How to mitigate Inflation
“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man”
While an uncertain pandemic and ongoing wars threaten economic recovery, companies are scrambling to cope with rising commodity prices, supply constraints, and higher wages due to labor shortages.
With a rising Producer Price Index (PPI) since the first half of 2021, companies face tremendous pressure, especially in the Euro area, where the PPI has surged up to 30% (Trading Economics, 2022).
Such a ”comparable” surge in Europe was last experienced in the early half of 2008 and was part of the great recession of 2008. The evidence for that period showcased that the best practice for companies was to push through price increases in relation to the PPI. Nevertheless, these practices might be working to a certain degree, but if you want to improve the situation significantly, companies need to take essential steps to uplift performance and productivity to reduce costs.
Links between inflation and commodity prices
Inflation is predominantly defined as the process of rising prices. It is widely argued that commodity prices are one of the leading indicators for inflation based on two basic channels.
The first one is that commodity prices are generally more responsive to general economic shocks, indicating rising inflation. The second one is that changes in commodity prices mirror idiosyncratic shocks, like an environmental disaster that wipes out a major automotive parts supplier. As a result, price increases are inevitably passed down the line (Furlong and Ingenito, 1996).
Nevertheless, the strongest argument for a direct link between future inflation and commodity prices is that commodity prices respond more quickly to economy-wide demand shocks.
Back in the day, companies' only primary tool to mitigate inflation was in-house cost cutting and pass-through of price increases to their customers. However, the current market situation is different with a volatile labor market, restricted supply chains post COVID-19, ongoing war in the Ukraine, or jams of significant trade routes combined with unchanged high consumer demand. Therefore, companies need to look beyond cost cutting to stay competitive. Hence, scaling a sustainable healthy business and strategically investing in innovation and working systems/programs to gain higher resilience will be vital.
The following three steps will be crucial to mitigate Inflation!
I. Prepare & Inform: Rejection Letter, Quick Checks and Spend Impact Break Down
- If a suppliers approaches you for a price increase request, the first thing you should do is reject the request or if you have no leverage with your supplier, ask for more detailed information to get a deeper understanding of the request and at least try to buy more time. Delaying a price increase can make a big short term impact towards your cash flow. Ask for a detailed cost break down, ask questions that help you better understand the request, ask for proof that the supplier request is valid. Also check your contractual status, did your supplier agree to your T&C’s. Did they accept the terms on your purchase order? Try to involve your legal department to check the contractual agreements.
- Understand your impact on your spend. What parts, plants are impacted? How much would be the annual and calendar year impact if you have to accept the price increase. provide a heads-up to your management or internal stakeholders of the potential risk. Most companies have already a standard procurement dashboard or a BI tool in pace to visualize their suppliers spend and part spend. If that is not the case, the old but good excel tool still is used to understand potential spend exposure and spend developments.
- Do you have alternatives? Are there any parts that are dual-sourced with other suppliers? Pick your top parts from the supplier and start a (global) benchmark if you have not done so in the last 24 months. They question will come to understand what are alternatives to accepting this price increase
- If you have a cost model software in use or cost model engineers that can help calculate the ideal price for some of the parts, kick-off this process to understand how much the gap is to an ideal greenfield or brownfield calculation. This will help you also in the negotiations with the supplier.
Did you know that on average 28% of all price increase requests are accepted. Means that 72% are negotiated away or can be considered cost avoidance. If you have not, start a cost avoidance tracking file to understand what the supplier requested and what was paid at the end of the day - also what was the requested implementation data and actual implementation date. See if you can beat the 28% standard.
II. Start Deep-Diving
Start using your tools from your Procurement Toolbox:
- Reinforce T&C’s and Contractual Agreements
- Determine if any of the impacted parts are dual sourced that you are buying from another supplier
- Start deep diving the supporting documentation, e.g. the supplier cost break downs. If you get a cost break down from a supplier, compare to their original cost break down when they originally quoted the business. If you did not get one, ask the supplier to complete one for how the cost was before, so that you can do a proper A-to-B comparison on each of the cost drivers. Check for external market intelligence data and sources to validate the request.
- How is the supplier categorized? Can you use the supplier categorization as a leverage point? For example, if the supplier is categorized as “strategic” and eligible to win new business or an “active desource” supplier that you want to exit anyway. If there are on an active desource list, this request might help you to fast-track this initiative. If there are a “strategic” supplier, use this in your negotiations to this status is at risk if they push this request through uni-laterally. You can even consider putting a supplier on New-Business-Hold and formerly communicating this to the supplier if you feel the request is not justified or reasonable.
- Involve or request VA/VE involvement. Can the raw material be replaced? Can another raw material be used? Can an alternative raw material supplier be used? Can process steps be outsourced to another sub-supplier? Can some of the process steps to produce the part be eliminated or be improved to reduce costs? Can some of the process steps be automated? What can you do to offset some of the inflation costs?
- Do you have any new business opportunities? Can you use any new business opportunities to offset the current price increase? You should leverage this as much as possible if this is a strategic supplier.
Other initiatives you could use as well:
- E-Auction | Reverse Auctions
- Competitive Benchmarking
- Involvement of Cost Engineering
- Localization Opportunities
- Linear Progression Pricing (LPP)
- Raw Material Walks
- Increase of MOQ
- Customer Recovery | Pass through Inflation
If you need more detail on any of the purchasing tool box levers, please feel free to reach out to us and we can share additional background info.
III. Build your Negotiation Strategy - Use your Leverage Points
If you have sticked to the proper steps highlighted above and are using your toolbox effectively you will be fully prepared for your negotiation rounds with your supplier. The best way to support your negotiations is with data. Market Data, Benchmark data, Historic Data, Contractual Data, Forecast Data. Summarize your offset potentials in a presentation. Summarize your leverage points, pin-point to the supplier what your requests are, take control of the supplier meeting and drive down your counter leverage points one by one. Remember that negotiations are always about finding a compromise that will ultimately has to work for the supplier and will work for your company. But with the right data sets and preparation, you can make sure you will get the best possible result.
Being quick and efficient as well as thorough in your analysis is inevitable for mitigating inflation as well as transparency down to the cost driver level, in combination with up-to-date market and business intelligence. This might be impossible for procurement professionals, but not if you deploy the right tools to support your staff by giving them all the opportunities they need to strategically position your company at the top of the class.
We truly believe that digitalization and innovation are key drivers for reducing pain points and overcoming common challenges for procurement organizations. Significantly when mitigating inflation in a challenging market situation.
„When the wind of change blows, some build walls and others, windmills. “
General Personal Note from the Author:
With thousands of open head counts and procurement departments complaining about too much workload, it is vital to eliminate work to open up resources to strategically think ahead.
Eliminating work doesn't mean missing out on not prioritized work tasks; it means using technology and procurement solutions of today's capabilities to open up time and reduce manual labor. This newly gained time can then be used to strategically position your company, like setting up strategies or preparing for supplier negotitions.
But how is it done?
Supplier meeting preparations or searching for important data from different ERP systems can be time-consuming. Furthermore, running the essential analysis to make decisions based on that data can take weeks. But being quick and efficient is vital for making business decisions, especially with rising inflation.
Without the right tools and strategies in place, many procurement organizations are facing major setbacks and problems due to the complexity of today's market. It's time to invest in proper tools that combine up-to-date market data to identify your spending risks and potential, as well as using business intelligence to automatically run every single procurement analysis with a push of a bottom down to cost drive levels. This allows you to unlock and analyze your procurement data because it is vital for fighting inflation.
No procurement professional has the time and the resources to do all of the analysis alone, let alone interpret it. Usually, professionals can only focus on their top suppliers/parts and leave out tonnes of unlocked potential.
Only with this kind of insight are you "truly" able to prepare for inflation as best as possible.
What does it mean for my business when raw materials increase, logistic costs go to the roof, or exchange rates fluctuate? What impact does it have on my business?
To answer those questions in time without the right tools in place is hard for procurement organizations, making counteracting even more difficult when wasting valuable time. With modern procurement tools, you can track and observe the impacts of changing exchange rates / increasing raw material prices / higher logistic costs,… to prepare and counteract as soon as possible.
Furthermore, it gives you the advantage of observing supplier price agreements in real time to renegotiate prices based on the actual market data. Thus, you can prepare in advance for possible price increases and preparer to counter possible costs based on past data.
Therefore, companies need to invest in adequate procurement tools which incorporate business intelligence and market data; otherwise, it is too much to handle and a total waste of potential.
"With thousands of open head counts and procurement departments complaining about too much workload, it is vital to eliminate work to open up resources to strategically think ahead."
Co-Founder and Managing Partner
Furlong, F. and Ingenito, R., 1996. Commodity Prices and Inflation. [online] http://Frbsf.org . Available at: <https://www.frbsf.org/economic-research/wp-content/uploads/sites/4/furlong.pdf> [Accessed 12 April 2022].
Trading Economics, 2022. Monthly PPI change by country 2022 | Statista. [online] Statista. Available at: <https://www.statista.com/statistics/1034559/monthly-producer-price-index-change-major-economies/#professional > [Accessed 6 April 2022].
intelflow | January 2023
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