Supplier segmentation lessons in the wake of COVID-19

Supplier segmentation is more necessary than ever for businesses during COVID-19. Here's how to start the process and why it matters for your business.

As companies have dealt with COVID-19's effects, businesses have increased their focus on supply chain management and suppliers in particular. The events of the past year have underscored the importance of understanding each supplier's value to an organization.

It's impossible for a company to put the same level of energy into each supplier relationship. Organizations must segment suppliers so they can invest resources where it matters most.

Here's how to segment suppliers so each vendor is getting the right amount of attention.

What is supplier segmentation?

Supplier segmentation, a critical component of supplier relationship management, is the process by which organizations group their suppliers into categories based on a number of factors.

Understanding a company's vendors and their importance to the organization are crucial early steps in the supplier relationship management process, said David Saunders, senior consultant at Ultra Consultants, a firm that serves the manufacturing and distribution industries. Supplier segmentation is a way of accomplishing this.

Companies have a variety of tools they can use to segment their suppliers.

One of the most useful is Kraljic's Supplier Segmentation Model, Saunders said. The method is named for Peter Kraljic, who in a 1983 Harvard Business Review article proposed using the model to assess purchases. Businesses make a quadrant, similar to Gartner's Magic Quadrant, which divides suppliers into four categories based on associated risks and other factors. For example, suppliers of less critical commodity items are in a different category than suppliers of key technologies.

The model has various benefits for the user.

One is that the model ranks the relationship with the supplier above short-term profitability consideration, Saunders said. In addition, instead of focusing on supply risk, the model attempts to evaluate the necessity or difficulty of finding an alternative supplier.

"For those suppliers that are strategically important to the business but [are easily replaced by] alternate suppliers, there is a great opportunity to develop a collaborative, win-win relationship," he said.

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Companies can choose to use a different model, but being methodical about segmentation is necessary for successful supplier relationships.

Applying either the Kraljic model or a hybrid model of one's own making is extremely important, Saunders said.

How to segment suppliers

Dividing suppliers into specific groups makes it easier for companies to evaluate each relationship.

Organizations should follow the Deloitte priority model and divide suppliers into three categories, said Peter Bolstorff, executive vice president of the Association for Supply Chain Management (ASCM), which works to define global standards for supply chain operations. The categories are strategic, important and transactional.

They are roughly analogous to the top, middle and base of a pyramid.

Transactional, the bottom level, is by far the most common relationship type, Bolstorff said. It comes to about 80% of buying volume. Strategic and important share the other 20%. However, even though they represent a smaller percentage, 80% of spending typically ends up going to the important and the strategic categories. Strategic suppliers, which are difficult to replace and strategically vital, can most help advance a business model, although all of the relationships are important.

Another way companies often categorize suppliers is with a ratio of risk and value. Disruption is a fact of life, and having the right mix of suppliers is critical for lowering risk.

"I think COVID has focused most folks on two categories -- high risk, low value and high risk, high value," Bolstorff said.

That can mean evaluating whether a company has all the suppliers it needs.

If not, a business often should seek out additional sources of supply, Bolstorff said. For example, if a business has been mostly seeking low-cost suppliers in Asia, it should probably add some North American sources, even if those suppliers are more expensive.

Why does supplier segmentation matter?

Companies that segmented suppliers were able to avoid some of the effects of COVID-19.

ASCM studied Fortune 2000 companies' supply chain resilience and identified laggards and leaders. ASCM found that leaders, who made use of segmentation as part of their best practices, predicted COVID-19's effects earlier, with some detecting demand side changes as far back as November 2019.

Since COVID-19, a group of the laggards has awakened and they are seeing that if they don't get on the stick, they will end up in survival mode.
Peter BolstorffExecutive vice president, Association for Supply Chain Management

The laggards didn't fare as well.

Leaders were able to "balance demand and supply earlier on and plan ahead more strategically," Bolstorff said.

Leaders employed other supply chain management best practices besides segmentation, but that practice was an important one. Now more companies are realizing supplier segmentation's importance.

"Since COVID-19, a group of the laggards has awakened and they are seeing that if they don't get on the stick, they will end up in survival mode," Bolstorff said.

Segmentation should be a priority at every level of a company.

"Segmentation is a strategic issue, and it has to happen at the highest level with the chief procurement officer and chief supply officer," Bolstorff said. "They [need to] own it and [be] accountable for it."

What technology supports segmentation?

Companies can choose from a variety of software to support supplier segmentation.

"Modern systems -- both robust ERP and SCM solutions -- can assist in compiling the information necessary to evaluate suppliers as well as manage them going forward, thus eliminating the need to manage and monitor the segmentation manually," Saunders said.

There are a number of choices.

Multiple technology players have offerings that can deliver segmentation-related functionality, said Michael Wohlwend, a supply chain consultant at Alpine Supply Chain. NetSuite, which is now owned by Oracle, is a leading choice for supplier segmentation, as is Microsoft Dynamics and SAP S4/HANA. The market also includes customizations and add-ons, either from one of those three companies or smaller players.

"It is similar to what has happened with the Salesforce environment," Wohlwend said.

Technology can also support better sourcing.

The pandemic has put everyone into a B2C business mode, since so many traditional distribution routes like retail have been disrupted, Wohlwend said. More than ever, companies need technology that will help them understand suppliers and navigate changing circumstances.

"A lot of big organizations use something like Coupa or Ariba to source things," he said. "We are now seeing a pivot, with people trying to better understand the items they are sourcing and how they can be acquired."

Companies have more possibilities now if they're seeking new software.

There has been an expansion and growth of technologies and platforms, Wohlwend said. For example, One Network emphasizes a networked and more collaborative approach to procurement and sourcing.

Supplier performance management can help support ongoing segmentation insight.

These systems will support different levels of performance monitoring through supplier scorecards, Saunders said. Scorecards can be key for keeping an eye on supplier relationships.

Companies need software with specific capabilities if their supplier segmentation is going to succeed.

According to Bolstorff, a business should invest in the following capabilities:

  • Transactional (e.g. invoice and payment processing)
  • Supplier communications
  • Intelligent supply analytics
  • Category management or segment management
  • Source execution (e.g. for transaction automation)
  • Digital contract management
  • Procurement and compliance (ensuring environmental, social and corporate governance issues are covered)

Some of those capabilities are included in ERP suites, Bolstorff said, and others are part of Service Resource Planning products. However, there aren't products that include all of these capabilities.

How to tell if supplier segmentation has succeeded

How can a business tell if its processes, investments and strategy are leading to successful supplier segmentation?

Several areas need to be scrutinized, Bolstorff said. The two main customer-facing indicators are supply reliability and agility, which is the ability to respond to unexpected demand and mitigate supply risk.

There will be indicators within the company as well.

On the internal side, success should be measured by cost viewed through inventory levels and payment terms, Bolstorff said.

"We would then look at the performance across all of those buckets," he said.

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