Supply Chains, Markets and Power: Mapping Buyer and Supplier Power Regimes (Routledge Studies in Business Organizaton and Networks, Number 18)

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply Chains, Markets and Power

This book makes an important contribution to current debates in both business strategy and supply management. It explains why an understanding of the concept of power is critical to the appropriate management of buyer–supplier relationships in extended supply chain networks, and also shows how power can be used to explain the unique patterns of profitability in different networks. Taking issue with the current orthodoxy in supply and value chain management, the authors endeavour to take resource-based thinking forward by stressing the need for a dynamic and entrepreneurial conception of resource acquisition and management, and by placing the company in the wider context of the supply chain network. They: • • •

•

Outline the four basic types of exchange relationship: buyer dominance, supplier dominance, interdependence and independence. Move beyond these initial categories to identify six different types of buyer and supplier dominance. Illustrate the usefulness of this power-based categorisation of exchange relationships by examining seven case studies drawn from a range of industrial and service sectors. Explain why integrated supply chain management initiatives often fail, and why certain zones within a supply chain network are more profitable.

Supply Chains, Markets and Power will be essential reading for all those with a professional or academic interest in supply chain management. Andrew Cox is CIPS-sponsored Professor and Director of the Centre for Business Strategy and Procurement at Birmingham Business School. Paul Ireland is Research Fellow at the Centre for Business Strategy and Procurement, Birmingham Business School. Chris Lonsdale is Lecturer in Supply Chain Management at The University of Birmingham, and Director of the University’s specialist Purchasing and Supply MBA. Joe Sanderson is Research Fellow at the Centre for Business Strategy and Procurement, Birmingham Business School. Glyn Watson is Lecturer in Supply Chain Management at the Centre for Business Strategy and Procurement, Birmingham Business School.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Routledge Studies in Business Organizations and Networks

1 Democracy and Efficiency in the

Economic Enterprise Edited by Ugo Pagano and Robert Rowthorn

10 Authority and Control in Modern Industry Theoretical and empirical perspectives Edited by Paul L. Robertson

2 Towards a Competence Theory of the Firm Edited by Nicolai J. Foss and Christian Knudsen

11 Interfirm Networks Organization and industrial competitiveness Edited by Anna Grandori

3 Uncertainty and Economic Evolution Essays in honour of Armen A. Alchian Edited by John R. Lott Jr

12 Privatization and Supply Chain Management Andrew Cox, Lisa Harris and David Parker

4 The End of the Professions? The restructuring of professional work Edited by Jane Broadbent, Michael Dietrich and Jennifer Roberts 5 Shopfloor Matters Labor-management relations in twentieth-century American manufacturing David Fairris

13 The Governance of Large Technical Systems Edited by Olivier Coutard 14 Stability and Change in HighTech Enterprises Organizational practices and routines Neil Costello 15 The New Mutualism in Public Policy Johnston Birchall

6 The Organization of the Firm International business perspectives Edited by Ram Mudambi and Martin Ricketts7

16 An Econometric Analysis of the Real Estate Market and Investment Peijie Wang

7 Organizing Industrial Activities Across Firm Boundaries Anna Dubois

17 Managing Buyer–Supplier Relations The winning edge through specification management Rajesh Nellore

8 Economic Organization, Capabilities and Coordination Edited by Nicolai Foss and Brian J. Loasby 9 The Changing Boundaries of the Firm Explaining evolving inter-firm relations Edited by Massimo G. Colombo

18 Supply Chains, Markets and Power Mapping buyer and supplier power regimes Andrew Cox, Paul Ireland, Chris Lonsdale, Joe Sanderson and Glyn Watson

Supply Chains, Markets and Power Mapping buyer and supplier power regimes Andrew Cox, Paul Ireland, Chris Lonsdale, Joe Sanderson and Glyn Watson

•

GE

RO

LE UT D

l

ou

y Ta

or

p

•

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

& F r n cis G a

r

London and New York

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

First published 2002 by Routledge 11 New Fetter Lane, London EC4P 4EE Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001 Routledge is an imprint of the Taylor & Francis Group This edition published in the Taylor & Francis e-Library, 2003. © 2002 Andrew Cox, Paul Ireland, Chris Lonsdale, Joe Sanderson and Glyn Watson. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Supply chains, markets and power : mapping buyer and supplier power regimes / Andrew Cox . . . [et al.] p. cm. Includes bibliographical references and index. 1. Business logistics. 2. Marketing. I. Cox, Andrew W. HD38.5 .S8963 2001 658.5–dc21 2001019767 ISBN 0-203-29927-2 Master e-book ISBN

ISBN 0-203-16355-9 (Adobe eReader Format) ISBN 0–415–25727–1 (Print Edition)

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Contents

List of figures List of tables Notes on authors Preface: power and the Janus-faced corporation

vii ix x xi

PART I

Power in supply chains and markets 1 Power, rents and critical assets

1 3

2 The key attributes of buyer and supplier power

24

3 Towards an analytical typology of supply chain power regimes

53

PART II

Power regimes in supply and value chains

77

4 Site-specific convenience, branding and regulation: the sources of asset criticality in the forecourt retailing supply chain

79

5 Regulation, site specificity and scale: the sources of asset criticality in the industrial sugar supply chain

102

6 Site specificity and price stickiness under regulation: the sources of asset criticality in the industrial electricity supply chain

124

7 Asset specificity, switching costs and limited competition: the sources of asset criticality in the aerospace fuel equipment supply chain

145

vi Contents 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

8 Information asymmetry and ex post lock-in to branded and regulated asset specificity: the sources of asset criticality in the motor insurance supply chain

163

9 Information asymmetry, innovation, scale and regulation: the sources of asset criticality in the new car supply chain

185

10 Information asymmetry, moral hazard and branded reputation: the sources of asset criticality in IT systems integration supply and value chains

207

PART III

A research agenda for analysing business power

231

11 Linking descriptive and analytical approaches to business thinking

233

Bibliography Index

254 263

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Figures

A 1.1 1.2 1.3 2.1 2.2 2.3 2.4 2.5 3.1 3.2 3.3 3.4 3.5 4.1 4.2 5.1 5.2 6.1 6.2 6.3 7.1

Abstractive reasoning about causality in sustainable business success Supply chains and value chains Critical assets and the ideal business situation for the Janus-faced corporation The potential power structures for a dyadic exchange Supply chain and market competence Objective interests and the architecture of exchange Determining the relative utility of a resource Buyer power resources and the architecture of demand Supplier power resources and the architecture of supply Isolating mechanisms and buyer and supplier interests Exchange-power heterogeneity An eight-category framework for analysing dyadic exchange Value appropriation in double-dyad exchange regimes Value appropriation in supply chain power regimes The forecourt retailing supply chain: functional stages and key resources The power regime for the supply of tobacco, confectionery, soft drinks and snacks by forecourt retailers The industrial beet sugar supply chain: functional stages and key resources The power regime for industrial beet sugar The industrial electricity supply chain: functional stages and key resources The power regime for traditional electricity supply to industrial customers The power regime for on-site electricity supply to industrial customers The aerospace fuel equipment supply chain: functional stages and key resources

xii 5 8 21 25 28 33 44 46 57 61 62 69 73 82 93 104 115 127 135 141 148

viii Figures 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

7.2 8.1 8.2 8.3 9.1 9.2 10.1 10.2 10.3

The power regime for aerospace fuel equipment The motor insurance supply chain: functional stages and key resources The changing face of the downstream motor insurance revenue chain The upstream motor insurance sub-regime The new car supply chain: functional stages and key resources The power regime for new cars The development of the IT systems integration supply chain The supply chain for IT systems integration: functional stages and key resources The power regime for a typical IT systems integration project

156 167 178 179 188 197 208 211 219

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Tables

2.1 4.1 5.1 6.1 7.1 8.1 8.2 9.1 10.1 10.2 10.3 10.4 11.1 11.2 11.3

Mechanisms that impede imitative competition The convenience retailing value chain The industrial beet sugar value chain The industrial electricity value chain (1993–7) The aerospace fuel equipment value chain Market share in UK general insurance The value chain for motor insurance The value chain for new cars Top five suppliers in key UK hardware markets, by revenue Key players in the UK software market, shares by value Breakdown of the management consultancy market, 1997 The value chain for an IT systems integration project Critical assets and power resources in the seven supply chain power regimes Types of dyadic exchange in the seven supply chain power regimes An analytical categorisation of double-dyad sub-regimes and profit margins

37 92 114 133 153 168 175 196 212 214 215 218 238 244 247

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Notes on authors

Andrew Cox is CIPS-sponsored Professor and Director of the Centre for Business Strategy and Procurement (CBSP) at Birmingham Business School. He is currently involved in two EPSRC-funded research projects developing audit tools and techniques for effective supply chain management. His most recent publications are Power Regimes: Mapping the DNA of business and supply chain relationships; Business Success: A way of thinking about strategy, critical assets and operational best practice; and Advanced Supply Management: The best practice debate. He will shortly produce, with colleagues at the CBSP, reports on the impact of e-business on business practices in the UK in the E-Business Report 2001. Paul Ireland is Research Fellow at the CBSP. He has published several papers and books on supply chain management in the information technology and construction industries. His current research interests also include e-business and its impact on business strategy. Chris Lonsdale is Lecturer in Supply Chain Management at the University of Birmingham, and Director of the University’s specialist Purchasing and Supply MBA. He has written widely in the area of supply chain management and outsourcing, and has worked in a number of organizations in recent years advising on risk management. Joe Sanderson is Research Fellow at the CBSP. His current research interests include supply management strategy and practice, particularly in public sector and regulated organizations, and their link with organizational change. His most recent publication, Power Regimes, focuses on inter-organizational power dynamics in supply networks. Glyn Watson is Lecturer in Supply Chain Management at the CBSP. Amongst his research interests are the study of power in supply chains and European business issues. He has published in both areas.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Preface Power and the Janus-faced corporation

In 1997 one of the current authors published a book entitled Business Success (Cox 1997a). In that book an argument was developed about the need for business thinking to move from an empiricist to an abstractive way of thinking. By abstractive reasoning one means the development of a way of thinking that starts from a theoretical specification of causality (deductive thinking) that is then tested empirically to ascertain whether the original theory of causality is proven or not (inductive thinking). In Business Success a theory of causality was developed about how and why entrepreneurs and companies achieve sustainable success in business (see Figure A). Essentially, the theory developed was that sustainable success arises from an ability to achieve innovation in supply. Furthermore, for this to be sustainable, the innovation would have to close the market for that product or service to potential competitors. This implied that market closure, or some form of temporary or permanent monopoly, was seen as a prerequisite of the ability to earn above-normal returns. Market closure against competitors was seen as essential because it allows the supply innovator to appropriate value from both buyers and suppliers in the supply chain network that has to be created to deliver the product or service that they own and/or control. This relationship was conceptualised as a power relationship in which the monopoly owner and/or controller of the particular supply chain resource was able to leverage value from customers, competitors, suppliers and employees. The possession of such a power capability through the ownership and/or control of a supply chain resource was defined as a critical asset. Subsequent research and empirical testing since 1997 have led the current research team to recognise a number of important modifications that need to be made to this original theoretical starting point. The initial conclusion that, in an ideal world, ownership and/or control of a nonreplicable supply chain resource is one of the keys to sustainable business success still stands. Nevertheless, it is true that the transparent monopoly of a supplier over a buyer often leads to regulation and control over rentearning capabilities. This was recognised in Business Success, but what was not properly articulated therein was the fact that, even if a supplier has

• Does this mean the original theory is wrong and should be discarded, or can it be adapted (further developed) to explain more satisfactorily the causes of sustainable business success?

THEORY TESTING

• There is evidence that market closure or monopoly leads to above-normal returns • There is also evidence that monopoly is often regulated • There is also evidence that supply monopolists cannot always leverage successfully if buyers also have countervailing power resources • There is evidence of above-normal returns being achieved in highly contested markets

EMPIRICAL TEST OF HYPOTHESES

• Sustainable business success is normally achieved by one party gaining ownership and/or control (power) over scarce supply chain resources, so that they can leverage value from others in the chain

INDUCTIVE THINKING

• Innovators in supply are monopolists at the point of innovation • Success can only be sustained by first movers if imitation by others can be stopped • Market closure or monopoly must be prequisites of sustainable business success • Sustainable business success is measured by an ability to achieve above-normal returns

DEDUCTIVE THINKING

TESTABLE HYPOTHESES

THEORY BUILDING

Figure A Abstractive reasoning about causality in sustainable business success.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Preface 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

xiii

ownership and/or control of a supply chain resource as a monopolist, this alone cannot constitute possession of a critical asset. For a critical asset to be created there must be more than just monopoly ownership of a supply resource against potential competitors. A critical asset can only be truly owned and/or controlled effectively to leverage value if there is a dominance of one party in an exchange relationship over another. This implies that, to properly understand the rent-earning capability of any supply chain resource, the relative power attributes of both buyers and their suppliers must be understood. In Business Success the focus of analysis was primarily on how suppliers closed markets to competitors so that they could take advantage of customers and their own suppliers. What was underdeveloped therein was the need to properly understand the countervailing powers that customers (buyers) have over even monopoly suppliers. It follows logically that there must be circumstances in which monopoly suppliers have ownership and/or control of supply chain resources from which they are unable to appropriate above-normal returns from their relationships with customers and their own suppliers. The monopoly ownership by UK entrepreneur Sir Clive Sinclair of an electric three-wheeler car would clearly fall into this category. The vehicle is unique but nobody currently values it in such a way that the innovator can earn abovenormal returns from ownership. This is because there has been insufficient demand from potential customers to allow the entrepreneur to appropriate any value at all. In the Sinclair case, therefore, the supplier has no leverage over the buyer because the customer does not value what is being offered. In a very real sense the supplier, while still a monopolist, is a supplicant with the customer, who in this circumstance has relative power over the supplier. This is, of course, very different from the Microsoft and Intel cases described in detail in Business Success, where the supplier has relative power over the customer. In these two cases the supplier was seen to be a relative monopolist operating in a market with very high levels of demand, in which potential customers were faced with very few realistic short-term options. In both of these cases it is clear that the relative power of the supplier over all potential buyers is very high indeed. Our empirical testing of the original theory about sustainable success has, therefore, led us to conclude that there is a need to better specify the exchange relationships between buyers and suppliers in order to understand how above-normal returns are achieved in the business context. This is for three reasons. The first is the need to build into the original work in Business Success a more inclusive specification of market closure mechanisms. Subsequent research has led us to conclude that some of the work of the resource-based school of strategic thinking provides the basis for a more inclusive specification of how market closure can be achieved. In particular the work by Rumelt on ‘isolating mechanisms’ (Rumelt 1984,

xiv Preface 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

1987), and by Molho on information asymmetry (Molho 1997), provide the basis for a more inclusive specification of market closure by suppliers against buyers. The second area of work that provides a valuable insight into the ways in which sustainable business success can be achieved, and which was underdeveloped in the original theory outlined in Business Success, is the seminal contribution to business thinking of Oliver Williamson. Williamson’s monumental work in developing a transaction–cost approach to economic thinking provides the basis for understanding in more detail the fundamental bases on which exchange relationships between buyers and suppliers take place (Williamson 1975, 1985, 1999). While we recognise Williamson’s contribution, we do take slight issue with his approach, if only because we believe his work does not properly conceptualise the meaning of power in buyer and supplier exchange relationships (Cox and Watson 1999). Despite this, we must acknowledge the immense debt our own thinking owes to his specification of the importance of moral hazard, through bounded rationality, uncertainty and incomplete contracting, as the basis for the creation of critical assets in buyer–supplier exchange relationships. Finally, we also have to build into our original starting point the empirical fact that above-normal returns (defined here as above-double-digit profit margins) can also be earned by suppliers on a sustainable basis in highly contested, as well as monopoly, markets. The cases of financial services and consultancy are classic examples of this reality. It might be said that this fact alone invalidates the original theory that market closure is the basis of business success. We do not accept this viewpoint, although we are confident that some may adopt it as a critique of our original work. We do not adopt it because, in our view, the ability to earn abovenormal returns in a highly contested market must be due to market failure. This must arise through the inability of a buyer to obtain information in such a way as to allow them to use it against suppliers to drive returns to normal levels. This implies that the suppliers must be in possession of a critical asset in their relationships with buyers. As we will show in this book, a critical asset is best understood not primarily in terms of the ownership and/or control of any particular supply chain resource per se, but rather in relational terms. The key to understanding what a critical asset is resides in an understanding of whether or not ownership and/or control of a particular supply chain resource provides the basis on which a buyer or supplier can achieve dominance in an exchange relationship with others. In the case of financial services and consultancy, even though a contested market exists, it is clear that it provides no mechanism to drive returns to normal levels. This is because there is a tendency for standard industry pricing by all suppliers, which the customer has no power to question, because the service provided is a credence good based on a defensible

Preface 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

xv

information asymmetry between the supplier and the buyer. In this circumstance we would argue that the suppliers have power over the buyers irrespective of which supplier any buyer chooses to source from. Despite the need to specify more clearly the sources of power in buyer and supplier exchange relationships our subsequent work has not led us to question many of the original ideas that informed the way of thinking in Business Success. In particular it was argued in that volume that thinking about business management must be focused always on the specification of who has power over whom in supply relationships. Furthermore, business strategy and operational practice must be understood in terms of supply and value, rather than primarily market ways of thinking. The strategic positioning decision made by any entrepreneur or company must, therefore, be based on the successful resolution of two key questions. The first question is ‘Which supply chain resources should we seek to own and/or control in an attempt to innovate against competitors so that we can appropriate and accumulate value for ourselves from participating in any network of supply and value chains?’ The second question is linked to this but focuses on the operational management of value appropriation and accumulation, once the strategic positioning decision has been made. The question is ‘How can we defend our ability to appropriate and accumulate value for ourselves, by ensuring that the suppliers of those resources that we choose not to own are not able to put themselves in a position to leverage value from us?’ It is for this reason that one refers to the Janus-faced corporation. For any entrepreneur or company that wishes to be sustainably successful an understanding must be developed about how to own and control critical assets that provide opportunities to create customer dependency and ‘lockin’. Such understanding normally requires a competence in effective demand and strategy management. This is the first face of effective business management. What is less clear in the literature on business management, however, is the fact that it is equally as important for the effective appropriation and accumulation of value that entrepreneurs and companies understand the critical importance of competence in procurement and supply management. The second key question that has to be resolved relates, therefore, to the issue of how (once a strategic positioning decision has been made) a company ensures that its suppliers do not leverage the value it has appropriated and accumulated from its supply chain relationship with its own customers. In the current business literature, as outlined in Business Success, it is clear that very little attention has historically been devoted to this second face of effective business management. This is particularly surprising today when one of the most common practices amongst major companies has been to outsource to suppliers a substantial number of the supply chain resources that were formerly owned and/or controlled internally.

xvi Preface 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Furthermore, it was argued in Business Success that, to be successful in effective procurement and supply management, companies have to undertake two primary tasks. The first is to recognise the strategic importance of the make/buy decision. Knowing which supply chain resources are currently (or have the capability in the future to become) critical assets is an essential element of effective strategic and operational alignment. The second task, in the defence of the value that any company appropriates and accumulates, is to acquire the ability to ensure that suppliers are unable to turn the supply chain resources that they own and control into critical assets that can be leveraged against the company when it buys. To put this another way, the key requirement is for companies to understand operationally how to place their suppliers into highly contested or dependent relationships in which the buyer leverages value from the supplier rather than the other way round. Obviously, it follows from this that if companies are to become effective in their ability to appropriate and accumulate value they must understand how to effectively manage the supply relationships (and the extended tiers of supply relationships) within the multitude of supply chains that serve them. This fact implies that competence in procurement and supply management must be equally as important for business success as effective demand and strategy management (Cox 1997b, 1998, 1999b; Watson and Sanderson 1997). It is essential, therefore, to recognise that companies face two ways in their supply chain relationships. Companies are Janus-faced. They have to build relationships as sellers (suppliers) to customers (buyers), while at the same time acting as customers (buyers) to their own suppliers. It is self-evident that business competence must reside, therefore, in the ability of practitioners to understand how to manage the inevitable and constant struggle over value between buyers and suppliers in supply chain networks. To achieve sustainable business success, therefore, it is not enough to understand how to innovate with supply so that markets can be closed to competitors. It is also essential to understand the power struggle over value appropriation and accumulation that occurs between buyers and suppliers at all stages in the supply chain networks that are created to produce products and services for final consumers (Cox et al. 1999). Recognising the importance of this understanding is essential for practitioners of, and commentators on, business management. The research undertaken by the team at the Centre for Business Strategy and Procurement in Birmingham over five years demonstrates, however, that this recognition is not as well developed as it could be. It seems clear that most practitioners and commentators simply do not understand the critical importance of procurement and supply competence to business success (Cox 1999b). Furthermore, most commentators do not recognise that effective business management is a game in which power is constantly in play between buyers and suppliers (as well as their respective competitors).

Preface 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

xvii

Not all of the aspects of power in business can be fully addressed in this present book, due to a lack of resources and time. Nevertheless, since all business relationships take place in supply chain and market circumstances, this volume seeks to provide a better understanding of two related phenomena. The first is the types of supply and value chains that exist for buyers and sellers to operate within. The second area of concern is, if there are different types of supply and value chain, what are the power regimes that can exist between buyers and suppliers within them? Given the desire to understand the types of supply and value chain that can exist, and the buyer and supplier power regimes that persist within them, the structure of the book is self-explanatory. In Chapter 1 we describe the circumstances that allow any entrepreneur or company to own and control critical assets that allow above-normal returns to be earned. This is a more detailed elaboration of the original argument, presented in Business Success, that critical assets will always be those supply chain resources that allow monopoly (permanent) or entrepreneurial (temporary) rents to be earned. In particular there is a modification of the original argument to take account of the role of information asymmetries and credence goods in the creation of critical assets in highly contested markets. In Chapter 2 we explain in more detail how critical assets can be sustained and/or diminished through the relative power of buyers and suppliers in exchange relationships. The chapter also outlines the key attributes that buyers and suppliers must possess if they are to achieve effective leverage over one another in their power struggles over value. In Chapter 3, the major theoretical contribution of the book is made. In this chapter we set out our view of the universe of dyadic power relationships that can exist in buyer and supplier exchange relationships. Our view is that there are eight primary types of buyer and supplier relationship. In order to analyse the type of supply chain network any company is operating within, these theoretical types must, in our view, be empirically analysed and linked together. This means that, while it would be more satisfactory to have discovered that there are just a few, descriptive types of supply and value chain, analytically there must be an extremely large number of potential types. These analytical types (or power regimes) will be based on the extended dyadic inter-relationships that occur between buyers and suppliers in specific supply and value chains. It is our view that practitioners and commentators cannot hope to understand how to manage markets and supply chains effectively unless these power regimes (based on extended dyadic buyer and supplier relationship types) are properly understood. Rather than pursuing the latest fashions in business management thinking, therefore, practitioners should be encouraged to understand the objective circumstances of power that they are operating in. Only when this has been achieved will it be possible, in our view, for practitioners to know what it is appropriate to do (Cox 1996, 1997b, 1999b; Watson and Sanderson 1997).

xviii 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Preface

It should be clear why we believe that the first three chapters of this book provide an invaluable guide for practitioners. They explain how practitioners can close markets to their competitors so as to acquire critical assets for themselves. This is achieved by an analysis of the major isolating mechanisms that provide the means by which value appropriation and accumulation can be sustained. More importantly, perhaps, a way of thinking is provided for practitioners about buyer and supplier exchange relationships and the power regimes that these create. This is essential for a proper understanding of the objective supply chain and market circumstances that the practitioner faces. If these circumstances are better understood, then choosing appropriate action to improve the strategic and operational business position of the firm ought, in our view, to be easier for the practitioner. To this end, in Chapters 4 to 10 we provide an analysis of the power regimes operating in seven very different types of supply and value chain networks. In Chapter 11 some thoughts are provided about the need for future research to understand the objective circumstances of supply and value chain power regimes in more detail. Four issues are discussed. First, the need to undertake far more analytical rather than descriptive research into the myriad of supply and value chain networks. Second, the need for future work on power regimes to focus on sub-regimes as well as on primary regimes. Third, the need to link the structures of power with the behaviour of individuals within these contingent circumstances. Fourth, the need to understand the types of countervailing strategy that practitioners should adopt to shift the balance of forces in particular power regimes in their favour. Finally, in any preface it is only proper that a vote of thanks is given to all of those who have materially assisted in making this book possible. First, we would like to thank the Engineering and Physical Sciences Research Council for providing us with a grant to make this study possible. The EPSRC (Project No. GR/L86395) has provided us with funding for four years to undertake the work in developing this study, as well as to undertake an audit of the strategic and operational tools and techniques that companies are currently using to align their business strategies and operational practices. There is no doubt that, without this generous support, this current volume could not have been produced. This book, the shorter companion volume entitled Power Regimes: Mapping the DNA of Business and Supply Chain Relationships (Cox et al. 2000), and the special issues of Supply Chain Management: An International Journal (1999) and The Journal of Supply Chain Management (2001) constitute the first fruits of this research project. This current volume provides the theoretical findings from the first two years of the EPSRC study. In due course there will be an additional two-volume study. This two-volume study will outline the current strategic and operational tools and techniques being used by practitioners, and seek to establish how successful these have been in implementation.

Preface 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

xix

While the EPSRC has provided the financial support for this study, the results reported here would also not have been possible without the active support of those practitioners who volunteered their time to participate in the research project. While the names of these individuals and their companies must remain anonymous for commercial reasons, it is only right that we express our thanks for the time, effort and intellectual endeavours that they and their colleagues have contributed to this study. At the CBSP it is necessary to thank Andy Passey for his work on the insurance supply chain. He undertook some embryonic research and made it come alive. Finally, and not for the first time, Jackie Potter and Michele Donovan must be especially thanked for their unstinting efforts in making the administrative side of the project run like clockwork. It goes without saying, of course, that neither they, nor those practitioners who have assisted us, are responsible for any of the views expressed herein. The arguments presented – with whatever strengths and weaknesses they may contain – are the responsibility of the authors alone.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Part I

Power in supply chains and markets

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

1

Power, rents and critical assets

This book presents a way of thinking about business strategy and operational alignment. It also focuses on what causes firms to be sustainably successful. We will be concerned with three key concepts in our discussion of business success. The first two concepts, power and how rents are earned in markets, should at least be familiar. The concept of critical assets is, however, likely to be completely new to a great many readers. The aim of this chapter is to explore each of these concepts and to demonstrate how they can be drawn together into a coherent and robust theory of business success. This will involve the development of a rigorously defined and empirically testable concept of power in relationships between firms. We start from the premise that the ideal position for a firm to be in to achieve sustainable business success is one in which it has power over others. By power we mean the ability of a firm (or an entrepreneur) to own and control critical assets in markets and supply chains that allow it to sustain its ability to appropriate and accumulate value for itself by constantly leveraging its customers, competitors and suppliers. We contend that the successful exploitation and protection of these sources of power will enable a firm to be sustainably successful. Success is represented by the firm’s ability to earn rents. The concept of critical assets was first elaborated and discussed in Business Success (Cox 1997). The core argument of that book was that the primary aim of business strategy should be supply innovation leading to the creation of one or more power advantages in order to earn rents. This proposition is based on the idea that, within any supply chain, some of the resources that are used to deliver an end product or service are highly valued in utility terms by a large number of buyers or suppliers and are relatively scarce or unique in ownership, by virtue of being difficult, or sometimes impossible, to copy. It is this combination of high utility and relative scarcity that enables particular supply chain resources to become critical assets both in a buyer–supplier exchange and in a market context. The possession of such critical assets provides the basis by which markets can be closed to competitors and value can be leveraged from customers and suppliers in supply and value chains. The principal aim of this book

4 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

is to build upon and to empirically test these ideas. Our concern is to understand the major attributes of market closure, and of buyer and supplier power, and to explain the particular supply and value chain circumstances in which we might expect a critical asset to be created. One of the most original elements of Cox’s earlier work (1997) was the contention that business strategy should focus on both supply chains and markets, rather than purely on markets as in more orthodox approaches. See, in particular, the influential works by Michael Porter (1980, 1985). The basic reasoning behind this view is that supply always precedes ‘effective’ demand and that a market cannot logically exist until a firm or an individual has taken an entrepreneurial risk with uncertainty. Following this logic forces us to think first and foremost in supply and value chain terms. Supply innovation implies that an entrepreneurial decision to try to fulfil a consumer’s unarticulated demand leads to the creation of a supply chain before a value chain or a series of markets, energised by effective demand, has emerged. In short, the activities of a supply innovator bring into being the series of vertical exchange relationships that we call a supply chain. A supply chain is defined here as ‘the series of functional stages that use various resources to transform a raw material into a finished product or service and to deliver this product or service to the ultimate consumer’ (Cox 1997: 211). This conception of a supply chain is very similar to that employed by the mainstream literatures on logistics, operations management and supply chain management (Houlihan 1984; Farmer and Ploos van Amstel 1991; Christopher 1992; Harland 1996; Saunders 1998). It also corresponds to the concept used by writers concerned with what is known as lean supply (Lamming 1993, 1996). This is where the similarity between this book and these literatures ends, however. All of these writers are interested in the way in which goods and services are physically created and how they flow between firms through a series of interrelated functional stages before delivery to the end customer. Their shared concern is with how these twin processes of product creation and product flow can be managed to achieve greater operational efficiency. The aim is to deliver a better and less costly product to the end customer by integrating and coordinating the physical relationships in the supply chain. The aim of this book, however, is not simply to examine the supply chain as a physical flow of goods and services. Rather, as we noted above, we are interested in the supply chain as a series of exchange relationships between buyers and suppliers. More specifically, we are interested in how variations in the power balance of these relationships affect the flow of value through the chain. Where supply innovation stimulates an effective demand, this creates a corresponding value chain in which the exchange of goods and services is mirrored by the exchange of money. This exchange relationship is shown in Figure 1.1. The value chain is thus defined as ‘a series of financial

Power, rents and critical assets 5 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

relationships that starts with the ultimate consumer buying the finished product or service and, ultimately, results in all of those who participate in the chain of supply relationships being allocated a share of the revenues flowing from the ultimate consumer’ (Cox 1997: 211). It should be emphasised that this is a very different way of thinking about the concept of the value chain to that used by Porter (1985). Porter’s value chain does not focus on the process of financial exchange between firms, but instead looks at the flow of value between the various functional activities within the firm. He uses the concept in this way because he wants to describe and understand which of these functions add value to the firm’s output and which consume value. Porter’s concern in doing this is to identify those functions within the firm that are undermining its overall efficiency and should therefore be managed more effectively. Our conception of the value chain is different, however, because our principal concern is with the distribution of revenues from the ultimate consumer at each of the functional stages in the supply chain. In addition, we are interested in the nature of competition for the revenues at each stage in the chain. This brings us to a consideration of markets. According to the theory of perfect competition, a contested market will emerge where there are opportunities for firms to make profits. Profits are

THE VALUE CHAIN Suppliers consuming a proportion of the 100 per cent of revenue that the end customer provides in exchange for finished products and services End customers providing 100 per cent of value for the products and services provided by a supply chain

THE EXCHANGE RELATIONSHIP The share of the 100 per cent of revenue that is provided by buyers to suppliers in exchange for what they provide at all stages in the supply chain

THE SUPPLY CHAIN The stages of physical production necessary to turn raw materials into finished products and services

Figure 1.1 Supply chains and value chains. Source: adapted from Cox (1997: 211).

Unextracted or undeveloped physical or raw materials

6 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

defined as earnings in excess of a firm’s costs of production and they are available when the price commanded by a unit of output is higher than its marginal cost. This theory also argues that the entry of more and more firms into a profitable market will normally, in the long run, drive the market price down until it reaches an equilibrium with the average cost of production. At this point, supply and demand are in balance and the opportunity to make profits has been dissipated by market competition. Only those firms that are able to break even at this long-run equilibrium price will remain in the market. The fundamental insight of this theory for the present discussion is that, over the long run, profits will tend towards zero, because their existence stimulates increasing levels of competition from new market entrants. This is an important insight, because it helps us to understand that longterm business success, which is essentially about making money, should not be based primarily upon a strategy that emphasises efficiency and the making of profits. These, as the theory of perfect competition contends, will inevitably lead to the creation of a contested market, which will, in turn, lead to the dissipation of the available profits. This hardly seems like a recipe for long-term business success, but on what alternative basis might strategy be made? The answer put forward in this current volume is that strategy should focus on the acquisition and exploitation of supply chain and market power, and the pursuit of rents. It is vital, therefore, for us to provide a clear definition of the concept of rents and to clarify how rents differ from profits. Perhaps the easiest way to define rents is to say that they are earnings in excess of the firm’s costs of production that are not eroded in the long run by new market entrants. To use the technical economics jargon, rents persist in long-run equilibrium while profits tend towards zero. The reasons for the existence of rents in a particular market are determined primarily by whether those rents are Ricardian or entrepreneurial. We will discuss the specific features of each of these types of rent later in the chapter. For now it is sufficient to note that both types are a function of the existence of highly valued and relatively scarce resources in a market. Rents will be appropriated by the owners or controllers of these resources as long as their relative scarcity can be maintained. This, in turn, relies on an absence of competition from imitative or substitute resources (Peteraf 1993: 182). Following this logic, we argue that the basis on which rents are earned is through the possession of what we call critical supply chain assets. Critical assets are based on supply chain resources that can be made relatively scarce, and that allow their owners both to close the market for this particular supply chain resource to other potential competitors, and to effectively leverage value from their downstream customers and upstream suppliers. The relative scarcity of the resources on which such assets are

Power, rents and critical assets 7 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

based implies, of course, that only a very small number of firms is likely to have them within any particular supply chain or market at any given time. Thus the appropriation of rents is likely to be a relatively unusual phenomenon. Our conception of business strategy as an entrepreneurial process by which the firm attempts to acquire and control unique and highly valued resources as a means of earning rents places our work broadly within the so-called ‘resource-based’ school of strategy. This school has its foundations in the work of Penrose (1959). More recent contributions include Lippman and Rumelt (1982), Nelson and Winter (1982), Rumelt (1984, 1987), Wernerfelt (1984), Teece (1987), Dierickx and Cool (1989), Barney (1991), Castinias and Helfat (1991), Connor (1991), Mahoney and Pandian (1992), Peteraf (1993), Amit and Schoemaker (1993), Kay (1993), Teece et al. (1997), Galunic and Rodan (1998) and Lieberman and Montgomery (1998).) However, the simple proposition that it is the possession of critical assets in supply chains and markets that enables some firms to earn rents still leaves open the question of precisely how these rents are earned. The short answer to this question is that the possession of a critical asset gives a firm the potential to achieve relative market closure through a position of dominance over competitors. If this can be achieved, then it is likely that a firm in possession of such a critical asset also has the potential to achieve effective leverage over customers and suppliers in the context of particular supply chain transactions. We contend that rents are earned through the continuous actualisation of potential supply chain and market power. In other words, a firm earning rents will recognise that it has to focus on both supply chain and market power and will employ that power effectively. The firm will use its market power over weaker and less effective competitors by closing the market to them. It will also use its supply chain power over dependent suppliers to extract cost and quality improvements, while using its power over dependent customers to increase, or at least maintain, its share of the total revenues earned in its market over the business cycle. It is predicted, therefore, that the outcome of an effective use of supply chain and market power will be the appropriation of rents over the longer term. In essence, then, the ideal position for earning rents – or high levels of profit on a sustainable basis – is fairly simple to understand. When an entrepreneur or a company is selling to customers the ideal must always be to have monopoly ownership of inimitable supply chain resources that are needed (not merely wanted) and highly valued by everyone. When an entrepreneur or a company is buying from suppliers, the ideal must always be to be a monopsonist who is able to source from suppliers located in highly contested markets in which there are low switching costs and low barriers to market entry. These ideal business relationships are indicated in Figure 1.2. We also argue, however, that the majority of critical assets will provide the firm that possesses them with only a temporary opportunity to earn rents.

8 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

THE IDEAL POWER POSITION FOR THE JANUS-FACED CORPORATION Downstream relationships

Competitive relationships

Upstream relationships

Ownership and control of a marketbased critical asset

A Janus-faced entrepreneur or company effectively possessing both market and supply chain power

Ownership and control of a supplybased critical asset

The power situation

The power situation

The power situation

A large number of dependent customers who highly value a product or service that they need rather than want

All potential competitors permanently or temporarily excluded by effective market closure to create a monopoly position

A monopsony buyer able to create highly dependent suppliers who operate in highly contested markets with low switching costs and low barriers to market entry

Figure 1.2 Critical assets and the ideal business situation for the Janus-faced corporation.

This is because other entrepreneurs or entrepreneurial firms will be constantly looking for ways in which the resources underpinning a critical asset can be imitated or substituted. There are essentially three main mechanisms through which firms without critical assets might seek to reconfigure the existing structure of power in any particular market, or supply and value chain. These are product innovation, process innovation and supply chain innovation. The common focus of all three types of innovation is on the functionality delivered by a supply chain to the ultimate consumer. A supply chain is thus conceived in terms of the need or want that it fulfils, rather than in terms of the concrete products or services that it currently delivers. The aim of a product or process innovator is to satisfy an existing supply functionality by means of a completely new product or process. This is done in an effort to replace the existing critical asset(s) with new assets that are possessed by the innovator. Supply chain innovators take this reconfiguration of power one step further. They do this either by replacing an existing supply chain with a new one that delivers the same functionality, or through the creation of a completely new supply functionality with a new supply chain to deliver those needs or wants. In both cases the ultimate aim is the same, namely to create a new structure of supply

Power, rents and critical assets 9 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

chain power, based on new critical assets, that operates in favour of the innovator. The fundamental point to be made is that those firms that currently have critical assets can never afford to rest on their laurels. Rents are earned not simply from the continuous actualisation of supply chain and market power, but also from an active understanding of how that power might be eroded by other firms through a process of imitation and/or innovation. The potency of most critical assets can be eroded over time, although the extent to which this is possible varies from supply chain to supply chain, depending on the pace of imitation and/or innovation, and from resource type to resource type. By understanding the threats to its resources, and therefore to its supply chain and market power base, a firm should be able both to defend them and to proactively enhance its dominant position. Conversely, a firm that currently lacks critical assets of its own must constantly look for innovative methods by which it might achieve a more favourable position in an existing or a completely new supply chain. To pursue imitation of those who possess critical assets – which is the dominant strategy of most companies – must be seen as a second-order strategy. The reason for this is that successful imitation normally results only in a highly contested market. Only innovation provides the basis, therefore, for the creation of the critical assets that sustain rents. This focus on the relationship between innovation, structures of market and supply chain power and the firm’s performance (i.e. whether or not it is able to earn rents) forces us to consider where our analysis sits in relation to the insights of industrial economics. In particular, we need to say a few words about the synergy or otherwise between our model and the structure–conduct–performance (SCP) paradigm used by industrial economists. In simple terms, the SCP model is based on the notion that every firm is embedded within a particular market structure, and that this structure has implications for the firm’s behaviour (i.e. conduct) and its performance. As Dobbs (2000: 215) notes, early work done within the SCP paradigm suggested that the direction of causation between these three variables was such that market structure determined the firm’s conduct, which in turn determined the firm’s performance. This early work also suggested that market structure was primarily determined by the extent to which the technology of production created entry barriers. Thus, where the technology of production in a particular market gave rise to substantial sunk costs it was assumed that only a few large firms would be able to operate profitably within that environment. (For a discussion see Scherer 1980.) In the more recent literature, however, this structurally deterministic view of causation has given way to the notion that these variables are interrelated in a complex system of feedback loops. (See, for example, Tirole 1993; Martin 1994; Dobbs 2000.) Thus, we now have a conception that

10 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

allows for the possibility of a firm taking deliberate, strategic actions in order to shape the technological conditions and the market structure within which it operates. Such actions, which might take the form of product, process or supply chain innovation, are designed to influence both the firm’s own performance and the performance of those around it. Moreover, the SCP model has also been broadened to include the impact of government policy on each of these factors. As Dobbs (2000: 215–16) argues, the government can use measures such as privatisation, regulation and the award of exclusive property rights to substantially change the structure of an industry, to influence the way in which the firms in that industry conduct themselves, and to shape their performance. Again, however, the literature recognises that there is a series of two-way relationships between structure, conduct, performance and government policy. Thus, for example, the firm is seen as being able to undertake deliberate actions to influence government policy in order to create a more favourable regulatory environment for itself. In sum, therefore, we can see how the model of strategic behaviour being proposed here has a fundamental premise in common with the refined SCP paradigm. Rather than being seen as slaves to their structural environment, firms are seen as having the potential to shape that environment in order to improve their performance relative to that of their competitors. These ideas form the focus of the discussion in Chapters 2 and 3 which centres on the analysis of supply chain rather than market power. The reason for this focus is that the bases of market power have been well documented already (by, for example, Porter 1980, 1985) and need no further elaboration here. The relationship of market power to supply chain power is not as fully developed, however, and this is the subject matter of the theoretical chapters that follow. Supply chains, it will be argued, are very different from one another at a descriptive level. This view is relatively uncontroversial given that the types of products and services necessary to bring a car to the ultimate consumer are very different from those required to bring legal services to customers. More importantly, however, it will also be argued that supply chains differ from one another at an analytical level. By this we mean that supply chains can be categorised with respect to the different types of power structures that they contain, structures which are created by the possession of different types of power resources or resource combinations at different stages in the chain. The nature of the power structure in a supply chain has a direct impact on the process of exchange and, therefore, on a firm’s capacity to appropriate rents. Before we can proceed into this territory, however, it is essential that we gain a deeper understanding of why business strategy should ideally be focused on acquiring and exploiting supply chain and market power to earn rents, rather than on enhancing operational and transactional efficiency in pursuit of profits.

Power, rents and critical assets 11 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Effective business strategy: between efficiency and power play The subject of business strategy, as one leading observer of the phenomenon of the firm once noted, is inherently complex (Williamson 1991). Not only does it encompass many different functional areas in business – marketing, finance, manufacturing and supply – but, being genuinely interdisciplinary in nature, it has invited contributions from economics, politics, sociology and organization theory (to say nothing of business studies itself ). The need for some kind of clarity on the subject, therefore, is paramount. This is why it has become increasingly common to divide the literature on the subject into two camps of related thinkers: one that focuses upon the importance of efficiency and a second that focuses upon the importance of power. Market contestability, efficiency and profit Of these two camps, it is the approach that focuses on the importance of efficiency as the basis of strategic necessity that has the longer history. The emergence of this approach has its origins in mainstream economics. Mainstream economics, itself, came rather late to the subject of business strategy and the firm. Indeed, some 160 years were to pass between the establishment of economics as a modern discipline with the publication of Adam Smith’s Wealth of Nations in 1776 and economists’ first credible attempts to explain why firms exist (Coase 1937). Prior to these attempts, economists had been more concerned with arguing over the environmental conditions that determined the processes of exchange (and the impact of governmental action upon these conditions) than they were with undertaking a proper analysis of the institutions that were responsible for generating the need for much of the exchange in the first instance. Until the 1930s at least, the firm was treated as a ‘black box’ and, consequently, explanations of business success were significantly underdeveloped. The environmental conditions that they described were ones where the state of economic nature was a competitive one in which business success, indeed business survival, could only be achieved by passing value on to the customer. Each industrial sector was held to consist of carbon-copy firms producing almost indistinguishable products, competing with each other on the basis of price. A firm’s income, therefore, was contingent upon its ability to bring its products to market more cheaply than its competitors, and consequently upon its ability to control the cost of its factor inputs (sometimes described as second-order economising). Effective cost control was best achieved via arm’s-length adversarial exchange where firms behaved promiscuously towards their suppliers, selecting on the basis of which of the latter the market signalled was the cheapest. By the 1930s, however, a number of economists began to find gaps in this account of the firm and its operations, not least because it failed to

12 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

explain the existence of the firm itself. Foremost amongst these economists was Ronald Coase. Coase (1937) argued that if, as conventional economics suggested, the price mechanism was capable of perfectly coordinating the provision of goods and services, then there should be no need for additional coordination in the form of an authoritative structure. If conventional analysis was correct and markets could effect perfect coordination, then the existence of such a structure might properly be regarded as superfluous and consequently an indicator of market failure. Coase argued that to see firms as examples of business failure was absurd. Rather, he claimed, the reverse was true. The process of exchange was not a frictionless activity. There was a cost to using the pricing mechanism that conventional economics had overlooked. This cost occurred as a result of the need to negotiate, to exchange, and to monitor and ensure the satisfactory compliance with the terms of the contractual settlement. The greater the potential cost, the greater the need for some kind of additional purposive coordination. At a certain point, centralised coordination became necessary and a firm appeared. An effective business strategy, therefore, rested not just on minimising the costs of a firm’s factor inputs. It also required the firm to manage the process of exchange itself as efficiently as possible – what has come to be referred to as first-order economising. It is the explication of the principles of firstorder economising that now constitutes the main agenda for this approach to business strategy. Today, one of its leading proponents is Oliver Williamson. Williamson worked and greatly expanded upon this basic theme by taking the transaction as his basic unit of analysis and then systematically mapping the circumstances that gave rise to the need for different levels of additional coordination for a given transaction. (See particularly Williamson 1975, 1985 and 1996.) He then matched these to their appropriate forms of governance. For Williamson the critical variables were uncertainty and what he referred to as asset specificity. Many contracts, he argued, were entered into under circumstances where there was considerable speculation as to whether the conditions that pertained at the time when the agreement was first made would still hold true months or even years further down the line. Orthodox economics had always assumed that individuals and firms operated under conditions of hyper-rationality. Economic actors were perfect calculating machines who made all their decisions on the basis of perfect information. Williamson rejected both assertions and instead argued that rationality was bounded. Although individuals and firms attempted to take decisions on the basis of calculations of self-interest, they lacked the intellectual equipment, information and prescience to do so effectively. Not surprisingly, therefore, contracts drawn up under such circumstances were necessarily incomplete – with blanks left where the potential for uncertainty was greatest. Incompleteness could occur for a number of reasons. It would

Power, rents and critical assets 13 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

occur if not all the relevant future contingencies could be imagined; if the details of some future contingencies were obscure; if a common understanding of the nature of future contingencies could not be reached; if a common and complete understanding of the appropriate adaptations could not be reached; if the parties were unable to agree on which contingency had actually materialised; or, finally, if the parties were unable to agree on whether actual adaptations to realised contingencies corresponded to those specified in the contract. While incomplete contracting has the advantages that it leaves room for flexibility in the relationship and allows the possibility of revision as and when the future becomes more certain, it also has a number of attendant risks. Principally, there is the risk that, when it becomes necessary to renegotiate the terms of exchange, the contracting parties will fail to reach an agreement. This might be for entirely honest reasons but not necessarily so. Firms were not simply self-interested, they were also devious. Many, if they saw a gap in the letter of the agreement and a way to fill that gap that worked to their advantage, could not be trusted not to pursue it. For Williamson, opportunism could take one of three forms: blatant, subtle and natural. Of these, he was most concerned with subtle opportunism. This he described as self-interest seeking with guile. It included all calculated efforts to mislead, deceive, obfuscate or otherwise confuse. He distinguished it from simple self-interest seeking, according to which individuals played a game with fixed rules that they reliably obeyed. Williamson was at pains to point out that not all contractors were necessarily dishonest. The difficulty for the firm was that it is impossible in advance to distinguish the good from the bad. The firm, therefore, had to work from the assumption that all contractors were potentially bad and to manage its relationships accordingly. The potential cost of opportunism to the firm would not be serious if, upon its detection, an association could be terminated and the firm could seek out a more reputable partner. However, Williamson argued that such was not always the case. It was particularly not the case under what he called conditions of high asset specificity. Many transactions required a firm to make substantial, dedicated investments in support of them. (He identified six types of specialised investment: site, temporal, physical, human, dedicated and brand.) Firms could stand to gain considerably from such investments, not least because they were frequently designed to raise productivity. With potential gain, however, also came considerable risk. Often the investments that a firm was required to make were non-fungible – that is to say, they had little value to the firm outside the existing association. Under such circumstances, the termination of the association entailed a costly write-off for the firm, which in turn could make the firm reluctant to undertake an otherwise potentially profitable investment.

14 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

The solution to this dilemma was for both firms to create close ties with one another so as to minimise the risk of opportunism or, where it occurred, to spot it early and punish it. This involved the building of credible commitments into the relationship. These might be principally of two types. First, while one party only made the dedicated investment, the other party could post a bond that it would forfeit if it attempted to act opportunistically. This bond, which is known in transaction cost parlance as a hostage, would be used to create a condition of bilateral dependency (more commonly referred to as interdependency). Second, both parties to the contract could be required to finance the dedicated investments necessary to support the transaction. This, too, was to be used to create a condition of interdependency. Williamson proposed that there was a direct relationship between the specificity of the assets (or investments) needed to support a transaction and the degree of additional coordination needed to prevent any opportunism and manage the exchange efficiently. The degree of additional coordination required for any given transaction grew in direct proportion to the level of specialised investment that the firm/firms were required to make. After a certain point it no longer made sense to protect the relationship with safeguards like hostages. Instead, the firm would choose to vertically integrate and carry out the transaction within its own boundaries. Williamson and his disciples did not reject the orthodox framework outright, therefore, but merely amended it. They remained faithful to the basic principle that, over the medium and long term, market competition compelled all firms to act in an allocatively efficient manner. Whatever autonomy the firm appeared to enjoy in its short-term decision-making processes, the reality was that it was severely constrained by the need to survive in the long term. What they argued, however, was that the mechanism by which the exchange was managed was as important a part of the strategic agenda of the firm as was its choice of partner. Market closure, power and rent There is little doubt as to the quality of the work of economists and about the many important contributions that they have made to the subject of strategic management. What is missing from their accounts, however, is the role of power in the dynamics of exchange and the contribution that it can make to an understanding of business strategy. This is no oversight. Williamson himself explicitly addressed the issue at length (Williamson 1995). He argued, however, that power had little or no part to play in determining relations between firms and their study. His arguments were as follows. First, and perhaps most tellingly, he argued that power was frequently poorly and tautologically defined. The problem of tautology arose because the concept of power was often used as little more than ex post rationalisation

Power, rents and critical assets 15 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

of what had occurred between two contracting parties. The tautology could be expressed in the following terms: the fact that one contracting party had gained an advantage from a transaction indicated its power; conversely, because a contracting party had power, it was able to gain an advantage from the transaction. Nowhere in this account of what had happened was there any explanation of why the former firm had power over the latter. Williamson argued that, if the subject of power was to receive any serious analytical attention, then it needed to be properly defined. This meant that the presumed causes of a firm’s power had to be clearly specified through a dual process of induction and deduction. Only then, he argued, would it be possible to generate refutable hypotheses to be used in testing the concept’s validity. While this is undoubtedly a robust criticism of the use of power by writers of business strategy, it is not a criticism of the contribution that power can make per se. Furthermore, it is the current authors’ hope that the discussion of critical assets developed in the pages that follow will make good any previous sin on this count. Williamson drew directly on his own work to make his other criticisms of the power perspective. He argued that the risk of a buyer becoming dependent on a supplier was not a function of power, but occurred simply as a result of bad management. Ex post dependency, for example, was a function of inadequate contracting that had left room for opportunism. A farsighted buyer should, from past experience if nothing else, have been appraised of the circumstances that might place it in a position of dependency. By learning from the experience, therefore, it should have been able to construct appropriate governance structures to avoid a repeat of the problem. If the buyer failed to display such iterative learning, at least on a consistent basis, then the costs imposed upon it by the opportunistic behaviour of its suppliers would reach such a level that its competitiveness and, ultimately, its survival would be threatened. Again this criticism has some force. A dependency that arises ex post can often be traced to poor contracting on the part of the dependent firm. The fact that a dependent relationship arising out of post-contractual opportunism can be avoided does not imply, however, that every buyer will necessarily learn its lesson. Nor does it mean that failure to do so will threaten the buyer with extinction. Such a threat will only become real if the buyer contracts badly while its competitors do not. If all contract badly then none is at a disadvantage. And in many industries this is in fact the case. Effective contract management is one of the least developed business competencies, despite the fundamental contribution that it can make to the profitability of the firm. However, the part that Williamson has played in highlighting the role of ex post dependency is a crucial one. He has sensitised us to the fact that a situation of dominance and dependence can arise even though a dominant supplier does not have structural power based on a lack of suitable alternative suppliers for a buyer. The dominance in this case is a function

16 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

of an informational rather than a structural asymmetry between the contracting parties. The better-informed supplier is able to create and sustain a dependency for as long as the buyer fails to properly understand the costs and functionality of the good or service that it is buying. The other area where power might manifest itself is pre-contractual leverage. Williamson argues, however, that cases of market dominance are comparatively rare. Furthermore, even where they do occur, there are relatively strict limits on the degree to which a monopolist (if a firm is selling) or a monopsonist (if it is buying) can leverage its customers or suppliers. Williamson assumed that the continuous use of leverage would eventually make it unprofitable for both parties to the contract to continue their association. Furthermore, the attempt to exercise power would lead it to suffer severe damage to its commercial reputation and, as a consequence, to its business. However, Williamson is simply describing the limits to leverage in a given circumstance. Right up until that cut-off point the dominant party can appropriate value and the weaker party still remain profitable. More importantly, however, cases of market dominance are rather more common than Williamson and other economists would have one believe. Transaction cost economics is, therefore, very powerful in the way it can explain what strategy a firm must pursue if it is to survive under conditions where its markets are highly contestable. However, if the economists’ assumptions are correct, then they cannot explain why any individual or institution would undertake the investments necessary to set up a firm in the first instance. If the commercial environment was always so hostile that all investors had to look forward to were low or negative margins, and where aggressive cost control was a prerequisite for economic survival, no rational actor would risk their money. Consequently, the world cannot be so hostile as the one described by economists. Entrepreneurs must enjoy some prospect, at least, of finding areas in which to invest where the degree of market contestation does not drive returns towards zero. The originator of this idea was Joseph Schumpeter (1942). He argued that the notion of innovation through speculation was incompatible with the world of competition. Nobody would invest without the hope of compensating gains. These gains, he suggested, appeared in the form of the high and sustained profits earned by monopolists and oligopolists. Schumpeter’s insights have spawned a significant literature in recent years. Research in this area has focused principally on the concept of monopoly rents. Authors such as Caves and Porter (1977), Ghemawat (1986) and Lieberman and Montgomery (1998) have been concerned with the range of first-mover advantages, entry barriers and intra-industry mobility barriers that allow certain firms to maintain a dominant market position and, thereby, to earn rents. A related avenue of research is that focusing on the concept of entrepreneurial rents (Rumelt 1987). These are, in essence, the same as monopoly rents in that they flow to dominant firms

Power, rents and critical assets 17 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

that are protected from imitative competition by one or more first-mover advantages. It should be stressed, however, that the concept of rent used by these models differs significantly from the original formulation proposed by David Ricardo (1965) as part of his case against the UK’s Corn Laws. Ricardo was trying to explain why returns varied widely across different landholdings. He noted that, not only did returns vary, but also that the land itself differed considerably with respect to its fertility. Returns tended to be highest where the land was most fertile, because that land was more productive. That is, the more fertile land could generate a given level of output at a lower cost than its less fertile counterpart. These lower costs of production delivered economic returns in excess of break-even for the owners of the most fertile land. What characterised these returns, differentiating them from conventional profits, was their tendency to persist in equilibrium. Ricardo explained this phenomenon in terms of the relative shortage of the factor of production responsible for generating the return (namely the fertile land) and the inability of other landowners to bring their stock up to an equivalent standard. That is, the landowner possessed a scarce resource that added value, but which could not readily be imitated. He described these returns as rents, because the profits went to the owners of the land rather than to the tenant farmers that actually worked on the land. The essential difference between Ricardian rents and their more recently conceived monopoly or entrepreneurial counterparts, therefore, is that the former flow from the employment of existing factors for existing uses, while the latter are earned from new combinations of resources and from risk taking in the face of uncertainty. Furthermore, Ricardian rents are perfectly possible within an open and competitive market, because they are simply returns generated by superior resources that give their owners lower costs of production. Conversely, monopoly or entrepreneurial rents are earned through the conscious exploitation of a dominant position (Peteraf 1993: 181–2). Before such a dominant position can be achieved, however, an act of supply innovation must inevitably take place. This means that an entrepreneurial firm or individual must identify a gap in the market and attempt to fill it with a new product or service offering. In doing this, the entrepreneur must calculate whether or not there is likely to be a sufficient volume of effective demand for the supply innovation to make it economically viable. Finally, if such an innovation is to lead to a sustainable position of dominance, and therefore to the earning of rents, it must be protected from imitation or substitution by potential competitors. In short, effective business strategy is not about being efficient and making profits under conditions of intense competition. Rather, it is about supply innovation that limits the scope for competition in supply chains and markets through a firm’s ownership or control of unique, valued and

18 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

inimitable resources. These are the basis of the power advantages that we call critical assets. This supply chain and market power gives the firm the potential to earn monopoly or entrepreneurial rents for as long as it can be protected. The strategic challenge facing all firms, therefore, is to identify exactly what is market and supply chain power, how it may be acquired and then how it may be protected. The remainder of this chapter is concerned primarily with the nature of power in supply chain (or commercial exchange) relationships. The link with market power, which has already been well documented, is alluded to throughout the discussion.

The foundations of business power In this final section we address the defining characteristics of a critical asset in more detail. We discuss the meanings of resource utility and resource scarcity and look, in particular, at their relationship with supply chain and market power. We begin with a definition of power. Williamson’s (1995) claim that the concept of power lacks analytical precision is probably the most important charge levelled against it. It is also the most difficult to refute. The first step in attempting to address this problem is to construct such a definition. This is, however, no simple matter. Even the most cursory examination of the power literature demonstrates that, while there is much that these writers agree upon, there are many more issues about which they do not concur. Power is an ‘essentially contested concept’ (Gallie 1955). This means that it is a concept whose meaning, while amenable to rational debate, cannot be formally verified. These difficulties can, of course, be overcome by using a working definition, which applies solely in the context of a specific study. The working definition of power that will be employed in this study is ‘the ability of one actor to affect the behaviour of another actor in a manner contrary to the second actor’s interests’ (Lukes 1974). It is not enough, however, simply to choose one definition from amongst the many on offer, because each definition is based upon certain key assumptions. It is vital, therefore, to explore these assumptions and to explain why this particular definition is preferred to the alternatives. The first point about power is that it is relative. Power is not something like money that can be accumulated and stockpiled. In other words, no one firm has power in all contexts. Change the context and you change a firm’s power. Second, a buyer–supplier exchange can never solely be about power, because there is always some measure of mutual interest between two contracting parties. The fact that firms are resource constrained means that they cannot do everything for themselves. They cannot extract all of the necessary raw materials; they cannot fabricate and then assemble all of the components; they cannot provide all of the distribution and marketing; and, finally, they cannot provide all of the support and ancillary services necessary to the production of a good or service.

Power, rents and critical assets 19 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

They must, therefore, look to others to provide them with the goods and services that they are incapable of supplying for themselves. Thus, two contracting parties are dependent upon one another to the extent that each is able to offer the other something that it wants. However, recognising that a degree of mutual interest is a prerequisite of any buyer–supplier exchange is not the same as saying that there is an equivalence of interest. Given that each firm is being offered something that it requires, and that each has to give up something in return, it is in their interests to ensure that the terms on which the exchange takes place offer them the maximum possible benefits. In order to achieve this it is imperative that each firm is able to influence or even control the other’s behaviour. Their capacity to do so will depend principally on the perceived ability of each contracting party to grant, hinder or deny the other’s gratification relative to the other’s perceived ability to do the same to them. In short, a firm’s ability to achieve the outcomes that it values – because this involves exchange – requires it to be able to conduct such exchange in a manner that is most beneficial to itself. This ability is in turn reliant upon another’s dependency on the resources that the firm controls. The notion that the power of one actor over another is a function of resource dependency (or asymmetrical interdependence) has a long intellectual pedigree. The literature has its roots in the work of writers such as Emerson (1962), Blau (1964), Thompson (1967) and Jacobs (1974). While there are clearly subtle differences in emphasis between these writers, each does subscribe to the fundamental premise that an actor, be it an individual, a subunit within an organization or an organization as a whole, will tend to be influenced by those other actors that control the resources that it needs. For example, Thompson argues that: an organization is dependent on some element of its task environment (1) in proportion to the organization’s need for resources or performances which that element can provide, and (2) in inverse proportion to the ability of other elements to provide the same resources or performances. (1967: 31) The same intellectual premise is present in various models of intraorganizational power. For example, Hickson et al. (1971) contend that power is held by those in an organization who are able to reduce the uncertainties experienced by that organization. Moreover, they contend that the more important the uncertainty to the effective functioning of the organization and the more irreplaceable the actor, the more influential he or she will be. Salancik and Pfeffer (1974) present a similar view in their study of a university. They conclude that the power of one department over others in an organization is a function of the amount of important resources contributed by that department relative to the amount of resources contributed by others.

20 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Pfeffer and Salancik (1978) have also made an important contribution to the literature on resource dependency and inter-organizational power. They consider the basis of power in a number of inter-organizational contexts and conclude that one organization tends to be influenced more by another, the greater the importance of that second organization to its functioning and survival. Despite the undoubted significance of this resource dependence perspective in disciplines such as political science, social psychology, sociology and economics, it has played a relatively minor role thus far in the supply chain management literature dealing with relationships between buyers and suppliers. The relative invisibility of power in this literature might be partly attributable to a focus by academics and practitioners on concepts such as lean supply, which imply that firms should be more open, trusting and collaborative. While such notions might seem ethically appealing, we contend that they are not based upon a sound understanding of what is actually possible, or desirable, in most buyer–supplier relationships. The small number of notable works in this field that do recognise the importance of issues of power and dependency include those by Provan and Gassenheimer (1994), Ramsey (1994), Frazier and Antia (1995), and Keep et al. (1998). It is our aim to build upon, to deepen and to challenge the insights expressed in these texts. We owe most of our intellectual stimulus, however, to the seminal work by Emerson (1962). Emerson argues that the dependency of one actor upon another is a function of two variables: resource utility and resource scarcity. If we apply these variables to the exchange relationship between a buyer (firm A) and a supplier (firm B), the buyer’s utility function refers to the extent to which its goal(s) (or motivational investment(s)) is/are mediated by the supplier. Logically, the opposite formulation would apply to the supplier’s utility function. On the other hand, the degree of scarcity from the buyer’s perspective relates to the extent to which firm A can achieve its goals outside of the A–B relation. In other words, scarcity is determined by the extent to which there exists a firm C, D or E that can substitute for B in meeting A’s needs. Again, the degree of scarcity from the supplier’s perspective would be based on the opposite formulation. As can be seen in Figure 1.3, we can combine these variables to create four possible power structures in which a transaction between A and B might take place. If A offers B resources that are relatively scarce and that B regards as having a relatively high utility, while B’s resources are relatively plentiful and are of relatively low utility for A, then A has power over B. This structure is represented in the lower right-hand quadrant of the matrix. If the exact opposite is true in terms of resource scarcity and utility, then logically B must have power over A (upper left-hand quadrant). The remaining quadrants represent those circumstances in which there is no power relation between the firms. In the lower left-hand position,

Power, rents and critical assets 21 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

HIGH

B is dominant over A

A and B are interdependent

(B has critical asset)

(No critical asset)

A and B are independent

A is dominant over B

(No critical asset)

(A has critical asset)

LOW

HIGH

Relative scarcity and utility of B’s resources in transaction with A

LOW

Relative scarcity and utility of A’s resources in transaction with B

Figure 1.3 The potential power structures for a dyadic exchange.

the relative scarcity and utility of A’s resources for B and of B’s resources for A are low. Each firm is said to be independent of the other. Finally, in the upper right-hand quadrant the relative scarcity and utility of A’s resources for B and of B’s resources for A are high. This creates a situation of bilateral dependency or interdependency. The same model could also be used to assess the structural context of a transaction between B and one of its suppliers (C). We would again consider the relative utility and scarcity of the resources that B and C bring to their transaction. By performing the same analysis for each of the buyer–supplier transactions that takes place at each of the functional stages in a supply chain, we would be able to build up a picture of the power structure for each firm operating at each of those stages. It is this picture that is the key determinant of the pattern of revenue appropriation along the corresponding value chain. A firm that achieves dominance over its immediate suppliers or customers at a particular stage in a supply chain might be expected to have a significant influence over revenue appropriation both at that stage and further upstream or downstream in the chain. The thinking in this book is thus based upon the premise that the power structures at one stage in a supply chain both are

22 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

influenced by and have an influence upon the power structures at other stages in the chain. Clearly, though, there are variations between firms and transactions in terms of the dimensions of utility and scarcity. This means that the resources that give firm A power over firm B in the context of a particular transaction will not necessarily give it power over firms C, D or E in the context of an equivalent transaction. Similarly, firm A will not necessarily have power over firm B in the context of an entirely different transaction, because the utility and scarcity of the resources that each brings to the association is likely to be different. In short, power relationships in supply chains are transaction specific. Although this simple example serves to establish the basic relationships between resource utility, resource scarcity and power, it still leaves open the question of how one might determine the relative magnitude of these variables in the context of particular buyer–supplier relationships. This question forms the focus of the discussion in Chapter 2.

Conclusions In conclusion, we return to the fundamental point made in this chapter. Sustained business success, defined as the earning of rents, is primarily a function of the possession of both market-based and supply chain-based critical assets. A critical asset is created when a firm is able to achieve sustained dominance over its competitors by superior supply innovation, and by the creation of a sustainable dominance in a transaction with a customer or a supplier within a supply and value chain relationship. As is shown in Figure 1.3, supply chain power is based upon owning or controlling a supply chain resource that combines high degrees of utility and scarcity for a buyer or a supplier in the context of a particular transaction. It is always this combination of the two variables that provides the basis for supply chain power. If, for example, a buyer is facing an extensive pool of interchangeable and openly competitive suppliers, it makes no difference how high is the utility of the resource that it is attempting to buy. In these circumstances none of the suppliers can exert supply chain power, because the relative scarcity of the resource in question is low. In this context we would argue that none of the suppliers was in possession of a critical asset because there is high imitability leading to a highly contested marketplace. Of course, as our discussion of Williamson’s work demonstrated, we also need to be sensitive to the possibility of equivalence in an exchange relationship. The acquisition of supply chain and market power may be the surest route to business success in the longer term, but in the short term this may be difficult or even counterproductive. Firms also need, therefore, to equip themselves to deal with transactions undertaken in conditions of interdependence and independence. As is shown in Figure 1.3,

Power, rents and critical assets 23 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

interdependence exists when the relative scarcity and utility of the resources held by both buyer and supplier are high. Conversely, independence refers to a situation in which the relative scarcity and utility of the resources held by both parties are low. The alternative strategies in these circumstances rest either on supply innovation to create a critical asset that creates market and/or supply chain power, or on the pursuit of more efficient transactions and operational processes. The possibility of supply innovation means that both dominant and dependent firms should be constantly aware that most power relations are unlikely to be permanent. There is a strong probability, particularly over the longer term, that potential competitors, as well as dependent buyers or suppliers, will attempt to reduce their vulnerability by searching for supply innovation, or by seeking out new suppliers or customers through product, process or supply chain innovation. Similarly, the conditions that create resource scarcity may contain the seeds of their own destruction. The existence of rents will tend, barriers to entry allowing, to attract new market entrants. If it is possible for these new entrants to imitate, or to provide a substitute for, the scarce resource(s) in question, this will have the effect of reducing their scarcity by creating a larger pool of alternative firms. Given these possibilities, it is clear that earning rents depends not just upon achieving and exploiting a position of dominance, but also upon the effective protection of this position. Finally, given the four basic buyer–supplier power structures illustrated in Figure 1.3, it is clear that business success is essentially about an understanding of appropriate behaviour in a wide variety of different supply chain and market circumstances. Whether a firm should, or indeed is able to, follow a strategy based on the exploitation of critical assets in pursuit of rents, or whether it should pursue an efficiency-based strategy, is dependent on the power position in which it finds itself vis-à-vis its competitors, customers and suppliers. The next chapter takes this line of thinking forward by exploring the attributes of supply chain power. This is achieved by analysing in much greater depth the four basic power structures that can exist between a buyer and a supplier. The main objective is to develop a deeper understanding of the relative sustainability of particular buyer and supplier power resources. This, in turn, should allow us to provide a more sophisticated categorisation of supply chain power through a better understanding of the circumstances that give rise to buyer dominance, supplier dominance, buyer–supplier interdependence and buyer–supplier independence.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

2

The key attributes of buyer and supplier power

As we noted in the conclusion to Chapter 1, there are four potential power structures for a buyer–supplier exchange. These are buyer dominance, supplier dominance, buyer–supplier interdependence and buyer– supplier independence. As we also noted, none of these structures is likely to be permanent. Poorly placed buyers and suppliers will almost certainly attempt, over the longer term, to improve their power position vis-à-vis particular customers or suppliers through product, process or supply chain innovation. Given this probability, we concluded that business success is essentially a function of understanding under which supply chain and market circumstances it is appropriate to use particular operational tools and techniques. This understanding, or supply chain and market competence, is based, therefore, upon the acquisition of two types of knowledge. Knowledge 1 is knowledge of the full range of operational tools and techniques available to an individual to transform the current structure of power to their advantage. Knowledge 2 is a knowledge of supply chain and market power structures (Cox 1999). The relationship between these two types of knowledge and an understanding of appropriateness in action is outlined in Figure 2.1. The objective of this chapter is to lay the foundations for the development of Knowledge 2. It is our contention that an understanding of supply chain power structures must begin with an in-depth consideration of the four dyadic power structures that can exist between a buyer and a supplier. This contention is based upon the view that supply chain power structures are best analysed and explained in terms of the dynamics of multiple dyadic interactions, which are themselves directly impacted by the market-based power circumstances impinging on buyers and suppliers at their position in a supply chain. The task of linking buyer–supplier dyads in this way, to create a supply chain typology, will form the focus of Chapter 3. For now, though, our principal concern is to take forward the discussion from the previous chapter, relating to the concepts of resource utility, resource scarcity and power. In taking the discussion forward, this chapter

Buyer and supplier power 25 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

SUPPLY CHAIN AND MARKET COMPETENCE

UNDERSTANDING

KNOWLEDGE 1 Knowing the universe of tools and techniques that can be used by practitioners in supply chains and markets

Appropriateness is about understanding when to use particular tools and techniques under specific circumstances to deliver corporate goals operationally

KNOWLEDGE 2 Knowing in detail the range of contingent supply chain and market circumstances that face your firm

STRATEGIC CLARITY Strategic goals about means and ends must be clearly articulated in supply chain and market terms

Figure 2.1 Supply chain and market competence. Source: adapted from Cox (1999).

is divided into three main sections. The first part addresses the epistemological and ontological challenges presented by studying the concept of power. Power was defined in the previous chapter as ‘the ability of one actor to affect the behaviour of another actor in a manner contrary to the second actor’s interests’ (Lukes 1974). In order to explain how, and with what impact, power can be exercised, the key is to understand what is meant by the concept of interests. The distinction between objective interests and subjective interests, or preferences, is explored. The importance of this distinction for an analysis of power resources is also considered. The second section discusses the relationship between the concepts of resource utility, resource scarcity and power in much greater detail than was possible in the first chapter. We explain how resource utility can be understood from the buyer perspective and from that of the supplier. We also consider what determines the relative degree of utility attached to a particular transaction by each of the contracting parties. A deeper understanding of the determinants of resource scarcity is facilitated by a review of the resource-based literature dealing with first-mover advantages (Lieberman and Montgomery 1998), isolating mechanisms (Rumelt 1984) and mobility barriers (Caves and Porter 1977).

26 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

Finally, in the third part we develop the basis of our supply chain typology by considering what we call the architectures of demand and supply. Our principal concern is to understand the specific structural and informational resources available to buyers on the one hand, and to suppliers on the other. The key insights in this section are that power resources can be differentiated both in terms of their creation and maintenance costs, and in terms of their relative durability. On this basis it is possible to distinguish different degrees of buyer dominance, supplier dominance, buyer–supplier interdependence and buyer–supplier independence.

Interests, preferences, information and power The various perspectives on power, and the definitions derived from them, can be crudely disaggregated into what might be called an objective view and a subjective view. Analysts adopting each of these views would probably agree that a power relation involves a conflict of interest between two or more parties. Furthermore, they would also probably agree that the resolution of this conflict is determined by the resources that each party has at its disposal, and the skill with which these resources are deployed. Where an analyst taking an objective view of power parts company with one adopting a subjective view is on the approach that each takes to the concept of interests. This represents a crucial difference, because it directly delimits the range of circumstances in which power relationships are held to exist. For writers adopting a subjective view, an actor’s interests are held to be equivalent to its expressed preferences or desires. Within this conception, a power relationship exists if actor A desires outcome x and actor B desires outcome y, and if A can achieve its preferred outcome against the explicit and direct opposition of B. The study of power within the subjective view thereafter entails an examination of those resources that A or B might consciously deploy to secure their expressed preferences. Few would argue that this does not represent an important dimension to the concept of power. Writers adopting an objective view would claim, however, that this is not the only dimension to power, nor indeed the most important dimension. They contend that there are other aspects to power, that can only be highlighted once the definition of interests is expanded beyond the articulation of preferences. Dowding (1996: 22), for example, suggests that an actor’s interests are also dependent upon its needs, which cannot necessarily be adduced from what that actor says or does. If we accept this premise, our enquiry into the nature of power resources must be commensurately enlarged. This study adopts an objective view on the concept of interests. The following discussion concentrates, therefore, on the implications of this view for an understanding of interests in buyer–supplier relations. For writers adopting an objective view of power, interests are not always correctly perceived by those who attempt to articulate them (Connolly

Buyer and supplier power 27 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

1974; Lukes 1974). They may be distorted in a number of ways. Ignorance and the existence of social norms both alter preferences and obscure the recognition of needs. Beyond these structural distortions, interests are subject to conscious manipulation so that conflicts that might be expected to arise remain latent. The subjective approach, the focus of which is exclusively on observable conflict, is incapable of recognising this critical exercise of power. Nonetheless, manipulation of interests through the careful management of information is a fact of everyday life. Indeed, such manipulation to gain a power advantage is particularly common in the area of commerce, although economists have accepted this fact only quite recently. Until the early 1960s, information and its manipulation had never been formally or explicitly incorporated into economic theory (Levine and Lippman 1995). Prior to this time, neo-classical theory was comfortable in the belief that, despite the existence of private information (Molho 1997) and the selfinterested orientation of economic actors, the laws of supply and demand, coupled with the calculating faculties of economic agents, were sufficient to keep individuals and institutions honest. This myth was exploded when these behavioural assumptions about the processing capabilities of economic man were relaxed. Economists have started to recognise that, if one of the participants in an exchange is unable to effectively monitor the position or actions of the other, the relatively informed party will probably take the opportunity to pursue its interests with guile. Central to this process of distortion are attempts to manipulate the expectations of the vulnerable party in ways that are least damaging to the manipulator. The objective view generates certain methodological difficulties of its own, however. The analyst is presented with the problem of distinguishing an actor’s real interest from one that is false, because the actor’s expressed preferences cannot be taken at face value. It is an easy matter for the researcher to spuriously ascribe particular interests to an actor, because he or she does not understand that actor’s needs. One way out of this dilemma is to undertake a counterfactual conditional judgement about what an actor might reasonably be expected to want, if it was aware of all the alternatives and the costs and benefits that might be expected to flow from them. Under this conception, an option x, can be held to be more in an actor’s real interest than a second option, y, if the actor, having experienced the results of both x and y, decides to choose option x (Connolly 1974: 64). Judgements about what an actor might reasonably be expected to want in the commercial context are of course complex, but have been extensively modelled by economists. Figure 2.2 is broadly representative of their approach to this type of problem. The model, which depicts an exchange between a hypothetical seller and its hypothetical customers, is, of course, pedagogic. It is built upon certain, simplifying assumptions and it is not

28 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

A Pm

Consumer surplus

B Pc

Income transfer to monopolist

C Deadweight loss

MC

De ma nd Cu rve Qm

Qc

Figure 2.2 Objective interests and the architecture of exchange.

intended to be an accurate depiction of a real exchange. Rather, it is simply designed to clarify the issues at hand. The assumptions employed in the model relate to the hypothetical seller’s cost curves and the demand curve. In this instance the marginal costs of the supplier are assumed to be constant and their fixed costs zero. This is what gives the cost curve its peculiarly regular shape. The demand curve is assumed to be downward sloping. This is not an unreasonable assumption. Different customers value a product differently. Some customers are prepared to pay a great deal for a commodity while others are prepared to pay next to nothing. As the price for a good or service goes up, therefore, the effective demand for it goes down. The model looks at the relative welfare gains or losses that exist when one side of an exchange is able to leverage the other. Under conditions of perfect competition economists assume the supplier must price its products at Pc (or, where Marginal Cost = Marginal Revenue). Its output at this price is Qc (or where the MC curve intersects with the Demand Curve). This constitutes the best possible deal for the supplier’s customers or, in other words, their objective interest. It can be observed, however, that many of the supplier’s customers are paying less for the product than it is worth to them. They are obtaining a surplus from the exchange.

Buyer and supplier power 29 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

When the seller has power, however, a number of things happen. First, the price rises. Second, as the price rises some of the consumers are driven out of the marketplace (numbers depending upon the elasticity of demand), so that output falls to Qm (or, output under conditions of monopoly). This leads, third, to a loss of production (the deadweight loss area C) and four, to a transfer of value from the consumers to the seller. In this instance the transfer is represented by area B. This means a fall in consumer surplus of area BC so that the total consumer surplus is now area A. A monopolist supplier, wishing to maximise its return, would not of course charge a single price. Rather, it would segment its customer base and sell each unit of output for the maximum it could obtain for it. This would secure the total consumer surplus. Extracting the total consumer surplus for every transaction constitutes the supplier’s objective interest. Of course, neither party is required to obtain its commercial ideal before an exchange will take place. Even under conditions of perfect competition, where consumers extract the entire consumer surplus, it is still profitable for the seller to make the exchange. Likewise, buyers are still able to buy ‘profitably’ up until the point that the price of a product exceeds the value derived from its consumption. What is critical, however, is that the ‘loser’ is not able to trade as profitably as they might otherwise have done. Given these definitions of objective interests, it is necessary for each side to know how far the other side is prepared to concede before it is no longer profitable to do a deal. The buyer needs to know, with certainty, its supplier’s costs of production. Conversely, if the supplier is to pursue its objective interests it is imperative that it conceals this same cost information while obtaining data on the buyer’s utility function. Information is critical, therefore, to an understanding of power in exchange relationships. The economics literature makes an important distinction between information that is public and information that is private (Molho 1997). The idea of public information broadly equates to the notion of common knowledge, which simply means something that is widely known. Private information, by contrast, is information that is tightly controlled. In the context of a buyer–supplier exchange, this refers to information that is only known by one of the contracting parties. The existence of such an information asymmetry is the prerequisite of concealment and manipulation. Without this asymmetry, the objective interests of both parties are revealed and, power resources permitting, they can be aggressively pursued. The two key problems generated by private information and imperfect observability have specific names in economics. The first is adverse selection, which is a condition of supplier opportunism that occurs prior to a contract being signed. The second is moral hazard, which refers to supplier opportunism that occurs once the buyer has signed a contract. In order to understand the condition of information asymmetry, it is necessary to consider the way in which the buyer gathers and processes

30 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

information about the supplier. We need to understand the nature of these activities both prior to and following the sourcing decision, and to consider how much effort the buyer is prepared to put into these tasks (Office of Fair Trading 1997). The rational buyer would, of course, like to possess perfect information about the supplier with which it is negotiating or has negotiated. This information is not always easy or cheap to come by, however. When such information is difficult and/or costly to obtain, relative to the expected payback, the buyer will usually fall back on a proxy indicator of production costs, price. The more sophisticated buyer will attempt a detailed price comparison between the supplier, its competitors and the range of possible substitutes. Thereafter, the buyer might use the threat of placing the contract elsewhere to get additional price concessions from its preferred supplier. The less sophisticated buyer will simply use its past experience of acquiring similar goods or services as a basis for assessing whether the price seems fair. In both instances, however, a preoccupation with price obscures the fact that suppliers may well be making sizeable returns. The buyer cannot know this, however, unless it takes the trouble to perform in-depth cost modelling exercises with each of its suppliers. In contrast to the buyer’s information resources, the information possessed by the supplier about its own costs of production is usually quite good. The rational supplier, wishing to maximise returns, will attempt to capitalise on the buyer’s relative ignorance by keeping this cost information private. The size of the search costs that must be incurred by the buyer is critical to the supplier’s capacity to maintain this information asymmetry. Since these search costs vary widely, a supplier will make a conscious effort to segment buyers on the basis of its perception of the size of these differentials. Prices will also vary accordingly. Buyers with high costs of search, and unable to get easily at the true costs of production, should expect, therefore, to pay high prices relative to those buyers that have somewhat lower search costs. Furthermore, the supplier will have an incentive to raise the search costs for each of its customers across the board. This can be achieved by increasing the level of uncertainty surrounding the product offering through innovation. Such a move would make information more difficult to acquire and process, and would leave buyers less well informed. On occasion, when the product or service cannot be changed in substance, the supplier may resort to making false claims about its cost base. How far a supplier is prepared to push these claims will be determined by the extent to which it expects them to be countered by competitors, or else discovered by some other means and, thereafter, widely communicated (Office of Fair Trading 1997). The above discussion demonstrates that the magnitude of a buyer’s search costs will determine whether or not information about a supplier’s costs of production remains private. If these costs are relatively low, then

Buyer and supplier power 31 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

the buyer will be better placed to achieve its objective interests in a particular exchange relationship. Conversely, if a buyer’s search costs are relatively high, then it will be less likely to achieve an objectively good deal. Regardless of how well informed a buying company is, however, it can still be expected to pursue what it perceives to be the best deal from a particular supplier. The extent to which a buyer is successful in achieving either its objective (informed) interests or its subjective (ill-informed) interests is likely to be determined by the relative balance of power resources that buyer and supplier bring to a transaction.

Mapping the dimensions of buyer and supplier power: resource utility and resource scarcity As we noted in the first chapter, the capacity of either buyer or supplier to achieve its aims rests primarily on the perception of its ability to grant, hinder or deny those resources that are valued by its opposite number (Emerson 1962). The use of the word ‘perception’ here highlights the fact that, just as a buyer and a supplier might not understand their objective interests, so they might also be uncertain about the objective level of power resources that they have at their disposal. We have also seen that the ability of a buyer or supplier to obtain its own gratification, and to hinder or deny the gratification of its opposite number, is a function of two variables: resource utility and resource scarcity. We have not yet established, however, how one might determine the relative magnitude of these variables in the context of particular buyer–supplier relationships. This question forms the focus of the discussion in this section. Looking first at resource utility, we contend that it is a composite measure of two factors. The first factor is the operational importance of a particular resource in a business, while the second is the commercial importance of that resource to a firm’s overall revenue-generating activities. From a buyer’s perspective, the issue of operational importance relates to the degree to which a particular resource (good or service) is indispensable to the provision of the firm’s supply offering. The degree to which a resource is indispensable relates, in turn, to the number of substitutes that might readily take its place. For example, access to a network infrastructure would constitute a resource of high operational importance for a provider of cable communication services, because without the network the service could not be delivered by any other means. Similarly, microprocessor chips represent a resource of high operational importance for a PC assembler, because they are fundamental to the delivery of an information-processing functionality. However, many resources are of relatively low operational importance, because their absence or replacement would not prevent a firm from delivering its supply offering. For example, a firm may need competent managers, but it is not operationally essential for these managers to be

32 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

provided with luxury company cars or ostentatious office surroundings. The types of cars or office surroundings that are provided are, to some extent, at the firm’s discretion. The notion of operational importance is somewhat different from a buyer’s perspective, because the key resource in which a supplier is interested is a buyer’s expenditure. Clearly, revenue cannot be assessed in terms of the degree to which it is indispensable to a finished good or service. There is a need, therefore, to assess the operational importance of a buyer’s expenditure on other bases. We contend that there are two major determinants of the operational importance of a buyer’s expenditure. The first determinant is the ratio between a buyer’s expenditure with a particular supplier and that supplier’s total sales revenue. Thus, if a buyer’s expenditure is a relatively small proportion of the supplier’s total sales revenue, then the buyer’s expenditure will have a relatively low level of operational importance for the supplier. If, however, the ratio of expenditure to total sales is higher, then the importance of the buyer’s expenditure will increase commensurately. The second key determinant is the regularity and predictability of the buyer’s expenditure. We can assume, therefore, that a supplier will have a preference for those buyers that can offer regular and predictable expenditure. A regular and predictable spend allows a supplier to make a credible commitment to future investment in R&D and capital equipment. A repeat demand for relatively simple goods or services allows a supplier to streamline its production processes and, thereby, to achieve cost efficiencies. It might be argued, however, that under certain circumstances a supplier would actually seek to increase the complexity of a good or service in order to differentiate its offering from those of other suppliers. Such differentiation becomes important when the supplier is providing what is essentially a commodity. This process of creating a bespoke good or service is only likely to occur, however, if it leads to a significant increase in the buyer’s search costs. Under these conditions the supplier should be able to premium price with impunity and more than recoup the costs of extra complexity. The fact that a resource, be it good, service or money, is of high operational importance to a buyer or a supplier is not sufficient in itself, however, to give the resource a high utility for a particular firm. Firms are typically multi-business entities, active in a number of different markets, some of which are commercially more important than others. By this we mean that some of the supply chains in which the firm is active contribute more than others to its revenues and profitability. Those areas of business that represent the bulk of the firm’s revenue-generating activities are described as primary activities (these take place within its primary supply chains), while the remainder are described as support activities (these take place within the firm’s support supply chains). The relationship between the operational importance of a resource, its commercial importance, and the commensurate utility ascribed to that resource by the firm is illustrated in Figure 2.3.

Buyer and supplier power 33 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

This figure shows that for a resource to have a high utility for a particular buyer or supplier it must be both operationally and commercially important. Conversely, a resource will have a low utility for a particular buyer or supplier if it has a low operational importance and the transaction takes place in a support activity. The relative utility of resources falling into one of the two other possible categories – low operational importance and primary activity, or high operational importance and support activity – is indeterminate and has to be judged on a case-by-case basis. It might be argued, however, that a resource falling into the latter category would have a higher utility, because its high operational importance signifies that it is necessary and cannot easily be replaced by an alternative resource. The relative scarcity of a resource is the second variable that determines whether or not a firm has a critical asset and will be able to establish a position of structural dominance over its customers or suppliers. The relative scarcity of a resource is essentially a function of its imitability/ substitutability. In other words, if a resource is relatively easy and cheap to imitate/substitute, and it is in demand, then it is likely to be available from a large number of firms. Conversely, if a resource is difficult or expensive to imitate/substitute then the number of firms that have it is likely to be highly restricted. Such a resource would be relatively scarce.

HIGH

COMPLEMENTARY RESOURCE

CRITICAL RESOURCE

LOW–MEDIUM UTILITY

HIGH UTILITY

RESIDUAL RESOURCE

KEY RESOURCE

LOW UTILITY

MEDIUM–HIGH UTILITY

primary activities Degree of commercial importance

LOW support activities

LOW

HIGH

readily substitutable

non-substitutable

Degree of operational importance

Figure 2.3 Determining the relative utility of a resource.

34 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

The fundamental question to be asked about any transaction is how scarce are the resources on either side of the association? For example, from the perspective of a firm seeking to source a particular good or service, we need to ask whether or not the firm is the sole customer for potential suppliers. Is it, in other words, a monopsonist? We also need to ask how many potential suppliers there are for the particular good or service in question. Is the supply base highly restricted (monopoly or oligopoly supply) or is there a large number of suitable suppliers? If we are to develop a properly strategic understanding of the bases of supply chain and market power, however, we must go beyond these basic descriptive questions to seek explanations for the imperfect imitability or imperfect substitutability of certain resources. There is an extensive literature offering a range of explanations for these conditions. The degree to which a firm’s competitive position is threatened by substitutes is, of course, a key part of Porter’s (1980) well-known ‘five forces’ model. The vast majority of resource-based work, however, has focused to a greater extent on the issue of imperfect imitability. Amongst the most insightful of these texts are those by Bain (1956), Caves and Porter (1977), Lippman and Rumelt (1982), Rumelt (1984, 1987), Ghemawat (1986), Yao (1988) and Dierickx and Cool (1989). The paper by Caves and Porter (1977) builds on the work of Bain (1956) to introduce the concept of ‘mobility barriers’. These differ from the simple entry barriers discussed by Bain, because, rather than preventing market entry outright, they serve to isolate one or more firms from competition within a market. Ghemawat (1986) argues that inimitable positions are based upon size advantages, preferential access either to customers or resources, and/or restrictions on competitors’ options. Yao’s (1988) paper, by contrast, focuses much more on the characteristics of the market than of the firm. He develops the concept of entry barriers and argues that production economies, sunk costs, transaction costs and imperfect information can best explain market failure. The paper by Dierickx and Cool (1989) makes a very different and important contribution to our understanding of imperfect imitability. They focus on the factors that prevent the imitation of valuable but nontradeable asset stocks. It is precisely these kinds of non-tradeable resources and capabilities that are the major concern of resource-based thinking. They cannot be bought and sold and they are almost impossible to imitate, because their development is ‘path dependent’. This means that their existence is dependent upon preceding levels of organizational learning and investment. It is difficult, if not impossible, for would-be imitators to discover and replicate the same developmental process. A key factor in this is what has been called causal ambiguity (Lippman and Rumelt 1982). Perhaps the most important contribution to this debate, however, has been that made by Rumelt (1984, 1987). He developed the idea of isolating mechanisms (Rumelt 1984) to refer to factors that impede imitative

Buyer and supplier power 35 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

competition and, thereby, make it possible for a firm to earn rents. Rumelt (1987: 145–8) describes two main types of isolating mechanisms: property rights to scarce resources and various quasi-property rights in the form of first-mover advantages. This second category includes information impactedness, buyer switching costs, reputation effects, buyer search costs, communication good effects, and economies of scale when specialised assets are required. In the discussion that follows we show how each of these mechanisms, either individually or in combination with others, operates to impede the process of imitation. The key characteristics of each of the mechanisms discussed are shown in Table 2.1. We look first at the question of scale economies in combination with asset specialisation (Rumelt 1987: 146). This mechanism might also be referred to as natural monopoly (Cox 1997: 292–3). By this we mean that, at a particular stage in a supply chain, it is inefficient for there to be more than one firm operating. A natural monopoly arises as a result of the huge fixed costs involved in production or service delivery. The magnitude of these costs acts as a barrier to entry, because it would be impossible for a second firm to offer the same good or service at a competitive price and to earn enough to cover its investment. A single firm that is able to earn all of the revenues at a particular stage in the supply chain therefore most economically provides the good or service. Perhaps the best examples of natural monopoly occur in utilities supply chains like gas and electricity, in which the physical transmission network is provided by one firm. The important point from a power perspective is that the firms upstream and downstream from the owner or controller of the transmission network are faced with a situation of extreme scarcity. One of the most important isolating mechanisms is a property right granted by the state in the form of a licence, a patent or other regulatory protection (Cox 1997: 290–2; Rumelt 1987: 145). This mechanism often operates in tandem with natural monopoly as a means of ensuring that the monopolist makes pricing and output decisions that are in line with the ‘public interest’. In return, the monopolist is given state-guaranteed protection from competition. This regulatory protection can take one of two forms. Either the monopolist is taken into public ownership, in which case its decisions are directly controlled by the state, or the firm is privately owned and publicly controlled by an agency of the state. The latter mode of protection is that which currently exists at some stages of the utilities supply chains in the UK. State-guaranteed property rights also exist, however, in conditions that are not characterised by natural monopoly. The awarding of oil exploration and drilling licences is a classic example. Once the exploration and drilling rights have been granted to a particular company, then they are not available to any other company for the duration of the licence. The state uses this mechanism to ensure that the firms extracting oil are economically viable and operate safely. More importantly, though, these licence

36 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

conditions represent barriers to market entry. However, it is the award of patent protection to new products that provides perhaps the best-known example of property rights. Another major group of isolating mechanisms rests on the relatively superior competence of particular firms (Cox 1997: 294–5). By this we mean a firm’s ability to build into its standard operating practices an understanding of the need to constantly innovate, rather than to rely on the copying or adaptation of what others are doing. On the basis of this understanding the firm is able to provide goods or services that are either objectively better, in terms of their functionality, than those offered by its competitors, or that are perceived to be better as a result of branding. This enables the firm to gain and sustain, at least temporarily, a dominant share of the market at a particular stage in a supply chain. The effect of a relatively superior competence, therefore, is to limit competition in the market and to create a relative scarcity of the resources provided at that stage in the supply chain. Two of the main supply chains in the IT industry provide good examples of this phenomenon. The first example is IBM’s historic and continuing dominance of the assembly of mainframe computer hardware and the related software, while the second is Intel’s dominance of the market for microprocessor chips. In both cases, the dominance is built on a combination of objectively innovative products and a subjective view that these firms deliver the best products in the market. This subjective view is a prime example of the reputation effect identified by Klein and Leffler (1981). The scarcity created by a relatively superior competence is by no means secure, however. For a firm in this position, the longevity of its commercial advantage, and therefore the key to its appropriation of rents, is tied to the degree of causal ambiguity that surrounds its innovation (Lippman and Rumelt 1982). If the cause of its innovation is transparent then imitation will follow quickly and the opportunity to earn rents will be lost. Some innovations, however, are inherently complex. This means that the degree of causal ambiguity is much higher and, consequently, that the time frame within which rents can be earned will be significantly longer. Another factor that will protect the rent stream flowing to an innovator in such a situation is a high degree of information impactedness (Rumelt 1987: 146). This means that the knowledge on which an innovation is based remains largely tacit and uncodified. A number of Rumelt’s (1987) isolating mechanisms are also present where a product or service that is under sole ownership or control becomes an industry standard. The important feature of an industry standard that is not held in common ownership or control is that it operates, like a system of licensing, as a barrier to market entry. Firms attempting to enter the market at a particular point in a supply chain can only do so on the terms set by the owner or controller of the industry standard. These terms will inevitably favour the owner. Similarly, firms operating both upstream

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Table 2.1 Mechanisms that impede imitative competition Mechanism

Characteristics

Property rights

The state or another legitimate authority (e.g. a firm) grants a licence or a patent to guarantee exclusive ownership or control of a relatively scarce resource for a specified period and under given conditions.

First-mover advantages Economies of scale

If the minimum efficient scale of a business is comparable to the size of the market, and if the assets required are specialised to this use, a situation of natural monopoly occurs. Additional entrants would be unable to cover their fixed costs while pricing competitively.

Information impactedness

This means that the knowledge on which an innovation is based remains largely tacit and uncodified. It is difficult for potential competitors to obtain critical knowledge under these circumstances, unless a key employee decides to defect.

Causal ambiguity

This occurs if the basis of an innovation is particularly complex and ‘path dependent’. At the limit, even the innovating firm may be unable to trace the precise causality of its innovation. In these circumstances imitation is impossible.

Reputation effects

Buyers cannot accurately evaluate many products and services until after they have been consumed. A supplier’s reputation therefore plays a critical role in its ability to sell such ‘experience’ goods/services. First movers can obtain reputational advantages, because the strength of a supplier’s reputation depends largely on the length of time that it has been providing satisfactory goods or services.

Buyer switching costs

If early buyers of a new product find it subsequently costly to switch to a competitor’s offering, then the first mover has an advantage. These costs are high when the buyer must make substantial dedicated investments in people or equipment in order to use the product.

Buyer search costs

These are high when the buyer is required to invest substantial amounts of time and money in understanding the complexities of different supply offerings. Firms seek to economise on these costs by free riding on the presumed analyses of the well informed and buying the market leader’s product or service. This provides a first-mover advantage as long as followers’ products are not significantly better.

Communication good effects

These effects arise when a product or service acts as a means of social coordination between different users (e.g. telephone networks, PC software). When a communication good is also an experience good, as in the case of software, then there is a need for standardisation and ‘reputation bonding’. The first-mover’s product or service may thus become a de facto industry standard.

Collusive cartels

Under conditions of oligopoly firms often cooperate on sourcing, pricing and output decisions. Potential market entrants are blocked by a coordinated response.

Source: adapted from Rumelt (1987).

38 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

and downstream from the owner or controller of the standard will be forced to do business on their terms, because there are no viable alternatives (Cox 1997: 295–6). Perhaps the most infamous example of this type of resource scarcity is Microsoft’s ownership of the industry-standard operating system for PCs. IBM inadvertently created the foundations for this industry standard by granting Microsoft the exclusive rights to develop and sell an operating system for its PCs and to sell the same system to IBM’s competitors. Given the desire by subsequent entrants to the PC assembly market to follow IBM’s lead (with the exception of Apple), Microsoft’s software inevitably became the dominant operating system. Microsoft’s subsequent ability to maintain its dominance in this market has been based on a number of Rumelt’s (1987: 146–7) isolating mechanisms. Perhaps the most important of these have been the significant buyer switching and evaluation costs that would be involved in moving to competing products, and the communication good effects that flow from the system’s role as a platform for all other PC software products. The final isolating mechanism is slightly different from those discussed above, because it protects more than one firm from imitative competition. We are referring here to the creation of a collusive cartel, on a formal or an informal basis, between firms that are nominally competitors (Peteraf 1993: 182; Cox 1997: 295–6). The emergence of collusive cartels tends to occur in mature industries where the scope to differentiate on the basis of innovation has largely been played out. Following a period of sometimes quite intense competition, the weaker players are forced out of the market, leaving just a few large firms. Such a market structure is referred to as an oligopoly. Under these circumstances it is common for firms to cooperate on sourcing, pricing and output decisions, because they recognise that there is more money to be made by agreeing to share the available revenues than by pushing down prices, and therefore profits, in a zerosum conflict. Collusive price-fixing therefore allows a number of firms to earn rents. In their relationships with suppliers, the members of a cartel will act collectively to minimise what each has to pay for a range of common goods and services. Cooperation between firms extracting oil from the North Sea on the procurement of common items of capital equipment is a prime example of cartelistic buying. Similarly, a firm sourcing from suppliers that are organized into a cartel is likely to find that it is paying artificially high prices. This is true, for example, of the supply market for heavy electrical equipment, which operated as a formal cartel until relatively recently and even now shows evidence of informal collusion (Konstadakopulos 1995). Thus far, we have been discussing the various mechanisms that protect scarce resources from imitation by horizontal competitors and, thereby, give the owners or controllers of these resources the potential to earn rents. We contend, however, that there is another important basis for resource

Buyer and supplier power 39 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

scarcity that thus far has been given scant attention by the mainstream resource-based literature. Resource scarcity, we argue, can also be a function of an information asymmetry between firms involved in a vertical buyer– supplier relationship. The notion of information asymmetry relates to the condition of bounded rationality. It is based on the distinction that economists draw between public and private information (Molho 1997). As we noted earlier, the former term refers to information that is either generally available or can be obtained by interested parties at relatively little cost. Private information, by contrast, represents hidden knowledge. In the context of a transaction, hidden knowledge is that which is known to just one of the contracting parties and which can only be obtained by the other through the expenditure of significant time and money, if at all. When a transaction is undertaken in a condition of private information, the firm that owns or controls the information is able to use it as a source of scarcity. This scarcity results from the opportunistic exploitation of superior knowledge in one of two ways. First, the privileged firm can use its superior knowledge to distort the other party’s perception of the range of viable alternative firms with which it can undertake the transaction. For example, a firm buying highly complex IT services might not have the specialist knowledge needed to properly test the supply market. It might, therefore, award a contract simply on the basis of a supplier’s reputation. This is a classic example of what is known as a ‘credence good’, which refers to something that a buyer is incapable of valuing even after it has been consumed. The buyer is therefore relying on the supplier to act honestly in providing value for money, which creates substantial room for opportunistic behaviour. When such opportunism occurs in the pre-contractual phase of a transaction it is referred to as adverse selection. This kind of information asymmetry can also lead to the emergence of industry-standard pricing, which allows a number of market leaders to earn rents. Under these circumstances a buyer may believe that it is dealing with an open and competitive supply base. Nevertheless, suppliers are collectively able to price above the long-run average cost of production, because the buyer is ignorant of the true costs of the good or service that it is buying. This condition is particularly prevalent in the supply of consultancy and other professional services. It is possible for buyers to use privileged knowledge to create a condition of adverse selection by promising a supplier regular business in the future in order to get a better deal on a current contract. In this context, the information asymmetry relates to the buyer’s superior knowledge of its projected spending. For such information-based leverage to be effective, however, a supplier must be convinced by the buyer’s promises. Second, a privileged supplier can also use its superior knowledge to cause the buyer to agree contractual terms and conditions that constrain

40 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

the range of options available to it in the future. It is not uncommon, for example, for a buyer to sign a five-year framework agreement when a two-year fixed term contract would have given it the necessary protection from opportunistic behaviour and the ability to re-contract should things go wrong. The supplier has used the relative uncertainty of the buyer to get guaranteed work for five years. More importantly, this is within a flexible framework agreement that allows the supplier to dictate the future requirements of its customer. Such post-contractual opportunism is known as moral hazard. The potential leverage brought about by an information asymmetry between buyer and supplier is not, however, likely to be as effective or as durable as that derived from property rights to relatively scarce resources or quasi-property rights in the form of first-mover advantages. As Williamson (1985) argues, a buyer or a supplier should be able to avoid long-term dependency on an opportunistic supplier or customer through a combination of experiential learning and a governance structure with the appropriate safeguards. Nevertheless, for those buyers or suppliers without the chance to acquire supply chain and market power based on property rights or first-mover advantages, the effective exploitation of information asymmetries can often prove to be a fruitful secondary strategy. Indeed, a recent study of outsourcing found ample evidence of suppliers using the relative ignorance of buyers to create situations of lock-in, particularly when the buyer is required to make substantial dedicated investments to support the transaction (Lonsdale and Cox 1998). The study found that this type of dependency is particularly prevalent in the outsourcing of bespoke and specialist services such as IT. Finally, we must also consider the very real possibility that firms might have neither relatively scarce resources nor informational advantages. In these circumstances, firms cannot hope to earn rents. They must therefore pursue an orthodox business strategy based on the continual improvement of productive and transactional efficiency and the pursuit of profits.

The architectures of demand and supply The conclusion reached in Chapter 1 was that, by combining the relative utility and scarcity of the resources brought to an exchange by buyer and supplier, we are able to create four basic dyadic power structures. These are buyer dominance, supplier dominance, buyer–supplier interdependence and buyer–supplier independence. The likelihood that a buyer will achieve its objective interests over those of a supplier is expected to be highest in those circumstances where, both pre- and post-contractually, the buyer is perceived to be the dominant party (i.e. the buyer has a critical asset). Conversely, the likelihood that the buyer’s costs of acquisition will be inflated is thought to be greatest under conditions of supplier

Buyer and supplier power 41 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

dominance (i.e. the supplier has a critical asset). In the case of interdependency, it is expected that honour between buyer and supplier will be shared, because neither has a critical asset. Under these circumstances, the principal task facing the protagonists is to find an outcome that is mutually recognised as fair. Finally, in the case of independence, despite the fact that neither buyer nor supplier possesses a critical supply chain asset, the buyer is expected to be the major beneficiary from the exchange. We reach this conclusion on the assumption that the supplier will be forced, under conditions of commodity-based exchange, to pass value to the buyer simply to retain the latter’s business. These insights are not sufficient in themselves, however, to meet the test of analytical clarity set for the concept of power by Williamson (1995). The key determinants of resource utility and scarcity remain, at best, vague in their articulation. This lack of precision has a further disadvantage. As the discussion in the previous section revealed, utility and scarcity have a variety of causes and these determinants can combine in a host of different ways. This fact is significant, because it suggests that the four basic power structures – buyer dominance, supplier dominance, buyer– supplier interdependence and buyer–supplier independence – are not monolithic. Instead, they can be subdivided. It is these subdivisions that are the basis upon which we can begin to construct a typology of dyadic exchange. Our approach to the construction of such a typology will be to organize buyer–supplier dyads on the basis of the core characteristics, or architectures, of demand and supply. These are developed and discussed below. Buyer power resources and the architecture of demand When a rational supplier is making decisions about its negotiating posture in relation to a potential customer, it will ask itself three key questions. First, it will ask what is the value of the transaction relative to its total revenues and how does this value stack up against the possible costs incurred in servicing the contract? This refers to the issue of utility. Second, the rational supplier will ask, if the business is lost or not won, what is the scope for finding a compensatory exchange opportunity elsewhere? This refers to the issue of scarcity. Third, the supplier will ask what is the scope for opportunism in the transaction? These are the building blocks that, taken together, form the architecture of demand. As we discussed earlier, from the perspective of a supplier the utility of an exchange opportunity is composed of three elements: the volume of the buyer’s spend relative to the supplier’s total sales revenue; the frequency and predictability of the buyer’s spend; and, finally, its complexity. An ideal contract for a supplier is one that is large, relatively simple, and therefore cheap, to service, and likely to result in repeat business. Volume in this context

42 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

has both a product and a transactional dimension. The product dimension of volume relates to the breadth of the supplier’s product range and to the relative importance of each of these constituent businesses to the supplier’s total revenue stream. The transactional dimension, on the other hand, concerns the relative contribution that a specific transaction makes to a particular segment or a range of segments. The utility that a supplier attaches to a particular exchange tends, ceteris paribus, to be highest in those instances that involve a key contract (or potential customer) in a key segment, the loss of which could cripple the supplier. It is here that the supplier would be expected to give the greatest exchange concessions. This conclusion would be modified, however, if the supplier’s reliance were matched by a similar reliance on the part of the actual or potential customer. Conversely, for low-volume customers in residual sectors it is unlikely that the supplier would be prepared to make any significant concessions. Turning to the issue of transaction frequency, the central factor is that a higher level of frequency offers the supplier stability and certainty. All enterprises have fixed and semi-fixed costs that must be covered before they can break even. Furthermore, the maintenance of a competitive position in a marketplace frequently requires a supplier to undertake additional specialised investments. The key insight in this regard is that fixed and semi-fixed costs are easier to cover, and speculative investments are easier to justify, when there is a high probability of repeat business. The final consideration is the complexity of a transaction and, by extension, the costs associated with servicing the contract. Some customers are more difficult and, consequently, more costly to manage than others. They might, for instance, require significant sales effort and, thereafter, sales support. Alternatively, they might require additional bespoke research effort, while being prepared to absorb only some of the costs that this effort entails. These difficulties and complexities make the buyer’s business less attractive to the supplier. Set alongside the relative utility derived from a buyer’s business, the supplier must also consider the substitutability of the business. This concerns the issue of buyer scarcity for the supplier. The supplier needs to consider the likelihood that it will be able to replace the buyer’s business with an exchange of equivalent utility, if it is not awarded the contract or if it loses the business. The answer to this question lies in a combination of the structure of the market into which the supplier sells, and/or its competitive position amongst potential suppliers. These issues will be revisited when the dynamics of supply are considered in the next sub-section. For example, a supplier might find that it is selling, or trying to sell, into a marketplace where there is only one buyer. In this case, there is no other exchange option for the supplier outside of this particular relationship. Other demand structures, by contrast, afford the supplier many alternative sources of exchange. The buyer clearly

Buyer and supplier power 43 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

benefits when the options facing the supplier are limited and suffers as the supplier’s options increase. These variables combine with the buyer’s costs of information to complete the architecture of demand. This is summarised in Figure 2.4(a). The costs of obtaining informational resources, and the consequences of not possessing them, have already been described. It is worth noting, however, that some of the factors that determine the general attractiveness of servicing an exchange relationship also impact directly on the buyer’s search and monitoring costs. The frequency and complexity of an exchange, particularly when a product includes a number of intangible attributes, can significantly affect these costs. Indeed, the additional advantages derived by the supplier from an information asymmetry in its favour can, on occasion, more than compensate for any costs that flow from the difficulty of the business. Although Figure 2.4(a) may appear to be complex, the variables mapped on the horizontal axis can be aggregated to simplify our understanding of the buyer’s power resources. When this is done two critical questions emerge. First, by looking at the volume, frequency, complexity and substitutability of the buyer’s spend we can ask to what extent is the buyer valued by the supplier? That is, to what extent is the buyer structurally capable of denying, hindering or gratifying the supplier’s preferences and needs? Second, we can ask to what extent is the buyer capable of monitoring supplier opportunism? By asking these questions, we are able to create the four-box matrix shown in Figure 2.4(b). As Figure 2.4(b) shows, the buyer is in the best potential power position in the salient-informed category. It has a clear idea of its objective interests from the outset, it is capable of monitoring the achievement of these interests over time, and it has a favourable demand architecture. Such a buyer should, at the very least, expect to get a fair deal from its supplier. If the supplier’s own power resources are not commensurately robust, however, then the buyer would expect to do rather better by dominating the process of exchange. A buyer is likely to be weakest when it is in the residual-ignorant category. It has few resources with which to negotiate and it has no clear idea of what is its position of maximum commercial advantage. The best a buyer in this position can hope for is to be sourcing from a commodity supply market. Under such circumstances the supplier also has few power resources, because the buyer has a large pool of alternative suppliers from which to choose. If supplier resources are working against the buyer, however, then it will face sustained leverage. Predicting the exchange outcomes in the residual-informed and the salient-ignorant categories is more problematic, however. The fortunes of the residual-informed buyer will vary significantly according to the level of supplier power resources. If an exchange is undertaken with a supplier possessing significant power resources then the buyer’s position is similar to that of the residual-ignorant buyer. All that differentiates them is that

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

(a) Volume of business to supplier Low

High Frequency

Low

High

Low

High

Product complexity High

Low L

H

L

H

Low L

High

Low

High

Transactional substitutability H L H L H L H

Low Buyer’s search costs High

(b) Value of business to supplier

Low

Low

High

Residual-informed

Salient-informed

Power resources low to medium

Power resources high

Residual-ignorant

Salient-ignorant

Power resources low

Power resources medium to high

Buyer’s search costs

High

Figure 2.4 Buyer power resources and the architecture of demand.

Low L

H

High L

H

Buyer and supplier power 45 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

the residual-informed buyer understands the quantum of its exploitation, while the residual-ignorant buyer does not. The residual-informed buyer might, therefore, act to improve its situation. In those exchanges involving a supplier with few power resources (commodity supply market), the residual-informed buyer is in a rather better position. If the residual-informed buyer is conducting an exchange under these circumstances, it is not vulnerable to leverage and it is also well placed to spot supplier opportunism and to respond accordingly. In the final category, the salient-ignorant buyer is in a position of unrealised power. This power can be realised if the buyer is prepared to invest time and money in becoming better informed about its supply options. Over the longer term, the objective of such a buyer should be to move into the salient-informed category. Supplier power resources and the architecture of supply As the review of resource-based thinking earlier in this chapter demonstrated, there are numerous isolating mechanisms which enable suppliers to create and sustain the desired condition of resource scarcity (Rumelt 1987). Of those discussed, perhaps the most important are natural monopoly, property rights granted by the state or another legitimate authority, collusion under conditions of oligopoly, causal ambiguity and information impactedness around an innovation, and buyer switching costs created by dedicated investments. The insights of resource-based writers remain underdeveloped, however, in that they are largely descriptive. They list the different mechanisms that can be used to effect market closure, but have relatively little to say on the subject of how they differ in their impact upon the buyer or supplier. We contend that such closure mechanisms should not be treated all of a piece, but should be divided on the basis of their likely sustainability and the costs incurred in maintaining them. Almost all of the mechanisms of closure degrade over time. However, not all of them degrade at the same pace. What distinguishes rents from profits is this element of sustainability. It can be plausibly argued, therefore, that, ceteris paribus, the greater the sustainability of a closure mechanism, the higher the level of power resources that it confers upon a supplier. Similarly, the costs of maintenance vary greatly from mechanism to mechanism. Indeed, some incur little or no cost, while others are extremely expensive to support. If these insights are combined with our earlier discussion of resource utility from the buyer’s perspective, and with the role that effective information management has in creating, maintaining or destroying scarcity, we are able to generate a model of supplier power resources. This model is illustrated in Figure 2.5. Before we can look in detail at each of the categories in Figure 2.5, we must clarify the dimensions along which they are organized. The first

46 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

dimension concerns the degree of utility derived from a particular good or service by the buyer. Utility, as our earlier discussion made clear, is a function of both the operational and the commercial importance of a good or service for the buyer’s supply offering. The operational importance of a good or service concerns the degree to which it can be replaced by a substitute resource or dispensed with altogether. Commercial importance, on the other hand, refers to whether a particular good or service is used by the buyer in a primary or a support activity, and what it contributes overall to the revenue and cost profile of the company. This formulation allows us to determine the relative utility that the buyer is likely to ascribe to a specific good or service. For simplicity, Figure 2.5 combines the four utility categories developed in our earlier discussion (see Figure 2.3) into two broader categories. The first of these categories covers goods and services with a low to medium utility. This encompasses resources with a relatively low level of operational importance (high substitutability) and which might, or might not, be commercially important. It is the fact that these resources can be readily substituted (or discarded) that is most important for an understanding of supplier power resources. The second broad category covers goods and services with a medium to high utility. Following the logic developed above, this category includes resources with a relatively high level of operational importance (low substitutability) and which might, or might not, be commercially important. In this case, it is the fact that these resources cannot be easily substituted (or discarded) that is critical in determining supplier power resources. As we have already argued, however, the power resources available to a supplier cannot be understood solely in terms of the utility ascribed to Sustainability/cost ratio of scarcity mechanisms

Low to medium Information Innovation asymmetry

Medium to high Supplier collusion

Property rights

Dedicated Natural investments monopoly

Medium to high

Power resources low to medium

Power resources medium to low

Power resources medium to high

Power resources high

Power resources high

Power resources high

Low to medium

Power resources low

Power resources low

Power resources low to medium

Power resources low to medium

Power resources low to medium

Power resources low to medium

Utility of good or service for buyer

Figure 2.5 Supplier power resources and the architecture of supply.

Buyer and supplier power 47 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

its goods or services by a buyer. We must also consider the scarcity of the resources that the supplier has to offer. This variable is plotted along the second dimension in Figure 2.5. Our conception of scarcity differs, however, from that developed by the majority of the resource-based literature in that it is intended to be predictive rather than largely descriptive. Thus we are not simply interested in whether or not a particular good or service is relatively scarce in supply. We are also interested in the specific characteristics of the different mechanisms that create and maintain scarcity. As we have already noted, we are particularly concerned with the likely sustainability of each closure mechanism and with the costs that a supplier must incur in maintaining each mechanism. These two factors are combined and mapped along the horizontal axis of Figure 2.5. It is our contention that the ratio between sustainability and cost tends to increase as we move from left to right along this axis. This does not mean, however, that the absolute cost of maintaining each mechanism rises from left to right. Instead, we are concerned with how long resource scarcity can be maintained relative to the costs of achieving this outcome. Thus, while the costs of creating and maintaining an information asymmetry over a buyer may be small compared with those incurred in achieving patent protection, a condition of scarcity based upon a legally enforceable property right is likely to be much more sustainable. We contend that this ratio, in conjunction with the utility ascribed to a good or service by a buyer, can be used to predict the level of power resources possessed by a particular supplier in the context of a specific exchange. These predictions are presented in each of the twelve categories in Figure 2.5. In the case of scarcity based upon an information asymmetry, suppliers tend to have a relatively low level of power resources at their disposal. As a result, it is difficult, if not impossible, for suppliers to earn rents. The supplier’s power in this context is dependent upon the buyer’s willingness and capacity to incur the search costs involved in overcoming the asymmetry. Where the buyer’s informational resources are lacking, because the costs of search are high (at least relative to the expected benefits from such a search), then there is some scope for the supplier to use leverage. ‘Informed’ buyers should find it a relatively simple matter, however, to use the threat of switching to negotiate the price down towards the average cost of production. The crucial question is whether or not buyers will take the trouble to discover the true costs of production and the full range of supply opportunities available to them. The supplier’s power resources might be slightly more substantial, however, if the good or service in question has a high level of utility for a particular buyer. This view is based on the assumption that an informed buyer will find it more difficult to switch suppliers for a good or service that is both operationally and commercially important. If a good or service has a high level of operational importance this implies that the buyer’s activities might be significantly disrupted, at least for a short period of

48 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

time, by the act of switching. Furthermore, if a good or service has a high level of commercial importance this implies that such a disruption might prove costly. Together, these factors would make the buyer’s threat of switching less credible. The buyer would have an incentive to stay with the same supplier, which would boost the supplier’s power resources in any negotiation over price. One of the most common uses of information asymmetry to give the buyer a perception of scarcity is branding in a commodity supply market. Such exercises tend to be very costly, however, and the perceived scarcity that they create is unlikely to be particularly durable. Furthermore, the impact of branding on a supplier’s net welfare can often be highly negative, because it distorts the costs of production. While most industries show evidence of branding, firms in some industries will brand heavily. Indeed, in some cases the costs of promotion can spiral out of control, which has an adverse effect on the net welfare of all suppliers. For example, supplier X spends £100, so that supplier Y must respond in kind. Because supplier Y has just nullified supplier X’s effort, X must then up the ante. Again Y responds, and again supplier X’s efforts are nullified. In this type of tit-for-tat behaviour competitors X and Y lose out, because they are investing to little or no effect. The buyer also loses out, however, because they ultimately must absorb the costs of their supplier’s wasted promotional effort. In the next category, scarcity based on product or process innovation, the level of a supplier’s power resources is contingent upon the extent to which an innovation can be protected from competitive imitation and upon the utility of the good or service in question. Scarcity in this category is derived from the ownership of unique skill-sets that give rise to unique, but non-patentable, technologies (Rumelt 1987: 145). Although these skills and technologies are not legally defendable, they may nonetheless be difficult to imitate for one of two reasons. The first reason is that they are very complex or causally ambiguous (Lipmann and Rumelt 1982). The second is that they are deeply embedded in the protocols of the supplier from which they originated, and they are only tacitly understood by the employees of that supplier. In this case, imitation is only possible if a key employee defects to a rival supplier. The problem with this type of scarcity is that, although goods and services may be difficult to imitate, imitation is not impossible. Unless the basis for the supplier’s competitive advantage is upgraded on a regular basis, it has a propensity to degrade. Suppliers are forced, therefore, to invest, sometimes heavily, simply to stand still. Of course, the degree of dynamism that characterises production can vary widely, both between sectors and over time. This impacts directly on the sustainability of the rents that the successful supplier is able to appropriate. Thus, we assume that, where the buyer ascribes a medium to high utility to an innovative good or service, and where the innovation can be

Buyer and supplier power 49 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

successfully protected, the supplier’s power resources will be medium. A medium to high utility implies that this good or service is operationally important for the buyer (low substitutability) and, in some cases, commercially important. We might therefore expect that the buyer would have an interest in doing business with the most innovative supplier, because an innovative good or service might provide the buyer with a competitive advantage. On the other hand, if the supplier were unable to protect its innovation, its power resources would be significantly reduced, because the buyer would have a greater number of suppliers with which to do business. Finally, we assume that the supplier’s power resources are always low when it is doing business with a buyer in the low to medium utility category. In this case, the good or service is much less important operationally (high substitutability), which implies that the buyer would be much less concerned with innovation and more concerned with price. In this category, the management of information through brand building can be critical for a supplier to inform buyers of its competitive advantage, and to extend the duration of its rent-appropriating capabilities once that advantage has been lost. Typically, a lag will exist between an objective shift in the competitive dynamics of the supply market and a buyer’s subjective perceptions of those dynamics. Although leadership may have passed from a particular supplier to a rival, or the supply market may have become commodity-based, a supplier might be able to act as if there had been no such shift and undertake the process of exchange accordingly. In contrast to the first two categories in Figure 2.5, those mechanisms of market closure based on supplier collusion, property rights, dedicated investments and natural monopoly offer the supplier the prospect of relatively sustainable rent appropriation at little cost. We assume, therefore, that the ratio between sustainability and cost for these mechanisms falls somewhere in the medium to high range. The category of scarcity based on collusion covers situations in which suppliers operate within an informal cartel. Although no single supplier possesses a set of unique attributes that make it indispensable to buyers, members of such cartels collude tacitly to fix prices and, thereby, to earn rents. A buyer attempting to source from such a structure will find that its threat of switching carries little credibility in a negotiation. Calculations of self-interest lead suppliers to hold the line on pricing strategy. If a supplier was to break ranks and drop prices to win additional business, it would almost certainly invite retaliation from the other cartel members. This would result in a mutually destructive price war, in which any incremental improvements in market share would be more than offset by the loss of revenue incurred through the fall in prices. Although subject to temporary blips, collusive arrangements of this type tend to be both sustainable and relatively stable.

50 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

In this category, the management of information through brand building is critical, not to win new business, but to serve as a deterrent for potential market entrants. Unless the putative entrant can match its competitors’ levels of advertising expenditure, it is unlikely to be successful in establishing itself as a credible alternative. The impact of brand building on the buyer is clearly negative, therefore, in that it artificially limits the range of supply options with which the buyer is faced. On the basis of these insights, we assume that a supplier’s power resources are contingent, as before, on the utility that a buyer ascribes to a good or service and on the stability of the supply market cartel. For goods and services with a medium to high utility, and that are being bought from a relatively stable cartel, we assume that the supplier’s power resources are high. Conversely, for goods and services with a medium to high utility that are being bought from a relatively unstable cartel, we assume that the supplier’s power resources are somewhat lower. In this case, an outbreak of price competition would confer a bargaining advantage upon the buyer. The power resources available to suppliers in the low to medium utility category are contingent to a greater extent on the utility that a buyer ascribes to a particular good or service. Thus, when the good or service supplied from within a cartel has a low utility (high substitutability) for the buyer, the supplier’s power resources are commensurately low. No matter how stable the cartel is, the buyer has relative freedom to employ one of a wide range of substitute goods or services if the deal being offered by a supplier outside the cartel is more favourable. As the utility derived from a good or service increases, however, the supplier’s power resources also increase. This can be explained by the fact that an increasing degree of utility implies both fewer substitutes for a good or service and an increase in commercial importance. Together these factors would make a buyer’s threat of switching less credible. The three remaining categories in Figure 2.5 (scarcity created by property rights, by dedicated investments and by natural monopoly) afford suppliers the highest level of power resources under conditions of medium to high utility. Conversely, for goods and services of low to medium utility, we predict that a supplier would have only low to medium power resources. In the former case, a supplier would have significant power resources, because it is, effectively or literally, a monopoly provider of goods or services that have few if any substitutes for the buyer. In the latter instance, the fact that the supplier is a monopoly provider confers fewer power resources, because the buyer has a wider range of substitutes available to it. Thus, we assume that, under these circumstances, the buyer would be more likely to abandon a supplier if the outcome of an exchange relationship proved to be unsatisfactory. Switching in this way might require certain dedicated investments to be written off, but given that these

Buyer and supplier power 51 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

goods or services are of relatively limited operational and commercial importance, the financial incentives to remain with an existing supplier are unlikely to be strong. Property rights to scarce resources, in the form of licences, patents and trademarks, are usually granted by the state. It is possible that one firm might license another to undertake specific activities on its behalf, as we discussed earlier in the IBM and Microsoft case. Ultimately, however, property rights only exist in so far as they are underpinned by a statesanctioned legal system. Scarcity created by dedicated investments can exist either before a buyer–supplier exchange takes place (ex ante) or after an exchange has occurred (ex post). The prime example of ex ante scarcity exists when a supplier is operating under conditions of natural monopoly. An ex post scarcity, on the other hand, is most likely to be created when a buyer undertakes transaction-specific investments that give rise to sunk cost dependencies of the kind that Williamson (1985) believes should be rare, but which experience shows us are commonplace. In this case, a buyer would find that its choice of suppliers for related contracts would be limited to one, because choosing a different supplier would require these substantial investments to be written off. The critical feature of all of these categories is that the scarcity created by these mechanisms is highly sustainable and relatively inexpensive to maintain. Although the initial investments necessary to create the revenue stream might have been very substantial, once a property right or dedicated investment is in place, the supplier has effectively been granted a ‘licence’ to print money. In the case of many property rights, however, this licence will probably have a clear expiry date. This means that, once the period of protection comes to an end, the supplier will have to reinvest in a new good or service in order to generate further rents. In some instances, however, the supplier might find that the rent stream dries up altogether, because its legally sanctioned monopoly is removed. The role of information management in each of these categories is interesting, because in none of these cases does the supplier require an information advantage to win market share or to create direct barriers to competitive imitation. Rather, the role played by information is principally one of legitimisation. In the case of ex post scarcity created by dedicated investments, the supplier must provide a credible justification for the buyer to undertake these investments. In essence, the supplier must convince the buyer that the long-term commercial benefits of such investments, in terms of higher functionality, are significantly greater than the short-term costs of undertaking them. In the cases of natural monopoly and of property rights, the privileged supplier must provide a credible justification for the creation and maintenance of state-sponsored protection from other potential suppliers. This

52 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

implies that property rights are a double-edged sword, in that they can be used either to create/sustain a supplier’s rent-appropriating capacities or to set strict limits on them. When the state attempts to make a calculation about whether it should act for or against the supplier, it must undertake a careful balancing act. On the one hand, the state must assess the costs to society and to consumer welfare of a Pareto-inefficient outcome. On the other hand, the state must look at the direct impact on employment of reducing/removing the supplier’s property rights. If a supplier can persuade the state that the benefits of competition are relatively small and widely dispersed, compared to the costs, then its position will be afforded significant supplementary protection (Lindblom 1977).

Conclusions The central objective of this book is to develop a deeper understanding of supply chain and market power. As we noted in the first chapter, this objective is based, partly at least, on a desire to address the criticisms levelled at the concept of power by writers like Oliver Williamson. Williamson’s key criticism is that the utility of power as an analytical, and therefore explanatory, category has been constrained by the way in which successive writers have failed to adequately map its key dimensions and attributes. In the past, power has generally been employed as a piece of ex post rationalisation. Little effort has gone into understanding its key attributes, which has meant that researchers have been unable to make detailed predictions about the likely outcomes of specific power relations. This chapter has attempted to rectify this shortcoming in the context of buyer–supplier relations, by starting to map the key attributes of buyer and supplier power. In the next chapter we will continue this mapping process by analysing the sustainability of isolating mechanisms in more detail, and by developing a typology of dyadic power structures. This categorisation of buyer–supplier dyads represents only a stepping-stone to our final objective, however, which is to develop a full analytic, rather than descriptive, typology of supply chain power structures.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

3

Towards an analytical typology of supply chain power regimes

The previous chapter mapped the key dimensions and attributes of supply chain and, therefore, market power in some detail. This chapter takes the analysis further and outlines how a model of exchange can be created to explain the categories of power that exist within supply chain networks and how critical assets are sustained. Such a model falls into two distinct phases. The focus of the first phase is specifically dyadic; that is, it offers a simple model of exchange that involves just two agents (a buyer and a seller). This dyadic model constitutes a refinement of the fourfold categorisation employed so far (namely buyer power, supplier power, buyer– supplier interdependence and buyer–supplier independence). The second task is to extend this analysis to the supply chain context. In the past, a number of analysts have expressed a belief that supply chains or supply networks can be codified into descriptive types in order to provide recommendations that will allow practitioners to manage their supply chain and market relationships more effectively (Hakansson 1982; Ford 1990; Hakansson and Snehota 1995; Harland 1996; Fisher 1997; Saunders, 1998). It is our intention to show that this is a false hope. Supply chains defy simple categorisation, such as by product or service, or as innovation or process networks. Any supply network providing goods or services consists of a wide variety of supply chains, each with a multitude of buyers and suppliers. It is not the description of what these supply chain actors do that is the key to understanding business success. Rather, it is the ability of these actors to use power resources that is analytically of interest (Cox 1997; Watson and Sanderson 1997). In the place of a descriptive supply chain typology we will offer the suggestion that product and service supply networks, containing within them a multitude of supply chains, are somewhat analogous to puzzles with an undefined picture. Analytically, whether we describe these as supply networks or supply chains, they consist of a series of power dyads. (There is much debate and confusion about the meaning of supply chains and supply networks. By a supply network we mean a collection of supply chains that are brought together within a company to create a particular product or service. By a supply chain we mean a specific set of immediate

54 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

dyadic relationships for one of the items that might be required to create a product or service.) It is the number of agents in the chain (or network) and the nature of the power dyads between them that determine the distribution of value, not what the chain or network is constructed to produce, that should be of most importance for the analyst. Only by understanding the complex interconnections between different types of power dyad within any supply chain or network is it possible to determine how value appropriation and accumulation occurs. Such an understanding should also enable us to determine when value is likely to flow down a supply chain (towards the end customer) and when it is likely to be trapped (appropriated by one or a number of powerful firms). Before proceeding with the task of building this analytical typology of power regimes, however, it is necessary to recapitulate and refine our earlier discussions, specifically in relation to the subject of interest. The suggestion that the objective interests of both buyer and supplier, in a particular transaction, can be understood in terms of the capacity of each agent to influence the gross profit margin in its favour needs further elaboration. This is because, as should be obvious from our earlier discussion of the various types of supply-side scarcity, each isolating mechanism has slightly different characteristics in terms of its sustainability and its costs of maintenance. Moreover, it is clear that these differences are far from trivial in terms of their impact on the interests of buyers and suppliers. Our first objective in this chapter is to map these differences more fully, thereby giving greater texture to our understanding of power in dyadic exchange.

Understanding the impact of isolating mechanisms on buyer and supplier interests Thus far, our discussion of power has employed gross profit margin as a proxy for objective interest. In a number of important respects, however, this is an oversimplification. As should be apparent from our discussion of isolating mechanisms, the impact of these mechanisms is not restricted to the supplier’s ability to negotiate a ‘good deal’. Rather, isolating mechanisms can be differentiated on the basis of three further variables. The first variable is the sustainability of the mechanism, the second is the cost of maintaining it, and the third is the extent to which the mechanism delivers unintended side-benefits to the buyer. We refer to these sidebenefits as epiphenomena. The issue of a mechanism’s sustainability is of limited importance where the buyer’s sourcing requirements represent a one-off or an occasional need. The fact that other firms are consistently leveraged by a dominant supplier is an irrelevance for a buyer that comes to the supply market only once. The majority of the products and services that flow through a firm’s primary supply chain, however, have to be sourced on a repeat

Analytical typology of supply chain power regimes 55 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

basis. For example, a car manufacturer would soon cease production if it was to run out of steel. Likewise, a confectionery manufacturer requires a continuous supply of sugar, while a power generator needs a continuous supply of gas, coal or oil. In such cases, the relative sustainability of a supplier’s isolating mechanism, where one exists, can have a major impact on the buyer’s costs of production. The second variable that helps to determine the character of an isolating mechanism is the costs associated with its maintenance. Two issues are germane here. The first issue is whether or not the mechanism of closure is costly to maintain once it has been established. The second is confined to those circumstances where an isolating mechanism is costly to maintain, and relates to the question of which party bears these costs. For any firm making a supply offering, all the costs of doing business have to be recovered if the firm is to continue to trade. Some of these costs go directly into the goods or services that the firm sells, while others are necessary just for doing business (overheads). ‘Isolating’ costs, however, are those costs that are generated simply so that a firm can earn a good price for its products on a sustained basis. These costs are frequently unproductive for both buyer and supplier. For the buyer, the costs are unproductive because, in most instances, they offer no value-added and because, in one way or another, they must be paid. For the supplier, they are unproductive because they impact directly on the firm’s bottom line. The price that the supplier’s customers are able to pay for the supplier’s products is fixed by their utility profiles and by the need to remain profitable themselves. Regardless of a buyer’s degree of dependency on a particular supplier, the buyer’s resources are finite. Consequently, if the supplier hikes its price beyond a certain point, it might no longer be profitable for the buyer to trade if it cannot pass these costs on to its own customers. This leads us to the notion that the supplier’s price is fixed. Thus, while a supplier may be able to recover part of the cost of an isolating mechanism directly from its customers, and disproportionately from its weaker ones, the remainder of the cost must be subtracted from the supplier’s own profit margin. While many isolating mechanisms have a financial cost attached to them and most are unproductive, some isolating mechanisms do in fact offer the customer unintended value-added. This value-added constitutes the third variable by which these mechanisms should be judged. These benefits are epiphenomenal, that is, they are unintended benefits that flow from a self-regarding act. The supplier’s intention when it attempts to close a market is to appropriate value on a sustained basis. In some instances, however, in order for a supplier to appropriate this value it must offer the customer something in return. This frequently occurs in those instances where the supplier’s competitive advantage rests on a product or process innovation that can be imitated with relative ease. Given such imitability, the innovation has

56 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

to be continuously renewed to prevent the firm’s competitive advantage from being lost. Continuous innovation requires the supplier to undertake additional value-adding investment, from which the customer might be expected to benefit. Similarly, in the case of ‘status’ branding, the buyer receives more than just the functionality offered by the product or service in question. Certain luxury products, such as a Mercedes car or a Rolex watch, also confer an all-important social status on the buyer. The nature of the costs associated with these closure mechanisms stands in sharp contrast to those associated with other types of closure. In the case of ‘promotional’ branding, for example, where the closure cost is primarily a dead weight, the mechanism offers the buyer little or no epiphenomenal benefit. These three variables – sustainability, maintenance costs and epiphenomenal benefit – are brought together in Figure 3.1. The buyer’s exchange interests are least adversely affected where the isolating mechanism has relatively low sustainability (that is, the buyer’s ability to get a good deal is not damaged in the long term), relatively low maintenance costs, and where it offers the buyer a high degree of compensatory benefits. This is marked as the Point of maximum interest for the buyer in Figure 3.1. ‘Maximum interest’ here refers to the buyer’s best interest under conditions of supply closure. Objectively, the buyer’s point of maximum interest is likely to occur where a supply market is highly contested. Clearly, the buyer’s interests are most adversely affected when the reverse is true, namely when the isolating mechanism has a relatively high sustainability, relatively high costs of maintenance, and offers the buyer little in the way of compensatory benefits. This combination of circumstances is marked in Figure 3.1 as the Point of minimum interest for the buyer. From the supplier’s perspective, it is preferable that an isolating mechanism has a relatively high sustainability and relatively low maintenance costs. The issue of sustainability is self-evident and requires no further elaboration. The case for a relatively low-cost mechanism, however, requires further explanation. Notwithstanding the fact that the costs of market closure can often be passed on to the customer, they still eat into the quantum of potential return. Where a buyer is locked into a dependent relationship, the supplier may continue to leverage on price up until the point that substitutes, where they are available, become viable, or up to the point where it becomes unprofitable for the buyer to trade. If the isolating mechanism has a substantial cost component, then, given that the point of maximum leverage is fixed, this cost must be subtracted from the additional returns that the supplier might otherwise earn. In the case of the final variable, epiphenomenal benefit, the impact on the supplier’s exchange interests is unclear. In the short term, the existence of such a benefit should not impact on the nature of the deal that the supplier is able to negotiate. If he is offered a life-belt, the drowning man is required to pay the asking price, whether he is happy or not. Over

Analytical typology of supply chain power regimes 57 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Relative sustainability of isolating mechanism HIGH

LOW

Relative cost of maintaining isolating mechanism LOW POINT OF MAXIMUM INTEREST FOR THE BUYER

HIGH

HIGH Product or process innovation (low causal ambiguity and information impactedness) Information asymmetry (status branding)

Quantum of sidebenefits for the buyer

POINT OF MINMUM INTEREST FOR THE SUPPLIER

LOW Information asymmetry (promotional branding)

LOW

HIGH

POINT OF MAXIMUM INTEREST FOR THE SUPPLIER Product or process innovation (high causal ambiguity and information impactedness) Supplier collusion Property rights Dedicated investment

POINT OF MINIMUM INTEREST FOR THE BUYER

Economies of scale/ natural monopoly Information asymmetry (credence goods)

Figure 3.1 Isolating mechanisms and buyer and supplier interests.

the longer term, however, the disgruntled buyer is more likely to look for ways to break a dependency than one that thinks it is getting a good deal. The general perception is that you have to pay for quality. Furthermore, a supplier that is able to demonstrate that its isolating mechanism offers the buyer some associated benefit is less likely to face hostile regulatory interest than one that is not. These factors – relatively high sustainability, relatively low maintenance costs and relatively high epiphenomenal benefit – are brought together in Figure 3.1 in the box marked as the Point of maximum interest for the supplier. Once again, the opposite combination of factors is indicated in Figure 3.1 as the Point of minimum interest for the supplier. As with the point of minimum interest for the buyer, the supplier’s point of minimum interest refers to its minimum interest given conditions of supply market closure. An inferior position would exist in the context of a contested supply market. Having established these points of minimum and maximum interest for both buyer and supplier, it is then necessary to locate the range of different isolating mechanisms within the analytical framework. In this way we are able to establish which of the mechanisms might be expected to create particularly advantageous circumstances of exchange for a buyer

58 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

or a supplier, and which might be expected to create particularly disadvantageous circumstances. The process of matching each mechanism with an analytical category is, however, an inexact process. As such, it is an exercise that is likely to generate disputes. A number of the isolating mechanisms, it might be argued, would be better located in a different category. Moreover, as the case of branding illustrates, some of the mechanisms can be comfortably located in more than one category. What is offered in Figure 3.1, therefore, is more in the way of a set of plausible estimates, rather than definitive analyses of the character of particular isolating mechanisms. What should be clear from these estimates is that the majority of the isolating mechanisms do not coincide with either party’s point of minimum or maximum interest. The two exceptions to this observation are innovation combined with high causal ambiguity/information impactedness, which coincides with the point of maximum interest for the supplier, and promotional branding, which coincides with the supplier’s point of minimum interest. This observation highlights the fact that suppliers are often forced to make complex trade-offs between relative sustainability, costs of maintenance and degree of side-benefits when adopting particular isolating mechanisms. In five of the mechanisms shown in Figure 3.1, two of these three characteristics are supportive of the supplier’s exchange interests, but the third runs counter to them. These mechanisms are supply market collusion, property rights, myopic dedicated investment on the part of the buyer, economies of scale/natural monopoly, and information asymmetry based on credence goods. Their sustainability is relatively high and, once in place, they can be maintained at relatively little cost. Relatively speaking, therefore, these mechanisms are highly favourable to the exchange interests of the supplier. These mechanisms are not ideal, however, because none of them delivers significant side-benefits to the buyer. Consequently, there is always a possibility that, over time, the buyer will become disenchanted with the limited supply market options available to it and will look for ways to create greater contestation. Moreover, the majority of these isolating mechanisms have no public interest defence. This suggests that the state is likely to act in support of any efforts by disenchanted buyers to create greater contestation in the supply market. The possible exceptions in this regard are property rights and natural monopoly. Property rights, for example, might be defended on the grounds that they encourage the private sector to invest, and thereby lead to the creation of employment. It might also be argued that robust property rights, particularly those applying to intellectual property, provide an indirect side-benefit to the buyer, because they encourage a higher degree of product and process innovation. Natural monopoly, on the other hand, can be defended on the grounds of allocative efficiency. Yet even here the supplier is vulnerable, because natural monopolies are also prime areas for regulatory oversight.

Analytical typology of supply chain power regimes 59 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Of the other isolating mechanisms, neither product nor process innovation nor information asymmetry based on various types of branding represent particularly attractive options for the supplier. Both can be relatively ephemeral and both can be relatively expensive to maintain. Of the two, innovation is probably the more attractive option, because the high returns that accrue to the supplier can be justified as a due reward for entrepreneurial risk taking. Moreover, the provision of an innovative product or service can be interpreted as an epiphenomenal benefit for the buyer. (These circumstances are reflected in the case of Intel’s continuing dominance of the supply market for microprocessors. Although Intel is forced to undertake continuous innovation, supported by strong promotional branding, in order to maintain its position in the market, the costs associated with these isolating mechanisms are justified by the willingness of buyers to pay a premium price for the firm’s products.) No such public interest defence can be associated with promotional branding, which is, for the most part, non-value-adding. An exception to this conclusion occurs for certain consumer goods, such as luxury cars and jewellery, where the brand is the value proposition. We refer to this in Figure 3.1 as status branding. Supplier collusion, property rights, dedicated investments, economies of scale/natural monopoly, and credence goods are all highly disadvantageous for the buyer, because they work so well for the supplier. The durability of these isolating mechanisms is relatively high and they offer the buyer little prospect of epiphenomenal benefits. The most that can be said of any of them is that their maintenance costs are relatively low, which means that the buyer is unlikely to pay significant additional isolating costs. In the case of a dedicated investment, however, the buyer usually bears all of the up-front costs. Under certain circumstances, the two remaining isolating mechanisms (branding and innovation) are likely to be inflationary for the buyer, because they are relatively costly for the supplier to maintain. These isolating mechanisms do, however, offer the buyer advantages that the others do not. Information asymmetry based on promotional branding is advantageous for the buyer, because in general it has a relatively low sustainability. This is because the apparent scarcity created by promotional branding is only sustainable for as long as the buyer is unwilling to assess the value propositions offered by non-branded alternatives. Status branding and innovation, on the other hand, may often offer the buyer some epiphenomenal benefit. In the case of innovation, this side-benefit to the buyer is likely to be particularly pronounced under those circumstances in which the supplier is forced to innovate on a continuous basis simply to stay ahead of imitative competition. Continuous innovation tends to be associated with those innovative products and processes that exhibit low levels of causal ambiguity and information impactedness.

60 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

Power, value appropriation and dyadic exchange Having outlined the likely impact of the various isolating mechanisms on the exchange interests of buyers and suppliers, it is now possible to develop a broad typology of power regimes in dyadic exchange. Before we can do this, however, one additional problem must be addressed. This problem relates to the issue of complexity. There is a large number of variables that might be included in a typology of buyer and supplier exchange. Given this complexity, we believe that it is not necessary to utilise all of the variables that might be included for the purposes of this study. Our view is that certain variables can be safely omitted without major detriment to the sophistication of the analysis. The three candidates for potential exclusion from the typology are information, scarcity and utility. The candidate that we would prefer to omit is utility, on the grounds that it offers a level of precision that is not required by the study. Power, as has been stated on repeated occasions, is relative. This of course means that it is not a commodity that can be accumulated like money or land, but that it varies according to the protagonists involved, the structural and informational resources that they have at their disposal and the skill with which each of the parties can deploy these resources. This is why it makes no sense to talk about the power of oil companies, software houses or large automotive firms. Some oil companies, software houses and automotive companies may have considerable power over some of their customers or suppliers, but not others. Other oil companies, software houses and automotive companies dealing with the same sets of customers and suppliers may have very little power. In short, exchange relationships involving sets of buyers and suppliers operating at similar points in the supply chain may exhibit considerable exchange-power heterogeneity. The principle of scarcity-based exchange heterogeneity is one that has a long history amongst analysts. Indeed, it is one of the central planks upon which much strategic management (particularly resource-based) thinking is built. As Peteraf (1993) has argued: A basic assumption of resource-based work is that the resource bundles and capabilities underlying production are heterogeneous across firms. One might describe productive factors in use as having intrinsically differential levels of ‘efficiency’. Some are superior to others. Firms endowed with such resources are able to produce more economically and/or better satisfy customer wants. Heterogeneity implies that firms of varying capabilities are able to compete in the marketplace and, at least, breakeven. Firms with marginal resources can only expect breakeven. Firms with superior resources will earn rents.

Analytical typology of supply chain power regimes 61 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Scarcity, however, is not the only source of exchange-power heterogeneity. Utility in particular often plays a major part in explaining power differences between two parties operating from what, in most respects, are similar circumstances. This insight is illustrated in Figure 3.2. The figure depicts a set of hypothetical exchange possibilities that exist between a buyer (A) and three potential suppliers (B1, B2 and B3). Each of the suppliers is offering products that are broadly similar in respect of their price and functionality. What distinguishes B1 and B2 from B3, however, is the relative importance of the contract to each of the suppliers. While in the case of both B1 and B2 the contract is of only residual importance to the supplier, for B3 the contract represents the difference between business success and failure. If the buyer were to undertake the exchange with suppliers B1 or B2 it would find itself involved in a situation of independence. An association with supplier B3, by contrast, would place it in a position of dominance. However, while no less critical than scarcity for offering an explanation of power differences between contracting parties, utility can be removed without damaging our analysis in the way that the removal of scarcity might. It is safe to remove the utility of the buyer to the supplier, because the scarcity of demand operates as a crude proxy for utility. When asking about demand scarcity (exchange opportunities for B outside of the A–B relationship), one is also asking a question about the importance (utility) of the A–B relationship to B. In the instance of the utility of the supplier to the buyer, while no such analytical substitute operates, the scope of the study does not require the presence of one. This is because the emphasis of the case studies is on the primary supply chains of firms. Almost by definition this implies that they rank highly on any commercial– operational salience index. Since all of the exchange examples share this

A

Buyer–supplier independence

B1

Buyer–supplier independence

B2

Buyer dominance

B3

Figure 3.2 Exchange-power heterogeneity.

62 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

same common denominator, it is possible to construct the model as though supplier utility was not a variable at all. The analytical framework consists, therefore, of three elements that are crucial to an understanding of the relative power of buyers and suppliers in exchange relationships. The first element comprises the buyer’s costs of search (themselves a function of transactional frequency, product and transactional complexity and product tangibility). The second element is buyer scarcity or scarcity of demand (a function of market size, market structure and the general attractiveness of the buyer’s business to the supplier). The third and final element is supplier scarcity or scarcity of supply (that is, commoditised supply versus practices that distort competition). This third element requires us to focus on the concept of isolating mechanisms and, in particular, on the way in which different mechanisms affect the interests of buyers and suppliers. At a very general level, we are interested in whether a supply market is highly contested or whether it is relatively closed to competition through the use of various isolating mechanisms. At a more specific level, we are interested in the nature of particular mechanisms in terms of their relative sustainability, maintenance costs and side-benefits. By linking together our three primary variables (buyer’s costs of search, buyer scarcity and supplier scarcity) it is possible to create eight

Buyer power resources Costs of search

Nature of supply market scarcity

Low

High

Low

High Scarcity of demand

Low

High

Low

High

Category 1

Category 2

Category 3

Category 4

Buyer dominance with transparent supply-side contestation

Opportunistic supplier dominance with many potential suppliers

Buyer dominance with opaque supply-side contestation

Category 5

Category 6

Category 7

Category 8

Transparent supplier dominance

Buyer– supplier interdependence

Opaque supplier dominance

Buyer– supplier independence

Opportunistic supplier dominance with few potential suppliers

Figure 3.3 An eight-category framework for analysing dyadic exchange.

Analytical typology of supply chain power regimes 63 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

primary categories of dyadic exchange. These categories are illustrated in Figure 3.3 and described in detail below. Category 1 brings together low costs of search and low demand–supply scarcity. This is Adam Smith’s ideal of a highly competitive supply market, in which suppliers are offering commoditised products to a customer base that is fragmented but well informed about supply market offerings. A balance of power exists under such circumstances; that is, no party has power over the other. We refer to this category of dyadic exchange as buyer–supplier independence. Nonetheless, there are winners from such relationships. The major beneficiaries are individual customers and society in general. The individual buyer benefits because, in order to survive, the supplier must pass value to its customers. The supplier achieves this either through constant innovation or by cutting its margins to the point where it is able to recover its costs of production, but little more. Society benefits because of the Pareto-efficient allocation of resources. Category 3 is superficially similar to Category 1, because buyer and supplier scarcity are low in both cases. The major difference, however, is that the buyer’s costs of search are relatively high in Category 3. Consequently, the buyer experiences information-based problems both preand post-contractually. Pre-contractually, the complexity or intangibility of the good or service being purchased makes it difficult for the buyer to undertake proper ex ante comparisons between suppliers. Post-contractually, a lack of experience makes it difficult for the buyer to monitor the supplier’s ex post behaviour, and supplier opportunism is rife. In both of these circumstances, the buyer is being affected by the supplier in a manner contrary to that which the buyer would accept if he had better information. We refer to this category of dyadic exchange as opportunistic supplier dominance with many potential suppliers. If the buyer were able to spot the supplier’s opportunism it might terminate the relationship. The difficulty that the buyer faces, however, is that industry-wide supplier opportunism is endemic. This is due to the fact that there are many buyers, all of which visit the market only rarely, and none of which is able, therefore, to develop detailed industry knowledge or to communicate such information to others. Many specialised, but still highly contested, commodity trades display these characteristics. Plumbing and basic legal services are prime examples of this situation, in which the supplier trades on the ignorance of the buyer. In both Categories 2 and 4, the structure of supply is commoditised and the structure of demand is highly concentrated. The two categories differ, however, in relation to the buyer’s relative costs of search, which are low in Category 2 and high in Category 4. Nonetheless, in both cases the balance of power favours the buyer. We refer to Category 2 as buyer dominance with transparent supply-side contestation. In these circumstances, the buyer’s negotiation and monitoring advantages over the supplier are manifest. This is because the supplier operates

64 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

in a highly contested commodity-based market, which makes it relatively easy for the buyer to undertake extensive ex ante comparisons between alternative offerings. Consequently, the supplier’s behaviour, both pre- and post-contractually, is relatively transparent. Moreover, if the buyer chose to exit from the association, this would place a crippling burden upon the supplier without doing commensurate damage to the buyer. The buyer is faced with many suitable and easily interchangeable supply offerings. The supplier, on the other hand, is faced with a situation in which there are relatively few suitable customers. We refer to Category 4 as buyer dominance with opaque supply-side contestation. In this circumstance, as in Category 2, the buyer’s power is derived from the contested nature of the supply market and from the relative costs to the supplier of detection if its attempts to behave opportunistically are discovered. Despite the high costs of search for the buyer, the supplier is discouraged from behaving opportunistically, because there are so few alternative buyers in the market. In the case of Category 3, where high search costs provide ample discretion for supplier opportunism, the supplier can take comfort from the fact that if the buyer detects such behaviour this will almost certainly be post-contractually, and ‘another sucker will be along in a minute’. In Category 4, however, where buyer scarcity is relatively high, the supplier can take no such comfort. It is the consequences rather than the threat of buyer exit in this circumstance that keeps the supplier honest and the buyer on top. Categories 5–8 are distinguished from Categories 1–4 in that the supplier is attempting to appropriate value from the buyer through the creation of a critical asset. This will always involve the use of some form of isolating mechanism to create a high degree of supplier scarcity. This scarcity may arise structurally or it may be based – as in the case of branding – on the buyer’s perceptions of value. Categories 5 and 7 in our framework are classic examples of structural supplier dominance. In both cases, since there are many buyers in the market, it is difficult for the buyer to make itself important to the supplier (or suppliers in the case of an oligopoly). This means that an individual buyer is dependent on the supplier for the good or service that it must purchase. However, while the supplier is dominant in both of these circumstances, Categories 5 and 7 do differ in terms of the relative informational ‘advantages’ that are conferred on the buyer. In Category 5, which we call transparent supplier dominance, the buyer’s costs of search are relatively low. Consequently, the buyer is well aware that the supplier is taking advantage of the situation, and is able to calculate the quantum of its exploitation. In Category 7, however, the buyer’s costs of search are relatively high. We call this opaque supplier dominance. This means that, although the supplier’s dominance is clear, the buyer cannot calculate the extent to which it is being exploited. We contend that opaque supplier dominance is much more favourable to the supplier than a circumstance in which the supplier’s dominance is

Analytical typology of supply chain power regimes 65 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

relatively transparent. This is primarily because regulation is always a threat to a dominant supplier. Regulation is a double-edged sword in that it can be used either to create, sanction or indirectly sustain a firm’s rentappropriating capacities, or to set strict limits on them. When the state tries to make a calculation about whether it should act for or against any given firm, it must undertake a careful balancing act. On the one hand, the state must assess the costs to society in general and to buyer welfare in particular of a Pareto-inefficient outcome. On the other hand, it must look at the direct impact on employment of reducing a dominant supplier’s protection. If the dominant supplier can persuade the state that the benefits of competition are relatively small and widely dispersed compared to the costs of regulation, then its position will be afforded significant supplementary protection. Under those circumstances where there is no epiphenomenal pay-off either to the buyer or to society, however, then the state is more likely to try to control the supplier’s pricing and output policies. Before the state can act, however, it must first perceive an ‘abuse of power’. If the supplier’s customers themselves do not perceive such an abuse, because the supplier’s dominance is opaque, they are unlikely to communicate the problem to the state and thereby to trigger the state into action. Category 6 represents the circumstance which we call buyer–supplier interdependence. This dyadic exchange circumstance arises both ex ante and ex post. Ex ante it arises because there is relatively high scarcity on both the demand and supply side of the relationship. While the buyer’s costs of search are relatively low, which means that it can explore the range of supply market offerings with ease, there are few suitable alternatives. Similarly, the supplier must find a suitable buyer from amongst a highly restricted choice. Ex post interdependence normally arises as a consequence of dedicated investments that are undertaken by a buyer and a supplier after they have made a contractual commitment. In this circumstance, the burden of any investments is normally borne equally by both parties. Alternatively, when a disproportionate share of the burden has been accepted by one of the parties, this is offset by a series of credible contractual safeguards to protect the vulnerable party. Given these ‘hostages’ (Williamson 1985), exit from the relationship becomes an unattractive option for either party. Under these conditions, the rewards and the costs of creating and maintaining the association will normally be divided on the basis of ‘fair shares’ for both participants. Moreover, the informational resources at the buyer’s disposal ensure that, where questions of value distribution arise, the supplier is unable to cheat the buyer. By contrast, cheating by the supplier is likely to be a common feature of Category 8. We call this circumstance opportunistic supplier dominance with few potential suppliers. As with Category 6, the buyer and supplier in Category 8 are structurally interdependent. In contrast to Category 6, however, the

66 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

capacity of the buyer to monitor its ‘partner’ is severely restricted. The significant information asymmetries that exist between the buyer and the supplier mean that the scope for supplier opportunism in the relationship is extensive. The supplier is unlikely to be disciplined by the threat of detection because the threat is not credible, and because the consequences that flow from being caught are limited. This is because, with a relatively high level of supplier scarcity, the buyer will find it almost impossible to exit from the relationship. The gap that exists between the buyer’s power resources and the supplier’s capacity to manipulate the buyer’s preferences means that this exchange circumstance must be characterised as one of information-derived supplier dominance. It follows from this discussion that the causes of buyer or supplier dominance, buyer–supplier independence and buyer–supplier interdependence might be expected to have objectively definable characteristics. We have outlined the circumstances in which demand and supply characteristics create eight different power regimes in buyer and supplier exchange relationships. Clearly, this analysis can be taken to a further level of sophistication by incorporating variables such as the utility of a buyer’s spend to a supplier’s business, and the sustainability, maintenance costs and epiphenomenal benefits of a supplier’s isolating mechanism. If this is undertaken, it is clear that a more detailed typology of dyadic exchange can be developed that allows us to specify thirty-six categories of buyer–supplier exchange. Such a level of sophistication is not, however, required for the purposes of this study and we will confine our analysis to the eight-category framework outlined above. (The thirty-six-category framework is outlined in Cox et al. (2000).) At the outset of this chapter, we argued that the search for an operationally useful guide to action could not be derived from descriptive typologies of supply chains. Our reason for taking this stance is that, while systematic description undoubtedly has a basic role to play in business research, an analytical understanding is a far superior guide to managerial action. This is because analysis enables us to make predictive statements about probable outcomes under specified circumstances. We also contend that supply chains need to be analysed in power terms, because successful business is ultimately about the ability of participants in networks of supply chains to appropriate and accumulate value from others. This ability is, in turn, a function of a firm’s power over either its customers or its suppliers, or preferably over both. Given this, we contend that it is not enough simply to understand the sources of power for buyers and suppliers in dyadic exchange relationships. Rather, in order to understand properly the bases of sustained value appropriation and accumulation, it is also necessary to understand how value flows within and between the multiplicity of dyadic exchange relationships that exist in even the simplest supply chains.

Analytical typology of supply chain power regimes 67 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Power and value appropriation: from dyadic exchange to power regimes Despite the important insights that an analysis of dyadic exchange can offer, the picture outlined above remains partial. This is because buyers and suppliers do not operate in a vacuum. The process of bringing any good or service to market requires a chain (or more accurately a network) of such exchanges. This observation is not simply of descriptive significance, it is of analytical importance also. This is because the complex juxtaposition of different exchange dyads impacts directly upon the value appropriation proposition in specific buyer–supplier pairings. The situation is somewhat analogous to that of planetary movement. The path that the Earth follows through space is shaped by the location of its satellite, the Moon, but only in part. More significant still is the broader stellar environment in which both bodies exist. The question that arises from such an observation is whether (or rather to what extent) this environmental impact is random or whether it is regularised and operates according to a set of discernible rules? In this section, we will suggest that such a set of rules does in fact exist. We conceive of supply chains as being like a combination of coloured blocks, with each block consisting of a dyadic exchange. The ‘colour’ of the block is determined by the power relationship that exists between the participants of the dyad. When placed together the dyads form a mosaic pattern. The nature of this mosaic pattern is determined by which block is placed next to another. The flow of value through a supply chain network is dictated by the unique combination of power structures that are contained within the mosaic pattern of the network. This point may be most simply illustrated through a number of examples. Figure 3.4 consists of sixteen highly stylised exchange regimes. Each regime is comprised of two interlocking exchange dyads (A–B and B–C). Each dyad is categorised according to the power relation that exists within it; that is, according to whether the exchange is characterised by buyer power, supplier power, buyer–supplier interdependence or buyer–supplier independence. In the figure, the existence of buyer power is indicated by the symbol (A > B or B > C); supplier power by (A < B or B < C); buyer–supplier interdependence by (A = B or B = C); and buyer–supplier independence by (A 0 B or B 0 C). These sixteen regimes are divided into four groups on the basis of the power relation that exists between A and B. This is described in the text as the downstream relationship. Group 1 contains those regimes where A has power over B (A > B). Group 2 contains those regimes where A and B are interdependent (A = B). Group 3 contains those regimes where A and B are independent of one another (A 0 B). Finally, Group 4 contains those regimes where B has power over A (A < B). We have then placed four regimes within each of these four groups, on the basis of the power relation that exists between B and C. Each one of

68 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

the four possible power relations between B and C is represented in each group. We refer to this as the upstream relationship. This leads to the generation of sixteen exchange regimes in total. The flow of value between exchange partners is held to operate according to the set of rules that we have already articulated. Where a situation of buyer power or of buyer–supplier independence exists, we contend that value flows from the supplier to the buyer (B to A, or C to B). Where a situation of supplier power exists, we contend that value flows from the buyer to the supplier (A to B, or B to C). Where a situation of interdependence exists, we contend that the pains and gains of the association (and therefore the value proposition) must be shared. Those actors within each regime that are in a position to appropriate and accumulate the available value are represented by a black square, while those from which the value is being appropriated are shown as a white square. In Regime 1, synchronised buyer dominance (A > B > C), C is compelled by its dependence on B to pass the value on to B. In short, C is forced to sell its products to B at or near cost. At the same time, B cannot appropriate the value for itself, but, for the same reason, must pass the savings on to A, along with the value that arises out of the A–B relation. Consequently, A obtains the maximum possible commercial benefit from the intermediary inputs necessary to produce its own goods or services, and at the lowest possible cost. The same outcome occurs in Regime 2, downstream dominance– upstream independence (A > B 0 C), and Regime 3, downstream dominance–upstream interdependence (A > B = C), but for different reasons. In the instance of Regime 3, B and C would in the normal course of events share the dividends of the association. Yet under these particular circumstances the dividends are nil, because B’s dependence on A requires it to pass the maximum possible value to its customer or face extinction. Since C’s interdependence with B means that its fate is inextricably tied to B’s, C must also give up its share of the value in order to survive. In Regime 2, C passes the value to B not because of its dependence, but because, if it does not delight its exchange partner, a competitor will. Once again, B is then forced to pass the value to A as a result of A’s dominance. In the final case in Group 1, Regime 4, upstream dominance–downstream dependence (A > B < C), A and C jointly appropriate the value. A appropriates the value from B, in the same way as in the other regimes in the group. Unlike the other regimes in Group 1, however, A cannot also appropriate the value from C, because C has power over B. Consequently, C does not need the B–C relation, nor, by implication, the A–B–C network. The key insight that we should derive from this set of examples is that, for many supply chain participants, the power relation that determines their ability to appropriate value is located within a dyadic relationship

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Group 1 Regime 1

A

A>B

Regime 3

A

Synchronised buyer dominance

B

B>C

C

Downstream dominance– upstream interdependence

A>B

B

B=C

Regime 2

A

A>B

Regime 4

C

A

Downstream dominance– upstream independence

B

B0C

C

Upstream dominance– downstream dependence

A>B

B

B
C

Group 2 Regime 5

A

A=B

Regime 7

A

Downstream interdependence– upstream dominance

B

B>C

C

Synchronised interdependence

A=B

B

B=C

C

Regime 6

A

A=B

Regime 8

A

Downstream interdependence– upstream independence

B

B0C

C

Downstream interdependence– upstream dependence

A=B

B

B
C

Group 3 Regime 9

A

Downstream independence– upstream dominance

A0B

B

B>C

C

Regime 11 Downstream independence– upstream interdependence

A

A0B

B

B=C

C

Regime 10 Synchronised independence

A

A0B

B

B0C

C

Regime 12 Downstream independence– upstream dependence

A

A0B

B

B
C

Group 4 Regime 13 Upstream dependence– downstream dominance

A

A
B

B>C

Regime 14 Downstream dependence– upstream independence

C

Regime 15 Downstream dependence– upstream interdependence

A

A
B

B=C

A

A
B

B0C

C

Regime 16 Synchronised buyer dependence

C

A

A
B

Figure 3.4 Value appropriation in double-dyad exchange regimes.

B
C

70 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

between others in the chain. Moreover, this may be a relationship over which these participants have no direct influence. This is true for the B–C relation in Regime 1 (A > B > C), where the value is lost from the association altogether. This is also true for the B–C relation in Regime 2 (A > B 0 C), and the B–C relation in Regime 3 (A > B = C). Indeed, the only regime in this group where one of the participants in each dyad is able to keep the value that they have appropriated as a direct consequence of their dyadic relationship is Regime 4 (A > B < C). In this case, both A and C retain the value that they have appropriated from B. Turning to Regime 5 in Group 2, downstream interdependence– upstream dominance (A = B > C), A and B are the net winners from the association. B extracts the value from C in the form of at or near cost prices, but A also benefits from the B–C exchange because it is interdependent with B. A and B negotiate with each other on the basis of ‘fair deal’ principles. This means a settlement where the supplier’s margins are not at cost, but where its returns are not supernormal either. Since the B–C relation permits B to control its costs, the returns that B can expect to obtain from A will be calculated from a lower cost base. Hence, A does not simply share value appropriation from its relationship with B, but also benefits from B’s relationship with C. A similar outcome is obtained within Regime 6, downstream interdependence–upstream independence (A = B 0 C), because B’s independent (highly contested) relationship with C means that B is once again able to extract value from C in the form of at or near cost prices. In Regime 7, synchronised interdependence (A = B = C), the value is shared equally, because each of the parties is dependent upon the other. A is dependent upon B, which is in turn dependent upon A. In the same way, B is dependent upon C, which is in turn dependent upon B. Consequently, A and C are also interdependent because, if either party fails, B would suffer equally. Finally, in Regime 8, downstream interdependence–upstream dependence (A = B < C), it is C that appropriates the value. A and B are dependent upon one another and share the value that is created by their association. B, however, is dependent upon C. C can use this advantage to appropriate value from both A and B. If A is unprepared to pass its share of the value to C, C can exit from its relationship with B. This action would also have a significantly detrimental impact on A. As Figure 3.4 shows, the value appropriation outcomes for the exchange regimes in Group 3 are identical to those for the regimes in Group 1. This is because a situation in which A has power over B (A > B) is assumed to lead to the same value outcome as one in which A and B have an independent exchange relationship with one another (A 0 B). In both cases, the value is assumed to flow from B to A. Nonetheless, the underlying reason for this outcome is different in each case. In the regimes in Group 1,

Analytical typology of supply chain power regimes 71 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

A appropriates the value from B as a result of B’s dependence on A. B must sell its goods or services to A at or near cost price, because it simply cannot afford to lose A’s custom. B has no (or very few) alternative buyers. In the regimes in Group 3, however, A appropriates the value from B because A can switch to another supplier with relative ease and at little cost to itself if B’s value proposition is deemed to be unsatisfactory. In a circumstance of buyer–supplier independence, B should, in principle, be able to replace A with an alternative customer with equal ease. In practice, however, B is likely to find this a difficult, if not impossible, task. The problem for B is that the buyer’s costs of search are relatively low under these exchange circumstances. Consequently, if A regarded B’s supply offering as unsatisfactory, then other buyers will probably reach the same conclusion. In order to stay in business, therefore, B is forced to pass value to A (or an alternative buyer) by improving its supply offering. The titles of each of these Group 3 regimes are as follows. Downstream independence–upstream dominance (Regime 9) describes those circumstances where A 0 B > C. Synchronised independence (Regime 10) describes those circumstances where A 0 B 0 C. Downstream independence–upstream interdependence (Regime 11) describes those circumstances where A 0 B = C. The last regime in this group, downstream independence–upstream dependence (Regime 12), describes those conditions where A 0 B < C. Finally, we turn to the value outcomes for the regimes contained within Group 4. In Regime 13, upstream dependence–downstream dominance (A < B > C), B uses its dominance over both its customer (A) and its supplier (C) to appropriate the value created by these dyadic associations. B is also the principal beneficiary in Regime 14, downstream dependence– upstream independence (A < B 0 C). This is partly because the B–C relation is characterised by buyer–supplier independence, which means that C is forced by supply market contestation to pass the value to B. It is also because A is dependent upon B. A must therefore accede to B’s wishes to avoid the damaging consequences that would occur if B chose to withdraw from the association. In Regime 15, downstream dependence–upstream interdependence (A < B = C), B makes money out of A, but is forced to share the value with C. The interdependence that exists between B and C means that the parties are likely to share the value appropriated from A on a relatively equal basis. Moreover, the fact that B is able to make good money out of A means that the dividends available to be shared are likely to be reasonably large. Finally, in Regime 16, synchronised buyer dependence (A < B < C), B appropriates value from A, but is in turn squeezed by C. Consequently, it is C which appropriates the lion’s share of the value within this regime. The double-dyad exchange regimes discussed above provide a rather stylised version of how supply chain power relationships actually operate.

72 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

It is possible, however, to apply the same rules to a more sophisticated representation of a supply chain. In Figure 3.5 we have constructed two hypothetical supply chain power regimes. These are based on the linkage of dyadic exchange relationships consisting of eight agents (A, B, C, D, E, F, G and H). We have then joined these agents together by means of seven exchange dyads (A–B, B–C, C–F, B–D, D–G, B–E and E–H) to create a complex network of relationships linked together to create goods and/or services for end customers. In effect, these could be seen as supply chains consisting of an end customer (A), an assembler (B), three components suppliers (C, D and E) and three suppliers of raw materials (F, G and H). In both of these hypothetical supply chain power regimes the B–C relation (B > C), the C–F relation (C > F), the B–D relation (B < D), the D–G relation (D = G), the B–E relation (B = E) and the E–H relation (E 0 H) remain fixed. The only difference between the two networks is the A–B relation. Two of the four possible dyadic exchange circumstances are mapped on to this relationship in each power regime. Buyer dominance and buyer–supplier independence are grouped together in Power Regime 1, while supplier dominance and buyer–supplier interdependence are grouped together in Power Regime 2. As we will explain later, the dyadic exchange circumstances have been grouped together in this particular way, because, in the context of each of these power regimes as a whole, they lead to the same value appropriation outcomes. In both of the power regimes shown in Figure 3.5, the value flows from F to C to B as a result of the series of cascading power relationships that operate to B’s advantage. Like a series of Russian dolls, C appropriates value from F, only to see this value in turn appropriated by B. Similarly, in the double-dyad exchange regime containing B, E and H, E is able to appropriate value from H by virtue of the independent relationship between them. E must then share at least some of this value with B, because these two actors do business on the basis of an interdependent exchange relationship. In both networks, however, B’s grip on the value that it appropriates from each of these double-dyad exchange regimes is at best only tenuous. This is because, in the remaining double-dyad exchange regime (containing B, D and G), B is dependent on D and is, therefore, likely to be leveraged by D. At the same time, D’s interdependence with G means that the benefits that D derives from its association with B are likely to be shared with G. As we can see, therefore, the value appropriation outcomes on the supply (upstream) side of the assembler (B) are the same in both of our hypothetical exchange networks. The principal difference between the networks relates to the exchange circumstances that exist between B and its end customer (A). In Power Regime 1, B is assumed either to be dependent upon A (A > B) or to have an independent relationship with A (A 0 B).

Analytical typology of supply chain power regimes 73 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply Chain Power Regime 1 B>C

A

A>B A0B

B

B
B=E

C

D

E

C>F

D=G

E0H

F

G

H

Supply Chain Power Regime 2 B>C

A

A=B A
B

B
B=E

C

D

E

C>F

D=G

E0H

F

G

H

Figure 3.5 Value appropriation in supply chain power regimes.

In both of these exchange circumstances, B is forced to pass value to A by pricing its product at or near the cost of production. Consequently, in Power Regime 1 B is being leveraged both by its customer and by one of its major component suppliers (D). Any value that B is able to appropriate in its relationships with C and E is therefore immediately passed on to A (in the form of low prices) and D (in the form of inflated boughtin costs). The profit margin being earned by B in these circumstances is likely to be extremely low. The value appropriation outcome from the A–B relation in Power Regime 2 is radically different. In this case, B is assumed either to be interdependent with its customer or to have power over A. As Figure 3.5 shows, the value appropriation outcome under both of these exchange circumstances is a function of B’s dependence on D. Thus, where A and B are interdependent with one another, A is forced to share in the exploitation being visited on B by D. All of the value created by the association between A and B is appropriated by D, which then shares this value with G. Conversely, where A is dependent upon B, B is able to appropriate

74 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

value from A by charging a price that is significantly above its cost of production. Nevertheless, B cannot retain this value in the form of higher margins, because it must pay the inflated prices being charged by D. As before, D shares the value that it appropriates from B with G.

Empirically validating the typology of buyer–supplier exchange and supply chain power regimes It seems clear, therefore, that this approach to analysing the dyadic relationships that operate between buyers and suppliers in the complex networks of dyadic exchange that constitute supply chain power regimes provides a much needed corrective to the current fashion for descriptive rather than analytical approaches to supply chain mapping. This theoretical underpinning also demonstrates that there is a significant potential for power imbalances in exchange relationships to undermine the search by practitioners for integrated supply chain management solutions. The reasons for this are self-evident. If operational efficiency is to be achieved in a supply chain, then the flow of inputs from raw materials to the assembled good or service needs to be effectively coordinated. All too often, however, the requisite level of coordination cannot be achieved, because supply chains are characterised by power regimes that are inimical to an uninterrupted flow of value from the end customer to raw material providers. It is for this reason – the self-regarding efforts of the multitude of actors in complex supply chain networks to appropriate and accumulate value – that so many attempts at integrated supply chain management have failed, and will continue to do so. It follows from this conclusion that researchers need to understand empirically how the flow of value occurs within various supply chain power regimes. Clearly, the possession by a buyer or supplier of a critical asset in any network of dyadic exchange relationships will provide the basis for those possessing these to appropriate a disproportionate share of the flow of value in a particular supply chain power regime. Thus, the next stage in our research must be to consider whether or not there are regular patterns of value appropriation taking place in particular descriptive networks of supply chain exchange. As we do not know the answer to this question, the next part of this book analyses empirically the exchange relationships that appear to exist within seven descriptively different supply chain power regimes. These regimes cover automotive assembly, insurance, electricity supply to industrial users, information technology services, aerospace fuel equipment, forecourt retailing and industrial sugar processing. As we shall see, the power regimes that exist within each of these supply chain networks are very different. The location of those firms that possess critical assets in their exchange relationships with their customers and their suppliers varies quite significantly. This demonstrates that, while

Analytical typology of supply chain power regimes 75 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

the analytical approach developed here can be used to great effect in explaining the flow of value in particular supply chain power regimes, we are still some way from, and perhaps will never achieve, a comprehensive codification of the analytical properties of supply and value chains. This is because business is dynamic and entrepreneurs are constantly looking for ways in which they can change the existing structures of power in supply chain networks to their advantage. Consequently, the typology of dyadic exchange regimes developed in this chapter is perhaps as far as one is able to take the process of codification.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Part II

Power regimes in supply and value chains

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

4

Site-specific convenience, branding and regulation The sources of asset criticality in the forecourt retailing supply chain

Introduction This chapter maps and analyses the supply and value chain for forecourt retailing in the UK. Its main aim is to explain the appropriation of value in the chain by considering which firms are powerful and what the bases of that power might be. The supply and value chain is best defined as a sub-set of the wider supply and value chain for convenience retailing. In other words, the forecourt shop is one of a number of different types of small retail outlet that offer the end customer a particular functionality based around the core characteristic of convenience. This general notion of convenience can be broken down into four more concrete characteristics. These are ease of access, whether by car or on foot; extended opening hours, and in some cases 24-hour service; a focus on top-up, impulse and distress purchases, which means that convenience stores aim to complement, rather than to compete with, larger outlets; and a wide but shallow product range. A cornerstone of forecourt retailing, and of convenience retailing in general, is the existence of a convenience premium. This means that customers are prepared to pay a higher price, in some cases up to 10 per cent higher, for products that they might normally buy in a supermarket, simply because they can be bought more conveniently. Thus, demand in this market is highly price-inelastic and competition tends to focus more on convenience factors. There is, however, a small number of known value items (KVIs), such as bread and milk, which do not attract such a price premium. In these cases, prices tend to be in line with those charged by the major supermarket retailers. The other principal types of convenience outlet are newsagents (CTNs), symbol groups such as the SPAR Group, non-affiliated independents (the classic corner shops) and off-licences. It should be stressed, however, that forecourt shops do occupy a particular niche within the convenience retailing sector, because they are intrinsically linked with the selling of petrol and petroleum-related products. It is also important to note that convenience retailing as a whole is just one of a number of trading formats within the generic grocery retailing

80 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

supply and value chain. The other main retail formats are the superstore, the supermarket, the discount store and the specialist store, such as a butcher’s or a baker’s shop. The relevance of placing convenience retailing and, within it, forecourt retailing in this more general context is that all of these trading formats share essentially the same functional stages on the upstream side of their supply and value chain. Consequently, the nature of the exchange dynamics in forecourt retailing is fundamentally dependent on the dynamics affecting all of these other types of grocery retailing. As will become clear, one of the key drivers of change in forecourt retailing is the increasingly concentrated structure of the retail stage in the supermarket supply and value chain. This market concentration has, in turn, driven a process of consolidation amongst grocery processors and manufacturers, which has had a direct impact on the dynamics of exchange in forecourt retailing. Moreover, the supermarkets have also played a crucial role in the development of many forecourt shops into what are, in effect, miniature supermarkets. This role has two main elements. First, the major supermarket chains have in recent years become significant players in the retailing of petrol. They entered this market through aggressive price cutting, thereby forcing forecourt retailers affiliated to the major oil companies to enter into a sustained price war. This increased level of price competition in what was formerly a fairly cosy oligopoly has driven the profit margin on petrol sales down to virtually zero. As a consequence, the major oil companies have been forced to turn their attention to the development of the forecourt retail offering as a source of higher and more sustainable profitability. Second, two of the major supermarket chains, Tesco and Safeway, have launched a forecourt retail offering of their own. These players have explicitly attempted to take the forecourt shop on to a different plane by introducing what are essentially smaller versions of their larger stores. Perhaps more important, though, is the fact that Tesco and Safeway have brought their full armoury of retailing expertise and technology into the forecourt arena. These developments pose a significant threat to the traditional forecourt shop by raising the expectations of the end customer. In most cases, the major oil companies have responded to these challenges by attempting to enhance and standardise the quality and range of their forecourt retail offering. In the case of BP Amoco, however, the oil company has responded by establishing a number of high-profile, jointly operated sites with Safeway. These interrelationships will be discussed in much greater detail below. For now, though, we can use this more general context to define the forecourt retailing supply and value chain as having four key functional stages. These are raw material production, involving fishing, agriculture and horticulture; the processing and manufacturing of grocery products; grocery distribution; and convenience retailing.

Site-specific convenience, branding and regulation 81 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Clearly, the first two of these stages are very broadly defined and encompass many hundreds, if not thousands, of different markets and product categories. In order to make the following analysis more manageable, therefore, it is necessary to focus on the exchange dynamics for a small sample of products. This sampling process is made much easier by the fact that five product categories currently account for around 75 per cent of total sales by value in a typical forecourt outlet. These are tobacco (39.2 per cent), lottery tickets (10.6 per cent), confectionery (10.2 per cent), soft drinks (8.5 per cent) and snacks (5.3 per cent) (Haines 1997). This chapter will consider the exchange dynamics for four of these product categories. We have decided to omit lottery tickets from our analysis, because they are not, strictly speaking, a grocery product. Consequently, they do not fit easily within the four supply and value chain stages that we have defined above. As in the other case study chapters in this volume, the discussion that follows has three main aims. The first aim is to descriptively map the physical supply chain for forecourt retailing, focusing on four of the top five product categories. This will involve a more in-depth discussion of the four key functional stages than has been undertaken so far. As before, we will consider the key resources needed by an organization to operate at each stage in the chain and will identify the major players. The second aim is to descriptively map the corresponding value chain for forecourt retailing. This will involve looking at the distribution of value in the chain, measured in terms of the gross profit margins typically being earned at each functional stage. The final aim is to identify and discuss the factors that determine the distribution of value in the chain. As ever, the focus here will be on the dynamics of exchange between firms at various stages in the chain.

Mapping the supply chain The four key functional stages in the forecourt retailing supply chain are shown graphically in Figure 4.1. We will consider each of these stages in turn, discussing them in terms of the primary activities carried out at a particular stage, the resources needed to support these activities, and the major firms operating at that stage. We begin with the production of consumable raw materials. Raw material production The descriptive mapping of the raw material stage of this supply chain presents a significant challenge, because it might potentially encompass literally hundreds of different types of crops and animal products. Moreover, there is usually a great diversity of suppliers for each of these many consumable raw materials. In order to overcome this inherent

82 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

CONVENIENCE RETAILING

GROCERY DISTRIBUTION

Supplier coordination skills to ensure high levels of operational efficiency

Supplier coordination skills to ensure high levels of operational efficiency

Strong and flexible brand that can be built upon in related product categories

Effective in-store layouts and product displays to maximise limited space

An efficient and secure IT system for inventory management

Significant capabilities in product or process innovation

a government licence to operate

Understanding of how offering should be differentiated from that of other convenience retailers

Data on retail trends and product innovation

Production skills to ensure high levels of operational efficiency

ability to produce efficiently and to satisfactory quality

Large market share in one or more product categories to achieve economies of scale/scope

access to fertile land or good-quality pasture

System to gather and analyse customer data Convenient outlet locations providing easy access for target customers

A large-scale, ideally nationwide, distribution network

GROCERY PROCESSING

RAW MATERIAL PRODUCTION Various resources required by producers of different raw materials, but common ones are:

Volume sales to generate good supplier discounts

Figure 4.1 The forecourt retailing supply chain: functional stages and key resources.

complexity, the following description will focus on six crops that are crucial components of the four main product categories sold through forecourt retail outlets. These crops are tobacco, sugar beet, sugar cane, wheat, potatoes and peanuts. Tobacco, in all of its various processed forms, is the biggest single product category sold through a typical forecourt shop. The sugar extracted from sugar beet and sugar cane is, of course, the key ingredient in both confectionery and soft drinks. Finally, wheat, potatoes and peanuts are all used extensively in the production of snack foods, such as crisps and savoury biscuits. Despite this diversity of crops and animal products, however, it is possible to define a single primary activity that is common to all of the firms operating at this stage in the supply chain. This is the cultivation and harvesting of natural resources to produce consumable raw materials. The diversity of crops and animal products also means that the resources required by firms to operate at this stage in the chain do vary somewhat. Nevertheless, three generic resources can be identified as common to the production of all consumable raw materials. These are a government licence to operate, which guarantees certain standards of safety and hygiene, an ability to produce crops efficiently and to satisfactory levels of quality, and access to fertile land or good-quality pasture.

Site-specific convenience, branding and regulation 83 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Given this diversity of crops and animal products, it is hardly surprising that, in ownership terms, the raw material stage is highly fragmented. In the UK alone, there are approximately 155,000 enterprises producing consumable raw materials. These vary greatly in size, from family-run smallholdings to large agri-businesses with many thousands of acres. At present, no single producer has a dominant share of a particular market segment. Nevertheless, the trend is towards consolidation, because profit margins for the majority of crops and animal products are diminishing rapidly. Margins are under pressure as a result of two interconnected factors. The first is the reform of the EU Common Agricultural Policy (CAP), which has reduced subsidies and increased the level of foreign competition facing UK farmers. These developments have created a situation of over-supply for many consumable raw materials. The second factor has been the emergence of a number of food safety scares, such as the BSE and foot-and-mouth crises. These scares have led to a weakening of demand for certain products and to higher costs of production for UK farmers in the form of more stringent health and hygiene regulations. Against this background, the major supermarket chains and the large grocery processors/manufacturers have been able to use their volume buying power to extract ever lower prices from many raw material producers. This implies that the process of market consolidation at this stage in the chain is likely to accelerate in the future. Looking specifically at each of the six crops mentioned earlier, we must introduce a number of important qualifications to the general picture outlined above. First, developments in the UK agricultural sector have no bearing on the supply of tobacco or peanuts, because these crops are grown exclusively outside the EU. The main regions from which tobacco is supplied are North and South America and southern Africa, while the vast majority of peanuts are imported from western Africa. Nevertheless, these are both relatively open and competitive supply markets, in which no single producer is dominant. Second, the supply of sugar beet, sugar cane and wheat diverges significantly from the broad picture outlined above, because producers of these crops receive a guaranteed minimum price under the CAP. As we shall see later, this regulatory protection has historically allowed farmers in these market segments to earn healthy profit margins on a sustained basis. Consequently, the pressure for consolidation to achieve economies of scale is currently much less pronounced for producers of these three crops. That said, the EU has plans to significantly reduce the level of price support over the next few years. Finally, the characteristics of the potato supply market are very much in line with the picture of a fragmented commodity market outlined above. Potatoes are a staple crop grown by a large number of farms of all sizes. Moreover, imports, both from within the EU and from third countries, command a significant share of the UK market.

84 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

Grocery processing/manufacturing The key activity at this stage in the supply chain is the transformation of consumable raw materials into finished products for final consumption. The transformation of consumable raw materials into a finished product may involve both processing and manufacturing, as with most refined grocery products, or it may solely require processing, as with the washing and packaging of fruit and vegetables. Where both activities are required, they are often carried out within the same firm. In some notable cases, however, the raw material is processed by one firm and then sold on to another to be used in manufacturing. Raw sugar, for example, is processed by British Sugar, which is the sole buyer of UK-produced sugar beet, and Tate & Lyle, which processes imported sugar cane. Neither of these firms is allowed, however, to manufacture sugar-based products, such as confectionery and soft drinks. The exchange relationships between these two sugar processors and the various manufacturers of confectionery and soft drink products are not discussed in this chapter. Instead, they are analysed in the industrial sugar supply chain case reported elsewhere in this volume. The focus here is on those firms that manufacture the finished grocery products. As we noted above, this stage encompasses the production of a huge range of food, drink and tobacco products. The UK food, drink and tobacco market as a whole was worth approximately £70.5 billion in 1995 (Key Note 1996). This discussion concentrates, however, on the four main product categories sold through forecourt retail outlets. In descending order of importance, these are tobacco goods, confectionery, soft drinks, and snacks. Whatever the grocery product in question, there are three resources that are essential to any firm operating at this stage in the supply chain. The first, and perhaps most important, of these resources is a strong and flexible brand. Branding is important both as a means of attracting a higher rate of return through differentiation and as a means of building a market presence in related product categories. There are many examples of this so-called ‘brand extension’, particularly in the confectionery and soft drinks markets. A second and related resource is a significant capability in product or process innovation. This capability is needed to ensure that the brand reflects a genuine difference in product functionality, rather than being the value proposition in and of itself. The third key resource comprises the technical and production skills necessary to ensure high levels of operational efficiency. This resource has become increasingly important as the market share of branded grocery products has been eroded by own-label substitutes. In addition to these three resources, which are essential in the sense that they are necessary for any processor/manufacturer to make a reasonable margin, we might also identify a further resource that would give its

Site-specific convenience, branding and regulation 85 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

owner a relatively sustainable competitive edge. This is a large market share in one or more product categories so that a processor/manufacturer is able to achieve both scale and scope economies. Significantly, the importance of this final resource is strongly supported by the nature of the market structure for each of the four key product categories. That is, each product category is dominated in the UK by three or four firms, with the remainder of the market being carved up between a large number of small niche players. The UK market for tobacco goods was worth approximately £11.7 billion in 1997 (Key Note 1998). Two main manufacturers command over 70 per cent of this market. These are Gallaher, with a market share of 37.7 per cent, and Imperial, with a market share of 32.5 per cent. Between them, these two firms control most of the best-known brands of cigarette sold in the UK. There are also two other manufacturers that are worthy of note. These are Rothmans, which has a 6.6 per cent market share, and R. J. Reynolds, which has a 2.1 per cent share. Both of these companies are losing market share to Gallaher and Imperial. The fundamental dynamics of this market are intense brand-based competition and a declining level of demand. The demand for cigarettes in the UK, as in the rest of the western world, is in long-term decline as a result of greater health consciousness and a growing view that smoking is anti-social. In this context, it is hardly surprising that the market has experienced a substantial degree of consolidation over the last decade. Turning to the UK market for confectionery products, the statistics show that this was worth around £4.9 billion in 1996 (Key Note 1997a). In this case, there are three main manufacturers, which collectively control just under 70 per cent of the market. These are Cadbury Schweppes, which has around 30 per cent of the market, Nestlé Rowntree, which has a 20 per cent share, and Mars, which has some 18 per cent of the market. Again, these large players own most of the major brands in both the chocolate-based and the sugar-based segments of the market. Cadbury Schweppes, for example, is the parent company of Cadbury and of Trebor Bassett. Similarly, the takeover of Rowntree by Nestlé has given the combined group control over many famous brands. This market presents interesting competitive dynamics, because confectionery products are regarded by most consumers as an affordable luxury. Consequently, the demand for these products is largely insensitive to price increases and the market has grown steadily during the post-war period. Market growth has also been stimulated by brand extension. In particular, leading confectionery brands have been used to sell ice cream products, soft and milk-based drinks and chilled desserts. The success of this strategy for the main players in this market highlights the importance of a strong and flexible brand. As we noted in Chapter 3, branding is a relatively costly and ephemeral means of limiting competitive pressure. It is vital, therefore, for a firm to

86 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

maximise its return from expenditure on brand building. Despite the undoubted importance of branding in this market, competitive pressure, in the form of own-label products, has increased steadily in recent years. Market consolidation has been the inevitable result. The characteristics of the next product category, soft drinks, are in many ways closely related to those of the confectionery market. This is hardly surprising, given that brand extension has led to a significant convergence between these two markets. The UK soft drinks market was worth approximately £7.9 billion in 1995 (Key Note 1996). The demand for soft drinks has grown rapidly over the last decade and shows no sign of declining in the near future. This growth has been driven by a combination of brand extension into sugar-free alternatives and, more recently, by the emergence of bottled water as a leading product within this category. Again, there are three dominant manufacturers of sugar-based soft drinks in the UK. These are Cadbury Schweppes, which distributes Coca-Cola, Britvic Soft Drinks, which distributes Pepsi, and SmithKline Beecham, which owns leading brands such as Ribena and Lucozade. Premier Waters is the leading player in the rapidly growing bottled water segment of the market. As in the confectionery market, the leading soft drink brands are under increasing competitive pressure from own-label alternatives, particularly those produced by the major supermarket chains. This challenge is doubly problematic for the manufacturers of branded products, because just under 70 per cent by volume of soft drinks are sold through the supermarkets. Consequently, the gross profit margins available to the manufacturers on branded products have been severely squeezed. Once again, the manufacturers have responded to this pressure by consolidating the market to achieve economies of scope and scale. The last of our four main product categories is snack foods. This market was worth approximately £2 billion in the UK in 1996 (Key Note 1997b). Unlike the previous product category, the demand for snacks has grown steadily rather than meteorically over the past decade. This steady growth trend is predicted to continue in future, and is expected to be focused mainly on low-fat and premium adult snacks, particularly for the main branded manufacturers. Branded manufacturers are expected to focus on these product lines, because own-label products have a significant and growing presence at the more basic end of the market. In 1995, for example, own-label products accounted for some 47 per cent of nut sales and around 27 per cent of crisp sales in the UK (Key Note 1997b). Once again, the supermarkets loom large in the production and retailing of own-brand products. Their price discounting activities have vastly increased the competitive pressure on branded manufacturers. The response of branded manufacturers to this pressure has been twofold. First, as we have noted, they have begun to segment the market by shifting their attention to the development of low-fat and high-quality

Site-specific convenience, branding and regulation 87 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

adult snacks. These snacks attract a small price premium. Second, they have restructured and consolidated their product portfolios to achieve economies of scale. As a result, each of the main product segments in this market is now dominated by a single branded manufacturer. Walkers Snack Foods is by far the biggest supplier of crisps in the UK, with some 53 per cent of this segment in 1995. The next biggest branded manufacturer, Golden Wonder, had only 9 per cent of this segment in that year (Key Note 1997b). Walkers Snack Foods was formed by a merger between Walkers and Smiths in January 1995. The combined group subsequently moved out of the nut segment altogether, when it sold its stake in Planters to Derwent Valley Foods. The leading supplier of both nuts and savoury snacks in the UK is KP Foods. The company had 46 per cent and 33 per cent of these segments respectively in 1995 (Key Note 1997b). Further market consolidation is expected across this product category, driven in particular by the need to reduce excess manufacturing capacity. Grocery distribution This functional stage involves the bulk transfer of finished grocery products from the manufacturer to the convenience retailer. This product transfer is carried out either directly by the manufacturer, or indirectly by a specialist wholesaler. Wholesalers can, in turn, be divided into two main categories. These are cash and carry wholesalers and delivered wholesalers. Firms in the former category provide large warehouses to which individual retailers have access, while firms in the latter provide a product consolidation and delivery service. The following discussion will focus primarily on wholesaling rather than direct distribution. The vast majority of convenience retailers, forecourt retailers included, still use either one or both types of wholesaler to acquire their goods. It is usually uneconomic for a convenience retailer to deal direct with a manufacturer, because the product volumes involved are relatively small. That said, direct distribution is likely to become more prevalent in future, as the major supermarket chains increase their interests in forecourt retailing through joint ventures or as independent players. The main activities involved in cash and carry or delivered wholesaling are product consolidation and warehousing, transportation, inventory management, and the provision of marketing advice and promotional material to the retailer. In short, a wholesaler might best be seen as a point of coordination for the numerous product categories, each representing a discrete supply chain, that are sold through convenience retail outlets. There are three resources that are essential for any firm to operate successfully at this stage in the supply chain. First, a wholesaler must have the requisite supplier coordination skills to achieve a high level of

88 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

operational efficiency. Second, the firm needs an efficient and secure IT system for inventory management. In effect, such a system would provide technological support and an information processing capability for the firm’s supplier coordination skills. Finally, the firm needs a capability in gathering and interpreting data on retail trends and product innovation. The significance of such a capability is that it would enable the firm to understand, and thereby to create a satisfactory match between, demand and supply. Given that a wholesaler is ultimately no more than an intermediary between manufacturer and retailer, this resource is clearly critical to the long-term survival of any firm at this stage in the chain. In addition to these three core resources, we might also identify two more resources that would give their owner a relatively sustainable competitive advantage in what is essentially a low margin commodity business. The essence of both of these resources is scale. The first is a large-scale, ideally nationwide, distribution network. Such a network would allow the wholesaler to service the needs of the largest convenience retail chains, many of which also operate on a nationwide basis. In a market where fixed costs are high and price competition is fierce, it is imperative for firms to acquire and sustain a substantial market share to cover their fixed costs. Moreover, the sheer size of the fixed costs involved in setting up a nationwide distribution infrastructure can act as an effective barrier to new market entrants. The second additional resource is the counterpoint of a large customer base, namely a guarantee of substantial sales volumes to ensure price discounts from the dominant branded grocery manufacturers. Given that the wholesaler has little choice but to offer its customers the leading brands under conditions of intense price competition, it must handle a substantial volume of these products if it is to make a reasonable margin on the transfer. Significantly, the dynamics of the grocery wholesaling market in recent years have provided a clear indication of the fundamental importance of scale for competitive success. Both the cash and carry and the delivered wholesale segments of this market have undergone substantial consolidation. This process has been driven by intense price competition against a background of broadly static demand. Probably the most influential factor in the dynamics of this market in recent years has been the adoption by supermarket retailers of direct distribution. The supermarkets are buying grocery products in such large volumes that they are now able to bypass wholesalers and deal direct with the manufacturers. Indeed, in most cases the supermarkets have become the dominant channel of distribution. This allows them to buy at very favourable prices, even from the largest branded manufacturers. As a consequence of these developments, the wholesaling market has become increasingly focused on the needs of the convenience retail sector. The demand in this sector is growing slowly, but it is still substantially smaller than that which has been lost to direct distribution by the supermarkets.

Site-specific convenience, branding and regulation 89 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

The UK market for cash and carry was worth approximately £9.4 billion in 1997 (IGD 1998). Historically, the principal customers of these firms were hotels and restaurants. In recent years, however, the customer base has shifted more towards convenience outlets. This sector represented around 33 per cent of the cash and carry customer base in 1998 (IGD 1998). Forecourt retailers are recognised as a particular growth opportunity within the overall convenience retail sector. Three major players dominate this segment of the wholesaling market as a result of the consolidation discussed above. These are Booker, which has 25 per cent of the market, Makro, with 10 per cent of the market, and Batley’s, with 6 per cent of the market (IGD 1998). Beyond these large nationwide firms, the cash and carry market is composed of numerous small firms with a primarily local customer base. Turning to delivered wholesaling, it is clear that this segment of the market has undergone an even greater degree of consolidation than that in the cash and carry sector. Indeed, 90 per cent of the market is controlled by just three firms. These are Palmer and Harvey McLane, which has a massive 46 per cent of the market, Booker Wholesale Foods, with 31 per cent of the market, and the SPAR Group, with 15 per cent of the market. This market was worth around £5.2 billion in 1997 (IGD 1998). As we noted above, the traditional customers of these firms were the supermarket retailers. The growth of direct distribution has ensured, however, that the major delivered wholesalers now do most of their business with convenience retailers. Forecourt retailers, in particular, account for a significant and growing share of their sales. This trend is being stimulated by the efforts of the major oil companies (Shell, Esso and BP Amoco) to standardise and improve their forecourt retail offerings. The oil companies are beginning to use one or two delivered wholesalers to manage and consolidate all of their product needs on a nationwide basis. Convenience retailing The key activity at this final stage in the supply chain is the presentation of a wide range of finished grocery products under one roof for sale to the end customer. As we noted at the outset of this chapter, the convenience retailing sector and, within it, forecourt retailing, offer a particular functionality to the end customer in terms of ease of access, extended opening hours, and a wide but shallow product range. Convenience retail outlets operate as a complement to the larger supermarkets and superstores. They are primarily in business to service top-up, impulse and distress purchases. There are five resources that are essential to any firm operating at this stage in the supply chain. The first of these comprises the supplier coordination skills needed to achieve high levels of operational efficiency. Given the

90 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

limited storage space available in most convenience stores, it is essential that product turnover is relatively rapid and continuous. Conversely, it is also important that there are no product shortages. One of the cornerstones of successful convenience retailing, therefore, is to manage the flow of products in a way that minimises waste, while maximising the level of stock on the shelves. A second and related resource is a capability in designing in-store layouts and product displays in a way that makes maximum use of the limited space. Third, a firm operating at this stage in the chain needs an understanding of how its offering should differ from that of other convenience retailers. The key to success for any firm at this stage is to maximise the convenience factor. The fourth important resource is an IT system that enables the firm to gather and analyse data about customer behaviour. In a sense, this resource supports the first three, because it enables the retailer to track product sales and the use of additional services. This information plays a vital role in supplier coordination, product promotion and in-store layout, and in the redesigning or introduction of services to enhance the convenience factor. The final, and perhaps most important, resource at this stage in the chain is the ownership of convenient outlet locations to provide easy access for target customers. Significantly, this resource also has a bearing on the extent to which a particular forecourt retailer faces direct competitive pressure. Thus, in a limited number of locations, such as motorway service stations, the forecourt retailer faces little or no competition. The existence of such a localised monopoly is likely to be reflected in the profit margins earned under these circumstances. Conversely, a forecourt outlet that is situated close to the centre of a town or a city is likely to face much greater competition from other convenience stores. A forecourt retail outlet that is situated on a main trunk route between towns or cities is likely to face an intermediate degree of competition, primarily from other forecourt outlets. The degree of competition facing a forecourt retailer, therefore, is essentially a function of the distance between alternative outlets. The objective of most convenience store customers is to minimise the distance that they have to travel to fulfil their needs or wants. This is particularly true in the case of forecourt customers, because many of them are travelling in a professional capacity. Consequently, time is more important than money. The UK convenience retailing market as a whole was worth approximately £15.1 billion in 1996 (Haines 1997). This market has grown significantly in recent years as a result of changing patterns of work and the development of out-of-town supermarkets. Convenience stores in general, and forecourt outlets in particular, have been forced to respond to the growing demand for late-night and Sunday shopping. As already pointed out, forecourt outlets are one of five main types of convenience store, the others

Site-specific convenience, branding and regulation 91 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

being newsagents (CTNs), symbol groups, such as the SPAR Group, nonaffiliated independents (the classic corner shops), and off-licences. Despite the overall growth in the convenience market, the competition within and between these different formats remains intense. As we noted earlier, however, competition is focused more on the convenience factor than on prices. The main losers in this competitive struggle in recent years have been the independents and off-licences. Firms in these formats have suffered, primarily because they have been unwilling or unable to embrace the demand for new services. The market share commanded by forecourt outlets, on the other hand, has grown rapidly. Forecourts had some 20 per cent of the UK convenience retail market in 1996 (Haines 1997). Forecourt outlets can be divided into two main categories, petrol wholesaler-owned and independent. Broadly speaking, 40 per cent of forecourt sites are owned by petrol wholesalers, such as BP Amoco, Shell and Esso, and 60 per cent are independently owned. The low and falling profit margins being made on petrol sales mean, however, that many independently owned sites are being forced to close down. This is particularly true of sites in rural areas, where the volume of petrol sold is too low for retailers to cover their high fixed costs. Consequently, the balance between wholesaler-owned and independent sites is moving in favour of the former. There are some fifteen petrol wholesalers active in the UK forecourt market. Market concentration is relatively low, with the top three firms collectively earning just over 30 per cent of sales revenues. The largest players are BP–Mobil, with approximately 11 per cent of sales, Esso, which has around 10.5 per cent of the market, and Shell, with around 9.5 per cent of sales. (Market shares are based on authors’ estimates using data from Haines (1997).) The market is even more open and competitive if we take the independent sector into account. Independently owned sites can be subdivided into three main categories. These are solus dealers who own one or a small number of sites, forecourt outlets based on supermarket sites, and forecourt outlets based at motorway service stations. No single player, within any of these sub-categories, currently has a significant share of overall sales revenues. That said, it seems clear that the major supermarket chains will provide a challenge to the position of the leading petrol wholesalers in future.

Mapping the value chain We turn next to the value chain that corresponds to the supply chain described above. Table 4.1 provides a broad overview of the pattern of value appropriation that results from the supply relationships that we have mapped out. In this case, the pattern of value appropriation is represented by the return on sales (ROS) typically achieved by firms operating at each stage in the supply chain. We recognise, of course, that these figures present

92 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

Table 4.1 The convenience retailing value chain

Typical gross profit margin (ROS) (%)

Convenience retailing

Grocery distribution

Grocery processing

Raw material production

20–25

1–2

6–10 without effective own-label competition

20–25 on crops within the CAP

3–5 with effective own-label competition

1–3 on crops outside the CAP

Source: authors’ estimates based on various industry reports.

a simplified picture of a complex and nuanced reality. Profit margins vary significantly, both between firms in the same sector and between different product lines within a single company. That said, these generalised figures are still meaningful enough to give us a broad understanding of which stages within the convenience retailing supply chain offer firms relatively sustainable profit opportunities and which do not. It is immediately obvious from the figures in Table 4.1 that by far the highest gross profit margins in this supply chain are earned by the convenience retailers themselves and by farmers operating under the auspices of the EU Common Agricultural Policy (CAP). Conversely, the least profitable functional activities in this chain are grocery distribution and the production of consumable raw materials outside the regulatory protection of the CAP. In the next section of the chapter, we identify and discuss some of the key determinants of this value distribution. This discussion will be structured around a network model, which illustrates the exchange dynamics operating between firms at adjacent stages of the chain. The relationship between these exchange dyads and the wider distribution of value in the chain is explained on the basis of the insights developed in Chapter 3.

Value distribution and the dynamics of exchange There are five major exchange relationships or dyads in the value chain for forecourt retailing. The exchange dynamics for each of these dyads, and the wider interrelationships between them, are illustrated in the network model shown in Figure 4.2. The nature of these dynamics, and the resultant distribution of value in the network, depend on the power structure of the individual dyads. These power structures are represented

Site-specific convenience, branding and regulation 93 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9111 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

B
A

A
B

B0C

C

C
D

D0E D<E

E

B0D

Figure 4.2 The power regime for the supply of tobacco, confectionery, soft drinks and snacks by forecourt retailers. A – end customer, B – convenience retailer, C – grocery distributor, D – processor/manufacturer, E – raw material producer.

using the nomenclature developed in Chapter 3. To recap briefly, buyer power is indicated by the symbol (>), supplier power by (<), buyer–supplier interdependence by (=), and buyer–supplier independence by (0). Based on the assumptions articulated in Chapter 3, certain actors in the network are deemed to be in a position to earn rents rather than profits. Those actors with a capacity to earn rents are represented by means of a shaded box, while those that are able to earn only normal profits appear in a clear box. A box that is both shaded and clear represents an actor that is able to earn rents, but only under certain circumstances. The first of the five major exchange relationships in this value chain is that between the end customer (A) and the convenience/forecourt retailer (B). As the figure shows, this relationship can be characterised in power terms as one in which the retailer has power over the customer (A < B). At a superficial level, this characterisation seems counter-intuitive. There are over 38,000 convenience outlets in the UK and, as we saw earlier, the market is highly fragmented in terms of ownership. There are also many millions of individual customers. In simple number terms, therefore, it might seem more appropriate to describe this relationship as being based upon buyer–supplier independence. The gross profit margins typically earned by convenience retailers are, however, far higher than one would expect in a situation of commoditised exchange. Gross margins of 20–25 per cent are typical. A closer examination of this relationship reveals that, despite what the wider market structure might imply, this is not a simple commoditised exchange. In a commodity market situation, rival suppliers are differentiated

94 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

purely on the basis of price, and the buyer is able to switch suppliers with relative ease and at little or no cost should a better deal emerge. Moreover, the buyer’s search costs are relatively low, because the good or service in question is to a large extent standardised. Together, these factors mean that the supplier is forced to pass value to the buyer, in the form of price reductions, simply to retain his or her custom. If we consider the dynamics of exchange in this case, however, it is clear that these conditions are only partly fulfilled. The most important difference is that the end customer’s primary concern in choosing a convenience retailer is not price, but convenience. As we noted earlier, the gross margins earned at this stage in the supply chain reflect the availability of a convenience premium on most product categories. This premium is normally 5–10 per cent above supermarket prices. There is a small number of known value items (KVIs), such as bread and milk, which are priced at supermarket rates due to the customer’s price sensitivity. For the vast majority of products, however, the end customer is primarily interested in the ease with which a product can be bought. This does not mean that the customer is unaware that products bought from a convenience outlet are premium priced. Indeed, the customer’s costs of search in this case are relatively low, because the products sold through convenience outlets tend to be standardised across the grocery retail sector as a whole. This means that it is relatively easy for the customer to make price comparisons between different retailers, should he choose to do so. The important point, however, is that the typical customer of a convenience outlet is not particularly interested in making price comparisons. His or her principal, and some cases sole, interest is to minimise the inconvenience involved in making a purchase. Consequently, he or she is likely to perceive the costs of switching to an alternative supplier to be prohibitively high. Travelling to an alternative supplier, even one that is relatively close at hand, involves an element of inconvenience that the customer is trying to avoid. This unwillingness to switch on the part of the customer gives the supplier power in the form of a highly localised monopoly. Thus, although supplier scarcity across the convenience sector as a whole is relatively low in nominal terms, the reality is that customer inertia creates a relatively high level of supply-side scarcity. This exchange relationship can therefore best be located in Category 5 of our typology of dyadic power structures (transparent supplier dominance). There are, of course, situations in which the inconvenience caused by switching is small relative to the saving that the buyer might achieve by transferring his or her custom. Thus, where there is a number of convenience outlets in close proximity to one another, such as in a town centre, the power advantage enjoyed by the retailer is likely to be undermined by the threat of switching. Forecourt retailers in this situation might be expected to price at the lower end of the premium range. Indeed, in

Site-specific convenience, branding and regulation 95 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

the case of the miniature forecourt supermarkets established recently by Safeway and Tesco the price premium has been abandoned almost completely. These players have recognised that their brands are associated by the consumer with a particular level of prices. Conversely, a forecourt retailer operating on the site of a motorway service station or an out-of-town superstore has a much more captive customer base, because the nearest alternative is likely to be many miles away. In such cases, a site-specific advantage is linked with customer inertia, providing the retailer with a relatively durable local monopoly. The retailer is likely, therefore, to price at the upper end of the premium range. In short, the location of an outlet, and the property right to that location, is fundamental to the sustainability of the power advantage enjoyed by a forecourt retailer. We turn next to the exchange relationship between the convenience retailer and the grocery distributor. The gross profit margin typically earned by grocery distributors is 1–2 per cent. This exchange dyad is shown as (B 0 C), which means that the convenience retailer and the grocery distributor do business with one another under conditions of buyer–supplier independence (Category 1 in our typology of dyadic power structures). As we noted above, buyer–supplier independence is characterised by intense price-based competition between broadly similar suppliers, that are trying to win the custom of a relatively large number of similar buyers. The product offering of each supplier is highly standardised, which makes the buyer’s search and switching costs relatively low. Grocery distribution is an easily replicable activity, based around product consolidation, storage and transportation. The outcome, in value terms, of this type of exchange relationship is that the supplier (grocery distributor) is forced to pass value to the buyer (convenience retailer) simply to retain his or her business. This means that the prices charged by grocery distributors, and by extension their gross profit margins, tend to be very low. The major strategic problem facing grocery distributors is that the demand for their services has been broadly static in recent years. This lack of market growth is due to the decline of the independent grocery retail sector and the increasing dominance of the large supermarket chains, which deal direct with the grocery processors/manufacturers. The inevitable response to this combination of static demand and overcapacity has been a process of market consolidation. Grocery distributors have recognised that the only way to make a sustainable profit, while maintaining low prices and covering the high fixed costs of a distribution network, is to control a larger share of the market. As we noted earlier, it is also vital for a distributor to have a large volume of sales if it is to achieve a strong negotiating position against the dominant branded processors/manufacturers. Significantly, though, this consolidation of the distribution market has not, in itself, altered the power structure that underpins the exchange

96 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

relationship between the convenience retailer and the grocery distributor. This exchange dyad continues to be characterised by buyer–supplier independence, because the retailer retains an open choice between distributors, albeit a more limited choice. Consolidation should thus be seen as having given the remaining distributors greater cost efficiency through economies of scale, rather than as having altered the balance of power in their favour. There are signs, however, that the power structure of this exchange relationship may in some cases be shifting towards buyer–supplier interdependence. This shift is occurring where some of the leading forecourt retailers are beginning to consider the possibility of preferred supply relationships with one or two of the major delivered wholesalers, such as Booker or Palmer and Harvey McLane. These retailers are assessing the potential savings that might accrue if a preferred distributor was given the task of coordinating all of their upstream supply relationships. At present, such coordination is largely non-existent, because the major oil companies lease their forecourt outlets, singly or in small groups, to independent operators. These operators are basically free, within the terms of their lease, to purchase their stock from whatever supplier they might wish. Clearly, the setting up of a preferred supply arrangement would require one or both of the parties (oil company and grocery distributor) to undertake substantial dedicated investments in storage, logistics and IT systems. Assuming that such investments were undertaken jointly, the relationship would be characterised by interdependence. There would, of course, be the potential for one of the parties to acquire a power advantage over the other if these dedicated investments were largely or wholly one-sided. The next set of exchange relationships in this network comprises those involving the convenience retailer (B), the grocery distributor (C) and the grocery processor/manufacturer (D). We can divide these dyads into two sub-categories. The first sub-category contains those dyads in which there is an independent relationship between buyer and supplier. These are shown in Figure 4.2 as (B 0 D) and (C 0 D). The second contains those dyads in which the grocery processor/manufacturer has a power advantage over the convenience retailer or the grocery distributor. These dyads are shown in Figure 4.2 as (B < D) and (C < D). The fundamental difference between these two sub-categories of exchange dyads is the importance and sustainability of branding. As we noted in Chapter 3, branding is a somewhat costly isolating mechanism with relatively low sustainability. It also offers few, if any, side-benefits to the buyer, because the costs of brand building are ultimately borne by the customer in the form of higher prices. It might be argued that branding is of some benefit to the buyer if it reflects a genuine difference in product functionality, because it reduces the buyer’s search costs. In the vast majority of cases, however, branding is used by a supplier to create an artificial sense of scarcity in what is fundamentally a commodity market. This is

Site-specific convenience, branding and regulation 97 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

nowhere truer than in the key product categories sold through forecourt outlets. Despite what the manufacturers might claim, it is reasonable to assume that one chocolate bar, soft drink, snack or packet of cigarettes is much the same as any other. The difference lies in the perception created by branding. In the first sub-category of exchange dyads outlined above, the existence of effective competition from own-brand substitutes undermines this perceived scarcity. Thus, where a retailer or a distributor is not dependent on a particular branded product to attract customers, the exchange is characterised by buyer–supplier independence (Category 1 in our typology of exchange dyads). The buyer’s search and switching costs are relatively low, and the supplier is forced to pass value to the buyer to retain its business. Under these circumstances, we might expect the processor/manufacturer to earn a gross profit margin in the lower range shown in Table 4.1 (3–5 per cent). In the second sub-category of exchange dyads, however, there is little or no effective competition from own-label substitutes. Consequently, branding gives the processor/manufacturer a somewhat more durable power advantage over the retailer or the distributor. This supplier power advantage is probably best placed in Category 5 in our typology of exchange dyads, because the buyer’s costs of search are relatively low. In this case, we might expect the processor/manufacturer to earn a gross margin in the higher range shown in Table 4.1 (6–10 per cent). Beyond these basic exchange dynamics, we must also consider the role of sales volume as a potential countervailing power resource available to the convenience retailer or the grocery distributor. Where a retailer or a distributor represents a source of significant sales volume for a processor/ manufacturer, the retailer or distributor should be able to leverage price concessions from the processor/manufacturer. Conversely, where a retailer or a distributor buys relatively small volumes of a product, then we might expect it to have limited leverage over price. This insight explains why even the largest forecourt retailers are continuing to use the major grocery distributors to deal with the dominant branded processors/manufacturers. By taking account of this countervailing power resource, we are further able to explain the heterogeneity of the gross profit margins that are earned by grocery processors/manufacturers. Moreover, in extreme cases we might expect a retailer or a distributor with a very large and regular demand for a particular product to achieve more favourable exchange dynamics than those that are illustrated in Figure 4.2. Thus, a retailer or a distributor buying very large volumes of a branded product, for which there are effective own-label alternatives, might be expected to have a power advantage over the processor/manufacturer. In short, buyer–supplier independence would be transformed into buyer dominance, and the supplier’s profit margin would be squeezed even further. On the other hand, a retailer or a distributor buying very large volumes

98 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply chains, markets and power

of a branded product, for which there are no effective own-label alternatives, might be expected to have an interdependent relationship with the processor/manufacturer. Each party would have its own power resources and would, therefore, be forced to share the value created by the exchange relationship. It must be emphasised, however, that none of the major forecourt retailers buys anything like the volume of products that would be necessary to achieve these more favourable exchange dynamics. One or two of the largest grocery distributors do come close to the necessary volumes in certain product categories (for example, Palmer and Harvey McLane distributes a large share of the cigarettes in the UK market). Even their efforts, however, are insufficient to substantially alter the basic power structures of these exchange dyads. The entry of two of the UK’s major supermarket chains into the forecourt retailing sector does suggest, though, that we might have to characterise these dyads differently in future. It seems reasonable to assume that both Tesco and Safeway will bring the volume leverage available to them in their wider businesses to bear in their forecourt ventures. The final two exchange relationships in this network are those between the grocery processor/manufacturer (D) and the raw material producer (E). The first of these dyads, shown in Figure 4.2 as (D 0 E), is representative of the exchange relationships that exist between grocery processors/ manufacturers and the producers of tobacco, peanuts and potatoes. This indicates that these relationships are characterised by buyer–supplier independence or commoditised exchange (Category 1 in our typology). Above certain minimum quality thresholds, all three raw materials are relatively standardised between different suppliers. They are bought and sold either in spot markets, with numerous potential buyers and suppliers, or under longer-term contracts designed to hedge against spot price fluctuations. As with all commodity-based exchange relationships, the buyer’s search and switching costs are relatively low. This means that the raw material producer is forced to pass value to the grocery processor/ manufacturer by, at the very least, matching the lowest price in the market. As a consequence of this exchange dynamic, the gross profit margin earned by a producer of one of these raw materials tends to be relatively low. Margins are typically between 1 and 3 per cent, with the upper end of this range being achieved by virtue of operational efficiency improvements. These margins are, of course, based on the assumption that the available supply in the market is in excess of the effective demand. A supply-side shortage, caused by some form of natural disaster or disease, would inevitably push up prices and with them profit margins. That said, this insight simply reinforces the fact that it is the wider forces of supply and demand that determine the prices, and thereby the margins, that the producers earn in these exchange relationships.

Site-specific convenience, branding and regulation 99 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

In the case of the three other raw materials that we discussed earlier, however, the forces of supply and demand do not operate in a completely unfettered manner. Instead, the state, through the mechanism of the EU Common Agricultural Policy (CAP), has a direct influence over the value that is appropriated by producers of sugar beet, sugar cane and wheat. The CAP was established to provide financial support to the agricultural industries of the Member States and, thereby, to guarantee security of supply in nationally important sectors. The exchange relationship between a grocery processor/manufacturer and a producer of one of these raw materials is represented in Figure 4.2 as (D < E). This means that the raw material producer has a power advantage over the processor/manufacturer by virtue of the regulatory protection provided under the CAP (Category 5 in our typology of exchange dyads). This regulatory protection, or property right to use the parlance developed in Chapter 3, provides for a minimum price that is guaranteed by the UK government. The minimum price set for each of these three raw materials makes it possible for producers to earn gross profit margins of 20–25 per cent, although this depends to some extent on operational efficiency. From the producer’s perspective, this is a highly sustainable and relatively low-cost isolating mechanism. It creates a situation of quasi-monopoly supply and allows a producer to earn substantial monopoly rents. The CAP pricing mechanism does not, however, offer any noticeable epiphenomenal benefits to the grocery processor/manufacturer. Moreover, the processor/manufacturer is fully aware that it is being forced by state intervention to pass value to the raw material producer, because its costs of search are relatively low. Each of these raw materials is traded in an international commodity market with full price transparency. The quantum of the rents being earned by these protected raw material producers can therefore be seen in the gap between international market prices and the minimum prices guaranteed under the CAP. As we noted earlier, however, these rents are now being threatened by plans to open up EU agricultural markets to greater competition from third country producers. Such a liberalisation would clearly redistribute the value in this exchange relationship in favour of the grocery processor/manufacturer by creating a situation of buyer–supplier independence. A lack of political will, however, may yet undermine these plans.

Conclusions This chapter has demonstrated that convenience retailing in general, and forecourt retailing in particular, is in a state of flux. We have argued that the current structure of power in this supply chain operates in favour of certain types of convenience retailers, and in favour of certain raw material producers that are protected by the CAP. A small number of very large grocery processors/manufacturers are also able to make reasonable

100 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

returns on the basis of their ownership of strong and flexible brand names. The power advantages conferred by these brands are, however, increasingly vulnerable due to the emergence of effective competition from own-label alternatives. The least profitable activity in this supply chain at present is the provision of specialist wholesale distribution services. We have argued further that this structure of power, and the associated distribution of value, is being challenged by two developments. The first is a self-contained development involving plans to weaken the protection given to raw material producers under the CAP. If these plans come to fruition, we might expect to see value being passed from raw material producers to grocery processors and manufacturers. This transfer of value would be in the form of an equalisation of prices between the UK and world markets. The second development is more systemic and is likely to prevent the processors and manufacturers from retaining the value that they might appropriate due to a weakening of CAP protection. This is the increasingly large presence of supermarket chains, such as Tesco and Safeway, in the forecourt retail sector. The entry of these players into this market challenges the existing structure of power in the supply chain in two main ways. First, they are providing a much more sophisticated retail offering to the end customer than has historically been the case. As we have noted on a number of occasions, these players have created a new form of miniature supermarket by drawing on their vast experience in multiple grocery retailing. They have combined the essential requirements of a convenience outlet with the benefits of a supermarket, including supermarket prices. Second, they have brought with them a key power resource that is not available to even the largest oil companies, namely volume grocery sales across their business. This resource gives the supermarket chains a sustainable power advantage over the major grocery processors/manufacturers. It also allows them to bypass the grocery distribution stage of the chain and to deal directly with the processors/manufacturers. Together, these cost advantages enable the supermarket players to make gross profit margins that are comparable with other convenience retailers, but without the need for premium pricing. The entry of Safeway and Tesco into forecourt retailing therefore represents a very real challenge to the position of all the other actors in this supply chain. Interestingly, the response to this challenge by some of the major oil companies may create a more favourable power position for those players that are currently most vulnerable, the grocery distributors. These oil companies have realised that they do not have the expertise in-house to create a more sophisticated and standardised convenience offering. Consequently, they have decided to establish preferred supply relationships with one or two of the major grocery distributors. Their aim is to use these preferred suppliers as a point of coordination for all upstream supply relationships, in the same way that integrated

Site-specific convenience, branding and regulation 101 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

service providers (ISPs) have been used in the oil exploration and production supply chain. The major danger facing the oil companies, of course, is that the dedicated investments needed to support these preferred supply relationships are unbalanced and become a source of dependency. This highlights, yet again, that the key to sustainable value appropriation is an understanding of the power dynamics that underpin every exchange relationship.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

5

Regulation, site specificity and scale The sources of asset criticality in the industrial sugar supply chain

Introduction According to popular opinion, UK agri-business is dominated by the large grocery multiples. Consequently, it is generally argued that UK agribusiness is controlled by the likes of Tesco, Sainsbury’s, Safeway and ASDA. It is believed that the power of these firms runs bi-directionally, taking in both customers and suppliers. Certainly, by the standards of food retailing in the rest of the industrialised world, returns for the UK’s supermarkets are relatively high. For their part, the supermarkets argue that, when taking account of the levels of service that they offer their customers and the breadth of their product ranges, their margins are justifiable. Furthermore, they also point to the fact that, when compared to the returns earned elsewhere in the economy, the 5–6 per cent margins that they make are not particularly excessive. However, the supermarkets’ critics are highly scathing about the way in which they deal with their suppliers. Many of these suppliers, it is suggested, are being leveraged to the point of bankruptcy. Any claims about partnership between buyers and suppliers in this supply chain have a somewhat hollow ring. In short, these critics argue that the UK’s major supermarket chains are earning monopoly rents. There may be some substance to the critics’ case. After all, it is just such claims that recently prompted the UK’s Office of Fair Trading to launch an investigation into the grocery retailing sector. However, particularly in the upstream part of the supply chain, such claims are an over-generalisation. Some suppliers are weaker than others, while there are suppliers that cannot be described as weak at all. In this chapter we will describe the exceptionalism of the supply and value chain for industrial sugar. Derived from either beet or cane, sugar is a relatively homogeneous sweetener used extensively in the agri-alimentary industry. It might vary either in relation to the degree to which it has been purified or the form in which it is consumed. However, with a number of minor exceptions, the offerings of rival producers are more or less identical to one another.

Regulation, site specificity and scale 103 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

The system of sugar production in the UK is a legally sanctioned quasiduopoly. Its competitive dynamics are determined by a system of regulatory oversight that consists of quotas and price support. Just two companies, British Sugar and Tate & Lyle, are granted a quota to produce sugar in the UK. Each company produces a little over a million tonnes a year. Together, the two companies account for nearly 90 per cent of the sugar consumed in the UK. The remaining 10 per cent is supplied to retail and industrial users through a network of sugar merchants and direct imports from outside the UK. It is the existence of these merchants that makes this industry a qualified duopoly. The supply and value chain for beet sugar consists of three distinct sets of dyadic exchange relationships, or subregimes, each of which exhibits its own competitive dynamics. The first sub-regime comprises the grocery retailers, both multiple and independent, and the food and drink manufacturers. The second links the food and drink manufacturers to the sugar beet processor, both directly and indirectly by way of the sugar merchants. The third and final sub-regime links the sugar beet processor to those actors involved in producing the beet, namely the seed manufacturers, the fertiliser and agrichemical manufacturers, and the farmers. Each of these sub-regimes is demarcated from its neighbour by a disjuncture in the structure of power that prevents the value from flowing smoothly along the chain. The analysis contained in this chapter is presented in two main sections. The first section is descriptive and includes a general overview of the physical supply chain as well as a number of introductory remarks concerning its competitive dynamics. The second section examines the exchange relationships within the supply chain through the analytical lens developed in Chapter 3. The chapter concludes by summarising the discussion and by making a number of points of comparison with the other case studies contained in the book.

Mapping the supply chain The market for sugar in the UK includes the production of sugar, syrup and sugar surrogates based on the use of sugar beet or cane. It does not include the production of glucose and glucose syrup, which form part of the supply chain for starch. Demand for the product is substantial, standing at about 2.1 million tonnes white sugar equivalent per annum (1998–9 figures). Some sugar goes into animal foodstuffs but the vast majority is consumed by people either directly (in tea, coffee or home baking) or indirectly as an ingredient in other products. Overall, the demand for retail sugars is on a downward trend, which has been brought about by the increased use of artificial sweeteners, the reduction of sugar intake in tea and the decline in home baking. The demand for industrial sugar, however, has remained more or less stable in recent years, even rising slightly.

104 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

This has resulted in almost unchanged levels of overall consumption for the last twenty years. In common with most agri-alimentary supply chains, the supply chain for industrial sugar involves a diverse range of actors and stages. It includes, but is not limited to, firms involved in agriculture, food manufacturing and retailing. In all, there are five stages of note: seed production, beet farming, sugar processing and distribution, food and drink manufacturing, and grocery retailing. These stages are shown graphically in Figure 5.1.

GROCERY RETAILING Site specificity and economies of scale are important in grocery retail Site specificity is tied to the ability to locate in areas of high population density, high income and with good communication links Economies of scale work both ways. They allow firms to maintain the advertising outlays necessary to bring in custom. They also allow retailers to leverage off their supply bases

SUGAR FOOD AND DRINK PROCESSING AND MANUFACTURE DISTRIBUTION Economies of scale are critical at this part of the chain

The right to process is determined by licence

Some of these economies relate to the costs of production. The minimum efficient scale of production for canned soft drinks is relatively high as is the cost for counterline chocolates. The minimum efficient scale of production for sugar sweets, by contrast, is somewhat lower

The incomes of processors are determined by regulation that both establishes output levels and sets minimum levels of compensation

The main economies of scale relate to advertising. These are some of the highest in industry

The cost of factor inputs impacts on profitability. The relatively high cost of processing cane sugar as compared to beet sugar can make cane sugar less profitable to manufacture

SUGAR BEET FARMING

SEED PRODUCTION

The right to grow is established by contract (licence). Listed growers may pass their contracts on to their heirs. The position of licensed growers is defended by the industry’s peak organisation, the NFU

The right market is established by licence. Licence is granted on the basis of demonstrated competence

Thereafter, incomes are determined according to an EU regulatory formula

There are some niche players, however, for whom economies of scale are not a factor

Figure 5.1 The industrial beet sugar supply chain: functional stages and key resources.

Seed production Beet seed represents the raw material of the chain, although in no practical sense could it be considered to be properly ‘raw’. The British climate is a relatively difficult one in which to grow sugar beet seed. In order that the commercial crop can be grown efficiently, it is necessary for the seed to conform to a very high specification. The UK government regulates

Regulation, site specificity and scale 105 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

seed quality under EU statute. This involves seed regulations stipulating minimum germination standards, purity standards, moisture content, isolation distances for food crop production and methods of sampling. Licence to sell is then regulated by MAFF (through EU statute). Seed varieties are tested for Distinct, Uniformity and Stability (DUS). That is, they are tested to ensure that they represent a new product rather than a ‘me too’ imitation. Varieties passing the DUS process are then placed on a national catalogue and an EU common catalogue which enables them to be sold in all EU countries. Before they can be sold, however, there is an additional hurdle that they must pass. British Sugar (the UK’s sole beet processor) and the growers fund a body known as the British Beet Research Organization (BBRO) and Education Committee which commissions research into beet production in the UK. This includes variety testing. Trials funded by this organization look at the economic value of each variety. This is known as Value for Cultivation and Use (VCU). Respectively the two arms of the regulatory process ensure that the product marketed in the UK is new and adds value. An additional body, NIAB (under the Ministry of Agriculture), undertakes trials and draws up the list of approved seed varieties. Varieties on this list determine which companies will or will not market products in the UK. Currently, just six companies have approved varieties of beet seed in the UK. These are Delitzsch, KWS, Novartis, Betaseed, Danisco and Advanta. Unless farmers use seeds from a British Sugar approved list, growers are not permitted to deliver a crop for sugar manufacture. The listing or de-listing of a variety of seed is contingent upon its performance in trials. Once the seed has been selected, and prior to planting, it is treated for disease and predation through the use of insecticides and fungicides. It is then pelleted and planted. Fertilisers contain one or more of the three primary plant nutrients: nitrogen, phosphorus or potassium. A given fertiliser may contain these elements singly, in which case it is referred to as a straight fertiliser, or it may contain them in combination, which makes it a multi-nutrient fertiliser. Just over half the fertilisers sold in the UK contain nitrogen as their primary growth stimulant. The remainder of the market is shared between potash and phosphate stimulants in roughly equal proportions. The chemical make-up of these fertilisers is significant, because it plays an important part in determining the competitive dynamics of the industry. Fertilisers are relatively simple chemicals and, although they are aggressively branded, there is little to distinguish one brand from the next. At the same time, the technologies used in their manufacture are highly sophisticated and the production facilities involved are capital intensive. In the hunt for competitive advantage, much of the expertise of the manufacturers has centred on making the most efficient use of the raw material input necessary to the production of the fertiliser. This is ammonium

106 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

nitrate in the case of nitrate fertilisers, and phosphate rock deposits in the case of phosphates. These efforts have proven to be only partially successful. European firms still remain relatively high cost producers, because these raw materials occur in relatively small quantities within the EU. Suppliers operating from regions where the raw materials occur in abundance, for example Russia, eastern Europe and the US, enjoy a marked cost advantage. This has enabled Russian and eastern European firms in particular to make significant inroads into the European market in recent years, which has added to the levels of competitive intensity in the industry. Consequently, the industry has experienced considerable consolidation in recent years. Western Europe, for example, has just five major players in the market. These are Norsk Hydro, Kemira, BASF, Grande Paroisse and Fertiberia. Several factors have added to these pressures and have accelerated the trend towards consolidation. Specifically, in an attempt to control agricultural overproduction, the EU has attempted to reform the Common Agricultural Policy. In a number of areas production quotas have been cut and, if less food is being grown, there is naturally less demand for fertilisers. Agricultural reform has also had a major influence in the market for agrichemicals. Here, however, the impact of regulation has not been confined to attempts to limit agricultural output. Rather, driven by concerns for public health and environmental spillover, there has been a concerted effort on the part of the authorities to significantly reduce the use of agrichemicals. Like the fertiliser market, the agrichemical industry has experienced substantial rationalisation in recent years. During the 1990s the market declined by some 20 per cent. Notwithstanding these pressures, there is still a huge demand for these chemicals. The exact intensity of use tends to be dictated by the climate and the nature of the crop being grown. Warm, dry climates tend to encourage pests, while cold, humid climates tend to encourage widespread fungal growth. Generally speaking, the industry is research and development intensive (R&D represents nearly 10 per cent of turnover) and firms wishing to compete successfully must first acquire the critical mass required to undertake such research efficiently. This is why just five companies dominate the market globally. All of these companies are European in origin. They are BASF, Ciba-Geigy, AgrEvo, Zeneca and Bayer. Of these, AgrEvo, Zeneca, BASF and Bayer all offer specialist products for the beet market. The agrichemical companies tend to concentrate research effort in those areas where demand is strongest. This means particularly cereals. In the case of sugar beet, demand is comparatively low. In the UK, for example, only some 2 per cent of arable land is given over to beet production. For companies like Bayer or BASF, pesticides targeted for use in beet production probably account for no more than 1 per cent of their agricultural

Regulation, site specificity and scale 107 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

business. As a consequence, very few new patented products are coming on to the UK market each year and those that are already in existence have reached the end of their patented life. Once off patent there will be considerable opportunity for imitators to push generic ‘me too’ substitutes. The final actor in this part of the supply chain is Germain’s. For reasons of productive efficiency, beet seeds are chemically treated prior to being planted. Once treated, they are coated to improve the efficiency of the planting process itself. While a number of companies is capable of offering this pelleting service on a worldwide basis, Germain’s is the sole provider in the UK. It is a sister company of British Sugar (both are part of the ABF group) and it pellets, treats and boxes the seed for British Sugar. Distribution of the seed is undertaken by British Sugar acting on behalf of the growers who have placed orders through the processing company on an at-cost basis. The process is done in cooperation with the NFU. Based on the regional climate in which they are operating and the characteristics of the soil into which they are planting, growers indicate to British Sugar which of the approved seed varieties they wish to use for their beet crop. The choice of pesticides and fungicides is also made at this point. Sugar beet farming Although sugar accounts for only a relatively small proportion of arable production in the UK, there are some 9,000 enterprises involved in beet production. Growers vary enormously in terms of both their size and their efficiency. Some farming businesses are in effect large corporations, while others are small family concerns. Beyond the obvious impact of the adoption or non-adoption of best practice production techniques, the main factor that determines differences in efficiency between producers is likely to be the land on which different farmers cultivate their crops. Beet farming is highly regulated. This regulation covers not only which farmers can produce a beet crop and the quantities that they can produce, but also where farmers can sell their crop and the price that they can get for it. These regulations form part of a broader regime that operates for the industry more generally. This regime includes an intervention price that constitutes a minimum threshold below which the EU sugar price will never fall. In order to ensure that the benefits of the regime are shared with the farmers, sugar processors must pay the growers a certain price for a standard quality of beet. The basic beet price is calculated from the intervention price by subtracting the costs of delivering the beet to factories and processing it into sugar, and by adding the processor’s sales of molasses (a by-product of sugar manufacture). There is a further dimension to the compensation formula. This relates to beet that does not conform to a standard quality. Under the regime and the terms of the Inter-Professional Agreement, the processor deducts

108 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

a soil and crown tare at the point of delivery. If it has not been properly topped, if it has been damaged, or if it is otherwise unfit for processing, there will be further deductions or else the product will be rejected altogether. More importantly, further adjustments are made to the price received by the farmer on the basis of the sugar content of the product that he delivers. Both the farmers and the processor therefore have an incentive to minimise waste and processing costs. These processing costs are determined, in part, by the sugar content of the beet. A higher sugar content enables a reduction in processing costs. Broadly speaking, the Inter-Professional Agreement formula encourages the adoption of those seed varieties that will produce high sugar yield, because the system is geared to encourage this. The standard sugar content is set at 16 per cent. If the content falls by 1 per cent then the price that the farmer receives falls by 9 per cent. If the content falls by 3 per cent then the price falls to only 71 per cent of the standard price. Below this figure, the price falls by 1 per cent for every 0.1 per cent reduction in the sugar content. Conversely, reimbursement levels rise rapidly if the sugar content rises. An additional 9 per cent is added to the price for every 1 per cent that the farmer can add to sugar content up to 17 per cent of his output. For an additional 1 per cent to 18 per cent this would equal an 8 per cent increase in price, and from 18 per cent onwards the price is increased by 7 per cent. The scheme is designed to be fair to both the grower and the processor and replaces an earlier framework that had penalised processors by frequently requiring them to pay growers for ‘phantom sugar’ that did not exist. Sugar processing and distribution There is no ‘natural’ reason for the level of concentration in this part of the supply chain. The investment necessary to install an efficient processing plant, although substantial, is somewhat lower than that required in the automotive, petrochemical or steel industries. Indeed, it has been suggested that building a plant of minimum scale efficiency would account for no more than 6 per cent of the total sales in an average marketing region. Notwithstanding the fact that, by European standards, the UK’s market is smaller than some, there is still little reason to suppose that theoretically there is not room for a number of processors in the industry. As we noted earlier, however, the UK system of sugar production and distribution is comprised of a regulated duopoly, as well as a network of independent distributors or merchants. Both British Sugar and Tate & Lyle sell directly to industrial and retail customers and indirectly through the merchants. Only British Sugar obtains its sugar from the beet crop. Tate & Lyle derives its sugar from imported raw sugar cane, which it obtains from countries in the African–Caribbean–Pacific (ACP) grouping.

Regulation, site specificity and scale 109 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

This is significant for two reasons. First and most obviously, it is significant because the set of upstream supply chain stages described so far do not apply to Tate & Lyle. Although there are some regulatory similarities, the actors involved and the processes of production are different. Second, it is significant because, although the incomes of cane farmers are protected like those of beet farmers, the levels of protection are different. The formula governing the compensation of cane farmers is relatively simple. It is accepted that British Sugar is the more dominant of the two firms and the ‘price’ market leader. The incomes of all European sugar processors are protected by the same regime that governs the incomes of the growers. The EU’s sugar regime operates a system of quotas that are designed to limit the quantity of sugar that receives support and thereby to prevent over-production. Each Member State is allocated an A quota and a B quota, which it must then distribute between its processors. The difference between the A and B quotas relates to a system of production levies that the processors must pay to help finance the cost of disposing of any surplus production. Quota A sugar incurs a levy of around 2 per cent. The quota B levy is much higher, usually in the order of 38 per cent. In theory, processors can sell their sugar anywhere in the EU. In practice, the bulk of Europe’s processed sugar is sold nationally. Beyond the A and B quotas there is a non-quota sugar (informally known by the industry as C sugar). This is an unsanctioned surplus, which cannot be sold in the EU and must be sold on the world market where prices are usually much lower. Processors receive no compensation for quota C sugar. If processors do not wish to sell their surplus, they may store it until the following year. The processors must make a declaration as to how much sugar they are going to block (this is known as block exemption). This surplus will then be counted towards their new A quota. Historically, tied to the different quotas, the European authorities operated a system of price support that acts as a safety net for the processors. It ensures that the processors do not lose money should the price of sugar collapse. The European authorities guarantee to compensate the processors for any income shortfalls that come within the A and B quotas. This is the intervention price. Above the intervention price there is also a target price. This is a theoretical price in that it represents the price that the authorities expect the processors to get when they sell their sugar. In the past, tied to the target price was a threshold price. The threshold price was equal to the target price plus a storage levy. It included the costs that would have been incurred from transporting sugar from the EU country with the greatest surplus to the country with the greatest deficit. This threshold price was the minimum price at which sugar could be imported into the EU from non-EU countries. Once again, it was designed to safeguard the beet growers’ incomes. Prior to the GATT agreement, EU sugar products were protected from global imports through the application of

110 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

import levies. A fundamental change resulting from the Uruguay round has been the replacement of variable duties with fixed tariffs for agriimports. In the old regime, the price of imports remained unchanged regardless of fluctuations in world sugar prices. Now, the levies imposed on imports from non-EU producers fluctuate as the world price fluctuates. This obviously reduces the degree of protection enjoyed by EU producers. Its full effects, however, have not yet been realised since the introduction of the new system is being phased. The sugar merchants form one of the distribution routes through which imports may enter the EU. There are two major merchants operating in the UK. These are Napier Brown & Company, and James Budgett Sugars Limited. A third merchant, the Billington Food Group, is the major importer of direct consumption raw sugar (brown sugar). Merchants have the choice of either buying their sugar from one of the two UK processors, or of obtaining it from overseas. Sugar can be imported either from another EU processor or from outside the EU altogether. This arrangement means that the merchants are the processors’ major customers as well as their major competitors. The impact of the merchants on the supply chain is pivotal. Without a mechanism through which sugar can be channelled into the UK from outside, the national processors could potentially enjoy greater latitude with respect to their pricing strategies. Imports, therefore, provide a cap on the processors’ capacity to appropriate value from the supply chain. In 1986 British Sugar was fined by the European Commission for an alleged abuse of its dominant position within the UK. Following this, British Sugar introduced a compliance programme and gave certain undertakings to the Commission that, in future, it would ‘engage in normal reasonable pricing practices that in no way can be construed as predatory’ (British Sugar 1997: 10). Subsequently, British Sugar has operated a volumetric pricing policy that ensures that larger buyers enjoy more attractive prices than smaller buyers. The merchants buy in bulk and obtain sizeable discounts. This means that, when processors and merchants are competing to win the contracts of smaller customers, the merchants (which are not bound by the volumetric rules) are able to sell their output at a price that British Sugar cannot always match. The survival of the merchants, and therefore the continuing presence of alternative suppliers in the marketplace, is thereby guaranteed. Food and drink manufacturing Sugar and its derivatives are used extensively in food and drink manufacturing. It is used in canned foods, cereals, beer and soft drinks. The largest markets for sugar, however, are the confectionery, bakery and soft drinks markets. The UK confectionery market, for example, was worth an estimated £4.9 billion in 1996 (Key Note 1997). It is made up of chocolates and sugar confectionery.

Regulation, site specificity and scale 111 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

The chocolate category is a complex category that includes counter-line products, for example Kit Kat, Mars Bar and Twix, boxed chocolates such as Dairy Box and Milk Tray, moulded products like Cadbury’s Dairy Milk, Galaxy and Fruit and Nut, and bagged self-lines such as M&Ms, Smarties and Maltesers. Likewise, the market for sugar sweets can be divided into mints, toffee, fudge, liquorice, fruit sweets, chewing gum and medicated products. The supply of these products in the UK is highly concentrated and dominated by domestic producers. By the early 1990s, just three companies (Cadbury Schweppes, Nestlé Rowntree and Mars) were responsible for producing nearly 70 per cent of all of the confectionery consumed in the UK. Cadbury (owned by Cadbury Schweppes), Nestlé Rowntree and Mars dominated the production of chocolate, and between them accounted for 75 per cent of the market. The market for sugar sweets was slightly less concentrated, although Trebor Basset (also owned by Cadbury Schweppes), Nestlé Rowntree and Wrigley alone met nearly half of all consumer demand. Success in the marketplace is based on developing and patent protecting a popular formula, like the Mars Bar or Cadbury’s Dairy Milk, and thereafter branding it aggressively. Mars, for example, spends in excess of £0.5 billion a year to promote itself and its brands. This constitutes a major barrier to entry to potential competitors wishing to enter this marketplace. The ice cream and soft drinks markets both conform to a similar pattern to that present in the confectionery market. The UK soft drinks market was worth approximately £7.9 billion in 1995 (Key Note 1996). It is a rapidly expanding market and consists of two main categories: dilutables (7 per cent by value) and carbonates (70 per cent by value). The market is dominated by Coca-Cola Enterprises, which distributes Coca-Cola, and Britvic, which distributes Pepsi. The other major players are Cadbury Schweppes and SmithKline Beecham, which specialises in health and sport drinks like Lucozade. The ice cream and frozen dessert market has also grown rapidly in recent years. Its products are categorised on the basis of consumption patterns. That is, on the basis of whether a product is bought on impulse and consumed immediately (e.g. an ice cream cone), or whether it is taken home for storage and consumption at a later date (e.g. a tub of ice cream). Once again, just a few companies dominate the UK marketplace, protecting their position through product extension and aggressive brand building. The chief producers are Walls, Nestlé Lyons and Mars. Also important in this sector is Richmond Foods which specialises in producing own-label products for supermarkets. Given the relative strength of the incumbents, there is little independent competition in these three markets. One source from which the manufacturers have faced a challenge, however, is the multiple retailers. Own-label production and marketing has expanded rapidly in recent years. This expansion has gone hand in hand with the development of grocery

112 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

superstores. Prior to the 1980s, own-label products had a poor reputation. They were normally perceived by customers as cheap and cheerful alternatives to some of the weaker branded products. Over the intervening period, however, the grocery multiples have taken their own-label products up-market. They are not simply pitching them as ‘me too’ products, but rather as high value alternatives. This has not eradicated branded products, however, which are still seen as the ‘traffic generators’ necessary to bring customers into the store. Indeed, the degree to which own-labelling has taken off varies considerably between the multiples. Some stores, Marks & Spencer for example, own-label everything. Other stores, like Kwik Save, have been slow to perceive the advantages of own-labelling. Furthermore, the penetration rates of own-labelling vary widely from product to product. The degree to which own-label penetration occurs within a product range seems to be inversely related to the degree to which consumers also purchase the goods on impulse from other retail formats. By this criterion, confectioners have fared quite well, notwithstanding attempts by the grocery multiples to introduce their own alternatives. By contrast, the performance of the soft drinks and ice cream manufacturers has been patchier. The ice cream manufacturers face a threat in the area of their ‘take-home’ lines, while many of the supermarkets now offer alternatives to branded cola drinks and lemonades. Grocery retailing The subject of grocery retailing is discussed extensively in the case chapter dealing with forecourt retailing. Consequently, it is only necessary to crudely sketch its details here. The emphasis will be placed on the structure of production as it affects the supermarkets’ suppliers rather than their customers. The two most important statistics that relate to the industry refer to the proportion of food and non-alcoholic beverages that is sold through grocers and the level of concentration in grocery retailing. Taken together, grocers are responsible for over 76 per cent of all food sold in the UK. Specialist bakers account for a further 3.7 per cent, newsagents and tobacconists 3.1 per cent, off-licences 0.6 per cent, mixedgoods retailers 6.1 per cent, and other outlets such as butchers and fishmongers 19.9 per cent. Food and drink manufacturers wishing to sell their products are forced, therefore, to go through the grocery sector. There are around 23,500 independent grocers in the UK. Their numbers are falling, however, as is their share of the market. Together, they account for little more than 5 per cent of all food sales. The market is now dominated by the large grocery multiples, and four companies in particular. These companies are Tesco (with 20.3 per cent of the market), Sainsbury’s (with 18.4 per cent), Safeway (with 10.8 per cent) and ASDA (with 10.4 per cent).

Regulation, site specificity and scale 113 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

These supermarket chains owe their market dominance to a combination of two factors. The first is site specificity. The level of business that a grocery multiple achieves is closely linked to the area in which it is located. That is, its proximity to a large, relatively affluent population, and the transportation network that ties it to that population. The acquisition of premium sites is critical to the success or failure of an individual store. The four largest grocery multiples have proven particularly adept at finding such sites or at developing them from scratch where none existed already. The second factor critical to the success of these supermarket chains is their scale. Their size allows them to advertise heavily to bring custom into their stores. Thereafter, the scale of their business allows them to negotiate aggressively to get the best possible deals from their suppliers. How good a deal a supermarket chain is likely to get is linked to the popularity of a food manufacturer’s brand and the scope for that manufacturer to find alternative outlets for its products. In comparison with other food manufacturers, the manufacturers of confectionery goods and soft drinks are in a relatively strong position. Not only, as we have already noted, are their brands robust, but such manufacturers also enjoy a wider range of distribution alternatives than most. For example, although tobacconists and off-licences are responsible for selling only a very small proportion of all foods sold in the UK, the ranges that they offer consist almost entirely of the types of products supplied by participants in the sugar supply chain. Therefore, while the grocery multiples account for 76 per cent of all food bought in the UK, manufacturers of confectionery products only market 25 per cent of their output through this channel. Fifteen per cent of their output is sold through independent grocers, while 21 per cent is sold through tobacconists. Even so, the grocery multiples still remain the confectionery manufacturers’ most important customers. These manufacturers are not immune, therefore, to the same sorts of pressures that have helped to bring the grocery multiples into such disrepute in recent years.

Mapping the value chain Having described the supply chain, we must now turn to the subject of its relationship with value. Before explaining this relationship, however, it is first necessary to describe it. Here one encounters a number of problems. The figures contained in Table 5.1 are for the most part suggestive. This need to provide ‘guesstimates’ is occasioned by three factors: the natural modesty of successful firms, industry heterogeneity and multiproduct ambiguity. First, those supply chain actors that are making high returns are understandably somewhat coy about the scale of their good fortune. Both the sugar processor and the beet farmers are cases in point. There is little to

114 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Table 5.1 The industrial beet sugar value chain

Typical gross profit margin (ROS) (%)

Grocery retailing

Food and drink manufacturing

Sugar processing and distribution

Sugar beet farming

Beet seed production

Data N/A

6–10 without effective own-label competition

25 for processors

25

5–10

3–5 with effective own-label competition

Data N/A for merchants, but significantly lower than 25

Source: authors’ estimates based on interview data and industry reports.

be gained from explaining to a customer just how successfully they are being leveraged. Second, the returns made by specific actors at certain points in the supply chain vary widely. Again, the case of the beet farmers is illustrative. Differences in the quality of a farmer’s main factor input – the land on which they plant and harvest their crop – impact directly on the revenues that can be generated and the costs that are incurred in doing so. Some land is conducive to growing beet with a high sugar content that requires a minimal use of supplements and pesticides, while other land is not. Consequently, some farmers are more profitable than others. Third, supermarkets are an example of multi-product ambiguity par excellence. Indeed, the very idea of a ‘super’ market conveys the impression not simply of scale, but of a diverse product range. In this context, it is simply impossible to gain an accurate idea of the margins that a retailer earns on confectionery or soft drinks by looking at his general levels of profitability. All of these factors should be recognised when considering the figures in Table 5.1. In the next section of the chapter, we identify and discuss some of the key determinants of the value distribution represented in Table 5.1. As before, this discussion will be structured around a network model, which illustrates the exchange dynamics operating between firms at adjacent stages of the chain. The relationship between these exchange dyads and the wider distribution of value in the chain is explained using the insights developed in Chapter 3.

Value distribution and the dynamics of exchange There are nine major dyadic exchange relationships in the value chain for industrial beet sugar. The exchange dynamics for each of these dyads,

Regulation, site specificity and scale 115 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

and the wider interrelationships between them, are illustrated in the network model shown in Figure 5.2. The nature of these dynamics, and the resultant distribution of value in the network, depends on the power structure of the individual dyads. As before, these power structures are represented using the nomenclature developed in Chapter 3. Based on the assumptions articulated in that chapter, certain actors in the network are deemed to be in a position to earn rents rather than profits. Those actors with a capacity to earn rents are represented by means of a shaded box, while those that are able to earn only normal profits appear in a clear box. The first two dyads in this exchange network link the food and drink manufacturers to the grocery retailing and distribution sector. One of these dyads ties the manufacturers to the grocery multiples (A > C), while the other ties them to the independent grocery sector (B < C). Next, there are the relationships that tie the sugar merchants and the processors to the food and drink manufacturers (C 0 D and C < E), the relationship that links British Sugar to the farmers (E = F), and the relationship that links the processors more generally to the sugar merchants (D < E). The final three dyads link the beet farmers to the seed producers (F 0 G), the fertiliser manufacturers (F 0 H), and the agrichemical manufacturers (F 0 I). This section will deal with each of these exchange dyads in turn. It will also consider the question of dyadic interaction. It will be argued that, where the dyads come together, there is clear evidence of three distinct sub-regimes operating within the supply chain. The first sub-regime is that which links the food and drink manufacturers to the grocery retailers. In this case, it will be argued that the power advantage rests with the multiple grocers. The sustainability of this advantage is contingent, however, upon

A>C

F0G

A

G C

B

B
C0D

C<E

D

E

D<E

E=F

F

F0H

F0I

H I

Figure 5.2 The power regime for industrial beet sugar. A – multiple grocer, B – independent grocer, C – food/drink manufacturer, D – sugar merchant, E – sugar processor, F – beet farmer, G – seed producer, H – fertiliser manufacturer, I – agrochemical manufacturer.

116 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

the relative importance of own-label products in particular categories. The second sub-regime is that which links the sugar processors with the merchants and the food and drink manufacturers. This regime clearly works to the advantage of those selling the sugar, as is evidenced by the prices that the sugar companies charge for their output. Typically they are higher in the EU than on the world market. The third and final sub-regime is that which links the beet farmers and British Sugar to those actors that provide the key agricultural inputs. Here, it will be suggested that supply-side competition ensures that the sub-regime works to the advantage of the farmers. They are able to simultaneously leverage their suppliers and enjoy an interdependent relationship with their sole customer. It will also be suggested, however, that this advantage is vulnerable. While, in theory, the pivotal position of British Sugar should give it enormous leverage in the marketplace, in practice the regulatory framework under which it operates gives it no incentive to try to control the value appropriation strategies of the fertiliser and agrichemical manufacturers. The cost of the sugar processor’s principal factor input (the beet) is fixed by a formula. Therefore, any rise in, for example, a pesticide manufacturer’s prices would affect the farmers’ margins and not its own. The exchange dynamics for sub-regime 1: marketing ‘sugar’ products The first sub-regime concerns the marketing of sugar-based products. The major food and drink manufacturers, shown as C in Figure 5.2, have two distinct sets of customers. These are the grocery multiples (A) and the independent food retail sector (B). Perhaps not surprisingly, the power structures operating in each of these exchange contexts are somewhat different. Broadly speaking, most food and drink manufacturers are at a distinct disadvantage when it comes to their relationship with the grocery multiples. This situation of buyer power is represented in Figure 5.2 as (A > C) (Category 2 in our typology of exchange dyads). One of the main reasons for this power imbalance is that many of the goods that these manufacturers supply are homogeneous. That is, there is little to distinguish one carrot, one lemon or one piece of meat from another. These products cannot be branded and are, in effect, commodities. Moreover, even those products that are branded are being promoted with diminishing results. This is particularly the case when there are many acceptable alternatives to the branded good – acceptable, that is, to the supermarket’s customers. The rapid expansion of own-labelling on the part of supermarkets in recent years has greatly expanded the range of products for which this is true. The case of breakfast cereals is a good example of this phenomenon. Twenty years ago there was little scope for own-labelling in this area,

Regulation, site specificity and scale 117 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

because customers felt comfortable with their traditional brands. Then companies like Tesco started to market their own ‘basic’ alternatives. Greater experience in the marketplace, however, taught the grocery multiples that they need not promote their own-labels as down-market alternatives. Today, in many instances, own-labels are pitched to customers as equivalent offerings. The successful establishment of own-labelling as a concept, therefore, has given the grocery multiples greater choice when it comes to considering their sourcing strategy for a particular product. It has also meant that a manufacturer’s branding strategies must be directed as much towards fighting the ‘vertical competition’ as they are towards fighting its traditional horizontal rivals. While the grocery multiples have been able to increase their choices in recent years, however, the food and drink manufacturers have seen their options contract. The development of large, out-of-town retail outlets has all but destroyed many high streets. Thirty years ago, high streets contained an abundance of independent grocers, butchers, bakers and dry goods retailers. Today, most customers prefer to obtain all of their groceries in one go, under one roof. As we have already indicated, Tesco and Sainsbury’s alone now account for nearly 40 per cent of all food sales in the UK (Key Note 1996). For many food and drink manufacturers, being unable to sell their products to the grocery multiples means being unable to market their products at all. For this reason, a power imbalance has developed that works markedly in favour of the grocery multiples in the retailing sector. What is true for the food industry generally is also to some extent true for the soft drinks and confectionery industries. Supermarkets are important and powerful customers that in many instances account for the bulk of a manufacturer’s sales. There are, however, two main reasons why manufacturers of sugar-based products are less in thrall to the grocery multiples than many other food and drink producers. First, producers of confectionery products have been more successful than most in developing and protecting the status of their brands. The grocery multiples have enjoyed some success in establishing own-label alternatives for basic products in the area of moulded chocolates, but they have had next to no success in breaking into the counter-line market. In customers’ minds, there is currently no acceptable alternative to a Mars Bar. At the same time, as we have already seen, the independent grocery retail market is rather more robust for ‘sugar’ products than it is for other types of grocery product (a full description and analysis of this market is given in the chapter on forecourt retailing). Furthermore, these outlets do not enjoy the luxury of being able to establish own-label alternatives. In exchange relationships between the large confectionery manufacturers and the independent grocery sector, therefore, the power clearly lies with the manufacturer. This situation of supplier power is shown in Figure 5.2 as

118 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

(B < C) (Category 5 in our typology of exchange dyads). The existence of supplier power in these circumstances also impacts directly on the relationship between the manufacturers and the grocery multiples, because it gives the manufacturers a range of retail options that producers of other foodstuffs probably do not enjoy. The exchange dynamics for sub-regime 2: sugar processing and distribution The second sub-regime involves three sets of actors, the food and drink manufacturers (C), the sugar merchants (D), and the sugar processors (E). It comprises three exchange relationships: that between the manufacturers and the merchants (C 0 D), between the manufacturers and the processors (C < E), and between the merchants and the processors (D < E). The first of these relationships is characterised by buyer–supplier independence and falls into Category 1 in our typology of exchange dyads. The latter two relationships are characterised by supplier power and fall into Category 5 in our typology. The same regulatory protection that determines the cost of the processors’ primary inputs also guarantees the incomes of the processors. The gross margins made by British Sugar are of the order of 25 per cent. Although the margins made by Tate & Lyle are smaller as a result of the relatively higher costs associated with the combination of the raw material and its processing of sugar cane, they are still impressive. Despite the complexities and subtleties that have to be taken into account when considering this sub-regime, it is still to all intents and purposes a duopoly when it is stripped back to its basics. Imports play only a marginal role in the supply chain. Many of the sugar processors’ industrial customers are reluctant to make use of them. This reluctance stems from the core priorities of an industrial customer: quality and security of supply. Occasionally an appreciation of the value of sterling relative to that of the Euro will make imports more commercially attractive. For the most part, however, any temporary switch of supply to take advantage of short-term market opportunities is of limited appeal. Companies like Cadbury, Mars and Walls are obsessive when it comes to protecting their brand image. The experience of Coca-Cola’s attempts to reformulate its products has served as a cautionary tale to the food and drink industry. In 1985, Coca-Cola launched a product called New Coke in an attempt to fight off the intense competition that it faced from PepsiCo at the time. The launch was a disaster and the company had to return to its ‘original’ recipe. Since that time most branded food companies have been reluctant to tinker with the ingredients that they put in their products. Buying these ingredients from outside the UK is perceived as taking a risk.

Regulation, site specificity and scale 119 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Although sugar might appear to be a food commodity, processed sugars vary enormously in terms of both their variety and their quality. Food and drink manufacturers, therefore, know what they are buying when they obtain their products from either British Sugar or from Tate & Lyle. To switch to an alternative supplier is to gamble on the quality of the product and on whether the source will still be available in six months’ time. Although small as a total proportion of UK sugar consumption, sugar imports are not small in terms of their commercial impact. If the processors attempt to push prices up too high, then the customers might draw in imports either via the merchants or direct from elsewhere in the EU. As customers of the processors, however, the merchants face a similar power situation to that experienced by other industrial users (supplier dominance). While, in theory, the merchants have considerably greater latitude when it comes to considering from whom they should source their sugar, in practice the terms on which they obtain their supplies are rigid. This is because the cost of obtaining refined sugar from British Sugar is partly determined by the volumetric pricing formula, the origin of which is described earlier in the chapter. The more sugar that a customer buys, the better the deal that they get. Because the merchants are very large customers for the sugar processors the deal that they get is relatively competitive. However, even a ‘competitive’ deal is only a relatively good deal. Furthermore, the merchants have only limited scope to improve their position by attempting to play one source of supply off against another. Tate & Lyle has little incentive to go head to head with British Sugar in a pricing war to win additional business. This is because the system of EU quotas limits the volume of sales that Tate & Lyle or British Sugar is allowed to make. Assuming that either company is able to sell all that it is able to produce in the EU, then cutting prices will not increase output. Rather, it will simply erode revenue, as the company markets the same amount of sugar for less money. Furthermore, even if Tate & Lyle did not manage to sell its quota, it would still be ill served by a sustained price conflict with British Sugar. This would be a war that Tate & Lyle would find hard to win, because the lower cost base associated with processing beet as opposed to cane would always give British Sugar the advantage in such a conflict. Finally, although the merchants can source from outside the UK, they do not obtain a significantly better deal by doing so. The A and B quota sugar prices of other EU processors are similar to those operating in the UK. Buying supplies from the rest of Europe is of little or no benefit therefore, particularly when the additional costs of transportation are taken into account. Furthermore, regardless of world market prices, sugar cannot be competitively imported from non-EU countries because of the levies. In short, British Sugar dictates the terms when it comes to the costs of obtaining sugar in the UK, whether the customer is a food and drink

120 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

manufacturer or a merchant, up to the point where it is attractive for a customer to import. The costs that the merchants must incur when obtaining their sugar, is shaped by what they can acquire it for from the big two. After that, they are just intermediaries. Because most of the value in this part of the supply chain comes from processing, the merchants’ margins are determined by what they can get for this intermediary activity. This affects their flexibility in relation to price. Just as the merchants’ costs are inflexible, so are their prices. If the merchants attempt to drop their prices they will eat into their profit margins (although some do this in order to win prestige business). If, on the other hand, they attempt to unilaterally raise their prices, then their markets will dry up as their customers switch to one of the big processors. Therefore, while, relatively speaking, the competitive threat of the merchants means little to British Sugar or Tate & Lyle, the competitive threat of the processors to the merchants means a great deal. The processors enjoy considerable market power over their customers. The merchants, however, are a protected species. The exchange dynamics for sub-regime 3: agricultural inputs In a number of important respects, the exchange relationships that link the beet farmers (F) to the seed producers (G), the fertiliser manufacturers (H), and the agrochemical manufacturers (I) are very similar. As Figure 5.2 shows, all three dyads are characterised by buyer–supplier independence, which places them in Category 1 in our typology of exchange relationships. Furthermore, the gross profit margins that these different suppliers earn all fall within the 5–10 per cent range. For these reasons, it is worth considering these three dyads together. The first characteristic that each of these exchange relationships has in common is the lack of supplier scarcity (i.e. not sole source). As the first section of this chapter made clear, however, the reason for this lack of scarcity differs in each instance. In the case of the fertiliser manufacturers, the lack of obvious differences between the end products on offer is the basis of this supply-side commoditisation. All of the major fertiliser companies use branding to some extent, but in reality the chemical characteristics of one phosphate or nitrate fertiliser are very much like those of another. Although particular farmers might have a preference for a particular brand, on the whole farmers constitute relatively sophisticated customers. Furthermore, scientific data on the performance of different products are widely available. Consequently, farmers simply would not tolerate premium pricing, and would switch brands if a particular supplier tried to pursue such a strategy. This structural disadvantage might be offset if the fertiliser manufacturers were able to create some sort of informal cartel. However, the current

Regulation, site specificity and scale 121 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

climate would probably make such collusion difficult, and it would certainly make it unstable. Overcapacity in the industry would probably cause one or other of the producers to break rank as they attempted to grow their market share and thereby to stabilise their position. Furthermore, the relatively low cost producers from the US and eastern Europe would certainly take the opportunity to undercut the incumbents and to establish themselves in the UK market. Although, in theory, the agrichemical market offers greater scope for product differentiation, in practice it too is a mature, commodity-based industry. The sugar beet market is simply too small to warrant the speculative research effort necessary to produce innovative pesticide, fungicide or herbicide solutions. Without such solutions, there would be little prospect that any of the supply-side actors would be able to acquire the power resources necessary for them to appropriate value from the farmers. Indeed, the fact that many of the existing formulas are nearing the end of their patented life can only mean that competition in the industry will become more intense in the future. The area that holds the greatest prospect of a shift in the structures of power is the development of new varieties of beet seed. If public hostility to so-called ‘Frankenstein’ foods was to abate, then biotechnology companies like Monsanto might conceivably revolutionise the sector. A variety of seed that was resistant to disease and required less pesticide input would greatly reduce a farmer’s costs of production. Currently, new strains of seed have to prove their economic value in trials. That is, seed producers have to be able to demonstrate that the improvement that a new seed can make to crop yield will compensate for its greater unit cost. If genetically modified crops were able to do this, then they certainly could be priced at a premium. However, public hostility to these foods remains fierce and Monsanto has actually considered abandoning crop trials in the UK altogether. In the absence of such genetic breakthroughs, improvements in crop strains are likely to continue to be incremental and based on selective breeding programmes. Success is therefore likely to be defined in terms of a particular seed producer obtaining a licence to market its products, not in terms of its capacity to appropriate an entrepreneurial rent from product innovation. Corresponding to the lack of supplier scarcity at this point in the supply chain, there is no real scarcity on the demand side either. On one level this assertion seems counter-intuitive, because British Sugar might be thought to occupy a dominant position at this stage of the supply chain. Such a view is predicated on British Sugar’s role, undertaken in conjunction with its pelleting subsidiary Germains, as a central point of coordination for the exchange relationships that exist between the beet farmers and their primary suppliers. This coordination service is offered at cost and is aimed at reducing the farmers’ transaction costs. It is also closely monitored

122 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

by the NFU to ensure that there is no opportunism on the part of British Sugar. Without a single point of contact like British Sugar, the effort required to coordinate the exchange relationships between 9,000 farmers and their primary supply base would be considerable. It should be stressed, however, that the part played by British Sugar is primarily administrative. This is because the price that the processor pays for its beet is fixed and is not directly affected by changes in the cost base of the farmers. Consequently, British Sugar has no real incentive to use its position as the sole buyer of sugar beet in the UK to exert leverage over the farmers’ major suppliers. In effect, therefore, the agrichemical suppliers and the seed producers are faced by over 9,000 separate buyers. Nonetheless, as we have noted elsewhere in this volume, a situation of buyer–supplier independence operates in favour of the buyer, because suppliers are forced to pass value to their customers simply to retain their business. This exchange dynamic is reflected in Table 5.1 in the relatively low gross margins being earned by seed producers. Margins of 5–10 per cent are typical. In so far as the relationship between the farmers and their suppliers raises any commercial issues for the processor at all, they are confined to two areas. First, the processor is concerned that the farmers should not access any technologies that would adversely affect the crop and make the act of processing the raw beet more costly. Second, there may be certain tensions between the seed producers, the farmers and British Sugar. This is for the reasons that have already been extensively described in the first section of the chapter. To recap briefly, it is in the interests of both the farmer and the processor for the farmer to use a variety of seed that is capable of producing a crop that yields a high sugar content. The final exchange relationship in this part of the supply chain needs to be understood in the context of the commercial conflicts of interest that exist between the sugar processor and the farmers. These have already been described at length elsewhere, and so there is no need to recapitulate them at length here. All that needs to be said is that the relationship between these two actors, represented in Figure 5.2 as (E = F), is one of structural interdependence (Category 6 in our typology of exchange dyads). This characterisation is based on the fact that there is a single, wellinformed buyer that is operating as part of a legally sanctioned duopoly. This legal sanction, while guaranteeing a beet farmer’s capacity to appropriate value from British Sugar (the typical gross margin earned by a farmer is around 25 per cent), also sets limits to it. These limits are to some extent flexible, however, in that the price that the farmer gets for his crop rises and falls in line with its quality. Moreover, the farmer’s cost base changes on the basis of his relative operational efficiency. This is shaped, in turn, by the farmer’s competence and by the fertility of the land to which he has access. The rents earned by a sugar beet farmer are

Regulation, site specificity and scale 123 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

primarily based, therefore, on a legal guarantee, but they also vary in line with his ownership of a scarce natural resource, fertile land. A farmer that is in possession of a particularly fertile plot of land will be in a position to enhance his regulatory rents with efficiency-based Ricardian rents.

Conclusions We can draw two main sets of conclusions from this case. The first set relates to this study, while the second relates to popular perceptions about grocery supply chains. In relation to the themes of this volume we have tried to demonstrate that, while power plays a major part in the exchange process, its influence is not universal. For example, in the exchanges that take place between the beet farmers, the seed producers and the fertiliser and agrichemical manufacturers, power is absent. Furthermore, it is absent from the exchange relationship between the sugar merchants and the food and drink manufacturers. In all of these cases, the structure of exchange that exists is characterised by buyer–supplier independence. Power plays a major part, however, in most of the other exchange relationships in this case. In terms of supplier power, the sugar processors are the actors that most obviously enjoy a privileged position. The regulatory protection that they receive gives them what we have called a critical asset. Similarly, the relationship that exists between the food and drink manufacturers and the independent grocery trade clearly favours the former. This power imbalance is based on the fact that independent retailers simply must have the manufacturers’ brands if they are to draw customers into their outlets. In the case of the relationship between the manufacturers and the grocery multiples, however, a different structure of power exists. Here, the critical asset is based on scale and site specificity and runs to the advantage of the retailer. However, the retailer’s power in the relationship is not as marked for sugar-based goods as it is for other products. Neither is it as marked as the popular perception about the UK’s food industry would tend to suggest. In so far as a general picture of retailer dominance can be painted, an argument can clearly be made for the exceptionalism of the supply chain for industrial sugar. Finally, we must consider the exchange relationship that exists between the sugar processors and the farmers. Here, the high margins made by the farmers would tend to suggest that this is another situation characterised by supplier power. However, the system of regulation that governs exchange in this supply chain forces us to see the processors and the farmers as being inextricably linked. Indeed, as we have seen, the regulatory rents earned by the processors from their customers are shared with the farmers on a roughly equal basis. The exchange relationship that exists between these actors could, therefore, most accurately be characterised as one of interdependence.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

6

Site specificity and price stickiness under regulation The sources of asset criticality in the industrial electricity supply chain

Introduction This chapter maps and analyses the supply chain for industrial electricity in England and Wales. Its main aim is to explain the appropriation of value in the chain by considering which firms are powerful and what the bases of that power might be. The supply chain is best defined as a subset of the generic supply chain for electrical energy. The generic chain can be defined as the process of converting a primary fuel source into electrical energy and delivering that energy to the end user. The specific supply and value chain under consideration is therefore to some extent defined by its end customer. In this case, the end customer is an industrial concern from one of the following sectors: chemicals; food, beverages and tobacco; iron and steel; paper; mechanical engineering; mineral products; vehicles; electrical engineering; non-ferrous metals; textiles; and construction. In 1997 these sectors accounted for approximately 32 per cent of UK demand for electricity (MarketLine 1998). Another vital element of definition, however, is the volume of electricity required by the end user. This has a crucial impact on the price paid by the end user and therefore on the appropriation of value by the electricity supplier. Traditionally, electricity demand has been segmented into three types of customer: those that use more than 1 megawatt (MW) per annum, those that use between 100 kilowatts (kW) and 1 MW per annum and, finally, those that use less than 100 kW per annum. The focus of this chapter is on the first two segments, because it is here that we find the vast majority of industrial users. Customers in the final segment (below 100 kW per annum) are primarily domestic. The analysis presented here must also take account of a number of important political, economic and environmental variables that have impacted on both the demand and supply sides of the electricity supply chain over the last decade. A key factor on the demand side is that the UK demand for electricity in all sectors is exhibiting slow growth. Between 1993 and 1997, the average growth rate for all sectors, and for industrial users in particular, was a mere 2 per cent per annum (MarketLine 1998).

Site specificity and price stickiness 125 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

This compares very unfavourably with the average annual growth rates of 7–8 per cent experienced in the 1960s (McGowan and Thomas 1989). The reasons for this slow growth are far too complex to discuss in detail here. In simple terms, however, it can best be explained as a combination of market saturation and of pressure on industry to cut its costs and to be ‘greener’ by being more energy-efficient. A related demand-side factor has been the pressure from industrial users for electricity prices to be consistently reduced in real terms. This pressure has driven a number of significant changes on the supply side. Perhaps the most obvious and significant of these changes were the privatisation and liberalisation of the UK electricity supply chain in the period 1990–1. Before 1990, the totality of the electricity supply chain, with the exception of primary fuel supply, was owned and controlled by the state through the Central Electricity Generating Board (CEGB). All of the other key functional stages (generation, transmission, distribution and supply) were vertically integrated within this single organization. Generation and transmission were centrally controlled, while distribution and supply were the responsibility of local electricity boards operating under the auspices of the CEGB (McGowan and Thomas 1992). The privatisation process launched in March 1990 has had two crucial impacts on this supply chain. First, within England and Wales, ownership of the supply chain was divided along the lines of the key functional stages. Ownership of the nonnuclear generation function was divided between PowerGen and National Power, which were newly privatised and separated divisions of the CEGB. The nuclear generation function at that stage remained within the public sector under the name Nuclear Electric. In 1996, however, the nuclear generation function was also split between two organizations, British Energy and Magnox Electric, and the former was privatised. Another renamed and privatised division of the CEGB, the National Grid Company, was given ownership of the national transmission system in England and Wales. Finally, ownership of the distribution and supply functions in England and Wales was divided among twelve regional electricity companies (RECs). Before privatisation, these had been the local electricity boards under the CEGB (McGowan and Thomas 1992). Within Scotland and Northern Ireland, however, a different approach was taken. The Scottish model was based on the old CEGB structure in that the electricity supply chain remained vertically integrated. The only difference after privatisation was that there were two separate, vertically integrated companies. Scottish Power was given responsibility for the southern half of the country, while Scottish Hydro-Electric was given ownership of the key functional stages in the north. In Northern Ireland privatisation did not occur until 1992. Again, a slightly different structure of ownership and control was put in place. Generation is owned separately from transmission, distribution and supply, which remain vertically integrated within Northern Ireland Electricity (McGowan and Thomas 1992).

126 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

The changes described above are of more than purely historical interest, however, because they provide us with a radically different picture of the electricity supply chain in England and Wales from that which existed before privatisation. Rather than looking at a flow of goods and services, and a parallel flow of value, which are almost exclusively within the boundaries of one organization (the CEGB), we are now faced by a series of transactions between separate firms operating at one or more of the key functional stages in this supply chain. Allied to this restructuring is the second crucial development since privatisation. This has been the state’s efforts to improve the efficiency of the organizations operating along this supply chain and to force them to pass more value to the end customer in terms of both lower prices and better service quality. The state has pursued these objectives through a combination of liberalisation where possible, and regulation where market competition is not economically feasible. Briefly, competition has been introduced, with varying degrees of success, into the generation and supply stages of the supply chain. It has not been possible, however, to liberalise the transmission and distribution functions due to their natural monopoly status. The goals of improved efficiency and of greater value for the end customer have therefore been pursued by means of price cap regulation (OFFER 1998a). The discussion that follows has three main aims. The first aim is to descriptively map the physical supply chain for industrial electricity. This will involve a more in-depth discussion of the key functional stages in the chain than has been carried out so far. We will also consider the resources needed by an organization to operate at each stage and will identify those firms that are currently the owners of those resources. The second aim is to descriptively map the corresponding value chain for industrial electricity. This will involve looking at the distribution of value in the chain, measured in terms of the revenues and gross profit margins typically being earned at each functional stage. The final aim is to identify and discuss the factors that determine the distribution of value in the chain. The primary focus here will be on the dynamics of exchange between firms at various stages in the chain and the critical role played by regulation in shaping these dynamics.

Mapping the supply chain There are five key functional stages in the supply chain for industrial electricity. As shown in Figure 6.1, these are the supply of a primary fuel source, generation, transmission, distribution and supply. We will consider each of these stages in turn, discussing them in terms of the primary activities carried out at that stage, the resources needed for these activities, and the major firms operating at a particular stage. We begin with the primary fuel stage.

Site specificity and price stickiness 127 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Supply Efficient and secure system for managing customer data Strong negotiating and contract management skills Understanding of specific customer requirements Good reputation and strong brand

Distribution

Transmission

Free access to land on which network infrastructure is based

Free access to land on which network infrastructure is based

Technical skills to ensure safe, reliable and efficient operation

Technical skills to ensure safe, reliable and efficient operation

Licence to operate

Licence to operate

Generation Technical skills to ensure efficient use of fuel and plant Expertise in repair and maintenance to minimise ‘down time’ Access to specific sites for efficient fuel delivery and electricity transfer

Primary Fuel Licensed access to specific sites Expertise in finding and exploiting those sites as efficiently as possible Ability to provide a reliable supply of satisfactory quality

A diversity of plant

Figure 6.1 The industrial electricity supply chain: functional stages and key resources.

Primary fuel The primary fuel stage is perhaps the most complex to map descriptively, because there is a number of different supply markets operating here. These represent the six main types of fuel used to generate electricity in the UK, namely coal, nuclear, gas, renewables, coal and oil derivatives and oil itself. There is, however, a single primary activity that is common to all of these fuel types. This can be defined as the capture/extraction and refining of a raw energy source followed by the delivery of that refined energy source to the generator. Again, the diversity of different fuel types means that the resources required by suppliers do vary somewhat. Nevertheless, the following three resources can be identified as common to the provision of all fuels. These are licensed access to specific sites, an expertise in finding and exploiting these sites as efficiently as possible, and an ability to provide a reliable supply of satisfactory quality. In identifying the major firms operating at the primary fuel stage it is easiest to place the six fuel types into four groups, because there is a good deal of overlap between types. The first group combines suppliers of coal and coal derivatives. Together, these fuels are used to generate some 40 per cent of the UK’s electricity (MarketLine 1998). At this level, coal and its derivatives are currently the most used fuel types, but their share has declined significantly from over 70 per cent in 1991. This decline is principally due to a much greater use of gas. Since privatisation in 1994, the dominant UK supplier of coal and its derivatives has been RJB Mining. This company accounts for around

128 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

70 per cent of UK production. The next largest UK producer is Scottish Coal with around 10 per cent of production. The remaining 20 per cent of production is divided between some fifty independent mining companies, each operating one or two mines. In addition to buying coal from UK producers, electricity generators can, of course, use imported coal bought on the international spot market. The use of imported coal has, in fact, grown significantly, following the withdrawal of a government mandate that generators should buy the bulk of their coal from UK producers, particularly RJB Mining. The second group of fuel suppliers provides gas, oil and oil derivatives. This group is composed of the twenty-five or so major oil and gas companies operating in the North Sea, including Shell, BP, British Gas and Amerada Hess. Collectively, these fuels account for around 30 per cent of UK electricity production, with gas forming the lion’s share at 26 per cent (MarketLine 1998). As was noted above, the use of gas has grown rapidly since 1991, when the EU deregulated it as a fuel for generation. Its popularity is principally due to its high burn efficiency and low ‘greenhouse’ emissions as compared to other fossil fuels, such as oil. The use of oil and its derivatives is declining rapidly from a very low base. The third major group of fuel suppliers is made up of those who provide material for nuclear reactors. Nuclear fuel has a relatively stable share of UK electricity production at around 27 per cent (MarketLine 1998). This is a supply market where extraction of the major fuel source (uranium) and reprocessing of spent fuel are tightly regulated. Uranium is scarce and very costly to extract and the disposal of nuclear waste also poses a costly and difficult challenge. It has become increasingly common, therefore, for existing fuel rods to be reprocessed. In the UK, the vast majority of this work is done at Sellafield. The final group of fuel suppliers is collectively referred to as renewables. The main fuels in this group, in descending order of importance, are household and industrial refuse, hydro-electricity, landfill gas, sewage gas and wind power. Together, renewable fuel sources account for 3 per cent of UK electricity production (MarketLine 1998). This share is growing very slowly under the influence of the government’s Non Fossil Fuel Obligation, which requires electricity suppliers to buy a certain percentage of their power from renewable generation. This is the one fuel source, particularly in the case of hydro-electricity and wind power, over which the generator often has joint ownership. Those schemes based on the burning of refuse will usually involve small-scale, localised generation for a factory, a hospital or a housing estate. Generation The key activity at this stage is the conversion of a primary fuel source into electrical energy. This conversion involves a variety of plant types

Site specificity and price stickiness 129 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

depending on the fuel used, but the fundamental process always includes the same steps. First, the fuel source is converted from potential energy to kinetic energy to drive turbines. Second, the motion of these turbines generates high-voltage electrical energy. Whatever the plant type in question, there are three resources that are essential to any firm operating at this stage in the supply chain. The first of these comprises the technical skills necessary to ensure an efficient use of fuel inputs and plant capacity, so that the generator achieves the maximum electricity output for a given unit of fuel. A second and related resource is an expertise in repair and maintenance to minimise the time when a generating set is inoperable. In combination, these first two resources are vital if a generator is to achieve and maintain a low-cost operation. The third key resource for a generator is access to suitable sites on which to build their power stations. The suitability of a site is determined primarily by its proximity to its fuel source and to the transmission network. Where these distances are great, the costs of a generator’s output will inevitably be higher. In addition to these three resources, which are essential in the sense that they are necessary for any generator to operate efficiently and effectively, we might also identify a further resource that would give its owner a competitive edge. This is a diversity of plant types running on a range of different fuels. The primary advantage to be gained from this resource is that it allows a generator to hedge against fuel price fluctuations by producing electricity with the cheapest fuel available at a particular point in time. Since privatisation, the government has tried to create a competitive market at this functional stage in the supply chain. The basis of this market was laid down in 1990, when the generation capacity of the CEGB was split between National Power (48 per cent market share), PowerGen (30 per cent market share) and Nuclear Electric (22 per cent market share). Since then, the market has become more fragmented, with new entrants being encouraged by the deregulation of gas and by regulatory intervention from OFFER. Liberalisation has been facilitated through a wholesale trading mechanism called ‘the Pool’. This mechanism, managed by the National Grid Company, brings together the range of major power producers (MPPs) currently operating in England and Wales and the range of companies now involved in electricity supply. At present, there are twenty MPPs. The largest of these, with their 1997 market share shown in brackets, are National Power (23.6 per cent), PowerGen (21.3 per cent), British Energy (17.6 per cent), Eastern Group (10.2 per cent) and Magnox Electric (6.6 per cent) (MarketLine 1998). These figures demonstrate that National Power and PowerGen have suffered significant reductions in market share over the last five to six years. A large element of these losses has occurred as a result of OFFER’s edict that they should sell 6,000 MW of coal-fired plant to Eastern Group

130 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

(OFFER 1998b). As we shall see in our analysis of the value chain, however, this redistribution of generation market shares has not yet delivered the effective price competition desired by the regulator. To complete this overview of generation, we should note that privatisation has not been accompanied by the introduction of competition in either Scotland or Northern Ireland. In Scotland, the generation function is shared between Scottish Power, Scottish Hydro-Electric (now part of a larger group called Scottish and Southern Energy following a merger with Southern Electric) and Scottish Nuclear, which is part of British Energy. These generators do not compete with one another, but the supply businesses of Scottish Power and Scottish Hydro-Electric are required to buy a certain proportion of their electricity from the other companies (OFFER 1998c). There is pressure from National Power and PowerGen for market opening north of the border, but this is unlikely to occur given that there is already excess capacity. Transmission This functional stage involves the bulk transfer of electrical energy along high-voltage wires to localised distribution networks. The transmission network consists of pylons carrying overhead lines in rural areas, underground cables in more urbanised areas, and sub-stations connected to the regional distribution networks. The key resources required to operate at this stage in the supply chain are threefold. First, an organization needs free access to the land on which the transmission network is based, so that it is able to perform vital repair and maintenance tasks. This does not mean, however, that the organization needs to own all of the land surrounding the network, simply that it should enjoy a right of unfettered access across land that is owned by a variety of private individuals and organizations. The second key resource is the technical skills necessary to ensure safe, reliable and efficient transmission. Finally, an organization needs a licence to operate granted by the state. The transmission function is carried out in England and Wales by a single organization, the National Grid Company (NGC). Between 1990 and 1995, the NGC was jointly owned by the RECs, which meant that a degree of vertical integration remained between the transmission and distribution stages of the chain. Then in 1995 the RECs were required to float their shares in the NGC on the Stock Market (OFFER 1998d). The logic for retaining transmission as a monopoly function after privatisation has to do with the very high fixed costs of operating such a network. In this situation of natural monopoly, it is simply uneconomic for there to be more than one network in a specified geographical area. The same situation of natural monopoly applies to the transmission networks in Scotland and Northern Ireland. In Scotland, however, ownership of the single

Site specificity and price stickiness 131 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

network is shared by Scottish Power and Scottish Hydro-Electric (OFFER 1998c). Distribution The distribution function involves the transfer of high-voltage electricity, drawn from access points in the transmission network, through a localised distribution network which reduces the voltage and which provides a connection to the premises of the end customer. The localised distribution network consists of overhead lines in rural areas, underground cables in urban areas and a number of sub-stations operating at successively lower voltages. The key resources required for efficient and effective operation at this stage are the same as those required in the transmission stage, namely open land access, the right technical skills and a licence to operate. The distribution function in England and Wales is performed by twelve regional monopolies (the RECs), which mirror the local electricity boards that existed before privatisation. The RECs own the distribution infrastructure linking the transmission grid to the end user in their respective franchise areas (OFFER 1998e). These regional networks display the same characteristics of natural monopoly as the national transmission network owned and managed by the NGC. In the first few years after privatisation, government policy was designed to maintain a strict separation of ownership between the RECs and between the RECs and UK generators. More recently, however, this policy has been relaxed and there have been a number of REC takeovers by generation companies (National Power and Midlands Electricity, PowerGen and East Midlands Electricity, and Scottish Hydro-Electric and Southern Electric). As the generation function becomes ever more competitive, ownership of a distribution monopoly represents a guaranteed, although regulated, income stream (Financial Times 1998; OFFER 1998f, 1998g). The distribution function in Scotland and Northern Ireland is also performed by companies that enjoy a regional monopoly (Scottish Power and Scottish Hydro-Electric in the former and Northern Ireland Electricity in the latter) (OFFER 1998c). Supply This is the final functional stage in the electricity supply chain. It involves the bulk purchase of electricity from generators and its sale to end users. Electricity is bought in one of two ways: either from the Pool or, more commonly, under a direct contract with a generator. This is essentially a trading activity backed up by meter reading, billing and collection of customer payments. Supply companies are also increasingly offering their industrial customers ‘value-added’ in the form of energy management services. This is a response to the significant levels of competition that

132 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

have developed at this stage in the chain following the phased liberalisation of the 1 MW+ segment (1990) and the 100 kW+ segment (1994) (OFFER 1998h). Given these conditions of open competition in what is a commodity market, there are four key resources required by a firm at this stage in the chain. The first is an efficient and secure system for collecting and managing customer information. The second resource is a combination of good negotiation and contract management skills to win and retain customers and to purchase electricity at favourable prices. Third, a firm needs an in-depth understanding of customer needs and wants. Finally, the firm needs a good reputation and a strong brand identity, because the product itself cannot be a basis for differentiation. There are now four groups of companies operating in this market: the RECs, generators such as National Power and Scottish Hydro-Electric, independent suppliers such as Independent Energy and Norsk Hydro and industrial users operating on-site combined heat and power (CHP) units (MarketLine 1998). In the 1 MW+ sector, PowerGen and National Power are the market leaders, sharing some 40 per cent of the market between them. Conversely, in the 100 kW+ sector competition has yet to develop to the same degree and the RECs have managed to retain a greater share of the market. This can be seen in the fact that just over 50 per cent of the output in this sector was still being supplied by local RECs in 1996–7 (MarketLine 1998). This position is being eroded, however, by the increasing popularity of CHP units, which provide a cheap and flexible supply of electricity for major users. Of course, CHP schemes also pose a threat to the major generators, because they sell their surplus electricity to the Pool, thereby further fragmenting the market. A number of the MPPs have moved to counter this threat by establishing on-site CHP plants of their own. Scottish Hydro-Electric, for example, has five CHP plants servicing Arjo Wiggins Appleton (Dover), BNFL (Sellafield), Salt Union (Runcorn), the East Lancashire Paper Company (Radcliffe) and Smurfit Townsend Hook (Kent) (MarketLine 1998).

Mapping the value chain We turn next to the value chain that corresponds to the supply chain described above. The question to be addressed in this section is what kind of value distribution is produced by the supply relationships that we have mapped out? The answer is provided in Table 6.1. Table 6.1 reveals a number of interesting anomalies. Perhaps the most prominent of these is that the gross profit margin (ROCE) typically being earned by the generators seems more characteristic of an uncontested market with significant barriers to entry than of the fragmented and contested market that we described earlier. The share of revenue typically

Site specificity and price stickiness 133 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

taken by the generators from the end user further supports this supposition. These figures reveal that between approximately 40 and 50 per cent of the price paid by an industrial user for a unit of electricity flows to the generator. This, in combination with the fact that only 4–6 per cent of the retail price is retained by the supplier, suggests that the wholesale price of electricity is artificially high. In the next and final section, we identify and discuss some of the key determinants of the value distribution shown in Table 6.1.

Value distribution and the dynamics of exchange The key to understanding the value distribution in this, and any other, supply chain is to look at the dynamics of exchange between firms operating at adjacent functional stages. We must also understand how the exchange dynamics between firms at adjacent stages of the chain impact upon the value being appropriated at others. In order to achieve this understanding, we must construct an exchange network on the basis of the insights developed in Chapter 3. We develop and discuss two such networks in this section. Before we move on to this task, however, a number of preliminary comments can usefully be made. The core argument put forward in the opening theoretical chapters of this volume was that the dynamics of exchange in a supply chain are an indicator of the extent to which a firm has power over its customers and suppliers. Such dynamics are the fundamental determinant, therefore, of the profit margins that a firm can expect to earn as a supplier and of the prices that it can expect to pay as a buyer. For example, a firm selling a simple commodity in competition with many other suppliers will have little or no power over a particular buyer. This insight is based on the fact that the buyer can switch relatively easily to a new and cheaper source of supply should one emerge. Consequently, Table 6.1 The industrial electricity value chain (1993–7) Supply

Distribution

Transmission

Generation

Primary fuel

Typical gross profit margin (ROCE) (%)

1–2

6–8

6–8

18–22

4–6

Typical revenue distribution for 1 MW+ user (%)

6

16

1

47

30

Typical revenue distribution for 100 kW+ user (%)

4

23

5

38

30

Source: authors’ calculations based on MarketLine (1998) data.

134 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

the seller is forced to pass value to the buyer by, at the very least, matching the lowest price in the market. Conversely, a monopoly supplier dealing with a relatively large number of buyers will potentially have immense power. It is not enough, however, simply to describe the balance of power in particular exchange relationships in this, or any other, supply chain. We must also analyse the factors that determine the nature of these exchange relationships and consider how, if at all, these relationships might be transformed over time. A number of the primary factors that might be expected to determine the nature of exchange relationships are discussed in Chapter 3. To recapitulate briefly, we argue that the balance of an exchange relationship can be understood as a function of the power resources that buyer and supplier bring to a particular transaction. The power resources available to a buyer are assumed to be a function of two main factors, the scarcity or uniqueness of the buyer and the buyer’s costs of search. The power resources available to a supplier, on the other hand, are assumed to be a function of the scarcity or uniqueness of its product or service offering. We also identify a number of important differentiating features of the various isolating mechanisms that might create a situation of supply scarcity. These are sustainability, costs of maintenance, and the existence of side-benefits for the buyer. On the basis of these features, we suggest that certain isolating mechanisms are particularly favourable to the interests of the supplier (high sustainability, low cost, with significant side-benefits), while others are in the interests of the buyer (low sustainability, low cost, with significant side-benefits). Objectively, of course, a buyer’s interests are best served where no such isolating mechanism exists and the supply market is highly contested. Assuming that the supply market is closed, however, the buyer’s interests are least adversely affected where the mechanism of closure is of low sustainability, does not impose excessive costs on the supplier, and offers the buyer some form of compensatory benefit. These theoretical assumptions form the foundation of the discussion that follows. They are used to analyse and interpret the value distribution illustrated in the previous section. The discussion also considers the critical intervening role of state regulation at those stages where effective market competition cannot be introduced (transmission and distribution) and at those stages where competition is being managed (generation and primary fuel supply). Before we can proceed with this discussion, however, we must first provide a descriptive map of the exchange relationships that go to make up the value chain for industrial electricity. In essence, there are eight major exchange relationships or dyads in this value chain. The exchange dynamics for each relationship can best be understood by arranging them into two separate power regimes. These power regimes are shown in Figures 6.2 and 6.3. Figure 6.2 illustrates the power regime for the

Site specificity and price stickiness 135 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

traditional mode of supply to the end user, while Figure 6.3 illustrates the increasingly popular mode of supply using an on-site generating plant. Each power regime will be discussed in turn.

Exchange dynamics for traditional electricity supply There are six dyadic exchange relationships in the power regime shown in Figure 6.2. The distribution of value in the network depends, as we argued earlier, on the power structure of the individual dyads and on the way in which they are linked together. The power structure of the individual dyads is represented using the nomenclature developed in Chapter 3. Thus, buyer power is indicated by the symbol (>), supplier power by (<), buyer–supplier interdependence by (=), and buyer–supplier independence by (0). Based on the assumptions articulated in Chapter 3, certain actors in this network are deemed to be in a position to earn rents rather than profits. Those actors with a capacity to earn rents are represented by means of a shaded box, while those that are able to earn only normal profits appear in a clear box. A box that is both shaded and clear represents an actor that is able to earn rents, but only under certain circumstances. The first of these six exchange dyads is that between the industrial customer (A) and what is referred to here as a network supplier (B). This is a supplier that delivers electricity through the traditional mechanism involving the generation, transmission and distribution stages of the supply chain. Electricity is bought wholesale and sold on to the end user. A major

B
A

A0B

B

B
B<E

C

D

D0F D=F

F

E

Figure 6.2 The power regime for traditional electricity supply to industrial customers. A – industrial customer, B – network supplier, C – distributor, D – generator, E – transmitter, F – primary fuel supplier.

136 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

element of the costs of doing this consists of the use of system (UOS) charges levied by the transmission and distribution companies. As we shall see, however, these charges are fixed by the regulator and not by the market mechanism. The most important cost of sale incurred by the network supplier is in the buying of wholesale electricity. It is this factor that has the greatest impact on its gross profit margins. The exchange relationship between a network supplier and an industrial customer is structured according to classical market principles. There are around 50,000 buyers and more than twenty suppliers and there are no significant barriers to market entry and exit. This relationship is represented in Figure 6.2 as (A 0 B), which means that the customer and the supplier do business under conditions of commoditised exchange or buyer– supplier independence (Category 1 in our typology of exchange dyads). In these circumstances, rival suppliers are differentiated purely on the basis of price and the buyer is able to switch suppliers with relative ease and at little or no cost should a better deal emerge. Furthermore, the buyer’s search costs are relatively low, because electricity is a standardised service that is bought frequently and on a repeat basis. Consequently, the supplier is deterred from acting opportunistically, because such behaviour can be identified and punished by the buyer relatively easily. Together, these factors mean that the network supplier is forced to pass value to the industrial customer simply in order to retain his business. Since liberalisation, competition between network suppliers has explicitly been around lowest price. Furthermore, the margins earned by network suppliers have been squeezed by the artificially inflated price of wholesale electricity. Gross margins of 1–2 per cent are typical. These inflated wholesale prices are principally due to the inadequacies of the Pool mechanism, which give the generator a structural power advantage over the network supplier (Bunn et al. 1998). The precise nature of this advantage, represented as (B < D) in Figure 6.2, is discussed in greater detail below. Suffice to say, however, that the position of the network supplier (B) in the subregime represented by (A 0 B < D) ensures that the supplier is unable to earn rents. It is forced to pass value to the end customer (A) in the form of falling prices, and its major input cost (wholesale electricity) is kept artificially high due to the leverage available to the generator (D). We turn next to the exchange relationships between the network supplier (B) and the owners of the transmission (E) and distribution (C) infrastructures. The gross profit margin typically being earned by transmission and distribution companies is 6–8 per cent. These two dyads are shown in Figure 6.2 as (B < E) and (B < C), which means that, in each case, the owner of the infrastructure has a power advantage over the network supplier. These dyads fall into Category 5 in our typology (transparent supplier dominance). The basis of this power advantage for both transmission and distribution companies is the fact that they operate as natural monopolies within the geographical area covered by their network.

Site specificity and price stickiness 137 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

The existence of a natural monopoly for a certain functional activity implies that it is uneconomic for more than one firm to perform that activity. This occurs when the production technology being used requires very high, non-recoverable fixed costs and much smaller variable costs. The network infrastructures used for the transmission and distribution of electricity exhibit both of these characteristics. In terms of the categorisation developed in Chapter 3, natural monopoly is a highly sustainable and low-cost isolating mechanism. It confers significant structural power on the supplier in each of these dyads and guarantees that the value appropriated by these firms will never be competed away by horizontal competitors. In short, these firms are in a prime position to earn monopoly rents. An important feature of natural monopoly is that the buyer is fully aware of the supplier’s power advantage. By definition, the buyer’s search costs are zero, because there are no alternative suppliers. Perhaps even more important, however, is the fact that the state is also fully aware of the power advantage enjoyed by the transmission and distribution companies. Consequently, the revenues typically earned at these stages in the supply chain are principally determined by regulation. This operates in the form of periodic price capping under an RPI + or – X formula. The principal aims of price capping have been to prevent an abuse of the monopoly positions enjoyed by these companies, while at the same time encouraging greater operational efficiency. The regulatory mechanism has been designed so that the transmission and distribution companies are able to earn monopoly rents if they out-perform the price cap through significant efficiency gains. These rents are only available, however, for the duration of the price cap, which is usually five years. At the end of each five-year period, the cap is adjusted to bring prices back in line with marginal costs, thereby eroding the firm’s rent-earning capacity. Further rents can only be earned if the transmission or distribution company continues to achieve efficiency gains (OFFER 1998a). Since privatisation, this regulatory mechanism has performed relatively well. The setting of progressively tighter price caps has reduced average revenues in real terms. Price capping has thereby forced transmission and distribution companies to achieve sizeable efficiency improvements in order to maintain a 6–8 per cent margin. It should be emphasised, however, that these reported margins probably underestimate the true quantum of value appropriation at these stages in the supply chain. This conclusion relates to the fact that the price cap is primarily based on cost and revenue data provided to the regulator by the transmission and distribution companies. It is clearly in the interests of the regulatees, therefore, to be selective in the provision of such information to achieve a more favourable regulatory outcome. This selective use of information to gain an advantage can be conceptualised as a regulatory game from which an equilibrium, the negotiated price cap, results (Kahn 1971; Sappington and Stiglitz 1987).

138 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Regulation is also a critical feature of the exchange relationship between the network supplier (B) and the generator (D). The gross profit margin typically earned by a generator on the sale of wholesale electricity is between 18 and 22 per cent. Furthermore, wholesale prices have changed very little since privatisation, while generation costs (fuel, capital and operations) are estimated to have fallen by almost 50 per cent (Professional Engineering 1999b). As we have already noted, such margins hardly seem to reflect the emergence of effective competition at this stage in the supply chain. The underlying reason for these inflated profit margins lies in the distorted system of price setting within the Pool. It has been widely argued that these distortions give generators the opportunity to manipulate prices in the generation market in their favour, and thereby create a situation of quasi-monopoly supply (Bunn et al. 1998). Indeed, the electricity industry regulator, Callum McCarthy, was recently reported to have said that ‘The Pool has provided a means by which generators are protected from competitive pressures, rather than being put under pressure to which they have to respond competitively’ (Professional Engineering 1999a). In Figure 6.2, therefore, the generator is shown as having a power advantage over the network supplier (B < D). The buyer’s search costs are relatively low, because the product being bought is a standardised commodity that is differentiated only on the basis of price. The buyer is thus well aware of its exploitation at the hands of the supplier, but can do nothing to overcome it. This dyad therefore falls into Category 5 in our typology (transparent supplier dominance). In this part of the supply chain, regulation is acting as the classic doubleedged sword. On the one hand, the market has been liberalised in an attempt to serve the public interest. The Pool was established after privatisation as a mechanism to facilitate and encourage the entry of new players into the generation market. The pricing mechanism was designed in such a way that new entrants were offered an attractive rate of return on their investments. On the other hand, this same mechanism has led to ‘stubbornly high’ prices in a nominally more competitive market (Professional Engineering 1999a). The Pool price is set for each half-hour of the day by means of bids from generators. The generators make their bids in response to a demand forecast for each half-hour established by the NGC. The bids fall into three categories: base-load plant (lowest marginal cost), mid-merit plant (median marginal cost), and peaking plant (highest marginal cost). The Pool price is set by the most expensive plant required to meet forecast demand for a particular half-hour. At times of highest demand, when almost all of the available generation capacity is called into action, this is peaking plant; at times of lower demand, this is mid-merit plant. The Pool price therefore varies in accordance with the demand for electricity at particular points in time (OFFER 1998i).

Site specificity and price stickiness 139 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

The problem with this system is that it makes it possible for those generators that own the majority of peaking plant (principally coal- and oil-fired stations) to act as price setters at times of highest demand. This then allows these generators to make handsome margins on electricity generated by their base-load and mid-merit plants, which are principally gas-fired. It is clear, however, that this pricing system benefits all generators, because everyone receives the Pool price or a price indexed to it (Bunn et al. 1998). As a result of these failings, the one-sided bidding system in the Pool has now been replaced with a bilateral trading system offering short-, mediumand long-term packages at various price levels. These New Energy Trading Arrangements (NETA) are designed to create more choice for buyers of wholesale electricity and therefore more effective price competition between generators (Martineau Johnson 1998; OFFER 1998i). The final two exchange relationships in this network are those between the generator (D) and the primary fuel supplier (F). The first of these dyads, shown in Figure 6.2 as (D 0 F), is representative of the vast majority of the exchange relationships between generators and primary fuel suppliers. This indicates that exchanges in this part of the network are usually characterised by buyer–supplier independence (Category 1 in our typology of exchange dyads). Primary fuels are standardised commodities that are bought and sold either in international spot markets, with numerous potential buyers and suppliers, or under longer-term contracts designed to hedge against spot price fluctuations. In both cases, it is the wider forces of supply and demand that determine prices, and therefore revenues and margins (Barfe 1998). As with all commodity-based exchange relationships, the buyer’s search and switching costs are relatively low. This means that the fuel supplier is forced to pass value to the generator by at least matching the lowest price in the market. The supplier must do this simply to retain the contract. As a consequence of this exchange dynamic, the gross profit margin earned by a primary fuel supplier tends to be relatively low. It is typically between 4 and 6 per cent, with the upper end of this scale being achieved by virtue of operational efficiency improvements. Nevertheless, the forces of supply and demand do not operate in a completely unfettered manner in this part of the supply chain, because the state takes an interest in the types of fuel used by generators. In recent years, the state has attempted to influence the fuel mix and, in some cases, the sources of supply used by particular generators. It has done this to achieve a variety of policy goals including security of supply, protection of employment in national fuel industries, and protection of the environment (DTI 1998). For example, between 1991 and 1998 the UK government promoted the building of gas-fired power stations, because gas is a much cleaner and more efficient source of electricity than other fossil fuels. It is also much less controversial than nuclear power. Importantly, though, this ‘dash for gas’ did not involve the promotion and protection

140 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

of a particular supplier or suppliers. Indeed, government policy has ensured that the gas supply market has become much more open and competitive in line with the exponential growth in demand. Until recently, however, the same could not be said of the exchange relationship between a generator and a coal supplier. Between 1994 and 1998 the government forced those generators with coal-fired plant (National Power, PowerGen and Eastern Group) to buy the bulk of their fuel from high-cost UK producers, in particular RJB Mining. This was explicitly done to protect jobs in a politically sensitive industry. For the duration of this regulatory protection, some of the exchange relationships at this point in the regime were characterised by buyer–supplier interdependence. This is shown in Figure 6.2 as (D = F). In this case, state protection for the supplier created an interdependency rather than a power advantage, because the supplier was forced to deal with specified buyers under strictly defined terms and conditions. The arrangement was also fully transparent, which acted as a deterrent to supplier opportunism. Nonetheless, this exchange relationship was much more favourable to the supplier than that pertaining under normal circumstances. Rather than being forced to pass value to the generator, the fuel supplier was able to retain a greater share for itself by charging prices above the prevailing market rate. Since 1998, however, this explicit protection for UK coal producers has been replaced by more informal protection in the shape of a moratorium on the building of gas-fired power stations (DTI 1998). Given that this informal protection can do nothing to prevent UK electricity generators from buying imported coal, however, the exchange relationship is now characterised, like all the rest at this point in the power regime, by buyer–supplier independence. To sum up, the revenues and margins earned by suppliers of different primary fuels are primarily determined by supply and demand conditions. The demand for particular fuels does not, however, vary according to purely commercial criteria. Governmental priorities are also critical in understanding the distribution of value at this stage in the supply chain. Exchange dynamics for on-site electricity supply In addition to the primary power regime discussed above, there is a second, less complex regime based around the relatively new technology of onsite generation and supply through small-scale gas-fired plant. Industrial customers generally use this type of plant as a source of both electricity and heat, which is why it is described as combined heat and power (CHP) plant. This is an extremely fuel-efficient technology, because when gas is burnt to produce electricity, heat is produced as a by-product. In a standard gas-fired power station, this heat would simply be lost into the environment, but CHP plant allows the end user to recycle it to produce

Site specificity and price stickiness 141 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

steam for heating purposes. As Figure 6.3 shows, this power regime is composed of only three exchange relationships. The regime is constructed on the assumption that the CHP plant is owned and operated as a joint venture between the customer and the generator/supplier. There is a small number of very large industrial users that own and operate their CHP plant without third party involvement. The vast majority of schemes established thus far, however, are managed within a joint venture framework. Most industrial customers are unwilling to bear the technical and financial risks of a CHP scheme without support from a third party specialist such as Scottish Hydro-Electric or PowerGen. The exchange relationship between the on-site generator/supplier (B) and the primary fuel supplier (C) requires only the briefest attention, because its characteristics were discussed in detail in the previous subsection. As Figure 6.3 shows, this relationship is one of buyer–supplier independence (B 0 C). In other words, the on-site generator/supplier buys fuel, in this case gas, from an entirely open supply market. Before its privatisation in 1986, British Gas had a monopoly over gas supply in the UK. Since then, however, the supply market has been progressively deregulated. By 1997, there were around seventy suppliers of gas to industrial and commercial users in the UK (Barfe 1998). Gas is now a commodity that is traded either in an international spot market or on the basis of longer-term contracts designed to hedge against spot price fluctuations. In both cases, price is the only means by which a supplier can differentiate itself from its competitors. Consequently, the gas supplier is forced to pass value to the on-site generator/supplier by keeping its prices at, or below, the prevailing market rate. The most interesting elements of this network are the two exchange relationships between the industrial customer (A) and the on-site generator/supplier (B). As Figure 6.3 shows, the dynamics of exchange between these two actors vary according to whether we consider the situation before an agreement is made (ex ante) or after the deal is done (ex post). Ex ante, this exchange relationship is characterised by buyer–supplier independence (A 0 B). This is true even though the absolute number of buyers and suppliers is somewhat lower than for traditional network supply. The number of potential buyers is lower as a result of technical considerations and customer inertia. There are also fewer suppliers, with only five major

A

A0B (ex ante) A=B (ex post )

B

B0C

C

Figure 6.3 The power regime for on-site electricity supply to industrial customers. A – industrial customer, B – on-site generator/supplier, C – primary fuel supplier.

142 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

players currently providing CHP schemes. Despite this more restricted supply base, however, the service offering of each major supplier is basically the same, because the technological basis of CHP plant is widely understood. Moreover, on-site generators/suppliers are unable to premium price their service, because they are still in competition with network-based suppliers. Once an industrial customer agrees to establish a CHP plant, however, the exchange relationship with the chosen on-site generator/supplier is characterised by a significant degree of structural interdependency (A = B). This interdependency arises as a result of the substantial dedicated investments undertaken by buyer and supplier in support of the transaction. The setting up of a CHP plant to serve the individual needs of a particular industrial customer implies that this kind of transaction is characterised by a high degree of asset specificity for both parties. The supplier cannot readily use the plant to service the needs of another customer. The buyer has a sunk cost commitment to the plant that cannot easily be written off. It therefore has no credible threat of switching to achieve a better deal from the supplier. The risk of supplier opportunism is minimised by the relative ease with which the buyer can compare its electricity price with those being offered by network suppliers. Consequently, the buyer and supplier are forced by their structural circumstances to work together for mutual benefit. In terms of value appropriation, this exchange dynamic implies that the clear cost advantages of a CHP plant compared with network supply will be shared equitably by the customer and the generator/supplier. These cost advantages are derived from four main factors. The first factor is the much higher fuel efficiency of CHP plant. It is generally agreed that the fuel efficiency of CHP plant is between 80 and 90 per cent, while the burn efficiency of large-scale gas-fired power stations is around 45–50 per cent (MarketLine 1998). The second factor is the absence of transmission and distribution charges from the total bill. The third is the fact that a part of the costs can be recouped by selling surplus electricity to other users through the Pool. The fourth and final factor is the financial incentives provided by the UK government to encourage industrial users to establish CHP schemes. Perhaps the most important of these incentives is the exemption of most CHP schemes from the Fossil Fuel Levy (MarketLine 1998). Thus, the industrial customer can expect to receive electricity priced below the prevailing market rate, while the on-site generator/supplier can expect to make a gross margin above the 1–2 per cent typically earned by network suppliers.

Conclusions At each functional stage in a supply chain there are certain resources that provide a basis for operational effectiveness. If these key resources can be

Site specificity and price stickiness 143 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

owned or controlled in a way that is unique or difficult to imitate, and they are vital to customers or suppliers, then they become what we have called critical assets. These assets are the foundations of supply chain and market power. They give their owners or controllers the potential to appropriate value on a sustainable, long-term basis, because they create a market structure characterised by low or non-existent contestation. We might therefore expect a firm that possesses a critical asset to be earning supernormal profits, or rents, on a sustained basis. The key insight provided by the electricity case, however, is that the creation and/or effective exploitation of critical assets is in some circumstances constrained by state intervention in support of the ‘public interest’. There are three key resources at the end-customer point in the chain: information on the specific needs and wants of individual customers; strong local reputation and branding; and reliable access to competitively priced bulk electricity. Given the government’s policy of stimulating open competition in electricity supply, it is unlikely that any of these resources could be owned or controlled as critical assets without inviting regulatory intervention. The increasing popularity of energy self-sufficiency, through the use of on-site CHP plant, has also raised the level of market contestation at this stage in the supply chain. The key resource at both the transmission and distribution stages is the network infrastructure itself. This infrastructure has the characteristics of a natural monopoly and it therefore provides the basis for a critical asset. As we have seen, however, the earning of monopoly rents by the owners of this resource is heavily regulated under an RPI – X pricing formula designed to encourage operational efficiency. Furthermore, the rentearning capacity of the transmission and distribution companies is being threatened at the margins by the increasing popularity of on-site CHP plants. At present, this threat is fairly insignificant, but it does show how technological change can begin to erode seemingly insurmountable power advantages. The key resources at the generation stage of the chain are ownership of a broad portfolio of plant types and an ability to operate that plant as efficiently as possible. Again, it is unlikely that these resources will, in future, be owned or controlled as critical assets by individual firms, because the regulator is concerned to promote greater price competition between generators. Additionally, the trend in equipment manufacture is away from nationally unique standards towards EU-wide functional standards as part of the Single Market programme (Thomas and McGowan 1994). The fact that high profit margins have been consistently earned at this stage since privatisation does demonstrate, however, that generators have enjoyed a power advantage over network suppliers. As we saw earlier, this power advantage is the result of the inadequacies of the Pool pricing mechanism. The market has become more fragmented in line with the regulator’s objectives, but it is widely believed that the one-sided pricing mechanism

144 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

has allowed all of the generators to benefit from the price-setting activities of a few dominant players (Professional Engineering 1999b). Finally, the key resources at the primary fuel stage of the chain are licensed access to specific sites, an expertise in finding and exploiting these sites as efficiently as possible, and an ability to provide a reliable supply of satisfactory quality. Here again the state looms large. State intervention has not only helped to create a critical asset in the short term (the guaranteed contracts awarded to RJB Mining between 1994 and 1998) but, through a process of liberalisation, has also ensured that one or more fuel suppliers has not achieved long-term market dominance. In spite of the privatisation process, this supply chain remains a creature of the state, because electricity is regarded as an essential public service. The exploitation of existing critical assets and the creation of new ones will therefore always be heavily circumscribed by the regulator’s desire to pass value to the end customer. The firms operating in this supply chain are being forced to delight the consumer as opposed to simply satisfying them.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

7

Asset specificity, switching costs and limited competition The sources of asset criticality in the aerospace fuel equipment supply chain

Introduction This case study highlights the fact that a strong market position is not always enough for a firm to achieve its business objectives. An additional factor is the strength of the firm’s position in its primary supply chain. The case also acts as a critique of lean thinking, or at least the way in which the philosophy is portrayed by many of its proponents, i.e. as appropriate to all circumstances. It will be shown in this chapter that, despite the existence of an industry-wide initiative to promote supply chain cooperation, certain firms within the supply chain do not perceive the chain to be of sufficient importance to their goals to contribute to efforts to make it more efficient and effective. The case concerns the production of fuel equipment for military use. This equipment is a highly sophisticated piece of technology, which consists of a number of specialist sub-assemblies. The ultimate end-customers for this product are armed forces, which require a capability for re-fuelling their military aircraft. The market for the product at present is very limited, at least in aerospace terms. This is something that is important in shaping the power structure embedded within the chain. This supply and value chain case is set against the background of efforts by national governments to reduce defence spending and a less tolerant attitude on the part of governments towards cost overruns. Following the fall of the Berlin Wall in 1989 and the break-up of the Soviet Union in the early 1990s, there was much talk from western European politicians about the possibility of a ‘peace dividend’. It was perceived that the case for automatic, across the board annual increases in defence spending, for the retention of such large armed forces and for the deployment of forces in certain parts of the world had been significantly reduced. Whilst much of the optimism of the early 1990s has been dispelled by the problems that have arisen in many of the countries of the former communist bloc – especially the old Yugoslavia and the former Soviet republics – as well as by continuing tensions in the Gulf, moves to reduce defence spending have still been attempted. For example, the British Army

146 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

has been substantially reduced in numbers, to the point where certain high-ranking officers have questioned its ability to undertake some of its traditional roles. Whilst certain structural changes have been made to many western European military forces, this was not believed to be the only opportunity for cost cutting. A further opportunity was thought to lie in the development of better procurement practices. In the cold war years, many governments operated cost-plus arrangements with defence contractors and tolerated equipment faults and cost and time overruns. Over the past ten years, however, governments have increased their focus on procuring defence equipment more effectively. This increased focus on defence spending has affected all firms in the aerospace industry. In the UK, this pressure has been added to by evidence of a lack of national competitiveness. In the 10 years from the mid-1980s to the mid-1990s, the UK share of the aerospace market fell from 13 per cent to 9 per cent (SCRIA 1996: 1). One response has been an industry initiative, Supply Chain Relationships in Aerospace (SCRIA). The aim of this initiative is to increase the value delivery of the chain (i.e. increased product functionality at reduced cost) through the development of greater cooperation and coordination in the industry’s supply chains. In an introduction to its code of practice, the body comments: Our industry’s competitiveness depends largely on the performance of its supply chain[s]. No single company can act independently of its customers or suppliers. A more efficient supply chain will increase the competitiveness of UK aerospace products. This efficiency will only be achieved through continuously improved processes and clear communication between all participants . . . Joint action is therefore critical to the success of our industry [and requires] changes in our culture and practices. (SCRIA 1996: 1) There are problems, however, with this statement, something arguably highlighted by the case in this chapter. Those behind this industry initiative are correct in ascribing many of the problems of competitiveness to those occurring in buyer–supplier relationships – it is a major factor in this case. However, it is not true (in any meaningful sense) to say that no company acting within an aerospace supply chain cannot act independently of its customers and suppliers – or independently of the overall objectives of the supply chain, however defined. This is because, in many supply chains, there are significant differences in the extent to which supply chain players are dependent on that supply chain for the achievement of their overall business objectives. For example, a firm could be operating within a supply chain, but the revenues or profits generated through that participation could be of very

Asset specificity and limited competition 147 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

little significance to it. Worse still, the business might be quite expensive to service. At the same time, however, the other players in the supply chain – to which the chain is of much greater significance – may be dependent on the products and services that such a firm is providing. This situation, which has been described as negative transaction specific asymmetry, leaves the dependent players in the chain very vulnerable to the possibility that the dominant player will ‘free ride’ on the chain and not adhere to the overall supply chain objectives (Watson and Sanderson 1997). This situation is particularly liable to occur in supply chains that, on one hand, deliver low volumes, but, on the other, include the supply of key inputs from large multinational firms. A key theme of this chapter is the way in which this case represents an example of ‘one-eyed lean thinking’, rather than the ‘lean supply’ that SCRIA is attempting to promote. (The concept of ‘one-eyed lean supply’ was developed by Watson and Sanderson (1997) to illustrate how lean supply can be undertaken, but with the benefits mainly accruing to certain players within the chain. Certain supply chain actors can ‘free ride’ on a lean regime.) The discussion that follows has three main aims. First, the physical supply chain for this particular type of fuel equipment is described. This supply chain consists of a variety of inputs, ranging from basic commodity components to specialist, high technology sub-assemblies. Second, the corresponding value chain is described. In this analysis, the fortunes of the key players that operate within the chain are assessed. This analysis shows that certain players are earning higher margins than others within the chain. In the final part of the chapter, the differences in the margins being earned by the various players are explained. The explanation focuses on the concept of power and how this is distributed unevenly along the chain. It is revealed that, not only does the power structure within the chain lead to certain firms earning higher than average margins, but it also affects the ability of the supply chain as a whole to deliver a low cost product that would significantly increase the demand for that product. As a result, the case provides an example of how lean thinking cannot be successfully applied in all supply chain circumstances.

Mapping the supply chain One of the most important facts about this supply chain is that it is a lowvolume supply chain. The demand for the fuel equipment offered by the chain is very low by aerospace standards. The market for this equipment fluctuates from year to year – a further important fact – from a low of about £3 million to a high of £20 million. The aerospace sector is, of course, a series of multi-billion dollar industries. The supply chain has six main stages, starting with the raw materials for the product and ending with the integration of the fuel equipment on

148 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

to a mobile fuel tanker. This chapter does not deal with the raw materials stage of the chain. Instead, it begins with the production of generic components. The other stages in the chain concern the production of bespoke components, the production of sub-assemblies, the assembly of the equipment and the integration of the equipment with the fuel tanker. A diagram of the supply chain is shown in Figure 7.1. In this section, each supply chain stage is described in terms of the primary activities carried out at that stage, the resources needed for these activities and the level of competition at each stage. We begin at the upstream end of the supply chain with a description of the generic component stage. Generic components This stage of the chain consists of the manufacture of standard, low technology, commodity components. These include the standard bolts, nuts and washers used in the product. Whilst these components are clearly needed as part of the end product, they possess a very low value in terms of their proportion of the overall cost of the equipment. These components also do not possess any valuable intellectual property. As a result, the bespoke component manufacturers, the sub-assemblers

FINAL INTEGRATION Integration of the equipment with the mobile fuel tanker Technical skills in both the development of the mobile tanker and the integration of the equipment with the tanker

ASSEMBLY AND TESTING

SUBASSEMBLIES

Integration of the sub-assemblies and other components to produce the finished fuel equipment

Manufacture of both productspecific and generic engineering subassemblies

Testing of the equipment to ensure that it complies with stringent safety standards High technology skills and equipment

Manufacturing expertise in the various areas covered at this stage

BESPOKE COMPONENTS

GENERIC COMPONENTS

Manufacture of specificallydesigned, low technology components

Manufacture of generic, low technology components

Low technology manufacturing and machining capability

Low technology manufacturing and machining capability

Research and development capability

Research and development capability

Figure 7.1 The aerospace fuel equipment supply chain: functional stages and key resources.

Asset specificity and limited competition 149 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

and the assemblers, all of whom purchase from suppliers at this stage of the chain, are able to source from a competitive market. Suppliers at this stage are not able to premium price on the basis of superior functionality. Competent procurement managers are able, therefore, to attain low prices for these inputs, although this is often by consolidating the relevant expenditure from the production of other equipment within their firms. Many buyers in this supply chain have adopted the standard purchasing practice of using a small number of ‘preferred suppliers’. This allows them to benefit from the competitiveness of the market, without risking the quality and delivery problems that could arise from spot market purchasing. Bespoke components This stage of the chain is the first that deals with processes that are productspecific. At this stage of the chain, firms manufacture the main components of the fuel equipment, for example fabrications and machined components, both designed to the specification of the equipment. Whilst these components are product-specific, they are still very low technology parts which are the outcome of manufacturing processes that are very easy to replicate. Therefore, whilst a new supplier would have to gear up to produce these specific parts, there is no shortage of firms that could undertake the task. The result is that these parts are also sourced from a very competitive market. Again, buyers usually run a number of preferred suppliers alongside each other in order to get the benefits of competition, whilst minimising the risk of product-defects and delays. Sub-assemblies It could be argued that this is the key stage of the supply chain, in that a number of suppliers at this stage dictate the way in which the chain operates. Many of the products manufactured at this stage are specialist high technology sub-assemblies that are crucial to the functionality of the end product. Valuable intellectual property is embedded within these products. This requires buyers to specify other sub-assemblies used in the fuel equipment in accordance with particular design features. In addition, a number of these sub-assemblies account for a significant proportion of the cost of the end product. The sub-assemblies produced at this stage of the chain differ in terms of the degree to which they represent specialist technology. This fact is important as it affects the complexity of the procurement task. In the case of two of the specialist sub-assemblies the buyer faces a highly concentrated supply market. For others, the nature of the product means that there is tendency for the buyer to develop high sunk and switching costs. It is therefore far more problematic for purchasers to source from many of the supply markets at this stage of the chain, than is the case in the

150 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

two supply markets discussed above. The supply market circumstances for each of the major sub-assemblies are discussed in turn below. Ram air turbine This is a highly specialised piece of equipment. The supply market has been affected in recent years by consolidation that has left buyers with very few firms from which to choose. Indeed, there is a clear market leader that provides a turbine with clear technological superiority when compared with those produced by competing suppliers. Unfortunately for those firms operating at the equipment assembly stage, the suppliers of this subassembly have a very low dependence on this particular supply chain for their overall revenue. As a result, assemblers of aerospace fuel equipment are perceived by these suppliers as ‘nuisance’ customers and have a very low ranking in their order of priorities. MA4 couplings The market for this sub-assembly is dominated by a single supplier. Furthermore, even if other suppliers were to be able to offer the specific type of couplings required, very high switching costs would accompany the conversion to these alternatives. Flow transmitter There is a number of firms offering this part. However, as with the MA4 Couplings, if the equipment assembler tried to change its supplier it would incur very high switching costs. Actuator There is a number of firms that provide this part, but once one type has been chosen it is designed into the equipment. This means that, once again, there are very high costs associated with switching suppliers. Fuel pump There is a competitive market for fuel pumps. Nevertheless, switching costs are still a problem in this case. Hose drum There is a competitive market for this sub-assembly. The equipment assembler can use this market to discipline suppliers, because the costs of switching to alternative suppliers are relatively low.

Asset specificity and limited competition 151 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Potentiometer As with the hose drum, there is a competitive market for this part. Switching costs are also relatively low. DC motor DC motors are a standard input into the end product. There is a competitive market for such motors and movement between suppliers is not particularly problematic. Gearings Gears are also a standard sub-assembly for which there is a competitive market and low switching costs. There is a range of supply market circumstances, therefore, at this stage of the chain. Buyers face a particular problem in terms of the supply market circumstances for air turbines. There is a concentrated market for this part and it represents about 15 per cent of the total revenue flowing through the entire supply chain. Other elements at this stage of the supply chain are also problematic, however, because re-sourcing would incur very high switching costs. High switching costs mean that the buyer is dealing with an effective ‘monopoly’, such is the difficulty for the buyer in accessing the other suppliers in the market. Equipment assembly and testing This stage of the chain consists of the main integrating task. At this stage, all of the sub-assemblies discussed in the previous section are brought together to make the finished product. This product is then tested. This is a key activity, because the end customer will not purchase a fuel system unless it has gone through a series of well-recognised and rigorous tests. The market at this stage of the chain is very limited. There are only three assemblers of this type of equipment anywhere in the world. This number has now effectively been reduced to two, however, because the market leader recently purchased its main competitor. Furthermore, the only remaining competitor is widely regarded as technologically inferior. It is therefore unlikely to sell its products outside its own national boundaries. The prospect of new competitors emerging in the near future is remote. First, the barriers to entry for potential new players are very high – significant start-up investments would have to be made – and, given the small size of the market, any attempt to enter would represent a high risk decision. Second, the existing players have considerable tacit knowledge that is of great value in product development and that would take new entrants

152 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

considerable time to build up. Third, given the nature of the product, buyers are very concerned about safety. These concerns mean that reputation is a significant business asset. Again, this is something that would take considerable time to establish. Finally, and linked to safety requirements, any new entrant would have to be given industry qualification before it could commence trading commercially. Although the few players in this market are relatively safe from new entrants, they are disciplined by the existence of substitutes. There are two main types of aerospace fuel equipment. These are ground-based and airborne. This case concerns the production of the latter type of equipment. Thus, although airborne re-fuelling is unquestionably the most appropriate method for certain types of military action, there is an obvious alternative. Indeed, most air forces have historically looked at the cost differential between these two methods and have decided that the more limited functionality of the ground-based alternative still represents the best value for money given their requirements. Despite their strong market position, therefore, firms at this stage of the chain are price-takers, because the functionality being offered is considered by many potential customers as something of a luxury. Indeed, the strategy of the fuel equipment assembler in this supply chain is to reduce the cost of the equipment in order to increase the attractiveness of the value proposition and thus increase demand. There is evidence of considerable elasticity of demand. At a certain price threshold it is predicted that demand would more than double. Final integration As in the case of the previous stage in the chain, there is a relatively limited number of players in this market. The difference between the two stages, however, is that the equipment assemblers are much more dependent on this supply chain than are the operators of mobile fuel tankers. The tanker operators are major manufacturing and assembly companies, for whom this is something of a sideline. However, this supply chain is a profitable sideline and, as a consequence, they are committed to operating in the chain. The commitment of these firms is underpinned, of course, by the commitment of individuals working within them. For these people the fact that the division dealing with the business of this supply chain is only a small part of the firm’s overall revenue is of little day-to-day relevance. As individuals, they are judged by the success of their division. Given their commitment to the chain, the tanker operators share the same challenge as the equipment assemblers – the need to reduce the cost of their superior functionality so as to increase demand. Indeed, apart from the occasions when the tanker operators and equipment assemblers compete to be awarded the prime contractor role in a particular contract, they cooperate, recognising their mutual interests.

Asset specificity and limited competition 153 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Mapping the value chain Having established the stages and structure of the physical supply chain, attention can now be turned to the flow of value running back through the chain from the end customer. There are two tasks to be completed. First, the share of total revenue appropriated at each stage of the chain needs to be ascertained. Second, the profit margins being earned by players at each stage of the chain also need to be documented. The information to do this accurately is not fully available. Firms obviously guard information about their product-specific profit margins very carefully, so what are presented in this section are estimates based on interview data. Revenue shares within the chain As with many manufacturing supply chains, the firms most identified with the chain, i.e. the sellers of the finished product, are predominantly assemblers rather than manufacturers. Eighty-five per cent of the cost of the fuel equipment is bought in by the assembler from the upstream supply chain stages. As will be discussed in the next section, this is an important fact, because many of the supply markets that the assembler is buying from are problematic. Either there are few suppliers, or, where there is competition in the market, there are high switching costs associated with abandoning an existing supplier. The revenue shares within the chain are shown in Table 7.1. As Table 7.1 reveals, 70 per cent of the revenues within the chain are accounted for in the sub-assembly stage of the chain. Yet it has already been noted that a number of the supply markets at this stage are problematic. Indeed, in the case of air turbines, the equipment assembler is in the supplier’s ‘nuisance’ category of customer. The standard marketing advice for such sales is to price high and risk losing the business. This situation is the most influential factor in the management of the chain. Table 7.1 The aerospace fuel equipment value chain Final integration

Assembly and testing

Subassemblies

Bespoke components

Generic components

Typical gross profit margin (ROCE) (%)

10–15

10–15

10–40

5–8

5–8

Typical distribution of revenue from mobile tanker operator (%)

–

15

70

12

3

Source: authors’ estimates based on interview data.

154 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

The distribution of margins within the chain In any business analysis, profit margins are always the most difficult pieces of data to ascertain. For obvious reasons, firms try to keep the profitability of individual products or services as ambiguous as possible to outside eyes. What follows, therefore, are estimates and deductions based upon firm behaviour. The figures are also estimates of market averages. Obviously, factors such as firm competence and output volumes will affect individual firm profitability. Generic component manufacture These firms are offering highly standardised commodities. There is little that they can do to differentiate their products or to build switching costs into the relationships with their customers. Under these circumstances, the main method of earning above average profits will be to develop a superior productive capability. Even this, however, is unlikely to take a manufacturer beyond the industry average profit margin of 5–8 per cent. Bespoke component manufacture Whilst being product-specific, the components produced at this stage of the supply chain are still commodities, easily copied and containing very little valuable intellectual property. Profit margins are again thought to be in the range 5–8 per cent. Sub-assembly manufacture The margins earned at this stage of the chain vary widely depending on the product in question. It is thought that, for certain products, where there is a concentrated market, margins could be as high as 40 per cent. Where there are high switching costs, margins are thought to be about 20 per cent. Where the buyer is in a strong position vis-à-vis the supplier, margins are more in the 10–15 per cent range. It is difficult to make an accurate judgement in the first two categories, however, as there is little cost and margin transparency. Fuel equipment assembly The margins at this stage of the chain are in the region of 10–15 per cent. This is reasonably well understood, because there is greater cost and margin transparency at this stage of the chain.

Asset specificity and limited competition 155 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Final integration As with the previous supply chain stage, there is a degree of transparency in respect of costs and margins. It is believed that the firms operating here are earning margins of 10–15 per cent. Value distribution and the dynamics of exchange The importance of the distribution of supply chain power in this case is tied up with the price sensitivity of the end-customer, or rather the potential endcustomer. Until the supply chain can deliver a product that is significantly cheaper than is currently the case, it will not be possible for final assemblers and sub-assemblers to increase revenues beyond the current relatively low level. This is because most potential customers consider the product a luxury. As a result, until the product is more affordable, customers will continue to rely on the functionality of their existing ground-based fuel equipment. Power comes into the equation because, in order to lower the cost of the product, certain key firms in the supply chain need to be persuaded to lower their costs and contribute to the shortening of cycle times. Unfortunately, these firms are amongst those that are least dependent on the success of the chain for the achievement of their overall business objectives. Appeals for their attention to the needs of the chain have, largely, fallen on deaf ears. This situation has serious implications for the ideas of the lean school (writers such as Hines (1994) and Womack and Jones (1996)), which are being championed in aerospace by the industry body SCRIA. Advocates of lean thinking, whilst they identify that supply chain power is restricting the achievements of the supply chain, do not always offer any credible ideas as to how these problems can be solved. Indeed, the existence and operation of SCRIA has done little to resolve the central problems in this supply chain, something repeated in other aerospace supply chains with similar properties. In this section, the dyadic exchange relationships within the value chain for aerospace fuel equipment are discussed. It will be shown how one set of dyadic relationships causes the central problem within the chain – that of high costs and cycle times – to be perpetuated. Before we can proceed with this discussion, however, it is necessary to provide a descriptive map of the exchange relationships that make up the value chain. In essence, there are eight major exchange relationships or dyads in this power regime, as shown in Figure 7.2. The distribution of value in the network depends on the power structure of the individual dyads and on the way in which they are linked together. The power structure of the individual dyads is represented using the methodology developed in Chapter 3. Thus, buyer power is indicated

156 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

by the symbol (>), supplier power by (<), buyer–supplier interdependence by (=), and buyer–supplier independence by (0). Based on the assumptions articulated in Chapter 3, certain actors in this power regime are deemed to be in a position to earn rents rather than profits. Those actors with a capacity to earn rents are represented by means of a shaded box, while those that are able to earn only normal profits appear in a clear box. A box that is both shaded and clear represents an actor that is able to earn rents, but only under certain circumstances. The first of these eight exchange dyads is that between the fuel tanker converter (A) and the equipment assembler (B). This relationship is represented in Figure 7.2 as (A = B), which means that these firms do business under conditions of interdependence. This is because there is a high level of supplier scarcity, a high level of buyer scarcity, and low search costs for the buyer. This dyad falls into Category 6 in the typology of dyadic power structures presented in Chapter 3. As was discussed earlier, the market for mobile fuel tankers is a very restricted one. There are only two major players in the market. The barriers to entry are very high, especially given the low volumes that currently characterise the market. There are also low buyer search costs. This is for two main reasons. First, tanker converters are very knowledgeable customers. Due to the nature of their operations, the buyers in these firms have a good understanding of the technology used in aerospace fuel equipment. Furthermore, these firms make regular visits to the marketplace, which means that they have a detailed understanding of the costs of this technology. Second, this knowledge through experience is accompanied by a requirement from the end customer (the defence departments of national governments) for a degree of transparency. In the UK, for B>D

A

A=B

B

B
C

C>D

D

D0E

E

C0E B0E

Figure 7.2 The power regime for aerospace fuel equipment. A – tanker converter, B – equipment assembler, C – sub-assembler, D – bespoke component manufacturer, E – generic component manufacturer.

Asset specificity and limited competition 157 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

example, Ministry of Defence auditors have the power to inspect the books of mobile tanker operators. The equipment assembler also possesses significant power resources. The assembler effectively operates in a monopoly supply market, now that it has acquired its only credible competitor. Consequently, the tanker converter has nowhere else to go for the assembler’s equipment. Moreover, the converter would not want the market leader to exit the market. Once these two sets of power resources are put together, we can see that this dyad is characterised by a condition of interdependence. This state of interdependence is recognised by both parties on a day-to-day basis. As the buyer does not want its only credible supplier to exit the market, the assembler is allowed to make a reasonable return on investments. There are two main aspects to this recognition. First, the tanker converter recognises the need for the assembler to satisfy its shareholders. Second, the converter recognises the need for the assembler to have sufficient funds to invest both in new technology and in developments that will reduce production costs. Moreover, the tanker converter knows that a close relationship with the equipment assembler will be mutually beneficial. The end customer is so price-sensitive that it is also in the interests of the converter to assist the assembler in reducing costs. The assembler also has a similar attitude. It is essential to the assembler that the two main tanker converters in the market continue to purchase its equipment. It is also essential to the assembler that the cost of the product is brought down, so that effective demand is increased. The fuel equipment assembly division represents a large part of the parent company’s overall turnover and it is one of the more profitable parts of the wider business. Success in this supply chain is of strategic importance, therefore, to the company at large. In recent years, following on logically from the coincidence of interest between the tanker converters and the fuel equipment assembler, there has been a number of joint initiatives aimed at reducing costs. These have focused both on the internal operations of the equipment assembler and on the interaction between the tanker converters and the assembler. Such initiatives have been fairly successful. The savings have been passed down the chain in order to reduce the total cost of the fuel equipment to the end customer, the armed forces. We turn next to the exchange relationships between the equipment assembler (B) and the manufacturers of the various sub-assemblies (C). The power structures between firms operating at these two stages of the supply chain need to be segmented because, as we discussed earlier, the sub-assembly stage is made up of a range of different products. In the case of the ram air turbine, MA4 coupling, flow transmitter, actuator and fuel pump, the sub-assembler’s relationship with the assembler is characterised by supplier dominance. This is shown in Figure 7.2 as (B < C). In the case of the hose drum, potentiometer, DC motor and

158 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

gearings, however, the sub-assembler’s relationship with the assembler is characterised by buyer–supplier independence. This is shown in Figure 7.2 as (B 0 C). The bases and implications of each of these power structures are discussed in turn below. As stated above, the equipment assembler has exchange relationships with the manufacturers of five sub-assemblies that are characterised by supplier dominance (Category 7 in our typology of exchange dyads). The dominant sub-assemblers are those supplying ram air turbines, MA4 couplings, flow transmitters, actuators and fuel pumps. Their dominance is based either on the fact that the assembler is buying from a highly restricted supply market or on the fact that the sub-assembly is characterised by a high degree of asset specificity. As far as these sub-assemblers are concerned, the trade provided by the assembler is of little significance, even to the divisions that are responsible for the production of the sub-assemblies. These suppliers form just a small part of very large multinational engineering and electronics companies. Moreover, the assembler has only limited information about many of the costs of production, and thus no clear understanding of the profit margins being earned by the sub-assemblers. As has been mentioned, asset specificity is the basis of the power resources available to a number of the sub-assemblers in this supply chain. This specificity arises for a number of reasons. First, much of the technology in aerospace fuel equipment is systemic. This means that the presence of a certain type of part within the equipment has implications for the other parts with which it interacts. If the assembler were to switch the supply of such a proprietary piece of technology, the specification of the other sub-assemblies and components around it would also need to be changed. Indeed, there might even be compatibility issues. Second, if the assembler wanted to buy a particular sub-assembly from a new supplier, then that supplier would first need to be approved to industry standards. This again adds to the costs of switching. Finally, the assembler is faced by the problem of high switching costs as a proportion of overall revenue, even when such costs are not high in absolute terms. Given that production volumes are so low, any sort of switching cost can seem very high in proportional terms. Switching is therefore hard to justify unless there is a complete breakdown in supply. Given the relative sustainability of their dominance over the equipment assembler, it is clear that these sub-assemblers are highly influential in shaping the conduct of the supply chain as a whole. As has been stated already, the effective demand for airborne re-fuelling equipment is relatively low and potential customers are very price-sensitive. The equipment undoubtedly provides a high level of re-fuelling functionality. At the current price level, however, this functionality does not generate a substantial effective demand. The majority of armed forces are satisfied with the lesser functionality provided by much cheaper ground-based

Asset specificity and limited competition 159 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

re-fuelling systems. The equipment assembler and the tanker operators have cooperated to improve the processes at their stages of the supply chain, in the hope of reducing production costs and generating a greater demand. There is a limit, however, to the impact that these firms can have on the total cost of the equipment. It is the sub-assembly stage of the supply chain that really holds the key to successful cost reduction, because it accounts for 70 per cent of the revenue flowing through the chain. As we have seen, however, the tanker operators and the equipment assembler are in a ‘catch 22’ situation with these key suppliers. At present, the demand of the chain for sub-assemblies is relatively low and very irregular. Consequently, the equipment assembler is considered by the subassembly manufacturers to be a ‘nuisance’ customer. The standard advice given by the marketing literature to firms with such customers is that they should be given a low priority, even at the risk of losing their business. This advice is, in many ways, reflected in the conduct of these suppliers. A senior manager from the equipment assembler reported that they are hard to negotiate with, that they show little interest in becoming involved in supply chain initiatives, and that, in some cases, they insist on having very long lead times. These lead times are often four or five times as long as those for which the assembler has been asking. Clearly then, the actions of these key sub-assemblers are preventing the equipment assembler and the tanker converters from achieving significant price reductions and improvements in delivery performance. If these actors could deliver an enhanced value proposition to the end customer, there is evidence to suggest that the demand for airborne re-fuelling equipment would increase. Given such an increase in effective demand, those subassemblers that are disinterested in the supply chain at present might begin to see it as an area of business that is worthy of greater attention. Thus far, however, the assembler and tanker operators have not been able to overcome this commercial contradiction. We turn next to the exchange relationships between the equipment assembler and those sub-assemblers that manufacture hose drums, potentiometers, DC motors and gearings. These exchange dyads, shown in Figure 7.2 as (B 0 C), are characterised by buyer–supplier independence. This places them in Category 1 in our typology of exchange dyads. We have located these relationships in this category, because they are characterised by a very low level of both buyer and supplier scarcity, low search costs on the part of the buyer, and low asset specificity. Consequently, the buyer’s switching costs are also relatively low, which means that the supplier is forced to pass value to the buyer simply to retain his business. Given these circumstances, the equipment assembler is generally able to get a good deal from suppliers of these sub-assemblies. The likelihood of a supplier acting opportunistically to improve its profit margin on a particular contract is extremely small, because the buyer can easily and cheaply detect and punish such behaviour.

160 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

The next set of exchange relationships in this regime are those involving the equipment assembler (B), the sub-assembler (C) and the bespoke component manufacturer (D). The bespoke components that go into airborne re-fuelling equipment account for about 12 per cent of the revenue that flows through the supply chain. Therefore, despite the simplicity of these components, they still account for an important proportion of the total cost of the fuel equipment. Nonetheless, in both of these exchange dyads, shown in Figure 7.2 as (B > D) and (C > D), the bespoke component manufacturer is a dependent party. Putting this another way, both of these exchange relationships are characterised by buyer dominance (Category 2 in our typology of dyadic power structures). This dominance is primarily due to the fact that bespoke component manufacturers tend to operate as preferred suppliers. By targeting their expenditure on a relatively small number of suppliers, the assembler and sub-assemblers increase the importance of their business in the eyes of a particular component manufacturer. The assembler and subassemblers also have good information on the costs of production of the various component manufacturers. Consequently, they are able to force down profit margins at this stage in the supply chain. This high level of information comes partly through the frequency with which the buyers visit the marketplace, and is partly a function of the inherent lack of complexity of many of these components. In short, the buyer’s costs of search are relatively low. As far as the component manufacturers are concerned, being chosen as a preferred supplier is a highly sought after status. These suppliers are operating in highly competitive markets, offering products that, while bespoke, are extremely difficult to differentiate. These are simple, low technology components that are easily imitated. In the normal course of events, suppliers of such components would have to market quite aggressively simply to retain a buyer’s business. Having regular demand from a large buyer will give the firm a degree of security and reduce its marketing costs. Therefore, whilst these suppliers are dependent and are making only modest margins, they will not necessarily be unhappy with their lot. The possession of regular, albeit low margin, business will often exceed their expectations. The final set of exchange relationships in this network consists of those that exist between the generic component manufacturer (E) and three of the other actors within the supply chain. These are the assembler (B), the sub-assembler (C) and the bespoke component manufacturer (D). As Figure 7.2 shows, each of these three dyads is characterised by buyer–supplier independence or commoditised exchange (Category 1 in our typology). The components produced by manufacturers represented at point E in the supply chain are, by their very nature, relatively standardised between different suppliers. Examples would include nuts, bolts, washers and screws. These components are the result of well-understood, and therefore easily

Asset specificity and limited competition 161 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

replicated, production processes. They are bought and sold either in spot markets, with numerous potential buyers and suppliers, or under longerterm contracts designed to hedge against spot price fluctuations. As with all commodity-based exchange relationships, the buyer’s search and switching costs are relatively low. Consequently, the generic component manufacturer is forced to pass value to each of these three other actors by, at the very least, matching the lowest price in the market. This means that the gross profit margin earned by the generic component manufacturer tends to be relatively low. Margins are typically between 5 and 8 per cent, with the upper end of this range being achieved by virtue of operational efficiency improvements.

Conclusions In the preceding section, the power structures of each of the dyadic relationships within the aerospace fuel equipment supply chain were analysed. It was stated that the key exchange relationships in this supply chain are those that exist between the equipment assembler and certain sub-assemblers. In this final section, these insights will be discussed in the context of the supply chain as a whole. The purpose of this discussion is to explain how and why value is appropriated at certain points within the chain. Starting at the upstream end of the chain, we have seen that the component manufacturers, both bespoke (D) and generic (E), have no power over any of the other firms in the supply chain, regardless of their position. The bespoke manufacturers operate under conditions of buyer dominance, while the generic manufacturers are forced to pass value to the buyer under conditions of commoditised exchange. Value flows, therefore, from the component manufacturers to both the equipment assembler (B) and the sub-assemblers (C). As we noted earlier in the chapter, the sub-assembly stage of the supply chain (C) presents two distinctive sets of exchange relationships with the equipment assembler (B). In some cases, the assembler and sub-assembler relate to one another on the basis of buyer–supplier independence. Under these circumstances, value passes through the chain towards the downstream end with reasonable efficiency. There is a number of sub-assemblers, however, who have a power advantage over both the assembler and the component manufacturers. Consequently, much of the value that is generated by the chain is appropriated by these sub-assemblers. The behaviour of these firms, as we have argued throughout the chapter, is a problem for the supply chain as a whole. Their unwillingness to contribute to a joint cost reduction programme, involving the equipment assembler and the tanker converters, has prevented a major increase in the effective demand for airborne re-fuelling equipment. This is a particular problem, however, for the equipment assembler, because

162 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

it is highly dependent on this supply chain for the achievement of its business objectives. The final relationship in this exchange network is that between the tanker converter (A) and the equipment assembler (B). This exchange dyad, as we have seen, is characterised by buyer–supplier interdependence. This power structure means, of course, that these firms must share the problem of trying to change the behaviour of the dominant sub-assemblers at point C in the supply chain. We can see, therefore, that the power structure embedded within this supply chain is preventing most of the actors within the chain from increasing their revenues. The problem is that the effective demand for airborne re-fuelling equipment will only be increased if the price of the end product is significantly reduced. Until this increase in demand is brought about, however, the problematic set of firms for the chain, those at point C, will not undertake the actions that will make a lower price possible. The main objective of each of the cases reported in this volume is to provide evidence to test the proposition that the conduct of the firms within a supply chain is determined by the power structures embedded within the chain. We contend that the evidence in this case is consistent with this proposition. Indeed, the equipment assembler in this supply chain is continually trying to find ways to overcome the commercial contradictions generated by the power structures that we have highlighted. This chapter also had an additional objective, which was to challenge the contentions of the lean school of thinking. The relevance of lean thinking to this case is that the aerospace fuel equipment supply chain is operating against the background of an industry-wide lean initiative called SCRIA. The basic message of SCRIA was that firms in the aerospace industry should collaborate with one another, because no company could improve its performance independently of its supply chain. The chapter has provided substantial evidence to challenge this contention. A number of the sub-assemblers at point C in the supply chain have little or no dependence on the chain for the achievement of their business objectives. Consequently, they can operate without too much regard to the aims and needs of other supply chain actors or, indeed, the supply chain as a whole. The problem is that these firms account for a significant proportion of the revenue flowing through the chain. Several initiatives have been introduced by the equipment assembler, in conjunction with the tanker converters, to try to overcome the commercial contradictions created by the behaviour and attitudes of these firms. Not surprisingly, given the supply chain power structures that we have identified, none of these initiatives has yet had any significant impact.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

8

Information asymmetry and ex post lock-in to branded and regulated asset specificity The sources of asset criticality in the motor insurance supply chain

The supply and value chain for motor insurance provides an interesting case example of two very distinct sub-regimes within one power regime. The motor insurance supply chain is divided into a downstream sub-regime of power in which, in recent times, the customer has started to receive a more substantial share of value than had been the case in the past. In the upstream sub-regime, however, value is largely appropriated by the manufacturers providing proprietary parts for the car repair industry. Recently, some of the major insurance companies have attempted to control the flow of value between themselves and their car repairers. Despite these attempts, it is unlikely that any insurance company will be able to turn its improved leverage of its car repairers into a critical asset either upstream or downstream. This is because of the continued dominance of the proprietary parts manufacturers over the ultimate costs of repairs in the upstream sub-regime.

An introduction to the role of motor insurance in the insurance industry There is a number of reasons why the UK’s insurance supply chain is worthy of in-depth analysis. First, the supply chain has a substantial economic significance, with a far wider commercial impact than its own profit and loss performance. The industry supports economic activity in general by providing a basis by which companies can take risks with uncertainty. The insurance industry arose historically to serve Britain’s mercantile interests. Trade meant going to sea, going to sea entailed risk, and risk had to be managed. It is not surprising, therefore, that an industry grew up to reduce the hazards of conducting business across wide stretches of water. It is also not surprising that the activity caught on, spreading first to other areas of commercial activity, and thereafter into domestic households. Today, the UK has the fourth largest insurance industry in the world. The significance of the UK’s insurance industry is not confined, however, to the fact that it gives people the confidence to undertake business exchange.

164 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Insurance companies also own a large slice of the British economy. Almost half of the personal financial wealth in Britain is held in life insurance policies and pension schemes. This money is channelled, in turn, into the UK’s publicly quoted companies. In 1997, insurance companies held nearly a quarter of the equity in companies trading on the UK stock market (Key Note 1997; ABI 1998). Given the significance of the insurance sector in the UK, it is perhaps surprising that comparatively little is known about its exchange dynamics. There is a substantial literature on the subject of risk assessment. There is work, too, on the impact of the insurance sector on UK investment. Very little, however, has been written about the nature of the supply chains operating in the UK insurance industry. Rectifying this gap in the literature is by no means an easy matter. No other industry affects so many firms and individuals. Even undertaking to describe it is something of a Herculean endeavour. Simplification helps, but only a little. At the highest level of aggregation the industry can be segmented along the lines of general and long-term insurance. The distinction between the two markets is primarily temporal. Long-term insurance represents the transfer of risk for an unspecified period of time. The category includes life and critical illness cover, as well as pensions. General policies, by contrast, relate to non-investment, fixed-term risks. Motor, property, professional indemnity and private medical cover all fall within this category. The problem for the analyst of the insurance industry is that each one of these discrete insurance activities, which provide examples of risk transfer, represents a distinct supply and value chain in its own right. Furthermore, each one of these supply and value chains possesses its own individual commercial exchange dynamics. When seen in this light, the simplification of a categorisation based on general versus long-term insurance is revealed to be an oversimplification. The way out of the problem is not to cover the whole sector, but to confine the enquiry to just one or two examples. In this chapter we examine the dynamics of exchange in the motor insurance supply chain. In relation to this specific supply and value chain the insurer appears to be engaged in a Faustian pact with the policyholder, albeit a conditional one. Ex ante, in order to win the policyholder’s business, the insurer must promise to pay out on their client’s loss should the need arise. The use here of the word ‘should’ is critical, because it is the reason that the pact is merely a conditional one. If the policyholder experiences no loss, then the insurance company retains their money. Furthermore, up until the moment that the insurance company has to make a payment it enjoys some leverage over its customer. The exchange between buyer and seller in this instance is characterised by information asymmetry, which was greater in the past than perhaps it is now. However, the limits to information asymmetry are defined by the

Information asymmetry and ex post lock-in 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

165

boundaries to the customer’s ignorance. Once the policyholder files a claim then they expect the insurer to make good the loss to the highest level of quality possible, and from their point of view, irrespective of cost. In the area of motor insurance this involves the insurer in a series of exchange relationships that have tended to operate to the advantage of the suppliers of repair services and, in particular, to the manufacturers of proprietary replacement parts. Obtaining value for money in this context has proved difficult for the insurance companies.

Mapping the motor insurance supply chain In effect, any insurance supply chain is made up of two discrete but interrelated sub-chains of functional activities. The first sub-chain, operating downstream of the insurer, involves the activity of risk transfer. This involves the end customer as policy-holder, the insurance company and sometimes a broker who acts as an intermediary between the end customer and the large number of insurance companies offering to manage the policyholder’s risk. The first sub-chain also includes the investment element of the insurer’s activities (but we are not, however, directly concerned with these activities in this chapter). The risk transfer relationship with the policyholder allows the insurance company to channel funds into its own dedicated investment activities. The insurance company then manages its investment portfolio either directly, or indirectly through independent asset management companies. It is here that the insurance company is able to generate most of its real income. These returns can be high if investment is handled wisely, but even if investment returns are high insurance companies can perform badly. This will normally occur if, in order to win customers, the insurance company under-prices its policy premiums relative to the risks that are being borne. If this occurs, then the premiums being paid by policyholders may be insufficient to cover the costs of making good on claims. In such circumstances insurance companies can fail, even if they invest their assets wisely. This explains why focusing on actuarial risks when setting premium rates is always important to insurance companies. It also explains why it is that – in recent years – there has been a far greater focus by the insurance companies on cost reduction in the upstream (or claims) supply and value chain. Given a sound investment policy and well judged premium rates, the only way in which additional returns can be made by insurance companies is through reducing the costs of operations internally within their business or with their extended networks of suppliers in the claims supply and value chains. For this reason it is imperative to describe and analyse the second subchain of functional activity in the insurance business that involves the payment of claims. Historically, this sub-chain was little different from the activity that occurred in downstream risk transfer. This was because, when

166 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

a policyholder made a claim, the insurance company met their expectation through a payment in cash. In an effort to save money, however, insurance companies have intervened directly into the process of making good on a loss. They have begun to offer replacement goods and services rather than simply providing cash. This has led to an exponential increase in the numbers of exchange relationships that insurance companies have to manage. They continue to have to manage the policyholder as claimant, but they now also seek to manage a whole range of suppliers and distributors of goods and services. More recently, there has been a movement to become involved in developing close working relationships, not only with first-tier suppliers but also with the extended network of suppliers within the whole supply and value chain. Today, insurance companies are major customers to manufacturers of white and brown goods, to the building trade, and to providers of healthcare services and automotive products. The key functional stages in the motor insurance supply chain are described in Figure 8.1. Each of these stages is discussed in terms of the primary activities carried out at a particular stage, the resources needed to support these activities and the major firms operating at that stage. We begin with the focal stage of the supply chain, insurance and reinsurance. Insurance and re-insurance The essence of an insurance company’s activities is to transfer risk by promising to cover a client’s losses, in cash or replacement goods, should the need arise. In return, the client or end customer pays a fee known as an insurance premium. Insurance companies develop products (policies), invest the premiums received from end customers and select the distribution channels through which policies will be sold. In 1998 there were 832 authorised insurance companies in the UK. Of these, nearly 600 were involved in the sale of general insurance. The remainder consisted of those companies offering purely long-term insurance products, those offering a mix of long-term and general insurance products, and a small number of highly specialised providers operating out of Lloyds of London (ABI 1998). Although the focus of this chapter is on the supply chain for one particular type of general insurance (i.e. motor insurance), it is worth dwelling briefly on long-term insurance because it provides an interesting contrast. Long-term insurance companies are big. Taken together, the annual combined net income from premiums of the top five companies is around £24.5 billion. The top twenty companies have a net income from premiums of nearly £60 billion. Taken on their own, the income from premiums of the three largest companies is £7,356 million for the Prudential Group, £5,978 million for Barclays Life Insurance and £4,057 million for Standard Life. Not only is the industry an industry of commercial giants, it is also a highly concentrated one. The top five companies have a combined market

Information asymmetry and ex post lock-in 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Intermediation and distribution

Risk transfer and management

Insurance is an experience good that, in common with many experience goods, has a high propensity towards adverse selection (during selling) and moral hazard (at the claims stage). Historically, this is how many intermediaries made their money – a position that was bolstered by the perception on the part of customers that there were high costs of switch associated with changing brokers

The increased commoditisation of motor insurance has depressed prices in the industry. Sales and sales volume are, therefore, now essential to business survival

More recently, aggressive (and in some instances direct) marketing on the part of the insurers has eroded the information asymmetries surrounding its purchase. Motor insurance has become a commodity and margins have fallen. These days intermediaries sustain profits through sales volume which means that economies of scale are key to business success

On the supply side the key determinants of success are actuarial skill (i.e. assessing the riskiness of particular clients) and claims management. In the area of claims management the essential capability is the ability to engineer greater flexibility on the part of policy holders as to the types/levels of replacement goods and services that they are prepared to accept

Repair services Success in these markets is contingent upon two factors: (a) Information asymmetry and moral hazard – especially the costs associated with monitoring and measuring the performance of service providers (b) The frequent creation of local monopoly status for garages due to policyholders’ preference to have repairs undertaken at the locations most convenient to them. This can be reinforced by the tendency towards high levels of asset specificity in the case of some repair services. On occasion this truncates insurance companies’ sourcing options further

167

Replacement components The supply of aftermarket motor components exhibits high levels of asset specificity. Parts are frequently non-fungible in that the use of particular components is confined to the model for which they were designed. When this is combined with OEM IPR protection, this confers on the supplier the status of a monopoly. Asset specificity and IPR protection are, therefore, key determinants of success in these markets

Figure 8.1 The motor insurance supply chain: functional stages and key resources.

share of 34 per cent, the top ten 53 per cent and the top twenty 81 per cent. (All figures were obtained from http://www.abi.org.uk) The final element that distinguishes the market is its performance. In recent years, boosted by the arrival of stakeholder pensions, the sector has experienced rapid growth. It is a highly profitable sector that is helped by the fact that it is less risky to insure against death than against auto theft, or indeed many other areas of general insurance. This facilitates planning and allows

168 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Table 8.1 Market share in UK general insurance Rank

Insurance company

Net premium income (£m)

Market share (%)

1 2 3 4 5 6 7 8 9 10

Royal Sun Alliance CGU Norwich Union Group AXA Group ZFS Group Cornhill Group Direct Line BUPA NFU Group Consolidated Financial Group TOP 20 TOP 10 TOP 5

3,279 2,846 2,224 2,222 1,922 835 607 480 457 444 18,296 15,315 12,493

10.1 8.8 6.8 6.8 5.9 2.6 1.9 1.5 1.4 1.4 56.3 47.1 38.4

income to be targeted towards the longer term, more profitable investment opportunities. Compared to the long-term insurance companies, the general insurance firms, while still substantial, are somewhat smaller. As can be seen in Table 8.1, Royal Sun Alliance has an annual net income from premiums that is less than half that of the Prudential. The combined total for the five largest firms is only £12,493 million, again less than half the total for their counterparts in long-term insurance. The gap is even more pronounced when the survey is expanded to take in other companies. The annual net income figure for the top twenty general insurance companies is £18,296 million, which is less than a third of that for long-term insurance companies. Comparisons of the market concentration figures also reveal long-term insurance to have the edge, although it is important not to exaggerate this point. When the sector is broken down, certain segments of the general insurance market reveal themselves to be every bit as concentrated as the long-term insurance market. Healthcare is a case in point. Between them BUPA and PPP Healthcare account for over 70 per cent of the private medical insurance market. More interesting than the crude market structures of the general insurance sector, however, is its competitive performance in recent years. The industry was recently described as being in dire straits (Economist 1999). Growth in this part of the industry is stagnant and in some areas the income from premiums is actually falling. In order to maintain profitability, firms face one of two options: increase market share or control costs. Tighter cost control can be achieved through improved actuarial competence or by improving claims management. Improved sales can be achieved organically or through consolidation. The trend towards market

Information asymmetry and ex post lock-in 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

169

concentration has already been described. Organic growth has taken the form of ‘conquest selling’ or ‘stealing’ customers away from competitors. Historically, once a customer took out a policy with an insurance company they tended to stay with that company. Intensive advertising on the part of the insurers, however, is causing a shift in this pattern of consumption. In many cases general insurance risk transfer is becoming a commodity business, which is driving down prices. Again, it is important not to overgeneralise. As with the question of concentration, health insurance does not conform to the overall pattern and it is still a long way from being considered a commodity by policyholders. The other set of actors at this point in the supply chain comprises the re-insurers. Re-insurance is effectively the activity of insuring the insurers. Although re-insurance occurs in most parts of the industry, it plays a crucial role in the insurance of large specific risks such as natural disasters. Re-insurance is organized on a global basis and, although London may represent one of the major trading centres for this service, the last UK-owned re-insurer, Mercantile & General, was sold by the Prudential to Swiss Re in 1996. Again, as with so many other parts of the industry, falling premiums are driving the industry to consolidate. Perhaps the most notable of the recent takeovers was Berkshire Hatherway’s 1998 acquisition of General Re for $22 billion. Today, the top ten re-insurers control 60 per cent of the global market. Consolidation has done little to reduce competition, however. There is still substantial overcapacity in the market, while consolidation downstream has led to the emergence of a number of powerful customers who negotiate aggressively on the cost of their premiums (Key Note 1997; ABI 1998). Intermediation and distribution Commentators have traditionally quipped that insurance is ‘sold, not bought’ and selling clearly plays a crucial role in determining the success of any product. There is a variety of different channels through which insurance companies might distribute their products. They might sell them directly to their policyholders or indirectly through intermediaries like brokers, tied agents, independent financial advisers (IFAs) or consultants. In the past, most insurance companies used intermediaries – attempts by most companies to sell directly have, until recently, met with limited success (Channon 1993). Intermediaries were historically the most effective route to customer business because few insurance companies could afford the costs of creating national in-house sales networks, based on physical locations around the country. As a result the insurance companies tended to work closely with intermediaries – and by preference with consortia of intermediaries – as a way of offering their products to as wide a base of customers as possible.

170 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Intermediaries naturally differ in respect to their size (large corporate or small independent high street), the type of policies they sell (general or long term), their customers (corporate or domestic), and the degree of independence from the insurer (‘honest broker’ or agent). The last categorisation is significant, because there are those who suggest that the dichotomy is a false one and that no intermediary is truly independent. Even where there are no formal linkages between insurer and intermediary, it might be argued that an intermediary always has an incentive to push the policy that is most profitable for itself rather than the one that is most suitable for the customer. Financial intermediation arose in the first instance as a mechanism by which a policyholder might reduce their costs of search. These costs arose as a result of the range of companies offering products and because of the diversity of their product offerings. These offerings needed interpretation if meaningful comparisons were to be made and, given that this was regarded as a technical job, it made sense for an independent agent to undertake the task. In the past, brokering was a highly profitable activity. At the beginning of the 1990s, for example, gross profit margins of 15–20 per cent were not untypical, while anecdotal evidence suggests that some firms were able to earn considerably more than this (BRP 1992). The key resources at the intermediary’s disposal were information asymmetry (the policyholder’s relative ignorance of the marketplace) and customer perceptions of the costs and risks of switching to an alternative insurer. More recently, however, many areas of the intermediation business have been challenged. This challenge comes from a number of sources. First, on the supply side, the fact that insurers have begun to market their products aggressively has transformed them into commodities and is removing the need for intermediaries altogether. The emergence of the Internet is only serving to reinforce this trend. Second, on the demand side, some of the insurers’ corporate customers are finding alternative mechanisms to manage their risk transfer needs. Rather than going through the traditional chain, they are opting to self-insure by creating ‘captive’ insurance subsidiaries. This is eating into the core business not just of the insurance companies, but of the intermediaries as well. Finally, the traditional intermediary networks are facing the threat of new competition as banks and building societies extend their own activities into intermediation – the so-called trend towards bancassurance. The high street banks and building societies have always had excellent distribution networks of their own. For this reason it has made sense for insurance companies to take them on as agents as a way out of their own commercial difficulties. This development has not come without a price, however. First, the insurance companies have had to cede some of their marketing independence to these (in some cases) very powerful players. More importantly, however, there is the risk that, once the banks have established themselves in the marketplace, they will find it convenient to

Information asymmetry and ex post lock-in 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

171

dispense with their suppliers, leaving the insurance companies without a distribution capability. In the meantime these deals are eroding the market shares of the incumbent intermediaries. Finally, intermediaries have had to face the threat of direct selling by insurance companies. The trend for direct selling began in 1985 when Direct Line was founded to sell motor insurance. For Direct Line, bypassing the traditional distribution chain offered the insurer access to the high margins traditionally enjoyed by the brokers. They could charge less than the other insurance companies and still make more money. The success of the new model encouraged competitive imitation. Churchill soon followed suit and by the early 1990s nearly a third of all insurance was sold in this way. Ian Chippendale (Direct Line’s CEO) has predicted that by 2003 the figure will rise to 70 per cent with a further 15 per cent being sold via the Internet. Few of Direct Line’s imitators have enjoyed its success, however. Imitation has simply pushed down prices and thus has reduced the dividends obtainable from this form of distribution. Not surprisingly, therefore, the trend towards consolidation that has marked the rest of the industry has also occurred here. A high volume of sales is a key success factor in an activity like intermediation, because it offers the intermediary some leverage over its suppliers. The market for international-brokering services has become so concentrated that just four players now account for 80 per cent of the market. At the level of the high street broker, network formation has gone hand in hand with this consolidation. The creation of networks offers the prospects of consolidation without the need for vertical integration. These brokerage networks enjoy close relationships with solicitors and accountants who refer clients to them. Upstream, these networks are involved in consortia buying. There are currently around twenty networks in the UK. The largest of these, DBS, has a membership of approximately 1,600. End customer The end customer energises the supply chain and ultimately creates the value that flows throughout. The customer’s requirement is for risk transfer. The law requires the consumer to undertake some risk transfer. Motor insurance, for example, falls into this category, although there are some voluntary elements to motor insurance. Other forms of risk transfer may be a precondition underpinning other commercial transactions. Banks and building societies require their customers to take out life insurance before they will provide them with a mortgage to buy a house. Most insurance, however, is undertaken on a purely voluntary basis to provide the customer with peace of mind. Consumers may take the form of a private individual or a corporate buyer insuring their company (e.g. for professional indemnity), its property (against damage or loss) or its employees (providing them with pensions or medical cover).

172 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Historically, the demand for risk transfer has been characterised by relatively low levels of consumer competence (ex ante at least). Insurance is an intangible, experience service. Comparisons between what is being offered by different companies are often made difficult by the technicality of the different product offerings and the lack of commensurability between them. The value of what is being offered may only become obvious ex post, when the policyholder makes their claim. It is at this point that the consumer can make a comparison between what they want and what is being offered. In one recent survey it was found that 75 per cent of people had been sold insurance that they did not need or that was not right for them (Key Note 1997). There is also a popular perception that insurance companies are guilty of moral hazard. This does not mean that an end customer has bought badly, but that the insurance company behaves badly once a claim is filed. Whether moral hazard actually occurs, or whether it is adverse selection on the part of the policyholder, the industry is coming under increasing regulation. This is a process that has been fuelled by the mis-selling of private pensions in the long-term market. Individuals were encouraged to opt out of their existing arrangements only to sign up to deals that cost more and provided less. In addition to the regulation of insurance markets, the greater commoditisation of certain segments is also working to reduce the informational disparities between the insurance companies and their intermediaries on the one hand, and their customers on the other. Supply of replacement parts and repair services The architectures of supply in the UK’s insurance claims markets are as heterogeneous as the replacement products and services supplied by the insurance companies. For this reason it is not possible to consider the dynamics of all of them. Rather, in the remainder of this descriptive section we shall confine ourselves to a discussion of the claims market for automotive goods and services. Running parallel to the supply and value chain for new cars (described in Chapter 9) there is a second chain dedicated to the after-market. Although both chains share many of the same actors, their exchange dynamics are radically different. Like the chain for new cars, the chain for spare parts begins with the component suppliers, sub-assemblers and, in some cases, the assemblers themselves. Collectively, these firms provide the replacement parts when a car needs to be repaired. After the production stage the spares pass to a range of specialist distributors (known in the industry as motor factors), from where they are passed on to the garage that effects the repair for the end customer (the policyholder who owns the vehicle). The market for automotive spares is not an easy one from which to source. The difficulty arises in part as a result of the high levels of asset

Information asymmetry and ex post lock-in 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

173

specificity embedded in the technologies being replaced. Prior to buying a new or a used vehicle the end customer enjoys a wide range of options. There are around fifty different marques on sale in the UK and, subject to income constraints, the end customer is free to buy from any manufacturer. Each vehicle makes use of very different technologies, however. This is true notwithstanding attempts by the assemblers to reduce their costs by standardising some production features across the range of their models. As a result of this component heterogeneity, there are substantial compatibility problems between different makes of car and even between different models of the same make. If the suspension system on a Ford Escort breaks down, replacing it with the suspension system of a RollsRoyce Silver Shadow is not a realistic proposition. The issue of the compatibility of spare parts would not be so critical were it not for a series of additional factors. The European Union’s block exemption rules formally permit the replacement of OEM (original equipment manufacturer) components with generic substitutes. However, the scope for the development of generic substitutes in the components markets has been limited by the fact that many of the technologies in question are proprietary, the IPR (intellectual property rights) for them resting with the assembler/sub-assembler/components supplier that developed the technology in the first instance. Even where a patent does not exist, the growing technological sophistication of a number of the sub-assemblies makes competitive imitation an unlikely prospect. In many instances, therefore, the ex post market for replacement parts is monopolistic. High levels of asset specificity constitute only part of the problem, however. The other rigidity in the marketplace rests in the characteristics of demand. Downstream of the parts manufacturers there is a specifier– customer split. The specifier in this case is the policyholder, while the customer is the insurance company. Once the policyholder has paid the premium, any repair work undertaken on the vehicle represents a free good. This makes the policyholder insensitive to the cost of repair. The policyholder is not, however, insensitive to the quality of the repair work undertaken. In most instances, like-for-like replacement is expected. This means fitting OEM parts, not the cheaper generic substitutes. For the insurance company this in effect means another monopoly sourcing situation. Of course, the insurance company might insist on having the cheaper parts fitted to the vehicle. However, given that the insurers themselves have helped to make motor insurance a commodity business with low costs of switching, this type of behaviour is likely to mean losing the policyholder to a competitor. There are some limits to the policyholder’s capacity to impose this straitjacket. This lies in the limits on the capacity to police the repair work done to the vehicle. Although many automotive parts are branded, where they are not marked in this way and where a market for generic substitution exists, the insurer has some flexibility with respect to their sourcing options.

174 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Car spares make their way to the repair shop via a set of specialist distributors. There are many motor factors operating in the UK and, although some larger groups exist (e.g. Partco, Finelist and Camberley Auto Factors), these are the exceptions. Similarly, while several large repair centres also exist, there is still an extensive tail of small independent operators. The larger groups tend to fall into certain recognisable categories. First, there are the repair-multiples like Kwik-Fit or Halfords. These specialise in offering a fast turnaround service on a limited range of simple repairs. Second, there are the franchise dealerships that offer a comprehensive repair capability, but usually for the vehicle makes for which they hold a franchise. These centres frequently handle those repairs that require technologically sophisticated diagnostic and repair competencies. Finally, there are the small independent garages. The market share of this final group is shrinking as the level of technological sophistication and specificity in the industry increases. They lack the competencies of their larger counterparts. Despite the obvious fragmentation of the marketplace, it is not as highly contested as it might be. There are two main reasons for this relative lack of contestation. First, there are the specialist skill sets of certain garages. Second, there is the problem described earlier of the specifier–customer split. Policyholders are not simply looking for OEM replacement parts for their vehicles, they are also looking for convenience when it comes to servicing. There is considerable heterogeneity with respect to the cost structures and pricing strategies of different repair shops. In an ideal world the insurance company would streamline its demand to channel it through those centres that offered it the best deals, and some insurance companies have been working to achieve this goal. There is, however, a basic tension between what is cost efficient for the insurer and what is convenient for the (price-insensitive) policyholder. This creates a considerable tension for the cost-optimising insurance company which has to be overcome.

Mapping the value chain for motor insurance We turn next to the value chain that corresponds to the supply chain described above. One of the major challenges of supply and value chain mapping is the acquisition of meaningful data on profit margins. As we have already noted at length, insurance companies are multi-product businesses. In addition to the numerous supply chains in which they are involved as part of their risk transfer activities, insurers also have extensive investment activities. Returns in the industry are likely to vary considerably from firm to firm, depending on their area of specialisation and on the success of their activities. Disentangling the profitability of particular lines of business based upon the publicly available data is all but impossible. That said, some lines of business are clearly less profitable than others. Unless the insurance company markets directly to its customers,

Information asymmetry and ex post lock-in 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

175

returns on motor insurance can be at or near zero. By contrast, health insurance can be very profitable. Gross margins of 15 per cent are not uncommon. Market volatility is also an important factor in the heterogeneity of profits. The actuarial competence of insurance companies is highly developed. Nonetheless, some markets are still not entirely predictable. For example, the hurricanes of 1987 and 1988 caught many UK insurers by surprise. The insurance companies were forced to make far higher claims payments for household damage than is usually the case. This affected their profitability for the years concerned. Similar challenges with regard to the measurement of margins occur at other points in the value chain. It is widely recognised that the aftermarket is far more profitable for suppliers of car components than is the supply of components for new vehicles. To what extent this is the case is, however, hard to gauge. Consequently, the figures provided in Table 8.2 are no more than illustrative estimates based on interview data. As can be seen, however, it is the manufacturers of proprietary parts that own the major critical asset in the motor insurance supply chain. The returns on proprietary parts are at an extremely high level, and mitigate the low margins often made by the manufacturers and assemblers when they sell new cars. After the branded parts manufacturers it is the intermediaries that have tended historically to obtain the highest returns, but these have normally been confined to small and localised areas of the country. This is also true for car repairers that have been able to premium price insurance related work, knowing that the ultimate customer is qualitysensitive but price-insensitive. Table 8.2 The value chain for motor insurance

Typical gross profit margin (ROS) (%)

End customer

Intermediation and distribution

Sale of insurance

Supply of replacement parts and repair services

Not applicable

10–15 on new policies

0–10 selling indirect

35–65 for production of proprietary parts

0–15 selling direct

5–25 for repair services

5–8 on renewals

5–8 for parts distribution and production of generic spares Source: authors’ estimates based on interview data.

176 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

The relatively high margins that these two actors were able to obtain in the past through information asymmetry between the ultimate customer and the insurance company footing the bill have recently been eroded. This has occurred because the insurance companies have sought to retain more of the value in the chain for themselves through direct selling and greater control over their car repair service providers. Ironically, while insurance companies can make substantial returns, it would appear that the current cut-throat competition that has now begun to occur in the direct sales market for motor insurance has led to a price war that may have reduced margins for everyone. Historically, companies like Direct Line may have been able to obtain high double-digit returns by cutting out the middleman, but today everyone is doing the same thing and the real beneficiary has been the customer rather than the insurance companies or their shareholders. These trends are described in more detail in the next section which outlines how the exchange dynamics over value have been changing in the downstream and upstream sub-regimes of the motor insurance power regime.

Value distribution and the dynamics of exchange All economic activity involves some risk and insurance companies offer firms and individuals the opportunity – for a premium – to transfer this risk to a third party. This gives rise to the creation of a supply chain network and power regime for motor insurance that has within it two quite distinct power sub-regimes. The first of these – the downstream power regime – is focused on revenue generation and links the insurance company directly, or via a series of intermediaries (insurance brokers of one kind or another), to the customer. There is a second power structure in the motor claims supply chain – the upstream power regime – that deals with the claims side of the business. Obtaining bottom-line improvement in any of these supply chains is dependent on the ability of insurance companies to manage quality and cost effectively in each one of these very different physical supply chains, each with their own unique power structures. Unfortunately for insurance companies, the upstream power regime has a further sub-division into two further sub-regimes. In one of these sub-regimes the insurance company finds it difficult to achieve either quality or cost improvement because of its dependency on the customer in the downstream power regime. This downstream dependency creates an upstream dependency that makes it impossible for insurance companies to leverage all of their suppliers effectively. Managing the downstream power regime The motor insurance revenue chain, as shown in Figure 8.2, is created physically by the needs of the car user (A). Driving can be a hazardous

Information asymmetry and ex post lock-in 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

177

activity. In the event of an accident there is an obvious risk of damage to the driver, passengers, the drivers and passengers of other vehicles, and to any passing pedestrians. Drivers are required by law, therefore, to transfer this risk to a third party (C) so that, in the event of liability, anyone who has been injured can be properly compensated. Drivers also seek to transfer the risk of damage to their vehicle since undertaking vehicle repairs can be an expensive business (Arrow 1971). In the past, when they looked to obtain insurance protection, most private individuals went through a broker, or intermediary (B). The job of the broker is theoretically to economise on the customer’s costs of search. This is achieved by the broker analysing the supply market (that is, the product offerings of insurance companies), undertaking the difficult job of comparison and making recommendations to the customer as to the best possible deal available (BRP 1992). Historically, this was not an arrangement that served the customer well because most consumers were relatively incompetent. (Due to lack of space the discussion here is confined to the individual customer rather than the corporate customer relationship with the broker/intermediary.) The product that they bought was complex, they had little or no information about it (hence the need to go through a broker), and they tended to exhibit high levels of loyalty towards existing sources of supply. Under these circumstances it proved relatively easy for the supply market to leverage the end-user (Diamond 1997). Mis-selling was commonplace. This is the practice whereby brokers sold the product that offered them and the insurance companies, rather than the customer, the best deal. This gave rise to a downstream power regime whose structure might be described as A < B = C, with the power lying with the insurer and the broker (King, et al. 1997). In recent years these practices have started to change. Slow growth in the industry, and new entrants offering direct channels (like telephone and Internet technology) between the insurer and the customer, have promoted consolidation in the insurance market (Channon 1993). As a result some insurance companies have attempted to achieve scale as a mechanism through which to obtain efficiency gains and, thereby, maintain their profitability. Slow growth has also prompted intensification in the level of competition between the key players. Many areas of the insurance industry business (motor insurance included) are now treated as commodities and it is a feature of such commoditisation that the supplier must normally pass value to the customer. The customers’ hands have also been strengthened recently by the fact that they now have greater familiarity with the product than they did in the past, which in turn has tended to erode their old loyalties. The insurance companies have assisted in this process themselves, of course, with their aggressive promotional campaigns and their drive to find direct channels to market. The rise of the Internet has also significantly

178 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

reduced the search and comparison costs for customers (Financial Times 1999). This process has directly affected the brokers. Many insurance companies have cut out the middleman, forcing those who survive into niche areas of the market (EC 1998). Consequently, the margins of brokers have also fallen. Today, assuming a modicum of competence on the part of customers at using the telephone or Internet to compare prices, the downstream supply chain power regime is best characterised as either one of buyer independence of brokers and the insurance companies (A 0 B = C), or independence of the insurers even when they sell direct (A 0 C). These changed power relationships are depicted in Figure 8.2. As this figure demonstrates, in the past the customer was effectively leveraged by the broker and by the insurance company. The basis for this leverage was information asymmetry between the end customer and the brokers and insurance companies. Today, however, assuming the customer is reasonably competent, it is possible to obtain objective and easily comparable quotes, either from brokers or directly from the insurance companies. In these circumstances the buyer has become independent relative to both the broker and the insurance company. This explains why premiums have fallen rapidly, and why there has been so much recent consolidation in the motor insurance industry, as companies reduce their prices in order to win business in a highly competitive market, or take out the brokers’ role in order to pass value to the customer. This is a classic contested market in which suppliers have to pass value to customers in order to survive. All of this has had a substantial impact on the capacity of insurance companies to manage the upstream power regime for motor claims. While hyper-competition in the UK’s insurance markets has not eradicated policyholder vulnerability to the risks of adverse selection, it has meant that the scope for insurance companies to practise post-contractual opportunism is constrained. If insurance companies attempt to cheat the customer once they put in a claim, that customer is likely to go elsewhere next time.

THE PREVIOUS POWER STRUCTURE

THE CURRENT POWER STRUCTURE THROUGH BROKERS

A A

<

B

=

0

C

B

=

C

DIRECT

A

0

C

Figure 8.2 The changing face of the downstream motor insurance revenue chain. A – customer/policyholder, B – insurance broker/intermediary, C – insurance company.

Information asymmetry and ex post lock-in 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

179

If insurance companies habitually practice ex post opportunism they are likely to earn a reputation for doing so, with the consequence that they may lose more than just a few customers. This in turn can create considerable sourcing difficulties and has led to the fragmentation of the motor claims power regime as a whole. The increasingly low switching costs for customers and the highly fragmented nature of the customer base prior to a claim being made, also makes this power regime an unsuitable candidate for coordination by the insurance companies. As an additional note, it is worth making the point that, post-contractually, power tends to lie with the claimant. This is because only the claimant truly understands the scale of the loss. The insurance company can attempt to police claims (and does, through the process of loss adjustment), but this is an imperfect activity. It is for this reason that, not only is the insurance company frequently placed in difficult sourcing situations, but the reparations that it is required to make for claims are frequently fraudulently inflated. This is why it is difficult, in a market like motor insurance, to hold on to the value initially appropriated from the policyholder, and also why margins are so slim. Managing the upstream supplier power regime Upstream of the insurer the acquisition of motor repair services (the second power sub-regime, as shown in Figure 8.3), involves a mixture of intangible and tangible exchanges. Claimants (A) normally claim a new car for a write-off or have their damaged vehicles taken to a garage (D). This garage or another garage (which may be independently owned or owned directly by an insurance company) will bid for the repair work. Whichever garage is successful in winning the bid will undertake the repairs using car

UPSTREAM POWER REGIME DOWNSTREAM POWER REGIME

A

0

B

0

=

< C

> =

D

0

E

=/0

< =/0

F

Branded parts power sub-regime Generic parts power sub-regime

G

Figure 8.3 The upstream motor insurance sub-regime. A – customer/policyholder, B – insurance broker/intermediary, C – insurance company, D – car repairers, E – distributors, F – branded parts suppliers, G – generic parts suppliers.

180 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

spares, obtained either directly from branded (F) or generic (G) component manufacturers, or through a distributor (E). The problem for the insurance company in the upstream power regime is that it selects who will undertake the repair but cannot always control the costs of the service. Thus, it can decide to have a multitude or just a few preferred suppliers, or to insource the process, but it is not able to control the vast bulk of the costs in the supply chain when it chooses any of these options. This is because, whether an insurance company insources or selects preferred suppliers, it makes little difference to its ability to leverage the bulk of the costs of parts. The reason for this is that the market for automotive spare parts is not an easy one from which to source. The difficulty arises in part because of the high levels of asset specificity embedded in the technologies being replaced. Prior to sourcing a new (or even used) vehicle the end user enjoys a wide range of options. There is a wide range of different marques on sale and, subject to income constraints, the end user is free to source from any manufacturer they choose. This is only part of the problem, however. Each vehicle manufacturer makes use of very different technologies. This is true, notwithstanding attempts by the assembly manufacturers to reduce their costs by standardising some production features across their model range. As a result of this component heterogeneity, there are substantial compatibility problems between makes and even models, even from the same assembly manufacturer. If the suspension system on a Ford Escort fails, replacing it with the suspension system from a Ford Mondeo may prove difficult. Similarly, the scope for parts substitution between the models of each assembly manufacturer are virtually nil. It would be impossible, for instance, to replace the seats from a Rolls-Royce Silver Shadow with those from a Lexus Sports Utility Vehicle. As we saw earlier, this problem is exacerbated by the fact that the European Union’s block exemption rules formally permit the replacement of only some OEM components with generic substitutes (EC 1998). This means that in the after-market for automotive parts the availability of nonbranded parts is limited to simple sub-components like body panels and brake linings (G). All of the more sophisticated parts are branded. This means that the intellectual property rights for them rest with the assembler, sub-assembler and/or components suppliers that developed the technology in the first instance. Even where a patent does not exist, the growing technological sophistication of a number of the sub-assemblies makes the competitive imitation of them an unlikely prospect. High levels of asset specificity constitute only part of the problem, however. An additional problem arises from the fact that, when the insurer or the car repairer seeks to source through a distributor (E), they possess little leverage because of their low volume relative to the volumes that distributors manage with both generic and branded parts suppliers. In this

Information asymmetry and ex post lock-in 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

181

circumstance the normal relationship with distributors (E) is one of independence. The best that the car repairers can achieve is to find some forms of interdependence through direct contacts with generic parts suppliers (G). This only occurs, however, if the car repairers are given a large share of the insurer’s business, and are able to consolidate spend enough to raise sufficient interest from the generic parts suppliers, in order to encourage some form of collaborative interdependence. But when the distributors are able to create such interdependence with generic parts suppliers (E = G) the relatively low volumes of the car repairers individually makes it difficult for them to appropriate any of the value that the distributors may extract from the generic parts suppliers. Neither the car repairers (D < F) nor the distributors (E < F) have much leverage over the branded parts suppliers in the after-sales parts business. This is a supplier dominant exchange relationship that ensures that the best efforts at cost reduction and quality improvement by the insurers, the car repairers and the distributors are constrained by the monopolistic situation that the branded parts suppliers find themselves in. The other rigidity in the marketplace is not on the supply but on the demand side. Downstream of the parts manufacturers there is a specifier– customer split. The specifier in this case is the policyholder while the customer is the insurance company. Once the policyholder has paid their premium, any repair work undertaken on their vehicle represents a free good. This makes them insensitive to the cost of repair. They are not, however, insensitive to the quality of the repair work undertaken. In most instances they expect like-for-like replacement. This means fitting OEM parts, not the cheaper generic substitutes. In many instances, therefore, the after-market for replacement automotive parts is monopolistic and characterised by supplier dominance over distributors and the car repairers and, ultimately, the insurance companies and their end customers. For the insurance company this, in effect, means another monopoly sourcing situation to manage. Of course, the insurance company might insist on having cheaper, generic parts fitted to the vehicle. However, given that the insurers themselves have helped to make motor insurance a commodity business with low costs of switching, this would mean losing the policyholder to a competitor. There are some limits to the policyholder’s capacity to impose this straitjacket. This lies in the limits in their capacity to police the repair work done to their vehicle. Many automotive parts are branded. Where they are not marked in this way and where a market for generic substitution exists, the insurer has some flexibility with respect to their sourcing options. In the case of the insurance company–repair shop (C–D) relation, it is again the insurer’s weakness in relation to the policyholder that potentially augments the power of repairers in the supply chain. The claimant’s insistence on convenience may give rise to localised monopolistic and/or

182 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

opportunistic supply structures. The insurance companies have learnt the costs of pandering to customer wishes in the past and now do not provide as much flexibility for customers in selecting repairers as they used to. The reason for this is because the insurers have recognised that determining the extent to which a vehicle is damaged and, thereafter, the effort/cost that must be expended on its repair may be hard to judge. Even after the work on the car is complete it may not be possible to make a sensible judgement about whether or not all of the work was really necessary. Insurance companies have always monitored repair shop costs but this in itself can be an expensive exercise. For these reasons, obtaining value for money can be next to impossible to achieve or even measure, especially when the claimant is insensitive to the price at which repairs are undertaken, and only interested in quality. It is for these reasons that, in recent years, UK insurers have experimented more and more with insourcing (with limited success) and (more successfully) with collaborative relationships based on creating interdependence or buyer dominance over a few dependent repairers. Despite these innovations it has to be said that the cost reductions and quality improvements achieved have not been as significant as the insurers would have wished for. The reason for this is not because they have not tried to undertake collaborative integrated supply chain management. It is because integrated supply chain management, based on collaboration, cannot be made to work in a power regime characterised by post-contractual customer dominance over quality and upstream control of costs by monopoly manufacturers of proprietary branded parts.

Conclusions It follows from this discussion of the motor insurance supply chain that there are few sources of asset criticality in the power regime at all today. Interestingly enough, while the most important source of above normal returns is still the branded and regulatory protected ownership of specific assets in the form of proprietary parts, all of the other sources of above normal returns appear to be subject to erosion. The reasons for this are simple enough to understand. The primary sources of above normal returns in the motor insurance supply chain historically were always based on information asymmetry. In the downstream (customer facing) power regime the customer historically paid ‘above the odds’ for insurance cover because there was an unholy alliance between the broker – who was supposed to act for the customer – and the insurance companies. Brokers were often guilty either of offering their clients only limited choice or, in the worst cases, of actively pushing those policies that provided them with the largest returns, rather than the policies that were in the best interests of the customer. In such an environment, the end customer was ignorant of the true costs of insurance or

Information asymmetry and ex post lock-in 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

183

of the alternatives available. This information asymmetry, plus the historic inertia of consumers in searching for alternatives, where the costs of search were almost impossibly high, ensured that a cosy ‘gentleman’s club’ operated within the downstream end of the supply chain. We characterised this type of relationship earlier in Chapter 3 as opportunistic supplier dominance with many potential suppliers. The advent of direct selling using the television, the telephone and the Internet has materially transformed the exchange dynamics in the downstream power regime. Now the customer is able to compare prices with a far higher level of transparency than was ever the case before. This, plus the fact that these new technologies also significantly reduce the costs of search, has ensured that both the intermediaries and the insurance companies have been faced with an unenviable business environment. In the past both the intermediaries and the insurance companies were able to make above normal returns from motor insurance business. Unfortunately, intermediaries now face the prospect, either of the complete loss of their livelihood as they are taken out of the chain, or at best having to survive on much lower margins. The situation is little better for the insurance companies. Since it is easy for the insurance companies to replicate the technologies that allow them to sell direct to the customer, and because the customer has greater transparency over pricing, the margins that the insurance companies have been able to make are now extremely low. This applies even to those with first-mover advantages who may have reaped the initial benefits of the new strategy. Unfortunately for the first movers the easy replication of this approach has ensured that all of the insurance companies now appear to be operating in a highly contested market, in which value has to be passed to the customer and cannot be retained for the shareholder. Only in the upstream power regime for proprietary parts is there evidence of the possession of a critical asset that can be sustained over time. The critical asset in the upstream power regime is the asset specificity that creates lock-in for the insurance companies when they source proprietary parts from the manufacturers for car repair work. This critical asset is best categorised as transparent supplier dominance because the insurance companies and car repairers know that it exists, and it is protected by intellectual property regulations. Elsewhere in the upstream supply chain in the past (and it may continue in some exchange relationships today) there has clearly been evidence of above normal returns being made – especially by car repairers. The critical asset that the car repairer has been able to appropriate in this circumstance is normally based on the category of relationship defined as opportunistic supplier dominance with many potential suppliers. This critical asset can only normally occur due to incompetence on the part of the buyer. It normally arises because the car repairer is not being managed effectively by the insurance company. In these circumstances the insurance

184 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

company allows the policyholder to determine which garage should be used and then pays the price that the car repairer demands. Even if competitive quotes are used, with loss adjusters checking the bids, if all the car repair companies are using premium pricing, then the true costs of the repair will be inflated by the hefty profit margin the car repairers are putting on insurance claims work. This practice is commonplace in the industry with car repair work that is non-insurance-related often being 50 per cent lower in cost than insurance-related work. The problem for the car repairers however is that this critical asset may not be sustainable because it has historically been based on information asymmetry between the car repairers and the insurance companies. Now that insurance companies are finding business more difficult, and their own margins are under pressure, it is inevitable that the more enlightened players have begun to remove their buying incompetence and have commenced supplier reduction and cost and quality transparency programmes. When this occurs the supplier dominance of the car repairers of the past is likely to be quickly replaced by either interdependence or buyer dominance. It is for this reason that many insurance companies have started to become more proactive in the management of their motor claims supply chains. Some have moved to insource (with limited success), while the more enlightened have started to create preferred supplier networks with transparent quality and cost management approaches to eradicate information asymmetries between themselves and their repairers. This practice has substantially transformed the upstream supply chain power dynamics for certain insurance companies, and reinforces the point made earlier that business strategies based on information asymmetry may not be as sustainable as those based on more enduring power resources. Despite this success, and their growing ability to leverage generic parts manufacturers and distributors through interdependent relationships when they have high volumes for certain generic parts, the general upstream power relationship is one in which the insurance companies do not possess significant leverage of the main element of cost. This element resides in the branded proprietary parts that are owned as a critical asset by the parts manufacturers.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

9

Information asymmetry, innovation, scale and regulation The sources of asset criticality in the new car supply chain

Introduction Outside of the public utilities, the European car industry has historically been the most politicised industry, reflecting its importance to the region’s economy. Each year alone, 11.5 million new vehicles are registered (DRI 1996a: 17–18). In the past Europe’s car markets were organized along strictly national lines. Each of the major European economies possessed at least one national champion producer. For Germany it was BMW, Mercedes-Benz and Volkswagen; for France, Renault, Citroën and Peugeot; for the UK, British Leyland (later rebadged as Rover); and for Italy it was Fiat. These companies disproportionately sourced and marketed on a domestic basis. In the case of sourcing, this was something that was deliberately encouraged by their sponsoring governments. In the case of marketing, it was the inadvertent consequence of each government simultaneously pursuing a strategy of national promotion. Each government was happy to see its own producer make foreign sales but was not prepared to see the widespread penetration of its own markets. The net result was that none of the large producers was able to sell its products abroad (at least not in any great numbers). The principal exception to this pattern was the European presence of two large US manufacturers (Ford and General Motors) and, from the late 1970s onwards, Honda, Nissan and Toyota from Japan. The entry of these Japanese producers into the European market, coupled with the recession of the early-1980s, has disturbed this cosy national structure. The initial response of national governments to these threats was an intensification of the strategies that had served as the blueprint for industrial development since 1945. Governments increased the level of their subsidies and they found subtle (and in some instances not so subtle) ways of keeping the foreign competition out of their markets. However, the continuing support of Europe’s national producers by their respective governments did not encourage Europe’s carmakers to catch up with their global competitors. Rather, it cushioned producers from feeling the worst effects of their inefficiency and retarded their

186 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

incentive to adapt. By the mid-1980s, a consensus emerged within Europe that autarky was no longer a viable strategy for industrial development. The launch of the Single Market programme in 1985 was recognition of this fact. This does not mean, however, that European car production has lost all of its national character. Vehicles are still produced to suit idiosyncratic national tastes and sourcing is still disproportionately national in its scope. Furthermore, a number of carmakers still depend on demand from their domestic markets for survival. However, the industry is changing and the supply chain is being restructured. As part of this process there has been a major shift in the structures of power within the supply chain. The old settlement placed the assemblers at the centre of the supply chain power regime. They dominated most of the stages of production. Those stages where they were not dominant were of little or no commercial interest. In responding to overcapacity and competition, car assemblers tried to cut costs by shifting the boundary of the firm. They started to outsource not just the production of many important components, but also the responsibility for their design. This has led to considerable consolidation at this point in the chain and to the creation of a relatively small number of super-suppliers. In some instances, these super-suppliers are as large as the assemblers themselves. In a number of instances too, these shifts in production responsibility have been accompanied by shifts in the structures of power in the supply chain. Furthermore, the competitive advantages that these outsourcing strategies were expected to deliver have proven to be, at best, temporary. In an attempt to improve margins, the car assemblers have been forced to rethink their supply strategies. This has led some of them to move into a number of areas traditionally regarded as non-core. This, as we shall see later, is also having an impact on the structures of power. Like the other cases in this volume, this chapter is divided into three main parts. It begins by describing the key functional stages of production and distribution in the automotive supply chain. In the second part, the chapter descriptively maps the corresponding value chain for the production of new cars. This involves looking at the distribution of value in the chain, measured in terms of the gross profit margins typically being earned at each functional stage. In the final part, the chapter discusses those factors that determine the distribution of value in the automotive supply chain. Here, it will be suggested that the supply chain defies the simple categorisations that some analysts have attempted to ascribe to it. It is not accurate to portray it either as a network of production interdependencies or as a system of feudal deference run for the benefit of the assemblers. The new competitive pressures in the industry have not eradicated the past, but they have modified it. In some areas this modification has been extensive, while in others it has proven to be more modest. In

Information asymmetry, innovation and regulation 187 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

both cases, the chapter attempts to draw out some of the subtleties that now mark exchange within the car industry.

Mapping the supply chain In essence, there are two separate, but interrelated, supply chains in the car industry. The first is the supply chain for new cars. The second is that for the car after-market, which involves the sale of second-hand cars, and the supply of automotive spares and servicing. This second chain is discussed in more detail in the chapter on general insurance. The markets within the supply chain for new cars are, with a few exceptions, hyper-competitive. As Figure 9.1 shows, this supply chain consists of five main functional stages. These are component manufacture (which is sometimes referred to as second-tier supply), sub-assembly (which is referred to as first-tier supply), assembly, retailing and distribution, and the end customer stage. This final stage consists of a mix of large corporate buyers, small corporate buyers and private individuals. The high degree of competition at the assembly stage in particular determines the overall exchange dynamics of the new car supply chain. Before we can discuss the commercial properties of this supply chain, however, it is first necessary to describe it. We begin with a closer look at the functional activity of design, which occurs at each of the first three stages of the supply chain.

Design Automotive production begins with design, which consists of three main elements. The first element is the concept itself. The key question that must be asked is what type of car is to be developed for which type of market segment? Thereafter, the design of the vehicle can be usefully divided into the macro-design (the development of the basic chassis, subassembly and component specification) and the micro-design (the development, to agreed specifications, of the vehicle’s constituent components). The first two elements of design tend to be undertaken by the car assembler. In particular, the assembler takes charge of concept origination. In the face of intense competition, however, the costs associated with developing new vehicle prototypes have increasingly forced car assemblers to source the design of sub-assemblies and components (the micro-design) from external suppliers. There are no hard and fast rules governing the degree to which this has taken place. Assemblers still tend to source internally the design and production of those sub-assemblies deemed to be critical to the competitive differentiation of their model. After that, the level of design outsourcing tends to be based on the judgement of the individual assembler. Some assemblers, notably the German manufacturers of prestige/executive

188 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

END CUSTOMER This marks the point of consumption, although in many instances the customer for the car will be obtaining it to lease or to hire it out to other users Customers are a mix of large and small commercial users as well as private individuals. The deal that they are able to obtain is largely determined by the particular car that they are buying. Some segments are more competitive than others The volume of business that customers can offer a dealer is also crucial in determining their bargaining power

RETAILING AND DISTRIBUTION Firms at this point in the supply chain sell the assembled product on behalf of the assembler The franchised dealer very much acts as the assembler’s agent. The assembler sets the terms of the exchange and failure on the part of the dealer to live up to the terms imposed on them will lead to the loss of their ‘licence’. Without a licence they have no product to sell

ASSEMBLY

SUB-ASSEMBLY

Assembly involves the basic design, construction and marketing of the vehicle. It usually also involves the manufacture of critical sub-systems

Sub-assembly involves the design and manufacture of a vehicle’s principal sub-systems. This can include things like lighting, brakes, seating, airbags and transmission systems

In the past, an assembler’s main source of protection was regulatory. Today this has disappeared and the market is intensely competitive Success depends on scale, which allows assemblers to simultaneously undertake the costly design and marketing necessary to stay in business

A major functional requirement of subassemblers is their project and supply chain management skills. In addition to undertaking the manufacture of the sub-system they are increasingly expected to manage the assembler’s supply base as well Success in subassembly is contingent upon two factors. The first is scale, which determines a subassembler’s capacity to undertake design work. The second is an effective mechanism to protect the IPR on an innovative design solution, should one emerge

COMPONENT MANUFACTURE This involves the manufacture of the components that go into the vehicle’s subassemblies The scope for undertaking design is limited at this point of the supply chain, although it is by no means completely absent. Many component manufacturers will attempt to add value through design as a way of engineering loyalty on the part of the sub-assembler For the most part, however, component suppliers sit at the bottom of the automotive food chain and they are expected to compete on cost This situation does change somewhat in the after-market. Here, end-customer lock-in does provide some scope for leverage

As with component suppliers, the position of sub-assemblers changes in the aftermarket. Again customer lock-in is the source of their advantage

Figure 9.1 The new car supply chain: functional stages and key resources.

vehicles, tend to be quite conservative in their outsourcing strategies. Other companies, including Rover, tend to compete more on cost than on quality, and have been much keener to rid themselves of the burden of microdesign overheads.

Information asymmetry, innovation and regulation 189 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Sub-assembly and component manufacture The components supply industry in Europe is basically comprised of three types of producer. These are large sub-assembly suppliers with a global presence and substantial R&D capability, medium-sized sub-assemblers with an in-house R&D capability, and small and medium-sized, secondtier parts suppliers. Like the assembly market, the structures of the new and used-parts industries have historically been highly fragmented, with small and medium-sized enterprises (SMEs) predominating. A simple comparison with the Japanese market illustrates this point. Aside from the 40,000 sub-contractors that comprise the lower tiers of component supply, there are approximately 300 major sub-assembly suppliers in the Japanese industry. On average, these sub-assemblers employ some 900 people and nearly half of them employ at least 500 people. By contrast, there are over 3,000 ‘major’ sub-assemblers in Europe. The average European sub-assembler employs around 270 people and only 10 per cent employ more than 500 people (DRI 1996b: 17–20). Furthermore, the larger Japanese sub-assemblers usually have close organizational and financial links with the major assemblers. Indeed, most of them are formally attached to groups around a specific car manufacturer. The role of the Japanese sub-assembler has also historically differed from that of its European counterpart, with the Japanese system placing a far greater responsibility on the sub-assembler for the achievement of design and process improvements (Maxton and Wormald 1994). This has resulted, it is frequently argued, in Japanese producers exhibiting far higher levels of labour productivity and quality control, as well as quicker design and development cycles and lower stock holding levels (Womack et al. 1990; Lamming 1993). In Japan, the design and manufacturing responsibilities for a new car are allocated broadly as follows. The assembler is responsible for producing about a third of the vehicle, as measured by value. Suppliers are expected to undertake the majority of the design work for the two-thirds of the vehicle that is outsourced. In Europe, by contrast, around 40 per cent of a new vehicle is produced in-house by the assembler. The assembler also performs most of the design work, including the design for those parts that are outsourced (Maxon and Wormald 1994). However, faced with rising competition, declining demand and chronic overcapacity, European assemblers have been forced to reconsider their relationships with their suppliers and the tasks they are asking them to perform. In particular, assemblers are keen to use the supply market to lower their fixed costs and, therefore, their break-even points. In addition to increasing the proportion of a vehicle that is sourced externally, European assemblers are passing responsibility for the design, delivery and installation of components to their suppliers. In effect, assemblers are attempting to transform suppliers, in particular those providing critical components, into co-makers. In order for the suppliers of sub-assemblies

190 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

and components to be able to undertake this pivotal design role, they must develop a wide range of competencies. Maxton and Wormald have defined these capabilities as follows: Mastery of specific product and materials technologies, design for manufacturing and assembly and design for cost are examples. Suppliers also need world-class manufacturing, engineering, testing and process control and superior management of materials flows. They also need strong project management capabilities and far more direct involvement on the part of senior management. (1994: 99) The perception of full-line assemblers, in particular, is that their suppliers must grow larger if they are going to bring their supply bases up to global standards. These larger suppliers would then be required to take full responsibility for the design of sub-assemblies and for the coordination of the second- and third-tier component manufacturers that contribute to the product. Taking its lead from the assembly market, the sub-assembly supply market started to consolidate during the 1990s. Today, the top twentyfive European sub-assemblers account for 40 per cent of component output. Indeed, five of the very biggest sub-assemblers (Bosch, Lucas-Valeo, Magnetti, ZE and GKN) have annual turnovers in excess of $1 billion. This makes them as large as some of the car assemblers that they supply. As a result, Europe’s component manufacturers are losing their European character and are becoming global instead (EIU 1997a,b). The strong market position of these sub-assemblers is further enhanced by product specialisation. No single supplier produces all types of sub-assembly. Behr, for example, specialises in cooling systems, Brembo in breaking systems, and Sogefi in filters. Even the five biggest sub-assemblers have a relatively narrow focus. Bosch, which is the world’s largest automotive equipment manufacturer, targets its efforts on starter systems, spark plugs, braking systems, lighting and windscreen wipers. Valeo dedicates its efforts towards starter equipment, heating and cooling systems, clutches and lighting. Tenneco, Bosal and Arvin are Europe’s major suppliers of car exhaust systems; Delphi, Johnson, Lear, Recaro and Bertrand Faure are the major manufacturers of seating; and Fichtel & Sachs, Valeo, LuK, AP and Quentin Hazell are the principal producers of clutches. The net result of this process of market consolidation is that the supply of particular sub-assembly systems has become concentrated amongst just a handful of manufacturers.

Assembly The car assembler sits at the heart of the production process in this supply chain, if not necessarily at the heart of the regime for value appropriation. In contrast to the other major industrial markets in the world, the

Information asymmetry, innovation and regulation 191 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

European car market possesses a large number of assemblers. These range from huge industrial giants like Volkswagen (VW), PSA and Ford, which sell millions of vehicles a year, to small assemblers like Ferrari and Lamborghini, the sales of which can be counted in the hundreds. In fact, there are some fifty different assembler brands operating in Europe at the current time. These brands, or marques, as they are more commonly known in the industry, encompass some 300 different models. Car assemblers can be most easily identified on the basis of a four-fold categorisation. An assembler can either be a full-range or volume producer, a manufacturing specialist, a transplant manufacturer, or an importer. Assemblers in the first of these four categories account for by far the largest share of the European new car market. Together, the top seven volume manufacturers account for 60 per cent of all new vehicles registered annually in the region. The two top-selling assemblers are the American giants, Ford and General Motors. Between them, these companies are responsible for 23 per cent of all sales in Europe. After the American producers, come the region’s large national champion producers. In descending order of their market share, these assemblers are VW with 10.3 per cent, Renault with 9 per cent, Fiat with 9.6 per cent, Peugeot with 6.6 per cent and Citroën with 4.6 per cent (EIU 1998). The penetration rates of the large American producers tend to be fairly evenly spread throughout the region, although, by volume, they make most of their sales in the UK. So, while Ford commands a market share of nearly 20 per cent in the UK, its market share in Belgium, Denmark, France, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain is generally around 10 per cent. By contrast, most of the European assemblers tend to be heavily reliant on their domestic markets. Peugeot makes 31.7 per cent of its sales in France, while Renault sells 35.3 per cent of its output at home. Similarly, VW makes 46.1 per cent of its sales in Germany, while Fiat sells 63.1 per cent of its cars in Italy. The UK, on the other hand, no longer has a major full-line assembler that is nationally-owned. Instead, UK customers obtain the bulk of their vehicles from the seven major assemblers discussed above. What characterises these assemblers, apart from the volume of their sales, is that they attempt to sell into most product segments. In the car industry, product segmentation tends to be determined by the characteristics of supply rather than demand. While in theory it should be possible to distinguish those customers whose focus is value for money, from those whose emphasis is upon social status, the market tends to be divided up on the basis of car size. There are three major car sizes (small, lower medium and upper medium) and competition in each of these segments is fierce. Together, these segments represent nearly 90 per cent of all new car sales. Although all of the big seven assemblers are active in each of these market segments, particular segments are more important than others to particular manufacturers. Citroën, Ford and Renault, for example, are

192 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

dependent on the small car market for at least 40 per cent of their sales (EIU 1998). Beyond this group of seven high-volume, full-line assemblers, there is a number of smaller assemblers selling between 30,000 and 50,000 vehicles each year. Collectively, these producers account for 20 per cent of the European market. The members of this second group can be further divided into two camps. First, there are those assemblers that attempt to produce cars for a wide range of market segments, but that lack the sales of the very large producers (EIU 1998). Within the UK market, the most notable member of this group has been Rover. Historically, Rover (or British Leyland as it used to be called) was the UK’s national champion in the car industry. Unlike the national champions of France, Germany and Italy, however, the company failed to adjust to the changing market conditions of the 1970s. Initially, it attempted to halt its decline by forming an alliance with Honda, one of the emerging Japanese producers. However, when Rover’s owner, British Aerospace, got into commercial difficulties it decided to sell the troubled assembler to BMW. This was a highly controversial deal that destroyed Rover’s successful relationship with Honda. Not even BMW, however, was able to arrest the competitive decline of Rover. As a consequence, BMW took the decision in March 2000 to dispose of Rover, which raised the possibility that the majority of the company’s workforce would be made redundant. The second camp of smaller-scale assemblers consists of specialist manufacturers like Alfa Romeo, Audi, BMW, Land Rover, Mercedes-Benz, Porsche and Volvo (EIU 1998). These specialist assemblers target specific market segments, such as that for executive or luxury cars. This market segment tends to be less competitive than those for small or lower mediumsized cars, and buyers of luxury cars are much less price-sensitive. Consequently, the margins earned by such specialist assemblers tend to be somewhat higher. The two remaining groups of assemblers operating in Europe are the importers, which is a residual category given the volume of cars produced in Europe, and the transplant manufacturers. The major transplant manufacturers come from Japan. Companies like Honda, Toyota and Nissan opted to set up greenfield production facilities, primarily in the UK, as a means of circumventing EU tariff and import restrictions. The Japanese began investing heavily abroad in the early 1980s when they first attempted to break into the US market. The first Japanese investment in Europe came in 1986, when Nissan set up a plant in Sunderland. This was quickly followed by an investment by Honda, which opened a factory in Swindon, and one by Toyota, which opened a facility in Burnaston near Derby (Maxton and Wormald 1994). These Japanese assemblers were particularly anxious to take advantage of the European Community’s (EC) plans to complete the Internal Market.

Information asymmetry, innovation and regulation 193 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Under the provisions of the Single European Act, third country firms that set up in the EC before the completion of the Internal Market would enjoy the same rights of market access that were to be granted to European producers. However, because many of these Japanese investments are so new, these assemblers have yet to properly establish themselves in the region’s markets. To date, their principal impact has been to force Europe’s incumbent assemblers to review their commercial practices, particularly in the area of supply chain management. Overcapacity in Europe’s car markets has been a chronic problem for some time. Fixed costs in the industry are substantial and account for around 30 per cent of an assembler’s total costs of production. These costs include design and engineering expenses, indirect wages, marketing and depreciation. Indeed, as assembly plants became more automated over the course of the 1980s, fixed costs continued to grow. The major impact of this was to increase an assembler’s break-even point. From 1993 onwards, however, demand in the region started to stall, making it increasingly difficult for assemblers to recover their investments. Initially, the drop in demand was interpreted by industry observers as a temporary blip. There was a number of underlying factors, however, that suggested that the year-on-year increase in demand that the assemblers had come to expect might be at an end. Most notably, the rapid growth in European sales before 1993 owed a great deal to German reunification and to the admission of Spain, Portugal and Greece into the EC. Almost overnight, these events led to an explosion in demand in these markets. After 1993, however, demand growth started to stagnate, leaving European assemblers with a surplus production capacity of around 30 per cent. This combination of overcapacity and intense competition has fostered significant restructuring in the European car industry. To date, the major casualties have been the specialist manufacturers, which have been absorbed by the larger, volume assemblers. For example, Audi, SEAT and Skoda have been acquired by VW; Ford has added Jaguar and Mazda to its portfolio; and General Motors has acquired Saab. In each case, the acquirer has opted to maintain, and in some cases even to enhance, the marque(s) of the target firm, whilst simultaneously attempting to obtain cost savings through design synergies, manufacturing rationalisation and the consolidation of spend. There is little evidence that this process is at an end, and it is widely believed that one or two of the big seven are themselves at risk. The major producers of France and Italy would appear to be particularly vulnerable in this regard. Peugeot and Citroën merged a number of years ago to form the PSA group, although both have continued to operate with a high degree of independence of one another. However, neither company has managed to establish itself internationally. It may be that, in a further round of mergers, Renault will acquire both. Fiat’s position is similarly precarious. In the Italian giant’s case, however, domestic consolidation has

194 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

reached its limits. If Fiat cannot retain its independence, then ownership of the company is likely to pass into foreign hands.

Retailing and distribution Notwithstanding the consolidation that has occurred elsewhere in the supply chain, car distribution in Europe continues to be conducted primarily through unwieldy networks of small, independently-owned franchised dealers (Maxton and Wormald 1994; Key Note 1996). These are typically family firms, operating with fewer than five outlets, that are granted permission by an assembler to sell its cars on an exclusive basis. Multi-franchising, or a dealer selling more than one assembler brand in an outlet, is comparatively rare. Car distribution in the UK follows two principal routes. Either an assembler will opt to go through the distributor–dealership route, or it will sell its vehicles direct to the end customer. For the most part, assemblers use dealers. For large orders, however, they may supply the customer direct. Furthermore, the advent of the Internet does hold out the possibility that low-volume private car buyers might also be able to dispense with the services of franchised distributors. Historically, UK car dealers were organized on a two-tier basis. In this system, a series of local car wholesalers operated alongside the retail outlets that they supplied. In recent years, however, there has been a change to this pattern. Assemblers have increasingly begun to show a preference for supplying cars direct to the retailer. In common with the rest of Europe, the UK market for car retailing and distribution is a fragmented one. That said, it is probably less fragmented than most. The reason for this lies in the fact that the UK market has an unusually high proportion of large corporate customers. The demands of these customers have led to the emergence of a small number of super-retailers, including Lex, Inchape, Hartwell, Cowie, Appleyard, Sanderson, Evans Halshaw, Lookers, Bristol Street, Henlys, AFG, Perry and Reg Vardy (Key Note 1996). In 1994, all of these firms had a turnover in excess of £300 million. The trend towards market concentration at this point in the supply chain is far from complete. At the end of the 1980s, the number of car retail sites in the UK stood at around 8,000. By 1996, this figure had fallen below 7,400. One of the main causes of this market consolidation has been the drive by the assemblers for additional sales. The assemblers expect their dealers to promote their cars aggressively. Although in some instances an assembler will contribute to these efforts, its contribution will be contingent upon the output of a particular dealer. In order to undertake the necessary promotion, therefore, a dealer must have deep pockets. Furthermore, the assemblers operate strict policies in relation to the upkeep and maintenance of their franchises. Most of the assemblers require that their dealers’ premises reflect the status of the product that they are selling. In the past,

Information asymmetry, innovation and regulation 195 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

a typical dealership might cost around £1 million to establish from scratch. Today, the start-up costs of a new outlet are close to double this figure. Consequently, it is increasingly difficult for small independent retailers to enter the market. Notwithstanding this trend towards consolidation, the retailing and distribution of new cars is still highly contested. The reason for this contestation again lies with the assemblers. Although dealers are offered territorial exclusivity for a given make of vehicle, they still face intense competition from the distributors of rival marques. While this might not render completely useless the exclusivity that a dealer enjoys, it does greatly reduce the potential that a dealer has for sustained value appropriation through market closure at this point in the supply chain.

End customer The UK market is unusual by European standards, in that commercial customers account for over half of the total demand for new cars. These commercial customers can be divided into two main camps. First, there is a comparatively small number of large customers that operate fleets of above twenty-five vehicles. The large volume producers, notably Ford, Rover and GM-Vauxhall, dominate the supply of new vehicles in this critical market segment. The significance of large corporate customers to the dealerships is further enhanced by the fact that there might be just a handful of such customers in the area for which a particular dealer has been granted promotional exclusivity. The market for large corporate customers can be further sub-divided into those organizations offering vehicles to their employees as part of their remuneration package, and third party vendors offering vehicles to such customers on a temporary (car hire) or semi-permanent (car leasing) basis (Key Note 1997). Leasing and hire companies both offer the business customer the option of using the vehicle without necessarily taking on the burden of permanent ownership. In the case of leasing, however, such a distinction can become confused, because vehicles may be offered for sale at the end of the agreement. Leasing has witnessed an explosion of new vendors in recent years, as many organizations have attempted to cut their overheads by outsourcing their fleet management activities to specialist service providers. Given the high capital requirements associated with running and maintaining such fleets, operators – particularly of hire cars – tend to be large concerns. In the area of car hire, for instance, two companies, Hertz and Eurodollar, dominate the European marketplace. The second category of commercial customer comprises the comparatively large number of small firms that have a requirement for only one or two vehicles. There are approximately 120,000 of such customers in the UK. Taken together with private individuals, small commercial customers account for around half of all new car sales. However, the demand

196 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

characteristics of such customers are completely different from those of the large buyer. Individuals and small businesses are unable to offer the dealers, or the assemblers, the same volume of demand as their larger counterparts. For this reason, the prices that these two types of customer pay for the same vehicle are very different. Indeed, the sale of new cars to private individuals and SMEs is frequently touted as one of the many examples of ‘rip-off’ Britain, whereby large multinational companies practice aggressive price discrimination across national borders.

Mapping the value chain Value and its relationship with the flow of physical resources in the new car supply chain is illustrated in Table 9.1. As with the other financial data contained within this volume, the figures are intended simply to be indicative. Particular caution should be exercised in relation to the typical gross profit margin given for the sub-assembly stage of the supply chain, where the range of returns enjoyed by the major industry players has been provided. As will be emphasised in the next section of the chapter, there is considerable exchange heterogeneity at the point at which the assemblers and sub-assemblers interact with one another. Indeed, the entire spectrum of dyadic exchange relationships is in evidence at this point in the supply chain. Under the circumstances highlighted previously, one might be tempted simply to aggregate together those sub-assemblers with low margins and to designate them dependent on one or more assemblers. Similarly, one might group together those sub-assemblers with high margins and designate them dominant over one or more assemblers. This, however, is to infer a cause from a hypothesised effect. It is not to demonstrate a positive correlation between the two. Possibly more than any of the other cases in this volume, the automotive example requires further analysis. In particular, it requires the systematic examination of a wide range of different sub-assembly supply chains before the impact of power on the value regime can be asserted with any degree of confidence. Given the limitations on space, however, the authors have chosen instead to content themselves with simply outlining the macro-trends and drawing conclusions about their consequences based upon structured interviews with participants in the new car supply chain. Table 9.1 The value chain for new cars

Typical gross profit margin (ROS) (%)

Retailing and distribution

Assembly

Subassembly

Component manufacture

5–12

5

0–13

0–5

Source: authors’ estimates based on interview data and various industry reports.

Information asymmetry, innovation and regulation 197 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Value distribution and the dynamics of exchange There are eight principal exchange dyads in the power regime for new cars. In some of these dyads there is a significant degree of exchange heterogeneity. This is particularly true in the relationship between the component manufacturer and the sub-assembler, and in the relationship between the retailer/distributor and the end customer. The power of the sub-assembler differs according to whether one is concerned with a large multinational OEM sub-assembler, a national OEM sub-assembler or an independent supplier to the after-market. Similarly, the experience of the large corporate customer cannot be equated with that of the smaller corporate purchaser or with that of the private individual. For these reasons, these two stages and their relationship with immediate upstream and downstream stages in the supply chain are represented more than once in Figure 9.2. This figure shows the exchange dynamics for each of the eight dyads, as well providing a representation of value appropriation in the broader power regime for new cars. As in each of the other cases, the nomenclature employed to indicate the balance of power in each exchange dyad is that developed in Chapter 3. Thus, the symbol (>) is used to denote buyer power, (<) to denote supplier power, (=) to indicate buyer–supplier interdependence, and (0) to denote buyer–supplier independence. A clear box indicates that the returns for an actor in the regime are relatively low and unsustainable, whilst a shaded box indicates that an actor is a major beneficiary of the regime.

A0D

A

D<E

E

E>G

A0C

C

C
D

G

B
B

D>F

F

F>G

Figure 9.2 The power regime for new cars. A – large corporate customer, B – private/SME customer, C – retailer/distributor, D – assembler, E – multinational sub-assembler, F – national sub-assembler, G – component manufacturer.

198 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Exchange relationships upstream of the new car assembler Historically, the markets for sub-assemblies and components have been highly fragmented and exchanges between firms operating at these points in the chain have been characterised by low levels of mutual trust and loyalty. The supply chain, upstream of the assembler, in some ways looked very much like the classical market ideal. That is, many buyers interacting with many suppliers, negotiating hard on price. A closer look at the processes of exchange, however, reveals that something very different was taking place. The supply chain differed from the textbook model of competitive exchange in one important respect. This related to the degree of bounded rationality and, as a consequence, information asymmetry that existed between the assemblers and their supply markets. The 1950s and 1960s was a period of unprecedented growth in the western European markets. The region’s car industry was one of the principal beneficiaries of this expansion. When economic growth started to collapse in the early 1970s, however, the car market was also one of the region’s major casualties. Under the weight of this pressure, and in conjunction with the additional pressure of competition from southeast Asia’s emerging car producers, Europe’s assemblers started to lose money. The first impulse of western governments was to protect and subsidise their national champions. When the losses started to mount, however, the assemblers were forced to address their own commercial practices and, in particular, their cost structures. Relations with suppliers deteriorated as the assemblers started to shop around in search of the cheapest price. For the supplier, winning a contract with an assembler one week was no guarantee of winning a second contract the next. If the assembler got a better offer, then the supplier would be dropped. Under these circumstances, the supplier had every incentive to hedge as an insurance against the uncertainty in the marketplace. Rather than trying to delight the customer as textbook economics would have predicted, suppliers instead chose to satisfice them. The supplier would, as a matter of routine, artificially inflate their profit margin. If the supplier then failed to win the contract, they had the option of dropping their prices in order to win back the business. Such opportunism was not confined to the issue of price, but extended to other areas of the exchange, like quality, timeliness of delivery and innovation. Under conditions of perfect competition such opportunism would not have been possible. The assembler would have detected the supplier’s attempts at guile and would have punished it with exit (or at least the threat of exit). Given the precariousness of the supplier’s position this would have made its opportunism almost impossible to sustain. However, the rules of perfect competition did not apply. The information necessary to monitor suppliers effectively was costly to obtain and did not flow freely

Information asymmetry, innovation and regulation 199 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

between the buyer and the supplier. While the opportunistic supplier might not prosper, it was still able to inflate prices above the costs of production and to hold them there. Rather than the structure of exchange between the assembler and those firms operating upstream in the supply chain being an example of buyer–supplier independence (Category 1 in our typology of exchange dyads), it was much closer to opportunistic supplier dominance with many potential suppliers (Category 3 in our typology). The introduction of competition from Japan’s assemblers did much to change this, however. Companies like Toyota, Nissan and Honda organized their supply bases along somewhat different lines to their Western counterparts and with markedly different results. The Japanese did not favour Europe’s haphazard supply chain structures, preferring instead a more purposive form of coordination. Furthermore, this purposive coordination led to suppliers that were more reliable, that produced components of higher quality and that, critically, were significantly cheaper. There has been a great deal of talk in the west of Japanese-style partnerships, but this is to misinterpret the Japanese model. Within the context of supply chain thinking, the concept of a true partnership implies, first, the existence of a coordinated attempt to eradicate waste and unnecessary cost in order to enhance the value delivered to the end customer. Second, true partnership implies an equitable distribution of the gains and pains generated between the members of the association. In short, partnership implies a balance of, or an absence of, power between those involved in an exchange. In the Japanese model, however, no such balance exists. Japanese assemblers exchange loyalty for performance. Particular suppliers will enjoy a preferred status and will be retained on an ongoing basis, but this is on condition that they are able to engineer year-on-year improvements in their output. What keeps the supplier incentivised, however, is not simply the ‘carrot’ of the promise of continued work. It is also the ‘stick’, or the credible threat that if the supplier does not perform then they will be replaced with another. If a component or sub-assembly is considered commercially critical to a vehicle then, as a matter of routine, a Japanese assembler will take an equity stake in the supplier. Where an assembler does not own an equity stake in a supplier, however, it rarely opts to single source. Instead, it will choose to source from two suppliers simultaneously, so that, if one supplier underperforms, then it knows that the business will go instead to a second supplier. Moreover, the scope for western-style opportunism is reduced, because Japanese assemblers insist upon cost transparency on the part of the supplier as a precondition of signing the deal. Thus, because Japanese assemblers have fewer suppliers to manage, the costs associated with monitoring them for opportunism are correspondingly lower. A Japanese-style relationship between the assembler and its supplier is, therefore, more akin

200 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

to buyer dominance with transparent supply-side contestation (Category 2 in our typology), than it is to a so-called ‘win-win partnership’. The operational success of Japanese lean production techniques has fostered widespread imitation in the west. The results of this benchmarking exercise have been patchy, however. First, the attempts have gone further and faster in some countries than in others. One cross-national study of the car industry found that the UK was significantly ahead of the rest of Europe (and even Japan) when it came to suppliers providing assemblers with a detailed breakdown of their production processes so that they could be costed (Sako et al. 1994). The same study also found that levels of atomistic adversarialism were higher in Europe than in the UK. More telling than the failure of some firms to adopt the techniques, however, has been the failure of some of the techniques when adopted. The UK automotive supply chain may be more collaborative than that of the rest of Europe. It is not, however, noticeably more efficient. Furthermore, even those European assemblers that have attempted to go down the integrated supply chain route have yet to experience the levels of operational improvement enjoyed by the Japanese (Sako et al. 1994). One possible explanation for the failure of lean production in a European context might be the form of implementation. Japanese practice has, as indicated above, been about creating complex networks of interlocking supplier dependencies. The assembler dominates the sub-assembler, who in turn dominates the component manufacturer. This creates a sub-regime that permits the assembler to drive its programme of operational improvement throughout the upstream supply network, while retaining the value created by the exercise for itself. This practice has been referred to elsewhere as ‘one-eyed lean enterprise’ (Watson and Sanderson 1997). Many European assemblers, however, have simply outsourced the design, production and supply chain coordination of key sub-assemblies without bothering to ensure that the structures of power that will support such an enterprise are in place. As Figure 9.2 shows, this has produced a somewhat hit-and-miss affair. In some instances, represented by the sub-regime (D > F > G), there has been a close replication of the Japanese model. In other cases, however, the deliberate attempts of European assemblers to engineer supplier consolidation, to create manufacturers of sufficient scale to compete effectively against their Japanese counterparts, has led instead to the creation of the super-suppliers described earlier in the chapter. It is often these sub-assemblers, rather than the assemblers, that now own and control critical areas of innovation and production. Consequently, it is these sub-assemblers that have the power in the upstream sub-regime (D < E > G). Instead of the assembler shaping the development of the supply chain, the sub-assembler sets the terms of the exchange and accrues the benefits. Of course, it is important not to exaggerate these effects. The difficulties that the assemblers experience with their sub-assemblers are not

Information asymmetry, innovation and regulation 201 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

common to all sub-assemblers or even, necessarily, to a majority of them. Therefore, the problem should be regarded as more of a trend rather than anything else. Furthermore, the difficulties are not distributed equally across all assemblers. The situation facing the large volume producers – Ford, VW, Renault, etc. – is not the same as that experienced by the smaller niche players. This is because it is the volume assemblers that have been the principal architects of the consolidation process. Moreover, in shaping the process, they have attempted to create a European supply base that will suit their specific needs. The smaller assemblers have seen many of their key suppliers disappear from the marketplace. They have been left to deal with a series of sub-assembly giants whose priorities are linked to serving the bigger assemblers. Under such circumstances it is not surprising that the smaller, specialist assemblers have little, or no, leverage over these sub-assemblers.

Exchange relationships downstream of the new car assembler If high levels of exchange heterogeneity make the classification of the assembler’s upstream exchange relationships problematic, a shift of focus downstream does nothing to simplify matters. As Figure 9.2 illustrates, the distinction between a large corporate customer (A) and a private individual or an SME (B) is not simply a descriptive one. The structures of power that underpin these two exchange contexts are also different, creating differences in the flow of value. The dominant relationship of an assembler with its franchised dealers and its smaller customers, represented in Figure 9.2 as (B < C < D), does something to alleviate the difficulties experienced by the assembler with its key, multinational sub-assemblers (D < E). Conversely, the primarily independent exchange relationship between the assembler and its large corporate customers, represented in Figure 9.2 as (A 0 D), serves to intensify these pressures. The first of the assembler’s downstream exchange relationships is that with the retailer and distributor (C). Although some assemblers in some countries own their dealership networks (e.g. Subaru and Daihatsu in Spain), most assemblers are linked to their customers through franchised dealers. For the most part, the relationship that exists between the two is shaped by a pattern of regulation that leaves the dealer at a distinct disadvantage in power terms (C < D) and, therefore, in commercial terms. However, this is something of an oversimplification. Some assemblers have more power in relation to their dealers than others do. Furthermore, assembler leverage over the distribution network does not necessarily compensate for the leverage enjoyed by large corporate customers as a result of their independent exchange relationships with the dealer (A 0 C) and with the assembler (A 0 D). In both cases, the supplier is forced to pass value to the end customer simply to retain his business.

202 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

The Treaty of Rome largely shapes the terms of exchange between the assemblers and the retailers/distributors. Typically, the rules governing the trading of goods such as cars would be derived from Articles 85(1) and (2). These articles forbid the existence of private agreements that restrict or distort competition. However, an additional article, 85(3), permits agreements where the benefit from a restrictive practice can be shown. Thus, a firm can request to have a whole industry exempted from the competition rules. Such a block exemption exists with respect to the assemblers and the dealers. This exemption covers the distribution, resale and servicing of new cars, as well as leasing, hire purchase or other finance agreements, and the provision of spare parts. The block exemption gives the assembler the right to determine who can sell its cars, where they can sell them and at what price. Specifically, when the assembler grants the dealer a licence to sell its vehicles, the assembler is in a position to set the territorial limits of the dealer’s operations. It is free to set limits on the dealer’s output by controlling the supply of vehicles to the dealer. This relates to both maximum limits as well as minimum thresholds and it can tie the dealership’s remuneration packages to these limits. Furthermore, the assembler is also in a position to demand exclusivity. That is, the assembler can insist that the dealer must sell only its vehicles within a given territory. Thereafter, the assembler enjoys a monopoly control over the technical information that is necessary for the dealer to undertake repairs and servicing. It also has the right to specify which replacement parts the dealer can fit to its vehicles. Failure on the part of the dealer to live up to the terms of the agreement may result in the loss of its franchise. Historically, the assembler has been free to grant a franchise for as few as four years. It has also been free to cancel the agreement with only one year’s notice. Given the significant start-up and maintenance costs associated with running a franchise, the commercial implications for the dealer of a cancellation of its franchise can be severe. The assemblers claim that such widespread powers are necessary to ensure the safety of the general public, as well as the orderly marketing of their products. It is axiomatic that cars can kill particularly when they are unsafe. By tightly controlling the distribution and servicing of new vehicles, assemblers are in a position to maintain the necessary standards of road safety. With respect to the issue of territorial jurisdiction, they would further claim that, without strict segmentation, competition would turn into hyper-competition to the detriment of the dealers. Others, notably the European competition authorities, are sceptical about the veracity of all the claims made for this system of marketing. Instead, these critics claim that the block exemption constitutes a rather crude attempt by the assemblers to control their dealers, as well as to leverage their smaller customers. In short, as Figure 9.2 shows, the block exemption places both the dealer and the smaller end customer in a

Information asymmetry, innovation and regulation 203 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

position of dependence on the assembler (B < C < D). Among franchised dealers, margins on the sale of new cars are notoriously low and falling. In the past, industry estimates put gross margins at 15 per cent. They currently stand at between 5–12 per cent, depending on the model being sold. Dealers now make most of their profits on selling used cars, where margins are around 40 per cent, or on after-market repairs and servicing, where margins can be as high as 50 per cent. Not all dealers are equally vulnerable, however. In the past, some of the smaller assemblers found themselves locked into the UK’s large multisite retail and distribution groups. In one notable example, Nissan was compelled to develop an alternative distribution network after its relations with AFG deteriorated (Maxton and Wormald 1994). A number of dealers has actually professed a preference for winning a franchise for particular niche assemblers, like Jaguar or Mercedes, rather than for the volume producers, precisely because the margins are more generous. With volume producers, remuneration packages are tied to sales levels. The problem for the dealers was that, historically, the assemblers were permitted to set these levels unilaterally. However, as we have already noted, the downstream power of the assemblers extends beyond the dealers. As Figure 9.2 shows, the assembler is also able to indirectly dominate the smaller end customer (B) by virtue of the dealer’s dominance in this dyadic relationship (B < C). One of the most significant features of the block exemption is that it permits the assemblers to practise a rather extreme form of price discrimination. Car prices vary substantially across the EU. Indeed, prices are substantially lower in the Mediterranean economies than they are in the northern Member States of the EU. For example, in the mid-1990s the average cost of a small car was 20 per cent higher in the UK than it was in Italy. Similarly, medium-sized and large vehicles were at least 15 per cent cheaper in the cheapest Mediterranean countries than they were in the UK. These figures are important, because they illustrate the sophisticated way in which the assemblers are able to segment the European market. Some nationalities have a higher propensity than others to pay high prices for certain commodities. Moreover, some brands are particularly strong in some economies. Where either of these conditions holds true, the assembler will set its prices accordingly. Furthermore, it is claimed that the assemblers are prepared to aggressively defend their right to price differently according to the prevailing national market conditions. In 1994, the French group, PSA, was taken to court for preventing its dealers from selling its vehicles to re-importers. These were firms that specialised in acquiring the PSA group’s cars in low cost economies and then selling them back cheaply into the relatively expensive French market. The European Court of Justice found against the assembler, arguing that it had extended too far the principles that lay behind the block exemption. Despite the ruling, levels of parallel trading

204 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

in the EU remain modest. This has given rise to the suspicion that at least some assemblers are threatening to withdraw the franchise of any dealer caught assisting in the so-called ‘grey market’ for vehicles. Of course, a lack of price harmonisation does not automatically prove the case that an abuse of power is taking place. Although price differentials might reflect differences in an assembler’s capacity to take advantage of particular customers in particular markets, they may also reflect differences in production costs or fluctuations in national exchange rates. The fact that vehicles marketed in the UK must be modified to take account of the peculiarities in Britain’s driving habits, undoubtedly adds to the assembler’s costs of production. At the same time, however, the impact of exchange rate fluctuations on national car prices in Europe should have disappeared with the advent of European Monetary Union (EMU). Furthermore, the magnitude and durability of such differences would tend to suggest that something more than exchange rate changes is responsible for the cost of new vehicles. The situation of the assemblers, relative to their large commercial customers, is somewhat different to that described above. In order to reach smaller end customers, an assembler will invariably go through its dealers. In order to reach its larger customers, the assembler has the option of either going through its dealers, or marketing to them directly. The first of these distribution channels is shown in Figure 9.2 as (A 0 C < D), while the second is shown as (A 0 D). This second, ‘direct-marketing’ option has proven to be a further point of tension between the assemblers and their distributors. Under pressure to shift metal and recover their high fixed investments, some assemblers have resorted to bypassing their franchisees and selling ‘nearly new’ vehicles to large corporate users. Generally speaking, these are ex-fleet models that have been leased to users for around three months, before being dumped on to the market via auction at 25–50 per cent below list price. Not only does this destroy the dealer’s market for new cars, but it also distorts the market for second-hand vehicles. The fact that the assemblers are prepared to resort to such practices illustrates their basic weakness in relation to this particular market segment. Relations between the assemblers and their large corporate customers are conducted under conditions of buyer–supplier independence (A 0 D). Rivalry between the volume producers is so intense, particularly for small and medium-sized vehicles, that they frequently have no option but to discount heavily for these large customers. Although there is little published data on the margins being earned on such sales, there can be little doubt that they are low and significantly smaller than the margins for private users. Overall, this creates a rather interesting dynamic within the power regime for new cars. As we argued in Chapter 3, the ideal exchange position for any firm is what we have called Janus-faced dominance. That is, a position in which the firm has leverage over both customers and suppliers. Historically, an assembler’s supply markets were highly fragmented and

Information asymmetry, innovation and regulation 205 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

highly contested. This offered the assembler an enormous opportunity to dominate its first-tier sub-assemblers as well as its second-tier component manufacturers. These opportunities were to some extent frittered away, however, through the inadequate monitoring of suppliers by the assembler. In effect, suppliers’ self-interest seeking was allowed to degenerate into self-interest seeking with guile. As the Japanese model clearly illustrates, however, the position of the suppliers was at best tenuous. By consolidating its supply base, an assembler might reduce its costs of monitoring and thereby remove the scope for supplier opportunism. Many of Europe’s assemblers learnt the wrong lessons from the Japanese experience. They failed to appreciate the fact that narrowing one’s supply base through the creation of performance relationships did not mean narrowing it to a point where a dependency or even, an interdependency, was created. The net result was that, in a number of instances, the structures of supplier leverage persisted even after the supply market had been reorganized. This time, however, the nature of the supplier’s commercial advantage was not informational and ephemeral, but structural and deep-rooted. Following the restructuring of the supply market, the newly created super sub-assemblers were able to leverage both the assemblers, and the second-tier component manufacturers. It is therefore these multinational sub-assemblers, rather than the assemblers, that have achieved the ideal exchange position of Janus-faced dominance. Furthermore, the assemblers are also losing out on the downstream side of the supply chain. While the block exemption rules continue to provide them with a significant commercial advantage over dealers and smaller customers, the requirement to make sales in order to recover their fixed costs means that the assemblers must discount heavily when selling to the large corporate buyer.

Conclusions One of the major lessons of this supply chain is that size matters. Furthermore, in terms of supply chain power resources, it probably matters more than any other resource. It is scale that allows fleet managers to negotiate the type of deal that simply is not available to the private end customer or the SME. It is also scale that is the prerequisite to an assembler’s ability to maintain the R&D spending on which manufacturers compete. Two authors (Maxton and Wormald 1994) have neatly summarised the importance of scale in the new car supply chain as follows. If a prestige assembler, like Mercedes-Benz, has sales of around 450,000 vehicles a year and incurs R&D costs of 5 per cent, it may only have a little over $1 billion a year to re-invest. Conversely, although a volume assembler is unable to charge as much for its products, if it achieves sales of 4.7 million vehicles a year, a similar research burden would still leave it with much deeper pockets. Indeed, the money available to continue the innovation

206 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

process could well be five times that available to the prestige assembler. In an industry that is so competitive and where particular models often fail to find a market, the commercial vulnerability of the smaller player is obvious. What is true for the assembler is also true for the sub-assembler. Scale matters, and over time this fact is bound to lead to the further concentration of the market and the further consolidation of the powerful player’s position. The case also shows, however, that scale is not the only factor influencing the appropriation of value in the new car power regime. Regulation has also played its part and continues to do so despite the various competition authorities’ attempts to modify the terms of the block exemption. Finally, this case shows that information asymmetry also plays a role in shaping the exchange dynamics of the industry. The high costs of search experienced by the smaller end customer mean that, even in a contested market, the car dealer is still able to act opportunistically and leverage the customer. This situation may, of course, change dramatically if the Internet allows end customers to overcome their current difficulties with the costs of search. If it does, margins in this supply chain may be lower in the future than they are currently.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

10 Information asymmetry, moral hazard and branded reputation The sources of asset criticality in IT systems integration supply and value chains Introduction This chapter provides both a descriptive and an analytical understanding of the supply and value chain for IT systems integration. The chapter explains which firms in the chain have power and how this impacts upon value appropriation. This is achieved using the following methodology. First, following the general discussion of the IT industry and the relevant theoretical perspectives, the chapter presents a descriptive mapping of the supply chain based on the key functional stages. Second, a descriptive mapping of the corresponding value chain, based on the revenues and gross profit margins typically being earned at each functional stage is presented. Finally, the chapter contains a discussion of the structures of power and the competitive dynamics, and by extension the appropriation of value, in the chain. The chapter shows that many participants in the multitude of supply chains that must be brought together by IT systems integrators achieve above normal levels of profitability at the expense of the end customer. While some suppliers – especially in the hardware supply chains – appear to achieve lower margins, the chapter indicates that, even in highly contested markets, suppliers can achieve above normal profit rates. These returns appear to be based primarily on buyer ignorance and information asymmetry vis-à-vis suppliers. As organizations become increasingly dependent on the possession and use of IT assets, a parallel development has occurred in the myriad of supply chains for IT products and services. These supply chains have rapidly become less integrated as the dominance of large system manufacturers has lessened. This has resulted in the emergence and development of quite distinct structures of power in the hardware, software, and services marketplaces. As these sectors continue to rapidly evolve their own natural economies, suppliers are tending to occupy smaller, more specialised niches in order to survive through the avoidance of a direct competitive battle with the established market leader.

• Invention of the microprocessor (e.g. Intel) • Growing scale and power of independent software vendors • User demand for lower switching costs through interface compatibility • Lower cost indirect channels

Forces of change • Focus and dominate specific segments in the supply chain • New business designs tuned to economics specific to that segment • Create additional value by integrating well with other members of the supply chain • Go to market via indirect channels or OEM • Unbundled offerings – charge separately for services and software (systems integration)

Characteristics of computer industry, early 1990s

Source: adapted from Hornbach (1996).

Figure 10.1 The development of the IT systems integration supply chain.

• Target an area of the market not already directly controlled by another vendor • Build a captive installed base and own and/or control as much of the supply chain as possible • Extend functionality and improve integration across that value chain to create opportunities for premium pricing • Go to market with a bundled hardware, software and services offering via direct sales force

Characteristics of computer industry, early 1980s

• The growth of the Internet and interconnected digital devices • Continued development of microprocessors and software within the PC market • Even lower cost indirect channels • Economies of scale in manufacturing

Forces of change

• Focus on dominating segments in the supply chain that will allow for success • Increasing overlap and convergence between supply chains • IT processing systems increasingly based on software and not hardware • Profitability still high due to buyer ignorance and information asymmetry vis-à-vis suppliers

Characteristics of computer industry, late 1990s

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Information asymmetry, moral hazard and reputation 209 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

There are firms, however, that are spanning these ‘niches’ in the provision of complete IT solutions to large organizations. The end result has been a proliferation in the number of IT suppliers with which any firm can do business in the delivery of their IT requirements. Figure 10.1 illustrates how the IT systems integration supply chain has developed since the early 1980s and outlines the major forces that have driven this development process. The fragmentation of the IT industry is not the only factor, however, that has increased the inherent difficulties facing those IT and procurement professionals who specify the firm’s information processing requirements. In addition, significant technological advances in IT products and services have opened up a range of different sourcing possibilities. The decision by managers as to whether they should internally maintain all the technological expertise they need to effectively compete is an increasingly difficult one. Driven by the pressure to reduce costs in the short term, firms are increasingly using external suppliers for IT-related services, which were previously provided internally. Therefore, not only has the number of potential suppliers increased, but the proportion of IT expenditures being directed out into the external marketplace has also increased. This expansion in both the number of suppliers and the proportion of IT budgets devoted to them has made IT supplier management an increasingly important concern. The spectrum of IT products and services ranges from relatively standardised commodities, such as computer supplies and office software licences, to highly specialised and customised development projects that are critical to the sustained success of an organization. For this continuum of IT products and services with differing criticalities, the gamut of possible supplier relationships ranges from purely independent transactional, price-based interactions through highly interdependent relationships to situations where dependent sourcing arrangements are the only alternative for the buyer. Therefore, in order to maximise the business value of purchased IT products and services, an effective supplier management strategy has become a critical component of the information management function. Another factor adding to the complexity that faces the end customer is the choice of the type of firm to deliver the solution. End customers find it difficult to fully understand the implications of the selection of the supplier, because systems integration and systems development are relatively intangible for those procuring the products and services involved. The choice of whether to select a single supplier that integrates the constituent supply chains or to go to each supply market separately is a key decision. End customers also have to decide to what degree to use the external market, a decision that is far more complex than the ‘simple’ outsourcing decision.

210 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

The end customer has to decide to what extent to use the external market in terms of developing the solution, integrating the solution and managing the implementation. In addition, because these services are likely to be extremely costly, the careers of key personnel within client organizations can rest on the success or failure of the sourcing decision. Therefore, the high degree of end customer uncertainty will combine with the already risk-adverse culture of many large firms, to steer decision-makers towards what are perceived to be ‘safe’ providers of IT solutions. Consequently, brand-image and reputation are critical success factors for suppliers of IT services. As in the other case study chapters in this volume, the discussion that follows has three main aims. The first aim is to descriptively map the supply chain for IT systems integration in terms of the chain’s key functional stages. We will consider the key activities undertaken by organizations operating at each of these stages and will identify the major players. The second aim is to descriptively map the corresponding value chain for IT systems integration. As before, this will involve looking at the distribution of value in the chain, measured in terms of the gross profit margins typically being earned at each functional stage. The final aim is to identify and discuss the factors that determine the distribution of value in the chain. As ever, the focus here is on the structures of power and, by extension, the dynamics of exchange between firms at the various stages of the chain.

Mapping the supply chain Figure 10.2 presents the key functional stages within the ‘basic’ IT systems integration supply chain. The diagram suggests that the supply chain is relatively simple, but the reality is quite different. We have already highlighted some of the inherent complexities associated with procuring IT systems from the myriad of IT supply chains. Another complicating factor is the project-specific nature of IT investments. Given this factor, it is difficult to talk in terms of a generic supply chain for IT systems integration. Nonetheless, it might plausibly be argued that there are certain basic functional activities that are required in undertaking the vast majority of IT projects. As Figure 10.2 shows, these activities are the production of computer hardware, the production of the related software, the provision of consultancy and support services to ensure that the overall IT solution delivers the required functionality, and finally the creation of that overall solution by the systems integrator. We will now consider each of the functional stages shown in Figure 10.2 in turn, discussing them in terms of the primary activities carried out at each stage, the resources needed to support these activities and the major firms operating at that stage. We begin with the production of computer hardware.

Understanding of how to achieve customer lock-in

Strong brand-image and reputation

Supplier coordination skills to ensure high levels of operational efficiency

System to gather and analyse data on key trends in hardware and software innovation

Strong brand-image and reputation In-depth understanding of end customer’s needs and wants across a range of sectors Access to data on key trends in hardware and software innovation Reliable access to high grade IT professionals and university graduates

PROVISION OF CONSULTANCY/SUPPORT SERVICES

Significant capabilities in product/process innovation Strong and flexible brand Robust and internationally enforceable IPR Wide product compatibility with existing hardware and software Reliable access to low cost and highly skilled software authors

SOFTWARE PRODUCTION

In-depth understanding of end customer needs and wants across a range of sectors

HARDWARE PRODUCTION Various resources required by producers of different hardware, but common ones are: Large-scale production facilities to ensure operational efficiency Access to competitive and reliable supplies of key components and raw materials Significant capabilities in product/process innovation Strong and flexible brand

SYSTEMS INTEGRATION

Figure 10.2 The supply chain for IT systems integration: functional stages and key resources.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

212 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Hardware production Sales of information processing hardware and the associated maintenance services account for approximately a third of the £32 billion computer market in the UK (Key Note 1997b). The term hardware encompasses computers (varying in size from large mainframes and enterprise servers to workstations and personal computers), peripherals, printers and various other input/output and storage devices. There are conflicting pressures on the firms producing these various types of hardware. Personal computers (PCs) form the largest and most dynamic sector of the hardware industry. Like peripherals, which form the next largest sector, PCs are a maturing product and the cost of the hardware is decreasing rapidly. Firms such as IBM, Compaq, Fujitsu and Toshiba in PCs, and Hewlett Packard, Seagate and Canon (in addition to IBM) in peripherals, are facing increased competition predicated on price. Table 10.1 shows the major players in each of the UK’s key hardware markets. Without an explosion in sales, the pressure on prices would have led to a decrease in the overall value of the hardware market. The fact that hardware is becoming more of a commodity in certain areas has provided less scope for the major players to premium price. It is for this reason that existing hardware manufacturers and service providers have focused on the more profitable area of systems integration services as an addition to, or a replacement for, their traditional manufacturing activities. The troubles faced by IBM and others have forced them to find related businesses, such as outsourcing, and to adopt strategies that are aimed at turning their existing client base into outsourcing and systems integration Table 10.1 Top five suppliers in key UK hardware markets, by revenue ($ million) Rank

Datacoms

Desktops

Large-scale systems

Peripherals

Servers

1

Cisco Systems $5,406m

IBM $12,911m

IBM $5,316m

IBM $10,633m

IBM $7,595m

2

IBM $3,797m

Compaq $11,228m

Fujitsu $5,052m

HewlettPackard $10,361m

HewlettPackard $4,396m

3

Lucent $3,400m

Fujitsu $9,807m

NEC $3,924m

Seagate $8,075m

Compaq $3,984m

4

NTT Data $3,300m

Toshiba $7,868m

Hitachi $1,829m

Canon $6,907m

NEC $2,566m

5

3Com $2,797m

Packard Bell NEC $7,500m

Unisys $828m

Quantum $4,950m

Toshiba $1,967m

Source: Key Note (1997b).

Information asymmetry, moral hazard and reputation 213 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

customers. Such firms face relatively low entry barriers into the systems integration market, but they have had to overcome the anxiety of end customers who think that they are still primarily suppliers of computer hardware. A key characteristic of the systems integration supply chain is that the solutions are technically complex. Consequently, end customers often do not fully understand the technology and are not in a position to exert effective control over what they are purchasing. However, not all elements of hardware have been commoditised. The large-scale market is particularly concentrated, with a small number of dominant players. There are high entry costs due to the required expenditures on research and development, manufacturing facilities and customer support. The sunk and switching costs may create a brand loyalty that is only threatened by the PC manufacturers offering a similar product in the form of a client-server architecture.

Software production The UK software market was worth £4.87 billion in 1997 (Key Note 1998). This market accounts for 17.9 per cent of the western European software market and approximately 6 per cent of the global market. Recent growth has been fuelled by the movement away from customised bespoke applications towards packaged software and by the high demand for PC software packages. The UK computer software market can be segmented by either the type of software offering (systems software, applications software or application tools) or by the nature of the revenue stream for the supplying organization (dependent on the type of licence). Applications software is consistently the largest sector of the market (48 per cent in 1997), but there has been a shift towards application tools (25 per cent) away from systems software (27 per cent). This move from customised applications running on proprietary mainframes and minicomputers towards generic software has resulted from the fact that more firms are adopting clientserver solutions. The software market is very diverse, with even the largest players accounting for less than 10 per cent of the market. As Table 10.2 shows, IBM is the largest company in the UK software market, closely followed by Microsoft. Apart from Microsoft, the majority of software organizations tend to be vertically integrated in both software development and hardware manufacturing. Outside of the mainframe market, where IBM is the dominant player and where proprietary operating systems are the norm, the operating system market divides into two groups, consisting of Microsoft and all others. The packaged generic software industry is characterised by extremely rapid technological change, which requires constant attention to the marketplace to monitor software technology trends, shifts in consumer

214 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Table 10.2 Key players in the UK software market, shares by value (%) IBM UK Microsoft ICL Misys Oracle Corporation Computer Associates JBA Holdings

7.4 7.2 3.4 3.3 3.1 2.7 2.2

SAP (UK) The Sage Group EDS UK Novell UK Sema Group Informix Software Digital Equipment Corp.

1.7 1.3 1.2 1.0 0.9 0.9 0.8

Source: Key Note (1998).

demand and rapid product innovation. The pace of change has recently become even greater due to the surge of interest in the Internet, other forms of online services, server-based networking and new programming languages, such as Java. Success is dependent upon reacting to these changes in computer technology and getting to the marketplace ahead of the competition. Major marketing and research and development resources are therefore required by the organizations to sustain and generate customer demand. In addition to these expenditures, the costs of the companies operating at this stage of the supply chain are mainly attributable to the labour costs of the software authors. This is certainly the case within the packagedproduct market that is dominated by large multinationals. However, these costs do not constitute prohibitive barriers to entry in all the software markets. The result is a high degree of fragmentation in areas like bespoke software, where personal contact is as important as marketing budgets. The packaged-products market, on the other hand, is controlled by major multinationals. The analysis presented later considers business software products within the supply chain. Like systems integration generally, analysis of customised bespoke software is made difficult by the project nature of this one-off, ad hoc and technically uncertain expenditure.

Provision of consultancy and support services As Table 10.3 shows, information technology is the largest sector in the management consultancy market in terms of value. IT assignments tend to be more costly due to the length of time required to complete projects. The structure of the IT consultancy market is changing rapidly due to entry by an increasing number of organizations, who are developing more sophisticated supply strategies centred around the creation of client ‘lockin’, through permanent dependencies and high switching costs. The market is highly contested. The principal consultancy providers come from IT companies, IT-specific consultancies, as well as from accountancy-based and other more general consultancies.

Information asymmetry, moral hazard and reputation 215 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Table 10.3 Breakdown of the management consultancy market, 1997 Analysis of consultancy fee income in the UK (%) Information technology Corporate strategy Financial systems Supply chain management Production management Human resources Project management Market activities Environmental studies

Suppliers to the UK consultancy market (fee income, £m, 1997) 41 21 11 10 8 4 3 2 1

Andersen Consulting Coopers & Lybrand PA Consulting Group IBM Consulting Deloitte & Touche KPMG Pricewaterhouse Gemini Consulting Cap Gemini McKinsey & Co Ernst & Young Sema Group

350 211 120 115 112 107 100 100 85 84 78 60

Source: Key Note (1997a).

The IT management consultancy sector can be divided into three: consultancy, systems development, and facilities management. Although these are categorised as separate activities, there are cases when the operation within one sector leads to work within another. In the context of management consultancy, facilities management refers to the management of a firm’s computer facilities by an external third party. As IT has developed technically and become more specialised, an increasing number of organizations have decided to outsource the management of this function to an external company. Through their understanding of the numerous IT supply chains, several of the leading consultancies, such as Andersen Consulting, have targeted this sector aggressively. At the same time, the growth in this sector has also encouraged mainline IT hardware and software companies to expand into consulting. The main attraction of this sector to the consultancies is that it provides a more regular, process-like stream of revenue, unlike traditional consultancy with its intermittent and project-specific demand characteristics.

Systems integration It is not possible to quantify exactly the number of systems integration firms that exist within the 50,000 UK companies currently operating in the computing services sector. The complexity stems from the fact that these companies, operating within many of the IT industry’s supply chains, make a varying percentage of their turnover from systems integration. Other services that contribute to the revenue generation of these firms may include facilities management, hardware and software support and maintenance, training and consultancy services.

216 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Of the 50,000 companies operating in the computing services sector, ten companies account for 40 per cent of UK systems integration revenues. These ten companies, in current order of business turnover, are: EDS, IBM, ICL, Sema, Andersen Consulting, Computer Sciences Corporation, Cap Gemini UK (Hoskyns), GEC-Marconi, Microsoft UK and Oracle UK. (The presence of Microsoft and Oracle in the systems integration market is a further example of upstream firms attempting to control more of the supply chain through offering integration and consultancy services to large organizations.) This demonstrates that the marketplace is highly contested, and that while there are many large players, there are also many hundreds of smaller systems integrators (Key Note 1997a). The structure of the market for systems integration is constantly changing due to acquisitions and an increase in the number of vendors. The costs of entry can be high because of the need for significant capital requirements and the need for a reputation and credibility for the successful implementation of business solutions. Despite this, the marketplace is attractive for new entrants due to the high level of achievable profits, the rapidly expanding market opportunities and the fact that efficient information processing is becoming increasingly critical for business success in the Internet age. This has prompted many organizations to find ways to overcome existing entry barriers. Systems vendors are attracted to the business by the high market growth rates for professional services. With the growth in hardware sales at less than 10 per cent and maintenance forces conducting less fix-it work as computers get more reliable, the allure of growth rates of over 20 per cent and upstream influences on system purchases is too much to pass up. In addition, there is a competitive element involved – if a computer or network vendor does not offer to perform outsourcing, others might. There are few single-vendor shops any more. Professional services firms and systems integrators facing uncertain project-by-project revenues and increasing competition from the systems vendors that used to be their suppliers, see the long-term nature of the contracts and the asset valuations as beneficial to their long-term revenue predictability and balance sheets (Gantz 1990: 26). Regardless of how functionally superior a firm’s product or service offering is, limited recognition in the marketplace will hinder the organization’s ability to capture market share. This places a burden on the sales force of the integrator to educate potential clients to their service offerings. This burden, in turn, lengthens the sales cycle and may preclude a company from being on a tender list. Thus, marketing activities and advertising are vital pre-sales activities to which integrators must dedicate resources. When end customers consider systems integration, IBM, HP, EDS, Digital and the large consultancy houses – Andersen Consulting, Ernst and Young, PricewaterhouseCoopers, KPMG and Deloitte and Touche – are the companies most recognised within the marketplace. This

Information asymmetry, moral hazard and reputation 217 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

is perhaps not surprising, given that these are the major players with large turnovers and significant marketing expenditures. It should be recognised that the majority of integrators do not have a segmented strategic approach for the markets in which they might potentially operate. The majority of integrators focus their efforts in an uncoordinated manner across all industries where they are not perceived to offer a differentiated offering from competitors. Focusing on certain sectors (the more profitable ones if these exist), and striving to become the best product and service provider within those sectors, may prove to be a more successful strategy in the long term. There are certain systems integrators who are perceived to be relatively stronger within certain markets. The recognition of this may be extremely beneficial for a number of players in the allocation of resources to certain sectors, in order to overcome the perceived dominance of IBM, HP, EDS and Andersen Consulting. This discussion has highlighted the importance of brand image and perception within the marketplace. The integrators need to understand their strengths and weaknesses and align these with the needs of the end customer. The allocation of resources to where the quantum of the opportunity is largest is key. It is important for firms to work as hard on marketing as they do on technology to increase awareness and familiarity with their service offerings.

Mapping the value chain We turn next to the value chain that corresponds to the supply chain described above. Table 10.4 provides a broad overview of the pattern of value appropriation that results from the supply chain relationships that we have mapped out. Based on a typical systems integration project, Table 10.4 reveals that value appropriation can be very high for many of the participants in the supply chain. (The authors acknowledge the problems in drawing conclusions from the analysis of a single typical project. However, the demand characteristics of systems integration projects result in the solutions being project-specific and one-off. It is for this reason that an ‘average’ project cannot be precisely defined.) The gross profit margins shown in Table 10.4 were estimated for a specific IT project, in which the systems integrator provided a complex high-value desktop solution for a financial services company. This project involved elements of hardware, generic and bespoke software and consultancy, all of which had to be integrated to deliver the solution as partially specified by the end customer. The project included many of the major firms in the IT industry. The profit margins given for each of the actors in the supply chain refer to their specific activities in this particular project, and not to their activities more generally. In order to arrive at these estimates, we carried out a detailed financial analysis of the companies concerned, and for key

218 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Table 10.4 The value chain for an IT systems integration project

Gross profit margin (ROS) (%)

Systems integration

Consultancy/ support services

Software production

Hardware production

15–20

25–30

Bespoke software production 20–25 Generic software production 10–15

Generic hardware assembly 3–5 Specialist hardware assembly 10–15 Component manufacture 2–10

Source: authors’ estimates based on interview data and various industry reports.

project elements a cost build-up was constructed. It should be noted that the majority of IT projects are one-off. Consequently, the margins for each of the suppliers will vary depending on the nature of the dyadic exchange relationships within the specific and unique supply chain that has to be created for the delivery of the specific product or service. Caution should therefore be exercised when deriving learning from this case and applying it across the IT industry generally. All of the exchange relationships in the value chain for systems integration might superficially be characterised as highly contested. Given this, it is somewhat surprising to see that profit margins in the order of 20–30 per cent are being made by many of the actors in the supply chain. It is only in the supply of hardware products that lower profit margins (2–15 per cent) are being made. In the next section of the chapter, we identify and discuss some of the key determinants of this value distribution. As before, this discussion will be structured around a power regime model, which illustrates the exchange dynamics operating between firms at adjacent stages of the chain. The relationship between these exchange dyads and the wider distribution of value in the chain is explained on the basis of the insights developed in Chapter 3.

Value distribution and the dynamics of exchange As we noted in Chapter 3, it is not possible to provide a simple supply chain typology or categorisation. Analytically, supply chains consist of a series of power dyads. It is the interrelationships between these dyads that determine the distribution of value in a supply chain. By understanding how different types of power dyad interlock, it is possible to determine where value is likely to flow down the chain (towards the end customer)

Information asymmetry, moral hazard and reputation 219 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

and where it is likely to be trapped (appropriated by the more powerful players). At this point, it should be remembered that power is a relative concept. It is not a commodity that can be accumulated, but one that varies according to the protagonists involved, the structural and informational resources that they have at their disposal and the skill with which these resources are deployed. The analysis that follows focuses on a certain set of buyers and suppliers within the systems integration supply chain. These firms exhibit considerable exchange-power heterogeneity across the different projects with which they are involved. The power regime for the particular IT project dealt with here is shown in Figure 10.3. The discussion that follows pays particular attention to the factors that determine the relative power position within each of the seven dyadic relationships shown in Figure 10.3. As in all of the other cases, the power structure of each exchange dyad is represented by means of the following nomenclature: buyer power is indicated by the symbol (>) supplier power by (<) buyer–supplier interdependence by (=) and buyer–supplier independence by (0). Again, certain actors in the regime are deemed to be in a position to earn rents rather than profits. Those actors with a capacity to earn rents are represented by means of a shaded box, while those that are able to earn only normal profits appear in a clear box. A box that is both shaded and clear represents an actor that is able to earn rents, but only under certain circumstances.

B0C B=C

A

A
B

B0D B=D

B=E

C D E

C0F C=F

D0G

E0H E
F G H

Figure 10.3 The power regime for a typical IT systems integration project. A – end customer, B – systems integrator, C – hardware producer, D – software producer, E – consultancy provider, F – component manufacturer, G – software author, H – IT consultant.

220 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

End customer–systems integrator dyad The exchange relationship between the end customer and the systems integrator is arguably the one that determines the appropriation of value in the entire supply and value chain. With limited understanding of, and insufficient information about, the supply base, many end customers do not have effective control over what they are purchasing. Systems integrators are able to take advantage of this buyer ignorance and behave opportunistically. This enables an integrator to create a position of dominance and, thereby, to earn gross margins approaching 20 per cent. This dyad, shown in Figure 10.3 as (A < B), falls into Category 3 of our typology (opportunistic supplier dominance with many potential suppliers). The dominance of the systems integrator is not just evident in this particular dyad. In many instances, the systems integrator is also able to influence the end customer to use specific suppliers over which the integrator has power in the context of particular transactions. This will be discussed in greater depth below. The end customer’s ability to control the systems integrator is, of course, determined by its capacity to attain power resources within the relationship, and at the same time to effectively monitor the integrator to reduce its scope for opportunism. The power resources of the buyer in relation to the supplier are determined by a number of demand and supply characteristics within the dyadic interaction. First, the relative volume of the business to the supplier is a key power resource in the relationship. Systems integration projects tend to be of high value and very important for the sustainable success of the end customer. However, this expenditure tends to account for a relatively small share of the major integrator’s turnover. The selection of a smaller congruent integrator will increase the relative power of the end customer. Second, the frequency of the exchange is critical in the determination of the power of the parties to the transaction. It has been discussed previously that the key demand characteristic that militates against effective procurement for the end customer is the irregularity of demand for IT products and services within the systems integration supply chain. However, elements of the solution may actually involve a regular spend, as in the case of maintenance. The complexity of the product and service offering is another element that determines the power resource. IT systems tend to be very complex in that the products and services are not always understood by those involved with specifying and procuring them. This may stem from the lack of a robust management information system and results in substantial information asymmetries within the exchange. These asymmetries may be enhanced by the purposive actions of the integrator. It should also be recognised that frequency and product complexity also directly impact on the capability of, and costs of, monitoring the vendor. This is a major element that increases the scope for opportunistic behaviour.

Information asymmetry, moral hazard and reputation 221 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Finally, the range of equivalent exchange relationships outside of the dyad will impact on the power of the buyer. Within the systems integration supply chain there is a multitude of vendors offering potentially similar products and services to a limited number of end customers. This degree of fragmentation, combined with the irregular demand for large IT solutions, results in a highly competitive and uncertain environment. In addition, end customers will be reliant on their IT procurement professionals being aware of the multitude of different offerings on a technology and business perspective. In contrast, on the supply side of this dyad, the critical power resources for the systems integrator are scarcity (real or maintained through the deliberate use of misinformation) and utility. The variable of information can also be introduced into the supply side to complete the picture of supplier power resources. Information can affect these supply structures in one of two ways. In the case of commoditised and dynamic-leadership markets, information in the form of brand building can be used to create/ destroy the consumer’s impression of scarcity. In the structural–behavioural and structural categories information plays an important legitimising role. The majority of vendors are operating within a highly competitive market. Those firms that implicitly understand the principles of critical asset theory, to increase the likelihood of success, attempt to capture market share through aggressive and opportunistic positioning within the profitable sectors. These firms attempt to offer a tailored and differentiated offering that is distinct from the competition and use the perception of their brand within the marketplace to further strengthen their position. It is the objective of the major vendors to use their considerable sales and marketing spends to decrease the perceived level of contestation through branding and information asymmetries. However, the use of branding is the most ineffective isolating mechanism in this instance – it is difficult and costly to maintain and offers only a ephemeral barrier. The capacity of the buyer to monitor the performance of the supplier is severely restricted and the scope for opportunism is extensive due to the significant information asymmetries. The buyer has insufficient information about the supply base and is unaware of the underlying strategies of the systems integrator. The buyer is also subject to moral hazard because of an inability to exit from the relationship due to the significant ex post switching costs created by dedicated investments and ex ante information asymmetries. Systems integration is a challenging marketplace for both the end customers and the integrators. For service providers in this supply chain, success is determined by the ability to capture market share through aggressive and opportunistic positioning in growth segments of the market. The attainment of market share is one factor that enables firms to acquire the power to leverage upstream suppliers and satisfice dependent downstream customers. Because systems integration services are relatively intangible,

222 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

potential end customers find it difficult to ‘take a test drive’ of the service before committing themselves contractually. The significant investments involved, the risks to the careers of key personnel, and the risk-adverse culture of many firms, means that there is a tendency for end customers to select systems integrators with a good brand image. End customers will, therefore, generally source from those systems integrators that are recognised market leaders. This perceived leadership vis-à-vis competitors may be attributable to a number of factors – high technological innovation, recognised service-level provision and large cost efficiencies associated with scope and scale. All of these factors will result in the company having a favourable brand image within the marketplace. The analysis presented in this chapter demonstrates how systems integrators may wish to optimise the presentation of a structured value proposition to end customers, in order to obtain the project in the first instance and also to maximise the level of value accumulated and appropriated visà-vis other supply chain parties. To prevent this, it is vital for end customers to understand the strategies and approaches of the integrators so that they can avoid the problems caused by inappropriate sourcing. In order to deliver the IT solution, the systems integrator needs to bring together all the hardware, software and consultancy supply chains that are required by the end customer. Therefore, the integrator needs to fully understand the functional requirements of the end customer and to match these to the product and service offerings from upstream organizations. An assessment of suitable ‘component’ suppliers will need to be undertaken on a project-specific basis. If, however, the end customer specifies the use of a certain product or service provided by a particular firm, this is likely to militate against the integrator’s freedom to choose those suppliers over which they have power.

Systems integrator–hardware producer dyad Each integrated solution requires a combination of a wide range of hardware components that may actually be specified by the end customer. However, in the majority of cases the integrator, in developing the solution to meet the requirements of the end customer, selects the hardware suppliers on a project-specific basis. The main criterion for this selection tends to be technical specification and not any commercial rationale. It is the case that they understand the poacher–gamekeeper philosophy when marketing solutions to end customers, but do not extend this thinking to the procurement of hardware. The systems integrator’s ability to control the hardware producer is dependent on a number of factors that determine the power resources in the relationship. First, the relative volume of the business to the supplier partly determines the relative power. Only the major systems

Information asymmetry, moral hazard and reputation 223 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

integrators have an expenditure of a size that interests the major vendors. The selection of suitable competent and congruent suppliers should take into account the salience and regularity of spend. It is for this reason that the frequency of the transaction is critical to the determination of the power balance between the parties. With integrators uncertain about the future workloads, they cannot promise a regular demand for the products they are sourcing. However, there may be occasions when the integrator is able to engineer a regular workload and negotiate a framework agreement for components required in all solutions. The complexity of the product and service offering is the second element that determines the buyer power resource. IT systems tend to be very complex in that the products and services are not always understood by those involved with specifying and procuring them. This would certainly be the case with end customers but one would assume that procurers within systems integrators would have full knowledge of potential suppliers of components, in order to meet the functional requirements of the solution. This means that it is relatively easier to monitor the vendor and this eliminates the scope for opportunistic behaviour. Finally, the range of equivalent exchange relationships outside the dyad will impact on the power of the buyer. Within the range of components required for solutions this impacts differently. The suppliers of the network and system components produced mainly for integrated solutions will be relatively weaker than suppliers of PCs and peripherals that are not dependent on the integrators for revenue. On the supply side, the majority of hardware vendors are operating within highly contested markets. However, suppliers of certain hardware, including high-end mainframes, operate within markets that are currently closed to effective competition. The main isolating mechanisms upon which this closure is based are product innovation and software switching costs with a relatively high degree of causal ambiguity. The previous analyses of buyer and supplier power resources demonstrate that this dyadic relationship is characterized either by buyer–supplier independence (Category 1 in our typology) or by buyer–supplier interdependence (Category 6 in our typology), depending on the degree of product specialisation. In the first instance, shown in Figure 10.3 as (B 0 C), the supplier is selling a relatively standardised product to a customer base that is fragmented, but well-informed. Although neither party has power over the other, we contend that the buyer will appropriate most of the value created by the exchange. Given that the buyer has very low search and switching costs, the supplier must pass value to the customer by pricing in line with its costs of production. In the latter case, shown in Figure 10.3 as (B = C), the supplier is selling a specialised product to a relatively concentrated and well-informed customer base.

224 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Hardware producer–component manufacturer dyad The relationship between the hardware producer and the component manufacturer mirrors the one between the systems integrator and hardware vendor. On the demand side, the volume of the business may be a significant proportion of the component supplier’s turnover and any irregularities in demand that exist downstream may be eliminated through parallel business with other firms. The hardware firms should fully understand the complexity of the product offering and have knowledge of the range of supply offerings. Therefore, the scope for the supplier to be opportunistic should be minimised. This opportunism is also controlled, as it is unlikely that the suppliers of components will have alternative exchange relationships outside the IT market. This dyadic relationship, shown in Figure 10.3 as (C 0 F), will be largely characterised by buyer–supplier independence (Category 1 in our typology of exchange dyads). However, using the same principles as in the previous section, a relationship involving specialised components is likely to be characterised by buyer–supplier interdependence (Category 6 in our typology). This relationship is shown in Figure 10.3 as (C = F). Commoditised component suppliers are selling their product to a large number of buyers and the balance of power would favour the buyer. Where the supplier is only able to supply a concentrated number of buyers, due to a dedicated investment to provide a specialised component, then the ex post relationship would be characterised as one of structural interdependence. In this instance the financial burden would have to be equally borne or the vulnerable party protected by credible contractual safeguards. It is assumed that exit from the relationship would be an unattractive option. In either circumstance, the buyer would have low costs of search, because those involved with the procurement of the components would understand the complex product and transaction characteristics.

Systems integrator–software producer dyad Integrated solutions tend to include elements of generic and bespoke software. The nature of the combination of software, and the actual software itself, will be determined by the specific requirements of the end customer. As discussed previously, the choice of the software supplier is determined by the relationship between end customer and integrator. The relative power of the integrator in this relationship will therefore impact upon the relative power of the parties in this dyad. The end customer needs to have a coherent blueprint for the technical solution that responds to current and future business needs. This can only be achieved through an understanding of the technology and the supply market and how supply chain innovation is likely to change the way in

Information asymmetry, moral hazard and reputation 225 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

which functionality is met. It should be remembered that the solutions to delivering this functionality are becoming increasingly based on software and not on hardware. Knowledge of the technical software is therefore a critical asset for systems integration and should be combined with knowledge of the contingent circumstances faced by the business to create appropriate sourcing strategies for software. The systems integrator’s ability to control the software vendor is dependent on the power resources within the relationship. The factors that determine these have been outlined previously and include salience of the business to the supplier, transactional frequency and complexity, and product complexity and tangibility. Only the large systems integrators have an expenditure that is sufficiently large to interest the major software vendors. However, even these integrators are uncertain about their future workloads, especially within certain industrial sectors. They are, therefore, unable to promise a regular demand for the majority of software products that they are sourcing. However, there may be products, such as operating systems, where the integrator is able to engineer a regular workload and negotiate a framework agreement for integration into all desktop solutions. The complexity of the software offering increases with the degree of customisation. However, procurers within systems integrators should have full knowledge of potential suppliers that could deliver the functional requirements of the solution. As a result, the monitoring of the vendor will be relatively easy and inexpensive and this reduces the potential opportunism of the supplier. The possible alternative relationships open to the software supplier outside the existing association would differ according to the nature of the software. Suppliers of generic packaged software would have greater scope for selling their products to a wider market than a supplier of highly specialised bespoke software for a specific customer segment. On the supply side, the majority of software vendors are operating within highly contested markets as the products that deliver the required functionality are largely commoditised. However, suppliers of certain bespoke applications operate within markets that are relatively closed to effective competition. The isolating mechanisms for this closure are property rights and continuous path dependent innovation. These mechanisms are durable but relatively expensive to maintain in terms of innovation. Certain firms that supply generic products, like Microsoft, are able to achieve gross profit margins in excess of 30 per cent (and we would assume unit margins of 90 per cent once the initial costs of R&D have been repaid) despite the low margin per unit. The possession of the de facto industry standard allows these firms to earn significant revenues due to their volume sales. Those firms that offer generic software products may still place a requirement on the customer for an element of tailoring to existing system software, applications software or application tools.

226 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Bespoke software firms are earning margins of up to 30 per cent, leveraging their brand and intellectual property in the development process. Such firms are using their relatively superior competence in supply innovation to provide the necessary functionality that end customers require and premium pricing is a result. These firms are also attempting to appropriate rents by artificially distorting the perceptions of the integrator (or end customer) through leveraging their brand and using information asymmetries. Software companies earn their revenues from either an open-ended, closed or hybrid licence that involves payment on either a one-off or regular basis. The relative power in the dyad will determine the outcome of the negotiation and the terms of the licence agreement between the parties. An analysis of the power resources on either side of this dyad demonstrates that the relationship is either characterised by buyer–supplier independence (B 0 D) or by buyer–supplier interdependence (B = D). Like many hardware suppliers, commodity software vendors are selling their product to a fragmented and well-informed customer base. This situation of independence results in neither party having power over the other. Nonetheless, the buyer is expected to appropriate the majority of value created by the exchange, because its costs of search and switching are relatively low. Buyers and suppliers of customised software are in a dyadic relationship characterised by structural interdependence. This interdependence may arise ex ante due to the high levels of innovation required on the part of the supplier that precludes entrants to the market, or ex post due to dedicated investments. There is a concentrated number of buyers that have low costs of search, because those involved with procurement understand the complex product and transaction characteristics.

Software producer–software author dyad The relationship between a software producer and an author is highly firm specific. With the skill of writing complex algorithmic software code not confined to the US where the majority of vendors are located, it is the case that the supply of software authoring is truly global, language not being a barrier. With wages constituting a major element of cost, software producers source from those nations with low wages. Sourcing is undertaken on a project basis with the buying firm understanding all aspects of the product and transaction. The range of alternative relationships for the supplier will depend on the skills of the individual. With a wide range of software languages, knowledge of programming confined to a limited number of these languages will restrict the potential work of the software author. The software authors themselves are operating within relatively competitive markets. There have been instances recently where, due to problems

Information asymmetry, moral hazard and reputation 227 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

associated with the year 2000, demand has exceeded supply and authors have been able to earn significant revenues. Whether working directly for end customers or for a software vendor this is not the case now. It is for this reason that the parties in this dyad (D 0 G) are in a relationship characterised by buyer–supplier independence (Category 1 in our typology). This independence is due to the large number of authors selling their services to a large number of potential customers.

Systems integrator–consultancy provider dyad The levels of profit attained by the firms involved in the provision of consultancy services to systems integration projects is attributable to the traditional way in which the service is procured. In many areas of consultancy the delivery mechanism may be well defined, but the actual offering is often misunderstood by the end customer. The offering, therefore, cannot be clearly specified prior to the start of the contract. There is also a tendency for clients to accept high industry-wide norms on consultancy day rates. This is a common problem for buyers of what may be referred to as professional services. The major issues surrounding procurement in this area are very similar to those faced by end customers in the selection of systems integrators. Because consultancy services are relatively intangible, systems integrators find it difficult to fully understand the specific elements and deliverables of the service before committing themselves contractually. The general risk-adverse corporate cultures will tend to steer decision-makers towards providers with good brand images. Integrators will wish to source those companies that are perceived to be the best in the assistance of the delivery of solutions. The confidence in the perceived image vis-à-vis competitors may be attributable to a number of factors – recognised service-level provision, innovative solutions and efficiencies associated with scope and scale. The systems integrator’s ability to control the consultancy firm is dependent on a number of factors associated with the nature of demand and supply in the transaction. The revenues from large IT solutions can be of significant importance to the large consultancy houses, especially if associated with a major client. The prestige from assisting with the delivery of a major IT solution may be transferred to success in winning further work. The same issues relating to uncertainty regarding future workload and the complexity of the solution apply to this dyadic relationship. The consultancy house will also be limited as to the possible alternative relationships open to them. The possible choice will be further restricted if the consultancy specialises in a certain type of hardware, software or customer. The nature of contestation within the supply side depends upon the type and scale of the solution. There may be certain solutions that require extensive resourcing or certain skills that preclude certain players from

228 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

offering their services to the integrator. In addition the markets may be closed through the use of branding and perception as isolating mechanisms within the relationship. These mechanisms may be relatively costly to maintain if extensive marketing is involved. The discussion above demonstrates that this dyadic relationship (B = E) is best characterised by buyer–supplier interdependence (Category 6 in our typology). With the consultant providing a relatively intangible service, the integrator often finds it difficult to monitor the supplier’s performance. However, there are two factors that act as a deterrent against the exploitation of this information asymmetry by the consultancy provider. First, the revenues from the business are important in allowing the consultancy provider to gain market share in a growing market. This will allow the systems integrator to leverage and source the best consultancy provider. This is further strengthened by the second factor. With brand and perception critical for sustainable success, the association with major clients is essential. These benefits may be lost if the consultancy provider is seen to be using an information asymmetry to exploit the systems integrator.

Consultancy provider–IT consultant dyad With circumstances similar to those surrounding the production of software, the relationship between the consultancy provider and the individual consultant is highly firm specific and important for long-term success. With the nature of output being highly intangible, the sourcing of consultants with the appropriate skills is vital. It is widely argued that there is no direct relationship between day rates and value for money from the actual output. It is perceived that the day rate only relates to the image of the firm and does not act as a mechanism for rationing the scarce resources of the firm. The consultants themselves are operating within relatively competitive markets. Within the IT consultancy market there are, however, certain areas where demand exceeds supply. As a result, certain consultants have been able to earn significant revenues. The power of the consultants is further strengthened by the fact that they are able to provide their services at any stage of the systems integration supply chain. Under these circumstances, the relationship between the parties in this dyad is characterised by opaque supplier dominance (Category 7 in our typology). This is shown in Figure 10.3 as E < H. However, where the nature of the consultancy does not require specialised skills, and the required skills are widely available, the relationship will be characterised by buyer–supplier independence (E 0 H). This is due to the large number of consultants selling their services to a large number of potential customers.

Information asymmetry, moral hazard and reputation 229 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Conclusions At each functional stage of the supply chain there are resources that, if owned and controlled in a unique way that is difficult to imitate, may enable certain firms to appropriate value on a sustainable basis. Within the systems integration supply chain, the sustainable profitability of the major players appears to be predicated on the ability of the systems integrator to utilise effective leverage over end customers through the possession of information asymmetries. The level of value appropriated by the integrator also has a large bearing on the value potentially appropriated by other interdependent players within the supply chain. The key insight provided by the systems integration supply chain case is that the end customer is being satisficed by integrators who are in a relatively superior position of power. Therefore, unless the end customer has a coherent blueprint for the technical solution that responds to its current and future business needs, it will be at a permanent disadvantage vis-à-vis the supplier. The end customer’s ability to develop such a blueprint is extremely limited, however, because the IT industry is involved in fundamental and rapid technological change. Having an understanding of how this change affects IT processing systems and capabilities is a key supply chain resource for systems integrators. Using this knowledge, systems integrators, consultancies and certain hardware and software suppliers are in a position to leverage the ignorance of end customers and, thereby, to further increase their margins. This knowledge can also be a major factor in the creation of dependencies and high switching costs that result in end customer lock-in. In summary, the demand characteristics and high asset specificity of IT systems integration projects create circumstances that drastically limit the strategic choices available for effective procurement and relationship management by the end customer. The fact that expenditure on IT solutions is of crucial importance to the end customer, and is also one-off, irregular and ad hoc, means that the opportunities for effective leverage over upstream supply chain participants are limited. The end customer is relatively dependent and the power in this supply chain appears to be firmly located with satisficing suppliers. This power is further enhanced by the operation of significant information asymmetries in favour of these suppliers, which, if used opportunistically, may lead to the creation of significant customer dependencies. Whether an end customer is able to ameliorate, or even reverse this situation, is heavily dependent on the extent to which the customer understands the issues discussed in this chapter.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Part III

A research agenda for analysing business power

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

11 Linking descriptive and analytical approaches to business thinking

In this final chapter two issues are addressed. First, we provide a summary of the key learning points from our analysis of the power resources that allow for the creation of six types of critical assets in buyer–supplier exchange relationships. This discussion focuses, in particular, on the discrete networks of dyadic exchange relationships (sub-regimes) in the seven supply chain power regimes that we have analysed. The aim here is to ascertain whether any of the eight primary buyer and supplier relationships outlined in our dyadic exchange typology is more commonly in operation than others. It is also important to see whether all of the eight categories of dyadic exchange specified in our original typology are to be found in these seven cases, or whether some do not occur at all. We also consider whether the cases studied here provide evidence of a significant correlation between a firm’s position in a sub-regime of dyadic exchange relationships and its capacity to earn high margins on a sustained basis. The second issue relates to the problem of distinguishing between descriptive and analytical ways of thinking. The aim of this volume has been to assist in a process in which the analysis of business success and failure can move from its current, primarily descriptive, approach to adopt a more prescriptive orientation. While we believe the work reported here has assisted in this goal, we still believe that we are some way from developing a truly analytical and prescriptive approach to business thinking. To this end, our discussion concludes with a summary of some of the key theoretical gaps that we believe exist in our own approach, and around which we believe further work is needed.

Testing the analytical utility of critical assets, power regimes and the eight-category typology of dyadic exchange The seven case studies presented in this volume provide substantial evidence to support the theoretical proposition that it is a firm’s ability to develop and sustain a situation of buyer or supplier dominance in an

234 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

exchange relationship that is one of the keys to business success or failure. By possessing ownership and/or control over supply chain resources that provide dominance in a dyadic relationship, a buyer or supplier is well placed to appropriate value from the other party to the exchange. As each of the case studies also demonstrates, however, a firm’s capacity to hold on to the value that it has appropriated from a particular dyadic exchange relationship, and thereby to earn rents, is determined by the firm’s position in the wider network of exchange relationships that we have called a power regime. More specifically, we are interested in the nature of the sub-regime within which the firm is located. As we argued in Chapter 3, we cannot hope to understand the flow of value in a supply chain simply by looking at discrete buyer–supplier pairings. Instead we must consider the way in which individual dyads interact with one another within the sub-regimes that go to make up the complete power regime. The concept of a sub-regime is used to denote the fact that value rarely, if ever, flows in an uninterrupted fashion from one end of a supply chain power regime to the other. Instead, the research reported in this volume provides ample evidence that value tends to be trapped in a number of discrete zones, or sub-regimes, within a power regime. This finding is of more than purely descriptive interest, however, because it implies that a dominant firm’s capacity to influence the flow of value is unlikely to extend beyond the boundaries of a discrete sub-regime. Before summarising the key learning from the seven power regime cases presented in this volume, it is perhaps worth stressing that the cases were not selected with the intention of proving the veracity of our theoretical propositions. On the contrary, the cases were selected in a somewhat reactive and random fashion. In preparing our proposal for research funding it was incumbent upon us to find partners from industry. In seeking partners we wrote to close to 100 companies and invited volunteers to participate in our research project. The seven case studies analysed here were, therefore, selected somewhat at random. Their inclusion was based on selfselection by the participants rather than any a priori selection on our part. Given this, it is significant that there is substantial evidence from these cases to support our expectation that a sub-regime in which a firm has dominance over both its customer and its supplier (what we have called Janus-faced dominance), or one in which a firm has dominance over its customer and an independent relationship with its supplier, will provide an opportunity for sustained value appropriation by the dominant party. The power regime cases also demonstrate that all but two of the eight categories of dyadic exchange are in operation in these supply chains. Moreover, in these seven cases at least, no other alternative dyadic exchange relationships were found to be operating. What is also of interest is that, in these cases, some of the dyadic exchange relationships were much more commonly in operation than others. These findings are discussed in greater detail below.

Linking approaches to business thinking 235 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Critical assets and power resources in the seven supply chain power regimes There are significant analytical differences between the concept of a critical asset and that of a power resource in the context of a dyadic exchange relationship between a buyer and a supplier. The concept of a critical asset refers to the way in which a buyer and a supplier relate to one another. More specifically, a critical asset is the name that we have given to a situation of buyer or supplier dominance, which can arise through six very different types of relational power. There are, as we argued in Chapter 3, two types of buyer dominance and four types of supplier dominance. The concept of a power resource is distinct from that of a critical asset, however. It refers not to the buyer–supplier relationship itself, but to a resource that a buyer or a supplier can own and/or control in the context of an exchange relationship and from which a critical asset may be created. As we argued in Chapter 2, the power resources available to a supplier often take the form of what has been called an isolating mechanism (Rumelt 1984). This term refers to those mechanisms (for example innovation combined with causal ambiguity, control over an industrial standard, or possession of a regulatory right) that allow a firm to achieve some degree of market closure, and which thereby give the firm the potential to achieve dominance over its customers in at least some of its exchange relationships. In addition to such isolating mechanisms, we have also identified information asymmetry as a further and equally significant source of supplier power resources. If the buyer is unable to effectively assess or monitor the level of value for money being offered or delivered by a supplier, then there is significant scope, both pre- and post-contractually, for the supplier to inflate its margins. The key power resources available to a buyer were also discussed in some detail in Chapter 2. In essence, we argued that a buyer’s power resources in the context of a particular exchange relationship are determined by the relative attractiveness of its business for the supplier (which is primarily a function of the volume and frequency of its spend and the uniqueness of its requirements), and by the buyer’s understanding of the supplier’s costs of production. It is our view that the power resources available to buyers and suppliers can, and do, vary widely from case to case, but that the nature of a critical asset cannot vary as widely. This is because the relational sources of power in exchange are limited to only six primary categories, while the nature of power resources changes dynamically. This dynamic change in the nature of power resources is primarily a function of technological change and of the related and ceaseless struggle by human beings over value appropriation (Cox 1997a). This struggle is manifest in the

236 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

constant competitive search for ownership and control over resources that can be used to destroy the current structures of power in supply chains and markets. This point about the limited range of possible critical assets and the greater complexity of the power resources that are available to buyers and suppliers is borne out by the evidence from our seven case studies. Table 11.1 below shows which of the six possible critical assets are present in each of our case study power regimes, and which, if any, do not occur. The table also describes the nature of the power resources upon which the identified critical assets are based. As Table 11.1 shows, it is those critical assets falling into Categories 2, 3 and 5 that occur most frequently in these seven supply chain power regimes. This does not mean, however, that these types of critical assets will necessarily be the most common in all power regimes. Rather, the types of buyer and supplier dominance that occur in particular power regimes will be contingent upon the unique interplay of power resources at the disposal of the firms operating within those regimes. All that one can say with certainty is that, whenever a firm is earning high margins, it is likely to have a critical asset in relation to either its customer or its supplier, or more likely in relation to both. When it comes to analysing the power resources that assist in the creation of critical assets in our seven case studies, regulation figures prominently as a source of high margins. In the forecourt retailing case, for example, regulation provides the basis by which retailers achieve ownership of unique and difficult-to-replicate site-specific assets in favourable locations. This is normally achieved through the state granting planning permission. Similarly, regulatory protection of certain raw material producers under the EU’s Common Agricultural Policy (CAP) allows them to earn guaranteed returns in their exchange relationships with grocery manufacturers. Regulatory protection by the EU also plays a key role in the industrial sugar case. Both the sugar beet growers and the sugar processor operate within a regulatory regime that allows them to earn high and sustainable margins from their main downstream exchange relationships. In the industrial electricity case, regulation in the form of the Pool pricing mechanism has provided a basis on which generators have been able to maintain artificially high prices despite the state’s best efforts to create greater competition. It is perhaps more accurate to say, therefore, that regulatory failure has given electricity generators the opportunity to earn high margins. Finally, in the motor insurance and automotive cases, regulation also plays an important role. In motor insurance the protection of proprietary rights for parts manufacturers against generic replication ensures that branded parts dominate quality and cost flows in the car repair market. In the automotive sector regulation in the form of a block exemption from

Linking approaches to business thinking 237 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

the EU competition rules allows car assemblers to determine the terms of exchange with car retailers and distributors. Our research has revealed, therefore, that regulatory rights are one of the most important power resources that allow firms acting as suppliers to appropriate value from their customers on a sustained basis. This is an important conclusion and one that should lead proponents of totally unregulated markets to think twice before espousing the benefits of the free market. Perfectly competitive markets are arguably the last thing that business people want, at least when they are acting as suppliers. As classical economic theory would predict, and as our case studies have confirmed, in these circumstances a supplier is forced to pass value to its customers simply to remain in business. Logically, of course, when that same firm is acting as a buyer, then a competitive supply market is exactly what it wants. It must be emphasised, however, that regulation cannot be conceived of purely as a power resource. State intervention can also be used to set limits upon the rent earning capacity of some companies in particular markets. The most obvious example of this in our study occurs in the case of transmission and distribution companies in the electricity industry. The pricing and investment decisions of these companies are heavily controlled by the state, because they operate within a context of natural monopoly. Nonetheless, there are clearly many circumstances in which favourable public sector regulation is the basis of a sustainable, and more importantly an exploitable, critical asset. As we have already noted, economies of scale are of major importance as a power resource underpinning the dominance of electricity transmission and distribution companies over their customers. Scale efficiencies, particularly when they are linked to significant sunk cost investments, act as a power resource for an incumbent supplier by providing a substantial barrier to new market entrants. In the extreme case, where the minimum efficient scale of production in a market is equivalent to the size of the effective demand in that market, a situation of natural monopoly is created. Scale efficiencies are also an important power resource in the automotive case. In particular, scale operates as a source of supplier dominance in many of the exchange relationships between the large multinational sub-assemblers and the smaller, specialist car assemblers. In recent years there has been a substantial degree of market consolidation at the sub-assembly stage in this supply chain power regime. This process has been driven by a combination of design and R&D outsourcing by the major car assemblers and massive overcapacity. The outcome has been the creation of a small number of very large sub-assemblers, that have taken ownership of many of the critical elements of product and process innovation. A related function of scale is that a dominant supplier often has significant volume leverage as a buyer of particular goods and services. Purchasing

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Table 11.1 Critical assets and power resources in the seven supply chain power regimes Types of critical assets

Power resources in the seven supply chain power regimes Forecourt retailing

Category 2 Buyer dominance with transparent supply-side contestation

Industrial sugar

Industrial electricity

Multiple grocers use volume leverage and own-labelling against brand-name food and drink manufacturers

Category 3 Opportunistic supplier dominance with many potential suppliers

Category 4 Buyer dominance with opaque supplyside contestation Category 5 Transparent supplier dominance

Category 7 Opaque supplier dominance

Category 8 Opportunistic supplier dominance with few potential suppliers

Retailers’ regulatory rights to site-specific assets. Manufacturer branding in absence of effective own-label competition. Guaranteed returns under EU regulation to farmers

Manufacturer branding used against independent grocers in absence of own-label competition. Sugar processor (and beet farmer) receive guaranteed returns under EU regulatory regime from manufacturers and merchants

Natural monopoly created by transmission and distribution networks. Regulatory failure creating price stickiness in the pool

Aerospace re-fuelling

Motor insurance

Assembler and subassemblers use volume leverage and cost transparency against bespoke component suppliers

Sub-assembler provides technically complex equipment with high asset specificity

1111

Automotive

IT systems integration

Volume leverage and cost transparency used by sub-assemblers against component suppliers, and by assembler against smaller sub-assemblers Information asymmetry providing opportunities for intermediaries and insurance companies to leverage customers, and for car repairers to leverage insurance companies

Information asymmetry operating in favour of dealer and against smaller end customer

Ex ante lock-in by customers to manufacturers’ branded proprietary parts, protected by regulatory rights

Multinational subassembler uses scale and innovation against specialist assembler. Regulatory right allows assembler to dictate forms of exchange with dealer

Systems integrator uses branded reputation and information asymmetry against end customer

Innovation with high causal ambiguity allows individual IT consultants to leverage consultancy provider

240 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

volume is an important power resource for buyers in three of our cases in particular. In the industrial sugar case, purchasing volume is the basis of buyer dominance in the exchange relationship between the multiple grocer and the grocery manufacturer. Given that the top two multiple grocers in the UK now account for nearly 40 per cent of all food and drink sales (Key Note 1996), it is clear that even the largest manufacturers are heavily reliant on supermarkets as their main channel of distribution. This accords the supermarkets a significant power advantage in their dealings with many manufacturers, in particular those facing effective own-label competition. In the aerospace re-fuelling case, the equipment assembler and the manufacturers of some of the sub-assemblies use volume, in combination with cost transparency, to leverage a small number of preferred suppliers of bespoke components. The important point here is that the volume of components being bought might not be large in absolute terms, but it is still a significant portion of the total output of these suppliers. In the automotive case, purchasing volume is the basis of buyer dominance in two exchange relationships. The first relationship is that between the car assembler and a relatively small-scale nationally based supplier of sub-assemblies. Here again, the assembler has power over the supplier, because it is buying a significant portion of the sub-assembler’s output. The second exchange relationship is that between a sub-assembler, be it a national or a multinational operator, and a preferred component supplier. Branding also appears as an important power resource in four of our seven case studies. In the forecourt retailing and industrial sugar cases, brand provides the basis for certain grocery manufacturers to dominate their customers at both the distribution and the retail stages of the supply chain. This brand-based supplier dominance only exists, however, in those product categories in which there is no effective own-label competition. Wherever the customer has the choice of buying an effective own-label alternative, the relatively ephemeral nature of promotional branding is revealed. Branding also appears as a power resource in the motor insurance and the IT systems integration cases. In the motor insurance case the branded parts that car assemblers build into their cars provide the basis for significant supplier dominance in the car repair after-market. In the IT systems integration case, the brand-based reputation of the systems integrator is used as a signal to the end customer to justify premium pricing. The main problem for the end customer in this supply chain power regime is that they are buying a package of IT hardware, software and consultancy, many elements of which are experience and credence goods. In these circumstances, it is in the systems integrator’s interests to invest heavily in brand-name capital, because, as Nelson (1970) and Darby and Karni (1973) argue, the ill-informed end customer uses this as a signal of the quality of what they are buying.

Linking approaches to business thinking 241 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

On a related front, our research indicates that there are three cases in which the supplier is able to achieve opportunistic dominance over the buyer by exploiting an information asymmetry. In the motor insurance case there were two clear circumstances in which information asymmetry has historically provided the basis for the creation of opportunistic supplier dominance. The first example relates to the potentially collusive exchange relationship between the insurance companies and the intermediaries (brokers), when they interface with the customer as policyholder. The second relates to the role of the car repairer when faced with an incompetent insurance company as buyer. Even though our research demonstrates that these exchange relationships are now being challenged by new technologies that provide lower search costs for consumers, and by more professional procurement approaches by some insurance companies, there is still the possibility that the uninformed may be subject to this type of supplier opportunism. In the automotive case, this asymmetry has traditionally operated in the exchange relationship between the car dealer and the private end customer. We characterise this exchange dyad as an example of opportunistic supplier dominance with many potential suppliers. The market for both new and used cars is clearly contested. Dealers are nonetheless able to leverage individual customers on an opportunistic basis, because such customers visit the market infrequently and the costs of undertaking accurate cost/ price comparisons are relatively high. Private car buyers could in theory become better informed, and therefore less vulnerable to supplier exploitation, but the costs of doing so tend to be viewed as prohibitively high. A similar information problem exists for the end customer in the IT systems integration case. As we noted earlier, many of the products and services brought together by the systems integrator are experience and credence goods. This is true even for the relatively standardised software and hardware products that form the bulk of IT systems packages. Moreover, end customers tend to visit the market relatively infrequently. Consequently, it is often difficult, if not impossible, for the end customer to assess and monitor whether the integrator is providing good value-formoney. The integrator therefore has a strong incentive to behave opportunistically by premium pricing. This strategy can only be sustained across repeated purchases, however, if the systems integrator also provides satisfactory levels of service. If the integrator fails to at least satisfice the end customer, then the customer is likely to take advantage of what is essentially a contested market by switching suppliers. Even if the customer is discouraged from doing this by high switching costs, the integrator will nonetheless suffer erosion of its other main power resource, its brand-based reputation. In these circumstances, the systems integrator must exploit its power advantage with caution. One of the most interesting findings of our research is the relative paucity of circumstances in the seven cases analysed in which product or process

242 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

innovation acts as a supplier power resource. Indeed, as Table 11.1 shows, there are only two exchange relationships in which innovation contributes significantly to the creation of supplier dominance. The first relationship is that between the large multinational sub-assembler and the small-scale specialist assembler in the automotive power regime. As we noted above, the balance of power in this exchange relationship has shifted decisively in favour of the sub-assembler through a combination of market consolidation and the outsourcing of design and R&D by the volume car assemblers. These two developments have created a situation in which the specialist assembler is heavily reliant upon perhaps one or two large multinational sub-assemblers for the design and development of each of the key systems within any car. This supply-side scarcity is compounded by the fact that smaller nationally based sub-assemblers cannot compete effectively with these multinational giants, because they generally have insufficient resources to undertake the same levels of continuous innovation. The second exchange relationship in which innovation contributes to a situation of supplier dominance is that between individual IT consultants and the consultancy firms by which they are employed. In this case the individual IT consultant is able to create a high degree of supply-side scarcity by developing innovative solutions that cannot be easily imitated by others in the market. Imitation is made difficult in this situation by the fact that much of the knowledge used to create an individual IT solution remains tacit and uncodified. The importance of this type of knowledge to the practice of IT consultancy in turn generates a high degree of causal ambiguity around particular solutions. In short, those IT consultants that are able to generate innovative and relatively inimitable solutions are in a strong position to premium price their services. It is perhaps worth noting, however, that in the motor insurance case it was clear that process innovation did initially provide for a degree of supplier dominance when Direct Line first began the process of direct selling using the television and telephone. The key learning from this case, however, is that process innovation of this kind only has a short period in which it can provide for supplier dominance in the market. This is because the process of replication by competitors is relatively easy, and the critical asset created cannot be sustained over the longer term in the face of increased market contestation as everyone copies the first mover. To conclude, our research shows that technically complex equipment characterised by a high level of asset specificity is an important power resource for suppliers of certain sub-assemblies in the aerospace re-fuelling case. As we noted in Chapter 6, the manufacturers of five particular subassemblies enjoy a position of opaque supplier dominance over the equipment assembler in this supply chain power regime. The dominant sub-assemblers are those supplying ram air turbines, MA4 couplings, flow transmitters, actuators and fuel pumps. Supplier dominance in each of these cases is based both on the fact that the supply market is highly

Linking approaches to business thinking 243 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

restricted (this is less true for fuel pumps) and on the fact that the subassembly is characterised by a high degree of asset specificity, which generates substantial switching costs. This specificity arises principally because much of the technology in aerospace fuel equipment is systemic. This means that the use of a particular supplier’s sub-assembly within the equipment has implications for the other sub-assemblies with which it interacts. If the assembler were to switch to an alternative supplier for such an integral sub-assembly, the specification of the other sub-assemblies and components around it would also need to be changed. The switching costs in these exchange relationships are further increased by the fact that new suppliers of these sub-assemblies can only be adopted after they have been approved to industry standards by the equipment assembler. The most common types of dyadic exchange Having established the nature of the power resources that underpin the various critical assets operating in our seven supply chain power regimes, we turn to the question of which type of dyadic relationship occurs most often. As we argued in Chapter 1, our expectation when we began this research was that buyer or supplier dominance, in whatever form, were unlikely to be the most common types of dyadic exchange relationship. The reasons for this expectation were twofold. First, we argued that buyer or supplier dominance is based primarily on the possession of relatively scarce resources that have a high utility for the other party to an exchange relationship. The notion that resource scarcity is a cornerstone of exchange power implies, of course, that only a relatively small number of firms are likely to have power over others within any particular supply chain power regime at any given time. Second, we argued that most positions of buyer or supplier dominance are only ever likely to be temporary. This is because other firms, and specifically those that are dependent on a particular customer or supplier, might be expected to continually look for ways in which the resources underpinning a power advantage can be imitated or substituted. Although there are notable exceptions such as natural monopoly, firms can over time erode the resources underpinning most power advantages. Indeed, as we argued in Chapter 2, certain power resources, such as promotional branding, are highly ephemeral. Given this, we might reasonably expect that the number of instances of buyer or supplier dominance in any particular supply chain power regime is likely to be small. Significantly, the findings from the seven case studies presented here support this initial expectation. As Table 11.2 demonstrates, by far the most common form of dyadic exchange in our research sample is buyer–supplier independence. This finding reinforces our assumptions about the relatively scarce and temporary

Opportunistic supplier dominance with few potential suppliers

Opaque supplier dominance

Buyer– supplier interdependence

1

2

1

3

2

1

1

5

Motor insurance

2

1

3

2

Automotive

1

4

1

5

IT systems integration

3

7

28

Total

0

2

11

14

1

2

4

Aerospace re-fuelling

Transparent supplier dominance

3

4

Industrial electricity

0

3

1

4

Industrial sugar

Buyer dominance with opaque supplyside contestation

Opportunistic supplier dominance with many potential suppliers

4

4

Buyer–supplier independence

Buyer dominance with transparent supplyside contestation

Forecourt retailing

Types of dyadic exchange

Table 11.2 Types of dyadic exchange in the seven supply chain power regimes

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Linking approaches to business thinking 245 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

nature of exchange power advantages. In this type of dyadic exchange neither buyer nor supplier has any power to adversely affect the interests of the other. Each party to a transaction has a wide range of exchange alternatives, and the costs of switching are negligible. Moreover, the chances of a supplier behaving opportunistically in these circumstances are limited, because it is relatively easy and inexpensive for a buyer to detect and punish such behaviour. Despite the absence of any power advantage in this type of dyadic exchange, however, we assume, in line with classical market economics, that the supplier is forced to pass value to the buyer simply to retain business. This means that the supplier must charge a price equivalent to or below those being charged by competing suppliers. In addition, the supplier must continuously innovate to achieve greater productive efficiency and thereby maintain or enhance its profit margin. In the longer term, only those suppliers that are able to at least break even at the prevailing market price will remain in business. As classical economics would tell us, therefore, this type of perfect market exchange should lead to the maximisation of both productive and allocative efficiency. This implies that there are substantial benefits from this type of exchange to firms and individuals as buyers and to society in general. For firms and individuals as suppliers, however, the picture is somewhat bleak. Significantly, of the seven other categories of dyadic exchange that we have proposed, transparent supplier dominance also figures prominently in our case studies. This finding is interesting, because, as we proposed in Chapter 2, it is the exploitation of this type of critical asset that is most likely to provoke regulatory intervention by the state. In circumstances where a supplier has a relatively clear and unambiguous position of dominance over at least some of its customers, those customers might be expected, assuming that the necessary conditions for collective action are in place, to lobby the state for measures to constrain or even to dissolve that power advantage. Following Olson (1971), it is assumed that such lobbying is most likely to occur when the number of firms that will benefit from state intervention is relatively small, which in turn limits the likelihood of free-riding. There is some evidence of such customer-driven state intervention in the industrial sugar power regime, where the European Commission and the UK government have recently responded to pressure from major grocery manufacturers to review the price support mechanism covering the sugar processors. There are, of course, also circumstances in which the state intervenes to constrain the power advantages enjoyed by certain suppliers without direct pressure from well-defined customer interests. This type of general public interest intervention has occurred recently in at least two of the cases analysed in this volume, with both the multiple grocers and the volume car assemblers being investigated for anti-competitive practices

246 Supply Chains, Markets and Power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

by the UK government (Competition Commission 1999; MMC 1999). In the automotive case, those firms that were the subject of the investigation were found to have relationships with many of their customers commensurate with what we have called transparent supplier dominance. The state responded by requiring these firms to reduce their UK prices to bring them in line with those being charged elsewhere in the EU (Competition Commission 2000). The supermarket investigation was still ongoing at the time of writing. Public interest intervention by the state also occurs on an ongoing basis in the UK electricity industry, because this supply chain contains significant elements of natural monopoly and incumbent advantage. Those organizations active at the generation, transmission and distribution stages of the electricity supply chain historically had highly defensible power resources providing the potential for significant leverage over customers. In practice, however, the use of these power resources was heavily circumscribed by the state through a combination of public ownership and vertical integration. The decision to privatise the industry in the early 1990s changed all of this. Since then, intervention through ownership has been replaced with active regulation of the pricing and investment behaviour of the transmission and distribution companies and ongoing efforts to create greater competition in the generation of electricity (Littlechild 1983; Helm 1994; Cox et al. 1999). Evidence of a correlation between sub-regime type and profit margins The final issue that requires our attention is the question of whether there is a systematic relationship between a firm’s power position within a subregime of dyadic exchange relationships and the size of its profit margins. Table 11.3 presents an analytical categorisation that is used to test for the existence of such a correlation. The table also contains data on sub-regime types and profit margins from each of the seven supply chain power regimes discussed in this volume. The discussion in the remainder of this section is divided into two main strands. First, we discuss the theoretical assumptions that underpin the analytical categorisation presented on the left-hand side of Table 11.3. Second, we comment upon the extent to which these assumptions are supported by the data presented on the right-hand side of the table. As we noted earlier, our research has shown that each power regime tends to be divided into a number of discrete zones of value appropriation, which we have called sub-regimes. Our research has also shown that dominant firms are largely unable to influence the flow of value in a power regime beyond the boundaries of the sub-regime of which they are a member. Consequently, we have taken the various sub-regimes within each of our case study power regimes as the appropriate level of analysis. When

Type 4 Focal firm has value appropriated from it e.g. A > B < C A>B>C A>B0C A>B=C

Type 3 Focal firm shares value appropriation with two others e.g. A = B = C

Type 2 Focal firm shares value appropriation with another one e.g. A = B > C A=B0C A
Type 1 Focal firm dominates value appropriation e.g. A < B > C A
Sub-regime type

Significantly below sub-regime average

At sub-regime average

Slightly above sub-regime average

Significantly above sub-regime average

Expected level of profit margin for focal firm

Multiple grocer > Food/drink manufacturer < Sugar processor (nonbranded) Fuel equipment sub-assembler > Bespoke component manufacturer 0 Generic component manufacturer Corporate end customer 0 Car dealer < Car assembler < Multinational sub-assembler Insurance companies > Car repairers 0 Distributors/Generic parts suppliers

End customer < IT systems integrator = Specialist hardware assembler = Component manufacturer Brokers = Insurance companies = Car repairers

Sugar processor = Beet farmer 0 Agricultural inputs Tanker converter = Fuel equipment assembler 0 Sub-assembler End customer < IT systems integrator = Bespoke software producer 0 Software author Brokers = Insurance companies > Car repairers Insurance companies = Car repairers 0 Generic parts suppliers

End customer < Forecourt retailer 0 Grocery distributor Network electricity supplier < Generator 0 Primary fuel supplier Fuel equipment assembler < Sub-assembler > Bespoke component manufacturer Car assembler < Multinational sub-assembler > Component manufacturer Car repairers < Branded parts manufacturer 0 Sub-component suppliers

Case examples

Table 11.3 An analytical categorisation of double-dyad sub-regimes and profit margins

5% (Av. 7.5%) 5% (Av. 8%)

5–8% (Av. 18%)

5% (Av. 12%)

10–15% (Av. 11%) 10–15% (Av. 10%)

20–25% (Av. 20%) 10–15% (Av. 10%) 5–25% (Av. 10%)

25% (Av. 20%) 10–15% (Av. 13%)

40% (Av. 21%) 13% (Av. 7%) 55–65% (Av. 24%)

20–25% (Av. 13.5%) 18–22% (Av. 10%)

Estimated profit margin for focal firm and sub-regime average

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

248 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

we consider the relative size of a firm’s profit margins, therefore, we do this in the context of the margins being earned by the other members of a particular sub-regime. As can be seen from Table 11.3, we have created a four-fold typology of double dyad sub-regimes. This is based on the extent to which the focal firm in a sub-regime is able to control the appropriation of value within that segment of the overall supply chain power regime. The term ‘focal firm’ is used here in a purely descriptive capacity to refer to the firm in the middle of a sub-regime. It is not used, as it is in the resource dependency literature (Pfeffer and Salancik 1978), to refer to a dominant organization at the heart of an inter-organizational network. In those sub-regimes referred to as Type 1, the focal firm has sole control over the process of value appropriation, by virtue of its dominance over its customer and its dominant or independent relationship with its supplier. These two sub-regimes represent the ideal power position for the focal firm, because a firm in these circumstances has the potential to buy cheaply and to sell at premium prices. Consequently, we expect that the focal firm in this type of sub-regime will be earning a profit margin that is significantly above the average (mean) margin for the sub-regime as a whole. Moving on to the Type 2 sub-regimes, in these circumstances the focal firm has joint control with one other actor over the process of value appropriation. In this case the focal firm is interdependent with either its customer or its supplier. If this interdependent relationship is between the focal firm and its customer then the supplier will be in either a dependent or an independent relationship with the focal firm. Conversely, if the interdependency is between the focal firm and its supplier, then the customer must be in a dependent position. We contend that these three sub-regimes represent a second-best power position for the focal firm. It has the potential either to buy cheaply or to sell at premium prices, but it is forced to share the value that it is able to appropriate with either its customer or its supplier. Consequently, we expect that the focal firm in these circumstances will be earning a profit margin that is just above the sub-regime average. In the third category of double dyad sub-regimes we locate those power circumstances in which the focal firm shares the appropriation of value with both of the other members of its sub-regime. The only sub-regime that falls into this category, therefore, is one in which the focal firm has interdependent relationships with both its customer and its supplier. This means that the focal firm’s desire for lower input and higher output prices must be balanced against the contrary demands of the customer and the supplier. Given this power structure, we expect that the focal firm will be earning a profit margin that is at, or closely aligned with, the sub-regime average. Finally, in those sub-regimes referred to as Type 4, the focal firm has little or no control over the process of value appropriation. There is a

Linking approaches to business thinking 249 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

total of ten double dyad sub-regimes that fall within this category. It is unnecessary to discuss each of these in detail here (a detailed exposition can be found in Chapter 3). Rather, all we need say is that the focal firm is dependent either on its customer, or on its supplier, or on both. In addition, the focal firm might have an independent relationship with its customer or with both its customer and its supplier. As a consequence of these power circumstances, the focal firm is forced to pass value either downstream or upstream or, in some cases, in both directions. In this case, we expect that the focal firm will be earning a profit margin that is significantly below the sub-regime average. Turning now to the case examples and profit margin data shown on the right-hand side of Table 11.3, it is clear that they provide fairly strong support for the expectations outlined above. The table contains a number of sub-regime examples drawn from across the range of seven cases. Each one represents a particular type of sub-regime based on our four-fold categorisation. The expected level of profit margin for the focal firm in each sub-regime is tested using the estimated profit margin data reported in each of the case study chapters. We acknowledge that this margin data is no more than an educated estimate based on interviews with senior managers and publicly-available industry reports, and that it cannot accurately capture the heterogeneous profit performance within particular industry sectors, or individual companies within those sectors. This is because, when companies derive their profits, these are not just a function of the specific relationship between a customer and any one supplier. Each company buys from a myriad of suppliers in which there are many different power structures that, taken together, contribute to the overall profitability performance of the company. Nonetheless, as we discuss below, there is a significant correlation between the expected and the estimated focal firm profit margin in each case example. The sub-regime average given for each case example is a simple arithmetic mean. This is calculated by adding together the margins for each member of the sub-regime and then dividing that total by the number of members. For those cases in which an end customer appears it is included in this calculation although it has no profit margin of its own. This emphasises the fact that all of the participants in a sub-regime play a role in shaping the distribution of value and must therefore be taken into account when thinking about profit margins. By comparing this average profit margin with the estimated profit margin for the focal firm, a pattern emerges that is largely commensurate with our expectations. Thus for each of the five Type 1 sub-regimes shown in Table 11.3 the focal firm’s estimated profit margin is significantly above the sub-regime average. For each of the sub-regimes falling into Type 2 and Type 3, the focal firm’s estimated profit margin is respectively just above or at the sub-regime average. Finally, for two of the four Type 4 sub-regimes the focal firm’s estimated profit margin is significantly below

250 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

the sub-regime average. The divergence is less marked in the automotive and motor insurance cases, but the focal firms (car repairers and assemblers) still have an estimated profit margin that falls below the sub-regime average. The reasons for this smaller divergence are probably linked to the specific characteristics of the power relationships in this sub-regime. As we discussed in Chapter 3, there are various different types of buyer and supplier dominance. Unfortunately, while this volume has identified and described these different types, a systematic analysis of their differential impacts on profit margins is outside the scope of this study and remains a question for future research.

A research agenda for theoretical refinement: from descriptive to prescriptive thinking The findings from our research project outlined above indicate that there is a strong correlation between a firm’s power position within a sub-regime of dyadic exchange relationships and the size of its profit margins in specific transactions. We believe that this demonstrates that a focus on buyer and supplier exchange relationships and supply chain power regimes is a fruitful one for those interested in analysing the sources of business success and failure. There is, however, a number of problems that arise in our analysis that we have had neither the time nor the resources to fully resolve during the present research project. The most important of these problems revolves around the need to move from a primarily descriptive to a prescriptive way of thinking. Much of what we have been able to do in this current volume has involved the development of a theoretical understanding of the key attributes of buyer and supplier power in dyadic exchange relationships. Relatedly, this has allowed us to specify eight categories of dyadic exchange, within which six types of critical asset have been identified, and around which sixteen sub-regimes of extended dyadic exchange have been built. Having achieved this it has then been possible for us to test our theoretical propositions in seven power regime case studies. This approach has been based on the abstractive reasoning methodology outlined in the preface to this volume. This work has, however, been primarily descriptive, in the sense that we have merely used our theoretical framework to describe the bases of highest and lowest value appropriation in various sub-regimes of extended dyadic exchange. It is our view that, to develop a truly useful methodology to guide business practice, robust theoretical description of what has happened in the past is not enough. To be able to develop a properly robust analytical approach to business practice, it is necessary to move beyond description to prescription. By this we mean an ability to understand, in advance of the development of a competitive market around particular buyer–supplier exchanges, which

Linking approaches to business thinking 251 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

types of power resources are most likely to create a sustainable critical asset for the firm as a buyer or a supplier. Furthermore, it is also necessary to be able to predict in advance of action which combination of the various types of critical assets will provide the firm with the greatest capacity to earn high margins. While we believe we have begun the process of specifying the attributes of buyer and supplier power in dyadic exchange relationships, it is crucial to recognise that additional work is necessary. In particular, our current work has not, in our view, fully specified the complexity of categories that exist on the supply side of dyadic exchange. Even based on the current, relatively simple conceptualisation of supplier power resources, we have already created thirty-six categories of dyadic exchange. Moreover, we also believe that further work remains to be done to fully categorise the demand side of dyadic exchange relationships. This work will form part of the future agenda for the current research team. There is also a need to develop a better understanding of the problem of effectively managing within supply chain power regimes. Our work thus far has focused on mapping and explaining the complex interactions between dyadic exchange relationships in supply chain power regimes. On the basis of the seven cases presented here, it seems clear that firms often find it difficult, if not impossible, to appropriate value from others operating outside the immediate sub-regimes in which they are directly involved. This leads us to conclude that many managers will find it difficult, if not impossible, to implement the kind of fully-integrated supply chain management strategy that has been promoted so vigorously in recent years. The reason for this is that a fully integrated supply chain presupposes that it will be possible to create a network of extended exchange relationships (sub-regimes) in which value will flow continuously from supplier to buyer and then on to the end customer. This, we would argue, is only likely to be possible in a few exceptional circumstances. This means that the majority of firms must focus their value appropriation strategies more on sub-regimes than on supply chain networks per se. Even though our analysis offers such valuable insights, it still offers only a partial guide for managerial action. In this regard there are three main lacunae in our work. First, we have focused our attention in this volume on the structural characteristics of buyer–supplier exchange relationships. We have developed a framework for describing and analysing the power resources that dictate the structural context of these relationships. We have then used this structural context to predict the likely distribution of value in sub-regimes of extended dyadic exchange. At present, therefore, our predictive framework explicitly avoids any discussion of the human dimension of buyer–supplier interactions. The value outcomes in our model are entirely determined by structure. Second, and largely as a result of this focus on structure, we have developed an analytical framework that has a static conception of the extended

252 Supply chains, markets and power 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

networks of dyadic exchange in our cases. The power regimes presented in each of our case study chapters are a snapshot view of what are actually dynamic systems, which generally, although not exclusively, contain repeated interactions between buyers and suppliers. Third, our model does not consider the relationship between intraorganizational alignment and the effective exploitation of a structural power advantage in buyer–supplier exchange. We have argued at length that one of the most important power resources available to a buying organization is a high and regular volume of spend. The effective exploitation of this power resource presupposes, of course, that the sub-units within an organization are both willing and able to align their demand for common goods and services so that volume leverage over suppliers is maximised. We need therefore to consider those intra-organizational factors that might help or hinder such an alignment. Together, these lacunae suggest the need for us to refine our analytical framework so that it takes account of the relationship between the behavioural and the structural dimensions of buyer–supplier interactions. We need to understand how managerial decision-making is both constrained by and leads to changes in the structural environments that we have described and analysed. There is an obvious link, therefore, between the work that we have reported here and the insights offered by game theory. The introduction of game theoretic reasoning into our analysis would allow us to model both the structure of a buyer–supplier game (either one-off or repeated), defined by the relative power resources of each player, and more importantly the skill with which these resources are utilised. This latter point is crucial, because experience tells us that a firm with a favourable power position does not always receive the bulk of the gains from trade as our current model would predict. Behavioural factors such as a refusal to negotiate or the use of delaying tactics, that are currently absent from our analysis, are clearly important for a proper understanding of value outcomes in buyer–supplier exchange (McMillan 1992). A good deal of our future efforts in theory development will be focused on these issues. By extension, it is also necessary for future research to focus on countervailing strategies. It is one thing for analysts to understand the structures of dyadic exchange that operate within supply chain power regimes. It is, however, altogether another thing to understand what can be done to transform current exchange relationships into relationships that allow the practitioner to create critical assets for themselves. It is our view that a firm’s capacity to earn high and sustainable margins depends primarily on whether it has a favourable power position, both upstream and downstream, in the sub-regime of which it is a member. While knowing this is a necessary condition of business success, the sufficient condition is the ability to find ways of owning and/or controlling supply chain resources so that they can become critical assets. The ability

Linking approaches to business thinking 253 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

to understand which supply chain resources provide the basis for future asset criticality is in our view what makes some people entrepreneurs and some people managers. Entrepreneurs can see what could be, and how value can be appropriated and accumulated by purposive action to transform current power structures into something new. Managers simply administer what is as efficiently as possible. The problem they face, of course, is that doing better with what is can only be achieved if there is a change in the current exchange relationships between buyers and suppliers. This implies that innovation in demand and supply – particularly if it is difficult to replicate – that creates critical assets in dyadic exchange relationships is ultimately the basis of all strategic and operational improvement in business, and therefore the basis for business success or failure.

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Bibliography

Preface: power and the Janus-faced corporation Cox, A. (1996) ‘Relational competence and strategic procurement management: Towards an entrepreneurial and contractual theory of the firm’, European Journal of Purchasing and Supply Management, 2(1): 57–70. Cox, A. (1997a) Business Success: A Way of Thinking About Strategy, Critical Supply Chain Assets and Operational Best Practice (Boston, UK: www.earlsgatepress.com). Cox, A. (1997b) ‘On power, appropriateness and procurement competence’, Supply Management, October: 24–7. Cox, A. (1998) ‘Clarifying complexity’, Supply Management, January: 34–6. Cox, A. (1999a) ‘Power, value and supply chain management’, Supply Chain Management: An International Journal, 4(4): 167–75. Cox, A. (1999b) ‘Improving procurement and supply competence’, in R. Lamming and A. Cox (eds) Strategic Procurement Management: Concepts and Cases (Boston, UK: www.earlsgatepress.com). Cox, A. and Watson, G. (1999) ‘On Power and Efficiency: The Ghost in the Machine of the Economic Institutions of Capitalism’ (CBSP Working Paper, 1/10/99), Birmingham Business School, University of Birmingham, 10 October. Cox, A., Sanderson, J. and Watson, G. (1999) ‘Poachers and Gamekeepers: On the Power of Buyers and Suppliers in Business to Business Relationships’ (CBSP Working Paper, 1/11/1999), Birmingham Business School, University of Birmingham, 21 November. Cox, A., Sanderson, J. and Watson, G. (2000) Power Regimes: Mapping the DNA of Business and Supply Chain Relationships (Boston, UK: www.earlsgatepress.com). The Journal of Supply Chain Management (2001), 37(2). (The whole of this issue is devoted to the work of the CBSP on power in supply and value chains.) Molho, I. (1997) The Economics of Information: Lying and Cheating in Markets and Organisations (Oxford: Blackwell). Rumelt, R. P. (1984) ‘Towards a strategic theory of the firm’, in R. Lamb (ed.) Competitive Strategic Management (Englewood Cliffs, NJ: Prentice Hall). Rumelt, R. P. (1987) ‘Theory, strategy and entrepreneurship’ in D. Teece (ed.) The Competitive Challenge (New York: Harper & Row). Supply Chain Management: An International Journal (1999) 4(4). (The whole of this issue is devoted to the work of the CBSP on supply and value chains.) Watson, G. and Sanderson, J. (1997) ‘Collective goods versus private interests: Lean enterprise and the free rider problem’, in A. Cox and P. Hines (eds) Advanced Supply Management (Boston, UK: www.earlsgatepress.com).

Bibliography 255 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Williamson, O. E. (1975) Markets and Hierarchies: Analysis and Anti-Trust Implications (New York: The Free Press). Williamson, O. E. (1985) The Economic Institutions of Capitalism (New York: The Free Press). Williamson, O. E. (1999) ‘Strategy research: Governance and competence perspectives’, Strategic Management Journal, 20(12): 1087–109. 1 Power, rents and critical assets Amit, R. and Schoemaker, P. J. (1993) ‘Strategic assets and organisational rent’, Strategic Management Journal, 14: 33–46. Barney, J. B. (1991) ‘Firm resources and sustained competitive advantage’, Journal of Management, 17: 99–120. Blau, P. M. (1964) Exchange and Power in Social Life (New York: Wiley). Castanias, R. and Helfat, C. (1991) ‘Managerial resources and rents’, Journal of Management, 17: 155–71. Caves, R. E. and Porter, M. (1977) ‘From entry barriers to mobility barriers: Conjectural decisions and contrived deterrence to new competition’, Quarterly Journal of Economics, 91: 241–62. Christopher, M. (1992) Logistics and Supply Chain Management: Strategies for Reducing Costs and Improving Services (London: Pitman). Coase, R. (1937) ‘The nature of the firm’, Economica N.S., 4: 386–405. Connor, K. (1991) ‘A historical comparison of resource-based theory and five schools of thought within industrial organisation economics: Do we have a new theory of the firm?’, Journal of Management, 17: 121–54. Cox, A. (1997) Business Success: A Way of Thinking about Strategy, Critical Supply Chain Assets and Operational Best Practice (Boston, UK: www.earlsgatepress.com). Cox, A. (1999) ‘Improving procurement and supply competence’, in R. Lamming and A. Cox (eds) Strategic Procurement Management: Concepts and Cases (Boston, UK: www.earlsgatepress.com). Dierickx, I. and Cool, K. (1989) ‘Asset stock accumulation and sustainability of competitive advantage’, Management Science, 35: 1504–11. Dobbs, I. (2000) Managerial Economics: Firms, Markets and Business Decisions (Oxford: OUP). Emerson, R. E. (1962) ‘Power-dependence relations’, American Sociological Review, 27: 31–41. Farmer, D. H. and Ploos van Amstel, R. (1991) Effective Pipeline Management: How to Manage Integrated Logistics (Aldershot: Gower). Frazier, G. L. and Antia, K. D. (1995) ‘Exchange relationships and inter-firm power in channels of distribution’, Journal of the Academy of Marketing Science, 23 (Autumn): 321–6. Gallie, W. B. (1955) ‘Essentially contested concepts’, Proceedings of the Aristotelian Society, 56: 170–1. Galunic, D. C. and Rodan, S. (1998) ‘Resource recombinations in the firm: Knowledge structures and the potential for Schumpeterian innovation’, Strategic Management Journal, 19: 1193–201. Ghemawat, P. (1986) ‘Sustainable advantage’, Harvard Business Review, Sept–Oct: 53–8. Harland, C. (1996) ‘Supply chain management: Relationships, chains and networks’, British Journal of Management, 7 (Special Issue): 63–81.

256 Bibliography 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Hickson, D. J., Hinings, C. R., Lee, C. A., Schneck, R. E. and Pennings, J. M. (1971) ‘A strategic contingencies theory of intra-organizational power’, Administrative Science Quarterly, 16: 216–29. Houlihan, J. (1984) ‘Supply chain management’, Proceedings of the 19th International Technical Conference of the British Production and Inventory Control Society: 101–10. Jacobs, D. (1974) ‘Dependency and vulnerability: An exchange approach to the control of organisations’, Administrative Science Quarterly, 19: 45–59. Kay, J. (1993) The Foundations of Corporate Success (Oxford: OUP). Keep, W. W., Hollander, S. C. and Dickinson, R. (1998) ‘Forces impinging on longterm business to business relationship in the US: An historical perspective’, Journal of Marketing, 62 (April): 31–45. Lamming, R. C. (1993) Beyond Partnership: Strategies for Innovation and Lean Supply (Hemel Hempstead: Prentice Hall). Lamming, R. C. (1996) ‘Squaring lean supply with supply chain management’, International Journal of Operations and Production Management, 16(2): 183–96. Lieberman, M. and Montgomery, D. (1998) ‘First-mover (dis)advantage: Retrospective and link with the resource-based view’, Strategic Management Journal, 19: 1111–25. Lippman, S. A. and Rumelt, R. P. (1982) ‘Uncertain imitability: An analysis of interfirm differences in efficiency under competition’, The Bell Journal of Economics, 13: 418–38. Lukes, S. (1974) Power: A Radical View (Oxford: OUP). Mahoney, J. and Pandian, J. R. (1992) ‘The resource-based view within the conversation of strategic management’, Strategic Management Journal, 13: 363–80. Martin, S. A. (1994) Industrial Economics: Economic Analysis and Public Policy, 2nd edn (Englewood Cliffs, NJ: Prentice Hall). Nelson, R. and Winter, S. (1982) An Evolutionary Theory of Economic Change (Cambridge, MA: Belknap Press). Penrose, E. (1959) The Theory of the Growth of the Firm (New York: Wiley). Peteraf, M. (1993) ‘The cornerstones of competitive advantage: A resource-based view’, Strategic Management Journal, 14: 179–91. Pfeffer, J. and Salancik, G. R. (1978) The External Control of Organizations: A Resource Dependence Perspective (New York: Harper & Row). Porter, M. (1980) Competitive Strategy: Techniques for Analysing Industries and Competitors (New York: The Free Press). Porter, M. (1985) Competitive Advantage: Creating and Sustaining Superior Performance (New York: The Free Press). Provan, K. G. and Gassenheimer, J. B. (1994) ‘Supplier commitment in relational contract exchanges with buyers: A study of inter-organizational dependence and exercised power’, Journal of Management Studies, 31(1): 55–68. Ramsey, J. (1994) ‘Purchasing power’, European Journal of Purchasing and Supply Management, 1(3): 125–38. Ricardo, D. (1965, original 1817) The Principles of Political Economy and Taxation (London: J. M. Dent & Son). Rumelt, R. P. (1984) ‘Toward a strategic theory of the firm’, in R. Lamb (ed.), Competitive Strategic Management (Englewood Cliffs, NJ: Prentice Hall). Rumelt, R. P. (1987) ‘Theory, strategy, and entrepreneurship’, in D. Teece (ed.), The Competitive Challenge (New York: Harper & Row).

Bibliography 257 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Salancik, G. R. and Pfeffer, J. (1974) ‘The bases and uses of power in organizational decision-making: The case of a university’, Administrative Science Quarterly, 19: 453–73. Saunders, M. J. (1998) ‘The comparative analysis of supply chains and implications for the development of strategies’, Proceedings of the 7th Annual IPSERA Conference, London: 469–77. Scherer, F. M. (1980) Industrial Market Structure and Economic Performance, 2nd edn (New York: Rand McNally). Schumpeter, J. (1942) Capitalism, Socialism and Democracy (New York: Harper & Row). Teece, D. (1987) ‘Profiting from technological innovation: Implications for integration, collaboration, licensing and public policy’, in D. Teece (ed.), The Competitive Challenge (New York: Harper & Row). Teece, D., Pisano, G. and Schuen, A. (1997) ‘Dynamic capabilities and strategic management’, Strategic Management Journal, 18: 509–33. Thompson, J. D. (1967) Organizations in Action (New York: McGraw-Hill). Tirole, J. (1993) The Theory of Industrial Organisation (Cambridge, MA: MIT Press). Watson, G. and Sanderson, J. (1997) ‘Collective goods versus private interests: Lean enterprise and the free rider problem’, in A. Cox and P. Hines (eds) Advanced Supply Management: the Best Practice Debate (Boston, UK: Earlsgate Press). Watson, G., Cox, A. and Sanderson, J. (1999) ‘Thinking strategically about supply chain management’, in D. Waters (ed.), Global Logistics and Distribution Planning, 3rd edn (London: Kogan Page). Wernerfelt, B. (1984) ‘A resource based view of the firm’, Strategic Management Journal, 5: 171–80. Williamson, O. E. (1975) Markets and Hierarchies: Analysis and Anti-Trust Implications (New York: The Free Press). Williamson, O. E. (1985) The Economic Institutions of Capitalism (New York: The Free Press). Williamson, O. E. (1991) ‘Strategising, economising and economic organisation’, Strategic Management Journal, 12 (Special Issue): 75–94. Williamson, O. E. (1995) ‘Hierarchies, markets and power in the economy: An economic perspective’, Industrial and Corporate Change, 4(1): 21–49. Williamson, O. E. (1996) The Mechanisms of Governance (Oxford: OUP). 2 The key attributes of buyer and supplier power Bain, J. (1956) Barriers to New Competition (Cambridge, MA: Harvard University Press). Caves, R. E. and Porter, M. (1977) ‘From entry barriers to mobility barriers: Conjectural decisions and contrived deterrence to new competition’, Quarterly Journal of Economics, 91: 241–62. Connolly, W. E. (1974) The Terms of Political Discourse (Oxford: Basil Blackwell). Cox, A. (1997) Business Success: A Way of Thinking about Strategy, Critical Supply Chain Assets and Operational Best Practice (Boston, UK: www.earlsgatepress.com). Cox, A. (1999) ‘Improving procurement and supply competence’, in R. Lamming and A. Cox (eds) Strategic Procurement Management: Concepts and Cases (Boston, UK: www.earlsgatepress.com). Dierickx, I. and Cool, K. (1989) ‘Asset stock accumulation and sustainability of competitive advantage’, Management Science, 35: 1504–11. Dowding, K. (1996) Power (Milton Keynes: Open University Press).

258 Bibliography 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Emerson, R. E. (1962) ‘Power-dependence relations’, American Sociological Review, 27: 31–41. Ghemawat, P. (1986) ‘Sustainable advantage’, Harvard Business Review, September– October: 53–8. Klein, B. K. and Leffler, K. B. (1981) ‘The role of market forces in assuring contractual performance’, Journal of Political Economy, 89: 615–41. Konstadakopulos, D. (1995) ‘The linked oligopoly concept in the Single European Market: Recent evidence from public procurement’, Public Procurement Law Review, 5: 213–34. Levine, D. and Lippman, S. (1995) ‘Introduction’, The Economics of Information, 1: xi–xliv. Lieberman, M. and Montgomery, D. (1998) ‘First-mover (dis)advantage: Retrospective and link with the resource-based view’, Strategic Management Journal, 19: 1111–25. Lindblom, C. E. (1977) Politics and Markets (New York: Basic Books). Lippman, S. A. and Rumelt, R. P. (1982) ‘Uncertain imitability: An analysis of interfirm differences in efficiency under competition’, The Bell Journal of Economics, 13: 418–38. Lonsdale, C. and Cox, A. (1998) Outsourcing: A Business Guide to Risk Management Tools and Techniques (Boston, UK: www.earlsgatepress.com). Lukes, S. (1974) Power: a Radical View (London: Macmillan). Molho, I. (1997) The Economics of Information: Lying and Cheating in Markets and Organisations (Oxford: Blackwell). Office of Fair Trading (1997) Consumer Detriment under Conditions of Imperfect Information (London: OFT). Peteraf, M. (1993) ‘The cornerstones of competitive advantage: A resource-based view’, Strategic Management Journal, 14: 179–91. Porter, M. (1980) Competitive Strategy: Techniques for Analysing Industries and Competitors (New York: The Free Press). Rumelt, R. P. (1984) ‘Toward a strategic theory of the firm’, in R. Lamb (ed.) Competitive Strategic Management (Englewood Cliffs, NJ: Prentice Hall). Rumelt, R. P. (1987) ‘Theory, strategy, and entrepreneurship’, in D. Teece (ed.) The Competitive Challenge (New York: Harper & Row). Williamson, O. E. (1985) The Economic Institutions of Capitalism (New York: The Free Press). Williamson, O. E. (1995) ‘Hierarchies, markets and power in the economy: An economic perspective’, Industrial and Corporate Change, 4(1): 21–49. Yao, D. (1988), ‘Beyond the reach of the invisible hand: Impediments to economic activity, market failures and profitability’, Strategic Management Journal, 9: 59–70. 3 Towards an analytical typology of supply chain power regimes Cox, A. (1997) Business Success: A Way of Thinking about Strategy, Critical Supply Chain Assets and Operational Best Practice (Boston, UK: Earlsgate Press, www.earlsgatepress.co.uk). Cox, A., Sanderson, J. and Watson, G. (2000) ‘Value Appropriation and Power: A Framework for Analysing Buyer and Supplier Exchange and Supply Chain Power

Bibliography 259 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Regimes’ (CBSP Working Paper, 1/3/2000), Centre for Business Strategy and Procurement, Birmingham Business School, UK, 27 March. Fisher, M. L. (1997) ‘What is the right supply chain for your product?’, Harvard Business Review, March–April: 105–16. Ford, I. D. (ed.) (1990) Understanding Business Markets: Interactions, Relationships and Networks (San Diego, CA: Academic Press). Hakansson, H. (ed.) (1982) International Marketing and Purchasing of Industrial Goods (Chichester: Wiley). Hakansson, H. and Snehota, I. (1995) Developing Relationships in Business Networks (London: International Thompson Business Press). Harland, C. M. (1996) ‘Supply chain management: Relationships, chains and networks’, British Journal of Management, 7 (Special Issue): 563–80. Peteraf, M. (1993) ‘The cornerstones of competitive advantage: A resource-based view’, Strategic Management Journal, 14: 179–91. Saunders, M. J. (1998) ‘The Comparative Analysis of Supply Chains and Implications for the Development of Strategies’, Proceedings of the 7th International IPSERA Conference, London, pp. 469–77. Watson, G. and Sanderson, J. (1997) ‘Collective goods versus private interest: Lean enterprise and the free rider’, in A. Cox and P. Hines (eds) Advanced Supply Management: The Best Practice Debate (Boston, UK: Earlsgate Press, www.earlsgatepress. co.uk). Williamson, O. E. (1985) The Economic Institutions of Capitalism (New York: The Free Press). 4 Site-specific convenience, branding and regulation Haines, D. (1997) Forecourt Retailing (Letchmore Heath: Institute of Grocery Distribution). IGD (1998) Grocery Wholesaling (Letchmore Heath: Institute of Grocery Distribution). Key Note (1996) The UK Food and Drink Industry (London: Key Note Ltd). Key Note (1997a) The UK Confectionery Industry (London: Key Note Ltd). Key Note (1997b) The UK Snack Foods Industry (London: Key Note Ltd). Key Note (1998) The UK Tobacco Industry (London: Key Note Ltd). 5 Regulation, site specificity and scale British Sugar (1997) British Sugar Compliance Manual, Internal Report, January. Key Note (1996) The UK Food and Drink Industry (London: Key Note Ltd). Key Note (1997) The UK Confectionery Industry (London: Key Note Ltd). 6 Site specificity and price stickiness under regulation Barfe, L. (ed.) (1998) The Energy Industry in the UK (London: Key Note Ltd). Bunn, D. W., Day, C. and Vlahos, K. (1998) ‘Understanding latent market power in the Electricity Pool of England and Wales’, in Pricing Energy in a Competitive Market (Palo Alto, CA: Electric Power Research Institute). DTI (1998) Review of Energy Sources for Power Generation (Cm 4071) (London: Department of Trade and Industry).

260 Bibliography 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Financial Times (1998) ‘Competition spurs jockeying by power behemoths’, 2 September: 19. Kahn, A. E. (1971) The Economics of Regulation: Principles and Institutions, vols I and II (New York: Wiley). MarketLine (1998) Industrial Electricity 1998 (London: MarketLine International Ltd). Martineau Johnson (1998) ‘Review of electricity trading arrangements’, Utilities Brief, 5: 1–2. McGowan, F. and Thomas, S. (1989) ‘Restructuring in the power-plant equipment industry and 1992’, The World Economy, 12(4): 539–55. McGowan, F. and Thomas, S. (1992) Electricity in Europe: Inside the Utilities (London: Financial Times Business Information Ltd). OFFER (1998a) Controlling Prices (Birmingham: Office of Electricity Regulation). OFFER (1998b) Generation (Birmingham: Office of Electricity Regulation). OFFER (1998c) Industry Structure in Scotland (Birmingham: Office of Electricity Regulation). OFFER (1998d) Transmission (Birmingham: Office of Electricity Regulation). OFFER (1998e) Distribution (Birmingham: Office of Electricity Regulation). OFFER (1998f) PowerGen plc Bid for East Midlands Electricity plc: A Consultation Paper by OFFER (Birmingham: Office of Electricity Regulation). OFFER (1998g) Proposed Merger of Scottish Hydro-Electric plc and Southern Electric plc to form Scottish and Southern Energy plc: A Consultation Paper by the Director General of Electricity Supply (Birmingham: Office of Electricity Regulation). OFFER (1998h) Supply (Birmingham: Office of Electricity Regulation). OFFER (1998i) How Electricity is Traded (Birmingham: Office of Electricity Regulation). Professional Engineering (1999a) ‘Offer tells generators to prepare for Pool reform’, 10 February: 12. Professional Engineering (1999b) ‘Will new style Pool lead to electricity price plunge?’, 11 August: 17. Sappington, D. and Stiglitz, J. (1987) ‘Information and regulation’, in E. Bailey (ed.) Public Regulation (Cambridge, MA: MIT Press). Thomas, S. and McGowan, F. (1994) The European Market for Transmission and Distribution Equipment (Brighton: Science Policy Research Unit, University of Sussex). 7 Asset specificity, switching costs and limited competition Hines, P. (1994) Creating World Class Suppliers (London: Financial Times/Pitman). SCRIA (1996) Working Together: Code of Practice (London: DTI/Society of British Aerospace Companies). Watson, G. and Sanderson, J. (1997) ‘Collective goods versus private interest: Lean enterprise and the free rider problem’, in A. Cox and P. Hines (eds) Advanced Supply Management: The Best Practice Debate (Boston, UK: Earlsgate Press, www.earlsgatepress.com). Womack, J. and Jones, D. (1996) Lean Thinking: Create Wealth and Banish Waste in your Organization (London: Simon and Schuster).

Bibliography 261 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

8 Information asymmetry and ex post lock-in to branded and regulated asset specificity ABI (1998) An Industry Sector Report: Facts, Figures and Trends (London: Association of British Insurers). Arrow, K. J. (1971) ‘Insurance, risk and resource allocation’, in S. E. Harrington (ed.) Foundations of Insurance Economics (London: Kluwer Academic Publishers). BRP (1992) BRP, An Industry Sector Report: Insurance Brokers (London: Business Ration Report). BRP (1997) An Industry Sector Report: Insurance Brokers (London: Business Ration Report). Channon, D. (1993) ‘Direct Line Insurance plc: new approaches to the insurance market’, in C. Baden Fuller and M. Pitt (eds) Strategic Innovation (London: Routledge). Diamond, D. (1997) ‘Financial intermediation and delegated monitoring’, Review of Economic Studies 51: 393–414. EC (1998) Single Market Review – Impact on Services: Insurance (London: European Commission, Kogan Page). Economist (1999) ‘Capital punishment’, 16 January: 77. Financial Times (1999) ‘Direct Line in web-site launch’, 1 September: 18. Key Note (1997) UK Insurance Market, 4th edn (London: Key Note Ltd). King, G., Smallman, C. and van Weegen, M. (1997) ‘Management strategy in UK insurance broking’, Management Decision, January/February: 58–67. 9 Information asymmetry, innovation, scale and regulation DRI Europe (1996a) ‘Motor vehicles’, in Panorama of EC Industry (Brussels: CEC). DRI Europe (1996b) ‘Motor vehicle parts and accessories’, in Panorama of EC Industry (Brussels: CEC). EIU (1995) The Future of Car Retailing in Western Europe (London: EIU). EIU (1997a) European Automotive Components, Part 1: The Industry Vol. 1 (London: EIU). EIU (1997b) European Automotive Components, Part 2: The Market (London: EIU). EIU (1998) The New Car Market in Europe (London: EIU). Key Note (1996) Car Dealerships (London: Key Note Ltd). Key Note (1997) Vehicle Leasing and Hire (London: Key Note Ltd). Lamming, R. (1993) Beyond Partnership (Hemel Hempstead, UK: Prentice Hall). Maxton, G. and Wormald, J. (1994) Driving Over a Cliff? (Wokingham: EIU/AddisonWesley Publishing). Sako, M., Lamming, R. and Helper, S. (1994) ‘Supplier relations in the UK car industry: Good news – bad news’, European Journal of Purchasing and Supply Management 1(4): 237–48. Watson, G. and Sanderson, J. (1997) ‘Collective goods versus private interest: Lean enterprise and the free rider problem’, in A. Cox and P. Hines (eds) Advanced Supply Management: the Best Practice Debate (Boston, UK: Earlsgate Press). Womack, J. P., Jones, D. T. and Roos, D. (1990) The Machine that Changed the World (New York: Rawson Associates).

262 Bibliography 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

10 Information asymmetry, moral hazard and branded reputation Gantz, J. (1990) ‘Outsourcing: Threat or salvation?’, Networking Management, October: 25–40. Hornbach, K. (1996) ‘Competing by business design – the reshaping of the computer industry’, Long Range Planning, 29(3): 616–28. Key Note (1997a) UK Computer Services Market (London: Key Note Ltd). Key Note (1997b) UK Computer Hardware Market (London: Key Note Ltd). Key Note (1998) UK Computer Software Market (London: Key Note Ltd). 11 Linking descriptive and analytical approaches to business thinking Competition Commission (1999) Competition Commission Invites Evidence on Supermarkets in the UK, Press Release, 21 April. Competition Commission (2000) New Cars: A Report on the Supply of New Motor Cars within the UK (London: HMSO). Cox, A. (1997a) Business Success: A Way of Thinking about Strategy, Critical Supply Chain Assets and Operational Best Practice (Boston, UK: Earlsgate Press, www.earlsgatepress.com). Cox, A., Harris, L. and Parker, D. (1999) Privatisation and Supply Chain Management (London: Routledge). Darby, M. R. and Karni, E. (1973) ‘Free competition and the optimal amount of fraud’, Journal of Law and Economics, 16: 67–88. Helm, D. R. (1994) ‘British utility regulation: theory, practice, and reform’, Oxford Review of Economic Policy, 10 (3): 17–39. Key Note (1996) The UK Food and Drink Industry (London: Key Note Ltd). Littlechild, S. C. (1983) Regulation of British Telecommunications’ Profitability (London: HMSO). McMillan, J. (1992) Games, Strategies and Managers (Oxford: OUP). MMC (1999) MMC Invite Evidence on the Supply of New Motor Cars, Press Release, 17 March. Nelson, P. (1970) ‘Information and consumer behavior’, Journal of Political Economy, 78: 311–29. Olson, M. (1971) The Logic of Collective Action (Cambridge, MA: Harvard University Press). Pfeffer, J. and Salancik, G. (1978) The External Control of Organizations: A Resource Dependence Perspective (New York: Harper & Row). Rumelt, R. (1984) ‘Towards a strategic theory of the firm’, in R. B. Lamb (ed.) Competitive Strategic Management (Englewood Cliffs, NJ: Prentice-Hall).

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

Index

adverse selection 29, 39 aerospace fuel equipment: asset specificity 242–3; power resources 239, 240 aerospace fuel equipment supply chain 145–52, 161; bespoke components 149; equipment assembly and testing 151–2; final integration 152; functional stages 148; generic components 148–9; subassemblies 149–51 aerospace fuel equipment value chain 153–61; exchange relationships 155–62; power regime 156, 161–2; profit margins 154–5; revenue shares 153 agrichemicals 106–7, 120–3 Andersen Consulting 216–17 asset criticality: motor insurance 182, 184; see also critical assets asset specificity 12, 13, 35; aerospace equipment 158, 242–3; motor insurance 172–3, 180–1 automotive components 189–90 automotive repair work 173–4, 181, 183–4 automotive spares 172–4, 175, 180–1 branding 49–50, 59, 84–6; confectionery 85, 111; costs of 48; extension 84, 85–6; food and drink 118–19; perceived scarcity 96–7; power resource 240; tobacco goods 85; see also ownlabelling business strategy 11–18 buyer: exchange interests 56, 57; expenditure 32; information resources 30; power resources 41–5, 134, 223, 235

buyer dominance 21, 24, 40, 97, 123; aerospace equipment 160, 161; motor insurance 182; opaque supply-side contestation 62, 64, 238–9, 244; transparent supply-side contestation 62, 63–4, 238–9, 244 buyer–supplier independence 21, 24, 41, 63, 68, 71; aerospace equipment 158, 159, 160, 161; forecourt retailing 93, 95–6, 97, 98; industrial electricity 136, 139, 141; industrial sugar 118, 122; IT industry 223, 224, 226, 227, 228; most common dyadic exchange 243–5; motor insurance 178–9, 181; new car industry 201, 204 buyer–supplier interdependence 21, 24, 41, 62, 65, 244; aerospace equipment 156, 157, 162; groceries retailing 96, 98; industrial electricity 140; industrial sugar 122; IT industry 223, 224, 226, 228; motor insurance 181, 182 car assembly 190–4; European practices 191, 200–1; exchange relationships 201–5; Japanese practices 199–200; market share 191; product segmentation 191–3 car industry: overcapacity 186, 193; power resources 239, 240, 241; regulation 236; restructuring 186; scale 205–6; see also automotive...; new car supply chain cartel 37, 38, 50 cash and carry groceries 88, 89 causal ambiguity 34, 36, 37 chocolate manufacturing 111

264 Index 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

CHP see combined heat and power plants closure mechanisms see isolating mechanisms Coase, Ronald 12 collusive cartels 37, 38 combined heat and power (CHP) plants 140–2 commercial importance 31, 32, 33, 46 commoditisation 177 competition: aerospace equipment 146; forecourt retailers 90; industrial electricity 126; new car industry 193–4, 195 component manufacturer, IT industry 224 computer industry 208; see also IT industry; IT systems integration... confectionery production 85, 111, 117 consultancy services, IT industry 214–15, 227–8 convenience premium 79, 93–4 convenience retailing 79–80, 82, 89–91; profit margins 92, 93; value chain 92 costs: new car industry 193; supply 55 countervailing strategies 252 critical assets 3, 6–8, 18, 22; case studies summary 235–9; erosion of 9; industrial sugar 123; IT industry 221 cultivation of crops 82–3 customer base 88, 95 dedicated investments 51, 59 defence spending, reduction 145–6 demand: architecture of 41–5; motor repair work 173; see also supply and demand demand curve 28 dependency 15–16 differentiation 32 direct selling: motor insurance 171, 178, 183; new car industry 204 distribution: groceries 88; industrial electricity 131, 135–6; motor insurance 169–71; new car industry 194–5, 201–3 double-dyad exchange regimes 67–72 downstream relationship 67–71, 176–9 duopoly, sugar production 103, 108 dyadic exchange: aerospace equipment 155–61; categories 62–5; common types 243–6; forecourt retailing 92–9;

industrial electricity 135–40; industrial sugar 114–23; IT systems integration 218–28; new car supply chain 197; power regimes 60, 67–74; research 250–3; sub-regimes 234, 247–50; validation 74–5 economies of scale 37, 237 EDS 216–17 efficiency 11–14 electricity: demand and supply 124–6, 131–2; generation 128–30; prices 125; regulation 236; see also industrial electricity supply chain end customer: aerospace equipment 145–6, 155; groceries 89; industrial electricity 124; IT industry 209–10, 220–2; motor insurance 171–2; new car industry 195–6 energy sources 127–8, 140–1 epiphenomenal benefit 56–7 Europe, new car industry 185–6, 190, 192–3, 200–1 ex post value 172 exchange model 27–9, 53 exchange relationships 4–5, 18–19, 24, 60–6; aerospace equipment 155–62; categories 62–5; forecourt retailing 92–9; industrial electricity 134–42; industrial sugar 114–23; IT industry 218–28; motor insurance 176–82; new car industry (downstream) 201–5; new car industry (upstream) 197, 198–201; on-site electricity supply 140–2; value appropriation 72–4 exchange-power heterogeneity 60–1, 219–28 expenditure, buyer 32 fertilisers 105–6, 120 firms 11–14 first-mover advantages 35, 37 first-order economising 12 focal firm, sub-regimes 247–9 food and drink manufacturing 110–12, 116–18 forecourt retailing 79–101; competition 90; market share 90–1; power resources 238, 240

1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

forecourt retailing supply chain 81–91; convenience retailing 89–91; functional stages 82; grocery distribution 87–9; grocery processing/manufacturing 84–7; raw material production 81–3 forecourt retailing value chain 91–9; exchange relationships 80, 92–9 functionality 8 gas supply 140–1 government sponsorship 185–6 grocery distribution 87–9 grocery processing/manufacturing 84–7 grocery retailing 7–18, 112–13 gross profit margin (ROCE) see profit margins hardware production, IT industry 212–13, 222–4 Hewlett Packard 212, 216–17 IBM 212, 213, 216–17 ice cream market 111 imitability 33, 34, 48, 55 independence 22–3 industrial electricity supply chain 124–32; competition 126; distribution 131, 135–6; functional stages 127; generation 128–30; primary fuel stage 127–8; impact of privatisation 125–6; supply 131–2, 136; transmission 130–1, 143 industrial electricity value chain 132–44; combined heat and power plant 140–2; costs 136; exchange dynamics 133–40; natural monopoly 137; power regimes 134–5, 141–2; profit margins 132–3, 136, 138; regulatory mechanism 137–9 industrial sugar: power resources 238, 240; regulation 236 industrial sugar supply chain 103–13; food and drink manufacturing 110–12; functional stages 104; grocery retailing 112–13; seed production 104–7; sugar beet farming 107–8; sugar processing and distribution 108–10 industrial sugar value chain 113–23; agricultural inputs 120–3; exchange relationships 114–23; marketing sugar

products 116–18; profits 113–14; sugar processing and distribution 118–20 industry standard 36–8 information: management 49–50, 51; public and private 29; search costs 30–1, 37, 43, 44 information asymmetry 29–30, 39–40, 47–8, 59, 241; insurance industry 164–5; motor insurance 182–3; new car industry 205–6 innovation 8–9, 16, 55–6, 59, 242 insurance industry 163–5; market share 166–8; see also motor insurance supply chain Intel, market dominance 59 interdependency 14, 22–3 interests 25, 26–7; buyer and supplier 56–7; manipulation of 27 intermediation, motor insurance 169–71, 177, 183 intervention price 107, 109 isolating mechanisms 45, 49–50, 62, 235; costs 55; epiphenomenal benefit 56–7; impact 54–9; industrial electricity 134; range 57–9; sustainability 47, 54–5, 56; types 34–8; value-added 55–6IT industry 207–10; innovation 242; power resources 239, 240, 241; profit margins 217–18, 225 IT systems integration supply chain 210–17; consultancy and support services 214–15; development 208; functional stages 210; hardware production 212–13; software production 213–14; systems integration 215–17 IT systems integration value chain 217–28; component manufacturer 224; consultancy provider 227–8; end customer 220–2; exchange relationships 218–28; hardware producer 222–4; power regime 219; software author 226–7; software producer 224–7; systems integrator 220–3, 224–5, 227–8; value appropriation 229 Janus-faced dominance 8, 204, 234 Japan, new car industry 185, 189, 192, 199–200

266 Index 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

key resources: aerospace equipment 148; forecourt retailing 82, 89–90, 100; industrial electricity 127, 130, 142–4; industrial sugar 105; IT industry 210; motor insurance 167; new car industry 188 knowledge 24, 25 lean supply 4 leverage 39–40, 43; motor insurance 177; pre-contractual 16; by supermarkets 98, 102; by volume 98, 237–40 major power producers (MPPs) 129, 132 market 5–6 market closure 7 market concentration 168–9, 171 market consolidation: grocery retailing 80, 83, 85, 86, 95–6; motor insurance 177; new car industry 191, 194–5 market dominance 16 market fragmentation: automotive spares 174; electricity 129; IT industry 209, 214, 221; raw material production 83 market power 7, 18 market share: car assembly 191; food and drink manufacturing 117; forecourt retailing 90–1; grocery manufacturing 85–6; insurance industry 166–8; IT industry 212, 214, 215, 216 Microsoft 38, 213, 216–17 mobility barriers 34 models: dyadic exchange 27–9, 53–4; power 19, 27–9; strategic behaviour 10; structure–conduct–performance 9–10 monopoly 35–6, 51, 58, 137 monopoly rents 16 moral hazard 29, 40 motor insurance: innovation 242; power resources 239, 240, 241; regulation 236 motor insurance supply chain 163, 165–74; end customer 171–2; functional stages 167; insurance and reinsurance 166–9; intermediation and distribution 169–71; replacement parts and repair services 172–4 motor insurance value chain 174–84; downstream power regime 176–9; upstream power regime 179–82, 183–4

MPPs see major power producers National Grid Company (NGC) 129, 130 natural monopoly 35, 51, 58, 137 new car supply chain 187–96; assembly 190–4, 201–5; asset criticality 185–96; design 187–8; end customer 195–6; functional stages 188; retailing and distribution 194–5; sub-assembly and component manufacture 189–90, 196, 199–201 new car value chain 196–206; exchange relationships (downstream) 201–5; exchange relationships (upstream) 198–201; power regime 197 NGC see National Grid Company niche suppliers, IT 207–9 objective interest 28–9 oil companies, forecourt retailing 80, 91, 96, 100–1 opaque supplier dominance 62, 64–5, 228, 238–9, 244 operational importance 31–2, 33, 46 opportunism 13–14, 198–9 opportunistic supplier dominance 241; few potential suppliers 62, 65–6, 238–9, 244; many potential suppliers 62, 63, 183, 199, 220, 238–9, 244 overcapacity, new car industry 193 own-labelling, sugar products 111–12, 116–17 potato production 83 power 14–18; definition 3, 15, 18, 25; foundations 18–22; models 19, 27–9; objective view 26–7; subjective view 26 power regimes 20–2, 23; aerospace equipment 156, 161–2; categories 60–6; dyadic exchange 40–1, 60, 67–74; forecourt retailing 92–100; industrial electricity 134–5, 141–2; industrial sugar 115–23; IT industry 219; motor insurance 176–82; new car industry 197; sub-regimes 234, 246–50; validation 74–5; value appropriation 72–4

Index 267 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

power resources: case studies 239–40; industrial electricity 134; industrial sugar 238, 240; summary 235–43 power structures see power regimes premium, convenience 79, 93–4 price capping 137–9 price differentials 204 price stickiness see price capping price support 83 primary activities 32–3 privatisation, electricity 125–6 product complexity 220, 225 product segmentation 191–3 profit 11–14; definition 5–6 profit margins: aerospace equipment 153, 154–5; convenience retailing 92, 93; correlation with sub-regime 246–50; industrial electricity 132, 136, 138, 143–4; industrial sugar 113–14; IT industry 207, 217–18, 225; motor insurance 174–6, 178, 183–4; new car industry 196 property rights 35–6, 37, 51, 58 quotas, EU sugar production 109–10, 119 raw materials: production 81–3; supply and demand 98–9 re-insurance 169 regional electricity companies (RECs) 125, 130, 131, 132 regulation 236–7; industrial electricity 126, 137–9, 236; new car industry 206; raw materials production 99, 123; sugar beet production 106, 107 rents 3, 7, 14–18; definition 6; entrepreneurial 16–17; monopoly 16–17; Ricardian 17 research agenda 250–3 resource dependency 19–20 resource scarcity 20–3, 31–40, 47–9, 51, 60–2 resource utility 31–3; dyadic exchange 61–2; low to medium 33, 46, 49, 50; medium to high 33, 46, 47–8, 49 resources see key resources restructuring: electricity industry 125–6; new car industry 186

retailing: groceries 7–18, 112–13; new car industry 194–5; see also forecourt retailing Ricardian rents 17 Ricardo, David 17 risk transfer, motor insurance 165–6, 171–2, 177 Safeway, forecourt retailing 80, 98 scale, new car industry 205–6 SCP see structure–conduct–performance model SCRIA see Supply Chain Relationships in Aerospace site-specific convenience 82, 90, 95 snack foods 86–7 soft drinks market 86, 111–12, 118 software: author 226–7; production 213–14, 224–7 state intervention 245–6; see also regulation strategic behaviour model 10 structure–conduct–performance (SCP) model 9–10 sub-assemblies: aerospace equipment 149–51, 158–9, 161; new car industry 189–90, 196, 199–201 sub-regimes, and profit margins 246–50 substitutability 31, 33, 34, 42 sugar beet: farming 107–8; seed production 104–7, 121 sugar merchants 110, 119–20 sugar production 82, 83, 84; duopoly 103, 108; EU quotas 109–10, 118; processing and distribution 108–10, 118–20; see also industrial sugar supply chain superior competence 36 supermarkets: forecourt shops 80, 100; grocery retailing 112–13, 240; monopoly rents 102; wholesaling 88 supplier: collusion 59; exchange interests 56–7; ideal contract 41–2; information resources 30; preferred 160; value and volume of business 44 supplier dominance 21, 24, 40, 242, 243; aerospace equipment 156, 157, 158; motor insurance 181; opaque 62, 64–5; transparent 62, 64

268 Index 1111 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 5 6 7 8 9 40111 1 2 3 4 45111

supplier power resources 45–52, 134–7; see also isolating mechanisms supply, architecture of 45–52 supply chain 5; aerospace equipment 145–52, 161; definition 4, 53–4; forecourt retailing 81–91; industrial electricity 124–32; industrial sugar 103–13; IT systems integration 210–17; and market competence 24–6; motor insurance 163, 165–74; new car industry 187–96; power regimes 20–2, 23, 60–75 Supply Chain Relationships in Aerospace (SCRIA) 146–7, 155 supply and demand: convenience retailing 98–100; industrial electricity 125–6, 131–2 supply innovation 4, 17, 23 supply network, definition 53 support activities 32–3 switching costs: aerospace equipment 149–51, 158, 159, 243; motor insurance 179 synchronised...: buyer dependence 69, 71; buyer dominance 68, 69; independence 69, 71; interdependence 69, 70

systems integration, IT industry 215–17, 220–3, 227–8 Tesco, forecourt retailing 80, 98 threshold price, sugar beet 109 tobacco production 82, 83, 85 transaction cost economics 16 transactions 42 transparent supplier dominance 62, 64, 94, 238–9, 244, 245–6; motor insurance 183 upstream relationship 68–71, 179–82, 183–4 utility see resource utility value appropriation 229 value chain 4–5; aerospace fuel equipment 153–61; forecourt retailing 91–9; industrial electricity 132–44; industrial sugar 113–23; IT systems integration 217–28; motor insurance 174–84; new car industry 196–206 wholesalers, groceries 87–8, 89 Williamson, Oliver 12–16, 41