Rules of engagement: A better way to interact with suppliers

In today's global business environment, success depends more than ever on supplier relationships: how effectively companies select their suppliers and then manage, measure, and grow those relationships. Indeed, the bond between buyers and suppliers is so important that "relationship" may be too weak a word; the successful ones are more like collaborative partnerships in which suppliers help their customers achieve their business objectives.

Among the many levers that companies need to employ in order to successfully develop and maintain such collaborations across the value chain are supplier segmentation, based on the business objectives the suppliers help you achieve, and mutually agreed-upon interaction models, or supplier-specific action plans that set the rules of engagement. In this article we will discuss the value of those approaches and how to implement them.

Article Figures

[Figure 1] A three-step process for supplier segmentationEnlarge this image

[Figure 2] Supplier clusters profilesEnlarge this image

[Figure 3] Supplier segments objectivesEnlarge this image

[Figure 4] Example organization of interaction principlesEnlarge this image

[Figure 5] Supplier interaction modelEnlarge this image

SUPPLIER SEGMENTATION
Many companies today have accumulated a proliferation of unmanaged or poorly managed suppliers that are supporting their businesses. This situation often arises out of historical imperatives to chase incremental sales and cost improvements—a strategy that in some cases has contributed to substantial value creation, but not without incurring certain "costs."

In general, companies are plagued with a range of problems that stem from supplier proliferation, some of which can be attributed to their inability to effectively manage those partners. Common issues that arise from this situation include: failures of products to conform to company or regulatory standards, uncompetitive customer service levels due to unforeseen delays and miscommunications, and overly complex product designs and portfolio offerings that are not sufficiently differentiated in the minds of consumers and other customers. Moreover, as suppliers proliferate, supply risk exposure—from price volatility, political and economic instability, environmental disasters, and a host of other, difficult-to-predict factors—often increases to an unacceptably high level.

In short, today's supply management challenges go beyond cost containment. Tomorrow's leaders will differentiate themselves not through achieving lower costs, but through producing a range of other benefits. That is, they'll create more value by optimizing their effectiveness at every step of the value chain.

One effective way to achieve this is to organize efforts around specific business objectives. Because senior management is well aware of challenges facing the company, it has likely set objectives to meet those challenges. These might include, for example, objectives aimed at reducing nonconformances, improving customer service, or lowering supply risk exposure. Sometimes the objectives at the corporate level can be broad and somewhat theoretical, but in a well-functioning organization, the business planning organization should translate them into more specific and useful—though often multidimensional and complex—actions at the business-unit level and even at the level of individual functions, such as manufacturing or procurement. (Throughout the rest of this article, we'll use the term "business objectives" to refer to these specifics.)

A supplier segmentation effort—like every business activity—should be driven by practical business objectives. Different businesses have different objectives, and so supplier evaluations should focus on the suppliers' abilities to deliver on those objectives in ways that create value. For example, if you have an objective of reducing nonconformances, then the suppliers that can help you meet that objective are creating more value than the ones that provide marginally better cost performance—and supplier segmentation should reflect that. Figure 1 summarizes this process: designing supplier segmentation based on business objectives, segmenting suppliers according to their capabilities against those objectives, and creating interaction models and action plans. (In the second half of this article, we'll discuss how these action plans are developed.)

Thus, when conducting supplier segmentation, a company must look both outward and inward. The "outward" part consists of a rigorous, analytical evaluation of suppliers' capabilities. For example, Supplier X is good at innovation but has a high cost structure, Supplier Y is the cheapest but is not always dependable, and Supplier Z is slightly more expensive but is reliable. Of course it should be much more sophisticated than that, and you may even borrow from advanced statistical methods (such as software that performs clustering analyses to find patterns within a seemingly disparate sample set) to identify different types of capability clusters in your supply base. But in order to correctly judge which combinations of suppliers create the most value, it is also necessary to look "inward"—to get cross-functional involvement in prioritizing the capabilities needed to achieve your business objectives. Figure 2 shows an example of this type of clustering analysis.

Think of the statistically-driven, analytical evaluation as a bottom-up approach to segmenting suppliers, and the inward look at your company's strategic priorities as more of a top-down approach. By combining these into a sort of hybrid, you gain the benefits of both. Bottom-up statistical clustering segments suppliers with similar characteristics. Meanwhile, top-down strategic clustering defines which segments have the most important strategic implications. You can then seek closer partnerships with the suppliers in the strongest segments while urging suppliers in the weaker segments to either improve their capabilities or exit your supply chain.

We can illustrate with an example. Let's say that your top-down analysis identifies three strategic priorities: reducing nonconformances, lowering supply risk exposure, and ensuring dependable delivery. Your bottom-up analysis—although it has evaluated other capabilities such as containing costs and innovating—should group suppliers based on their performance in just these three characteristics:

• Some suppliers are good at all three—they're your best partners.
• Others may be good at two out of three—you can explore with them how to improve their scores in the lagging category. Meanwhile, you can address internally how to mitigate their weaknesses, for example, by developing risk management strategies for the suppliers that expose you to certain risks.
• Others may be good at none or only one of your three priorities, and these may be targets for rationalization. Granted, if the one dimension in which a supplier excels is truly strategic, then you might retain it as a niche supplier. And if a supplier provides you with something that is critical, and there are no easily obtained substitutes, then you may have to stay with that supplier for a while. But in general, you'll find that some suppliers in this segment could be eliminated, a process that will help you achieve your business objectives more quickly.

Note that the results of segmentation are thus a series of action plans. The action plans for top suppliers include the details of how to deepen and strengthen your collaborative partnership. For suppliers with potential, the action plans involve encouraging them to meet that potential. And for less capable suppliers, the action plans may involve ending the relationship. Figure 3 outlines a hypothetical example of this approach.

In short, suppliers should be segmented and managed differently based on the business objectives they help you achieve. Furthermore, this segmentation should involve an analytical technique that is both repeatable and objective. Of course, each individual situation brings complications. But this is where your internal strategic analysis can get very interesting and potentially very rewarding.

For example, you're likely to have more than three strategic priorities—depending on the complexity of your portfolio, your strategic priorities may differ dramatically for different product lines. Some product lines may require innovative capabilities, others reliability, and others a low cost structure. But if you can group together products with similar objectives, then you can manage each set of supply chains for its objectives. In other words, you'll be segmenting your product base as well as your supply base. From a mass of undifferentiated needs and capabilities, you will segment the needs of certain groups of products along with the capabilities of certain groups of suppliers. The more you can pair the product groups' needs with suppliers' capabilities, the more value your segmentation effort can create.

Doing segmentation this way often involves a cultural shift for supply chain functions like manufacturing and procurement. To accomplish these aims, these functions have to be highly strategic in how they think about long-term business objectives. They have to work collaboratively with other functions to achieve these goals. And they must be profoundly action-oriented when translating segmentation analyses into results. We don't want to minimize the effort that such a transformation may require. But we do want to point out the benefits of making that effort: Because it is driven by business objectives, this type of segmentation has the powerful effect of creating value in areas that are important to upper management.

INTERACTION MODELS
Value is created not by a segmentation analysis but by the actions you take based on that analysis. The action of rationalizing inappropriate suppliers is a good start. But the real potential comes in the collaborative, mutually supportive relationships you establish with the suppliers whose capabilities best fit your needs. By building trust and transparency with these companies, you can eliminate inefficiencies, collaborate on innovations, and take advantage of each other's strengths.

Any such partnership requires an interaction model. The interaction model defines expectations around how you interact at all times in the relationship: how much information you share, when and how you share it—in essence, the rules of engagement. For that reason, some companies prefer to think of an interaction model as an engagement model.

Unlike a contract, which tends to be the work of lawyers and be written in legal language, an interaction model is a more conceptual framework that includes roles and responsibilities, process maps, decision guidelines, and so forth. This model defines for your cross-functional team which partner-suppliers to engage with, when, and how. The more explicit the model, the more useful it will be in the day-to-day execution of joint activities with your suppliers.

Thus, to achieve a collaborative partnership you must first design (or redesign) your partnership models to build on your strengths and achieve your business objectives. You should have an interaction model for each segment or cluster of suppliers—each set of suppliers with whom you are going to create value in similar ways.

The interaction points are the key to collaboration. Indeed, the points where partnerships often break down—and thus deserve particular attention in the model—are the interfaces of two elements of the value chain, such as Source and Make, or Make and Deliver. Value is created when you make your value chain as seamless as possible; these interfaces represent the old "seams."

As you develop interaction models internally, you may want to think about a set of interaction principles that describe where and how you will work differently than in the past. For example, to achieve business objectives aimed at reducing delivery time, you might develop interaction principles around the planning function that define how supply and demand planning and inventory management activities are managed, and by whom (you or your supplier-partner). These principles would be associated with specific measures of desired outcomes, such as fill rate, "on time in full" delivery, or end-to-end lead time. Figure 4 shows one example of how companies can organize and define their interaction principles.

Developing interaction models for numerous supplier-partners may sound like a lot of work—but don't forget, this is an outcome of your segmentation effort. The interaction model, defined at the segment level, provides the broad blueprint for how to engage suppliers in that segment. When applying the blueprint to a specific supplier, you may want to tailor it based on unique market conditions or that supplier's constraints. Such tailoring should be a set of slight, inexpensive, and manageable tweaks (see Figure 5). Consider the example discussed earlier, of a segment of suppliers that perform well in most of your critical categories but expose you to too many risks. For this segment, some of your critical interaction principles will center on risk management, and your interaction model should implement them with a focus on communicating, evaluating, and minimizing potential exposures. You may have specific evaluation methods for a particular supplier, but the principles remain the same.

At the supplier level, you then create specific action plans that define activities you will conduct with the supplier to implement the interaction model. For example, let's say your "Segment A" interaction model has suppliers performing both supply and demand planning, and perhaps collocating their demand planners with your brand team. But if one supplier in Segment A has not yet performed demand planning, then part of the action plan would be for your planning organization to help that supplier transition to these activities, including introducing them to their counterparts in marketing and procurement.

The segment interaction model and supplier-specific action plans, then, are much like a contract, but rather than outline a legal arrangement, they pragmatically outline the operational nature of your relationship: who is responsible for which activities, and how those will be measured. What process adjustments can lead to maximum savings? How will innovation performance be measured? Who will participate in internal client cross-functional teams, and how often will they perform reviews?

These types of questions are vital to the relationship, and by using your segment interaction model as a blueprint for specific action plans, you ensure that they are resolved early on, and ideally to mutual advantage. The proof of this success, of course, will come in actual performance. Thus, as part of the model, you should design supplier scorecards to track and provide feedback on supplier performance. By building measurements into every dimension of the model, you will ensure that problems can be quickly identified and addressed.

In short, with an interaction model and supplier-specific action plans, you can apply key value drivers strategically, ahead of time, using a disciplined, objective, repeatable approach:

• In which areas do you need to control risk?
• Which steps in the supply planning process have the greatest effects on your key value drivers (cost, for example)? And how can you best achieve results at those steps (such as by using the supplier's volume to gain discounts)?
• How can you gain value beyond cost benefits (by cutting time to market, or improving reliability, or maximizing risk management practices, for example)? How should responsibilities be divided so as to capture that value?

These questions will inevitably vary by company and by segment. They, like your segmentation strategy as a whole, are determined by your business objectives.

Transparency for all
Collaboration with suppliers is becoming a high priority for an increasing number of companies. Leaders in industries such as consumer packaged goods, where brutal competition has forced them to focus on efficiency, recognize that they must investigate all potential levers for creating value. As a result, they are actively pursuing collaboration across the supply chain. But you can expect the trend to hit other industries as well.

For example, we've recently had some experience in the pharmaceutical industry, where leaders have long been distinguished by superior innovation and marketing rather than efficiency. Yet even here it's clear that tomorrow's leaders will improve earnings not through those factors, but through excellence in operations.¹ The pharmaceutical industry is abandoning vertical integration and is instead becoming a world of collaborative partners, where orchestration is the essential competency.

Of course, if orchestration were easy, it would already have been accomplished—in pharmaceuticals as well as in other industries. Although many companies have productively leveraged collaborative partnerships, it is nevertheless a daunting task to try to coordinate the activities of a far-flung supply chain across a large and diverse portfolio, and so the concepts of segmentation and interaction models are still limited in their application. In fact, that's why the first step toward truly thriving with collaborative partnerships has to be to segment the supply base into smaller, more manageable chunks. We believe that coming years will see more such partnerships in most industries—and the best way to start on that journey is to segment your supply base to identify good candidates for partnership.

Regardless of industry, partnerships are all about transparency. Not only must you be willing to be transparent with a partner you trust, but the partnership also depends on both sides taking advantage of that transparency to act quickly and in mutually beneficial ways.

A good interaction model and supplier-specific action plans increase transparency—making you a more desirable partner for your suppliers. In this way, successful execution of the segmentation effort and resulting partnerships better achieves your (and your management's) business objectives.

Note:
1. David M. Powell and Paul Schroder, "Addressing Pharmaceutical Industry Disruptors with Virtual Partnerships, Corporate Renewal, and Active Risk Management," Ivey Business Journal, July/August 2012.