The IndustryWeek Value Chain Survey: The Big Squeeze

April 1, 2002
Small and midsize manufacturers say price-cut mandates and online reverse auctions compromise quality and endanger their businesses. Supporters of the practices say the strongest suppliers will survive, making supply chains more efficient.

Where will it all end? That's the question many executives at small and midsize manufacturers are asking as they struggle to comply with mandatory price cuts. These suppliers are feeling especially pressured to cut costs as OEMs and large Tier I companies, equipped with a powerful new technology-the online reverse auction-are driving prices down to subterranean levels on everything from tires to pumps to assembled components. Critics of the forced price reductions say they arbitrarily require producers to reduce the quality of materials and parts and trim necessary labor. What's more, they complain that the painful vice-grip on suppliers not only hurts quality, but ultimately leads to plant closings as manufacturers can't afford to stay in business. "Many companies have gone out of business as a result, but that's just a bump in the road for a Ford or a GE or a Daimler-Chrysler," says Paul Wood, purchasing manager at Betts Industries Inc., Warren, Pa., a maker of valves, lighting systems, and other parts for over-the-road tank trucks. "They'll use you up like a dishrag and then throw you away." Proponents of mandatory price cuts and online reverse auctions as a means to reduce costs say they merely hasten the natural business process of weeding out the weaker, less efficient producers. The topic is controversial. Despite an outpouring of letters to IndustryWeek from suppliers after a recent column on this topic (Starving Suppliers Not The Answer), few suppliers wanted to be identified in the letters or for this report for fear of losing their large customers. And some representatives of Tier 1 and OEM companies either didn't want to be interviewed or didn't want to be identified in this report. "There's a lot of resistance, but the OEMs are in a position to drive a lot of business to those suppliers that are willing to change and embrace new business practices," says Bill Davidson, former professor of management at the University of Southern California Marshall School of Business Administration and chairman of Mesa Research, Redondo Beach, Calif. "The market power is with the Tier I and OEM companies, and if you want to do business with them, expect to get squeezed." Mandatory price reductions are fairly common in industry today. Toyota Motor Corp., the standard-setter for many management practices followed by U.S. manufacturing over the last decade, requires its suppliers to cut prices annually. More than half (56%) of manufacturers participating in a recent IndustryWeek value-chain survey reported that they had required their suppliers to cut prices as a contractual obligation. Daimler-Chrysler AG last year told suppliers they would have to reduce their costs by 15% over the next three years. "Chrysler felt that their suppliers were overcharging them compared to what their competitors were paying for the same parts," explains Martin Piszczalski, president of Sextant Research, an IT consulting firm in Ann Arbor, Mich. "They told their suppliers, if they didn't do it, they wouldn't consider them for future contracts." Even so, Piszczalski warns, the long-term effect on the supplier community is bound to be constrictive. "Sooner or later," he warns, "This will drive some suppliers out of business." General Motors Corp., which spends $130 billion annually worldwide, takes a different tack. "We are working individually with each supplier, and each has an individual target," says spokeswoman Renee Rashid-Merem. "Some have been aggressive in reducing costs already, but others have not been as aggressive." GM works with its suppliers, she says, in an effort to develop savings that the OEM and the supplier can share. The online reverse auction, in which suppliers are pitted against each other in a downward bidding spiral, is by far the most popular technology enabling manufacturers to slash their overall spend. "The financial benefit of online reverse auctions is simply too attractive for most senior managers to ignore," says Bob Emiliani, professor and director of the Center for Lean Business Management at Rensselaer Polytechnic Institute in Hartford, Conn. Says a vice president of business development at a manufacturing firm, who preferred to not be identified: "The Internet provides the efficient tools to accelerate this process to the point where decades of (building) margins can be lost in an hour of frantic price cutting." Ford Motor Co., which is using Oracle Corp.'s iProcurement system to replace more than two dozen systems and five manual purchasing processes, declined to comment about its online purchasing program. "Ford is in the first year of a three-year e-procurement project," explains Paul Hebeler, Oracle automotive industry director. "Right now they don't wish to get the message out because the suppliers that they buy from . . . feel like they're taking a squeeze from their customer. It gives them a sense of exploitation." It may be exploitative, but it sure is popular. Purchase Pro, one of dozens of vendors of online reverse auction technology, reported that in the month of December 2001 alone, 150 reverse auctions were held using its e-Source system. The low bids on these auctions totaled $45 million, versus opening or high bids totaling $72 million. In other words, the implied savings totaled $27 million. There were 13 manufacturers doing the purchasing, while more than 1,400 suppliers placed more than 2,500 bids for their business. Spurred by former chairman Jack Welch to accelerate its use of the Internet, General Electric Co. has moved aggressively to pare the costs of its purchases through online auctions. In 2000, the company employed online auctions for $6 billion in purchases, with an estimated savings of $480 million. In 2001, the company figured its online auction spending would increase to $14 billion. "I have personally experienced a reverse auction sponsored by GE," says the manufacturing firm vice president who asked to remain unnamed. "We were bidding on $5 million in new business that our competitor had locked up for several years, so we were thrilled to get a chance to take some market share. The online bidding took several hours. We watched as our gross margins dropped from 35% to between 10 to 12%. "We were stunned that the incumbent retained all of the business even though we got written confirmation that we were the lowest bidder. We learned that . . . all we were was cannon fodder for the OEM buyer to use against the existing supplier. A complete waste of time and energy! The next time I am invited to an Internet auction, I will think long and hard." Actually, it's not surprising that the low bidder failed to get the contract, according to procurement managers, who are quick to point out that price isn't the only factor in making a purchasing decision. "We reconvene after the auction with our team to determine if we are going to stay with the incumbent or go with another supplier," says Dumond Lowery, director of global strategic sourcing at Dana Corp. The Toledo, Ohio-based Tier I automotive supplier last year purchased $650 million worth of goods via online auctions. In fact, not all OEM and Tier I manufacturers are fully enamored of mandatory price cuts. Some choose instead to work with their suppliers to keep prices down voluntarily. "There's not a '5%-or-you're-out' aspect to our contracts," says Andrew Wellener, business development manager Goodrich Aerospace, Charlotte, N.C. "We're asking for cost control on the part of our suppliers, not cost reduction." Clearly, though, all manufacturers are feeling the heat to cut costs. "We have no choice," says Jim Semon, general manager in charge of the business development team at Manco Inc., Avon, Ohio. "We have to be a low-cost provider. Economics is a factor. It has to be." He adds that Manco, manufacturer of Duck brand duct tape and other products, also tries to work with its suppliers to control costs. "Through a collaborative effort, we can find ways to take cost out," he says. For manufacturers that supply the Tier Is and OEMs, what's the answer? One solution is to find a new product or market. One manufacturer of white plastic sprinkler pipes discovered a way to use the material for clapboard-style home siding. A manufacturer that made foam pipe insulation, also a commodity-type product, created the Funnoodle product that kids play with in swimming pools. Consultant Piszczalski offers the example of the Budd Co., a Troy, Mich.-based automotive supplier, that came up with a proprietary technology for a self-dimming rearview mirror. It's this kind of advanced product, he says, that offers a manufacturer a shield against mandatory price cuts-at least until the competition catches up. "If there are no alternative suppliers, that's a good way to avoid getting beaten up over the price," he says. "A sole-source supplier has a lot more bargaining power than a commodity supplier." Buzz Adams, president of Peak Value Consulting, a consulting firm in Pasadena, Calif., agrees that innovation is one way to avoid the price squeeze. "The best defense is having some unique product where they're not going to take the work elsewhere," Adams says. "If you're a vendor and you want to keep a contract, the key is value-added." And, Adams points out, a manufacturer that produces a unique product or technology can charge more. "It's the uniqueness that gets you a premium," he adds. "If you're in a commodity business, your margins are going to be low." In fairness to the OEMs demanding price cuts, Adams says, "I can see the logic from their standpoint. Overhead and administrative costs for manufacturing are bloated. A lot of industries still have dramatically inefficient operations, and this is forcing them to re-examine everything they do. People have to get a lot more efficient. If you are in a commodity business, in the end it will come down to price." Wood of Betts Industries says his company manufactures "a niche product for a niche market. It doesn't mean we don't have to be aggressive and efficient," he adds. "We have competition like anybody else. But purchasing is not like kids trading baseball cards. It's about relationships. Understanding your suppliers and your products and your markets, as well as the supply and demand equation, is what makes a good purchasing professional." Adams believes manufacturing that offers value-added products will remain competitive. Without that uniqueness or special technology that makes a product better or different, though, price will tend to take over. "When you look at the world economy, things are going to gravitate to the lowest-cost production," he concludes. In other words, let the supplier beware.

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