How To Manage Your Most Important Suppliers

Editor’s note: Longtime Chief Executive columnist Jonathan Byrnes passed away on May 7 at age 75 after a long and valiant fight against cancer. The MIT professor, consultant and cofounder of Profit Isle was a brilliant mind, thoughtful businessperson—and kind man. We will miss him. This column is one of several that he submitted to us before his passing.

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Managing your most important suppliers can either be an endless source of conflict or a premier way to accelerate your long-term profitability. All too many managers default into zero-sum relationships centered on periodic price negotiations in which the supplier generally has the upper hand. Many astute managers, on the other hand, create win-win relationships in which both parties join to create a strong profit growth for all involved.

Four questions are essential to successfully managing your most important suppliers:

• Which are our most important suppliers?

• How important are we to each of them?

• How can we deepen and grow our relationship when both we and our supplier are important to each other?

• How can we build our relationship with an important supplier when we are an unimportant customer?

Identify your most important suppliers

Two factors determine a supplier’s importance: profitability and criticality.

An Enterprise Profit Management solution is the key to determining a supplier’s profitability (i.e. how much profits the supplier’s products or services are enabling you to generate).  EPM, which creates a full, all-in P&L for every transaction (every invoice line), can start providing this information in a few weeks. In our experience, this is the profit segmentation that almost always emerges:

• Profit Peak suppliers—typically about 20 percent of the suppliers generate 150 percent of a company’s profits;

• Profit Drain suppliers—typically about 30 percent of the suppliers erode about 50 percent of these profits; and

• Profit Desert suppliers—typically the remainder of the suppliers produce minimal profits.

We have seen this profit segmentation in all aspects of almost every company—including customers and products.

Your Profit Peak suppliers are extremely important because they account for the lion’s share of your profits. Your Profit Drain suppliers cause significant losses that erode a large portion of your profits. However, if you can work with a Profit Drain supplier to make it a Profit Peak (typically by reducing your operating costs, like over-frequent replenishment orders), the supplier will become important as well. Some Profit Desert suppliers have the potential to grow to Profit Peaks, and these are important.

Supplier criticality is the second important factor. This has several dimensions. For example, a number of your Profit Peak customers might view one of your smaller suppliers, perhaps a firm with unique technology, as particularly critical to their businesses. Other smaller suppliers might be developing a set of new products that will be very important in a few years. In both of these cases, it is wise to nurture the relationship, even though your current earnings from these suppliers might be low or even negative.

Determine your importance to your important suppliers

Profitability and criticality are again the key factors that determine how important you are as a customer to your essential suppliers.

Many suppliers simply gauge a customer’s importance by revenue volume. This is problematic because without Enterprise Profit Management, these firms cannot distinguish their high-revenue Profit Peak customers from their high-revenue Profit Drains.

If a supplier uses EPM, it will be able to accurately determine its profitability on its sales to you. In many cases a supplier finds that a number of its customers with moderate revenue are, in fact, very profitable. In this case, the supplier often will signal your importance by seeking to build the relationship.

Less capable suppliers will simply revert to revenue as a guide to determine customer importance. If you employ EPM, you will have a full profile of the profits each supplier generates for you, along with the operating costs involved (including potential operations issues like overly frequent ordering and expediting). This essential information will enable you to roughly estimate the supplier’s profits on your business. This will allow you to show the supplier that it is earning disproportionate profits from selling to you, even though its revenues are relatively low, and hence that you are more important than your purchase volume suggests.

Customer criticality is important to a supplier as well. This manifests along several dimensions. For example, some customers are seen as trendsetters. Although a trendsetter’s purchase volume may be low, its market impact would be high. Similarly, other customers might be seen as technical authorities. Again, the customers’ actual purchase volumes might be low, but their impact on the market would be disproportionately high. Yet other customers might be seen as important prospects for strong growth.

Together, these factors determine how your most important suppliers view you.

Deepen your relationship when you and your supplier are important to each other

Being an important customer to an important supplier is an ideal situation. However, all too many managers consider this an end-goal and move on to other tasks. This is a huge mistake. Instead, savvy managers view this an opportunity to step on the gas and make the relationship better and better.

The first step in making a good relationship great is to put your EPM supplier profile under the microscope and scout for opportunities to improve the profitability of both you and your supplier. Most often, this is a win-win process that makes both sides much better off. You can examine operating factors like the frequency of replenishment orders, or opportunities to substitute products that will have higher net profit for the supplier.

The objective is to find ways for each company to help the other. This process should be managed jointly by a team of operating managers from both companies. It works best when both companies employ EPM, so they can pinpoint profit opportunities on both sides.

For example, a few years ago, I supervised an MIT thesis on building aircraft carriers. One of the most important components in a nuclear-powered aircraft carrier is the set of huge valves that pipe water into and out of the reactor. Although the supplier was a very reliable, sophisticated company, these valves were chronically very late and usually had major cost overruns.

The thesis investigated this problem and found that the underlying cause was that the time required by the supplier to obtain components and construct the valves was about two years, but the ship’s design engineers would not release the requirements until about six months before the valves were scheduled to be installed. The reason was that they didn’t want to be held responsible for possible change orders, so they retained the drawings until the last possible minute.

The answer was clear: release preliminary requirements and drawings about every six months for the two years before the valves were scheduled to be installed. This allowed the supplier to order most components and begin construction, while it enabled the ship’s design engineers to make final modifications along the way. It was a win-win for both parties.

Once a team analyzes the current situation for profit opportunities, the next step is to look for ways to change the underlying assumptions of the relationship. For example, in Japan, many highly successful companies operate under the philosophy of “vendor co-destiny,” in which both the customer and the vendor understand that they are committed to the relationship, and both will make fundamental changes to make the relationship more profitable.

In some manufacturing situations, committing to longer-term volume orders enables the supplier to make capital investments that will lower costs or improve flexibility, benefiting both parties. Similarly, a distribution company can partner with a major supplier to co-invest in creating a technical team with relevant tools to back up the distributor’s sales force on both new sales and after-sales service.

In addition, as an important customer, you can partner with your important suppliers to gather market intelligence and experiment by probing new markets with current products, or existing markets with prototype products, or both. In the context of a secure, mutually profitable relationship, this investment will pay off well for both firms.

Build your relationship with important suppliers when you are not an important customer

This is a more difficult situation, but one that offers big returns to those who manage it well. Many managers simply focus on trying to negotiate to stem the price increases that a powerful supplier might impose.

More astute managers use their EPM supplier profiles to identify ways to improve the profits that they make on a powerful supplier by targeting operating and sales costs that are often unmeasured and unmanaged. Some managers might reduce the frequency of replenishment, while others might focus on reducing the cost of expedited supplier shipments by improving their demand forecasting or agreeing to take substitute products when supply is tight. These improvements will often enable you to maintain your profitability, even in the face of a major supplier’s price increase.

It certainly is possible to try to reduce the supplier’s operating cost, but for a relatively small customer, it is often hard to gain the supplier’s focus or bandwidth to engage in this discussion.

Even if a customer does not generate enough profits for the supplier to consider it important, it can improve its criticality to the supplier by becoming a testbed for innovations that the supplier can roll out to its whole customer base. You can start this process by engaging the supplier’s marketing and/or supply chain managers, rather than the supplier’s sales reps, in a discussion of how they can create opportunities for the supplier to explore, develop and test new ideas and possibilities.

This approach enables the supplier’s managers to try new things at little risk or cost—especially if you are a relatively unimportant customer that is representative of the supplier’s broader customer base. As the relationship develops new, viable initiatives that can be rolled out to the supplier’s customer base, you will become much more critical to the supplier and will quickly find the supplier working closely with you to find additional ways to improve the business for both firms.

Create strong profit growth

The process of managing your relationship with your most important suppliers is one of the most critical, but perilous, imperatives a manager can face. The key to success is to recognize and carefully analyze and manage the all-in economics and balance of power in the relationship.

When both you and your supplier are important to each other, you need to step on the gas and develop innovative new ways to grow your relationship’s profitability for all involved. This should be an ongoing joint process, not an occasional ad hoc initiative. This way, both you and your supplier will be constantly pushing the frontier on mutual value creation, and staying far ahead of the competition. This should be a major source of profitable growth—the worst thing you can do is declare victory and move on to other things.

The more difficult situation is when you are a relatively unimportant customer for one of your most important suppliers. The goal is to systematically build your positioning and value as a customer in subtle, but effective, ways like becoming a testbed in which the supplier can explore, develop, and prove out new concepts that the supplier can roll out to its overall customer base.

In both situations, successful major supplier relations require both systematic analysis and creative management. This is the key to insulating your company from important supplier general price increases, and creating strong, lasting profit growth.