A Potential Scenario
A business purchases a critical item for one of its main products. The demand is high but it is more than 50% of the total cost. The margin on the product is very low
They only use one supplier and they are unaware of any other source. The business is approached by a new company, claiming to be a new supplier in the market.
Their initial proposal is 20% more competitive.
The business is successful but it has no dedicated procurement function.
They would like to improve on their margin but cannot afford to endanger supply.
How should they proceed?
Quantifying the Opportunity
Initially the business should look to obtain more information about the potential new supplier. How long have they been trading, what other products do they manufacture and who are their customers? The business will need to approach some of these customers to obtain direct feedback on the performance of the potential new supplier. Financial due diligence should also be carried out to make sure they are stable for the long term.
An initial small batch of the product could then be taken for review. This would cover sample approving the product in terms of dimensional and raw material specifications. Its functionality should also be tested.
In parallel to quantifying the opportunity the business will need to need to understand any obligations or contractual liabilities it has with its current supplier.
Are there any minimum quantities in the agreement and will there be any financial penalties should the business have the opportunity to source some of the demand with the other supplier?
Even if they are allowed to move demand away is there a minimum notice period that they have to give? The business will need to absolutely certain that the new supply source is a valid one before making any such decisions.
It is important that the business ensures that any proposal from the potential new supplier is on the same basis as their current source.
The price should include delivery to their premises as well as any specific packaging or transportation specifications.
The product needs to be made in similar production batches. If the potential new supplier is planning on making the item in much larger quantities, this might account for the price difference but it will also expose the business to potential obsolescence should the item need to be modified in any way.
The business will need to understand the term the pricing is going to be fixed for. In addition, it should be understood and agreed on how any price movement is triggered and how it is managed by both parties. It is important that a baseline is agreed and that independent data is used if the parties look to use pricing indices as the basis on managing the price of the product.
Assuming that the business is able to satisfactorily cover all these points, they then have a decision to make.
They should look to take advantage of the opportunity but they also need to protect the business and their source of supply.
Initially the business could look to source 10% of the overall demand with the new supplier. This will allow them to explore the opportunity without raising any concerns with the current supplier.
Ideally, the products from the new supplier should be assembled separately from the main production area. As a minimum they will be marked with a specific reference so that full trace ability is available once the items are in the market.
Provided that there are no issues the business can then decide on how to proceed. They could just move 100% of the demand to the new supplier and significantly increase their margin on one of their main products.
Another option for them would be to open re-negotiations with the current supplier on the basis of a dual source agreement. While supplier consolidation is usually the most beneficial, for instances such as these protecting supply is likely to take precedence.
There are no right and wrong decisions as this stage, as it will depend on the business itself, its relationships with the suppliers and the outcome of any discussions.
There most certainly would be many more points to cover for this scenario to develop successfully but I hope that my initial thoughts are useful.
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