Supplier segmentation is the process of allocating suppliers into distinct groups so that limited resources can be allocated to manage them effectively. It is one of the building blocks of a supplier relationship management (SRM) program.
Why is supplier segmentation important?
Organizations need to build sustainable partnerships with their strategic suppliers to obtain the best value possible. Suppliers that you can identify as strategic, or key, to your operations need a high level of engagement and closer focus than others. By segmenting your suppliers into groups based on certain criteria e.g. level of spend or criticality, you can decide on the type and level of attention needed. It is not practical to monitor or work with all suppliers closely. There needs to be a balance between time spent on monitoring suppliers and the benefit to be achieved.
Why do we need to develop collaborative relationships with our strategic suppliers? Because we want to:
a) reduce costs
b) make process improvements
c) encourage innovation in products or services.
To achieve c) we need to be open and transparent with those key suppliers and focus on building trust. It is generally accepted that strategic relationships with key suppliers deliver competitive advantage and a positive return on investment.
Segmenting suppliers can also identify your level of exposure to risk, e.g. a single source of supply for a product or service. Failure of a supplier can cause major disruption and an inability to satisfy your customers.
Ways to segment suppliers
1. The matrix approach
The volume of spend is often the starting point of supplier segmentation. When plotted alongside value, we have a framework for splitting your supplier base into different segments. Value is defined as how important a supplier is in terms of business continuity.
Strategic suppliers usually make up around 10% - 15% of the number of suppliers in the database. This classification method, based on the original Kraljic matrix, can be customized to provide more detailed sub-groups within each quadrant. More about this later.
At its simplest, High value/High spend is often deemed Strategic.
2. The pyramid approach
A pyramid is a different way of viewing the supplier database using the same priorities: strategic, important, and transactional. This is often the preferred way for medium and smaller size companies to segment suppliers.
A supplier pyramid typically has 3-4 tiers, depending on whether partners are split into their own group at the top of the pyramid or grouped in the strategic category. As we move up the pyramid, the value of suppliers increases and number of suppliers in that category decreases.
Factors that influence segmentation
The industry you are in and your type of business influence your approach. Consider the following:
- The total volume of annual spend and projected spend growth
- The complexity of the service or products purchased
- The value a supplier brings to the business e.g. innovation or continuous improvement
- Whether supplier is global or regional, how many business units buy from them
- Total number of active suppliers in the database
- Supplier risk, e.g. failure to supply, financial stress
- Potential of each supplier e.g. a smaller diverse or local supplier might be more valuable than your current spend with them suggests
Best practices in supplier segmentation
- Apply the 80/20 rule. Focus on the top 80% of spend which usually equates to 20% of the supplier database.
- Consider both subjective and objective input when segmenting key suppliers. This means considering quality, responsiveness, delivery performance as well as overall spend.
- Share the chosen model with internal users so that all touchpoints with a supplier model are covered. This will ensure consistent messaging and promote better relationships.
- Engage your key suppliers in conversation about innovation and continuous improvement. Relationship building has its financial rewards – it should be mutually beneficial.
Review your segmentation at least annually. Economies are dynamic, risk profiles change. A company’s fortune can fluctuate from year to year and new suppliers emerge. A once-strategic supplier may have to be reassigned if a product or service is no longer fit-for-purpose. The capability to segment suppliers effectively is a competitive advantage.
Using technology to smooth the way
Spend analysis tools are now used widely in procurement. It could make sense to pre-allocate your suppliers automatically based on annual spend into three main groups: strategic, important, and transactional as a starting point. Suppliers can then be reallocated, as required, by the user based on other qualitative information. Using a supplier segmentation application tool ensures that all suppliers are allocated to a group and are not duplicated.
Sievo's Spend Analysis solution includes a supplier segmentation tool which allows users to update supplier segmentation values directly in the analytics interface. Spend can then immediately be analyzed by supplier segment across dashboards like price opportunities, payment terms and spend development.
The second article on this topic will develop these ideas and provide insights from some leading Chief Procurement Officers to help guide your supplier segmentation.