What is Supplier Power?
In Porter’s Five Forces, supplier power is the degree of control a provider of goods or services can exert on its buyers. Supplier power is linked to the ability of suppliers to increase prices, decrease quality and limit the number of products they will sell. Usually, the numbers of suppliers of a particular resource greatly determine supplier power. For example, if a firm needs steel to produce their product, and there is only one seller of steel in the market, then the steel company has a strong supplier power. However, if there are many steel suppliers, then each individual supplier has less power then if there was only one supplier.
In some industries, the balance of power is drastically shifting from buyers to suppliers. The fast-food industry is a perfect case in point. Fast-food restaurant owners rely on just one supplier for many things: packaging materials, napkins, and restroom supplies, among others. The supplier then works in conjunction with multiple buyers in the same locale, which gives them high leverage in contract negotiations. The shift happens because of multiple reasons, which we will highlight later. In a few instances, suppliers are even able to edge out their competitors, with companies finding themselves in much weaker positions.
How is Supplier Power Created?
1. Number of Suppliers
One leading cause of bargaining power is the number of suppliers designated to meet a company’s demands. Ideally, if a firm can choose from multiple suppliers, the suppliers’ bargaining power reduces. The organization enjoys the freedom to choose a supplier who meets their demands in the best way. But in the case of a monopoly or oligopoly market structure, whereby companies face limited options, suppliers gain a lot of bargaining power.
Occasionally, companies agree to long-term contracts with just one or a few suppliers to reduce supplier risk. Although the practice favors the suppliers, it leaves very little room for flexibility on the part of the organization. It also means that suppliers exert more control over the terms and conditions of the contract.
3. Switching Costs
Switching costs refer to the additional expenses that a company will incur if it decides to shift from one supplier to another. The expenses include setup and configuration, infrastructure costs, legal fees, cost of customization and more. If the switching costs are too high, the firm owner may just decide to stick to their current supplier. This, in turn, gives their supplier a great deal of power.
How to Minimize Supplier Power?
Regardless of the reason, companies that are rendered weak by their suppliers ought to address the situation strategically. Here are a few viable solutions:
1. Bring Value to Your Supplier
Adding value is the easiest route to take if you want to redefine your relationship with your supplier. Proving that you possess value to your supplier not only helps to rebalance the power equation, but it also transforms a commercial transaction into an effective partnership. Some of the ways that you can add value are:
2. Become a Gateway to New Markets
One of the most economical ways to address a power imbalance problem is to give your supplier a market opportunity. Your supplier will regard their business with you as more than just the numbers your business alone provides.
3. Reduce Supplier’s Risks
If your company is in a position to decrease the risks faced by its supplier, it can negotiate for decreased prices in exchange.
4. Change How You Buy
If your company is not able to add any value to your supplier, the next best solution is to alter your pattern of purchasing. But since the approach can affect other departments in your organization, it calls for a close collaboration and examination of your entire firm. The following are some of the ways to change how you purchase:
- Consolidate Purchase Orders
The consolidation strategy carries risk but can be effective. For example, take an aircraft manufacturer, whose business departments used to purchase components independently from one large supplier. The supplier decided to double the prices in its original quotation, allowing him to make gross margins of up to 20%. Individually, the business units do not enjoy much power to initiate changes in the supplier’s unpleasant behavior. So, the different unit heads came together, consolidated their expenditure data and went to the supplier’s top executive threatening to suspend all purchases if no changes were made. The supplier is left with no option but to reduce the prices.
- Decrease Purchase Volume
Another way to change your purchasing pattern is to decrease the volume of goods that you’re purchasing. You can achieve it by switching to a substitute or another low-cost resource or raw material. By merely showing that you’re willing to do this, your supplier is likely to become more open to negotiating better terms.
5. Create a New Supplier
If altering your demand becomes impossible, your next best bet is to produce an entirely new supply source. As is the case in the first two solutions, the approach shifts demand away from your current supplier. The tactic is the best to take in situations where one supplier drives others from doing business. For instance, you can bring in a supplier from an adjacent industry.
In one example, a renowned airline managed to cut down on its food costs and improve quality by luring a European-based catering firm to enter the U.S. airline-catering industry. Initially, the U.S. catering market used to be dominated by two well-established suppliers who were reluctant to lower prices. The new entrant employed a creative and external production model that resulted in reduced prices in exchange for long-term contracts.
6. Play Hardball
If none of the strategies above cause your supplier to reconsider its pricing terms, you may need to resort to ruthless ways. You can do this by suspending all your purchases, eliminating your supplier from future transactions, or threatening litigation. One or a combination of the tactics above can make your supplier become open to negotiations.
The Bottom Line
To sum up, suppliers can achieve too much bargaining power in contracts. Luckily, there are several methods that firms can employ to redefine their relationships. For one, they can add value to suppliers by introducing them to new markets or mitigating the risks they face.
Alternatively, they can modify purchase patterns by buying less or consolidating purchase orders. Another technique is to create a new supplier, who will give your current supplier new competition. If all these strategies fail, you may need to play hardball.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. Check out the additional resources below to help you along your finance career path: