Over the years I have learned that every new management buzzword
brought into the boardroom reduces shareholder value by 10%. Last year's
buzzword was paradigm shift, which basically says that everything we
did before is wrong now, but it isn't our fault.
This year's phrase is strategic partnering or, as they say in California,
becoming one with your customers. All over the country managers are
embracing their large customers, sharing information from their financial
accounts and agreeing to multiyear sales agreements at profit margins
of one-third to one-half lower than normal.
Partnering with a gorilla is the quickest way to increase sales, but
when you dance with a gorilla, the gorilla always leads.
Wave after wave of downsizing, restructuring and consolidation since
1980 has left many industries dominated by a few large companies. Those
big companies want to exercise their enhanced market power every way
they can. One way is by reducing the number of suppliers, sometimes
to only one or two and to work with them intensively to get quality
and delivery schedules right.
For good or bad, strategic partnering is not going to go away, but
if your company finds itself propositioned by a gorilla, here are some
lessons I have learned that may be useful to you.
Lesson one: Don't let him squash your margins. When
a big customer approached one of our companies to submit a proposal
to become its sole supplier, our managers came up with a plan. We could
reduce our normal 23% gross profit margins, do the extra business for
only 16% and still earn over 30% on the additional capital employed.
Fortunately, we looked deeper. The managers were counting only the
marginal costs of doing the extra business. For example, if the project
utilized an expensive machining center at less than full capacity, they
counted the costs of the additional operator hours but not the capital
costs of the machine.
This is good thinking for short-term work, but it is deadly for long-term
contracts. All resources used, including administration and capital
charges, need to be included when you price long-term contracts. When
figured correctly, the returns failed our company's internal hurdles.
We raised the bid to the customer. It's still our customer.
Lesson two: Think return on capital, not margin. Many
partnering arrangements begin by establishing an agreed-upon gross margin
based on the benefits of bigger volume. But more volume requires more
plant, equipment, inventories and the like. Make sure an adequate return
on this capital is figured in your price.
Lesson three: Be careful of formulas for setting prices.
Lots of partnering agreements include language designed to allow the
seller to pass on a portion (usually half) of cost increases to the
customer, and requiring that all cost reductions be passed along as
well. Unfortunately, government price indexes are notoriously inaccurate
measures of your costs. Don't build them into your pricing agreements.
Lesson four: Just say no to blackmail. The managers
of one company I know thought they were doing a very good job supplying
a big customer with products at reasonable prices. Then, just as they
were ready to close a merger that involved valuing the company using
its recent cash flow numbers and booking of business, the customer pulled
the rug out from under them. It demanded an immediate 12% across-the-board
price reduction and a rebate of more than $2 million on past business—or
it would take its business elsewhere. The customer knew the announcement
of the lost business would kill the merger. The board just said no to
the blackmail. It didn't lose the business.
Lesson five: Keep your books private. Once a customer
becomes your partner, he may ask to see your financials or to audit
your costs. In a friendly voice, tell him no. Your records are private.
If you find a way to drastically lower your costs, and can sell products
to your customers at prices lower than your competitors, you are entitled
to make high returns on capital.
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