Bargaining power of Customers
August 2007 (School for Startups)
In general, industries are more attractive when buyers (your customers) have little power to set the terms and conditions under which they will buy. Powerful buyers put pressure on industry profits. Buyers are particularly powerful when:
a) Purchasers are large, relative to suppliers. For example, consider the position of small farmers producing fruit and vegetables. They are contracted to supply the large supermarkets and so commit large proportions of their produce to such contracts. Subsequently, they risk huge losses if the resulting produce does not meet the stringent quality criteria of the supermarkets or their customers. In this scenario, the purchasers (supermarkets) are much larger and so can exert pressure on the suppliers.
b) The products or services offered are undifferentiated. Customer bargaining power is greatly increased. Customer bargaining power is greatly increased when using the Internet to evaluate products/services and compare prices. This is particularly true for standardised products, for example batteries.
c) Purchases represent a significant proportion of the buyer’s costs, in which case these costs will be subject to great scrutiny. Although not a perfect analogy, customers do scrutinize and haggle on car prices, perhaps because it is such a large cost within their total annual purchases.
d) There are few switching costs (e.g. redesign of the buyer’s product or service, payment of design or development costs). The buyers can thus easily switch to an alternative supplier. Take for example internet search engines. Anyone searching the web can easily switch to another search engine at their convenience.
e) The buyer has the potential to take over the supplier (backward integration). Many successful fast-food chains and supermarkets own farms.
f) The buyer’s product or service is not strongly affected by the quality of the supplier’s product, so the buyer would only make purchases based on costs. For example, a company that generated energy from biofuel is less interested in what the biomass is and more interested in how cheap it is.
g) The buyers earn low profits, in which case they will pressure supplier prices down in an attempt to increase margins. A convenient store which generates a low profit margin would try to exert pressure on its suppliers to reduce costs to increase profits.
h) The buyer has full information about the supplier’s cost structure or the supplier’s competitive position and can use this information to exert pressure on the supplier.