The article below is written by Robin Adriaans on January 31, 2012

The recent global financial crisis displayed it once again: markets are becoming more and more turbulent and volatile. Commodity prices show more erratic behavior and are being driven to extremes on a regular basis. This wild price volatility is caused by:

  • Scarcity of natural resources – e.g. rapidly changing prices for energy, food, copper and several other raw materials
  • Shorter product life cycles – e.g. phones, laptops
  • Uncertain global economic climate – e.g. current developments in the Middle East

A creative procurement mind is needed to face these challenges. Procurement professionals have to broaden their view of the supply chain. However, the vast majority of professionals focus on cost reduction through (re)negotiations of price.

Limited bargaining power

It is common for procurement professionals to have poor visibility into the real cost breakdown of commodities. Missing the forest from the trees, they don’t invest time and energy into discovering the market developments and influences on each cost component. This lack of understanding leads to negotiation strategies based on sophisticated bluff poker. And, cost analysis too often pivots on cost allocation and cost efficiency rather than seeking the answer to the question, “why are costs at a certain level”?

The procurement function is regularly confronted with resistance and demands from their business customers: “Why should we switch suppliers? I’m not waiting for process disturbances! What are the costs and efforts of switching to another supplier/material?”  Procurement professionals are faced with a dilemma, because they have:

  • Limited transparency into the competitiveness of tariffs and underlying value drivers of their suppliers/materials
  • Incomplete view of mutual dependencies between cost drivers
  • Responsibilities to mitigate risks of becoming too dependent on a supplier
  • Requirements to realize certain saving targets

This limited visibility into the cost structure of the supply chain makes organizations insecure about performance of past sourcing effort: Was the right decision made? What risk exposure is there? Am I getting a fair price? When do I need to address this commodity again?

Market Price Index (MPI)

Implementing Market Price Index helps procurement organizations to gain structural insight in cost structures and drivers and their interdependence. The Market Price Index combines supply and demand data with economic and commodity development information to provide a more holistic view of the commodity. It reflects influencing factors and cost drivers on commodities, raw materials or services.  Additionally, it helps organizations to compare and understand actual price developments from suppliers over a longer period of time.

Figure 1 four most important influencing areas on the Market Price Index

The Market Price Index approach leverages market intelligence and provides up-to-date insight into relevant market trends and developments, changes in supply market structure, cost drivers, relative market shares and competitive situations.

Making MPI a success

Setting up a commodity profile report for a product or service is the beginning, not the end of the process. Your organization must create pillars of the success to support the MPI.

  1. Cost Drivers not Cost Prices – Cost drivers encourage procurement professionals to deep dive into the total supply chain
  2. Supplier Engagement – Set up a dialogue with the supplier on the MPI framework and amending the cost drivers to levels that are in line with the perception of the supplier. After all, facts can be verified and to keep a long-term agenda suppliers can’t afford a contradiction in terms
  3. Continuous Improvement – Embed the Market Price Index principles in your procurement processes as a part of commodity profiling (systematic regular updates) to ensure continual development across the supply base
  4. New Skill Acquisition – MPI will require new skill sets, such as the ability to understand market mechanisms and the macro and microeconomic influences in the end-to-end product supply chain
  5. Information Sharing – Set up a cost driver database and make MPI data accessible in a web-based environment across an organization’s intranet
  6. Data Diversity – Gain access to multiple data sources

Even if it is not possible to unlock all cost drivers at the beginning or to assess the extent of cost driver’s influence, this helps you to identify a list of appropriate indices, cost drivers and rates which can be the starting point to break through year-over-year price increases.

In the long-term, MPI improves the level of procurement intelligence, awareness and maturity throughout the organization. By understanding price developments, organizations can identify opportunities and potential risks. It also enables procurement professionals to develop better sourcing strategies, negotiate more effectively, reduce risk and contribute to corporate objectives, such as growth and corporate responsibility.