In Uncertain Times, Big Companies Need to Take Care of Their Suppliers

The resilience of a supply chain is dependent on the reliable performance of the suppliers who make it up, but the fiscal health of many of lower-tier firms is often not visible to executives at companies several tiers up. This is especially true for original equipment manufacturers (OEMs) like automakers or industrial equipment producers who often have many lower-tier suppliers. The problem is that many of these OEMs designed their procurement strategies and supply agreements during a time when the global geopolitical and trading environments were comparatively benign, with steady growth of cross-border trade, low inflation, and stable raw materials and logistics costs. The pandemic and the war in Ukraine have revealed many vulnerabilities of global supply chains, but the disproportionate impact on many smaller suppliers is just beginning to be revealed. It’s time to revisit some of the assumptions underlying supply chain practices and redesign some of them for a new era of volatility and unpredictability. Let’s start with the principles that are the foundations of outsourcing and the practices that many OEMs have developed over the years. The motivation for outsourcing the manufacture of part or all of a product is to focus on some value-added work in house while harnessing an outside division of labor for the rest. Outsourced suppliers often are specialists who have unique skills or capabilities that the OEM lacks. Outsourcing can lead to a better utilization of assets and reduce the capital intensity of an OEM’s operations. Suppliers who do this work can, in principle, pool demand across multiple customers and achieve better scale economies. They can then share some of the cost savings in the form of lower prices passed on to their customers. While manufacturers have outsourced parts of their production for many decades, the rapid growth in offshoring to China in the 2000s has contributed mightily to an environment of muted inflation, in spite of occasional sharp swings in commodity and energy prices. This fostered the growth of some contracting processes such as long-term fixed-price contracts with annual price reductions. The auto industry placed additional burdens on suppliers: Contracts for vehicle components not only included quantities needed for production; they also required the provision of spare parts after a model was no longer available for sale, a time that might stretch out as much as a decade or longer. If producing the part — say, a windshield — required special tooling such as molds or dies, those tools then had to be kept around as well. Manufacturers also pushed production offshore in pursuit of lower costs. Managers at one U.S. domestic firm explained to me how a 15% savings after the higher transportation costs were factored in was sufficient to justify moving production to a Chinese supplier, and people at another U.S. manufacturer recounted how a 25% savings was sufficient to push the bulk of high-volume production there. This meant that the company lost the bulk of the production volume, and it had to sell what was left at a “pressured” (i.e., lower) price. At the same time, manufacturers pursued lean inventories and just-in-time production, putting the burden on suppliers to hold stock by imposing punitive terms if one of their production lines had to stop because of missed deliveries. The idea was to offload risk to suppliers — the risks of material cost increases, the risks and costs associated with carrying inventory, and the risks of supply chain disruptions further upstream. Over the last two years, even the largest firms have not been able to foresee strings of disruptive events — from semiconductor shortages and raw material shortages and cost increases to operational and logistics hurdles. Yet while U.S. automakers announced strong or record profits, many small suppliers have really struggled. The CEO at one lower-tier supplier who didn’t want to be identified told me that the price of petrochemical-based resins that it used to make plastic parts has doubled in the last year, and those resins made up 40% to 50% of the company’s product costs. With its single-digit margins, it had no ability to absorb the increases, but it was unable to pass along cost increases. “They [the customer] refuse to even meet with us, and just say they have a fixed price contract,” he explained. Another small supplier’s CEO told me that while his company was tied to a 10-year fixed-cost contract, his customer, a U.S. automaker, could change suppliers at will. In the early days of the pandemic, some OEMs cut their orders on a single day’s notice, leaving the company holding inventory and having to spread its employment and fixed costs over what volumes remained. This firm — whose managers, fearing reprisals by its OEM customers, requested that it not be identified — described the Detroit OEM “standard playbook” as a string of constant threats to move their work elsewhere. Stellantis even recently announced that for new purchase contracts, “all future events are deemed foreseeable” by suppliers. One has to wonder if anyone could foresee the events of the past two years. The consequences of past buying practices for supply chain resilience are clear. By driving production offshore, companies have ended up with far-flung supply lines subject to logistics disruptions and huge cost escalations. Transactional behavior toward domestic suppliers has weakened them, and in industries such as autos and aerospace, it has driven consolidation. This ultimately weakens OEMs’ bargaining power, while reducing the diversity of their supply base. Given the new world that they are facing, OEMs should change their practices. Here are some suggestions: Move beyond transactional behavior toward strategic partnerships. OEMs should recognize that a major benefit of having multiple suppliers is resiliency, and while competition between them will ensure fair pricing, it should not be used as a tool to drive a race to the bottom. Some firms already have a more enlightened view. For decades, Toyota has ensured that it understands a supplier’s costs and then negotiates prices without repeated rounds of threats. It also works with individual suppliers to improve their productivity and performance. “You can sit and have conversations. They actually care,” the CEO of one company told me. “I don’t have the potential to make as much money [with them], but the business is really solid, very stable.” Large companies should also directly manage relationships with lower-tier suppliers that are strategically important. Implement greater pricing flexibility in contracts. This means recognizing the reality that we are moving into an era of increased volatility in commodity and energy pricing. Approaches might include some form of indexing to commodity prices or frequent market pricing comparisons. If your first knowledge of one of your supplier’s difficulties comes from a force majeure declaration or a notice of commercial impracticality, you have failed. If your supplier fails, it will only increase your costs as you have to seek alternatives under pressure. Rethink inventory levels and where stock is carried. It is premature to proclaim the complete end of just-in-time (JIT) inventory practices given that there still are many benefits to keeping low inventory in the pipeline that may be subject to engineering changes or at risk of being unneeded or becoming obsolete. But you should agree who in the supply chain should hold how much and who should assume the associated costs and risks. Detroit OEMs historically have used punitive contract penalties for supply shortfalls, and suppliers probably haven’t sufficiently priced these risks into the contracts they signed. It’s time for a more collaborative approach. If we have learned anything about supply chains over the last two years, it is the need to adapt to new circumstances. It’s time to take a more strategic view of supplier relationships. Manufacturers should remember the reason they outsourced in the first place was because the supplier did work they themselves couldn’t or didn’t want to do internally. Healthy suppliers are a big part of a more resilient supply chain — one that can adapt in this rapidly changing world.

In Uncertain Times, Big Companies Need to Take Care of Their Suppliers

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