Some of Japans most dominant companies owe their success not only to technology and process expertise but also to an often-overlooked factor:

During the past decade, they’ve been quietly turning their supplier relationships into a tool for innovating faster while radically cutting costs. Welcome to the new keiretsu—a modern version of the country’s traditional supply system.

During its heyday, in the 1980s, the traditional keiretsu system—an arrangement in which buyers formed close associations with suppliers—was the darling of business schools and the envy of manufacturers everywhere. Although there was some tentative movement in the West toward keiretsu- like supplier partnerships at the time, the rise of manufacturing in lowwage countries soon made cost the preeminent concern. Most Western companies today wouldn’t dream of investing in supplier relationships that would require signifcant care and feeding. Indeed, many people probably assume that keiretsu died when

Japanese manufacturers initiated Westernstyle cost-cutting tactics.

But some Japanese automakers have revived and reinvented keiretsu. Toyota provides an instructive example. Its recent stumbles in quality notwithstanding

(about which more below), our research suggests that Toyota has gained enormously from the new keiretsu. It now has supplier relationships that are more open, global, and cost-conscious than they ever were, yet it has deepened the trust, collaboration, and educational support that were the hallmarks of keiretsu in their earlier form. Having conducted interviews and gathered data during 39 visits to auto plants and 192 visits to parts makers in

Japan and overseas, and analyzed two decades’ worth of auto-manufacturing data, we believe that Toyota’s current supplychain system represents one of the company’s greatest advantages.

Through a detailed look at Toyota, we will describe how the new keiretsu depart from tradition and will explore numerous lessons for developed-world and emergingmarket companies seeking to innovate rapidly while cutting costs.

The Old and New

Keiretsu at Toyota

The traditional keiretsu consisted of obligational relationships based on trust and goodwill. (For the purposes of this article, we’ll focus on vertical keiretsu, those among a manufacturer and its suppliers, and we’ll ignore horizontal keiretsu, which involve cross-holdings among companies centered on a bank.) That’s in sharp contrast to Western-style arm’s-length supplier relationships, which are governed by as much contractual clarity as possible.

In the traditional keiretsu world, an original- equipment manufacturer (OEM) would draw on exclusive, decades-long relationships with key suppliers, in which it often owned signifcant shares. The OEM would buy individual parts (not systems) at prices that weren’t very competitive—they were usually based on what it had paid for parts for its most recent model.

However, as practiced by Toyota, the new keiretsu breaks from tradition in four ways:

• Instead of buying exclusively from companies with which it has long-term relationships,

Toyota also sources from the global market, including from megasuppliers whose streamlined operations allow them to ofer very low prices. This gives it fexible sourcing and keeps costs down.

• When setting target prices for longterm suppliers, Toyota looks at the prices ofered by multiple global companies, another boon in containing costs.

• Instead of buying individual parts, the automaker demands that suppliers provide integrated systems of components. This helps it develop high-quality products while reducing costs and development time.

• Toyota encourages suppliers to enhance their ability to provide these integrated systems and to become involved in product development at the planning stage.

At the same time, Toyota hews to the traditional keiretsu model in important ways:

• Despite the automaker’s tough demands, its relationships are still based on trust, cooperation, and educational support for suppliers. The level of mutual commitment and assistance is perhaps even greater than in the 1980s.

• Contracts governing the relationships are ambiguous, consisting of general statements and nonbinding targets. For example, rather than insisting on specifc prices or price reductions for each year of a contract, as U.S. automakers typically do, Toyota states its expectations of annual cost reductions over the life of a contract— and shares the benefts by allowing suppliers who achieve those reductions to maintain their prices for a certain period of time. Spelling out specifics, Japanese companies believe, would encourage partners to do only what they were instructed to, and nothing more. Toyota counts on its suppliers to go the extra mile—to learn about and meet customers’ demands, help develop innovative processes, find and correct errors, and do whatever it takes to meet deadlines.

After the Bubble

The new keiretsu grew out of a crisis that affected the Japanese auto industry as a whole. In the early 1990s Western car manufacturers initiated radical cost-cutting programs, fueling the growth of megasuppliers such as Magna, Johnson Controls, and Valeo. To stay ahead, Japanese automakers turned to megasuppliers as well.

Moreover, the bursting of the Japanese economic bubble created a period of stagnation that stretched into the country’s

“lost decades.” With sales and profts falling, some automakers went in search of capital, opening themselves to investment by foreign companies such as Renault, Ford,

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