SUPPLIER DEVELOPMENT IN A

GLOBAL MARKET

“ T H E P R I N C I P L E S O F E X T E R N A L

E C O N O M I E S ”S E P T E M B E R 2 0 1 0

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External economies of scale (ES) occur outside of a firm, within an industry

. . .

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. . . when an industry’s scope of operations expands due to, for

example, the creation of a better transportation network, resulting in a

subsequent decrease in costs for a company working within that

industry, external economies of scale are said to have been achieved.

SUPPLIER DEVELOPMENT IN A

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Example: since some economies of scale may require a larger market than

is possible within a particular country — for example, it would not be

efficient for Liechtenstein to have its own car maker, if they would only

sell to their local market. A lone car maker may be profitable, however, if

they export cars to global markets in addition to selling to the local

market.

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With external Economies of Scale, all firms within the industry will benefit.

(What Are Economies of Scale? By Reem Heakal, January 2003)

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Facing challenges such as rising fuel costs, in which the decision to

maintain the manufacturing process within the ―partners‖ home region

can result in either a diminished profit or reduced competitiveness . . .

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. . . versus developing strategic satellite clusters in which a portion of the

manufacturing process leverages local resources as a means of

levelling the playing field . . .

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. . . can potentially increase the risk in key areas such as quality control (i.e.

the Mattel tainted paint nightmare)

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While the principles of external economies have traditionally been

associated with the manufacturing industry . . .

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. . . the emergence of clustering and the global value chain has in effect

redrawn the boundaries of its applicability.

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Ironically, the idea of looking beyond the ―localized‖ or ―regionalized‖

structure normally associated with external Economies of Scale, is a

concept that is not new . . .

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was first presented by E.G. Robinson in 1931 and expanded upon in his

book The Structure of Competitive Industry in 1958.

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The question according to Robinson is one of immobility versus mobility.

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Robinson defined an immobile external ES as one which ―require the firms

to be in close proximity to one another‖ for benefits to be realized.

SUPPLIER DEVELOPMENT IN A

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The Risks: according to experts, the absence of a dedicated private and public sector policy regarding the development of localized clusters prompting speculation on whether the clusters built through the national or international lead firms success will consolidate into a self-sustainable and durable regional specialization.

Note: Lead firms according to Gereffi ―undertake the functional integration and coordination of international dispersed activities.‖

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Case Reference: The Associated Manufacturing Marketing Group (AMMG)

SUPPLIER DEVELOPMENT IN A

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The Problem: In the case of the AMMG, its formation was predicated by the

challenged New Brunswick economy which created a vacuum in terms

of supplying traditional ―central‖ enterprise clients. In short, you have

a group of companies that have core competencies which ranks

amongst the best in the world, but lacked the necessary regionalized

client base that is essential to ensuring the collective long-term viability

of the sector.

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The Solution: A joint ―venture‖ of what the AMMG web site refers to as ―five

well-established manufacturing firms,‖ this innovative, privately funded

consortium’s main objective is to develop new business on a

cooperative basis both domestically as well as internationally.

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The Solution: AMMG is a private initiative which seeks to develop a

collaborative, full-service supply chain network as a means to

effectively identify and service viable export markets.

SUPPLIER DEVELOPMENT IN A

GLOBAL MARKET

Conversely, ―external economies of scale which are available to firms

located well beyond the territory in which they are provided‖ Robinson

defined as being mobile.

SUPPLIER DEVELOPMENT IN A

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One example of external ES which Robinson cited in the 1930s as being

mobile was the Liverpool cotton exchange of the early 1900s, which

could be utilized by firms both locally as well as globally to the apparent

benefits of all stakeholders.

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GLOBAL MARKET

The Key: with the emergence of the global value chain, it is critical to

realize that the ―value chain perspective‖ extends beyond the realm of

manufacturing to include ―other activities in the supply of goods and

services, including distribution and marketing.

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The Key: The policies that define the buyer supplier relationships, including

the role of local government is a key to success.

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What are the relationship parameters or structures?

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Humphrey and Schmitz* identified ―three possible types of governance . . .

* Governance in global value chains by John Humphrey and Hubert Schmitz

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a) network implying cooperation between firms of more or less equal power

which share their competencies within the chain;

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b) quasi-hierarchy involving relationships between legally independent

firms in which one is subordinate to the other, with a leader in the chain

defining the rules to which the rest of the actors have to comply and . . .

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c) hierarchy when a firm is owned by an external firm.

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The Questions: Does your organization operate under a immobile versus

mobile External ES structure?

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The Questions: Under what governance model does your current External

ES operate?

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Case Reference: Tesco control of the production of mangetout (snow peas

or snap peas) in Zimbabwe

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Case Specifics: Tesco was clearly calling the shots, even though it did not

own the farms or the packing facilities.

In reality, Tesco only takes ownership of the product when it arrives at the

chain’s regional distribution centres in the UK.

But this does not prevent Tesco from influencing what happens at earlier

points in the chain.

SUPPLIER DEVELOPMENT IN A

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The Fallout: Tesco endured adverse publicity surrounding a TV

documentary about the conditions for workers growing mangetout in

Africa, exported to the supermarket chain.

The retailer was also criticized regarding concerns surrounding the

perceived threat it poses to small businesses due to the monopoly it

imposes over products.

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Case Reference: Wal-Mart and Vlasic Pickles

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Case Specifics: “Young remembers begging Wal-Mart for relief. “They

said, „No way,‟ ” says Young. “We said we‟ll increase the price”–even

$3.49 would have helped tremendously–”and they said, „If you do

that, all the other products of yours we buy, we‟ll stop buying.‟ It was a

clear threat.” Hunn recalls things a little differently, if just as ominously:

“They said, „We want the $2.97 gallon of pickles. If you don‟t do it, we‟ll

see if someone else might.‟ I knew our competitors were saying to Wal-

Mart, „We‟ll do the $2.97 gallons if you give us your other business.‟ ”

Wal-Mart‟s business was so indispensable to Vlasic, and the gallon so

central to the Wal-Mart relationship, that decisions about the future of

the gallon were made at the CEO level.” o from influencing what

happens at earlier points in the chain.

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Case Specifics: ―The story is that Vlasic, a premium pickle brand, agreed to

sell a gallon jar of pickles in Wal-Mart for an absurdly cheap price. What

happened is fairly predictable. Why would consumers buy a small jar

for $3.00 when they could get a gallon for the same price? Yet the

margin on the gallon jar was incredibly thin, so despite the increased

volumes, the pickle maker took in less and less, especially when you

factor in Wal-Mart’s insistence (stated up front) that suppliers lower

their prices each year.‖

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Case Specifics: Finally, Wal-Mart let Vlasic up for air. “The Wal-Mart guy‟s

response was classic,” Young recalls. “He said, „Well, we‟ve done to

pickles what we did to orange juice. We‟ve killed it. We can back off.‟

“Vlasic got to take it down to just over half a gallon of pickles, for $2.79.

Not long after that, in January 2001, Vlasic filed for bankruptcy.”

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Wal-Mart – a pattern of predatory practices . . .

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• On balance, firms that derive less than 10% of their sales through Wal-Mart averaged 39.1% in gross margin, the percentage of profit realized before items such as fixed costs and interest expense are considered. For those falling between 10% and 20%, gross margin was 36.2%. Above 20%, and margin dipped a little bit more, to 35.4%.

• This trend is most pronounced in the apparel-and-accessories category, where average gross margin drops from 48.7% for companies generating less than 10% of sales through Wal-Mart to 28.7% for those selling 20% or more. Food and beverage also shows a big disparity, where the same breakdown shows average gross margins dropping from 39% to 22%.

• In all, only 25 of 333 companies managed to beat their sector gross-margin average while generating at least 10% of their revenue through Wal-Mart. Only 7 that sold more than 20% there did it

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• The numbers show that company size has little to do with Wal-Mart dependency at least once you get past the top handful. The 10 companies that sell through Wal-Mart in the highest percentages, a list that includes apparel maker Jaclyn and personal-care company CCA Industries average a relatively paltry $107 million in market cap (CCA is the only top 10 member whose gross margins beat its sector average). Past the top 10 companies that generate at least 10% of their sales through Wal-Mart carry an average market cap of $5.9 billion, more than the $4.9 billion average of those firms that sell less than 10% there.

• While Wal-Mart squeezes margins of suppliers of all sizes, it’s still true that smaller companies tend to feel a tighter pinch. For example, beverage company Cott, even with a market cap in excess of $1.2 billion doesn’t have the brand strength of Coca-Cola or PepsiCo, whose products are in more demand at supermarkets, convenience stores and other outlets. So Cott, whose primary business is producing and distributing company-brand carbonated soft drinks, turns to Wal-Mart for 38% of its sales, compared with less than 10% for the two beverage titans. The result? Cott’s gross margin of 12.4% last year was about a third of the industry average, while Coke and Pepsi both registered more than 50%.

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Why are the relationship parameters or structures also referred to as ―chain

governance‖ important?

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Referencing Humphrey and Schmitz once again, ―The main reason for

specification process parameters along the chain is risk.‖

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Process parameters are established and enforced when there are ―potential

losses arising from a failure to meet commitments re delivering the

right product on time or, a failure to ensure that the product conforms

to the necessary standards (re think Mattel paint scandal).

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One possible reason for breakdowns such as with the Mattel situation is

linked to what Keesing and Lall referred to as the ―gap between the

capabilities required for the domestic market and those required for the

export market.‖

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Based on the existence of this gap, both Keesing and Lall stressed that

―parameter setting and enforcement may be required to ensure that

products and processes meet the required standards.‖

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While challenges may arise in those circumstances where the gap ―has to

be closed quickly,‖ the suggested course of action would be to ―invest

in a few selected suppliers and help them to upgrade.‖

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The Questions: In your opinion, why did Mattel fail to enforce the proper

parameters in relation to the paint incident?

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The Questions: To what degree should the gap between domestic market

requirements and export market requirements influence your

organization’s decision to use suppliers from within a specific foreign

cluster?

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The Questions: If you choose to invest in developing a few selected

suppliers in an effort to quickly close the capability gap, at what risk are

you of running into the problems referenced earlier pertaining to

diminished profit or reduced competitiveness?

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The Questions: Being apprised of the fallout associated with Tesco’s

control of the production of mangetout, at what point does the nature of

your ―influence‖ over suppliers cross the line?

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The Questions: Based on these as well as other elements of establishing a

globalized supply chain, and if possible, does it make more sense to

deal with domestic or close proximity foreign suppliers (re like Canada

and the United States)?