Supplier Competition: A Great Tool for Reducing Cost

How long has it been since your suppliers felt competitors chasing their business?

If you have to think deeply to remember when you last made your suppliers compete, it’s been too long.   Supplier competition is a powerful tool for reducing cost, and if you don’t use it, your costs are too high.  You might think you don’t have any problems, and maybe you don’t, but you’re still missing opportunities for improved profitability.  You may be in a situation where you don’t have to compete for your work and cost is not an issue, but that’s highly unusual and it probably won’t last long.

Groundwater Arsenic Reduction:  A Windfall Market

A real company, which we will refer to as Watco, faced exactly this situation in its water treatment business a few years ago.  Watco sells large custom-engineered treatment plants for municipal and commercial water purveyors.  Watco was recognized as the dominant water services company in what was a small market.   Due to Watco’s position in the market, its engineers didn’t worry about keeping costs down; in fact, they did just the opposite.  Watco designed the battleships of the water treatment business, with all metal construction, extensive instrumentation, and an approach that guaranteed the plants would be expensive.  Watco used its same preferred suppliers for years, without much emphasis on keeping costs down.  It was a comfortable arrangement, but it was bound to end.

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In 2003 the U.S. Environmental Protection Agency tightened the maximum allowed arsenic contaminant levels in drinking water.  Suddenly, the water from thousands of previously-compliant wells required arsenic reduction.   The arsenic-laden wells were particularly pronounced in the southwestern United States, where arsenic naturally occurred in groundwater.  Watco’s senior management thought they had a windfall.  What they didn’t realize was that this federally-induced windfall would attract hungry competition.  The new competitors came to market with creative and lower cost approaches.

The initial results were predictable.  Watco watched as others made inroads into what had previously been regarded as a Watco market.  To Watco’s credit, the company did not sit on its hands.  The engineers and managers knew they had to find a way to reduce their costs quickly, or a significant chunk of the arsenic market would disappear.

Watco’s problems were not unusual, and they had two approaches to address the issue.  The company could reduce its margins substantially (not surprisingly, this did not go over well with Watco’s corporate chieftains), or it could find a way to reduce costs without eroding margins.  The guys at Watco opted for Door No. 2.

Watco’s approach was similar to that of many others who design and deliver large-scale, custom-engineered products – they didn’t manufacture anything.  Watco’s water treatment business ran on a project-by-project basis, and it would be inefficient to set up a factory.  Watco purchased or subcontracted everything.   Pipes, valves, vessels, treatment media, instrumentation, the control system, and even site construction and installation went to outside suppliers.

To be competitive, Watco recognized it had to address the existing design approach and its long-term, cozy relationships with its suppliers.  Here’s what they did:

  • Watco took a hard look at its design, and in a classic value-engineering approach, the company stripped out all non-essential features.  Watco made sure that its designs met client specifications; they also eliminated any features that went beyond what the spec requirements.  This effort will be the subject of a future article.
  • Watco introduced supplier competition on nearly every component used in its water treatment plants.  The company realized that virtually 100% of its costs went to supplier-purchased goods, and most of the cost reductions would have to come from lower supplier prices.

Watco’s first steps involved identifying all sole-source components and services (that was relatively easy; initially, it was almost everything).   Watco found that multiple suppliers were available for nearly everything, and they proceeded to solicit bids.  The company’s existing suppliers, not surprisingly, came back with substantially lower prices.   It was a sobering experience for Watco’s management when they realized the opportunities they had missed earlier.

Watco had a few instances in which it had to buy from sole source suppliers, as these suppliers were the only ones providing a particular component or service.  Watco could have simply lived with the prices provided by these sole source suppliers, but it did not.  Watco evaluated vertically integrating into these areas, and it let the suppliers know it was doing so.  In many cases, such an approach would not have been feasible, but Watco found that just the appearance of its evaluations motivated suppliers to drop prices.

A Suggested Supplier Reduction Approach

How can you efficiently replicate Watco’s approach for introducing supplier competition?  Here’s a suggested approach:

  1. Identify everything your organization buys, what you pay for it, and if you compete it.
  2. Identify the high cost items that are not competed.  These items offer the greatest potential for cost reduction and these should be competed first (even the lower-cost items, though, offer potential for competition-induced cost reduction).
  3. Determine if competition will lower the cost.  If the item is a standard component and you’re a small market (for example, light bulbs from General Electric), it’s not likely that competition will help much.  If the item is custom made to your specifications, however, competition offers great cost reduction potential.
  4. Identify suppliers you want to bid.  You need to research the suppliers well.  There’s no return in buying from a low quality or persistently-delinquent source.
  5. Develop a specification that defines exactly what you want, and ask for supplier inputs.  The suppliers may recognize areas where unnecessary cost is built into the specification.
  6. Bid the work, but reject nonresponsive bids (if a supplier can’t get a responsive proposal to you on time, there’s nothing but trouble ahead).
  7. After selecting the lowest-cost responsive supplier, ask them for a lower price (it never hurts to ask).

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There are risks in introducing supplier competition, of course.  If a supplier does not understand its costs, or if it underbids the work and hopes to somehow make it up later, the supplier may default (you need to critically assess suppliers; you can’t just give work to the low bidder).  New suppliers present a performance risk (you need to assess if the supplier can do the work).  If your description of the work is vague, you may get a service or a product that doesn’t meet your needs (your specs have to be exact, correct, and unambiguous).   And finally, your existing supplier may dump you if you attempt to compete the work.  If you’re a major part of their business, they probably won’t walk away, but if your work is small or difficult, an existing supplier may lose interest.  If this happens you could be in a worse position than you were before you introduced competition.  You have to predict existing suppliers’ likely reactions.  It’s a subjective assessment, as is the case in many business decisions.

Watco’s Results

Watco did very well with its supplier cost reduction effort, creating a win-win situation for itself and its clients.   Watco won nearly every project it pursued in the southwestern United States, winning more than 50 competitively-bid projects with an average price of just under a million dollars per treatment plant.  While doing so in an intensely-competitive environment, Watco did not have to erode its margins.  Based on these successes, Watco held on to its dominant water treatment equipment market position.  Finally, Watco’s clients benefited enormously with sharply lower water treatment equipment costs.

Supplier competition is an important element of any cost reduction program.  It worked for Watco and it can work for you.

Editor’s Note: Want to optimize your cost structure? Bring this expertise into your organization!  Our new Cost Reduction: Opportunities and Strategies course, taught by Joe Berk, can help you achieve measurable cost reduction quickly and in a risk-managed manner.  The course teaches hard techniques grounded in practical experience – no esoteric, touchy-feely, or abstract concepts here. The technquies are applicable across industries, not just to manufacturing.