Picture this: your family is celebrating your grandmother’s birthday. The festivities have taken place, and now it’s time to cut the cake – a cake that you personally baked the day before. Your grandparents split a slice between them; your parents take a sliver each; you grab a piece for yourself; and now it’s your little brother’s turn. Except instead of offering him a similarly sized piece, your dad pushes the entire remainder of the cake onto your brother’s plate. You look on in disbelief – why is he getting the biggest slice?
Now imagine that you’re a specialty materials company. You have invested hundreds of millions of dollars and dozens of years in developing a high-performance polymer. You’re the only one who can provide it, and yet your customers are taking this material, placing coatings on it, and subsequently capturing significantly higher margins on their products than they are willing to pay you for yours. They get half the cake – you get less than a fifth.
But what are you supposed to do? You could try to steal the proverbial cake from your metaphorical little brother – i.e., advance downstream in the value chain – but a move like that could result in negative consequences. Just as grabbing the cake could get you sent to your room for a time out, a failed attempt to compete directly with your customers could result in permanent loss of revenue and hard-won relationships. On the other hand, if you do it right, you could end up with an all-new customer base and much higher margins – and that is the sweetest treat there is.
We encountered this precise dilemma during a recent client engagement, and identified three key questions that our client would have to answer before any decision was made:
Are you willing to invest the capital required?
There are several different options for moving down the value chain, including M&A and joint venturing, but in this case, our client wanted to take a more “build-it-yourself” approach. For them and for others considering a similar approach, the main factor in determining whether to attempt to compete with one’s customers is the level of capital investment required to develop necessary capabilities. This includes not only the purchase of equipment and machinery required for downstream manufacturing processes, but also the hiring of additional employees with relevant knowledge and expertise.
Luckily, our client already had plenty of employees with knowledge of various coating technologies, and would just need some additional equipment to utilize those skill sets. While investing in this capital equipment would not be a trivial matter, the potential gains in revenue and margins would far offset any initial losses.
Are you willing to risk customer relationships?
Another consideration is the relative importance of – and likely response from – the customers you would be competing against if you were to move downstream. If you would be going up against large customers responsible for a significant portion of your sales, the risk is higher. This was our client’s situation – for them, forward integration would mean competing against customers responsible for over half of their sales. Caution is imperative in this type of scenario, and our client is now wisely taking some time to evaluate whether they can justify putting such a significant portion of their business in jeopardy.
A failed attempt to compete directly with your customers could result in permanent loss of revenue and hard-won relationships.
With a more diverse customer base, on the other hand, companies can afford to bypass customers in niches where they feel they’re not capturing high enough value. On a separate project a few years ago, a client had developed a novel neurostimulation medical device but was concerned that commercializing it could jeopardize customer relationships. Our assessment found that their product outperformed all existing offerings from their customers. Furthermore, the potential value it could capture was well worth risking the loss of their neurostim customer base, which comprised a relatively small part of their overall business. At our recommendation, they moved ahead with an acquisition that enabled them to bolster their offering and bring the product to market.
Are you able to build and maintain new downstream relationships?
A final challenge to successfully transitioning further downstream is developing and maintaining relationships with your customers’ customers. Many companies have limited visibility into the problems and unmet needs of players two steps down the supply chain. By opening a line of dialogue with important stakeholders at these companies before you attempt to forward-integrate, you can pressure-test whether you have what it takes to serve their needs on an ongoing basis. Are your sampling and applications engineering capabilities up to snuff? Can you move quickly to provide rapid product revisions when the customer demands them? If the answer to these questions is “no,” or “we’re not sure,” you should reconsider your downstream play.
Making the decision to move downstream in the value chain is never an easy one. The financial gains of making this transition can be significant, but the risk of straying too far from your core and alienating key customers is often too much to justify. However, if the transition doesn’t require significant capital investment, or only affects a small subset of customers, the gains in revenues and margins may be high enough to make the investment worthwhile. If you see your customers reaping profits that you believe you deserve, don’t hesitate – go and get your fair share of the cake!