Did you mean soul-searching? No. We’re talking about supply chain management here. Putting your eggs all in one basket has risks and rewards whether you’re contracting with a supplier of widgets or looking for a soulmate. This post was written by Eli Snir, lecturer in management.

In today’s supply chains specialization is key. Together with specialization comes an increasing fragmentation of the supply chain. Each company or entity focuses on a single component or subassembly, providing world-class quality in its domain of expertise. As a result, in many instances, large brand owners are unable to map out the entire supply chain of their products.

With the multitude of vendors available for supplying any subassembly or service, a key question to consider is whether to sole-source a subcomponent or service, or rather to use a multi-source approach. The multi-source approach appears to have several key advantages. First, it provides the client with an exit strategy. If at any point a vendor fails to deliver on his promise, the client can shift away from that vendor. Second, multi-sourcing also allows for ongoing benchmarking. Performance of one vendor can easily be compared to others, as several vendors are providing comparable services.

Conversely, sole-sourcing seems to be fraught with risk. There are several frameworks for delineating sourcing risks, although I prefer the Transaction Cost Economics approach. Risks can be sorted into several groups:

• Strategic Misrepresentation – claiming to be something the company isn’t. Offering lower price or higher quality than it knows it can consistently provide. In the context of manufacturing these claims may involve production capacity, delivery flexibility, minimum batch sizes, quality, or numerous other factors usually not specified in contracts.

• Shirking – once the relationship is forged the vendor may not deliver everything that’s promised, while requiring full payment. Usually shirking is limited to dimensions of the relationship that are not explicitly mentioned in the contract, or that do not have incentives tied to them. As examples, a company may close a manufacturing facility, stop working overtime, require additional payment for weekend shipments, or have inconsistent quality.

• Hold-up – in the dynamic environment faced by nearly all companies today, the signed contract is frequently irrelevant by the time the ink dries. That’s especially true when the magnitude of the relationship is large, perhaps encompassing multiple years. A vendor’s reaction to their customer’s changing business environment defines the trust between parties. Customers frequently require modifications from initial specification in any of the dimensions of the agreement. These probably increase the vendor’s cost, resulting in requests for additional payments. Without recourse, the customer ends up paying more for what is, in their perspective, the same product or service.

This raises the question, when does sole-sourcing make sense? Put differently, when do the benefits from specialization and contracting only with the best-in-breed vendor outweigh the risks detailed above?

To answer this, I consider sourcing relationships on a continuum. At one end of the continuum are transactions of near-commodities. In these sourcing opportunities multiple vendors are competing for business, constantly. Some examples include contract manufacturing of generic consumer electronics and garment-making, where there are hundreds or thousands of vendors competing for the opportunity to serve the customer. Similarly, shipping services are commoditized with multiple vendors offering nearly indistinguishable service. At the other end of the continuum I place those transactions that require the most specialization – a single vendor provides outstanding value to the customer. While others may compete to serve, there is one provider that clearly stands out from the pack. With this preface I have a surprising recommendation: sole-sourcing is most appropriate at both ends of the continuum, but not in the middle. In the middle of the continuum multi-sourcing is essential in limiting risk, without a substantial increase in cost.

For commoditized products and services, with a plethora of providers, sole-sourcing is viable because risks are minimal. The market provides insurance. There will always be an alternative vendor to the incumbent, and the cost difference will be reasonable. It may take some time to change vendors, but the customer holds the option to rebid the business as is fit. Recognizing the possibility of being replaced holds the vendor in check.

But it’s still unclear why I recommend to sole-source for commoditized services. Here lies the second advantage of sole-sourcing – collaboration. Recognizing that the business environment is dynamic and quite volatile for both the client and the vendor, collaboration across the supply chain is a crucial tool to increase efficiency.

A sole-source relationship provides a framework for parties to recommend modifications to internal business processes that reduce cost for other parties. For example, flexibility in delivery schedules or in batch sizes may be inconsequential for the customer, but offer substantial cost savings for the vendor.

Collaboration also allows for optimizing lead times throughout the supply chain. Customers naturally want short lead times to react to changes in demand and reduce inventory. Manufacturers prefer long lead times to optimize production processes. The optimal lead time depends on product and demand characteristics. A sole-source relationship facilitates revealing cost structures, enabling finding the balance between competing desires and paying a fair price for that service.

What about the benefits of benchmarking found in multi-sourcing relationships?

When opting for a sole-source relationship the onerous is on the customer to realize potential benefits. While benchmarking against a second provider isn’t possible, the client has the responsibility to benchmark against current industry trends and current opportunities from the market. The client also has to monitor switching costs to assure that the option of changing vendors is viable, keeping the vendor on his toes. Both parties need to know that the client can find a different supplier relatively easily, and yet both prefer to maintain the current relationship to realize mutual benefits.

Now let’s look at the other end of the continuum when there is only one viable vendor for the product or service under discussion. In many instances, a company contracts out to a single provider, because there are very few viable alternatives. This vendor may have access to unique technology, lower cost, higher quality, or a unique patent. This is frequently also the case when sourcing to low-cost countries where reputable manufacturers are difficult to find. More likely, however, is that the sole-source vendor is a result of mutual learning. The client and supplier grew together, and this supplier has intimate knowledge of the client’s needs. Or perhaps the client was chosen initially in a competitive bidding process, but after winning the contract developed relationship-specific skills, which cannot be easily replicated by a new vendor.

The benefits of these types of relationships, when managed correctly, are obvious. Access to a best-in-breed supplier confers higher quality at lower cost. Specialization by the vendor of services and products directly linked to the customer’s needs expand the pie. Collaboration opportunities abound. Through deep knowledge, trust, and multiple points of contact across companies they monetize the value of collaboration. Optimizing the joint supply chain produces substantial gains, thereby enhancing the value of the relationship further.

Frequently, however, this manifestation of sole-sourcing is a transient state.

First, the risks of these relationships cannot be immediately mitigated. Specifically, shirking and hold-up opportunities arise, and over time the client may perceive that the vendor is earning more than his fair share of the pie. Cost increases that in the past were absorbed by the vendor are now easily passed on to the customer.

Second, the factors that justified entering into a sole-source relationship may disappear. A technology that was offered by only a single vendor is now widely available; the low-cost provider saw costs rising; superior quality may be offered by other vendors; patents expire. Without convincing justification for sole-sourcing the client searches for an exit opportunity.

In the dynamic environment facing both suppliers and customers the justification of a sole-source partnership needs to be reevaluated frequently. While many partnerships may be sustainable for a long time, it should come as no surprise that the depth and breadth of partnerships ebb and flow.