determinants of bargaining power in oem … of bargaining power in oem negotiations dong-sung cho...

Determinants of Bargaining Power in OEM Negotiations

Dong-Sung Cho Wujin Chu

The objective of this article is to develop a model that mea-

sures the distribution of bargaining power between a sourcer of

OEM (original equipment manufacturer) products and a

manufacturer (i.e., supplier) of OEMproducts. i7te article first

introduces the characteristics of OEM contracts that distinguish

themselves from other buyer and seller relationships. It then

presents a dyadic model of bargaining power between manufac-

turers and sourcers of OEM products. The model is applied to

a case history of OEM negotiations between HS Corporation,

A Korean footwear manufacturer, and Nike of the United States.

The model proves to be useful in two ways. First, it provides a

framework for understanding the dynamics of OEM contract

negotiations that transpired between HS and Nike. Second, the

model suggests ways each party can enhance its bargainingpo-

sition.

INTRODUCTION

In the 1980.5, we witnessed a variety of forms of international collaboration between firms of different nationali-

The authors acknowledge the capable research assistance of Joe-Hyong Kim,

Sumi Kim, and Gyu-Seok Oh.

Industrial Marketing Management 23, 343-355 (1994) o Elsevier Science Inc., 1994 655 Avenue of the Americas, New York, NY 10010

ties. Whereas the traditional modes of international collaboration have been joint ventures and licensing, today we are seeing alliances in the areas of technology development, manufacturing, logistics, marketing, and provision of services [13]. In particular, OEM-based contracts have emerged as one of the more popular forms of collaboration.

OEM-based contracts first became popular in the 1970s when the United States began to lose its competitiveness in the manufacturing sector. At the time, Japan was a major OEM manufacturer (i.e., supplier) for the U.S.-based firms. However, the appreciation of the Japanese yen along with the depreciation of the U.S. dollar has shifted Japan’s position from an OEM manufacturer to a sourcer. Instead, the newly industrialized countries (NIC) such as Korea and Taiwan, followed by Thailand, Malaysia, and Indonesia, emerged as major new OEM manufacturers for U.S. and Japanese firms.

An increase in OEM-based contracts has provided the NIC firms not only with opportunities to grow in size, but also a chance to learn advanced technology of the sourcers. However, many of these OEM manufacturers have become prisoners of the OEM sourcers’ product development and marketing networks. Indeed, there are many cases where

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OEM contracts are different from other buyer-seller relationships.

these firms have been forced to accept disadvantageous contracts, as a result of their weaker bargaining position vis- a-vis the sourcers, which has led to squeezed profitability. On the other hand, there are cases where an OEM manufacturer improved its bargaining position and went on to become a major force in the market.

When do OEM sourcers lose bargaining power vis-a-vis OEM manufacturers, and when do they increase it? In this article, we develop a model of bargaining power to measure the distribution of bargaining power between the OEM sourcer and the OEM manufacturer. We also explore ways the sourcer and manufacturer can enhance their respective bargaining power over one another.

CHARACTERISTICS OF THE OEM CONTRACT

The OEM contract was originally conceived and used by manufacturers of widely recognized and branded products to source parts and components as inputs to their assembly of final products. A prominent example would be a contract between General Motors and manufacturers of various automobile parts. In this case, General Motors is the Original Equipment Manufacturer or “sourcer” of OEM products, whereas the parts suppliers are regarded as “manufacturers” of OEM products. This original terminol- ogy of the OEM contract has gradually extended its application, eventually to a situation where manufacturers supply final products to the sourcers so that the latter can focus on product development and marketing without being involved in any of the manufacturing [8].

Such an extended application of the OEM contract has

DONG-SUNG CHO is a professor of strategy and international business at the College of Business Administration, Seoul National University.

WUJIN CHU is a senior lecturer at the School of Management, Seoul National University.

typically taken place between firms of different nationali- ties. For example, all of the U.S.-based TV makers except one shut down their assembly plants in the 1970s and began to source their TVs from Japan, and then from develop ing countries such as Korea and Taiwan. In the 198Os, many of the Japanese TV makers in turn moved their assembly plants to Malaysia, Thailand, and other less developed countries and began to source their TVs from these countries to sell as their own brands.

The rationale behind the proliferation of international OEM contracts is straightforward: as the number of manufacturers increases and the price competition becomes intense in the mature stage of the product life cycle, firms in the advanced nations lose their price competitiveness vis-a-vis firms in the developing countries; yet they still maintain their leads in R & D and marketing. An international OEM contract is a marriage of the complementary skills residing in the two groups of countries.

There are several benefits of OEM sourcing. First, there is no need to possess production facilities of one’s own. Therefore, OEM sourcers can promptly respond to rapidly changing market environments with little, if any, fixed costs. Second, as substitute suppliers abound in several NICs and developing countries, OEM sourcers often have stronger bargaining power than OEM manufacturers. Third, OEM contracts allow sourcers lower costs of production than joint venture operations. This is because joint venture companies in general have to pay more for local labor and other costs of production than OEM manufacturers, which are essentially domestic companies [2, 91.

Nevertheless, OEM, sourcing has its shortcomings too. Most prominently, sourcing is typically based on a short- term contract. Therefore, sourcing plans based on OEM contracts tend to be more unstable and involve more risks than those based on in-house operations. Also, OEM manufacturers can learn the product and marketing technology of the sourcer, enabling the manufacturer to become a direct competitor.

From an OEM manufacturer’s perspective, the OEM contract also brings in various benefits. First, an OEM contract enables the manufacturers to have access to new mar-

kets and multiple marketing channels with the sourcers’ brands. Such access would not be attained with their own brands. Manufacturers can also do away with marketing effort and concentrate on production activities, where their indigenous competitiveness resides.

Second, manufacturers can overcome entry barriers into overseas markets that a new entrant inevitably faces. En- try barriers exist in various forms, but one of the more important barriers today is import restrictions. It is easier to export OEM-based products than own-branded products to a country that exercises protective trade policies. This is because OEM sourcers are typically the ones who would be most annoyed by, and file suits against, unfair importa- tion of products. However, they are not likely to do so against OEM-based products that they import themselves.

Third, with sales secured by the sourcers in advance, manufacturers may increase productivity through economies of scale by investing in mass production facilities. Fi- nally, manufacturers can expedite their learning in areas of quality control and product development by working with their sourcers. Manufacturers can also obtain market information on foreign countries through the sourcers. This information could be invaluable to a firm in the early stage of exportation.

The OEM contract, however, leaves manufacturers with many disadvantages. First of all, manufacturers become complacent and tend not to develop their own brands. In other instances, sources stipulate in the OEM contract that manufacturers cannot develop their own brands. The manufacturers, without an own brand, cannot differentiate their products for higher price and brand loyalty, and constantly have to search for buyers who will order sufficient volume for their facilities. Furthermore, .manufacturers cannot establish a stable long-term production and investment plan because their future plans are often determined by a small

TABLE 1 Advantages and Disadvantages of OEM Contracts

Advantages for the sourcer

Sourcers can be flexible by not investing in manufacturing facilities

The abundance of OEM manufacturers in the newly industrialized and

developing countries gives strong bargaining advantage to sourcers

Sources can source the products cheaper by OEM contracting than by a

joint venture

Disadvantages for the sourcer OEM sourcing plans tend to be relatively less stable than plans based on

in-house operations OEM manufacturers can develop into competitors

number of OEM sourcers. In short, manufacturers must live with risks and low margins.

Second, as manufacturers increase their production ca- pacities without a parallel increase in marketing effort, they will depend more and more on the buyers, only to lose their bargaining power. Particularly in mature industries with excessive production facilities, suppliers outnumber buyers, thus weakening the manufacturers’ bargaining position further (see Table 1 for a summary). Indeed, it would be no exaggeration to claim that the core of an OEM strategy is the management of bargaining power between the partners. In the next section, we will introduce a framework for analyzing the determinants of bargaining power between buyers and suppliers.

AN ANALYTICAL FRAMEWORK FOR BARGAINING POWER

Numerous research studies have been conducted on the issue of bargaining power between a buyer an a seller in marketing channels of distribution. These studies have laid the groundwork for understanding types of power, sources of power, use of power, channel conflict, and channel member satisfaction (see Gaski [6] for a review). Furthermore, channel researchers have developed scales to measure power in a channel relationship [4, 5, 6, 7, 10, 151 and tried to relate the use of coercive versus noncoercive power to outcome measures such as channel member satisfaction and performance.

Although this stream of research has provided much in- sight into channel management issues, there has been no research that has specifically looked at power in OEM contract negotiations. Further, current literature on power in channels of distribution is not directly applicable to a situation where the buyer and the seller could be in direct com-

Advantages for the manufacturer

Access to new markets

Circumvent trade barriers

Exploit scale economies through better capacity utilization Learn the sourcer’s product and marketing technologies

Disadvantages for the manufacturer

Manufacturer becomes complacent, thereby not developing its own brand

As manufacturers expand production capacity with a concurrent expansion of its sale and marketing activities, it becomes even more

dependent on the sourcer

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There are many ways to increase bargaining power.

petition with each other, as could be the case between an OEM sourcer and its manufacturer. As stated by Stern and El-Ansary [14], “[power is a channel member’s] ability to control the decision variables in the marketing strategy of another member in a given channel at a different level of distribution.” The implicit assumption made by channel re-

searchers is that channel members involved in different levels of distribution are not in direct competition with each other. However, the OEM situation is exactly one in which sellers and buyers simultaneously function as partners and as potential or current competitors.

In such a context, the industry competition framework developed by Porter [12], which is applicable both to ver- tical as well as horizontal bargaining situations, provides us with a basis to systematically understand the distribution of bargaining power in the OEM contract. Although

our model is based on Porter’s industry competitive framework, there are still some difficulties in directly applying Porter’s framework in analyzing bargaining power between a sourcer and a manufacturer in an OEM contract for the following reasons.

First, Porter’s framework is a model for evaluating the competitiveness in industries where a buyer or a supplier has a single criterion as an objective: to increase profit by lowering or raising the price. In the OEM situation, however, players look after not only their profits but also other

strategic factors, such as new product and market development, increased competitiveness against competitive business systems, and capacity utilization.

Second having developed his framework basically with U.S. firms in mind, Porter has not given due attention to a distinctive difference between developed and developing economies as bases of the partners in a typical OEM con-

tract. Third, Porter has not made it clear weather the propen-

sity of suppliers to exercise bargaining power functions in the same manner as the case of buyers.

A NEW MODEL OF BARGAINING POWER BETWEEN OEM PARTNERS

In his book, Porter [12] mentions that the degree of participants’ bargaining power in negations can be measured

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by a combination of participants’ intrinsic bargaining power and managers’ propensity to exert it. Although we adopt this basic premise for the reasons cited in the previous section, it appears that reinforcement and modification of Porter’s framework is needed before a more systematic model can be applied to an OEM situation. By looking at the sources of a firms bargaining power, we will show that intrinsic bargaining power comes from structural variables that constitute the whole industry, and propensity to exert power is influenced by variables related to situations a specific firm faces. In other words, industry-specific variables (e.g., the degree of industry concentration) affect intrinsic bargaining power, and firm-specific variables (e.g., buyer’s business philosophy) affect the propensity to exert power.

In developing our model of bargaining power in the OEM contract, we note that whereas variables forming intrinsic bargaining power are identical for both the manufacturer and the sourcer, variables inlluencing the propensity to exert power are different between them because they are firm- specific. In Figure 1, the outcome of an OEM contract is determined by the relative bargaining power of the sourcer

FIGURE 1. A Model of Bargaining Power in the OEM Contract

and the manufacturer of OEM products. The bargaining power of each party is in turn determined by a multiplica- tion of intrinsic bargaining power and the propensity to exert power. Namely, a firm’s bargaining power is highest when its intrinsic bargaining power is high, and the firm exercises it. A firm’s bargaining power will be in the mid-range when its intrinsic bargaining power is high, but it is not exercised or when its intrinsic bargaining power is low and it is exercised by the firm. A firm’s bargaining power will be lowest when its intrinsic bargaining power is low, and the firm does not exercise it.

In the next two sections, we will examine the determinants of intrinsic bargaining power and the factors influencing the propensity to exert power. In explaining these determinants and factors, we will use an example of a manufacturer of portable hydraulic tools in Korea (an OEM manufacturer) supplying it’s products to a hardware company in the United States (an OEM sourcer) by way of illustration.

Determinants of Intrinsic Bargaining Power

EXISTENCE OF SUBSTITUTE MANUFACTURERS. When a sourcer has many manufacturers to source from, the sourcer’s intrinsic bargaining power will be increased, whereas the manufacturer’s intrinsic bargaining power will be decreased. This because the sourcer will then be less dependent on one particular manufacturer. (When the hardware company sources standardized portable hydraulic tools, it may be able to source from many substitute manufacturers. In this situation, the hardware company’s intrinsic bargaining power will be increased.) PURCHASE VOLUME RELATIVE TO MANUFACXJRER SALES. When a sourcer purchases a high percentage of a manufacturer’s sales, the sourcer’s intrinsic bargaining power will be increased, whereas the manufacturer’s intrinsic bargaining power will be decreased. This is because the manufacturer will then be more dependent the sourcer. (When the manufacturer of portable hydraulic tools sells most of its products to the hardware company, the hardware company will have greater intrinsic bargaining power, since it is a customer that the manufacturer is heavily dependent on.) ABILITY OF BACKWARD (FORWARD) INTEGRATION. When a sourcer can pose a credible threat of backward integration, its manufacturer cannot charge to a high a price, for the sourcer may then integrate backward into manufacturing. When such a threat exists, the sourcer’s intrinsic bargaining power will be increased. Similarly, when there is a threat of forward integration, the manufacturer’s intrinsic bargaining power will be increased. (When the hardware company has the capability to buy or build its own

manufacturing facilities for portable hydraulic tools, the manufacturer of portable hydraulic tools cannot charge too high a price since this will act as an inducement for the hardware company to have its own manufacturing facilities.) SWITCHING COSTS. When a sourcer faces a high cost of switching manufacturers, the sourcer’s intrinsic bargaining power will be decreased. Similarly, when a manufacturer faces high cost of switching sourcers, the manufacturer’s intrinsic bargaining power will be decreased. (If the switching costs for the hardware company is too high because of the investment in time and effort already made to forge the current relationship, the hardware company’s intrinsic bargaining power will be decreased.) DEGREE OF PRODUCT DIFFERENTIATION. Demand for more differentiated products by customers weakens the intrinsic bargaining power of sourcers, for such demand will restrict the number of appropriate manufacturers that the sourcer can buy from. Also, a manufacturer’s ability to tailor products for specific customer segments will give the manufacturer greater intrinsic bargaining power. (If the final customer has a specific preference for a product that can best be met by using the particular portable hydraulic tool, the manufacturer’s intrinsic bargaining power will be increased.) MANUFACIXJRER’S INVOLVEMENT IN MARKETING AND SALES. When a manufacturer has little sales and marketing activities of its own, the manufacturer’s intrinsic bargaining power will be decreased, and the sourcer’s intrinsic bargaining power will be increased. (If the manufacturer of portable hydraulic tools has no access to the market other than through the hardware company, the manufacturer’s intrinsic bargaining power will be decreased.) TECHNOLOGICAL LEADERSHIP. When a manufacturer has superior technology, the manufacturer will have greater intrinsic bargaining power since the sourcer will have few alternative manufacturers to source from. However, in general, it is often the case that sourcers are the ones with superior technology that manufacturers in developing countries want to learn. Under this situation, sourcers with superior technology will have greater intrinsic bargaining power. (When the manufacturer of portable hydraulic tools makes a technologically superior product, it will gain intrinsic bargaining power.) INFORMATION ABOUT CONTRACT PARTNERS. With full information about manufacturers, a sourcer can obtain an advantageous bargaining position, for it can place orders at the most favorable price. An analogous situation arises when the manufacturer has full information about sourcers. (When the hardware company has full information about alternative sources of supply, it will have greater intrinsic bargaining power. Likewise, if the manufacturer of porta-

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The OEM contract is determined by the relative bargaining power of

the two parties.

ble hydraulic tools has full information on demand of the hardware companies, it will have greater intrinsic bargaining power.)

Next, we examine the firm’s propensity to exert power, As mentioned previously, the propensity to exert power is firm specific rather than industry specific. Therefore, a variable that will make the sourcer more likely to exert power may have no impact on the manufacturer’s propensity to exert power. Here, we make the implicit assumption that the sourcer would be more interested in quality, cost, and profit, whereas the manufacturer would be more interested in price, volume, learning, and capacity utilization. These assumptions are supported by conceptual work and case studies of OEM relationships [3, 8, 9, II].

Factors Influencing the OEM Source& Propensity to Exert Power

CONTRIBUTION OF MANUFACTURER TO QUALITY IMPROVE-

wars. When a sourcer wants to position itself as a quality- goods marketer and the manufacturer contributes signifi- cantly to the sourcer’s quality strategy, the sourcer will be less likely to exercise its bargaining power. (If the portable hydraulic tools are a critical element in the hardware company’s product lime, the hardware company will be less likely to exert its bargaining power.) SOURCER’S PROFITABILITY. When a sourcer suffers from low profits, it would take pains to cut cost, including buying cost. In such a case, the sourcer is more likely to exercise its bargaining power in order to obtain better prices. (When the hardware company is operating at a low profit margin, it will exercise its bargaining power to lower the buying cost of portable hydraulic tools as much as possible.) MCYFIVATION OF SOURCER IN PURCHASING. In general, the more the sourcer’s motivation is not narrowly defined as minimizing the cost of input, the less the sourcer is likely to use its bargaining power. (If the motivation of the hardware company is to forge a long-term relationship with the manufacturer of portable hydraulic tools aimed at improv-

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ing quality of the tools, it will be less likely to exert its bargaining power.)

Business Philosophy. When a sourcer sees an OEM transaction as a “zero-sum game,” it will be ready to exert its power to the fullest extent to ensure its profit. However, another sourcer who has a philosophy of “co-prosperity” would be lenient to its counterpart and restrain itself from “squeezing” its manufacturers. (A philosophy of close cooperative relationship between the hardware company and the manufacturer of portable hydraulic tools will make the hardware company less likely to exert its bargaining power.)

Factors Influencing the OEM Manufacturer’s Propensity to Exert Power

SLACK IN PRODKHON CAPACITY. One of the main reasons for a manufacturer to enter into an OEM business is the desire to utilize its capacity. So when there is idle capacity or when a manufacturer has difficulty ensuring its production volume, it will be willing to accept less attractive orders. (When the manufacturer of portable hydraulic tools is facing idle capacity, it will be less likely to exercise its bargaining power, as such an action could result in a loss of orders that would make the capacity utilization problem even worse.) NEED FOR LEARNING MARKETING AND TECHNOLOGY. Not a few manufacturers in developing countries have a desire to become a world-class manufacturer/marketer. The desire spells desperate need of learning advanced technology and marketing skills that companies of developed countries have, and makes manufacturers in developing countries willingly sacrifice their bargaining positions. (If the manufacturer of portable hydraulic tools desires to learn advanced technology and marketing skills of the hardware company, it is less likely to exert its bargaining power.) DFSIRE FOR RAPID GROWTH. For firms in developing countries, which usually have neither established brand name

nor other attributes to attract consumers, it is not easy to build volume and achieve rapid growth. OEM-based manufacturing is one of the easiest ways for them to build volume. The stronger their desire to grow rapidly, the more they are willing to accept the source& stronger voices. (If the manufacturer of portable hydraulic tools desires to grow rapidly, it is more likely to accept an unfavorable contract in order to build volume.) BUSINESS PHIU)SOPHY. When a manufacturer sees an OEM transaction as a “zero-sum game,” it will be ready to exert its power to the fullest extent to ensure its profit. Another manufacturer who has the philosophy of “co- prosperity,” however, would be lenient to its counterpart and restrain itself from “gouging” its sourcers. (A philosophy of close cooperative relationship between the hardware company and the manufacturer of portable hydraulic tools will make the manufacturer less likely to exert bargaining power.)

Returning to Figure 1, we see that the individual determinants of intrinsic bargaining power of the OEM sourcer will be combined to make up the value of intrinsic bargaining power of the OEM sourcer. Similarly, we may obtain the value of intrinsic bargaining power of the OEM manufacturer. Also, individual factors influencing the OEM source& propensity to exert power will be combined to determine the value of the sourcer’s propensity to exert power, and likewise for the OEM manufacturer. Finally, in order to compute bargaining power of a firm, we multi- ply intrinsic bargaining power by the firm’s propensity to exert power. The bargaining power of each firm, in turn, determines the outcome of the OEM contract. In the next section, we present a case analysis of HS Corp., a Korean footwear manufacturer and OEM manufacturer for Nike and Reebok of the United States. We then analyze the case to show how our bargaining model can be used to compute bargaining power indices for H.S. Corp. and Nike. (A formal development of our measurement procedure is presented in the Appendix.)

A CASE STUDY: HS IN BETWEEN NIKE AND REEBOK (The case history is excerpted from Cho [7] and Nam 1711 with the authors’ permission.)

History of HS Corp.

HS Corp.‘s history began with a family-run rubber shoe manufacturer, Dong Yang Rubber, which was established in 1945. Due to high demand created by the war during 1950-l 953 and the rubber shoe boom in the following years,

Dong Yang rapidly expanded its volume. In 1977, HS Corp was established as an affiliate of Dong Yang in order to promote the company’s exports.

The cooperation with Nike provided the momentum for HS to start a series of capacity expansion. HS began its business with America’s Nike Co. in 1977, when Nike signed an agreement with HS to supply a small load of orders of athletic shoes on an OEM basis. Since then, the size of orders has increased dramatically. The two companies worked so well together at that time, that 75 % of Nike’s total imports from Korea were supplied by HS. In August 1981, upon signing a technology license contract with Nike, HS started domestic sales of premiumquality athletic shoes under the name “Poong-Young Nike.”

The OEM contract between HS and Nike made a big impact on both sides. Nike was able to grab a lion’s share of the world’s sport shoe market, based on a stable supply of footwear by HS that was high quality and low cost. HS also benefitted in many ways. First, HS was able to learn human engineering and other advanced product technology from Nike. Second, the OEM contract enabled HS to accumulate information about buyers in foreign countries that otherwise would not have been reached. Third, the contract provided HS with a sizable order on a regular basis, which stabilized its production. Fourth, the contract instilled a new concept of “high quality professional athletic shoes” in the Korean market, and HS pulled through with a major share of this market.

In 1981, HS’s first full fiscal year since establishment, HS exported $167 million in value and recorded second place in footwear exports among Korean companies. Fur- ther, domestic sales grew rapidly due to the Olympic Com- mittee’s 1981 decision to hold the 1988 Summer Olym- pics in Seoul, and the liberalization of school uniforms worn by students in junior high and high schools.

American Footwear Industry and Rivalry between Nike and Reebok

The sports giant, Nike Inc., had swept across the globe with its “Nike” brand of athletic shoes in the 1980s. The key factor behind Nike’s success was the worldwide jogging boom, but other factors also contributed to Nike’s success. Nike possessed and developed the following strengths: (a) Outstanding R & D ability; (b) top quality products; (c) cost advantage due to foreign sourcing; (d) reliable supply; and (e) outstanding brand image. As a result, Nike took 30% of the U.S. athletic shoe market in 1984 com- pared to Adidas’ 19 % . Then came Converse and Puma.

As the jogging boom began to wane in the mid-1980s

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Constantly monitoring one’s bargaining position is important.

Nike’s inventory began to mount. In the second and third quarters of 1985, Nike suffered a loss for the first time since its establishment. In the United States jogging was “out,” and aerobics was “inr Also, in choosing a brand, consumers put more weight on fashion than on function and quality.

It was Reebok that lead the trend and introduced fashion- able aerobic shoes. In 1983, Reebok gained widespread popularity when it first came out with free style aerobic shoes that were comfortable and outstanding in quality. The secret behind Reebok’s success was fancier colors and softer leather. This smart pair of sneakers captured the hearts of young and trendy customers. Reebok’s total sales in 1985 reached $307 million, from mere $66 million in 1984. Ree- bok implemented an aggressive strategy for market penetra- tion. In 1986, it increased its advertising budget to $10 million, began TV advertising, and had its employees write up and turn in the reports about what they were able to gather from health clubs and other social gatherings.

Nike’s Demand: To Take or Not To Take?

The U.S. athletic shoe market was worth $4 billion a year in the 1980s. The market had enjoyed rapid growth since 1983. With Reebok as a newcomer, the competition became intense. Nike had been enjoying its position as the market share leader in the United States. Therefore, Ree- bok, a leader of the new trend, was an unwelcome guest. Moreover, the fact that HS was the biggest supplier of not only Nike but also Reebok was something Nike could not ignore.

HS and Reebok began their relationship with a small order of 300 pairs in 1981, which shot up to 48 % of all HS’s exports in 1985. In dollar terms, Reebok’s order reached $37 million in 1984, and then $120 million in 1985, which exceeded HS’s sales to Nike of $98 million in the same year. In 1981, Nike and HS had signed a technology license contract that restricted HS up to a monthly supply of 200,000 pairs to those brands other than Nike. Nike had not enforced the contract until August 1985, when it demanded HS to observe the condition as well as to lower the price of shoes supplied by HS, and to raise the royal- ties from domestic market sales of Nike-branded shoes. Nike also came with the ultimatum that if HS did not ac-

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cept Nike’s condition, Nike would not only switch its OEM parternship to other manufacturers but also terminate the brand licensing agreement in the Korean market. In Novem- ber of the same year, Nike demanded that HS choose between Nike and Reebok. Regardless of the decision, HS was to face a collateral condition of lowering the price to Nike.

In the minds of HS executives, there had already been an accumulation of discontent with Nike. In their eyes, Nike had frequently demanded unreasonable and unacceptable conditions by exercising the bargaining power that Nike had acquired by diversifying its sources of purchase. For example, at the end of 1984, Nike demanded an establishment of a joint venture among all of Nike’s OEM manufacturers in Korea including HS. Moreover, Nike demanded that HS undertake the poorly managed subsidiaries of Nike in Malaysia and Ireland. This request was eventually with- drawn due to strong objections of HS executives, but such cases were not rare. As another example, in 1985, Nike mandated HS to buy back all the athletic shoes that Nike had in its inventory due to a decrease in jogging-shoe demand. The fact that Nike was able to have such a strong influence on HS was due to Nike’s superior bargaining power over Korean suppliers. Nike had chosen the “divide and rule” policy by diversifying its sources to seven major suppliers. If one supplier was not submissive, it would simply drop orders and assign the load to another.

HS could not easily ignore Nike’s demand because Nike had been the benefactor of HS’s rapid growth, and it was still a big buyer taking 40 % of HS’s total exports. The trou- ble was that HS could not afford to break up with Reebok just to hold on to Nike. Reebok’s orders were approaching a half of HS’ total export. By 1985, Reebok was already a bigger buyer than Nike. Comparing Reebok and Nike, Reebok was more like the rising sun. HS was concerned not to lose either one of the two.

Severance of the Relationship between HS and Nike

While HS was agonizing between Nike and Reebok, it tried to strike a compromise with Nike. In the midst of it all, Nike abruptly sent a notice in December 1985, un-

equivocally canceling the OEM contract and the brand licensing of domestic sales with HS. With this notice from Nike, HS lost the best partner since the first deal in 1977. At the same time, HS had lost 40% of its total exports, which was equivalent to $100 million. After its separation from Nike, HS expanded its OEM-based exports through Reebok. Without Nike, HS had no other choice than to depend heavily on Reebok for its OEM sales. Simultane- ously in the domestic market, it introduced its own-brand “LX CAF” in 1986. In the domestic market, HS had to com- pete intensely with Nike, which had come in with Nike Korea (a joint venture of Nike International with another domestic firm).

While HS was going through hardships, Nike could not afford to just sit and enjoy. As a matter of fact, when Nike was announcing the separation, Nike’s sourcing office managers in Korea were very apprehensive about the separation and were against such a decision. Nike came with the ultimatum because its management believed that they had a second alternative in China. For the same reason that Nike first switched its buying sources from Japan to Korea (70%), Taiwan (16%), Thailand, and Hong Kong in the 197Os, Nike made small-sized supply agreements with shoe- makers in the Philippines and Malaysia beginning in 1980, as production cost in Korea and Taiwan began to increase. As the major source, however, Nike had China in mind.

TABLE 2

Negotiations between Nike and China began in 1980. The supply agreement was signed and the production got underway in October of that year. At the time, Nike executives expected China to supply 100,000 pairs a month in the first stage. By the mid 198Os, it was to be raised to one million pairs. However, things did not work out that way. Nike was faced with unforeseen problems of bureau- cracy within the socialist economic system; laborers and managers without motivation, and no concern for quality control and inventory management. Moreover, the industry on the whole was backward, causing difficulties in a stable supply of raw materials and engineers. Soon Nike recognized that the goal of securing a monthly supply of one million pairs by the mid 1980s from China would not be realized.

In order to secure the necessary volume, Nike turned back to Korea in 1987. Returning to Korea, it could not bypass HS, the largest footwear manufacturer. Despite its weakened position, Nike had to sit at the table with HS and agreed to accept a 50% increase in the price of shoes supplied by HS, from $8 to $12 per pair.

CASE ANALYSIS

The collaboration between HS and Nike is a typical case of an initially successful OEM contract between a NIC-

Distribution of Bargaining Power between Nike and HS in the Early Period of the OEM Contract

Intrinsic Bargaining Power of Nike

Determinants Importance of Power Weight

Determinant 1 0.14 Determinant 2 0.14 Determinant 3 0.08

Determinant 4 0.08 Determinant 5 0.08 Determinant 6 0.20 Determinant 7 0.20 Determinant 8 0.08

Weighted Average

Nike’s Propensity to Exert Power

Factors lnfuencing Importance Propensity Weight

Factor 1 0.25 Factor 2 0.25 Factor 3 0.25 Factor 4 0.25

Weighted Average

Nike’s Bargaining Power: 7:82 X 8 = 62.56

Evaluation

9 8

5

5

6

9 9

7

7.82

Evaluation

8

8 8

8

8

Intrinsic Bargaining Power of HS

Importance Determinants Evaluation Weight of Power

1 0.14 Determinant 1 2 0.14 Determinant 2 5 0.08 Determinant 3 5 0.08 Determinant 4 4 0.08 Determinant 5 1 0.20 Determinant 6 1 0.20 Determinant 7 3 0.08 Determinant 8

2.18 Weighted Average

HS’s Propensity to Exert Power

Importance Factors Influencing Evaluation Weight Propensity

3 0.25 Factor I 3 0.25 Factor 2 3 0.25 Factor 3 3 0.25 Factor 4 3 Weighted Average

HS’s Bargaining Power: 2.18 X 3 = 6.54

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based firm in need of technology and market access and a multinational firm in search of a low-cost production base. Simultaneously, it is also the success story of a NIC-based firm enforcing an efficient OEM strategy vis-a-vis a multinational corporation that was fully exercising its bargaining power. Let us take a look at what both sides have gained through the OEM contract. BENEFITS M NIKE. For Nike, the OEM contract enabled

it to focus its resources on R & D, product design, and marketing without the burden of production, and still maintain a cost advantage. For example, in 1985, Nike’s total sales were close to $1 billion, but only about 100 employees were engaged in production out of 3,500 persons employed in the United States. Also, by securing supplies through OEM contracts from various manufacturers, Nike was able to maintain strong bargaining power and source products at a low cost. BENEFITS TO HS. On the other hand, HS also made good

use of its OEM contract. By taking orders from various firms of advanced nations such as Nike and Reebok, HS was able to acquire the appropriate product and production know-how in manufacturing high quality athletic shoes. The OEM-branded products manufactured by HS earned customers’ trust, thus securing sufficient orders. Also, without developing their own marketing and sales capability, HS had access to major markets of the United States and Europe. However, HS had to pay the price of its success, namely, a weakening of bargaining power and declining profitability.

Based on the model presented previously, the earliest period of the OEM contract between Nike and HS could be described with the numbers in Table 2. The ratings in Table 2 were derived by a panel of five members using the Delphi method. The panel consisted of five persons, i.e. two business school professors, one journalist, and two researchers of leading economic research institutes in Seoul. In choosing the key informants, we asked knowledgeable subjects from outside the organizations under study. A better alternative would have been to designate members of HS and Nike to be the key informants since bargaining power is a subjective perception held by the parties involved. How- ever, it was impossible to get the two parties to cooperate in such a study because of the emotion-charged and sensi- tive nature of the relationship that transpired between them. In fact, in many of the interesting cases of OEM contracts that present us with much variation in the bargaining power of the parties involved, our method of using outside key informants may be the best feasible method.

The numbers assigned to the determinants of intrinsic

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bargaining power in Table 2 could be interpreted in the following way. One of the most important reasons for HS’s participation in the OEM contract was its weakness in marketing (determinant 6) and product technology (determinant 7). Therefore, a low evaluation of 1 was assigned to HS to these determinants. For Nike, since there were many substitute sources that could easily match the quality and low-cost position of HS, and since the orders from Nike were quite large, the evaluation of the determinant for Nike (determinant 1) was as high as 9. The other variables were awarded scores between 5 to 8. Since relative bargaining power was the dominant factor in the outcome of the negotiations between Nike and HS, a constant sum scale sum- ming to 10 was used (i.e., for each determinant, the sum of evaluations for HS and Nike sum to 10). Also, importance weights were assigned to each determinant.

With respect to the propensity to exert power, the sourcer and the manufacturer had differences also. From the perspective of HS, factors such as enthusiasm to learn advanced technology, sizable slacks in production capacity, and a big ambition to grow into a large firm would leave HS without much incentive to exert its bargaining power upon the buyer. Therefore, an evaluation of 3 was given to all of the four factors. On the contrary, 8 was given to Nike’s four factors. Also, each factor was given equal importance weight.

Intrinsic bargaining power is derived by a weighted average of the evaluations of the determinants multiplied by their importance weights. Similarly, propensity to exert power is derived by a weighted average of the evaluations of the factors multiplied by their importance weights. Fi- nally, bargaining power is derived by multiplying intrinsic bargaining power by the firms propensity to exert power.

The bargaining power of Nike and HS during the earlier period (i.e., 1970s) can be evaluated by multiplying intrinsic bargaining power with the propensity to exert power. Drawn up from the evaluation, it is clear that Nike was able to exert almost unlimited bargaining power of 62.56 upon HS, whose bargaining power was only 6.54. How- ever, the Delphi group of five members substantially changed the values assigned to each determinants of intrinsic bargaining power and factors influencing the propensity to exert power in 1985 in favor of HS, as shown in Table 3.

There were several causes for the change. First, with the entry of Reebok, another large-scale buyer, HS was able to decrease its dependence on Nike. HS also felt that Nike’s technology was less attractive because they had already ac- cumulated substantial technology by producing Nike products. Also, the desire and possibility of developing its own

TABLE 3 Distribution of Intrinsic Bargaining Power between Nike and HS in 1985

Intrinsic Bargaining Power of Nike

Determinants Importance

of Power Weight

Determinant 1 0.15

Determinant 2 0.15

Determinant 3 0.15

Determinant 4 0.10

Determinant 5 0.10

Determinant 6 0.15

Determinant 7 0.10

Determinant 8 0.10

Weighted Average


Factors lnfuencing Importance

Propensity Weight

Factor 1 0.25

Factor 2 0.25

Factor 3 0.25

Factor 4 0.25

Weighted Average

Nike’s Bargaining Power: 4.95 x 7 = 34.65

Evaluation

3 5

4

5 5

7

6

5 4.95

Evaluation

7 7

7

7

7

Intrinsic Bargaining Power of HS

Importance Determinants

Evaluation Weight of Power

7 0.15 Determinant 1








5.05 Weighted Average



6 0.25 Factor 1

6 0.25 Factor 2

6 0.25 Factor 3

6 0.25 Factor 4

6 Weighted Average

HS’s Bargaining Power: 5.05 x 6 = 30.30

brand and executing independent marketing grew higher. Further, the fact the Japan was pushed out of the position as an OEM manufacturer and that the other NIC-based and Chinese firms did not prove to be high quality substitute suppliers enhanced HS’s bargaining position at the expense of Nike.

As a result, Nike’s intrinsic bargaining power had decreased. Meanwhile, due to low profitability, Nike’s pmpen- sity to exert power increased to 7. HS’s will to learn had declined substantially, and there was not much slack in its production capacity. Thus HS’s propensity to exert power was assigned a value of 6. The reason why this figure was not higher can be explained by HS’s oriental business philosophy of growing together with its partners.

All together, the magnitude of bargaining power in 1985 was 34.65 for Nike and 30.30 for HS. The numbers show that HS’s bargaining power was still weaker than that of Nike’s but it became considerably stronger than in the earlier period. Since Nike’s strong bargaining power was not due to its intrinsic bargaining power of 4.95 versus HSs 5.05, but supported by its propensity to exert power, one could easily predict a turning of the wind. However, Nike pressed for its demands without due consideration to the situation, which ultimately led to the separation of the two.

The Delphi group evaluated the bargaining power of both

sides after their separation in Table 4. In this recent period, Nike failed to find appropriate substitute suppliers. Thus HS became a more prominent source of supply. As Nike’s orders decreased, Nike’s role as a marketing channel and technology supplier became less important to HS. In terms of the propensity to exert power, therefore, Nike was assigned with 5, given the fact the HSs contribution to Nike’s high-quality strategy was reinstated. With a slack in production capacity caused by the cancellation of Nike’s large- scale orders, HSs propensity to exert power was assigned with 5. The bargaining power of the both sides based on the Delphi group’s evaluation was 22.75 for Nike 27.25 for HS. It shows that HS gained an edge over Nike in the distribution of bargaining power, resulting in the OEM contract between the two in HS’s favor.

CONCLUSION

We developed a new model to measure bargaining power in the OEM contract by integrating the characteristics of the OEM contract within a general framework of a bargaining power model. We then applied the model to a case of OEM contracting between HS and Nike. From the analysis, we learned that OEM contracts had provided a chance

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TABLE 4 Distribution of Intrinsic Bargaining Power between Nike and HS after the Separation in 1985

Intrinsic Bargaining Power of Nuke

Determinants Importance of Power Weight

Determinant 1 0.15

Determinant 2 0.15 Determinant 3 0.15

Determinant 4 0.10

Determinant 5 0.10

Determinant 6 0.15

Determinant 7 0.10

Determinant 8 0.10 Weighted Average


Factors lnfuencing Importance Propensity Weight

Factor 1 0.25

Factor 2 0.25

Factor 3 0.25

Factor 4 0.25

Weighted Average

Nike’s Bargaining Power: 4.55 x 5 = 22.75

Evaluation

3

4 4

5

5

6

5

5 4.55

Evaluation

5

5

5

5

5

lntrlnsic Bargaining Power of HS

Importance Determinants Evaluation Weight of Power

I 0.15 Determinant 1

6 0.15 Determinant 2 6 0.15 Determinant 3





5 0.10 Determinant 8 5.45 Weighted Average



5 0.25 Factor 1

5 0.25 Factor 2

5 0.25 Factor 3

5 0.25 Factor 4

5 Weighted Average

HS’s Bargaining Power: 5.45 x 5 = 27.25

to those firms of developing countries to grow in size and to acquire technology. Therefore, for a firm in the earlier stage of growth or internationalization, we found the OEM strategy as one of the viable alternatives. We also learned from the analysis that the distribution of bargaining power between the OEM partners could be analyzed quantitatively and in a systematic fashion. This quantification allowed us to judge why the OEM contract between HS and Nike did break up and why they reunited later under different conditions.

This article provides both sourcers and manufacturers involved in the OEM contract with a number of useful ideas on ways to enhance bargaining power.

Sourcers Sourcers need to diversify manufacturers who supply OEM products. Sourcers should be cautioned not to give out R&D and marketing expertise all at once. Sourcers should assess whether their bargaining power comes from their intrinsic bargaining power or their propensity to exert power. Most importantly, sourcers must pay close attention to changes in their relative bargaining power. This is because relative bargaining power has a large effect on the profitability of the OEM contract.

h4anufacturers Manufacturers need to diversify sourcers in the short run, so that they do not become dependent on a single sourcer. In the long run, manufacturers should make an effort to produce and sell products with their own technology, marketing channel, and most of all, their own brand. Manufacturers must also pay close attention to changes in their relative bargaining power.

As shown in the case, a close monitoring of bargaining power is an essential aspect of managing OEM contracts. Our model presents a useful managerial tool for both sourcers and manufacturers for measuring bargaining power in an OEM contract. Finally, a firm learns from its suc- cesses as well as its mistakes. The case study of Nike’s successful management of its OEM contracts initially, and its later mismanagement, is a valuable lesson not only for Nike but also for other firms involved in OEM contracts.

APPENDIX: A FORMAL DEVELOPMENT OF THE PROCEDURE FOR MEASURING BARGAINING POWER

Let us make a more systematic evaluation of the variables related to the bargaining power of each side. The de-

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terminants of intrinsic bargaining power of the sourcer, Isi, and the manufacturer, Imi, are each assigned a value between 0 to 10. There are two ways of doing this. One would be to assign independent values from 0 to 10.

(a) 0 < I,, < 10, and 0 < Iti < 10 for i = 1,. . . ,n

where n is the number of determinants of intrinsic bargaining power. Another method would be to assign a constant sum to each factor.

(b) I,, + I,i = 10, I,j 2 0, and I,i > 0 for i = 1,. . . ,n.

Method (a) is more general than (b) since it has no constant sum restriction. Method (b) will be particularly useful in situations where relative bargaining power is the dominant factor in determining the outcome of OEM negotiations.

Each variable is also assigned with a weight (W, > 0) that sums to 1.

Cp=1Wi = 1.

Then, the following formula for the intrinsic bargaining power of the sourcers, I,, can be generated:

1, = Cy= 1 W,I,i,

Similarly, the intrinsic bargaining power of the manufacturer, I,, is:

1, = C:=1WiI,i.

It is also necessary to assign the points to the factors that influence the sourcer’s propensity to exert power, P,,, and the manufacturer’s propensity to exert power, P,+ However, the content of each factor does not coincide between a sourcer and a manufacturer. We assign a value between 0 and 10 to each of the factors that affect a firm’s propensity to exert power (i.e., 0 Q Psi < 10, and 0 < P,i < 10). We then have the following formulae.

P, = Ct = 1 WiP,i, and

where Wi is the importance weight assigned to each factor; I is the number of factors that influences the sourcer’s propensity to exert power; J is the number of factors that influences the manufacturer’s propensity to exert power; and both P, and P, are values between 0 and 10.

Now the magnitude of a total bargaining power possessed by a sourcer, B,, and bargaining power possessed by a manufacturer, B,, in the OEM situation is obtained by the following formulae:

Bs = I, x P,

B, = I, x P,

The method presented here leaves a problem of judg- ment in quantifying each variable and the weights. How- ever, bargaining power is essentially a subjective and relative concept [4,5,6,7], since the basis of one’s bargaining power is the other’s belief or expectation of how one will create an impact upon the other.

Therefore, subjectivity in quantifying bargaining power is the problem that cannot be avoided, no matter which approach is used. Nevertheless, this problem may be al- leviated by the use of generally accepted evaluation tech- niques such as expert opinion or the Delphi method.

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