Managing Supplier Relationships

EPISODE #221 TRANSCRIPT

Times are tough. No matter what country you're in, inflation is on the rise, input costs are escalating, and companies are tightening their belts. Many are laying off staff in an attempt to preserve their margins and keep the wolves away from the door. And it won't be long before companies squeeze their suppliers in an attempt to find further cost reductions. 

Unfortunately, the companies that supply goods and services to your business are facing exactly the same pressures that you are. Their costs are rising too, and they're experiencing the same difficulty in finding and keeping really good people. So, how do you make sure that you're getting the best deal possible from all your suppliers without squeezing them to the point that they can't deliver what you need? Or in the worst case, they end up going out of business. 

ELEMENTS OF A GOOD CONTRACT

Let's start with a couple of things that I think are really relevant when it comes to managing supplier relationships: 

The first is that it's the contract that sets the tone for how the relationship is managed. You have to have a strong, clear contract in place. But, in the best customer/supplier relationships, once the contract's been negotiated, it goes into the bottom drawer and rarely sees the light of day. Why? Because you manage on the core principles of the relationship with give and take, and you try to serve the intent of what's been agreed. 

On the other hand, if you go by the letter of what you're entitled to in the contract… Well, that's all you'll ever get. You’ll never get the sometimes invaluable benefits that come from being flexible, and working through the swings and roundabouts with your supplier. 

I’m not going to go into negotiating techniques in this article. Negotiation skill is a complex and nuanced capability, and we  produced a podcast episode some time ago that covers this in a little more detail. If you’re interested in learning more, you can listen to Ep.75: Negotiation Fundamentals.

There are a few core principles to think about when establishing a new supply contract: 

1. It isn't a zero sum game 

Think about the size of the pie. The more value you can create in the overall deal, the more there is to share between the two parties once you get to that stage of the negotiation - so don't be transactional. 

2. Think about the outcome you want 

What does a good negotiation result look like? You both have to walk away satisfied that you've got a good deal. If not, you'll have problems later on. The core concept here is the best price isn't necessarily the best deal. 

3. Think about the appropriate allocation of risk 

You really have to know what you're doing here. Each risk should ultimately be assigned to whichever party is in the best position to manage it - and how you price that risk is critical. 

For example, when I was negotiating multi-year, high value contracts in bulk rail haulage, we understood risk profoundly. We had teams of analysts performing complex statistical analyses of historical operating patterns in order to price our risk. If we found ourselves in a negotiation and one of our customers said, “We think you should take on this risk”, we were able to determine the likelihood and the consequence of that risk occurring in a way that enabled us to price it appropriately:

“Okay, you want us to take on the risk of an event at the coal terminal load out facility? No problem. We're happy to take it, and that's going to cost you an additional 7 cents per tonne.” 

Having a handle on risk to that extent means you're much more likely to write a profitable contract.

THE ROLE OF PROCUREMENT TEAMS

Many larger organizations create specific functions for procurement where specialist expertise is deployed to handle all supplier contracting. Procurement people generally have skills in tender creation and evaluation, risk analysis, negotiation, vendor management, and so forth. However, relying on a centralized procurement team can create as many problems as it solves - so just be a little wary. 

The scoreboard that's normally given to a procurement team is one-dimensional: cost savings. If you're going to create a centralized team, you have to be able to justify that expense by getting better price outcomes with your suppliers, right?!. 

But we often tend to forget how much more there is to a supplier relationship than just the price we pay. Remember, the cheapest deal isn't necessarily the highest value deal, and although price is incredibly important, you also need to think about the balance of other factors as well.

So, how do you balance the contract price with the critical factors of service, quality, and risk? This is why it's so important not to just abrogate accountability for negotiating a contract to the procurement team. If indeed it's a supplier that you are going to have to manage, you need to be involved in the process. 

There are two important things to remember about supply contracts: 

1. No matter how good the contract is, if the teams that the contract is intended for don't actually use it, it's not very useful 

In my days as a CIO, I saw contracts in large organizations with computer hardware suppliers that provided preferential pricing - and sometimes these would deliver deep savings: more than 30 percent discount to what you'd pay in the retail market. Yet there were pockets of the business that didn't actually purchase their hardware off the contract. Why? Because it was easier and more convenient to go down to the local Best Buy and pay retail price. No paperwork, no bureaucracy, no scrutiny, and no wait time. 

2. As soon as the contract's been executed, the procurement team likes to take a victory lap and claim the cost savings 

Unfortunately, the only thing an improved supply contract gives you is the potential to create savings. If the contract isn't administered properly by the business unit that sources its goods and services from it, the savings never materialize. For example, many contracts, like those for air travel, have rebates that are negotiated if certain volume thresholds are met. But someone has to track the volume and apply for the rebate. 

I've often seen money left on the table through poor contract management, so don't let this happen to you. That's unnecessary leakage simply through lack of attention - and in my view, it's just dumb sh!t. If you really want to solve the dilemma of the disconnect between the procurement team and the part of the business that actually uses the contract, here’s a really good hack: 

When procurement claims a saving, don't just applaud and stop there 

Have the business unit verify and agree to the projected saving. There may be a little tension in this step, but that’s to be expected. Once the amount has been agreed, modify the business budget accordingly to bake in the savings. Quite often, this is the only way you'll be able to track and capture the potential benefits of a well negotiated contract.

INCREASING THE VALUE OF SUPPLIER CONTRACTS

As I said at the outset, if you're facing increasing challenges with your cost base, chances are that your suppliers are too. But if the squeeze is on and you want to find cost savings in your supply contracts, how do you find fertile ground for negotiation? 

Let's get one thing really clear: a negotiation should always be about trading terms. If you simply ask for something for nothing, you might get what you want, but your supplier will feel bullied. They’ll find a way to get even with you, and you may never know where and when they do that. 

So, what can you trade? When you’re tightening your belts, price reductions are a blunt instrument. Even if you manage to win some, they don't come without consequences and flow on effects. So, think about negotiating something else that can deliver value instead of just trying to always pull the price lever. 

Let me lay out six common value levers that are not solely based on price, which you can use to extract additional value from your supplier contracts. 

1. Trade less valuable terms in exchange for price reductions 

Maybe you can negotiate a lower price if you reduce the service levels that the contract stipulates. For example, you can approach a supplier to ask, “What if we change the guaranteed turnaround time from one hour to four hours? Would that enable you to reduce your price?” 

2. Optimize the supply chain

Supply-chain harmonization can unlock a lot of value. I remember the story of a major steel producer in Asia who was able to unlock a material amount of value by negotiating the storage and delivery of steel to its customers. This improved the efficiency for both parties and they were able to share those benefits.

3. Beware of gouging

Having said that you should always trade terms, there are instances of straight out gouging, where your suppliers will make extraordinary profits on certain items. It's important to be aware of this, and sniff out any of those items. In a procurement transformation I ran many years ago, we used a technique called cleansheet modeling, which is an analytical tool, used to deconstruct the component costs of a product in an attempt to determine what the supplier margins truly are. 

In one case, we found a piece of equipment for which the supplier was charging almost $2,500 per unit. When we deconstructed the component parts, added in allowances for shipping and handling, and a reasonable markup based on the supplier's cost of capital, we figured it was actually worth only a little more than $400. 

Now, that was a fun conversation to be involved in. We actually sat across the table from them and said, “Look, we know we've been paying almost $2,500 for this piece of equipment, but let us show you our calculations.” The looks on their faces were priceless! We clearly caught them out. Needless to say, the pricing of that item plummeted - overnight! And the supplier amended the contract accordingly. That was worth it.

4. Take advantage of not asking for a price reduction

There have been times in the past where I've actually said to suppliers, “We're happy to hold the price where it is for now because we know you’re under pressure too. But in return, when it comes to a trade off between your customers…  Well, guess what? We want to be at the front of the queue. We want to have access to your best people, your fastest response times, and your premium assets - and we’d like that written into our contract.” 

That worked particularly well. We got the benefit of elevated priority with that supplier, which ultimately made our own business more efficient, and it didn't cost us anything. The only thing we had to do was point out the fact that we weren't like all their other customers in trying to squeeze them on price. 

5. Build in year-on-year price reductions 

This puts a trajectory of continuous improvement into the contract. Your supplier commits to baking business improvements into what they do. In the past, I've written large contracts like this as a supplier by estimating the trajectory of improvement that comes through higher productivity, improved process efficiencies, and deploying leading edge technology. 

If you’re a supplier, it's great to be able to say to a customer, “Hey, you don't need to pit us against our competitors to get a better deal. We're going to hold ourselves to account for getting better every year and passing a share of those savings onto you, through the contract.” 

If you're a customer, you can ask for that too. It doesn't impact your supplier's current business, but it sets an expectation of efficiency improvement over time. And if they're not doing that already, what the hell are they doing?

6. Build contingency terms into contracts to manage current unknowns

This allows you to factor in changes that may occur in the future. For example, today the price of diesel fuel might be $4.75 per gallon, and that's the assumption that your supplier has made to price the contract. But if the diesel price falls to $4.50, well guess what? You might want a share of that extra profitability to come through to you as the customer. 

This recognises the current realities of the market, so you're not trying to squeeze their margins now, but it bakes in the expectation that things might improve in the future. And if you’re smart, it means that the future benefit doesn't just land in your supplier's NPAT line.

THE ILLUSION OF RISK TRANSFER

There’s one more very important point: we’re sometimes comforted by the illusion of risk transfer. If we’re finding that something is very difficult to manage, it can seem really attractive to just outsource the problem: “Get an external supplier to take it on, then we don't have to worry about it anymore. They'll carry the risk, not us.” 

For example, we may be finding it difficult to get highly competent and capable people in the critical area of cybersecurity. They're overly expensive, their turnover's high, and no sooner do we find a good person, than another good one leaves. It's just a revolving door of high-cost, low-skill… and management headaches. The temptation is to say, “Bugger it. I'll give it to a supplier to manage.” 

But a better question is, can an external supplier manage the risk better than I can? Often this might well be the case. Specialist cybersecurity firms may find it easier to attract and retain the skills that you need - at least with a higher likelihood of success than you’re going to have trying to build a cybersecurity team in say, a law firm. So there is something in this. But although the logic isn't necessarily wrong, the theory and the reality can sometimes be really far apart. 

Often the market is the market, and your potential supplier faces exactly the same pressures in managing that function as you are already experiencing yourself doing it internally. If you’re finding it hard to manage a risk, chances are so are your suppliers. But you manage to give yourself this warm fuzzy feeling when you've negotiated and executed a good contract that shifts the risk to the supplier.

Well, here's the thing: let's say you manage to outsource your cybersecurity. The contract allocates the risk firmly to the supplier, and there might even be penalties in the contract for not meeting the service levels that have been agreed. But what happens when there's a cybersecurity incident? A ransomware attack? Theft of your customer's personal information? Blackouts to critical systems? 

Where do you think people are going to look to apportion accountability for that failure? I'll give you a hint: it's not the supplier. This is why I call it the illusion of risk transfer. You can outsource the task, but you can't outsource the accountability for running your company the way your stakeholders expect. 

Managing supplier relationships can be tricky, so I hope this article has given you a few practical ideas for how to optimize yours. Our tendency is to focus on the one-dimensional lever of price, and while that's pretty important, there's so much more value to be captured if you get creative and look further afield.

RESOURCES AND RELATED TOPICS:

• Ep. #29: Winning Without Self Interest - Listen Here

• Ep. #39: Getting Results When You Don’t Have Control - Listen Here

• Ep. #53: Don’t Overdo Collaboration - Listen Here

• Ep. #75: Negotiation Fundamentals - Listen Here

• Ep. #95: The Joys of Outsourcing - Listen Here

• Ep. #117: Managing Natural Tensions - Listen Here

• Join the Crush Your Career Challenge 2022 - Here

• Buy the NO BULLSH!T LEADERSHIP BOOK - Here

• Explore other podcast episodes - Here

• Take our FREE Level Up Leadership Masterclass - Start Now

• Check out our 8-week online leadership program, Leadership Beyond the Theory - Learn More

YOUR SUPPORT MATTERS

Here’s how you can make a difference:

• Subscribe to the No Bullsh!t Leadership podcast

• Leave us a review on Apple Podcasts

• Repost this episode to your social media

• Share your favourite episodes with your leadership network

• Tag us in your next post and use the hashtag #nobsleadership