
supply offering. This relates, in turn, to the number of substitutes that might readily
replace the particular good or service. For example, access to a network infrastructure
would constitute a resource of high operational importance for a provider of cable
communication services. Without such a network the cable company cannot offer its
services at all. However, many resources are of relatively low operational importance,

43
Managing the Supply Base within Business Markets

because their absence or replacement would not prevent a firm from delivering its
supply offering. For example, a firm may need competent managers, but it is not
operationally essential for these managers to be provided with luxury company cars or
ostentatious office surroundings.

From a supplier’s perspective, however, the notion of operational importance is


somewhat different, because the key (although not the only) resource in which a
supplier is interested is a buyer’s expenditure. Clearly, revenue cannot be assessed in
terms of the degree to which it is indispensable to a finished good or service. Instead,
we contend that the key determinant of the operational importance of a buyer’s
expenditure is the regularity and predictability of the buyer’s expenditure.

It is axiomatic that business people, whether in their role as buyers or suppliers, have
a preference for situations characterised by low degrees of uncertainty and
complexity. Most people are, by their nature, risk averse. We can assume, therefore,
that a supplier will have an operational preference for those buyers that can offer
regular and predictable expenditure. A regular and predictable spend allows a supplier
to make a credible commitment to future investment in R & D and capital equipment,
as well as sustaining profitability. It is clear, however, that operational importance
will be conditioned, not only by the predictability of demand, but also by the capacity
of the supplier to generate ‘acceptable returns’ (profits) from any given level of
regular and predictable demand.

This demonstrates the close relationship between operational and commercial


importance. The capacity to generate ‘acceptable returns’ by the supplier is linked
directly to the commercial importance of the buyer to the supplier’s business. Here it
is useful to adopt the line taken by Scott and Westbrook that the first determinant of
commercial importance is the ratio between a buyer’s expenditure with a particular
supplier and that supplier’s total sales revenue. Thus, if a buyer’s expenditure is a
relatively small proportion of the supplier’s total sales revenue, then the buyer’s
expenditure will have a relatively low level of commercial importance for the
supplier. If, however, the ratio of expenditure to total sales is higher, then the
importance of the buyer’s expenditure will increase commensurately.

The second determinant of commercial importance is not directly related to current


revenue, but is associated with the future revenue generating opportunity presented to
the supplier by having a relationship with a buyer. Suppliers know only too well that
some relationships with particular buyers are ‘highly attractive’. This is because the
supplier can build future marketing strategy around its association with a highly
prestigious buyer and anticipate a growth in the scale of its market share.

The fact that a resource, be it a good, a service or money, is of high commercial


importance to a buyer or a supplier is not sufficient in itself, however, to give the
resource a high utility for a particular firm. Firms are typically multi-business entities,
active in a number of different markets, some of which are operationally and
commercially more important than others. By this, we mean that some of the supply
chains in which the firm is active contribute more than others to its revenues and
profitability. Those areas that represent the bulk of the firm’s revenue generating

44
Managing the Supply Base within Business Markets

activities are described as primary activities, while the remainder are described as
support activities. The relationship between the operational importance of a resource,
its commercial importance, and the commensurate utility ascribed to that resource by
the firm is illustrated in Figure 2.

Taking these factors into account it is possible to arrive at an understanding of the


relative utility of any resource in buyer-supplier, business-to-business relationships.
Figure 1 shows that for a resource to have a high utility for a particular buyer or
supplier, in other words for it to be a critical resource, it must be both operationally
and commercially important. Conversely, a residual resource is one that has a low
utility for a particular buyer or supplier because it has a low operational importance
and the transaction takes place in a support activity.

Figure 1. The Relative Utility of Firm Resources

Logically, there must, therefore, be two other types of resource utility. Those
resources that have a low operational importance, but which occur in a primary area
of activity, might be referred to as complementary resources. These resources will
have low to medium utility for buyers and suppliers. Resources that have a high
operational importance, but occur in support activity areas, might be referred to as key
resources. These key resources will often have a high to medium utility because their
high operational importance signifies that they are necessary and cannot easily be
replaced by alternative resources.

Resource Scarcity

The second major attribute of buyer and supplier power is the relative scarcity of a
resource. The scarcity of a resource is primarily determined by its imitability or its
substitutability. In other words, if a resource is relatively easy and cheap to imitate or
substitute, and it is in demand, then it is likely to be available from a large number of
firms. Conversely, if a resource is difficult or expensive to imitate or substitute then
the number of firms in possession of the resource is likely to be highly restricted.
Such a resource would be imperfectly imitable or imperfectly substitutable and would,
as a result, be relatively scarce.

45
Managing the Supply Base within Business Markets

A fundamental question to be asked about any buyer-supplier exchange is how many


credible alternatives there are on either side of the association? A supplier needs to
consider how likely it is to be able to replace a buyer’s business with an exchange of
equivalent utility, if it is not awarded the contract or if it loses the business. The
answer to this question lies in a combination of the structure of the market into which
the supplier is selling and its competitive position amongst potential suppliers. A
buyer, on the other hand, needs to consider how many credible alternative suppliers
there are for a particular good or service. Is the supply base highly restricted, or are
there a large number of suitable suppliers?

If we are to develop a proper understanding of buyer and supplier power, however, we


must go beyond these basic descriptive questions to seek explanations for the
imperfect imitability or the imperfect substitutability of certain resources. There is an
extensive literature in what is termed the ‘resource-based’ school of strategy that
offers a range of explanations for these conditions. The degree to which a firm’s
competitive position is threatened by substitutes is, of course, a key part of Porter’s
well-known ‘five forces’ model. The vast majority of the work of the ‘resource-based’
school, however, has concerned the other issue - imperfect imitability.

One of the most important contributions to this debate was made by Rumelt. He
developed the idea of ‘isolating mechanisms’ to refer to those factors that impede
imitative competition and, thereby, create and maintain conditions of resource
scarcity. These mechanisms are crucial for understanding why there may be only one,
or a small number of buyers for particular goods or services. Equally, they help us to
understand why particular goods or services can only be bought from one or a small
number of suppliers.

Rumelt proposes two main types of isolating mechanisms: property rights to scarce
resources and various quasi-property rights in the form of first-mover advantages.
This second category includes information impactedness, buyer switching costs,
reputation effects, buyer search costs, communication good effect, and economies of
scale when specialised assets are required.

There is insufficient space in the context of this volume to discuss each of these
mechanisms in detail. Instead, their key characteristics are shown in Table 1 and
discussed at length in Supply Chains, Markets and Power. The key feature of these
mechanisms is, however, that they create barriers to protect the unique market
position of one, or a small number of firms. By doing this, they give buyers or
suppliers dealing with the protected market few credible alternatives. This lack of
alternatives is a key power attribute for the firm or firms that are being protected.

However, resource scarcity can also be a function of an information asymmetry


between firms involved in a vertical buyer-supplier relationship. Such asymmetries, as
we noted earlier, are often a key part of power imbalances between buyers and
suppliers. The notion of information asymmetry relates to the distinction that
economists draw between public and private information. The former term refers to
information that is either generally available or can be obtained by interested parties at
relatively little cost. Private information, by contrast, represents hidden knowledge. In

46
Managing the Supply Base within Business Markets

the context of a transaction, hidden knowledge is that which is known to just one of
the contracting parties and which can only be obtained by the other through the
expenditure of significant time and money, if at all.

Perhaps the best example of private information is a supplier’s costs of production.


When a transaction is undertaken under conditions of private information, the firm
that owns or controls the information is able to use it as a source of scarcity. This
scarcity results from the opportunistic exploitation of superior knowledge in one of
two ways.

Table 1. Mechanisms Impeding Imitative Competition

Mechanism Characteristics
The state or another legitimate authority (e.g. a firm) grants a licence or a
Property rights patent to guarantee exclusive ownership or control of a relatively scarce
resource for a specified period and under given conditions.
If the minimum efficient scale of a business is comparable to the size of the
Economies of market, and if the assets required are specialised to this use, a situation of
scale natural monopoly occurs. Additional entrants would be unable to cover
their fixed costs while pricing competitively.
This means that the knowledge on which an innovation is based remains
Information largely tacit and uncodified. It is difficult for potential competitors to obtain
impactedness critical knowledge under these circumstances, unless a key employee
decides to defect.

Causal ambiguity This occurs if the basis of an innovation is particularly complex and ‘path-
dependent’. At the limit, even the innovating firm may be unable to trace
the precise causality of its innovation. In these circumstances, imitation is
impossible.

Reputation effect Buyers cannot accurately evaluate many products and services until after
they have been consumed. A supplier’s reputation, therefore, plays a critical
role in its ability to sell such ‘experience’ goods/services. First movers can
obtain reputational advantages, because the strength of a supplier’s
reputation depends largely on the length of time that it has been providing
satisfactory goods or services.

If early buyers of a new product find it subsequently costly to switch to a


Buyer switching competitor’s offering then the first mover has an advantage. These costs are
costs high when the buyer must make substantial dedicated investments in people
or equipment in order to use the product.

These are high when the buyer is required to invest substantial amounts of
Buyer search costs time and money in understanding the complexities of different supply
offerings. Firms seek to economise on these costs by free-riding on the
presumed analyses of the well-informed and buying the market leader’s
product or service. This provides a first-mover advantage as long as
followers’ products are not significantly better.

This effect arises when a product or service acts as a means of social co-
Communication ordination between different users (e.g. telephone networks, PC software).
good effects When a communication good is also an experience good, as in the case of
software, then there is a need for standardisation and ‘reputation bonding’.
The first mover’s product or service may thus become a de facto industry
standard.
Under conditions of oligopoly firms often co-operate on sourcing, pricing
Collusive cartels and output decisions. Potential entrants are blocked by a co-ordinated
response.

First, the privileged firm can use its superior knowledge to distort the other party’s
perception of the range of viable alternative firms with which it can undertake the
transaction. For example, a firm buying highly complex IT services might not have
the specialist knowledge needed to properly test the supply market. It might,
therefore, award a contract simply on the basis of a supplier’s reputation. This is often

47
Managing the Supply Base within Business Markets

what buyers have to resort to in the case of ‘credence goods’, a term which refers to
something that a buyer is incapable of evaluating even after it has been consumed.
The buyer is therefore relying on the supplier to act honestly in providing value for
money, which creates substantial room for opportunistic behaviour. When such
opportunism occurs in the pre-contractual phase of a transaction it is referred to as
adverse selection.

This kind of information asymmetry can also lead to the emergence of industry
standard pricing. Under these circumstances, a buyer may believe that it is dealing
with an open and competitive supply base. Nevertheless, suppliers are collectively
able to price above the long-run average cost of production, because the buyer is
ignorant of the true costs of the good or service that it is buying. This condition is
particularly prevalent in the supply of consultancy and other professional services.

However, it is also possible for buyers to use privileged knowledge to gain an


advantage in a similar manner. This is done by promising a supplier regular business
in the future, in order to get a better deal on a current contract. In this context, the
information asymmetry relates to the buyer’s superior knowledge of its projected
spending. For such information-based leverage to be effective, however, a supplier
must be convinced by the buyer’s promises.

A privileged supplier can also use its superior knowledge to persuade the buyer to
agree to contractual terms and conditions that constrain the range of options available
to it in the future. It is not uncommon, for example, for a buyer to sign a five year
framework agreement when a two year fixed term contract would have given it the
necessary protection from opportunistic behaviour and the ability to re-contract
should things go wrong. The supplier has used the relative uncertainty of the buyer to
get guaranteed work for five years. More importantly, this is within a flexible
framework agreement that allows the supplier to dictate the future requirements of its
customer. Such post-contractual opportunism is known as moral hazard.

The potential leverage brought about by an information asymmetry between a buyer


and a supplier is not, however, likely to be as effective, or as durable, as that derived
from property rights to relatively scarce resources or quasi-property rights in the form
of first-mover advantages. As Oliver Williamson, possibly the most eminent academic
writer in this area today, argues, a buyer or a supplier should be able to avoid long-
term dependency on an opportunistic supplier, or customer, through a combination of
experiential learning and the adoption of a governance structure with appropriate
safeguards.

Nevertheless, for those buyers or suppliers without the chance to acquire relatively
scarce resources based on property rights or first mover advantages, the effective
exploitation of information asymmetries can often prove to be a fruitful secondary
strategy. Indeed, a recent study of outsourcing by Lonsdale and Cox found ample
evidence of suppliers using the relative ignorance of buyers to create situations of
lock-in, particularly when the buyer is required to make substantial dedicated
investments to support the transaction. The study found that this type of dependency

48
Managing the Supply Base within Business Markets

is particularly prevalent in the outsourcing of bespoke and specialist services such as


IT.

Whether or not a buyer or seller possess particular resources that have scarcity or
utility value for the other party to the exchange will over-determine the power in the
relationship between the two parties. This process is analogous to the way in which
biological bases come together to create the genetic code that determines specific
characteristics in an organism. Instead of creating webbed-feet, a trunk or an
exoskeleton, however, the relative utility and scarcity value of particular resources in
an exchange relationship will create either a situation of buyer dominance,
interdependence, independence or supplier dominance in a particular part of a supply
chain. And, just as certain biological characteristics shape the effectiveness with
which specific life forms interact with their environment, these power structures
impact on the commercial success of the firms directly involved in the exchange
relationship.

It must be recognised, however, that a firm will not have just one category of
relationship with its dyadic customers and suppliers. All firms develop a wide range
of dyadic power relationships with a multitude of different customers and suppliers 
each of whom have their own unique power resources. To focus only on dyadic
relationships is however myopic. What lean thinking tells us, if nothing else, is that a
commercial focus needs to be much wider than this. Many seemingly intractable
problems with suppliers originate not from the immediate supplier, but rather from the
supplier’s suppliers upstream. Similarly, changes in the commercial climate
downstream are nearly always fed back along the supply chain, and sometimes with
catastrophic effect. A firm that does not have an eye on what is happening with its
upstream and downstream relationships is likely, therefore, to be overtaken by events.
If practitioners are to master the world of upstream and downstream relationship
management it is our view they need to understand its geography better – certainly
better than many currently do.

Our next chapter turns to look at this world in more detail and it does so by extending
the perspective that we have tried to develop in the previous two. If one buyer-
supplier relationship represents one element in a supply chain, what happens when
you start to combine these elements? In biology if you combine them you create a
unique organism with unique capabilities. But what does uniqueness mean in supply
chain terms?

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Managing the Supply Base within Business Markets

Managerial Behaviour in Business Networks6

Introduction

Over the past 30 years, there has been a heated debate within economics as to how
managerial behaviour should be characterised. In this debate, many factors have been
advanced that are believed to influence such behaviour. These factors have been
divided into two sub-sets, something that reflects the distinction between behavioural
disposition and behavioural action. Behavioural disposition refers to the behavioural
preference of an individual manager. Behavioural action, by contrast, is the result of
that manager considering whether his or her behavioural preference is feasible, given
the particular transactional context in question. In this paper, we look at both and then
incorporate them into a ‘calculative model’.

Influences on the Behavioural Disposition of Managers

In terms of the influences on the behavioural disposition of managers, five factors are
deemed within the literature to be particularly significant. The first factor cited is
national culture, a controversial notion (Clark, 2000), understood here as beliefs,
learned behaviour patterns and values shared, to differing degrees, by a significant
proportion of the citizens of the same nation. National culture is often referred to as a
‘thin’, ‘universalistic’, ‘impersonal’ or ‘macro’ influence on managerial behaviour
(Williams, 1988; Deutsch, 1973; Shapiro, 1987).

One economist who has discussed the relationship between national culture and
managerial behaviour is Arrow (1974). Arrow argued that capitalist societies ‘in their
evolution have developed implicit agreements to certain kinds of regard for others,
agreements which are essential to the survival of the society or at least contribute
greatly to the efficiency of its working’ (Arrow, 1974, p26). He terms this agreement
‘a generalized morality’. Arrow’s argument was very much in line with the earlier
work of Parsons (1951) and Durkheim (1933), who identified the notion of
‘solidarity’ as an explanation for behaviour.

Hofstede, however, has been more specific than Arrow, arguing that such ‘implicit
agreements’ are more likely in societies that are characterised by collectivist attitudes
than those that are characterised by individualist attitudes (Hofstede, 1980). Many,
although not all (for example, Hinnings et al, 1974), argue, therefore, that managerial
6
This is part of an early version of a paper published in Policy and Politics by Glyn Watson and Chris
Lonsdale.

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Managing the Supply Base within Business Markets

behaviour will be different in different parts of the world (Trompnaars, 1994;


Williamson, 1996a; Nooteboom, 2002). The Chinese ‘guanxi’ and the Japanese
‘kieretsu’ systems, for example, are often contrasted with Anglo-Saxon business
methods (Lee, 1997; Womack, Jones and Roos, 1990).

A second factor cited is business theory, particularly that relating to business ethics.
Whilst national culture and values have certainly been an influence on business
theory, this is not the whole picture. For example, within societies that Hofstede’s
model would consider to be strongly individualist, the two aforementioned strands of
business ethics – simple self-interest seeking and self-interest seeking with guile (or
opportunism) – compete within business schools and economics departments. The
idea of simple self-interest seeking tends to dominate the teaching of traditional neo-
classical economics and strategic management, whilst the idea of self-interest seeking
with guile tends to dominate the teaching of managerial economics and business
finance (It may seem curious to many, but arguments have quite happily been
constructed by some economists and management commentators (Carr, 1968; Stalk
and Lachenauer, 2004) as to why the latter type of behaviour is ethically justifiable).

Business ethics is now commonly covered on business education programmes.


Clearly, whether such education is informed by one or the other of the two positions
outlined above (or, indeed, any other) is potentially going to have an impact on the
managers who receive such education. Indeed, in recent years, there has been some
soul-searching in the US as to whether management education in the US contributed
to the rash of corporate scandals that were revealed at the turn of the century
(Ghoshal, 2003; Schiller, 2005).

A third factor is organisational culture, again something influenced by broader


national influences, but again not synonymous with them (Nooteboom, 2002).
Organisational culture has been defined as ‘a collection of relatively uniform and
enduring values, beliefs, customs, traditions and practices that are shared by an
organisation’s members, learned by new recruits and transmitted from one generation
of employees to the next’ (Huczynski and Buchanan, 2001). Through formal (for
example, codes of practice) and informal (for example, de facto incentive structures
and socialisation) mechanisms, companies impose very different attitudes on their
employees as to what types of behaviour should attract censure and reward (Peters
and Waterman, 1982; Nooteboom, 2002). The most obvious recent example of this is,
of course, Enron. The internal culture of this company encouraged ruthless and
ultimately illegal behaviour, something that was only discovered due to a financial
oversight by the company’s accountants (Curver, 2003).

A fourth factor concerns the psychology of business managers. Research in this area
has suggested that a significant proportion of business managers, particularly senior
business managers, have personality traits that are conducive to opportunistic
behaviour (Babiak, 1995 and 1996; Doren, 1997). Much of this research has focused
upon explaining very extreme forms of management behaviour, such as the actions of
many senior US executives in the late 1990s to early 2000s. The actions of Enron’s
Michael Fastow, WorldCom’s Bernie Ebbers and Sunbeam’s Al Dunlop, for example,
have been deemed so extreme as to require psychological explanation. The result has

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Managing the Supply Base within Business Markets

been terms such as ‘toxic leaders’ (Lipman-Blumen, 2005), ‘corporate psychopath’


(Hare and Babiak, 2005) and ‘successful psychopaths’ (Lilienfeld, 1998; Lynam et al,
1999).

However, consideration of psychological factors should not merely be confined to


extreme forms of management behaviour. Personality characteristics can also explain
less dramatic examples of opportunistic business behaviour. The key to this is the
adoption of a dimensional approach to personality classification. Whilst some
psychologists believe that behaviour patterns resulting from personality disorders are
qualitatively distinct from ‘normal’ behaviours – a categorical approach (Millon,
1981) – others argue that the difference is quantitative – the aforementioned
dimensional approach (Morey et al, 1985). For example, Board and Fritzon (2005,
p18) comment: ‘With mounting evidence that strongly challenges the presumption
that personality disorders represent discrete, natural classes, there are good grounds to
argue for an approach that observes characteristics of personality disorders as simply
exaggerated forms of normal behaviour’.

The significance of this ‘dimensional’ approach is that it puts individuals on a


continuum of behaviours, rather than in categories. This means that diagnosis
becomes less of a case of all or nothing. People are seen as being at different places
on a continuum of behaviours. So, whilst ‘toxic leaders’ may be placed on the end of
the continuum, other managers exhibiting anti-social, but less dramatic, behaviours
can be observed within the scale as well.

This dimensional approach was recently applied by two British psychologists to


managerial behaviour. Their research found that even senior managers that would not
be placed alongside the aforementioned category of ‘corporate psychopath’ had very
high scores with respect to narcissistic, compulsive and, particularly, histrionic
personality traits (Board and Fritzon, 2005). These traits are extremely relevant to the
study of opportunism. Histrionic personality characteristics, for example, include
manipulation, deception, self-regard and superficial sociability (Board and Fritzon,
2005).

What the research also found was that the scores achieved by the senior managers in
this respect were a good deal higher than the average found within the population.
This is important to the study of business philosophy as it means that economists are
not required to believe that society is highly populated with the opportunistic to
believe that business is. It can be argued that self-selection is at play, that certain roles
within business attract managers with certain personality traits.

The final factor thought to affect a manager’s behavioural disposition concerns the
social relations between managers involved in relationships containing repeated
interactions (Provan, 1993). Granovetter, for example, has argued that views of
managerial disposition that characterise it as opportunistic are flawed as they
constitute an ‘undersocialised’ perspective. That is, they are views that disallow ‘any
impact of social structure and social relations on production, distribution or
consumption’ (Granovetter, 1985, p483). Granovetter argues that, in reality, ‘social

52
Managing the Supply Base within Business Markets

relations often become [over time] overlaid with social content that carries strong
expectations of trust and abstention from opportunism’ (Granovetter, 1985, p490).

Therefore, for Granovetter, the previously stated influences on managerial disposition


miss the point. A behavioural disposition is not fixed, it can change over time as a
relationship develops. Nooteboom (1996, pp987-88) develops this perspective further
by saying that managers are easily capable of recognising the changing nature of a
social relation over time: ‘It is reasonable to say that prior to transaction one is
uncertain about the partner’s potential opportunism, and hence should take
opportunism into account. Once one takes time into account, in ongoing transactions,
it is unreasonable to ignore the formation of perceptions about propensities towards
opportunism and the possibility of building trust’.

However, there are counter-arguments to the views of Granovetter and Nooteboom.


First, it can be argued that the influence of certain variants of national culture,
business philosophy and organisation culture, as well as the apparent psychology of
many managers, will prevent social relations from affecting business conduct. Some
managers will, perhaps, call this ‘being professional’. The second argument concerns
the fact that many strategies of opportunism (for example, some manifestations of
hold-up) are long-term in nature. ‘Traps’ are set, ex ante, which are specifically
designed to be exploited years after the contractual period has commenced. It can be
argued, therefore, that it is not just initial Hobbesian alienation that causes
opportunistic behaviour (i.e. getting your retaliation in first). It is something much
more fundamental about managers’ behavioural disposition.

Third, it can also be argued that even when social relations do affect managerial
behaviour they can be interrupted by the individuals in question leaving the scene.
Particularly in Anglo-Saxon economies, managers frequently move either within or
between companies. Finally, some companies, reputedly including UK supermarkets
(Lawrence, 2004), take no chances on the build-up of ‘inefficient’ social relations and
circulate their staff as a matter of policy. Therefore, whilst it would be folly to deny
that social relations can develop and affect managerial behaviour, there are many
counter-influences that make Granovetter’s argument that social relations are the key
driver of behaviour somewhat unconvincing. His use of time to explain behaviour is
partly, but not sufficiently, qualified.

Transaction-Specific Factors Influencing the Behavioural Actions of Managers

The five factors discussed above have all been identified in the literature as influences
on the behavioural disposition of managers. However, this is not the end of the story.
As was mentioned above, there is a distinction to be made between a manager’s
behavioural disposition and his or her behavioural action. Behavioural action is
affected not only by the behavioural disposition of managers, but also by transaction-
specific factors. Four factors, in particular, predominate within the economics
literature. The first is the principle of contingent renewal (Axelrod, 1984; Frank,
1988; Bowles and Gintis, 1998). The idea here is that behavioural action is affected
by the ability of the buying organisation to make future contracts dependent on
current performance. A problem, however, with this mechanism, apart from the fact

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Managing the Supply Base within Business Markets

that a manager may not have any future business to offer, is that it assumes an
alignment between the interests of the company and the interests of the manager
acting on the company’s behalf. This may not always be the case – the possibility
explored by economists researching the principal-agent problem.

The second factor is reputation (Weigelf and Camerer, 1988; Williamson, 1996b;
Fitzroy et al, 1998). The behavioural actions of managers are deemed by some
economists to be affected by their desire to maintain the reputation of their company
in the marketplace for fair dealing. However, there are two objections to reputation
being evoked as a factor in constraining opportunistic behaviour. First, the principal-
agent problem again potentially intervenes. Second, there is a large amount of
evidence to suggest that many companies that have been involved in large scandals
have emerged apparently unscathed (Williamson, 1996b). Not all companies suffer
the fate of Arthur Andersen. UK and US financial services companies, for example,
despite their involvement in myriad pension, mortgage, life insurance and share-
selling scandals have continued to operate unhindered and to great effect.

These two factors – contingent renewal and reputation – also need to seen in concert
with the relative expectation level on the part of the manager that his or her behaviour
will be detected. If, on the one hand, managers are considering the potential size of
the cost of being revealed as opportunistic (i.e. they are considering the issues of
contingent renewal and reputation), they are also likely to consider the chances of
being revealed. The chances of being caught can be understood in two ways. First, in
terms of the detection regime that the other party has constructed. Second, in terms of
the type of opportunistic strategy that is being employed. The inherent nature of hold-
up, for example, means that it will always be obvious to the other party. This is less
the case with adverse selection and moral hazard.

The third transaction-specific factor addresses the possibility that a manager may, in
some transactional circumstances, be working as part of a group. Any model of
managerial behaviour must take into account the possibility of this, as peer influence
within a group situation has been shown to be common (Feldman, 1984). The
possibility in this context is that a group-level view on behavioural standards emerges.
If this view is in conflict with the behavioural preference of the manager in question,
then that person may well modify his or her actions, for fear of the disapproval of the
other group members. This will particularly be a possibility if the group contains that
person’s line managers (Asch, 1951).

The fourth transaction-specific factor is the potential size of the gain from
opportunism. When managers consider their company’s reputation and the potential
future business being offered by a customer, it is done against a consideration of the
short-term gains available. As Nooteboom (1996, p988) concedes: ‘Golden
opportunities of defection are tempting, even to the trustworthy’. As a result,
managers within buying organisations, when considering likely supplier behaviour
need to consider the nature of the transaction in question and the short-term
opportunities for exploitative gains it provides.

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Managing the Supply Base within Business Markets

Characterising Managerial Behaviour: A Calculative Model

For the authors, it is necessary to synthesise all of the aforementioned factors in order
to possess a comprehensive model of managerial behaviour. The synthesis, which
assumes both parties are risk-neutral, takes the form of a trade-off between the costs
and gains from opportunistic behaviour. It is, in other words, a calculative model
(Watson, 2004). In terms of the cost side of the model, the first element concerns the
possibility of personal dissonance. The model states that different managers will, to
differing degrees, incur a personal cost from acting in an opportunistic manner.

On the one hand, this will be a function of the manner in which they have been
socialised, through national culture, business theory and organisational culture. For
example, it is argued that managers from nations that possess a predominantly
individualist political culture are likely to feel less dissonance when acting
opportunistically. On the other hand, it will be a function of their personality traits –
although there is considerable evidence that there is a link between national cultural
influences and personality formation (James, 2003). It has already been noted that
certain personality traits are highly conducive to business opportunism and that they
are commonly found in particularly senior business managers.

The second element of the cost side of the model concerns the depth of the
relationship under consideration. Clearly, the betrayal of well-established
relationships will be more significant, and provide a higher barrier of dissonance, than
the betrayal of recently-formed associations. For some, although not all, this barrier
will be insurmountable. However, having said this, the earlier point about the long-
term nature of some strategies of opportunism needs to be taken into account here.
Social relations are less likely to affect opportunistic behaviour if that behaviour has
been carefully planned over a long period of time and is expected to unfold over a
long period of time. It is surely illogical to argue otherwise.

Third, managers will also, when considering their behavioural actions, consider the
commercial costs that could potentially be incurred as a result of an act of
opportunism. Two concepts were noted here: contingent renewal and reputation, the
former relating to the specific customer in question and the latter to the customer
market in general. Managers will need to consider the potential long-term costs to
their company of their short-term actions. However, two caveats are needed here. The
first caveat is the issue of detection. Managers will consider the issues of contingent
renewal and reputation in concert with their views on the chances of revealed as
opportunistic.

The second caveat is the issue of the principal-agent problem. If this management
problem is factored into a model of managerial behaviour, as it must be, it tells us that
not all managers will concern themselves to the same extent with the potential impact
of opportunism on their company. The extent to which they do will depend again on
the cultural, educational and personality factors referred to above (not all managers’
attitudes to their companies will accord to the characterisation enshrined within the
principal-agent model), as well as a managers’ intended tenure at his or her company.

55
Managing the Supply Base within Business Markets

Fourth, managers will consider the cost of peer disapproval, something that
particularly arises if they are working within a group on a particular contract.
Managers will not want their behaviour to affect their prospects within the
organisation. So, it is possible that they will modify their behaviour if the group has
expressed disapproval of that type of behaviour. Opportunistic behaviour or a refusal
to act opportunistically could both potentially attract group disapproval.

Having dealt with the cost side of the model, attention now needs to turn to the gain
side. Under the model, all of the potential personal and commercial costs from
opportunism will be considered by managers against the size of the likely short-term
gain from opportunism, both on a company and a personal level. It goes without
saying that, in different relationships situations, the gains from acts of opportunism
will be different. On some occasions they will be substantial, either in real terms or as
a proportion of the contract value, and on others they will not. This refers back to
Nooteboom’s observation about ‘golden opportunities of defection’. Nooteboom
argued that ‘golden opportunities’ would tempt even the trustworthy. Under the model
being presented here, it would be tempting to the degree that it counter-balanced the
personal and commercial costs.

Finally, it is important that one more concept is incorporated into the model. This is
the concept of bounded rationality (Simon, 1947). All of the calculations vis-à-vis the
commercial elements in the model will be subject to a manager’s inherent bounded
rationality. On both the cost and gain side of the model, a manager’s calculations may
simply be wrong, especially in complex relationships, something that could push a
manager in either direction – towards or away from opportunistic behaviour –
depending on the nature of the error.

Applying the Model to the UK Context

This constitutes, therefore, a model that takes into account nation, educational
influences, organisational influences, personality type, group dynamics, time,
managerial capabilities and commercial circumstances. It incorporates both the
contingency demanded by Granovetter (i.e. it does not assume that all people or all
circumstances are the same) and the variety of personal and commercial influences
demanded by the overall literature.

The view of the authors is that, in the UK, the model points very much towards a high
proportion of managers – not all and not all to the same degree – possessing an
opportunistic disposition. The authors believe this for four reasons. First,
individualistic cultural influences are prominent in the UK. Second, the evidence on
the previously discussed psychological factors is persuasive. Both of these two factors
will have the effect of reducing the personal dissonance associated with opportunistic
actions (whether that is in relation to the manager’s exchange partner or his or her
own company). Third, frequent changes to personnel in companies are common
within the UK. This factor will reduce the number of occasions when long-term social
relations are formed. Fourth, although not specific to the UK, many opportunistic
practices are long-term in nature, so, for the reasons discussed earlier, relationship
longevity is not always going to provide protection.

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Managing the Supply Base within Business Markets

However, despite this analysis, it needs to be reiterated that whether or not


opportunistic actions will follow in any particular case where a manager has an
opportunistic disposition will depend on the contingent commercial circumstances.
The distinction between preference and action always needs to be at the forefront of
any assessment of managerial behaviour.

In terms of the customer response required given this characterisation of the self-
interest orientation of UK managers, the authors adopt the position of Williamson
(1993). He argued that, given the perceived prevalence of opportunistic tendencies,
and given the inherent difficulties of distinguishing between the opportunistic and the
non-opportunistic, caution is advised. This is especially the case, of course, in
relationships where the stakes are high.

Therefore, this article has briefly put forward a model for interpreting managerial
behaviour. When applied to the UK, it has indicated that opportunistic behaviour is
likely to be commonplace. Before finishing, it is necessary to make two further
comments. First, this article is concerned with supplier opportunism. However, this
should not be taken as a sign that the authors believe that buyers are not capable of
such behaviour. Second, Granovetter argues that models from transaction cost
economics based upon an assumption of opportunism are ‘undersocialised’. This may
or may not be fair comment. However, even if it is fair, it does not mean that all
models that are based on opportunism are necessarily similarly ‘undersocialised’. It is
possible to come to the same conclusion through more or less satisfactory routes.

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Deutsch, M. (1973) The Resolution of Conflict: Constructive and Destructive


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Managing the Supply Base within Business Markets

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Managing the Supply Base within Business Markets

PART II: IMPLEMENTATION

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Managing the Supply Base within Business Markets

Managing the Internal Client Relationship: An


Analytical Framework for Aligning Demand and
Supply7

Introduction

In this article we develop a framework for analysing the relationship between the
purchasing function and its internal clients within the firm. In particular, the article is
concerned with the impact of this relationship on the management of the firm’s
demand for externally sourced goods and services. In most firms we have come across
the management of internal demand has represented the most serious challenge to the
purchasing team.

The purchasing process, on most occasions, is a cross-functional activity. Many of the


critical contributions to the process are made by the purchasing department’s internal
client – which could be managers from marketing, IT, manufacturing, distribution and
so on. When the internal client contributes to the process it expresses a series of
preferences. These could concern, for example, the development of a particular
product or service specification or the selection of a particular supplier or suppliers.

These preferences can often adversely affect the degree of influence, or power, the
firm has over its suppliers. This is because internal client preferences can lead, for
example, to a fragmentation of the firm’s demand for a good or service or a reduction
in the availability of supply options. Why, in our view, this reduction in influence or
power is important is that, in common with many other writers in the area of
purchasing and supply chain management, we believe that there is a direct (although
not complete) relationship between the buyer-supplier power relation and the value
for money achieved by the buyer (Cox et al, 2002; Williams, 2001, Kapoor and
Gupta, 1997; Ramsay, 1996; Ramsay, 1995). According to Cox et al this is true
whether the firm is seeking to acquire value for money from leverage or collaboration
(Cox et al, 2002).

On many occasions, any reduction in purchasing power caused by the internal client
preference will be justified by wider business considerations. As with most business
decisions, there is an element of ‘trade-off’ within purchasing decisions. However,
there will be other occasions when the internal client preference will have no wider

7
This chapter is a pre-publication chapter written by Chris Lonsdale and Glyn Watson

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Managing the Supply Base within Business Markets

justification. On those occasions, the role of the purchasing manager will be to try to
change the internal client preference. To do this effectively the purchasing manager
needs a structured way of thinking. The role of this article is to provide such a way of
thinking.

The article is divided into five main parts. Problems with the management of internal
demand can only be understood in the context of a theory of the management of
external supply. Therefore, in the first two parts of the article we provide that context.
In part one, we discuss the theoretical debate over the management of supply that has
taken place over the past 20 years. Having briefly revealed our own position on the
management of supply in part one, in part two we discuss our position in more detail.

Having established the supply management context, we then move onto the main
focus of the article – the management of internal demand. In part three of the article,
we discuss what we believe are the main internal demand management problems
experienced by firms and show how they impact upon buyer-supplier power. In part
four, we discuss the causes of internal demand management problems. Finally, in part
five, we offer a number of initiatives that have been shown to alleviate the internal
demand management problems experienced by firms.

The Debate over the Management of Supply

There has been much debate over the past twenty years as to how firms should
manage their supply relationships for improved performance. Over this time, a
number of schools of thought have emerged offering very different prescriptions. The
lean supply school has taken a very optimistic position on management’s capacity for
planning and control and advocated the development of collaborative relationships not
just with immediate suppliers, but throughout the supply chain (Womack and Jones,
1990 and 1996; Lamming, 1993; Hines, 1994; Macbeth and Ferguson, 1995; Hines et
al, 2000; Landeros et al, 1995; Ellram, 1995; Burt, 2002).

The agile supply school is very much a close relation, although its operational
prescriptions have been designed for supply chains with very different demand
characteristics (Harrison et al, 1999; Towill, 1996; van Hoek, 1998). A third school,
the IMP group, has taken a very different position to those taken by the two previous
schools. It dismisses out of hand the assumptions about planning and control that
underpins the lean and agile supply theories and instead takes an ‘emergent’ view of
strategy (Ford et al, 1998; Hakansson and Snehota, 1992; Ford (ed), 2002).

All of these schools of thought have, over the past two decades, provided significant
evidence supporting their positions. A question, therefore, presents itself. If these
schools of thought are so diametrically opposed (the lean and agile schools on one
side, the IMP group on the other) how can they all be able to present evidence that
supports their views? In our view, it is because all three schools have not dealt
satisfactorily with the concept of power.

As we have said, the lean and agile supply schools argue that management has a
considerable ability to plan and control their supply networks. They present the

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Managing the Supply Base within Business Markets

Japanese automotive industry as an example of how this ability has been put to
constructive use. The lean and agile schools also point to the UK’s food retail sector
for further examples. The IMP group argues that these industries are exceptions and
that their supply chain practices should not be extrapolated into a holistic theory of
supply chain management. The IMP group supports its view with evidence from many
other supply networks in many other industries that do not adhere to this ‘exceptional’
model.

However, this exchange merely reinforces our own view that the concept of buyer-
supplier power should be central to any theory of supply chain management. The
reason, in our view, why Japanese automotive assemblers and UK food retailers are
able to plan and control their supply networks is because they hold power over the rest
of the supply network – they are dominant buyers. As for the counter-examples
provided by the IMP group, where planning and control is not possible, these are
simply examples of supply networks where the power structures are more varied. In
the examples provided by the IMP Group, the buyer does not have power over the rest
of that network and, therefore, cannot impose its will. Therefore, for us the way to
explain the fact that all three schools are able to provide supportive evidence is very
simple. It is that power can either facilitate or constrain efforts to co-ordinate the
activities of suppliers.8

The Power Regimes Model

If power is such a central concept to purchasing and supply chain management how
can it be recognised and utilised by managers. The starting point is a familiar one - the
work of Richard Emerson. He argued that power is the property of social relationships
rather than any single individual or group. He also argued that power comes out of
dependency. In his now famous quote he put forward that ‘the dependence of actor A
upon actor B is (1) directly proportional to A’s motivational investment in goals
mediated by B, and (2) inversely proportional to the availability of those goals to A
outside the A-B relation’ (Emerson, 1962). To use different words, what Emerson was
referring to here was the concepts of utility and scarcity.

These concepts are easily transferable to a supply chain context. On the one hand, if,
for example, a supplier (A) highly values the demand for its products or services
provided by the buyer (B) then it can be said that the buyer’s (B) demand is of high
utility to the supplier (A). Then, if the supplier (A) is unable to find such a level of
demand for its products or services from other buyers then that buyer’s (B) demand
will also be deemed to be scarce. On the other hand, if, for example, the transaction
between the buyer (B) and supplier (A) in question is very important to the buyer (B)
then it can be said to be of high utility to it. Furthermore, if the buyer (B) can only
source the particular product or service from the said supplier (A) then the product or
service provided by the supplier (A) can be said to be scarce.

There is a third concept, however, that needs to be added to Emerson’s model. The
assumption within Emerson’s model is that the participants in the relationship are
8
For a fuller discussion of this view see Watson, Cox and Lonsdale (2002) Understanding the Limits to
Management Action in Supply Networks, Proceedings of the BAM Conference, London, September.

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Managing the Supply Base within Business Markets

aware of their objective interests. However, not least in buyer-supplier relationships,


this is not always the case. Often in buyer-supplier relationships there is an
information asymmetry between the two parties. One or both parties are not in
possession of all the relevant information about the transaction. Therefore, a
separation emerges between the objective interests of one or both parties and their
subjective view of their interests. In short, information is a power resource. If one
party to the transaction has superior relevant information to the other, for example
over cost structures, supply market structures or buyer budget limits, then they will
supplement their power position. This third element, therefore, needs to be added to
the buyer-supplier power resource model.

When we combine Emerson’s observations with the concept of information


asymmetry, four generic power positions between (in our case) a buyer and a supplier
can be established. These are buyer dominance, buyer-supplier interdependence,
buyer-supplier independence and buyer dependence. For example, a buyer would be
dominant over a supplier if three conditions held true. First, the buyer offers the
supplier resources that are both relatively scarce and regarded by the supplier as
having a relatively high utility. Second, the supplier’s resources are relatively plentiful
and are of relatively low utility for the buyer. Finally, the buyer has better information
about the transaction than the supplier (Cox, Sanderson and Watson, 2000).

Therefore, managers are able to establish the power relation that exists between their
firm and its suppliers.9 From our research, there is no question that there is a direct
(although incomplete) relationship between this buyer-supplier power relationship and
the value for money outcome achieved by the buyer (Cox et al, 2002). Furthermore,
there are also implications of buyer-supplier power for the type of relationship
strategy that the buyer is seeking to develop with a supplier.

Our research has shown very clearly that firms seeking to develop collaborative
relationships with suppliers when they are either dependent on those suppliers or are
in a position of independence are unlikely to meet with success (Cox et al, 2002).
Whilst there is no direct link between relationship management styles and buyer-
supplier power – there are a range of other variables that impact upon any decision
over relationship choice – the concept of power is certainly an important variable.

Buyer-Supplier Power Relations, Value for Money and Problems with Internal
Demand Management

Having established our theoretical framework for supply management we can now
turn to the main focus of the article, the management of internal demand. In this
section of the article, we outline the main demand management problems experienced
by firms and show how such problems can impact upon a firm’s power position and
thus impact upon its ability to obtain value for money.

9
This power relation is a ‘pre-contractual’ power relation. Power can also shift between the buyer and
the supplier post-contractually, although this does not concern us directly here. For a discussion of
post-contractual power see Lonsdale and Cox (1998) and Lonsdale (2001).

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Managing the Supply Base within Business Markets

In our experience, there are six main demand management problems from which firms
can suffer. These are over-specification, a too-early specification, changes in
specification, poor demand information, the fragmentation of spend and ‘maverick’
buying practices. We will look at each of these in turn.

Product or Service Over-specification


When setting out to purchase a good or service interested parties within a buying firm
need to come to an agreement on a value for money proposition. Value for money, of
course, is calculated in terms of a trade-off between functionality and cost. However,
in many firms what that trade-off should be is highly contested. In many firms the
buyer’s internal client, whether that be, for example, an engineer, a marketing
manager or a manufacturing manager, will often seek to over-specify the product or
service required. Purchasing practitioners refer to this as internal clients seeking to
‘gold plate’ the product or service. Often a product or service is specified by internal
clients in a manner that exceeds the firm’s requirements, whether that be in terms of
customer satisfaction, internal safety standards or technical production standards.

Premature Establishment of the Specification


A second common problem is the premature establishment of a specification. The
main risk here is that internal clients build a supplier’s offering into their design
before the firm has had an opportunity to negotiate with the supplier. If the buyer’s
purchasing team starts to negotiate with the supplier after the firm has developed
significant ‘sunk costs’ in their solution, then it will be negotiating with a supplier that
has an effective monopoly position.

Frequent Changes in Specification


This third problem, the frequent alteration of the specification, is often experienced by
firms during the purchase of complex services. To some extent, some degree of
change in the specification is inevitable given the level of uncertainty that usually
surrounds such purchases. However, some internal client behaviour can make it far
worse than it need be. Particularly when a firm is outsourcing, it will often move to
the specification stage of the transaction before it really knows what it is that the firm
requires. This then leads to many changes to the specification which, again, if the firm
has built up significant sunk costs in the supplier’s solution will leave the firm open to
opportunistic behaviour, even at the pre-contractual stage.

Poor Demand Information


A fourth demand management problem is the supply of poor demand information.
One of the key aims of lean supply is to improve the flow of information throughout
the supply chain. Poor demand information leads to supply chain actors keeping high
levels of inventory as ‘insurance’ – one of the seven supply chain muda (Hines et al,
2000). Furthermore, the late placing of orders due to poor demand information can
often put the buying firm in a poor position in relation to a supplier, which in some
circumstances will be exploited.

Fragmentation of Spend
Perhaps the most pervasive demand management problem within firms is the
fragmentation of spend. If you go to most firms, the purchasing team can provide you

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Managing the Supply Base within Business Markets

with data that shows that it is buying many different types of very similar products
from a large number of suppliers. Furthermore, it can often provide you with data that
shows that the firm is also going to those suppliers for a succession of small orders.
This situation will often be due to the fact that internal clients have preferences for
certain products from certain suppliers. The lack of consolidation of demand leads to
a lack of leverage and consequently causes the firm to pay more than it needs to for its
supply inputs.

Maverick Buying
A final demand management problem covered here is that of ‘maverick buying’. This
is buying that takes place outside of the established organisational rules. In most firms
there is a fairly high incidence of purchasing’s internal clients either buying outside
the contracts that have been set up or buying using procedures that are unconducive to
obtaining value for money. The effect of maverick buying can be to either fragment
the firm’s spend or lead to higher prices being paid as the maverick buyer does not
have either access to information on the supply market or the necessary skills in
contracting and negotiation.

Demand Management Problems and the Power Regimes Model

Having established a range of demand management problems it is necessary to show


how these can be interpreted within our supply management framework. We will do
this by selecting two of the demand management problems, analysing their
consequences for buyer-supplier power and therefore value for money. The two
problems chosen are fragmentation and over-specification.

The Fragmentation of Spend and Buyer-Supplier Power


Earlier in the article, it was established that buyer-supplier power can be analysed
with the help of Richard Emerson’s power and dependence model. The two concepts
that are central to Emerson’s model are scarcity and utility. It was also established
earlier that these two concepts need to be supplemented by a further concept, that of
information. It was then argued that in order to understand the power relationship
between a buyer and supplier it was necessary to understand the relative utility,
scarcity and information resources of both parties to a transaction.

Once this model is understood, it is clear how demand management problems can be
interpreted within it. In the case of the fragmentation of spend, the key issue affecting
the power relation is the effect of the fragmentation on the scarcity and utility of the
buyer’s resources to the supplier. If, for example, a buying firm’s demand for a
particular product or service is fragmented across as many as ten suppliers then the
scarcity and utility value of the fragmented spend will be lower to those suppliers than
it would be if the spend was consolidated with fewer suppliers.

Over-Specification and Buyer-Supplier Power


In the case of over-specification, the key issue is different. Here, the effect of over-
specification can be to cut down the number of suppliers that can service the buying
firm’s requirements. There are a number of ways in which this can occur, we will

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Managing the Supply Base within Business Markets

consider just one. A buying firm might specify in a manner that creates a very high
technological barrier for suppliers to surmount. It may be that only a few suppliers are
able to provide such a level of technology. In this scenario, therefore, the specification
of the product or service will have increased the power resources of the capable
suppliers because the buyer’s supply options will have contracted – or, in other words,
the scarcity of supply will have increased.

The Cause of Demand Management Problems

We have thus far established our supply management theoretical framework and
shown how demand management problems can be interpreted within it. We now turn
our attention to the cause of demand management problems. If purchasing managers
are to address the problems they face they need to understand their root causes. Our
analysis of the causes of internal demand management problems is drawn, not
surprisingly, from the organisation theory literature and the analysis that has been
undertaken into organisational decision-making.

Understanding why firms suffer from demand management problems is a two-stage


process. First, we need to understand why different and conflicting preferences arise
within organisations. In our case, we are talking about the conflict of preferences that
can occur between the purchasing manager and his or her internal client. Second, we
need to understand how conflicts over preferences are resolved within organisations.
That is, what factors lead to certain organisational actors’ preferences being
influential in organisational decision-making. In our case, we are looking to
understand why the purchasing function is not always, or usually, able to get its own
way when its preferences conflict with those of its internal clients.

Our interpretation of the way that outcomes are reached internally is consistent with
our interpretation of the way they are reached externally to the firm. In terms of
external supply management, our thinking takes for granted that there will often be
conflicts of interest or preferences between buyers and suppliers and that these
conflicts will, ceterus paribus, be resolved according to the relative power resources
of the two parties. These assumptions are, in their own way, also present in our model
of internal management and decision-making. Conflicts of interest are assumed to
arise within organisations on many occasions (because of absolute and relative
scarcity) and it is also assumed that these conflicts are, ceterus paribus, resolved
according to the relative power resources of the two or more parties.

In this respect, our model conforms to what Jeffrey Pfeffer called the ‘political model’
(Pfeffer, 1981). This model contrasts with what he calls the ‘rational model’ The main
elements of these two models can be seen in Figure 1. By making this simple
distinction, Pfeffer is drawing our attention to the assumptions that underpin the
different ideas that sit within the area of organisation theory. Certain theories are very
much based upon a view of the firm that has faith in managerial and organisational
rationality. Within this view, managers are able to collect the necessary information
for decision-making and then dispassionately analyse this information to develop a
number of decision-making options. These options are then compared, with the final
decision being made on the basis of which maximises the outcome. Power in such

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Managing the Supply Base within Business Markets

organisations is centralised. It could be argued that the lean production theory sits as a
‘rational model’ within the organisation theory literature.

Figure 1. Rational versus Political Models of Organisation

As can be seen in Figure 1, the ‘political model’ is the opposite of the ‘rational
model’. In this model conflict, politics and individual limitations are seen as a
commonplace, with the implication being that organisations move forward
incrementally through compromise, bargaining and experimentation.

The Literature on Internal Demand Management and the Internal Client


Relationship
Before we examine our ‘political model’ in more detail, we need to review the
existing literature on the relationship between the purchasing function and its internal
clients. It is appropriate to do this at this stage, as the literature on the subject would
appear to divide along the lines of Pfeffer’s model. For example, there is a section of
the literature that considers the creation and development of cross-functional teams.
Much of this literature considers the success of such cross-functional teams as
depending on management commitment. Robert Trent (1998) comments that ‘the
relationship between member effort and team effectiveness has received minimal
attention by academics and practitioners’. As a result, he puts forward a model to
assist in creating the right cross-functional team. This model concerns functional
representation, team size, member and leader selection and training requirements.
Trent put forward similar ideas in research undertaken with Robert Monczka (Trent
and Monczka, 1994). These contributions to the literature can, broadly speaking, be
placed in the ‘rational model’ of organisation theory. Whilst there is some discussion
about authority and influence, these writers do not see the world in the way that
Pfeffer described as ‘political’.

By contrast, other writers have definitely been arguing from the ‘political’
perspective. Prominent amongst these are Larry Smeltzer and Sanjay Goel. In their
research they see the essential problem of the internal client relationship and, indeed,
the whole subject of purchasing’s role within the firm, very differently. Citing
research by Ellram and Pearson (1993), Smeltzer and Goel report that purchasing is
excluded in most firms from most key decisions. In response, they argue: ‘In view of
the critical role the purchasing function can play in providing an organisation a

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Managing the Supply Base within Business Markets

sustainable competitive advantage, an effort must be made to understand how


purchasing managers can increase their influence in the organisation’ (Smeltzer and
Goel, 1995, p2). Smeltzer and Goel then proceed to set out a model for understanding
the main sources of organisational power and how they apply to the purchasing
function.

The Development of Conflicting Preferences within Firms


As has been mentioned, our framework for understanding the internal client
relationship very much sits within Pfeffer’s ‘political model’. Indeed, as will become
clear, it seeks to add to the insightful work of Smeltzer and Goel (1995). The task
begins with a discussion about why conflicting preferences arise within firms in the
first instance. There are three main issues that contribute to the development of
conflicting preferences within firms – in our case within the relationship between the
purchasing manager and his or her internal client. These are bounded rationality,
functional cultures and the principal-agent problem.

Bounded Rationality
The idea that managers within firms are not perfect calculating machines has long
been established. In the 1950s Herbert Simon put forward the concept of bounded
rationality (Simon, 1957). He rejected the notion that managers are outcome
maximisers and described decision-making as ‘a search process guided by aspiration
levels’ (Selten, 2001, p13). What this means is that a manager’s search process
continues until an alternative is found that reaches or surpasses his or her aspiration
level (although this level itself is not set in stone). This aspiration level may be some
distance away from what might be seen objectively as the ideal solution to a problem.
James March argued that the causes of bounded rationality were problems of
attention, problems of memory, problems of comprehension and problems of
communication (March, 1994, p10).

Simon coined the word ‘satisficing’ to describe this type of decision-making


behaviour and it is not difficult to see how such behaviour might contribute to demand
management problems. Particularly if internal clients are making decisions without
the assistance of procurement managers, they are likely to select a product or service
that sufficiently meets their aspirations (or, perhaps, a product or service that the
supplier’s salesperson suggests will meet their aspirations).

Functional Cultures and Inter-departmental Inconsistency


A second contributor to different and conflicting preferences is functional culture.
Organisations are divided into sub-units and usually these sub-units take the form of
functional departments. Managers in these functions are usually functional specialists.
These functions can either be commercial, such as purchasing, marketing, HR or
finance and accounting, or operational, such as engineering or, in the case of a
hospital, medicine.

Functional departments tend to have their own cultures (March, 1994). These cultures
will contain general assumptions about the operation of the firm and what is required
to make it successful. These assumptions will also be applied to specific decisions as
and when they arise. The culture of a function will often very quickly influence the

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Managing the Supply Base within Business Markets

perspective of a manager working within it. This is not surprising as managers will
develop friendships and discuss problems predominantly with managers from within
their function. They will, over time, also develop a shared sense of experience. The
impact of functional culture will often be further entrenched by the functionally-based
professional training that many managers go through.

Again, it is not difficult to envisage how this factor might contribute to demand
management problems. If we think about the specification of a particular good or
service, there may well be assumptions amongst a purchasing manager’s internal
clients about what is important. For example, we recently looked at the decision-
making process for the purchase of printed marketing materials in a financial
institution. The purchasing department had recently managed to cut down the number
of paper types used for marketing materials by nearly ten-fold. Prior to this move,
various marketing managers had ascribed great importance to subtle differences in
paper quality, differences that were totally lost on most other participants in the
decision-making process. The insistence on such variations had, however, a
significant commercial implication for that firm.

Individualism and the Principal-Agent Problem


The final contributor to different and conflicting preferences we are to include here is
the principal-agent problem. This problem arises not from the division of the firm into
horizontal sub-units but from the division of the firm into vertical hierarchies.
Managers have two different loyalties when they work within firms. First, they have a
loyalty to their firm, which after all is paying their wages. However, those writing
within the ‘political model’ also argue that managers tend to have a second loyalty –
that being a loyalty to themselves and their careers. The principal-agent problem
refers to situations where these two loyalties are in conflict, and where the result is
that the decisions that managers make are more about securing their own personal
advantage than furthering the interests of the firm.

It goes without saying that one of the incentives for managers to favour their own
interests over the interests of the firm is advancement within the firm hierarchy.
March comments: ‘Definitions of self – preferences and identities – are shaped by
features of the hierarchical competition for getting ahead. Self-worth is defined by
promotion and therefore by the qualities required for promotion. Individuals who are
involved in competition for career advancement find their identities shaped by that
competition. They conform in order to be acceptable. They differ in order to
differentiate and distinguish themselves’ (March, 1994, p114). In other words,
hierarchies not only organise individuals, they create them.

There are many that reject this rather cynical view of the motivations of managers
within firms and, indeed, unquestionably not all managers conform to such a
behavioural model. However, the case of those arguing from within the ‘rational
model’ has been somewhat undermined in recent times by the succession of scandals
coming out of the United States and elsewhere which have highlighted the principal-
agent problem. Indeed, the use of stock options was an attempt to address the
principal-agent problem. In the procurement context, we can easily envisage how the
principal-agent problem might cause a sub-optimal specification or supplier selection

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Managing the Supply Base within Business Markets

decision. This will not always be related to hierarchical advancement, but over the
respectable or less respectable benefits that might accrue from selecting a particular
supplier.

The Resolution of Conflicting Preferences within Firms


In the last section, we reviewed the reasons why conflicting preferences might arise in
the relationship between the purchasing manager and his or her internal client. On
some occasions the internal client’s preference will prove to be well founded.
However, that is not what concerns us here. Having outlined how conflicting
preferences might arise within firms, we now need to explore how these preferences
might be resolved. That is, how certain actors within firms manage to ensure that their
preferences become the main driver behind the eventual business decision. As was
mentioned earlier in the article, our view here is consistent with our view about how
decisions are resolved outside the firm – i.e. between the firm and its suppliers. This
consistency relates to the prominence we give to the concept of power as a means of
resolving conflicts.

Therefore, in this section we outline various ideas about the way in which power and
politics plays a key role in resolving conflicts of preferences that routinely occur
within firms. There are two aspects of power and politics to be considered. First, the
vertical power relations that stem from the hierarchical structure of firms. Second, the
horizontal power relations that can be understood by returning to the basic principles
laid out by Emerson – that is that power arises out of dependency.

Vertical Power Relations and Authority


We can define power as the ability of one actor to affect the behaviour of another
actor in a manner contrary to the second actor’s interests (Lukes, 1974). One way in
which this can occur within firms is through formal hierarchy and authority. Despite
the fact that many firms have flattened their organisational structures somewhat over
the past two decades, they are still, in essence, hierarchical power structures. Certain
managers are given formal authority to make decisions and override the preferences
of other managers lower down the hierarchy. An example of this that affects the
ability of purchasing to pursue its preferences is the absence in many firms of any
purchasing representative on the executive board. Another example is the positioning
of purchasing within a number of firms as a sub-group reporting to the Finance
Director.

Horizontal Power Relations and Interdepartmental Dependency


Whilst many conflicting preferences are resolved through the use of formal authority
this is not the only domain of organisational power and politics. Conflicting
preferences also exist between managers in departments that are at an equal position
in the organisational hierarchy. If we are to understand organisational power and
politics, therefore, we also need to consider horizontal power relations.

Whilst there are many different theories and models about what confers power upon
managers in their horizontal relations with other departments, the preference of the
authors is to return to Emerson’s model of power and dependency, which was used to
interpret power relationships between buying organisations and their suppliers. In this

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Managing the Supply Base within Business Markets

case, we adapt Emerson’s model for internal power relations by proposing that: ‘Sub-
unit A will have power over Sub-unit B to the extent that A has an ability to fulfil the
requirements of B, and has a monopoly on that ability’.

To utilise Emerson’s model in the cause of interpreting internal horizontal power


relations is by no means our own invention. It has long been used in such a way. The
original adaptation came from Hickson et al back in 1971. They developed what they
called ‘A Strategic Contingencies Theory of Intraorganisational Power’ (Hickson et
al, 1971). Hickson et al argued that strategic contingencies are events and activities
both inside and outside an organisation that are essential for attaining organisational
goals. Accordingly, the theory proposed that those departments that are most
responsible for dealing with key resource issues, uncertainties or dependencies in the
environment – the strategic contingencies – will become the most powerful.10

Hickson et al explained further, quoting Thompson: ‘A newer tradition enables us to


conceive of the organisation as an open system, indeterminate and faced with
uncertainty, but subject to criteria of rationality and hence needing certainty … we
suggest that organisations cope with uncertainty by creating certain parts specifically
to deal with it, specialising other parts in operating under conditions of certainty or
near uncertainty’ (Hickson et al, 1971, p197). They continued: ‘Thus organisations
are conceived of as inter-departmental systems in which a major task element is
coping with uncertainty. This task is divided and allotted to the subsystems, the
division of labour creating an interdependency among them. Imbalance of this
reciprocal interdependence among the parts gives rise to power relations’ (Hickson,
1971, p198).

Therefore, as was seen with the model for buyer-supplier relationships earlier in the
article, power comes from dependency. Yet the ability to cope with uncertainty alone
is not sufficient to create dependency and, therefore, endow a sub-unit with power
resources. Two other variables are provided by Hickson et al. First, a sub-unit must be
non-substitutable in its fulfilment of another sub-unit’s requirements (e.g. coping with
uncertainty for them). Second, the activities of the sub-unit must be central to the
workflow of the organisation and be essential to that workflow, i.e. a cessation of its
activities would substantially impede the workflow of the organisation.

Hickson et al comment: ‘The [three] variables are each necessary but not sufficient
conditions for the control of strategic contingencies, but together they determine the
variation in interdependence between sub-units. Thus contingencies controlled by a
sub-unit as a consequence of its coping with uncertainty do not become strategic, that
is, affect power, in the organisation without some values of substitutability and
centrality’ (Hickson et al, 1971, p204).

Therefore, the resolution of any conflict within an organisation can be understood


with reference to these elements. However, if we are to measure the overall power of
a sub-unit within an organisation, we need to add a fourth proposition. This is that the

10
There is, of course, a potential connection between vertical and horizontal power relations. It has
been argued that the ability of departments to deal with strategic contingencies provides them with
horizontal power that eventually allows them to gain greater formal authority within the firm.

72
Managing the Supply Base within Business Markets

more contingencies that a sub-unit controls the greater is its power within the
organisation. Therefore, if a sub-unit solves the problems of many other sub-units, on
many issues that are central to the organisation’s workflow then that sub-unit is likely
to have a prominent standing within the organisation.

Strategic Contingencies and Purchasing’s Influence within the Organisation


Once a model for measuring sub-unit power has been established we can start to
consider the circumstances when the purchasing sub-unit will be in a strong
organisational position. It is not our intention to discuss these circumstances in this
article. However, we can briefly mention the significant contribution that has already
been made by Smeltzer and Goel (1995). Smeltzer and Goel argue convincingly that
purchasing’s influence will be greater in organisations where there is intense industry
rivalry (and thus a pre-occupation with internal costs), where key supply markets are
complex and restricted and where purchases constitute a high proportion of company
turnover. Under such circumstances, there will be many instances where purchasing
will be coping with uncertainty for departments in aspects of the business that are
central to the firm’s well-being. It may be that the purchasing department will be the
only department that has the expertise to deal with the uncertainty.

Modelling Demand Management Problems within the Firm


In this section, we have sought to explain why so many firms suffer from problems
over the management of their internal demand for bought in products and services.
The model we have presented is consistent with our thinking about external buyer-
supplier relationships and, as was mentioned earlier, sits squarely within what Pfeffer
called the ‘political model’ of organisation theory.

The intention in this article has been to provide a framework that scopes the problem
of internal demand management and locates it within our work on external supply
management – the power regimes model. We have sought to enlist organisation theory
in the cause of understanding a critical problem within the purchasing and supply
management field. However, the intention was not to go in depth into the organisation
theory we have utilised. There has been no attempt, therefore, to be exhaustive in our
coverage and usage of the organisation theory literature as it relates to decision-
making and power and politics. Omissions identified by the reader should be seen in
that context.

Developing a Strategy for Addressing Demand Management Problems

Thus far we have identified various internal demand management problems,


understood their significance for the achievement of value for money from suppliers
and explored why those problems come about. One final task, therefore, is to provide
some ideas as to how managers might address such problems. It is to this task the
article now turns.

In this section, we discuss the development of a strategy for dealing with demand
management problems. The discussion is by no means exhaustive. There are, of
course, any number of tips and hints that could be included. In a recent article, Peter
Smith gave a practitioner perspective on how to deal with internal clients and offered

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Managing the Supply Base within Business Markets

many useful suggestions, not least the view that purchasing managers should not try
to sell grand schemes to internal clients until they have solved the minor problems
that have an adverse impact on them on a day-to-day basis (Smith, 2002).

However, our aim here is to discuss ways of addressing demand management


problems in terms of the concepts that we have used thus far to conceptualise the
problem. In this section we will look at four different ideas that could be part of a
strategy to address demand management problems. The order of them is not intended
to suggest an ordering of management action. First, a model is presented that allows
purchasing managers to prioritise the areas of spend they are seeking to influence.
Second, a model is provided to guide purchasing managers in building support for
their attempts to improve the management of demand. Third, the idea of creating new
management roles that transcend the boundaries of the purchasing department and an
internal client department are explored. Finally, the idea of formal buying councils is
discussed.

Prioritising Areas of Spend


If a purchasing manager is seeking to improve the internal management of demand for
products and services within the firm he or she needs to think about how to proceed.
There are likely to be many areas of spend that require attention, so a system of
prioritisation is needed. The system that we suggest is based upon the ideas about
internal demand management and external supply management that we have already
discussed in this article. For us, the prioritisation of management effort should depend
on two issues: the economic potential from changes in the management of demand
and the operational scope for changing the management of demand. What this means
is explained below.

The Economic Potential from Changes in the Management of Demand


When purchasing managers are considering which areas of spend they should seek to
prioritise for attention, the first consideration must be the economic potential that
exists within an area of spend. This potential comes from a number of sources. Let us
consider that the internal demand initiative we are considering is an attempt to
consolidate a firm’s demand for a particular product. First, we need to consider the
size of spend for that particular product. There is no point allocating valuable and
scarce management resource on a low value area of spend (not in this respect at least).
Second, we need to consider the extent of the problem. Managers need to consider the
extent to which their firm’s demand for this product is currently fragmented across a
number of suppliers.

Third, managers need to consider the extent to which consolidating the spend for this
product with fewer suppliers will yield economic gains. This will depend on two
factors. One, will the consolidation yield a considerable reduction in transaction
costs? Two, will the increased spend with one or more suppliers have any impact on
those suppliers attitude to our firm? The latter question can be answered by returning
to the ideas presented earlier in the article on buyer-supplier power. Using the ‘power
regimes’ model outlined earlier, it can be assessed as to whether the increased
consolidation of spend will significantly improve the power position of the buying

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Managing the Supply Base within Business Markets

firm vis-à-vis the relevant suppliers. If it will, it is likely that the consolidation effort
will yield economic gains.

The Operational Scope for Changes in the Management of Demand


Purchasing managers can, therefore, assess the economic potential from changes in
the management of demand for a particular good or service. However, as should be
clear by now from this article, this is only half of the picture. The other half concerns
the internal political environment. Therefore, when prioritising areas for attention
managers need to assess the operational scope for change. There are two issues here
that need to be considered. First, it may be that for logistical or product-related
reasons it is not practical to change the way in which certain products or services are
purchased.

Second, it may be that there are significant political barriers to changing the way that
certain products and services are purchased. As we have discussed at length in this
article, conflicts over preferences about supplier selection or the specification of a
good or service can arise between purchasing managers and their internal clients. In
the case of certain products or services there may be great sensitivities over, for
example, the specification or the selection of suppliers. What makes this sensitivity a
particular problem is that it may be that the internal client in question has greater
organisational power than the purchasing manager or department. This superior power
position will potentially diminish the scope for the purchasing manager to promote
any change within a particular area of spend.

Therefore, it is our view that if purchasing managers are looking to prioritise areas of
spend they should do so using these two broad criteria. A tool we have used with
various clients has been a ‘prioritisation matrix’, which brings together the economic
and political criteria. This matrix can be seen in Figure 2.

Figure 2. Prioritising Areas of Spend for Internal Demand Management


Initiatives

Alternative Approaches to Prioritisation


Having positioned various areas of spend on the matrix, purchasing managers are in a
position to order their priorities. From our research in this area, and from our general
contact with purchasing managers, there are definitely two schools of thought on this
prioritisation issue. There are those in one camp that argue that areas of spend should
be prioritised for attention solely on their merits – i.e. the extent of the problem they

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Managing the Supply Base within Business Markets

present the organisation. This is irrespective of the sensitivity of the issues at hand and
the power of the relevant internal clients.

However, we are advocating a different approach. This approach is based upon


starting with areas of spend that are not politically sensitive. The reasoning behind
this is that purchasing managers should look for areas of spend that allow him or her
to build up support and credibility for the idea of reforming internal demand. If
purchasing can deliver benefits to internal clients in areas of spend that are not
politically sensitive, the hope is that the credibility this will generate will open the
door to involvement in areas that are more sensitive. Our approach to prioritising
areas of spend will particularly apply to firms where there has been a history of poor
relations between the purchasing department and its internal clients.

Building Internal Alliances


Either before or after having prioritised areas of spend for attention, purchasing
managers need to try to build up an alliance of managers outside the purchasing
department that supports its general aims. In Figure 3, a basic segmentation matrix (a
matrix for classroom use, not for use within the organisation) is presented which seeks
to categorise the non-purchasing participants in the purchasing process. The criteria
by which these participants are categorised are threefold. First, the internal client’s
level of understanding about purchasing issues. Many managers holding conflicting
preferences do so out of ignorance of the implications of their actions for the value for
money achieved by the firm. Therefore, in some cases it will be sufficient for the
purchasing manager to take on the role of an educator for a change in preference to
occur. In this sense, some internal clients are ‘potential allies’.

Figure 3. Creating Internal Alliances – A Basic Segmentation

Second, the internal client’s attitude to cross-functional issues. Certain people within
firms have a reputation for looking positively upon cross-functional initiatives,
whereas others are seen as indifferent. Third, the organisational power of the internal
client. Some managers’ opposition to the initiatives of the purchasing department is

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Managing the Supply Base within Business Markets

more important than that of others. By the same respect, some managers are more
important allies than others, purely because they are in a better position to influence
decision-making.

Therefore, the first task of the purchasing manager is to consolidate its allies and key
allies. Then it should try to convert the potential allies and potential key allies to the
purchasing cause through the aforementioned educative role. Having put together this
alliance, the purchasing manager is in a better position to tackle those managers that
are opposed to its initiatives. Indeed, if sufficient support is obtained by the
purchasing manager, it may be that the initiative gets turned into a permanent formal
operating procedure. In many organisations we can already see this happening. Senior
purchasing managers spend most of their time circulating the firm talking, persuading
and enlisting others into his or her way of thinking.

Creating Cross-Functional Management Roles


A further idea for dealing with intra-organisational conflicting preferences and power
relations is the creation of cross-functional managers. These can either be purchasing
managers transferred to the internal client department or managers in the internal
client department that are given a new role that concerns itself with the purchasing
issues that arise out the department’s actions. In the case of the latter, many instances
of this initiative can be seen in the UK’s National Health Service (NHS). The NHS
struggles with a whole host of internal demand management problems and one
response has been to give a senior nurse, for example, training and responsibility for
purchasing in his or her department. This person is in a good position to judge on
issues like specification, as he or she has both commercial and medical knowledge.

The Creation of Buying Councils


One of the initiatives that can follow efforts to gain allies and win over internal clients
is the creation of internal buying councils. Such initiatives have a chequered history,
but can be made to work if handled properly. The idea behind buying councils is that
various interested parties are brought together to try to agree on universal standards
and suppliers for ‘common user items’ – those purchases that are used throughout the
organisation. Who these interested parties will be is obviously different in the case of
centralised and decentralised purchasing operations.

An example of a firm that has developed this kind of arrangement is IBM. Within its
global procurement operation it has 17 commodity councils, which seek to bring
together managers from its innumerable operations around the world. An example
based upon the IBM model is shown in Figure 4. The aforementioned NHS is also
developing initiatives in this respect and is about to launch a pilot of six ‘supply
management confederations’ in different parts of the UK (Arminas, 2002).

Conclusion: Managing in a Political Environment

There are two distinct ways of thinking within business management. There is the
‘rational’ approach and the ‘political’ approach. The divide is crucial. The advice
given to managers, in this case on managing internal demand, will be completely
different depending on which approach the academic takes. We take the ‘political’

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Managing the Supply Base within Business Markets

approach and so, consequently, our model for managing internal demand focuses
upon dealing with conflicts over preferences and asymmetries of power.

Figure 4 Representation of IBM’s ‘Commodity Council’

Purchasing managers will never solve the problems associated with internal demand
management. However, by understanding the nature of the organisational
environment and by understanding how to react to it, managers can start to improve
matters in individual areas of spend. Then, hopefully, over time and through continual
contact with internal clients, purchasing managers can amend dysfunctional internal
client behaviour (where it exists) and disseminate a better understanding of the
purchasing agenda and how it can benefit the firm.

References

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Managing the Supply Base within Business Markets

The Role of Competence and Congruence in Supplier


Selection Decisions11

Introduction

Organisations in both the public and private sectors are under ever-greater pressure to
maximise the value for money they achieve in their transactions with suppliers.
However, if they are to be successful in achieving this, it is crucial that they possess a
robust supplier selection methodology as part of their purchasing and supply
management process. However, whilst all purchasing and supply academics agree on
the importance of effective supplier selection, there is considerable disagreement as to
what should constitute the key criteria for such a decision.

In this article, the authors present their views on what the key criteria are. It is argued
that supplier selection criteria can be placed under two main headings: supplier
competence – i.e. the ability of a supplier to fulfil the buyer’s requirements - and
supplier congruence – the incentive for a supplier to want to fulfil the buyer’s
requirements. It is the contention of the authors that most discussions on supplier
selection have focused on supplier competence, but ignored the crucial issue of
supplier congruence, thus leaving a large gap in the analysis.

The article is divided into six main parts. First, there is a brief discussion of where
supplier selection fits into the procurement and supply management process. Second,
there is a review of existing academic work on supplier selection. Third, there is a
discussion of the first main issue regarding supplier selection – supplier competence.
Fourth, there is a discussion of the second main issue – supplier congruence. Fifth, the
overall supplier selection model is presented. Finally, the article is concluded.

Supplier Selection and the Procurement and Supply Management Process

The procurement and supply management process involves a number of key stages.
We will assume that the organisation has already undertaken a segmentation of spend
exercise and is focusing its energies on those areas of spend that are operationally
and/or commercially important. If so, the key stages include the development of a
specification (a task that requires both procurement and internal client input), the
sending out of ‘requests for information’ (if required), the sending out of ‘requests for

11
This chapter is a pre-publication chapter written by Andrew Cox, Glyn Watson, Chris Lonsdale and
Rachel Farmery

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Managing the Supply Base within Business Markets

quotation’, cost and/or quotation analysis, negotiation, the selection of a supplier or


suppliers, relationship and contract selection and post-contract management.

Academic Discussion on Supplier Selection

Supplier selection is an element of the procurement and supply management process


that has received considerable attention from academics. One of the earliest works on
supplier selection, written by Dickson (1966), identified over 20 tactical performance
attributes which managers might trade off when choosing a supplier. More recent
articles by Kraljic (1983), Browning et al (1983) and Soukup (1987) have preferred to
talk in terms of the strategic importance of the supplier selection process. However,
despite this, they have still been largely concerned with the trade-off between quality
and cost attributes.

When considering the capabilities of suppliers in terms of quality, academics have


drawn managers’ attention to quality standards such as ISO 9000. The possession by
suppliers of such quality accreditation can be used by procurement managers as a way
of seeking to ensure a certain baseline of performance. Some have taken a wider view
of quality, however, particularly when the buyer is seeking a collaborative
relationship. The former CBI body, Partnership Sourcing Ltd, compiled an extensive
list of the quality attributes required by potential partners. These included a capability
in JIT and e-procurement, the possession of an in-house design capability and the
possession of a ‘change culture’ (Saunders, 1994). Burt and Doyle’s quality criteria
also included the issue of trust (1993) as did that of Hughes (2001).

In terms of ascertaining the cost performance of suppliers, managers have commonly


been introduced to the process of quotation analysis. Beyond this, where the exercise
is justified by the significance of the item of spend, managers are encouraged to
undertake cost analysis and appreciate the issues of fixed and variable costs, cost
attributability and the relative value of consulting financial accounts (Hughes et al,
1998).

Whilst the above writers have brought many important issues to the attention of
managers, all of their work concerns the issue of supplier competence. That is, what
the supplier is technically capable of delivering. Very few writers (Hughes et al being
an honourable exception) have recognised that this is not sufficient for an effective
supplier selection decision to be made. The reason for this is that knowing what a
supplier might be capable of delivering is very different from knowing what a supplier
has the incentive to deliver. It is critical, therefore, that any discussion of supplier
selection includes not only a consideration of supplier competence, but also of
supplier congruence. That is, the extent to which the power relationship between the
buyer and the supplier provides an incentive for the supplier to deliver a high level of
value for money. It is to a discussion of such a model that the article now turns.

A Model for Supplier Selection

Our alternative model for supplier selection is set out in Figure 1. It can be seen that
whilst we agree that managers need to consider the trade-off between quality and cost

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Managing the Supply Base within Business Markets

– i.e. they need to establish a value for money proposition – a further trade-off exists
between supplier competence and supplier congruence. Later in the article, the
implications of this trade-off will be discussed in detail. First, however, we must set
out what we mean by supplier competence and supplier congruence.

Figure 1. A Model for Supplier Selection

Supplier Competence
Supplier competence is a function of three broad categories of performance: product
or service functionality, cost to buyer and confidence in the supplier. To establish a
comprehensive supplier competence rating all three need to be considered by buyers.
However, because a buyer’s value for money proposition will be different for
different goods and services, the ratings attached to the three aspects of supplier
competence must be weighted in each case. For example, when a marketing-driven
company is seeking to purchase the services of an advertising agency, it is likely that
the perceived functionality of the agencies in question will be a more important
consideration than their cost breakdowns. Alternatively, a firm buying a catering
service may well place cost competitiveness much higher than quality.

Figure 2. The Supplier Competence Matrix

Figure 2 shows how purchasing managers can capture information on supplier


competence. First, the manager needs to weight the three attributes: functionality, cost
and confidence. Second, the manager needs to make a judgement on the capability of
the supplier with respect to those three attributes. Third, the manager needs to

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Managing the Supply Base within Business Markets

calculate a weighted score for each of the three attributes. Fourth, the manager needs
to add together the three weighted scores to arrive at an overall rating of supplier
competence.

It is worth noting that this matrix is not just applicable to the initial supplier selection
decision, but can also be used during the contract to measure the supplier’s
performance over time. There are three different ways that the purchasing manager
can use the matrix during the contract. First, the purchasing manager can use it to
benchmark the supplier against its past performance. Second, the purchasing manager
can use it to benchmark the supplier against the firm’s target value for money
proposition. Third, the purchasing manager can use it to benchmark the supplier
against an external benchmark or another supplier he or she is sourcing from.

Having established how the supplier competence matrix consists of three criteria and
explained how it might be used, it is now necessary to discuss the three criteria in
more detail.

Functionality
The first supplier competence criterion is functionality. For each transaction, the
buyer will have a set of functionality requirements. These will include certain product
attributes, a level of product quality, certain value-added services, certain delivery
expectations and certain payment terms. In Table 1, the generic elements of
functionality required by Hewlett-Packard are set out. These are standard
requirements against which its suppliers are judged.

Table 1. Hewlett-Packard’s Functionality Requirements

Increasingly, an important additional aspect of functionality required by buyers is the


ability to trade online. Some buyers insist on being able to place orders online, which
requires the supplier to have a sophisticated order fulfilment system. The trend
towards suppliers having to be Internet-compliant is only likely to accelerate in the

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Managing the Supply Base within Business Markets

future, despite the problems that many firms have been encountering with their e-
procurement strategies.

Cost to the Buyer


The second supplier competence criterion is cost competitiveness. The extent to
which purchasing managers will investigate the cost competitiveness of the short-
listed suppliers will very much depend on the significance of the spend. If the spend is
relatively insignificant then the manager may just take the supplier’s quotations at
face value and then use them as the basis for negotiation and/or comparison. For the
key areas of spend, however, he or she may decide to undertake a cost analysis in
order to try to establish more precisely the gap between the supplier’s costs and its
suggested price. When undertaking cost analysis, there are two issues in particular
that need to be considered: the attributability of cost and the fixed and variable make-
up of cost. These are discussed below.

We will deal first with the issue of cost attributability. A supplier will calculate its
quoted price by adding (a) the total of those costs that are directly attributable to
supplying the customer’s product to (b) the total of those costs that are indirectly
attributable to supplying the customer’s product. Directly attributable costs are those
costs that can be attributed solely to the products or services provided under the terms
of the contract in question. For example, the raw materials used in a particular
customer’s order.

Conversely, indirectly attributable costs are those costs that are also incurred in the
fulfilment of the contract in question, but are not specific to it. For example, the R&D
costs incurred in the development of a generic industrial product. A certain proportion
of these costs will need to attributed to each customer’s order. Other indirectly
attributable costs concern the overheads necessary to operate the business. These
include factory maintenance, worker supervision, lighting, heating and administration.
These costs also need to be shared across a large number of contracts, as they will
have supported a large number of contracts.

The purchasing manager will seek to ensure that the directly attributable costs charged
by the supplier are accurate. In the case of complex purchases, this will not always be
easy. However, an even greater challenge concerns the need to ensure that the
indirectly attributable costs are accurate. To have any chance of being successful in
this, the purchasing manager will need to know a range of facts about the supplier.
These include the supplier’s turnover in the relevant product area, the proportion of
that turnover that is accounted for by the buyer’s business, the research and
development costs incurred by the supplier and the overheads incurred by the
supplier. Overhead allocation is a particularly difficult area for the purchasing
manager to assess. Indeed, on many occasions, even a supplier’s own accountants are
unsure as to how overheads should be allocated to their products. There remains,
therefore, much room for the supplier to play games.

A second issue that the purchasing manager needs to consider when undertaking cost
analysis is the output effect. A supplier’s output has an impact on its costs per unit.
The extent of this impact, however, is dependent on the cost make-up of the good or

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Managing the Supply Base within Business Markets

service concerned. Purchasing managers need to consider, therefore, the way in which
the supplier’s costs are likely to behave in response to output.

When we talk about the make-up of cost we are talking about the way in which the
costs incurred by the supplier are divided between fixed costs, variable costs, semi-
fixed costs and semi-variable costs. Fixed costs are those costs that remain constant
over a wide range of activity for a specified time period. This includes capital
equipment, salaries and lease charges. Semi-fixed costs are costs that increase at
intervals within specific time periods and are incurred when capacity limits are
reached. Variable costs are costs that vary in direct proportion to the volume of
activity. For example, contract labour and direct materials. Semi-variable costs
contain both a fixed and variable element. Examples of semi-variable costs are energy
consumption or maintenance.

If a purchasing manager knows that the product he or she is buying has a heavy fixed
cost element then he or she will know that its unit cost will be highly sensitive to
output. For example, in many engineering scenarios where the buyer’s request is
bespoke, the fixed and variable cost structure is so extreme that whilst it may cost the
buyer £100,000 for one piece of equipment, the cost of two may only be £105,000 and
three £106,500. It goes without saying, therefore, that an understanding of the cost
make-up of purchases is an essential part of a purchasing manager’s knowledge.

Confidence in the Supplier


The third supplier competence criterion concerns the confidence that the buyer has in
the supplier as a company. There are two main issues: the reputation of the supplier
and the financial condition of the supplier. Buyers will tend to allocate a higher
weighting to this criterion when they are looking to have a medium or long-term
association with a supplier.

In terms of the supplier’s reputation, the main issue concerns supplier behaviour. The
buyer will want to know whether the supplier has a reputation for honest practice or
whether it has a reputation for acting opportunistically. Examples of opportunistic
behaviour could be attempts to engineer and exploit lock-in, attempts to exploit
changes in the buyer’s requirements, a tendency to be non-forthcoming with financial
and product information, a tendency to act adversarially in relationships or a tendency
to make promises that are not fulfilled.

In order to obtain information about such issues, purchasing managers could ask other
managers within their firm, managers in other firms, industry consultants and
commentators, consult reports or industry journals or join a benchmarking club where
information is exchanged in a formal manner.

In terms of the supplier’s financial condition, there are various types of analysis that
can be undertaken to build up an overall picture. The place to start is with the
supplier’s annual accounts. The financial ratios contained within them can provide
some useful information, albeit information that must be treated with caution. It
should be made clear, however, that what purchasing managers are looking for are
financial trends over time, rather than the figures for any particular year. Firms can

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Managing the Supply Base within Business Markets

patch up the figures for one or two years in the hope that things improve. This is more
difficult to do over an extended period.

There are various ratios that the purchasing manager might seek to calculate. First, the
current ratio, which explores the ability of the supplier to meet its short-term
liabilities. Second, the debt ratio, which reveals the supplier’s level of debt gearing.
Third, the interest burden ratio, which reveals the extent to which the supplier’s
earnings are used to pay the interest on its accumulated debts. Fourth, profitability
ratios, that will also give an indication of the ability of the supplier to invest in the
future. Finally, inventory and asset turn, which can give some impression of the
supplier’s operational efficiency. It must be stressed again, however, that there is great
scope for the manipulation of financial accounts. Nevertheless, if managers study the
financial trends of potential suppliers they may well build up a reasonable picture.

Supplier Congruence
Therefore, the first main issue concerning supplier selection is supplier competence.
However, as stated at the beginning of the article, an understanding of supplier
competence alone is not sufficient for a manager to make effective supplier selection
decisions. There is a world of difference between the ability of a supplier to provide
value for money and the inclination of a supplier to provide value for money.
Therefore, we need to introduce the concept of supplier congruence. What is meant by
supplier congruence is the existence, or otherwise, of an inclination on the part of the
supplier to act in a manner that is consistent with the value for money requirements of
the buyer. This inclination comes from the existence of incentives. Incentives, in turn,
come from power. Therefore, an understanding of congruence comes from an
understanding of power.

Over recent years we have written a great deal about the concept of buyer-supplier
power and its impact on buyer supplier relationships (Cox et al, 2000; Cox et al, 2002;
Cox et al, 2003). We have argued that there is a relationship between the value for
money obtained by buyers and buyer-supplier power. When a supplier is dominant it
is able to realise high margins from its transactions with a buyer and dictate the
conduct of the relationship with that buyer. In short, the supplier is able to determine
what, if any, collaborative activity takes place and on what terms. When the buyer is
dominant, the reverse is the case. The buyer is able to limit the supplier to ‘normal’
profits and is also able to determine the relationship agenda. Where there is a situation
of independence, the buyer is, again, able to use the market to force the supplier to
accept ‘normal’ profits. Finally, in a situation of interdependence the two parties
negotiate both the returns to the supplier and the nature of the relationship.

Understanding the implications of buyer-supplier power is one thing, but how do we


recognise it? Buyer-supplier power can be recognised by comparing the power
resources of the two parties. First, determining a supplier’s power resources requires
consideration of the three key supply characteristics of any transaction: utility,
scarcity and information. Utility, in this context, refers to the importance of a
supplier’s offering to a buyer, both operationally and strategically. Scarcity, in this
context, refers to the availability to the buyer of equivalent supply offerings from
other suppliers and is determined by potential new entrants, contestation in the

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Managing the Supply Base within Business Markets

existing supply market and substitutes for the supply market. Information, in this
context, refers to the information the supplier has on the buyer’s utility function, the
size of its budget and the urgency with which it requires the good or service.

A similar process is undertaken to determine a buyer’s power resources. Utility and


scarcity, in this context, refer to the importance of a buyer’s business for a supplier.
Utility refers to the value of a buyer’s spend to the supplier and scarcity refers to the
availability to the supplier of equivalent exchange opportunities from other buyers.
For example, a buyer has a relatively high importance to a supplier if the transaction
is a large proportion of suppliers total sales revenue, is part of a repeat and predictable
revenue stream, requires little change to a supplier’s processes/products and where the
supplier has few equivalent exchange opportunities. Information, in this context,
refers to the knowledge the buyer has of the supplier’s costs, its supply market options
and the likely behaviour of the supplier both pre- and post-contractually.

Where the power resources of the buyer are high and the supplier’s are low, then the
transaction is characterised by buyer dominance. Where the power resources of the
supplier are high and the buyer’s are low, then the transaction is characterised by
supplier dominance. Where the power resources of both parties are low, then the
transaction is characterised by independence. Finally, where the power resources of
both parties are high, then the transaction is characterised by interdependence. This
rationale is represented in Figure 3.

Figure 3. The Buyer-Supplier Power Matrix

Undertaking such congruence, or power, analysis aims to establish what the incentives
are in a buyer-supplier relationship. Different power structures provide different
incentives for suppliers to act either adversarially or non-adversarially. Such an
analysis is an essential part of a supplier selection methodology. Managers need to
know not only what suppliers can do, but also what they are likely to do.

Positioning Suppliers on the Supplier Selection Matrix

Once the analysis of both supplier competence and supplier congruence has been
undertaken it is necessary to bring the two elements together. As we have seen, a
supplier’s competence is judged in terms of functionality, cost and confidence. These
three elements are weighted and scored to produce a weighted score, with these

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Managing the Supply Base within Business Markets

weighted scores then added together to produce an overall supplier rating. A


supplier’s congruence is judged in terms of buyer-supplier power. This is understood
by comparing the relative power resources of the two parties. Undertaking this dual
analysis for a supplier allows the supplier to be positioned on the supplier selection
matrix. If undertaken for a number of suppliers, the relative position of those suppliers
can also be identified on the matrix.

As can be seen in Figure 4, the positioning of suppliers in this way can allow the
purchasing manager to make an informed supplier selection decision as he or she will
understand the trade-offs available in terms of competence and congruence. In Figure
4, supplier A is in the optimum position for a buyer, because it has achieved a good
supplier performance rating and the buyer enjoys a position of dominance over it.
Selecting a supplier in such a position should lead to the buyer getting excellent value
for money. However, if there is no supplier available to the buyer in such a virtuous
position, then it will be forced to choose between suppliers B, C, D and E.

Figure 4. Supplier Selection Options

Supplier E is a non-starter, given that it has an unacceptably poor competence rating.


Supplier D has both a modest competence and poor congruence rating, so that
supplier can also be discounted too. Yet the choice between C and B is less
straightforward. On the one hand, supplier B possesses a high level of competence.
However, given the power relationship it is unlikely to be an easy supplier to deal
with. On the other hand, supplier C will be very keen to obtain work from the buyer,
being in a supplier dependent position, but its positioning shows that it is weak in
terms of competence. So which supplier does the buyer choose? Well, it all depends
on the nature of the transaction.

If the firm has an urgent need for a product with a high level of functionality, it may
be that it has no choice but to select supplier B. However, if the buyer has the time to
develop a supplier, before the good or service is required by the firm, then it may wish
to select the more compliant supplier, C. Alternatively, the buyer may wish to divide
the spend between the two. It could give 80% of the business to B, but also give 20%
to C, in order that it has the opportunity to develop supplier C. The hope would be

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Managing the Supply Base within Business Markets

that, in time, the buyer would have two quality suppliers to choose from, neither of
which enjoys supplier dominance.

In real supply market situations, of course, the positioning of suppliers will be


different to that seen in Figure 4. However, the purchasing manager will still benefit
from being able to see the trade-offs that exist in whichever supply market he or she is
managing.

Conclusion

Existing supplier selection advice focuses on the relative competence of suppliers.


This is a necessary, but insufficient focus for supplier selection decisions. Judgements
about supplier competence need to be combined with assessments of supplier
congruence. Only when both of these two issues are considered can purchasing
managers be confident of making the right selection choice.

References

Browning, J. M., Zabriskie, N. and Huellmantel, A (1983) “Strategic Purchasing


Planning”, Journal of Purchasing and Materials Management, (19:1), Spring, 19-24.
Burt, D. and Doyle, M. (1993) The American Keiretsu, Homewood, Irwin.
Cox, A., Sanderson, J. and Watson, G. (2000) Power Regimes, Boston: UK, Earlsgate
Press.
Cox, A., Ireland, P., Lonsdale, C., Sanderson, J. and Watson, G. (2002) Supply
Chains, Markets and Power, London, Routledge.
Cox, A., Ireland, P., Lonsdale, C., Sanderson, J. and Watson, G. (2003) Supply Chain
Management, London, Financial Times Pearson.
Hughes, B. (2001) Managing External Suppliers, Oxford, Chandos.
Hughes, J., Ralf, M. and Michels, B. (1998) Transform Your Supply Chain, London,
International Thompson.
Kraljic, R. (1983) “Purchasing must become supply management”, Harvard Business
Review, (61), 109-117.
Saunders, M. (1994) Strategic Purchasing and Supply Chain Management, London,
Pitman.
Soukup, W.R. (1987) “Supplier Selection Strategies,” Journal of Purchasing and
Materials Management, vol. 23, no. 2, 77-82.

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Managing the Supply Base within Business Markets

Developing ‘Fit-for Purpose’ Buyer/Supplier


Relationships: An Analytical Framework12

Introduction

Over the past 10 to 15 years, the academic field of purchasing and supply
management has developed significantly. The discipline can now claim to possess a
credible body of work. However, one of the less impressive aspects of the discipline’s
development has been its treatment of supplier relationship management. It is fair to
say that over the last 10 to 15 years conventional wisdom has stated that the
development of collaborative relationships represents best practice purchasing and
supply. It is the view of the authors that this view is misguided and that managers
need to adopt a fit-for-purpose approach to the issue.

In our view, the underlying reason why this conventional wisdom emerged was the
epistemological approach adopted by a number of purchasing and supply academics.
Adopting an empiricist approach, various writers observed the successes of
collaboration in certain industrial circumstances and took the view that such
successful practice could be replicated elsewhere. As a result, what emerged to guide
practitioners in the area of supplier relationship management was a series of tools
taken or adapted from a number of what were believed to be exemplar companies. In
our view, what practitioners actually required of academics was the development of a
theoretical framework, developed initially from first principles and then tested
empirically.

Whilst the danger of adopting an empiricist approach to model building in the social
sciences is the risk that what works in one context might not work in another, in the
supplier relationship management arena another problem has been encountered. This
was that the researchers observing exemplar companies, such as Toyota, in our view,
misunderstood what they saw. They assumed that as Toyota and its suppliers were
working collaboratively it meant that they were also acting in a non-adversarial
manner. This was not the case.

Whilst Toyota and its suppliers were engaged in all sorts of joint development
projects, aimed at enhancing design and innovation and reducing waste, there was no

12
This chapter is an adapted version of a paper delivered by Chris Lonsdale, Glyn Watson, Andrew
Cox and Joe Sanderson to the Institute of Supply Management Conference, Nashville, Tennessee in
May 2003.

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question as to which party was obtaining the greatest benefits from the collaboration –
Toyota. Toyota was working with its suppliers to increase the surplus value (that is,
the gap between the supplier’s costs and the buyer’s utility) being generated in its
transactions, but was then appropriating most of that value. Why was Toyota able to
do this? It is very simple. It was because Toyota was dominant over most of its
suppliers.

The merit of this example is that it allows us to question the assumption that managers
face a choice between the bad old ways of adversarial, arm’s length relationships and
the new, best practice ways of non-adversarial, collaborative relationships. It allows
us to see that such a choice is a false dichotomy. It is perfectly possible, for example,
for relationships to be adversarial and collaborative.

In an attempt to make a contribution to the debate over supplier relationship


management, we built two models. The first, descriptive, model identifies the
potential, generic supplier relationship types that exist in business markets. Having
identified the potential relationship types, we then developed a further model that
consisted of the factors that drive which of these relationship types is eventually
adopted in transactions between buyers and suppliers. Both of these models are
discussed in the remainder of the article.

Generic Supplier Relationship Management Types

As was suggested in the Toyota example discussed above, we believe that in order to
understand supplier relationship management, and in order to be able to identify the
types of relationships that can be found in business markets, we need to view
relationships as consisting of two main dimensions. These dimensions are the way of
working between the two parties and the way in which the surplus value created in the
relationship is shared between the two parties. Often when commenting on buyer-
supplier relations, observers tend to treat the two elements as opposites. In fact this is
not the case. Both elements (as we shall show) are to be found in all exchanges.
What differs across relationship styles is the extent to which one of the elements
dominates a particular deal.

In terms of the way of working, we can crudely divide working methods into a choice
between a collaborative (proactive) way of working and an arm’s-length (reactive)
way of working. By an arm’s-length way of working, we mean that the two parties
engage in very little contact during the relationship, beyond the exchange of the basic
commercial information – what is to be supplied, at what price, by what date, etc –
that needs to be exchanged in order for a transaction to take place. Such a level of
interaction will often be highly appropriate when the transaction involves the supply
of basic ‘off-the-shelf’ goods and services.

A collaborative way of working is where the level of interaction is higher and the
relationship involves the creation of additional surplus value through some form of
innovation or waste reduction. The different ways that buyers and suppliers can
collaborate has been codified in a recent article by Cannon and Perrault (1999). They
identify four categories of buyer-supplier interaction: product / process information

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Managing the Supply Base within Business Markets

exchange, operational linkages, co-operative norms and relationship-specific


adaptations.

Supply relationships, therefore, fall somewhere on a continuum between arm’s length


and collaborative. Clearly, the more a buyer and a supplier engages in the categories
of activities Cannon and Perreault have classified for us, the closer towards the
collaborative end of the continuum the relationship is. This then constitutes the first of
the two main supplier relationship dimensions.

The second dimension of a supplier relationship is the division of surplus value. This
dimension can be explained with reference to basic economics. As was mentioned
earlier, the term surplus value refers to the difference in a transaction between the
supplier’s costs and the buyer’s utility function. A supplier is not expected to go into
business if there is no prospect of making a profit. Therefore, included in its costs is a
reasonable profit margin, something economists refer to as ‘normal profits’. The
buyer’s utility function, meanwhile, is determined by the extent to which it values the
product. If the product in question is priced beyond its utility then it will exit the
market. The importance of these two points is that they bound the transaction within a
certain terrain. That terrain is referred to as the surplus value.

Having identified the concept of surplus value, we now need to explain the factors
behind how it is shared between the two parties. For us the major factor is buyer-
supplier power (Cox et al 2000; Cox et al, 2002;, Cox et al, 2003). By combining
insights provided by sociology and industrial and institutional economics, it has been
shown that buyer-supplier relationships can be characterised by one of four generic
power positions. These are buyer dominance, supplier dominance, buyer-supplier
independence and buyer-supplier interdependence. How the surplus value is shared is
related to which of these four power positions pertains.

Where the buyer is dominant the buyer takes all of the surplus value. This is also the
case where there is a situation of independence. The reason why the buyer is able to
take all of the surplus value is that in both situations there is a competitive market. In
a situation of interdependence - i.e. both parties are highly reliant on each other - the
surplus value is shared, as the two parties are both able to negotiate from a position of
relative strength. Finally, where the relationship is characterised by supplier
dominance the supplier takes either a majority of the surplus value or all of it. Which
of these occurs will depend on whether the supplier is able to price discriminate. If the
supplier is unable to price discriminate, it may well be that an individual buyer’s
utility function is still in excess of the price being charged by the supplier.

The situations described above all relate to an arm’s-length relationship and the
surplus value that is created by the supplier’s standard offering. However, we can also
model the division of surplus value when the relationship between the buyer and
supplier is collaborative. In economic terms, the reason why a buyer and a supplier
enter into a collaborative relationship is to either reduce the supplier’s costs or
increase the buyer’s utility.

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Managing the Supply Base within Business Markets

For example, a buyer and a supplier could decide to undertake an exercise of process
activity mapping. Having mapped out the process, they may decide that there is
considerable waste in the process that can be easily eradicated. This action will reduce
the supplier’s costs and increase the amount of surplus value. Alternatively, a process
activity mapping exercise could cause the two parties to realise that an adaptation to
the configuration of the supplier’s product would allow the buyer to simplify its own
production process, thus reducing its own costs of production. If this was the case, this
innovation would increase the buyer’s utility function for the product. If this increase
in the buyer’s utility was greater than the increase in the supplier’s costs caused by the
adaptation then there will also be an increase in the amount of surplus value.

However, under our assumptions, even if there has been collaboration between the
two parties that has led to an increase in the amount of surplus value, there is still the
question of how that surplus value is divided. Under our assumptions, the fact that the
two parties have collaborated does not change the fact that the buyer-supplier power
relation will determine how that increased surplus value is divided.

Having discussed the two main dimensions of supplier relationships, it is now


possible to present our model of the generic relationship types to be found in business
markets. This is shown in Figure 1. As can be seen, we have identified six generic
types. These come from the three possible divisions of surplus value and the two
different ways of working.

Figure 1. Generic Supplier Relationship Management Types

Making Supplier Relationship Choices

It needs to be recognised that all that this first model does is set out the generic
relationship types that can be found in business markets. It does not tell managers
what type of relationship to adopt in the particular circumstances he or she faces. To
do this the manager needs to consider a number of questions. These questions are the
basis of the second of the two models we have developed.

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Managing the Supply Base within Business Markets

Managers need to ask the following. First, what are the likely benefits from
collaboration? Second, what will be the cost to the firm of the collaborative activities?
Third, what is the probability of the collaborative activity being successfully
executed? Fourth, what is the power relationship with the supplier and how will this
impact (a) whether the supplier will be interested in collaborating and, if it is, (b) the
way in which the surplus value created will be divided? (Watson et al, 2003; Cox et
al, 2003).

Having considered these factors the purchasing manager will be able to assess
whether it is desirable or possible to enter into a collaborative relationship with a
supplier and will know which of the two parties is likely to dominate the exchange.
This assessment will see the relationship being positioned in one of the six boxes in
the above matrix, as will all assessments of all buyer-supplier transactions.

In attempting to answer the four questions outlined above it’s helpful to view
decisions about supplier management (or indeed all management decisions) as a form
of investment. This is because all decisions carry with them a cost (question two) that
is expected to yield a return (question one). This is true, even if the cost is the time
that it takes to perform the task. Time, like everything else is a scarce resource. If the
manager spends it in pursuing an unproductive activity, then they lose the opportunity
to do something more profitable.

The return that a manager gets from his or her investment is highly variable. It
depends upon what the action is intended to achieve. The yield may take the form of
the firm getting ‘the right man for the job’ in the case of the human resource manager
properly chasing up references. Alternatively, it may take the form of reduced
production downtime in the case of the operations manager putting in place a rigorous
programme of repair and maintenance. For the purchasing and supply manager
adding-value – as we have seen - means getting products or services from vendors,
streamlining processes or obtaining simple cost savings.

As with all investments, however, the attainment of the manager’s goals is to an


extent speculative (question three). Thus, it carries with it an element of risk. Time
spent trying to develop a supplier may take weeks or even months of effort but offer
very little by way of tangible return. Consequently, business competence generally
and supply competence specifically, centres on the manager being able to take that
option that offers the firm the best investment:return ratio – after risk has been
factored into the equation. Part of this investment:return ratio calculation has to do, of
course, with the way in which risk and reward are divided up between the two parties
(question four). This is a function of power.

Even the most reactive (arm’s-length) strategy for managing a supplier requires an
upfront investment. This investment can be as minimal as researching and negotiating
the contract and then placing the order. However, for some of the more ambitious
(collaborative) strategies the investments can be substantial. They can cover not just
administrative effort but can include any dedicated investments that the vendor needs
to make to satisfy the firm’s requirements. For example, in defence markets some

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Managing the Supply Base within Business Markets

governments spend millions and even billions of pounds, euros or dollars in the
development of new weapons systems. Generally speaking, reactive strategies
represent a cheaper option for the firm than do proactive (collaborative) strategies.
This is because reactive strategies imply that the upfront investments are largely
administrative. By contrast, proactive strategies are defined by the fact that the
investment process spills over into product or process development itself.

Figure 2. Alternative Generic Supply Strategies

Reactive and proactive strategies also differ in respect to the pay-off itself. With
reactive strategies, the return takes the form of negotiating better deals with existing
suppliers or better deals with alternative suppliers. In the case of reactive supplier
selection (see Figure 2) the gains are confined to the first tier, whilst in the case of
reactive supply chain sourcing they extend out to tiers 2, 3, 4 etc. By contrast,
proactive management involves additional benefits like waste reduction and/or
product enhancement (development). Because of this, proactive strategies also raise
the possibility of exploitable technologies. As a result, proactive strategies also have
to consider issues of ownership.

As with those decisions relating to internal management, supply management


strategies also carry with them an element of risk. For example, a manager might
spend many hours researching a supply market in an attempt to get a better deal, only
to find that the firm already obtains the best possible price. Similarly, as the defence
industry illustrates, many proactive supplier development strategies involve the outlay
of considerable sums of money with no observable return. The weapons systems do
not materialise, or else materialise late and over budget.

However, choosing between the generic supply strategies involves an additional


element that is not necessarily to be found when it is a case of the firm investing in its
own internal capabilities. Supplier (or supply chain) strategies are cooperative
activities. This is because they involve two separate organisations (the buyer and the
supplier) working together. At the same time, because they involve two separate

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organisations they also involve a competitive element, with each side attempting to
maximise its potential gain. Power impacts on this process, determining which side
assumes the upfront risk in a relationship and which side obtains the majority of the
subsequent gains. Generally speaking, it is better to be powerful than not. This then,
is the basic framework that informs the firm’s strategic choices. How it can be used
in practice can be illustrated through example.

In this example we will begin by imagining that a supply manager is being asked to
choose between option (a) reactive supplier selection, and option (b) a programme of
proactive supplier development. In the case of option (a) the buyer is operating in an
independent relationship with its supplier. In the case of option (b) the buyer starts
from the same power position but understands that as a result of investments that both
parties must make in the relationship, both parties will move to a situation of
interdependence. In short, the manager is being asked to choose between a Buyer-
Skewed Adversarial Arms-Length relationship on the one hand and an Non-
adversarial Collaborative relationship on the other.

In the first example the firm believes that its supplier is padding its costs. For this
reason, the procurement and supply department wishes to investigate the marketplace
in more detail. Such an investigation would require an investment in management
time that has been estimated at £1,000. Given the volume of business than the firm
does with the supplier it has been calculated that there is a reasonable (50%)
probability that through the initiative the firm could save £4,000. What then, is the
expected pay-off for the firm? This can be calculated by multiplying the return with
the probability that the return will be achieved, and then subtracting the upfront cost.
In this instance the expected pay-off would be as follows: (£4,000 x 50%) - £1,000 =
£1,000

As with all investments as long as the expected return exceeds the upfront cost, it
makes sense. However, reactive supplier selection is not the firm’s only option. It
may also pursue option (b) proactive supplier development. What the firm needs to
know is which of the two strategies offers the better return.

We can assume for the reasons stated above that proactive supplier development is the
more expensive of the alternatives. Again the firm costs its managerial time at
£1,000. However, it has also estimated that the strategy will require an additional
investment by one or both of the parties. This investment (costed at £4,000) is to
augment the supplier’s manufacturing capability. However, it has been calculated that
the subsequent gain will generate savings of the order of £12,000. For reasons of
simplicity we again assume that the probability that the initiative will work is 50%.

What is the pay-off in this instance? Under conditions of interdependence buyers and
sellers can be expected to share the risks and rewards of any initiative. Since the
buyer’s administrative costs come to £1,000 and its share of the dedicated investments
equal £2,000 (50% of £4,000), its upfront exposure totals £3,000. Although, if the
initiative works, it will deliver gross gains of £12,000, from this figure the buyer will
ultimately have to cover all the costs (£1,000 + £4,000) and share with the supplier
the net gains (£5,000 divided by two equals £2,500). From an investment of £3,000

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Managing the Supply Base within Business Markets

the supply manager’s net gains are a half chance at £2,500 (£1,250). Consequently,
the case for a strategy of proactive supplier development under these circumstances
appears weak.

What can be seen from the example so far is that the attractiveness of particular
options is likely to be highly sensitive to changes in any of the four key variables
(investment, return, risk and power). If the buyer is operating from a position of
dominance (Buyer-Skewed Adversarial Collaboration) then the argument for
proactive supplier development is greatly strengthened. The supply manager can
compel the vendor to assume all of the upfront risk, only shouldering the cost of his or
her management time. The firm’s exposure is therefore only £1,000. Should the
investment deliver on the gains the firm will have to cover the vendor’s costs but is in
the position to keep the entire net surplus of £5,000). Therefore, for an investment of
£1,000 the firm can expect to make £5,000 x 50%. This then makes proactive
supplier development more attractive than reactive supplier selection.

Operationalising the Supplier Relationship Choice

Contrary to the impression given in the above example, in practice selecting the
appropriate generic supply strategy is an art rather than a science. In most cases it
will just not be possible to obtain accurate data on the costs, returns and risks
surrounding an investment. As a result most managers will have to fall back on
collecting data that is indicative of what is likely to result from adopting a particular
choice.

To begin with, the manager needs to identify and collect data on the various types of
cost associated with the planned strategy. This includes data on the different
administrative tasks that the firm must perform plus data on any dedicated
investments that the initiative requires. Consequently, if the initiative will take up one
full-administrator’s time for two months and the administrator’s salary works out at
£2,000 a month, then a figure of £4,000 needs to be calculated and recorded.
Similarly, if the initiative requires one or either of the two parties to invest in
specialist technologies then this also should be recorded.

Although, the manager is being asked to quantify his or her investments, it is


important to remember that there are a number of other issues at stake. Any
investment is relative. Relative that is to the resources that a firm has at its disposal.
Firms in a cash-rich industry like pharmaceuticals can often afford to throw money at
a problem if it arises. An SME working in the fourth-tier of an automotive supply
chain may not have the personnel or time to consider a proactive initiative of any sort.
Consequently, managers need to consider not just what the upfront cost is, but to what
extent the activity is likely to divert scarce resources away from more productive uses.
Generally speaking, therefore, proactive supplier development or supply chain
management tends to be reserved for either major items of spend (i.e. areas that the
firm spends a lot of money on), or commercially sensitive areas (i.e. areas that
contribute to, but are not necessarily essential for the maintenance of the firm’s core
competencies).

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Managing the Supply Base within Business Markets

When calculating cost, managers also have to be able to calculate the costs to their
organisation should something go awry. Contingency planning, after all, is part and
parcel of good management. It is possible, for example, that the administrative effort
required has been under or overestimated. It is possible, also, that the commitment for
dedicated investments has to be revised in light of the fact that the initiative was
under-financed also. Whatever the reason, should the costs spiral the additional
expenditures need to be allocated. Furthermore, how they are allocated will
determine just how profitable the initiative proves to be in the long run.

Firms have to be particularly careful because proactive strategies can expose the firm
to significant contractual risk (what some analysts refer to as moral hazard).
Sustaining the commitment of a vendor depends upon a firm’s ability to motivate
them. Motivation can take the form of a carrot (bonuses for good performance), or a
stick (the cancellation of the initiative or the whole contract if the performance is
poor). But in order for the incentive structure to work it must be credible. This means
being able to monitor the supplier to see if they are complying with the terms of the
deal; and having the ability to punish the supplier (by invoking penalties or by
threatening exit), if they are not. Imagine a myopic and doddery old teacher trying to
keep discipline in a playground if his head teacher has told him that even if he catches
one of the children misbehaving, he is not allowed to threaten them with punishment.
Under such circumstances the children in his charge would run wild. So it is with
suppliers.

In the next phase, therefore, the manager needs to determine the structure of power
that exists between the buyer and the supplier. For the reasons we have already
covered, different power structures will allow the upfront costs to de divided in
different ways. In the case that the supplier is dominant, for example, the buyer can
expect to foot most of the bills upfront – regardless of the ultimate success of the
exercise. By contrast, in an interdependent relationship both parties would expect to
take a more equitable share of the risks.

When determining the power structure, though, it is necessary for the manager to
think about power as both a dynamic and a contingent phenomenon. Power is
dynamic because it changes over time. This is especially so in those instances where
the manager is considering some form of collaborative association. The very act of
undertaking a dedicated investment means lock-in for one (or both of the) party/ies.
Power is contingent, because the power structure that finally emerges is likely to be a
function of how responsibility for undertaking the investments is allocated.

One of the central tasks that the firm has to perform, therefore, concerns being able to
spot those areas where there is significant scope for opportunism (in this case in the
form of trying to renegotiate the risk-reward allocation) and to be able to craft
safeguards against the risk. Where contractual safeguards cannot properly be
introduced, then the firm would probably be better to retain the competence within the
organisation, rather than to outsource it.

Moral hazard is frequently a problem in supply management because effective


monitoring is always an issue. However, sometimes the risks are particularly acute.

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Managing the Supply Base within Business Markets

Contracting which takes place in a highly volatile or uncertain environment is difficult


because it raises the issue of renegotiation. Buyers attempt to draft contracts in as
complete a fashion as possible but when an environment is particularly volatile,
specifying the all the terms of an agreement in advance is likely to prove next to
impossible. This in itself need not present a difficulty unless the firm becomes
locked-in to its outsourced provider. If this happens the supplier may choose to
renegotiate on terms that benefit it, rather than its customer.

Contractual lock-in occurs if the contract requires the buyer to make some form of
highly specialised investment in the relationship. The investment might take the form
of time. An organisation that has spent months negotiating and implementing an
outsourced relationship might be reluctant to write-off all of this hard work –
especially if re-sourcing means repeating the effort with no greater chance of success
next time around. Alternatively, firms might have made substantial and non-fungible
investments in specialised training or equipment (otherwise known as asset specific
investments). Less creditably, though, firms are often reluctant to call time on a
poorly performing supplier if the managers who negotiated the contract have a
significant reputational investment in the deal. Calling a halt to the affair means
admitting that they got it wrong and nobody likes doing that. Whatever the form of
the lock-in, the effect is the same: the firm loses its capacity to impose costs on the
vendor and thus its ability to impose discipline.

Of course just because a contract presents the firm with a risk, it does not follow that
the risk cannot be managed and that the generic supply strategy cannot be effectively
managed. For example, one strategy often pursued by firms involves unbundling a
contract. This means separating out those elements that pose a risk from those that do
not. The highly risky elements are retained in-house and only the less risky elements
are outsourced. The supplier may even be asked to post a bond or share the costs of
the dedicated investments, as a sign of its good faith (i.e. to show that its word of
honour and commitment to the relationship are credible).

Having recorded all data relating to pre- and post-contractual power structures, the
manager must then consider the issue of contractual uncertainty. First, they should
indicate their level of confidence in the initial investment estimates
(high/medium/low). Should their confidence be low they should then indicate
whether the costs will ultimately be revised downwards (or more importantly),
upwards. If the manager concludes that there is a significant risk that the estimates
regarding one of the more substantial areas of investment are soft, then they will need
to allocate exposure. If it is likely that the initiative will lead to the firm being locked
into the relationship and the cost figures are considered soft, the manager may well
wish to consider whether or not the strategy makes commercial sense. If the gains do
not justify the initiative, it may make sense instead to internalise the activity within
the firm. Insource not outsource.

Finally, the manager must think about the returns from the investment. However,
performing such a calculation is by no means straightforward. This is because the
concept of Value for Money (VFM) is actually an equation, where dividing
functionality by cost arrives at the figure. Improving VFM can be achieved in the

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Managing the Supply Base within Business Markets

following obvious ways: improving functionality while reducing cost; improving


functionality while maintaining cost; or maintaining functionality while reducing cost.
However, it can also be achieved in a number of less obvious ways: improving
functionality while increasing cost (where the functionality increase is greater than the
cost increase); or reducing functionality while reducing cost (where the fall in
functionality is less than the fall in cost)

It is not necessary for all of the elements of a deal to improve in order for the deal
itself to improve. If the manager’s strategy is essentially reactive, then there will be
only one type of change: a change in price. However, if a strategy is pro-active a
number of different things might happen. The functionality of the supplier’s products
might be improved. There may be dynamic efficiency gains. The relationship might
also lead to the creation of exploitable new technologies. It is then up to the manager
to ensure that it is his or her organisation that profits from them.

Having identified the range of changes that are possible the manager must then be
able to quantify the nature of the change. Here, three broad options are available.
First, the outcome from collaboration would be positive (i.e. the initiative results in
reduced margins, improved efficiency, improved functionality or delivers exploitable
new technologies). Second, the outcome from the initiative would be negative (the
initiative would cost more than it would yield). Finally, the outcome of the initiative
would be neutral (investment would be equal to return). Of course (as when the
manager is calculating cost), when calculating return he or she must also factor in the
element of risk. Are the projections are accurate or have they greatly
underestimated/overestimated the returns.

Having completed the above, the manager is now in a position to make a judgement
of his or her preferred strategy. The strategy is worth pursuing if the projected
allocated gains exceed the projected allocated costs, after the pattern of risk has been
factored into the equation. The strategy is optimal, though, if it is likely to result in
the greatest pay-off of each of the four alternatives.

Conclusion

We have set out in this article six generic supplier relationship types. We have also
argued that none of these six types of supplier relationship represents ‘best practice’.
Many academics disagree with this and argue that non-adversarial collaborative
relationships constitute a superior form. In our judgement, such a view is misguided
for three main reasons. First, collaborative relationships are not always necessary
because of the nature of the transaction. Second, it is perfectly possible to have a
collaborative relationship with a supplier over which you are dominant. Indeed, we
would argue that collaboration is much easier when you are dominant. Third,
collaborative arrangements with suppliers are not always possible. There are many
occasions when the incentive structure within a relationship is such that the supplier
has no interest in dedicating scarce management resources to it. This will often be the
case in situations of supplier dominance. In such situations there is very little the
buyer can do about it.

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Therefore, rather than thinking in terms of a best practice relationship style, managers
should understand the alternative types that exist in business markets and assess
which of these are desirable and / or possible in the circumstance in question.

References

Cannon, J. and Perreault, W., ‘Buyer-Seller Relationships in Business Markets’,


Journal of Marketing Research, 1999, pp439-460.
Cox, A., Sanderson, J. and Watson, G. Power Regimes, Boston: UK, Earlsgate Press,
2000.
Cox, A., Ireland, P., Lonsdale, C., Sanderson, J. and Watson, G. Supply Chains,
Markets and Power, London, Routledge, 2002.
Cox, A., Ireland, P., Lonsdale, C., Sanderson, J. and Watson, G. Supply Chain
Management: A Guide to Best Practice, London, Financial Times Pearson, 2003.
Watson, G., Cox, A., Lonsdale, C. and Sanderson, J. ‘Thinking Strategically about
Supply Chain Management’, in Waters, D. (ed), Global Logistics and Distribution
Planning, London, Kogan Page, 2003.

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10

Managing Negotiations in Business Markets13

Introduction

The principle of contingency is critical to the effective management of suppliers. This


applies to all the key tasks in the supplier management process including supplier
relationship management (Lonsdale, Cox and Watson, 2003), contract management
and, the subject of this short paper, negotiation management. The principle of
contingency stresses that no single approach to managing suppliers is appropriate
under all circumstances. Rather, different approaches are appropriate under different
circumstances. In this paper, we will discuss how managers can implement the
principle of contingency in the area of negotiation management.

The Contingency and Appropriateness in Purchasing and Supply Management

Over the past twenty years, the purchasing and supply profession has been bombarded
by advice from both academics and consultants. Most of this advice has been directed
at moving the profession away from its adversarial, arm’s length past. Before the
1980s, much of the advice given to purchasing professionals was about how to act
adversarially in order to reduce price. Increasingly, however, this type of advice was
seen to be not only inadequate, but actually damaging. The argument was that ‘lower
price’ had been confused with ‘better value for money’, which were in actual fact very
different things.

Adversarial, arm’s length procurement practice is essentially based upon the perfect
competition model. This states that there are many buyers and many suppliers, all
products sold in the market are homogenous, both parties to a transaction possess
perfect information, there is ease of entry and exit in and out of the market and there
are no barriers to buyers switching suppliers. When a supply market conforms to this
model, and some come pretty close (crude oil and other spot markets, for example), it
makes sense to manage supply in an adversarial, arm’s length manner. The aim of the
game is simply to get the lowest price using competition.

However, most business markets are very different to the perfect competition model.
There are a whole range of different market structures, products are heterogeneous
and are often tailored to the specific requirements of the customer, there is often a
great deal of information asymmetry, exit and entry are often constrained, as is the

13
This chapter is a pre-publication chapter written by Chris Lonsdale and Glyn Watson

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ability to switch suppliers. When buying from a supply market that conforms to this
description the employment of adversarial, arm’s length approaches to managing
suppliers is likely to be far less effective. Buyers requirements are not just about
lowest price, but also concern innovation and adaptation.

As a result, from the 1980s onwards academics and consultants advised practitioners
to move away from such approaches and adopt a much more collaborative approach
to supplier management. Managers were encouraged to develop ‘partnership’
relationships with suppliers, which combine a collaborative way of working with a
non-adversarial approach to the division of surplus value (Lonsdale, Cox and Watson,
2003). It was argued that if buyers and suppliers collaborated to either reduce the
costs of production or increase the value of the product to the buyer (or both) then
both parties would benefit, as the ultimate customer in the supply chain would be
better served.

However, the advice of the past 20 years has constituted a classic case of ‘throwing
the baby out with the bath water’. Whilst undoubtedly being inappropriate in some
circumstances, adversarial, arm’s length approaches to managing suppliers serve other
situations very well. By the same respect, there are times when partnership
approaches are inappropriate. Therefore, rather than collaborative, ‘partnership’
approaches representing a new ‘best practice paradigm’, as many suggested (for
example Carlisle and Parker, 1989; Lamming, 1993; Hines, 1994; Christopher, 2000),
collaboration is just a management tool to be used in those circumstances when it can
be justified.

If anything should be considered ‘best practice’ it should be the adoption of a


contingency approach to purchasing and supply management. A contingency
approach recognises that ‘one size fit all’ approaches are misguided (whatever they
recommend) and that the key is to understand when particular approaches are
appropriate to particular circumstances.

Figure 1 – Managing Appropriately in Negotiation

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Managing the Supply Base within Business Markets

The process has three stages, as can be seen in Figure 1. First, managers should map
out the universe of management tools and techniques that are at their disposal in a
particular area of management (‘features of negotiation’ in this context). Second, they
should map out the variables that are key to determining the different circumstances
that they face. Third, they should adopt a theoretical position that allows them to
understand which tool is appropriate for which circumstance.

Managing Negotiations Appropriately in Business Markets

So, in purchasing and supply management, including negotiation, managers need to


adopt a contingent approach. We now look at the application of contingency thinking
to negotiation in more detail. We do this in two parts. First, we examine certain key
factors that create different supply market and transactional circumstances. Second,
we examine a number of different aspects of buyer-supplier negotiation practice. In
line with the contingency principle, we assess how circumstances might influence
how managers approach the execution of those aspects of practice.

Alternative Supply Market and Transactional Circumstances

We look here at three important factors that create different supply market and
transactional circumstances. These factors interact and are the frequency of purchase,
the level of post-purchase supplier involvement and buyer-supplier power.

Frequency of Purchase
The first key factor is the frequency of purchase. Some of the firm’s transactions with
suppliers will represent one-off purchases, or at least purchases that are relatively
infrequent. This will often occur in project environments, where many of the goods
and services the firm purchases are specific to the particular project they are involved
with. Large capital purchases would be an example. Often with this type of purchase
the buyer will have no further dealings with the supplier of the good or service, at
least not in the short to medium-term. As a result, there is no ongoing relationship
between the buyer and the supplier that has to be sustained or developed.

Level of Post-Purchase Supplier Involvement


The second key factor is the level of post-purchase supplier involvement. Again, a
buyer’s purchases can be divided between those that involve a low level of post-
purchase supplier involvement and those that involve a high level. In the first category
are many goods that the firm buys. For example, if the firm is buying stationary or
basic components there will be little post-purchase involvement with the supplier.
Rather, the supplier will simply deliver the required goods in line with the purchase
order. There may be a need at some stage after the purchase for advice on usage, but
contact will be minimal.

However, there are two other types of purchase that involve a much higher level of
post-purchase supplier involvement. First, the firm will buy many goods that require
significant after-sales services and / or maintenance. If a supplier provides a software
system to a firm the contractual agreement will often include the provision of a
helpdesk or help-line which employees can use if they have problems in using the

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Managing the Supply Base within Business Markets

system. Alternatively, if the firm buys a complex piece of capital equipment the
contract will usually include a maintenance agreement.

Second, the firm will also be a purchaser of services. In the case of services, the
involvement between the buyer and the supplier will obviously continue after the
point of purchase. If a firm purchases training or consultancy from a supplier the
interaction between the two parties will run for the length of the contract, which could
be a number of years.

Buyer-Supplier Power Relations


The third key factor that will affect the approach managers should take to a
negotiation is the buyer-supplier power relation. Power plays a major role in the
relationship between any buyer and supplier. Power has a significant influence on the
degree to which a buyer is able to achieve value for money in its dealings with
suppliers. This is true whether the firm is in an arm’s length or collaborative
relationship type.

We have discussed the concept of power at length in many other sources (Cox et al,
2000; Cox et al, 2002; Cox et al, 2003). To understand the concept we must study the
relative power resources of the two parties. There are three power resources: utility,
scarcity and information. Utility refers to the importance of the transaction to both
parties. Scarcity refers to the ability of each party to satisfy its needs elsewhere.
Information refers to the degree to which there is information asymmetry in the
transaction.

Having assessed the relative power resources of the two parties we are now in a
position to make a judgement on the power relationship that exists between the two
parties. This relationship can be one of four types: buyer dominance; buyer-supplier
interdependence; buyer-supplier independence, and buyer dependence.

A Contingent Approach to Negotiation Management in Business Markets

Having detailed three key factors that determine the different supply market and
transactional circumstances facing buyers, we can see how they impact upon
negotiation practice. We will look first at negotiation style.

Alternative Negotiation Styles


When we think about negotiation styles we need to consider two issues that are
pertinent. First, the behavioural approach taken by the buyer. Second, the commercial
attitude taken by the buyer. When negotiation consultants deal with the issue of
behaviour they tend to refer to two extreme types. They argue that buyers can try to
pursue their agenda through emotional behaviour or through logical behaviour.

An emotional approach can encompass many different things such as the use of anger,
guilt, pity and fear. This approach tends not to deal with the facts of the transaction in
great detail, but rather focuses on broader issues. For example, a manager may get the
impression that his or her opposite number is averse to open conflict. At the beginning
of the negotiation, therefore, the manager could react angrily to one of his or her

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counterpart’s suggestions regarding an aspect of the transaction. The idea is, of


course, to try to make the counterpart take into account the manager’s reaction when
making future suggestions. An alternative emotional behavioural approach is to
appeal to your opposite number’s better nature.

The opposite of this is the logical approach. Here the buyer seeks to pursue his or her
agenda through the use of reasoned argument and adherence to the facts. Therefore, if
the buyer feels he has a good argument on a particular issue of the negotiation, he or
she may wish to set out that argument in detail and explain clearly why a certain
demand is being made. A logical approach may also involve the negotiation being
tightly structured, as one aspect after another is fully discussed.

The second issue relevant to negotiation styles is the commercial attitude taken by the
buyer. Here again, we can break down the issue into a choice between two opposites:
coercion and compromise or bargaining. A coercive attitude is one that is focused on
making the other party accept your demands. The opposite approach is one that
accepts the need for bargaining or compromise. Bargaining concerns the trading of
concessions across different aspects of the transaction, whilst compromise concerns
the settling of differences on one aspect.

If we put both of these issues together we get four alternative relationship styles.
Having assessed the four options managers can then assess their suitability for the
different circumstances they face. With negotiation it is not so simple as to say that
certain negotiation styles always fit certain circumstances. There are always likely to
be other factors at play that will mix things up. For example, the history between the
two firms. In any case, all we have done is present four generic options – in reality
approaches will contain shades of grey. Nevertheless, it is possible to make certain
linkages.

For example, it seems sensible that under conditions of buyer dominance the buyer
adopts a negotiation style of logic / coercive. Under conditions of buyer dominance
the buyer will expect to take the lion’s share of the surplus value – thus a coercive
commercial attitude. However, this should be achievable merely through the logical
explanation of the buyer’s superior position. The buyer can simply explain that he or
she has other options.

Keeping the negotiation on such a footing will help with buyer-supplier relations
moving forward. This will often be important, as it is commonplace under conditions
of buyer dominance for the buyer to wish to enter into a long-term, collaborative
association with the supplier. Even though the buyer has the whip hand in this
relationship, it will still be preferable if this collaboration takes place on amicable
terms. However, if the dominant buyer only wishes a one-off purchase then it can be
less concerned about its negotiation style.

Under conditions of interdependence, it would appear that the logic / bargaining


and/or compromise style fits best. An interdependent relationship will often, or
perhaps even usually, involve follow-up purchases and post-purchase collaboration.
Again a logical approach to negotiation will assist in getting such a relationship off on

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the right foot. In terms of the commercial attitude of the buyer, the mutual dependence
will lead to a need to bargain and compromise.

Under conditions of independence there is not the same imperative. If the relationship
between the buyer and the supplier goes sour it does not matter too much as there are
plenty of other suppliers in the marketplace. Independent relationships will also often
be one-off and involve relatively little post-purchase supplier involvement. Therefore,
whilst the buyer will look at get the lion’s share of the surplus value – a coercive
commercial attitude – the manner in which it tries to achieve this is not obviously
indicated.

Finally, under conditions of buyer dependence the negotiation is an opportunity to try


to salvage a difficult commercial situation. Certainly, assuming that the supplier ‘s
representative is well informed, this is not likely to be best achieved through the
demonstration of a coercive commercial attitude. In terms of the behavioural
approach, whilst there is not a clear indication, it may be that a general emotional
appeal to fairness will be the best bet with some suppliers.

Conditioning as a Negotiation Tactic


A further common negotiation tool is conditioning. This is the process of feeding the
opposite number information – either true or otherwise – in a manner that is designed
to change their perceptions of the negotiation. The buyer will seek to play up the
strengths of his or her own position and highlight the weaknesses of the supplier’s
position. The supplier’s representative will, of course, often seek to do the same.

To give an example of conditioning, a buyer could indicate to the supplier’s


representative that he or she had been in contact with an alternative supplier and
explain that this supplier was a credible alternative. Alternatively, the buyer could
seek to convince the other party that the transaction was of a relatively low
importance to the firm.

However, one would have to question whether such an approach was always
appropriate. If the nature of the transaction was such that led to the buyer seeking a
genuine partnership with the supplier – i.e. the situation is one of interdependence and
there are likely to be subsequent transactions with the supplier – then it may benefit
the firm more to develop a more open and transparent relationship, rather than trade in
cunning words or deeds designed to mislead. On the other hand, if the transaction is a
one-off and involves no significant post-purchase involvement with the supplier then
it will often be worth attempting to obtain a tactical advantage by this means.

Using Time as a Negotiation Tactic


With the issue of time, similar issues arise. In many negotiations time will be a
resource. It will be the enemy of one side and the friend of the other. This will be for a
variety of reasons to do with the two parties commercial positions of the two parties.
One party will often require a commercial settlement more urgently than the other
(see Figure 2). For example, the buyer may urgently need an engine part or software
module so it can deliver a product to its own customer, which might be demanding a

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Managing the Supply Base within Business Markets

short lead-time. Alternatively, the supplier may need to cut a deal quickly because it
has cash-flow problems or the like.

Figure 2 – Time as a Resource in a Negotiation (see lecture notes)

A questions remains, however, as to whether it is always sensible for a buyer to try to


exploit time advantages as and when they arise. The answer is surely not. If the buyer
is dependent on the supplier for a purchase of high utility then it might leave itself
open to damaging retaliation should its tactics be recognised. In other transactional
circumstances, there may also be reasons not exploit such advantages. If there is a
need for the two parties to work together over time in a relationship then such tactics
may affect the working relationship and lead to the potential benefits of collaboration
not being realised – benefits that might far exceed any short-term tactical benefits that
are gained from exploiting time advantages. The same ‘blow back’ might also be
experienced if the firm is likely to re-buy in the near future.

Conclusion

As in all aspects of the purchasing and supply management process, there is a need to
think about what is the right approach to undertaking negotiations with suppliers.
Managers need to consider the nature of the transaction and how that will affect the
need for interaction and collaboration between the two parties. It may be that, having
considered these factors, the buyer decides that the potential long-term gains of
working collaboratively with a particular supplier are not worth being put in jeopardy
by attempts at short-term tactical gain.

As a result, it may be that exploiting time advantages and conditioning supplier


representatives into actions that are against their interests (and may be subsequently
discovered as such) are not deemed the right negotiation tactics for that particular
commercial situation/supplier. However, there may be other circumstances where
short-term (and somewhat adversarial) negotiation tactics are deemed the right choice.
In short, managers need to adopt a ‘fit-for-purpose’ approach to negotiation and
consider each transaction on its merits.

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Of course, there are many other aspects of negotiation beyond the ones discussed
here. For example, there are issues related to the fact that many business negotiations
are cross-national (Gelfand and Brett, 2004). However, issues of nation sit squarely
within the contingency principle – national differences are simply another feature of
the exchange circumstances that affect choices over practice. Non-verbal
communication (or ‘body language’) (Collett, 2003; Ekman and Friesen, 2003;
Morris, 1994), another significant aspect of negotiation not covered here, is a slightly
different case.

There are certainly some features of non-verbal communication that are worth
considering in all exchange circumstances, for example, signals that suggest
confidence (but not arrogance) and assertiveness (but not aggression). It is also
perhaps wise to always be conscious of the possibility that the other party might be
using influencing tactics such as ‘mirroring’ (sometimes referred to as ‘copy-catting’).
Whether you wish to use such, essentially underhand, tactics yourself, however, might
depend on the exchange circumstances.

References

Carlisle, J. and Parker, R. Beyond Negotiation, Wiley, Chichester, 1989.


Christopher, M. ‘The Agile Supply Chain: Competing in Volatile Markets, Industrial
Marketing Management, 29, 2000, 37-44.
Collett, P. The Book of Tells, Bantam Books, London, 2003.
Cox, A., Sanderson, J. and Watson, G. Power Regimes, Boston: UK, Earlsgate Press,
2000.
Cox, A., Ireland, P., Lonsdale, C., Sanderson, J. and Watson, G. Supply Chains,
Markets and Power, London, Routledge, 2002.
Cox, A., Ireland, P., Lonsdale, C., Sanderson, J. and Watson, G. Supply Chain
Management: A Guide to Best Practice, London, Financial Times Pearson, 2003.
Ekman, P. and Friesen, W. Unmasking the Face, Malor, Cambridge MA., 2003.
Gelfand, M. and Brett, J. The Handbook of Negotiation and Culture, Stanford
Business Books, California, 2004.
Hines, P. Creating World Class Suppliers, Pitman, London, 1994.
Lamming, R. Beyond Partnership, Prentice Hall, New York, 1993.
Lonsdale, C., Cox, A. and Watson, G. Developing ‘Fit-for Purpose’ Buyer-Supplier
Relationships: Beyond Partnership – Alternative Supplier Relationship Types,
Proceedings of the Institute of Supply Management (USA) Conference, Nashville,
Tennessee, May 2003.
Morris, D. Body Talk: The Meaning of Human Gestures, Crown, New York, 1994.

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11

Contracts and Contract Management:


Developing Self-Enforcing Agreements14

Introduction

There has been much discussion recently on Spend Matters and elsewhere (for
example, in reports by the UK’s National Audit Office) about why so many major
sourcing projects (and, indeed, routine procurement exercises) go wrong. As
contributions have mentioned, this is not a discussion that will deliver a single answer.
However, a major reason for failure seems to be that buying organisations frequently
enter medium or large-scale contracts without possessing any ‘self-enforcement
mechanisms’. In this short article, the author will discuss what is meant by this
statement, providing examples of both successful and unsuccessful practice.

What is a Self-Enforcing Agreement?

The aim of the buying organisation when it procures goods and services should be to
develop an agreement with a supplier that (a) represents good value for money (to the
extent that market conditions permit) and (b) is self-enforcing. What do we mean by
an agreement that is self-enforcing? It is an agreement between the two parties that is
delivered by the supplier without significant conflict, either in or out of court. Such an
agreement is designed to take the pressure off contract management, although
assiduousness in contract management is still required.

Developing a Self-Enforcing Agreement

Part of the task of developing a self-enforcing agreement was summed up well by


Fiona Czerniawska and Peter Smith (2010) in their recent book concerning the
procurement of professional services: “A good contract defines responsibilities
clearly, is easy to understand and is reasonable and balanced in the eyes of both
parties. As such, it sets the scene for a relationship that may not require much
contractual argument”.

There are a number of elements here. First, the possibility of conflict arising out of a
lack of clarity and poor communication is raised. On many occasions, conflict occurs
purely because of carelessness. Participants to a business-to-business exchange need
to ensure that they execute effectively the basics in terms of contract development.

14
A shorter version of this chapter, written by Chris Lonsdale, originally appeared on the website
Spend Matters in May 2012.

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Managing the Supply Base within Business Markets

Second, the need to (if possible) avoid resentment on the part of the opposite number
is also stressed. A feeling that the other party has been unreasonable and punitive in
negotiations (or other forums for reaching an agreement) can generate a desire to gain
revenge during contract execution, with many contract periods providing innumerable
opportunities to do so. This can then lead to ‘tit for tat’, as the relationship
degenerates and the costs of conflict mount.

The Role of Self-Enforcement Mechanisms

Beyond this foundation provided by Czerniawska and Smith (2010), it is necessary for
buying organisations to consider whether their hopes for a positive commercial
outcome are underpinned by any self-enforcement mechanisms. Such mechanisms
can be understood as contractual or non-contractual features of an exchange that assist
in ensuring that the supplier fulfils (or even exceeds) its obligations under the contract
without significant conflict. They are particularly useful where uncertainty entails an
incomplete contract. Many familiar concepts, mechanisms and practices within the
business-to-business field need to be understood as alternative self-enforcement
mechanisms, with some amenable to being used in combination. We review these
below.

Credible threat of a return to the market


The most obvious self-enforcement mechanism is the (expressed or implied) threat of
exiting a relationship and returning to the supply market, assuming that alternative
sources of supply exist. When organisations are able (and prepared) to go ‘sharp-in,
sharp-out’, when this is understood by the supplier and when the buyer has
considerable visibility of the actions of the supplier (so any under-performance or
opportunism (Williamson, 1975) will be discovered), the supplier has a motivation to
fulfil (or even exceed) its obligations without conflict, or indeed without much
‘prodding’. This is, of course, the basis of market economics, or at least the standard
neo-classical version.

However, in the case of many medium and large-scale sourcing projects or


procurement exercises, exiting a relationship is not straight-forward. Even if there are
provisions in the contract allowing the two parties to exit under certain circumstances,
in practical terms such a move may be time-consuming and expensive and not
attractive unless the relationship has very seriously broken down.

For example, a report reviewing the contractual negotiations between a UK central


government agency and its IT outsourcing supplier noted that the costs that would be
incurred by the government agency if it switched suppliers amounted to £75 million
(National Audit Office, 2001). It was also noted that there would be considerable and
lengthy operational disruptions as well.

Trust and relational contracting


In these circumstances, managers must look elsewhere for a credible self-enforcement
mechanism. One option, of course, is trust (Nooteboom, 2002). Intentional trust, not
to be confused with competence trust, is a second self-enforcement mechanism – in

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Managing the Supply Base within Business Markets

that it is a further reason why a supplier might fulfil (or even exceed) its obligations
under a contract without significant conflict.

In a sourcing situation that clearly does not conform to the ‘sharp-in, sharp-out’
conditions of neo-classical economics, managers within buying organisations can
(should they possess ‘feasible foresight’) anticipate that they will be significantly
locked-in to a supplier once a contract commences and thus vulnerable to ‘hold-up’
(Alchain and Woodward, 1988). An option in order to avoid hold-up is to select a
supplier that has a track record of trustworthy behaviour – that is, a track record of not
exploiting lock-in or other buyer vulnerabilities for additional profit.

Such a supplier fulfils or exceeds its obligations under the contract (and desists from
exploiting buyer lock-in and any information asymmetries that might arise) because of
an ethical commitment to ‘fair dealing’. It is that ethical commitment that is the self-
enforcing mechanism.

Managing a business-to-business exchange using trust as the self-enforcement


mechanism is referred to within the academic literature as relational contracting
(Schepker et al., 2014), with terms such as ‘partnering’ and ‘collaboration’ used
within business circles. As well as leading to the fulfilment of supplier obligations,
trust can also reduce the buying organisations’ transaction costs, whether they be
search costs, negotiation costs, contracting costs or monitoring costs.

Choosing a ‘congruent’ supplier


However, many managers within buying organisations feel uncomfortable about
relying too much upon trust. It may develop during a contract period, but this is not
guaranteed and, indeed, not that likely in some business sectors. As a result, managers
must, once again, look elsewhere.

A further option is to, again, focus on the selection of the supplier, but, this time,
include in the selection criteria the extent to which a supplier values your business. It
can be argued that suppliers that highly value your current and future business are
more likely to deliver upon their promises than those that consider your organisation
to be, at best, a routine customer.

In a recent report, Future Purchasing and Vantage Partners (2010) referred to this as
finding suppliers with which there exists ‘strategic interdependence’. Cox et al. (2003)
referred to it as the selection of a ‘congruent’ supplier. Both are essentially talking
about the buyer selecting a supplier over which it has a degree of power (Lukes,
1974). Power, in particular the power resource of utility (Cox et al., 2003), is another
self-enforcement mechanism.

The development of credible commitments


Managers can also try to develop mutual dependency or lock-in. In a project or
procurement exercise, it may be possible for both parties to make non-transferable
investments in the relationship (sometimes called asset-specific investments) and thus
both have a stake in its success. The transaction cost economics literature calls such a
move the making of ‘credible commitments’ (Williamson, 1985). Equity joint

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ventures can perform this role, as can what are referred to in the aerospace industry as
‘risk-sharing partnerships’ (see case below), although both have other objectives as
well. The latter are commercial arrangements whereby the supplier, rather than being
recompensed by the buyer for its products upon delivery (subject to a payment
period), agrees to make an upfront investment in, for example, the design,
manufacturing and assembly of its product, with its pay-back coming if and when its
customer’s overall product starts to sell and generate revenue.
--------------------------------------------------------------------------------------------------------
Case Study - Risk-Sharing Partnerships in Aerospace

ITP and Rolls-Royce have signed (on 6/2/09) a contract under which ITP will enter
into a Risk and Revenue-Sharing Partnership (RRSP) for the Low Pressure Turbine
(LPT) of the Trent XWB engine. The Trent XWB will power Airbus' new A350 XWB.
The contract could amount to a turnover of 4.9 billion euros over the course of the
engine's life.

The LPT is a fundamental component of the Trent engine. The turbine incorporates
the latest design tools to optimise aerodynamics, with the aim of reducing the engine's
sonic footprint and fuel consumption. Achieving a more efficient engine means higher
temperature resistance is needed which, in turn, makes the mechanical design ever
more complex. Turbine components are subjected to stress levels similar to those
which would be produced by suspending a weight equivalent to 200,000 cars.

The signing of this agreement consolidates ITP's position as the key supplier of LPT
for Rolls Royce’s large civil engines. ITP's participation in this RRSP contract will
cover responsibility for the assembly, manufacture and design of the LPT.

An RRSP, used widely in the aerospace industry and very much in the mould of the
‘hybrid’ or ‘bilateral contracting’ governance structure put forward by Transaction
Cost Economics, is a contractual arrangement whereby the supplier funds part or all
of the up-front development and production costs of the ‘module’ it is supplying to the
customer (in this case the LPT). The supplier then receives part or all of its payment
in the form of a share of the revenue eventually generated by the overall product (in
this case a Trent engine).

This type of arrangement is used instead of the conventional purchase method


whereby the customer simply agrees a price with the supplier for providing the
‘module’, something that is largely paid by the customer ‘upfront’, i.e. before the
customer has started selling the overall product.

Accordingly, the development of the LPT for the Trent XWB will require an upfront
investment of more than 250 million euros by ITP, including material and non-
material investments affecting activity in design, manufacturing and assembly. Much
of this investment will be specific to the production of the LTP for the Trent XWB.

Ignacio Mataix, chief executive of ITP, said: "The agreement we have reached
represents a new step in our strategic alliance with Rolls-Royce in the motorisation of
large commercial aircraft. At the same time, it is an enormous challenge, which will

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Managing the Supply Base within Business Markets

demand the maximum from our productive efficiency in order to make it viable in ITP.
We will need the support of all the social agents who participate with us, directly or
indirectly”.

Mataix’s statement reflects the way in which the use of an RRSP (as against a
conventional purchase method) for a buyer-supplier exchange that is complex,
uncertain and involves ‘asset-specific’ investments affects the risks and incentives
present.

With the conventional purchase method, Rolls Royce would be taking on most of the
financial risk. It would be paying upfront for the development and production of the
LPT (and for the development and production of all of the other ‘modules’ it was
sourcing from suppliers), without knowing how well the engine would sell in the
market, or whether the initial development and production cost estimates would be
accurate. Under the RRSP, ITP is sharing in that commercial risk.

Also, while there is no reason for believing it is the case with these two companies,
the aerospace industry has a history of sometimes difficult buyer-supplier
relationships. The asset-specific investments (and safety certificates) required in
order to develop, produce and sell a product such as an aerospace engine means that
customers have extreme difficulties in switching suppliers during engine development
and production.

Under the conventional purchase method, this fact has often led to supplier attempts
to significantly raise prices during that period of time – transaction cost economists
call this ‘hold-up’, exploiting ‘lock-in’. Suppliers will often negotiate harder once
they feel safely installed as a supplier for the life of the engine.

Under RRSP, the incentives change and the supplier’s priority becomes delivering its
‘module’ as efficiently as possible and to the highest level of quality. It needs the
engine to be a commercial success to see a return on its own investment, so it is
incentivised to make its contribution to that success. Its upfront investment, therefore,
can be considered a self-enforcement mechanism.

(Case story is an amended version of a website announcement by ITP).


--------------------------------------------------------------------------------------------------------

Where it is not practical for both parties to make non-transferable investments, a


different way of making a credible commitment is via the posting of ‘hostages’
(Williamson, 1985). These are financial payments made by one party to an exchange
to offset the vulnerability to hold-up of the other party to the exchange (vulnerability
that arises from having made non-transferable investments). Such payments can be in
the form of a parent company guarantee, liquidated damages or performance bonds.

Operating in a similar manner - i.e. also directed at protecting the party to the
exchange that will be vulnerable to hold-up due to its making of non-transferable
investments, and thus potentially discouraged from actually making such investments
– is the idea of property rights allocation. Property rights can be offered to the

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Managing the Supply Base within Business Markets

potentially vulnerable party as a way of reducing its vulnerability and thus increasing
its willingness to make non-transferable investments.

Contractual bonuses and deductions


Another common, if often badly implemented, self-enforcement mechanism is the use
of contractual incentives. Deductions, bonuses and gain-shares can be included in the
contract as a way of encouraging suppliers to align their performance with the wishes
of the buying organisation. The problem with using such incentives, however, is that
it is often very difficult to make them challenging yet realistic to achieve (as a high
level of knowledge regarding production or service delivery is required) and very easy
to design them in a manner that encourages gaming and other undesirable behaviour.
In particular, it can be hard to successfully lead toward desired performance suppliers
that are really determined opportunists.

Reputation
Buying organisations can also benefit from the desire of a supplier to maintain its
reputation in the market place – reputation is a further self-enforcement mechanism.
Reputation is by no means a perfect mechanism, and doesn’t seem to operate at all in
some business sectors, but research suggests that it is often effective at encouraging
suppliers to honour, or even go beyond, agreements.

Different Mechanisms, Same Aim

There are numerous other self-enforcement mechanisms that could also be discussed,
for example, dual sourcing. The key point, however, is that managers entering into a
significant contract should be asking themselves a key question related to the above
discussion about self-enforcement. That is, what is my reason for believing that the
supplier or suppliers will adhere to (or exceed) the agreement reached in the
negotiations?

Is it that I can use the threat of exit? Is it that I have chosen a supplier that can be
trusted to honour its agreements? Is it that I have chosen a supplier that highly values
my business? Is it that I have developed other mechanisms? Is it that I have developed
a combination of mechanisms - some can and, indeed, should be used in combination
(for example, too much strain should not be put upon contractual incentives)?

If this question cannot be answered satisfactorily then there is a high risk of contract
management becoming something of a struggle. All bets are likely to be off regarding
risk transfer, collaboration and innovation will come at a premium and hold-ups may
occur over variations - all leading to a poor value for money outcome. Indeed, an
inability to develop/negotiate any self-enforcement mechanisms is sometimes a
prompt for buying organisations to re-consider its make-buy decision.

The Importance of Effective Internal Management

It is necessary before we finish, however, to return to the beginning – the beginning of


the procurement process that is. Many of the self-enforcement mechanisms that have
featured here need to be negotiated with the supplier. It will help, therefore, if the

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Managing the Supply Base within Business Markets

buying organisation has a reasonable bargaining position going into those


negotiations.

The strength of a buying organisation’s bargaining position is partly a function of


market conditions, over which it may have relatively little control. However, its
strength is also a function of the effectiveness (or otherwise) of the organisation’s
internal buying behaviours. This is with respect to the demand and supply-side
information it possesses, specification decisions, decisions regarding the correct
number of suppliers to be engaged in a given spend area and the governance
arrangements developed for negotiation and relationship contact with suppliers.

Where the buying organisation exhibits effective behaviours in these respects it will,
as it will have maximised its bargaining position, maximise its chances of both
securing a good initial agreement and developing the self-enforcement mechanism or
mechanisms that will see that deal being adhered to by the supplier during the contract
period, even if there are high switch costs, high levels of uncertainty and the supplier
is opportunistic in nature. If the buying organisation’s internal behaviours are poor, by
contrast, then it may find life more difficult – and, indeed, open itself up to further
supplier opportunism.

An example of how good internal behaviours can assist the firm in securing both an
advantageous agreement and self-enforcement mechanisms is seen with National
Savings and Investment (National Audit Office, 2003). This is described below.

--------------------------------------------------------------------------------------------------------
Case Study – National Savings and Investments
In 1997, National Savings and Investments (NS&I) outsourced its business
operations. This included everything the organisation undertook (e.g. call centre, IT
and processing operations), except for the design and marketing of its financial
products. The ensuing transaction was, not surprisingly, characterised by a high level
of asset specificity and switching costs - and uncertainty. It was also, self-evidently, a
business critical transaction to NS&I.

As NS&I is a public sector organisation, the transaction had to be undertaken in


accordance with the EU procurement regulations. The carefully-crafted initial call for
proposals yielded 90 responses. From these, the NS&I procurement team eventually
generated a shortlist of four potential suppliers. Two of these four were then taken to
‘final bidding’ - the then ubiquitous EDS and a ‘challenger’ firm, Siemens Business
Services (SBS). NS&I’s procurement policy here included keeping both parties in the
frame until it had negotiated a ‘draft contract’ with both of them.

Following all of these stages, a final decision was made to award the contract to SBS.
It was reported that SBS edged EDS on a number of criteria: price, risk transfer
(including liability limits) and transparency arrangements. The contract was for 10
years, with an option to extend.

The NS&I procurement team consisted of a number of different parties. As well as


including NS&I operations and contract managers, there was also a senior

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Managing the Supply Base within Business Markets

management presence and external advisors from HM Treasury and the private
sector. Considerable time was taken to ensure that there was agreement within the
team over both means and ends. It was also felt that there was a need to take time
over the negotiations. This was not easy as there was political pressure for a quick
settlement. However, this was resisted.

The result of the procurement process was the following contractual agreement with
SBS. SBS was to take responsibility for all of the operational tasks relating to the
provision of NS&I financial products. SBS also accepted an undertaking to reduce the
operational costs year-on-year during the 10-year contract period, by percentages, at
the time, covered by commercial confidentiality.

Further contractual conditions included the following. First, the management of new
NS&I products was to be opened up to competition if SBS’s performance was poor.
Second, NS&I would share in SBS profits, if they were deemed to be excessive. Third,
SBS was to take sole responsibility for operational errors. Fourth, 42 KPIs were
established, with an accompanying monitoring regime. Fifth, SBS is obliged to help
with the switching of suppliers (if and when NS&I decide that change is necessary).
Sixth, a formal change process was established to manage the consequences of
uncertainty.

Underpinning all this was a further condition - that SBS’s parent company, Siemens
AG, guarantee SBS’s obligations. Following the negotiations, liability was set at up to
£250m (£120m in any two-year period). The NAO concluded that the liability
provision placed ‘the onus on SBS to improve [should it find itself in a] loss-making
position’.

While procurements such as this are never entirely trouble-free, the outcome of the
outsourcing appears to have been quite positive. A full audit was undertaken by the
NAO after five years. It concluded that NS&I had ‘added value’ to the taxpayer in the
amount of £176m in 2001-2002 and £220m in 2002-2003. Operational performance
was also said to have improved. For example, customer response times had, by 2003,
come down from seven to three days, putting them in line with industry ‘best
practice’. Both parties decided to activate the extension option in September 2004,
leaving the revised contract renewal date as 2014. The NAO provided further
approval regarding performance under the contract in 2005.

Most recently, in 2013, the NAO reported that SBS (acquired by Atos in 2011) had
‘saved £530 million [for NS&I] since 1999, while avoiding significant redundancy
costs’, although the assumptions adopted in this calculation may mean that this figure
is somewhat overstated. The NAO also reported that in 2012 Atos had ‘won a fresh
competition to provide services until 2021, proposing further efficiency savings and a
strategy encouraging customers to switch from post and over-the-counter services to
telephone and online banking’.
--------------------------------------------------------------------------------------------------------

In this procurement exercise, NSI ensured that it possessed the necessary knowledge
and skills (accessing outside organisations where necessary), considered carefully the

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Managing the Supply Base within Business Markets

make-buy decision, managed the internal pressure for a quick settlement of the
negotiations and used the time it earned through stakeholder management by
staggering the selection process.

While there were, no doubt, many bumps along the road, this effective internal
management assisted NSI in securing both a good initial agreement and the self-
enforcement mechanisms – credible commitments, contractual incentives and
compete clauses – that reduced the possibility of post-contractual hold-up. NSI also
acted in accordance with the discussion in this article by deciding to select a supplier
that it felt was ‘congruent’ with NSI (Cox et al., 2003). SBS very much valued this
contract and were thus incentivised to deliver customer satisfaction.

Conclusion

There are, therefore, four main steps to self-enforcement (see Figure 1). First,
effective internal behaviours. Second, ‘reasonable’ behaviour in negotiation. Third,
getting the basics of contracting right. Fourth, developing self-enforcement
mechanisms.

Figure 1. An Overview of the Four Steps

With respect to the latter, none are perfect, not all can be used in all transactional or
commercial circumstances and not all are common to all industrial sectors. But they
are potential options that might well be effective in reducing the burden on contract
management as buying organisation seek to secure good value in often difficult
contractual circumstances.

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Managing the Supply Base within Business Markets

References
Alchian, A. & Woodward, S. (1988). The Firm is Dead: Long Live the Firm. Journal
of Economic Literature, 26 (1), 65-79.
Cox, A., Ireland, P., Lonsdale, C., Sanderson, J. & Watson, G. (2003). Supply Chain
Management: A Guide to Best Practice. London, Financial Times Prentice Hall.
Czerniawska, F. and P. Smith (2010). Buying Professional Services. London, The
Economist.
Future Purchasing & Vantage Partners (2010). Value Delivered by Strategic Supplier
Relationship Management in Major Organisations. Guildford, UK and Boston, USA,
Future Purchasing & Vantage Partners.
Lukes, S. (1974) Power: A Radical View. New York, Free Press.
National Audit Office (2001) NIRS 2 Contract. London, The Stationary Office.
National Audit Office (2003) National Savings and Investments: PPP with Siemens
Business Services. London, The Stationary Office.
Nooteboom, B. (2002) Trust. Cheltenham, Edward Elgar.
Schepker, D., Oh, W-Y., Martyno, A. & Poppo, L. (2013). The Many Futures of
Contracts: Moving Beyond Structure and Safeguarding to Coordination and
Adaptation. Journal of Management, 40 (1), 193-225.
Williamson, O. (1975) Markets and Hierarchies. New York, Free Press.
Williamson, O. (1985). The Economic Institutions of Capitalism. New York, Free
Press.

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Managing the Supply Base within Business Markets

12

Blue Eyes and Brown Hair: Making Sense


of Supply Chain Individuality15

Introduction

What makes an individual unique is the combinations of his or her constituent parts,
none of which are necessarily unusual in themselves but which, when taken together,
provide a human being’s individuality. There are many people born with blond hair
(not to mention those who acquire their blond hair out of a bottle), but there are
somewhat fewer numbers of people with blond hair and blue eyes. There are fewer
still with blond hair, blue eyes, a small nose and perfectly formed teeth. Of those with
these characteristics, however, none are exactly the same.

Supply chains are the same in that no two are identical. Even firms offering very
similar products or services to very similar markets will not necessarily share all the
same customers and all the same suppliers. And, even if they did, their respective
power positions would still, in all probability, be different.

It follows, therefore, that attempting to characterise types of supply chains is rather


like trying to characterise types of human beings  it cannot be done simply or
descriptively if one still hopes to do justice to the subject. Just as it is possible to talk
descriptively about human beings in terms of whether they are men or women, tall or
short, thin or fat, it is also possible to talk descriptively about supply chains. Supply
chains can produce goods or services; they can be innovative or static and they can be
project based or process orientated.

The problem is, whether we are talking about human beings or supply chains, none of
the characteristics described above tell us very much about the motives, aspirations or
capabilities of the human beings or supply chains that we are describing. What we
really need is ways of thinking analytically and predictively about what human
beings, or supply chains, are capable of doing or becoming. When we talk about
human beings this would equate to us being able to make predictions about the type of
person an individual is, and how they are likely to behave under particular
circumstances. This is akin to saying that a person is hard working or lazy, kind or
cruel, morose or happy, altruistic or selfish.

15
This chapter originally appeared in Cox, A., Sanderson, J. and Watson, G. (2000) Power Regimes,
Earlsgate Press.

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Managing the Supply Base within Business Markets

When we apply this way of thinking to supply chains it means that we are searching
for a way of thinking that allows us to make analytic and predictive statements about
how a supply chain can be managed, and how relationships should be organised to
achieve particular valued outcomes. This would be equivalent to being able to say that
one supply chain is, or is not, conducive to an integrated supply chain management
approach. Or that a particular supply chain has a power structure that lends itself to
short-term and agile adversarial opportunism rather than long-term non-adversarial,
collaborative relationship building. But how is one to arrive at this predictive and
analytic approach to supply chain analysis?

Our view is that the answer to this question is simple enough if one starts from first
principles in building an analytical picture of any supply chain. Rather than trying to
look at the big picture all at once and then encapsulate all of the diversity of a supply
chain in just a few words, a better approach is to look at the constituent elements of
the chain individually and then piece them together like a jigsaw. Then, the question
becomes, not what type of supply chain is this descriptively, but what, analytically, is
the power regime that has to be managed in the extended network of dyadic buyer and
supplier exchange relationships in the chain?

This chapter attempts to explain how to begin this way of thinking by first looking at
a simple supply chain and its power regime. Having explained how a simple supply
chain power regime is analysed we move on to explain how the power regimes that
exist in more complicated supply chain networks can be analysed.

Power in Simple Regimes

Figure 1 is made up of 16 highly stylised buyer-supplier exchanges. They each


represent a power regime. Each regime is comprised of two interlocking buyer-
supplier relationships, which we call AB and BC. Here the reader should not be
intimidated by the rather technical-looking use of symbols. It might look like maths,
but it is not. It is just a short hand to accompany the description – so the reader can
see more clearly, which regime we are talking about.

Each of the buyer-supplier relationships, which we will call dyads from now on, is
categorised according to the power relation that exists within it. That is, according to
whether the exchange is characterised by buyer dominance (or power), supplier
dominance (or power), buyersupplier interdependence or buyersupplier
independence. In the figure, the existence of buyer power is indicated by the symbol
(A > B or B > C); supplier power by (A < B or B < C); buyersupplier
interdependence by (A = B or B = C); and buyersupplier independence by (A 0 B or
B 0 C).

These 16 regimes are divided into four groups on the basis of the power relation that
exists between A and B. This is described in the text as the downstream relationship.
It is called this because physically, goods and services are being passed from the firm
(B), down the chain to its customer (A). It is rather like a river flowing, down into the
sea.

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Group 1 contains those regimes where A has power over B (A > B). Group 2 contains
those regimes where A and B are interdependent (A = B). Group 3 contains those
regimes where A and B are independent of one another (A 0 B). Finally, Group 4
contains those regimes where B has power over A (A < B). We have then placed four
regimes within each of these four groups, on the basis of the power relation that exists
between B and C. Each one of the four possible power relations between B and C is
represented in each group. We refer to this as the upstream relationship, because the
firm (B) stands between the source (C) and its final destination (A). This leads to the
generation of 16 exchange regimes in total.

Table 1. Value Appropriation in Double-Dyad Exchange Regimes


Group 1
Regime 1 Synchronised Buyer Dominance Regime 2 Downstream Dominance–
Upstream Independence

A>B B>C A>B B0C


A B C A B C

Regime 3 Downstream Dominance– Regime 4 Downstream Dominance–


Upstream Interdependence Upstream Dependence

A>B B=C A>B B<C


A B C A B C

Group 2
Regime 5 Downstream Interdependence– Regime 6 Downstream Interdependence–
Upstream Dominance Upstream Independence

A=B B>C A=B B0C


A B C A B C

Regime 7 Synchronised Interdependence Regime 8 Downstream Interdependence–


Upstream Dependence

A=B B=C A=B B<C


A B C A B C
G rou p 3
R eg im e 9 D ow nstream Independence– R eg im e 10 Synchronised Independence
U pstream D om inance
A0B B>C A0B B0C
A B C A B C
R eg im e 11 D ow nstream Independence– R eg im e 12 D ow nstream Independence–
U pstream Interdependence U pstream D ependence

A0B B=C A0B B<C


A B C A B C
G rou p 4
R eg im e 13 D ow nstream D ependence– R eg im e 14 D ow nstream D ependence–
U pstream D om inance U pstream Independence

A<B B>C A<B B0C


A B C A B C
R eg im e 15 D ow nstream D ependence– R eg im e 16 Synchronised B uyer D ependence
U pstream Interdependence
A<B B=C A<B B<C
A B C A B C

The flow of value between exchange partners is held to operate according to the
following set of rules. Where a situation of buyer power or of buyersupplier
independence exists, we contend that value flows from the supplier to the buyer (B to
A, or C to B). In the context of independence, this occurs because competition in

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Managing the Supply Base within Business Markets

either B’s or C’s marketplace is forcing them to offer their respective customers a
good deal. If they don’t, their customers will go elsewhere.

In the context of buyer dominance, value flows to the customer because the supplier
has few alternatives for its products. Where a situation of supplier power exists, we
contend that value flows from the buyer to the supplier (A to B, or B to C). Again, the
reason for this should be obvious. If there is no real choice in the supply market, or if
firms in the supply market are co-operating to fix prices, then its/their customers
would not expect to get the best possible deal. Where a situation of interdependence
exists, we contend that the pains and gains of the relationship will tend to be shared.
In effect, this type of power structure best supports the lean ideal.

Those actors within each regime that are in a position to appropriate and accumulate
the available value are represented by a black square, while those from which the
value is being appropriated are shown as a white square. This is to make it easier for
the reader to spot at a glance, the winners and losers from each power regime.

It is unnecessary to describe the exchange characteristics of all of the different power


regimes shown in Figure 3. By just describing a few examples the reader should be
able to work out on their own what is happening in the remainder. A more detailed
exposition is provided, however, in the longer companion volume to this book, Supply
Chains, Markets and Power.

Listed in the order that they appear, the regimes that will be discussed are Regime 10
(Synchronised Independence), Regime 7 (Synchronised Interdependence), Regime 13
(Downstream Dependence-Upstream Dominance), and Regime 4 (Downstream
Dominance-Upstream Dependence). As we shall see, the selection of these four types
is not undertaken randomly, but rather is a reflection of the particular and important
type of business context that each highlights.

If one were to turn to an economics textbook to find out what the power regime in a
supply chain ought to look like, it would soon be obvious that this issue is not
addressed. However, if one were to extrapolate from what the textbook says about
dyadic relationships, the reader would soon find that the power regime would
approximate to Regime 10, Synchronised Independence.

Economists like to conceive of economic relationships taking place in an ideal world,


comprised of many interlocking markets, which in turn are inhabited by a myriad of
buyers and sellers. Furthermore, in this ideal world information would be relatively
costless and easy to obtain. Under such circumstances firms would be forced to
compete constantly just to survive.

This is because in such a market, with information so easy to obtain, any supply
innovation would be easily copied and the value to the firm that created it would be
quickly dissipated. Furthermore, in a world of free information, opportunism would
be impossible. The opportunistic behaviour of the would-be cheat would easily be
spotted and any such firms would quickly lose their business with any of the

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Managing the Supply Base within Business Markets

customers or suppliers of which they tried to take advantage. They would also
probably lose their reputation into the bargain, as word got around.

In such a world, value always passes to the end-customer. If C is not prepared to


delight B or if B is not prepared to delight A, then the buyer in each case, will find a
firm that will. Therefore, C passes value to B and B then passes it onto A.

Fortunately for the firm, however, the economist’s model is something of a rarity.
What entrepreneur would want to speculate in an environment where it was
guaranteed that their profits would quickly fall towards zero. There are some
observers who would actually go so far as to say that it describes an environment that
has never, will never and could never exist.

More common is the circumstance in which, despite the existence of many buyers and
many sellers, one side still has certain informational advantages over the other party.
In a world where there is no customer loyalty (because there is such a wide choice of
suppliers), but in which information is not freely available, people will learn to cheat.
Indeed, in such an environment, opportunism becomes a commercial necessity.
Suppliers are forced to inflate prices as a hedge, so that they can bring them down
again if it looks like they will lose a contract and they need to win back the business.
Without such a hedge, the firm has no fallback position.

Similarly, the supplier may not make available all of the innovation that they might.
Once again, the hope would be to offer it when it was most needed. Certainly, without
the guarantee of repeat business, many firms will be reluctant to invest in their
customers.

This is what lean thinkers say has happened in many Western markets. The difficulty
with such an approach, they claim, is that when firms are finally exposed to
competition from markets where opportunism and hedging has not been the norm,
they find themselves considerably behind the productivity frontier. In the place of
opportunism lean supply offers co-operation. Where interdependency exists, where
continuity of relationship is guaranteed, the requirement to hedge is eradicated.

Furthermore, the ability to do so is also removed. In an interdependency information


is exchanged and when this happens it is difficult to cheat without getting caught.
Instead of confronting each other, the participants in a lean enterprise work together to
improve the position of everyone associated with the network. ‘All for one and one
for all’ might well be the motto. The regime that probably most closely describes this
circumstance is Regime 7, Synchronised Interdependence.

In Regime 7 (A = B = C), the value is shared equally, because each of the parties is
dependent upon the other. A is dependent upon B, which is in turn dependent upon A.
In the same way, B is dependent upon C, which is in turn dependent upon B.
Consequently, A and C are also interdependent, because if either party fails, B would
suffer equally.

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Managing the Supply Base within Business Markets

One problem with this regime type is that it may not be the most profitable position
for the firm to be in. It is almost certain that it will not be the most flexible.
Interdependence requires the firm to share and consult. If £100 is saved through co-
operation, a fair allocation would be one third to each of the participants. This would
be one third that might not otherwise have been available in an arms-length
adversarial existence, but it is two-thirds less that the firm would have got if it had
configured the supply chain so that it could engineer the savings and keep all of them
for itself.

Similarly, interdependence is a discipline. Parties cannot just do what they want, but
must proceed through mutual consent. Compromise is not a dirty word, but it is
definitely a difficult one and sometimes a dangerous one. Sometimes the firm needs to
follow its own path, whatever the consequences for others. Interdependence places
restriction on the pursuit of self-interest.

This is why most business strategy writing tends to see the world in a rather different
way. Regime 13, Downstream Dependence-Upstream Dominance (A  B  C), in
which a firm B, is able to leverage both its supplier and customer relationships to
appropriate the bulk of the value, probably comes closest to the model developed by
Michael Porter in his 1980 book, Competitive Strategy. Conversely, the Downstream
Dominance-Upstream Dependence illustrated in Regime 4 (A  B  C) probably
comes closest to Porter’s model of business failure. Certainly, in such a regime, firm
B would be the net loser.

Power in Complex Regimes

The double-dyad exchange regimes discussed above provide a rather stylised version
of how supply chain power relationships actually operate. It is possible, however, to
apply the same rules to a more sophisticated representation of a supply chain. In
Figure 2, we have constructed two hypothetical supply chain power regimes. These
are based on the linkage of dyadic exchange relationships consisting of eight agents
(A, B, C, D, E, F, G and H).

We have joined these agents together by means of seven exchange dyads (AB, BC,
CF, BD, DG, BE and EH) to create a complex network of relationships linked
together to create goods and/or services for end customers. In effect, these could be
seen as supply chains consisting of an end customer (A), an assembler (B), three
components suppliers (C, D and E) and three suppliers of raw materials (F, G and H).

In both of these hypothetical supply chain power regimes the BC relation (B  C),
the CF relation (C  F), the BD relation (B  D), the DG relation (D = G), the
BE relation (B = E) and the EH relation (E 0 H) remain fixed. The only difference
between the two networks is the A-B relation. Two of the four possible dyadic
exchange circumstances are mapped on to this relationship in each power regime.
Buyer dominance and buyersupplier independence are grouped together in Supply
Chain Power Regime 1, while supplier dominance and buyersupplier
interdependence are grouped together in Supply Chain Power Regime 2. As we will
explain later, the dyadic exchange circumstances have been grouped together in this

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Managing the Supply Base within Business Markets

particular way, because, in the context of each of these power regimes as a whole,
they lead to the same value appropriation outcomes.

In both of the power regimes shown, the value flows from F to C to B as a result of
the series of cascading power relationships that operate to B’s advantage. Like a series
of Russian dolls, C appropriates value from F, only to see this value in turn
appropriated by B. Similarly, in the double-dyad exchange regime containing B, E
and H, E is able to appropriate value from H by virtue of the independent relationship
between them. E must then share at least some of this value with B, because these two
actors do business on the basis of an interdependent exchange relationship.

In both networks, however, B’s grip on the value that it appropriates from each of
these double-dyad exchange regimes is at best only tenuous. This is because, in the
remaining double-dyad exchange regime (containing B, D and G), B is dependent on
D and is, therefore, likely to be leveraged by D. At the same time, D’s
interdependence with G means that the benefits that D derives from its association
with B are likely to be shared with G.

As we can see, therefore, the value appropriation outcomes on the supply (upstream)
side of the assembler (B) are the same in both of our hypothetical exchange networks.
The principal difference between the networks relates to the exchange circumstances
that exist between B and its end customer (A). In Supply Chain Power Regime 1, B is
assumed either to be dependent upon A (A > B) or to have an independent
relationship with A (A 0 B). In both of these exchange circumstances, B is forced to
pass value to A by pricing its product at or near the cost of production.

Table 2. Value Appropriation in Complex Power Regimes


S u p p ly C h a in P o w e r R e g im e 1 .

B >C C >F
C F

A >B B <D D =G
A B D G
A 0B

B =E E 0H
E H

S u p p ly C h a in P o w e r R e g im e 2 .

B >C C >F
C F

A =B B <D D =G
A B D G
A <B

B =E E 0H
E H

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Consequently, in Supply Chain Power Regime 1, B is being leveraged both by its


customer and by one of its major component suppliers (D). Any value that B is able to
appropriate in its relationships with C and E is therefore immediately passed on to A
(in the form of low prices) and D (in the form of inflated boughtin costs). The profit
margin being earned by B in these circumstances is likely to be extremely low.

The value appropriation outcome from the AB relation in Supply Chain Power
Regime 2 is radically different. In this case, B is assumed either to be interdependent
with its customer or to have power over A. As the diagram shows, however, the value
appropriation outcome under both of these exchange circumstances is a function of
B’s dependence on D. Thus, where A and B are interdependent with one another, A
is forced to share in the exploitation being visited on B by D. All of the value created
by the association between A and B is appropriated by D, which then shares this value
with G.

Conversely, where A is dependent upon B, B is able to appropriate value from A by


charging a price that is significantly above its cost of production. Nevertheless, B
cannot retain this value in the form of higher margins, because it must pay the inflated
prices being charged by D. As before, D shares the value that it appropriates from B
with G.

It seems clear, therefore, that this approach to analysing the dyadic relationships that
operate between buyers and suppliers in the complex networks of exchange adds an
additional level of understanding to many of the current descriptive approaches
towards supply chain categorisation. It should also suggest that there is a significant
potential for power imbalances in buyer-supplier relationships to undermine the
search by practitioners for integrated supply chain management solutions.

The reasons for this are self-evident. If operational efficiency is to be achieved in a


supply chain, then the flow of inputs from raw materials to the assembled good or
service needs to be effectively co-ordinated. All too often, however, the requisite level
of co-ordination cannot be achieved, because supply chains are characterised by
power regimes that are hostile to an uninterrupted flow of value from the end
customer to raw material providers. It is for partly this reason  the self-regarding
efforts of some supply chain actors to appropriate value  that so many attempts at
integrated supply chain management have failed, and will continue to do so. And, it is
to this issue of appropriate business management in supply chain relationships that we
now turn.

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13

Cases in Supply Base Management

In the last chapter of this module reader, we present a series of case exercises that we
use in our teaching of make-buy, procurement and supply management. We tend to
prefer cases that are quite short and focus upon a particular aspect of the topic in
question. For reasons of copyright, we have only included in this chapter cases that
we have written in their entirety ourselves.

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Make/Buy at CNT: An Outsourcing Case Study

Introduction and Recent History

Comm-Net Technologies (CNT) is a manufacturer of telecommunications equipment.


Its main product is a piece of hardware used by telecommunications providers to test
the frequency settings of their own equipment. The company currently enjoys a
market share of 45% in a market that is a niche part of the overall telecommunications
hardware industry. The recent financial figures for CNT are as follows:

2008 2009 2010


Overall Turnover (£m) 123.9 134.6 141.3
Turnover in Frequency Testing Equipment (£m) 102.4 110.2 116.0
Other Turnover (£m) 21.5 24.4 25.3
Profit after Tax (£m) 25.6 26.6 26.3
Market Share Frequency Testing Equipment 47.3% 46.4% 44.8%

The reason for CNT’s historic success is the superior technology it has consistently
developed. CNT’s product has allowed its customers to measure the frequency of their
systems far more accurately than those of its competitors. This is something that
CNT’s customers value highly as it enables them to provide their own (industrial)
customers with a more reliable service.

However, there is a price to pay for the superior functionality. CNT’s product, at
£1780, is over twice as expensive as the most expensive of its rivals. This is of some
significance, as CNT’s average customer will be using over 2000 of the products at
any given time. To put it another way, whilst CNT’s customers have been prepared to
pay a premium for CNT’s technology they are still price sensitive and have been
keeping a close eye on the development of CNT’s competitors.

The Changing Market for Frequency Testing Equipment

And herein lies the problem for CNT. Whilst currently being in a strong market
position there is change in the air. CNT’s lower cost rivals are getting better. As was
mentioned above, CNT’s pricing policy has always been based upon the fact that it
has a technological lead and that the superior functionality of its product makes a
significant contribution to its own customers’ competitive position.

Whilst CNT’s competitors have not been able to directly imitate the continually
developing processing capability of the CNT product, two rival companies, Frequency
Labs Europe and FTE, are getting to the stage where their ‘copycat’ alternatives are
almost as effective. At the moment CNT’s customers have certain sunk costs in their
arrangement with it, but their buyers are just starting to talk about these alternative
products in negotiations – although just in terms of subtle hints at the moment.

The key for CNT is time to market. Over the 18 years that the company has been in
business, CNT has brought out a new version of its product every 5 to 8 months -

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something that hasn’t really changed over the years. Historically, this has been fine,
but now CNT’s competitors are reacting quicker to CNT. Both Frequency Labs
Europe and FTE are now able to bring out their ‘nearly’ alternatives before CNT has
moved onto a new generation of product. Previously, whenever CNT’s rivals have
brought out a decent alternative, CNT have blown them out of the water very quickly
with a new leap forward. Now CNT’s competitors have a window of opportunity
before CNT moves the game on – the ‘me-too’ products are getting better and coming
out quicker.

It is clear that CNT’s historical position of being able to bring out an improved
product every 5 to 8 months is not sustainable. If CNT is to continue to be able to
premium price it has to improve on the current length of time it takes to develop and
bring to market its new generation product. It would also help if it could get its
production costs down as well. Running the large production plant in the M4 corridor
is expensive and the employee benefits at CNT are generous. Even market leaders
need to think about cost.

But there is a significant structural problem for CNT. Currently, CNT is a highly
vertically integrated company that develops and produces nearly all the product in-
house. This is now looking a rather cumbersome way of organising, especially when
placed against the more ‘fleet of foot’ Frequency Labs Europe and FTE.

CNT’s Product and Production Process

There are various elements to CNT’s product and production process that need to be
understood.

Research and Development


In order to produce a new version of the testing box CNT have to undertake
significant research and development. This is particularly directed at the frequency
processors and operating software. It is this R&D that allows CNT to maintain its
technological lead and is something that the company is fully committed to.

The Make-up of the Product


The product itself consists of the following parts:

 Frequency processors
 Operating software
 Steel fabrication for the product’s casing
 Generic printed circuit boards and assemblies
 Equipment cooling system
 Digital display system
 Electrical system and cabling
 Various minor components

Assembly and Beyond


Once these elements have been updated and manufactured there are four further
stages to the production process:

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 Assembly
 Product testing (there are industry certification standards that have to be met)
 Packaging
 Transporting to customers

The first two of these stages are worthy of discussing a little further. The
configuration and assembly stage, of course, is where CNT production engineers
bring together all of the separate elements to produce the final product. However,
there are three parts to the process. First, the main framework of the box is assembled.
This involves putting together the PCBs and PCAs, the cooling system, the display
system, the electrical system and cabling and housing it in the steel casing. The
second stage involves the integration of the frequency processor with the basic
framework. This is a high technology, CNT-specific processor that provides the
testing box with superior speed and accuracy. Finally, there is the installation of the
proprietary software. The software is designed slightly differently for each of CNT’s
customers so that the equipment is fully compatible.

The testing stage is where the CNT engineers ascertain that the product, once in its
finished state, performs at a level that not only clears the industry standard, but also
conforms to CNT’s own standards, which are higher. The testing stage also makes
sure that the equipment is fully compatible with the particular customer’s systems.
This testing task is a highly specialist one that requires an understanding of both the
product as a whole and the software, in particular.

After-Sales Service
A final issue that should be mentioned is CNT’s after-sales service. CNT offer a
comprehensive service to its customers that includes:

 On-site maintenance service


 Instruction on use
 ‘Troubleshooter’ helpline
 Warranty deals

CNT’s Future Options

As was mentioned, at present the whole process of researching, developing and


producing a new version of the product takes 5 to 8 months. As soon as the product is
finished and tested it is sent straight to market – there is no strategic product timing
here.

CNT’s board has now set up a production sub-committee to investigate how the
company can reduce this lead-time. It is believed that reducing the level of vertical
integration will have a significant impact on this, and provide opportunities to reduce
the company’s costs of production. However, there is concern in the company about
outsourcing. The company has only previously outsourced its facilities and is
concerned that it might end up ‘outsourcing its competitive advantage’. The first task
of the sub-committee, therefore, has been to undertake an analysis of what are CNT’s
‘core’ and ‘non-core’ activities.

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Task:

The sub-committee has produced a matrix and this is to be completed for a review at
the next board meeting:

‘Core’ ‘Non-Core’ Outsource


Yes/No
Research and Development
Manufacture of frequency processor
Development of operating software
Manufacture of steel casing
Manufacture of PCAs and PCBs
Manufacture of cooling system
Manufacture of digital display system
Manufacture of electrical system and
cabling
Manufacture of minor components
Assembly of testing box
Testing of the testing box
Packaging
Transportation to customers
After-sales service

The year of the case is 2011.

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Managing the Supply Base within Business Markets

Breakthrough Pharmaceuticals: The


Outsourcing of the Payroll Function

Background to the Case

Breakthrough Pharmaceuticals plc (BPharm) is a large manufacturer of anti-biotics.


Established in 1968, the company now has a turnover of $2.3 billion and employs
about 5,700 people. During the 1970s and 1980s, the company made very large
profits. It was able to do this because it acquired patent protection for a number of its
cutting edge medical products.

However, in recent years BPharm’s fortunes have declined. Its research and
development activities have not led to any major new breakthroughs and most of its
products are now ‘off-patent’ and being replicated by generic drug companies. As a
consequence, BPharm’s profits have fallen and the company is now much more
interested in cost control than was ever the case in the past.

This new focus on cost control has been the driver behind a number of structural
changes that have been made, not least in the area of manufacturing. Basically, the
company no longer manufactures its drugs – this has been outsourced to contract
manufacturers.

However, the company’s outsourcing has not stopped there. Over the past 2 years,
BPharm has outsourced many of its corporate support services, to suppliers with much
lower wage structures. Already, the list of services that have been outsourced is a long
one. It includes cleaning, catering, reprographics, security, logistics, building
management, aspects of corporate information technology, warehouse management,
corporate training and development, accounts payable and receivable and even certain
low-value procurement.

This programme of outsourcing has been largely successful, although there have been
difficulties with some of the information technology suppliers and the company
suspects that the procurement service provider is not passing on to BPharm all of the
cost savings it is achieving on its behalf.

The Outsourcing of the Payroll Function

The latest decision is that the payroll function is to be outsourced. This function
includes the calculation and management of not only pay, but also pensions, taxation
and performance-related bonuses. Whilst it is extremely important for morale that
employees get paid promptly at the end of every month, it is clear that this, like the
other support services outsourced thus far, is a non-core activity for BPharm.

This decision, like all the others, has been made by the ‘Support Services Outsourcing
Review Panel’. This panel is empowered by the chief executive and chaired by the
finance director. The job of procurement, therefore, is not over whether payroll is

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outsourced but rather over how it is outsourced. And, as with any outsourcing, there
are a number of issues that need to be sorted out.

Details of the Outsourcing of the Payroll Function

The payroll function is a sizeable department in its own right. It currently employs 45
people, which include clerical staff, pension advisors, software developers and finance
specialists. The current operating costs of the department can be seen in Exhibit 1.

Exhibit 1: BPharm Payroll Operating Cost Structure


______________________________________________________________________

Salaries $ 1, 618, 869


Employer Pension Contributions to Payroll Staff $ 219, 290
Equipment, Materials, etc $ 178, 534
Overhead Allocation $ 473, 867

Total Annual Operating Costs $ 2, 490, 560


______________________________________________________________________

In October 2000, following the decision to outsource, the procurement department put
out a request for quotation (RFQ). The conditions that BPharm procurement laid
down was that bidders should provide detailed and disaggregated information on
labour costs, equipment and materials costs and overheads. BPharm procurement
informed suppliers that they would be allowed a profit margin on top of these costs of
8%. By the closing date of 31st December seven credible bids were received. After an
analysis of these, it was decided that the procurement team should pursue negotiations
with the company Bergman Consulting. This company has a good profile in the
market and its proposal for undertaking the operation was a cut above the rest. A
headline summary of its proposal can be seen in Exhibit 2.

Exhibit 2: Bergman Consulting: Proposal for BPharm Payroll Operation


_______________________________________________________________

Labour costs $ 1, 423, 987


Equipment, Materials, etc $ 168, 879
Overhead Allocation $ 356, 988

Total Annual Operating Costs $ 1, 949, 854

Profit as a Percentage of Total Operating Costs $ 155, 988

Annual Charge to BPharm 2000-2001* $ 2, 105, 842


_______________________________________________________________

* This charge will be held at the same rate for the year 2001-2

The figure of $2.1 million that Bergman Consulting has put forward would represent a
cost saving to BPharm of 15.4%. This saving is to be achieved through lower labour
costs and lower equipment costs. The lower labour costs reflect the fact that Bergman
Consulting believes that it can run the operation with less than the current number of
employees. The plan is for BPharm employees to transfer with the contract and

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become Bergman Consulting employees. Bergman says that it only requires 39 of the
45 BPharm employees, but as it happens this reduction can be achieved without any
redundancies, as 10 of the BPharm employees do not wish to transfer to the supplier
and are moving to employment elsewhere.

The lower equipment costs, meanwhile, reflect the economies of scale that the
specialist supplier is able to provide. It is running similar operations for a number of
other clients and, whilst Bergman Consulting will still be using BPharm’s existing
software system, scale economies will be achieved in other parts of the operation.

In summary, the deal is expected to be a standard transaction. Bergman Consulting is


a company with many clients in this and other fields of treasury management so this
contract only represents a small part of its turnover. BPharm expect a good deal,
however, because the market for this type of service is highly contested. BPharm’s
view is that it expects both parties to see the contract as a positive but relatively
unremarkable transaction. The changeover to Bergman Consulting is expected to take
about two to three weeks.

Bergman Consulting’s Offer of a Software Update

Being a straightforward transaction, the procurement team from BPharm had expected
to close the deal very quickly, but a slight complication has emerged. The finance
director in charge of BPharm’s outsourcing review panel recently contacted the Head
of Procurement and reported that Bergman Consulting, having been told that it was in
a good position to win the contract, have offered to update BPharm’s payroll and
pensions software.

BPharm’s current software is, amongst other things, used to keep a database of its
employees’ financial records, manages the company’s payments to its employees and
the IRS, produces payslips and other relevant documentation and manages the process
of transferring cash from the company’s bank account to those of its employees.
There are no major problems with the current BPharm software system, but it is an
old system that has more efficient successors. Being a specialist service provider,
Bergman Consulting has the very latest in financial software. The company has
developed proprietary software that performs all of the above listed tasks much better
and contains other features as well.

For example, its software has the additional facility of being able to undertake
scenario planning. It can calculate how company employment policy changes will
affect both the company as a whole and employees as individuals. This capability
allows users to put a number of different potential policies through the system and
receive data sets that can be used to inform board level discussions. This is something
that is currently done by BPharm slowly, labour intensively and on the basis of
estimation.

Bergman Consulting says that it is offering the new system for two reasons. First, the
account manager says that it is a gesture of goodwill and a sign of the company’s

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intention to “develop good and lasting working relations”. It wishes BPharm to see it
as a ‘partner’ rather than a mere supplier.

Second, Bergman Consulting are looking to gain financially from the offer, something
that it is being quite open about. The new system will significantly increase the
efficiency of the whole operation and will mean that staff numbers can be reduced
further. If we remember, in the original offer the plan was to reduce staff numbers
from the current 45 to the lower number of 39. As ten BPharm payroll employees did
not wish to be transferred, four new employees were going to have to be recruited to
cover the net shortfall.

Bergman Consulting is now saying that if the new system is adopted replacing those
four employees will not be necessary. Furthermore, it claims that the new system
would lead to further efficiency gains. Bergman Consulting estimates that all this will
yield a further cost saving about 7.6% - on top of the 15.4% already in the bid.
Bergman Consulting’s proposal suggests that should this additional cost saving be
achieved it should be split, 60% to the buyer and 40% to the supplier.

The Process of Changing to Bergman Consulting’s Software

There is no doubt that Bergman Consulting are offering a good system. It is also clear
that the Finance Director, eyeing further cost savings, is keen to accept the offer.
However, the procurement team argued that the full implications of accepting the
system needed to be investigated. This is what it came up with after it had looked into
the matter.

First, the change-over appears to be something that could be managed fairly safely
and efficiently. Although the two systems are different they are from the same broad
‘family’ of systems. Therefore, a reasonably straightforward data transfer exercise can
be undertaken. There will be some disruption during the process, but this can be
minimised if handled properly.

Second, although the transfer does not provide insurmountable problems, once it is
undertaken it cannot be reversed. Whilst data can be transferred from an old to a new
system, the reverse is not possible as the old system does not understand all of the
commands of the new. BPharm’s old system, therefore, would become obsolete.

Third, if the new system was adopted the transferred BPharm employees would need
to be trained to use it. Bergman Consulting says that it will be happy to provide this
training at its own expense (In any case it runs classes on operating its systems
already, so putting some extra people in those existing classes costs it virtually
nothing). It is estimated that the training of the 35 transferred staff will take about 4
months.

Fourth, the procurement team has also found out that if BPharm wished, at a later
date, to terminate its relationship with Bergman Consulting and move to another
supplier it would not be able to transfer the software system with the employees. The

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Managing the Supply Base within Business Markets

new system would remain the property of Bergman Consulting. Therefore, there
would be another data transfer exercise and, potentially, another need for training.

Finally, the Bergman Consulting account manager has said that if its system was
adopted there would have to be a few changes to BPharm’s employment
arrangements. One or two aspects would make using the software difficult. The
account manager did not think, however, that these changes would become
substantial.

Future Environmental Conditions for the BPharm Payroll Department

There is another factor that needs to be taken into account. This is that BPharm is
currently in the middle of a significant review of its employment and re-numeration
policies. The changes are likely to affect the numbers of tiers in the company
structure, the number of employees in the company and the way in which the
company pays out bonuses.

Even with a fairly rudimentary knowledge of information technology, the


procurement team thinks that this review will create a need to make fairly significant
changes to the payroll software system. At present, however, it is not clear exactly
what the new policies will be and what changes to the software would be required.

Task:

So this is the stage that the procurement team is at. First, the decision has been made
to outsource the payroll function. That is not in doubt. Second, BPharm will select
only one supplier for the service provision. Third, Bergman Consulting are by some
distance the best of the suppliers that responded and are in line to win the contract.

1. Should BPharm accept the offer of the software update?


2. Why?

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Organisational Buying Behaviour:


Developing a Programme of Action within RUHT

Background to the Case

It is 2014 and you are a member of the Procurement and Supply Management team
(PSMT) at the Rushmore University Hospital Trust (RUHT). The Trust works out of a
well-respected university medical school with a strong record of medical research
excellence.

Your team’s new leadership has been tasked with reviewing the Trust’s existing
procurement and supply management practices, and outcomes, with a view to
reducing supply input costs by 15% over a three year period.

Third-party spend at the RUHT is £74.5 million (out of an overall Trust turnover of
£234.7 million), with about £61 million of that being accounted for by medical spend,
£8 million by estates management and much of the balance accounted for by agency
medical staff.

Current Procurement and Supply Management Practice in RUHT

The PSMT is well organised, has good systems and its staff possess good, if not ‘best
in class’, procurement and supply management skills and experience. It has set up
good value Trust-wide contracts for the non-medical and agency staff spend that, in
the main, it controls or manages with largely like-minded non-medical managers.

However, the Finance Director believes that the Trust must improve procurement and
supply management in the much larger medical equipment and product areas. Savings
targets cannot simply go on being achieved through giving the cleaning supplier
another ‘squeeze’ and other short-term (and potentially counter-productive) tactics.

Practices, and outcomes, here are mixed. There is some good practice, but also
problems (various manifestations of poor VFM – see later). The causes of the
problems mainly relate to the location of authority for procurement decisions and how
that authority is exercised.

The RUHT’s medical spend is managed by its 9 clinical budget centres, with authority
for spending residing with extremely independent-minded clinicians. Although these
clinicians are able to use the PSMT, there is no statutory obligation for them to do so
(except for the completion of legal paperwork). This is a principle called ‘clinical
preference’.

As a result, sometimes the first that the PSMT knows about a clinical purchase is
when it receives an invoice from a supplier for something already delivered. Clinical
input into procurement decisions is essential, but a total by-passing of PSMT is not
ideal.

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The clinicians at the RUHT have a long record of being resistant to any attempt to
curb their freedom. Most recently, this resistance has been driven by the experience of
the 2012 ‘value-for-money’ initiative. A majority of clinicians feel, with some
justification, that this initiative had an adverse impact on patient care. A number of
leading clinicians have refused to even discuss procurement issues since.

Not all clinicians are ‘anti-procurement’ however. The PSMT has historically had a
good relationship with certain clinicians - respected senior clinicians as well as junior
ones - and has assisted them with their procurement and supply management in the
past. Indeed, some clinicians, particularly those with experience in overseas health
systems, recognise the need for changes to RUHT commercial practice.

Specific Demand Problems within the Medical Spend

Despite the fact that there is considerable commonality in the non-specialist medical
goods and services that are required across the 9 budget centres, it is not unusual for
each of the centres to be buying the same equipment and products from the same
suppliers, but separately and under very different terms.

In other categories of medical expenditure there is a different problem - spend


fragmentation across the budget centres, with multiple suppliers used for the provision
of similar equipment or products. Part of this results from clinicians having ‘favoured’
suppliers, although admittedly their preference is sometimes for the good reason that
those suppliers provide the equipment they were trained on.

A further difficulty experienced by the Trust is supplier opportunism. Partly this


consists of the aforementioned opportunistic pricing – suppliers taking advantage of
clinician ignorance. However, there is also significant evidence of some suppliers
targeting the principal budget-holders in each of the 9 centres and attempting to ‘buy’
their way into the Trust - training packages, invitations to medical conferences,
support for research, etc. Such sales tactics often lead to problems, for example, the
Trust buying equipment or products with specifications beyond the needs of patients,
with a price to match.

All this means that across the medical spend there is a whole collection of demand
management problems. A good example of the consequences can be seen in the
purchase of x-ray film and chemicals. In this area of spend the price paid by the
centres differs by as much as 45%.

Recent Events

Both of the two most senior managers in your team are new to the RUHT and last
week had their first meeting with some of the Trust’s clinicians. The managers are
meeting with clinicians from each of the 9 budget centres - this meeting was with
those clinicians involved in the purchase of theatre products.

This centre’s medical spend includes a wide variety of purchases including heart
valves, neuro-stimulators, sutures, angiography equipment, grafts, gloves,

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Managing the Supply Base within Business Markets

oxygenators, patient warming blankets, chest drains, respiratory consumables,


headwear and masks. There are then also common medical items such as cannulas,
syringes, dressings, etc.

The meeting did not go well, with the clinicians reacting negatively to the prospect
(despite being described in positive terms – “commercial support”) of their
independence once again coming under threat and their specifications and/or supplier
preferences being challenged. The clinicians argued that, for example, supplier
consolidation was likely to threaten patient care, with many clinicians (a majority of
the group) making, often highly complex, medical arguments for the exceptional
nature of their needs.

The meeting had ended with little progress made, although your senior managers
(recruited from the private sector) had learnt much about the nature and magnitude of
their task.

Having reflected on the meeting, the two senior managers came to the view that it was
not a case of clinicians as a whole being either ‘right’ or ‘wrong’ in their opposition.
Rather, whether or not clinician arguments were valid actually depended on the nature
of the item of spend in question. Understanding more about this was deemed
necessary before the rest of the budget centre meetings.

Profile of the Medical Expenditure

On examination, certain features of the medical spend became clear. First, medical
goods and services vary enormously by value. For example, angiography equipment
and its maintenance accounts for a large proportion of the annual spend in Theatres,
whereas chest drains account for very little.

However, second, it was noticeable that there was no correlation between the
purchases that generated the greatest clinician opposition to change and the amounts
of money being spent.

The third thing that was noticeable was the different competitive structures that
existed for the different spend items. Some markets were completely undifferentiated
with abundant sources of supply. Not surprisingly, in these markets supplier average
margins tended to be low.

Other markets were different. For example, suppliers in some markets were highly
differentiated, with certain suppliers offering equipment and products based upon
leading proprietary technology. If the Trust wanted this technology, sometimes
required to enable the clinician to provide ‘leading edge’ treatments, then they had to
pay the premium prices such technology commanded.

In a third type of market, equipment and products were generally of similar


technological advancement, but differed in terms of whether or not they required
proprietary consumables and maintenance. Many medical purchases require
significant consumables and maintenance so ‘whole life cost’ is a key issue. Not

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surprisingly, supplier pricing is sensitive to this issue, with ‘lock-in pricing’ common
and sometimes employed in an opportunistic manner.

Task

The task for your team is to prepare a brief five minute presentation for the next
‘Chief Executive’s Forum’ outlining your initial thoughts on a programme of action
for taking forward medical-related procurement and supply management within the
RUHT. This will particularly need to concern the problems, the key variables that
distinguish both clinical personnel and medical spend categories and what those
variables might mean for the prioritisation and nature of action.

This case is a fictitious representation of consultancy work undertaken within an


NHS hospital trust.

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Managing the Supply Base within Business Markets

Developing a Procurement Strategy for


Drug Delivery Systems

The Task

It is early 2013. You are part of a procurement strategy team working within a large,
urban NHS Trust. You and your team have been tasked with reviewing the current
approach of the Trust to the procurement of ‘drug delivery systems’, with a view to
developing a coherent strategy for the next five years.

The Historical Situation within the Trust

Every year the Trust spends around £620,000 on disposable syringes and cannulas,
which are used by clinicians and by patients themselves to deliver a wide variety of
drugs. The most substantial usage by patients themselves is amongst insulin-
dependent diabetics, who get their disposable syringes free on prescription. However,
despite the sizeable amount of money being spent on this category, historically it has
never been given much attention. This is partly due to the lack of resources assigned
to supply management and partly due to the diverse user base. Until recently, syringes
and cannulas have represented two distinct supply markets. This is because suppliers
of cannulas (used for intravenous drug delivery) have not also produced syringes
(used for intra-muscular injection) and vice versa. There has not, therefore, been
scope for consolidation across the two products and the Trust has had to deal with two
different sets of suppliers

Recent Developments in Drug Delivery Systems

Recent technological developments, however, mean that this separation could well
disappear in the near future. Although conventional syringes and cannulas still
account for the overwhelming proportion of intravenous and intra-muscular drug
delivery across the NHS, over the last twelve months an innovative, non-invasive
delivery system has started to be introduced by a small number of leading teaching
hospitals. This system is based on technology that uses air, delivered under high
pressure, to pass a measured dose of medication through the patient’s skin without
breaking it. The air-shot system works equally well for intravenous or intra-muscular
drug delivery, and it can be used either for single, one-off doses, or for a gradual dose
over a number of hours. In short, the system has the potential to replace both syringes
and cannulas.

The air-shot system promises to have a number of both clinical and commercial
advantages. On the clinical side, the system is likely to be extremely beneficial for
those patients who need to take drugs by intravenous or intra-muscular means over the
long term and on a very regular basis. The most obvious patients in this position
would be insulin-dependent diabetics and cancer sufferers undergoing chemotherapy.
In the former case, regular daily injections cause significant scar tissue, which can
reduce the effectiveness of the insulin taken and thereby undermine blood sugar

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Managing the Supply Base within Business Markets

control. In the latter case, long-term use of a cancer patient’s veins to deliver
chemotherapy drugs can result in the collapse of those veins. Regular use of a cannula
to deliver drug therapy also carries a significant risk of infection, which can prove
fatal in a cancer patient given their compromised immune system. These days, such
events often lead to litigation (The trust has to keep a contingency fund for litigation
payments). Clearly, these problems and, therefore, the attendant benefits of the air-
shot system, are much less pronounced for general category patients who use syringes
and cannulas on a short term and irregular basis.

The main commercial advantage of the air-shot system is that it is re-usable. It


removes the need to use a brand new syringe or cannula for each new dose of drugs
and/or for each new patient. Repeated use of the same air-shot device is perfectly safe
as long as the device is sterilized between uses. Product tests have shown that the
average lifetime of a device is around three years. Furthermore, these tests revealed
that the devices require very little or no maintenance during that period. The longer-
term cost advantages of the system, therefore, despite the need for a substantial up-
front investment, are obvious. Each device currently costs around £600. In
comparison, each disposable syringe currently costs on average £1.20, whilst each
disposable cannula costs on average of £2.25. Once an air-shot device has been used a
certain number of times, therefore, because of the virtual absence of opex costs
(consumables and maintenance) it is, in effect, free to the user.

The substantial price currently being charged for the air-shot system reflects the
determination of the (as yet, single) manufacturer to recover what has been a rather
sizeable investment in R&D. The result of this high price has, not surprisingly, been a
dampening down of demand for the system. Just how quickly this new technology
takes off is likely to be almost entirely contingent upon the pace at which the price
falls.

The User Base of Drug Delivery Systems and the New Air-Shot Technology

As noted above, those patients that might use the air-shot system can be divided into
two categories: regular, long-term users and irregular, short-term users. In your Trust,
the size of spend associated with each category is relatively equal (regular: 48% /
irregular: 52%). This is quite unusual (it is usually more like 25/75), but occurs
because the Trust is a regional centre for the treatment of cancer and diabetes. Those
clinicians treating patients in the first category (regular, long-term users) are likely to
be relatively price insensitive, because they will experience both the clinical and the
commercial benefits of the system fairly quickly. Consequently, they are likely to give
strong support to the rapid introduction of the system. Indeed, certain clinicians in
your Trust are already making noises to that effect, having observed developments in
other (mainly teaching) trusts and having been targeted by sales reps.

Conversely, those clinicians treating patients in the second category (irregular, short-
term users) are much less likely to be interested in a switch to the air-shot system,
because the clinical benefits are much less pronounced and the commercial benefits
will take longer to be realized, if at all. Indeed, unless the price of the system falls
dramatically, it could be five years or more before air-shot makes any serious inroads

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Managing the Supply Base within Business Markets

into this category of patients. Estimates of the likely penetration rates for the air-shot
system across the NHS as a whole are shown below.

Figure 1: Projected Penetration Rates (% of NHS Patients) for the Air-Shot System
under Different Pricing Scenarios

Scenario 1: £600 for each device

2013 2014 2015 2016 2017


5% 10% 18% 26% 31%

Scenario 2: £350 for each device

2013 2014 2015 2016 2017


7% 16% 54% 75% 84%

The Supply Base for Drug Delivery Systems

It is because of the emergence of this new drug delivery technology that your Trust is
rethinking its existing procurement strategy. Currently, the Trust spreads its
expenditure between seven suppliers – four suppliers of syringes and three suppliers
of cannulas.

Syringes
The purchase of syringes accounts for 46% of the overall spend on drug delivery
systems. As was mentioned above, this is currently divided between four suppliers.
The breakdown is as follows: IST Ltd (15%), EuroMed (15%), SyTech (11%) and
Premier Line (5%). Price competition in this market is quite fierce – there are other
suppliers besides these four – and all of the suppliers price their products (each
supplier offers a range of products with a slightly different specification) around the
£1.20 mark. Service levels in this market have been pretty mediocre in the past,
although the service provided by EuroMed has been slightly better than the rest. All of
the supplier’s products conform to the necessary regulatory standards. None of the
suppliers in this market are currently supplying, have plans to supply or, indeed, the
capability to supply, the new air shot technology.

Cannulas
The remaining 54% of the spend on drug delivery systems is accounted for by
cannulas. The nature of competition in this market is somewhat different to that in the
syringe market. There is competition in the market, but there is greater variation
between the suppliers. There are four main suppliers in the market, three of which are
used by the Trust. Global Injection Systems (GIS) account for 32% of the overall drug
delivery systems spend, whilst DDS Ltd account for 17% and CanMed 5%.

The market leader is undoubtedly GIS. Its conventional cannulas are technologically
more advanced and reliable than any of its rivals and it offers a better service than any
of its rivals. Despite this, its prices are lower than those offered by its rivals. Its main
rival is DDS, which is beginning to catch up technologically with GIS, although its

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prices and service levels still lag some way behind. CanMed, and the fourth supplier,
LLB (not used by the Trust), used to be serious rivals of GIS, but are now being left
behind not only by GIS, but also by DDS, which is looking to get out of a situation
where it is merely seen as a price competitor to CanMed and LLB. CanMed, which
still supplies your Trust with a small amount of cannulas, offers a fairly ordinary
product range and prices it about the same level as DDS (and LLB). Its service levels
are average. CanMed and LLB both have about a 9% market share. DDS’s market
share is about 18%, with GIS taking the balance

Air Shot System


Out of all of the suppliers in both of the supply markets, only GIS and DDS can offer,
or are close to offering, the new air shot system. GIS’s product is already on the
market and being used by a number of Trusts in the UK, as mentioned earlier in the
case. DDS, meanwhile, has developed air shot system capabilities, but is still a little
way off bringing its version to market.

Recent Developments - GIS

Mindful of its business strengths, GIS is pushing hard to win all of your Trust’s
expenditure on drug delivery systems. It is making its bid on its claim that it is the
market leader. Its sales people argue that not only does it have the most advanced and
reliable technology – it has been the first to market with the air shot system and is still
the only supplier of that technology – but it also provides a good service and offers its
conventional cannulas at a marginally lower price than its rivals. This claim is not
without foundation, as was stated above. Indeed, it is because these claims are largely
true that GIS has won, not only a sizable proportion of your Trust’s expenditure over
the last five years, but also a sizable proportion of the spend of many other NHS
Trusts around the country.

The secret of GIS’s price advantage is its innovative procurement strategy. When the
Berlin Wall came down, GIS was one of the first companies to move into Eastern
Europe, where wage rates were low, but indigenous educational and skills levels high.
Taking an equity stake in one of the leading Czech medical equipment firms, it
switched final assembly and the production of a number of key components to its
partner. Even given the additional logistics costs associated with sourcing so far from
home, and its slightly lower prices for conventional cannulas, GIS still manages to
realize a profit margin of the order of 17% for conventional cannulas and 35% for its
air-shot devices, although your Trust is not yet a purchaser of the latter.

Indeed, it is its level of margins that is the principal source of tension between your
Trust and GIS. Despite the enormous cost savings that GIS has made in recent years,
it has steadfastly refused to pass them onto your Trust. Your team has taken the view
that 17% is far too a high margin for conventional cannulas and it is also worried
about the early evidence of the margins being earned on the new air shot system. The
dissatisfaction of your team is reflected elsewhere in the NHS. In a recent meeting of
the senior purchasing managers in your regional strategic health authority area,
managers from other Trusts reported similar stories about their dealings with GIS. Yet

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Managing the Supply Base within Business Markets

it is very difficult for your Trust to do anything about GIS’s attitude, as whilst it
values your business it can happily survive without it.

The deal that GIS has now put forward is that if your Trust will agree to sign a single
source deal (it will source any syringes you require on your behalf, whilst at the same
time obviously pushing the cross-product potential of its new technology), it will
promise to cut its prices, reducing its margins on conventional cannulas to 9% and its
margins on the air-shot system to 20%. If your Trust will not sign the deal, then its
prices for conventional cannulas will remain unchanged. Furthermore, in the case of
the air-shot system, GIS is threatening to delay passing its new innovation onto your
Trust, reserving it instead for its ‘priority’ customers. This would not please your
internal clients, the clinicians.

Recent Developments - DDS

Your Trust’s other main supplier of cannulas is, of course, DDS. DDS is very much
an emerging ‘star performer’. Even as recently as two years ago it was just another
‘me too’ supplier of conventional cannulas, fighting it out with LLB and CanMed.
Today, it is GIS’s major competitor. DDS comes close to matching GIS’s
conventional cannula technology in most aspects. However, as was mentioned earlier,
its service performance is average and its prices are 5% higher than GIS’s (despite
earning gross margins of only 2.5%), although 0.5% lower than its other two
competitors. The difficulty is DDS’s cost base. Most of its production and that of its
component suppliers is located in high wage economies. Although it has ambitious
plans to expand its global sourcing strategy, the fruits of these initiatives are twelve
months off.

In the meantime the company's low levels of profitability are hampering its attempts
to effectively bring to market its version of the air-shot system. Insiders confidently
estimate that, with considerable investment, DDS could close the performance gap on
GIS on conventional cannulas in twelve months and get its air shot devices to market
in twenty. In order to find this investment, however, DDS needs additional revenues
from the NHS, including from your Trust which has the 5th largest spend in the
service. Without additional revenues DDS is unlikely to make the leap to the new air-
shot technology at all.

Task:

1. Where on the Competence-Power (Congruence) matrix would you position


each of the suppliers in the case?
2. What is your procurement strategy for the next five years?
3. What supplier development and/or supply base development activities would
you undertake, if any?

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Managing the Supply Base within Business Markets

AMI/Easton Negotiation Case Exercise

Introduction
This case concerns your company, AMI, an assembler of aerospace engine hardware
and Easton Technology, its single-source supplier of XPX components. In 2010, the
two companies signed a six-year contract. This contract is now coming up for renewal
(in 5 months, April 2016) and a cross-functional team of which you (a procurement
manager) are a part has been made responsible for dealing with the negotiations. Thus
far, there has been a single move by the two parties – an AMI ‘marker’ and an Easton
response (see later in case). The task now is to develop an AMI position to take into
the negotiations. The clock is ticking, but there is still time to decide how to proceed
in this area of expenditure – the switching costs are relatively low.

Background to the Case


Easton is the leading manufacturer of XPX components for use in engine hardware. In
the late-2000s, it developed its superior XPIII version of an XPX. While this product
would have come to the attention of the market sooner or later, what catapulted
Easton from obscurity to market leadership was its six-year contract with AMI. AMI
was its first blue chip customer, massively increased its turnover (see Exhibit 1) and
provided credibility. AMI’s contract is for about $100m per annum and since the
contract was won in 2010 Easton has gone from strength to strength, supplying most
of the large assemblers in the market and making above-average profits at its stage in
the supply chain.

Exhibit 1: Easton Technology – Summary of Financial Performance 2008-2014

2008 … 2011 2012 2013 2014 2015


Annual Turnover ($m) 21.1 132.8 492.8 596.7 623.1 637.7
Profit after Tax ($m) 2.5 8.7 67.1 71.4 52.1 50.3
AMI as % of Turnover - 73.9 22.1 17.7 16.7 16.5

However, over the past six to eight months signs have just started to emerge that its
golden run might be coming to an end. For a time, Easton’s competitors struggled to
match its technological advances - copying was not easy, as the XPIII is not easily
‘reverse engineered’. Recently, however, Easton’s competitors have made progress in
catching up. In particular, two companies – Fox Solutions and Dana Systems – have
come up with ‘me too’ XPX products that are close to matching the XPIII on
functionality (how close depends on who in AMI you talk to) and are also close to
matching the XPIII on cost (price comparisons depend on who the customer is).
Furthermore, there is talk of Fox Solutions bringing out a further product, taking its
functionality even closer – the word is that this will probably be in Q3/Q4 2017.

Where there is doubt about the competitiveness of these two suppliers, however, is
over service. Fox and Dana’s service capabilities and performance are average and
compare quite unfavourably with the close and effective relationship that has been
established over the past five years by AMI and Easton – a service that includes an
extensive after-sales technical service and considerable ‘social capital’.

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Managing the Supply Base within Business Markets

Yet despite its excellent service, the fact remains that Easton has not followed up its
technological advances of the late-2000s with any similar advance. It has become a bit
complacent and not reacted to competitor developments, something that perhaps
explains the slowdown in the company’s growth and profitability over the past year –
again, see Exhibit 1.

In response to all this, finally recognising the danger, Easton has in recent months
increased investment in new product development. The research and development
facility has been expanded and the company has purchased a number of patents and
other potentially valuable technology from smaller operations, such as university spin-
offs. At the same time, Easton is stepping up its promotional effort. The company still
has a good brand image and it is hoping that the goodwill associated with the brand
will provide it with breathing space as it tries to accelerate bringing to market a new
generation of XPX products. It also has good relationships established with end-users
within its customer organisations, including, as mentioned, AMI.

The Basis for Contractual Negotiations between AMI and Easton Technology
AMI and Easton are now preparing to enter negotiations for a new contract. AMI has
a requirement for a similar technology to that currently being provided – the
functionality provided by the existing XPIII is sufficient for its needs. As has been
described, the technology in this market has not moved on very much over the past 5
years and also AMI do not any longer consider this part of the hardware to be a key
feature as far as its ultimate customers are concerned.

As a result of Easton’s excellent performance in the past, AMI has indicated that it
might be prepared to sign a new contract on similar terms to those that defined the
last. This would mean a contract based upon a ‘cost-plus’ arrangement, whereby
Easton would earn a 4-5% profit. While being based on similar terms, the new
contract with Easton could represent an increase in volume. AMI, faced with
increasing demand for its own hardware, need to increase its purchase volumes in this
commodity area by about 35%. While AMI will want to look further at Easton’s cost
structure before entering negotiations, these basic outlines of its initial position have
been passed to Easton’s senior management.

Easton has come back with a response, the main aspect of which is a resistance to sign
a new contract on the same terms as the old one. Its senior management team argues
that it was only prepared to sign the 2010 contract on the basis of a cost plus 4.5%
profit margin because it was keen to win AMI’s business. This was, however, a
preferential rate that reflected the position of the company at that particular time. In
the past few years the company has done business on a completely different basis -
‘value pricing’, a reflection of its market leadership on both product functionality and
service.

As AMI is a ‘good and valued customer’, however, Easton has expressed an initial
willingness to stay with a cost-plus formula for the new contract, but with a 14%
margin. Given the comparative costs of Easton, Fox and Dana, this would make it the
most expensive of the three leading XPX suppliers (9% would see the prices of the
three suppliers be approximately the same).

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Managing the Supply Base within Business Markets

Task

To develop an AMI position to take into the initial negotiation. The questions below
can assist with this:

1. What is AMI’s current value for money proposition for XPX (F/C)?
2. To what extent does Easton’s market offering/attitude fit with that proposition?
3. What is the power relationship between AMI and Easton?
4. What do your answers to Q1 to Q3 mean for your commercial position on the
negotiation with Easton and your negotiation plan? As part of that plan, what
negotiation style should AMI (initially) adopt with Easton?

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Managing the Supply Base within Business Markets

Recognising Alternative Supplier Relationship


Management Types: Case Exercise

The Brief

In the lecture, you were introduced to six alternative, generic supplier relationship
management types – different ways in which buyers and suppliers interact. What we
would like you to do now, is see if you can recognise which type of relationship
characterises each of the case examples set out below.

Some of the cases are anonymous. This is because they concern some of our research
sponsors who provide us with access to their private information on the understanding
that their anonymity is maintained. We are able, however, to reveal the sector they
come from and other generic details.

Case 1 – Hewlett-Packard’s Telecoms Testing Equipment Division

In the 1980s, the telecommunications testing equipment division of Hewlett-Packard


(HP) outsourced a large amount of its manufacturing operations to its supply base,
mainly in an attempt to reduce its time to market. However, it was careful only to
outsource those parts of the manufacturing process that would permit the company to
be dominant after the act of outsourcing – it wished to control the sharing of the
surplus value.

HP ensured that its dominance continued over the course of the contract by
developing a policy whereby the suppliers produced to HP designs, sometimes on HP
equipment – thus avoiding the risk of lock-in, which can shift the balance of power.
HP also kept the switching costs low by pursuing a further policy of single sourcing
the part, but dual sourcing the technological capability. These policies were backed up
by a systematic and well-resourced performance measurement system.

However, despite instituting these safeguards, HP also expressed a willingness to


work closely with its suppliers and help them improve, should their performance
become sub-optimal. HP stated that it was perfectly prepared – although not
indefinitely - to commit managerial resources towards the development of suppliers,
whether that development be aimed at reducing cost, improving quality (for example,
lowering defect rates) or eradicating development problems in the innovation process.

Given the importance to HP of receiving quality inputs from its manufacturing sub-
contractors, this approach to supplier relationship management covered most of its
manufacturing supply base. The only exceptions concerned suppliers providing basic
inputs such as minor, generic components.

Relationship Type ……………………………………………………..

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Managing the Supply Base within Business Markets

Case 2 – UK-based Alcoholic Beverage Manufacturer

Recently, we undertook a project for a large, UK-based alcoholic beverages


manufacturer. The project concerned the purchase of a particular type of electrical
system, something bought regularly for the retail outlets the company’s beverages are
sold in. The case concerns the relationship between this firm and its current supplier
of this electrical equipment.

The beverage firm was the supplier in question’s second largest customer – so it was
of very high utility to the supplier. On the other hand, the supply market was very
tight, with the supplier being the better of the two main players (none of the others in
the market could service any more than a fraction of the requirements of the buying
firm, so there were only two credible options for it).

After years of fairly conflictual relations, the two parties decided to start afresh and
signed a three-year contract in 1998. This contract contained a commitment to work
together on the design of certain features of the equipment (features that were
important to the buying firm’s sales) and a commitment to work together to reduce
cost. The agreement was designed so that both parties would get an even return on
their investment in the relationship. For example, both sides received a share of the
cost savings realised – an arrangement supported by a high degree of transparency.

Relationship Type ……………………………………………………..

Case 3 – A UK-based High Street Bank

The third case concerns the relationship between a UK-based high street bank and its
suppliers of printed marketing materials – the flyers you see in the bank outlets
advertising credit cards and different types of accounts, etc. The printing supply
market is extremely contested. The barriers to entry are relatively low and the process
of printing utilises basic technology. It is very difficult for the suppliers in the market
to differentiate themselves in manner that is valued by their customers. Even
reliability of service is taken as a given.

The bank, meanwhile, is an attractive customer to any supplier in this market. Its
annual demand for printed materials is about £25 million and although it divides this
spend between a number of suppliers, the contracts its hands out are still some of the
biggest around.

The bank currently divides its spend between 6 suppliers and pursues a similar
relationship approach with all of them. As the printing process is very basic and
straightforward, the contact between the bank and its suppliers is limited to the
ordering process and the performance measurement process. In terms of the latter, the
bank’s procurement team measure the performance of the printing suppliers on a
regular basis. This monitoring concerns the reliability of its order fulfilment and the
quality of its products.

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Managing the Supply Base within Business Markets

The price of the suppliers’ products is generated through negotiation. As there are
many suppliers bidding for the work, the bank is able to get the suppliers to
aggressively bid against each other. The ability of the bank’s procurement team to
manage this negotiation process has increased recently with the advent of Internet
purchasing, in particular the creation of ‘reverse auction’ software.

Relationship Type ……………………………………………………..

Case 4 – The Aerospace Business Network

The structure of most aerospace supply chains is very different to, say, the structure of
retail supermarket supply chains, where one player dominates the whole scene. In
most aerospace supply chains, there are numerous very large, powerful firms at many
of the stages of the supply chain. For example, in the supply chain for civil airline
engines, the end customers are very powerful (Boeing and Airbus dominate), the
assembly market has only a few very powerful players (for example, Rolls Royce,
Bombardier and Pratt and Whitney) and the sub-assemblies markets are similarly tight
and populated by big players (for example, Goodrich, Shorts and TRW).

Given this supply chain structure, it is not surprising that when the aerospace industry
tried to emulate the retail market and implement lean supply, as it did in the UK under
the SCRIA initiative (Supply Chain Relationships in Aerospace), the outcome was
very different from that achieved by, say, Wal-Mart or Tesco. The following scenario
is typical of what often occurs in this sector.

The relationship in question concerns an engine assembler and one of its suppliers of
engine casing sub-assemblies. The engine assembler is a large international player
with a turnover of about £8 billion. The organisation faces a tight customer base that
is extremely price sensitive. The purchase in question was worth around £40 million
over a seven-year period.

Yet whilst the buying organisation is offering significant business, a power resource,
the supplier itself has considerable power resources. It is unquestionably the market
leader, in what is, in any case, an extremely tight supply market. It also boasts a multi-
billion pound turnover. Overall, analysis suggests that the supplier is marginally the
dominant player in the relationship.

Despite the fact that the supplier is dominant, it is still prepared to work closely with
the buyer, although given that it is supplying such a complex piece of kit it cannot
really do otherwise. In the relationship, the supplier works closely with the buyer on
the specification, on design improvements (as the project moves forward) and on
defect reduction.

However, when it comes to the commercial aspects of the relationship, the supplier’s
attitude is very different. In addition to the above initiatives, the relationship also
came to include a number of value stream mapping exercises (Hines et al, 2000). This

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Managing the Supply Base within Business Markets

involves mapping processes in order to identify wasteful activities. As is often the


case, the mapping exercises yielded significant returns. However, the supplier refuses
to pass the bulk of the resultant cost savings onto the buyer – keeping them itself as
increased profit.

Furthermore, the supplier is also unwilling to enter into cost transparency initiatives.
The supplier has a dual focus within this supply chain. Whilst it obviously has an
interest in assisting the supply chain provide an attractive value proposition to the end
customer, it is also concerned with its own sectional interests. Keeping cost
information private is an example of it prioritising its own interests above those of the
supply chain. Given its power position within the supply chain, it has the power
resources to be able to do this.

Relationship Type ……………………………………………………..

Case 5 – Flight Re-Fuelling Equipment

The final case also concerns the aerospace industry, in particular, the relationship
between an assembler of flight re-fuelling equipment and its main sub-assembly
supplier. The market for airborne re-fuelling equipment is a niche market. The
turnover of the market, at the time of the research, was only about £20 million per
annum, in a good year. For the equipment assembler (the market leader in a market of
two players) this was not necessarily a problem in itself, but became one because of
the structure of the supply market.

The key sub-assembly in the equipment had to be purchased from a very large multi-
national (turnover $120 billion) that was the only supplier of such a sub-assembly.
What the assembler wanted was a collaborative relationship with the supplier (whose
sub-assembly accounted for about 55% of the overall cost of the re-fuelling
equipment) so the two parties could work together to reduce cost. This was crucial to
the assembler as its own customer base was very price sensitive.

However, the assembler was a ‘nuisance customer’ for the supplier and not only was
it not prepared to commit resources to any cost reduction initiatives, but it also
charged prices that included something like a 40% profit margin. Furthermore, it
operated lead-times that were four or five times longer than those requested by the
buyer (Cox et al, 2002).

Relationship Type ……………………………………………………..

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Managing the Supply Base within Business Markets

Managing the Requirement for AST


in the Automotive Sector

The case (real, but anonymised) is set in May 2011.

Background

AutoCorp (AC), a car assembler, currently spends about €53m annually on an


operationally important product, AST, used in electrical manufacturing. AST is a raw
material, refined for use in electronics. The supply market for AST is pretty
competitive and suppliers serve other sectors that produce similar electrical systems.
Longer-term, the future of the supply market is a little uncertain as substitutes are
slowly emerging, but it remains attractive and in the last year or so has attracted the
attention of private equity.

AC currently has four suppliers on its preferred (and certified) supplier list. Having
four not only facilitates competitive tension, but is also necessary to acquire all the
AST variations required and to have additional capacity relatively available (see
later). Because of certification costs, the four suppliers are unlikely to be joined by
others in the immediate future.

Movement to an LTA

One of these four, EuroAST (EA), currently has 73% of AC’s overall demand,
including some EA proprietary products. In 2007, AC and EA signed a six-year deal,
termed an ‘LTA’. From the point of view of AC, an LTA made sense, despite there
being a competitive market, because of its potential to provide greater stability and
security – key requirements here.

This stability and security is in terms of a capped ‘price smoothing’ agreement and
hoped-for consistent delivery and quality, as the two parties moved forward together.
This is not a given in what is quite a volatile market, with short-term exploitation of
advantage common. Indeed, the six-year deal was something of a ‘relationship re-
launch’ after many years of periodic conflict.

Despite this ‘mixed’ history, that EA should be chosen by AC to be its lead AST
supplier is not a total surprise, as EA is thought to be in the supply market’s top three
in terms of quality, efficiency and (when circumstances warrant/permit) customer
relationship management. EA is also privately owned, whereas the other two of the
top three are parts of larger conglomerates.

The attraction for EA of the 6-year deal, apart from the obvious, is that the security of
demand allows it invest in its business. AC also has a reputation (again, when
circumstances warrant/permit) for being a good customer, so there was also an
opportunity to gain from working with it if conflict could be better managed. The 6-
year deal, which has a 3-year extension option, was, and is, quite a significant one for

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EA - AC now accounts for about 18% of its turnover (comfortably its biggest
customer) and is ‘blue chip’.

However, EA is not a supplier without strengths itself (notwithstanding the possibility


of future substitutes). It has some high-performing proprietary products, a good
service reputation (as mentioned earlier) and the applications for AST are growing.
Therefore, it could replace AC’s demand, although it would take considerable time
and money. Another factor in the relationship is that there are switch costs for AC.
Individual AST products as well as AST suppliers have to be certified - and EA
currently provides most of them to AC, as we have seen. Also, if AC were to
completely replace EA as a supplier it would need to put at least one new supplier on
its preferred supplier list – for capacity and coverage.

There are also now relational sunk costs for AC. The two have been working together
closely for nearly four years under this deal and some of the hoped-for stability and
security has come about (see below). Part of this has been due to the mutual
commitment represented by the six-year contract. It has also, however, been the result
of better relationship governance within AC. Previously, different SBUs had dealt
with EA separately, causing familiar problems of ‘queue jumping’, mixed messages,
divide and rule by EA and poor communication of demand information by AC. The
relationship with EA is now co-ordinated better.

Contractual Information

In terms of contractual details, there are clear quality and lead-time obligations for EA
to meet, reporting mechanisms, mutually-agreed capped pricing indices to achieve
‘price smoothing’ (with a mechanism to deal with the possibility that prices exit
completely the range upon which the pricing mechanism is based), cost transparency
requirements and change control provisions. There is also a break clause and damages
provisions relating to serious supplier non-performance. Considerable efforts have
been made to make the contract clear and reasonable in the eyes of both parties.

Beyond this, however, there is a mutually-held view that the two parties have
embarked upon a ‘strategic partnership’, not just to deliver the original agreement, but
also to work together to improve cost, quality and delivery – and each other’s
commercial success. A process for improvement ideas to be proposed has been
established and this is supplemented by an agreement on gain-sharing. The
commitment to the relationship on the part of the two parties is also shown by what is
not in the contract - there is currently, by design, little in the way of an exit strategy
for either AC or EA (unless, as mentioned, seriously unreasonable behaviour occurs).

Contract Management Activities

In addition to contractual clarity and agreement, the two parties also seek to use
contract and relationship management to encourage innovation and keep disputes to a
minimum – that is, ‘keep the contract in the drawer’. The main relationship activity is
in three areas:

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Commercial interaction: A senior procurement manager within the AC central


procurement team and a senior account manager within EA deal with the commercial
direction of the relationship – e.g. pricing, delivery, quality and improvement. More
junior staff from both sides then deal with day-to-day management. Contact at both
levels is regular: thrice daily (junior) and twice weekly (senior).

Technical interaction: An AC technical team from across the SBUs, led by a senior
technical manager, deals with the EA technical leads on approvals and improvements.
There are monthly technical audits and daily contact.

Logistical interaction - Various logistics people in the different AC SBUs work on


forecasting, buffer stocks, delivery, etc., dealing with counterparts in EA.
A key part of keeping disputes to a minimum is strict rules. Key decisions all have to
go through the senior commercial and technical managers on both sides, i.e. four
people in total.

Reflections on the Relationship

The senior AC procurement manager commented on the relationship: ‘I am always


negotiating new products or process changes within EA, as part of the improvement
side. Also, we look at the investment EA is making to ensure its capacity is going to
be ready to match our future needs.’

The senior AC technical manager commented likewise: ‘We check out the voracity
and implementation of changes to the manufacturing process, routinely visiting EA
and holding technical workshops on process changes or demand planning, for
example, when needed. We invite EA to bring ideas to these workshops, as well as
bringing our own. When ideas yield benefits, the gains are divided on the basis of
contribution.’

The senior EA account manager also commented: ‘It is very good, very open. The
reasonableness of AC’s requirements, bearing in mind its own pressures, is part of
this. We also have good access to AC’s top people – with many customers we don’t.
The contract usually ‘stays in the drawer’ as both sides have a pretty good
understanding of how it works and what the obligations of both parties are. Parts of
the contract have been taken out to create a standard operating procedure - so we only
get the contract out when there are more serious problems. We know what to discuss
and when’.

The senior AC procurement manager adds that the relationship also seems to compare
well with the AST relationships of its competitors: ‘We feel that the pricing is
competitive, quality well-above average and that the security offered by the long-term
agreement is delivering the hoped-for wider production benefits’.

There are tensions, of course. Some are the product of success – a sudden increase in
AC demand due to their winning of new orders. Others are more difficult and often to
do with cost issues. It is also the case that much of the ‘low-hanging fruit’ has been
picked.

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Task:

1. Thinking about both the ‘structural’ features of the exchange and the various
actions of the two parties, why do you think this contract has largely ‘self-
enforced’?
2. What challenges to this happy state of affairs do you think the relationship
faces over the coming years?

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Conflict Management Case Exercise: Contract between the


Ministry of Defence and Devonport Management Limited

In 1997, the Ministry of Defence signed a contract with Devonport Management


Limited to design and build new and upgraded facilities for the re-fitting and
refuelling of the Royal Navy’s submarines, including its nuclear submarines. As with
many defence projects, the project was highly complex, involving a number of
upgrades to docks, together with the development of new nuclear fuel handling
facilities.

To the external observer, the uncertainty in this project was related to two elements.
The first concerned design. Until the designs for the different aspects of the project
were completed it was not possible to ascertain exactly what the costs would be for
those aspects. The second concerned regulation. The project had to conform to the
1992 Safety Assessment Principles issued by the Health and Safety Executive’s
nuclear regulator, the Nuclear Installations Inspectorate. The exact manner in which
the Safety Assessment Principles would affect the different elements of the project
was not known a priori.

The original contract, signed in 1997, tried to put some kind of framework around the
project. Most significantly, the two parties decided to make an a priori estimate of the
project cost – between £576 million and £650 million. Devonport Management
Limited was then incentivised under the contract to complete the project for a cost at
the lower end of this range. If the project came in at £576 million, Devonport
Management Limited would earn a management fee (essentially a profit) of £30
million. The closer the cost moved to £650 million, the lower Devonport Management
Limited’s profit would be. If the costs actually exceeded the £650 million figure,
Devonport Management Limited would have to suffer a loss, unless the cost increase
could unambiguously be demonstrated to have resulted from the post-contractual
activities of the Ministry of Defence.

As it turned out, the complexity and scope of the project was far greater than either of
the two parties had anticipated. The uncertainty characterising the project had led to a
total cost that far outstripped the a priori estimates. In the autumn of 2002, it was
announced that the final cost would be at least £933 million. The figure was
announced as an estimate as there were still, five years into the contract, outstanding
design issues that were said to threaten to push the actual final figure significantly
higher than the £933 million figure.

This cost overrun of (at least) £283 million led to a series of accusations as to who
was to blame and post-contractual re-negotiations as to who should bear the additional
cost. The view of the Ministry of Defence was that Devonport Management Limited
should bear the main burden of any cost overrun, as agreed in the 1997 contract. It did
accept responsibility for some error on its own part, related to the late provision of
some design information, but claimed that the cost implications of this only ran to £38
million.

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The Ministry of Defence argued that this still left £245 million outstanding as
Devonport Management Limited’s responsibility. In any case, the Ministry of
Defence took the view that between £86 and £110 million of this £245 million cost
overrun was nothing to do with anything that might be described as the consequences
of uncertainty and was actually the result of the poor performance of Devonport
Management Limited and its sub-contractors.

Devonport Management Limited, not surprisingly, took a different view of events.


Like the Ministry of Defence, it took some responsibility for the cost overrun. It
admitted mistakes, but argued that these were only responsible for £20 million of the
£283 million cost overrun. The main culprit, Devonport Management Limited argued,
was the regulatory environment, that forced it to increase its costs in a manner it could
not possibly been expected to have anticipated. It argued that it ended up operating in
an environment of uncertainty, caused by regulation, and that contractually this
uncertainty was the Ministry of Defence’s responsibility.

Specifically, Devonport Management Limited pointed to a new 1996 agreement


between the Ministry of Defence and the Nuclear Installations Inspectorate. This
agreement, it argued, caused a ‘sea-change’ in regulation and caused changes to the
conduct of the project that, under the previously mentioned clause in the contract, was
the responsibility of the Ministry of Defence. This view, however, was rejected by the
Ministry of Defence which argued that the 1996 agreement merely formalised the
existing regulatory arrangements, arrangements that it claimed Devonport
Management Limited knew about before it signed the contract in 1997.

The result of all this was that in 2002 Devonport Management Limited launched a
series of legal claims against the Ministry of Defence that sought to make it
responsible for most of the cost overrun. In considering how to respond to these
claims and potential future negotiations, the Ministry of Defence considered the
strength of its position in the relationship. The evidence was sobering.

First, it did not own the Devonport facility and there was nowhere else where it could
re-source the work in any realistic timeframe. The facility was asset-specific. Second,
it had no desire to enter into a legal fight with Devonport Management Limited as this
would have caused a further delay to the completion of the project. This was deemed
militarily and politically unacceptable. Third, an insistence on Devonport
Management Limited absorbing the cost overrun was likely to force Devonport
Management Limited into liquidation. Its assets were only valued at £60 million.

Together, these three factors meant that the Ministry of Defence was in a very weak
post-contractual power position. As a result, it agreed to enter into new negotiations
with Devonport Management Limited. However, Devonport Management Limited
knew, of course, that the Ministry of Defence was only doing this, and so soon after
Devonport Management Limited had issued its threat, because of the weakness of its
position and pushed for a settlement that met its demands.

The result was that the Ministry of Defence agreed to pay all but £43 million of the
cost overrun. In the initial estimate, made in 1997, the Ministry of Defence forecast

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that the project would cost the UK Government between £576 million and £650
million. The re-negotiated figure now stands at £849 million, which, as has been
mentioned, could still increase further.

This case is a summary of a report by the National Audit Office (2002).

Task:

1. Using some of the economics concepts introduced in the module, scope this
contractual scenario.
2. What was the cause of the dispute between the MOD and DML in this case?
3. Why did the MOD not seek to escalate the conflict after the initial resistance
of DML to its demands?
4. How might the MOD have managed the contract better?

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Self-Enforcing Agreements: National Savings and


Investments and Lord Chancellor’s Department

Read the following two cases and undertake the task at the end of the document.

Case 1 – National Savings and Investments

In 1997, National Savings and Investments (NS&I) outsourced its business


operations. This included everything the organisation undertook (e.g. call centre, IT
and processing operations), except for the design and marketing of its financial
products. The ensuing transaction was, not surprisingly, characterised by a high level
of asset specificity and switching costs - and uncertainty. It was also, self-evidently, a
business critical transaction to NS&I.

As NS&I is a public sector organisation, the transaction had to be undertaken in


accordance with the EU procurement regulations. The carefully-crafted initial call for
proposals yielded 90 responses. From these, the NS&I procurement team eventually
generated a shortlist of four potential suppliers. Two of these four were then taken to
‘final bidding’ - the then ubiquitous EDS and a ‘challenger’ firm, Siemens Business
Services (SBS). NS&I’s procurement policy here included keeping both parties in the
frame until it had negotiated a ‘draft contract’ with both of them.

Following all of these stages, a final decision was made to award the contract to SBS.
It was reported that SBS edged EDS on a number of criteria: price, risk transfer
(including liability limits) and transparency arrangements. The contract was for 10
years, with an option to extend.

The NS&I procurement team consisted of a number of different parties. As well as


including NS&I operations and contract managers, there was also a senior
management presence and external advisors from HM Treasury and the private sector.
Considerable time was taken to ensure that there was agreement within the team over
both means and ends. It was also felt that there was a need to take time over the
negotiations. This was not easy as there was political pressure for a quick settlement.
However, this was resisted.

The result of the procurement process was the following contractual agreement with
SBS. SBS was to take responsibility for all of the operational tasks relating to the
provision of NS&I financial products. SBS also accepted an undertaking to reduce the
operational costs year-on-year during the 10-year contract period, by percentages, at
the time, covered by commercial confidentiality.

Further contractual conditions included the following. First, the management of new
NS&I products was to be opened up to competition if SBS’s performance was poor.
Second, NS&I would share in SBS profits, if they were deemed to be excessive.
Third, SBS was to take sole responsibility for operational errors. Fourth, 42 KPIs

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were established, with an accompanying monitoring regime. Fifth, SBS is obliged to


help with the switching of suppliers (if and when NS&I decide that change is
necessary). Sixth, a formal change process was established to manage the
consequences of uncertainty.

Underpinning all this was a further condition - that SBS’s parent company, Siemens
AG, guarantee SBS’s obligations. Following the negotiations, liability was set at up to
£250m (£120m in any two-year period). The NAO concluded that the liability
provision placed ‘the onus on SBS to improve [should it find itself in a] loss-making
position’.

While procurements such as this are never entirely trouble-free, the outcome of the
outsourcing appears to have been quite positive. A full audit was undertaken by the
NAO after five years. It concluded that NS&I had ‘added value’ to the taxpayer in the
amount of £176m in 2001-2002 and £220m in 2002-2003. Operational performance
was also said to have improved. For example, customer response times had, by 2003,
come down from seven to three days, putting them in line with industry ‘best
practice’. Both parties decided to activate the extension option in September 2004,
leaving the revised contract renewal date as 2014. The NAO provided further
approval regarding performance under the contract in 2005.

Most recently, in 2013, the NAO reported that SBS (acquired by Atos in 2011) had
‘saved £530 million [for NS&I] since 1999, while avoiding significant redundancy
costs’, although the assumptions adopted in this calculation may mean that this figure
is somewhat overstated. The NAO also reported that in 2012 Atos had ‘won a fresh
competition to provide services until 2021, proposing further efficiency savings and a
strategy encouraging customers to switch from post and over-the-counter services to
telephone and online banking’.

Case 2 – Lord Chancellor’s Department

In the early 1990s, the Lord Chancellor’s Department (LCD), now Ministry of Justice,
developed a national IT strategy and in 1997, after a false start with PWC in
1995/1996, invited proposals to build and operate a system to link all the relevant
criminal justice bodies. As in the case of NS&I, this transaction was characterised by
considerable asset specificity and switching costs – and uncertainty. The transaction
was also of high importance to LCD.

Again, with LCD being a public sector organisation, a formal competition was held
and the ITT yielded 19 expressions of interest. Unfortunately, this led to only three
bidders, with two of those, TRW/Bull and EDS, dropping out of the running at or
before the final bid stage. ICL-Fujitsu (ICLF) was left as the only bidder. After much
consideration, LCD decided to continue with the process, rather than hold another
competition, and ICLF was chosen as the preferred bidder.

LCD was confident that the ICLF bid was a good one – and, there was a need for a
new system to be put in place as soon as possible, as the multiple existing systems had
become very unreliable, affecting legal operations. This confidence, however, was

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based upon a fairly high-level view. During the limited negotiations that occurred
prior to the exit of TRW/Bull and EDS, there had been no detailed investigation of the
ICLF financial model, and the confidence seemed largely based upon ICLF
assurances.

In July 1998, the two parties signed a £146 million contract whereby ICLF was to
build and operate (for 10.5 years) a new IT system that would cover all of the
agencies involved in the criminal justice system. As with the NS&I contract, there
were various provisions in the contract aimed at managing ICLF’s performance and
assigning responsibility for adverse outcomes - KPIs, responsibility for errors, etc. A
further similarity with the NS&I contract was that ICLF was subjected to a
termination penalty. This was set at £10m. Three years after LCD started working
with PWC, the project was finally ready to commence.

In October 1998, however, ICLF came back to LCD claiming that further work had
revealed that £146 million was an underestimation of the likely project cost and that it
needed a further £38 million. Naturally, LCD was not happy about this, but
considered it “too risky to start the process again” and that £184 million still
represented good VFM, so it agreed to ICLF’s demand.

In October 1999, ICLF came back again and demanded a considerable further revision
to the contract – it now wanted £319 million for a 14-year period. What is more, ICLF
threatened to walk away from the contract if LCD did not agree to this demand in
time for it to be recorded in their January shareholder statement. This threat was
deemed credible by LCD as ICLF’s forecast of losses greatly outweighed the £10
million termination payment.

In considering how to respond to the threat, the LCD team took into account that (a)
switching suppliers would cause a (political unacceptable) delay, as a new system was
needed as a matter of urgency, (b) switching suppliers would be very costly and (c)
another ‘PWC situation’, where a contract collapses, would be damaging to team
members. Consequently, the LCD team took the view that it had little choice but to
agree to the ICLF demand.

In April 2001, ICLF came back for a third time - this time it demanded £283 million
for an 8-year obligation - and, for the same reasons as in October 1999, the LCD team
agreed to the demand. It called matters to a halt, though, in February 2003 when ICLF
came back for a fourth time, demanding £400 million for ‘an enhanced infrastructure
and full core application’. Rather than agreeing to this fourth demand, the LCD team
went back to the department to inform it that the relationship with ICLF had broken
down.

The initial outcome of this was an arrangement whereby LCD worked with three
suppliers, with ICLF just providing the infrastructure (for a price of £232 million - an
agreement still allowing ICLF a 7% profit margin, although it claims that this profit is
offset by earlier losses). By the end of 2003, LCD reported that the expected overall
cost of project stood at £390 million for an 8.5 year contract. By 2011, however, the
NAO reported that the system’s development had overrun the 8.5 year prediction and

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that the cost had reached £447 million and was still rising. It was also reported that
there had been problems with record-keeping on the system, to the point where there
were concerns that up £1.4 billion of court fines might remain uncollected.

Task:

Explain the very different outcomes to the two cases. Try to establish a chain of
causality in each case.

The data for this exercise was obtained from National Audit Office and House of
Commons Public Accounts Committee documents.

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Birmingham Business School

University of Birmingham

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