Finding the Right Mix Among Firm Resources, Investments and Governance
Original equipment manufacturers face challenges in working out long-term contracts with suppliers.
ANN ARBOR, Mich.—A new study reveals that original equipment manufacturers (OEMs) face complex trade-offs when working out contract terms with their suppliers of parts, components and sub-assemblies.
The research suggests that OEMs run the risk of signing supplier contracts that either are too loosely structured to achieve targeted cost reductions or too tightly written to permit product and/or service improvements after the ink dries. Furthermore, OEMs with unique customer-side assets, such as strong brand equity or customer loyalty, have limited flexibility on the supplier side and may be forced to sacrifice product quality-enhancing initiatives.
In their recent study published in the Journal of Marketing Research, Mrinal Ghosh of the University of Michigan's Stephen M. Ross School of Business and George John of the University of Minnesota advise OEMs to abandon the naïve notion that these contract terms always should be written as tightly as possible. Instead, they say, managers should view themselves as "governance value engineers," who add value by engineering contract terms that strike the right balance between the desired outcome (lower costs vs. enhanced quality) and the firm's own resources (great vs. small).
"OEMs seeking to cut costs should strive to engineer complete, though complex, contracts featuring fixed prices, standardized designs and gain-sharing formulas," said Ghosh, assistant professor of marketing. "These terms protect the necessary investments and motivate suppliers to find ways to reduce costs. Successful companies such as Toyota often use gain-sharing formulas to motivate cost reductions by suppliers."
In contrast, when the primary goal is to improve products and/or services, OEMs are better off engineering more flexible (incomplete) supplier contracts that encourage fine-tuning over time, the researchers say.
"Allowing for adjustments offers greater expected gains than locking in the initial terms, so these types of contracts should include cost-plus prices, changeable designs and change orders," Ghosh said.
There is, however, an additional wrinkle to the analysis, the researchers say. Flexible contracts could expose OEMs with unique customer-side assets to opportunistic re-negotiation by their suppliers—thus, such OEMs are likely to experience greater difficulty than those with relatively weaker customer-side assets in attaining quality-enhancing outcomes. In contrast, all OEMs can successfully pursue cost-reduction outcomes vigorously with their suppliers.
In their research, Ghosh and John analyzed buyer-supplier purchasing agreements, drawing on sample responses from 193 OEM managers in three industry sectors and 80 corresponding suppliers. Using their governance value analysis (GVA) model, they sought to determine the best three-way fit among firm resources, investments in supplier relationships and governance (contract terms) for maximizing desired outcomes, such as cost reductions and end-product/service improvements.
The study shows that OEMs possessing more resources in the end-product market generated diminished levels of end-product enhancement when they aligned their investments with more flexible (incomplete) contract terms than did OEMs possessing fewer resources. For cost-reduction outcomes, OEMs that aligned their investments with less flexible (complete) contract terms improved their cost cutting regardless of the resources the firm possessed.
Their results exposed a previously unrecognized weakness of strong firms that attempt to engage their suppliers through close ties, and prompted Ghosh and John to develop practical guidelines for engineering the desired tightness of supplier-contract terms.
Written by Claudia Capos
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