In modern manufacturing, individual parts of complex products usually come from another source. Sometimes that source goes into business for itself and competes against the firm it once supplied.
This is not unheard of in high tech, with Samsung serving as a go-to example of the phenomenon called value-chain climbing. Samsung's history goes back much further, but arguably entered the public consciousness with semiconductors and component manufacturing, which were its primary businesses from the mid-1990s to 2008. Samsung was, and still is, the primary supplier of the processors used in Apple's iPhones. But Samsung now also makes its own line of smartphones. So what is the best strategy for a firm like Apple to stay ahead?
Lundquist College Assistant Professor of Operations and Business Analytics Zhixi Wan and his coauthor, University of Michigan's Brian Wu, take on the subject in a paper titled “When Suppliers Climb the Value Chain: A Theory of Value Distribution in Vertical Relationships," which was recently accepted to Management Science, a top journal in the field.
Wan joined the Lundquist College in December 2014. He teaches the core operations management course for the Department of Operations and Business Analytics. His research focus is supply chain management operations and strategy.
Wan and his coauthor use game theory modeling as a methodology to investigate value-chain climbing in supplier-manufacturer relationships.
“The math is beautiful," he said.
The authors explain the conventional wisdom considers two options for when a supplier becomes a competitor: pay more to the supplier to keep it loyal (“accommodating") or terminate the relationship (“dumping"). Dumping the supplier, however, may not be strategic as the maker must now find another supplier or produce the part itself, likely at a higher cost.
But Wan and his coauthor's research identified a third option—“squeezing."
This option is similar to that of a master and apprentice. In this context, the supplier accepts a smaller payment for the part, sometimes close to actual cost, while learning about the master's product, marketing, and business practices. While this is happening, the master firm is developing the next generation of the product, and squeezing as much value out of the supplier as possible.
“In the short term, the manufacturer gets cheaper parts, but in the long term the supplier may come along and compete," Wan said.
Ideally, the master firm has already moved on to the next iteration, so the by the time the apprentice firm gets its product to market, the master firm is marketing the next big thing and the firms are not directly competing.
Or, the apprentice may never enter the market at all due to cost, risk, and other factors, and the firms may choose to continue the relationship. If the firms stick together, the master firm may up the payout to the supplier firm, so the supplier is no longer operating on such a slim profit margin.
Governments in some emerging markets, such as China, the authors assert, intentionally adopt a policy of using local markets to acquire advanced knowledge held by the foreign firm. Foreign firms know this and typically accept the deal anyway.
“Our study reveals the existence of a squeezing relationship as an alternative explanation of this paradoxical phenomenon," the study noted.
All three options—accommodating, dumping, and squeezing—individually have merit in certain circumstances, and each should be evaluated when strategizing in the short and long term, they noted.
A second paper coauthored by Wan on the subject of supplier competition was also recently accepted by the prestigious Management Science journal. Publication dates for both studies have not yet been announced.