It’s April and tariff anxiety is hitting fever-pitch levels with the stockmarket down 4% YTD and senior executives worrying yet again about their supply chains. Today’s announcement of significant tariffs of at least 10%, 25% for Europe, Mexico and Canada, and 34% for China, causing the S&P 500 to drop 1.5% in late trading.
Supply chains can shift quickly in response to tariffs, if they are perceived to be long-lasting or permanent. Much of the tariff bluster coming from the Trump administration is negotiation tactics and judging by the outrage in the media, it's working. Both Canada (77% of exports representing almost 25% of Canada's GDP go to the US) and Mexico (80% of exports representing almost 30% of Mexico's GDP go to the US) are so incredibly dependent on US trade that they will likely cave.
China is different. As the US's key geopolitical rival, trade policy is part of the national security tool kit. Europe is hard to predict, but hopefully, cooler heads will prevail.
Global Supply Chain Drives Global Wealth
The global supply chain is a self-organized network connecting suppliers, via layers of intermediaries, to consumers and is a miracle of modern technology. It has enabled new business models and raised the standard of living throughout the world dramatically through Ricardian specialization to an almost unimaginable level. In 1990, 38% of humanity lived in extreme poverty vs. 8.6% today. The fact that over 1.2BN people have been raised out of poverty is a testament to the success of global capitalism and the supply chain, which for example, makes iPhones with components sourced in 43 countries.
China’s entry into the WTO, NAFTA/USMCA, Private Equity’s unrelenting focus on efficiency, and the dramatic growth in outsourcing, resulted in huge shareholder value being created and everybody got used to savings generated by Strategic Sourcing.
Tariff Troubles
The first inkling of things to come may have been the 2018 China tariffs. Sudden and drastic supply chain shifts resulting from tariffs caused buyers to move production across Asia in a matter of months. It resembled a mad game of “musical chairs”, as producers competed to secure scarce non-China manufacturing capacity all over Asia, but it proved that it could be done.
COVID really jolted the manufacturing sector, with a total collapse of some supply chains, raising serious resilience issues with supply chain executives focussing on diversification and developing alternative supply lines. Because of lack of availability of supply, cost focus was out the window for a while, until inflation brought it back to the forefront in 2022.
Predictably, the second Trump administration is refocussing on tariffs as both a geopolitical negotiation tool, as well as an alternative revenue source to reduce deficits. Only time will tell how this works out in the macro sense, but in the meantime, executives have to act in the best interest of their companies and shareholders.
A Cost Model Approach
We believe that supply chain management needs to be more sophisticated, proactive and flexible, given that conditions can change month to month with little warning. We will make the point that smart corporate buyers need to have pre-negotiated deals with alternative suppliers that they can fluidly switch in and out of. It’s not useful to have supplier relationships without deterministic economics, yet in dynamic markets, such economics are constantly shifting.
We developed a methodology we call “competitive cost models” that put a buyer-supplier relationship on a fair, yet competitive footing. Unlike “Pentagon style” cost-plus pricing, we do not worry about a single supplier’s cost structure and unlike indexing, we go into much more detail, separating cost factors into three basic buckets:
Specification driven, i.e. cost is driven by what the good or service is and how it’s specified by the buyer (e.g. a bigger steel part is more expensive). The competitive cost model needs to capture all of the price fluctuation driven by specification changes.
Market force driven, i.e. cost is largely not under the supplier’s control, and forcing the supplier to commit to such pricing would result in risk-padding. We parameterize these cost elements explicitly, and allocate the risk appropriately between the parties.
Supplier controlled, i.e. any cost elements that the supplier can or should control. We subject these cost elements to maximum competition to drive true win-win long-term agreements. Innovation and productivity are crucial elements here and we take great care to preserve and enhance innovation incentives. This approach protects the suppliers from inappropriate risk transfer and enables longer-term agreements with self-adjusting economics.
How It Works
Strategic Sourcing is a well understood process that most readers will be familiar with, so I will focus here on the novel elements that pertain to improving flexibility, resiliency and outcomes.
Category sourcing RFP processes often apply the 80/20 rule and focus on the most frequently purchased items in a category, leaving the tail unsourced and unpriced. Suppliers know this, and I have seen many cases where most of the supplier’s profit came from the tail, change orders, or the replacement of sourced items with never-sourced items having only slightly varying specs.
The way to avoid this outcome is to organize the RFP effort around a “competitive cost model” that captures the key cost drivers of the supplier industry and allows a buyer to compute a total price for an individual item using a “process pricing approach” with formulae, specs, component prices, and indices that are a good proxy for the industry cost curve. Note that this is not the same as a “cost-plus” model or a “should cost” model for an individual supplier, but rather an a priori structured pricing agreement between the buyer and the supplier that governs pricing across all the items in the category. Buyers can use this technique to establish and competitively maintain “efficient pricing frontiers” across a range of categories.
Often, the top items are still priced as catalog items, but having an understanding of the category cost components allows for better negotiation and resiliency analysis on the non-catalog items. It’s one thing to have alternative sources, but quite another to have priced alternatives when things go wrong.
Analytically Challenging Process
Given the significant financial benefits of an optimized supply chain and the large amounts of data analysis required to embark on a sophisticated Strategic Sourcing effort, it almost always makes sense to supplement the organization with external experts and leverage sourcing technology.
We have almost 30 years of experience in assisting corporations in Strategic Sourcing, and we have developed proprietary RFP technology that can automate the comprehensive sourcing approach described above. By leaving nothing unpriced, we generally double the savings and gain a much deeper understanding of the available alternatives in a particular supplier industry. In combination with our existing category pricing models for hundreds of industries, we are able to execute “Baseline to Contract” sourcing projects much faster and at a fraction of the typical cost.
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