The basic idea is that by using their bargaining power as a powerful buyer, some customers can capture a high proportion of the value you create for them by forcing down your selling prices and increasing your costs to serve them.
This applies to both business to business transactions and business t o consumer although it’s usually a more powerful force in B2B because of the size of the deals.
Introduction To The Bargaining Power Of Buyers And Customers
This is the third article focused on Michael Porter’s Five Forces model for Industry Analysis:
The other forces are:
This focuses on how buyers can use bargaining power to reduce the profits of a business and what the business can do to resist.
Negotiations With Buyers – Win-Win or Win-Lose?
There are two elements to any negotiation between a buyer and a seller:
- How can you add value to my business?
- What price will you charge?
The first is collaborative. The customer wants the supplier to add as much value as possible and the supplier wants to establish the existence of benefits which create a competitive advantage over the competition.
When it comes to price, any reduction the buyer negotiate with a supplier transfers profit from the supplier to the buyer.
In a commodity business where there is little or no differentiation, little time is spent of the first question because buyer preference is won on price. A stronger buyer will negotiate hard on the customer value elements and then claim that the produce / service combination is close to what’s available from competitors so a deal is possible if “the price is right.”
How well each party performs in he negotiations will depend on individual negotiation skills of the buyer and sales-person and the industry structure which usually biases the negotiating power one way or another.
Two Major Factors Determine Relative Bargaining Power Of Buyers
- The price sensitivity of the customer to paying a high or low price.
- The relative bargaining power that comes from a readiness to walk away from any deal and go elsewhere.
Price Sensitivity And Its Impact On the Bargaining Power Of The Buyer
Buyers will be more willing to switch from one supplier to another to get a lower price if:
- The product is important to the buyer because it represents a high proportion of costs but there is little difference in the products from one supplier or another. The buyer knows that the product can be bought from somewhere but doesn’t particularly care where, provided the price is the lowest.
- The buyer will be much more sensitive to price if the buyer and its industry is under competitive pressure in its own market and has to fight for every drop of profit. Good times economically can protect suppliers from the excessive use of the bargaining power of buyers but as markets get tougher (see PEST Analysis) pressure to reduce prices will increase as buyers try to compensate for profit lost in its market. This can be a major threat which should be on your SWOT analysis.
The Ability To Walk Away And Its Impact On The Bargaining Power Of Buyers?
The second factor that determines whether buyers or sellers capture the majority of the profit from a transaction is the bargaining power that comes from the knowledge you can walk away from any deal you don’t like.
It’s a wonderful position to be in
If you are a seller and the business is performing well, it is important to keep reminding yourself that you always have a choice. You don’t have to accept any deal the supplier proposes, only the deals that are profitable.
Michael Porter’s Five Forces model says that the buyer has the advantage in bargaining power if:
- The buyer is large and the supplier is small. This suggests that the deal is more important to the supplier.
- There are few buyers and many suppliers. The buyer has the choice of many suppliers to play off against each other but the supplier knows that to achieve good sales volumes, at least one of the small number of large accounts needs to be captured.
- The buyer knows the undifferentiated product very well and has no problem comparing goods and prices from different suppliers. Buying apples v apples and dominating the price negotiation is easy. It gets much more difficult to compare apples with oranges and feel confident that the deal is right for you.
- The buyer does not incur any penalties or other switching costs from moving its purchases from one supplier to another.
- The buyer can make a credible threat to enter the suppliers industry and provide its own supplies of the product unless the price is very low while the supplier cannot move into their customers market safely. This issue of vertical integration forward and back is a big topic which I will be covering in future business strategy articles.
- There are substitutes available from another a related industry and supplies are readily available.
Can you see how some of these factors apply to your relationships with your customers and hinder your negotiations?
The Bargaining Power Of Buyers May Not Just Be Price Pressure
It is easy to fall into the trap of thinking that the bargaining power of a buyer is focused on getting the best price and often it is.
Sometimes a strong buyer will insist on extra service requirements (next day delivery at no cost) or a favourable financial arrangement (extended credit terms or consignment stock) which increases the costs to service and makes that customer less profitable to the supplier.
How To Protect Your Business From The Bargaining Power Of Buyers
Chapter 6 of Michael Porter’s book Competitive Strategy is titled Strategy Towards Buyers and Suppliers and looks in detail at the bargaining power of buyers.
You can reduce the bargaining power of buyers through strategy although you may not like some implications.
- You can differentiate your products or services. If a buyer wants what you sell but cannot get it from someone else, then the power relationship shifts in your favour. Although a professional buyer will try to knock down your prices and get the best deal, you may have a stronger position that you think. It is a common problem in negotiating to think that the other party has the stronger bargaining power because you want the business.
- You can also use the other generic strategy, cost leadership to protect your profits. Competitors who behave rationally can only go to a certain price before they lose money. Irrational competitors who lose money on each transactions won’t be survive for long.
- You can target the less price sensitive buyers and buyers where the costs to serve are less. If you don’t have a differentiation or cost advantage, then the high volume customers may not be right for you. The sales volumes may look good but margins will be small and you will be better filling your capacity with business from smaller customers.
- Understand your product or service costs and be ready to walk away from any deal that is wrong. If you don’t have a walk away price, the buyer will know that he or she can keep pushing to extract more price reductions. Understand the cost implications of the extras that a powerful buyer will ask for and where you or they have a cost advantage. I worked with a client who came under pressure to concede on extended terms and foreign exchange risks when it would have cost the buyer much less to put those aspects into place.
- Make sure you’re not trying to sell an over-engineered or r-specified solution. Different buyers want different things and if you’re selling something with features or benefits that the buyer doesn’t appreciate then you’re incurring costs to provide something that the buying won’t pay for. Have a low-priced base offering and add extras to it that the buyer does want.
- To fight back against the bargaining power of buyers who are highly concentrated, a firm can consolidate its part of the industry value chain.
How To Choose Buyers Who Won’t Use Their Bargaining Power
Factors to look out for when looking for buyers who are not sensitive to price and therefore less likely to use their bargaining power include:
- Buyers for whom the cost of the purchase is small relative to the rest of the business – who cares about the cost of paper clips when time is limited and there are more important things to do.
- Where the penalty for product failure is high – sometimes quality and reliability is much more important than price.
- The product will be an important part of the supplier’s product because it is a de facto standard – PC assemblers risk being excluded from consideration by their customers if they don’t use Windows and Intel microprocessors.
- The buyer wants a custom designed product and there are few suppliers with the capabilities to deliver to the right standard.
- The buyer is very profitable and is in a powerful position with its customers and can pass on cost increases easily.
- The buyer is poorly informed about the market.
Conclusion on The Bargaining Power Of Buyers
Powerful buyers represent a serious threat to the profitability of individual firms and all the firms in the industry.
Careful strategy can help you to reduce the damaging effects of the bargaining power of buyers.