When a company is looking for a strategic supplier, the critical first step is to choose the right supply model, which will make or break the relationship. Unfortunately, many organizations do not operate with sourcing strategies: they are based on purchasing strategies that were developed more than 30 years ago.
Take, for example, the Kraljic Matrix introduced in 1983 by McKinsey consultant Peter Kraljic in the 1983 classic Harvard Business Review Essay “Purchasing Should Become Supply Management”. Kraljc suggested that buyers categorize purchases across two dimensions—profit effect and risk. To help organizations simplify the approach, he created a quadrant “matrix”, which is an immediate result due to its simplicity. Today, the Kraljic Matrix is considered by many to be the standard purchasing portfolio management model.
Once categories of expenditure are classified, Kralczyk suggested that the next step for the purchasing organization is to “weigh the bargaining power of its suppliers against its power as a customer”. Based on the strength of the enterprise in relation to its supplier, it is observed that there are three basic purchasing strategies: exploitation (in the case of the dominance of the buyer), equilibrium (in the case of a balanced relationship) and diversification (in the case of the dominance of the supplier).
Kraljic suggested that the “exploit” strategy is the preferred approach and encourage purchasing organizations to use their power to reduce supply risk and get the best price using your power – whether by standardizing volumes or simply by using their market leverage through competitive bidding.
Caveats to best practices
Another example is a “best practice” of using the “seven step” sourcing process. This process – made popular by AT Kearney – now has many variations ranging from five to 11 steps. No matter which method you use, there is a weak point that applying “best practices” in the sourcing process can easily be overkill for many of the things organizations buy.
Second, while many sourcing initiatives are one-time projects from “needs” to “disposal,” there is a huge opportunity to create value before and after the supply cycle. This is particularly true (i) for direct expenditure items, where early supplier involvement in design can lead to significant value; and (ii) in outsourcing relationships that require ongoing and more collaborative supplier relationships.
Research shows that up to 70% of the cost impact of a spending category is determined at the product or service design stage. Keep in mind: If a buyer is required to purchase a class after design, that buyer can only process 30% of the cost, which dampens the ability to achieve cost-reduction goals. Third, many outsourcing initiatives such as complex outsourcing contracts are not “one and done”. Rather, it requires constant collaboration and governance, and there is no “elimination” aspect – rather a constant evolution and demand for innovation over the life of the outsourcing contract.
Weaknesses of traditional strategies
While these ancient strategies “work” to some extent, they are not effective in today’s ever more global, complex and dynamic environment. why? Almost all supplier contracts today are based on transaction-based economics approaches. This creates a transitional “buy and sell” contract structure and economic model that supports supplier relationships (eg cost per unit produced, per pallet in warehouse, per minute of call center support, or per IT server).
The problem is that the more a supplier sells, the more money they make. Often this directly conflicts with the buyer’s goals to reduce costs. The result? An endless battle over price with one side winning at the expense of the other.
For simple transactions with abundant supply and low complexity, the transaction model is likely to be the most effective method. But the real weakness of traditional transaction approaches emerges when the business environment is more complex, with diversity, interdependence, dedicated assets or processes. Simply put, the transactional approach cannot produce market-based price equilibrium in variable or multidimensional trade agreements: other approaches are more appropriate.
But what are these other methods?
SIG has embraced the philosophies behind the University of Tennessee’s pioneering work on sourcing business models – using concepts and the book. Strategic Sourcing in the New Economy: Harnessing the Potential of Modern Procurement Business Models To educate today’s sourcing professionals on a continuum that includes seven sourcing business models (see figure below).
Sourcing a business model The theory states that there are seven business models for sourcing and it is important to establish your contract and economic model with your supplier based on the one best suited to the business environment.
Primary Provider Model
The underlying provider model uses a transaction-based economic model, which means that it typically has a set price for individual products and services for which there is a wide range of standard market options. This model is used to purchase low-cost, standardized goods and services in a market where there are many suppliers.
Certified Provider Form
An authorized provider also uses a transaction-based model with goods and services purchased from suppliers that meet a pre-defined set of qualification characteristics, quality criteria, proven past performance, or other selection criteria. Often an organization has a limited number of pre-approved suppliers of different classes from which buyers or business units can choose. One company can easily be substituted for another if the supplier fails to meet the performance standards.
Preferred Provider Model
One of the main differences between Preferred Provider and other transaction-based models is that the buyer chooses a more strategic relational approach. Buying companies seek to do business with a preferred provider to simplify the procurement process and build long-term relationships with key suppliers. They often enter into multi-year contracts using a master services agreement that allows them to efficiently conduct recurring business. It is still the preferred provider model for transactions, but the way the parties work together and the efficiencies achieved go beyond a simple purchase order.
Performance-based/managed services model
A performance-based model is generally a formal long-term supplier agreement that combines a relational contracting approach and an output-based economic model, based on the supplier’s ability to meet pre-determined performance standards or savings goals.
Performance-based agreements shift thinking away from activities to predetermined outcomes or events. Some companies call outcomes “results,” but in performance-based agreements, the meaning of “result” is well defined as the achievement of an event or output that is usually limited in nature and thus easy to understand. A good example of the output is the supplier’s ability to achieve pre-defined Service Level Agreements (SLAs).
Earned Business Model
The acquired sourcing business model is highly collaborative: the buyer and the supplier have an economic interest in each other’s success. The Vested model combines the results-based economic model with the Nobel Prize-winning concepts of behavioral economics and principles of shared value – firms enter into collaborative, win-win arrangements designed to create value for buyer and supplier beyond the traditional buying and selling economics of a transaction-based agreement.
The earned business model works best when a company has transformational or innovative goals that it cannot achieve on its own or using traditional transaction sourcing models.
Shared Services Form
The shared services model is an in-house organization based on a large-scale outsourcing arrangement. With this approach, operations are centralized to a “shared service” department or organization that charges members for the services used. Organizations use this model for a variety of functional services such as human resources, financial operations, and administrative services such as claims processing in healthcare.
If the organization does not have sufficient internal capabilities to obtain mission-critical goods and services, but does not wish to outsource or invest in a shared services organization, it may choose to develop a capital partnership. Stock partnerships create a legally binding entity and take a number of different legal forms, from the acquisition of a supplier or the creation of a subsidiary, to a stock-sharing joint venture.
Bottom line? This is your bottom line. Organizations must choose the sourcing business model best suited to their situation in order to improve transaction cost economics through a more strategic, complex, and dependent relationship, leading to a shift to sourcing hierarchies to use more modern performance-based and earned agreements. And—where appropriate—sourcing professionals should research when it makes sense for a company to make investments to transform the in-house supply.
If you don’t invest in the education of supply professionals, you are likely to find yourself further behind in creating value for your organization. Begin your learning to treat your organization as the gift of knowledge. You can buy the book Strategic resources in the new economy on Amazon and enroll in the SIG University Certified Resource Professional Program.