One of the baseline strategies for building effective supply chains is to develop closer relationships with key suppliers, customers, and third-party logistics service providers. A primary objective of this relationship-building is to gain a better understanding of the technical, operating, and strategic views of the supply chain partners. Successfully accomplishing this objective requires a reciprocal and continuing commitment of human, technical, and information resources on the part of the supply chain partners.

Most of the big reengineering projects of the 1990s incorporated key elements of relationship-building. They focused on rationalizing the vendor base, building value-creating interfaces with key customers, and strengthening supply chain functionality. The net result typically was fewer suppliers, a stronger focus on key customers, and better integration of information/costs/performance systems across the supply chain.

For the most part, these developments have been positive. Yet there's an often-overlooked, sometimes unpleasant side effect of supply chain reengineering that executives need to recognize. It's called the "cost of switching."

The term refers to all of the costs incurred in building new relationships in the supply chain. Costs for the buyer, for example, might include searching for and qualifying new vendors. There are various systems and administrative costs that the buyer typically incurs as well. The costs for the seller might be related to excess capacity, misallocation of resources, unfunded or underfunded investment, an idle facility, and so forth. For both parties, there's a "learning curve" cost of dealing with new people and processes. In short, the costs of switching established and key partners in the supply chain can be enormous—from both a financial and operational perspective.

Our experience and observations have led to the formation of five propositions that executives may want to consider as they develop their supply chain relationships.

Proposition No. 1: As supply chain relationships become more integrated and long term, the risks and the costs of switching increase for both parties.

For the seller, the costs usually involve a front-loaded investment with continuing investment needed to understand the customer's business. The risk is that the seller will not earn a reasonable return on its investment. The seller may see a return on investment (ROI) coming from being named a "prime vendor," or from participating in collaborative planning and forecasting activities, or by benefiting from the buyer's business stability. In any case, the payoff for a front-loaded investment would most likely be found in indirect areas (for example, plant scheduling, inventory reduction, and so forth). Most companies are unable to evaluate this indirect ROI because of their own costing deficiencies and a traditional profit-center orientation. In a worst case scenario, the seller makes all the required front-end investment and then the buyer exits the relationship.

The buyer's principal risk is that it will lose a primary vendor and have to replace that supplier within a short time. To be sure, the buyer has some front-end investment in the relationship. Meetings, preliminary specifications, testing, and so forth all carry front-end costs. And as the relationship develops, both the buyer and the seller must further invest in maintaining the relationship. If a key seller exits a relationship, either on a voluntary or involuntary basis, the buyer must quickly replace the product or the service it lost. Depending on the availability of alternative vendors in the marketplace, the disruption could create problems relating to quality, production scheduling, and customer service.

Proposition No. 2: As the power of the buyer increases in relation to other supply chain partners, the costs of switching will fall disproportionately on those other partners.

A buyer with channel power can shift the costs of relationship-building to the seller. The buyer, for example, may specify the "rules of engagement" under which a relationship will be built and maintained. The party that sets the ground rules has an obvious advantage in any game. In a supply chain context, the buyer could make it financially and operationally more difficult for the seller to exit the relationship.

Proposition No. 3: The more complex the relationship between the buyer and the seller, the higher the costs of switching.

Ending a simple relationship may be as straightforward as moving from one contract warehouse in City A to another one in City B. Though this type of switch incurs some costs and risks of customer-service problems during the transition period, the exposure overall is relatively low. Granted, there have been lawsuits over this type of switching behavior, typically focusing on performance issues, contractual requirements, or intellectual property. Such legal actions by either party, of course, can rapidly escalate both the elapsed time and costs of switching. Yet generally speaking, the more complex relationships—where buyer and seller are developing compatible systems in bar coding, information technology, forecasting, quality, and so forth—entail a much higher exit cost for either party.

Put another way, in a purely transactional relationship, the switching costs are usually not significant. That's not the case when relationships go deeper.

Proposition No. 4: The greater the degree of technology integration between the seller and the buyer, the higher the costs of switching.

Information technology increasingly has become the enabler of supply chain relationships. This technology demands a serious commitment—both human and monetary. As the buyer and the seller integrate their systems, they leverage this investment. Exiting the relationship not only forecloses on the initial technology investment but also on the value added from the leveraging opportunities.

Proposition No. 5: The longer the buyer-seller relationship, the higher the costs of switching.

There is an evolutionary progression in a relationship that takes place between the buyer and the seller over time. As the partners' interests converge and new opportunities to add value to the supply chain are identified, the seller-buyer relationship becomes deeper and more interdependent. As the business processes of the buyer and the seller begin to bond over time, the formal and informal barriers to exiting the relationship rise.

As organizations seek to forge closer relationships through alliances, partnerships, and other joint activities, the supply chain links become more interdependent. This interdependence, in the main, is a positive development. It means that partners can share information, assets, and even human resources to make the supply chain more effective and efficient. However, every initiative that depends upon an outside business partner—whether upstream to vendors or downstream to customers—carries a certain degree of risk. And it carries a cost of ending the relationship.

The fact of the matter is most companies are so anxious to form relationships that they don't adequately assess the costs and risks involved. The most successful companies, on the other hand, seem to understand intuitively the propositions enumerated above. Before committing to a supply chain relationship, they develop a clear understanding of the costs and risks of ending it.