Getting hit with cost increases? Be prepared, more are coming.
Driving competitive advantage in the face of today’s inflationary challenges through deploying effective cost management strategies.
by Graham Leary and Dan Wooldridge
After more than a decade of low single digit inflation, creating a predominately buyers’ market, the tide may be turning. Emails, letters, and calls from suppliers announcing price increases are gathering speed. With a 2021 productivity budget to achieve, you now find your team spending a significant amount of their time fending-off a growing flow of increases. Team members newer to the profession, will likely have little experience managing through a rising cost environment.
What is driving these increases?
- Year-over year commodities prices have increased substantially, notably for: energy, transportation, shipping, metals, grains/oilseeds, lumber, and plastics.
- In sectors of the economy, capacity was idled to compensate for lower demand during COVID or was impacted as a result of maintaining a safe work environment. Some firms are struggling to return to normal capacity levels, for a variety of reasons e.g., auto’s have been suffering part shortages.
- Global stimulus programs. According to Ruchir Sharma, Head of Emerging Markets and Chief Global Strategist at Morgan Stanley Investment Management, 20% of all the dollars in circulation in the world were printed in the year 2020.
- Market psychology. Discussions about rising inflation in the business media have been central in recent months, contributing to a broader sentiment that all prices must be rising.
Developing effective cost-management strategies
Regardless of the operating environment businesses should develop comprehensive strategies to manage their portfolio of supplier spend. In this heightened time of rising prices and flow-on risks to the P&L, additional emphasis on our team’s knowledge of markets, understanding key cost drivers, ensuring broad cross-functional engagement, and having a well thought out negotiation-playbook are critical. While it is unrealistic to hold the line on all price increases, we want to avoid: 1) suppliers “margining-up” i.e., passing through more cost than they are actually experiencing 2) negatively impacting quality or service and 3) becoming competitively disadvantaged.
Knowledge of markets
Knowledge of the markets that drive costs for key ingredients is crucial in a prospectively inflationary environment. While market information from suppliers is very helpful, a firm will want to develop and maintain native knowledge of key input costs in order to validate or challenge market circumstances contended by suppliers as supporting cost increases. In many cases, specific industry knowledge is not readily available or even easy to understand. For this reason, category or sourcing managers for key ingredients, products or services should be charged and supported to develop and maintain market knowledge resources that allow for objective awareness of and reporting market dynamics and, where possible, tools and methods to proactively manage cost structures.
Understanding key cost drivers
The underlying cost of goods or service procured will often have a small number of major cost drivers. Think the 80:20 rule. For example, it could be 2-3 raw materials plus a major component of packaging. Conducting an internet search, reviewing the product ingredients list, locating an industry expert, or analyzing a supplier’s financial reports (if a public company) are several avenues to start building basic cost-models. Also, recognize pricing includes the supplier’s margin, which is not directly impacted by commodity prices. Let us say for example you are buying a product and the price is $120. You learn from reviewing your supplier’s annual report their gross margins are 40%, therefore on average, $72 of your price is influenced by changes in their product cost, not all of it.
Faced with the burning-platform of an onslaught of rising prices creates an opportunity to bring different functions within an organization together to develop a multifaceted program focused on mitigating the financial impact. A team of sourcing, marketing, finance, quality, and supply chain personnel can plan and prioritize programs that will maximize impact with available resources. Qualification of additional suppliers, flexible formulations, product tear-downs, packaging optimization and competitive product analysis are examples of work-streams that can be augmented.
Having well trained, experienced negotiators in the sourcing organization and even across broader functions within the organization is vital. The processes and knowledge we’ve covered so far, for example, in developing cost models, commodity knowledge, and qualifying alternative suppliers will all contribute to, and become, important levers.
When being barraged with price increases, details can become clouded and we risk becoming persuaded with feelings and emotion. We hear phrases like “the increase feels reasonable or it feels fair”. It’s critical that we dig-in and begin with a play-book of questions. This will help sift out the facts and allow us to better prepare to negotiate.
Example of playbook questions
- Is this increase commensurate with the estimated inflation impact for the major cost drivers?
- Were price decreases passed-on when those inflation cost drivers were historically lower?
- Did our supplier forward-buy at lower prices?
- To what extent do we estimate our supplier’s overall profitability and viability to be impacted?
- What are our alternatives?
- How long is the increase effective for? (we likely want to avoid being back at the table in 30 days)
- Is there a process or any agreement to normalize our price when cost drivers decrease?
- Are there inefficiencies that could be realized?
- How will an increase impact our ability to compete?
- Are there other services of value the supplier can provide?
Starting with a construct of thoughtful playbook questions creates time and a foundation to begin a substantive negotiation. As we enter the negotiation, an expectation that this is the suppliers opening offer and that there is room to move (e.g., on price and timing), should be our anchoring point. Along the way, communication within our organization is paramount. Alignment of all stakeholders (including c-suite where appropriate) on strategy, steps, and timeline will increase likelihood of better results.
A rising price theatre underscores the criticality of your organizations need to have sophisticated cost and supplier management processes, including access to relevant data, developing the right skills within your teams, and implementing cross-functional supporting processes. While today may be a chaotic and a demanding time, mastering these areas will help place your organization in a stronger position to compete and deliver superior longer-term results.
Graham Leary is the President of James Alistair – a procurement and strategic sourcing consulting firm
Dan Wooldridge is the Vice President of Moving Parts – a commodity risk consulting firm