December 09, 2013
For the last 15 years, airframers and major subsystem providers have been on the wrong end of what seems like a zero-sum game with their suppliers. Prices have gone up, and suppliers' negotiating power—along with profits—has risen as well. The trend has been more pronounced in some areas of the supply chain, but on the whole, the upstream players have captured a declining portion of industry profits.
This is not destiny. OEMs and systems providers have the power to recapture some of the value they have conceded. To do this, however, they need to become good at estimating what the sourced parts should cost. Should-cost estimation capability has atrophied in many OEMs as procurement staffs have focused more on transactional activities. They are unable to identify inefficient suppliers that pass along high cost structure and opportunistic ones looking to exploit the absence of economic transparency.
This is exacerbated by market factors. Some supply markets are genuinely constrained, often the consequence of deft moves by market leaders. In other cases, OEMs have made tactical decisions to cede intellectual property to select suppliers or resorted to single sources in an effort to reduce supply chain complexity or benefit from some scale.
The issue centers on custom parts, which account for a large share of direct material spending and where pricing is not transparent. To address this, OEMs and systems providers should start by segmenting their supply bases by relative economic performance and by supplier power ratio. The former provides a comparison of the economic profit captured by suppliers in a given market with that of their customers. Supplier power ratio can highlight the concentration of suppliers to customers in a given market.
When viewed along these two dimensions, OEMs and system providers can use three generic strategies depending on the products being sourced and the associated supply market structure:
Threaten to defect: In markets where suppliers capture excess profits while having low supplier power, threatening to switch is the most promising tactic. The threat should be triggered by a supplier's unwillingness to lower prices to a reasonable level. Only credible threats are relevant. OEMs and system providers believe switching is costly for customized parts. The costs can be high in some cases, but can be overcome in most. However, this approach is possible only if the buyer has excellent capabilities to assess switching costs and economic alternatives.
Collaborate with suppliers: When components come from a supplier whose profit and power are lower than the systems provider's, joint cost reduction is optimal. Joint cost reduction is based on the reality that there are policies, activities and practices on both the customer and supplier sides that introduce inefficiencies into the supply chain, driving up product cost. However, to pursue this, the OEM or system provider needs to know the “ideal cost” of the part and the contribution of the supplier's expense structure to the product cost.
Pursue longer-term strategies: The most challenging situation for OEMs involves suppliers of large and highly complex subsystems. These markets tend to be highly concentrated, with suppliers having substantial intellectual property along with product and process expertise. OEMs have limited options in the short-term to alter the balance of power. In the longer-term, they can pursue several approaches, for example: structure incentives with suppliers; shift designs to eliminate the need for the assembly; integrate the function of the assembly into a larger subsystem that they design and manufacture, or signal their intent to invest in new suppliers or to pursue vertical integration.