There is a killer on the loose near the start of the value chain. Suppliers of basic materials¹ have seen tough times as their own suppliers consolidated and customers squeezed their margins. Now some of those customers are using a kind of sophisticated professional purchaser, known as a "sourcer," who threatens to rub out the meager margins that remain. Armed with a detailed knowledge of the suppliers’ economics, the sourcer spurns the traditional approach of building close relationships in favor of extracting the most value at the lowest possible cost. Some suppliers may not survive the assault.

Indeed, this mismatch can destroy value quickly. One global producer of specialty lubricants recently acquired several service businesses in an effort to distinguish itself from competitors. The initial strategy was sound. But then sourcers demanded that the supplier bundle its new services with the lubricants at no extra charge. To preserve sales volumes, the supplier acquiesced. In the end, what had started as a sensible effort to combine a chemical business that had a 5 percent return on sales with service businesses that had a 15 percent ROS gave the company an overall ROS of less than 5 percent.

Some suppliers have suffered so much from the sourcers’ attacks that countering them, rather than passively watching margins erode further, must now be a strategic priority. A first step is for suppliers to understand how sourcers have shifted the odds against them. The second is to use that understanding by fighting back through internal improvements and by taking advantage of the mentality of the sourcers to create value for both them and the suppliers. And suppliers must take a much tougher negotiating stand—if necessary, reducing their services to customers or even abandoning customers, however long-standing, that have become too expensive to serve.

Smart stuff

Professional sourcers first appeared about ten years ago. Initially, they targeted retailers and distributors; later they moved up the value chain to include suppliers of basic materials. Instead of looking for suppliers that offer the lowest unit price for products, sourcers concentrate on reducing their companies’ total cost of owning the products in question. The total cost of ownership (TCO) includes all expenses incurred in getting and using products—not only invoice prices, but also costs such as delivery, storage, and the disposal of packaging materials and by-products.

Sourcers start by using their volume to squeeze as much value out of a supplier as possible. This approach isn’t new, but they win additional value by shifting costs and risks to suppliers. Sourcers don’t care about the effect this line of attack might have on relationships: the goal is to grab value. Knowledge is the second important weapon of the sourcers, who understand their own economics and the total cost of using products or services and, no less important, the economics and offerings of their key suppliers—often better than the suppliers do. Why? Because sourcers systematically aggregate all of the available information from their own organizations, other suppliers, trade magazines, other customers (legally, through consortiums), industry experts, and the like. Meanwhile, the information that suppliers have about themselves lies in various functions and IT systems and usually hasn’t been pulled together. Sourcers therefore have intimate knowledge of the economic impact of their options (for example, the cost of switching suppliers), so they can generally decide on their sourcing strategies and pinpoint acceptable trade-offs before they even start discussions with suppliers.

Sourcers, for example, typically shift costs such as freight, storage, and financing to sellers by having sales contracts specify delivered rather than plant-departure prices, thereby excluding the cost and risk of getting goods from the supplier’s to the user’s plant. Another tactic is to shift risk to the supplier by using fixed-price contracts,² which force it to absorb unexpected price hikes for raw materials. Since the mid-1990s, pulp and paper manufacturers, for example, have demanded fixed prices for hydrogen peroxide on contracts with terms of up to a year. Because of this price cap, many hydrogen peroxide makers posted returns well below their cost of capital in 2001, when a sharp rise in natural-gas prices pushed up their costs. In theory, suppliers benefit from fixed-price contracts if raw-materials prices fall. In reality, when that happens, suppliers bent on preserving relationships with their customers often let sourcers, who watch upstream prices carefully for such opportunities, cut prices by renegotiating contracts prematurely.

Costs in most basic-materials industries are rising because consolidation among their own suppliers has pushed up the price of raw materials and because a drive for high-tech, efficient production has forced them to make large capital investments. Meanwhile, strong competition and the commod-itization of formerly differentiated products are holding down the price of the basic materials these companies sell. The supplier’s sales force is an easy target for professional sourcers, since in basic-materials industries most incentive plans for sales reps are based on volume, which predisposes them to accept the sourcers’ demands. When margins are thin, sales reps often try to build sales volumes by offering buyers the lowest list price and even giving away services, particularly to large customers. Managers encourage this volume mentality by pressing for greater market share at almost any cost. And these industries as a whole emphasize the importance of retaining customers, thereby prompting sales reps to avoid measures that could jeopardize relationships with them.

The sourcers’ apprentice

Most companies in basic-materials industries already feel pressure from sourcers. Many such companies have so far followed a strategy of "stealth" defense; that is, they hope to stay off the sourcers’ radar screens by keeping a low profile. But sourcers are systematically moving up the value chain and will eventually confront almost all companies.

When that happens, suppliers must be able to avoid surrendering value on any terms the sourcers choose. The key to success is to understand the sourcers’ approach, which focuses on total value rather than lowest price, and to prepare the organization for a new kind of selling. In this way, a supplier can restore the balance of power with its buyers and give them greater value while not threatening its own viability.

For most basic-materials suppliers, two measures should go a long way toward rebalancing the scales: countering the knowledge of the sourcers by understanding the economics of the companies they work for and retraining the supplier’s entire organization to sell not just volume but also more value (Exhibit 1). The amount of emphasis a supplier places on each option should depend largely on how active sourcers are in its industry. A company that has already been critically weakened by their power probably also needs to reevaluate its core business—that is, the way it makes (as opposed to sells) its products.

Wise up

Since sourcers come to the negotiating table armed with a detailed understanding of their own and the supplier’s economics, the supplier must do the same. That is, it must understand how it makes (and loses) money from its current customers, the key factors that make them buy, and its competitors’ blind spots.

The sales reps and managers of a supplier often have only a vague understanding of its economics

As we have seen, the sales reps and even the managers of a supplier often only vaguely understand its economics, because the relevant information is dispersed across functions and IT systems. Thus, for example, sales reps who must factor the cost of freight into an invoice price when their own company pays for shipping may have only a rough idea of what the real cost might be. A detailed analysis of individual transactions at one European chemical company showed that, for some clients, freight expenses borne by the supplier actually exceeded the invoice price when expedited arrangements were factored in. Warehousing too, though not always itemized on invoices, can sharply reduce a customer’s value to a supplier.

Indeed, suppliers rarely calculate the pocket price3 for each order or customer. But the pocket price is vital for making a key strategic decision: whether the supplier should walk away from any customer’s business. At a minimum, information about a customer’s historical price performance should strengthen the supplier’s resolve during negotiations by showing where losses usually occur. If a company’s customer base is very fragmented and scrutinizing individual accounts isn’t practical, analysis of groups based on considerations such as purchasing patterns, key buying factors, or size could inform these decisions.

To raise prices or cut service levels for an underperforming customer to the point where it might defect, a supplier’s sales force must embrace a profound cultural change and develop the ability to assess risk. The payoff is a better negotiating stance and thus improved margins. Dropping a customer always poses dangers, but they can be mitigated by a thorough knowledge of the business at risk. When one large North American petrochemical supplier, for example, saw its market threatened by an Asian competitor offering lower prices, the supplier, in a carefully calculated move, let go three of its largest but most unprofitable customers (whose sourcers tried to force it to offer full service free of charge). The North American supplier understood what was fundamentally important to its customers as well as the weaknesses of its new competitor. Two of the three defecting customers came back to the supplier after just two months of coping with the competitor’s poor logistics and even poorer product quality. Indeed, they accepted higher net prices and longer, guaranteed-volume deals.

A supplier can find out its customers’ key buying factors and its competitors’ blind spots, initially by questioning its sales and marketing employees and then by holding thorough discussions with its current and prospective customers. The insights it gains will help the sales force and managers weigh potential trade-offs in negotiations with particular buyers. Say that one of them threatens to switch suppliers to get a lower price. If the sales force knows from the customer analysis that another buying factor—for example, the level of service—concerns this customer less than price, the supplier can offer to cut both its prices and its service levels, thus keeping the customer and its previous margin. Such trade-offs must of course be managed to assure that the company balances the risk of losing volume and the ability to control fixed costs across the entire customer portfolio. An accurate knowledge of customers also gives a sales force the power to deny historic discounts, rebates, or other services that have ceased to make business sense. Such information, for example, inspired a large European aluminum processor to stop playing lifeguard for a disloyal clientele. Some of this company’s largest customers had begun to source up to 20 percent of their business from new East European producers. When the new suppliers missed a delivery date, the old one often rescued these customers by expediting their emergency orders, but the incumbent eventually decided to let them feel the full pain of the shift to lower-quality suppliers. As a result, 90 percent of the customers stopped using them and asked the incumbent for guaranteed-supply agreements at higher prices.

Sell value

A knowledge of customers includes an understanding of their requirements as well as their economics. By looking at a product or service from the viewpoint of the customer and understanding its total cost of ownership and the way it creates value, a supplier can determine how existing or new offerings could help the customer add still greater value (Exhibit 2). Such "value selling" differs from the common costs-plus approach, which bases prices on the sum of cost components; it is instead based on creating, emphasizing, and capturing more of the economic value from a product or service for all downstream players. A supplier that takes this approach goes beyond its current catalog by inventing combinations of products and services and by suggesting outsourcing opportunities that meet each customer’s long-term needs better than its competitors could.

Selling value is different from the traditional job of selling basic materials. To make the transition and master the art of value selling, a company must often change the skills and even the personnel of its sales force, which will have to undertake additional knowledge-building activities such as conducting interviews with customers, end users, and industry experts; visiting customers’ sites; and even placing orders with competitors to experience their service and processes directly.

Suppliers that identify combinations of products and services capable of reducing a customer’s total cost of ownership can bring a strong package to the negotiating table. Typically, costs related to acquisition, operations, and safety and assurance can be cut. One global packaging supplier, for instance, saw that it could reduce the operating costs of its customers in the consumer electronics industry by designing a more durable box that would reduce their losses from broken televisions. By quantifying the total value of that cost reduction, the supplier justified incorporating some of the additional value into the price of the better boxes. Although they then had higher prices and margins, the customers’ total cost of ownership fell because fewer breakages occurred. The value may seem obvious, yet the sales pitch couldn’t be made until the supplier estimated the cost of the broken television sets, offered guarantees to its customers, and helped them to track the impact. In certain instances, this type of bundling could even serve as the foundation for new business units offering broad-based solutions (for example, consulting services for packaging).⁴

Consider another example of the way suppliers can benefit from reducing their customers’ overall expenses. A global paint manufacturer recognized that labor accounted for two-thirds of the costs of its professional customers. Acquiring paint was particularly labor-intensive because painters left their work sites to purchase supplies as needed. By delivering paint directly to work sites and changing its formulation to provide for one-coat application, the supplier made orders easier to fulfill and lowered these customers’ overall costs. Although the price of the paint didn’t rise immediately, the improvements shifted discussions with customers away from price and toward the value offered by the supplier and seemed likely to yield a margin improvement over time.

Selling value in this way answers the sourcers’ main concerns. It proclaims that the supplier has the interests of its customers in mind and that both parties have a common understanding of what is on the table. And such a compelling value proposition also makes alternative suppliers less attractive to customers.

Risk is another common problem that suppliers can assume for sourcers if the price is right. To start, a supplier must understand the historic and potential risks in question—such as volatile raw-materials prices or a shortage of supply—and the way they affect the customers’ product costs. Then the supplier must understand who is absorbing these risks now and at what expense. With this knowledge in hand, the supplier can set a range of prices it will charge for accepting different levels of risk. Above all, it should make its minimum (or walk-away) prices clear to its sales reps so that they don’t create new options on the spot during negotiations.

One metal company that supplies the aerospace and automotive industries, for example, developed a deep understanding of the costs and risks of its customers’ supply chains, from raw materials to inventory control. It also calculated its own costs in the same areas. After analyzing the two positions, it proposed to some customers that it assume, for a reasonable price, the risks inherent in the entire supply chain. These moves actually thinned the supplier’s margins at first but also locked in customers for the duration of their product programs—up to a decade in aerospace—and allowed the supplier to eventually increase its margins by improving performance all along the value chain.

To meet the sourcers head-on, suppliers must be willing to make these tough decisions. The trick to getting this approach to pay off is knowing how much flexibility you have instead of making uninformed trade-offs, under duress, that are almost guaranteed to be disadvantageous.

A course of action

Many companies will find that defining the level of threat posed by sourcers is the starting point for deciding on a course of action and its tempo. In the worst case, the sourcers’ tactics will affect most of a company’s business, and executives may well feel that the whole enterprise is under attack. In this event, the supplier should immediately move to build a knowledge base that will allow it to go head-to-head with sourcers as soon as possible. Thereafter, it will know enough to drop customers that ask for too much and to take a firmer stand in negotiations. Shifting to value selling will be a secondary priority. In the hardest cases, where the margins of the core business have been cut to unsustainable levels,⁵ management may have to consider more fundamental changes, such as forming joint ventures with service companies, buying distributors to gain better access to customers, or selling portions of the company.

A company less severely affected by sourcers can take a more balanced approach, not only by developing an improved knowledge base but also by making the move to value selling. In this case, a supplier has more time to preempt some of the pressure sourcers could bring to bear in the future—a strategy that would set the tone for discussions with them and uncover new sales opportunities. Still, the company must be ready to counter more aggressive demands from its customers by holding firm to its pricing policy and resolving to walk away if the full cost of serving them is unacceptably high.

Sourcers have only begun to pressure basic-materials suppliers and to threaten their long-standing relationships with customers. To counter these dangers, suppliers and others must consider the sourcer’s mind-set by selling their products in a better-informed, more value-oriented way.