Correct supplier segmentation can help drive and deliver increased value for your supply chain. Some organizations segment their suppliers by how much they spend with them, the general thought being the more we spend with them, the more important they are for our organization.
However, this is not always the case. How much you spend with a supplier is no clear indication of whether that supplier is a strategic partner for your organization. And this is why you should perform a proper supplier segmentation - to determine the role in helping to deliver value to the end customer a supplier provides.
What is supplier segmentation?
No two suppliers are alike, as they can impact your business in different ways. Because of this, suppliers must be divided into different groups.
Supplier segmentation is the process of dividing suppliers into distinct groups based on needs, characteristics, or behavior. This process incorporates:
preparing supplier segmentation teams;
reviewing supplier segments;
identifying opportunities with suppliers;
developing product/service agreements;
generating supplier/cost profitability reports.
Why is supplier segmentation important?
Suppliers who are vital to your organization need a higher level of engagement. By classifying each of your suppliers using pre-agreed criteria, you can decide upon the appropriate level of attention needed to ensure that they deliver superior service/products.
Supplier segmentation can also provide insights into your supply base regarding the extent each vendor is important to your business operations. This enables you to develop a closer working relationship with key suppliers at all levels (executive, operational, and transactional).
Last but not least, by categorizing your suppliers, you can also identify your level of exposure to risk. For example, many organizations depend on a single source of supply for critical goods and services. If that source is unable to fulfill its offering, you’ll also be unable to satisfy your customers.
Types of supplier segmentation
Based on the product/service supplied, suppliers can be classified into one of four quadrants (also known as the Kraljic Matrix.):
However, the classification can also depend on:
breadth of supply base;
volume of supplied goods and/or services.
Taking into account these attributes, you could segment your suppliers by:
1. Spend: annual spend with a supplier is essential. You should also take a look at the YOY spend growth as there could be a supplier that doesn’t have substantial spend, but you plan on increasing their scope and consider them as a strategic partner in the future.
2. Innovation/collaboration: this refers to the:
specificity of the offer: whether the supplier is offering a unique or customized product/service or an off-the-shelf one.
breakthrough offering: together with your supplier, you’re creating a new market segment, entering a new market, capture market share, etc.
3. Supplier risk: this not only influences the supplier segmentation but also your sourcing strategies and supply plans. There are two types of risk you should consider:
potential failures: this helps you assess the magnitude of the impact on your organization caused by a failure of supplier products/services.
actual failures: past incidents/events are analyzed to determine the effect they had on business continuity.
4. Customer impact: suppliers whose products/services enable you to enhance your customers’ experience or increase your customer base significantly should be considered strategic partners.
How to perform supplier segmentation
Small and medium-sized organizations have successfully implemented supplier segmentation based on business criticality, like in the example below:
Priority 1 should include a small number of strategic suppliers as they often supply high-value and low-volume goods or services vital to your business operations. They are helping you grow your business by making investments in technology and new product development, and therefore they are high-risk and should be monitored closely.
Priority 2 should cover a larger number of important suppliers, companies that enable you to run your business on an everyday basis. You could rely on alternative sources of supply if they fail, but it would be inconvenient or stressful to replace them. Risks associated with this category are mainly related to quality, service, and reputation, so you should focus on supplier performance and contractual obligations.
Last but not least, Priority 3 will include the rest of your suppliers, mostly low-value but high-volume vendors. They supply easily replaceable commodities or services and the risk level is low, so you should only monitor their conformance to price and service levels.
Larger organizations with big supply bases and mature supplier relationship management (SRM) programs will see better results by implementing the Kraljic Matrix.
How to perform supplier segmentation using the Kraljix Matrix
The Kraljic Matrix is one of the most effective ways to deliver accurate supplier segmentation and has been proposed by Peter Kraljic in 1983. In the HBR article where it was published, he argued that that supply item should be mapped against two key dimensions: risk and profitability.
Risk relates to the likelihood of an unexpected event in the supply chains to disrupt operations, while profitability describes the impact of a supply item upon the bottom line. By putting these two dimensions together, you get a two by two matrix that looks like this:
Each of these categories represents a different buyer-supplier relationship type and requires a distinct set of sourcing strategies.
1. Non-critical items
These items are low-risk and have a low impact on your organization’s profitability. The most common example of non-critical items is office stationery. They are important for employees to perform their duties, but they don’t have a significant impact on your business, nor does their absence represent a serious threat.
For this type of items, e-auctioning and catalogs are the best way to redirect responsibilities either directly to suppliers or to internal customers that are requisitioning the goods.
2. Leverage items
For items with high profitability and a low-risk factor, buyers possess the balance of power in the relationship with suppliers. Procurement professionals take advantage of this factor to drive lower prices, and suppliers can be easily substituted as their offerings are almost the same.
3. Bottleneck items
On the flip side, there are items with high risk but low profitability. Here, the strength is in the hands of suppliers as they can drive prices upwards.
The supplier relationship is demanding, even though they have a limited impact on an organization’s profitability, and procurement professionals found that these suppliers absorb more of buyers’ time compared to any other segment.
To solve this, organizations can employ innovative internal activities to redevelop product requirements so that it can be replaced with another and preferably sourced from a leverage supplier.
4. Strategic items
Lastly, high supplier risk and high-profit impact items cover strategic suppliers, the most critical to your business.
Managing strategic suppliers requires a diverse array of skills and can subsume a significant proportion of executive time in sponsoring and directing the relationship. In the relationship with strategic partners, you can expect long-term commitment as well as proactive development.
Whichever method you choose, the result should allow you to select the appropriate level of engagement with suppliers. However, keep in mind that supplier segmentation should be performed at least once a year to ensure the best outcome. Should one of your key suppliers fail to fulfill its offering, this could cause you to reputational damage and even force you to shut down business operations.