Tuesday, September 9, 2008

Analogy #205: Dating Among Friends

If you want to mess up a perfectly good relationship among friends, start having some of them date each other. I’ve seen it happen many times. There will be a group of mutual friends that like to hang out together. Then, two in the group start having a serious dating relationship with each other. Suddenly, the dynamics in the group change.

Now, all of these same people can be a little less comfortable hanging around together. The two that started dating may prefer more private time away from the group…or maybe the others feel awkward being with the daters (the proverbial “third wheel”). And if someone else in the group is jealous because they wished they were having that dating relationship the other person, then it gets even messier.

Now if some in the group get married, it can change the dynamics between the married ones in the group and the unmarried ones. The gang may end up splitting into two groups—the married and the unmarried.

A similar situation could occur among guys who hang out together if one of the guys starts dating the younger sister of one of the others in the group. All of that free-flowing conversation about girls may no longer be as free flowing. Suddenly, that isn’t just a girl—it’s my baby sister—and “nobody is going to talk that way about my sister.” The friendships can become strained.

People are not the only ones who have relationships. Businesses (and their leaders) do as well. Businesses have relationships with their suppliers. They have relationships with their customers. They even have relationships with their peers in the same industry.

As long as everyone feels pretty much like equals, these relationships can be somewhat friendly and work smoothly. However, if some of these businesses start pairing up to form more serious relationships, it can ruin the old gang of friends.

For example, you may not be as friendly with a supplier if they start a serious relationship with one of your peers and end up merging with them. Now, buying from your supplier feels like you are lining the pockets of your competitor and that feels less comfortable.

And if a competitor gets a little too cozy with one of your customers, you may become as angry as if one of your friends was taking advantage of your little sister.

Therefore, if your strategy calls for creating some more serious relationships with others in the supply chain (like acquisitions, mergers, strategic alliances, etc.), be careful. Sure, it may seem all romantic and wonderful to hook up. However, it could upset a lot of your other relationships in a negative manner. The negative unintended consequences with the rest of the gang may outweigh and benefits of the pairing up.

The principle here is that a handful of stronger relationships in the supply chain may end up putting your firm in a weaker overall position with the rest of the marketplace. In the end, you may be worse off than before. In other words, by dating a couple of your friends, you may alienate the rest of your friends.

This may appear to run contrary to conventional wisdom. When it comes to strategy, it is commonplace to hear references to staying close to your core business (stick to what you know). And what could be closer to your core business (and knowledge base) than the neighboring pieces of the supply chain? Therefore, there is a temptation to want to form stronger associations (or acquisitions or startups) above you (suppliers) or below you (customers) in the supply chain.

For example, many retailers are moving upstream to get stronger control over their suppliers, creating exclusive brands or even buying out the supplier. Approximately half the sales at Kohl’s and JC Penney come from such relationships. Nervous suppliers (who are not part of the deal) are responding by opening up their own retail stores (becoming their own customer).

At first, one can dream up reasons why this could be a wise move. First, it is assumed that more ownership of the supply chain leads to more control and that more control leads to the ability to extract more profits. Second, it is assumed that there are some synergies and economies of scale in there somewhere which will lower your expenses.

Unfortunately, my experience and observations have shown me that reality usually works in the opposite direction. More often, the move to control more of the supply chain can serve to lower sales and increase costs. Allow me to explain why.

Buying a Supplier
First, let’s look at what happens if you acquire one of your main suppliers. Typically, prior to the acquisition this supplier had other customers besides you. Many of those other customers may be your direct competitors. When the supplier was independently held, all of these competitors would be okay with all buying from this same supplier. It was a happy group of friends.

However, once you purchase this supplier, the relationships change. These direct competitors suddenly have less desire to purchase from that supplier, because that money would now be going into the same company as one of their direct competitors (namely you). The fear would be that the profits from the supplier could be funneled into your core business and used to make life more difficult for them. So they start purchasing more from another supplier.

Your purchase of that supplier has made the supplier less desirable for no other reason than the fact you own it. You have tainted its independence with your connection to it. Sales for the supplier will most likely drop with these other customers and it is usually unlikely that you will throw enough extra business at them to make up the difference.

And even if you could throw more business to the supplier you purchased to make up for the supplier’s lost sales volume, consider this. There was a reason before why that supplier was not getting all of your business. They probably didn’t deserve it. Just because you now own them may not have made them any more deserving of that business.

And, of course, your negotiating stance has changed with that supplier now that you own them. Before, if you could negotiate tough terms with them, you got a disproportionately higher share of the value chain profits as they got disproportionately less. In other words, you could put the squeeze on the supplier and win at their expense.

However, if both sides of the negotiating table are owned by the same company, then you are only putting a squeeze on yourself. In fact, because you become more of a captive audience to your supplier, you will probably have less aggressive negotiations and end up paying more than you did before.

As a result, when you buy a supplier, there are forces at work to destroy value. There is pressure for the supplier’s sales to go down (do to defections from your competitors) and for your core business’ costs to go up (due to a weaker negotiating stance with the owned supplier).

Buying a Customer
A similar problem occurs if you make an acquisition downstream in the supply chain. The customers you did not acquire will resent the fact that you purchased one of their competitors, and weaken the sales of your core business as they abandon you.

If you own your customer, you may negatively change the focus of that company. Instead of letting them focus on their customer, you may try to get them to act in the best interest of your core business. For example, you may force them into purchasing too much inventory from you, or inventory they would not otherwise want. If you make them try to please your needs, rather than their own needs or their customer’s needs, you will make them less profitable.

And if you avoid this influence and let them run as before, then you have not created any synergies. The benefits of the purchase (for which you probably paid a premium) start to vaporize.

So again, when you buy a customer, there are forces at work to destroy value. You pay a premium price for the opportunity to destroy the company’s worth, for no other reason than the fact that you own it.

When you purchase firms directly above you (supplier) or below you (customer) in the supply chain, you have upset the old order of business for the entire supply chain. Unfortunately, these changes tend to work against you rather than for you. Synergies and economies of scale fail to occur to any large measure. Instead, the results tend to be alienation of customers and higher costs—a bad combination.

There’s an old saying that one shouldn’t date people at the company where they work. Not only may it make things awkward at work during the period of dating, but it can get really ugly at work afterwards when the couple breaks up. Once you determine that the types of acquisitions mentioned in this blog are often mistakes, you may want to sever the relationship and sell the business (i.e., break up). However, by then a lot of the relationship damage in the supply chain is already done, so it will still be ugly.

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