4 Procurement Strategies for the Current Inflationary Market
Why Procurement Should Be Proactive Instead of Reactive
Prices on nearly all goods and services, from raw materials to labor and transportation services, are skyrocketing. In the wake of the COVID-19 pandemic and through the recovery of the U.S. economy, demand for goods has surged, and supply chains are currently strained like never before.
Forbes pointed out in a recent article that prices in June climbed 5.4% year-over-year and 0.9% over the past month, the biggest monthly gain since June 2008.
1 PPI Lumber and Wood Products: Softwood Lumber; 2 Linerboard 42 lb. unbleached kraft, price per ton (U.S. industry average); 3 PPI Industrial Gas Manufacturing: Nitrogen; 4 PPI Metals and Metal Products: Cold Rolled Steel Sheet and Strip; 5 NASDAQ Cotton Index, 6 DAT Dry Van Spot Rates
In an environment where supply is constrained and suppliers seem to hold much of the power, how can a company’s procurement function make the most impact? If you’re looking to your procurement organization for help, where do they fit in, and how can they help hold your ground?
Our perspective is that—especially in the face of an inflationary market—companies must be proactive with strategic sourcing and procurement activities rather than reactive. Do not wait for suppliers to present you with unchecked price increases or limitations on capacity; instead, do the homework to remain up to speed on markets trends and conditions, and act early, as appropriate.
If you’re not already being an active participant, here are our recommendations.
1. Get Visibility – Fast.
Do you know who your top suppliers are, and are you talking to them regularly? Do you know what is going on in your supply base?
If your people are out spending with rogue suppliers where a formal contract/agreement doesn’t exist and you don’t have visibility into this type of spend, you could be doing all of the right things from a corporate perspective and still be losing ground.
In the current environment, where suppliers are having to prioritize customers to determine who gets supply and who gets the first wave of price increases, the companies that have developed strong supplier relationships and provided solid recurring volume will almost always come out ahead. On the other hand, your non-preferred suppliers (i.e., the ones with whom you are doing one-off deals) will likely have your organization at the top of the list to receive full brunt of any price increase. Another important strategy is to make sure that you identify and develop secondary supplier relationships. With supply chains in such a fragile state, it is inevitable that suppliers will have to deal with their own supply chain disruptions. If you wait for a dreaded call that your orders are delayed or your supplier is out of raw material/capacity, you’ll be stuck scrambling for options with no time to spare, along with the majority of that supplier’s other customers. Unfortunately, these last-minute backup suppliers are likely going to service their existing customers first and then charge you a hefty premium if there is anything left.
On the positive side, despite the current challenges, we view these challenges as long-term opportunities for procurement organizations to position themselves more strategically going forward. As prices are going up, at several clients, we have seen many business units that have traditionally kept procurement at arm’s length and preferred a “DIY” purchasing model now suddenly inviting procurement to help as budgets are being impacted and groups are desperate for assistance. If procurement teams can think strategically and execute at a high level, this creates a great opportunity to establish new internal relationships and position the procurement function as a true strategic part of the business.
Are you receiving and analyzing transaction data from suppliers?
Suppliers may not be required to notify you of price increases, and even if they are, they may be operating outside of what was agreed to in the contracts. If you aren’t regularly analyzing transaction-level detail, so you may be getting hit a lot harder than you realize!
2. Establish Price Change Mechanisms.
If you don’t have some sort of mechanism to govern price changes, you are significantly more likely to get hit with the full brunt of each round of price changes.
A best-in-class approach is to establish very clear price-change mechanisms — for example, if the raw material or third-party index cost increases by X amount, your price goes up by Y amount. This makes pricing very predictable, as it is agreed upon in advance. In the absence of such an agreement, you’ll be stuck in an ad hoc negotiation every time, typically with a supplier who is engaging in the same negotiation with hundreds of other clients. The supplier has all of the data and controls the narrative, so will be much more prepared to win one-off negotiations such as this. In addition to a clear price-change mechanism, it’s also a good strategy to establish a limit to the frequency of price changes (i.e., limiting suppliers to price increases once or twice a year).
We also remind clients that from a price change/ad hoc negotiation standpoint, the raw materials price isn’t the total cost input on any type of good or service. Take corrugated, for example: If you’re buying corrugated, the price of linerboard is the most significant cost driver. But if the price of linerboard goes up 10%, that doesn’t mean your price should go up 10%. Like any business, other costs, such as labor, overhead, and profit, are all factored into suppliers’ pricing. Make sure that you understand these costs, and work to limit the level of any increase — it should always be less than the raw material price change, and you’re giving the supplier additional margin if you agree to apply the raw material percentage change to your total cost.
A final important note about price change mechanisms — any price change mechanism should use the same formula to move both up and down. With prices in many areas at all-time highs, suppliers have been very effective in passing along the corresponding price increases. However, if and when prices begin to recede from all-time highs, suppliers have no incentive to as actively move prices back down. It is imperative that 1) any price-change language reference all price changes, not just increases, and 2) you actively monitor raw material costs and indices to make sure that your suppliers are passing along pricing relief based on the same methodology they use so actively to pass increases. A great recent example is very recent lumber price decreases – is your company still paying top dollar for pallets or have your suppliers passed through the recent decreases? If you wait for suppliers to pass along decreases out of goodwill, you will likely be waiting a long time.
3. Do Your Homework/Research, and Get Creative.
If you want to have success in negotiations with your suppliers in the current market, you need to know what the key cost drivers are in a given category, understand what is happening in that category from a market standpoint, and adjust your strategy accordingly.
For example: if you were looking at pallets a couple of months ago, lumber prices were through the roof and capacity was strained, so just assuming that you would be able to take an RFP and drive savings would have not been a smart move.
Another great way to position yourself for success is to track how all suppliers in a given category are reacting to the current market. If one supplier is pushing a 20% increase and the other is pushing a 5% increase, you should use this to negotiate and perhaps reallocate your volume to the one that is giving you the more favorable deal.
A clear example of the difference in outcomes across companies is illustrated in the ocean freight graph below. While pricing has increased on this sample lane for everyone, the gap between the highest and lowest prices has widened significantly. The companies receiving the high pricing at the top of the graph are those that have not built strong relationships, do not have visibility into real-time market intel, and are relying on their carrier to inform them of what market rates are at the time. Those getting the lowest prices generally have agreements in place with price change mechanisms, have provided reliable volumes, and are actively monitoring the market and evaluating backup options. While no company is immune from market conditions, the stress test is widening the gap between those with strong foundations and processes and everyone else. The cost of being reactive is a steep one.
4. Think About the Total Cost of Ownership.
If your strategy is to run a bid and beat up your suppliers, and you are only focused on unit cost and the bid process, in this market you will likely end up in a worse situation than you started in for many categories. This doesn’t mean that you shouldn’t do anything; you just have to approach things in a more strategic way.
We advise clients to think about the following three potential savings levers:
- Price – What are the underlying pricing levers that will allow you to achieve the most value? These could be things like a full competitive bid, incumbent renegotiations, extension of the current deal to avoid price increases, group purchasing solutions, or protection from future price increases.
- Process – How do you procure the goods/services in a way that maximizes value? Answering this requires looking at things like order size, compliance, lifecycle cost management, etc.
- Demand – How can you influence the demand or need for a good/service? Considerations include things like SKU rationalization, schedule optimization, complexity reduction, demand reduction, etc.
Inflation is real, as is its impact on current market conditions — so you need to set realistic expectations. If you are making big promises internally about savings relative to historical costs in certain areas, they could come back to bite you.
This is a battle (metaphorically, of course), and you shouldn’t be naïve and unprepared without the proper data, analytics, and category knowledge. While most companies are being affected by supply shortages and price increases, those that move quickly and think strategically are minimizing the impact, and those that wait are facing serious threats to their bottom line and operations. Be realistic about where you are, and move quickly to cover gaps. With procurement as the first line of defense in this challenge, you need to ensure you have the necessary horsepower to ensure continuity of supply, minimize service disruptions, and preserve value.