An important force within the Five Forces model is the bargaining power of suppliers. All industries need raw materials as inputs to their process. This includes labor for some, and parts and components for others. This is an essential function that requires strong buyer and seller relationships. If there are fewer suppliers or if they have certain strengths and knowledge, then they may wield significant power over the industry.
In this article, we will look at 1) understanding suppliers, 2) bargaining power of suppliers, 3) effect on target market, 4) example – the diamond industry, and 5) example – the fast food industry.
Types of Suppliers
Depending on the industry, there are different types of suppliers. Some of these may be:
- Manufacturers: Manufacturers are producers of either the entire product or components that feed into the end product manufacturing process. If the parts supplied are generic and have easily available alternates, the manufacturer will have less power. Conversely, if the manufacturer has important expertise or no competing producers, they will have significant say in the value chain.
- Distributors & Wholesalers: These types of suppliers purchase products in large quantities from different companies, store these goods and eventually sell to retailers. These products may be made available at higher prices than if bought directly from the manufacturers, but this allows purchases to be made in smaller quantities than a manufacturer will be willing to supply.
- Independent Suppliers/Craftspeople: These people manufacture unique items in small quantities and provide them exclusively through representatives or trade shows.
- Importer: These suppliers will purchase from international sources and sell to local retailers. They essentially act like domestic wholesalers/distributors for these products.
Given the importance of suppliers to the entire value chain, it is in the interest of companies to create and maintain good supplier relations. Some strategies that can be employed to this end include:
- The first step is to evaluate the cost and the value of the entire supply chain. With proper understanding, a supplier’s importance to the process can be evaluated
- Another important step is to build two way relationships with the suppliers. This can enable both parties to work together to achieve lower production costs that benefit everyone.
- Companies need to accept accountability for their end of the process. This means putting in orders on time and not requiring unnecessary changes later on.
- There need to be service level agreements and performance evaluation metrics predefined to keep an objective measure of performance. This will allow clear expectations to be set and followed up on.
- In addition to penalties, incentives also need to be established to encourage value creation through optimized production and delivery times.
- Critical information regarding the process needs to be shared with the supplier to ensure that there are no delays or unnecessary costs incurred. Open communication channels with the required levels of security and confidentiality will help strengthen the relationship with suppliers.
- There need to be plans in place for exceptional circumstances and emergencies. If processes are in place then the risk associated with them can be minimized.
- Contingency plans should be put together to avoid disruption to the value chain. Natural disasters or other disruptive events can be managed smoothly if all parties know the plan of action.
- Honesty should be rewarded in cases where an exceptional situation occurs and a warning is issued in time and up front. No penalties should be put on the supplier in these situations.
- Meaningful meetings that focus on the critical issues for value chain improvement as well as relationship development can strengthen the buyer seller link.
BARGAINING POWER OF SUPPLIERS
When suppliers have bargaining power, they can apply pressure on a company by charging higher prices, adjusting the quality of the product or controlling availability and delivery timelines. Within the five forces framework, there is an understanding that when suppliers have this bargaining power, they can affect the competitive environment and directly influence profitability for the company.
Factors that Increase Supplier Power
Suppliers may have more power:
- If they are in concentrated numbers compared to buyers.
- If there are high switching costs associated with a move to another supplier.
- If they are able to integrate forward or begin producing the product themselves.
- If they have specific expertise or technology needed to manufacture goods.
- If their product is highly differentiated.
- If there are many buyers and none make up significant portions of sales.
- If there are no substitutes available.
- If there are strong end users who can exert power over the organization in favor of a supplier (This can be the case in labor situations).
In all of these cases, the bargaining power of suppliers is high to demand premium prices and set their own timelines.
POWERFUL SUPPLIERS AND THE TARGET MARKET
When a company’s suppliers have significant power over the value chain, it can directly impact how the company serves its own customers. Depending on what power the supplier chooses to exert, a company may have to reflect this through product prices, product quality and quantity available. Too much disruption in any of these areas may even mean that a company is no longer able to stay in business. A company may need to end operations or shift to another industry to avoid being dictated by the whims of a supplier.
The first issue a company usually has to face from a strong supplier is increased costs. A supplier who knows that they cannot be removed may insist on raising prices for their raw material too soon, or ahead of agreed upon timelines. If the buyer has to choice but to pay these prices, the resultant increase in total production cost will either need to be absorbed by the company itself or passed on to the consumer. If the profit margin does not allow the company to absorb this pressure, it will mean higher prices in the market. The target market may not be receptive to this change and sales may suffer. A loss of customers to a competing product or substitute may be another undesirable outcome.
If a supplier is unwilling or unable to meet quantity targets, then the company may have to deal with demand that outweighs supply. This can happen either in regular scenarios if the company decides to try and increase sales or at peak sale times such as holidays or special occasions where people tend to buy more of some types of products.
There may be cases where the supplier decides to compromise on the quality of the product in order to bring down costs. This will directly impact the company’s product offering and may create a negative impact on the end consumer if the quality issues are significant enough to impact user experience. There may be an increase in complaints, returns and exchanges, and in worse cases, an entire switchover to another product.
Dictating Industry Dynamics
If a single large supplier chooses to supply to only certain companies, it may end up with the power to push companies out of the industry. In these cases, a company will be helpless and unable to save itself. If the product is a fully manufactured by a supplier, they may also choose to deign selling it directly to the customer often at a lower price.
Mitigating Supplier Power
If supplier power becomes too strong in the market, companies will try to find ways to reduce this power. If the demand for the product is high enough, there may be ways to develop alternate ways to produce or sell a product that reduces the supplier power. Product re-design, or product line diversification may be some of the ways that companies can try to dislodge powerful suppliers.
EXAMPLE – THE DIAMOND INDUSTRY
The diamond industry worldwide has historically been controlled by De Beers, a world famous and cartel like company. In addition the industry is global in nature making a regional analysis irrelevant. The supply chain moves from one country to the next. Over the years, this power has moved from De Beers to a more widespread competitive marketplace with a few major competitors and some second tier ones. The modern diamond industry started in 1867 when diamonds were discovered in South Africa. Prior to this, limited quantities were extracted from India and Brazil.
There are 3 types of diamond segments are industrial diamonds which have use in manufacturing processes, jewelry diamonds that are rough diamonds polished to be used in ornaments, and investment diamonds that are high quality gemstones with special characteristics. The diamond supply chain is vast including processes such exploration, mining, sorting, cutting and polishing, jewelry manufacturing, and even retailing.
DeBeers And The Global Diamond Industry
Issues in the Industry
There are several issues that are pertinent to the diamond industry. These include:
- The industry has shifted from a pure monopoly to more of an oligopoly or consolidated one.
- Awareness within the diamond producing countries to be more involved in the process and to take ownership of this resource.
- There is a decrease in the supply if diamonds but an increase in worldwide demand
- An awareness about and movements against conflict or blood diamonds which has made it necessary for suppliers to employ better practices.
- The synthetic diamond market is growing because technology has allowed the manufacture of these almost at par with the value of natural ones. This has shifted profitability and customer perceptions of value
Five Forces Analysis
Keeping these industry dynamics in mind, the five forces analysis is discussed below:
Bargaining Power of Suppliers
There is increasingly larger number of competitors in the market which has meant a larger supply of diamonds in the market. In the past, De Beers solved oversupply problems by collecting and storing them to be sold when deemed appropriate by them. This meant enormous power of the supplier over the industry. With the change in market structure and pressure by anti-cartel laws, this power has diminished somewhat. De Beers now focuses more on repositioning itself as the supplier of choice and not the only supplier. The company has handled bans on stockpiling by reducing mining and leaving diamonds inside mines. There is also more of a focus on stronger vertical integration, by moving to value-added retailing and partnerships with premium fashion brands such as Louis Vuitton.
- Threat of New Entrants: Before the breakup of the De Beers monopoly, it was virtually impossible for new entrants to jump into the industry. With forced change in business practices, stronger implementation of laws and discovery of diamonds in areas outside of the De Beers scope of control, competition has now increased in the market. There is now room for about 3 more major players and several smaller niche operators who often consolidate and manage to compete in smaller segments.
- Bargaining Power of Buyers: Historically, consumers had no control over the diamond industry, its pricing and supply. With an economic downturn in the industry, there was reduction in demand which lead to an oversupply problem and reduced prices. To address this, major companies reduced mining operations and turned the industry back to its higher demand lower supply model. Once again, the buyer’s power is non-existent in this industry.
- Threat of Substitutes: The biggest threat to the diamond industry are from high quality high tech synthetic diamonds. These directly impact the basis of the value of the diamond, i.e. the customer perception of its rarity and value. The price of diamonds are not a true indicator of their value or supply. But it is all in the perceptions of the consumers. With synthetic diamonds, consumers will begin to challenge the diamond as a rare natural item and in some places they may overtake the sale of natural diamonds. In addition, these are sustainable and not the result of invasive mining activities. They are also easy to identify as not originating from a conflicted area. All these aspect make the threat of substitutes a real one
- Competitive Rivalry: In a change from previous industry structures, the broken cartel now means that there is some competitive pressure from the industry. There are still limited players, but overall, the increased presence of different companies means a more competitive market.
EXAMPLE – THE FAST FOOD INDUSTRY
Suppliers play a key role in the value chain of the fast food industry. Chain restaurants rely on suppliers for food items, packaging, napkins, as well as items like plates and spoons. The same suppliers may be serving competing chains in an industry. This means that the power of these suppliers needs to be assessed by any company looking to enter the industry. A strong supplier may be able to effect profitability, quality of products and force companies to raise prices. The following factors may raise the bargaining power of suppliers:
- If the suppliers have a larger base of customers, then they will be able to exert more control over the buyer. When the bulk of sales in not made up of one company’s business, the supplier can afford to drop a buyer who resists its efforts to exert control.
- If there are only a few suppliers in the market then they will manage to have more control. Fast Food chains can simply pick other suppliers in industries where suppliers are manifold. In this case the supplier will have to meet the buyer’s demands or sell a highly differentiated product.
- Suppliers with strong brand names of their own will be able to exert more control. Generic products on the other hand will have significantly less bargaining room. For example, condiment makers who supply to chain stores may be able to leverage consumer preferences for their product over a generic one of the same type. Also, beverage choices such as a preference for Coca Cola over Pepsi may drive people from one chain to the other
Any fast food chain needs to consider what power suppliers in its regional market exert before making the decision to move into that market or expand operations.