Journalism - The Case for Fewer, Better Suppliers

While with Applied Materials, I was invited to participate in the launch of a company-sponsored trade quarterly, AMAT Manufacturing Magazine. The focus of the magazine was quality control and waste reduction in a high-tech manufacturing environment. I typically wrote two or three features per issue and several small reviews or profile pieces. Here is an example.

By Chris Smith

AMAT Manufacturing Magazine

January 1998

Until recently, the traditional relationship between supplier and manufacturer has been an adversarial one. Often the requirements of a manufacturer's fixed setup were in contention with the fluctuations of a supplier's piece-part price. Each player attempted to negotiate a "win" for his or her side. Contract negotiations were characterized by seesawing advantages between the two. If the buyer lacked a suitable alternative source for a part, power shifted to the supplier and the price of a piece-part remained high. Conversely, when several viable sources were available, the buyer gained advantage over the supplier and piece-part prices dropped. Over time, buyers evolved strategies to help manage their supplier relationships under these conditions.

Through the 1970s, the basic strategy was to identify multiple domestic suppliers for each part and have them bid against each other in a price war. The thought was that competition between suppliers would result in the lowest possible piece-part price. As an added benefit, it was argued that the ability to second-source parts would pressure the selected suppliers to keep their prices low. The result of this strategy was price containment, at least in the short term, but there was a hidden cost - supplier and buyer had no sense of a shared destiny. Relationships were difficult to maintain for any length of time since the overriding purchasing criterion was that "I will buy the part from you only as long as I cannot negotiate a lower price elsewhere." Since the long-term problems with this practice were slow to surface, the basic strategy went unchallenged.

In the 1980s, increasing pressure from competitors and an explosion of inexpensive suppliers in Asia led many high-technology firms to shift their procurement focus offshore. This decision was entirely consistent with the lowest-price strategy. There were clear short-term economic benefits to this decision, but it also led to an increase in overhead costs that were only belatedly recognized. Now, the supplier was no longer located down the street or even in another state, but across the Pacific Ocean. Lead times changed from days to weeks or even months, and inventory levels increased proportionally. Defective material followed a time consuming and often tortuous path back to the overseas supplier. Equally important, the administrative overhead often led to very high burden rates since contracting, ordering, and monitoring were all complicated by physical distance and cultural barriers. Despite these severe drawbacks, the strategy remained in place throughout the decade.

By the late 1980s, the piece-part price strategy came under increasing scrutiny as it failed to provide a sustainable competitive advantage. Manufacturing companies that had once been highly vertically integrated were now outsourcing all but their most important core processes. Purchased parts constituted a growing percentage of the total manufacturing costs. Constant effort was spent on driving down the piece-part price - Seemingly to no avail as cost structures and product quality failed to keep pace with the competition. The fact that many highly successful Japanese companies, such as Toyota and Sony, were following a completely different supply chain strategy compounded the issue. Instead of having many suppliers competing for the same part, these companies partnered with a few select suppliers and nurtured long-term relationships. The immediate piece-part price was not the sole, or even the primary criterion for selecting a supplier. To people versed in the old strategy, this seemed an absurd move that would inevitably lead to higher costs and a loss of market share. This also led to rising trade tensions as Japanese subsidiaries in the U.S. bypassed local suppliers in favor of their long-term partners located in Japan. Under the old "piece-part price is everything" view of the world, the only possible explanation for not selecting cheaper local sources was simple trade bias. A closer look, however, leads to some startlingly different conclusions and illustrates the need for a new supplier relationship strategy.

The "Fewer, Better" Strategy
In the high-technology industry, product life cycles are decreasing precipitously as customers constantly demand the latest, fastest, highest quality, most cost-effective equipment. This, in turn, applies a steady, downward price pressure and a torrid pace of new product development for any company wanting to remain competitive. Meeting these requirements is not easy, and best-practice companies such as Toyota and Sony rely on their suppliers to help. Consider the seats used in Toyota's automobiles. Who is in the best position to quickly design a new seat with improved quality and lower manufacturing costs? Who keeps abreast of the latest seat technology? Whose core competence is seat design and manufacturing? The answer to each of these questions is clearly the seat supplier, not Toyota, and this is the rationale behind the "fewer, better" supply-chain strategy.

For most suppliers, there is enormous financial risk in making large capital investments in new processes and technologies. Under the old strategy of finding the lowest current piece-part price, how many suppliers will be willing to risk these capital expenditures? In contrast, consider the same questions under a long-term supplier relationship, such as at Toyota. The seat supplier knows that their financial success and Toyota's are linked by a common destiny. Process and technology changes are now a shared venture between the two companies, and many such activities can be done in parallel. New product development is undertaken at the supplier level in anticipation of Toyota's needs. Changes in the supplier's processes are no longer negotiated across a table by corporate attorneys, but developed jointly with Toyota engineers. These and a myriad of other simplified and faster methods help to dramatically improve key performance metrics such as cost structure, time-to-market, and product quality.

The net effect of this strategy is a shift in focus away from the current piece-part price and towards a total-cost-of-ownership model. The issue is now understanding and quantifying all of the essential costs associated with procuring material from a particular supplier. It is important to identify previously overlooked or ignored costs in this analysis. Examples include the costs of managing a supplier relationship (negotiations, performance monitoring), transaction costs (orders, receipts, invoices), and those costs associated with poor performance. Perhaps most difficult of all is attempting to quantify the indirect benefits of maintaining a long-term relationship with a small set of suppliers. These are real benefits, however, and as Toyota and other best-practice companies show, these collaborations can have a significant strategic impact.

Applied's Supply Chain
Purchased parts comprise a high percentage of the cost of the equipment manufactured by Applied Materials. This means that there is an enormous potential for controlling overall manufacturing costs within the supply chain. Furthermore, certain key suppliers have an important role to play in speeding up the new product development process. As a result, Applied is currently transitioning to a "fewer, better" strategy with its supply base. The objective is to identify a select set of suppliers on which to focus corporate attention. These suppliers will ultimately become technology partners and an instrumental part of Applied's total design capabilities.

The "right" number of suppliers is difficult to establish precisely, but best-practice companies tend to follow the rule of thumb that more suppliers are needed to support products that are more complex. As the overall complexity of the business increases - range of commodities, industry characteristics, technology requirements - the "right" number of suppliers increases commensurately. By these measurements, Applied is a very complex business and requires a supply chain strategy that takes into account the characteristics of each commodity. There are ten well-established commodity groupings - machined parts, fabricated parts, OEM parts, electrical components, power supplies, ceramics, quartz, plastics, pumps, and gas delivery - plus some relatively new commodities such as factory automation equipment. It is critical to recognize that each commodity has very different characteristics. The pump commodity group, for example, falls in a highly concentrated industry with a limited number of very sophisticated suppliers. In direct contrast, there are no dominant suppliers of machined parts since this industry is highly dispersed. Therefore, even after reducing the number of machined part suppliers, the total number is likely to be many times larger than the number for pumps.

In 1996, Applied had more than 2000 different production suppliers. In four years time, it is anticipated that this number will drop to approximately 250 strategic suppliers. From this much smaller base, new business processes will be put in place to support the technology and capacity requirements of the new millennium.