It is difficult to build a strategic plan in most years, but looking forward to 2019/2020 there is a great deal of uncertainty. With the threat of trade wars, tariffs, rising prices, labor shortages, and disruptive innovation, many sourcing professionals are tossing the dice and hoping for the best. Some industries like construction, automotive, electronics and appliances are looking great through the end of 2018, but are seeing a slowing of orders and consumer demand for 2019.
Many of the experienced sourcing professionals can read the tea leaves and see suppliers pushing to turn the long-term buyer’s market to a seller’s market by an onslaught of requests for price increases citing everything from tariffs, labor and healthcare to justify the increased pricing. The successful elimination of avoidable price increases requires both a proactive and reactive approach to cost containment. The worst thing you can do is take an ad hoc approach or fail to create a plan of action. If you fail to plan, you plan to fail.
In the process described below, steps 1 through 3 are the preemptive phase and steps 4 through 9 are the reactive phase of the price increase staircase.
Preemptive cost containment
The Preemptive phase of a supplier price increase is designed to shape and change supplier expectations so they do not to attempt to raise the price to your company.
Step 1: Predict your exposure
Understand the marketplace in which you are operating. What are the potential drivers of a supplier’s request for an increase, and when will they drive the supplier to request the price increase? Ideally, you will have done a cost analysis, breaking apart the supplier’s cost to understand the cost drivers of material, labor, overhead and profit. If you are unable to do a full cost analysis, you may have done a price analysis. You and your company will be in the best position to challenge the increase.
Step 2: Ward off potential requests
Requesting a forecast of future price movements from a supplier to inform the organization’s budgeting process can be damaging. This allows suppliers to groom the organization to expect a certain level of increase and you to be pleased when the supplier asks for less. Supply management professionals must turn the tables and groom suppliers to accept the principles of continuous improvement and expect reduced costs and prices. The first agenda item for every supplier meeting should be cost and value improvement. The astute supply management professional will always reply to a “Dear Valued Customer” price increase letter with a firm return letter conditioning against the increase.
Make the process of requesting an increase “difficult,” requiring the sales representative to work hard. Demand three months’ notice, in writing, of all increase requests and insist that the invoices are accompanied by a detailed statement of the actions the supplier has taken to reduce or eliminate the need for an increase. Similarly, a rigorous internal approval system will deter supply management professionals from accepting increases without challenge because of time pressure or the desire for a quiet life. Such a program of deterrence should put the supplier on alert that price increases require approvals and that the supplier must genuinely face margin erosion for a price increase to be considered.
Step 3: Anticipate and block the increase
The supply management professional must be armed with a forecast and planned activities to pre-empt requests. Investigate alternative materials, specifications, and suppliers. In highly competitive supply chains and supply markets, it may be possible to prepare the issue of an RFI, RFQ, RFP or auction immediately before the forecasted request arriving. Gather data about suppliers that are planning increases. Have their volumes gone up (over recovery of overheads), have they built a new facility (improved productivity)? Is there a rationale for demanding a reduction ahead of their request? Offer an extension to the current contract if prices remain stable. Whatever strategy you employ, don’t sit and wait for the price request to hit your desk.
Reactive cost containment
After the supplier has sent notification of a price increase, you should take the following actions.
Step 4: Respond
It is appropriate to quickly react negatively to a supplier’s announcement of a price increase; however, delaying a personal meeting to discuss the increased pricing is a good tactic. It is essential to emphasize that cost and value improvement, not price escalation, is company policy. In the communication to the supplier:
- Refer to the principles under which the relationship was founded (and operates)
- Offer to work together to identify the cause and work jointly to remove and contain future increases
- Assure that you have continuous improvement clauses in all of your agreements
- Provide contract language indicating that all price increases require justification with factual data supporting any requests
- Specify notice periods of 90+ days
- Use longer payment terms to your advantage
Step 5: Oppose
If the supplier persists, base your responses upon objective data drawn from research of the cost drivers. In competitive markets, you should use the leverage from supplier rationalization and item rationalization in the competitive market.
Use the information gathered for developing preemptive action to support your view that no increase is needed. Let the supplier try to “break” your analysis rather than justify rationally for the rise. In this way, you control the agenda and are likely to reveal more information about the supplier’s cost base that would be exposed otherwise. Any costs within the supplier’s absolute control require a rigorous challenge. It is also critical to challenge that labor increases with an offset by productivity and automation.
Step 6: Corroborate
Use external sources to validate the factors claimed to contribute to the increase. If material costs are involved, sources such as CIPS-Supply Management reports can be used to confirm the movements claimed. Be aware that changes in yield/waste (continuous improvement) will be a crucial part of such validation activity. It is not sufficient to say that material Y has gone up by 5 percent; you should question whether materials have changed, reduced, light-weighted or substituted.
Step 7: Eliminate or minimize
If some level of increase appears unavoidable, then look for offsetting additional value from the supplier. Postponing the implementation of the increase by six months will halve its fiscal year impact and may “buy” valuable time to develop further tactics to avoid its effects. Other options are to lengthen payment terms, set up consignment stocks or increase year-end rebates. The sales representative will, in all likelihood, be measured only on the increase in headline prices achieved, so offsetting tactics can prove very productive.
By this stage, the supplier should understand that any negotiation is going to be difficult and underpinned by facts and data. If you are operating with a single source, it may be worthwhile introducing a cost variation clause, to provide a set of principles that govern cost and price movement.
Make it clear that any movement negotiated will remain in force until costs dictate a change, up or down, rather than for a specified period (such as 12 months). In a competitive market, however, you may wish to agree to fixed prices for a period as a buffer from anticipated cost increases. Always negotiate increased value if you are forced to accept a price increase. You can negotiate innovation, higher safety stocks, free storage, drop trailers, more top-grade materials quality improvements, and any other value component available to offset the price increase.
The critical message to drive home to suppliers is that price increase requests will not be considered merely because a specified period has elapsed. Break the cycle of annual demands for a price increase.
Step 8: Keep track and record
While price increases are not good news, they are important news. Price increases should be reported as part of supply management performance, as should cost containment achieved throughout active resistance. Such cost containment (the difference between formal requests and what was agreed) involves significant resource and yet is often invisible in management reports. If containment goes unreported, the actual contribution of supply management to a business will never be fully appreciated.
While there is no guarantee that inflation will show its ugly head, it is always best to be prepared and have a strategy when it does. There is little doubt that Savvy Sourcing Professionals will include the proactive and reactive approaches in the strategic planning process along with plans to rationalize SKU’s and suppliers if the economic conditions change.
What’s your plan?