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SUPPLEMENTAL ARTICLE

Counteract Increases in Supplier Leverage

Author(s):

Foster Finley
Foster Finley is managing director at AlixPartners, LLP in New York.

Bradley Boggess
Bradley Boggess is director at AlixPartners, LLP in New York.

June 2010, Inside Supply Management^® Vol. 21, No. 6

While bankruptcies and M&As can shift supplier leverage, implementing a threat review board can prevent or mitigate the effects of these events.

Economists would have us believe that the law of supply and demand keeps commercial terms between buyers and sellers securely in check. While this may be true over the long run, a buyer's day-to-day reality is often impacted by increased supplier leverage, mandating short- and intermediate-term responses. Some examples of these all-too-common increases in supplier leverage include:

1. The supplier's acquisition by another company — perhaps by a competitor or a pre-existing supplier
2. Its filing for bankruptcy protection
3. Commodity-price swings or regulatory changes influencing pricing or availability.

A threat review board (TRB) can counteract such shifts in leverage by employing a defined supply strategy, detecting prospective issues in advance and developing appropriate tactical responses. While not guaranteed to restore the balance of power, high-impact TRBs can often help mitigate or eliminate negative financial or supply-continuity ramifications by:

• Anticipating supplier "events," such as financial distress or commodity volatility
• Evaluating the importance of the involved suppliers
• Assessing the feasibility to pass through negative purchase price variances (PPVs)
• Minimizing the negative financial impact of re-sourcing goods and services.

The TRB is another layer of risk management within the organization. It entails collaboration across business functions to leverage knowledge in preventing or mitigating the impacts of changes in supplier relationships. And as a team, it leverages solutions to problems that could impact other areas of the organization. The most effective TRBs include (at a minimum) supply management executives, commercial business representation from participating business units, and finance executives.

The Benefit of Foresight

The adage "forewarned is forearmed" is especially relevant here, particularly in the case of acquisitions and bankruptcies. These seldom occur without some form of advance notice. And in today's economic environment, it appears that supply management executives can expect more of both. When the implications of imminent market events are significant, such as the events caused by the recent recession, it is a TRB's charter to serve as an active steering committee, assessing each situation and providing guidance on a course of action.

Many experts project a continuation in M&A activities for the rest of this year, which would profoundly affect supplier bases and buyer relationships. And, while no one can see the future, commodity or category managers usually have the responsibility of monitoring their respective supply markets and recognizing indications of imminent events. Monitoring can occur via trade journals, industry newsletters, supplier-specific financial filings, press releases and earning announcements, or industry business news. In the event that two significant suppliers join together — suggesting a commensurate increase in resulting supplier leverage — the savvy supply management group will identify and communicate the risk in advance.

U.S. Chapter 11 filings in 2009 were record-setting, and data through March 2010 indicate this may be another year of substantial distress. Bankruptcy filings increase supplier leverage, of course, not due to any structural change in the company-supplier relationship, but due to court protection of the supplier, and the supplier's pressing need for liquidity. This often has a direct and material impact on the commercial terms with buyers. Financial impacts may take the form of unilateral price increases or faster payment terms, or, in the worst case, may pose an immediate risk to obtaining goods or services.

TRB leadership is critical in supplier-bankruptcy situations. A distressed supplier may be unable to continue to perform — risking supply continuity. This can result in a need for a buyer-provided cash infusion (to fund, for example, raw-material inputs) or emergency relocation of tooling to alternate suppliers.

Like M&A transactions, bankruptcy filings seldom occur without advance warning. And when an entire supply base segment is distressed, contemplating movement between suppliers may not improve the buyer's situation. Because of this situation, understanding the relative liquidity position of the supplier with respect to its peer group is often more valuable than knowing when or with certainty a bankruptcy will occur.

Prioritizing Suppliers

A core function of the TRB is to prioritize the pipeline of prospective market occurrences and the likely effect of these occurrences on the organization. A key to this activity is to prioritize suppliers. Suppliers vary widely in terms of overall importance to your business and the extent to which a supplier's goods or services can be re-sourced or moved.

High-risk or high-priority market developments, such as the acquisition of a critical supplier, demand immediate attention, with a plan in place, and appropriate dedication of resources to take action. Critical suppliers have several traits, such as: having a significant portion of the overall spend reliance on proprietary processes or technologies, maintaining difficult-to-obtain regulatory certifications, employing product-specific tooling, accessing unique resources such as raw materials and having limited direct competition. Growing leverage among these types of suppliers can be challenging and time-consuming to offset — reinforcing the importance of exploiting advanced awareness.

Conversely, there are some suppliers whose goods or services are relatively interchangeable or constitute limited financial exposure. In these circumstances, growth in supplier leverage is relative, and may be counteracted by moving your business or harnessing viable competitive threats. In other words, even well-entrenched suppliers of interchangeable goods or services may be emboldened to try and drive through price increases. Well-prepared supply management professionals can stave off would-be increases through a combination of periodic market sampling quotes and should-cost modeling insights. Armed with this information, buyers can counter a threat of increases with opposing facts and a swift means of rapid business relocation. Less consequential situations may be deferred or effectively ignored.

Containing Commodity Costs

Certain macro-economic situations may prove easier to join than resist, such as price spikes in energy, metals or resins. In fact, increases of these types can sometimes be parlayed into opportunities. For example, a thorough evaluation of public, U.S.-based less-than-truckload (LTL) trucking companies reveals that fuel surcharge programs became major profit contributors for some operators, and became increasingly beneficial as fuel prices rose.

Commercial representatives on the TRB can help guide efforts for a pass-through of such commodity increases. Volatility and the outlook for commodity markets can have a pronounced impact on commercial pricing mechanisms. For example, a commercial agreement to set the raw material portion of a product's price at the time of shipment for every order can be unpredictable and administratively burdensome. By contrast, quarterly or biannual repricing can simplify administration, but may introduce instability from index movements when the once-every-six-month resetting coincides with a momentary price peak or trough. This, in turn, will drive an artificial variance to budget. Of course, very stable indexes pose less risk of such volatility.

The advantage of applying this sort of downstream commercial leverage to recoup rising commodity prices is that it is not mutually exclusive from cost-containment actions. Negotiating commodity price-sharing arrangements with suppliers can alter sensitivities to price index movement and can complement the effect of other supply-base cost-containment initiatives.

Managing Uncertainty

Supply bases and relationships with buyers will probably continue to be in great flux for the foreseeable future — whether through M&A activities, supplier liquidity issues or commodity price swings. Establishing an executive-level TRB to guide the supply management function and other affected functional areas through inevitable supplier-leverage increases can greatly mitigate negative results. The TRB's ultimate effectiveness, however, will always depend on supply management professionals' timely information, market intelligence and day-to-day vigilance.

For more information, send an e-mail to author@ism.ws.

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