How to Survive the Raw Materials Pricing Maelstrom

Download PDF Version

Commodities prices are on the rise. Since the commodities price trough in early 2009, businesses have experienced sharp price movements, with overall increases of more than 100% in certain commodity segments. And volatility in commodities pricing is only expected to continue, as the aftermath of the earthquake and tsunami in Japan unfolds, the unrest in the Middle East continues, and China’s demand for raw materials continues to grow.

This volatility in commodities pricing can have direct and significant impacts on the bottom line. During the 2008 run-up in commodity pricing, we saw the totality of price increase requests amount to more than $1 billion for one Fortune 100 manufacturer. In many cases, suppliers demanded price hikes to be implemented retroactively, for increases as large as 50 percent or more. During that last period of severe commodities inflation, most corporations were ill-equipped to handle cost fluctuations of this magnitude, although nearly all were vulnerable to them.

We learned from the price spike in 2008 that dramatic runs in commodities prices take a quarter or two to work their way through value-added supply chains. We’re in the middle of one such run now, so management should not take false comfort if suppliers haven’t begun demanding price increases yet. The price increase requests can be numerous and overwhelming. And while we can’t predict the future, we can prepare for it, and smart management teams are acting now to strengthen their purchasing functions.

In as little as 90 days, companies are transforming their purchasing department to handle the challenges posed by commodity volatility by focusing on three key areas: people, processes, and enablers. By training buyers in the processes and tools for managing price increases, management can create an effective purchasing team skilled in evaluating, negotiating, and mitigating supplier price increases—in any economic environment.

PEOPLE: BUILD THE RIGHT TEAM

When commodity prices rise, manufacturers can be overwhelmed with supplier price increase requests, and it can be very difficult to determine which requests are legitimate and which are opportunistic. A standardized and consistent approach to handling these requests is critical to effective procurement management. Companies need dedicated Price Increase Management (PIM) teams who are trained and equipped to handle requests.

Often, buyers who deal with supplier price increase requests are not prepared to respond appropriately. Often they have limited legal experience and too much empathy with suppliers with whom they work day-to-day. Buyers may lack the necessary data and documentation to analyze requests and make sound, objective decisions. This lack of preparedness can cost a company dearly in unnecessary, and unjustified, materials cost increases.

The first step in forming a Price Increase Management (PIM) team is to identify a senior-level procurement executive who can lead the effort on a day-to-day basis. This individual not only will lead the process of training the buyers to act as a PIM team and evaluate and negotiate price increase requests but also will monitor performance on an ongoing basis. The team will be trained to follow a framework of processes that ensure costs remain competitive, that the impact of any cost increases is delayed as long as possible, and that additional value is consistently extracted from suppliers when pricing adjustments must be granted.

PROCESSES: TAKE A CONSISTENT APPROACH

Rather than handle each supplier price increase on an ad hoc basis, the PIM team will be trained to employ a rigorous approach that is both standardized and differentiated, requiring different levels of review for different types of situations (figure 1). This robust review process triggers resource deployment, provides visibility, drives consistency and, in doing so, ensures maximum and sustainable value from supplier relationships. This approach also enables buyers to evaluate and respond to price requests that fall outside existing agreements based on the circumstances of each request. Throughout the process, the PIM team will follow a standardized communications process to facilitate a fact-based, fair, and collaborative resolution to each request. In this way, the PIM team will be able to achieve the lowest total cost to the company, while recognizing all the complexities of the segment, market conditions, suppliers’ health, and risk involved.

ENABLERS: EQUIP THE TEAM WITH THE RIGHT TOOLS

It’s important to understand how effective the procurement effor ts are at any stage of the commodities price cycles by evaluating supplier pricing movements against movements in underlying commodity pricing. But in times of heightened volatility, this is critical. Establishing and maintaining an index-normalized pricing system enables management to understand how markets are really behaving and how best to negotiate any resulting price adjustments with suppliers. It also enables an objective measure of the effectiveness of the procurement organization and whether they are winning or losing against the commodity markets.

The PIM team should be equipped with an offline database that links publicly available raw material indices to known part weights or percent raw material content at the part, supplier, and category level. Updated monthly as indices move, this database can provide management with ‘real-time’ commodity-exposure risk reports ahead of supplier requests. With this resource, well-trained PIM team members will be better able to determine whether those requests are reflective of actual cost increases or of opportunism on the part of suppliers seeking to improve their margins. This will also increase visibility into how much of the performance against budget is being driven by market fluctuations, and how much is driven by the actions of the PIM team (figure 2).

Internally, forecasts can be used to support risk management (spot/long-term buys, hedging, etc.), budgeting, and purchasing strategic objectives. The raw materials tracking module enables management to understand and anticipate risk and likelihood of supplier price increases requests, and can be integrated into budgeting, strategy and performance management. Understanding these risks enables management to identify the right level of exposure for the business and set commercial agreement parameters accordingly. For example, when, if ever, are indexed or fixed-price contracts preferred or allowed? And under what terms?

Once processes and practices are ingrained, and the organization is clear on the direction, IT investments can be made to transition the offline prototype forecasting and analytical tool into the organization’s formal materials and purchasing systems. However, IT is an enabler and not the answer; it’s critical to also have the appropriate people, processes and discipline.

KEYS TO SUCCESSFUL SUPPLIER INCREASE MANAGEMENT

• executive level sponsorship
• clear internal communication, understanding and follow-through on the process
• rigorous analysis and planningconcise and common process and tools
• full-time negotiation and analytical support
• dedicated legal support
• willingness to take aggressive but thoughtful positions with suppliers when appropriate

CONCLUSION

A sound procurement strategy and process is a key part of any smart management approach, but in the current environment of prolonged uncertainty, it’s essential that people, processes and tools be finely tuned to handle the supplier pricing pressures that are sure to arise. Continued volatility in commodities prices means business leaders must be prepared for a range of possible commodity cost impacts. By fine-tuning the procurement department for smart management of supplier price increases, businesses can prepare for fielding and resolving these requests—no matter how many or how much.

A CASE IN POINT

The Situation: Recently, a large manufacturer faced an unprecedented decline in sales volumes. Suppliers were becoming more anxious, given the industry outlook on volumes and the increases in commodity prices. The manufacturer faced hundreds of supplier threats totaling hundreds of millions of dollars in repricing exposure (price increases, one-time payments, restructuring costs, working capital needs). Despite significant efforts to fend off these repricing demands, purchasing price variance fell well short of annual financial targets.

The Solution: Management formed a Price Increase Management team comprised of the CPO and top purchasing executives to review all major supplier threats in a three-stage process. Negotiation teams were required to identify the business case for considering each request, the most desirable outcome, the least acceptable alternative, and the best alternative to the negotiated agreement. To create visibility across the organization, management published a Consolidated Threat File on a bi-weekly basis.

The Impact: Improved consistency and visibility enabled the teams to resist supplier demands and distinguish “real threats” from unjustified supplier requests. Over a two-month period, more than 500 cases were reviewed and addressed:

• 30% of the threats (by dollar volume) were mitigated or deemed unsubstantiated and had no financial impact
• 20% of the threats (by dollar volume) were negotiated or settled based on sound negotiation tactics for less than 50 cents on the dollar
• 50% of the threats (by dollar volume) were deemed justified based upon contracted raw material indexing and company/supplier commodity risk sharing agreements
• Where pricing relief was granted, the company was able to translate pricing increases into favorable terms (e.g., protection against future repricing demands, supplier cost transparency, supplier value engineering commitments). Ultimately, the company was able not only to survive the raw materials maelstrom but also to beat their annual financial targets. In addition, the company launched a more robust—and sustainable—process for handling and addressing future challenges (i.e., the current commodity pricing volatility).

Download PDF Version

  Back to Top