Building on mature strategic sourcing practices can transform organizations beyond corporate borders and capture value
Most people learn the value of co-operation in the home, the schoolyard or on the sports field. Most companies recognize the need to promote cooperative and collaborative working in their organizations too, and many have made strenuous efforts to break down internal barriers and foster closer working relationships. As an increasing fraction of the value of products and services moves out into the extended supply chain, however, companies are finding it much harder to extend their collaborative processes across corporate boundaries.
Some companies have tried supplier collaboration with only limited success. Others believe they have run out of room in their collaborations. We believe that most companies can get more from supplier collaboration if they start again from first principles—that is, if they rethink the nature of their strategic supplier relationships.
We define supplier collaboration as the joint development of capabilities for both the customer and supplier for the purposes of reduced cost, process improvements, and innovation in products or services. In 2012, McKinsey surveyed more than 100 large global companies on supplier collaboration practices. The survey distinguished traditional sourcing tools (such as clean-sheet cost models) from strategic investments and long-term projects with suppliers for co-development.
The results were fascinating. Although over a third of the respondents said they collaborated with suppliers, fewer than 10 percent could demonstrate systematic efforts on supplier collaboration. More importantly, among those who did collaborate, the EBIT growth rate was double that of their peers.
Do suppliers benefit from such relationships, too? Yes, they can. Their business is more stable, they become more cost-competitive, and they improve their core capabilities. The suppliers can then deploy these capabilities to win more business externally. In a 2010 survey of the auto industry, we found the suppliers that gave Toyota and BMW the highest cost reductions also rated the two OEMs as their best customers. That is the mutual benefit of long-term collaboration.
Our experience shows there are three keys to developing profitable supplier collaboration.
1. Build a foundation of internal collaboration before external collaboration
Before embarking on a new program that demands a significant amount of time and resources, it’s important to know if the company has the internal capabilities and strategy alignment to make the external collaboration a success. Under-investing in these internal activities is one of the top reasons supplier collaborations fail.
So how do you assess or determine whether your organization has the capabilities to make this kind of collaboration a success? First, consider the skills required for the particular type of collaboration desired (described in more detail in the next section). For example, do your buyers have a solid foundation in clean-sheet modeling and sourcing strategy development? Do you have access to internal expertise in lean, supply-chain management, and product development on what would become the supplier collaboration team? Only after you’ve addressed these needs would your organization be ready for supplier collaboration.
As an example, take a procurement function that is comprised primarily of tactical buyers who spend much of their day fulfilling orders. They may not have the expertise to identify joint cost-reduction opportunities or to work with suppliers to improve the product development processes. Organizations in this position are better served by investing in traditional sourcing and leadership capabilities first. Until this happens, suppliers have little incentive to try anything more ambitious.
But companies that have the fundamentals in place need to focus on more advanced, collaboration-specific skills, such as value-sharing mechanisms and developmental agreements. Value-sharing models need to be simple, and properly incentivize performance for both the customer and the supplier. Common incentives for suppliers range from extending contract length to splitting cost savings 50/50, negotiating a pre-determined benefit to the buyer (e.g., 5 percent cost reduction per year) with the rest going to the supplier, or to joint investment in capital projects for further capacity. Joint Developmental Agreements (JDAs), recommended in cases where IP (Intellectual Property) might be created, must clearly define the scope of the work, confidentiality obligations, intellectual property rights, exclusivity terms, and release criteria, to name a few.
Building momentum with small wins is important. Ultimately, though, supplier collaboration teams should work on large and ambitious projects for the maximum impact. To do so, the collaborating companies must align on which suppliers, products or service lines to invest in, and it’s important to do this with the input of relevant cross-functional leaders internally such as manufacturing, R&D, engineering, and product line leadership.
Together, you need to answer the following questions:
What business units, product or service lines should be prioritized based on factors that include potential profitability, urgency, risk, and crossfunctional leadership support?
- Which suppliers are providing critical components or services?
- Is the spending for prioritized products or service lines growing?
- Is it specific to a particular geography?
- Is the opportunity to reduce cost, improve performance, or conduct product innovation big enough to justify the resources required?
- Will this help to gain a competitive advantage?
A large North American industrial equipment manufacturer wanted to unlock the potential of supplier collaboration. To determine which suppliers to invest in, it took a three-point approach.
First, the manufacturer ranked their suppliers’ strategic value, by mapping the importance of the products they supplied versus the ability to obtain them. Second, it reviewed each supplier’s performance versus expected capabilities. This helped the company to define what the supplier could bring to a developmental program. Finally, the manufacturer evaluated these results to determine which suppliers to partner with to increase collaboration (see Exhibit 2). A side benefit of this exercise was a clear understanding of the relative value (or lack thereof) of their different suppliers, leading to insights on which ones needed to be replaced, motivated, or rewarded.
In this formative phase, you must clearly outline the goals of the program as well as the roles, responsibilities and time commitment of the teams. Business and functional leaders will need to provide support from the outset, and cross-functional leadership teams must be committed for the long haul.
2. Design the program to meet a specific business imperative
We have identified three types of supplier collaboration programs. Each meets different business objectives and requires varying levels of expertise to execute.
- Collaboration for cost reduction focuses on cutting costs for both sides beyond traditional sourcing levers. Suppliers are treated as partners, not as cost centers, necessitating the development of long-term, trusting relationships. Some examples of how interactions change: negotiations are based on full transparency into costs, with healthy margins and growth guaranteed; specifications are jointly optimized to eliminate unnecessary features; and demand transparency is created based on production patterns to optimize inventories. This kind of cost-based program requires mature procurement competencies, but is also the least complex compared to other collaboration options. A company with no or minimal experience in supplier collaboration programs may choose to begin here and work its way up.
- Collaboration for value beyond cost: this could be the right program for companies that want to improve safety or the quality of products, develop additional sources of supply for a new or capacity-constrained component, or work with a supplier on lean improvements. While these changes can and will reduce costs, the work is focused on value beyond purchase price, and requires a greater degree of cross-functional expertise to execute. One example would be an oil major company collaborating with an upstream drilling services provider to contain the cost and time of capital projects.In another case, a leading freight railroad had outsourced the repair of its railcars to a sole supplier. Despite high rates of idle time and waste, the supplier continued to win the annual contract. The railroad company wanted to partner with a competitive supplier who would also work with it to reduce the operational and capital costs that would eventually be charged back. The railroad approached multiple companies, including the incumbent, with the carrot being a long-term contract in exchange for competitive pricing as well as a collaboration program to improve the supplier’s operations. The result was a significantly more competitive bid price from the incumbent, and identification of 15 percent additional savings through joint lean initiatives focused on operational efficiency and capital cost reduction. Once the railroad mastered the basics of supplier collaboration, it embarked on supplier innovation, a more complex lever.
- Collaboration for innovation is the practice of working with suppliers to improve the pace and quality of product or process innovation. It creates value in areas like design, speed-to-market, and consumer insights. This form of collaboration requires the most time, money, and trust; it also carries the most risk because of the experimental nature of developmental work and the need for more two-way trust than ever before. The two partners may have to negotiate sophisticated agreements on IP rights, licensing agreements, and warranties. The payoff, however, can be significant in the form of a better, more timely and competitive product (see example in Exhibit 3).
In the case of the railroad, a new program was started to de-specify head-hardened rail steel with an existing supplier and design a new rail steel specification. The end result was tens of millions of dollars in value creation per year through better TCO (Total Cost of Ownership). In order to embark upon the project, the railroad company needed advanced skills.
3. Build transparency and trust
Transparency and trust are essential for sustained success. A survey of 35 strategic suppliers to a large, global medical device company dealing with quality and cost issues found the majority did not trust that their innovative solutions were consistently and seriously considered by the customer. They considered this a primary reason for poor collaboration. The survey signaled to the company that it needed to restart its relationships on the basis of transparency (e.g., more clear, two-way feedback), with the expectation that greater trust would follow.
Successfully creating transparency and trust, however, can deliver remarkable value. One company in the financial services used just this approach to address persistent poor performance by its network of litigation service providers. It did this by first changing the way it interacted with vendors, simplifying lines of communication and establishing regular weekly calls with them. Then it introduced a transparent vendor performance management system, tracking results and error rates, and discussing them with each vendor in monthly reviews. The company supported these efforts with changes in its own organization through the creation of dedicated teams for vendor performance management and collaboration.
Finally, the company modified its working processes in ways that addressed key pain points and allowed both it and its vendors to benefit. For example, it gave vendors power of attorney to sign documents on its behalf, reducing frustrating delays as documents were sent back and forth. It also changed the way work was allocated, so higher performing vendors got more, and it collaborated with its vendors to identify and eliminate unprofitable lines of work. The result of this effort was a startling shift in vendor performance. The cash recovered by litigation rose by nearly 80 percent, while the company found that it needed a third fewer staff to manage its vendors, and saved even more in filing fees and expenses. Even more importantly, the relationship between the company’s line teams and vendors was transformed, with free, open communication and a constant exchange of ideas.
Creating successful partnerships like this one is complicated, with a number of requirements. Some are preconditions that must be in place before the collaboration kicks off; others follow through the collaboration itself.
Preconditions: Write them down
- Spell out the parties’ different commitments, including, at a minimum, capital expenditure and personnel (on both a leadership and working level)
- Align to standard contract terms on the length of the agreement, renewal terms, and volume and price ranges
- Specify the product range covered and the scope of the development effort. Options and agreements on the use of alternative suppliers and use of the capabilities developed by the supplier with any other customers must be explicit.
- A value-sharing model must detail the targets of cooperation, defining the benefits and agreeing on how to share those benefits. Too many times the customer proposes a model that does not offer enough value, or the right value, to its suppliers, stalling the program before it even begins.
As an example, lithography equipment manufacturers for the semiconductor industry deal with extremely short product lifecycles, new technologies, and wildly fluctuating demand patterns. To incentivize suppliers to partner up with them, a leading lithography system manufacturer offered high margins (as a volatility buffer), equipment financing, and purchase guarantees with narrowing windows from systems to components. This value-sharing mechanism sustained the supply chain through the cycle, jointly reduced costs, dealt with wild swings in demand, and stabilized throughput and delivery. Both the customer and suppliers benefited.
Ongoing work through collaboration
These are matters that need to be co-developed and refreshed throughout the collaboration. For instance, supply chain management and operations teams must work out how to deal with exceptions to the agreement, such as through a joint review board. Similarly, for the collaboration to grow and sustain, there needs to be a mechanism to generate, evaluate and prioritize new ideas. If there is a foundation of trust and transparency, the collaboration will continue to grow.
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The expression “win-win” is often overused. But highly effective collaborations between suppliers and purchasers are just that. The best result in competitive advantage for all players, and drive innovation and growth.
The authors would like to thank Frédéric Lefort, a principal in McKinsey’s Gothenburg office, and Lissy John, a consultant in the Washington DC office, for their contributions to our research efforts and to this article.
About the authors: JehanZeb Noor is an associate principal in McKinsey’s Chicago office, where Aurobind Satpathy is a director, Jeff Shulman is a principal in the Dallas office, and Jan Wüllenweber is a director in the Cologne office