Strategy Toward Buyers and Suppliers
This article develops some of the implications of structural analysis for buyer selection, or the choice of target customers or customer groups. It also explores some implications of structural analysis for purchasing strategy. Policies toward both buyers and toward suppliers are often looked at too narrowly, with the primary focus on operating problems. Yet through attention to broad issues of strategy toward buyers and suppliers, the firm may be able to improve its competitive position and reduce its vulnerability to their exercise of power.
Buyer Selection
Most industries sell their products or services not to a single buyer but to a range of different buyers. The bargaining power of this group of buyers, viewed in aggregate terms, is one of the key competitive forces determining the potential profitability of an industry. Chapter 1 has examined some of the structural conditions that make an industry's buyer group as a whole more or less powerful.
Yet it is rare that the buyer group facing an industry is homogeneous from a structural standpoint. Many producer-goods industries, for example, sell products to firms in a wide variety of businesses that use the product in differing ways. These firms can differ widely in their volumes of purchases, the importance of the product as an input to their production processes, and so on. Buyers of consumer goods can also vary a great deal in the quantity of a product they purchase, in income, in education, and along many other dimensions.
An industry's buyers can also differ in their purchasing needs. Different buyers may require differing levels of customer service, desired product quality or durability, needed information in sales presentations, and so on. These differing purchasing needs are one reason why buyers have different structural bargaining power.
Buyers differ not only in their structural position but also in their growth potential, and hence in the probable growth of their volume of purchases. Selling an electronic component to a firm like Digital Equipment in the rapidly growing minicomputer industry offers greater prospects for growth than selling the same component to a black and white television manufacturer.
Finally, for a variety of reasons the costs of servicing individual buyers differ. In electronic component distribution, for example, servicing buyers who order components in small quantities is a great deal more costly (as a percentage of sales) than serving higher-volume purchasers because the costs of servicing an order are largely fixed with respect to quantity shipped. The primary costs are paperwork, processing, and handling, which are not greatly affected by the number of components involved.
As a result of this heterogeneity, buyer selection-the choice of target buyers-becomes an important strategic variable. Broadly speaking, the firm should sell to the most favorable buyers possible, to the extent it has any choice. Buyer selection can strongly affect the growth rate of the firm and can minimize the disruptive power of buyers. Buyer selection with attention to structural considerations is an especially important strategic variable in mature industries and in those where barriers caused by product differentiation or technological innovation are hard to sustain.
Some concepts for buyer selection will be developed below. After identifying the characteristics of favorable, or "good," buyers, some strategic implications of buyer selection will be discussed. One such key implication is that a firm can not only find good buyers but also can create them.
A framework for buyer selection and strategy
There are four broad criteria, drawn from the previous discussion, that determine the quality of buyers from a strategic standpoint:
if a firm has differing capabilities for serving these needs relative to competitors. The firm will improve its competitive advantage, other things being equal, if it targets its efforts toward buyers whose particular needs it is in the best relative position to serve. The significance of the growth potential of buyers for strategy formulation is self-evident. The higher the growth potential of a buyer, the more probably its demands for the firm's product will be increasing over time.
Buyers' structural position is usefully divided into two parts for purposes of strategic analysis. Intrinsic bargaining power is the leverage the buyers can potentially exert over sellers, given their clout and the alternative sources of supply available. This leverage may or may not be exercised, however, because buyers also differ in their propensity to exercise their bargaining power to force down a seller's margins. Some buyers, even though they may purchase large quantities, are not particularly price sensitive. Or they are willing to trade price against other product attributes in a way that preserves the margins of the sellers. Both intrinsic bargaining power and the propensity to exercise it are crucial strategically, because unexercised power is a threat that can be unleashed by industry evolution. Buyers who have not been price sensitive can rapidly become so as their industries mature, for example, or as some substitute product begins to put pressure on their own margins.
The final key buyer characteristic from a strategic standpoint is the costs to the firm of servicing particular buyers. If these costs are high, then buyers that are "good buyers" based on other criteria may lose their attraction, because the costs more than offset any higher margins or lower risks in serving them.
These four criteria do not necessarily all move in the same direction. The buyers with the greatest growth potential can also be the most powerful and/or the most ruthless in exercising their power, though not necessarily. Or the buyers with little bargaining power and low price sensitivity may be so costly to service that the benefits of higher realized prices may be outweighed. Finally, the buyers the firm is best suited to serve may fail all the other tests. Thus the ultimate choice of the best target buyers is often a weighing and balancing process among these factors, measured against the firm's goals. To assess where a particular buyer falls with respect to the four criteria is a matter of applying the concepts of structural and competitor analysis to their situations. Some of these factors will now be discussed.
Purchasing needs relative to a firm's capabilities
The need to match buyers' particular purchasing needs with the relative capabilities of the firm is self-evident. Such a match will allow the firm to achieve the highest level of product differentiation vis-a-vis its buyers compared to competitors. It should also minimize the cost of serving these buyers relative to competitors. For example, if the firm has strong engineering and product development skills it will achieve the greatest relative advantage in serving the buyers who place greatest stress on custom varieties. Or if the firm enjoys an efficient logistical system relative to its competitors, this advantage will be maximized by serving the buyers for whom cost is crucial or for whom the logistics of reaching them are most complex.
Diagnosing the purchasing needs of particular buyers is a matter of identifying all the factors that enter into each buyer's purchase decision and the factors involved in executing the purchase transaction (shipping, delivery, order processing). These can then be ranked for individual buyers or buyer groups within the total buyer population.
Buyer's growth potential
The growth potential of a buyer in an industrial business is determined by three straightforward conditions:
• the growth rate of its industry;• the growth rate of its primary market segment(s);• its change in market share in the industry and in key segments.
The growth rate of the buyer's industry will depend on a variety of factors, such as the position of the industry vis-a-vis substitute products, the growth of the buyer group to which it sells, and so on.
Some market segments within an industry will usually be growing faster than others. Thus the buyer's growth potential also depends in part on what segments it is primarily serving or those it could and will potentially serve. Assessing the growth potential of particular segments requires basically the same analysis as assessing the growth potential of the industry, although at a lower level of aggregation.
The market share of a buyer in its industry and in particular market segments is the third element in growth analysis. Both the buyer's current share and the likelihood that this share will move up or down is a function of the buyer's competitive situation. Assessing this state requires a competitor analysis as well as a diagnosis of present and future industry structure, as is outlined in other chapters.
All three of these elements jointly determine the growth potential of the buyer. If a particular buyer is in a strong position to gain share, for example, it may offer possibilities for substantial growth even in a mature or declining industry.
The growth potential of a household buyer is determined by an
• analogous set of factors:• demographics;• quantity of purchases.
The first factor, demographics, determines the future size of a particular consumer segment. The number of well-educated consumers over twenty-five will be increasing rapidly, for example. Any stratum of income, education, marital status, age, and so on can be similarly analyzed by using demographic techniques.
The quantity of the product or service the particular consumer segment will purchase is the other key determinant of its growth prospects. This will be determined by such factors as the existence of substitutes, social trends which shift underlying needs, and so forth.
Intrinsic bargaining power of buyers
The factors 'that determine the intrinsic bargaining power of particular buyers or buyer segments are similar to those described in Chapter 1, which determine the power of the industry's buyer group as a whole, although they will need to be extended somewhat. Here I will present the criteria that identify buyers without much intrinsic bargaining power, relative to others, because these will be good buyers for purposes of buyer selection:
They purchase small quantities relative to the sales of sellers. Small-volume buyers will have less leverage to demand price concessions, freight absorption, and other special considerations. The volume of of a particular buyer will be most significant in giving it bargaining leverage when the seller has high fixed costs.
They lack qualified alternative sources. If the particular buyers' needs are such that there are few alternative products that will meet them satisfactorily, their bargaining leverage is limited. For example, if the buyer needs an unusually high-precision part because of the design of the final product, there may be few sellers that can supply it. A good buyer, using this criterion, is one who has a need for features of the particular seller's product or service that are unique. Qualified alternative sources can also be limited by needs for extensive testing or field trials to insure seller compliance with needed specifications, such as is common in telecommunications equipment.
They face high shopping, transactions, or negotiating costs. Buyers who face particular difficulties in securing alternative quotes, negotiating, or conducting transactions generally have less intrinsic Power. The cost to them of finding a new brand or new supplier is great, and they are forced to stick with their existing ones. For exarnple, buyers located in isolated geographic areas may have such difficulties.
They lack a credible threat of backward integration. Buyers who are in a poor position to backward integrate lose an important bargaining lever. The buyers of a product usually differ greatly in this ability. For example, of the numerous purchases of sulphuric acid, only the large users, who are fertilizer manufacturers or oil companies, are really in this position. The other buyers of sulphuric acid have less bargaining leverage.
They face high fixed costs of switching suppliers. Some buyers will face particularly high switching costs because of their situations. For example, they may have tied the specifications of their product to that of a particular supplier or made heavy investments in learning how to use a particular supplier's equipment.
The major sources of switching costs are as follows:
• costs of modifying products to match a new supplier's product;• costs of testing or certifying a new supplier's product to insure substitutability;• investments in retraining employees;• investments required in new ancillary equipment that is necessary to use a new supplier's products (tools, test equipment,etc.);• cost of establishing new logistical arrangements;• psychic costs of severing a relationship.
Any of these can be higher for particular buyers than for others.
Switching costs may also afflict the seller, who may have to bear fixed costs of changing buyers. Switching costs facing sellers yield bargaining power to buyers.
Price sensitivity of buyers
Individual buyers can also differ greatly in their propensity to exercise whatever bargaining power they have in bargaining down seller margins. Buyers who are not price sensitive at all, or who are willing to trade price for performance characteristics of the product, are usually good buyers. Once again the conditions determining the price sensitivity of individual buyers are similar to those determining the price sensitivity of the buyer group as a whole, presented in
Buyers who are not sensitive to price tend to fall into one or more of the following categories:
The cost of the product is a small part of the cost of the buyer's product cost and/or purchasing budget. If the product is a relatively low-cost item, the perceived benefits of price shopping and bargaining tend to be low. Note that the relevant cost is the total cost of the product per period, not the unit cost. Unit costs may be low, but the number of units purchased may make the item very important. The efforts of the consumer or purchasing agent, whichever is applicable, will tend to be directed toward the higher-cost items. For industrial buyers, this often means that senior, specialist purchasing agents and company executives buy high-cost items, and more junior, generalist purchasing agents handle all the low-cost items as a group. For consumer buyers, a low-cost item does not justify the high costs of shopping and product comparison. As a result, convenience may be a major motive in purchase, and purchase will be based on less "objective" criteria.
The penalty for product failure is high relative to its cost. If a product that fails or does not meet expectations causes the particular buyer to pay a substantial penalty, then the buyer will tend not to be price sensitive. The buyer will be much more concerned about quality, willing to pay a premium for it, and will tend to stick with products that have proven themselves in the past. A good example of this product characteristic is found in the electrical products industry. Here electrical controls sold to buyers for use in production machines may encounter lower price sensitivity than controls sold to buyers using them for more mundane applications. Failure of the controls for a piece of expensive production equipment can idle it as well as a number of workers, if not an entire production line. Products sold to buyers who will use them in interrelated systems may also imply particularly high failure costs, because failure of the Product may bring the whole system down.
Effectiveness of the product (or service) can yield major savings or improvement in performance. Turning the previous condition around, if the product or service can save the buyer time and money if it performs well or can improve the performance of the buyer's product, then the buyer will tend to be insensitive to price. For example, an investment banker's or consultant's services can produce major savings through accurate pricing of stock issues, valuation of acquisition candidates or approaches to solving campany problems. Buyers with particularly difficult pricing decisions, or with high stakes in solving problems, will tend to be willing to pay a premium for the very best advice. Another example is provided by the "logging" of oil fields. Companies like Schlumberger use sophisticated electronic techniques to detect the probable presence of oil in rock formations. Accurate readings can yield major savings in drilling costs, and oil drilling companies happily pay high fees for this service, particularly the companies that face very difficult and costly wells because of great depth or offshore location. Related to savings like these are savings to the buyer from timely delivery, rapid product servicing in the event of breakdowns, and many others. Some buyers are willing to pay premiums to companies that can perform well in areas such as these. Products that can yield the buyer improvements in performance include such things as prescription drugs and electronic equipment.
The buyer competes with a high-quality strategy to which the purchased product is perceived to contribute. Those buyers competing with a high-quality strategy are often quite sensitive about the inputs they purchase. If they perceive that the input enhances the performance of their product or if the brand of the input carries prestige value which will reinforce their high-quality strategy, they will tend to be insensitive to the price of inputs. For these reasons manufacturers of costly machinery often will pay a premium for electric motors or generators made by the prestige supplier.
The buyer seeks a custom designed or differentiated variety. If the buyer wants a specially designed product, then this desire is often (though not always) accompanied by the willingness to pay a premium price for it. This situation can lock the buyer into a particular supplier or suppliers, and it may be willing to pay a premium to keep those suppliers happy. Such buyers may also believe that such extra effort deserves compensation. A good example of a company built on such a strategy is Illinois Tool Works, who goes to elaborate lengths to custom design its fasteners to specific customer's needs. This policy has led to high margins and great customer loyalty.
A buyer with high intrinsic bargaining power, however, may demand unique or custom products but not be willing to pay extra for them. Serving these buyers puts the seller in the worst of situations, because it elevates costs without elevating margins.
The buyer is very profitable and/or can readily pass on the cost of inputs. Highly profitable buyers tend to be less price sensitive than those in marginal financial condition, unless the purchased product is a major cost item. Some of this attitude may be based on the fact that the highly profitable buyers fall into one of the categories listed above, and part may be attributable to a higher propensity to assure the seller a fair return. Although it could be argued that highly profitable buyers are that way because they are good bargainers, in practice it seems that the priorities of such buyers are placed less on aggressive bargaining over price and more in other areas.
The buyer is poorly informed about the product and/or does not purchase from well-defined specifications. Buyers who are poorly informed about the cost of an input, demand conditions, or criteria on which alternative brands should be evaluated tend to be less price sensitive than very well-informed buyers. If buyers are very well informed about the state of demand and suppliers' costs, on the other hand, they can be ruthless price bargainers. This is the case with many large purchasers of commodities. Poorly informed buyers, however, tend to be swayed by subjective factors and to be less certain about squeezing suppliers' margins. However, the buyer must not be so poorly informed as to not recognize that competing products differ.
The motivation of the actual decision maker is not narrowly defined as the cost of inputs. The price sensitivity of the buyer depends in part on the motivation of the actual purchaser or decision maker in the buyer's organization, which can vary a great deal from buyer to buyer. For example, purchasing agents are often rewarded for cost savings, which makes them very narrowly price oriented, whereas plant managers may have a longer-run outlook based on plant productivity.' Depending on the size of the company and many other factors, a purchasing agent, plant manager, or even senior executive may be the actual decision maker. In consumer goods, different members of the family may be the decision maker for different products. Different consumers can have different motivation systems. The more the decision maker's motivation is not narrowly defined as minimizing the cost of inputs, the less price sensitive the buyer is likely to be. 'For a discussion of this point see Corey (1976).
The factors promoting price insensitivity can work jointly. For example, most buyers of Letraset, a high-speed transfer process for lettering artwork and drawings, are architects and commercial artists. For them the cost of the lettering is small compared to the cost of their time, and attractive lettering reflects strongly on the overall impression left by design work they have done. Architects and artists are most concerned with instant availability of a large selection of different lettering styles. As a result, buyers of Letraset tend to be extremely price insensitive and have allowed Letraset to earn very high margins.
The factors discussed above also mean that large buyers are not necessarily the most price sensitive. For example, large buyers of construction machinery use their equipment heavily and generally purchase a wide line of machines, preferring to deal with one supplier. A single supplier allows them to take advantage of parts interchangeability and interacting with a single service organization. They are willing to pay a premium for a reliable line of machines, so that they can be kept intensively utilized, and for products whose service costs are low. Small contractors, on the other hand, only purchase a few types of construction machinery and often use them less intensively. They are much more sensitive about purchase:price since the cost of equipment is a major cost item to them.
Costs of serving buyers
The costs of serving different buyers of a product can vary greatly, usually for one of the following reasons:
• order size;• selling direct versus through distributors;• required lead time;• steadiness of order flow for purposes of planning and logistics;• shipping cost;• selling cost;• need for customization or modification;
Many of the costs of serving buyers can be hidden, and some are quite subtle. They can be obscured by overhead allocation. Usually to ascertain the cost of serving different types of buyers a firm must do a special study, because data in sufficient detail are rarely a part of normal operating statements.
Buyer selection and strategy
The notion that buyers differ along the four dimensions previously discussed means that the choice of buyers can be a critical strategic variable. Not all firms have the luxury of selecting their buyers, and not all industries have buyers that differ significantly along these dimensions. In many cases, however, the option of buyer selection is present.
The basic strategic principle in buyer selection is to seek out and attempt to sell to the most favorable buyers available based on the criteria outlined above. As was noted earlier, the four criteria may yield conflicting implications for the attractiveness of a particular buyer. The buyer with the most growth potential may also have the most power and be the most price sensitive, for example. Thus the choice of the best buyer must balance all four criteria against the capabilities of the firm relative to its competitors.
Different firms will be in differing positions to select buyers. A firm with high product differentiation may be able to sell to good buyers that are unavailable to many of its competitors, for example. The intrinsic power of buyers may also vary for different firms. A very large firm or one with unique product variety may be less affected by the size of the buyer than a smaller firm, to cite just one possibility. Finally, firms have differing capabilities with respect to serving particular buyers' needs. Thus the most favorable buyers to sell to will depend on the position of the individual firm in some respects.
There are a number of other strategic implications of buyer selection:
The firm with a low-cost position can sell to powerful, pricesensitive buyers and still be successful. If a firm is the low-cost producer, no matter how powerful or price sensitive the buyer the firm will be able to earn above-average margins for its industry, because the seller can meet the prices of its competitors and still earn better returns than they do. But there is an element of circularity in this statement in some businesses. The seller may sometimes have to sell to "lousy" buyers if it is to achieve a cost advantage because it needs the volume.
The firm without a cost advantage or differentiation must be selective about its buyers if it desires an above-average return. Without a cost advantage, the firm must focus its efforts on buyers vrho are less price sensitive if it is to outperform the industry average. This requirement may mean that such a firm must deliberately give up sales volume in order to maintain such a focus. Without a cost advantage, building volume for its own sake is self-defeating because it exposes the firm to less and less favorable buyers. If the firm cannot achieve cost leadership, it must be careful not to become stuck in the middle by selling to powerful buyers.
Good buyers can be created (or the quality of buyers improved) through strategy. Some of the characteristics of buyers that make them favorable can be influenced by the firm. For example, one important strategy is to build up switching costs-by persuading the customer to design the firm's product into his product, by developing custom varieties, by assistance in training of customer personnel to use the firm's product, and so on. Furthermore, clever selling can shift the decision maker for the product from an individual who is price sensitive to one who is less price sensitive. The product or service can be improved to yield potential savings to particular types of buyers; and many other actions can be taken to improve the quality of the buyer from the firm's point of view, by affecting the characteristics of good buyers previously identified.
This analysis suggests that one way in which the formulation of strategy can be viewed is to create favorable buyers. It is obviously better, as a matter of strategy, to create good buyers that are locked into the particular firm rather than to create ones that will be good buyers for any competitor.
The basis of buyers' choice can be broadened. An approach to creating good buyers which is so important as to warrant separate discussion is broadening the basis of buyers' choice. Ideally, the basis can be shifted away from purchase price and in directions where the firm has some distinctive abilities or where switching costs can be created.
There are two fundamental ways to broaden buyers' choice. The first is to increase the value added the firm provides to the buyer,' which involves such tactics as
• providing responsive customer service;• providing engineering assistance;• providing credit or rapid delivery;• creating new features of the product.
The notion here is simple. Increasing value added broadens the attributes on which choice is potentially based. It may allow the transformation of a product which is a commodity itself to one that can be differentiated.
A distinct but related way to broaden the basis of buyers' choice is to redefine the way the buyer thinks about the product's function, even if the product and service offering itself is the same. Here the buyer is shown that the cost or value of the product to him is not only the initial purchase price but involves such additional factors
• resale value;• maintenance cost and downtime over the product's life;• fuel cost;• revenue generating capacity;• cost of installation or attachment.
If the buyer can be convinced that such factors as these enter into the actual total cost or value of the product, then the firm has the potential opportunity of demonstrating that its product has superior performance along these dimensions and thereby justifies a price premium and buyer loyalty. Of course, the firm must be able to deliver on its promises of superiority, and its claims must be to some extent distinctive vis-a-vis its competitors or the potential higher margins will soon be eroded. Widening the basis of buyers' choice requires a combination of effective marketing on this basis and product development that supports the story convincingly. General Electric has practiced this strategy very successfully for decades in the large turbine generator industry.
High-cost buyers can be eliminated. A commonly used strategy to boost return on investment is to eliminate the high-cost buyers from the customer base. This tactic can often be quite effective since there is a common tendency to proliferate marginal customers, particularly in the growth phase of an industry's development. Eliminating high cost buyers is also often fruitful since the costs of serving individual buyers are rarely studied. However, it is crucial to recognize that there are other aspects to the desirability of buyers than merely their costs of servicing. High-cost buyers can be very price insensitive, for example, and amenable to price increases that more than cover the cost of serving them once the true cost of serving them has been ascertained. Or high-cost buyers may offer significant contributions to a firm's growth which can be essential in reaping economies of scale or necessary for other strategic purposes. Thus a decision to eliminate high-cost customers should involve a study of all four elements of buyer attractiveness.
The quality of buyers can change over time. Many of the factors determining a buyer's quality can change. As an industry matures, for example, buyers tend to become more price sensitive in many businesses because their own margins are squeezed and they are more expert purchasers. From a strategic standpoint, then, it is important not to base a strategy on selling to buyers whose quality will erode. Conversely, early recognition of a buyer group that is likely to become particularly favorable represents a major strategic opportunity. Penetrating such buyers early may be easy if they have low switching costs and few other competitors are interested. Once in the door, switching costs can be elevated through strategy.
Switching costs should be considered in making strategic moves. In view of the potential importance of switching costs, the impact of all strategic moves on switching costs should be considered. For example, the presence of switching costs means that it is often much cheaper for a customer to upgrade or augment an already purchased product then replace it altogether with another brand. This consideration may allow the firm with units already in place to earn very high margins on upgrading, as long as upgrading is priced properly in relation to the cost of competitors' new units.
Purchasing Strategy
The analysis of suppliers' power in Chapter 1 coupled with a reverse application of the principles of buyer selection can help a firm in formulating purchasing strategy. Although there are many aspects of purchasing strategy, procedures, and organization that go well beyond the scope of this book, some issues can be usefully examined by using the industry structure framework. Key issues in purchasing strategy from a structural standpoint are as follows:
• stability and competitiveness of the supplier pool;• optimal degree of vertical integration;• allocation of purchases among qualified suppliers;• creation of maximum leverage with chosen suppliers.
The first issue is the stability and competitiveness of suppliers. From a strategic point of view, it is desirable to purchase from suppliers who will maintain or improve their competitive position in terms of their products and services. This factor insures that the firm will purchase inputs of adequate or superior quality/cost to insure its own competitiveness. Similarly, selecting suppliers who will continue to be able to meet the firm's needs will minimize the costs of changing suppliers. Structural and competitor analysis, discussed throughout this book, can be used to identify how a firm's suppliers will fare along these dimensions.
The second issue, vertical integration xamines the strategic considerations in decisions to integrate vertically. Here I assume that the firm has decided what items to purchase outside, and the question is how to purchase them so as to create the best structural bargaining position. In allocating purchases among suppliers and creating bargaining power, the third and fourth issues, we can turn to structural analysis. In Chapter 1, the following conditions were identified as leading to powerful suppliers of a particular input:
• concentration of suppliers;• lack of dependence on the customer for a substantial fraction of sales;• switching costs facing the customer;• a unique or differentiated product (few alternative sources);• threat of forward integration.
The analysis of buyer selection earlier in this chapter added a number of other conditions in which the supplier will hold the power visa- vis the buyer:
• buyer lacks a credible threat of backward integration;• buyer faces high information, shopping, or negotiating costs.
In purchasing, then, the goal is to find mechanisms to offset or surmount these sources of suppliers' power. In some cases this power is built into industry economics and is out of the firm's control. In many cases, however, it can be mitigated by strategy.
Spread Purchases. Purchases of an item can be spread among alternate suppliers in such a way as to improve the firm's bargaining position. The business given to each individual supplier must be large enough to cause the supplier concern over losing it-spreading purchases too widely does not take advantage of structural bargaining position. However, purchasing everything from one supplier may yield that supplier too much of an opportunity to exercise power or build switching costs. Cutting across these considerations is the purchaser's ability to negotiate volume discounts, which is partly a matter of bargaining power and partly a matter of supplier economics. Balancing these factors, the purchaser should seek to create as much supplier dependence on its business as possible and reap the maximum volume discounts without exposing itself to too great a risk of falling prey to switching costs.
Avoid Switching Costs. Good purchasing strategy, from a structural standpoint, involves the avoidance of switching costs. The common sources of switching costs have been identified earlier, and other subtle areas exist as well. Avoiding switching costs means resisting the temptation to become too dependent on a supplier for engineering assistance; insuring that employees are not coopted; avoiding suppliers' efforts to create a custom-variety or custom-engineered application without a clear cost justification that outweighs possible future exercise of leverage; and so on. This policy may involve deliberately requiring that an alternate supplier's product is used some of the time, disapproving investments in ancillary equipment that are tied to a particular supplier, and resisting supplier products that involve specialized training procedures for employees, among other things.
Help Qualify Alternate Sources. It may be necessary to encourage alternate sources to enter the business, through funding development contracts and contracts for a small part of purchases. Some purchasers have actually helped capitalize new sources or gone overseas to persuade foreign firms to come into the business. It may also be desirable to help new suppliers minimize their costs of becoming qualified sources. Mechanisms range from extreme attentiveness to finding new suppliers by the purchasing staff to subsidizing the cost of testing new suppliers' products.
Promote Standardization. All firms in an industry may be well served by promoting standardization of specifications in the industries from which they purchase inputs. This policy helps reduce suppliers' product differentiation and undercuts the erection of switching costs.
Create a Threat of Backward Integration. Whether or not the purchaser actually desires to backward integrate into, an item, its bargaining position is helped by the presence of a credible threat. This threat can be created through statements, leaked word of internal studies of the feasibility of integration, creation of contingency plans for integration with consultants or engineering firms, and so on.
Use of Tapered Integration. When the volume of purchases allow it, a great deal of bargaining leverage can be gained through tapered integration, or partial integration into a particular item while buying some or even the majority of it from outside suppliers.
The objective of all these approaches is obviously to lower the total long-run costs of purchasing. It should be recognized that using some of them may actually raise some aspects of narrowly defined purchasing cost. For example, maintaining alternative sources or fighting against switching costs can involve expenses that could be avoided in the short run. However, the ultimate purpose of such expenses is to improve the bargaining position of the firm and hence its long-run input costs.
A number of points emerge. First, it is important to avoid the situation in which too narrow a short-run cost-cutting orientation undermines potentially valuable purchasing strategies like those outlined above. Second, any additional costs created by such a purchasing strategy must be weighed against its long-run benefits in mitigating suppliers' bargaining power. Finally, since the cost of purchasing from different suppliers can vary, the firm should purchase from low-cost suppliers unless there are offsetting benefits in terms of long-run bargaining power.
Taken from Competitive Strategy. Techniques for Analyzing Industries and Competitors by Michael E. Porter (1998)
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