My Strategic Supplier is Making Abnormal Profits – So What?

Your profits reflect the success of your customers.” – Ron Kaufman

Money Bag – Creative Commons licence v4.0

Introduction

In many transactional, fixed price contracts, customers are often oblivious to their supplier’s actual profit margins. However; with many collaborative contracts, we often use open book financial reporting. In these circumstances, we can see where the money goes and how much profit is being made.  Commercial managers may be alarmed when they see suppliers make abnormal profits, but we should never over-react to such revelations.   On the contrary, abnormal, or high profits may be a symptom of a high performing team that is driving innovation for the benefit of the customer.  This blog explores these themes where we focus on value rather than price.

Are Profits Really Abnormal?

Effective commercial managers on the buy side possess the commercial acumen to understand the supplier’s business. Effective relationships demand mutual understanding as described in the Automotive Industry by Liker and Choi

“Unlike most companies we know, Toyota and Honda take the trouble to learn all they can about their suppliers. They believe they can create the foundations for partnerships only if they know as much about their vendors as the vendors know about themselves.”[1]

Not all industries are equal and profit margins are highly variable.  The Australia Department of Defence in their Profit Principles recognise three elements of the contract profit rate, comprising:

  • Return for Contractual Risk. For example, firm fixed price contracts are far riskier to suppliers than cost reimbursement contracts.  A higher profit margin would therefore be expected in fixed price arrangements.
  • Return for Activity Risk. Complex, developmental activities carry far greater risk than simple, commercial off the shelf activities.  Suppliers will factor in additional profit for the risky developmental tasks.
  • Return for General Business Risk.  Profit is to be expected on shareholder returns, general and administrative activities, managing sub-contractors, and general resource management.[2]

Included in the contractual risk profit provisions will inevitably be a supplier’s factor for relationships.  With a proven track record of positive relationships with their customer, a supplier may abate their profit margins, knowing that their commercial partner will act reasonably and fairly if things go wrong.  Conversely, if a supplier is dealing with a difficult customer, then they may load up their profit margin (or add contingency) to cater for the drama of working with a troublesome counterparty (or even worse, refuse to do business with that customer).  The following examples illustrate this point:

“In my opinion, [Ford] seems to send its people to ‘hate school’ so that they learn how to hate suppliers. The company is extremely confrontational.”[3]   – Supplier Executive Manager

“Starve before doing business with the damned Navy. They don’t know what the hell they want and will drive you up a wall before they break either your heart or a more exposed part of your anatomy.” – Kelly Johnson, Vice President at Lockheed Martin[4]

Even if you consider yourself a ‘perfect customer’ and suspect supplier profits are high (taking into account contract risk, activity risk, and business risk), there may be no real cause for alarm. The next step is to ask yourself, why are profits are high?

Cause and Effect

All highly competent people continually search for ways to keep learning, growing, and improving. They do that by asking WHY” – Benjamin Franklin

Perceptions of price can be important as the price itself.[5]  A cynical manager who is exploring high supplier profits would immediately assume that the supplier is acting opportunistically and gouging the customer.  This is a very dangerous starting point to adopt (even if the premise could be true). A useful starting point is to explore why profits are high by asking the following questions:

  • Are the profits high in the long term or are they cyclical? Depending on the project or business lifecycle, profit margins can vary widely over the medium to long term.
  • Is the supplier reinvesting profits into their business?  Where a supplier is investing in the relationship, seeking innovative ways of doing business, and adding future value then this should be encouraged.
  • Are you, as the customer, gaining ‘abnormal value’ from the relationship? So long as the customer’s strategic needs are being met and value is being delivered then we should not be too fussed about supplier profits.

If, after the exploring the issues above, it is revealed that value is not being delivered and suppliers are not investing in the relationship then a recalibration of the relationship may be required.  This does not mean that price becomes the only consideration. Do not let the pendulum swing too far in the other direction.

Driving value

The collaborative commercial model should be designed so that all parties win, or all parties lose.  There are a myriad of remuneration and non-price mechanisms we can use to achieve this. In addition to the commercial model, we also need to foster a collaborative culture and operate as one team.  Kanara goes further to state that customers should “treat your vendors like employees.”[6] If we are truly engaged in a collaborative model then customers should “learn to love their supplier’s profits”[7].  The caveat of course is to ensure the relationship continues to deliver value to both parties.  In addition to the remuneration strategy, we can also look at other ways to enhance the profit pool for both buyers and suppliers such as:

  • Initiate a continuous improvement and innovation fund where some of the savings can be distributed to each parties’ profit pool and the remainder used to fund additional continuous improvement and efficiency initiatives (thus creating future savings).
  • Encourage suppliers to reinvest in their business by increasing their scope of work within the customer’s organisation and offer longer term contracts.

Conclusion

High supplier profits may not necessarily be a bad thing.  So long as customers are provided with value then it may be a very positive sign to see high supplier profits, especially where customers and suppliers work together collaboratively to jointly create value.  Ideally, we should craft a commercial model where parties seek to continuously innovate and pursue excellence.  Nevertheless, there is also an important message for suppliers in this discussion. Never turn up to a customer meeting or contract negotiations driving a Maserati.[8]


[1] Jeffrey Liker and Thomas Y. Choi “Building Deep Supplier Relationships” Harvard Business Review (December 2004).

[2] CASG Profit Principles v1.0 (2017) p2.

[3] Liker et al, opcit. 

[4] Rich & Janos “Skunk Works: A Personal Memoir of My Years of Lockheed” (2013).

[5] Sandeep Heda, Stephen Mewborn and Stephen Caine “How Customers Perceive a Price Is as Important as the Price Itself” Harvard Business Review (January 2017).

[6] Ken Kanara “Rethink Your Relationship with Your Vendors” Harvard Business Review (March 2020).

[7] Anon.

[8] Quote attributed to Andrew Pyke https://www.linkedin.com/in/andrewpyke/

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About John Davies

John is a recognised authority in collaborative contracts, relational contracts, and novel procurement options. John has conducted extensive research into alliance contracts and governance frameworks from both the buy side and sell side. John has authored collaborative contract better practice guides, performance-based contract evaluation guides, and tender evaluation guidelines for major programs. You can find his CV at LinkedIn.