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On the Dark Side of Strategic Sourcing: Experiences from the Aerospace Industry

Author(s): Christian Rossetti and Thomas Y. Choi

Source: The Academy of Management Executive (1993-2005) , Feb., 2005, Vol. 19, No. 1
(Feb., 2005), pp. 46-60

Published by: Academy of Management

Stable URL: https://www.jstor.org/stable/4166152

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? Academy of Management Executive, 2005, Vol. 19, No. 1

On the dark side of strategic
sourcing: Experiences from the

aerospace industry

Christian Rossetti and Thomas Y. Choi

Executive Overview

American manufacturing has undergone dramatic changes during the last two

decades. Manufacturing firms were re-engineered, downsized, and restructured.
Employees were dismissed, divisions were scrapped, and subsidiaries were spun off. As a
consequence, outsourcing to external suppliers increased significantly, which in turn
resulted in the increased saliency of strategic sourcing and its economic implications.
Strategic sourcing integrates the buying firm’s strategic decisions with those of its key
suppliers, thus promoting trust and decreasing transaction costs. However, a dark side of
strategic sourcing has emerged. Some firms established long-term contracts with their
suppliers, set up mutually dependent relationships, and then began to strangle suppliers
with relentlessly short-term, cost-driven decisions. As a result, the buying firms and their
suppliers have now become competitors in the same market. Simply put, there is serious
long-term risk associated with firms becoming strategically integrated with suppliers and
then mistreating them for short-term gains. This paper demonstrates that misapplying the
tenets of strategic sourcing can result in the disintegration of the existing supply chain
and weaken the buying firm’s long-term competitiveness.

The anthology of American business is laden with

accounts of strategic blunders. The firms featured
in these stories missed opportunities, misjudged

competitors, developed losing strategies or, in
some cases employed poorly executed winning

strategies. Toward the end of 1990s, we began ob-
serving the tell-tale signs of a strategic blunder in
the aerospace industry. Although original equip-

ment manufacturers (OEMs)’ had implemented
strategic sourcing during the past decade, their
long-established supply chain was coming apart-

suppliers were selling their wares directly to the

buyers’ customers.2 We refer to this phenomenon
as “supply chain disintermediation,” and it has

widespread and broad economic implications for
the industry.3

We were disheartened that the core tenets of

strategic sourcing had been misapplied. Contrary
to the OEMs’ rhetoric surrounding long-term rela-

tionships and co-prosperity that underscore strate-

gic sourcing, in many instances their supplier
relationships were marked by infidelity. The disin-

tegration of the relationships seemed particularly

poignant given that OEMs’ outsourcing had in-
creased substantially, including their reliance on
suppliers. The stage had been set for close rela-

tionships, but it was marked by gamesmanship
and deception. Consider the fact that these OEMs

are large multibillion dollar companies (e.g., Boe-
ing, Airbus, General Electric, and Honeywell),

which are the major providers of airframe, propul-
sion, and auxiliary units, and the suppliers are
typically small companies traditionally regarded
as being at the mercy of these large buyers. How-

ever, when faced with the OEMs’ strategic sourc-
ing initiatives, segments of the aerospace supply
base are reacting atypically. Many suppliers are

deciding to short-circuit the decades-old aero-
space supply chain and supply aftermarket re-
placement parts directly to the buyer’s customers.
The aftermarket has long been regarded as the
OEMs’ sacred cash cow and was strictly off-limits
to the suppliers.

Our goal is to explain how the misapplication of
strategic sourcing can ‘lead to unintended conse-

quences for the buying firm’s competitiveness-

46

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2005 Rossetti and Choi 47

vis&i ~~Misapplication of Strategic Sourcing xzs
as*g t~~~~~~~~ Short-term perspectivie

.-*.gS ~~~~~~A Dishonesty s
a K~~~~~~~~~~~ Overyly simplistic views >Y

;>y ~~~~~~~~~~~What Happened a?>
A Infidelity -*S

. . . . … . …… ………. ..A Increased. *&.9 ~~~~~~~~~~~~~~~~~~~~~~competition < Promise of Strategic f aS g3 ~Sourcing gaiziaAga ~~~~~~~~~What Did Not Happen b A Productive . % < >XG ~~~~~~~~~~~~~~~~~~~~~rel at io ns h i p s

~~~~~~~~A Improved a ~~~~~~~~~~~~~~~~~~capabilities i;tb
FIGURE 1

Overall Framework

what we refer to as the dark side. From our per-

spective, the dark side had been steadily casting

its shadow over the aerospace industry for some

time. Indications have been present in aerospace
trade magazines as well as in academic publica-

tions, and corroborating evidence has been found

in the Federal Aviation Administrations (FAA) da-

tabases, court records, and even supplier web-

sites.4 Our own study conducted during the past
three years confirmed our suspicion that there are

dangers associated with replacing strategic sourc-

ing with short-term price-based decisions and sac-

rificing relationships for short-term profits. Al-

though strategic sourcing promises reduced costs

and increased efficiency, it is also true that with

more outsourcing the implications for missteps be-

come greater. Figure 1 illustrates how the initial

promises of strategic sourcing became unfulfilled

and led to unintended consequences when the te-

nets of strategic sourcing were misapplied by the

aerospace OEMs.5
First, we describe the historical context under

which original strategic sourcing initiatives were

planned. Next, we describe the promises of strate-

gic sourcing and how major OEMs in the aero-

space industry began implementing it. We then

identify misapplications of strategies and their
negative consequences. Finally, we discuss how

corporate strategies should be modified to account

for the changes that have occurred in their supply

chains.

The Aerospace Supply Chain in a Historic

Context

Fifty years ago, the aerospace industry, like most

industries during this period, was vertically inte-

grated. OEMs began outsourcing first to increase

capacity during the war years and later when the
introduction of jet aircraft increased demand for

new aircraft. Although parts may have come from

a variety of suppliers, they were shipped through
the OEMs, as depicted in Figure 2. OEMs used this
practice to ensure quality and to control distribu-

tion channels. Because the FAA requires that the

company authorized to manufacture a part is en-

tirely responsible for its quality, OEMs inspected
most parts they outsourced. Forcing suppliers to
ship all parts to the OEM ensured that its custom-
ers, the aircraft operators, did not interact with the
suppliers. By separating suppliers and customers,

OEMs were able to effectively control their supply
chain for decades.6

Like most complex, high-performance products
with high intellectual value, the majority of an

aerospace product’s cost is in its design. However,

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48 Academy of Management Executive February

Supplier Operator

Supplier Oeao

Supplier Oeao

FIGURE 2

Historical Supply Chains

the market has never been willing to pay for the
high design cost. Consequently, the OEMs entice
the market to buy their new products by selling at
or near cost; they then recoup their investment
through aftermarket profits. This business strategy
is commonly referred to as the “razor and blade”
model, wherein the manufacturer gives its razors
away in order to lure the buyer into paying for
high-margin replacement blades. However, the
payback period for aerospace products is longer
and riskier. In general, a new commercial aircraft
product breaks even about ten years after its intro-
duction. This risky practice is highly dependent
upon achieving a critical mass of products (e.g.,
engines) in the field and then maintaining high
margins on aftermarket parts.

Although aircraft operators have enjoyed the low
markup on new products for over 30 years, they
begrudgingly accepted the high prices they pay for
spare parts. However, when commercial airline de-
regulation took place in the early 1980s and profits
were replaced with losses, the airlines became
inflamed. Even as their customers were going
bankrupt, OEMs continued their aftermarket mark-
UpS.7 Clearly, there was a high demand for less-
expensive spare parts, and some suppliers were
tempted to satisfy this demand. However, the
OEMs kept them in check through government reg-
ulations and threats of retaliation. Suppliers bold
enough to enter the aftermarket arena usually lost
all business with the OEM whose part they were
selling. Furthermore, aftermarket suppliers often
found themselves in court for copyright infringe-
ment or patent violations.8

There were also incentives to remain loyal, how-
ever. Even when OEMs frequently switched suppli-

ers, there was enough business for everyone. Also,
in the early 1990s, even when military budgets
were cut and commercial airline revenue declined,
suppliers’ revenues were maintained because of
the OEMs’ increased outsourcing.9 One supplier
described this period as the era of “happy, fat, and
stupid.” Although the industry was unraveling,
suppliers were unaware of the implications.10
Then, as the industry recovered in the mid-1990s,
the OEMs discovered a new method to manage
costs-strategic sourcing. As OEMs initiated stra-
tegic sourcing, margins and revenues for suppliers
declined. Thus, the “happy, fat, and stupid” mem-
bers of the aerospace supply base went bankrupt,
were bought up, or woke up.”

Promise of Strategic Sourcing

For aerospace OEMs, the rate at which outsourcing
was being practiced grew exponentially in the late
1990s. Typical American manufacturers outsource
between 50 and 70 percent of the total value-add of
their products. To those outside supply chain man-
agement this percentage may seem high, but
many executives continue to push their strategic
sourcing groups to find more opportunities outside
the company.’2

Increased outsourcing is particularly attractive
to upper management because it improves many
of the metrics that stock analysts use to judge
company performance. As corporate pay has be-
come increasingly intertwined with stock perfor-
mance, activities that improve analyst ratings take
the forefront in executive initiatives. The effect that
outsourcing has on financial ratios is straightfor-
ward-shedding specific assets allows a company

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2005 Rossetti and Choi 49

Table 1

Strategic Sourcing Initiatives: Definitions and Outcomes

Strategic Sourcing
Initiative Definition Intended Outcomes

Supply Base Rationalization Reduction of the total number of suppliers * Decreased resources needed to manage
suppliers

* More focused relationship building

Commodity Management Matching corporate needs for parts of similar 0 Increased understanding of supply markets
processes and materials with the changing for given commodity
capabilities of the supply base. 0 Decreased supplier’s internal cost due to

improving economies of scale
* Closer technical relationship between buyer

and supplier

Spend Consolidation Increased dollar spent on purchases from one 0 Increased purchasing leverage
supplier * Increased interdependence between buyer

and supplier

Global Sourcing Exploiting global markets for improved * Decreased cost per part
capabilities, such as low-cost labor for the * Increased competition in supply market
manufacturing of labor-intensive parts

Sole Sourcing Agreements Purchasing a product or family of products * Lower prices from suppliers
from one supplier 0 Increased interdependence between buyer

and supplier
Long-Term Agreements An understanding that buyer-supplier * Improved quality, delivery and price due to

relationship will extend over several years supplier’s buyer-specific investments
or indefinitely * Expectation of trust and co-prosperity

between buyer and supplier

JIT Purchasing Minimization of supply lead time 0 Reduced level of inventory
* Increased supplier responsiveness

to increase return on assets (ROA) and return on
investment (ROI), and decreasing the head count
increases revenue per employee.13

However, there is more to outsourcing than sim-
ply creating a leaner firm. An important part of the
equation is the firm’s ability to decrease the costs
of outsourced goods relative to those produced in-
house. If the buying company is large enough, it
can simply use its market pressure to force suppli-
ers to decrease their prices. It can also threaten to
source in low cost markets overseas. Reducing in-
ternal costs is much harder, and can involve union
negotiations, a costly layoff, or new internal pro-
cesses. Renegotiation is free, fast, and effective.
The ease of reducing prices is not the only motiva-
tion. Reducing prices decreases costs of goods
sold, which has a tremendous effect on earnings.
With high price to earning ratios, reducing the
price of purchased goods by 5 percent can theoret-

ically increase the company’s stock by as much as
200 percent.’4

Basically, the more the buying firm outsources
and the harder it pressures its suppliers, the
greater the potential for a stock increase-in the

short term. A general impression among the exec-
utives is that strategic sourcing initiatives promise
5 to 15 percent cost savings. And for the most part,
these initiatives deliver.’5 As more companies re-

ported the effects of their strategic sourcing initia-
tives, the practices have increasingly gained favor
with the Fortune 500.16

But strategic sourcing is more than simply reduc-
ing input prices. It is designed to align the capa-
bilities of the supply base with the buyer’s market
opportunities. This is usually accomplished

through the implementation of several analytical
and operational initiatives, as shown in Table 1.

One of the important intended outcomes is a stra-
tegic partnership between a buyer and a supplier
that will maximize their collective market pres-
ence and profitability.17 In addition to the defini-
tions of different strategic sourcing initiatives, Ta-
ble 1 lists the intended outcomes associated with
each initiative.

Misapplication of Strategic Sourcing

As evidenced in Table 1, almost all strategic sourc-
ing initiatives intend to establish a closer buyer-
supplier relationship. This improved relationship
is facilitated by using a smaller number of suppli-

ers and the expectation of long-term relationships.
Table 1 also shows that promises of long-term re-

lationships are not enough. The majority of the cost
savings are gained through increased efficiencies
caused by better communication and trust. These

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50 Academy of Management Executive February

can only happen in a close working relationship.
Simply put, a close working relationship pays rent
because the buyer and the supplier reduce the cost
of safeguards and the cost of transactions.’8

During the process of implementing strategic
sourcing, however, many OEMs in the aerospace
industry seem to have focused on the short-term
issues. They sacrificed long-terms costs for short-
term price targets. They overlooked the fact that
the cost savings are derived from having a close
working relationship with suppliers. And because
their attention was consumed by short-term issues,
they failed to apply a basic tenet of commodity
management-to keep abreast of the changing
supply market and the regulations that governed it.

Short-Term Cost Targets at All Costs

The purchasing literature warns of sacrificing
competitive priorities for short-term cost gains. We
observed that long-term cost implications were
overlooked, corporate objectives and market con-
siderations were ignored, and quality was pushed
aside. The major cause of the misapplication of
strategic sourcing is the pressure placed on the
purchasing department to deliver year-over-year
price reductions. Purchasing and commodity man-
agers stated that the goals were set with the im-
plicit understanding that price reductions must be
met by any means.19 One commodity manager
said, “Promotions are based entirely on reaching
PPV (purchase price variance) targets.”20 Another
said, “It looks like my bonus is in question; I didn’t
reach my price targets this quarter.” Long-term
aspects such as overall efficiencies and the costs
of switching suppliers were not included in the
commodity manager’s reward structure. After re-
viewing the financial analyses used to justify over
a dozen sourcing decisions, we confirmed that
many important costs were not included. In many
cases, when these costs were included, the wrong
decision had been made.2′

Management’s reward structure based on PPV
can do much more than increase the total operat-
ing cost; it can lead purchasing managers to ne-
glect corporate interest. For example, one commod-
ity manager’s corporate office attempted to shun a
few suppliers that were entering its aftermarket.
However, when one of these suppliers offered the
required PPV and promised to meet future cost
reduction targets, this manager did not think twice
about striking a deal with the supplier. Akin to
aiding and comforting the enemy, this commodity
manager was supporting behavior that his com-
pany perceives as a threat. In another example, a
commodity manager was willing to make cost-

quality tradeoffs in order to achieve the purchase
price variance. This commodity manager went
against the high-quality requirements of the aero-
space industry and used a supplier with inferior
quality but a price 20 percent lower than other
competitors in order to achieve his year-end PPV
objective.

Turning a Blind Eye to Relationships: Long-Term
Expectations, Short-Term Reality

The desired outcome of strategic sourcing is to
improve the buyer’s competitive priorities (cost,
quality, and delivery), and much of this is accom-
plished by creating an environment where the sup-
plier trusts the buyer. According to the tenets of
strategic sourcing, this trust is based on the expec-
tation that relationships with a smaller number of
suppliers would be more intimate, improving in-
formation sharing, understanding, and communi-
cation. Once buyer-supplier relationships move
from short-term spot exchanges to long-term serial
exchanges, suppliers are willing to work with the
buyer to improve transactional efficiencies and re-
duce the time it takes to move a product’s market.22
Therefore, lower costs are based on long-term in-
creased efficiencies, not simply short-term price
reduction.

When practiced with the sole aim of reducing the
short-term purchase price, these initiatives create
dissonance between buyers and suppliers. Accord-
ing to our discussions with suppliers, strategic
sourcing and commodity management have irre-
trievably damaged buyer-supplier relationships.
We often heard from both the suppliers and buyers
that “the entire aerospace supply chain is entirely
cost focused.” The aerospace industry that for
years competed on capabilities now competes al-
most exclusively on year-over-year price reduc-
tions.23 It appears that long-term relationships now
exist in name only.24

With incentive structures pegged to year-over-
year PPV, commodity managers are not motivated
to form truthful and honest buyer-supplier relation-
ships. For example, OEM representatives enter ne-
gotiations stating that volumes will increase. They
promise that relationships will last, while knowing
that if a better opportunity presents itself, they will
switch suppliers. In other words, suppliers that
trust these words and increase their dependence
on the buyer are punished instead of rewarded.
One seasoned supplier manager concluded, “Only
a sucker would take a commodity manager’s words
at face value.” In the end, trust, which is the bed-
rock of strategic sourcing, becomes the stumbling
block for suppliers.

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2005 Rossetti and Choi 51

Sourcing with Eyes Wide Shut

Due to the complexity of their products and the
repercussions of failures, the FAA has played an
important role in the development of aerospace
supply chains. The strict regulations of the FAA
have prohibited many manufacturers from enter-
ing the aerospace industry. However, as airlines
increased pressure on the FAA to improve compe-
tition in the aftermarket, the amount of part man-
ufacturing authorities (PMA) granted has in-

creased dramatically.25 With recent regulatory
changes, a PMA is almost assured for reputable
aerospace suppliers, particularly if they have ex-
perience producing a part or similar parts, as is the
case with existing OEM suppliers. Although the
OEMs knew about the changes, they failed to real-
ize that their suppliers could become their compet-
itors far more easily.26

An important component of the PMA certification
process is testing, and here the OEMs missed the
emergence of important new alliances between

aircraft operators and parts suppliers. If an OEM
wants to change a part’s design it must assemble a
special test platform and then equip it with expen-
sive telemetry. Contrarily, if an aftermarket sup-
plier has reverse engineered a part, it can simply
contact an airline and ask for a test vehicle. Air-
lines are more than willing to provide a reputable
supplier with a vehicle to test its newly reverse
engineered part, especially if the airline has a
fleet of vehicles that regularly require this part for
routine maintenance and repair. The airline can

then be assured savings of a 20 percent to 90 per-
cent on this part if testing is successful.27

What Happened

We now consider what actually happened because
of the effects of misapplied strategic sourcing-the
outcomes of the changing supply chains in the
aerospace industry.

Supply Chain Disintermediation

Faced with this new reality of increasing instabil-
ity and decreasing profits, suppliers are doing
something that was unimaginable ten years ago.
Suppliers are being pressed to play a high-risk
game by entering their buyer’s aftermarket sales
business. Suppliers that once had long-standing
relationships with aerospace OEMs are now emerg-
ing as competitors. Airlines, that for years endured
near-monopoly OEM pricing practices, are eager to
purchase suppliers’ aftermarket products and aid
their full-fledged market entry. As shown in Figure
3, after years of channel dominance, the aerospace
original equipment manufacturers are losing con-
trol of the supply chain that they built.

The cost of disintermediation is great. From the
perspective of the OEMs, if suppliers take $1.00 of
aftermarket share, this is the equivalent of taking
up to $1.40 of their revenue.28 However, there is a
secondary cost, which could be more important to
the OEM’s long-term survival than the loss of im-
mediate revenue. Operators that are able to reduce
maintenance, repair, and overhaul (MRO) costs,
will be able to greatly extend the profitable use of
their existing aircraft. Operators retire airplanes
for a variety of reasons; however, at certain point
MRO costs rival the equipment’s revenue genera-

Supplier ——————————————————— Operator

Operator

Operator

FIGURE 3.

Emerging Supply Chains

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52 Academy of Management Executive February

tion capabilities. If operators can decrease this
cost substantially, new equipment sales will de-
crease. This will delay the cycle of new sales and
ensuing aftermarket sales, causing a delayed but
large ripple through the aerospace OEMs’ revenue
cycle.

Disintermediation certainly represents a funda-
mental structural change to the supply chain. It
has created new relationships among the players.
Prior to the implementation of strategic sourcing,

buyer-supplier relationships may have suffered
from the inefficiencies associated with competitive

buyer-supplier relationships. The buyer-supplier
relationships that evolved now suffer from some-

thing much worse-antagonism is usually present
among the fiercest competitors. Not only are the

suppliers concerned with their own well being,
they also associate their competitive priorities
with the buyer’s downfall.

Suppliers as Competitors

Suppliers that enter the aftermarket are potent
competitors to the OEMs. These PMA competitors

often have lower overhead, greater knowledge of
the parts they produce, and better customer ser-

vice. For example, suppliers are able to offer
shorter order lead time for the aircraft operators.

When OEMs implemented just-in-time (JIT) prac-
tices, they pushed inventories upstream. For this

reason, one supplier called such practice “Just Isn’t
There.” Consequently, when an operator orders a

part, most OEMs quote their supplier’s lead time,
on average six to 14 weeks. The OEMs then contact
the suppliers to check if they have the part in stock.
However, if the supplier is selling in the aftermar-
ket, it may not be responsive to the OEMs. The
supplier may wait and see if the aircraft operator
contacts it directly for an order, promising it in 24 to
48 hours, compared to the six to 14 weeks offered by
the OEMs.

Suppliers also have an enormous price advan-
tage over their OEM counterparts. Development
time for a new aerospace product can be up to five
years and can represent 80 percent of the total cost
associated with producing the first unit. In con-

trast, a suppler can reverse engineer a part in less
than five weeks. One engineer stated that the
OEMs face the same challenge as “Columbus in
search of the new land.” The OEM takes all the
risks ensuring that the new design will function
according to its intended specifications. Reverse
engineering is “just following the route already
mapped by the OEM.” With its lower overhead,
lower risk, and minimal research and design, PMA
suppliers …