Pergamon European Journal of Purchasing & Supply Management Vol 2, No 1, pp. 57-70, 1996 Copyright © 1996 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0969-7012/96 $15.00 + 0.00 0969-7012(95)00019-4 Relational competence and strategic procurement management Towards an entrepreneurial and contractual theory of the firm Andrew Cox The Centre for Strategic Procurement Management, University of Birmingham, Edgbaston, Birmingham B15 2SQ, UK This article explains what a strategic procurement management approach to effective business strategy is. This proactive approach is contrasted with current reactive and simplistic approaches to purchasing and supply management. A proactive approach to business management requires firms to recognise that their boundaries need to constantly change in response to consumer preferences; and, that the most effective operational tool for deciding on the "effective boundaries" of the firm will be based on analysing types of relational competences. This approach links competences, relationships and asset specificity in order to procure a supply and value chain which reduces the costs of transactions and improves profitability. Keywords: strategy, procurement, competences, relationships, asset specificity what is strategic procurement management and how is it different from the traditional conception of purchasing and supply management? (b) how does one develop a proactive rather than reactive approach to external resource management? and (c) what is the proper relationship between theory building, conceptualization and operational practice? In elaborating on these issues it will also be necessary to critically appraise some relatively new concepts and ideas in the purchasing and supply literature. The reason for doing this is that there is a danger of the profession becoming confused with fashionable concepts or ideas (fads). The danger with fads is that they develop a life of their own. New concepts and ideas are taken up by practitioners under pressure, who need to demonstrate their 'state of the art' knowledge and expertise but who do not have the time to assess the practical utility of a concept for their own unique business environment. Often fads have not been properly evaluated empirically before they are touted as the latest 'cure-all' for every management problem (New, 1994). The difficulty is that these fads can, if not properly understood and rigorously analysed, be implemented incorrectly or out of context and can do far more harm than good. t TQM and BPR are but two examples of this, and now, within purchasing and supply, we have our own candidates for fad status in partnership sourcing, lean supply and network sourcing. This is a revised version of a paper presented to the First Worldwide Research Symposium on Purchasing and Supply Chain Management, College of Business, Arizona State University, Tempe, Arizona (23-25 March 1995). 1An example of this myopia was indicated to me recently by a professional consultant who indicated that he had found one major company in the USA that had partnerships for all and every type of external relationship, irrespective of the specificity of the assets involved. Introduction This paper seeks to contribute to a better understanding of what causes firms to limit the boundaries of the organization and to resist the vertical integration of all aspects of production and supply. Necessarily, this task involves a discussion of which types of external resource management relationships firms ought to adopt and under what circumstances. The second task of the paper is to address the problematic of conceptualization and theory building within the developing discipline of purchasing and supply chain management. The key conceptual issues to be addressed in this regard are: (a) 57 A Cox The major reason fads fail is that those who rush to implement new concepts and ideas often fail to understand that the relationships which work successfully in one business environment may not be as successful when transplanted elsewhere. It follows from this that, insofar as academic enquiry can aid business practice, there is a special intellectual project which the academic community must undertake to assist business decision-making. This project is the development of a coherent body of empirically verified knowledge concerning which types of sourcing and supply relationships might best be used under what circumstances, and with what costs and benefits to business profitability. To achieve this, however, it is first necessary to define the range of external sourcing and supply relationships which are theoretically possible for the firm. This is analytically necessary before we can begin to address the key question of under which circumstances and conditions are any of our theoretically possible relationships 'fit for purpose'. Furthermore, in specifying what is 'fit for purpose' we must focus consistently on the underlying raison d'Otre of the firm. I take this to be the creation of profit (or a margin) within a particular market structure. As I shall argue, however, many writers in the field seem to ignore this defining criteria for the firm when they discuss supply chain relationships--the relationships they discuss often appear to be more important than the underlying purpose for which external contracts are placed in the first place. All too often one reads today about the opportunity for purchasers to become the 'architects of the value chain'2 or of purchasing being a 'win-win' relationship (Bevan, 1988). It is difficult to understand what this means in practice. If the management of a supply and value chain is nothing more than seeking to make a sustainable margin (or profit) for the firm, then everyone in the company has to be involved in the process, not just purchasing. Team building and multi-functionality require an holistic approach to management, not an inverted form of snobbery on the part of purchasing, as practitioners seek (and rightly so in my view) to question functionalism within the firm. Furthermore, since all contractual relationships, whether implicit or explicit, are based on de facto or de jure power struggles over scarce resources, the idea that these internal or external contracts can somehow become a 'win-win' situation for everyone in the market, or even in equal measure for all participants to a contract, is surely a serious misunderstanding of reality. But to say this now is to begin to develop my conclusion before I have laid out the argument which underpins it. The basic argument of this paper is that the decision about which types of external resource 2This was the theme of the keynote address by Professor Dan Jones, Cardiff Business School at the 3rd IPSERA Conference. 58 management relationships firms should use must always be firmly grounded both in a theory of the firm and in an understanding of how firms survive and prosper through the management of their supply and value chains. To pick one type of external relationship and reify this above all others is a recipe for business disaster and academic myopia. In the final analysis firms must choose those internal and external relationships which best maximize business profitability and not pick the latest fad and hope that it will cure all ills. To say this is to argue that there are no short-cuts to business success and that firms will only prosper if they adopt a flexible and open approach to their internal and external resource management strategies. This requires that we, as academics, develop a comprehensive understanding of the nature o f the firm and the range of hypothetical external sourcing and supply relationships which companies can use to procure for themselves a sustainable position within a supply and value chain. Towards an entrepreneurial and contractual theory of the firm Before we can develop a theory of the firm which will assist our understanding of how to develop successful external resource management relationships for business profitability, it is important to understand that much of the current discussion about concepts in purchasing and supply is based on an atheoretical and unscientific approach to the development of knowledge. If the procurement profession is to be able to develop robust concepts, which can then lead to the creation of useful operational tools and techniques, then it is first necessary to base these concepts on firm theoretical foundations. Unfortunately, like many nascent disciplines, the current state of academic discourse in procurement is best characterized as pre-scientific. What this means is that practitioners, and the academics studying their work, are aware that certain practices (historically in the automobile industry) are innovative and capable of achieving significant business benefit. The problem is that it has not been established under which conditions and for what circumstances these practices (like internal multi-functional team building, lean production systems, external network sourcing, partnerships and lean supply) are replicable across dissimilar industries and firms. The consequence is that both academics and practitioners are left to describe what has transparently transformed the car industry, and to emphasize those functional aspects of internal and external organizational change that have impacted, reactively, on the traditional purchasing and supply function within car firms. The problem with this approach is that it is atheoretical. It is not linked in any way to a theoretical understanding of the firm and the proper role for purchasing and supply (procurement) in the successful Regional competence and strategic procurement management of a business. It is proselytizing in a theoretical void, in which practitioners and academics who have studied the new developments in one industry attempt to discover if similar practices are occurring in other sectors and firms or, failing that, seek to encourage practitioners in other firms and sectors to implement similar approaches in order to test out the validity of the successful tools and techniques utilized elsewhere. This approach can be termed 'barefoot empiricism' or 'systematic empiricism'. It is an approach which is common in social science practice, but it has, correctly in my view, been heavily criticized as a pseudo-science (Wilier and Willer, 1973). While the space is not available here to discuss the epistemology of the social sciences, it is important for academics in procurement to recognize that robust concepts, which provide practical and useful tools and techniques for operational application, can only be refined if they are first grounded in a scientific approach. This approach must reject 'systematic empiricism' (or fad generation) in favour of abstractive reasoning, in which the nature of the firm and the laws of motion and survival which sustain it are taken as the starting points for theory building. This theory building must start not from a reliance on descriptive systematic observations of discrete events in the real world, but with the testing of a genral law developed through inductive reasoning. By this means, empirical cases can be utilized to test the validity of a general law or theory and, in so doing, ensure the development of robust, predictive and operationally useful concepts, tools and techniques. This abstractive approach to theory building will allow the further development of both theory (when cases disprove general rules and lead either to adaptation or falsification and the development of a new theory) and the creation of testable and operationally practicable concepts deduced from general laws. Only by this method will it be possible to locate the practical and theoretical utility of procurement as a subdiscipline within a more general theory of the firm and business management. Tables 1 and 2 provide a summary of the current side of the art of procurement as a discipline and also indicate the tasks that the profession faces as it attempts to develop theoretical, conceptual and disciplinary rigour. It is clear from these tables that for the profession to move forward there must be an attempt to provide a theoretical clarification of the optimal role for procurement within business management. Only by this means will it be possible both to develop operationally practical concepts, tools and techniques and to assess under which circumstances and conditions they are 'fit for purpose'. This necessarily requires a theoretical discussion of the range of optimal relationships the firm can have with its external environment. Any discussion of the proper form of relationship between the firm and its external environment must start with an appraisal of the seminal work of Table 1 Procurement as a pre-scientific discipline Functional Emphasis on procurement as a discrete and autonomous function within the organization. Tendency to functional imperialism by practitioners and academics Reactive Lack of awareness of optimality in designing practical concepts, tools and techniques. Tendency to react to 'given' organizational problems, structures and functional specifications and turf Descriptive Academic research focused on describing what practitioners do in discrete case studies. Inability to link specific cases to general predictive rules or laws of business success Systematic Empiricism Misguided reliance on evidence speaking for itself. Untheoretical research and the development of fads, short-term fixes and dissatisfaction by practitioners about the fruits of academic knowledge Atheoretical An inability to provide any theoretical specification of the optimal role of procurement within an organization. An inability to use abstractive reasoning to test general laws based on inductive reasoning Table 2 Procurement as a scientific discipline Business and Market Process Specific Clear awareness of the meaning of "procurement' as a process or method for achieving a 'sustainable position' for an organization within specific supply and value chains in particular discrete markets Proactive An ability to use deductive reasoning to construct optimal procurement strategies, based on 'fit for purpose' awareness of business and market processes Predictive Robust concepts, with operationally practical tools and techniques, which can be used predictably in given market circumstances to achieve specific outcomes Abstractive Empirical analysis as the 'servant' of theory building and testing rather than as the 'master' of the scientific process. Rejection of fads in favour of systematic theory building to provide general laws Theoretical The 'master' of the discipline. A clear specification, which starts from inductive reasoning, of the optimal role for procurement in business management. The use of empirical case studies to test the utility of the theory abstractively Williamson (1979) on transaction cost analysis. Williamson has laid the foundations for a procurement discipline through his analysis of the factors that determine the internal and external boundaries of the firm. 59 A Cox In summary, Williamson's work has questioned neoclassical views of the firm, which emphasize the role of the firm as a system of production rather than of exchange. By emphasizing the importance of transactions as a determining feature of the structure of the firm, Williamson has shifted the focus towards the notion that firms are best viewed as a nexus of contracts (Aoki et al, 1990). The importance of this interpretation is that it forces us to address the possibility that firms are not given entities existing as objects within a static market structure, but rather that they are potentially fluid and flexible constructs whose internal structures and external boundaries may change as circumstances dictate and opportunities require. Williamson's approach forces us to ask what the proper boundaries of the firm are and why they shift and change? His answer, of course, is that particular forms of organization are best suited to achieve particular business goals, because they result in more or less efficient transaction costs. Thus, since firms must seek to economize (or reduce costs) at all times, successful strategies for firms must be those that constantly address the issue of which type of internal or external relationships are most useful to achieve a particular purpose. Since the answer to this question will vary under specific business circumstances and contexts, the specific internal and external relationships (or contracts) that a firm implicitly or explicitly creates will also be subject to change and adaptation. What arises from this is an immediate realization that the issue of whether to 'make or buy' is not straight forward, it is always a problematic issue for the firm (Williamson, 1990). In this view the firm is conceptualized as nothing more than a 'governance structure' in which the key strategic decision must be to assess the relative efficacy of alternative means of contracting amongst potential suppliers of goods and services--both internal and external. The contractual conundrum can, of course, be resolved either through vertical integration or through outsourcing: they key strategic decision for the firm is, then, to decide what the boundaries should be between these two extremes of internal or external contract. Williamson's answer to this problem is to argue that the decision about internal or external contractual forms will almost always be made by reference both to the 'scope for economizing', and to the importance for the survival of the firm of the specificity of the assets that are to be produced or purchased for the survival of the firm. He argues that the decision must '...align transactions (which differ in their attributes) with governance structures (which differ in their costs and competences) in a transaction cost economizing way' (Williamson, 1990, p 13). The major drawback with this approach is that it does not tell us how the firm should resolve the problem of choice. Rather it poses a major challenge to the profession to undertake the empirical research 60 that will allow us to ascertain under which circumstances and conditions internal or external contractual relationships are more or less useful in achieving lowest transaction costs. The reason for this is that, while Williamson's work is seminal in focusing our attention on the importance of the institutional structures and boundaries of the firm, his own explanation of which transactions should be undertaken through internal or external contractual forms is, arguably, less compelling. The reason for this is his reliance on 'sunk costs' as the defining criteria for asset specificity and the decision as to whether goods or services should be produced internally or externally.3 What do we mean by 'asset specificity'? Williamson argues that the major reason that firms decide to carry out activities internally or externally will be largely based on the relative degree of asset specificity embedded in the relevant contractual relationship (Ricketts, 1974). Thus, if particular skills or services have high asset specificity--in other words if they are well established and 'sunk' within the standard operating procedures and human assets of the organization--then these activities will be undertaken internally. If, on the other hand, the relevant transactions are not well established or 'sunk' in the human assets of the firm, then there will be a tendency for these transactions to be sourced externally due to low asset specificity. This will be particularly true if there is a low level of uncertainty about the availability of the goods or services to be produced. Middle order asset specificity transactions where there are also relatively high levels of uncertainty will lead to forms of sharing, cooperation and bilateral relationships with external suppliers (Reve, 1990). On the face of it this is a persuasive argument, but there is a significant problem here both in theory and practice. If we accept this view of the relationship between transaction costs and asset specificity, it leads us to conclude that firms are likely to be stuck within particular operating structures and consequently poorly placed to react responsively to strategic shifts in market and competitive conditions. If firms must react quickly and responsively to changing technology and competitive market pressures, the decision about whether to undertake transactions in-house or externally cannot be tied to a view of asset specificity that is based on the 'sunk costs' of past transactions. This is surely a recipe for inertia and myopia and, arguably, bears little relationship to how successful firms react to changing market signals in the real world. Successful firms adapt and shift theft internal and external structures and relationships in order to compete for the future. This implies that the determining factors behind asset specificity and transaction costs must be the 3I would like to thank Robin C a m m i s h of SmithKline B e e c h a m and Jon H u g h e s of A D R Consultants for c o m m e n t s on an earlier draft of this paper. The c o m m e n t s and advice of my colleagues, Dr David Parker (on sunk costs) an Professor Kieron Walsh (on contracts) have also greatly assisted m y thinking in writing this paper. Regional competence and strategic procurement relationship of the transactions to the competitive position of the firm in the market. What is wrong, therefore, is not Williamson's notion that the degree of asset specificity is crucial in determining whether relationships will be internal or external, but rather his underlying assumptions about what determines a successful strategy for the firm. Implicit in Williamson's view is the idea that firms are successful because of their ability to retain human assets that have learned well-established routines and practices that are very expensive to replicate by others. This demonstrates that, despite his relatively successful attempt to challenge neo-classical thinking, some of its tentacles have been retained in his own analysis. What is needed is an approach to understanding asset specificity that is embedded in an entrepreneurial rather than a productive view of the firm. This can, perhaps, be achieved by recourse to the Austrian school as represented by the work of Kirzner. Kirzner argues that an entrepreneur is any person (or firm) who is alert to untapped or undeveloped possibilities for transactions that will generate a margin or profit (Ricketts, 1994). It follows, therefore, that successful individuals or firms (which are nothing more than groups of individuals coming together to achieve profitable exchange) will be those who are able to create for themselves skills or a knowledge base that will allow them to command a sustainable position within a supply and value chain, which, in turn, allows them to make a regular and sufficiently acceptable margin or profit level. This may be through economizing (reducing transaction costs) on existing methods of production and exchange, or through the development of completely unforeseen opportunities for production and exchange (reconfiguring transaction costs). If one accepts this view of the firm, then our definition of asset specificity and its relationship to transaction costs will also need to be modified accordingly. Under Williamson's initial interpretation, asset specificity is related to 'sunk costs' and the relative degree of uncertainty in market relationships. Using an entrepreneurial view of the firm, asset specificity can be defined not in terms of existing 'sunk costs' but rather in relation to whether or not the specific skills or knowledge of the organization contribute to the maintenance or creation of sustainable positions for profit within specific supply and value chains. In this interpretation, therefore, the more a particular skill or knowlege base contributes to the maintenance, or creation, of profitability, the more it should be regarded as of high asset specificity. When the skills or knowledge are not key to the development of profitability, then the more they can be regarded as of lower asset specificity. This interpretation is linked directly to the idea that firms have 'core competences' or skills that they must defend at all costs if they are to survive and prosper in a market-place (Hamel and Prahalad, 1994). Such core skills or competences are always of high asset specificity, because in their absence the firm is unable to retain control of a sustainable position on a supply and value chain. The example of IBM's relative failure in the PC market testifies to the importance of this insight. IBM came to believe that some of its expertise and skills (building mainframe computer hardware and providing expensive after-sales service) were the core competences of the firm. In fact, the core competence of the firm was the ability to provide hardware and software that processed data in ways customers thought was fit for their purposes. When technology changed the conditions in the market, IBM effectively outsourced two of its core competences--writing software programmes to process data to Microsoft, and microchip technology to Intel--and concentrated instead on producing hardware. It can be argued that the skills and knowledge this required were not core competences in this market, technology proved them to be assets of low or medium specificity (Cox and Court, 1995). This simple example provides, I believe, a clear insight into how asset specificity should be defined. If we are to understand why a firm must make some things and buy others, and also help firms to understand which of the myriad of skills, expertise and transactions available are key to their success, then we must redefine asset specificity in terms of 'fitness for purpose' of skills, expertise and transactions in achieving a sustainable position for the firm in a supply and value chain. This approach I have termed 'relational competence analysis'. To accept this approach is to adopt an entrepreneurial view of the firm and base it firmly within Williamson's transactional and contractual scheme of analysis. Thus, high asset specificity refers to the skills and expertise that are the core competences of the firm in sustaining their position to make profit in a market. These transactions should always be undertaken within the firm if it is to retain its ability to make profits. Low asset specificity refers to those skills or expertise that are not key to the success of the firm and can be outsourced to those firms that are most competitive in the market o n a relatively arms'-length basis. Medium asset specificity refers to complementary skills or expertise that are potentially significant to the sustainability of a firm's role but are not core competences. Normally these skills can be outsourced--although the type of contractual relationship and the closeness of the transactions to the firm used will be related to the relative degree of importance of the skills and expertise to the core competences of the initial contracting firm. Redefining asset specificity in this way provides us with a more useful typology of external resource management scenarios than is possible under Williamson's initial formulation. This notion of entrepreneurial, core competence, and 'fit for purpose' asset specificity allows us to develop a heuristic model of the determining factors relating to the boundaries of the firm and to the forms of internal and external contractual relationships that firms and individuals may develop as they seek to create and to defend sustainable 61 A Cox positions in markets. The work of Reve (1990) provides an additional stimulus to our development of an entrepreneurial and contractual theory of the firm. Building on Williamson's work and combining this with the insights of agency theory, Reve has gone most of the way in defining a contractual theory of the firm. In criticizing the static and overly determinist strategic positioning model of Porter, Reve has also helped to develop the entrepreneurial view of the firm. Reve's argument is that Porter's model can only be a partial theory of strategy, because it provides only a method for competitively positioning the firm. Because this theory is primarily based on raising barriers to competitors who seek to enter the market, Reve contends that it can only be a partial theory of management strategy and of the firm. What is needed according to Reve is an understanding of strategy as 'duality'. By drawing on the work of Williamson and Teece, Reve argues that strategy is '...the match between a firm's unique resources and its relationship to an everchanging environment to attain its best performance' (Reve, 1990, p 134). This is a major theoretical breakthrough, because it takes Williamson's view of transaction costs into the realms of 'core competence' and 'fit for purpose' asset specificity. In Reve's approach firms have unique resources (core competences and skills) that they must use responsively and with adaptability to meet the challenges of an ever changing environment. Core competences are never 'sunk cost' in this interpretation, they are clearly the skills that allow firms to sustain a position within a market. As Reve argues: '...The strategic core of a firm is represented by assets of high specificity which are necessary to attain the firm's strategic goals ..... The strategic core is the raison d'etre of the firm, defining its economic rationale within an industry' (Reve, 1990, p 139); and 'The nexus of contracts view of organisations then reduces to conceiving the firm as an efficient bundle of skills and incentives. The skills are needed to reatise economic opportunities, and the incentives make sure that the skills are kept in place' (Reve, 1990, p 136). By using transaction cost analysis, Reve is able to argue that the core competences of the firm are normally of four types: Site Specificity (Resource Immobility), Physical Asset Specificity (Technological Advantages), H u m a n Asset Specificity (Know How Advantages), and Dedicated Assets (Specialized Investments). It is these skills that a firm must defend internally at all costs if it is to sustain a position on a value and supply chain. Firms that undertake this analysis and remain static face immense peril, however. The strategic core of the firm may be successful this year, but next year it may have very little value as technology and competitive structures change. Reve argues forcefully that the strategic core must be deliberately defined and redefined on a continuous basis. This requires that the firm is always proactive in its assessment of market opportunities and threats. But, it 62 also means that the firm must always be challenging its existing standard operating procedures (SOPs) and the internal and external contracts it has with individuals, either as employees or as external firms. Relatedly, what the efficient boundary of the firm should be will also change over time and can never be taken as a given. It will always be that organizational form of economic governance that links internal and external skills and expertise in such a way as to sustain the firm's ability to generate a margin (profit) within a supply and value chain. A typology of external contractual relationships If this is accepted it does provide us, as Reve shows, with a most useful tool with which to begin to understand what should be done internally within the firm, what should be outsourced, and under what contractual terms and conditions. If a firm is to survive and prosper, then core skills, as defined by their relevance to the sustainability of a margin, will always be controlled through internal contracts. Complementary skills of medium asset specificity will be outsourced through close external contracts based on various forms of alliance. Low asset specificity skills will be outsourced through arms'-length contracts using competitive market signals. Thus, 'the properties of the transaction determine what constitutes the efficient boundary of the firm' (Reve, 1990, p 144). This is demonstrated schematically in Figure 1. NATURE OF ASSET SPECIFICITY AND COMPETENCE TYPE OF CONTRACTUAL RELATIONSHIPS HIGH ASSET SPECIFICITY INTERNAL CONTRACTS I AND INCENTIVES (CORE COMPETENCES) MERGERS ACQUISITIONS RELATIVELY HIGH I i M]EDIUM ASSET SPECIFICITY VARIABLE BOUNDARY OF TH]E FIRM STRATEGIC SUPPLIER , ALLIANCES NETWORK SOURCING (COMPLEMENTARY COMPETENCES) SINGLE SOURCING PREFERRED SUPPLIERS FIXED [ BOUNDARY OF THE FIRM RELATIVELY LOW LOW ASSET SPECIFICITY p ADVERSARIAL LEVERAGE (RESIDUAL COMPETENCES) Figure 1 A typology of internal and external contractual relationships Regional competence and strategic procurement LOW ASSET SPECIFICITY MEDIUM ASSET SPECIFICITY HIGH ASSET SPECIFICITY (VARIABLE BOUNDARY OF THE FIRM EXTERNALLY) q PARTNERSHIP RELATIONSHIPS 4 ARMSLENGTHPARTNERSHIPS M E R INTERNAL CONTRACTS STRATEGIC SUPPLIER ALLIANCES NETWORK SOURCING SINGLE SOURCING PREFERRED SUPPLIERS NEGOTIATED JOINT VENTURE NEGOTIATED SINGLE SOURCED VERTICAL INTEGRATION THROUGH MULTIPLE PARTNERSHIPS NEGOTIATED SINGLE SOURCED SUPPLIER RESTRICTED N U M B E R OF SUPPLIERS ADVERSARIAL LEVERAGES OF THE MULTIPLE SUPPLIERS IN COMPETITIVE MARKETS F R I M Figure 2 A continuum of asset specific external contractual forms EXTERNAL CONTRACTS MEDIUM ASSET SPECIFICITY LOW ASSET SPECIFICITY INTERNAL CONTRACTS HIGH ASSET SPECIFICITY STRATEGIC ALLIANCES NETWORK SOURCING SINGLE SOURCING PREFERRED SUPPLIER ADVERSARIAL LEVERAGE ARMSLENGTH F PARTNERSHIPRELATIONSHIPS RESIDUAL COMPETENCES COMPLEMENTARY COMPETENCES RELATIVE DEGREE OF STRATEGIC IMPORTANCE LOW ~ TO CORE COMPETENCES CORE COMPETENCES HIGH Figure 3 A step-ladder of external and internal contractual relationships W h a t Figure 1 shows is that there is a grey area for firms in terms of the types of contractual relationships they should have between relatively high and low asset specific skills. U n d e r high asset specificity and core competences the form of contract is c l e a r - - i t must be internal to the organization. For low asset specific goods and services that represent residual competences, the contracts will be external and can be adversarial and based on competitive m a r k e t criteria. The real problem for ascertaining what the efficient boundary of the firm should be arises, of course, for medium asset specific goods and services. These complementary competences require differential treatment, because the nearer they are to the core competences of the firm, the more the firm will have to consider vertical integration through merger and acquisition. The further away from the core competences of the firm, the less there is a need for medium asset specific skills to be vertically integrated. This insight allows us to develop a range of hypothetically possible external contractual relationships. These are defined on a continuum as shown in Figure 2 and as a step-ladder as shown in Figure 3. 63 A Cox The placing of a particular relationship on both the continuum and the step-ladder is determined by the degree to which firms can operate at relative arms'length in their external contractual relationships, as against their desire to vertically integrate the production of goods or services internally. At the same time, the position of a relationship on the continuum and the step-ladder is also differentiated in terms of the relative degree of power between participants, and the relative ownership that partners to external contracts have in the eventual goods or services that are produced from the contractual relationship. Thus, the closer market competences are to low asset specificity, the more likely it is that there will be several, if not a multitude, of potential suppliers for a given product or service. The more the competences approximate to core competences of high asset specificity, then the greater the likelihood that external relationships may lead to merger and acquisition or, failing that, result in very close, single sourced negotiated contracts in which both parties have some clear ownership rights in the goods or services produced. The basic definition of each type of asset specific external contractual relationship is provided below. Adversarial leverage This is the most commonly understood form of external contractual relationship. This form of relationship is always arms'-length, and the recipient of leverage is in a dependent situation in terms of power. The prime contractor is always in the position of being able to choose alternative sources of supply because there are multiple sources of supply, and relative certainty about replacement goods and services from alternative suppliers. Consequently the supplier has no ownership rights over the goods or services produced. Preferred suppliers These are suppliers who are judged to be the best to provide complementary goods or services that are of medium asset specificity, but which are at the lower end of the continuum or ladder or strategic importance to the firm. Given the relatively low level of importance of these goods and services, the firm will normally choose a restricted number of suppliers after using forms of vendor rating and accreditation. Single sourcing This concept refers properly, in terms of the analysis presented here, to the supply of medium asset specific, complementary goods or services which are of increasing sensitivity to the core competences of the firm. The most significant analytic distinction, of course, is that single sourcing--if it is to be analytically and conceptually distinct from other forms of external contracti n g - m u s t refer to single sourced and negotiated external contracts where there is also a blurring of ownership and power relationships. 64 The distinction here is not that firms are deciding to have a single sourced relationship with a preferred supplier, who is granted a relatively permanent preferential relationship for a variety of tasks. The aim here is clearly to reduce transaction costs and economize but without the costs associated with vertical integration. Single sourcing will only be practical, therefore, when the goods or services to be purchased are of relatively high strategic importance for the firm. Network sourcing and partnerships It follows from this that, before a merger or acquisition vertically integrates the external production of goods or services into a firm, there is, theoretically, a final stage at which it is possible to create a hybrid form of business organization. This is the ultimate extension of external partnership without vertical integration. Network sourcing is the idea that it is possible to create a virtual company at all levels of the supply chain by engineering multiple-tiered partnership relationships at each stage, but without moving to vertical integration. In this way, a first-tier supplier who controls an extremely important medium asset specific expertise for the prime contractor has a partnership with the prime contractor in the value chain and then develops partnerships with those second-tier suppliers who find themselves in the same position. This chain reaction can then be passed down the supply chain. Obviously, at each level of the supply and value chain each supplier will have to choose those specific external contractual relationships that are 'fit for purpose'. Nevertheless, the idea of network sourcing is clearly one in which the prime contracting firm acts as a locomotive for the reduction of transaction costs within the total supply and value chain. This is achieved by building serial and multiple partnerships, based on performance criteria attached to cost reduction targets, with those suppliers of medium asset specific goods and services that are most closely linked to the core competences of the firm. The idea is that firms at each stage will then 'pass the parcel' by informing and educating others at each level of the supply chain. The aim is to achieve cost reductions by achieving vertical integration through multiple and serial joint ventures at all levels of the supply chain. Clearly, under such a supply and value chain relationship the issues of ownership, control and power become incredibly blurred and confused. It is likely, therefore, that such network sourcing relationships will only be possible in mature industries where asset specificity is constantly being reduced and multiple and serial sub-contracting is thereby facilitated. It is important to recognize, however, that the real benefit of network sourcing is that those firms which are the gatekeepers of particular supply and value chains are in a position, short of joint ventures and vertical Regional competence and strategic procurement integration, to massively shape and influence the multiple tiers of the supply chain if they use their influence to cascade 'best practice' and 'fit for purpose' techniques through the supply chain. This will be based on finding partners who are interested in collaborative forms of sourcing rather than adversarial forms. It will seem strange to some readers that this typology does not provide a specific conceptual staging post for 'partnership sourcing'. This is a deliberate choice and not an oversight. The reasons 'partnership sourcing' is excluded directly from this theoretical typology are twofold. First, partnership can, theoretically, refer to a range of relationships--from 50/50 joint ownership through to preferential sourcing in which there is no ownership whatsoever by the suppliers, but in which the preferred supplier recognizes that there is a shared and collaborative relationship within a competitive market structure. In these circumstances, the concept is generic and refers to a complex range of dissimilar collaborative relationships. In this sense it does not define a unique supply relationship at all. Secondly the term has been so misused and misunderstood by practitioners and academics alike that it serves little purpose to further confuse the profession by linking it to one specific or particular form of collaborative sourcing here. It is best left as a general catch-all term referring to all forms of collaborative rather than adversarial sourcing relationships. Partnership relationships are, therefore, only used in Figures 2, 3 and 4 to refer to collaborative procurement forms in general. 4 Strategic supplier alliances These are negotiated, single sourced relationships with a supplier of a complementary product or service. These are classically referred to as joint ventures, because they normally involve the development of a much closer relationship that is negotiated between the main contracting firm and a complementary supplier. This will normally take the form of a joint venture based on joint ownership of the final product or service. It will also create a completely new and independent legal entity or organization, which is separate from the firms making up the alliance. The relationship here is closer than under other forms of supplier contracting because the power in the relationship is based on equivalence. The negotiated contractual relationship will lead to the development of a product or service over which both parties have some proprietary claim. The claim may not be 50/50, but the defining characteristics of a bilateral strategic alliance are that the degree of complementarity is 4This reasoning owes a great deal to discussion with Neill Irwin and Michael Wilkins at Partnership Sourcing Ltd about how they conceive their own role in developing sourcing relationships. The arguments presented here are, however, mine alone and ought not to be attributed to Partnership Sourcing Ltd in any way whatsoever. extremely high, and the ownership and power relationship within the contract is less clear cut than with other more arms'-length supplier contracts. This is the final stage before a firm considers the complementarity to be so important that vertical integration through merger and acquisition is undertaken. Strategic procurement management, relational competence analysis and proactivity It is interesting that the most striking examples of network sourcing have been found in the automotive industry, which is an extremely mature industry (Hines, 1994). It is also true that much of the most stimulating writing about external contractual relationships in recent years, which has led to the development of concepts like partnership sourcing and lean supply, has come from academics and practitioners learning lessons from the experiences of prime contracting firms in the world car industry (Lamming, 1993, 1995; Robertson, 1995; Womack et al, 1990). There is, however, a danger here. If it is the case that network sourcing is only possible in mature industries, and if partnership sourcing refers only to a range of external collaborative contractual relationships, then we must be careful about assuming that these forms of external contract will be 'fit for purpose' in every and all external supply circumstances. The danger at the moment is that there appears to be a tendency amongst some writers in the profession to ignore this fact. There is a tendency to assume instead that there is somehow a best type of external relationship, which, if it is properly understood and implemented, will lead to lower costs, improved quality and higher profitability. This viewpoint can be defined as follows: 'Leverage bad, partnership good, networks better, lean supply best'. The essential argument of this paper is that lean supply is not an end state it is what proactive firms must do at all times. In attempting to achieve lean supply then sensible firms will use whichever external relationships--from leverage to partnerships and networks--provide them with the greatest competitive and profit-making advantage. It is important to recognize this, because some practitioners are already beginning to become jaundiced about the assumption that lean supply is an end state. The problem is that, while writers may believe it, or normatively want it to be true, practitioners know it does not accord with business reality. When there is a conflict between academic proselytizing and practical reality, then it behoves academics to go back to the drawing board. This is what this article attempts to do. As I have argued above, we cannot claim, on an a priori basis, that any one form of external contractual relationship is superior to all others. The proper role for the academic is not to sell fads, but to first ascertain the full range of hypothetical relationships that are theoretically possible, and 65 A Cox then to begin the process of outlining those variables that are potentially the most significant in shaping the relative utility of particular relationships in discrete business contexts. This view may appear, at first sight, to undermine much of the pathbreaking work that some academics and practitioners have accomplished in raising the profile and importance of purchasing and supply within the business community. To counsel caution is not, however, to deny the importance of external resource management for business success. Rather it is to say that, in order to develop a mature profession, we need to regroup before taking the next steps forward. This regrouping must first involve the development of a properly understood theoretical framework, with which to analyse the costs and benefits of external contracts and relationships under varying business conditions. Secondly, it must lead to the development of a coherent body of empirically verified knowledge about which external relationships and contracts are 'fit for purpose' and under which conditions. Thirdly, it must involve linking these insights, and the unique competences of those trained in purchasing and supply, to the strategic management of the firm. When one adopts this view, then the agenda for the future is both clear and immensely challenging for the purchasing and supply profession. The reason is that, if we begin to conceptualize the firm as a 'nexus of contracts' as described above, then the role of those trained in analysing, framing and negotiating contracts becomes key to the strategic management of the firm as a whole. If the firm is nothing more than a conduit through which consumer preferences and wants are satisfied by engineering goods and services along supply and value chains, then those trained in understanding contracts and margins will have a comparative advantage as firms throw off their neo-classical production shackles and confront a world of core competences, asset specificity and transaction costs. The future role for those trained in negotiation, contracting and incentives will, if the analysis presented here is correct, be of immense importance for the future success of firms. This arises primarily from the insights of transaction cost and agency theory, and the realization that the boundaries of the firm are not, or should not be, fixed in time or space. Rather, firms are best seen as transitional phenomena in which those who control the core competences of the firm, financially and politically, have to constantly analyse the relative efficacy of existing internal and external contracts in sustaining a profitable position within specific supply and value chains. This means that in the future there will be a definite need for professional managers trained in the arts of assessing the relative costs and benefits of internal and external contracts for the successful achievement of a sustainable position on specific supply and value chains. The skills that will be required will be those of 66 assessing which contractual relationships--both internal and external--are most 'fit for purpose' in achieving reductions in costs and improvements in value and quality. This professional expertise can be best described as the value, quality and cost (VQC) approach. It applies to internal contracts within the organization as much as it does to external contracts and relationships. It will require an end to functionality--amongst purchasing professionals as well as others--and an emphasis on the constant re-engineering of the relationship between core competences and external and internal relationships in order to sustain a profitable margin. The conceptual tool that can be used to achieve this flexible approach to business management, and that has been outlined in summary here, is known as 'relational competence analysis'. This approach is only part of what ought to become the .discipline of strategic procurement management, to distinguish it from the reactive and primarily external focus of traditional purchasing and supply management. It is but one of the tools which a more self-confident profession will be able to develop if it can only reject the pre-scientific ways of the past and embrace the scientific and theoretically predictive path to the future. The basic structure of a strategic approach to procurement management is presented schematically in Figure 4. Building on Reve's (1990) own attempt to create a new strategic approach to management, which links value chain positioning with contract theory, we are now in a position to outline what a strategic approach to procurement management might look like. The first point to make is that strategic procurement management (SPM) can never be reactive, it must always be proactive. This means that SPM must always be focused on the ultimate role of the firm. This is taken to be the engineering of a sustainable position for an individual or individuals on a supply and value chain which provides opportunities for the development of an acceptable margin or profit. In the final analysis, the goal of SPM is about making money, nothing else. Achieving this, however, is more difficult than it seems because many companies simply do not understand, or have lost sight of the fact, that they are in business to make money. This is often a result of the bureaucratization of business, as firms become more successful and grow in size. Under these conditions, employees often become more concerned with redistribution than accumulation, as politics and internal conflicts over scarce resources dominate day to day affairs. Attempts to reform the dysfunctional aspects of internal standard operating procedures (SOPs) through TQM and BPR techniques are, however, doomed to failure, unless they first start from the raison d'etre of the firm--making money. The SPM approach, outlined in Figure 4, consciously attempts to achieve this by linking market and value chain positioning to the internal and external contractual U~mate Downsl~eam Boundary of the Firm li~i~] Uitirnate Upstream Boundary of the Firm l ~owo.~.m E~ema, ~mao° M~na0emoo, SUSTAINING EFFECTIVE DEMAND VARIABLE DOWNSTREAM BOUNDARY HE FIRM LEAN ENTERPRISE LEAN SUPPLY VARIABLE OF THE FIRM ,DVERSARIAU PREFERRED h AN(~ MARKETING I SUPPLIER ~ A R T N E R ~ H I P I S T R A T E G I C I ............. i ALLIANCES STRATEGIC ALLIANCES ALLIANCES W1TH Ultimate Consumers COMPETITORS I I COMPLEMENTARY ALLI/~NCES UPSTREAM f BOUNDARY OF THE RRM i I NETWORK i SOURCING i i IPARTNERSHIPPREFERRED II SOURCING II SUPPUERS I I I I I i I I I I I I COMPLEMENTARy COMPETENCES with Adversarial Expressed Leverage and in Potential Competitive )-ACTIVE STRATEGIC DEMI MANAGEMENT AND VALUE POSITIONING Wants and Preferences ~EXTERNA~ CONTRACTS ,o/,° " \ c/ ~ u ~ , - R ' / PRO-ACTIVE STRATEGIC SUPPLY MANAGEMENT Markets EXTERNAL C~ONTRACTS i i i i i i "Fitf~, purpose" External Procurement Management i i J i "Fit for purpose" Internal Procurement Management i i "Fit for pt~qx~e" External Procurement Management r i i MARKET AND VALUE CHAIN POSITIONING PRICE 100% PRODUCT or SERVICE < : ~ 100% Figure 4 Strategic procurement management, the firm and the market ---.3 O% VALUE CHAIN SUPPLY I CHAIN 0% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 10% MARGIN FOR COMPANIES COMPANY A 30% MARGIN B 20% MARGIN C 20% MARGIN x × × 100% D10%MARGIN E10%MARGIN × F G- K × VALUE CHAIN PRICE ULTIMATE CONSUMER COMPANY A 20% VALUE B 20% VALUE ADDED ADDED × C 10% VALUE D 10% VALUE ADDED × OO% Figure 5 A hypothetical m a r k e t and value chain positioning m o d e l ADDED × E 10% VALUE F 10% VALUE G 5% H 5% I 5% J 5% K 5% ~UPPLY CHAIN ADDED ADDED X PRODUCT OR SERVICE X X X X X X Regional competence and strategic procurement relationships which underpin the firm as a business unit. The first task in an SPM approach is to undertake value chain positioning (VCP). Value chain processing refers to the process by which the key decision-makers within a firm consciously undertake market positioning through an analysis of the totality of supply and value relationships within their markets. This is achieved through the use of 'margin-cost analysis'. Figure 5 provides an example, hypothetically, of what such a model might look like. The model is an attempt to understand what the relationship is between the value added which any firm achieves in the market, and its profit margin. The use of this tool is crucially important if firms are to develop a successful SPM approach, because without a thorough understanding of who adds value and what profit margins are, it is difficult for firms to adopt a strategic approach to their businesses. Thus, the key decision-makers of the firm must always be proactively seeking to understand how costs and value are created in their own supply and value chains, and in relation to their competitors. This is why, in Figure 4, market positioning is consciously linked with the management of internal and external contractual relationships. It is essential that firms are continuously aware of the possibilities and opportunities for engineering profit by moving up and down their respective supply and value chains, or by reconfiguring existing supply markets to create new product and service opportunities. The unique approach that SPM can bring to the creation of a sustainable profitable advantage is the realization that the key tasks for strategic decisionmaking are: first, to ascertain what the efficient boundaries of the firm are so that they can be created to reduce transaction costs and improve quality and value (relational competence analysis), and, secondly, to recognize that achieving this may well require collaborative as well as competitive relationships. This brings us full circle to our earlier discussion of the relative importance of internal and external contractual relationships for a theory of the firm. The SPM approach consciously recognizes that the boundaries of the firm are not fixed in time or place, and that what the efficient boundaries of the firm might be is an empirical not a normative question. Thus, as outlined in Figure 4, the SPM approach recognizes that for a firm to achieve sustainable, profitable advantage it must constantly assess the relative utility of a range of collaborative and competitive external contractual relationships. In assessing their utility, it is not possible for the firm to declare that one form of relationship is superior to another. On the contrary, which form of relationship is 'fit for purpose' can only be ascertained by reference to the overall strategic goals of the firm in terms of its market and value positioning objectives. The role for the manager trained in SPM techniques is, however, transparent: it is the proactive engineering of value (or a profit margin) through the use of relational competence techniques on both the existing and the potential internal and external contractual relationships of the firm. If this definition is accepted, then a new and challenging world beckons for the traditional purchasing and supply profession. As Figure 4 indicates, strategic procurement management cannot be defined, as purchasing and supply used to be, in relation to upstream external supply management alone. On the contrary, the engineering of value requires that practitioners must be involved in all aspects of corporate decision-making. While there is no space here to elaborate this in detail, Figure 4 indicates the potential scope of the SPM approach for business decision-making. The historic focus of purchasing and supply, on lean supply considerations and the proper external management of the vendor base, is retained--with the important caveat that the choice of external contractual relationships on the supply side must be informed, at all times, by an awareness of asset specificity and the notion of 'fit for purpose' in achieving a sustainable profit margin. Most challenging for the embryonic profession, however, are the new opportunities which an entrepreneurial and contractual approach to strategy offers in terms of the effective management of downstream external demand, and a pivotal role in internal relational competences analysis, focused on the creation of lean enterprise. Though space precludes a more detailed discussion, it is clear that the SPM approach requires the same degree of flexibility and proactivity with regard to the management of effective demand as is required for external supply relationships. Not surprisingly, using the contractual and entrepreneurial methodology outlined here, it is evident that external demand management involves the engineering of similar types of competitive and collaborative relationships with customers and clients. But here lies one of the major problems with business organizations. There is nearly always a disjuncture between what the sales and marketing sides of the firm perceive their roles to be, and what purchasing and supply think it should be, and vice versa. Only strategic procurement management can overcome this disjuncture because only this approach eschews business functionality to recognize the centrality of value chain and market positioning as the keys to business strategy. The third key focus of the SPM approach must, therefore, be the development of an extended relational competence approach to the creation of'a lean enterprise (Womack and Jones, 1994). It is not possible here to elaborate in detail how this can be achieved, although I have discussed this elsewhere (Cox, 1995), but it is clear that a contractual approach to the efficient boundaries of the firm, which emphasizes core competences, transaction costs analysis and 69 A Cox asset specificity, is the key to engineering value for the lean enterprise. Such an awareness offers the traditional purchasing and supply professions a major challenge in the future. This challenge is that successful firms will adopt a strategic approach to procurement management and, in so doing, major opportunities will become evident for those who can seize the time and develop their skills. For those who do not, this focusing by firms on proactive value engineering within the total business context, rather than on reactive and adversarial purchasing, may well be the harbinger of doom as the traditional role of purchasing in the functional firm gives way to the multi-functional lean enterprise of the future. 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